UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10‑Q
(Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the three months ended September 30, 2017
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 001‑37540
hostesslogoa07.jpg
HOSTESS BRANDS, INC.

(f/k/a GORES HOLDINGS, INC.)
(Exact name of registrant as specified in its charter)
Delaware 
(State or other jurisdiction of
incorporation or organization)
47‑4168492 
(I.R.S. Employer
Identification No.)
1 East Armour Boulevard 
Kansas City, MO 
(Address of principal executive offices)
64111 
(Zip Code)
(816) 701‑4600
Registrant’s telephone number, including area code





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S‑T (§229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non‑accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b‑2 of the Exchange Act.:



Large accelerated filer o
Accelerated
filer x
Non‑accelerated filer o 
(Do not check if a
smaller reporting company)
Smaller reporting company o
Emerging growth company x


☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b‑2 of the Act). Yes o No x


Shares of Class A common stock outstanding - 99,632,183 shares at November 3, 2017
Shares of Class B common stock outstanding - 30,398,777 shares at November 3, 2017





HOSTESS BRANDS, INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2017

INDEX
 
 
Page
Item 1.
 
 
 
 
 
 
 
Item 2.
Item 3.
Item 4.
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.






Cautionary Note Regarding Forward Looking Statements
This Quarterly Report on Form 10-Q (“Quarterly Report”) contains statements reflecting our views about our future performance that constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that involve substantial risks and uncertainties. All statements contained in this Quarterly Report other than statements of historical fact, including statements regarding our future results of operations and financial position, our business strategy and plans, and our objectives for future operations, are forward-looking statements. Statements that constitute forward-looking statements are generally identified through the inclusion of words such as “believes,” “expects,” “intends,” “estimates,” “projects,” “anticipates,” “will,” “plan,” “may,” “should,” or similar language. Statements addressing our future operating performance and statements addressing events and developments that we expect or anticipate will occur are also considered as forward-looking statements. All forward‑looking statements included herein are made only as of the date hereof. It is routine for our internal projections and expectations to change throughout the year, and any forward-looking statements based upon these projections or expectations may change prior to the end of the next quarter or year. Readers of this Quarterly Report are cautioned not to place undue reliance on any such forward-looking statements. As a result of a number of known and unknown risks and uncertainties, our actual results or performance may be materially different from those expressed or implied by these forward-looking statements. Risks and uncertainties are identified and under “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2016, as updated by subsequent filings. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these risk factors. We undertake no obligation to update any forward-looking statement, whether as a result of new information, future events, or otherwise. The discussion and analysis of our financial condition and results of operations included in Item 2- Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our Consolidated Financial Statements and related notes included in Item 1 of this Quarterly Report on Form 10-Q.



4



HOSTESS BRANDS, INC.
CONSOLIDATED BALANCE SHEETS
(Unaudited, amounts in thousands, except shares and per share data)


September 30,
 
 
December 31,
ASSETS
2017
 
 
2016

(Successor)
 
 
(Successor)
Current assets:

 
 

Cash and cash equivalents
$
101,171

 
 
$
26,855

Accounts receivable, net
100,733

 
 
89,237

Inventories
33,812

 
 
30,444

Prepaids and other current assets
6,791

 
 
4,827

Total current assets
242,507

 
 
151,363

Property and equipment, net
166,931

 
 
153,224

Intangible assets, net
1,929,082

 
 
1,946,943

Goodwill
580,349

 
 
588,460

Other assets, net
7,804

 
 
7,902

Total assets
$
2,926,673

 
 
$
2,847,892

 
 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
 
 
 
 
 
 
Current liabilities:
 
 
 
 
Long-term debt and capital lease obligation payable within one year
$
11,357

 
 
$
11,496

Accounts payable
53,451

 
 
34,083

Customer trade allowances
35,150

 
 
36,691

Accrued expenses and other current liabilities
11,051

 
 
21,656

Total current liabilities
111,009

 
 
103,926

Long-term debt and capital lease obligation
988,476

 
 
993,374

Tax receivable agreement
175,487

 
 
165,384

 Deferred tax liability
366,457

 
 
353,797

Total liabilities
1,641,429

 
 
1,616,481

Commitments and Contingencies (Note 14)

 
 

Class A common stock, $0.0001 par value, 200,000,000 shares authorized, 99,992,183 and 98,250,917 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively
10

 
 
10

Class B common stock, $0.0001 par value, 50,000,000 shares authorized, 30,398,777 and 31,704,988 shares issued and outstanding at September 30, 2017 and December 31, 2016, respectively
3

 
 
3

Additional paid in capital
923,739

 
 
912,824

Accumulated other comprehensive loss
(43
)
 
 

Retained earnings (accumulated deficit)
28,593

 
 
(15,618
)
Stockholders’ equity
952,302

 
 
897,219

Non-controlling interest
332,942

 
 
334,192

Total liabilities and stockholders’ equity
$
2,926,673

 
 
$
2,847,892

See accompanying notes to the unaudited consolidated financial statements.

5


HOSTESS BRANDS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, amounts in thousands, except shares and per share data)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
2017

 
September 30,
2016
 
September 30,
2017
 
 
September 30,
2016

(Successor)

 
(Predecessor)
 
(Successor)
 
 
(Predecessor)
Net revenue
$
192,250

 
 
$
196,197

 
$
579,967

 
 
$
548,757

Cost of goods sold
113,885

 
 
113,618

 
333,861

 
 
309,427

Gross profit
78,365

 
 
82,579

 
246,106

 
 
239,330

Operating costs and expenses:
 
 
 
 
 


 
 


Advertising and marketing
8,871

 
 
10,381

 
24,304

 
 
27,529

Selling expense
7,606

 
 
8,271

 
24,418

 
 
23,175

General and administrative
14,494

 
 
10,784

 
43,416

 
 
32,015

Amortization of customer relationships
5,994

 
 
156

 
17,860

 
 
468

Business combination transaction costs

 
 
4,049

 

 
 
7,065

Impairment of property and equipment
1,003

 
 

 
1,003

 
 
7,267

Related party expenses
92

 
 
1,058

 
284

 
 
3,431

Tax receivable agreement liability remeasurement
1,589

 
 

 
1,589

 
 

Recall and other costs (recoveries)

 
 
(3,787
)
 

 
 
473

Total operating costs and expenses
39,649

 
 
30,912

 
112,874

 
 
101,423

Operating income
38,716

 
 
51,667

 
133,232

 
 
137,907

Other expense:
 
 
 
 
 
 
 
 
 
Interest expense, net
9,966

 
 
18,004

 
29,831

 
 
53,746

Loss on modification of debt
2,122

 
 

 
1,948

 
 

Other expense
182

 
 
173

 
1,309

 
 
2,344

Total other expense
12,270

 
 
18,177

 
33,088

 
 
56,090

Income before income taxes
26,446

 
 
33,490

 
100,144

 
 
81,817

Income tax expense (benefit)
10,316

 
 
(23
)
 
31,608

 
 
294

Net income
16,130

 
 
33,513

 
68,536

 
 
81,523

Less: Net income attributable to the non-controlling interest
6,581

 
 
2,329

 
24,325

 
 
4,110

Net income attributable to Class A shareholders/partners
$
9,549

 
 
$
31,184

 
$
44,211

 
 
$
77,413

 
 
 
 
 
 
 
 
 
 
Earnings per Class A share:


 

 

 
 
 
Basic
$
0.10


 

 
$
0.45

 
 
 
Diluted
$
0.09


 

 
$
0.42

 
 
 
Weighted-average shares outstanding:
 
 
 
 
 
 
 
 
 
Basic
99,557,183


 

 
98,920,808

 
 

Diluted
105,418,566


 

 
105,840,673

 
 


See accompanying notes to the unaudited consolidated financial statements.


6


HOSTESS BRANDS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited, amounts in thousands)


 
Three Months Ended
 
 
Nine Months Ended

September 30,
2017
 
 
September 30,
2016
 
 
September 30,
2017
 
 
September 30,
2016
 
(Successor)
 
 
(Predecessor)
 
 
(Successor)
 
 
(Predecessor)
Net income
$
16,130

 
 
$
33,513

 
 
$
68,536

 
 
$
81,523

Other comprehensive loss:
 
 
 
 
 
 
 
 
 
 
Unrealized income (loss) on interest rate swap contract designated as a cash flow hedge
565

 
 

 
 
(100
)
 
 

Income tax (expense) benefit
(172
)
 
 

 
 
31

 
 

Comprehensive income
16,523

 
 
33,513

 
 
68,467

 
 
81,523

Less: Comprehensive income attributed to non-controlling interest
6,712

 
 
2,329

 
 
24,299

 
 
4,110

Comprehensive income attributed to class A shareholders/partners
$
9,811

 
 
$
31,184

 
 
$
44,168

 
 
$
77,413



See accompanying notes to the unaudited consolidated financial statements.

7





HOSTESS BRANDS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
(Unaudited, amounts in thousands, except shares data)
Partners’ Equity (Deficit)
Hostess Holdings, LP
(Predecessor)


Class A

Class C

Total Partners’
Equity (Deficit)

Non-controlling
Interest
Balance – December 31, 2015

$
(276,084
)

$
(346,046
)

$
(622,130
)

$
(37,991
)
Distributions to partners

(2,439
)

(8,134
)

(10,573
)

(555
)
Unit based compensation

345
 

344
 

689



Net income

38,707
 

38,706
 

77,413


4,110

Balance – September 30, 2016

$
(239,471
)

$
(315,130
)

$
(554,601
)

$
(34,436
)
Stockholders’ Equity
Hostess Brands, Inc.
(Successor)
 
Class A Voting
Common Stock
 
Class B Voting
Common Stock
 
Additional
Paid-in Capital
 
Accumulated
Other Comprehensive Loss
 
Accumulated
Losses / Retained Earnings
 
Total
Stockholders’
Equity
 
Non-controlling
Interest

Shares
 
Amount
 
Shares
 
Amount
 
 
 
 
 
 
 
 
 
 
Balance–December 31, 2016
98,250,917

 
$
10

 
31,704,988

 
$
3

 
$
912,824

 
$

 
$
(15,618
)
 
$
897,219

 
$
334,192

Comprehensive income

 

 

 

 

 
(43
)
 
44,211

 
44,168

 
24,299

Share-based compensation
435,000

 

 

 

 
7,990

 

 

 
7,990

 

Exchanges
1,306,211

 

 
(1,306,211
)
 

 
12,609

 

 

 
12,609

 
(12,609
)
Distributions

 

 

 

 

 

 

 

 
(12,940
)
Exercise of public warrants
55

 

 

 

 
1

 

 

 
1

 

Tax receivable agreement arising from exchanges, net of income taxes of $1,845

 

 

 

 
(9,685
)
 

 

 
(9,685
)
 

Balance–September 30, 2017
99,992,183

 
$
10

 
30,398,777

 
$
3

 
$
923,739

 
$
(43
)
 
$
28,593

 
$
952,302

 
$
332,942



See accompanying notes to the unaudited consolidated financial statements.


8



HOSTESS BRANDS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, amounts in thousands)
 
 
 
Nine Months Ended
 
 
 
September 30,
2017
 
 
September 30,
2016
 
 
 
(Successor)
 
 
(Predecessor)
Operating activities
 
 
 
 
 
Net income
$
68,536

 
 
$
81,523

 
Depreciation and amortization
28,576

 
 
9,054

 
Impairment of property and equipment
1,003

 
 
7,267

 
Debt discount (premium) amortization
(647
)
 
 
2,486

 
Non-cash loss on debt modification
1,729

 
 

 
Non-cash change in tax receivable agreement liability
1,589

 
 

 
Gain on sale of property and equipment
(10
)
 
 
(153
)
 
Share-based compensation
7,990

 
 
689

 
Deferred taxes
19,993

 
 
237

 
Change in operating assets and liabilities
 
 
 
 
 
 
Accounts receivable
(11,496
)
 
 
(13,555
)
 
 
Inventories
(3,368
)
 
 
(1,850
)
 
 
Prepaids and other current assets
(1,950
)
 
 
(9,397
)
 
 
Accounts payable and accrued expenses
7,369

 
 
17,098

 
 
Customer trade allowances
(1,541
)
 
 
(4,316
)
 
 
Other

 
 
430

 
Net cash provided by operating activities
117,773

 
 
89,513

 
 
   
 
 
 
 
Investing activities
 
 
 
 
 
Purchases of property and equipment
(22,755
)
 
 
(23,995
)
 
Acquisition of Superior

 
 
(50,091
)
 
Proceeds from sale of assets
85

 
 
4,350

 
Acquisition of software assets
(1,728
)
 
 
(1,917
)
 
Net cash used in investing activities
(24,398
)
 
 
(71,653
)
 
 
 
 
 
 
 
Financing activities
 
 
 
 
 
Repayments of long-term debt and capital lease obligation
(5,103
)
 
 
(6,985
)
 
Debt fees
(1,017
)
 
 

 
Distributions to partners

 
 
(10,573
)
 
Distributions to non-controlling interest
(12,940
)
 
 
(555
)
 
Proceeds from the exercise of warrants
1

 
 

 
Net cash used in financing activities
(19,059
)
 
 
(18,113
)
Net increase in cash and cash equivalents
74,316

 
 
(253
)
Cash and cash equivalents at beginning of period
26,855

 
 
64,473

Cash and cash equivalents at end of period
$
101,171

 
 
$
64,220

Supplemental Disclosures of Cash Flow Information:



 



Cash paid during the period for:



 



 
Interest
$
35,085


 
$
50,799



Taxes paid
$
12,902


 
$


Supplemental disclosure of non-cash investing:



 




Purchases of property and equipment funded by accounts payable
$
932


 
$
2,072


See accompanying notes to the unaudited consolidated financial statements.


9


HOSTESS BRANDS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS



1.    Summary of Significant Accounting Policies
Description of Business

Hostess Brands, Inc. is a Delaware corporation headquartered in Kansas City, Missouri. The consolidated financial statements include the accounts of Hostess Brands, Inc. and its wholly owned subsidiaries (collectively, the “Company”). The Company is a leading packaged food company focused on developing, manufacturing, marketing, selling and distributing fresh sweet baked goods in the United States. The Hostess brand dates to 1919 when the Hostess CupCake was introduced to the public, followed by Twinkies® in 1930. In 2013, the Legacy Hostess Equityholders (as defined below) acquired the Hostess brand out of the bankruptcy liquidation proceedings of its prior owners, free and clear of all past liabilities. After a brief hiatus in production, the Company began providing Hostess products to consumers and retailers across the nation in July 2013. Today, the Company produces a variety of new and classic treats primarily under the Hostess® and Dolly Madison® group of brands, including Twinkies®, CupCakes, Ding Dongs®, HoHos®, Donettes® and Fruit Pies.
On November 4, 2016 (the “Closing Date”), in a transaction referred to as the “Business Combination,” the Company, then known as Gores Holdings, Inc. acquired a controlling interest in Hostess Holdings, L.P. (“Hostess Holdings”), an entity owned indirectly by C. Dean Metropoulos and certain equity funds managed by affiliates of Apollo Global Management, LLC (the “Apollo Funds”, and together with entities controlled by Mr. Metropoulos, the “Legacy Hostess Equityholders”). Our “Sponsor” refers to Gores Sponsor, LLC, a Delaware limited liability company and the principal stockholder of Gores Holdings, Inc. prior to the Business Combination, and the “The Gores Group” refers to The Gores Group LLC, an affiliate of our Sponsor. In connection with the closing of the Business Combination, Gores Holdings, Inc. changed its name to “Hostess Brands, Inc.” and its trading symbols on NASDAQ from “GRSH” and “GRSHW,” to “TWNK” and “TWNKW”.
As a result of the Business Combination, for accounting purposes, Hostess Brands, Inc. is the acquirer and Hostess Holdings is the acquired party and accounting predecessor. Our financial statement presentation includes the financial statements of Hostess Holdings and its subsidiaries as “Predecessor” for periods prior to the completion of the Business Combination and of Hostess Brands, Inc., including the consolidation of Hostess Holdings and its subsidiaries, for periods from and after the Closing Date (referred to as the “Successor”). Unless the context requires otherwise, the “Company” refers to the Predecessor for periods prior to the Business Combination and to the Successor for periods after the Business Combination.
On May 10, 2016, the Company purchased the stock of Superior Cake Products, Inc. (“Superior”) located in Southbridge, Massachusetts. Superior manufactures and distributes eclairs, madeleines, brownies, and iced cookies sold in the “In-Store Bakery” section of retailers.
In the consolidated statements of operations, amortization of customer relationships (previously reported in the Predecessor’s unaudited quarterly financial statements within general and administrative) has been presented separately from general and administrative in the current period presentation, with conforming reclassifications made for the prior period presentation; recall and other costs (recoveries) (previously reported in the Predecessor‘s unaudited quarterly financial statements as a reduction of gross profit) have been presented as recall and other expenses along with amounts previously reported as loss on sale of property and equipment and bakery shutdown costs.

In the consolidated balance sheets, customer trade allowances (previously netted as an allowance against trade accounts receivable) are presented in current liabilities, with conforming reclassifications made for the prior period presentation.

For the three and nine months ended September 30, 2017, the Company recorded adjustments to previously reported gains on debt modifications, resulting in a pre-tax charge of $2.1 million and $1.6 million, respectively. The Company has determined that these corrections of errors are immaterial to the current and prior reported periods.

10




The Company has two reportable segments: Sweet Baked Goods and Other.
Basis of Presentation
The consolidated financial statements included herein have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and the rules and regulations of Securities and Exchange Commission (“SEC”). In the opinion of management, the unaudited consolidated financial statements include all adjustments necessary for the fair presentation of the Company’s financial position and of the results of operations and cash flows for the periods presented, all such adjustments were of a normal and recurring nature. The results of operations are not necessarily indicative of the results to be expected for the full fiscal year. The accompanying unaudited consolidated financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements and notes thereto for the fiscal year ended December 31, 2016.

Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and its majority-owned or controlled subsidiaries (including those for which the Company is the primary beneficiary of a variable interest entity), collectively referred to as the Company. All intercompany balances and transactions have been eliminated in consolidation.     
Use of Estimates
The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and judgments that affect the reported amounts of assets and liabilities at the date of the financial statements and for the reported amounts of revenues and expenses during the reporting period. Management utilizes estimates, including, but not limited to, valuation and useful lives of tangible and intangible assets, reserves for trade and promotional allowances, workers’ compensation and self-insured medical claims. Actual results could differ from these estimates. Certain prior year amounts have been reclassified to conform with current year presentation.
Accounts Receivable
Accounts receivable represents amounts invoiced to customers for goods that have been received by the customer. As of September 30, 2017 and December 31, 2016, the Company’s accounts receivable were $100.7 million and $89.2 million, respectively, which have been reduced by allowances for damages occurring during shipment, quality claims and doubtful accounts in the amount of $2.5 million and $1.9 million, respectively. In addition, there are customer trade allowances of $35.2 million and $36.7 million as of September 30, 2017 and December 31, 2016, respectively, in current liabilities in the consolidated balance sheets.
Inventories
Inventories are stated at the lower of cost or market on a first-in first-out basis.
Abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) are expensed in the period they are incurred.
The components of inventories are as follows:
(In thousands)
September 30,
2017
 
December 31,
2016
 
(Successor)
 
(Successor)
Ingredients and packaging
$
14,474

 
$
12,712

Finished goods
16,441

 
14,229

Inventory in transit to customers
2,897

 
3,503

 
$
33,812

 
$
30,444



11



Impairment of Property and Equipment
For the three and nine months ended September 30, 2017 (Successor), the Company recorded an impairment loss of $1.0 million related to a production line that was idled when the related production was transitioned to a third party. During the first quarter of 2016 (Predecessor), the Company recorded an impairment loss of $7.3 million when it closed multiple production lines at the Indianapolis, Indiana bakery and transitioned production to other facilities. The measurement of this loss was based on Level 3 inputs within the fair value measurement hierarchy.
Software Costs
Included in the caption “Other assets” in the consolidated balance sheets is capitalized software in the amount of $7.3 million and $7.4 million at September 30, 2017 and December 31, 2016, respectively. Capitalized software costs are amortized over their estimated useful life of five years commencing when such assets are ready for their intended use. Software amortization expense included in general and administrative was $0.6 million and $1.8 million for the three and nine months ended September 30, 2017 (Successor), respectively, compared to $0.5 million and $1.4 million for the three and nine months ended September 30, 2016 (Predecessor), respectively.
Concentrations
The Company has one customer that accounted for 10% or more of the Company’s total net revenue. The percentage of total net revenues for this customer is presented below by segment:
 
Three Months Ended
 
Nine Months Ended
 
(% of Consolidated Net Revenues) 
September 30,
2017
 
 
September 30,
2016
 
September 30,
2017
 
 
September 30,
2016
 
 
(Successor)
 
 
(Predecessor)
 
(Successor)
 
 
(Predecessor)
 
Sweet Baked Goods
18.8
%
 
 
18.1
%
 
18.9
%
 
 
20.3
%
 
Other
0.9
%
 
 
3.1
%
 
0.8
%
 
 
1.5
%
 
Total
19.7
%
 
 
21.2
%
 
19.7
%
 
 
21.8
%
 

Advertising Costs
Advertising costs, through both national and regional media, are expensed in the period in which the advertisements are run. These costs totaled $0.3 million and $0.6 million for the three and nine months ended September 30, 2017 (Successor), and $0.4 million and $1.5 million for the three and nine months ended September 30, 2016 (Predecessor), respectively. These costs are recorded within advertising and marketing expense on the consolidated statement of operations.
Derivatives
In April 2017, the Company entered into an interest rate swap contract to mitigate its exposure to changes in the variable interest rate on its long-term debt. This contract was designated as a cash flow hedge. Changes in the fair value of this instrument are recognized in accumulated other comprehensive loss in the consolidated balance sheets and reclassified into earnings in the period in which the hedged transaction affects earnings. Hedging ineffectiveness, if any, is recognized in earnings in the consolidated statements of operations. Payments made under this contract are included in the supplemental disclosure of interest in the consolidated statement of cash flows.

New Accounting Pronouncements
In August 2017, the FASB issued Accounting Standards Update No. 2017-12 (“ASU 2017-12”), Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities, which improves the financial reporting of hedging relationships to better portray the economic results of an entity's risk management activities in its financial statements and make certain targeted improvements to simplify the application of the hedge accounting guidance in current GAAP. The amendments in this update better align an entity's risk management activities and financial reporting for hedging relationships through changes to both the designation and measurement guidance for qualifying hedging relationships and presentation of hedge results. The effective date for the standard is for fiscal years beginning after December 15, 2018. The Company does not expect the adoption of this standard to have a material impact on its consolidated financial position, results of operations or cash flows.

12



In May 2017, the FASB issued Accounting Standards Update No. 2017-9 (“ASU 2017-9”), Compensation - Stock Compensation (Topic 718): Scope of Modification Accounting, which provides guidance about what changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718. Per ASU 2017-9, an entity should account for the effects of a modification unless all the following are met: (1) the fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of the modified award is the same as the fair value (or calculated value or intrinsic value, if such an alternative measurement method is used) of the original award immediately before the original award is modified. If the modification does not affect any of the inputs to the valuation technique that the entity uses to value the award, the entity is not required to estimate the value immediately before and after the modification, (2) the vesting conditions of the modified award are the same as the vesting conditions of the original award immediately before the original award is modified, and (3) the classification of the modified award as an equity instrument or a liability instrument is the same as the classification of the original award immediately before the original award is modified. The current disclosure requirements in Topic 718 apply regardless of whether an entity is required to apply modification accounting under the amendments in ASU 2017-9. The Company has early adopted ASU 2017-9 for the three months ended September 30, 2017. The adoption of this standard did not have a material impact on the Company’s consolidated financial position, results of operations, or cash flows.
In January 2017, the FASB issued Accounting Standards Update No. 2017-4 (“ASU 2017-4”), Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. ASU 2017-4 eliminates Step 2 from the goodwill impairment test. Step 2 required an entity to determine the fair value at the impairment testing date of its assets and liabilities following the procedure that would be required in a business combination. Instead, an entity should perform its goodwill impairment test and recognize an impairment charge by comparing the fair value of a reporting unit with its carrying amount. ASU 2017-4 will become effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted. The Company early adopted ASU 2017-4 and does not expect adoption to have a material impact on its consolidated financial position, results of operations or cash flows. Our goodwill impairment tests have not proceeded to Step 2 in any measurement period.
In February 2016, the FASB issued ASU No. 2016-02, Leases (“ASU 2016-02”), which is intended to improve financial reporting about leasing transactions. This standard requires a lessee to record on the balance sheet the assets and liabilities for the rights and obligations created by lease terms of more than 12 months. This standard will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, and early adoption is permitted. The Company is currently evaluating the impact the adoption of ASU 2016-02 will have on its consolidated financial position, results of operations or cash flows.
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), (“ASU 2014-09”), which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective for the Company on January 1, 2018. The standard permits adoption retrospectively to each prior report period presented, retrospectively to each prior report period presented utilizing practical expedient(s), or retrospectively with the cumulative effect of initially applying the standard at the date of initial application. In March 2016 and April 2016, the FASB issued ASU No. 2016-08 and ASU No. 2016-10, respectively, which clarifies the implementation guidance on principal versus agent considerations and also identifies performance obligations and the licensing implementation guidance, while retaining the related principles for those areas. The Company is in the process of completing its review of customer contracts to determine the impact that Topic 606 will have on the Company's consolidated financial statements. The Company plans to adopt the standard in the first quarter of 2018 retrospectively with the cumulative effect of initially applying the standard as of January 1, 2018.
The planned adoption dates for all standards not yet implemented are based on the Company’s assessment that it will lose its status as an Emerging Growth Company, as defined in the Jumpstart Our Business Startups Act (JOBS Act), as of December 31, 2017.
2. Business Combination

The purchase price for the Business Combination was allocated to the fair value of the assets acquired and liabilities assumed based on the preliminary valuations performed by the Company as of the Closing Date. During the nine months ended September 30, 2017 the Company revised its estimate of the future cash tax savings under the tax receivable agreement. This resulted in a $8.1 million decrease in goodwill, a decrease to the tax receivable agreement liability of $3.0 million, a $5.5 million decrease to deferred tax liabilities, and an increase to accrued expenses and other liabilities of $0.4 million.

13




3. Stock-Based Compensation

Hostess Brands, Inc. 2016 Equity Incentive Plan (Successor)

The Hostess Brands, Inc. 2016 Equity Incentive Plan (the “2016 Plan”) provides for the grant of various equity-based incentive awards to directors of the Company, certain members of Company management, and service providers to the Company. The types of equity-based awards that may be granted under the 2016 Plan include: stock options, stock appreciation rights (SARs), restricted stock, restricted stock units (RSUs), and other stock-based awards. There are 7,150,000 registered shares of Class A common stock reserved for issuance under the 2016 Plan. All awards issued under the 2016 Plan may only be settled in shares of Class A common stock.

Restricted Stock Units

During the nine months ended September 30, 2017, the following RSUs were granted under the 2016 Plan:

22,732 RSUs to directors of the Company. The units vest on November 4, 2017. These awards only contain service conditions.
297,500 RSUs to certain members of management. One-third of the units vest at each of the following dates: January 1, 2018, November 4, 2018, and November 4, 2019. Vesting is dependent upon positive earnings per share for the fiscal year ending immediately prior to the vesting date. Management has determined it is probable that these performance conditions will be met.
18,116 RSUs to certain members of management. One-third of the units vest at each of the following dates: June 1 of each of 2018, 2019, and 2020.These awards only contain service conditions.
372,036 RSUs to certain members of management. One-third of the units vest at each of the following dates; November 4 of each of 2017, 2018 and 2019. These awards only contain service conditions.
715,406 RSUs to certain members of management. The units vest on December 31, 2019. At the end of each of three annual performance periods ending December 31, 2017, 2018 and 2019, a portion of the units will be banked if the Company achieves certain EBITDA targets. Banked shares continue to be subject to continued service through the December 31, 2019 vesting date. Management has determined it is probable that a portion of the EBITDA target will be met for the 2017 annual performance period. Depending on actual performance during each performance period, award recipients have the opportunity to receive up to 225% of the granted units.

For the three and nine months ended September 30, 2017 (Successor), $1.8 million and $4.1 million of compensation expense related to the RSUs was recognized within general and administrative expenses on the consolidated statement of operations, respectively.

The following table summarizes the activity of the Company’s unvested RSUs for the nine months ended September 30, 2017:
 
Restricted Stock
Units
 
Weighted Average
Grant Date
Fair Value
Unvested units as of December 31, 2016 (Successor)

 
$

Total Granted
1,425,790

 
15.77

Forfeited
(79,543
)
 
15.78

Vested

 

Unvested as of September 30, 2017 (Successor)
1,346,247

 
$
15.77

As of September 30, 2017, there was $17.1 million of total unrecognized compensation cost related to non-vested RSUs granted under the 2016 Plan; that cost is expected to be recognized over the vesting periods as described above.

14



Restricted Stock Awards
On March 23, 2017, the Company granted 435,000 shares of restricted stock to the Company’s Chief Executive Officer under the 2016 Plan. One-third of the shares vest on each of the following dates: January 1, 2018 and November 4 of each of 2018 and 2019. Vesting at each date is also dependent upon positive earnings per share for the fiscal year ending immediately prior to the vesting date. Each restricted stock award had a grant date fair value based on the closing price of the Company’s common stock on the grant date and management’s assumption that there will be no forfeitures.
Management has determined that the shares of restricted stock are unvested stock awards as defined by accounting standards. If the vesting requirements of a restricted stock award are not satisfied, or the performance conditions not attained, the award will be forfeited and the shares of Class A common stock subject to the award shall be returned to the Company.
As of September 30, 2017, there was $4.1 million of total unrecognized compensation cost related to the non-vested restricted stock; that cost is expected to be recognized over the vesting periods described above. For the three and nine months ended September 30, 2017 (Successor), the Company recognized expense of $1.3 million and $2.8 million related to the restricted stock awards within general and administrative expenses on the consolidated statement of operations, respectively.
The following table summarizes the activity of the Company’s restricted stock awards for the nine months ended September 30, 2017:


Shares of
Restricted Stock
 
Weighted Average
Grant Date Fair Value
Unvested units as of December 31, 2016 (Successor)


 
$

Granted

435,000

 
15.78

Forfeited


 

Vested


 

Unvested as of September 30, 2017 (Successor)

435,000

 
$
15.78

Stock Options
During the nine months ended September 30, 2017, the Company granted 1,155,788 stock options to certain members of management under the Plan. The weighted average grant date fair value of $5.03 per option was estimated using the Black-Scholes option-pricing model (level 3) with the following assumptions:
 
Nine Months
Ended
September 30, 2017
Expected volatility (1)
27.53%
Expected dividend yield (2)
—%
Expected option term (3)
6.25 years
Risk-free rate (4)
2.1%
(1)
The expected volatility assumption was calculated based on a peer group analysis of stock price volatility with a look back period based on the expected term and ending on the grant date.
(2)
As of September 30, 2017, we have not paid any dividends on our common stock. As of the stock option grant date, we did not anticipate paying any dividends on our common stock over the term of the stock options. Option holders have no right to dividends prior to the exercise of the options.
(3)
We utilized the simplified method to determine the expected term of the stock options since we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate expected term.
(4)
The risk-free interest rate was based on the U.S. Treasury yield curve in effect at the time of grant which corresponds to the expected term of the stock options.

15



The stock options vest in four equal annual installments on varying dates through June 2021. As of September 30, 2017, there was $4.5 million of total unrecognized compensation cost related to non-vested stock options outstanding under the 2016 Plan; that cost is expected to be recognized over the vesting periods. For the three and nine months ended September 30, 2017 (Successor), there was $0.6 million and $1.1 million, respectively, of expense related to the stock options recognized within general and administrative costs on the consolidated statement of operations.
The following table summarizes the activity of the Company’s unvested stock options for the nine months ended September 30, 2017 (Successor):


Number
of
Options
 
Weighted Average
Remaining
Contractual Life
(years)
 
Weighted
Average
Exercise Price
 
Weighted
Average Grant
Date Fair Value
Outstanding as of December 31, 2016 (Successor)

 

 
$

 
$

Granted
1,155,788

 
5.77

 
15.85

 
5.03

Exercised

 

 

 

Forfeited
(44,371
)
 
5.75

 
15.78

 
5.03

Outstanding as of September 30, 2017 (Successor)
1,111,417

 
5.77

 
$
15.85

 
$
5.03

Exercisable as of September 30, 2017 (Successor)

 

 

 


Hostess Management, LLC Equity Interest Plan (Predecessor)

The Company established a profits interest plan under the 2013 Hostess Management, LLC (“Hostess Management”) Equity Incentive Plan (“2013 Plan”) to allow members of the management team to participate in the success of the Company. The 2013 Plan consisted of an approximate 9% ownership interest in the Company’s subsidiary, New Hostess Holdco, LLC. Hostess Management had three classes of units and required certain returns to ranking classes before other classes participated in subsequent returns of Hostess Management.
The Company recognized unit-based compensation expense of $0.3 million and $0.7 million for the three and nine months ended September 30, 2016 (Predecessor), within general and administrative expense on the consolidated statement of operations, respectively. All outstanding units under the 2013 Plan were redeemed and the 2013 Plan was terminated on November 4, 2016. As of December 31, 2016, there were no outstanding units.

Related Party Stock Awards

See note 15 for information regarding additional equity awards not issued under the 2016 or 2013 Plans.

4.    Property and Equipment
Property and equipment consists of the following:
(In thousands)
September 30,
2017
 
 
December 31,
2016
 
(Successor)
 
 
(Successor)
Land and buildings
$
31,296

 
 
$
30,275

Machinery and equipment
130,778

 
 
112,221

Construction in progress
15,363

 
 
12,334

 
177,437

 
 
154,830

Less accumulated depreciation
(10,506
)
 
 
(1,606
)
 
$
166,931

 
 
$
153,224



16



Depreciation expense was $3.1 million and $8.9 million for the three and nine months ended September 30, 2017 (Successor), and $2.5 million and $6.7 million for the three and nine months ended September 30, 2016 (Predecessor), respectively.
5.    Segment Reporting
The Company has two reportable segments: Sweet Baked Goods and Other. The Company’s Sweet Baked Goods segment consists of sweet baked goods that are sold under the Hostess® and Dolly Madison® brands. Other consists of Hostess® branded bread and buns, frozen retail (which consists of deep-fried Twinkies®, launched in August 2016), “In-Store Bakery,” or “ISB” (which includes Superior) and licensing.
The Company evaluates performance and allocates resources based on net revenue and gross profit. Information regarding the operations of these reportable segments is as follows:
(In thousands)
Three Months Ended
September 30,
2017
 
 
Three Months Ended
September 30,
2016
 
Nine Months Ended
September 30,
2017
 
 
Nine Months Ended
September 30,
2016
 
(Successor)
 
 
(Predecessor)
 
(Successor)
 
 
(Predecessor)
  Net revenue:
 
 
 
 
 
 
 
 
 
Sweet Baked Goods
$
173,552

 
 
$
174,473

 
$
524,731

 
 
$
508,288

Other
18,698

 
 
21,724

 
55,236

 
 
40,469

Net revenue
$
192,250

 
 
$
196,197

 
$
579,967

 
 
$
548,757

 
 
 
 
 
 
 
 
 
 
Depreciation and amortization:
 
 
 
 
 
 
 
 
 
Sweet Baked Goods
$
8,703

 
 
$
2,585

 
$
25,587

 
 
$
8,119

Other
1,019

 
 
583

 
2,989

 
 
935

Depreciation and amortization
$
9,722

 
 
$
3,168

 
$
28,576

 
 
$
9,054

 
 
 
 
 
 
 
 
 
 
Gross profit:
 
 
 
 
 
 
 
 
 
Sweet Baked Goods
$
72,965

 
 
$
76,777

 
$
230,217

 
 
$
227,322

Other
5,400

 
 
5,802

 
15,889

 
 
12,008

Gross profit
$
78,365

 
 
$
82,579

 
$
246,106

 
 
$
239,330

 
 
 
 
 
 
 
 
 
 
  Capital expenditures (1):
 
 
 
 
 
 
 
 
 
Sweet Baked Goods
$
9,109

 
 
$
9,312

 
$
24,772

 
 
$
25,701

Other
205

 
 
161

 
643

 
 
211

Capital expenditures
$
9,314

 
 
$
9,473

 
$
25,415

 
 
$
25,912


(1)
Capital expenditures consists of purchases of property and equipment and acquisition and development of software assets paid in cash or acquired through accounts payable during the three and nine months ended September 30, 2017 (Successor) and 2016 (Predecessor).

Total assets by reportable segment are as follows:
(In thousands)
September 30,
2017
 
 
December 31,
2016

(Successor)
 
 
(Successor)
Total segment assets:


 
 


Sweet Baked Goods
$
2,719,743

 
 
$
2,633,758

Other
206,930

 
 
214,134

Total segment assets
$
2,926,673

 
 
$
2,847,892



17


6.    Goodwill and Intangible Assets
Goodwill and intangible assets as of September 30, 2017 and December 31, 2016 were recognized as part of the purchase price allocation of the Business Combination as of the Closing Date. The amount allocated to goodwill and other intangible assets is subject to final valuation adjustments. These adjustments could have a material impact on goodwill and other intangible assets. During the nine months ended September 30, 2017, the purchase price allocation for the Business Combination was adjusted, resulting in a $8.1 million decrease to goodwill.
Activity of goodwill is presented below by reportable segment:
(In thousands)
Sweet Baked Goods
 
Other
 
Total
Balance as of December 31, 2016 (Successor)
$
518,759

 
$
69,701

 
$
588,460

Measurement period adjustment of the Business Combination
(8,111
)
 

 
(8,111
)
Balance as of September 30, 2017 (Successor)
$
510,648

 
$
69,701

 
$
580,349

Intangible assets consist of the following:
(In thousands)
September 30,
2017
 
December 31,
2016
 
(Successor)
 
(Successor)
Intangible assets with indefinite lives (Trademarks and Trade Names)
$
1,408,848

 
$
1,408,848

Intangible assets with definite lives (Customer Relationships)
542,011

 
542,011

Less accumulated amortization (Customer Relationships)
(21,777
)
 
(3,916
)
Intangible assets, net
$
1,929,082

 
$
1,946,943


Amortization expense was $6.0 million and $17.9 million for the three and nine months ended September 30, 2017 (Successor) and $0.2 million and $0.5 million for the three and nine months ended September 30, 2016 (Predecessor), respectively. The unamortized portion of customer relationships will be expensed over their remaining useful life, from 18 to 23 years. The weighted-average amortization period as of September 30, 2017 for customer relationships was 21.8 years. Future expected amortization expense is as follows:
(In thousands)
 
Remainder of 2017
$
5,994

2018
23,977

2019
23,977

2020
23,977

2021
23,977

2022 and thereafter
418,332


18



7.    Accrued Expenses
Included in accrued expenses are the following:
(In thousands)
September 30,
2017
 
 
December 31,
2016
 
(Successor)
 
 
(Successor)
Annual incentive bonuses
$
4,141

 
 
$
5,997

Payroll, vacation and other compensation
3,496

 
 
5,121

Self-insurance reserves
1,310

 
 
2,091

Accrued interest
224

 
 
4,885

Current income taxes payable
113

 
 
2

Workers compensation reserve
1,650

 
 
1,321

Interest rate swap contract
99

 
 

Litigation (Note 14)

 
 
1,100

Other
18

 
 
1,139

 
$
11,051

 
 
$
21,656


8. Debt
On May 19, 2017, the Company’s subsidiary, Hostess Brands, LLC, and its lenders amended the New First Lien Term Loan (Second Amended First Lien Term Loan). The Second Amended First Lien Term Loan requires quarterly payments of interest at a rate of the greater of the applicable LIBOR or 0.75% per annum (LIBOR Floor) plus an applicable margin of 2.50% per annum or the base rate plus an applicable margin of 1.50% per annum. The principal is paid quarterly at a rate of 0.25% of the aggregate principal balance with the remaining principal amount due upon maturity on August 3, 2022. The Second Amended First Lien Term Loan is secured by substantially all the Company’s present and future assets through a guarantor agreement. The interest rate charged to the Company on the New First Lien Term Loan from January 1, 2017 through May 18, 2017 was 4.00%. From May 19, 2017 through September 30, 2017, the interest rate charged to the Company on the Second Amended First Lien Term Loan was 3.73%.
A summary of the carrying value of the debt and the capital lease obligation is as follows:
(In thousands)
September 30, 2017
 
 
December 31,
2016
 
(Successor)
 
 
(Successor)
Second Amended First Lien Term Loan (3.7% as of September 30, 2017)
 
 
 
 
Principal
$
993,763

 
 
$

Unamortized debt premium and issuance costs
5,462

 
 

 
999,225

 
 

New First Lien Term Loan (4.0%)
 
 
 
 
Principal

 
 
998,750

Unamortized debt premium and issuance costs

 
 
5,396



 
 
1,004,146

Capital lease obligation (6.8%)
608

 
 
724

Total debt and capital lease obligation
999,833

 
 
1,004,870

Less: Amounts due within one year
(11,357
)
 
 
(11,496
)
Long-term portion
$
988,476

 
 
$
993,374

    

19


At September 30, 2017, minimum debt repayments under the Second Amended First Lien Term Loan are due as follows:
(In thousands)
 
Remainder of 2017
$
2,491

2018
9,963

2019
9,963

2020
9,963

2021
9,963

2022 and thereafter
951,420


Revolving Credit Facility
The Company had no outstanding borrowings under its Revolving Credit Agreement (the “Revolver”) as of September 30, 2017. See Note 14. Commitments and Contingencies for information regarding the letters of credits, which reduce the amount available for borrowing under the Revolver. Interest expense from the Revolver debt fee amortization was $0.1 million and $0.3 million for the three and nine months ended September 30, 2016 (predecessor), respectively.
9. Interest Rate Swap

In April 2017, the Company entered into an interest rate swap contract with a counter party to make a series of payments based on a fixed interest rate of 1.78% and receive a series of payments based on the greater of LIBOR or 0.75%. Both the fixed and floating payment streams are based on a notional amount of $500 million at the inception of the contract and will be reduced by $100 million each year of the five-year contract. The Company entered into this transaction to reduce its exposure to changes in cash flows associated with its variable rate debt and has designated this derivative as a cash flow hedge. At September 30, 2017, the effective fixed interest rate on the long-term debt hedged by this contract was 4.28%.
For the three and nine months ended September 30, 2017, no amounts were recorded in the consolidated statements of operations for ineffectiveness and there were no reclassifications from accumulated other comprehensive loss into earnings. As of September 30, 2017, the fair value of the interest rate swap contract of $0.1 million was reported within accrued expenses and other liabilities on the consolidated balance sheet. $1.5 million of unrealized losses recognized in accumulated other comprehensive income as of September 30, 2017 are expected to be reclassified into interest expense through September 30, 2018. The fair value of the interest rate swap contract is measured on a recurring basis by netting the discounted future fixed cash payments and the discounted expected variable cash receipts.  The variable cash receipts are based on the expectation of future interest rates (forward curves) derived from observed market interest rate curves (Level 2).

10. Equity
The Company’s authorized common shares consist of three classes: 200,000,000 shares of Class A common stock, 50,000,000 shares of Class B common stock, and 10,000,000 shares of Class F common stock (none of which were issued and outstanding at September 30, 2017 or December 31, 2016). As of September 30, 2017 and December 31, 2016, there were 99,992,183 and 98,250,917 shares of Class A common stock issued and outstanding, respectively. At September 30, 2017 and December 31, 2016 there were 30,398,777 and 31,704,988 shares of Class B common stock issued and outstanding, respectively.

20


Shares of Class A common stock and Class B common stock have identical voting rights. However, shares of Class B common stock do not participate in earnings or dividends of the Company. Ownership of shares of Class B common stock is restricted to owners of Class B units in Hostess Holdings. Class B units in Hostess Holdings may be exchanged (together with the cancellation of an equivalent number of shares of Class B common stock) by the holders thereof for, at the election of the Company, shares of Class A common stock or the cash equivalent of such shares. During the three months ended September 30, 2017, there was no activity. During the nine months ended September 30, 2017, 1,306,211 Class B shares were exchanged for Class A common shares.
As of September 30, 2017 and December 31, 2016, there were 37,499,890 and 37,500,000 public warrants, respectively, and 19,000,000 private placement warrants outstanding. Each warrant entitles its holder to purchase one-half of one share of our Class A common stock at an exercise price of $5.75 per half share, to be exercised only for a whole number of shares of our Class A common stock. The warrants became exercisable on December 4, 2016 (30 days after the completion of the Business Combination on November 4, 2016) and expire on December 4, 2021, or earlier upon redemption or liquidation. The Company may call the outstanding warrants for redemption at a price of $0.01 per warrant, if the last sale price of the Company’s common stock equals or exceeds $24.00 per share for any 20 trading days within a 30 trading day period ending on the third business day before the Company sends the notice of redemption to the warrant holders. The private placement warrants, however, are nonredeemable so long as they are held by the Company’s Sponsor or its permitted transferees. During the three months ended September 30, 2017, the private placement warrants were registered with the SEC for future potential sales to the public. When sold to the public, the private placement warrants will become public warrants.

11. Earnings per Share

Basic earnings per share is calculated by dividing net income attributable to the Company’s Class A shareholders for the period by the weighted average number of Class A common shares outstanding for the period excluding non-vested restricted stock awards. In computing dilutive earnings per share, basic earnings per share is adjusted for the assumed issuance of all applicable potentially dilutive share-based awards, including: public and private placement warrants, RSUs, restricted stock awards, and stock options.

Below are basic and diluted net income per share:

 
Three Months Ended
September 30, 2017
 
Nine Months Ended
September 30, 2017
 
 
(Successor)
 
(Successor)
Numerator:
 
 
 
 
Net income attributable to Class A shareholders (in thousands)
 
$
9,549

 
$
44,211

Denominator:
 
 
 
 
Weighted-average Class A shares outstanding - basic (excluding non-vested restricted stock awards)
 
99,557,183

 
98,920,808

Dilutive effect of warrants
 
5,717,416

 
6,844,613

Dilutive effect of restricted stock awards and RSUs
 
143,967

 
75,252

Weighted-average shares outstanding - diluted
 
105,418,566

 
105,840,673

 
 
 
 
 
Net income per Class A share - basic
 
$
0.10

 
$
0.45

 
 
 
 
 
Net income per Class A share - dilutive
 
$
0.09

 
$
0.42


For both the three and nine months ended September 30, 2017, stock options were excluded from the computation of diluted net income per share because the assumed proceeds from the awards’ exercise was greater than the average market price of the common shares.


21



12. Income Taxes
The Company is subject to U.S. federal, state and local taxes on its allocable portion of the income of Hostess Holdings, a partnership for U.S. federal and most applicable state and local taxes. As a partnership, Hostess Holdings is itself not subject to U.S. federal and certain state and local income taxes. The operations of Hostess Holdings include those of its C Corporation subsidiaries.
The income tax expense in the accompanying consolidated statement of operations is based on an estimate of the Company’s annual effective income tax rate and adjusted for discrete items, if any.  The Company’s estimated annual effective tax rate based on annual projected earnings for the year ending December 31, 2017 is projected to be 29.6% prior to adjusting for discrete items. During the three months ended September 30, 2017, the Company recorded a nonrecurring discrete charge of approximately $2.2 million related to a change in state tax law. The Company’s effective tax rate differs from the statutory rate primarily due to the portion of net income attributed to the non-controlling interest which represents an ownership interest in a partnership for income tax purposes.

Deferred income taxes are provided for the effects of temporary differences between the tax basis of an asset or liability and its reported amount in the accompanying consolidated balance sheets. The recognition of deferred tax assets is based on management’s belief that it is more likely than not that the tax benefits associated with temporary differences, net operating loss carryforwards and tax credits will be utilized. The Company is in an overall net deferred tax liability position of $366.5 million and $353.8 million as of September 30, 2017 and December 31, 2016, respectively, primarily due to temporary differences in the book basis as compared to the tax basis of its investment in Hostess Holdings.
The Company does not believe it has any significant uncertain tax positions and therefore has no unrecognized tax benefits at September 30, 2017, that if recognized, would affect the annual effective tax rate. Interest and penalties related to income tax liabilities, if incurred, are included in income tax expense in the consolidated statement of operations.


22


13.    Tax Receivable Agreement

The tax receivable agreement was entered into by the Company in connection with the Business Combination (the “Tax Receivable Agreement”) and generally provides for the payment by the Company to the Legacy Hostess Equityholders of 85% of the net cash savings, if any, in U.S. federal, state and local income tax that the Company actually realizes (or is deemed to realize in certain circumstances) in periods after the closing of the Business Combination (which periods may extend, unless the Tax Receivable Agreement is terminated early in accordance with its terms, for more than 15 years following any exchange of Class B Units of Hostess Holdings for shares of the Company’s Class A common stock or the cash equivalent thereof) as a result of (i) certain increases in tax basis resulting from the Business Combination; (ii) certain tax attributes of Hostess Holdings and its subsidiaries existing prior to the Business Combination and prior to subsequent exchanges of Class B Units; (iii) certain increases in tax basis resulting from exchanges of Class B Units; (iv) imputed interest deemed to be paid by the Company as a result of payments it makes under the Tax Receivable Agreement; and (v) certain increases in tax basis resulting from payments the Company makes under the Tax Receivable Agreement. The Company will retain the benefit of the remaining 15% of these cash savings. Certain payments under the Tax Receivable Agreement will be made to Legacy Hostess Equityholders in accordance with specified percentages, regardless of the source of the applicable tax attribute. Significant inputs used to preliminarily estimate the future expected payments include a tax savings rate of approximately 37%.

The following table summarizes activity related to the tax receivable agreement for the nine months ended September 30, 2017:

(In thousands)
 
 
Balance December 31, 2016 (Successor)
 
$
165,384

Measurement period adjustment of the Business Combination
 
(3,016
)
Balance arising from exchanges of Class B units for Class A shares
 
11,530

Remeasurement due to change in state tax rate
 
1,589

Balance September 30, 2017 (Successor)
 
$
175,487


During the three months ended September 30, 2017, the Company remeasured the Tax Receivable Agreement due to a change in a state tax law. This resulted in $1.6 million of expense on the consolidated statement of operations.


As of September 30, 2017 the future expected payments under the Tax Receivable Agreement are as follows:

(In thousands)
 
Remainder of 2017
$

2018
14,165

2019
10,375

2020
10,097

2021
9,845

Thereafter
131,005




23



14.    Commitments and Contingencies
Accruals and the Potential Effect of Litigation
Liabilities related to legal proceedings are recorded when it is probable that a liability has been incurred and the associated amount can be reasonably estimated. Where the estimated amount of loss is within a range of amounts and no amount within the range is a better estimate than any other amount, the minimum amount is accrued.
As additional information becomes available, the potential liabilities related to these matters are reassessed and the estimates revised, if necessary. These accrued liabilities are subject to change in the future based on new developments in each matter, or changes in circumstances, which could have a material effect on the Company’s financial condition and results of operations.
During the three months ended September 30, 2017, the Company paid an award in the National Frozen Distribution Consultants, Inc. (NFDC) arbitration of approximately $2.0 million.
From time to time, the Company is subject to various other legal actions, lawsuits, claims and proceedings related to products, employment, environmental regulations, and other matters incidental to its businesses.
Based upon information presently known, the Company does not believe that the ultimate resolution of such matters will have a material effect on the Company’s financial position, although the final resolution of such matters could have a material effect on its results of operations or cash flows in the period of resolution.
Contractual Commitments
The Company is a party to various long-term arrangements through advance purchase contracts to lock in prices for certain high-volume raw materials, packaging components and fuel for normal product production requirements. These advance purchase arrangements are contractual agreements and can only be canceled with a termination penalty that is based upon the current market price of the commodity at the time of cancellation. These agreements qualify for the “normal purchase” exception under accounting standards; therefore, the purchases under these contracts are included as a component of cost of goods sold.
Contractual commitments were as follows:
(In millions)
Total Committed
Commitments within 1 year
Commitments beyond 1 year
Ingredients
$
82.4

$
69.2

$
13.2

Packaging
$
44.3

$
39.1

$
5.2

Letters of Credit
The Company is a party to Letter of Credit arrangements to provide for the issuance of standby letters of credit in the amount of $2.2 million and $1.7 million, respectively. The arrangements support the collateral requirements for insurance. The Letters of Credit are 100% secured through our Revolver.


24



15.    Related Party Transactions
Prior to the Business Combination, the Company was party to an agreement to employ Mr. Metropoulos as the Executive Chairman. The agreement, dated April 2013, included payment of an annual salary, a performance bonus at the discretion of the board of directors, and expenses related to the use of his personal aircraft. For the three and nine months ended September 30, 2016 (Predecessor), $1.1 million and $3.4 million was expensed by the Company for this compensation agreement. The agreement with Mr. Metropoulos was terminated in connection with the Business Combination.
For periods prior to the Business Combination, related party expenses consisted of the normal annual cash payments associated with our employment arrangements with Mr. Metropoulos as Chief Executive Officer and/or Executive Chairman. In connection with the Business Combination, Mr. Metropoulos became party to new employment arrangements with the Company and its subsidiaries. Following the consummation of the Business Combination, the expense associated with Mr. Metropoulos’s employment arrangements is estimated to be approximately $0.3 million annually.

As part of the Business Combination, the Company agreed to grant shares of Class A common stock or Class B units of Hostess Holdings and equivalent shares of Class B common stock of the Company to an entity owned by Mr. Metropoulos if certain EBITDA thresholds are met for the year ended December 31, 2017.   The potential grants under this arrangement are between zero and 5.5 million shares.  Based on the nature of the arrangement, for U.S. GAAP purposes the potential grants are considered to be compensation for future services to be provided by Mr. Metropoulos. In order to receive 2.75 million shares under this agreement, adjusted EBITDA, as calculated pursuant to the terms of the Master Transaction Agreement entered into in connection with the Business Combination, (“MTA EBITDA”), for the year ended December 31, 2017 must be greater than $240.5 million. If MTA EBITDA is greater than $245.5 million, an additional 2.75 million shares will be awarded. As of September 30, 2017, management determined it was not probable that the Company would meet the 2017 MTA EBITDA thresholds.
Under the terms of Mr. Metropoulos’ employment agreement, the Company is obligated to grant additional equity (in the form of either shares of Class A common stock of the Company, or Class B units of Hostess Holdings and equivalent shares of Class B common stock of the Company) to Mr. Metropoulos if MTA EBITDA thresholds are met for the year ended December 31, 2018. The potential grants range from zero to 2.75 million shares. In order to receive 1.375 million shares under this agreement, MTA EBITDA for the year ended December 31, 2018 must be greater than $257.8 million. If MTA EBITDA is greater than $262.8 million, an additional 1.375 million shares will be awarded. As of September 30, 2017, management determined it was not probable that the Company would meet the 2018 MTA EBITDA thresholds.




25


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are a leading United States packaged food company focused on developing, manufacturing, marketing, selling and distributing fresh sweet baked goods coast-to-coast, providing a wide range of snack cakes, donuts, sweet rolls, snack pies and related products. We acquired the Hostess® brand and certain strategic assets out of the bankruptcy liquidation proceedings of Old Hostess Inc., its prior owner, free and clear of all past liabilities, in April 2013, and relaunched the brand later that year.

We operate five bakeries and three centralized distribution centers. Our direct-to-warehouse (“DTW”) product distribution system allows us to deliver to our customers’ warehouses. Our customers in turn distribute to their retail stores and/or distributors.

We have two reportable segments: “Sweet Baked Goods” and “Other”. Sweet Baked Goods consists of sweet baked goods that are sold under the Hostess® and Dolly Madison® brands. Other consists of Hostess® branded bread and buns, frozen retail (which includes deep-fried Twinkies®, launched in August 2016), “In-Store Bakery,” or “ISB” (which includes Superior Cake Products, Inc. (“Superior”), which we purchased in May 2016, and which manufactures and distributes eclairs, madeleines, brownies, and iced cookies in the ISB section of retailers) and licensing.

Hostess® is the second leading brand by market share within the Sweet Baked Goods (“SBG”) category, according to Nielsen U.S. total universe. For the 52-week period ended October 7, 2017 our market share was 17.0% per Nielsen’s U.S. SBG category data. We have a #1 leading market position within the two largest SBG Segments; Donut Segment and Snack Cake Segment, The Donut and Snack Cake Segments together account for 49.6% of the Sweet Baked Goods category’s total dollar sales.

Explanatory Note
Hostess Brands, Inc. (f/k/a Gores Holdings, Inc.) was originally incorporated in Delaware on June 1, 2015 as a special purpose acquisition company (SPAC), formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization, or other similar business combination with one or more target businesses. On August 19, 2015, Gores Holdings, Inc. consummated its initial public offering (the “IPO”), following which its shares began trading on the Nasdaq Capital Market (“NASDAQ”).
On November 4, 2016 (the “Closing Date”), in a transaction referred to as the “Business Combination,” Gores Holdings, Inc. acquired a controlling interest in Hostess Holdings, L.P. (“Hostess Holdings”), an entity owned indirectly by C. Dean Metropoulos and certain equity funds managed by affiliates of Apollo Global Management, LLC (the “Apollo Funds”). Hostess Holdings had acquired the Hostess brand and certain strategic assets out of the bankruptcy liquidation proceedings of its prior owner (“Old Hostess”), free and clear of all past liabilities, in April 2013, and relaunched the Hostess brand later that year.
In connection with the closing of the Business Combination, Gores Holdings, Inc. changed its name to “Hostess Brands, Inc.” and its trading symbols on NASDAQ from “GRSH” and “GRSHW,” to “TWNK” and “TWNKW”.
Following the Business Combination, Mr. Metropoulos and the Apollo Funds continued as stockholders and Mr. Metropoulos became Executive Chairman of Hostess Brands, Inc. On April 19, 2017, the Apollo Funds completed the public sale of substantially all of their holdings of Class A common stock. Other equityholders also sold shares of Class A common stock through the public sale.
As a result of the Business Combination, for accounting purposes, Hostess Brands, Inc. is the acquirer and Hostess Holdings is the acquired party and accounting predecessor. Our financial statement presentation includes the financial statements of Hostess Holdings and its subsidiaries as “Predecessor” for periods prior to the completion of the Business Combination and of Hostess Brands, Inc., including the consolidation of Hostess Holdings and its subsidiaries, for periods from and after the Closing Date. For convenience, we have also included supplemental pro forma information for the three and nine months ended September 30, 2016 that gives effect to the Business Combination as if such transaction had been consummated on January 1, 2016. References in this Quarterly Report to information provided for 2016 on a pro forma basis refer to such supplemental pro forma financial information.

26


Unless the context otherwise requires, “we,” “us,” “our” and the “Company” refer, for periods prior to the completion of the Business Combination, to Hostess Holdings and its subsidiaries and, for periods upon or after the completion of the Business Combination, to Hostess Brands, Inc. and its subsidiaries, including Hostess Holdings and its subsidiaries. Our “Sponsor” refers to Gores Sponsor, LLC, a Delaware limited liability company and the principal stockholder of Gores Holdings, Inc. prior to the Business Combination, and the “The Gores Group” refers to The Gores Group LLC, an affiliate of our Sponsor. “Metropoulos Entities” refer to Mr. Metropoulos and entities controlled by him that continue to hold an equity stake in us. “Legacy Hostess Equityholders” refer to the Apollo Funds and the Metropoulos Entities, collectively.
Principal Components of Operating Results
Net Revenue
We generate revenue primarily through selling sweet baked goods and other products under the Hostess® group of brands, which includes iconic products such as Twinkies®, CupCakes, Ding Dongs®, Zingers®, HoHo’s® and Donettes® and the Dolly Madison® brand and the group of products under the Superior on Main® brand (e.g., eclairs, madeleines, brownies and iced cookies). Our product assortment, which includes snack cakes, muffins, donuts and pies, is sold to customers’ warehouses and distribution centers by the case or in display ready corrugate units. Retailers display and sell our products to the end consumer in single-serve, multi-pack or club-pack formats. We sell our products primarily to supermarket chains, national mass merchandisers and convenience stores, along with a smaller portion of our product sales going to dollar stores, vending, club, and other retail outlets.

Our revenues are driven by average net price and total volume of products sold. Factors that impact unit pricing and sales volume include product mix, the cost of ingredients, the promotional activities implemented by our Company and our competitors, industry capacity, new product initiatives and quality and consumer preferences. We do not keep a significant backlog of finished goods inventory, as our fresh baked products are promptly shipped to our distribution centers after being produced and then distributed to customers.
Cost of Goods Sold

Cost of goods sold consists of ingredients, packaging, labor, energy, other production costs, warehousing and transportation costs for the distribution of our products to our customers. The cost of ingredients and packaging represent the majority of our total costs of goods sold. All costs that are incurred at the bakeries are included in cost of goods sold. We do not allocate any corporate functions into cost of goods sold.

Our cost of ingredients consists principally of flour, sweeteners, edible oils and cocoa, which are subject to substantial price fluctuations, as is the cost of paper, corrugate, films and plastics used to package our products. The prices for raw materials are influenced by a number of factors, including the weather, crop production, transportation and processing costs, government regulation and policies and worldwide market supply and demand. We also rely on fuel products, such as natural gas, diesel, propane and electricity, to operate our bakeries and produce our products. Fluctuations in the prices of the raw materials or fuel products used in the production, packaging or transportation of our products affect the cost of products sold and our product pricing strategy. We utilize forward buying strategies through short-term and long-term advance purchase contracts to lock in prices for certain high-volume raw materials, packaged components and certain fuel inputs. Through these initiatives, we believe we are able to obtain competitive pricing.

Advertising and Marketing

Our advertising and marketing expenses primarily relate to our advertising campaigns, which include social media, print, online advertising, local promotional events and monthly agency fees. We also invest in wire and corrugate displays delivered to customers to display our products off shelf, field marketing and merchandising to reset and check the store inventory on a regular basis and marketing employment costs.

Selling Expense

Selling expenses primarily include sales management, employment, travel, and related expenses, as well as broker fees. We utilize brokers for sales support, including merchandising and order processing.


27


General and Administrative

General and administrative expenses primarily include employee and related expenses for the accounting, planning, customer service, legal, human resources, corporate operations, research and development, purchasing, logistics and executive functions. Also included are professional service fees related to audit and tax, legal, outsourced information technology functions, transportation planning, and corporate site and insurance costs.

The majority of our research and development spend is dedicated to enhancing and expanding our product lines responding to changing consumer preferences and trends and continuing to enhance the taste of our products. In addition, our research and development organization provides technical support to ensure that our core products are consistently produced in accordance with our high quality standards and specifications. Finally, this department is charged with developing processes to reduce our costs without adversely affecting the quality of our products.

Related Party Expenses

For periods prior to the Business Combination, related party expenses consisted of the normal annual cash payments associated with our employment arrangements with Mr. Metropoulos as Chief Executive Officer and/or Executive Chairman. Following the consummation of the Business Combination, the cash expenses associated with Mr. Metropoulos’s employment arrangements are approximately $0.3 million annually.

Non-Controlling Interest

Subsequent to the Business Combination, Hostess Brands, Inc. consolidated the financial position and results of operations of Hostess Holdings. Mr. Metropoulos and the Metropoulos Entities hold their equity investment in us primarily through Class B limited partnership units in the Company’s subsidiary, Hostess Holdings, (“Class B Units”) and an equal number of shares of the Company’s Class B common stock (“Class B Stock”). Our Class B Stock has voting, but no economic rights, while Hostess Holdings’ Class B Units have economic, but no voting rights. Each Class B Unit, together with a share of Class B Stock held by the Metropoulos Entities, is exchangeable for a share of the Company’s Class A common stock (or at the option of the Company, the cash equivalent thereof). The Company holds 100% of the general partnership interest in Hostess Holdings and a majority of the limited partnership interests, and consolidates Hostess Holdings in the Company’s consolidated financial statements. The interest of the Metropoulos Entities in Hostess Holdings’ Class B Units is reflected in our consolidated financial statements as a non-controlling interest.

For periods prior to the Business Combination, Hostess Holdings consolidated the financial position and results of operations of New Hostess Holdco, LLC. The portion of New Hostess Holdco, LLC not owned by Hostess Holdings (which constituted a profits interest plan for management) was recognized as a non-controlling interest in its consolidated financial statements.

Factors Impacting Recent Results

Long-term Debt Refinancing and Interest Rate Risk Management

On November 18, 2016, we refinanced our first and second lien term loans (the “Former First and Second Lien Term Loans”) into one new first lien term loan in the aggregate principal amount of $998.8 million and with a maturity date of August 3, 2022 (the “New First Lien Term Loan”).
To manage the risk related to our variable rate debt, on April 7, 2017, we entered into an interest rate swap contract with a counter party to make a series of payments based on a fixed interest rate of 1.78% and receive a series of payments based on the greater of LIBOR or 0.75%. Both the fixed and floating payment streams are based on a notional amount of $500 million at the inception of the contract and will be reduced by $100 million each year of the five year contract.
On May 19, 2017, the New First Lien Term Loan was amended resulting in a 0.5% decrease to the margin applied to our variable rate (the “Second Amended First Lien Term Loan”). The maturity date of August 3, 2022 remained unchanged.
Acquisition of Superior
On May 10, 2016, we acquired the stock of Superior for $51.0 million, including cash. The purchase price was subject to working capital and other purchase price adjustments as described in the stock purchase agreement. Superior is located in Southbridge, Massachusetts and manufactures eclairs, madeleines, brownies, and iced cookies. We acquired Superior to expand our market and product offerings in the “In-Store Bakery” section of retailers.

28


Seasonality
Sweet baked goods revenues tend to be moderately seasonal, with declines during the early winter period, which we believe are attributable to altered consumption patterns during the holiday season. We expect this trend to continue and continue to be applicable to our business. We strive to mitigate the seasonality by running certain targeted promotional campaigns.
































29


Unaudited Statement of Operations
Historical and Pro Forma*
 
(Successor)
 
 
 
 
Historical i (Predecessor)
 
 
 
 
Pro Forma
 
 
(In thousands, except per share data)
Three Months
Ended September 30, 2017
 
%
of Net Revenues
 
 
Three Months
Ended September 30, 2016
 
 
Pro Forma
Adjustments

Three Months
Ended September 30, 2016
 
%
of Net Revenues
Net revenue
$
192,250

 
100.0
%
 
 
$
196,197

 
 
$


$
196,197

 
100.0
 %
Cost of goods sold
113,885

 
59.2

 
 
113,618

 
 
(185
)
ii
113,433

 
57.8

Gross profit
78,365

 
40.8

 
 
82,579

 
 
185


82,764

 
42.2


 
 
 
 
 
 
 
 
 
 
 
 

Operating costs and expenses:
 
 
 
 
 
 
 
 
 
 
 
 

Advertising and marketing
8,871

 
4.6

 
 
10,381

 
 


10,381

 
5.3

Selling expense
7,606

 
4.0

 
 
8,271

 
 


8,271

 
4.2

General and administrative
14,494

 
7.5

 
 
10,784

 
 
(346
)
ii
10,438

 
5.3

Amortization of customer relationships
5,994

 
3.1

 
 
156

 
 
5,938

iii
6,094

 
3.1

Impairment of property and equipment
1,003

 
0.5

 
 

 
 



 

Business combination transaction costs

 

 
 
4,049

 
 
(4,049
)
iv

 

Related party expenses
92

 

 
 
1,058

 
 


1,058

 
0.5

Tax receivable agreement liability remeasurement
1,589

 
0.8

 
 

 
 

 

 

Recall and other costs (recoveries)

 

 
 
(3,787
)
 
 

 
(3,787
)
 
(1.9
)
Total operating costs and expenses
39,649

 
20.5

 
 
30,912

 
 
1,543

 
32,455

 
16.5

Operating income
38,716

 
20.1

 
 
51,667

 
 
(1,358
)
 
50,309

 
25.7

Other expense:
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest expense, net
9,966

 
5.2

 
 
18,004

 
 
(4,623
)
v
13,381

 
6.8

Loss on modification of debt
2,122

 
1.1

 
 

 


 



Other expense
182

 
0.1

 
 
173

 
 


173

 
0.1

Total other expense
12,270

 
6.4

 
 
18,177

 
 
(4,623
)
 
13,554

 
6.9

Income before income taxes
26,446

 
13.7

 
 
33,490

 
 
3,265

 
36,755

 
18.7

Income tax expense (benefit)
10,316

 
5.4

 
 
(23
)
 
 
10,496

vi
10,473

 
5.3

Net income
16,130

 
8.3

 
 
33,513

 
 
(7,231
)
 
26,282

 
13.4

Less: Net income attributable to the non-controlling interest
6,581

 
3.4

 
 
2,329

 
 
6,852

vii
9,181

 
4.7

Net income attributable to Class A shareholders
$
9,549

 
4.9
%
 
 
$
31,184

 
 
$
(14,083
)
 
$
17,101

 
8.7
 %
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Earnings per Class A share:
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic
$
0.10

 
 
 
 
 
 
 
 
 
$
0.18

 
 
Diluted
$
0.09

 
 
 
 
 
 
 
 
 
$
0.18

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted-average shares outstanding:
 
 
 
 
 
 
 
 
 


 
 
Basic
99,557,183

 
 
 
 
 
 
 
97,589,217

viii
97,589,217

 
 
Diluted
105,418,566

 
 
 
 
 
 
 
97,589,217

viii
97,589,217

 
 
*For convenience, we have included this supplemental pro forma information for the three months ended September 30, 2016 that gives effect to the Business Combination as if such information had been consummated on January 1, 2016.
The unaudited pro forma statements of operations for the three months ended September 30, 2016 presents our consolidated results of operations giving pro forma effect to the Business Combination as if it had occurred as of January 1, 2016. The pro forma adjustments are based on available information and upon assumptions that our management believes are reasonable in order to reflect, on a pro forma basis, the impact of these transactions on the historical financial information of our Predecessor and Successor entities, as applicable.

30


The Business Combination was accounted for using the acquisition method of accounting. The estimated fair values of the acquired assets and assumed liabilities as of the Closing Date, which are based on the consideration paid and our estimates and assumptions, are reflected herein. The total purchase price to acquire Hostess Holdings has been allocated to the assets acquired and assumed liabilities of Hostess Holdings, based upon preliminary estimated fair values at the Closing Date. We utilized third-party valuation specialists to assist our management in determining the fair values of the acquired assets and liabilities assumed.
The unaudited pro forma financial information contains a variety of adjustments, assumptions and estimates, is subject to numerous other uncertainties and the assumptions and adjustments as described in the accompanying notes hereto and should not be relied upon as being indicative of our results of operations had the Business Combination occurred on January 1, 2016. The unaudited pro forma financial information also does not project our results of operations for any future period or date. The acquisition of Superior Cake Products, Inc. (“Superior”) occurred in May 2016. The unaudited pro forma consolidated financial information for the three and nine months ended September 30, 2016 does not include the results of the Superior acquisition and its related operations prior to the acquisition. We evaluated the impact of the Superior acquisition on the Company’s financial statements and concluded that the impact was not significant and did not separately warrant the inclusion of pro forma financial results assuming the acquisition of Superior on January 1, 2016 under SEC rules and regulations or under GAAP. The pro forma adjustments give effect to the items identified in the pro forma table above in connection with the Business Combination.

i.
The amounts in these columns represent our Hostess Holdings historical results of operations for the period reflected. Certain amounts previously reported within the 2016 Hostess Holdings quarterly financial statements have been reclassified to conform with the current financial statement presentation.
ii.
Represents the adjustment to depreciation expense associated with the allocation of purchase price to property and equipment.
iii.
Represents additional amortization expense associated with the fair value recognized for customer relationships in connection with the Business Combination.
iv.
This adjustment consists primarily of legal and professional fees and other costs associated with the Business Combination.
v.
Represents the reduction in interest expense due to the repayment of Hostess Holdings debt pursuant to the terms of the Business Combination.
vi.
Represents the effective income tax rate of 28.5%, giving effect to the non-controlling interest, a partnership for income tax purposes.
vii.
Represents the elimination of historical income attributable to the non-controlling interest and attributes a portion of the pro forma income to the non-controlling interest created in the Business Combination. Income is allocated to the non-controlling interest based on its pro rata share of the total equity of Hostess Holdings.
viii.
Represents the basic and diluted weighted average number of Class A shares that would have been outstanding had the Business Combination occurred on January 1, 2016. The outstanding warrants were determined not to be dilutive.




















31


Reconciliation of Adjusted EBITDA
Adjusted EBITDA is a non-GAAP financial measure commonly used in our industry and should not be construed as an alternative to net income as an indicator of operating performance or as an alternative to cash flow provided by operating activities as a measure of liquidity (each as determined in accordance with GAAP). This measure may not be comparable to similarly titled measures reported by other companies. We have included these measures because we believe they provide management and investors with additional information to measure our performance and liquidity, estimate our value and evaluate our ability to service debt.
We define adjusted EBITDA as net income adjusted to exclude (i) interest expense, net, (ii) depreciation and amortization, (iii) income taxes and (iv) as further adjusted to eliminate the impact of certain items that we do not consider indicative of our ongoing operating performance. These further adjustments are itemized below. You are encouraged to evaluate these adjustments and the reasons we consider them appropriate for supplemental analysis. In evaluating adjusted EBITDA, you should be aware that in the future we may incur expenses that are the same as or similar to some of the adjustments set forth below. Our presentation of adjusted EBITDA should not be construed as an inference that our future results will be unaffected by unusual or non-recurring items.
Adjusted EBITDA has important limitations as an analytical tool, and you should not consider it in isolation, or as a substitute for analysis of our results as reported under GAAP. For example, adjusted EBITDA:
does not reflect our capital expenditures, future requirements for capital expenditures or contractual commitments;
does not reflect changes in, or cash requirements for, our working capital needs;
does not reflect the significant interest expenses, or the cash requirements necessary to service interest or principal payments, on our debt;
does not reflect any cash requirements for the assets being depreciated and amortized that may have to be replaced in the future; and
does not reflect payments related to income taxes, the tax receivable agreement or distributions to the non-controlling interest to reimburse its tax liability.
Our presentation of adjusted EBITDA does not exclude the normal annual cash payments associated with our employment arrangements with Mr. Metropoulos as the Chief Executive Officer and/or Executive Chairman. These payments were $0.1 million and $0.2 million for the three and nine months ended September 30, 2017, and $1.1 million and $3.4 million for the three and nine months ended September 30, 2016, respectively. Following completion of the Business Combination, these cash expenses will be approximately $0.3 million annually.















32


Reconciliation of Adjusted EBITDA
(Unaudited)

 
 
 
 
 
(In thousands)
 
Three Months
Ended September 30,
2017
 
 
Pro Forma
Three Months
Ended September 30,
2016

 

 
 
 
Net income
 
$
16,130

 
 
$
26,282

Plus non-GAAP adjustments:
 
 
 
 
 
Income tax provision
 
10,316

 
 
10,473

Interest expense, net
 
9,966

 
 
13,381

Depreciation and amortization
 
9,722

 
 
9,103

Share-based compensation
i.
3,630

 
 

Tax receivable agreement liability remeasurement
ii.
1,589

 
 

Recall and other
iii.

 
 
(3,787
)
Other expense
iv.
182

 
 
173

Loss on debt modification
v.
2,122

 
 

Impairment of property and equipment
vi.
1,003

 
 

Adjusted EBITDA
 
$
54,660

 
 
$
55,625






i.
For the three months ended September 30, 2017, the Company recognized expense related to stock compensation awarded under the Hostess Brands, Inc. 2016 Equity Incentive Plan.
ii.
For the three months ended September 30, 2017, the Company incurred a loss on the remeasurement of the tax receivable agreement due to a change in a state tax law.
iii.
For the pro forma three months ended September 30, 2016, the Company recovered costs previously incurred in the second quarter of 2016 related to the voluntary recall of product containing undeclared peanut residue attributed to one of the Company’s suppliers.
iv.
During the three months ended September 30, 2017, the Company incurred professional fees related to the registration of certain privately held securities. During the pro forma three months ended September 30, 2016, the Company incurred professional fees attributable to the pursuit of a potential acquisition that has since been abandoned, and other special projects.
v.
During the three months ended September 30, 2017, previously capitalized debt issuance costs were expensed.
vi.
During the three months ended September 30, 2017, the Company transitioned the production of one of its products to a third party and recognized an impairment loss resulting from the idling of the related production equipment.






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Net Revenue
Net revenue of $192.3 million decreased 2.0%, or $3.9 million, compared to historical and pro forma net revenue of $196.2 million for the third quarter of 2016. The third quarter 2017 growth in net revenue from current year new product initiatives of $17.0 million, particularly Chocolate Cake Twinkies®, White Fudge Ding Dongs® and Golden Cupcakes was offset primarily by a decrease in net revenue from 2016 product innovations of $14.0 million, the impact of a co-manufacturer's production challenges of approximately $3.2 million and a decrease of revenue from discontinued items of $2.2 million. Net revenue for the quarter was also impacted by point of sale and shipment disruptions from hurricanes Harvey and Irma.
Cost of Goods Sold and Gross Profit
Cost of goods sold for the three months ended September 30, 2017 of $113.9 million represents an increase of $0.3 million or 0.2% from the historical costs of goods sold of $113.6 million for the three months ended September 30, 2016 and an increase of $0.5 million or 0.4% from the pro forma costs of goods sold of $113.4 million for the three months ended September 30, 2016. The increase in the three months ended September 30, 2017 from both historical and pro forma three months ended September 30, 2016 is primarily attributed to additional cost of transportation due to the tightening of shipping capacity and an increase in the percentage of orders on a refrigerated class of transportation.
Gross profit was $78.4 million for the three months ended September 30, 2017, a decrease of $4.2 million, or 5.1%, compared to historical gross profit of $82.6 million for the three months ended September 30, 2016 and a decrease of $4.4 million, or 5.3% compared to pro forma gross profit of $82.8 million for the three months ended September 30, 2016. The decrease in the three months ended September 30, 2017 from both historical and pro forma three months ended September 30, 2016 was primarily attributed to the tightening of shipping capacity and an increase in the percentage of orders on a refrigerated class of transportation, which caused a 120 basis point increase in the cost of transportation as a percentage of revenue. In addition, there was a shift in product mix due to growth in multi-pack and club-pack sales.
Gross margin was 40.8% for the three months ended September 30, 2017, compared to historical gross margin of 42.1% for the three months ended September 30, 2016 and pro forma gross margin of 42.2% for the three months ended September 30, 2016. The decrease in margin for the three months ended September 30, 2017 from both historical and pro forma gross margin for the three months ended September 30, 2016 is primarily due to additional transportation costs and a shift in product mix.
Gross profit for the Sweet Baked Goods segment for the three months ended September 30, 2017 was $73.0 million, or 42.0% of net revenue, compared to gross profit of