Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction
The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes and other financial information appearing elsewhere in this Report on Form 10-Q (the “Report”). In addition to historical financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business. All amounts are set forth in euros.
The following discussion and analysis relates to the results of the Company and should be read in conjunction with the financial statements and the related notes thereto and other financial information contained elsewhere in this Form 10-Q. For further discussion and analysis related to the results of the Company, please see our Form 10-K for the fiscal year ended December 31, 2012 filed with the SEC on April 16, 2013.
Overview
Southern States Sign Company is a hospitality company that owns and develops hotels and spas in Italy. We operate through our wholly owned subsidiary, Conte Rosso & Partners S.r.l. (“CR&P”) and, as a result, are classified as property investment specialists.
We intend to develop our presence in Italy and abroad with a target of owning 3,000 rooms within the next 3 to 5 years.
We are currently undergoing advanced negotiations with respect to investments in Rome, Bari and Florence in Italy, as well as in New York, and have started searches for investment opportunities in Milan, Florence, Paris and London. We are also planning to invest in high-growth potential countries such as Albania and some selected African countries.
In addition to the items discussed above, we plan to continue to refresh our hotel room product, pursue third-party development partners for additional hotel and restaurant concepts and renovate select facilities to improve our product offerings.
Critical Accounting Policies and Estimates
We believe the following accounting policies and estimates are most critical to aid in understanding and evaluating our reported financial results.
Basis of consolidation
All majority-owned subsidiaries in which CR&P has both voting share and management control are consolidated. All significant intercompany accounts and transactions are eliminated. Subsidiaries over which control is achieved through other means, such as stockholder agreements, are also consolidated even if less than 51% of voting capital is held. The equity attributable to non-controlling interests in subsidiaries is shown separately in the consolidated financial statements.
Basis of presentation
The consolidated financial statements for the six months ended June 30, 2013 and for the fiscal year ended December 31, 2012 are prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”).
The Euro is the functional currency of all companies included in these consolidated financial statements.
The amounts presented have been rounded to the nearest thousand.
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Acquisitions
Assets acquired and liabilities assumed in business combinations are recorded on our consolidated balance sheets as of the respective acquisition dates based upon their estimated fair values at such dates.
The results of operations of businesses acquired by us have been included in the consolidated statements of income (loss) since their respective dates of acquisition. In certain circumstances, the purchase price allocations are based upon preliminary estimates and assumptions. Accordingly, the allocations are subject to revision when we receive final information, including appraisals and other analyses. There were no contingent payments, options, or commitments specified in any of the following acquisition agreements.
Cash and cash equivalents
Cash and cash equivalents comprise cash balances, cash on current accounts with banks, bank deposits and other highly liquid short-term investments with original maturities of less than three months.
Accounts receivable & Allowance for doubtful accounts
Accounts receivable represents trade obligations from customers that are subject to normal trade collection terms, without discounts. The Company periodically evaluates the collectability of its accounts receivable and considers the need to record or adjust an allowance for doubtful accounts based upon historical collection experience and specific customer information. Actual amounts could vary from the recorded estimates. The Company has determined that as of June 30, 2013 and December 31, 2012 no allowance for doubtful accounts was required. The Company does not require collateral to support customer receivables.
Investments
Investments in unconsolidated affiliates over which we exercise significant influence, but do not control, including joint ventures, are accounted for using the equity method.
Investments in unconsolidated affiliates over which we are not able to exercise significant influence are accounted for under the cost method.
Property, plant and equipment
Property, plant and equipment are stated at acquisition cost less accumulated depreciation and adjustments for impairment losses. Property, plant and equipment also includes assets under construction and plant and equipment awaiting installation.
Subsequent expenditures are capitalized only when they increase the future economic benefits embodied in an item of property, plant and equipment. All other expenditures are recognized as expenses in the consolidated statement of income as incurred.
Capitalization ceases when construction is interrupted for an extended period or when the asset is substantially complete.
Where funds are borrowed specifically for the purpose of acquiring or constructing a qualifying asset, the amount of interest costs to be capitalized in a period on that asset is the actual interest cost incurred on the borrowing during the period.
Depreciation is charged on a straight-line basis over the estimated remaining useful lives of the individual assets. Depreciation commences from the time an asset is put into operation. Depreciation is not charged on assets to be disposed of or on land. The range of the estimated useful lives is as follows:
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Buildings and constructions: 33 years
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-
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Machinery and equipment: 2 – 20 years
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-
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Others: 5 years
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Long-Lived Assets
We evaluate the carrying value of our long-lived assets for impairment by comparing the expected undiscounted future cash flows of the assets to the net book value of the assets when events or circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. If the expected undiscounted future cash flows are less than the net book value of the assets, the excess of the net book value over the estimated fair value will be charged to earnings.
Fair value is based upon discounted cash flows of the assets at a rate deemed reasonable for the type of asset and prevailing market conditions, appraisals, and, if appropriate, current estimated net sales proceeds from pending offers.
We evaluate the carrying value of our long-lived assets based on our plans, at the time, for such assets and such qualitative factors as future development in the surrounding area and status of expected local competition.
Assets and liabilities held for resale
In connection with the strategy of concentrating in the portfolio of hotel, power, and plantations investments, in the periods presented we entered into various negotiations with potential purchasers to sell. Most of these sales concluded at the end of September 30, 2012.
The realized value of these assets are higher than the net asset carrying value and that resulted in a gain on discontinued operations.
Goodwill and Other Intangible Assets
We evaluate goodwill for impairment on an annual basis, and do so during the last month of each year using balances as of the end of September and at an interim date if indications of impairment exist. Goodwill impairment is determined by comparing the fair value of a reporting unit to its carrying amount in a two-step process with an impairment being recognized only where the fair value is less than carrying value. We define a reporting unit at the individual property level.
When determining fair value in step one, we utilize internally developed discounted future cash flow models, third party appraisals and, if appropriate, current estimated net sales proceeds from pending offers. Under the discounted cash flow approach we utilize various assumptions, including projections of revenues based on assumed long-term growth rates, estimated costs and appropriate discount rates based on the weighted-average cost of capital. The principal factors used in the discounted cash flow analysis requiring judgment are the projected future operating cash flow, the weighted-average cost of capital and the terminal value growth rate assumptions. The weighted-average cost of capital takes into account the relative weights of each component of our capital structure (equity and long-term debt) and is determined at the reporting unit level. Our estimates of long-term growth and costs are based on historical data, various internal estimates and a variety of external sources, and are developed as part of our routine, long-term planning process. We then compare the estimated fair value to our carrying value.
If the carrying value is in excess of the fair value, we must determine our implied fair value of goodwill to measure if any impairment charge is necessary. The determination of our implied fair value of goodwill requires the allocation of the reporting unit’s estimated fair value to the individual assets and liabilities of the reporting unit as if we had completed a business combination.
We perform the allocation based on our knowledge of the reporting unit, the market in which they operate, and our overall knowledge of the hospitality industry.
Leasing
All lease agreements of the Company and its subsidiaries as lessees are accounted for as finance leases. The Company recognizes the asset and associated liability on its balance sheet. Finance leases are capitalized at the beginning of the lease at the lower of the fair value of the leased property and the present value of minimum lease payments. Each installment of the lease is apportioned between the liability and finance charges so as to achieve an equal reduction in capital due for each payment made at constant rate on the remaining financial balances.
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Derivative financial instruments
The Company uses derivative financial instruments principally for the management of exposure to variable interest rates on long-term financing. All derivative financial instruments are classified as assets or liabilities and are accounted for at trade date. The Company measures all derivative financial instruments based on fair values derived from market prices of the instruments. Changes in the fair value of a derivative that is significant and that is designated and qualifies as a fair value hedge, along with the loss or gain on the hedged asset or liability, are recorded in the income statement.
As of December 31, 2012 there are no derivative instruments. During the 2012 there was only one derivative instrument hedging the risk of variable interest rates (an “interest rate cap”), the notional amount of which was € 4 million. This derivative instrument hedges the risk from change of interest rate on a mortgage loan facility with “bullet” repayments originally of € 8 million of which € 6.6 million is outstanding. This derivative was divested as part of our plan to focus on hotels only as of September 30, 2012.
Shareholder loans
Shareholder loans to the Company are all non-interest bearing. Italian law provides that the shareholders loans to a limited liability company ("S.r.l.") are not preferred and their repayment is subordinated to other categories of debt. As a result all shareholder loans are classified as non-current liabilities.
Severance indemnity fund
According to Italian accounting principles reflecting local law and applicable employment contracts, certain post-employment benefits accrue during the period of employment. Under U.S. GAAP, post-employment benefits are defined either as de fined contribution plans or defined benefit plans.
In defined contribution plans, the Company's obligation is limited to the payment of contributions to the Government or to a fund. Defined benefit plans are pension, insurance and healthcare programs which cover the Company's obligation, even implicitly, to provide the benefits due to former employees. The liabilities associated with defined benefit plans are determined on the basis of actuarial assumption (discounting) and accrued in the financial statements over the employment period required to obtain the benefits.
The severance indemnity fund required by Italian law is a liability similar to a defined benefit plan, which, however, according to Italian accounting principles, is not subject to discounting. Given the small number of Company employees any difference between the present provisions in the financial statements prepared in accordance with Italian GAAP and discounted value of these benefits is considered to be immaterial.
Revenue Recognition
Our revenues are derived from rent we receive according to rental agreements we have in place with hotel management companies. The majority of our rent is fixed and payable monthly. We recognize additional revenue that is variable based on a percentage of the operating profit of our rented hotels.
Taxes
Income taxes
We account for income taxes to recognize the amount of taxes payable or refundable for the current year and the amount of deferred tax assets and liabilities resulting from the future tax consequences of differences between the financial statements and tax basis of the respective assets and liabilities. We recognize the financial statement effect of a tax position when, based on the technical merits of the uncertain tax position, it is more likely than not to be sustained on a review by taxing authorities. These estimates are based on judgments made with currently available information. We review these estimates and make changes to recorded amounts of uncertain tax positions as facts and circumstances warrant.
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Results of
Operations
For the six months ended June 30, 2013 and June 30, 2012
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€’000
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Six Months Ended
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Six Months Ended
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June 30,
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June 30,
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2013
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2012
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Unaudited
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Unaudited
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Revenue from operations
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€
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1,159
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€
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2,284
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Direct operating and selling, general and administrative costs
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Direct operating costs
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216
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467
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Selling, general and administrative costs
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954
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26
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Amortization and depreciation
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1,176
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1432
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Total direct operating, selling, and administrative costs
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2,346
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1,924
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Operating Profit/(Loss)
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(1,187)
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360
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Interest income
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46
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Interest expenses
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1,146
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1,196
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Other income
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17
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Loss from continuing operations, before income taxes
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2,286
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819
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Income taxes
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75
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Loss from continuing operations, net of income taxes
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2,286
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894
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Net loss from operations of discontinued operations, after taxes
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864
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Net income/(loss) on disposal of discontinued operations, after taxes
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(32)
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3,315
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Net profit/(loss) from discontinued operations
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(32)
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2,452
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Consolidated net profit/(loss) for the period
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(2,318)
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1,558
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Less net loss attributable to non-controlling interests in the consolidated subsidiaries
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93
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165
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Net profit/(loss) attributable to owners of Southern States Sign Company
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€
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(2,225)
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€
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1,723
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Revenues
Revenues for the six months ended June 30, 2013 were € 1,159,000 as compared to € 2,284,000 for the six months ended June 30, 2012. The decrease of approximately € 1,125,000, or 49% is due mainly to the renegotiation of the management agreement of Ripa Hotel, which resulted in a reduction of approximately 30% of the annual rental fee.
Direct Operating Costs
Direct Operating Costs for the six months ended June 30, 2013 was € 216,000 as compared to € 467,000 for the six months ended June 30, 2012. This decrease of approximately € 251,000, or 54% is due mainly to the replacement of direct management of the Galzignano resort with third party management.
Selling, General and Administrative Costs
Selling, General and Administrative costs for six months ended June 30, 2013 and 2012 were approximately € 954,000 and € 26,000, respectively. Such expenses consist primarily of salaries and personnel related expenses, occupancy expenses, sales travel, consulting costs and other expenses. This increase is mainly due to the advisory costs due to the advisory costs in connection with the Share Exchange and pre-listing process.
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Amortization and Depreciation
Amortization and depreciation for the six months ended June 30, 2013 and 2012 were approximately € 1,176,000 and € 1,432,000, respectively. Such expenses consist primarily of depreciation of properties, plant and equipment held by CR&P and its subsidiary, Aral Immobiliare, S.r.l. The decrease of approximately € 256,000 was mainly due to the revaluation of the useful life of the assets.
Interest Income
Interest income for six months ended June 30, 2013 and 2012 was approximately € 46,000 and € 0, respectively. The increase was mainly due to the Company’s liquidity management efficiency which focused on the subsidiary CRP Service, S.c.a.r.l.
Interest Expense
Interest expense for six months ended June 30, 2013 and 2012 was approximately € 1,146,000 and € 1,196,000, respectively. The decrease was immaterial.
Other Income
Other Income for six months ended June 30, 2013 and 2012 was approximately € 0 and € 17,000, respectively. The amount shown in 2012 was immaterial.
Discontinued operations
During the six months ended June 30, 2012, we initiated the selling of non-hospitality subsidiaries to a related party (owned directly and indirectly by Mr. Conte) for a gain of € 3,315,000, net of taxes. The net loss from operations of discontinued operations was € 864,000. We have no continuing involvement with either divested subsidiary.
Income Taxes
Income taxes for the six months ended June 30, 2013 and 2012 were approximately € 0 and € 75,000, respectively. The decrease was immaterial.
Liquidity
and
Capital Resources
For the six month periods ended June 30, 2013 and 2012
As of June 30, 2013, we had cash and cash equivalents of approximately € 158,000, negative working capital of approximately € 5,191,000 and retained earnings of approximately € 5,133,000.
Cash Flows from Operating Activities
Our operating activities resulted in net cash provided by operating activities of approximately € 693,000 for the six months ended June 30, 2013 compared approximately € 3,882,000 cash used in the six months ended June 30, 2012.
The net cash used in operating activities for the six months ended June 30, 2013 reflects a net loss of approximately € 2,318,000, a net loss from sale of discontinued operations of approximately € 32,000 and a depreciation and amortization of approximately € 1,176,000. Changes in assets and liabilities included a decrease in trade receivables of approximately € 118,000, a decrease in related party receivables of approximately € 475,000, an increase in other assets of approximately €75,000, an increase in trade payables of approximately € 951,000, an increase in related party payables of approximately € 507,000, an increase in other payables of approximately € 49,000 and an increase in VAT taxes receivable of approximately € 434,000.
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The net cash used in operating activities for the six months ended June 30, 2012 reflects a net profit of approximately € 1,558,000, a net loss from operations on discontinued operations of approximately € 864,000 and a depreciation and amortization of approximately € 1,432,000, offset by a gain on disposal of discontinued operations of approximately € 3,315,000. Changes in assets and liabilities included a decrease in trade receivables of approximately € 2,089,000, a decrease in related party receivables of approximately € 879,000, a decrease in other receivables of approximately € 214,000, an increase in other assets of approximately € 78,000, a decrease in trade payables of approximately € 2,048,000, an increase in other payables of approximately €999,000, an increase in VAT tax receivable of approximately € 751,000 and an increase in other liabilities of approximately €1,610,000. The net cash used in operating activity of discontinued operations in the six months ended June 30, 2012 was approximately € 2,628,000.
Cash Flows from Investing Activities
The net cash used in investing activities for the six months ended June 30, 2013 of approximately € 349,000 consist primarily of other investing changes (approximately € 338,000 of cash outflow).
The net cash provided by investing activities for the six months ended June 30, 2012 of approximately € 2,966,000 consist essentially of cash inflow provided by investing activity on discontinued operations.
Cash Flows from Financing Activities
Net cash used in financing activities for the six month period ended June 30, 2013 was approximately € 321,000, which was mainly due to reimbursement of bank overdrafts of approximately € 2,061,000 and the repayment of long-term debt of approximately € 109,000, offset by a cash inflow due to the net issuance of shareholders loans (approximately € 1,631,000). Net cash provided in the six months period ended June 30, 2012 was approximately € 1,662,000, which was mainly due to the issuance of shareholder loans of approximately € 5,195,000, offset by repayment of long-term debt of approximately € 2,638 and the cash outflow related to the investing activity of discontinued operations (approximately € 921,000).
Future Liquidity Needs
We have evaluated our expected cash requirements over the next twelve months, which include, but are not limited to, interest payments, capital repayments, capital expenditures and working capital requirements. While we are able to manage certain aspects of these cash requirements, the level of income, rate of repayment of related party receivables and cost of debt, where variable, are outside of our control. We are also planning, but as of yet have no contractual commitments, to make acquisitions in the future, and while we wish to carry out some of these acquisitions through the issuance of shares, there can be no assurance that the vendors will accept such consideration, and consequently, we may have to make such acquisitions using cash. Also, we plan to further borrow funds in order to finance these acquisitions.
Based on existing assets, expected related party receivables repayments, business level, debt and interest rates, we believe our current resources are sufficient for at least the next twelve months.
However, to implement the business plan for the expansion of our assets, we will require additional financing in the future. The timing of our need for additional capital will depend on the timing of the completion of the planned acquisitions, the terms of such acquisitions and whether existing lenders are willing to continue to provide financing upon a change of control of such assets.
As detailed in the Form 10-K filed with the Securities and Exchange Commission on April 16, 2013, we are in the process of developing two properties which will require capital expenditure – the Green Park Hotel, which is being converted into apartments, and the expansion of the Masseria Hotel. As of the period covered by this Report, these projects have been temporarily suspended due to the resignation of Mr. Conte as described in the same Form 10-K.
Commitments and Contingencies
The Company and certain subsidiaries are defendants in legal actions in the normal course of business. Based on the advice of legal counsel, management believes that the amounts recognized and recorded as debt provisions or asset negative adjustments are sufficient to cover probable losses in connection with such actions.
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The risk provisions or negative adjustments are recognized when in accordance with the opinion of legal counsel the liability is probable and measurable.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.