(2) Financial Instruments
In July 2010, the Company entered into three interest rate swap agreements in accordance with Company policy to mitigate the impact of London Interbank Offered Rate (“LIBOR”) based interest expense fluctuations on Company profitability. These swap agreements, with a total hedged notional amount of $100 million, were entered into to hedge future cash interest payments associated with a portion of the Company’s variable rate bank debt. The Company has designated these swaps as cash flow hedges of future cash flows associated with its variable rate debt. All effective changes in the fair value of the designated swaps are recorded in other comprehensive income (loss) and are released to interest income or expense on a monthly basis as the hedged debt payments are accrued. Ineffective changes, if any, are recognized in interest income or expense immediately. For fiscal 2012, the Company recognized other comprehensive income of $0.6 million based on the change in fair value of the swap agreements and no hedge ineffectiveness for these swap agreements was recognized in interest income or expense over the same period. As of July 31, 2012, all swaps had matured.
In May 2012, Diamond closed an agreement to recapitalize its balance sheet with an investment by Oaktree Capital Management, L.P. (“Oaktree”). The Oaktree investment initially consisted of $225 million of newly-issued senior notes and a warrant to purchase approximately 4.4 million shares of Diamond common stock. Oaktree’s warrant became exercisable at $10 per share on March 1, 2013. The warrant is accounted for as a derivative liability and is remeasured at fair value each reporting period with gains and losses recorded in net income.
In July 2012, the Company entered into an interest rate cap agreement in accordance with Company policy to mitigate the impact of LIBOR-based interest expense fluctuations on Company profitability. This swap agreement had a total notional amount of $100 million and was entered into to mitigate the interest rate impact of the Company’s variable rate bank debt. The Company accounts for the interest rate cap as a non-hedging derivative.
In February 2013, the Company purchased 164 corn call option commodity derivatives. This purchase is in accordance with Company policy to mitigate the market price risk associated with the anticipated raw material purchase requirements of the Company. This agreement had a total notional amount of approximately $0.3 million and was entered into to mitigate the market price risk of future corn purchases expected to be made by the Company. The Company accounts for commodity derivatives as non-hedging derivatives.
For the quarterly period ended July 31, 2013, the Company sold 42 corn call options commodity derivatives. The amount of loss recognized in income associated with this sale was $0.1 million. As of July 31, 2013, the Company has 122 corn call option commodity derivatives.
The fair values of the Company’s derivative instruments as of July 31, 2013, and July 31, 2012 were as follows:
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Liability Derivatives |
Balance Sheet Location | Fair Value | ||||||||
| 2013 | 2012 | |||||||||
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Derivatives designated as hedging instruments under ASC 815: |
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Interest rate contracts |
Accounts payable and accrued liabilities | $ | — | $ | — | |||||
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Interest rate contracts |
Other liabilities | — | — | |||||||
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Foreign currency contracts |
Accounts payable and accrued liabilities | — | — | |||||||
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Total derivatives designated as hedging instruments under ASC 815 |
$ | — | $ | — | ||||||
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Derivatives not designated as hedging instruments under ASC 815: |
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Commodity contracts |
Prepaid and other current assets | $ | 29 | $ | 483 | |||||
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Interest rate contracts |
Other long-term assets | — | 10 | |||||||
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Foreign currency contracts |
Accounts payable and accrued liabilities | — | — | |||||||
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Warrants |
Warrant liability | (58,147 | ) | (46,821 | ) | |||||
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Total derivatives not designated as hedging instrument under ASC 815 |
$ | (58,118 | ) | $ | (46,328 | ) | ||||
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Total derivatives |
$ | (58,118 | ) | $ | (46,328 | ) | ||||
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The effects of the Company’s derivative instruments on the Consolidated Statements of Operations for fiscal 2013 and 2012 were as follows:
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Derivatives in ASC 815 Cash Flow |
Amount of Loss Recognized in OCI on Derivative (Effective Portion) |
Location of Loss Reclassified from Accumulated OCI into Income (Effective Portion) |
Amount of Loss Reclassified from Accumulated OCI into Income (Effective Portion) |
Location of Loss Recognized in Income on Derivative (Ineffective Portion) |
Amount of Loss Recognized in Income on Derivative (Ineffective Portion) |
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| 2013 | 2012 | 2013 | 2012 | 2013 | 2012 | |||||||||||||||||||||||
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Interest rate contracts |
$ | — | $ | (4 | ) | Interest expense | $ | — | $ | (585 | ) | Interest expense | $ | — | $ | (148 | ) | |||||||||||
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Foreign currency contracts |
$ | — | — | Net sales | $ | — | — | Net sales | $ | — | — | |||||||||||||||||
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Total |
$ | — | $ | (4 | ) | $ | — | $ | (585 | ) | $ | — | $ | (148 | ) | |||||||||||||
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Derivatives Not Designated as |
Location
of Loss Recognized |
Amount of Income
(Loss) Recognized in Income on Derivative |
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| 2013 | 2012 | |||||||||
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Commodity contracts |
Selling, general and administrative | $ | (235 | ) | $ | 192 | ||||
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Interest rate contracts |
Interest expense | (9 | ) | (43 | ) | |||||
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Foreign currency contracts |
Interest expense | — | (10 | ) | ||||||
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Warrants |
Loss on warrant liability | (11,326 | ) | (10,360 | ) | |||||
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Total |
$ | (11,570 | ) | $ | (10,221 | ) | ||||
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ASC 820 requires that assets and liabilities carried at fair value be measured using the following three levels of inputs:
Level 1: Quoted market prices in active markets for identical assets or liabilities
Level 2: Observable market based inputs or unobservable inputs that are corroborated by market data
Level 3: Unobservable inputs that are not corroborated by market data
Assets and Liabilities Measured at Fair Value on a Recurring Basis
The Company’s cash equivalents measured at fair value on a recurring basis were nil as of July 31, 2013. There were cash equivalents of $1.5 million as of July 31, 2012. These investments were classified as Level 1 based on quoted prices in active markets for identical assets, to value the cash equivalents.
The Company’s derivative assets (liabilities) measured at fair value on a recurring basis were $0 million and $0.5 million as of July 31, 2013 and 2012, respectively. The Company has elected to use the income approach to value the derivative liabilities, using observable Level 2 market expectations at the measurement date and standard valuation techniques to convert future amounts to a single present amount assuming that participants are motivated, but not compelled to transact. Level 2 inputs for the valuations are limited to quoted prices for similar assets or liabilities in active markets (specifically futures contracts on LIBOR for the first two years) and inputs other than quoted prices that are observable for the asset or liability (specifically LIBOR cash and swap rates). Mid-market pricing is used as a practical expedient for fair value measurements. Under Accounting Standards Codification (“ASC”) 820, “Fair Value Measurements and Disclosures,” the fair value measurement of an asset or liability must reflect the nonperformance risk of the entity and the counterparty. Therefore, the impact of the counterparty’s creditworthiness when in an asset position and the Company’s creditworthiness when in a liability position has also been factored into the fair value measurement of the derivative instruments.
The Company’s warrant liability measured at fair value on a recurring basis was $58.1 million and $46.8 million as of July 31, 2013 and 2012, respectively. The Company has elected to use the income approach to value the warrant liability and uses the Black-Scholes option valuation model. This valuation is considered Level 3 due to the use of certain unobservable inputs. Inputs into the Black-Scholes model include: remaining term, stock price, strike price, maturity date, risk-free rate, and expected volatility. The significant Level 3 unobservable inputs used in the valuation are shown below:
| 2013 | 2012 | |||||
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Expected volatility |
45.60 | % | 54.75% | |||
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Probability of Special Redemption |
0.00 | % | 0.00% | |||
In applying the valuation model, small increases or decreases in the expected volatility could result in a significantly higher or lower fair value measurement. Based on the Company’s operating results for the six months ended January 31, 2013, the Special Redemption did not occur. The Company recognized a loss for fiscal 2013, related to the warrant liability due to changes in the fair value of the warrant.
The following is a reconciliation of activity for fiscal 2013 liabilities measured at fair value based on Level 3 inputs:
| Warrant Liability | ||||||||
| 2013 | 2012 | |||||||
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Beginning Balance |
$ | (46,821 | ) | $ | — | |||
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Transfers out of Level 3 |
— | — | ||||||
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Total gains or (losses) (realized/unrealized) |
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Included in earnings |
(11,326 | ) | (10,360 | ) | ||||
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Purchases, issuances, sales and settlements |
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Purchases |
— | — | ||||||
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Issuances |
— | (36,461 | ) | |||||
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Sales |
— | — | ||||||
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Settlements |
— | — | ||||||
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Ending Balance |
$ | (58,147 | ) | $ | (46,821 | ) | ||
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Total amount of gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets still held at the reporting date |
$ | — | $ | — | ||||
Assets and Liabilities Disclosed at Fair Value
The fair value of certain financial instruments, including cash and cash equivalents, trade receivables, accounts payable and accrued liabilities approximate the amounts recorded in the balance sheet because of the relatively short term nature of these financial instruments. The fair value of notes payable and long-term obligations at the end of each fiscal period approximates the amounts recorded in the balance sheet based on information available to Diamond with respect to current interest rates and terms for similar financial instruments, except for the Oaktree debt.
The following table presents the carrying value and fair value of our outstanding Oaktree debt as of July 31, 2013:
| Year Ended July 31, | Year Ended July 31, | |||||||||||||||
| 2013 | 2012 | |||||||||||||||
| Carrying Value | Fair Value | Carrying Value | Fair Value | |||||||||||||
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Senior Note |
121,266 | 150,295 | 103,295 | 103,203 | ||||||||||||
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Redeemable Note |
89,660 | 75,147 | 81,686 | 51,601 | ||||||||||||
The fair value of the notes was estimated using a discounted cash flow approach. The discounted cash flow approach uses a risk adjusted yield to present value the contractual cash flows of the notes. The fair value of the notes would be classified as Level 3 within the fair value measurement hierarchy. The Company applies a fair value method for accounting for the paid-in-kind interest on the Oaktree debt. Under this method, the Company adjusts the interest expense based on fair value of the Oaktree debt. Accordingly, while interest expense recognition on Oaktree debt would be at the contractual rate, the Company will account for the related interest expense based on the fair value of the Oaktree debt at every interest payment date and reporting period end.