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(Currencies in Thousands, Except Per Share Data)
## NO TE A
## BUSINESS
The Consolidated Financial Statements include the accounts of Capital One Financial Corporation (the “Corporation”) and its subsidiaries. The Corporation is a holding company whose subsidiaries market a variety of financial products and services to consumers. The principal subsidiaries are Capital One Bank (the “Bank”), which offers credit card products, Capital One, F.S.B. (the “Savings Bank”), which offers consumer lending (including credit cards) and deposit products, and Capital One Auto Finance, Inc. (“COAF”) which offers auto loans. The Corporation and its subsidiaries are collectively referred to as the “Company.”
## BASIS OF PRESENTATION
The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) that require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.
All significant intercompany balances and transactions have been eliminated. Certain prior years’ amounts have been reclassified to conform to the 2002 presentation.
The following is a summary of the significant accounting policies used in preparation of the accompanying Consolidated Financial Statements.
## RECENT ACCOUNTING PRONOUNCEMENTS
In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 . This interpretation addresses consolidation of business enterprises of variable interest entities, which have certain characteristics. These characteristics include either that the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties; or that the equity investors in the entity lack one or more of the essential characteristics of a controlling financial interest. FIN 46 is designed to improve financial reporting by enterprises involved with variable interest entities by providing guidance and standards for consolidation of such entities in the financial statements. FIN 46 applies immediately to variable interest entities created after January 31, 2003, and on July 1, 2003 for variable interests acquired before February 1, 2003. See Note P, Commitments, Contingencies and Guarantees, for discussion of special purpose vehicles used in synthetic lease transactions. All securitization transactions that receive sale treatment under SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities – a
## Significant Accounting Policies
Replacement of SFAS No. 125 (“SFAS 140”), are accomplished through qualifying special purpose entities and such transactions are not subject to the provisions of FIN 46. The Company is currently evaluating FIN 46 and the corresponding impact to its financial statements.
In December 2002, the FASB issued Statement of Financial Accounting Standard No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure – an Amendment of SFAS No. 123 , (“SFAS 148”). SFAS 148 amends current guidance to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock- based employee compensation. The statement also amends the disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), to require prominent 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 reported results. SFAS 148 is effective for fiscal years ending after December 15, 2002. The Company has adopted and incorporated the applicable disclosure provisions of SFAS 148 in its consolidated financial statements for the year ended December 31, 2002.
In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34 . FIN 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45 requires the initial disclosure of applicable guarantees in all issuances of financial statements of interim or annual periods ending after December 15, 2002. The additional provisions for initial recognition and measurement are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002, irrespective of a guarantor’s year-end. The Company has adopted the disclosure provisions required by FIN 45 in its consolidated financial statements for the year ended December 31, 2002, and will adopt the recognition and measurement provisions for new or modified contracts subsequent to December 31, 2002. See Note P, Commitments, Contingencies and Guarantees, for discussion of special purpose vehicles used in synthetic lease transactions.
In July of 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”). SFAS 146 requires that a liability for a disposal obligation be recognized and measured at its fair value when it is incurred rather then at the date to the Company’s commitment to an exit plan, and severance pay in many cases be recognized over time rather than up front. The provisions of SFAS 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS 146 is not expected to have a material impact on the consolidated earnings or financial position of the Company.
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} | https://cdla.io/permissive-1-0/ | [] | overall_image/b22fee21f488d9c1a605f3b381ce4584704296a0be27249054ce72159b08d84a.png | In April of 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (“SFAS 145”). SFAS No. 145 rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, SFAS No. 64, Extinguishments of Debt Made to Satisfy Sinking- Fund Requirements . This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. SFAS 145 became effective and was adopted by the Company in May of 2002 and did not have an impact on the consolidated earnings or financial position of the Company.
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). SFAS 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of (“SFAS 121”), but retains the requirements of SFAS 121 to test long-lived assets for impairment and removes goodwill from its scope. In addition, the changes presented in SFAS 144 require that one accounting model be used for long-lived assets to be disposed of by sale and broadens the presentation of discontinued operations to include more disposal transactions. Under SFAS 144, discontinued operations are no longer measured on a net realizable value basis, and future operating losses are no longer recognized before they occur. The provisions of this Statement are effective for financial statements issued for fiscal years beginning after December 15, 2001. The implementation of SFAS 144 did not have a material impact on the consolidated earnings or financial position of the Company.
In June 2001, the FASB issued SFAS No. 141, Business Combinations (“SFAS 141”), effective for business combinations initiated after June 30, 2001, and SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), effective for fiscal years beginning after December 15, 2001. Under SFAS 141, the pooling of interests method of accounting for business combinations is eliminated. Under SFAS 142, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests in accordance with the pronouncement. Other intangible assets will continue to be amortized over their useful lives. Under the transitional provisions of SFAS 142, the Company identified its reporting units and performed the first of the required impairment tests of net goodwill and indefinite-lived intangible assets during 2002. The testing resulted in no impairment losses to any recorded goodwill of the Company.
## CASH AND CASH EQUIVALENTS
Cash and cash equivalents includes cash and due from banks, federal funds sold and resale agreements and interest-bearing deposits at other banks. Cash paid for interest for the years ended December 31, 2002, 2001 and 2000 was $1.4 billion, $1.1 billion and $.8 billion, respectively. Cash paid for income taxes for the years ended December 31, 2002, 2001 and 2000 was $585.8 million, $70.8 million and $237.2 million, respectively.
## SECURITIES AVAILABLE FOR SALE
The Company classifies all debt securities as securities available for sale. These securities are stated at fair value, with the unrealized gains and losses, net of tax, reported as a component of cumulative other comprehensive income. The amortized cost of debt securities is adjusted for amortization of
premiums and accretion of discounts to maturity. Such amortization or accretion is included in interest income. Realized gains and losses on sales of securities are determined using the specific identification method.
## REVENUE RECOGNITION
The Company recognizes earned finance charges and fee income on loans according to the contractual provisions of the credit agreements. When, based on historic performance of the portfolio, payment in full of finance charge and fee income is not expected, the estimated uncollectible portion is not accrued as income. As discussed below, the 2002 change in recoveries estimate resulted in an $82.7 million reduction of finance charges and fees deemed uncollectible for the year ended December 31, 2002. Amounts collected on previously charged-off accounts related to finance charges and fees are recognized as income. Costs to recover previously charged-off accounts are recorded as collection expense in non-interest expenses.
Interchange income is a fee paid by a merchant bank to the card-issuing bank through the interchange network. Interchange fees are set by MasterCard International Inc. and Visa U.S.A. Inc. and are based on cardholder purchase volumes. The Company recognizes interchange income as earned. The Company offers to its customers certain rewards programs based on purchase volumes. The provision for the cost of the rewards programs is based upon points awarded in the current year which are ultimately expected to be redeemed by program members and the current average cost per point of redemption. The cost of these rewards programs is deducted from interchange income. The cost of the rewards programs related to securitized loans is deducted from servicing and securitizations income.
Annual membership fees and direct loan origination costs are deferred and amortized over one year on a straight-line basis. Direct loan origination costs consist of both internal and external costs associated with the origination of a loan. Deferred fees (net of deferred costs of $45.2 million and $55.1 million in 2002 and 2001, respectively) were $325.9 million and $291.6 million as of December 31, 2002 and 2001, respectively.
## LOAN SECURITIZATIONS
Loan securitization involves the sale, generally to a trust or other special purpose entity, of a pool of loan receivables and is accomplished primarily through the public and private issuance of asset-backed securities by the special purpose entity. The Company removes loan receivables from the consolidated balance sheet for those asset securitizations that qualify as sales in accordance with SFAS 140. The trusts are qualifying special purpose entities as defined by SFAS 140. For those asset securitizations that qualify as sales in accordance with SFAS 140, the trusts to which the loans were sold are not subsidiaries of the Company, and are not included in the Company’s consolidated financial statements in accordance with GAAP. Gains on securitization transactions, fair value adjustments and servicing and other income on the Company’s securitizations are included in servicing and securitizations non-interest income in the consolidated statements of income and amounts due from the trusts are included in accounts receivable from securitizations on the consolidated balance sheets.
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The allowance for loan losses is maintained at the amount estimated to be sufficient to absorb probable losses, net of principal recoveries (including recovery of collateral), inherent in the existing reported loan portfolio. The provision for loan losses is the periodic cost of maintaining an adequate allowance. The amount of allowance necessary is determined primarily based on a migration analysis of delinquent and current accounts and forward loss curves. The entire balance of an account is contractually delinquent if the minimum payment is not received by the payment due date. In evaluating the sufficiency of the allowance for loan losses, management takes into consideration the following factors: recent trends in delinquencies and charge-offs including bankrupt, deceased and recovered amounts; forecasting uncertainties and size of credit risks; the degree of risk inherent in the composition of the loan portfolio; economic conditions; credit evaluations and underwriting policies.
The Company charges off credit card loans (net of any collateral) at 180 days past the due date, and generally charges off other consumer loans at 120 days past the due date. Bankrupt consumers’ accounts are generally charged-off within 30 days of receipt of the bankruptcy petition. Amounts collected on previously charged-off accounts related to principal are included in recoveries for the determination of net charge-offs. Costs to recover previously charged- off accounts are recorded as collection expense in non-interest expenses.
## PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated depreciation and amortization. The Company capitalizes direct costs (including external costs for purchased software, contractors, consultants and internal staff costs) for internally developed software projects that have been identified as being in the application development stage. Depreciation and amortization expenses are computed generally by the straight-line method over the estimated useful lives of the assets. Useful lives for premises and equipment are as follows: buildings and improvements — 5-39 years; furniture and equipment — 3-10 years; computers and software — 3 years.
## MARKETING
The Company expenses marketing costs as incurred. Television advertising costs are expensed during the period in which the advertisements are aired.
## CREDIT CARD FRAUD LOSSES
The Company experiences fraud losses from the unauthorized use of credit cards. Transactions suspected of being fraudulent are charged to non-interest expense after a sixty-day investigation period.
## INCOME TAXES
Deferred tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities, and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
## SEGMENTS
The Company maintains three distinct operating segments: Consumer Lending, Auto Finance and International. The Consumer Lending segment primarily consists of domestic credit card and installment lending activities. The Auto Finance segment consists of automobile lending activities. The International segment is comprised primarily of credit card lending activities outside the United States. The Consumer Lending, Auto Finance and International segments are considered reportable segments based on quantitative thresholds applied to the managed loan portfolio for reportable segments provided by SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information .
The accounting policies of these segments are the same as those described above. Management measures the performance of and resource allocation to each line of business within each reportable segment based on a wide range of indicators to include both historical and forecasted operating results. All revenue considered for the quantitative thresholds is generated from external customers.
## DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities , as amended by SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities – Deferral of Effective Date of FASB Statement No. 133, and SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities , (collectively, “SFAS 133”) on January 1, 2001. SFAS 133 required the Company to recognize all of its derivative instruments as either assets or liabilities in the balance sheet at fair value. The accounting for changes in the fair value (i.e., gains and losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and, further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, a company must designate the hedging instrument, based upon the exposure being hedged, as a fair value hedge, a cash flow hedge or a hedge of a net investment in a foreign operation. The adoption of SFAS 133 resulted in a 2001 cumulative-effect adjustment decreasing other comprehensive income by $27.2 million, net of an income tax benefit of $16.7 million.
For derivative instruments that are designated and qualify as fair value hedges (i.e., hedging the exposure to changes in the fair value of an asset or a liability or an identified portion thereof that is attributable to a particular risk), the gain or loss on the derivative instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk is recognized in current earnings during the period of the change in fair values. For derivative instruments that are designated and qualify as cash flow hedges (i.e., hedging the exposure to variability in expected future cash flows that is attributable to a particular risk), the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of future cash flows of the hedged item, if any, is recognized in current
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] | overall_image/ec55ea69c76f184a3c91a30ddbf816604d15f5b98e6ccd8cd6db05dbe4ce7899.png | earnings during the period of change. For derivative instruments that are designated and qualify as hedges of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income as part of the cumulative translation adjustment to the extent that it is effective. For derivative instruments not designated as hedging instruments, the gain or loss is recognized in current earnings during the period of change.
The Company formally documents all hedging relationships, as well as its risk management objective and strategy for undertaking the hedge transaction. At inception and at least quarterly, the Company also formally assesses whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the hedged items to which they are designated and whether those derivatives may be expected to remain highly effective in future periods. The Company will discontinue hedge accounting prospectively when it is determined that a derivative has ceased to be highly effective as a hedge.
## STOCK-BASED COMPENSATION
The Company applies Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) and related Interpretations in accounting for its stock-based compensation plans. In accordance with APB 25, no compensation cost has been recognized for the Company’s fixed stock options, since the exercise price of all such options equals or exceeds the market price of the underlying stock on the date of grant.
SFAS 123 requires for companies electing to continue to follow the recognition provisions of APB 25, pro forma information regarding net income and earnings per share, as if the recognition provisions of SFAS 123 were adopted for all stock compensation granted. For purposes of pro forma disclosure, the fair value of the options was estimated at the date of grant using the Black-Scholes option-pricing model and is amortized into expense over the options’ vesting period.
<img src='content_image/72500.jpg'>
(1) Includes amortization of compensation expense for current year grants and prior year grants over the options’ vesting period.
## CHANGE IN RECOVERIES CLASSIFICATION
During 2002, the Company changed its financial statement presentation of recoveries of charged-off loans. The change was made in response to guidelines that were published by the Federal Financial Institutions Examination Council (“FFIEC”) with respect to credit card account management. Previously, the Company recognized all recoveries of charged-off loans in the allowance for loan losses and provision for loan losses. The Company now classifies the portion of recoveries related to finance charges and fees as revenue. All prior period recoveries have been reclassified to conform to the current financial statement presentation of recoveries. This reclassification had no impact on prior period earnings.
The change in the classification of recoveries resulted in a change to the recoveries estimate used as part of the calculation of the Company’s allowance for loan losses and finance charge and fee revenue. The change in the recoveries estimate resulted in an increase to the allowance for loan losses and a reduction of the amount of finance charges and fees deemed uncollectible under the Company’s revenue recognition policy for the year ended December 31, 2002. The change in estimate resulted in an increase of $38.4 million to interest income and $44.4 million to non-interest income offset by an increase in the provision for loan losses of $133.4 million for the year ended December 31, 2002. Therefore, net income for the year ended December 31, 2002, was negatively impacted by $31.4 million or $.14 per diluted share as a result of the change in estimate.
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The Company manages its business by three distinct operating segments: Consumer Lending, Auto Finance and International. The Consumer Lending segment primarily consists of domestic credit card and installment lending activities. The Auto Finance segment consists of automobile lending activities. The International segment consists primarily of credit card lending activities outside the United States. The Consumer Lending, Auto Finance and International segments are disclosed separately. The “Other” caption includes the Company’s liquidity portfolio, new business initiatives, investments in external companies, and various non-lending activities. The “Other” caption also includes the net impact of transfer pricing, certain unallocated expenses, and gains/losses related to the securitization of assets.
The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. Revenue for all
## Segments
segments is derived from external parties. Performance evaluation of and resource allocation to each line of business within each reportable segment is based on a wide range of indicators to include both historical and forecasted operating results.
Management decision making is performed on a managed portfolio basis. An adjustment to reconcile the managed financial information to the reported financial information in the consolidated financial statements is provided. This adjustment reclassifies a portion of net interest income, non- interest income and provision for loan losses into non-interest income from servicing and securitization.
The Company maintains its books and records on a legal entity basis for the preparation of financial statements in conformity with GAAP. The following tables present information prepared from the Company’s internal management information system, which is maintained on a line of business level through allocations from legal entities.
<img src='content_image/59513.jpg'>
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] | overall_image/fb94d3f7130b7cd3bd12aa3ebea50d95d223f6d7e4081bd62effe76ad97a3329.png | During the year, the Company realigned certain aspects of its European operations. Charges related to the realignment of $12.5 million ($7.8 million after taxes) were recognized and allocated to the International segment.
During the year, the Company sold $1.5 billion of auto loans to multiple buyers. These transactions resulted in gains of $28.2 million for the Auto Finance segment. These gains were offset in part by compensation expense of $14.5 million ($9.0 million after taxes) that was recognized and allocated to the Auto Finance segment for the accelerated vesting provisions of certain
## Not C
Securities available for sale as of December 31, 2002, 2001 and 2000 were as follows:
restricted stock issued in connection with the acquisition of PeopleFirst, Inc. (“PeopleFirst”).
During the third quarter, the Company expensed $38.8 million ($24.1 million after taxes) related to the early termination of leases, unused facility capacity, and accelerated depreciation of related fixed assets. The Company allocated $35.3 million of these expenses to the Consumer Lending segment, $1.5 million to the other caption, $1.1 million to the Auto Finance segment, and $.9 million to the International segment.
## Securities Available for Sale
<img src='content_image/33593.jpg'>
<img src='content_image/33592.jpg'>
The distribution of mortgage-backed securities and collateralized mortgage obligations is based on average expected maturities. Act ual maturities could differ because issuers may have the right to call or prepay obligations.
Weighted average yields were determined based on amortized cost. Gross realized gains on sales of securities were $96.9 million and $19.1 million for the years ended December 31, 2002 and 2001, respectively. Gross realized losses were $19.4 million and $5.6 million for the years ended December 31, 2002 and 2001, respectively. Substantially no gains or losses on sales of securities were realized for December 31, 2000.
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The following is a summary of changes in the allowance for loan losses:
## Allowance for Loan Losses
<img src='content_image/99634.jpg'>
The $880.0 million increase in allowance for loan losses for the year ended December 31, 2002, reflects an increase in average reported loans, a rise in net charge- offs, the revised application of Subprime Guidelines (see Note O), and the $133.4 million one-time impact resulting from a change in recoveries estimate.
Loans totaling approximately $567.4 million and $284.5 million, representing amounts which were greater than 90 days past due, were included in the Company’s reported loan portfolio as of December 31, 2002 and 2001, respectively.
## Not E
Premises and equipment were as follows:
## Premises and Equipment
<img src='content_image/99636.jpg'>
Depreciation and amortization expense was $264.8 million, $236.0 million and $180.3 million, for the years ended December 31, 2002, 2001 and 2000, respectively.
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] | overall_image/be392cac359dc48c9005f3d0a33e9b27b4a6e5f5bb77f98dd9af8e5e13435196.png | ## What do you get when you combine great value and no hassles?
About 2.5 million new accounts!
Capital One’s credit card business is one of the largest, most profitable consumer-finance franchises in the world.
<img src='content_image/47280.jpg'>
We built our franchise with innovative products that offer consumers more for their money. Capital One ® made its mark years ago by pioneering balance transfer offers for credit card customers. Today our MilesOne ® frequent flyer card is a terrific deal. It’s redeemable on any airline. There are no blackout dates. The annual fee is small, and it comes with a low fixed interest rate.
We’re growing a sizable superprime business through several products, including the “No-Hassle” SM Platinum card, which offers a low fixed rate on both cash advances and purchases plus a level of convenience and service that make Capital One the hassle-free provider of choice.
With our proprietary information-based strategy and award-winning capabilities in marketing and information technology, Capital One continually finds profitable new market niches and creates products to serve them. Our lifestyle cards are successfully targeting hundreds of microsegments, from nurses and birdwatchers to newlyweds and new parents. We’re also building relationships with small-business owners with products that increase the flexibility and convenience of their borrowing.
Capital One’s innovations have revolutionized the credit card industry. We’ve lowered consumer borrowing costs, expanded access to credit and made it possible to customize the product to the borrower. By giving consumers a great deal and aligning each credit line and interest rate with the individual’s risk profile, we’re successfully meeting the needs of a diverse range of borrowers and winning their loyalty. We’re also generating profitable growth for Capital One.
The U.S. credit card business, which was large and growing when Capital One went public in 1994, is now twice that size and still growing. The convenience of the credit card has made it the payment method of choice for millions of consumers around the world, and we believe Capital One is well positioned to continue gaining market share by offering cardholders more for their money and creating profitable products that meet diverse needs.
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] | overall_image/6ef0b3f3223b050ecd221e233cc4196fbf4cc5daf788373c9caf1ec755963514.png | Borrowings as of December 31, 2002 and 2001 were as follows:
<img src='content_image/36221.jpg'>
## INTEREST-BEARING DEPOSITS
As of December 31, 2002, the Company had $17.3 billion in interest-bearing deposits of which $7.2 billion represents large denomination certificates of $100 thousand or more, with original maturities of up to ten years.
## SENIOR NOTES
## Bank Notes
## Senior and Subordinated Global Bank Note Program
The Senior and Subordinated Global Bank Note Program gives the Bank the ability to issue securities to both U.S. and non-U.S. lenders and to raise funds in foreign currencies. The Senior and Subordinated Global Bank Note Program has a total capacity of $5.0 billion of which $2.7 billion and $3.0 billion was outstanding at December 31, 2002 and 2001, respectively. In January 2003, the Bank increased its capacity under the Senior and Subordinated Global Bank Note Program to $8.0 billion. Prior to the establishment of the Senior and Subordinated Global Bank Note Program, the Bank issued senior unsecured debt through its $8.0 billion Senior Domestic Bank Note Program, of which $1.3 billion and $1.8 billion was outstanding at December 31, 2002 and 2001, respectively. During 2001, the Bank did not renew the Senior Domestic Bank Note Program for future issuances.
In July 2002, the Company repurchased senior bank notes in the amount of $230.4 million, which resulted in a pre-tax gain of $27.0 million.
During 2001, the Bank issued a $1.3 billion five-year fixed rate bank note and a $750.0 million three-year fixed rate senior note under the Senior and Subordinated Global Bank Note Program.
## Mandatory Convertible Securities
In April 2002, the Company completed a public offering of mandatory convertible debt securities (the “Upper Decs ® ”), that resulted in net proceeds of approximately $725.1 million. The net proceeds were used for general corporate purposes. Each Upper Dec ® initially consists of and represents (i) a senior note due May 17, 2007 with a principal amount of $50, on which the Company will pay interest quarterly at the initial annual rate of 6.25%, and (ii) a forward purchase contract pursuant to which the holder has agreed to purchase, for $50, shares of the Company’s common stock on May 17, 2005 (or earlier under certain conditions), with such number of shares to be determined based upon the average closing price per share of the Company’s common stock for 20 consecutive trading days ending on the third trading day immediately preceding the stock purchase date at a minimum per share price of $63.91 and a maximum per share price of $78.61.
The senior notes will initially be pledged to secure the holder’s obligations under the forward purchase contracts. Each holder of an Upper Dec ® may elect to withdraw the pledged senior notes or treasury securities underlying
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## Corporation Shelf Registration Statements
As of December 31, 2002, the Corporation had two effective shelf registration statements under which the Corporation from time to time may offer and sell senior or subordinated debt securities, preferred stock, common stock, common equity units and stock purchase contracts. The Corporation Shelf Registration statements had a total capacity of $2.2 billion all of which was available at December 31, 2002. There was $587.2 million available at December 31, 2001.
On November 11, 2002, the Corporation issued shares of its common stock having an aggregate value of $54.9 million to certain former shareholders of AmeriFee Corporation (“AmeriFee”) in connection with the termination of the stock purchase agreement relating to the Corporation’s acquisition of AmeriFee. Of this amount, $43.9 million of the Corporation’s common stock was issued through its shelf registration statement and $11.0 million was issued in an unregistered offering.
In January 2002, the Company issued $300.0 million of five-year senior notes with a coupon rate of 8.75%.
During 2001, the Corporation issued 6,750,390 shares of common stock in a public offering under the shelf registration statement that resulted in proceeds of $412.8 million.
## OTHER BORROWINGS
## Secured Borrowings
COAF, a subsidiary of the Company, currently maintains seven agreements to transfer pools of consumer loans accounted for as secured borrowings. The agreements were entered into between 1999 and 2002, relating to the transfers of pools of consumer loans totaling $6.2 billion. Principal payments on the borrowings are based on principal collections, net of losses, on the transferred consumer loans. The secured borrowings accrue interest predominantly at fixed rates and mature between June 2006 and September 2008, or earlier depending upon the repayment of the underlying consumer loans. At December 31, 2002 and 2001, $4.6 billion and $2.5 billion, respectively, of the secured borrowings were outstanding.
PeopleFirst, a subsidiary of COAF, currently maintains four agreements to transfer pools of consumer loans accounted for as secured borrowings. The agreements were entered into between 1999 and 2000 relating to the transfer of pools of consumer loans totaling approximately $886.0 million. Principal payments on the borrowings are based on principal collections, net of losses, on the transferred consumer loans. The secured borrowings accrue interest at fixed rates and mature between September 2003 and September 2007, or earlier depending upon the repayment of the underlying consumer loans. At December 31, 2002 and 2001, $243.0 million and $477.3 million of the secured borrowings were outstanding.
## Junior Subordinated Capital Income Securities
In January 1997, Capital One Capital I, a subsidiary of the Bank created as a Delaware statutory business trust, issued $100.0 million aggregate amount of Floating Rate Junior Subordinated Capital Income Securities that mature on February 1, 2027. The securities represent a preferred beneficial interest in the assets of the trust.
## Other Short-Term Borrowings
## Domestic Revolving Credit Facility
The Domestic Revolving Credit Facility (the “Credit Facility”) is available for general corporate purposes of the Company. The Credit Facility is comprised of two tranches: a $810.0 million Tranche A facility available to the Bank and the Savings Bank, including an option for up to $250.0 million in multicurrency availability; and a $390.0 Tranche B facility available to the Corporation, the Bank and the Savings Bank, including an option for up to $150.0 million in multicurrency availability. All borrowings under the Credit Facility are based on varying terms of LIBOR. The Bank has irrevocably undertaken to honor any demand by the lenders to repay any borrowings which are due and payable by the Savings Bank but have not been paid. The Credit Facility has a total capacity of $1.2 billion all of which was available at December 31, 2002. The Credit Facility expires in May of 2003.
## Multicurrency Facility
The Multicurrency Facility is intended to finance the Bank’s business in Europe and was initially comprised of two Tranches, each in the amount of Euro 300.0 million. The Tranche A facility terminated August of 2001. The Tranche B facility terminates August 2004. The Corporation serves as guarantor of all borrowings by Capital One Bank (Europe) plc under the Multicurrency Facility. Internationally, the Company has funding programs designed for foreign investors or to raise funds in foreign currencies allowing the Company to borrow from the U.S. and non-U.S. lenders, including foreign currency funding options under the Credit Facility discussed above. The Company funds its foreign assets by directly or synthetically borrowing or securitizing in the local currency to mitigate the financial statement effect of currency translations. The Multicurrency Facility has a total capacity of Euro 300.0 million ($315.0 million equivalent based on the exchange rate at closing) all of which was available at December 31, 2002.
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] | overall_image/e69003c854eecede262fa831e8f1c2bc85f911c1c846c224c72ea1be1e5ab6e5.png | ## Collateralized Revolving Credit Facilities
In April 2002, COAF entered into a $2.2 billion revolving warehouse credit facility collateralized by a security interest in certain consumer loan assets. The warehouse credit facility has several participants each with a separate renewal date. The facility does not have a final maturity date. Instead, each participant may elect to renew the commitment for another set period of time. All participants have renewal dates occurring in 2003. Interest on the facility is based on commercial paper rates. At December 31, 2002, $894.0 million was outstanding under the facility.
In October 2001, PeopleFirst entered into a $500.0 million revolving credit facility collateralized by a security interest in certain consumer loan assets. Interest on the facility is based on London InterBank Offering Rates (“LIBOR”). The facility matured in March 2002. At December 31, 2001, $.4 million was outstanding under the facility.
Interest-bearing deposits, senior notes and other borrowings as of December 31, 2002, mature as follows:
<img src='content_image/27190.jpg'>
## Not G
## STOCK-BASED COMPENSATION PLANS
The Company has five stock-based compensation plans, three employee plans and two non-employee directors plans. Under the plans, the Company reserves common shares for the issuance in various forms to include incentive stock options, nonstatutory stock options, stock appreciation rights, restricted stock awards and incentive stock awards. The form of stock compensation is specific to each plan. Generally the exercise price of each stock option will equal or exceed the market price of the Company’s stock on the date of grant, the maximum term will be ten years, and vesting is determined at the time of grant, typically either 33 1/3 percent per year beginning with the first anniversary of the grant date for options, three years from the time of grant for restricted stock or accelerated vesting option grants as described below.
The following table provides the number of reserved common shares and the number of common shares available for future issuance for each of the Company’s stock-based compensation plans as of December 31, 2002, 2001 and 2000:
<img src='content_image/27191.jpg'>
(1 ) The plan’s ability to issue grants was terminated in 1999. There are currently 457,500 options outstanding under the plan.
## Stock Plans
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] | overall_image/673141b362437caa9a8f038728e517e275a596a9f2b07f5ad274d675283724bb.png | A summary of the status of the Company’s options as of December 31, 2002, 2001 and 2000, and changes for the years then ended is presented below:
<img src='content_image/96452.jpg'>
The fair value of the options granted during 2002, 2001 and 2000 was estimated at the date of grant using a Black-Scholes option-pricing model with the weighted average assumptions described below:
<img src='content_image/96453.jpg'>
The following table summarizes information about options outstanding as of December 31, 2002:
<img src='content_image/96454.jpg'>
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The Company granted 2.5 million and .9 million restricted stock awards with a weighted average grant date value of $34.58 and $47.07 per share for 2002 and 2001, respectively. Restrictions generally expire in three years from the date of grant. The compensation cost that has been charged against income for the Company’s restricted stock awards was $27.7 million and $1.0 million for 2002 and 2001, respectively.
## ACCELERATED VESTING OPTION GRANTS
## EntrepreneurGrant V
In October 2001, the Company’s Board of Directors approved a stock options grant to senior management (“EntrepreneurGrant V”). This grant was composed of 6,502,318 options to certain key managers (including 3,535,000 performance-based options to the Company’s Chief Executive Officer (“CEO”) and Chief Operating Officer (“COO”)) at the fair market value on the date of grant. The CEO and COO gave up their salaries, annual cash incentives, annual option grants and Senior Executive Retirement Plan contributions for the years 2002 and 2003 in exchange for their EntrepreneurGrant V options. Other members of senior management had the opportunity to forego up to 50 percent of their expected annual cash incentives for 2002 through 2004 in exchange for performance-based options. All performance-based options under this grant will vest on October 18, 2007. Vesting will be accelerated if the Company’s common stock’s fair market value is at or above $83.87 per share, $100.64 per share, $120.77 per share or $144.92 per share in any five trading days during the performance period on or before October 18, 2004, 2005, 2006 or 2007, respectively. In addition, the performance-based options under this grant will also vest upon the achievement of at least $5.03 cumulative diluted earnings per share in any four consecutive quarters ending in the fourth quarter of 2004, or upon a change of control of the Company. Options under this grant qualify as fixed as defined by APB 25, accordingly no compensation expense is recognized.
## EntrepreneurGrant IV
In April 1999, the Company’s Board of Directors approved a stock option grant to senior management (“Entrepreneur Grant IV”). This grant was composed of 7,636,107 options to certain key managers (including 1,884,435 options to the Company’s CEO and COO) with an exercise price equal to the fair market value on the date of grant. The CEO and COO gave up their salaries for the year 2001 and their annual cash incentives, annual option grants and Senior Executive Retirement Plan contributions for the years 2000 and 2001 in exchange for their Entrepreneur Grant IV options. Other members of senior management had the opportunity to give up all potential annual stock option grants for 1999 and 2000 in exchange for this one-time grant. Under the original terms, all options under this grant would have vested on April 29, 2008, or earlier if the common stock’s fair market value was at or above $100 per share for at least ten trading days in any 30 consecutive calendar day period on or before June 15, 2002, or upon a change of control of the Company. In May 2001, the Company’s Board of
Directors approved an amendment to EntrepreneurGrant IV that provides additional vesting criteria. As amended, EntrepreneurGrant IV will continue to vest under its original terms, and will also vest if the Company’s common stock price reaches a fair market value of at least $120 per share or $144 per share for ten trading days within 30 calendar days prior to June 15, 2003 or June 15, 2004, respectively. In addition, 50% of the EntrepreneurGrant IV stock options held by middle management as of the grant date will vest on April 29, 2005, regardless of stock performance. Options under this grant qualify as fixed as defined by APB 25, accordingly no compensation expense is recognized.
## Director Accelerated Vesting Option Grants
In October 2001, the Company granted 305,000 options to the non- executive members of the Board of Directors for director compensation for the years 2002, 2003 and 2004. These options were granted at the fair market value on the date of grant and vest on October 18, 2010. Vesting will be accelerated if the stock’s fair market value is at or above $83.87 per share, $100.64 per share, $120.77 per share, $144.92 per share, $173.91 per share, $208.70 per share or $250.43 per share for at least five days during the performance period on or before October 18, 2004, 2005, 2006, 2007, 2008, 2009 or 2010, respectively. In addition, the options under this grant will vest upon the achievement of at least $5.03 cumulative diluted earnings per share for any four consecutive quarters ending in the fourth quarter 2004, or upon a change in control of the Company. Options under this grant qualify as fixed, as defined by APB 25, accordingly no compensation expense is recognized.
In April 1999, all non-employee directors of the Company were given the option to receive performance-based options under this plan in lieu of their annual cash retainer and their time-vesting options for each of 1999, 2000 and 2001. As a result, 497,490 performance-based options were granted to certain non-employee directors of the Company. The options would have vested in full if, on or before June 15, 2002, the market value of the Company’s stock would have equaled or exceeded $100 per share for ten trading days in a 30 consecutive calendar day period or upon change of control of the Company on or before June 15, 2002. The vesting provisions were not achieved and as such the unvested options were cancelled during 2002.
## ASSOCIATE STOCK PURCHASE PLAN
The Company maintains an Associate Stock Purchase Plan (the “Purchase Plan”). The Purchase Plan qualifies as a noncompensatory plan, accordingly no compensation expense is recognized.
Under the Purchase Plan, associates of the Company are eligible to purchase common stock through monthly salary deductions of a maximum of 15% and a minimum of 1% of monthly base pay. To date, the amounts deducted are applied to the purchase of unissued common or treasury stock of the Company at 85% of the current market price. Shares may also be acquired on the market. The Company terminated its 1995 Associate Stock Purchase Plan in October 2002 when shares available for issuance under such plan were exhausted, and implemented in substitution its 2002 Associate Stock Purchase Plan under substantially similar terms. An aggregate of 3.0 million common shares has been authorized for issuance under the 2002 Associate Stock Purchase Plan, of which 2.7 million shares were available for issuance as of December 31, 2002.
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] | overall_image/06ca0e09840e918385adc858a657aa19f2dddf4acbb920531da05db8f8568ead.png | ## DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN
In 1997, the Company implemented its dividend reinvestment and stock purchase plan (“1997 DRP”), which allows participating stockholders to purchase additional shares of the Company’s common stock through automatic reinvestment of dividends or optional cash investments. The Company issued 3.0 million and .7 million shares of new common stock in 2002 and 2001, respectively, under the 1997 DRP. The Company also instituted an additional dividend reinvestment and stock purchase plan in 2002 (“2002 DRP”) with an additional 7.5 million shares reserved, all of which were available for issuance at December 31, 2002.
## Not H Common and Preferred Shares
## SHARE REPURCHASE PROGRAM
In July 1997, the Company’s Board of Directors voted to repurchase up to 6.0 million shares of the Company’s common stock to mitigate the dilutive impact of shares issuable under its benefit plans, including the Purchase Plan, dividend reinvestment plan and stock incentive plans. In July 1998 and February 2000, the Company’s Board of Directors voted to increase this amount by 4,500,000 and 10,000,000 shares, respectively, of the Company’s common stock. For the years ended December 31, 2002 and 2001, the Company did not repurchase shares under this program. For the years ended December 31, 2000 and 1999, the Company repurchased 3,028,600 and 2,250,000 shares, respectively, under this program. Certain treasury shares have been reissued in connection with the Company’s benefit plans.
## CUMULATIVE PARTICIPATING JUNIOR PREFERRED STOCK
On November 16, 1995, the Board of Directors of the Company declared a dividend distribution of one Right for each outstanding share of common stock. As amended, each Right entitles a registered holder to purchase from the Company 1/300th of a share of the Company’s authorized Cumulative Participating Junior Preferred Stock (the “Junior Preferred Shares”) at a price of $200 per 1/300th of a share, subject to adjustment. The Company has reserved one million shares of its authorized preferred stock for the Junior Preferred Shares. Because of the nature of the Junior Preferred Shares’ dividend and liquidation rights, the value of the 1/300th interest in a Junior Preferred Share purchasable upon exercise of each Right should approximate the value of one share of common stock. Initially, the Rights are not exercisable and trade automatically with the common stock. However, the Rights generally become exercisable and separate certificates representing the Rights will be distributed, if any person or group acquires 15% or more of the Company’s outstanding common stock or a tender offer or exchange offer is announced for the Company’s common stock. Upon such event, provisions would also be made so that each holder of a Right, other than the acquiring person or group, may exercise the Right and buy common stock with a market value of twice the $200 exercise price. The Rights expire on November 29, 2005, unless earlier redeemed by the Company at $0.01 per Right prior to the time any person or group acquires 15% of the outstanding common stock. Until the Rights become exercisable, the Rights have no dilutive effect on earnings per share.
## Not I Retirement Plans
## ASSOCIATE SAVINGS PLAN
The Company sponsors a contributory Associate Savings Plan in which substantially all full-time and certain part-time associates are eligible to participate. The Company makes contributions to each eligible employee’s account, matches a portion of associate contributions and makes discretionary contributions based upon the Company meeting a certain earnings per share target. The Company’s contributions to this plan, all of which were in cash, amounted to $65.9 million, $64.3 million and $44.5 million for the years ended December 31, 2002, 2001 and 2000, respectively.
## OTHER POSTRETIREMENT BENEFITS
The Company sponsors postretirement benefit plans to provide health care and life insurance to retired employees. Net periodic postretirement benefit expense was $6.8 million, $3.1 million and $2.5 million in 2002, 2001 and 2000, respectively. The liabilities recognized on the consolidated balance sheets for the Company’s defined postretirement benefit plan at December 31, 2002, 2001 and 2000 were $17.4 million, $10.6 million and $7.7 million, respectively.
## Not J Other Non-Interest Expense
<img src='content_image/23016.jpg'>
## Not K Income Taxes
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets and liabilities as of December 31, 2002 and 2001 were as follows:
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## Deferred tax liabilities:
<img src='content_image/38503.jpg'>
During 2002, the Company increased its valuation allowance by $7.4 million for certain state and international loss carryforwards generated during the year.
At December 31, 2002, the Company had net operating losses available for federal income taxes purposes of $55.0 million which are subject to certain annual limitations under the Internal Revenue Code, and expire at various dates from 2018 to 2020. Also, foreign net operating losses of $56.7 million (net of related valuation allowances) were available, of which $55.7 million expires at various dates from 2005 to 2008.
Significant components of the provision for income taxes attributable to continuing operations were as follows:
<img src='content_image/38501.jpg'>
The reconciliation of income tax attributable to continuing operations computed at the U.S. federal statutory tax rate to income tax expense was:
<img src='content_image/38505.jpg'>
## Not L
The following table sets forth the computation of basic and diluted earnings per share:
<img src='content_image/38502.jpg'>
Securities of approximately 23,000,000, 5,217,000 and 5,496,000 during 2002, 2001 and 2000, respectively, were not included in the computation of diluted earnings per share because their inclusion would be antidilutive.
## Earnings Per Share
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<img src='content_image/23113.jpg'>
Unrealized gains (losses) on securities included gross unrealized gains of $80.6 million, $44.6 million and $17.1 million, and gross unrealized losses of $.4 million, $30.2 million and $18.3 million, as of December 31, 2002, 2001 and 2000, respectively.
During 2002, the Company reclassified $101.5 million of net losses, after tax, on derivative instruments from cumulative other comprehensive income into earnings.
During 2002, the Company reclassified $4.2 million of net gains on sales of securities, after tax, from cumulative other comprehensive income into earnings.
## Cumulative Other Comprehensive Income
## Summary of Acquisition Goodwill
<img src='content_image/23112.jpg'>
In October 2001, the Company acquired PeopleFirst. Based in San Diego, California, PeopleFirst is the largest online provider of direct motor vehicle loans. The acquisition price for PeopleFirst was $174.0 million, paid through the issuance of approximately 3,746,000 shares of the Company’s common stock. This purchase combination created approximately $166.0 million in goodwill, as approximately $763.0 million of assets were acquired and $755.0 million of liabilities were assumed.
In May 2001, the Company acquired AmeriFee. AmeriFee is a financial services firm based in Southborough, Massachusetts that provides financing solutions for consumers seeking elective medical and dental procedures. The acquisition was accounted for as a purchase business combination. The initial acquisition price for AmeriFee was $81.5 million, paid through approximately $64.5 million of cash and approximately 257,000 shares of the Company’s common stock. This purchase combination created approximately $80.0 million in goodwill. The goodwill prior to December 31, 2001 was amortized on a straight-line basis over 20 years. After December 31, 2001, the Company ceased amortization and performed impairment tests on the book value of the remaining goodwill in accordance with SFAS 142.
In July 2002 the Company’s Board of Directors voted to adopt a Termination Agreement and Mutual Release with prior owners of AmeriFee, ending the original acquisition agreement and settling all contingent consideration provisions. The Company agreed to terms that would provide a one-time payment of up to $55.0 million, payable in common shares or cash at the Company’s discretion, to prior owners of AmeriFee. On November 11, 2002, the Corporation issued shares of its common stock having an aggregate value of $54.9 million to the prior owners of AmeriFee in accordance with the terms of the Termination Agreement. Of this amount, $43.9 million in common stock was issued under the Corporation’s existing shelf registration statement and $11.0 million in common stock was issued in an unregistered offering. The full $54.9 million was accounted for as additional acquisition goodwill.
## Goodwill
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The Bank and the Savings Bank are subject to capital adequacy guidelines adopted by the Federal Reserve Board (the “Federal Reserve”) and the Office of Thrift Supervision (the “OTS”) (collectively, the “regulators”), respectively. The capital adequacy guidelines and the regulatory framework for prompt corrective action require the Bank and the Savings Bank to maintain specific capital levels based upon quantitative measures of their assets, liabilities and off-balance sheet items.
The most recent notifications received from the regulators categorized the Bank and the Savings Bank as “well-capitalized.” To be categorized as “well- capitalized,” the Bank and the Savings Bank must maintain minimum capital ratios as set forth in the following table. As of December 31, 2002, there were no conditions or events since the notifications discussed above that management believes would have changed either the Bank or the Savings Bank’s capital category.
<img src='content_image/78660.jpg'>
Since early 2001, the Bank and Savings Bank have treated a portion of their loans as “subprime” under the “Expanded Guidance for Subprime Lending Programs” (the “Subprime Guidelines”) and have assessed their capital and allowance for loan losses accordingly. In the second quarter of 2002, the Company adopted a revised application of the Subprime Guidelines, the result of which is to require more capital and allowance for loan losses to be
## Regulatory Matters
held against subprime loans. Under the revised application of the Subprime Guidelines, the Company has, for purposes of calculating capital ratios, risk weighted subprime loans in targeted programs at 200%, rather than the 100% risk weighting applied to loans not in targeted subprime programs. The Company has addressed the additional capital requirements with available resources. Under the revised application of the Subprime Guidelines, each of the Bank and the Savings Bank exceeds the requirements for a “well-capitalized” institution as of December 31, 2002.
For purposes of the Subprime Guidelines, the Company has treated as “subprime” all loans in the Bank’s and the Savings Bank’s targeted subprime programs to customers either with a Fair, Isaac and Company (“FICO”) score of 660 or below or with no FICO score. The Bank and the Savings Bank hold on average 200% of the total risk-based capital charge that would otherwise apply to such assets. This results in higher levels of regulatory capital at the Bank and the Savings Bank. As of December 31, 2002, approximately $5.3 billion or 28.0% of the Bank’s, and $3.8 billion or 32.4% of the Savings Bank’s, on-balance sheet assets were treated as “subprime” for purposes of the Subprime Guidelines.
In November 2001, the regulators adopted an amendment to the regulatory capital standards regarding the treatment of certain recourse obligations, direct credit substitutes (i.e., guarantees on third-party assets), residual interests in asset securitizations, and certain other securitized transactions. Effective January 1, 2002, this rule amended the regulatory capital standards to create greater differentiation in the capital treatment of residual interests. On May 17, 2002, the regulators issued an advisory interpreting the application of this rule to a residual interest commonly referred to as an accrued interest receivable (the “AIR Advisory”). The effect of this AIR Advisory is to require all insured depository institutions, including the Bank and the Savings Bank, to hold significantly higher levels of regulatory capital against accrued interest receivables beginning December 31, 2002. The Bank and the Savings Bank have met this capital requirement and remain well capitalized after applying the provisions of the AIR Advisory at December 31, 2002.
In August 2000, the Bank received regulatory approval and established a subsidiary bank in the United Kingdom. In connection with the approval of its former branch office in the United Kingdom, the Company committed to the Federal Reserve that, for so long as the Bank maintains a branch or subsidiary bank in the United Kingdom, the Company will maintain a minimum Tier 1 Leverage ratio of 3.0%. As of December 31, 2002 and 2001, the Company’s Tier 1 Leverage ratio was 11.95% and 11.93%, respectively.
Additionally, certain regulatory restrictions exist that limit the ability of the Bank and the Savings Bank to transfer funds to the Corporation. As of December 31, 2002, retained earnings of the Bank and the Savings Bank of $924.4 million and $408.4 million, respectively, were available for payment of dividends to the Corporation without prior approval by the regulators. The Savings Bank, however, is required to give the OTS at least 30 days advance notice of any proposed dividend and the OTS, in its discretion, may object to such dividend.
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## LINE OF CREDIT COMMITMENTS
As of December 31, 2002 the Company had outstanding lines of credit of approximately $165.5 billion committed to its customers. Of that total commitment, approximately $105.8 billion was unused. While this amount represented the total available lines of credit to customers, the Company has not experienced, and does not anticipate, that all of its customers will exercise their entire available line at any given point in time. The Company generally has the right to increase, reduce, cancel, alter or amend the terms of these available lines of credit at any time.
## LEASE COMMITMENTS
Certain premises and equipment have been leased under agreements that expire at various dates through 2012, without taking into consideration available renewal options. Many of these leases provide for payment by the lessee of property taxes, insurance premiums, cost of maintenance and other costs. In some cases, rentals are subject to increase in relation to a cost of living index. Total rent expenses amounted to approximately $63.2 million, $64.7 million and $66.1 million for the years ended December 31, 2002, 2001 and 2000, respectively.
Future minimum rental commitments as of December 31, 2002, for all non- cancelable operating leases with initial or remaining terms of one year or more are as follows:
<img src='content_image/6095.jpg'>
## GUARANTEES
## Residual Value Guarantees
The Company has entered into synthetic lease transactions to finance several facilities. A synthetic lease structure typically involves establishing a special purpose vehicle (“SPV”) that owns the properties to be leased. The SPV is funded and its equity is held by outside investors, and as a result, neither the debt of nor the properties owned by the SPV have been included in the accompanying consolidated financial statements. These transactions, as described below, are accounted for as operating leases in accordance with SFAS No. 13, Accounting for Leases. The Company has entered into maximum residual value guarantee agreements with the lessors of the
## Commitments, Contingencies and Guarantees
properties (the SPVs established in the lease structures), whereby the Company guarantees certain residual amounts to the lessors in the event of a sale of the property or expiration of the lease. The amount of the deficiency is recognized as rent expense on a straight-line basis over the remaining term of the lease. The accrual for a deficiency is required regardless of whether the Company expects to exercise a purchase option or renewal option at the end of the lease term.
In December 2000, the Company entered into a 10-year agreement for the lease of a headquarters building being constructed in McLean, Virginia. The agreement calls for monthly rent to commence upon completion, which is expected to occur in the first quarter of 2003, and is based on LIBOR rates applied to the cost of the buildings funded. If, at the end of the lease term, the Company does not purchase the property, the Company guarantees a maximum residual value of up to $114.8 million representing approximately 72% of the estimated $159.5 million cost of the buildings in the lease agreement. This agreement, made with a multi-purpose entity that is a wholly-owned subsidiary of one of the Company’s lenders, provides that in the event of a sale of the property, the Company’s obligation would be equal to the sum of all amounts owed by the Company under a note issuance made in connection with the lease inception. As of December 31, 2002, the estimated cost of the building provided a reasonable approximation of the fair value, and thus no deficiency existed and no liability related to the maximum residual value guarantee was recorded relative to this property.
In 1999, the Company entered into two three-year agreements for the construction and subsequent lease of four facilities located in Tampa, Florida and Federal Way, Washington. The construction of all four of these facilities was completed during 2001. The total cost of the buildings was approximately $98.8 million. Monthly rent commenced upon completion of each of the buildings and is based on LIBOR rates applied to the cost of the facilities funded. The Company had one-year renewal options under the terms of each of the leases, which were exercised during 2002 to extend the life of the leases through September of 2003. If, at the end of the lease terms, the Company does not purchase all of the properties, the Company guarantees a maximum residual value to the lessor of up to $84.0 million representing approximately 85% of the cost of the buildings in the lease agreement. During the fourth quarter, the estimated fair value of the facilities fell to a level below the maximum residual value guaranteed resulting in a deficiency of $22.0 million. Correspondingly, the Company has recognized $11.2 million as additional rent expense related to the deficiency as of December 31, 2002.
In 1998, the Company entered into a five-year lease of five facilities in Tampa, Florida and Richmond, Virginia. Monthly rent on the facilities is based on a fixed interest rate of 6.87% per annum applied to the cost of the buildings included in the lease of $86.8 million. The Company has two one- year renewal options under the terms of the lease, which have been exercised to extend the life of the lease through December of 2005. If, at the end of the lease term, the Company does not purchase all of the properties, the Company guarantees a maximum residual value to the lessor of up to $72.9 million representing approximately 84% of the costs of the buildings in the lease agreement. As of December 31, 2002, the estimated fair value of the facilities fell to a level below the maximum residual value guaranteed resulting in a deficiency of $13.0 million. Correspondingly, the Company recognized $.4 million as additional rent expense related to the deficiency as of December 31, 2002.
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} | https://cdla.io/permissive-1-0/ | [] | overall_image/ec0569800a57c59739619aad5d52527aa21d5058de1d5ec6bad906ca538d88c0.png | ## Other Guarantees
In connection with an installment loan securitization transaction, the transferee (off-balance sheet special purpose entity receiving the installment loans) entered into an interest rate hedge agreement (the “swap”) with a counterparty to reduce interest rate risk associated with the transaction. In connection with the swap, the Corporation entered into a letter agreement guaranteeing the performance of the transferee under the swap. If at anytime the Class A invested amount equals zero and the notional amount of the swap is greater than zero resulting in an “Early Termination Date” (as defined in the securitization transaction’s Master Agreement), then (a) to the extent that, in connection with the occurrence of such Early Termination Date, the transferee is obligated to make any payments to the counterparty pursuant to the Master Agreement, the Corporation shall reimburse the transferee for the full amount of such payment and (b) to the extent that, in connection with the occurrence of an Early Termination Date, the transferee is entitled to receive any payment from the counterparty pursuant to the Master Agreement, the transferee will pay to the Corporation the amount of such payment. At December 31, 2002, the maximum exposure to the Corporation under the letter agreement was approximately $26.7 million.
## SECURITIES LITIGATION
Beginning in July 2002, the Corporation was named as a defendant in twelve putative class action securities cases. All twelve actions were filed in the United States District Court for the Eastern District of Virginia. Each complaint also named as “Individual Defendants” several of the Corporation’s executive officers.
On October 1, 2002, the Court consolidated these twelve cases. Pursuant to the Court’s order, Plaintiffs filed an amended complaint on October 17, 2002, which alleged that the Corporation and the Individual Defendants violated Section 10(b) of the Exchange Act, Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act. The amended complaint asserted a class period of January 16, 2001, through July 16, 2002, inclusive. The amended complaint alleged generally that, during the asserted class period, the Corporation misrepresented the adequacy of its capital levels and loan loss allowance relating to higher risk assets. In addition, the amended complaint alleged generally that the Corporation failed to disclose that it was experiencing serious infrastructure deficiencies and systemic computer problems as a result of its growth.
On December 4, 2002, the Court granted defendants’ motion to dismiss plaintiffs’ amended complaint with leave to amend. Pursuant to that order, plaintiffs filed a second amended complaint on December 23, 2002, which asserted the same class period and alleged violations of the same statutes and rule. The second amended complaint also added a new Individual Defendant and asserted violations of Generally Accepted Accounting Principles.
The Corporation believes that it has meritorious defenses with respect to this case and intends to defend the case vigorously. The Corporation moved to dismiss plaintiffs’ second amended complaint on January 8, 2003. At the present time, management is not in a position to determine whether the resolution of this case will have a material adverse effect on either the consolidated financial position of the Corporation or the Corporation’s results of operations in any future reporting period.
## OTHER PENDING AND THREATENED LITIGATION
In addition, the Company is also commonly subject to various pending and threatened legal actions relating to the conduct of its normal business activities. In the opinion of management, the ultimate aggregate liability, if any, arising out of any such pending or threatened legal actions will not be material to the consolidated financial position or results of operations of the Company.
## Not Q
In the ordinary course of business, executive officers and directors of the Company may have consumer loans issued by the Company. Pursuant to the Company’s policy, such loans are issued on the same terms as those prevailing at the time for comparable loans to unrelated persons and do not involve more than the normal risk of collectibility.
## Not R
Off-balance sheet securitizations involve the transfer of pools of consumer loan receivables by the Company to one or more third-party trusts or qualified special purpose entities in transactions which are accounted for as sales in accordance with SFAS 140. Certain undivided interests in the pool of consumer loan receivables are sold to investors as asset-backed securities in public underwritten offerings or private placement transactions. The proceeds from off-balance sheet securitizations are distributed by the trusts to the Company as consideration for the consumer loan receivables transferred. Each new off-balance sheet securitization results in the removal of consumer loan principal receivables equal to the sold undivided interests in the pool from the Company’s consolidated balance sheet (“off-balance sheet loans”), the recognition of certain retained residual interests and a gain on the sale. The remaining undivided interests in principal receivables of the pool, as well as all billed finance charge and fee receivables, are retained by the Company and recorded as consumer loans on the consolidated balance sheet. The amounts of the remaining undivided interests fluctuate as the accountholders make principal payments and incur new charges on the selected accounts. The amount of retained consumer loan receivables was $6.6 billion and $5.7 billion as of December 31, 2002 and 2001, respectively.
## Off-Balance Sheet Securitizations
## Related Party Transactions
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] | overall_image/b85aacfcfa52e75ae9b302caf5eb69479c39d5387bb5a218bac345818a94950c.png | The following table presents the year-end and average balances, as well as the delinquent and net charge-off amounts of the reported, off-balance sheet and managed consumer loan portfolios.
<img src='content_image/49493.jpg'>
The Company’s retained residual interests in the off-balance sheet securitizations are recorded in accounts receivable from securitizations, and are comprised of interest-only strips, retained subordinated undivided interests in the transferred receivables, cash collateral accounts and accrued but unbilled interest on the transferred receivables. The interest-only strip is recorded at fair value, while the other residual interests are carried at cost, which approximates fair value. Retained residual interests totaled $1.1 billion and $934.3 million at December 31, 2002 and 2001, respectively. The Company’s retained residual interests, as well as the billed finance charge and fee receivables, are generally restricted or subordinated to investors’ interests and their value is subject to substantial credit, repayment and interest rate risks on the transferred financial assets. The investors and the trusts have no recourse to the Company’s assets, other than the retained residual interests, if the off-balance sheet loans are not paid when due.
The gain on sale recorded from off-balance sheet securitizations is based on the estimated fair value of the assets sold and retained and liabilities incurred, and is recorded at the time of sale in servicing and securitizations on the consolidated statements of income. The related receivable is the interest-only strip, which is based on the present value of the estimated future cash flows from excess finance charges and past-due fees over the sum of the return paid to security holders, estimated contractual servicing fees and credit losses. The Company periodically reviews the key assumptions and estimates used in determining the value of the interest-only strip. Prior to December 31, 2002, decreases in fair value below the carrying amount as a result of changes in the key assumptions were recognized in servicing and securitizations income, while, increases in fair values as a result of changes in key assumptions were recorded as unrealized gains and included as a component of cumulative other comprehensive income, on a net-of-tax basis, in accordance with the provisions of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities . Effective December 31, 2002 and for all subsequent periods, the Company recognizes all changes in the fair value of the interest-only strip immediately in servicing and securitizations on the consolidated statements of income. In accordance with EITF 99-20, Recognition of Interest Income and Impairment of Purchased and Retained
Beneficial Interests in Securitized Financial Assets , the interest component of cash flows attributable to retained interests in securitizations is recorded in other interest income.
The key assumptions used in determining the fair value of the interest-only strips resulting from securitizations of consumer loan receivables completed during the period included the weighted average ranges for charge-off rates, principal repayment rates, lives of receivables and discount rates included in the following table.
<img src='content_image/49499.jpg'>
If these assumptions are not met, or if they change, the interest-only strip and related servicing and securitizations income would be affected. The following adverse changes to the key assumptions and estimates, presented in accordance with SFAS 140, are hypothetical and should be used with caution. As the figures indicate, any change in fair value based on a 10% or 20% variation in assumptions cannot be extrapolated because the relationship of a change in assumption to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of the interest-only strip is calculated independently from any change in another assumption. However, changes in one factor may result in changes in other factors, which might magnify or counteract the sensitivities.
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] | overall_image/bce44a0d180978a2a87e9fbc65adc452158411c5a8d46d1f4fbf5d3039411c0f.png | ## Securitization Key Assumptions and Sensitivities
<img src='content_image/13111.jpg'>
Static pool credit losses are calculated by summing the actual and projected future credit losses and dividing them by the original balance of each pool of assets. Due to the short-term revolving nature of the consumer loan receivables, the weighted average percentage of static pool credit losses is not considered materially different from the assumed charge-off rates used to determine the fair value of the retained interests.
The Company acts as a servicing agent and receives contractual servicing fees of approximately 2% of the investor principal outstanding. The servicing revenues associated with transferred receivables adequately compensate the Company for servicing the accounts. Accordingly, no material servicing asset or liability has been recorded.
## Securitization Cash Flows
<img src='content_image/13122.jpg'>
(1) Includes all cash receipts of excess spread and other payments (excluding servicing fees) from the Trust to the Company.
For the years ended December 31, 2002 and 2001, the Company recognized $30.1 million and $68.1 million, respectively, in gains related to new securitization transactions accounted for as sales, net of transaction costs. These gains are included in servicing and securitizations income.
## Note S
The Company maintains a risk management strategy that incorporates the use of derivative instruments to minimize significant unplanned fluctuations in earnings caused by interest rate and foreign exchange rate volatility. The Company’s goal is to manage sensitivity to changes in rates by modifying the repricing or maturity characteristics of certain balance sheet assets and liabilities, thereby limiting the impact on earnings. By using derivative instruments, the Company is exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain in a derivative. When the fair value of a derivative contract is positive, this generally indicates that the counterparty owes the Company, and, therefore, creates a repayment risk for the Company. When the fair value of a derivative contract is negative, the Company owes the counterparty, and therefore, has no repayment risk. The Company minimizes the credit (or repayment) risk in derivative instruments by entering into transactions with high-quality counterparties that are reviewed periodically by the Company’s credit committee. The Company also maintains a policy of requiring that all derivative contracts be governed by an International Swaps and Derivatives Association Master Agreement; depending on the nature of the derivative transaction, bilateral collateral agreements may be required as well.
Market risk is the adverse effect that a change in interest rates, currency, or implied volatility rates has on the value of a financial instrument. The Company manages the market risk associated with interest rate and foreign exchange contracts by establishing and monitoring limits as to the types and degree of risk that may be undertaken.
The Company periodically uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps generally involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date. As a result of interest rate fluctuations, hedged assets and liabilities will appreciate or depreciate in market value. To the extent that there is a high degree of correlation between the hedged asset or liability and the derivative instrument, the income or loss generated will generally offset the effect of this unrealized appreciation or depreciation.
The Company’s foreign currency denominated assets and liabilities expose it to foreign currency exchange risk. The Company enters into various foreign exchange derivative contracts for managing foreign currency exchange risk. Changes in the fair value of the derivative instrument effectively offset the related foreign exchange gains or losses on the items to which they are designated.
The Company has non-trading derivatives that do not qualify as hedges. These derivatives are carried at fair value and changes in value are included in current earnings.
The asset/liability management committee, as part of that committee’s oversight of the Company’s asset/liability and treasury functions, monitors the Company’s derivative activities. The Company’s asset/liability management committee is responsible for approving hedging strategies. The resulting strategies are then incorporated into the Company’s overall interest rate risk management strategies.
## Derivative Instruments and Hedging Activities
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The Company has entered into forward exchange contracts to hedge foreign currency denominated investments against fluctuations in exchange rates. The purpose of the Company’s foreign currency hedging activities is to protect the Company from the risk of adverse affects from movements in exchange rates.
During the year ended December 31, 2002 and 2001, the Company recognized substantially no net gains or losses related to the ineffective portions of its fair value hedging instruments.
## CASH FLOW HEDGES
The Company has entered into interest rate swap agreements for the management of its interest rate risk exposure. The interest rate swap agreements utilized by the Company effectively modify the Company’s exposure to interest rate risk by converting floating rate debt to a fixed rate over the next five years. The agreements involve the receipt of fixed rate amounts in exchange for floating rate interest payments over the life of the agreement without an exchange of underlying principal amounts. The Company had entered into interest rate swaps and amortizing notional interest rate swaps to effectively reduce the interest rate sensitivity of anticipated net cash flows of its interest-only strip from securitization transactions over the next four years. During the year ended December 31, 2002, the Company terminated the interest rate swaps and amortizing interest rate swaps that effectively reduced the interest rate sensitivity of anticipated net cash flows of its interest-only strip from securitization transactions. These derivative fair values, net of taxes, were included in cumulative other comprehensive income and will be amortized into interest or servicing and securitizations income over the previous lives of the terminated swaps.
The Company has also entered into currency swaps that effectively convert fixed rate foreign currency denominated interest receipts to fixed dollar interest receipts on foreign currency denominated assets. The purpose of these hedges is to protect against adverse movements in exchange rates over the next four years.
The Company has entered into forward exchange contracts to reduce the Company’s sensitivity to foreign currency exchange rate changes on its foreign currency denominated loans. The forward rate agreements allow the Company to “lock-in” functional currency equivalent cash flows associated with the foreign currency denominated loans.
During the year ended December 31, 2002 and 2001, the Company recognized no net gains or losses related to the ineffective portions of its cash flow hedging instruments. The Company recognized net losses of $1.7 million and $5.1 million during the year ended December 31, 2002 and 2001, respectively, for cash flow hedges that have been discontinued because the forecasted transaction was no longer probable of occurring.
At December 31, 2002, the Company expects to reclassify $55.2 million of net losses, after tax, on derivative instruments from cumulative other comprehensive income to earnings during the next 12 months as terminated swaps are amortized and as interest payments and receipts on derivative instruments occur.
## HEDGE OF NET INVESTMENT IN FOREIGN OPERATIONS
The Company uses cross-currency swaps and forward exchange contracts to protect the value of its investment in its foreign subsidiaries. Realized and unrealized foreign currency gains and losses from these hedges are not included in the income statement, but are shown in the translation adjustments in other comprehensive income. The purpose of these hedges is to protect against adverse movements in exchange rates.
For the years ended December 31, 2002 and 2001, net losses of $3.2 million and $.6 million related to these derivatives were included in the cumulative translation adjustment.
## NON-TRADING DERIVATIVES
The Company uses interest rate swaps to manage interest rate sensitivity related to loan securitizations. The Company enters into interest rate swaps with its securitization trust and essentially offsets the derivative with separate interest rate swaps with third parties.
The Company uses interest rate swaps in conjunction with its auto securitizations that are not designated hedges. These swaps have zero balance notional amounts unless the paydown of auto securitizations differs from its scheduled amortization.
These derivatives do not qualify as hedges and are recorded on the balance sheet at fair value with changes in value included in current earnings. During the year ended December 31, 2002, the Company had net losses of $1.6 million. During 2001, the Company recognized substantially no net gains or losses related to these derivatives.
## Note T
The Company is active in originating consumer loans, primarily in the United States. The Company reviews each potential customer’s credit application and evaluates the applicant’s financial history and ability and willingness to repay. Loans are made primarily on an unsecured basis; however, certain loans require collateral in the form of cash deposits and automobiles serve as collateral for auto loans. International consumer loans are originated primarily in Canada and the United Kingdom. The geographic distribution of the Company’s consumer loans was as follows:
## Significant Concentration of Credit Risk
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## Not U
The following discloses the fair value of financial instruments whether or not recognized in the balance sheets as of December 31, 2002 and 2001. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. As required under GAAP, these disclosures exclude certain financial instruments and all non-financial instruments. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
The Company, in estimating the fair value of its financial instruments as of December 31, 2002 and 2001, used the following methods and assumptions:
## FINANCIALASSETS
## Cash and cash equivalents
The carrying amounts of cash and due from banks, federal funds sold and resale agreements and interest-bearing deposits at other banks approximated fair value.
## Securities available for sale
The fair value of securities available for sale was determined using current market prices. See Note C for fair values by type of security.
## Consumer loans
The net carrying amount of consumer loans approximated fair value due to the relatively short average life and variable interest rates on a substantial number of these loans. This amount excluded any value related to account relationships.
## Interest receivable
The carrying amount approximated the fair value of this asset due to its relatively short-term nature.
## Disclosures About Fair Value of Financial Instruments
## Accounts receivable from securitizations
The carrying amount approximated fair value.
## Derivatives
The carrying amount of derivatives approximated fair value and was represented by the estimated unrealized gains as determined by quoted market prices. This value generally reflects the estimated amounts that the Corporation would have received to terminate the interest rate swaps, currency swaps and forward foreign currency exchange (“f/x”) contracts at the respective dates, taking into account the forward yield curve on the swaps and the forward rates on the currency swaps and f/x contracts. These derivatives are included in other assets on the balance sheet.
## FINANCIAL LIABILITIES
## Interest-bearing deposits
The fair value of interest-bearing deposits was calculated by discounting the future cash flows using estimates of market rates for corresponding contractual terms.
## Other borrowings
The carrying amount of federal funds purchased and resale agreements and other short-term borrowings approximated fair value. The fair value of secured borrowings was calculated by discounting the future cash flows using estimates of market rates for corresponding contractual terms and assumed maturities when no stated final maturity was available. The fair value of the junior subordinated capital income securities was determined based on quoted market prices.
## Senior notes
The fair value of senior notes was determined based on quoted market prices.
## Interest payable
The carrying amount approximated the fair value of this asset due to its relatively short-term nature.
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The carrying amount of derivatives approximated fair value and was represented by the estimated unrealized losses as determined by quoted market prices. This value generally reflects the estimated amounts that the Corporation would have paid to terminate the interest rate swaps, currency swaps and f/x contracts at the respective dates, taking into account the forward yield curve on the swaps and the forward rates on the currency swaps and f/x contracts. These derivatives are included in other liabilities on the balance sheet.
<img src='content_image/32967.jpg'>
## Note V
## International Activities
The Company’s international activities are primarily performed through Capital One Bank (Europe) plc, a subsidiary bank of the Bank that provides consumer lending and other financial products in Europe and Capital One Bank - Canada Branch, a foreign branch office of the Bank that provides consumer lending products in Canada. The total assets, revenue, income before income taxes and net income of the international operations are summarized below.
<img src='content_image/32972.jpg'>
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## Note W
## Capital One Financial Corporation (Parent Company Only) Condensed Financial Information
The information presented in Note B, Segments, is prepared from the Company’s internal management information system used in performance evaluation and resource allocation by management, which is maintained on a line of business level through allocations from legal entities.
<img src='content_image/101208.jpg'>
(1) As of December 31, 2002 and 2001, includes $293.9 million and $122.1 million, respectively, of cash invested at the Bank instead of the open market.
<img src='content_image/101211.jpg'>
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Richard D. Fairbank Chairman and Chief Executive Officer Capital One Financial Corporation
Nigel W. Morris President and Chief Operating Officer Capital One Financial Corporation
W. Ronald Dietz (1)(2) Managing Partner Customer Contact Solutions, LLC
James A. Flick, Jr. (1)(3) President and CEO, Winnow, Inc.
Patrick W. Gross (1)(3) Chairman, Lovell Group
James V. Kimsey (2) Founding CEO and Chairman Emeritus America Online, Inc.
Stanley I. Westreich (2) President and Owner Westfield Realty, Inc.
$^{(1)}$Audit Committee
$^{(2)}$Compensation Committee
$^{(3)}$Nominating and Corporate Governance Committee
## Capital One Financial Corporation Executive Officers
Richard D. Fairbank Chairman and Chief Executive Officer
Nigel W. Morris President and Chief Operating Officer
Gregor Bailar Executive Vice President and Chief Information Officer
Marjorie M. Connelly Executive Vice President, Enterprise Services Group
John G. Finneran, Jr. Executive Vice President, General Counsel and Corporate Secretary
Larry Klane Executive Vice President, Corporate Development
David R. Lawson Senior Vice President and Chief Financial Officer
Dennis H. Liberson Executive Vice President, Human Resources
William J. McDonald Executive Vice President, Brand Management
Peter A. Schnall Executive Vice President, Chief Credit Officer
Catherine G. West Executive Vice President, U.S. Consumer Operations
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## Capital One ® is successfully putting its credit card expertise to work in the broader consumer lending market, where we see big opportunities for profitable long-term growth.
Auto finance, with more than $1 trillion in loans outstanding, is nearly twice the size of the credit card market. After two acquisitions and four years of making auto loans, Capital One has a $7 billion portfolio with steadily improving profitability. Our skill in analyzing credit risk and pricing each loan accordingly creates a win-win situation for us and our customers: we minimize lending risk, they get the best deal. As we’ve built scale, we’ve dramatically cut operating costs, from nearly 10% of loans outstanding in 1999 to 3.57% in 2002.
Our superprime auto finance business continues to grow rapidly despite the auto industry’s offers of low- or no-interest financing. Many consumers who do the math realize that they’ll come out ahead by combining a car manufacturer’s offer of a cash rebate with financing from Capital One Auto Finance. The largest Internet originator of auto loans, Capital One Auto Finance gives superprime borrowers no-hassle service and convenient access to financing, features that are generating exceptionally high levels of customer satisfaction.
In the $175 billion installment lending business, we market personal loans to superprime borrowers, high-income people with long and stellar credit histories. The low risk allows us to offer the loans at an exceptionally low fixed rate—7.9% in many cases, which is five percentage points below the industry average. Installment lending has added $4 billion in blue-chip assets to Capital One’s managed loans.
In 2002, we entered the small-business lending sector. With a Capital One business credit card, a small entrepreneur has hassle-free access to loans for operating capital—a big help in smoothing out cash flow and meeting extraordinary expenses. Our small-business lending is growing rapidly and yielding above-average returns.
The auto finance, installment and small-business lending markets are highly fragmented, presenting opportunities for significant gains in market share. We believe our information-based strategy will allow us to transform these businesses through direct marketing, innovative products and customization. The payoffs: better deals and less hassle for borrowers and new sources of profitable growth for Capital One.
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Annual Meeting Thursday, April 24, 2003, 10:00 a.m. Eastern Time Fairview Park Marriott Hotel 3111 Fairview Park Drive Falls Church, VA 22042
Principal Investor Contact Paul Paquin Vice President, Investor Relations Capital One Financial Corporation 1680 Capital One Drive McLean, VA 22102 (703) 720-1000
Copies of Form 10-K filed with the Securities and Exchange Commission are available without charge, upon written request to Paul Paquin at the above address.
Designed and produced by the Direct Marketing Center of Capital One:
Steve Clifton Jennifer Schaeffer Tom Maher Lance Rodgers Katie Roussel Brent Nultemeier Matthew W. Smith Patty O’Toole Gary Herrmann
Marketing Manager Financials Production Creative Director Art Director Designer Editor Copywriter Copywriter
Common Stock Listed on New York Stock Exchange Stock Symbol COF Member of S&P 500
Corporate Registrar/Transfer Agent EquiServe Trust Company, N.A. c/o EquiServe Share Holder Services P.O. Box 43010 Providence, RI 02940-3010 Facsimile: (201)222-4917 Tel: (800)446-2617 Hearing impaired: (781) 575-2692 E-mail: equiserve.com Internet: www.equiserve.com
By Overnight Courier to: 150 Royall Street Canton, MA 02021
Independent Auditors Ernst & Young LLP
## Corporate Information
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<img src='content_image/104878.jpg'>
<img src='content_image/104876.jpg'>
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Constellation Brands, Inc. is a leading international producer and marketer of beverage alcohol brands with a broad portfolio across the wine, spirits and imported beer categories. Well-known brands in Constellation’s portfolio include: Corona Extra, Pacifico, St. Pauli Girl, Black Velvet, Fleischmann’s, Mr. Boston, Paul Masson Grande Amber Brandy, Franciscan, Estancia, Simi, Ravenswood, Blackstone, Banrock Station, Hardys, Nobilo, Alice White, Vendange, Almaden, Arbor Mist, Stowells and Blackthorn.
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In Fiscal 2004, Constellation Wines expanded its portfolio of popular New World Wines and strengthened its global routes-to-market with the acquisition of BRL Hardy Limited (“Hardy”), Australia’s largest wine company. Additionally, Constellation Wines developed successful new labels from its premium vineyards to meet growing consumer demand, and reorganized its global structure to ensure individual companies continued to be nimble, quick and customer focused with a heightened level of streamlined efficiency to generate positive financial results.
## BROADER PORTFOLIO OF NEW WORLD WINES AND ADDITIONAL ROUTES-TO-MARKET
As a result of the Hardy acquisition, Constellation Wines became the largest wine company in the world and the largest Australian wine producer with a 22 percent share of the Australian wine market. With the growing popularity of Australian wines around the world, supported by the tripling of
Australian wine shipments to the U.S. to 15 million cases over the past five years, and industry expectations that this number may more than double by 2008, Constellation Wines is well positioned to benefit from its broad portfolio of quality Australian wines.
Along with the benefits of owning exciting new Australian wine brands, the Hardy acquisition also brought with it Nobilo Wine Group Limited from New Zealand and expanded global routes-to-market for Constellation Wines’ existing wine portfolio.
## ORGANIZED FOR RESULTS
To ensure the increased breadth and scale of the new global wine portfolio is lever- aged to maximum potential, Constellation Wines reorganized its global operations in 2004 into six operating companies to serve markets in the United States, the United Kingdom and mainland Europe, Australasia and the Rest of the World.
With independent sales, marketing and production functions, each of the
businesses focuses on its geographical area while leveraging the collective global intellectual, creative and financial resources of one of the world’s largest wine companies.
## THE AMERICAN WINE MARKET
As the second largest overall wine producer in the United States and the second largest premium wine company in the United States, Constellation Wines offers American consumers a choice of wines to celebrate any occasion.
In the United States, our focus is on profitable growth by concentrating our investments behind our premium wine brands such as Ravenswood, Covey Run, Blackstone, Banrock Station, Alice White and Hardys. Of the top 100 selling table wines in the U.S., these six brands rank among the fastest growing – twice the number of brands of our closest competitor.
Ravenswood’s popularity is propelling this line of outstanding wines towards the “million case” status, while consumer
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response to Covey Run has driven its sales up 26 percent. Since its acquisition in 2001, Blackstone has emerged as America’s favorite restaurant merlot priced at $30 and under, and sales have tripled to 1.2 million cases. Along with Ravenswood, Simi and Estancia, Blackstone is an excellent example of Constellation Wines’ organic growth through acquisitions.
In the popular wine segment, sales of Almaden wines are approaching ten million cases annually. Almaden has taken the box wine category in an exciting new direction with both Red and White Sangria debuting in innovative box packaging featuring bright, festive graphics.
Capitalizing on the success of Arbor Mist wines with fruit, Constellation Wines successfully launched Arbor Mist Wine Blenders – the first premixed blender beverage made with wine. Available in strawberry, blackberry and peach, Arbor Mist Blenders’ success made an impactful contribution to overall brand growth in excess of 10% in 2004.
## AUSTRALIAN WINE: AN AMERICAN SUCCESS STORY
The continuing demand for Australian wines in the United States presents an exciting opportunity for Constellation Wines. Banrock Station’s rich, full- flavored Australian wines are making a strong impression on American premium wine consumers. Within nine months of Banrock Station’s inter- national launch, its White Shiraz sold more than 60,000 cases. Alice White’s
bold, fruit-driven wines, with 27 percent growth, is one of the fastest-growing Australian wine brands in the U.S.
With consumer-friendly labeling and distinguishing varietal flavor, Australian wines are expected to continue to appeal to American wine consumers. With 20 vine- yards in Australia, and a strong American distribution network, Constellation Wines can offer consumers variety and quality in a range of price points.
## THE U.K. AND EUROPEAN MARKETS
The increasing demand for Australian wines is not restricted to the U.S. With a quarter share of the U.K. wine market, Australia has surpassed France as the dominant wine supplier in the United Kingdom. An added opportunity for Constellation Wines is that California wines have overtaken Italian wines to become the U.K.’s third largest wine source. With production and marketing strengths in both Australian and Californian wines, Constellation Wines is capturing an increasing number of retail outlets as a supplier of choice.
Constellation Wines dominates the U.K. branded wine market with strong sales of Hardys Stamp, Banrock Station, Hardys VR and Stowells, and we expect our position in this key market to grow significantly.
As California wines such as Echo Falls, sold exclusively in the U.K., earn continuing acceptance, Constellation Wines’ market share for U.S. wine in the U.K. should strengthen appreciably. Echo Falls’ 2003 introduction was one of the most successful wine launches in British history.
Constellation Wines also has a strong New Zealand presence in the U.K. The Nobilo brand has experienced a 30 per- cent rise in U.K. sales, driven primarily by the very popular Nobilo Sauvignon Blanc.
An integral part of the continuing success of Constellation Wines’ New World Wine portfolio in the U.K. is Constellation’s wholesale business Matthew Clark, which provides distribution to the on-premise U.K. wine market. This plat- form will continue to propel market share gains for Constellation Wines as well as increase its already strong standing and market share as a wholesaler.
Outstanding opportunities also abound in mainland Europe. A quarter century ago, New World Wines represented one-fourth of one percent of total imported wine sales. Today, it’s approximately 25 percent. Here, and elsewhere outside our core markets, we will continue to build our presence by delivering strong routes-to-market within countries with the best opportunities for New World Wines. We have focused our resources on a number of these targeted markets for the new fiscal year and beyond.
## A VISION OF GROWTH
Today, with operating companies in the United States, England, Europe, Asia, Australia and New Zealand to serve our customers, and over 50 vineyards produc- ing numerous award-winning wines, Constellation Wines has built a position of global strength with an outstanding portfolio of brands. With a broad New World Wine portfolio and strong global routes-to-market, Constellation Wines has the magnitude of brands to continue to deliver wines to suit growing consumer demand for variety and quality, and generate profitable growth.
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Constellation Beers distributes the Modelo portfolio of five highly popular Mexican beers: Corona Extra, Corona Light, Modelo Especial, Negra Modelo, and Pacifico in 25 primarily western states. Constellation Beers also nationally distributes St. Pauli Girl from Germany and Tsingtao from China.
Corona Extra, Corona Light, Modelo Especial, Negra Modelo, Pacifico and St. Pauli Girl all rank among the top 22 selling imported beers, positioning Constellation Beers as a growth leader in the industry.
Corona Extra, our flagship brew, is the seventh largest beer of all types in the United States and the leading imported brand since 1997. Corona Extra’s sales growth of 9 percent last year made it the fastest growing top-ten beer of all beers sold in the United States.
## AUTHENTICITY – A KEY INGREDIENT
A significant element in the popularity of Constellation Beers is authenticity. Unlike
some European, Asian and Australian brands brewed in Canada or the United States for the American market, the complete Modelo portfolio, St. Pauli Girl and Tsingtao are brewed in their country of origin.
Sales of imported beer have risen steadily since 1992 and this trend is expected to continue. The growth in imports has been driven primarily by the success and popularity of Mexican beer, which accounts for 44 percent of this category. Modelo, whose beers represent 87 percent of all Mexican imports, enjoys a compound annual growth of 12 percent over five years in the United States. The performance of the Modelo portfolio continues to be an outstanding growth opportunity for Constellation Beers achieving over 11 percent growth last year. Within our territory, two of every five bottles of imported beer purchased are Modelo products distributed by Constellation Beers.
Early this year, Constellation instituted a price increase for all Modelo brands. This action, driven by natural market forces and the tremendous popularity of these beers, was rolled out on a market and product basis.
## CORONA EXTRA TRANSCENDS ALL CULTURES
While Corona Extra’s national share of U.S. imports is close to 29 percent, its share within Constellation Beers’ territory is 33 percent – twice that of the closest competitor. In the U.S., the consumer preference for Corona Extra is evidenced by the fact that sales of Corona Extra exceed the sales of the number two, three and four imported beers combined.
The success of Corona Extra also transcends cultures. While the Hispanic community accounts for approximately 30 percent of our Mexican beer sales, in America’s most populous state, California, no domestic or imported beer – regular or light – in any package outsells the Corona Extra 12-pack.
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<img src='content_image/94289.jpg'>
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Based on this tremendous success, Constellation Beers worked closely with Modelo in introducing 24-bottle packages of Corona Extra, Corona Light and Pacifico. Twelve-packs of Modelo Especial and Negra Modelo were also redesigned for added sales impact in a cooperative effort between Modelo and Constellation Beers marketing specialists.
Corona Light reflects both the power of the Corona brand and the trend towards lower-calorie brews. While the sale of domestic light beers has grown moderately, the increase in imported light beers has reached double-digits over the past three years. On a national basis, Corona Light’s 17 percent sales growth in 2003 vastly exceeded competitors in the imported light category.
Corona Light, while distributed in concert with Corona Extra, is receiving dedicated marketing support through a sophisticated television campaign which debuted in 2004. Supporting Constellation’s strategy of placing marketing investments behind robust, high-margin brands, this powerful exposure is expected to further boost Corona Light’s sales growth.
## ST. PAULI GIRL DRAFT TO LAUNCH SOON
St. Pauli Girl, the number two imported German beer, realized a 3 percent volume gain last year, a rate of growth faster than the largest-selling German beer in the U.S. To capture an even greater share of the significant on-premise market and build on its performance, Constellation Beers is introducing a draft version of St. Pauli Girl that should prove very attractive to the on-premise consumer.
Perceptive branding decisions, powerful promotions and innovative packaging drive Constellation Beers’ sales and market share. Each of these tactical elements are supported and complemented by strong personal relationships developed throughout our strong routes-to-market.
A natural evolution of shopping patterns that affects the distribution of all consumer products is clearly evident within beer retailing. While on-premise maintains the largest share of the beer market with 25 percent of sales, convenience stores, at
23 percent, have outgrown food chains, 20 percent, and package stores, which serve 16 percent of the market.
## INVESTING IN PEOPLE
Constellation Beers’ response to changing consumer shopping patterns is a specialized channel focus. Here, sales executives are dedicated to serving specific national account categories, both for restaurants and each type of retail chain, including convenience, Hispanic, supermarket, pharmacy, clubs and mass merchandisers. From this perspective, they coordinate marketing programs with geographically based Constellation Beers sales managers assigned specifically to wholesalers.
Specialization of the sales force is critical because different categories of retailers have specific needs requiring a dedicated focus. Smaller stores featuring easy access and quick checkout, for example, generate a tremendous amount of volume in smaller, individualized purchases. Big-box stores, where price is the driving force, require completely separate marketing support.
The wisdom of Constellation Beers’ investment in high- quality sales professionals into the building of brands and relationships with channel partners is underscored by the results of an independent survey of beer distributors. Within the Modelo territory, Constellation Beers’ performance was rewarded with consistently superior marks – our overall effectiveness was judged by wholesalers as second only to the world’s largest brewing company. Constellation Beers achieved top honors in several individual categories, including quality of sales people and effectiveness of incentive programs. Results of this survey are reflected within performance evaluations of the individual members of the sales force and management team.
All indications point towards continued solid growth for Constellation Beers in sales and market share in fiscal 2005. The basis for this confidence lies not only in the popularity of imported beers, it is also underscored by the powerfully strong bonds consumers developed with our brands, and further sustained by insightful decisions regarding marketing and manpower support.
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Constellation Spirits’ leadership position, broad portfolio of popular priced brands and expanding breadth of premium niche spirits beverages have benefited from the overall growth in the spirits industry over the past six years. Several demographic trends have contributed favorably to spirits consumption, as have timely innovations throughout the industry and the renewed popularity of classic cocktails.
## LEADING INDUSTRY POSITION
Constellation Spirits is the third largest U.S. spirits company by volume, with a 10 percent share of the market. Because the industry is highly regionalized, with smaller producers holding strong niche positions, the importance of Constellation Spirits’ ranking as either number one or number two in Wisconsin, Kentucky, Nebraska, Iowa Montana, New York, Georgia, Florida, Colorado and Arizona is noteworthy.
Constellation Spirits’ leading brand is Black Velvet Canadian Whisky. As an industry, all Canadian Whiskies grew only 0.3 percent last year. Sales growth for Black Velvet, however, was tenfold
that of the entire category – up a full three percent. As the top growth performer in its category, Black Velvet gained critical market share in this important sector. Overall, Black Velvet is the 16th leading distilled spirit brand in the U.S., and the number one seller in three states. After a complete repackaging last year, Black Velvet Reserve, a premium 8-year-old Canadian Whisky, experienced a 29 percent case growth. This is another example of Constellation’s strategy of investing marketing funds behind higher-margin premium brands to maximize returns.
## EXTENSIVE PORTFOLIO
Constellation Spirits serves distributors and customers with a full portfolio of white, brown and specialty distilled spirits. Brown spirits include Scotch, American blends, Canadian Whisky and bourbon, while the white category covers gin, vodka, rum and tequila. Specialties include brandy, cordials and prepared cocktails.
Because of the volume of Black Velvet and its other whisky brands, Constellation Spirits has a significantly higher
proportion of its spirits business in the brown sector, than the industry at large. Further, brands such as Barton, Sköl and Fleischmann’s provide the company with a very strong represen- tation in the vodka category, the largest of all segments in the U.S. spirits industry.
## SUCCESSFUL PRODUCT INNOVATION
Constellation Spirits’ strategy is to maintain our strength where we have a major presence, and invest in higher- margin opportunities in underserved categories. Recent new product extensions and developments support this philosophy.
Beachcomber flavored rums are a powerful addition to one of the fastest growing product groups in the spirits industry. Featuring four popular flavors: coconut, pineapple, spiced and apple, Beachcomber rums generated shipments of almost 25,000 cases in their first year.
Chi-Chi’s added Mango Margarita to its line of pre-mixed cocktails last year, which helped boost brand sales over six percent.
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<img src='content_image/56841.jpg'>
<img src='content_image/56842.jpg'>
Barton’s Blue Wave is a blue raspberry flavored vodka – a prime ingredient in colorful cocktails popular among young adult consumers.
The 99 line of 99 proof schnapps has grown in popularity since their intro- duction eight years ago. The growth of this high-margin product has consider- ably strengthened our position in the cordial and liqueur category. 99 brand sales jumped 13 percent to over 90,000 cases on the growth of all three flavors: banana, apple and blackberry. Responding to this highly auspicious marketplace reception, Constellation Spirits will introduce 99 Oranges this year.
Caravella Limoncello and Orangecello imported from Milan, Italy, offer consumers the opportunity to experience
<img src='content_image/56843.jpg'>
this authentic Italian liqueur. The 64 and 60 proof drinks are commonly consumed ice-cold, neat or served in a mixed drink. Limoncello is also a flavored ingredient in the highly popular lemon martini.
These newly introduced, flavorful brands join a full array of successful Constellation Spirits products which compete in traditional categories.
## STRONG GROWTH CONTINUES
Speyburn, a ten-year-old, single-malt scotch whisky, priced under $20, out- performed the entire single malt sector by growing 12 percent. The Speyburn brand was founded in 1897, in the Speyside region of the Scottish Highlands. It is the only distillery to use the soft Speyside water from the Granty Burn, a major tributary of the River Spey.
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## FINANCIAL HIGHLIGHTS
For the Years Ended February 29 and 28 (in thousands, except per share data)
<img src='content_image/40855.jpg'>
*Comparable measures are provided because management uses this information in evaluating the results of the continuing operations of the Company and internal goal setting. In addition, the Company believes this information provides investors better insight on underlying business trends and results in order to evaluate year-over-year financial performance. The comparable financial results reflect the exclusion of: (i) the benefit from relief of excise taxes and duty taxes related to prior years of $9,185 and $2,342, respectively, and the associated costs of $1,093 for 2004; (ii) inventory step-up (cost of product sold) associated with the Hardy acquisition of $22,472 for 2004; (iii) the write-down of concentrate inventory in connection with the Company’s decision to exit the commodity concentrate product line in the U.S. of $16,827 for 2004; (iv) amortization expense of $11,572 for 2004 for deferred financing costs associated with noncontinuing financing, primarily related to the bridge loan agreement in connection with the Hardy acquisition; (v) loss on extinguishment of debt of $2,590 for 2002; (vi) amortization expense of $27,299, $19,504 and $19,792 for 2002 through 2000, respectively, reflecting the impact of SFAS 142 (goodwill amortization) as if it had been adopted as of March 1, 1999; (vii) restructuring and related charges of $31,154 for 2004 and $4,764 for 2003; (viii) non-recurring charges of $5,510 for 2000; (ix) imputed interest charges associated with the Hardy acquisition of $1,658 for 2004; (x) a gain on change in fair value of derivative instruments associated with financing the Hardy acquisition of $1,181 for 2004 and $23,129 for 2003. All amounts are on a pre-tax basis. Net income and earnings per share amounts on a comparable basis are net of income taxes at a rate of 36% for 2004, 39.3% for 2003 and 40% for 2002-2000.
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<img src='content_image/71140.jpg'>
Montezuma, the industry’s third largest selling tequila, is an important contributor to the portfolio. Montezuma profits grew over 40 percent in fiscal 2004.
Barton Gin and Barton Vodka represent over 1.5 million cases in sales. Fleischmann’s Vodka, the largest selling spirit in Wisconsin, generated growth of 3 percent higher than the previous year.
Specialty product sales growth was also driven by Mr. Boston flavored brandies/schnapps, Chi-Chi’s prepared drinks and the di Amore line of liqueurs which includes amaretto, sambuca and raspberry flavors.
Paul Masson Grande Amber Brandy is the industry’s number two domestically produced product in its category.
Placing marketing investments behind growth brands has served Constellation Spirits well. Further margin enhancements are generated through skillful operation of the business. By proficiently managing the wide breadth and broad scale of our beverage alcohol products, Constellation Spirits creates produc- tion economies that facilitate manufac- turing cost savings and distribution efficiencies. Significantly, Constellation Spirits produced nearly 20 million 9-liter cases of spirits last year – of which four million were produced/bottled for third parties. Here, we leveraged our scale to appreciably reduce average costs.
The future for Constellation Spirits is strong with growth trends continuing and opportunities for successful new product innovation an ongoing part of the growth strategy.
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## CONSTELLATION BEERS
## CHINA
Tsingtao
## GERMANY
St. Pauli Dark St. Pauli Girl St. Pauli NA
## MEXICO
Corona Extra Corona Light Modelo Especial Negra Modelo Pacifico
## CONSTELLATION SPIRITS
## WHISKEY BLENDS
Barton Fleischmann’s Imperial Old Thompson Royale Club Schenley Reserve
## BOURBON
Barclay’s Colonel Lee Kentucky Gentleman Kentucky Tavern 1792 Ten High Tom Moore Very Old Barton
## BRANDY
Barton Fleischmann’s CSR Hartley Jacques Bonet Mr. Boston Paul Masson Grande Amber
## CANADIAN WHISKY
Barton Black Velvet Canadian Host Canadian LTD Canadian Supreme Corby’s Golden Wedding MacNaughton McMaster’s Northern Light Schenley OFC
## COCKTAILS
Chi-Chi’s Mr. Boston
## CORDIAL/OTHER
di Amore Amaretto de Sabroso Barton Caravella Heather Cream Liqueur Montezuma Mr. Boston Paul Masson Cream Liqueur Sabroso Coffee Liqueur Spinelli Asti Spumante
## GIN
Barton Crystal Palace Czarina Fleischmann’s Glenmore Mr. Boston Schenley London Dry Sköl
## RUM
Barton Beachcomber Calypso Fleischmann’s Mr. Boston Sköl
## SCHNAPPS
99 Barton Mr. Boston
## SCOTCH
Highland Mist House of Stuart Inver House Lauder’s Old Pulteney Single Malt Speyburn Single Malt
## TEQUILA/MEZCAL
Capitan El Toro Monte Alban Mezcal Montezuma
## VODKA
Barton Blue Lightning Blue Wave Crystal Palace Czarina Fleischmann’s Glenmore Mr. Boston Schenley Superior Silver Wedding Sköl
## CONSTELLATION WINES (SOLD IN THE U.S.)
## FINE WINE
Barossa Valley E&E Chateau Reynella Columbia Drylands Eileen Hardy Estancia Franciscan Oakville Estate Leasingham Mount Veeder Quintessa Ravenswood Simi Tintara Yarra Burn
## PREMIUM WINE
Alice White Banrock Station Barossa Valley Estate Blackstone Brookland Valley Coastal Vintners Covey Run Dunnewood Farallon Hardys Hayman & Hill LaTerre Nobilo Paul Thomas Seventh Moon Starvedog Lane Ste. Chapelle Talus Veramonte Viña Santa Carolina
## POPULAR WINE
Almaden Arbor Mist Arbor Mist Wine Blenders Heritage Inglenook Manischewitz Nathanson Creek Paul Masson St. Regis – Non Alcohol Taylor California Cellars Vendange
## SPARKLING WINE
Cook’s Great Western J. Roget Mondoro
## DESSERT WINE
Cisco Cribari Paul Masson Taylor Wild Irish Rose
## CONSTELLATION WINES (SOLD IN THE U.K.)
## FINE WINE
Barossa Valley Estate E&E Chateau Reynella Drylands Eileen Hardy Estancia Leasingham Yarra Burn
## PREMIUM WINE
Banrock Station Barossa Valley Estate Black Tower Blackstone Echo Falls Hardys Houghton Keo Nobilo Ravenswood Seventh Moon Shamwari Stonehaven Talus Veramonte
## POPULAR WINE
Arbor Mist Nathanson Creek Paul Masson Stowells The Bend in the River Vendange
## WINE STYLE DRINKS
Babycham Biancella Concorde Country Manor Pink Lady Rougemont
## FORTIFIED BRITISH WINES/OTHER
Armadillo Cherry B K Ice (FAB) Old England Pony QC Sanatogen Scotsmac Snowball Stones Ginger Wine Tudor Rose VP Whiteways
## CIDER
Addlestones Blackthorn Cidermaster Copperhead Diamond White/Red Gaymers Olde English Ice Dragon K Natch Old Somerset Red C Special Vat Traditional White Star
## WATER
Strathmore – still, sparkling and flavored bottled waters
## MATTHEW CLARK WHOLESALE
The #1 independent com- posite drinks wholesaler in the U.K.
## CONSTELLATION WINES (SOLD IN AUSTRALIA)
## FINE WINE
Barossa Valley Estate E&E Drylands Eileen Hardy Houghton Jack Mann Leasingham
## PREMIUM WINE
Banrock Station Barossa Valley Estate Brookland Valley Hardys Houghton Moondah Brook Nobilo Starvedog Stonehaven Yarra Burn
## POPULAR WINE
Berri Estates Renmano Stanley Wines
## SPARKLING WINE
Omni Sir James
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<img src='content_image/65515.jpg'>
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] | overall_image/f229365166481f8c66f766e6447c24a47553b34f8088e810a862e38ecc1bf582.png | ## SELECTED FINANCIAL DATA. FIVE-YEAR STATEMENTS OF INCOME
For the Years Ended February 29 and 28 (in thousands, except per share data)
<img src='content_image/132496.jpg'>
(1) Effective March 1, 2003, the Company completed its adoption of Statement of Financial Accounting Standards No. 145 (“SFAS No. 145”), “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” Accordingly, the adoption of the provisions rescinding Statement of Financial Accounting Standards No. 4 (“SFAS No. 4”), “Reporting Gains and Losses from Extinguishment of Debt,” resulted in a reclassification of the extraordinary loss related to the extinguishment of debt recorded in the fourth quarter of fiscal 2002 ($1.6 million, net of income taxes), by increasing selling, general and administrative expenses ($2.6 million) and decreasing the provision for income taxes ($1.0 million).
(2) For a detailed discussion of restructuring and related charges for the years ended February 29, 2004, and February 28, 2003, see Management’s Discussion and Analysis of Financial Condition and Results of Operations under the captions “Fiscal 2004 Compared to Fiscal 2003 – Restructuring and Related Charges” and “Fiscal 2003 Compared to Fiscal 2002 – Restructuring and Related Charges,” respectively.
(3) The Company incurred nonrecurring charges of $5.5 million for the year ended February 29, 2000, related to (i) the closure of a cider production facility within the U.K. Brands and Wholesale segment in the United Kingdom and (ii) a management reorganization within the Popular and Premium Wine segment in the United States.
(4) All per share data have been adjusted to give effect to the two-for-one splits of the Company’s two classes of common stock in each of May 2002 and May 2001.
(5) Effective March 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142 (“SFAS No. 142”), “Goodwill and Other Intangible Assets.”
For the years ended February 29, 2004, and February 28, 2003, see Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and notes thereto.
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## OVERVIEW
The Company generates revenue through the production, marketing and sale of beverage alcohol products, primarily in North America, Europe and Australia. The Company has a broad portfolio of brands across the wine, imported beer and distilled spirits categories, and with the acquisition of Hardy in Fiscal 2004 solidified its position as the world’s largest wine company.
The Company’s business strategy is to remain focused across the beverage alcohol industry by offering a broad range of prod- ucts in each of the Company’s three major categories: wine, beer and spirits. The Company intends to keep its portfolio positioned for superior top-line growth while maximizing the profitability of its brands. In addition, the Company seeks to increase its rela- tive importance to key customers in major markets by increasing its share of their overall purchasing, which is increasingly impor- tant in a consolidating industry. The Company’s strategy of breadth across categories and geographies, and strengthening scale in core markets, is designed to deliver long-term profitable growth. This strategy allows the Company more investment choices, pro- vides flexibility to address changing market conditions and creates stronger routes-to-market.
The Company’s businesses fall within one of two areas: growth or scale. The growth businesses represent approximately 60% of the Company’s Fiscal 2004 net sales and include approximately half of the Company’s branded wine business (specifically pre- mium wines in the U.S. and wines in the U.K.), imported beer in the U.S. and the U.K. wholesale business. The scale businesses rep- resent approximately 40% of Fiscal 2004 net sales and include spirits, the remaining half of the Company’s branded wine business, cider, and non-branded sales. The scale businesses are operated to maximize profitability and cash flow and to maintain strong routes-to-market. With a solid foundation of growth and scale businesses, the Company expects to continue to be able to leverage sales growth into even higher growth in earnings and cash flow.
The U.S. beer industry has experienced a healthy pricing environment over the last several years; however, this could change due to market dynamics. Beginning January 2004, the Company raised prices to its wholesalers on the Company’s imported Mexican beer brands. The timing of this price increase resulted in a shift in sales volume from Fiscal 2005 to Fiscal 2004 due to wholesaler buy-in ahead of the price increase. As a result of the wholesaler buy-in and as retailers and consumers adapt to the high- er price, the Company expects a negative impact on volume trends for Fiscal 2005.
The Company remains committed to its long-term financial model of growing sales (both organically and through acquisitions), expanding margins and increasing cash flow to achieve superior earnings per share growth and improve return on invested capital.
## INTRODUCTION
The Company is a leading international producer and marketer of beverage alcohol brands with a broad portfolio across the wine, spirits and imported beer categories. The Company has the largest wine business in the world and is the largest multi-catego- ry supplier of beverage alcohol in the United States; a leading producer and exporter of wine from Australia and New Zealand; and both a major producer and independent drinks wholesaler in the United Kingdom.
Through February 28, 2003, the Company reported its operating results in five segments: Popular and Premium Wine (brand- ed popular and premium wine and brandy, and other, primarily grape juice concentrate and bulk wine); Imported Beer and Spirits (primarily imported beer and distilled spirits); U.K. Brands and Wholesale (branded wine, cider, and bottled water, and wholesale wine, distilled spirits, cider, beer, RTDs and soft drinks); Fine Wine (primarily branded super-premium and ultra-premium wine); and Corporate Operations and Other (primarily corporate related items). As a result of the Hardy Acquisition (as defined below), the Company has changed the structure of its internal organization to consist of two business divisions, Constellation Wines and Constellation Beers and Spirits. Separate division chief executives report directly to the Company’s chief operating officer. Consequently, the Company reports its operating results in three segments: Constellation Wines (branded wine, and U.K. whole- sale and other), Constellation Beers and Spirits (imported beer and distilled spirits) and Corporate Operations and Other (primari- ly corporate related items and other). Amounts included in the Corporate Operations and Other segment consist of general corpo- rate administration and finance expenses. These amounts include costs of executive management, investor relations, internal audit, treasury, tax, corporate development, legal, financial reporting, professional fees and public relations. Any costs incurred at the cor- porate office that are applicable to the segments are allocated to the appropriate segment. The amounts included in the Corporate Operations and Other segment are general costs that are applicable to the consolidated group and are therefore not allocated to the other reportable segments. All costs reported within the Corporate Operations and Other segment are not included in the chief oper- ating decision maker’s evaluation of the operating income performance of the other operating segments. The new business segments reflect how the Company’s operations are being managed, how operating performance within the Company is being evaluated by senior management and the structure of its internal financial reporting. In addition, the Company changed its definition of operat- ing income for segment purposes to exclude restructuring and related charges and unusual costs that affect comparability. Accordingly, the financial information for Fiscal 2003 and Fiscal 2002 (as defined below) have been restated to conform to the new segment presentation.
The following discussion and analysis summarizes the significant factors affecting (i) consolidated results of operations of the Company for the year ended February 29, 2004 (“Fiscal 2004”), compared to the year ended February 28, 2003 (“Fiscal 2003”),
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As discussed in Note 1 to the financial statements, the Company adopted SFAS No. 142 on March 1, 2002. Upon the adop- tion of SFAS No. 142, the Company ceased amortization of goodwill and indefinite lived intangible assets. Retroactive application of SFAS No. 142 is not permitted.
## ACQUISITIONS IN FISCAL 2004, FISCAL 2003 AND FISCAL 2002 AND JOINT VENTURE
## Acquisition of Hardy
On March 27, 2003, the Company acquired control of BRL Hardy Limited, now known as Hardy Wine Company Limited (“Hardy”), and on April 9, 2003, the Company completed its acquisition of all of Hardy’s outstanding capital stock. As a result of the acquisition of Hardy, the Company also acquired the remaining 50% ownership of Pacific Wine Partners LLC (“PWP”), the joint venture the Company established with Hardy in July 2001. The acquisition of Hardy along with the remaining interest in PWP is referred to together as the “Hardy Acquisition.” Through this acquisition, the Company acquired Australia’s largest wine pro- ducer with interests in wineries and vineyards in most of Australia’s major wine regions as well as New Zealand and the United States. Hardy has a comprehensive portfolio of wine products across all price points with a strong focus on premium wine produc- tion. Hardy’s wines are distributed worldwide through a network of marketing and sales operations, with the majority of sales gen- erated in Australia, the United Kingdom and the United States.
Total consideration paid in cash and Class A Common Stock to the Hardy shareholders was $1,137.4 million. Additionally, the Company recorded direct acquisition costs of $17.7 million. The acquisition date for accounting purposes is March 27, 2003. The Company has recorded a $1.6 million reduction in the purchase price to reflect imputed interest between the accounting acqui- sition date and the final payment of consideration. This charge is included as interest expense in the Consolidated Statement of Income for the year ended February 29, 2004. The cash portion of the purchase price paid to the Hardy shareholders and option- holders ($1,060.2 million) was financed with $660.2 million of borrowings under the Company’s March 2003 Credit Agreement (as defined below) and $400.0 million of borrowings under the Company’s Bridge Agreement (as defined below). Additionally, the Company issued 3,288,913 shares of the Company’s Class A Common Stock, which were valued at $77.2 million based on the sim- ple average of the closing market price of the Company’s Class A Common Stock beginning two days before and ending two days after April 4, 2003, the day the Hardy shareholders elected the form of consideration they wished to receive. The purchase price was based primarily on a discounted cash flow analysis that contemplated, among other things, the value of a broader geographic distribution in strategic international markets and a presence in the important Australian winemaking regions. The Company and Hardy have complementary businesses that share a common growth orientation and operating philosophy. The Hardy Acquisition supports the Company’s strategy of growth and breadth across categories and geographies, and strengthens its competitive position in its core markets. The purchase price and resulting goodwill were primarily based on the growth opportunities of the brand port- folio of Hardy. In particular, the Company believes there are growth opportunities for Australian wines in the United Kingdom, United States and other wine markets. This acquisition supports the Company’s strategy of driving long-term growth and positions the Company to capitalize on the growth opportunities in “new world” wine markets.
The results of operations of Hardy and PWP have been reported in the Company’s Constellation Wines segment as of March 27, 2003.
## Acquisition of Ravenswood Winery
On July 2, 2001, the Company acquired all of the outstanding capital stock of Ravenswood Winery, Inc. (the “Ravenswood Acquisition”), a leading premium wine producer based in Sonoma, California. On June 30, 2002, Ravenswood Winery, Inc. was merged into Franciscan Vineyards, Inc. (a wholly-owned subsidiary of the Company). The Ravenswood business produces, markets and sells super-premium and ultra-premium California wine, primarily under the Ravenswood brand name. The vast majority of the wine the Ravenswood business produces and sells is red wine, including the number one super-premium Zinfandel in the United States. The results of operations of the Ravenswood business are reported in the Constellation Wines segment and have been includ- ed in the consolidated results of operations of the Company since the date of acquisition.
## Acquisition of the Corus Assets
On March 26, 2001, in an asset acquisition, the Company acquired certain wine brands, wineries, working capital (primarily inventories), and other related assets from Corus Brands, Inc. (the “Corus Assets”). In this acquisition, the Company acquired sev- eral well-known premium wine brands primarily sold in the northwestern United States, including Covey Run, Columbia, Ste. Chapelle and Alice White. In connection with the transaction, the Company also entered into long-term grape supply agreements with affiliates of Corus Brands, Inc. covering more than 1,000 acres of Washington and Idaho vineyards. The results of operations of the Corus Assets are reported in the Constellation Wines segment and have been included in the consolidated results of opera- tions of the Company since the date of acquisition.
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On March 5, 2001, in an asset acquisition, the Company acquired several well-known premium wine brands, including Vendange, Nathanson Creek, Heritage, and Talus, working capital (primarily inventories), two wineries in California, and other related assets from Sebastiani Vineyards, Inc. and Tuolomne River Vintners Group (the “Turner Road Vintners Assets”). The results of operations of the Turner Road Vintners Assets are reported in the Constellation Wines segment and have been included in the consolidated results of operations of the Company since the date of acquisition.
## Pacific Wine Partners
On July 31, 2001, the Company and Hardy completed the formation of PWP, a joint venture owned equally by the Company and Hardy through March 26, 2003. Pacific Wine Partners LLC (“PWP”) produces, markets and sells a portfolio of premium wine in the United States, including a range of Australian imports. PWP also exports certain of its U.S.-produced wines to other coun- tries. In connection with the initial formation of the joint venture, PWP was given the exclusive distribution rights in the United States and the Caribbean to several brands, including Banrock Station, Hardys, Leasingham, Barossa Valley Estate and Chateau Reynella from Australia; and Nobilo from New Zealand. PWP also owns Farallon, a premium California coastal wine. In addi- tion, PWP owns a winery and controls 1,400 acres of vineyards in Monterey County, California.
On October 16, 2001, the Company announced that PWP completed the purchase of certain assets of Blackstone Winery, including the Blackstone brand and the Codera wine business in Sonoma County.
As a result of the Hardy Acquisition, PWP became a wholly-owned subsidiary of the Company. Accordingly, as noted above, its results of operations have been consolidated and reported in the Constellation Wines segment since March 27, 2003. Prior to March 27, 2003, the investment in PWP was accounted for using the equity method; accordingly, the results of operations of PWP from July 31, 2001, through March 26, 2003, were included in the equity in earnings of joint ventures line in the Consolidated Statements of Income of the Company.
## RESULTS OF OPERATIONS
## FISCAL 2004 COMPARED TO FISCAL 2003
## Net Sales
The following table sets forth the net sales (in thousands of dollars) by operating segment of the Company for Fiscal 2004 and Fiscal 2003.
<img src='content_image/39018.jpg'>
Net sales for Fiscal 2004 increased to $3,552.4 million from $2,731.6 million for Fiscal 2003, an increase of $820.8 million, or 30.0%. This increase resulted primarily from the inclusion of $571.4 million of net sales of products acquired in the Hardy Acquisition as well as increases in imported beer sales of $86.6 million and U.K. wholesale sales of $61.1 million (on a local curren- cy basis). In addition, net sales benefited from a favorable foreign currency impact of $74.6 million.
## Constellation Wines
Net sales for the Constellation Wines segment for Fiscal 2004 increased to $2,396.1 million from $1,673.3 million for Fiscal 2003, an increase of $722.8 million, or 43.2%. Branded wine net sales increased $566.2 million, primarily due to the addition of $548.4 million of net sales of branded wine acquired in the Hardy Acquisition. Wholesale and other net sales increased $156.5 mil- lion primarily due to a favorable foreign currency impact of $63.1 million, growth in the U.K. wholesale business of $61.1 million
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## Constellation Beers and Spirits
Net sales for the Constellation Beers and Spirits segment for Fiscal 2004 increased to $1,147.2 million from $1,058.3 million for Fiscal 2003, an increase of $88.9 million, or 8.4%. This increase resulted primarily from volume gains on the Company’s imported beer portfolio, which increased $86.6 million. Spirits net sales remained relatively flat as increased branded spirits sales were offset by lower bulk whisky and contract production sales.
## Gross Profit
The Company’s gross profit increased to $975.8 million for Fiscal 2004 from $760.7 million for Fiscal 2003, an increase of $215.1 million, or 28.3%. The Constellation Wines segment’s gross profit increased $200.4 million primarily due to gross profit on the sales of branded wine acquired in the Hardy Acquisition. The Constellation Beers and Spirits segment’s gross profit increased $42.5 million primarily due to the volume growth in the segment’s imported beer portfolio. These increases were partially offset by $27.8 million of net unusual costs which consist of certain items that are excluded by management in their evaluation of the results of each operating segment. These net costs represent the flow through of inventory step-up associated with the Hardy Acquisition of $22.5 million and the write-down of concentrate inventory recorded in connection with the Company’s decision to exit the commodity concentrate product line of $16.8 million (see additional discussion under “Restructuring and Related Charges” below), partially offset by the relief from certain excise tax, duty and other costs incurred in prior years of $11.5 million, which was recognized in the fourth quarter of fiscal 2004. Gross profit as a percent of net sales decreased slightly to 27.5% for Fiscal 2004 from 27.8% for Fiscal 2003 as an increase in gross profit margin from sales of higher margin wine brands acquired in the Hardy Acquisition was more than offset by the net unusual costs discussed above and a decrease in gross profit margin on the Constellation Wines’ U.K. wholesale business.
## Selling, General and Administrative Expenses
Selling, general and administrative expenses increased to $457.3 million for Fiscal 2004 from $351.0 million for Fiscal 2003, an increase of $106.3 million, or 30.3%. The Constellation Wines segment’s selling, general and administrative expenses increased $76.8 million primarily due to $67.7 million of selling, general and administrative expenses from the addition of the Hardy and PWP businesses. The Constellation Beers and Spirits segment’s selling, general and administrative expenses increased $7.9 million due to increased imported beer and spirits advertising and selling expenses to support the growth across this segment’s businesses, partially offset by foreign currency gains. The Corporate Operations and Other segment’s general and administrative expenses increased $8.9 million primarily due to additional deferred financing costs associated with the Company’s new bank credit facility and increased general and administrative expenses to support the Company’s growth. In addition, there was a $12.7 million increase in selling, general and administrative expenses related to unusual costs which consist of certain items that are excluded by manage- ment in their evaluation of the results of each operating segment. These costs consist primarily of the additional amortized deferred financing costs associated with the bridge financing in connection with the Hardy Acquisition of $11.6 million. Selling, general and administrative expenses as a percent of net sales increased slightly to 12.9% for Fiscal 2004 as compared to 12.8% for Fiscal 2003 due primarily to the unusual costs and the increased general and administrative expenses within the Corporate Operations and Other segment.
## Restructuring and Related Charges
The Company recorded $31.2 million of restructuring and related charges for Fiscal 2004 associated with the restructuring plan of the Constellation Wines segment. Restructuring and related charges resulted from (i) $10.0 million related to the realignment of business operations and (ii) $21.2 million related to exiting the commodity concentrate product line in the U.S. and selling its win- ery located in Escalon, California. In total, the Company recorded $38.0 million of costs associated with exiting the commodity concentrate product line and selling its Escalon facility allocated between cost of product sold ($16.8 million) and restructuring and related charges ($21.2 million).
The Company recorded $4.8 million of restructuring and related charges for Fiscal 2003 associated with an asset impairment charge in connection with two of Constellation Wines segment’s production facilities.
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Approximately half of the total charges in connection with exiting the commodity concentrate product line and selling the Escalon facility are non-cash charges.
## Operating Income
The following table sets forth the operating income (loss) (in thousands of dollars) by operating segment of the Company for Fiscal 2004 and Fiscal 2003.
<img src='content_image/2397.jpg'>
Restructuring and related charges and unusual costs of $71.6 million and $4.8 million for Fiscal 2004 and Fiscal 2003, respec- tively, consist of certain costs that are excluded by management in their evaluation of the results of each operating segment. Fiscal 2004 costs represent the flow through of inventory step-up and the amortization of deferred financing costs associated with the Hardy Acquisition of $22.5 million and $11.6 million, respectively, and costs associated with exiting the commodity concentrate product line and the Company’s realignment of its business operations in the wine segment, including the write-down of concen- trate inventory of $16.8 million and restructuring and related charges of $31.2 million, partially offset by the relief from certain excise taxes, duty and other costs incurred in prior years of $10.4 million. Fiscal 2003 costs represent restructuring and related charges associated with the Company’s realignment of its business operations in the wine segment. As a result of these costs and the above factors, consolidated operating income increased to $487.4 million for Fiscal 2004 from $405.0 million for Fiscal 2003, an increase of $82.4 million, or 20.3%.
## Gain on Change in Fair Value of Derivative Instruments
The Company entered into a foreign currency collar contract in February 2003 in connection with the Hardy Acquisition to lock in a range for the cost of the acquisition in U.S. dollars. As of February 28, 2003, this derivative instrument had a fair value of $23.1 million. Under SFAS No. 133, a transaction that involves a business combination is not eligible for hedge accounting treat- ment. As such, the derivative was recorded on the balance sheet at its fair value with the change in the fair value recognized sepa- rately on the Company’s Consolidated Statements of Income. During the first quarter of Fiscal 2004, the gain on change in fair value of the derivative instrument of $1.2 million was recognized separately on the Company’s Consolidated Statement of Income.
## Equity in Earnings of Joint Ventures
The Company’s equity in earnings of joint ventures decreased to $0.5 million in Fiscal 2004 from $12.2 million in Fiscal 2003 due to the acquisition of the remaining 50% ownership of PWP in March 2003 resulting in consolidation of PWP’s results of oper- ations since the date of acquisition.
## Interest Expense, Net
Interest expense, net of interest income of $3.6 million and $0.8 million for Fiscal 2004 and Fiscal 2003, respectively, increased to $144.7 million for Fiscal 2004 from $105.4 million for Fiscal 2003, an increase of $39.3 million, or 37.3%. The increase result- ed from higher average borrowings due to the financing of the Hardy Acquisition, partially offset by a lower average borrowing rate, and $1.7 million of imputed interest expense related to the Hardy Acquisition.
## Provision for Income Taxes
The Company’s effective tax rate for Fiscal 2004 declined to 36.0% from 39.3% for Fiscal 2003 as a result of the Hardy Acquisition, which significantly increased the allocation of income to jurisdictions with lower income tax rates.
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As a result of the above factors, net income increased to $220.4 million for Fiscal 2004 from $203.3 million for Fiscal 2003, an increase of $17.1 million, or 8.4%.
## FISCAL 2003 COMPARED TO FISCAL 2002
## Net Sales
The following table sets forth the net sales (in thousands of dollars) by operating segment of the Company for Fiscal 2003 and Fiscal 2002.
<img src='content_image/27919.jpg'>
Net sales for Fiscal 2003 increased to $2,731.6 million from $2,606.8 million for Fiscal 2002, an increase of $124.9 million, or 4.8%. This increase resulted primarily from increased sales of imported beer of $49.1 million and the impact of foreign curren- cy changes of $50.7 million in the Constellation Wines segment. Also contributing to the sales growth were increased sales in U.K. wholesale of $28.6 million (on a local currency basis), fine wine sales of $23.8 million and spirits sales of $7.6 million, offset by lower bulk wine, grape juice concentrate sales of $14.7 million, popular and premium branded wine sales of $13.9 million and U.K. branded sales of $9.4 million (on a local currency basis).
## Constellation Wines
Net sales for the Constellation Wines segment for Fiscal 2003 increased to $1,673.3 million from $1,605.1 million for Fiscal 2002, an increase of $68.2 million, or 4.2%. Branded wines sales increased $20.0 million due to increased fine wine sales of $23.8 million and a favorable foreign currency impact of $9.3 million partially offset by lower popular and premium wine sales of $13.9 million. The increase in fine wine sales resulted from an additional four months of sales of the brands acquired in the acquisition of Ravenswood Winery, Inc. (“Ravenswood”), completed in July 2001, of $14.1 million, as well as an increase of $9.7 million due to volume growth in the fine wine business partially offset by higher promotional costs and a shift towards lower priced fine wine brands. Popular and premium wine sales declined $13.9 million on lower volume offset slightly by higher average selling prices. Volumes were negatively impacted as a result of increased promotional spending in the industry, which the Company did not par- ticipate in heavily. In this competitive pricing environment, the Company continues to be selective in its promotional activities, focus- ing instead on growth areas, long-term brand building initiatives and increased profitability. Wholesale and other sales increased $48.2 million primarily due to a favorable foreign currency impact of $41.4 million and a $28.6 million local currency increase in U.K. wholesale sales due to the addition of new accounts and increased average delivery sizes, partially offset by lower bulk wine, grape juice concentrate and cider sales of $24.7 million.
## Constellation Beers and Spirits
Net sales for the Constellation Beers and Spirits segment for Fiscal 2003 increased to $1,058.3 million from $1,001.7 million for Fiscal 2002, an increase of $56.7 million, or 5.7%. This increase resulted primarily from a $49.1 million increase in imported beer sales. The growth in imported beer sales was due to a price increase on the Company’s Mexican beer portfolio, which took effect in the first quarter of Fiscal 2003. Spirits sales increased $7.6 million due primarily to increased bulk whiskey sales of $6.4 million, along with a slight increase in branded sales of $1.2 million.
## Gross Profit
The Company’s gross profit increased to $760.7 million for Fiscal 2003 from $695.2 million for Fiscal 2002, an increase of $65.6 million, or 9.4%. The Constellation Wines segment’s gross profit increased $30.8 million due to lower wine costs, the addi- tional four months of sales of the brands acquired in the Ravenswood Acquisition (completed in July 2001), a favorable mix of
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Constellation Brands experienced an outstanding Fiscal 2004. Despite a national and global business environment as challenging and competitive as the industry has experienced in decades, we achieved a 10 percent * increase in pro forma net sales through growth in each of our major categories: wine, imported beer, distilled spirits and U.K. wholesale. In a year of great change for Constellation, our success was evident in almost every critical financial measure that gauges our performance, including earnings growth, margin enhancements and cash flow.
*On a reported basis, net sales increased 30 percent. The statement that pro forma net sales increased 10 percent is based on comparable results and includes $478 million of net sales as if the Company had owned Hardy in the prior year period.
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## Selling, General and Administrative Expenses
Selling, general and administrative expenses decreased to $351.0 million for Fiscal 2003 from $355.3 million for Fiscal 2002, a decrease of $4.3 million, or (1.2%). The Company adopted SFAS No. 142 on March 1, 2002, and, accordingly, stopped amor- tizing goodwill and other indefinite lived intangible assets. Therefore, the decrease of $4.3 million consists of a decrease of $27.3 million of amortization expense from Fiscal 2002 offset by an increase of $23.0 million. The Constellation Wines segment’s selling, general and administrative expenses decreased $2.6 million due to lower amortization expense of $19.1 million partially offset by (i) higher selling costs to support the growth in the U.K. wholesale business, (ii) increased selling and advertising costs on certain popular and premium wine brands, and (iii) higher selling, general and administrative expenses to support the growth in the fine wine business. The Constellation Beers and Spirits segment’s selling, general and administrative expenses decreased $4.4 million due to lower amortization expense of $8.2 million partially offset by increased selling, general and administrative expenses to support the growth in the imported beer portfolio. The Corporate Operations and Other segment’s selling, general and administrative expenses increased $2.7 million primarily due to increased personnel costs to support the Company’s growth. Selling, general and administrative expenses as a percent of net sales decreased to 12.8% for Fiscal 2003 as compared to 13.6% for Fiscal 2002. This decrease was due to the reduced amortization expense noted above partially offset by (i) the percent increase in general and admin- istrative expenses growing at a faster rate than the percent increase in net sales across all segments, and (ii) the percent increase in the Constellation Wines segment’s U.K. wholesale and U.K. branded wine selling costs being greater than the percent increase in the U.K. wholesale and U.K. branded wine net sales.
## Restructuring and Related Charges
The Company recorded a property, plant and equipment impairment charge of $4.8 million in Fiscal 2003 in connection with the planned closure of two of its production facilities within its Constellation Wines segment in Fiscal 2004. During Fiscal 2004, the Company began the realignment of its business operations within this segment to further improve productivity. This realignment is not expected to have an impact on brand sales. No such charges were incurred in Fiscal 2002.
## Operating Income
The following table sets forth the operating income (loss) (in thousands of dollars) by operating segment of the Company for Fiscal 2003 and Fiscal 2002.
<img src='content_image/118793.jpg'>
Restructuring and related charges and unusual costs of $4.8 million for Fiscal 2003 consist of certain costs that are excluded by management in their evaluation of the results of each operating segment. These costs represent restructuring and related charges associated with the Company’s realignment of its business operations in the wine segment. As a result of the above factors, operat- ing income increased to $405.0 million for Fiscal 2003 from $339.9 million for Fiscal 2002, an increase of $65.1 million, or 19.1%. Fiscal 2002 operating income for Constellation Wines and Constellation Beers and Spirits included amortization expense of $19.1 million and $8.2 million, respectively.
## Gain on Change in Fair Value of Derivative Instruments
In February 2003, the Company entered into a foreign currency collar contract in connection with the Hardy Acquisition to lock in a range for the cost of the acquisition in U.S. dollars. As of February 28, 2003, this derivative instrument had a fair value of $23.1 million. Under SFAS No. 133, a transaction that involves a business combination is not eligible for hedge accounting treatment. As such, the derivative was recorded on the balance sheet at its fair value with the change in the fair value recognized separately on the Company’s Consolidated Statements of Income.
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The Company’s equity in earnings of joint venture increased to $12.2 million in Fiscal 2003 from $1.7 million in Fiscal 2002. Due to the formation of the joint venture in July 2001, there were seven months of earnings in Fiscal 2002 versus twelve months of earnings in Fiscal 2003. In addition, Fiscal 2003 benefited from an additional seven months of earnings due to the joint venture’s purchase of certain assets of the Blackstone Winery, including the Blackstone brand and the Codera wine business in Sonoma County, which was completed in October 2001.
## Interest Expense, Net
Interest expense, net of interest income of $0.8 million and $1.6 million for Fiscal 2003 and Fiscal 2002, respectively, decreased to $105.4 million for Fiscal 2003 from $114.2 million for Fiscal 2002, a decrease of $8.8 million, or (7.7%). The decrease result- ed from decreases in both the average borrowings for the year and the average interest rate for the year.
## Provision for Income Taxes
The Company’s effective tax rate for Fiscal 2003 declined to 39.3% from 40.0% for Fiscal 2002 as a result of the adoption of SFAS No. 142 on March 1, 2002.
## Net Income
As a result of the above factors, net income increased to $203.3 million for Fiscal 2003 from $136.4 million for Fiscal 2002, an increase of $66.9 million, or 49.0%.
## FINANCIAL LIQUIDITY AND CAPITAL RESOURCES
## GENERAL
The Company’s principal use of cash in its operating activities is for purchasing and carrying inventories and carrying season- al accounts receivable. The Company’s primary source of liquidity has historically been cash flow from operations, except during annual grape harvests when the Company has relied on short-term borrowings. In the United States, the annual grape crush nor- mally begins in August and runs through October. In Australia, the annual grape crush normally begins in February and runs through May. The Company generally begins taking delivery of grapes at the beginning of the crush season with payments for such grapes beginning to come due one month later. The Company’s short-term borrowings to support such purchases generally reach their highest levels one to two months after the crush season has ended. Historically, the Company has used cash flow from oper- ating activities to repay its short-term borrowings and fund capital expenditures. The Company will continue to use its short-term borrowings to support its working capital requirements. The Company believes that cash provided by operating activities and its financing activities, primarily short-term borrowings, will provide adequate resources to satisfy its working capital, scheduled prin- cipal and interest payments on debt, preferred dividend payment requirements, and anticipated capital expenditure requirements for both its short-term and long-term capital needs.
## FISCAL 2004 CASH FLOWS
## Operating Activities
Net cash provided by operating activities for Fiscal 2004 was $340.3 million, which resulted from $220.4 million of net income, plus $137.9 million of net noncash items charged to the Consolidated Statement of Income, less $18.0 million representing the net change in the Company’s operating assets and liabilities. The net non-cash items consisted primarily of depreciation of property, plant and equipment, deferred tax provision and amortization of intangible and other assets. The net change in operating assets and liabilities resulted primarily from an increase in accounts receivable and a decrease in accounts payable, partially offset by a decrease in inventories and an increase in accrued advertising and promotion.
## Investing Activities
Net cash used in investing activities for Fiscal 2004 was $1,158.5 million, which resulted primarily from net cash paid of $1,069.5 million for the purchases of businesses and $105.1 million of capital expenditures.
## Financing Activities
Net cash provided by financing activities for Fiscal 2004 was $745.2 million resulting primarily from proceeds of $1,600.0 mil- lion from issuance of long-term debt, including $1,060.2 million of long-term debt incurred to acquire Hardy, plus net proceeds from the 2003 Equity Offerings (as defined below) of $426.1 million. This amount was partially offset by principal payments of long-term debt of $1,282.3 million.
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## Operating Activities
Net cash provided by operating activities for Fiscal 2003 was $236.1 million, which resulted from $203.3 million of net income, plus $53.2 million of net noncash items charged to the Consolidated Statement of Income, less $20.4 million representing the net change in the Company’s operating assets and liabilities. The net noncash items consisted primarily of depreciation of property, plant and equipment and provision for deferred taxes, partially offset by a gain on changes in fair value of derivative instrument. The net change in operating assets and liabilities resulted primarily from an increase in inventories and a reduction in accrued excise taxes and adverse grape contracts partially offset by increases in accrued income taxes payable and accrued advertising and promo- tion expenses.
## Investing Activities
Net cash used in investing activities for Fiscal 2003 was $72.0 million, which resulted primarily from $71.6 million of capital expenditures.
## Financing Activities
Net cash used in financing activities for Fiscal 2003 was $161.5 million resulting primarily from $151.1 million of principal payments of long-term debt and $51.9 million of net repayments of notes payable. These debt payments were partially funded by $28.7 million of proceeds from employee stock option exercises and $10.0 million of proceeds from long-term debt which was used for the repayment of debt at one of the Company’s Chilean subsidiaries.
During June 1998, the Company’s Board of Directors authorized the repurchase of up to $100.0 million of its Class A Common Stock and Class B Common Stock. The repurchase of shares of common stock will be accomplished, from time to time, in manage- ment’s discretion and depending upon market conditions, through open market or privately negotiated transactions. The Company may finance such repurchases through cash generated from operations or through the senior credit facility. The repurchased shares will become treasury shares. As of May 14, 2004, the Company had purchased a total of 4,075,344 shares of Class A Common Stock at an aggregate cost of $44.9 million, or at an average cost of $11.01 per share. Of this total amount, no shares were repur- chased during Fiscal 2004, Fiscal 2003 or Fiscal 2002.
## DEBT
Total debt outstanding as of February 29, 2004, amounted to $2,047.9 million, an increase of $782.4 million from February 28, 2003. The ratio of total debt to total capitalization decreased to 46.3% as of February 29, 2004, from 51.9% as of February 28, 2003.
## Senior Credit Facility
## Credit Agreement
In connection with the Hardy Acquisition, on January 16, 2003, the Company, certain subsidiaries of the Company, JPMorgan Chase Bank, as a lender and administrative agent (the “Administrative Agent”), and certain other lenders entered into a new cred- it agreement (as subsequently amended and restated as of March 19, 2003, the “March 2003 Credit Agreement”). In October 2003, the Company entered into a Second Amended and Restated Credit Agreement (the “October Credit Agreement”) that (i) refinanced the then outstanding principal balance under the Tranche B Term Loan facility on essentially the same terms as the Tranche B Term Loan facility under the March 2003 Credit Agreement, but at a lower Applicable Rate (as such term is defined in the October Credit Agreement) and (ii) otherwise restated the terms of the March 2003 Credit Agreement, as amended. The October Credit Agreement was further amended during February 2004 (the “Credit Agreement”). The March 2003 Credit Agreement provided for aggregate credit facilities of $1.6 billion consisting of a $400.0 million Tranche A Term Loan facility due in February 2008, an $800.0 mil- lion Tranche B Term Loan facility due in November 2008 and a $400.0 million Revolving Credit facility (including an Australian Dollar revolving sub-facility of up to A$10.0 million and a sub-facility for letters of credit of up to $40.0 million) which expires on February 29, 2008. Proceeds of the March 2003 Credit Agreement were used to pay off the Company’s obligations under its prior Senior Credit Facility, to fund a portion of the cash required to pay the former Hardy shareholders and to pay indebtedness out- standing under certain of Hardy’s credit facilities. The Company uses the remaining availability under the credit agreement to fund its working capital needs on an ongoing basis.
The Tranche A Term Loan facility and the Tranche B Term Loan facility were fully drawn on March 27, 2003. As of February 29, 2004, the Company has made $40.0 million of scheduled and required payments on the Tranche A Term Loan facility. In August 2003, the Company paid $100.0 million of the Tranche B Term Loan facility. In October 2003, the Company paid an addi- tional $200.0 million of the Tranche B Term Loan facility. As of February 29, 2004, the required annual repayments of the Tranche A Term Loan and the Tranche B Term Loan are as follows:
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The rate of interest payable, at the Company’s option, is a function of LIBOR plus a margin, the federal funds rate plus a mar- gin, or the prime rate plus a margin. The margin is adjustable based upon the Company’s Debt Ratio (as defined in the Credit Agreement) and, with respect to LIBOR borrowings, ranges between 1.50% and 2.50%. As of February 29, 2004, the LIBOR mar- gin for the Revolving Credit facility and the Tranche A Term Loan facility is 1.75%, while the LIBOR margin on the Tranche B Term Loan facility is 2.00%.
The Company’s obligations are guaranteed by certain subsidiaries of the Company (“Guarantors”) and the Company is obli- gated to pledge collateral of (i) 100% of the capital stock of all of the Company’s U.S. subsidiaries and (ii) 65% of the voting cap- ital stock of certain foreign subsidiaries of the Company.
The Company and its subsidiaries are subject to customary lending covenants including those restricting additional liens, the incurrence of additional indebtedness (including guarantees of indebtedness), the sale of assets, the payment of dividends, transac- tions with affiliates and the making of certain investments, in each case subject to baskets, exceptions and/or thresholds. As a result of the prepayment of the Bridge Loans (as defined below) with the proceeds from the 2003 Equity Offerings (see Note 16), the requirement under certain circumstances for the Company and the Guarantors to pledge certain assets consisting of, among other things, inventory, accounts receivable and trademarks to secure the obligations under the Credit Agreement, ceased to apply. The primary financial covenants require the maintenance of a debt coverage ratio, a senior debt coverage ratio, a fixed charge ratio and an interest coverage ratio. As of February 29, 2004, the Company is in compliance with all of its covenants under its Credit Agreement.
As of February 29, 2004, under the Credit Agreement, the Company had outstanding Tranche A Term Loans of $360.0 million bearing a weighted average interest rate of 2.9%, Tranche B Term Loans of $500.0 million bearing a weighted average interest rate of 3.2%, undrawn revolving letters of credit of $18.6 million, and $381.4 million in revolving loans available to be drawn. There were no outstanding revolving loans under the Credit Agreement as of February 29, 2004.
## Bridge Agreement
On January 16, 2003, the Company, certain subsidiaries of the Company, JPMorgan Chase Bank, as a lender and Administrative Agent, and certain other lenders (such other lenders, together with the Administrative Agent, are collectively referred to herein as the “Bridge Lenders”) entered into a bridge loan agreement which was amended and restated as of March 26, 2003, containing commitments of the Bridge Lenders to make bridge loans (the “Bridge Loans”) of up to, in the aggregate, $450.0 mil- lion (the “Bridge Agreement”). On April 9, 2003, the Company used $400.0 million of the Bridge Loans to fund a portion of the cash required to pay the former Hardy shareholders. On July 30, 2003, the Company used proceeds from the 2003 Equity Offerings to prepay the $400.0 million Bridge Loans in their entirety.
## Subsidiary Facilities
The Company has additional line of credit arrangements available totaling $91.5 million and $44.5 million as of February 29, 2004, and February 28, 2003, respectively. These lines support the borrowing needs of certain of the Company’s foreign subsidiary operations. Interest rates and other terms of these borrowings vary from country to country, depending on local market conditions. As of February 29, 2004, and February 28, 2003, amounts outstanding under the subsidiary revolving credit facilities were $1.8 million and $0.6 million, respectively.
## Senior Notes
On August 4, 1999, the Company issued $200.0 million aggregate principal amount of 8 5/8% Senior Notes due August 2006 (the “August 1999 Senior Notes”). Interest on the August 1999 Senior Notes is payable semiannually on February 1 and August 1. As of February 29, 2004, the Company had outstanding $200.0 million aggregate principal amount of August 1999 Senior Notes.
On November 17, 1999, the Company issued £75.0 million ($121.7 million upon issuance) aggregate principal amount of 8 1/2% Senior Notes due November 2009 (the “Sterling Senior Notes”). Interest on the Sterling Senior Notes is payable semiannual- ly on May 15 and November 15. In March 2000, the Company exchanged £75.0 million aggregate principal amount of 8 1/2% Series B Senior Notes due in November 2009 (the “Sterling Series B Senior Notes”) for all of the Sterling Senior Notes. The terms of the Sterling Series B Senior Notes are identical in all material respects to the Sterling Senior Notes. In October 2000, the Company
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On May 15, 2000, the Company issued £80.0 million ($120.0 million upon issuance) aggregate principal amount of 8 1/2% Series C Senior Notes due November 2009 at an issuance price of £79.6 million ($119.4 million upon issuance, net of $0.6 million unamortized discount, with an effective interest rate of 8.6%) (the “Sterling Series C Senior Notes”). Interest on the Sterling Series C Senior Notes is payable semiannually on May 15 and November 15. As of February 29, 2004, the Company had outstanding £154.0 million ($287.2 million, net of $0.5 million unamortized discount) aggregate principal amount of Sterling Series C Senior Notes.
On February 21, 2001, the Company issued $200.0 million aggregate principal amount of 8% Senior Notes due February 2008 (the “February 2001 Senior Notes”). The net proceeds of the offering ($197.0 million) were used to partially fund the acquisition of the Turner Road Vintners Assets. Interest on the February 2001 Senior Notes is payable semiannually on February 15 and August 15. In July 2001, the Company exchanged $200.0 million aggregate principal amount of 8% Series B Senior Notes due February 2008 (the “February 2001 Series B Senior Notes”) for all of the February 2001 Senior Notes. The terms of the February 2001 Series B Senior Notes are identical in all material respects to the February 2001 Senior Notes. As of February 29, 2004, the Company had outstanding $200.0 million aggregate principal amount of February 2001 Senior Notes.
The senior notes described above are redeemable, in whole or in part, at the option of the Company at any time at a redemp- tion price equal to 100% of the outstanding principal amount and a make whole payment based on the present value of the future payments at the adjusted Treasury rate or adjusted Gilt rate plus 50 basis points. The senior notes are unsecured senior obligations and rank equally in right of payment to all existing and future unsecured senior indebtedness of the Company. Certain of the Company’s significant operating subsidiaries guarantee the senior notes, on a senior basis.
## Senior Subordinated Notes
On March 4, 1999, the Company issued $200.0 million aggregate principal amount of 8 1/2% Senior Subordinated Notes due March 2009 (“Senior Subordinated Notes”). Interest on the Senior Subordinated Notes is payable semiannually on March 1 and September 1. The Senior Subordinated Notes are redeemable at the option of the Company, in whole or in part, at any time on or after March 1, 2004. As of February 29, 2004, the Company had outstanding $200.0 million aggregate principal amount of Senior Subordinated Notes. On February 10, 2004, the Company issued a Notice of Redemption for its Senior Subordinated Notes. The Senior Subordinated Notes were redeemed with proceeds from the Revolving Credit facility on March 11, 2004, at 104.25% of par plus accrued interest. In the first quarter of Fiscal 2005, the Company recorded a charge of $10.3 million related to this redemp- tion.
On January 23, 2002, the Company issued $250.0 million aggregate principal amount of 8 1/8% Senior Subordinated Notes due January 2012 (“January 2002 Senior Subordinated Notes”). The net proceeds of the offering ($247.2 million) were used pri- marily to repay the Company’s $195.0 million aggregate principal amount of 8 3/4% Senior Subordinated Notes due in December 2003. The remaining net proceeds of the offering were used to repay a portion of the outstanding indebtedness under the Company’s then existing Senior Credit Facility. Interest on the January 2002 Senior Subordinated Notes is payable semiannually on January 15 and July 15. The January 2002 Senior Subordinated Notes are redeemable at the option of the Company, in whole or in part, at any time on or after January 15, 2007. The Company may also redeem up to 35% of the January 2002 Senior Subordinated Notes using the proceeds of certain equity offerings completed before January 15, 2005. The January 2002 Senior Subordinated Notes are unsecured and subordinated to the prior payment in full of all senior indebtedness of the Company, which includes the senior cred- it facility. The January 2002 Senior Subordinated Notes are guaranteed, on a senior subordinated basis, by certain of the Company’s significant operating subsidiaries. As of February 29, 2004, the Company had outstanding $250.0 million aggregate principal amount of January 2002 Senior Subordinated Notes.
## Guarantees
A foreign subsidiary of the Company has guaranteed debt of a joint venture in the maximum amount of $4.2 million as of February 29, 2004. The liability for this guarantee is not material and the Company does not have any collateral from this entity.
## CONTRACTUAL OBLIGATIONS AND COMMITMENTS
The following table sets forth information about the Company’s long-term contractual obligations outstanding at February 29, 2004. It brings together data for easy reference from the consolidated balance sheet and from individual notes to the Company’s consolidated financial statements. See Notes 10, 12, 13, 14 and 15 to the Company’s consolidated financial statements located in this Annual Report for detailed discussion of items noted in the following table.
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(1) Total unconditional purchase obligations consist of $20.3 million for contracts to purchase various spirits over the next five fiscal years, $2,131.3 million for contracts to purchase grapes over the next fifteen fiscal years, $78.9 million for contracts to purchase bulk wine over the next four fiscal years, and $67.5 million for processing contracts over the next 16 years. See Note 15 to the Company’s consolidated financial statements located in this Annual Report for a detailed discussion of these items.
## EQUITY OFFERINGS
During July 2003, the Company completed a public offering of 9,800,000 shares of its Class A Common Stock resulting in net proceeds to the Company, after deducting underwriting discounts and expenses, of $261.2 million. In addition, the Company also completed a public offering of 170,500 shares of its 5.75% Series A Mandatory Convertible Preferred Stock (“Preferred Stock”) resulting in net proceeds to the Company, after deducting underwriting discounts and expenses, of $164.9 million. The Class A Common Stock offering and the Preferred Stock offering are referred to together as the “2003 Equity Offerings.” The majority of the net proceeds from the 2003 Equity Offerings were used to repay the Bridge Loans that were incurred to partially finance the Hardy Acquisition. The remaining proceeds were used to repay term loan borrowings under the March 2003 Credit Agreement.
During March 2001, the Company completed a public offering of 8,740,000 shares of its Class A Common Stock, which was held as treasury stock. This resulted in net proceeds to the Company, after deducting underwriting discounts and expenses, of $139.4 million. The net proceeds were used to repay revolving loan borrowings under the Senior Credit Facility of which a por- tion was incurred to partially finance the acquisition of the Turner Road Vintners Assets.
During October 2001, the Company sold 645,000 shares of its Class A Common Stock, which was held as treasury stock, in connection with a public offering of Class A Common Stock by stockholders of the Company. The net proceeds to the Company, after deducting underwriting discounts, of $12.1 million were used to repay borrowings under the Senior Credit Facility.
## CAPITAL EXPENDITURES
During Fiscal 2004, the Company incurred $105.1 million for capital expenditures. The Company plans to spend approxi- mately $125.0 million for capital expenditures in Fiscal 2005. In addition, the Company continues to consider the purchase, lease and development of vineyards and may incur additional expenditures for vineyards if opportunities become available. Management reviews the capital expenditure program periodically and modifies it as required to meet current business needs.
## EFFECTS OF INFLATION AND CHANGING PRICES
The Company’s results of operations and financial condition have not been significantly affected by inflation and changing prices. The Company has been able, subject to normal competitive conditions, to pass along rising costs through increased selling prices. There can be no assurances, however, that the Company will continue to be able to pass along rising costs through increased selling prices.
## CRITICAL ACCOUNTING POLICIES
The Company’s significant accounting policies are more fully described in Note 1 to the Company’s consolidated financial state- ments located in this Annual Report. However, certain of the Company’s accounting policies are particularly important to the por- trayal of the Company’s financial position and results of operations and require the application of significant judgment by the Company’s management; as a result they are subject to an inherent degree of uncertainty. In applying those policies, the Company’s management uses its judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on the Company’s historical experience, the Company’s observance of trends in the industry, information pro- vided by the Company’s customers and information available from other outside sources, as appropriate. On an ongoing basis, the Company reviews its estimates to ensure that they appropriately reflect changes in the Company’s business. The Company’s criti- cal accounting policies include:
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• Inventory valuation. Inventories are stated at the lower of cost or market, cost being determined on the first-in, first-out method. The Company assesses the valuation of its inventories and reduces the carrying value of those inventories that are obsolete or in excess of the Company’s forecasted usage to their estimated net realizable value. The Company estimates the net realizable value of such inventories based on analyses and assumptions including, but not limited to, historical usage, future demand and market requirements. Reductions to the carrying value of inventories are recorded in cost of goods sold. If the future demand for the Company’s products is less favorable than the Company’s forecasts, then the value of the inventories may be required to be reduced, which could result in material additional expense to the Company and have a material adverse impact on the Company’s financial statements.
• Accounting for business combinations. The acquisition of businesses is an important element of the Company’s strategy. Under the purchase method, the Company is required to record the net assets acquired at the estimated fair value at the date of acqui- sition. The determination of the fair value of the assets acquired and liabilities assumed requires the Company to make esti- mates and assumptions that affect the Company’s financial statements. For example, the Company’s acquisitions typically result in goodwill and other intangible assets; the value and estimated life of those assets may affect the amount of future period amor- tization expense for intangible assets with finite lives as well as possible impairment charges that may be incurred.
• Impairment of goodwill and intangible assets with indefinite lives. Intangible assets with indefinite lives consist primarily of trademarks as well as agency relationships. The Company is required to analyze its goodwill and other intangible assets with indefinite lives for impairment on an annual basis as well as when events and circumstances indicate that an impairment may have occurred. Certain factors that may occur and indicate that an impairment exists include, but are not limited to, operat- ing results that are lower than expected and adverse industry or market economic trends. The impairment testing requires man- agement to estimate the fair value of the assets or reporting unit and record an impairment loss for the excess of the carrying value over the fair value. The estimate of fair value of the assets is generally determined on the basis of discounted future cash flows. The estimate of fair value of the reporting unit is generally determined on the basis of discounted future cash flows sup- plemented by the market approach. In estimating the fair value, management must make assumptions and projections regard- ing such items as future cash flows, future revenues, future earnings and other factors. The assumptions used in the estimate of fair value are generally consistent with the past performance of each reporting unit and other intangible assets and are also con- sistent with the projections and assumptions that are used in current operating plans. Such assumptions are subject to change as a result of changing economic and competitive conditions. If these estimates or their related assumptions change in the future, the Company may be required to record an impairment loss for these assets. The recording of any resulting impairment loss could have a material adverse impact on the Company’s financial statements.
## ACCOUNTING PRONOUNCEMENTS NOT YET ADOPTED
In December 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46 (revised December 2003) (“FIN No. 46(R)”), “Consolidation of Variable Interest Entities – an interpretation of ARB No. 51”, which will replace FASB Interpretation No. 46 (“FIN No. 46”), “Consolidation of Variable Interest Entities,” upon its effective date. FIN No. 46(R) retains many of the basic concepts introduced in FIN No. 46; however, it also introduces a new scope exception for certain types of enti- ties that qualify as a business as defined in FIN No. 46(R) and revises the method of calculating expected losses and residual returns for determination of primary beneficiaries, including new guidance for assessing variable interests. The application of the transition requirements of FIN No. 46(R) with regard to special purpose entities and existing variable interest entities did not result in any entities requiring consolidation or any additional disclosures. The Company is continuing to evaluate the impact of FIN No. 46(R) for its adoption as of May 31, 2004. However, it is not expected to have a material impact on the Company’s consolidated finan- cial statements.
In December 2003, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 132 (revised 2003) (“SFAS No. 132(R)”), “Employers’ Disclosures about Pensions and Other Postretirement Benefits—an amendment of FASB Statements No. 87, 88, and 106.” SFAS No. 132(R) supersedes Statement of Financial Accounting Standards No. 132 (“SFAS No. 132”), by revising employers’ disclosures about pension plans and other postretirement benefit plans. SFAS No. 132(R) requires additional disclosures to those in SFAS No. 132 regarding the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. SFAS No. 132(R) also amends Accounting Principles Board Opinion No. 28 (“APB Opinion No. 28”), “Interim Financial Reporting,” to require additional disclosures for interim periods. The Company has adopted certain of the annual disclosure provisions of SFAS No. 132(R), primarily those related to its U.S. postretire- ment plan, for the fiscal year ending February 29, 2004. The Company is required to adopt the remaining annual disclosure provi- sions, primarily those related to its foreign plans, for the fiscal year ending February 28, 2005. The Company is required to adopt the amendment to APB Opinion No. 28 for financial reports containing condensed financial statements for interim periods beginning
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In March 2004, the Financial Accounting Standards Board issued a proposed statement, “Share-Based Payment, an amendment of FASB Statements No. 123 and 95.” The objective of the proposed statement is to require recognition in an entity’s financial state- ments of the cost of employee services received in exchange for equity instruments issued, and liabilities incurred, to employees in share-based payment (or compensation) transactions based on the fair value of the instruments at the grant date. The proposed statement would eliminate the alternative of continuing to account for share-based payment arrangements with employees under APB No. 25 and require that the compensation cost resulting from all share-based payment transactions be recognized in an enti- ty’s financial statements. If adopted in its current form, the proposed statement would be effective for awards that are granted, modified, or settled in fiscal years beginning after December 15, 2004. Also, if adopted in its current form, the proposed statement could result in a significant charge to the Company’s Consolidated Statement of Income for the fiscal year ended February 28, 2006.
## METHODS OF DISTRIBUTION
In North America, the Company's products are primarily distributed by more than 1,000 wholesale distributors as well as state and provincial alcoholic beverage control agencies. In the Company's other markets, products are primarily distributed either directly to retailers or through wholesalers and importers. In Australasia, the distribution channels are dominated by a small number of industry leaders. Its U.K. wholesaling business sells and distributes the Company's branded products and those of other major drinks companies through a network of depots located throughout the United Kingdom.
## CAUTIONARY INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond the Company’s control, that could cause actual results to differ materially from those set forth in, or implied by, such forward-looking statements. All statements other than statements of historical facts included in this Annual Report, including the statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s business strategy, future financial position, prospects, plans and objectives of management, as well as information concerning expected actions of third parties are forward-looking statements. When used in this Annual Report, the words “anticipate,” “intend,” “expect,” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. All forward-looking statements speak only as of the date of this Annual Report. The Company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct. In addition to the risks and uncertainties of ordinary business operations, important factors that could cause actual results to differ materially from those set forth in, or implied, by the Company’s forward-looking statements contained in this Annual Report are as follows:
• The Company’s indebtedness could have a material adverse effect on its financial health.
• The Company’s acquisition or joint venture strategies may not be successful.
• Competition could have a material adverse effect on the Company’s business.
• An increase in excise taxes or government regulations could have a material adverse effect on the Company’s business.
• The Company relies on the performance of wholesale distributors, major retailers and chains for the success of its business.
• The Company’s business could be adversely affected by a decline in the consumption of products the Company sells.
• The Company generally purchases raw materials under short-term supply contracts, and the Company is subject to substantial price fluctuations for grapes and grape-related materials and the Company has a limited group of suppliers of glass bottles.
• The Company’s global operations subject it to risks related to currency rate fluctuations and geopolitical uncertainty which could have a material adverse effect on the Company’s business.
• The Company has a material amount of goodwill, and if the Company is required to write-down goodwill, it would reduce the Company’s net income, which in turn could materially and adversely affect the Company’s results of operations.
• The termination or non-renewal of imported beer distribution agreements could have a material adverse effect on the Company’s business.
• The Company’s financial statements for the three fiscal years ended February 28, 2002, were audited by Arthur Andersen LLP.
For additional information about risks and uncertainties that could adversely affect the Company’s forward-looking statements, please refer to the Company’s filings with the Securities and Exchange Commission, including its Annual Report on Form 10-K for the fiscal year ended February 29, 2004.
## QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company, as a result of its global operating and financing activities, is exposed to market risk associated with changes in inter- est rates and foreign currency exchange rates. To manage the volatility relating to these risks, the Company periodically enters into derivative transactions including foreign currency exchange contracts and interest rate swap agreements. The Company uses deriva- tive instruments solely to reduce the financial impact of these risks and does not use derivative instruments for trading purposes.
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The fair value of fixed rate debt is subject to interest rate risk. The fair value of fixed rate debt will increase as interest rates fall and decrease as interest rates rise. The estimated fair value of the Company’s total fixed rate debt, including current maturi- ties, was $1,274.8 million and $1,138.3 million as of February 29, 2004, and February 28, 2003, respectively. A hypothetical 1% increase from prevailing interest rates as of February 29, 2004, and February 28, 2003, would have resulted in a decrease in fair value of fixed interest rate long-term debt by $52.9 million and $53.1 million, respectively.
In addition to the $1.3 billion fair value of fixed rate debt outstanding, the Company also had variable rate debt outstanding (primarily LIBOR based) as of February 29, 2004, and February 28, 2003, of $860.0 million and $147.4 million, respectively. A hypothetical 1% increase from prevailing interest rates as of February 29, 2004, and February 28, 2003, would result in an increase in cash required for interest payments on variable interest rate debt during the next five fiscal years as follows:
<img src='content_image/19948.jpg'>
The Company has on occasion entered into interest rate swap agreements to reduce its exposure to interest rate changes relative to its variable rate debt. As of February 29, 2004, and February 28, 2003, the Company had no interest rate swap agreements out- standing.
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(in thousands, except share and per share data)
<img src='content_image/115443.jpg'>
The accompanying notes to consolidated financial statements are an integral part of these statements.
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] | overall_image/bbb1fcc34c4275aa2d4f009b8b8cf603cddc5288d8c7840dae76f241c543d12c.png | ## PRODUCTS AND BRANDS
Clearly, the acquisition of BRL Hardy Limited was an historic achievement for Constellation Brands, and truly, one of the single most significant events within the beverage alcohol industry in years. The successful integration of Hardy’s business and people within the Constellation Family stands out as a highlight of our accomplishments last year.
Based on a common vision, mutual respect, comparable sales histories and similar cultures, the Constellation and Hardy organizations have blended together seamlessly, resulting in one of the finest management teams in the industry.
While this acquisition created the world’s largest wine company; more importantly, it shaped Constellation into a far more competitive player in the highly aggressive global wine arena. Built on the synergistic combination of two powerful market forces, the newly resulting organization concentrates its focus categorically and geographically to exploit fully the tremendous global popularity of New World wines. In turn, equity in our powerful wine brands is heightened while long-term shareholder value is enhanced.
Fiscal 2004 was a solid year for our imported beer division, as witnessed by the strength of our relationship with Grupo Modelo. Joining forces, our two companies mutually implemented a Corona price increase consistent with the brand’s clear import leadership position and a healthy beer pricing environment. Recognizing the tremendous growth potential of Corona Light, we are escalating the marketing and sales investment behind this brand.
Our premium spirits business continues to grow with exciting niche products such as the 99 schnapps line and Blue Wave, and new entries such as Beachcomber flavored rums. Innovation of this distinction is sparking additional growth for Constellation Spirits, and is reflective of regeneration throughout the spirits industry.
## BREADTH + SCALE = LONG-TERM PROFITABLE GROWTH
Underlying our 2004 performance and our confidence for the years ahead is our consistent, overarching strategy: breadth plus scale equals long-term profitable growth.
Our breadth across product lines and geographies affords us growth- generating investment prospects unrivaled in the industry. Furthermore, our extensive range diminishes the inherent volatility and potential vulnerability that sometimes accompanies growth. As one of the world’s largest beverage alcohol companies, our scale gives us stronger routes- to-market, thereby leveraging our investments. Together, this unequalled breadth and scale propels our focus beyond short-term gain to investment opportunities based on growth and profitability over the long term.
<img src='content_image/92546.jpg'>
Within the highly competitive beverage alcohol environment, Constellation executes this strategy by concentrating sales and marketing investments in those brands and products where prospects for enhancing returns are greatest.
In 2005, we are making greater than normal investments in our growth wine brands, as well as our imported beer business. We expect this growth investment to result in margin expansion in Fiscal 2006.
## COMPETITIVE EDGE
Several other significant steps taken in Fiscal 2004 underscore our objective to enhance shareholder value and sustain long-term profitable growth.
The Hardy merger also facilitated the creation of Constellation Wines U.S. which combined various operating companies such as Canandaigua Wine Company and Pacific Wine Partners under a single umbrella; and Constellation Europe, which combined Matthew Clark and the former Hardy European organization; and Constellation Wines Rest of the World, which services key markets like Japan and Canada. Here, we’re creating unprecedented sales and supply synergies across categories and geographies and intensifying our attention to emerging world opportunities.
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<img src='content_image/83546.jpg'>
The accompanying notes to consolidated financial statements are an integral part of these statements.
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(in thousands, except share data)
<img src='content_image/189.jpg'>
The accompanying notes to consolidated financial statements are an integral part of these statements.
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(in thousands)
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The accompanying notes to consolidated financial statements are an integral part of these statements.
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## Description of business –
## NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Constellation Brands, Inc. and its subsidiaries (the “Company”) operate primarily in the beverage alcohol industry. The Company is a leading international producer and marketer of beverage alcohol brands with a broad portfolio across the wine, spir- its and imported beer categories. The Company has the largest wine business in the world and is the largest multi-category suppli- er of beverage alcohol in the United States (“U.S.”); a leading producer and exporter of wine from Australia and New Zealand; and both a major producer and independent drinks wholesaler in the United Kingdom (“U.K.”). In North America, the Company dis- tributes its products through wholesale distributors. In Australia, the Company distributes its products directly to off-premise accounts, such as major retail chains, on-premise accounts, such as hotels and restaurants, and large wholesalers. In the U.K., the Company distributes its products directly to off-premise accounts, such as major retail chains, and to other wholesalers. Through the Company’s U.K. wholesale business, the Company distributes its branded products and those of other major drinks companies to on-premise accounts: pubs, clubs, hotels and restaurants.
## Principles of consolidation –
The consolidated financial statements of the Company include the accounts of Constellation Brands, Inc. and all of its sub- sidiaries. All intercompany accounts and transactions have been eliminated.
## Management’s 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.
## Revenue recognition –
Sales are recognized when title passes to the customer, which is generally when the product is shipped. Amounts billed to cus- tomers for shipping and handling are classified as sales. Sales reflect reductions attributable to consideration given to customers in various customer incentive programs, including pricing discounts on single transactions, volume discounts, promotional and adver- tising allowances, coupons, and rebates.
## Cost of product sold –
The types of costs included in cost of product sold are raw materials, packaging materials, manufacturing costs, plant admin- istrative support and overheads, and freight and warehouse costs (including distribution network costs). Distribution network costs include inbound freight charges and outbound shipping and handling costs, purchasing and receiving costs, inspection costs, ware- housing and internal transfer costs.
## Selling, general and administrative expenses –
The types of costs included in selling, general and administrative expenses consist predominately of advertising and non-man- ufacturing administrative and overhead costs. Distribution network costs are not included in the Company’s selling, general and administrative expenses, but are included in cost of product sold as described above. The Company expenses advertising costs as incurred, shown or distributed. Prepaid advertising costs at February 29, 2004 and February 28, 2003, were not material. Advertising expense for the years ended February 29, 2004, February 28, 2003, and February 28, 2002, was $116.1 million, $89.6 million and $87.0 million, respectively.
## Foreign currency translation –
The “functional currency” for translating the accounts of the Company’s operations outside the U.S. is the local currency. The translation from the applicable foreign currencies to U.S. dollars is performed for balance sheet accounts using exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during the period. The resulting translation adjustments are recorded as a component of Accumulated Other Comprehensive Income (Loss) (“AOCI”). Gains or losses resulting from foreign currency denominated transactions are included in selling, general and administrative expens- es in the Company’s Consolidated Statements of Income. The Company engages in foreign currency denominated transactions with customers, suppliers and non-U.S. subsidiaries. Aggregate foreign currency transaction gains were $16.6 million in Fiscal 2004.
Aggregate foreign currency transaction gains were not material in Fiscal 2003 and Fiscal 2002.
## Cash investments –
Cash investments consist of highly liquid investments with an original maturity when purchased of three months or less and are stated at cost, which approximates market value. The amounts at February 29, 2004, and February 28, 2003, are not significant.
## Allowance for doubtful accounts –
The Company records an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. The majority of the accounts receivable balance is generated from sales to independent distributors with whom the Company has a predetermined collection date arranged through electronic funds transfer. The allowance for doubtful accounts was $17.2 million and $13.8 million as of February 29, 2004, and February 28, 2003, respectively.
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To meet the reporting requirements of Statement of Financial Accounting Standards No. 107, “Disclosures about Fair Value of Financial Instruments,” the Company calculates the fair value of financial instruments using quoted market prices whenever avail- able. When quoted market prices are not available, the Company uses standard pricing models for various types of financial instru- ments (such as forwards, options, swaps, etc.) which take into account the present value of estimated future cash flows.
The carrying amount and estimated fair value of the Company’s financial instruments are summarized as follows:
<img src='content_image/57375.jpg'>
The following methods and assumptions were used to estimate the fair value of each class of financial instruments:
Cash and cash investments, accounts receivable and accounts payable: The carrying amounts approximate fair value due to the short maturity of these instruments.
Investment in marketable equity securities: The fair value is estimated based on quoted market prices.
Currency forward contracts: The fair value is estimated based on quoted market prices.
Notes payable to banks: These instruments are variable interest rate bearing notes for which the carrying value approximates the fair value.
Long-term debt: The senior credit facility is subject to variable interest rates which are frequently reset; accordingly, the carry- ing value of this debt approximates its fair value. The fair value of the remaining long-term debt, which is all fixed rate, is estimat- ed by discounting cash flows using interest rates currently available for debt with similar terms and maturities.
## Derivative instruments –
As a multinational company, the Company is exposed to market risk from changes in foreign currency exchange rates and inter- est rates that could affect the Company’s results of operations and financial condition. Accordingly, the Company’s results of oper- ations are exposed to some volatility, which is minimized or eliminated whenever possible. The amount of volatility realized will vary based upon the effectiveness and level of derivative instruments outstanding during a particular period of time, as well as the currency and interest rate market movements during that same period.
The Company enters into derivative instruments, including interest rate swaps, foreign currency forwards, and/or purchased for- eign currency options to manage interest rate and foreign currency risks. In accordance with Statement of Financial Accounting Standards No. 133 (“SFAS No. 133”), “Accounting for Derivative Instruments and Hedging Activities”, as amended, the Company recognizes all derivatives as either assets or liabilities on the balance sheet and measures those instruments at fair value. The fair val- ues of the Company’s derivative instruments change with fluctuations in interest rates and/or currency rates and are designed so that any changes in their values are offset by changes in the values of the underlying exposures. The Company’s derivative instruments are held solely to hedge economic exposures. The Company follows strict policies to manage interest rate and foreign currency risks, including prohibitions on derivative market-making or other speculative activities. As of February 29, 2004, and February 28, 2003, the Company did not have any interest rate swap agreements outstanding. As of February 29, 2004, and February 28, 2003, the Company had foreign exchange contracts outstanding with a notional value of $735.8 million and $11.6 million, respectively.
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Certain of the Company’s derivative instruments do not qualify for SFAS No. 133 hedge accounting treatment; for others, the Company does not maintain the required documentation to apply hedge accounting treatment. In both of these instances, the mark to fair value is reported currently through earnings. Furthermore, when it is determined that a derivative is not, or has ceased to be, highly effective as a hedge, the Company discontinues hedge accounting prospectively. The Company discontinues hedge account- ing prospectively when (1) the derivative is no longer highly effective in offsetting changes in the cash flows of a hedged item; (2) the derivative expires or is sold, terminated, or exercised; (3) it is no longer probable that the forecasted transaction will occur; or (4) management determines that designating the derivative as a hedging instrument is no longer appropriate.
## Cash flow hedges:
The Company is exposed to fluctuations in foreign currency cash flows related primarily to sales to third parties, intercompa- ny sales, available for sale securities and intercompany loans and interest payments. Forward and option contracts are used to hedge some of these risks. Effectiveness is assessed based on changes in forward rates. Derivatives used to manage cash flow exposures generally mature within 24 months or less, with a maximum maturity of five years.
The Company records the fair value of its foreign exchange contracts qualifying for cash flow hedge accounting treatment in its consolidated balance sheet with the related gain or loss on those contracts deferred in stockholders’ equity (as a component of AOCI). These deferred gains or losses are recognized in the Company’s Consolidated Statement of Income in the same period in which the underlying hedged items are recognized, and on the same line item as the underlying hedged items. However, to the extent that any derivative instrument is not considered to be perfectly effective in offsetting the change in the value of the hedged item, the amount related to the ineffective portion of this derivative instrument is immediately recognized in the Company’s Consolidated Statement of Income.
The Company expects $14.1 million of net gains to be reclassified from AOCI to earnings within the next 12 months. The amount of hedge ineffectiveness associated with the Company’s designated cash flow hedge instruments recognized in the Company’s Consolidated Statements of Income during the years ended February 29, 2004, February 28, 2003, and February 28, 2002, was immaterial. All components of the Company’s derivative instruments’ gains or losses are included in the assessment of hedge effectiveness. In addition, the amount of net gains reclassified into earnings as a result of the discontinuance of cash flow hedge accounting due to the probability that the original forecasted transaction would not occur by the end of the originally spec- ified time period was immaterial for the years ended February 29, 2004, February 28, 2003, and February 28, 2002.
## Fair value hedges:
Fair value hedges are hedges that offset the risk of changes in the fair values of recorded assets and liabilities, and firm com- mitments. The Company records changes in fair value of derivative instruments which are designated and deemed effective as fair value hedges, in earnings offset by the corresponding changes in the fair value of the hedged items.
The Company is exposed to fluctuations in the value of foreign currency denominated receivables and payables, foreign cur- rency investments, primarily consisting of loans to subsidiaries, and cash flows related primarily to repatriation of those loans/investments. Forward contracts, generally less than 12 months in duration, are used to hedge some of these risks. Effectiveness is assessed based on changes in forward rates. Gains and losses on the derivative instruments used to hedge the for- eign exchange volatility associated with foreign currency dominated receivables and payables is recorded within selling, general and administrative expenses.
The amount of hedge ineffectiveness associated with the Company’s designated fair value hedge instruments recognized in the Company’s Consolidated Statements of Income during the years ended February 29, 2004, February 28, 2003, and February 28, 2002, was immaterial. All components of the Company’s derivative instruments’ gains or losses are included in the assessment of hedge effectiveness. There were no gains or losses recognized in earnings resulting from a hedged firm commitment no longer qual- ifying as a fair value hedge.
## Net investment hedges:
Net investment hedges are hedges that use derivative instruments or non-derivative instruments to hedge the foreign currency exposure of a net investment in a foreign operation. The Company manages currency exposures resulting from its net investments in foreign subsidiaries principally with debt denominated in the related foreign currency. Gains and losses on these instruments are recorded as foreign currency translation adjustment in AOCI. Currently, the Company has designated the Sterling Senior Notes and the Sterling Series C Senior Notes (as defined in Note 10) totaling £155.0 million aggregate principal amount as a hedge against the net investment in the Company’s U.K. subsidiary. For the years ended February 29, 2004, February 28, 2003, and February 28, 2002, net (losses) gains of ($45.9) million, ($24.0) million, and $4.4 million, respectively, are included in foreign currency trans- lation adjustments within AOCI.
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] | overall_image/ee9d8b0de656e4c2af54e957265119190de08822c6ef4d03ddcc61b1790c5d7b.png | ## Counterparty credit risk:
Counterparty risk relates to losses the Company could incur if a counterparty defaults on a derivative contract. The Company manages exposure to counterparty credit risk by requiring specified minimum credit standards and diversification of counterpar- ties. The Company enters into master agreements with our counterparties that allow netting of certain exposures in order to man- age this risk. All of the Company’s counterpart exposures are with counterparts that have investment grade ratings. The Company has procedures to monitor the credit exposure for both mark to market and future potential exposures.
## Inventories –
Inventories are stated at the lower of cost (computed in accordance with the first-in, first-out method) or market. Elements of cost include materials, labor and overhead and are classified as follows:
<img src='content_image/99574.jpg'>
A substantial portion of barreled whiskey and brandy will not be sold within one year because of the duration of the aging process. All barreled whiskey and brandy are classified as in-process inventories and are included in current assets, in accordance with industry practice. Bulk wine inventories are also included as in-process inventories within current assets, in accordance with the general practices of the wine industry, although a portion of such inventories may be aged for periods greater than one year. Warehousing, insurance, ad valorem taxes and other carrying charges applicable to barreled whiskey and brandy held for aging are included in inventory costs.
The Company assesses the valuation of its inventories and reduces the carrying value of those inventories that are obsolete or in excess of the Company’s forecasted usage to their estimated net realizable value. The Company estimates the net realizable value of such inventories based on analyses and assumptions including, but not limited to, historical usage, future demand and market requirements. Reductions to the carrying value of inventories are recorded in cost of goods sold. If the future demand for the Company’s products is less favorable than the Company’s forecasts, then the value of the inventories may be required to be reduced, which would result in additional expense to the Company and affect its results of operations.
## Property, plant and equipment –
Property, plant and equipment is stated at cost. Major additions and betterments are charged to property accounts, while main- tenance and repairs are charged to operations as incurred. The cost of properties sold or otherwise disposed of and the related accu- mulated depreciation are eliminated from the accounts at the time of disposal and resulting gains and losses are included as a com- ponent of operating income.
## Depreciation –
Depreciation is computed primarily using the straight-line method over the following estimated useful lives:
## Goodwill and other intangible assets –
<img src='content_image/99588.jpg'>
Effective March 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142 (“SFAS No. 142”), “Goodwill and Other Intangible Assets.” SFAS No. 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets and supersedes Accounting Principles Board Opinion No. 17, “Intangible Assets.” Under SFAS No. 142, goodwill and indefinite lived intangible assets are no longer amortized but are reviewed at least annually for impairment. Additionally, in the year of adoption, a transitional impairment test is also required. The Company uses December 31 as its annu- al impairment test measurement date. Intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives and are also subject to review for impairment. Upon adoption of SFAS No. 142, the Company determined that certain of its intangible assets met the criteria to be considered indefinite lived and, accordingly, ceased their amortization effec- tive March 1, 2002. These intangible assets consisted principally of trademarks. The Company’s trademarks relate to well estab- lished brands owned by the Company which were previously amortized over 40 years. Intangible assets determined to have a finite life, primarily distribution agreements, continue to be amortized over their estimated useful lives which did not require modifica- tion as a result of adopting SFAS No. 142. Nonamortizable intangible assets are tested for impairment in accordance with the pro- visions of SFAS No. 142 and amortizable intangible assets are tested for impairment in accordance with the provisions of SFAS No.
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## Other assets –
Other assets include the following: (i) deferred financing costs which are stated at cost, net of accumulated amortization, and are amortized on an effective interest basis over the term of the related debt; (ii) derivative assets which are stated at fair value (see discussion above); (iii) investments in marketable securities which are stated at fair value (see Note 7); and (iv) investments in joint ventures which are carried under the equity method of accounting (see Note 8).
## Long-lived assets impairment –
Effective March 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 144 (“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 Statement of Financial Accounting Standards 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 Accounting Principles Board Opinion No. 30, “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” for the disposal of a segment of a business (as previously defined in that Opinion). In accordance with SFAS No. 144, the Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds its fair value. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell and are no longer depreciated.
Pursuant to this policy and in connection with the restructuring plan of the Constellation Wines segment (see Note 20), the Company recorded losses of $2.1 million on the disposal of certain property, plant and equipment in Fiscal 2004. These losses are included in restructuring and related charges on the Company’s Consolidated Statements of Income as they are part of the restruc- turing plan.
In Fiscal 2003, the Company recorded an asset impairment charge of $4.8 million in connection with two of the production facilities disposed of in Fiscal 2004 under the Constellation Wines segment’s restructuring plan. One of the facilities, which was held and used prior to its sale in the fourth quarter of Fiscal 2004, was written down to its appraised value and comprised most of the impairment charge. The other facility, which was held for sale in Fiscal 2004, was written down to a value based on the Company’s estimate of salvage value. These assets were sold in the second quarter of Fiscal 2004. This impairment charge is includ- ed in restructuring and related charges on the Company’s Consolidated Statements of Income since it is part of the realignment of its business operations. The impaired assets consist primarily of buildings, machinery and equipment located at the two produc- tion facilities. The charge resulted from the determination that the assets’ undiscounted future cash flows were less than their car- rying values.
The Company recorded an asset impairment charge of $1.4 million in Fiscal 2002 in connection with the sale of the Stevens Point Brewery in March 2002. This charge has been included in selling, general and administrative expenses.
## Income taxes –
The Company uses the asset and liability method of accounting for income taxes. This method accounts for deferred income taxes by applying statutory rates in effect at the balance sheet date to the difference between the financial reporting and tax bases of assets and liabilities.
## Environmental –
Environmental expenditures that relate to current operations or to an existing condition caused by past operations, and which do not contribute to current or future revenue generation, are expensed. Liabilities for environmental risks or components thereof are recorded when environmental assessments and/or remedial efforts are probable, and the cost can be reasonably estimated. Generally, the timing of these accruals coincides with the completion of a feasibility study or the Company’s commitment to a for- mal plan of action. Liabilities for environmental costs were not material at February 29, 2004, and February 28, 2003.
## Earnings per common share –
Basic earnings per common share excludes the effect of common stock equivalents and is computed by dividing income avail- able to common stockholders by the weighted average number of common shares outstanding during the period for Class A Common Stock and Class B Convertible Common Stock. Diluted earnings per common share reflects the potential dilution that could result if securities or other contracts to issue common stock were exercised or converted into common stock. Diluted earn- ings per common share assumes the exercise of stock options using the treasury stock method and assumes the conversion of Preferred Stock (see Note 16) using the “if converted” method.
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] | overall_image/32bdcc5db91d718b9dc8d41af43081a96bfd0a6c412ecbceaabe587b23788bea.png | ## Stock-based employee compensation plans –
As of February 29, 2004, the Company has four stock-based employee compensation plans, which are described more fully in Note 16. The Company applies the intrinsic value method described in Accounting Principles Board Opinion No. 25 (“APB No. 25”), “Accounting for Stock Issued to Employees,” and related interpretations in accounting for these plans. In accordance with APB No. 25, the compensation cost for stock options is recognized in income based on the excess, if any, of the quoted market price of the stock at the grant date of the award or other measurement date over the amount an employee must pay to acquire the stock. The Company utilizes the disclosure-only provisions of Statement of Financial Accounting Standards No. 123 (“SFAS No. 123”), “Accounting for Stock-Based Compensation,” as amended. Options granted under the Company’s plans have an exercise price equal to the market value of the underlying common stock on the date of grant; therefore, no incremental compensation expense has been recognized for grants made to employees under the Company’s stock option plans. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock- based employee compensation.
<img src='content_image/109724.jpg'>
As reported in the Company’s Annual Report on Form 10-K for the year ended February 28, 2003, pro forma net income for the year ended February 28, 2002, was adjusted from the amount originally reported to properly reflect the increased expense, net of income tax benefits, primarily attributable to the accelerated vesting of certain options during Fiscal 2002. The accelerated vest- ing was attributable to the attainment of preexisting performance rights set forth in the stock option grants. The impact of the accel- erated vesting was not reflected in the Fiscal 2002 amount originally reported. The pro forma net income amount reflected above for Fiscal 2002 was reduced by $12.9 million for this matter. Basic pro forma earnings per common share and diluted pro forma earn- ings per common share for Fiscal 2002 were reduced by $0.15 and $0.16, respectively.
## 2. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS:
Effective March 1, 2003, the Company adopted Statement of Financial Accounting Standards No. 143 (“SFAS No. 143”), “Accounting for Asset Retirement Obligations.” SFAS No. 143 addresses financial accounting and reporting for obligations associ- ated with the retirement of tangible long-lived assets and the associated retirement costs. The adoption of SFAS No. 143 did not have a material impact on the Company’s consolidated financial statements.
Effective March 1, 2003, the Company completed its adoption of Statement of Financial Accounting Standards No. 145 (“SFAS No. 145”), “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145 rescinds Statement of Financial Accounting Standards No. 4 (“SFAS No. 4”), “Reporting Gains and Losses from Extinguishment of Debt,” Statement of Financial Accounting Standards No. 44, “Accounting for Intangible Assets of Motor Carriers,” and Statement of Financial Accounting Standards No. 64, “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements.” In addition, SFAS No. 145 amends Statement of Financial Accounting Standards No. 13, “Accounting for Leases,” to eliminate an inconsistency between required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. Lastly, SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The adoption of the provisions rescinding SFAS No. 4 resulted in a reclassification of the extraordinary loss relat- ed to the extinguishment of debt recorded in the fourth quarter of Fiscal 2002 ($1.6 million, net of income taxes), by increasing sell- ing, general and administrative expenses ($2.6 million) and decreasing the provision for income taxes ($1.0 million). The adoption of the remaining provisions of SFAS No. 145 did not have a material impact on the Company’s consolidated financial statements.
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Effective July 1, 2003, the Company adopted Statement of Financial Accounting Standards No. 149 (“SFAS No. 149”), “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” in its entirety. SFAS No. 149 amends and clar- ifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other con- tracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133. The adoption of SFAS No. 149 did not have a material impact on the Company’s consolidated financial statements.
Effective August 1, 2003, the Company adopted EITF Issue No. 00-21 (“EITF No. 00-21”), “Revenue Arrangements with Multiple Deliverables.” EITF No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. EITF No. 00-21 also addresses how arrangement consideration should be meas- ured and allocated to the separate units of accounting in the arrangement. The adoption of EITF No. 00-21 did not have a mate- rial impact on the Company’s consolidated financial statements.
Effective September 1, 2003, the Company adopted Statement of Financial Accounting Standards No. 150 (“SFAS No. 150”), “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes stan- dards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within the scope of SFAS No. 150 as a liability. The adoption of SFAS No. 150 did not have a material impact on the Company’s consolidated financial statements.
Also, as reported in the Company’s Annual Report on Form 10-K for the year ended February 28, 2003, effective March 1, 2002, the Company adopted EITF Issue No. 01-9 (“EITF No. 01-9”), “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products),” which codified various issues related to certain promotional payments under EITF Issue No. 00-14, “Accounting for Certain Sales Incentives,” EITF Issue No. 00-22, “Accounting for ‘Points’ and Certain Other Time- Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future,” and EITF Issue No. 00-25, “Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendor’s Products.” EITF No. 01-9 addresses the recognition, measurement and income statement classification of consideration given by a vendor to a customer (including both a reseller of the vendor’s products and an entity that purchases the vendor’s products from a reseller). EITF No. 01- 9, among other things, requires that certain consideration given by a vendor to a customer be characterized as a reduction of revenue when recognized in the vendor’s income statement. Prior to its adoption of EITF No. 01-9 effective March 1, 2002, the Company reported such costs as selling, general and administrative expenses. As a result of adopting EITF No. 01-9, the Company restated the amounts originally reported for net sales, cost of product sold, and selling, general and administrative expenses for the year ended February 28, 2002. Net sales were reduced by $213.8 million; cost of product sold was increased by $10.1 million; and selling, gen- eral and administrative expenses were reduced by $223.9 million. This reclassification did not affect operating income or net income.
## 3. ACQUISITIONS:
## Turner Road Vintners Assets Acquisition –
On March 5, 2001, in an asset acquisition, the Company acquired several well-known premium wine brands, including Vendange, Nathanson Creek, Heritage, and Talus, working capital (primarily inventories), two wineries in California, and other related assets from Sebastiani Vineyards, Inc. and Tuolomne River Vintners Group (the “Turner Road Vintners Assets”). The pur- chase price of the Turner Road Vintners Assets, including direct acquisition costs, was $279.4 million. In addition, the Company assumed indebtedness of $9.4 million. The acquisition was financed by the proceeds from the sale of the February 2001 Senior Notes (as defined in Note 10) and revolving loan borrowings under the senior credit facility. The Turner Road Vintners Assets acqui- sition was accounted for using the purchase method; accordingly, the acquired net assets were recorded at fair value at the date of acquisition. The excess of the purchase price over the fair value of the net assets acquired (goodwill), $146.2 million, is no longer being amortized, but is tested for impairment at least annually in accordance with the provisions of SFAS No. 142. The results of operations of the Turner Road Vintners Assets are reported in the Constellation Wines segment and have been included in the Consolidated Statements of Income since the date of acquisition.
## Corus Assets Acquisition –
On March 26, 2001, in an asset acquisition, the Company acquired certain wine brands, wineries, working capital (primarily inventories), and other related assets from Corus Brands, Inc. (the “Corus Assets”). In this acquisition, the Company acquired sev- eral well-known premium wine brands primarily sold in the northwestern United States, including Covey Run, Columbia, Ste. Chapelle and Alice White. The purchase price of the Corus Assets, including direct acquisition costs, was $48.9 million plus an earn- out over six years based on the performance of the brands. In addition, the Company assumed indebtedness of $3.0 million. As of February 29, 2004, the Company has paid an earn-out in the amount of $3.7 million. In connection with the transaction, the
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] | overall_image/b9fdc0dd3e2e9cbdc056a5b9f466840f270694e0f9574cbf12ed56f598befd94.png | Simultaneously, we’ve maintained our historically decentralized management structure for sales, marketing and production that keeps us responsive to our customers and markets.
Constellation is aggressively pursuing all practical margin-building opportunities. A strategic sourcing initiative undertaken during the year will advance cost savings and synergies across all divisions and companies around the world.
Our commitment to prudent financial management was demonstrated by our July equity offering which dramatically improved our balance sheet and leverage ratios. In Fiscal 2004 we once again generated record cash flow to pay down debt. We also recently refinanced major portions of our debt further lowering our average borrowing costs.
## LEADERSHIP
I believe a sustaining strength of our company is the people who make up the Constellation Family. They are the finest team in the beverage alcohol industry. Beyond their particular business acumen, craft skills and industry knowledge, Constellation executives, supervisors and associates at all levels typically apply two uncommon skills to their responsibilities: innovation and ownership.
Again last year, we won more “Impact Hot Brand” awards than any competitor. Here, it’s resourceful people who initiate and inspire new Constellation products, packaging, brand and line extensions that drive revenue, and achieve results that are the envy of the industry.
Every day our people live the notion of ownership. Beyond any vested interest in our success, our managers take responsibility for their results. Constellation sustains relatively flat, but highly nimble organizations because our people – from those closest to purchasing to those face-to-face with the customer – are accountable and empowered to meet the challenges and opportunities they encounter every day. The result is an unwaivering orientation towards long- term profitable growth.
## A PROVEN STRATEGY
Our focus on scale and breadth as primary drivers for long-term profitable growth has proven itself very conclusively during this era of highly intense industry competition. With the acquisition of Hardy transforming Constellation into the world’s largest wine company, the restructuring of our global wine business to create more nimble, customer and consumer focused sales, marketing and production companies, and the continued growth of our imported beer and spirits businesses, we are well poised to exploit fully our strengths in product breadth and organizational scale to continue to deliver long-term profitable growth.
My gratification by our past accomplishments is exceeded only by my anticipation of a powerful performance in 2005 and the coming years.
<img src='content_image/116748.jpg'>
<img src='content_image/116747.jpg'>
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] | overall_image/6e00f936097f865a1286592139096bf2983cd801ec5c10f2483ce9fcbdcff802.png | Company also entered into long-term grape supply agreements with affiliates of Corus Brands, Inc. covering more than 1,000 acres of Washington and Idaho vineyards. The acquisition was financed with revolving loan borrowings under the senior credit facility. The Corus Assets acquisition was accounted for using the purchase method; accordingly, the acquired net assets were recorded at fair value at the date of acquisition. The excess of the purchase price over the fair value of the net assets acquired (goodwill), $48.5 million, is no longer being amortized, but is tested for impairment at least annually in accordance with the provisions of SFAS No. 142. The results of operations of the Corus Assets are reported in the Constellation Wines segment and have been included in the Consolidated Statements of Income since the date of acquisition.
## Ravenswood Acquisition –
On July 2, 2001, the Company acquired all of the outstanding capital stock of Ravenswood Winery, Inc. (the “Ravenswood Acquisition”). The Ravenswood business produces, markets and sells super-premium and ultra-premium California wine, primari- ly under the Ravenswood brand name. The purchase price of the Ravenswood Acquisition, including direct acquisition costs, was $149.7 million. In addition, the Company assumed indebtedness of $2.8 million. The purchase price was financed with revolving loan borrowings under the senior credit facility. The Ravenswood Acquisition was accounted for using the purchase method; accordingly, the acquired net assets were recorded at fair value at the date of acquisition. The excess of the purchase price over the fair value of the net assets acquired (goodwill), $99.8 million, is not amortizable and is tested for impairment at least annually in accordance with the provisions of SFAS No. 142. The Ravenswood Acquisition was consistent with the Company’s strategy of fur- ther penetrating the higher gross profit margin super-premium and ultra-premium wine categories. The results of operations of the Ravenswood business are reported in the Constellation Wines segment and have been included in the Consolidated Statements of Income since the date of acquisition.
The following table summarizes the fair values of the assets acquired and liabilities assumed in the Ravenswood Acquisition at July 2, 2001, as adjusted for the final appraisal:
<img src='content_image/93325.jpg'>
The trademarks are not subject to amortization. None of the goodwill is expected to be deductible for tax purposes.
## Hardy Acquisition –
On March 27, 2003, the Company acquired control of BRL Hardy Limited, now known as Hardy Wine Company Limited (“Hardy”), and on April 9, 2003, the Company completed its acquisition of all of Hardy’s outstanding capital stock. As a result of the acquisition of Hardy, the Company also acquired the remaining 50% ownership of Pacific Wine Partners LLC (“PWP”), the joint venture the Company established with Hardy in July 2001. The acquisition of Hardy along with the remaining interest in PWP is referred to together as the “Hardy Acquisition.” Through this acquisition, the Company acquired Australia’s largest wine producer with interests in wineries and vineyards in most of Australia’s major wine regions as well as New Zealand and the United States. In addition, Hardy has significant marketing and sales operations in the United Kingdom.
Total consideration paid in cash and Class A Common Stock to the Hardy shareholders was $1,137.4 million. Additionally, the Company recorded direct acquisition costs of $17.7 million. The acquisition date for accounting purposes is March 27, 2003. The Company has recorded a $1.6 million reduction in the purchase price to reflect imputed interest between the accounting acqui- sition date and the final payment of consideration. This charge is included as interest expense in the Consolidated Statement of Income for the year ended February 29, 2004. The cash portion of the purchase price paid to the Hardy shareholders and option- holders ($1,060.2 million) was financed with $660.2 million of borrowings under the Company’s March 2003 Credit Agreement (as defined in Note 10) and $400.0 million of borrowings under the Company’s Bridge Agreement (as defined in Note 10). Additionally, the Company issued 3,288,913 shares of the Company’s Class A Common Stock, which were valued at $77.2 million based on the simple average of the closing market price of the Company’s Class A Common Stock beginning two days before and ending two days after April 4, 2003, the day the Hardy shareholders elected the form of consideration they wished to receive. The purchase price was based primarily on a discounted cash flow analysis that contemplated, among other things, the value of a broad- er geographic distribution in strategic international markets and a presence in the important Australian winemaking regions. The Company and Hardy have complementary businesses that share a common growth orientation and operating philosophy. The
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] | overall_image/eb4bc15f42a0da7e5833501a6594e7495af280db99a55f3b5554818328bbf43d.png | Hardy Acquisition supports the Company’s strategy of growth and breadth across categories and geographies, and strengthens its competitive position in its core markets. The purchase price and resulting goodwill were primarily based on the growth opportu- nities of the brand portfolio of Hardy. In particular, the Company believes there are growth opportunities for Australian wines in the United Kingdom, United States and other wine markets. This acquisition supports the Company’s strategy of driving long-term growth and positions the Company to capitalize on the growth opportunities in “new world” wine markets.
The results of operations of Hardy and PWP are reported in the Constellation Wines segment and have been included in the Consolidated Statements of Income since the accounting acquisition date.
The following table summarizes the estimated fair values of the Hardy Acquisition assets acquired and liabilities assumed at the date of acquisition. The purchase price allocation period ended on March 27, 2004, and the Company will record final adjustments to the valuation of certain assets in the first quarter of fiscal 2005; however, these adjustments are not material. The Company is in the process of finalizing the tax bases of assets acquired and liabilities assumed. Accordingly, deferred tax assets and deferred tax liabilities associated with temporary differences may be subject to further adjustments. Estimated fair values at March 27, 2003, are as follows:
(in thousands)
<img src='content_image/97654.jpg'>
The trademarks are not subject to amortization. None of the goodwill is expected to be deductible for tax purposes.
The following table sets forth the unaudited pro forma results of operations of the Company for the years ended February 29, 2004, and February 28, 2003, respectively. The unaudited pro forma results of operations give effect to the Hardy Acquisition as if it occurred on March 1, 2002. The unaudited pro forma results of operations are presented after giving effect to certain adjust- ments for depreciation, amortization of deferred financing costs, interest expense on the acquisition financing and related income tax effects. The unaudited pro forma results of operations are based upon currently available information and certain assumptions that the Company believes are reasonable under the circumstances. The unaudited pro forma results of operations for the year ended February 28, 2003, do not reflect total pretax nonrecurring charges of $30.3 million ($0.23 per share on a diluted basis) related to transaction costs, primarily for the payment of stock options, which were incurred by Hardy prior to the acquisition, partially off- set by the one-time tax benefit from a change in Australian tax consolidation rules effective January 1, 2003, related to acquisition basis adjustments to fair value of $10.6 million ($0.11 per share on a diluted basis). The unaudited pro forma results of operations do not purport to present what the Company’s results of operations would actually have been if the aforementioned transactions had in fact occurred on such date or at the beginning of the period indicated, nor do they project the Company’s financial position or results of operations at any future date or for any future period.
<img src='content_image/97656.jpg'>
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] | overall_image/c04bd7088977391d7d5339fc3549114f7acea35b9f60b24f74c275e4357b5174.png | 4. PROPERTY, PLANT AND EQUIPMENT:
The major components of property, plant and equipment are as follows:
5. GOODWILL:
<img src='content_image/63192.jpg'>
As discussed in Note 1, effective March 1, 2002, the Company adopted SFAS No. 142. The following table presents earnings and earnings per share information for the comparative periods as if Statement of Financial Accounting Standards No. 141 (“SFAS No. 141”), “Business Combinations,” and the nonamortization provisions of SFAS No. 142 had been applied beginning March 1, 2001:
<img src='content_image/63193.jpg'>
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] | overall_image/eaf6a4edb36c62b654cba49d37e3d788113c8cd51df326033cd0c07b3c9a3467.png | The changes in the carrying amount of goodwill for the year ended February 29, 2004, are as follows:
<img src='content_image/33528.jpg'>
The Constellation Wines purchase accounting allocations of goodwill totaling $650.1 million consist of $615.3 million of good- will resulting from the Hardy Acquisition, $33.4 million of goodwill previously included as part of the Company’s investment in PWP, and $1.4 million of goodwill resulting from an immaterial business acquisition.
## 6. INTANGIBLE ASSETS:
The major components of intangible assets are:
<img src='content_image/33529.jpg'>
The difference between the gross carrying amount and net carrying amount for each item presented is attributable to accumu- lated amortization. Amortization expense for intangible assets was $2.6 million, $2.2 million and $13.4 million for the years ended February 29, 2004, February 28, 2003 and February 28, 2002, respectively. Estimated amortization expense for each of the five succeeding fiscal years is as follows:
<img src='content_image/33530.jpg'>
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] | overall_image/6e3b47b4201ad27164c049008d1ce96192b51e127a0e2c79559a55be32e5578a.png | ## 7. OTHER ASSETS:
The major components of other assets are as follows:
<img src='content_image/3692.jpg'>
The Company’s investment in marketable equity securities is classified as an available-for-sale security. As such, gross unreal- ized losses of $0.6 million are included, net of applicable income taxes, within AOCI as of February 29, 2004. The Company uses the average cost method as its basis on which cost is determined in computing realized gains or losses. Realized gains on sales of securities during the year ended February 29, 2004, are immaterial.
Amortization expense for other assets was included in selling, general and administrative expenses and was $19.3 million, $3.7 million and $4.0 million for the years ended February 29, 2004, February 28, 2003, and February 28, 2002, respectively. Amortization expense for the year ended February 29, 2004, includes $7.9 million related to amortization of the deferred financing costs associated with the Bridge Loans (as defined in Note 10). As of February 29, 2004, the deferred financing costs asso- ciated with the Bridge Loans have been fully amortized.
## 8. INVESTMENT IN JOINT VENTURE:
On March 27, 2003, as part of the Hardy Acquisition, the Company acquired the remaining 50% ownership of PWP, the joint venture formed on July 31, 2001, which was previously owned equally by the Company and Hardy. Prior to March 27, 2003, the Company’s investment was accounted for under the equity method. Since the Hardy Acquisition, PWP has become a wholly-owned subsidiary of the Company and its results of operations have been included in the Consolidated Statements of Income since March 27, 2003.
In addition, in connection with the Hardy Acquisition, the Company acquired several investments which are being accounted for under the equity method. The majority of these investments consist of 50% owned joint venture arrangements. As of February 29, 2004, the Company’s investment balance in these equity investments was $8.4 million.
## 9. OTHER ACCRUED EXPENSES AND LIABILITIES:
The major components of other accrued expenses and liabilities are as follows:
<img src='content_image/3693.jpg'>
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Borrowings consist of the following:
<img src='content_image/129883.jpg'>
## Senior credit facility -
In connection with the Hardy Acquisition, on January 16, 2003, the Company, certain subsidiaries of the Company, JPMorgan Chase Bank, as a lender and administrative agent (the “Administrative Agent”), and certain other lenders entered into a new cred- it agreement (as subsequently amended and restated as of March 19, 2003, the “March 2003 Credit Agreement”). In October 2003, the Company entered into a Second Amended and Restated Credit Agreement (the “October Credit Agreement”) that (i) refinanced the then outstanding principal balance under the Tranche B Term Loan facility on essentially the same terms as the Tranche B Term Loan facility under the March 2003 Credit Agreement, but at a lower Applicable Rate (as such term is defined in the October Credit Agreement) and (ii) otherwise restated the terms of the March 2003 Credit Agreement, as amended. The October Credit Agreement was further amended during February 2004 (the “Credit Agreement”). The March 2003 Credit Agreement provided for aggregate credit facilities of $1.6 billion consisting of a $400.0 million Tranche A Term Loan facility due in February 2008, an $800.0 mil- lion Tranche B Term Loan facility due in November 2008 and a $400.0 million Revolving Credit facility (including an Australian Dollar revolving sub-facility of up to A$10.0 million and a sub-facility for letters of credit of up to $40.0 million) which expires on February 29, 2008. Proceeds of the March 2003 Credit Agreement were used to pay off the Company’s obligations under its prior senior credit facility, to fund a portion of the cash required to pay the former Hardy shareholders and to pay indebtedness outstand- ing under certain of Hardy’s credit facilities. The Company uses the remaining availability under the Credit Agreement to fund its working capital needs on an on-going basis.
The Tranche A Term Loan facility and the Tranche B Term Loan facility were fully drawn on March 27, 2003. As of February 29, 2004, the Company has made $40.0 million of scheduled and required payments on the Tranche A Term Loan facility. In August 2003, the Company paid $100.0 million of the Tranche B Term Loan facility. In October 2003, the Company paid an addi- tional $200.0 million of the Tranche B Term Loan facility. As of February 29, 2004, the required annual repayments of the Tranche A Term Loan and the Tranche B Term Loan are as follows:
<img src='content_image/129887.jpg'>
The rate of interest payable, at the Company’s option, is a function of LIBOR plus a margin, the federal funds rate plus a mar- gin, or the prime rate plus a margin. The margin is adjustable based upon the Company’s Debt Ratio (as defined in the Credit Agreement) and, with respect to LIBOR borrowings, ranges between 1.50% and 2.50%. As of February 29, 2004, the LIBOR mar- gin for the Revolving Credit facility and the Tranche A Term Loan facility is 1.75%, while the LIBOR margin on the Tranche B Term Loan facility is 2.00%.
The Company’s obligations are guaranteed by certain subsidiaries of the Company (“Guarantors”) and the Company is obli- gated to pledge collateral of (i) 100% of the capital stock of all of the Company’s U.S. subsidiaries and (ii) 65% of the voting cap- ital stock of certain foreign subsidiaries of the Company.
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As of February 29, 2004, under the Credit Agreement, the Company had outstanding Tranche A Term Loans of $360.0 mil- lion bearing a weighted average interest rate of 2.9%, Tranche B Term Loans of $500.0 million bearing a weighted average inter- est rate of 3.2%, undrawn revolving letters of credit of $18.6 million, and $381.4 million in revolving loans available to be drawn.
There were no outstanding revolving loans under the Credit Agreement as of February 29, 2004.
## Bridge facility –
On January 16, 2003, the Company, certain subsidiaries of the Company, JPMorgan Chase Bank, as a lender and Administrative Agent, and certain other lenders (such other lenders, together with the Administrative Agent, are collectively referred to herein as the “Bridge Lenders”) entered into a bridge loan agreement which was amended and restated as of March 26, 2003, containing commitments of the Bridge Lenders to make bridge loans (the “Bridge Loans”) of up to, in the aggregate, $450.0 mil- lion (the “Bridge Agreement”). On April 9, 2003, the Company used $400.0 million of the Bridge Loans to fund a portion of the cash required to pay the former Hardy shareholders. On July 30, 2003, the Company used proceeds from the 2003 Equity Offerings to prepay the $400.0 million Bridge Loans in their entirety.
## Subsidiary facilities –
The Company has additional line of credit arrangements available totaling $91.5 million and $44.5 million as of February 29, 2004, and February 28, 2003, respectively. These lines support the borrowing needs of certain of the Company’s foreign subsidiary operations. Interest rates and other terms of these borrowings vary from country to country, depending on local market conditions.
As of February 29, 2004, and February 28, 2003, amounts outstanding under the subsidiary revolving credit facilities were $1.8 million and $0.6 million, respectively.
## Senior notes –
On August 4, 1999, the Company issued $200.0 million aggregate principal amount of 8 5/8% Senior Notes due August 2006 (the “August 1999 Senior Notes”). Interest on the August 1999 Senior Notes is payable semiannually on February 1 and August 1. As of February 29, 2004, the Company had outstanding $200.0 million aggregate principal amount of August 1999 Senior Notes.
On November 17, 1999, the Company issued £75.0 million ($121.7 million upon issuance) aggregate principal amount of 8 1/2% Senior Notes due November 2009 (the “Sterling Senior Notes”). Interest on the Sterling Senior Notes is payable semiannual- ly on May 15 and November 15. In March 2000, the Company exchanged £75.0 million aggregate principal amount of 8 1/2% Series B Senior Notes due in November 2009 (the “Sterling Series B Senior Notes”) for all of the Sterling Senior Notes. The terms of the Sterling Series B Senior Notes are identical in all material respects to the Sterling Senior Notes. In October 2000, the Company exchanged £74.0 million aggregate principal amount of Sterling Series C Senior Notes (as defined below) for £74.0 mil- lion of the Sterling Series B Notes. The terms of the Sterling Series C Senior Notes are identical in all material respects to the Sterling Series B Senior Notes. As of February 29, 2004, the Company had outstanding £1.0 million ($1.9 million) aggregate principal amount of Sterling Series B Senior Notes.
On May 15, 2000, the Company issued £80.0 million ($120.0 million upon issuance) aggregate principal amount of 8 1/2% Series C Senior Notes due November 2009 at an issuance price of £79.6 million ($119.4 million upon issuance, net of $0.6 million unamortized discount, with an effective interest rate of 8.6%) (the “Sterling Series C Senior Notes”). Interest on the Sterling Series C Senior Notes is payable semiannually on May 15 and November 15. As of February 29, 2004, the Company had outstanding £154.0 million ($287.2 million, net of $0.5 million unamortized discount) aggregate principal amount of Sterling Series C Senior Notes.
On February 21, 2001, the Company issued $200.0 million aggregate principal amount of 8% Senior Notes due February 2008 (the “February 2001 Senior Notes”). The net proceeds of the offering ($197.0 million) were used to partially fund the acquisition of the Turner Road Vintners Assets. Interest on the February 2001 Senior Notes is payable semiannually on February 15 and August 15. In July 2001, the Company exchanged $200.0 million aggregate principal amount of 8% Series B Senior Notes due February 2008 (the “February 2001 Series B Senior Notes”) for all of the February 2001 Senior Notes. The terms of the February 2001 Series B Senior Notes are identical in all material respects to the February 2001 Senior Notes. As of February 29, 2004, the Company had outstanding $200.0 million aggregate principal amount of February 2001 Senior Notes.
The senior notes described above are redeemable, in whole or in part, at the option of the Company at any time at a redemp- tion price equal to 100% of the outstanding principal amount and a make whole payment based on the present value of the future payments at the adjusted Treasury rate or adjusted Gilt rate plus 50 basis points. The senior notes are unsecured senior obligations
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## Senior subordinated notes –
On March 4, 1999, the Company issued $200.0 million aggregate principal amount of 8 1/2% Senior Subordinated Notes due March 2009 (“Senior Subordinated Notes”). Interest on the Senior Subordinated Notes is payable semiannually on March 1 and September 1. The Senior Subordinated Notes are redeemable at the option of the Company, in whole or in part, at any time on or after March 1, 2004. As of February 29, 2004, the Company had outstanding $200.0 million aggregate principal amount of Senior Subordinated Notes. On February 10, 2004, the Company issued a Notice of Redemption for its Senior Subordinated Notes. The Senior Subordinated Notes were redeemed with proceeds from the Revolving Credit facility on March 11, 2004, at 104.25% of par plus accrued interest. In the first quarter of fiscal 2005, the Company recorded a charge of $10.3 million related to this redemp- tion.
On January 23, 2002, the Company issued $250.0 million aggregate principal amount of 8 1/8% Senior Subordinated Notes due January 2012 (“January 2002 Senior Subordinated Notes”). The net proceeds of the offering ($247.2 million) were used pri- marily to repay the Company’s $195.0 million aggregate principal amount of 8 3/4% Senior Subordinated Notes due in December 2003. The remaining net proceeds of the offering were used to repay a portion of the outstanding indebtedness under the Company’s then existing senior credit facility. Interest on the January 2002 Senior Subordinated Notes is payable semiannually on January 15 and July 15. The January 2002 Senior Subordinated Notes are redeemable at the option of the Company, in whole or in part, at any time on or after January 15, 2007. The Company may also redeem up to 35% of the January 2002 Senior Subordinated Notes using the proceeds of certain equity offerings completed before January 15, 2005. The January 2002 Senior Subordinated Notes are unsecured and subordinated to the prior payment in full of all senior indebtedness of the Company, which includes the senior credit facility. The January 2002 Senior Subordinated Notes are guaranteed, on a senior subordinated basis, by certain of the Company’s significant operating subsidiaries. As of February 29, 2004, the Company had outstanding $250.0 mil- lion aggregate principal amount of January 2002 Senior Subordinated Notes.
## Trust Indentures –
The Company’s various Trust Indentures relating to the senior notes and senior subordinated notes contain certain covenants, including, but not limited to: (i) limitation on indebtedness; (ii) limitation on restricted payments; (iii) limitation on transactions with affiliates; (iv) limitation on senior subordinated indebtedness; (v) limitation on liens; (vi) limitation on sale of assets; (vii) lim- itation on issuance of guarantees of and pledges for indebtedness; (viii) restriction on transfer of assets; (ix) limitation on subsidiary capital stock; (x) limitation on dividends and other payment restrictions affecting subsidiaries; and (xi) restrictions on mergers, con- solidations and the transfer of all or substantially all of the assets of the Company to another person. The limitation on indebted- ness covenant is governed by a rolling four quarter fixed charge ratio requiring a specified minimum.
## Debt payments –
Principal payments required under long-term debt obligations (excluding unamortized discount of $0.5 million) during the next five fiscal years and thereafter are as follows:
## Guarantees –
<img src='content_image/133714.jpg'>
A foreign subsidiary of the Company has guaranteed debt of a joint venture in the maximum amount of $4.2 million as of February 29, 2004. The liability for this guarantee is not material and the Company does not have any collateral from this entity.
## 11. INCOME TAXES:
Income before income taxes was generated as follows:
<img src='content_image/133715.jpg'>
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<img src='content_image/57459.jpg'>
The foreign provision for income taxes is based on foreign pretax earnings. Earnings of foreign subsidiaries would be subject to U.S. income taxation on repatriation to the U.S. The Company’s consolidated financial statements fully provide for any related tax liability on amounts that may be repatriated.
Deferred tax assets and liabilities reflect the future income tax effects of temporary differences between the consolidated finan- cial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income.
Significant components of deferred tax assets (liabilities) consist of the following:
<img src='content_image/57458.jpg'>
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some or all of the deferred tax assets will not be realized. Management considers the reversal of deferred tax liabilities and projected future tax- able income in making this assessment. Based upon this assessment, management believes it is more likely than not that the Company will realize the benefits of these deductible differences, net of any valuation allowances.
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] | overall_image/4fffcf4a4256fefee8acb89fd0a8ee55a28787c63e4bc9310c8091488146053c.png | Operating loss carryforwards totaling $47.7 million at February 29, 2004, are being carried forward in a number of U.S. and foreign jurisdictions where the Company is permitted to use tax operating losses from prior periods to reduce future taxable income. Of these operating loss carryforwards, $6.6 million will expire in 2019 and $41.1 million may be carried forward indefinitely. In addition, certain tax credits generated of $8.6 million are available to offset future income taxes. These credits will expire, if not utilized, in 2007 through 2009.
The Company is subject to ongoing tax examinations and assessments in various jurisdictions. Accordingly, the Company pro- vides for additional tax expense based on probable outcomes of such matters. The Internal Revenue Service is currently examin- ing tax returns for the years ended February 29, 2000, February 28, 2001, February 28, 2002, and February 28, 2003. While it is often difficult to predict the final outcome or the timing of resolution of any particular tax matter, the Company believes the reserves reflect the probable outcome of known tax contingencies. Unfavorable settlement of any particular issue would require use of cash. Favorable resolution would be recognized as a reduction to the effective tax rate in the year of resolution.
A reconciliation of the total tax provision to the amount computed by applying the statutory U.S. Federal income tax rate to income before provision for income taxes is as follows:
<img src='content_image/80576.jpg'>
The effect of earnings of foreign subsidiaries includes the difference between the U.S. statutory rate and local jurisdiction tax rates, as well as the provision for incremental U.S. taxes on unremitted earnings of foreign subsidiaries offset by foreign tax credits and other foreign adjustments.
## 12. OTHER LIABILITIES:
The major components of other liabilities are as follows:
## 13. PROFIT SHARING AND RETIREMENT SAVINGS PLANS:
<img src='content_image/80575.jpg'>
The Company’s retirement and profit sharing plan, the Constellation Brands, Inc. 401(k) and Profit Sharing Plan (the “Plan”), covers substantially all U.S. employees, excluding those employees covered by collective bargaining agreements. The 401(k) por- tion of the Plan permits eligible employees to defer a portion of their compensation (as defined in the Plan) on a pretax basis. Participants may defer up to 50% of their compensation for the year, subject to limitations of the Plan. The Company makes a matching contribution of 50% of the first 6% of compensation a participant defers. The amount of the Company’s contribution under the profit sharing portion of the Plan is a discretionary amount as determined by the Board of Directors on an annual basis, subject to limitations of the Plan. Company contributions under the Plan were $10.8 million, $10.9 million, and $10.5 million for the years ended February 29, 2004, February 28, 2003, and February 28, 2002, respectively.
During the year ended February 29, 2004, in connection with the Hardy Acquisition, the Company acquired the BRL Hardy Superannuation Fund (now known as the Hardy Wine Company Superannuation Plan) (the “Hardy Plan”) which covers substan- tially all salaried Australian employees. The Hardy Plan has a defined benefit component and a defined contribution component. The Company also has a statutory obligation to provide a minimum defined contribution on behalf of any Australian employees who are not covered by the Hardy Plan. Additionally in Fiscal 2004, the Company instituted a defined contribution plan that covers sub- stantially all of its U.K. employees. Company contributions under the defined contribution component of the Hardy Plan, the Australian statutory obligation, and the U.K. defined contribution plan aggregated $6.5 million for the year ended February 29, 2004.
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] | overall_image/feefa60bfd5d84c0a315ac1ca336211d3c51487866003a8d960119de397a3a16.png | The Company also has defined benefit pension plans that cover certain of its non-U.S. employees. These consist of a Canadian plan, an U.K. plan and the defined benefit component of the Hardy Plan. During the year ended February 29, 2004, the Company ceased future accruals for active employees under its U.K. plan. There were no curtailment charges arising from this event. Net peri- odic benefit cost (income) reported in the Consolidated Statements of Income for these plans includes the following components:
<img src='content_image/78690.jpg'>
The following table summarizes the funded status of the Company’s defined benefit pension plans and the related amounts included in the Consolidated Balance Sheets:
<img src='content_image/78689.jpg'>
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] | overall_image/bdf794c29942d7e2f548c2673e3aeff9e96a5010924b9902b865902a30664669.png | As of February 29, 2004, and February 28, 2003, the accumulated benefit obligation for all defined benefit pension plans was $290.3 million and $212.2 million, respectively. The following table summarizes the projected benefit obligation, accumulated ben- efit obligation and fair value of plan assets for those pension plans with an accumulated benefit obligation in excess of plan assets:
<img src='content_image/108068.jpg'>
The increase in minimum pension liability included in AOCI for the years ended February 29, 2004, and February 28, 2003, were $15.6 million and $42.5 million, respectively.
The following table sets forth the weighted average assumptions used in developing the net periodic pension expense for the years ended February 29, 2004, and February 28, 2003:
<img src='content_image/108069.jpg'>
The following table sets forth the weighted average assumptions used in developing the benefit obligation as of February 29, 2004, and February 28, 2003:
14. POSTRETIREMENT BENEFITS:
<img src='content_image/108070.jpg'>
The Company currently sponsors multiple unfunded postretirement benefit plans for certain of its Constellation Beers and Spirits segment employees. During Fiscal 2004, an amendment to one of the unfunded postretirement benefit plans modifying the eligibility requirements and retiree contributions decreased the postretirement benefit obligation by $0.6 million.
The status of the plans is as follows:
<img src='content_image/108075.jpg'>
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] | overall_image/599d28d61400420665d536b2912c0d7fa049309f14ff2f5af9676f883b1b31cc.png | Net periodic benefit cost reported in the Consolidated Statements of Income includes the following components:
<img src='content_image/32679.jpg'>
The following table sets forth the weighted average assumptions used in developing the benefit obligation as of February 29, 2004, and February 28, 2003:
<img src='content_image/32674.jpg'>
The following table sets forth the weighted average assumptions used in developing the net periodic non-pension postretirement expense for the years ended February 29, 2004, and February 28, 2003:
<img src='content_image/32675.jpg'>
The following table sets forth the assumed health care cost trend rates as of February 29, 2004, and February 28, 2003:
<img src='content_image/32677.jpg'>
Assumed health care trend rates could have a significant effect on the amount reported for health care plans. A one percent change in assumed health care cost trend rates would have the following effects:
## 15. COMMITMENTS AND CONTINGENCIES:
## Operating leases –
<img src='content_image/32676.jpg'>
Step rent provisions, escalation clauses, capital improvement funding and other lease concessions, when present in the Company’s leases, are taken into account in computing the minimum lease payments. The minimum lease payments for the Company’s operating leases are recognized on a straight-line basis over the minimum lease term. Future payments under noncance- lable operating leases having initial or remaining terms of one year or more are as follows during the next five fiscal years and there- after:
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<img src='content_image/50773.jpg'>
Rental expense was $38.7 million, $25.3 million, and $24.0 million for Fiscal 2004, Fiscal 2003, and Fiscal 2002, respectively.
## Purchase commitments and contingencies -
The Company has agreements with suppliers to purchase various spirits of which certain agreements are denominated in British pound sterling and Canadian dollars. The maximum future obligation under these agreements, based upon exchange rates at February 29, 2004, aggregate $20.3 million for contracts expiring through December 2007.
All of the Company’s imported beer products are marketed and sold pursuant to exclusive distribution agreements from the suppliers of these products. The Company’s agreement to distribute Corona Extra and its other Mexican beer brands exclusively throughout 25 primarily western U.S. states expires in December 2006, with automatic five year renewals thereafter, subject to com- pliance with certain performance criteria and other terms under the agreement. The remaining agreements expire through December 2008. Prior to their expiration, these agreements may be terminated if the Company fails to meet certain performance criteria. At February 29, 2004, the Company believes it is in compliance with all of its material distribution agreements and, given the Company’s long-term relationships with its suppliers, the Company does not believe that these agreements will be terminated.
In connection with previous acquisitions as well as with the Hardy Acquisition, the Company has assumed grape purchase con- tracts with certain growers and suppliers. In addition, the Company has entered into other grape purchase contracts with various growers and suppliers in the normal course of business. Under the grape purchase contracts, the Company is committed to pur- chase all grape production yielded from a specified number of acres for a period of time from one to fifteen years. The actual ton- nage and price of grapes that must be purchased by the Company will vary each year depending on certain factors, including weath- er, time of harvest, overall market conditions and the agricultural practices and location of the growers and suppliers under con- tract. The Company purchased $284.0 million and $166.6 million of grapes under contracts during Fiscal 2004 and Fiscal 2003, respectively. Based on current production yields and published grape prices, the Company estimates that the aggregate purchases under these contracts over the remaining terms of the contracts will be $2,131.3 million.
In connection with the Turner Road Vintners Assets acquisition, the Corus Assets acquisition and the Hardy Acquisition, the Company established a reserve for the estimated loss on firm purchase commitments assumed at the time of acquisition. As of February 29, 2004, the remaining balance on this reserve is $123.6 million.
The Company’s aggregate obligations under bulk wine purchase contracts will be $78.9 million over the remaining terms of the contracts which extend through fiscal 2008.
In connection with the Hardy Acquisition, the Company assumed certain processing contracts which commit the Company to utilize outside services to process and/or package a minimum volume quantity. In addition, the Company entered into a new pro- cessing contract in Fiscal 2004 utilizing outside services to process a minimum volume of brandy at prices which are dependent on the processing ingredients provided by the Company. The Company’s aggregate obligations under these processing contracts will be $67.5 million over the remaining terms of the contracts which extend through December 2014.
## Employment contracts –
The Company has employment contracts with certain of its executive officers and certain other management personnel with automatic one year renewals unless terminated by either party. These agreements provide for minimum salaries, as adjusted for annual increases, and may include incentive bonuses based upon attainment of specified management goals. In addition, these agreements provide for severance payments in the event of specified termination of employment. As of February 29, 2004, the aggregate commitment for future compensation and severance, excluding incentive bonuses, was $8.0 million, none of which was accruable at that date.
## Employees covered by collective bargaining agreements –
Approximately 31.2% of the Company’s full-time employees are covered by collective bargaining agreements at February 29, 2004. Agreements expiring within one year cover approximately 11.9% of the Company’s full-time employees.
## Legal matters –
In the course of its business, the Company is subject to litigation from time to time. Although the amount of any liability with respect to such litigation cannot be determined, in the opinion of management such liability will not have a material adverse effect on the Company’s financial condition, results of operations or cash flows.
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] | overall_image/97cfbbe26dafd11e53aa453a0587846872b7cfa8cb9b5c53219d9f5fa74e403f.png | ## 16. STOCKHOLDERS’ EQUITY:
## Common stock -
The Company has two classes of common stock: Class A Common Stock and Class B Convertible Common Stock. Class B Convertible Common Stock shares are convertible into shares of Class A Common Stock on a one-to-one basis at any time at the option of the holder. Holders of Class B Convertible Common Stock are entitled to ten votes per share. Holders of Class A Common Stock are entitled to one vote per share and a cash dividend premium. If the Company pays a cash dividend on Class B Convertible Common Stock, each share of Class A Common Stock will receive an amount at least ten percent greater than the amount of the cash dividend per share paid on Class B Convertible Common Stock. In addition, the Board of Directors may declare and pay a dividend on Class A Common Stock without paying any dividend on Class B Convertible Common Stock. However, under the terms of the Company’s senior credit facility, the Company is currently constrained from paying cash dividends on its common stock. In addition, the indentures for the Company’s outstanding senior notes and senior subordinated notes may restrict the payment of cash dividends on its common stock under certain circumstances.
In July 2002, the stockholders of the Company approved an increase in the number of authorized shares of Class A Common Stock from 120,000,000 shares to 275,000,000 shares and Class B Convertible Common Stock from 20,000,000 shares to 30,000,000 shares, thereby increasing the aggregate number of authorized shares of the Company to 306,000,000 shares.
At February 29, 2004, there were 94,566,611 shares of Class A Common Stock and 12,061,730 shares of Class B Convertible Common Stock outstanding, net of treasury stock.
## Stock repurchase authorization –
In June 1998, the Company’s Board of Directors authorized the repurchase of up to $100.0 million of its Class A Common Stock and Class B Convertible Common Stock. The Company may finance such purchases, which will become treasury shares, through cash generated from operations or through the senior credit facility. No shares were repurchased during Fiscal 2004, Fiscal 2003 and Fiscal 2002.
## Preferred stock –
In Fiscal 2004, the Company issued 5.75% Series A Mandatory Convertible Preferred Stock (“Preferred Stock”) (see “Equity Offerings” discussion below). Dividends are cumulative and payable quarterly, if declared, in cash, shares of the Company’s Class A Common Stock, or a combination thereof, at the discretion of the Company. Dividends are payable, if declared, on the first busi- ness day of March, June, September, and December of each year, commencing on December 1, 2003. On September 1, 2006, the automatic conversion date, each share of Preferred Stock will automatically convert into, subject to certain anti-dilution adjust- ments, between 29.276 and 35.716 shares of the Company’s Class A Common Stock, depending on the then applicable market price of the Company’s Class A Common Stock, in accordance with the following table:
<img src='content_image/74946.jpg'>
The applicable market price is the average of the closing prices per share of the Company’s Class A Common Stock on each of the 20 consecutive trading days ending on the third trading day immediately preceding the applicable conversion date. At any time prior to September 1, 2006, holders may elect to convert each share of Preferred Stock, subject to certain anti-dilution adjustments, into 29.276 shares of the Company’s Class A Common Stock. If the closing market price of the Company’s Class A Common Stock exceeds $51.24 for at least 20 trading days within a period of 30 consecutive trading days, the Company may elect, subject to cer- tain limitations and anti-dilution adjustments, to cause the conversion of all, but not less than all, of the then outstanding shares of Preferred Stock into shares of the Company’s Class A Common Stock at a conversion rate of 29.276 shares of the Company’s Class A Common Stock. In order for the Company to cause the early conversion of the Preferred Stock, the Company must pay all accrued and unpaid dividends on the Preferred Stock as well as the present value of all remaining dividend payments through and includ- ing September 1, 2006. If the Company is involved in a merger in which at least 30% of the consideration for all or any class of the Company’s common stock consists of cash or cash equivalents, then on or after the date of such merger, each holder will have the right to convert each share of Preferred Stock into the number of shares of the Company’s Class A Common Stock applicable on the automatic conversion date. The Preferred Stock ranks senior in right of payment to all of the Company’s common stock and has a liquidation preference of $1,000 per share, plus accrued and unpaid dividends.
As of February 29, 2004, 170,500 shares of Preferred Stock were outstanding and $2.5 million of dividends were accrued.
## Equity offerings –
During March 2001, the Company completed a public offering of 8,740,000 shares of its Class A Common Stock, which was held as treasury stock. This resulted in net proceeds to the Company, after deducting underwriting discounts and expenses, of $139.4 million. The net proceeds were used to repay revolving loan borrowings under the senior credit facility of which a portion was incurred to partially finance the acquisition of the Turner Road Vintners Assets.
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During July 2003, the Company completed a public offering of 9,800,000 shares of its Class A Common Stock resulting in net proceeds to the Company, after deducting underwriting discounts and expenses, of $261.1 million. In addition, the Company also completed a public offering of 170,500 shares of its 5.75% Series A Mandatory Convertible Preferred Stock resulting in net pro- ceeds to the Company, after deducting underwriting discounts and expenses, of $164.9 million. The Class A Common Stock offer- ing and the Preferred Stock offering are referred to together as the “2003 Equity Offerings.” The majority of the net proceeds from the 2003 Equity Offerings were used to repay the Bridge Loans that were incurred to partially finance the Hardy Acquisition. The remaining proceeds were used to repay term loan borrowings under the March 2003 Credit Agreement.
## Long-term stock incentive plan –
Under the Company’s Long-Term Stock Incentive Plan, nonqualified stock options, stock appreciation rights, restricted stock and other stock-based awards may be granted to employees, officers and directors of the Company. The aggregate number of shares of the Company’s Class A Common Stock available for awards under the Company’s Long-Term Stock Incentive Plan is 28,000,000 shares. The exercise price, vesting period and term of nonqualified stock options granted are established by the committee admin- istering the plan (the “Committee”). Grants of stock appreciation rights, restricted stock and other stock-based awards may con- tain such vesting, terms, conditions and other requirements as the Committee may establish. During Fiscal 2004, Fiscal 2003 and Fiscal 2002, no stock appreciation rights were granted. No restricted stock was granted during Fiscal 2004. During Fiscal 2003, 7,080 shares of restricted Class A Common Stock were granted at a weighted average grant date fair value of $28.41 per share. No restricted stock was granted during Fiscal 2002.
## Incentive stock option plan –
Under the Company’s Incentive Stock Option Plan, incentive stock options may be granted to employees, including officers, of the Company. Grants, in the aggregate, may not exceed 4,000,000 shares of the Company’s Class A Common Stock. The exer- cise price of any incentive stock option may not be less than the fair market value of the Company’s Class A Common Stock on the date of grant. The vesting period and term of incentive stock options granted are established by the Committee. The maximum term of incentive stock options is ten years.
A summary of stock option activity under the Company’s Long-Term Stock Incentive Plan and the Incentive Stock Option Plan is as follows:
<img src='content_image/39376.jpg'>
The following table summarizes information about stock options outstanding at February 29, 2004:
<img src='content_image/39377.jpg'>
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## Employee stock purchase plans –
The Company has a stock purchase plan under which 4,500,000 shares of Class A Common Stock may be issued. Under the terms of the plan, eligible employees may purchase shares of the Company’s Class A Common Stock through payroll deductions. The purchase price is the lower of 85% of the fair market value of the stock on the first or last day of the purchase period. During Fiscal 2004, Fiscal 2003 and Fiscal 2002, employees purchased 137,985 shares, 138,304 shares and 120,674 shares, respectively.
The weighted average fair value of purchase rights granted during Fiscal 2004, Fiscal 2003 and Fiscal 2002 was $6.60, $7.02 and $5.59, respectively. The fair value of purchase rights is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: risk-free interest rate of 1.0% for Fiscal 2004, 1.4% for Fiscal 2003 and 2.6% for Fiscal 2002; volatility of 22.2% for Fiscal 2004, 40.3% for Fiscal 2003 and 33.2% for Fiscal 2002; and expected pur- chase right life of 0.5 years for Fiscal 2004, Fiscal 2003 and Fiscal 2002. The dividend yield was 0% for Fiscal 2004, Fiscal 2003 and Fiscal 2002.
The Company has a stock purchase plan under which 2,000,000 shares of the Company’s Class A Common Stock may be issued to eligible employees and directors of the Company’s United Kingdom subsidiaries. Under the terms of the plan, participants may purchase shares of the Company’s Class A Common Stock through payroll deductions. The purchase price may be no less than 80% of the closing price of the stock on the day the purchase price is fixed by the committee administering the plan. During Fiscal 2004 and Fiscal 2003, employees purchased 27,791 shares and 758 shares, respectively. During Fiscal 2002, there were no shares purchased under this plan.
The weighted average fair value of purchase rights granted during Fiscal 2002 was $6.26. There were no purchase rights grant- ed during Fiscal 2004 and Fiscal 2003. The fair value of purchase rights is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions for Fiscal 2002: risk-free interest rate of 4.9%; volatility of 36.2%; and expected purchase right life of 3.8 years. The dividend yield was 0% for Fiscal 2002.
## 17. EARNINGS PER COMMON SHARE:
Earnings per common share are as follows:
<img src='content_image/13101.jpg'>
Stock options to purchase 0.1 million, 1.1 million and 2.2 million shares of Class A Common Stock at a weighted average price per share of $31.09, $27.41 and $20.70 were outstanding during the years ended February 29, 2004, February 28, 2003, and February 28, 2002, respectively, but were not included in the computation of the diluted earnings per common share because the stock options’ exercise price was greater than the average market price of the Class A Common Stock for the respective periods.
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] | overall_image/ae334d6669234d2ec76f86555d1c50af7f31f3f9128d441fe4aebc113b26d620.png | ## 18. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS):
Accumulated other comprehensive loss, net of tax effects, includes the following components:
<img src='content_image/25763.jpg'>
## 19. SIGNIFICANT CUSTOMERS AND CONCENTRATION OF CREDIT RISK:
Sales to the five largest customers represented 20.6%, 21.2%, and 19.1% of the Company’s sales for the years ended February 29, 2004, February 28, 2003, and February 28, 2002, respectively. No single customer was responsible for greater than 10% of sales during these years. Accounts receivable from the Company’s largest customer, Southern Wine and Spirits, represented 8.3%, 11.4%, and 10.0% of the Company’s total accounts receivable as of February 29, 2004, February 28, 2003, and February 28, 2002, respectively. Sales to the Company’s five largest customers are expected to continue to represent a significant portion of the Company’s revenues. The Company’s arrangements with certain of its customers may, generally, be terminated by either party with prior notice. The Company performs ongoing credit evaluations of its customers’ financial position, and management of the Company is of the opinion that any risk of significant loss is reduced due to the diversity of customers and geographic sales area.
The Company purchases the majority of its glass inventories from a limited number of suppliers. Glass bottle costs are one of the largest components of the Company’s cost of product sold. The glass bottle industry is highly concentrated with only a small number of producers. The inability of any of the Company’s glass bottle suppliers to satisfy the Company’s requirements could adversely affect the Company’s operations.
## 20. RESTRUCTURING AND RELATED CHARGES:
For the year ended February 29, 2004, the Company recorded $31.2 million of restructuring and related charges associated with the restructuring plan of the Constellation Wines segment. Restructuring and related charges resulted from (i) the realignment of business operations and (ii) the decision to exit the commodity concentrate product line in the U.S. and sell its winery located in Escalon, California. In addition, in connection with the Company’s decision to exit the commodity concentrate product line in the U.S., the Company recorded a write-down of concentrate inventory of $16.8 million, which was recorded in cost of product sold. For the year ended February 28, 2003, the Company recorded restructuring and related charges associated with an asset impair- ment charge of $4.8 million in connection with two of Constellation Wines segment’s production facilities (see Note 1). No restruc- turing and related charges were recorded for the year ended February 28, 2002.
The restructuring and related charges of $31.2 million for the year ended February 29, 2004, included $6.9 million of employ- ee termination benefit costs, $17.7 million of grape contract termination costs, $1.9 million of facility consolidation and relocation costs, and $4.7 million of other related charges, which consisted of a $2.1 million loss on the sale of the Escalon facility and $2.6 million of other costs related to the realignment of the business operations in the Constellation Wines segment.
The Company estimates that the completion of the restructuring actions will include (i) a total of $9.9 million of employee ter- mination benefit costs through February 28, 2005, of which $6.9 million has been incurred through February 29, 2004, (ii) a total of $22.1 million of grape contract termination costs through February 28, 2005, of which $17.7 million has been incurred through February 29, 2004, and (iii) a total of $4.8 million of facility consolidation and relocation costs through February 28, 2005, of which $1.9 million has been incurred through February 29, 2004. The Company has incurred other costs related to the restructur- ing plan for the disposal of fixed assets and other costs of realigning the business operations of the Constellation Wines segment and expects to incur additional costs of realigning the business operations of $1.3 million during the year ending February 28, 2005.
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## 21. CONDENSED CONSOLIDATING FINANCIAL INFORMATION:
The following information sets forth the condensed consolidating balance sheets as of February 29, 2004, and February 28, 2003, the condensed consolidating statements of income and cash flows for each of the three years in the period ended February 29, 2004, for the Company, the parent company, the combined subsidiaries of the Company which guarantee the Company’s sen- ior notes and senior subordinated notes (“Subsidiary Guarantors”) and the combined subsidiaries of the Company which are not Subsidiary Guarantors, primarily Matthew Clark and Hardy and their subsidiaries, which are included in the Constellation Wines segment (“Subsidiary Nonguarantors”). The Subsidiary Guarantors are wholly owned and the guarantees are full, unconditional, joint and several obligations of each of the Subsidiary Guarantors. Separate financial statements for the Subsidiary Guarantors of the Company are not presented because the Company has determined that such financial statements would not be material to investors. The accounting policies of the parent company, the Subsidiary Guarantors and the Subsidiary Nonguarantors are the same as those described for the Company in the Summary of Significant Accounting Policies in Note 1 and include the recently adopted accounting pronouncements described in Note 2. There are no restrictions on the ability of the Subsidiary Guarantors to transfer funds to the Company in the form of cash dividends, loans or advances.
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2004 was another year of record sales, earnings and cash flow for Constellation Brands. The business continued to grow organically and through acquisitions. Our growth businesses, imported beer, half our wine business and our U.K. wholesale business, continued to gain market share. With the acquisition of Hardy, we added a new growth engine, Australian wines. Our scale businesses, which are focused on profitability and steady cash flow and include spirits and the other half of our wine business, continued to deliver outstanding results. With our already solid foundation of growth and scale businesses, we will continue to leverage growth in sales into even higher growth in earnings.
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Subsets and Splits