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The following is an excerpt from a S-4/A SEC Filing, filed by FAVORITE BRANDS INTERNATIONAL INC on 2/4/1999.
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FAVORITE BRANDS INTERNATIONAL INC - S-4/A - 19990204 - LIQUIDITY

Liquidity and Capital Resources

Net cash provided by operating activities was $22.5 million, $32.6 million, $12.6 million in fiscal 1996, fiscal 1997 and fiscal 1998, respectively, and net cash used in operating activities was $2.4 million and $30.7 million in the first quarter of fiscal 1998 and the first quarter of fiscal 1999, respectively. The increase in cash provided by operating activities from fiscal 1996 to fiscal 1997 is principally attributable to the Acquisitions. The decline in cash provided by operations between fiscal 1997 and fiscal 1998 reflects an increased net loss and higher inventory levels in anticipation of the implementation of the Company's new regional distribution centers, which was partially offset by increased accounts receivable collections. The increase in net cash used in operating activities during the first quarter of fiscal 1999 compared to the first quarter of fiscal 1998 reflects the increased net loss in the first quarter of fiscal 1999 and a significant increase in accounts payable and accrued expenses in the first quarter of fiscal 1998.

The Company's liquidity requirements have arisen principally from acquisitions, capital expenditures, seasonal and general working capital requirements and debt service obligations. In fiscal 1996 and fiscal 1997, the Company spent $204.4 million and $336.2 million, respectively, in connection with the Acquisitions. Capital expenditures in fiscal 1996, fiscal 1997, fiscal 1998 and the first quarter of fiscal 1999 were $8.5 million, $31.0 million, $27.0 million and $5.6 million, respectively. These amounts were financed principally with net cash provided by operating activities, proceeds from bank borrowings or issuance of debt and equity securities.

Our earnings were insufficient to cover fixed charges by $80.3 million in fiscal 1998 and by $16.0 million for the 13 weeks ended September 26, 1998. During this period, fixed charges were funded by selling additional equity and obtaining additional bank borrowings. It is not certain that the Company will continue to have access to such additional funds in future periods. If the Company is not able to access such funds or does not improve its operating results and cash flow, the Company could be forced to reduce capital and other controllable expenditures and may not be able to meet its

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debt service obligations or comply with its debt covenants, all of which could have a material adverse effect on the Company's financial position, results of operations and liquidity.

The Company received $90.0 million and $60.0 million of capital contributions from Holdings in fiscal 1997 and fiscal 1996, respectively. The Company also received net proceeds (after the repayment of certain outstanding debt) from bank borrowings and the issuance of debt securities of $246.9 million and $131.4 million in fiscal 1997 and fiscal 1996, respectively. These proceeds were used primarily to fund the Acquisitions. The Company received net proceeds from financing activities of $17.3 million and $32.5 million in the first quarter of fiscal 1998 and the first quarter of fiscal 1999, respectively.

As a result of the integration and trade spending issues discussed above, the Company experienced liquidity problems in the third quarter of fiscal 1998 and obtained a short-term liquidity facility from a commercial bank with credit support provided by TPG, Holdings' controlling shareholder. Further, in May 1998, the Company completed a refinancing of all of its indebtedness other than the Senior Subordinated Notes through the issuance of the initial notes and borrowings under a term loan and a $75 million revolving credit facility from a group of lenders (the "Bank Facilities"). In connection with the refinancing, TPG made an additional $13.6 million equity investment in Holdings, which was then contributed to the Company in May 1998.

An amendment to the Company's Bank Facility was approved on September 25, 1998 and became effective in October 1998. This amendment:

. reset certain financial covenants through fiscal 2001,

. deleted certain other financial covenants,

. changed certain definitions, and

. increased the borrowing spread by 0.25 percent.

If the Company had not obtained this amendment, a default under its covenants would have subsequently occurred in fiscal 1999. In connection with the amendment:

. TPG agreed to loan the Company $17.0 million (the "Sponsor Loan"--terms of which are further described below), and

. the Company paid an amendment fee. The Company used the proceeds of the Sponsor Loan to repay borrowings under the Revolving Credit Facility.

The Sponsor Loan ranks senior unsecured and matures on November 20, 2005; the Sponsor Loan accrues interest at 10% per annum which is payable on the maturity date. In connection with the Sponsor Loan, Holdings' controlling stockholder also received a ten-year warrant to purchase 77,500 shares of Holdings' Common Stock at $0.01 per share. The Company has estimated the value of the warrants issued in connection with the Sponsor Loan to be $3.9 million using the Black- Scholes option valuation model. The Company intends to amortize this amount over the remaining life of the Sponsor Loan as interest expense.

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The Company remains highly leveraged. As of September 26, 1998, the Company's total debt was $590.4 million. The following table shows the breakdown of our total debt as of that date:

Total Debt as of September 26, 1998

                                                                Amount
Description                                                  (in millions)
-----------                                                  -------------
Senior Secured:
  Revolving credit facility.................................    $ 45.0
  Term B....................................................     150.0
Initial Notes...............................................     200.0
Senior Subordinated Notes...................................     195.0
Other.......................................................        .4
                                                                ------
                                                                $590.4
                                                                ======

At that date, the Company's stockholder's equity was $118.5 million. See "Risk Factors" for a description of risks related to the Company's indebtedness level and liquidity position.

The Company has two interest rate swap agreements that had a notional amount of $82.0 million as of September 26, 1998. These agreements expire in December 1999, requiring the Company to pay a fixed interest rate of 6.26% per annum and entitling the Company to receive variable interest based upon three month LIBOR rates. These agreements are not expected to materially affect the Company's results of operations or financial condition.

On October 1, 1998, the interest rate on the Company's $195 million Senior Subordinated Notes increased by 1.0% (from 10.25% to 11.25%) because the Company was unable to obtain a rating on such Notes of at least B- from Standard & Poor's Ratings Service and B3 from Moody's Investors Service, Inc. The Senior Subordinated Notes are rated CCC+ from Standard & Poor's Ratings Service and Caa1 from Moody's Investors Service.

In addition, pursuant to the exchange and registration rights agreement, in the event that:

. the registration statement is not declared effective by January 14, 1999 or

. the exchange offer for the initial notes is not completed by February 15, 1999,

then the Company will be obligated to pay liquidated damages of approximately $5,500 per day to the holders of the Senior Notes. The registration statement had not been declared effective as of February 3, 1999.

The Company's principal needs for liquidity are:

. to fund capital expenditures,

. for general working capital purposes and

. to fund continued restructuring and business integration costs.

The Company estimates that capital expenditures for fiscal 1999 will be approximately $46 million. The Company's principal source of liquidity is borrowings under its revolving credit facility. As of September 26, 1998, the Company had $4.2 million of outstanding letters of credit and $25.8 million available for borrowing under this facility. The proceeds of the $17.0 million Sponsor Loan

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that were obtained in October 1998 were used to repay borrowings under the Company's revolving credit facility. Based on the Company's current projections of operating results, the Company believes that cash from operations and amounts available under its revolving credit facility will be sufficient to meet its planned capital expenditures in fiscal 1999.

Based on the Company's current projections of operating results, the Company expects to fully utilize its revolving credit facility during most of the fourth quarter of fiscal 1999 and believes that it will be necessary to seek additional sources of liquidity in early fiscal 2000. The Company's projections of operating results involve numerous assumptions about its future sales, trade spending levels and other operating results. There can be no assurance that these results will be achieved or that the Company will be successful in obtaining such funds. If the Company is not successful in obtaining such funds it could have a material adverse effect on the Company's results of operations and financial condition.

Seasonality

The Company's sales and earnings are subject to a variety of seasonal factors, which vary among the Company's product lines. The Company's cash needs also vary based on seasonal factors, with the second and third fiscal quarters ordinarily generating the most significant working capital requirements. In light of the seasonality of the Company's business, results for any interim period are not necessarily indicative of the results that may be realized for the full year. The Company's working capital requirements fluctuate throughout the year as a result of increased inventory levels produced in anticipation of holiday sales and the Company offering extended terms on seasonal sales.

Inflation

Inflationary factors such as increases in the costs of ingredients, packaging materials, purchased product, labor and corporate overhead may adversely affect the Company's operating results. Although the Company does not believe that inflation has had a material impact on its financial position or results of operations for the periods discussed above, there can be no assurance that a high rate of inflation in the future would not have an adverse effect on the Company and its operating results.

Year 2000 Compliance

The Company has Year 2000 initiatives in three general areas: Information Technology ("IT") business systems; IT infrastructure; and non-IT systems (including embedded systems and exposure to third party systems).

IT Business Systems

The Company has completed the assessment of its IT business systems (i.e., manufacturing, distribution, financial software, etc.) and is testing most systems that it has identified as not being Year 2000 compliant. The Company's strategy is to remediate non-compliant systems in most cases through modification or upgrade. In certain circumstances, replacement will be necessary.

Most of the Company's IT business systems are scheduled to be fully Year 2000 compliant by the end of fiscal 1999. The cost yet to be incurred for these projects, principally reflecting external labor and outside service provider costs and limited hardware and software costs, is estimated to be approximately $2.5 million. These costs will be expensed as incurred, with the exception of the software and hardware acquisition costs, which will be capitalized.

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IT Infrastructure

Since late 1995, the Company has significantly upgraded and continues to upgrade its IT infrastructure. Personal computers and related software and local and wide area networks have been upgraded. As a result, this part of the IT infrastructure is substantially Year 2000 compliant.

The Company uses IBM mainframe and mid-range computers to run most of its critical business systems. This hardware, and corresponding operating system software, has been upgraded with Year 2000 compliant versions. The Company expects to verify compliance by the end of the third quarter of fiscal 1999.

The Company estimates that the costs yet to be incurred for these projects, which reflects external labor costs and limited additional hardware and software costs, should not exceed $350,000. These costs will be expensed as incurred, with the exception of the acquisition of new software and hardware, which will be capitalized.

Non-IT Systems

Embedded Systems

These items include any systems that incorporate computing devices for manufacturing, building and facility maintenance equipment. This includes electronic manufacturing equipment, such as assembly line, robotics, elevators, fire alarms, heating, ventilation and air conditioning systems (HVAC), building and office space security, time collection and reporting devices and interfaces. These systems are being assessed and updated on a facility by facility basis with the help of third-party consultants, most of whom specialize in Year 2000 compliance and remediation planning. All embedded systems are scheduled to be compliant by the end of fiscal 1999.

Based upon the assessments completed by the Company to date and certain assumptions, the Company estimates that remediation costs for embedded systems will be approximately $600,000. However, the Company has only completed a limited assessment of these systems and as the Company continues to review these systems, this estimate could change significantly.

Third Parties

The Company has sent Year 2000 compliance questionnaires to its major raw material suppliers to determine if these suppliers are addressing and preparing for the Year 2000 compliance with their systems. The Company is continuing to work with these third parties and has initiated a tracking system to monitor responses and to resolve issues as they arise.

The Company currently uses a number of third-party service vendors for many of its functions, including, but not limited to, warehouse management, carriers and pool distributors, automated payroll processing, insurance, banking collections and disbursements and benefit programs. The Company is initiating formal communications with these third-party providers to determine the extent to which these third parties are moving toward Year 2000 compliance. A tracking system will be used to monitor responses and resolve issues as they arise.

Many of the Company's customers currently place orders and receive acknowledgements using EDI systems. The Company has developed a plan to make its EDI systems Year 2000 compliant by the end of the third quarter of fiscal 1999.

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Year 2000 Risks

The principal Year 2000 risks to the Company related to its IT business systems and IT infrastructure are:

. the inability to recruit and/or retain key IT staff;

. the inability to locate and correct all relevant computer codes;

. the failure to complete, on a timely basis, the modifications and/or release upgrades to, as well as the selected replacements of, the IT business systems; and

. reliance on third parties' representations and ability to complete Year 2000 initiatives.

The principal risks to the Company with respect to its embedded systems is the Company's failure to identify and replace all Year 2000 non-compliant embedded systems. Until further assessments are completed in this area, the Company may not be able to estimate accurately the remediation costs or difficulties associated with these systems.

The principal risks to the Company with respect to its relationships with third parties are:

. the failure of key third parties to identify and implement required Year 2000 compliance and/or the Company's failure to timely recognize these third parties' non-compliance; and

. the failure to implement compliant EDI systems with key customers.

Contingency Plans

Contingency plans, where necessary, are expected to be completed during the third quarter of fiscal 1999 to address the risks discussed above. No assurance can be given, however, that the Company will be able to address the Year 2000 issues for all of its software and applications in a timely manner or that it will not encounter unexpected difficulties or significant expenses relating to adequately addressing the Year 2000 issue. If the Company or its major customers, suppliers or other third parties with whom the Company does business fail to address adequately the Year 2000 issue, or the Company fails to successfully integrate or convert its computer systems generally, the Company's business or results of operations could be materially adversely affected. See "Risk Factors--Failure of Year 2000 Compliance Initiatives Could Adversely Affect Us."

Recent Accounting Pronouncements

Segmental information

In 1997, the Financial Accounting Standards Board ("FASB") issued Statement 131, "Disclosure about segments of an enterprise and related information," which requires adoption in fiscal 1999. Statement 131 requires companies to report segment information based on how management disaggregates its business for evaluating performance and making operating decisions. The Company has reviewed Statement 131 and anticipates that it will report as a single segment after adopting that Statement.

Derivative instruments

In 1998, the FASB issued Statement 133, "Accounting for derivative instruments and hedging activities," which requires adoption in fiscal 2000. Statement 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. Management believes that the adoption of Statement 133 will not have a material impact on its financial reporting.

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BUSINESS

Overview

The Company was formed in September 1995 to acquire Kraft's marshmallow and caramel business and has grown primarily through five subsequent acquisitions. Today, the Company is the fourth largest confections company in the United States with a broad portfolio of marshmallow, fruit snack, branded gummi and general line candy products. The Company has the number one market position in branded and ingredient marshmallow products. The Company has the number two market position in fruit snacks, branded gummis and general line candy. Through its nationwide sales and distribution networks, the Company has achieved significant penetration in all major domestic trade channels.

The Company is the largest United States manufacturer of marshmallow products. We have the number one market position in branded and ingredient marshmallow products. The Company's Jet-Puffed marshmallow brand, which was developed by Kraft in the 1950's, has a 79% share of the branded marshmallow market and a 47% share of the total marshmallow market. We are also the market leader in the ingredient marshmallow category, which includes dehydrated marshmallow bits that are used primarily in cereals and hot beverages. The Company sells dehydrated marshmallow bits to every major cereal manufacturer in the United States and believes it has a 98% share of the dehydrated marshmallow bits market. The Company also manufactures private label marshmallow products.

The Company sells its fruit snack products under the Farley's brand name and holds the number two market position with a 22% market share. The Company's growth strategy for this category includes the use of exclusive licenses for popular children's characters, such as Nickelodeon's Rugrats. The Company markets a variety of gummi products under the Trolli brandname, including BriteCrawlers, Gummi Beans, Trolli Squiggles and Apple O's. Trolli has the number two market position in the gummi market with a 15% share.

The Company's general line candy is sold primarily under the Farley's and Sathers brand names and under private labels. Our product line includes more than 100 varieties of non-chocolate and chocolate candies, gummis, caramels, nuts and snacks. The Company is the second largest general line candy supplier in the United States and its Sathers line is the leading brand of general line candy in the convenience store channel.

The Company's retail products are sold to grocery stores, mass merchandisers, drugstores, convenience stores and club stores under branded and private labels. The Company sells its products through a sales network consisting of more than 25 independent food brokers supported by an internal sales organization that focuses on large national accounts, distributors and ingredients purchasers. The Company operates 13 manufacturing and packaging facilities and a nationwide distribution network that delivers products to more than 5,000 customers.

Industry Overview

The confections market consists of chocolate candy, non-chocolate candy, marshmallow products and fruit snacks. The Company competes primarily in the non-chocolate candy, fruit snack

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and marshmallow categories of the confections industry. Sales in the non- chocolate candy category in 1997 were approximately $4.6 billion. The non- chocolate candy category grew at a compound annual rate of approximately eight percent from 1990 to 1997, while the chocolate candy category grew at a compound annual rate of approximately four percent during the same period. The Company believes that the more rapid growth in the non-chocolate candy category is largely attributable to increased marketing efforts for non-chocolate candy (which has historically been under-marketed as compared to chocolate candy) and to continuing consumer concerns over the higher fat content associated with chocolate. Overall, the market for candy is growing, with per capita consumption of non-chocolate and chocolate candy in the United States increasing from approximately 18 pounds in 1987 to approximately 24 pounds in 1996.

The retail marshmallow market grew at a compound annual rate of approximately five percent from 1990 to 1997. The Company believes that this growth resulted from extensive marketing and increased consumer use of marshmallow products as an ingredient in such homemade snacks as marshmallow crispy treats. In the 52 weeks ended September 26, 1998, however, estimated sales in the retail marshmallow industry declined approximately two percent over the equivalent period ending in September 1997.

The fruit snack market (consisting of fruit rolls and fruit pieces) grew approximately seven percent in 1997. The Company believes that this growth is attributable to fruit snacks' image as a healthy and convenient snack, which appeals to parents, and their flavor and colorful shapes and characters, which appeal to children. In the 52 weeks ended September 26, 1998, the fruit snack market grew approximately seven percent over the equivalent period ending in September 1997.

The Company also competes in the non-chocolate candy category with its general line candy and gummis. The gummi market, which includes products such as Gummi Bears and Gummi Worms, grew approximately six percent in 1997. In the 52 weeks ended September 26, 1998, this market grew approximately eight percent over the equivalent period ending in September 1997. Management attributes this growth to the popularity of gummi products with children and new product introductions.

Competitive Strengths

Management believes that the following competitive strengths provide the Company with a foundation to enhance growth and further strengthen its position as an industry leader.

Leading Confections Company. The Company is the fourth largest confections company in the United States and is a leader in each of its four product categories. Management believes that its leading market position and size enable it to achieve extensive product distribution and realize purchasing and production economies, as well as provide a strong platform for new product introductions and line extensions.

Broad Array of Products. The Company offers an extensive range of products, including branded, private label and ingredient items. This enables our customers to satisfy many of their confections needs with a single vendor. The Company's products represent a balance between long- standing brands, such as Jet-Puffed marshmallows, and innovative

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products, such as Rugrats fruit snacks and Trolli gummis. These premium brands are complemented by a broad array of products targeted to value- conscious consumers. The Company's product offerings also enhance its ability to develop special sales and marketing programs, such as seasonal campaigns for Halloween and Easter.

Extensive Sales Network and Trade Penetration. The Company has an internal sales force of more than 50 representatives and a national network of more than 25 independent brokers who sell products to more than 5,000 customers located throughout the United States. The Company's extensive sales and distribution networks have contributed to its significant penetration in all major domestic trade channels. The Company's presence in these channels provides it with a significant opportunity to cross-sell existing products and launch new products.

Advanced Manufacturing Capability and Product Innovation. The Company's advanced manufacturing capabilities, proprietary technology and research and development efforts enable it to produce high-quality products and provide a platform for product innovations. With its research and development team, the Company has been a product development and improvement innovator. For example, the Company was the first to add vitamins to fruit snacks to increase their appeal as a healthy snack, and Trolli's BriteCrawlers gummi was named the 1996 non-chocolate Product of the Year by the Professional Candy Buyer trade magazine.

Acquisitions and Business Integration

Acquisitions

The Company was formed in September 1995 to acquire Kraft's marshmallow and caramel business. In August 1996, the Company acquired three companies, including Kidd, a major competitor in the private label marshmallow market, and Farley and Sathers, the country's second and third largest suppliers of general line candy, respectively. Subsequently, the Company acquired Dae Julie in January 1997 and Trolli in April 1997. Dae Julie and Trolli were both manufacturers and marketers of gummi candy.

Integration of the Acquired Companies

We began to consolidate the acquired businesses in fiscal 1998. These businesses consisted of 15 manufacturing and packaging facilities, more than 24 distribution facilities, two trucking fleets, six sales, marketing and customer service organizations, more than 6,000 stock keeping units and disparate information systems. Most of the integration initiatives discussed below have not included Trolli. As part of the Trolli acquisition agreement, the Company agreed to continue to operate Trolli as a separate subsidiary until December 31, 1998. Nevertheless, Trolli and Company operations are closely coordinated.

To date, the Company has completed a number of integration initiatives, including closing production facilities, consolidating certain sales, marketing and customer service functions, reducing the number of distribution facilities, consolidating two separate trucking fleets, eliminating more than

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1,400 stock keeping units and consolidating certain management information systems. More recently, at the end of fiscal 1998, we decided that we would close our Melrose Park production facility in December 1998 and our Skokie production facility in April 1999.

During fiscal 1998 the integration process proceeded more slowly and was more difficult than we anticipated. These difficulties, as well as a significant increase in trade spending, caused a substantial deterioration in our results of operations commencing in fiscal 1998. During the year we took a number of steps to address certain of our integration issues. We commenced a program at that time designed to control trade spending more effectively and in May 1998 successfully completed a refinancing of much of the Company's indebtedness, including the issuance of the initial notes.

Trade spending and integration problems continued, however, and are now expected to continue into fiscal 1999. As a result, we recently took a number of additional actions to address these issues and restructure our business. We have hired a new Chief Executive Officer; a President, Chief Operating Officer and Chief Financial Officer; and a number of other new key managers, including a Vice President of Sales and a Vice President of Information Systems. We have also implemented a number of additional procedures and controls to monitor trade spending more effectively and are now planning to implement new trade spending programs in the third quarter of fiscal 1999 for most of our products. We have also pursued a new quality control and testing program for marshmallow production, which is designed to reduce the level of lower quality marshmallows. We have centralized certain of our sales forecasting, production and capacity planning and inventory management functions in order to facilitate managing the supply chain more efficiently.

By January 1998, the customer service, sales and distribution functions of the Kraft, Kidd, Farley and Dae Julie operations and the Farley and Dae Julie production operations were consolidated to a common management information system. The Company continues to use a number of different management information systems. The Company's long-term strategic objective is to be fully integrated on an enterprise resource planning system. In the short term, the Company is directing resources towards resolving the Year 2000 issue, which is expected to be completed by the end of fiscal 1999. See "--Management Information Systems."

Although we have implemented a number of initiatives to address certain of our integration issues, it will be necessary to implement a number of additional initiatives over the next several years in order to effectively integrate the acquired companies. See "Risk Factors--Difficulty in Integrating Acquired Businesses May Continue to Adversely Affect Our Operations."

Business Strategy

The Company's goal is to become the premier provider of high quality non- chocolate confections. The Company intends to pursue this goal through the implementation of the following business strategies:

Completing Integration Initiatives. The Company will continue to focus its efforts on completing the integration of the acquired companies. Although the Company has accomplished a number of integration and consolidation initiatives, the Company is in the process of completing a number of other integration initiatives, including the implementation of coordinated

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promotional programs for each of its product categories, quality control procedures across all product areas, further systems consolidations, additional supply chain procedures and functions and trade spending controls. To implement these initiatives, the Company hired a new Chief Executive Officer; President, Chief Operating Officer and Chief Financial Officer; and a number of other new key managers including Vice President of Sales, Vice President of Information Systems and a Vice President of Supply Chain. Management believes that the completion of the integration process will allow the Company to reduce costs and improve operating efficiencies.

Implementing Marketing Initiatives. The Company is in the process of implementing a number of new marketing initiatives, which include the following:

Increasing Brand Equity and Awareness. The Company intends to reallocate its marketing expenditures to emphasize programs that increase consumer awareness of its products and that build brand equity. Such programs may include advertising, targeted couponing programs and product tie-ins with other major manufacturers, such as Nestle and Kellogg. The Company believes that a consumer-focused strategy, which the acquired companies had not emphasized, will enhance brand equity, increase sales across the Company's product lines and support the introduction of new products.

Enhancing Trade Promotion Programs. The Company intends to focus on trade promotions, such as in-store advertising and retail displays, designed to improve trade spending efficiency. The acquired companies had historically marketed their products primarily through aggressive trade promotions that emphasized discounts from list prices to retailers, and they generally lacked mechanisms to plan, control and execute their trade spending programs effectively. Beginning in the third quarter of fiscal 1999, the Company expects to implement new trade spending programs for most of its products.

Launching Line Extensions and New Products. The Company intends to leverage its existing brands, research, development and manufacturing capabilities and extensive sales network to introduce new products and extend its product lines. As part of these efforts, the Company has a non-binding letter of intent with Nickelodeon to become the exclusive licensee of Nickelodeon's Rugrats, Rugrats Movie and NickToons characters for fruit snack products through 2001. The Company has also introduced a number of new products in the last 12 months, including five new fruit snack products, a line of flavored caramels, Trolli Gummi Beans and Trolli Burger. The Company also has a number of new fruit snack, marshmallow, gummi and candy products under development.

Increasing Trade Channel Penetration. The Company plans to leverage its existing trade channel penetration, broad product offerings and strong brand names to cross-sell products and expand into additional trade channels. The Company's marshmallow and fruit snack products each have an ACV in the grocery channel in excess of 90%. Through its acquisition of Sathers, the Company also acquired an extensive convenience store distribution network. Specific opportunities being targeted by the Company include:

. increasing the distribution of Trolli gummis (ACV of less than 50%) and general line candy (ACV of less than 30%) in the grocery channel;

. further increasing distribution of the Company's products in convenience stores and drugstores;

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. developing additional distribution channels, such as vending, concessions and foodservice; and

. exploring international distribution opportunities.

Continuing to Reduce Costs. Management believes that through continued infrastructure investments, restructuring and cost reduction programs it can increase its efficiencies and reduce its costs. These initiatives are expected to include:

. completing the recently announced closure of two production facilities and outsourcing production of certain related candy products;

. further consolidating the distribution network by reducing the number of distribution centers used by the Company; and

. continuing to automate production facilities and to invest in advanced production equipment.

Products and Markets

The Company is the fourth largest confections company in the United States, with a broad portfolio of marshmallow, fruit snack, branded gummi and general line candy products. The Company's products are sold under proprietary brand names and private labels principally through grocery, mass merchandiser, drugstore, convenience store and club store channels. The marshmallow product category consists of branded, private label and ingredient products. Branded marshmallows and marshmallow creme are primarily sold under the Jet-Puffed brand name. The Company markets fruit snacks under the Farley's brand name. The Company markets gummis under the Trolli brand name and as part of its general line candy offering. General line candy, which includes bulk candy, gummis, caramels, nuts and snacks, is primarily sold under the Farley's and Sathers names.

Marshmallows and Marshmallow Creme (19.2% of Fiscal 1998 Net Sales)

The Company is the largest manufacturer of marshmallow products in the United States, with fiscal 1998 net sales of $147.0 million. The Company has the number one market position in the branded and ingredient categories.

Jet-Puffed. The Company's Jet-Puffed brand is the leading marshmallow and marshmallow creme brand. Jet-Puffed has a 79% share of the branded marshmallow market and a 47% share of the total marshmallow market. Its products include standard, miniature and fun-shaped marshmallows of varied colors and flavors, and marshmallow creme. The Jet-Puffed brandname was developed in the 1950's. The Company has implemented several initiatives to further strengthen brand awareness, including television advertising, aggressive consumer couponing and promotional tie-ins with leading consumer products manufacturers, including Nestle and Kellogg. In addition, the Company is pursuing initiatives to position Jet-Puffed as a snacking product, where management believes there is opportunity for growth.

Private Label. The Company also manufactures private label marshmallow products. Private label marshmallow products are sold primarily to grocery stores and mass merchandisers. The Company has standardized its production formulae and packaging and has implemented initiatives to eliminate lower volume and less profitable customer accounts. For example, the Company has increased the minimum production run for private label marshmallows and reduced the number of

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private label marshmallow formulae from eight to one. By targeting high-volume strategic accounts, management believes it can increase operating margins in its private label business.

Ingredient. The Company's ingredient business includes the manufacture of miniature marshmallows, dehydrated marshmallow bits and marshmallow creme, all of which are sold to food processors. These products are primarily used in popular children's cereals, hot beverage mixes (hot chocolate or cocoa), ice cream and snacks (primarily granola bars). The Company supplies dehydrated marshmallow bits to every major cereal manufacturer in the United States and believes that it has a 98% share of the dehydrated marshmallow bits market. Management believes that no other competitor currently has the technology to manufacture the diverse marbit colors and shapes required by cereal manufacturers. This advanced production and technical capability has made the Company the leader in the ingredients category.

Fruit Snacks (17.0% of Fiscal 1998 Net Sales)

The Company is the second largest manufacturer and marketer of fruit snacks in the United States, with a 22% market share. Fruit snacks, which are made in various shapes, colors and flavors, are divided into two principal subgroups:
fruit snack shapes and fruit snack rolls. The Company primarily markets its products through the grocery and mass merchandising channels.

The Company markets fruit snacks under the Farley's brand name. Some of the Company's more popular products include Farley's Dinosaurs, Zoo Animals, The Roll, Power Fruit and Troll, as well as licensed products such as Rugrats, Creepy Crawlers, Street Sharks and Teenage Mutant Ninja Turtles. The Company introduced two new fruit snack products, Rugrats Fruit Rolls and MegaMonster Roll, in August 1997, three new fruit snack products, Shark Wave, Alien Fruit Snacks and MVP Sports, in March 1998 and a new two-flavored fruitroll, Sidewinder, in October 1998. The Company currently holds an exclusive license to make Nickelodeon's Rugrats characters as fruit snacks through December 1998. The Company has entered into a non-binding letter of intent with Nickelodeon to be the exclusive licensee of the Rugrats, NickToons and Rugrats Movie properties for the fruit snack market through December 2001. The Company has sought to position its products with parents as healthy and convenient snacks (including through the addition of vitamins), while enhancing their appeal to children through the use of colorful shapes and popular children's characters.

Trolli Branded Gummi Products (9.2% of Fiscal 1998 Net Sales)

The Company's Trolli brand holds the number two position in the gummi market, with a 15% market share. Trolli's market share has increased each year since 1994, when it held only three percent of the market and was ranked number seven in the category. Trolli primarily markets its products through the mass merchandiser, drugstore and grocery channels.

Trolli has established a reputation as an innovative manufacturer and marketer of high quality gummis. Some products introduced by Trolli include BriteCrawlers, Peachies, Apple O's, Trolli Squiggles, Super Bears, Gummi Octopus, Strawberry Puffs and Gummi Beans. Trolli's BriteCrawlers product was named the 1996 non-chocolate Product of the Year by the Professional Candy Buyer, an
industry publication. In its 1997 acquisition of Trolli, the Company signed a 10-year product development agreement with Mederer GmbH, entitling Trolli to sell under an exclusive license in the United States and other specified countries any new Trolli products developed during the period.

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General Line Candy (53.2% of Fiscal 1998 Net Sales)

The Company is one of the two leading suppliers of general line candy in the United States. The Company's general line candy products are primarily sold under the Farley's and Sathers brand names, as well as under private labels. The Company's product offerings in this category include more than 100 varieties of candy (primarily hard, jelly, gummi, panned and cremes), caramels, nuts and snacks. The Company primarily markets its general line candy through mass merchandisers and convenience stores. Sathers is the leading brand of general line candy in the convenience store channel.

General line candy products are sold in a variety of weights and packages, depending upon the product and distribution channel. Many of the Sathers brand products are sold in two-for-$1 hanging bags, which are displayed on pegboards in retail outlets. Farley's branded products are generally sold in larger two- for-$3 hanging bags, "lay-down" bags (bags weighing one pound or more) and plastic tubs. Private label products are sold in either bag format, as well as in bulk. Except for seasonal varieties, such as candy corn, jelly beans and conversation hearts, and certain other products that are sold on a product-by- product basis, the Company generally markets its general line candy as a complete portfolio.

The Company manufactures and markets caramel products for the retail market under the Farley's brand name. The Company also produces a number of ingredient caramel products, mainly for sale to food processors for use in candy, snacks and as a dessert topping. Recently the Company launched a line of flavored caramels, including caramel apple, cappuccino and fudge flavors.

The following table sets forth the principal categories of the Company's general line candy and indicates representative products in each category.

Product Category          Representative Products
----------------          -----------------------
Gummis(1)................   Bears, Worms, Dinosaurs, Peach Rings, Green Apple Rings
Jells....................   Spice Drops, Orange Slices, Fruit Slices, Spearmint Leaves
Cremes/Pans..............   Cremes: Candy Corn, Indian Corn, Pumpkins, Harvest Mix, Easter Mallowcreams and Heart Darts
                            Pans: Jelly Beans, Cinnamon Imperials, Marshmallow Eggs, French Burnt Peanuts, Boston Baked Beans,
                            Jawbreakers
Hard Candy...............   Starlite Mints, Butterscotch Buttons, Lemon Drops, Cinnamon Discs, Butterscotch Discs, Butter
                            Toffee, Clearly Fruit
Chocolate................   Raisins, Peanut Clusters, Bridge Mix, Double Dipped Peanuts, Nonpareils, Malted Milk Balls
Nuts, Snacks & Naturals..   Yogurt Raisins, Sweet & Nutty Mix, Pineapple Wedges, Sunflower Seeds, California Mix, Really
                            Naturals
Caramels.................   Branded, Ingredient
Kiddie Candy.............   Combination of a variety of general line and rebagged candy
Other....................   Tang-a-roos, Sonic Boom bubble gum, Power Fruit


(1) Gummis do not include Trolli brand gummis.

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Marketing and Sales

The Company markets its products through a mix of consumer promotions, trade promotions and advertising. Consumer promotions include free-standing inserts, other targeted coupons (such as Catalina Marketing coupons, which are generated with consumers' sales receipts), product tie-ins with other major manufacturers, such as Nestle and Kellogg, bonus bags, television marketing and seasonal promotions. Trade promotions consist of temporary price reductions, in-store advertising, coupons in retail flyers and retail displays. However, Farley, Dae Julie and Kidd each historically relied heavily on trade promotions with less emphasis on consumer promotions and advertising. The Company's marketing strategy is to refocus its marketing efforts towards building brand equity through consumer promotions and advertising rather than trade spending and price discounting. In addition, the Company believes that it can implement a more effective and efficient trade spending program by focusing on trade performance that generates the greatest amount of consumer take-away. As part of its new emphasis on consumer promotions, in the fourth quarter of calendar 1998, the Company launched a print advertising campaign for its Jet-Puffed marshmallows. In addition, Trolli advertises its products in regional television campaigns, and in November 1998, the Company began a television campaign for its fruit snack product lines to coincide with the release of Nickelodeon's Rugrats Movie.

The Company's sales organization consists of four groups:

. a retail broker network;

. a national accounts group;

. a distributor/national chain group; and

. an ingredients group.

The Company's retail broker network consists of more than 25 independent brokers who are managed by the Company's internal sales force and present the Company's products to a broad range of retailer accounts, primarily grocery stores. The national account group consists of seven sales professionals who maintain relationships with the corporate headquarters of key national accounts such as Ahold (Stop & Shop, BI-LO), American Stores (Jewel, Lucky), Rite-Aid, Kroger, Kmart, Sam's Clubs, Target, Wal-Mart, and Winn-Dixie. The distributor/chain organization consists of 25 sales professionals who call directly on distributors that supply convenience store chains. Ingredients sales are managed through a separate direct sales force and broker network. Trolli sells its products through its own sales organization, which consists of a broker network managed by internal sales personnel.

In addition to marketing its existing product lines, the Company, through the efforts of its research and development team, engages in ongoing research activities to develop new products, improve the quality of existing products, improve and modernize production processes and develop and implement new technologies to enhance the quality and value of both current and proposed product lines.

Distribution

The Company currently distributes its marshmallow, fruit snack and general line candy products in the United States through a number of distribution centers. This distribution system uses a combination of common carrier trucking, Company trucks and rail transport to deliver products to

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more than 5,000 customers. Trolli separately distributes its gummi products through its own distribution network.

The Company has implemented several strategic initiatives designed to further consolidate and enhance the cost-effectiveness of its distribution network. The Company recently opened two new regional distribution centers in California and Texas. These two centers are operated by a third-party service provider for the Company and are strategically located to distribute certain of the Company's marshmallow, fruit snack and general line candy products. The Company intends to open additional regional distribution centers in order to consolidate further its distribution centers. By consolidating its distribution centers, the Company believes that it will be able to deliver products to its customers on a more timely and cost-effective basis. The Company has also established a "core carrier" trucking program to reduce its freight and distribution costs. As a result of acquiring five different distribution systems, the Company utilized more than 100 common carriers and more than 75 pooled distributors. The Company's new core carrier program, which generally involves 25 common carriers and 45 pooled distributors, should simplify the Company's operations and should allow the Company to negotiate more favorable freight rates. See "-- Acquisitions and Business Integration."

Customers

The Company's retail products are sold to grocery stores, mass merchandisers, drugstores, convenience stores and club stores. The Company's ingredient products are sold to a variety of major food company customers. Wal-Mart, Sam's Clubs and McLane (affiliated entities) in the aggregate accounted for approximately 17% of fiscal 1998 net sales. The Company's next largest customer accounted for approximately three percent of fiscal 1998 net sales. The Company has strong, long-standing relationships with many of its largest customers. As is customary in the confections industry, the Company's retail products are generally purchased by means of purchase orders. Continued consolidation in the retail food industry is expected to result in an increasingly concentrated customer base. See "Risk Factors--The Loss of Any of Our Major Customers Could Adversely Affect Our Sales."

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Production and Facilities

Currently, the Company produces its products at 10 manufacturing facilities and operates seven distribution centers, as set forth in the following table:

    Facility                        Products        Plant Size (Sq. Ft.)   Owned/Leased
    --------                        --------        --------------------   ------------
Kendallville, IN...........  Marshmallows,                297,000              Owned
                             Marshmallow Creme,
                             Dehydrated
                             Marshmallow Bits,
                             Caramels
Henderson, NV..............  Marshmallows                 115,000              Owned
Creston, IA................  Gummis                       232,000              Owned
Des Plaines, IL............  Gummis, Jells                121,000             Leased
Melrose Park, IL(1)........  Hard Candy, Jells            142,000              Owned
Skokie, IL(1)..............  Panned, Jells                 68,000             Leased
31st St., Chicago, IL......  Fruit Snacks, Panned         276,000              Owned
Belmont Ave., Chicago, IL..  Cremes, Chocolate            121,000             Leased
New Orleans, LA............  Hard Candy                    30,000        Owned (Land Lease)
Oklahoma City, OK..........  Cremes, Jells, Panned        160,000              Owned
Ligonier, IN...............  Warehouse and                109,000              Owned
                             Distribution Center
Round Lake, MN.............  Rebagging and                305,000              Owned
                             Distribution Center
Pittston, PA...............  Rebagging and                259,000              Owned
                             Distribution Center
Chattanooga, TN............  Rebagging and                302,000              Owned
                             Distribution Center
43rd Street, Chicago, IL...  Distribution Center          480,000             Leased
Fontana, CA................  Distribution Center          182,000             Leased(2)
Fort Worth, TX.............  Distribution Center          161,000             Leased(2)


(1) In fiscal 1998, the Company decided to close the Melrose Park and Skokie manufacturing facilities in December 1998 and April 1999, respectively.
(2) These facilities are leased by third parties pursuant to warehouse operating agreements.

To integrate the acquired companies, as well as to effect ongoing cost savings, the Company has closed a number of facilities and has reallocated products among its remaining facilities with the goal of manufacturing its complete product line in its most efficient and cost-effective facilities. In addition to production and distribution operations, the Company operates an advanced research facility at Kendallville that is used in the development of new products.

In addition to its manufacturing facilities and the distribution center/rebagging facilities noted above, the Company operates temporary warehouse facilities, sales offices and leased distribution centers in a number of states. The Company's corporate headquarters and a management information center are located in Lincolnshire, Illinois, and Trolli's headquarters are located in Plantation,

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Florida. The Company leases most of its warehouse facilities and offices. In connection with the rationalization of its manufacturing operations, the Company is also integrating and rationalizing its distribution system, including by consolidating its warehouse capacity. See "--Distribution."

Raw Materials

The Company uses agricultural commodities, flavors, other raw materials and packaging in the production of its products that are purchased from commodity processors, importers, other food companies and packaging manufacturers. The principal raw materials used in the Company's products are sugar, corn products (dextrose, starch and corn syrup), gelatin and packaging. Although two of Trolli's key ingredients are each available from only one domestic supplier, alternative international sources are available. All of the other key raw materials used by the Company are readily available from several sources. The Company has not experienced difficulty in obtaining raw materials. In accordance with standard industry practice, the Company obtains annual volume and price commitments from its sugar suppliers for the twelve month period, or "crop year," beginning each fall. Since January 1998, the Company has obtained quarterly volume and price commitments from its corn product suppliers. The Company does not otherwise hedge its raw material requirements. See "Risk Factors--We May Not Be Able to Pass Through Increases in the Prices of Raw Materials to Our Customers."

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