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 quarterly period ended March 31, 2008

or

¨ 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: 0-27378

NUCO 2 INC.
(Exact name of registrant as specified in its charter)

Florida
65-0180800
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)

2800 SE Market Place, Stuart, FL
 34997
(Address of principal executive offices)
(Zip Code)

(772) 221-1754
(Registrant’s telephone number, including area code)
 
N/A
(Former name, former address and former fiscal year, if changed since last report)

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 ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):
 
Large accelerated filer ¨
Accelerated filer x
   
Non-accelerated filer ¨ (Do not check if a smaller reporting company)
Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes ¨      No x
 
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:
 
Class
Outstanding at March 31, 2008
Common Stock, $.001 par value   
 
14,813,032 shares
 


 
NUCO 2 INC .

I nd ex

 
     
 
     
 
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P AR T I.
FINANCIAL INFORMATION

I TEM 1.
FINANCIAL STATEMENTS
NUCO 2 INC.
BAL ANCE SHEETS
(In thousands, except share amounts)
ASSETS
   
March 31, 2008
   
June 30, 2007
 
   
(UNAUDITED)
       
Current assets:
           
Cash and cash equivalents
  $ 332     $ 343  
Trade accounts receivable; net of allowance for doubtful
               
   accounts of $626 and $1,004, respectively
    8,863       11,823  
Inventories
    312       297  
Prepaid insurance expense and deposits
    3,743       3,121  
Prepaid expenses and other current assets
    6,416       1,412  
Deferred tax assets – current portion
    6,725       8,264  
Total current assets
    26,391       25,260  
                 
Property and equipment, net
    121,782       122,364  
                 
Goodwill, net
    25,909       25,909  
Deferred financing costs, net
    187       254  
Customer lists, net
    5,590       6,761  
Non-competition agreements, net
    185       512  
Deferred lease acquisition costs, net
    6,065       5,744  
Deferred tax assets, net
    482       3,813  
Other
    234       221  
      38,652       43,214  
Total assets
  $ 186,825     $ 190,838  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
 
Current liabilities:
               
Accounts payable
  $ 8,193     $ 6,061  
Accrued expenses
    2,685       2,043  
Accrued insurance
    1,725       1,054  
Accrued interest
    280       121  
Accrued payroll
    2,836       2,357  
Other current liabilities
    631       314  
Total current liabilities
    16,350       11,950  
                 
Long-term debt
    25,350       34,750  
Customer deposits
    4,333       4,246  
Total liabilities
    46,033       50,946  
                 
Commitments and contingencies
               
Shareholders' equity:
               
Common stock; par value $.001 per share; 30,000,000 shares authorized;
               
   issued 16,008,636 shares at March 31, 2008
               
   and 15,921,066 shares at June 30, 2007
    16       16  
Additional paid-in capital
    178,910       174,831  
Less treasury stock at cost; 1,195,604 shares at March 31, 2008
               
   and 921,409 shares at June 30, 2007
    (30,018 )     (22,937 )
Accumulated deficit
    (5,139 )     (12,126 )
Accumulated other comprehensive income (loss)
    (2,977 )     108  
Total shareholders’ equity
    140,792       139,892  
Total liabilities and shareholders’ equity
  $ 186,825     $ 190,838  
 
See accompanying notes to financial statements.
 
 
3
 
NUCO 2 INC.
STA TE MENTS OF INCOME
(In thousands, except per share amounts)
(UNAUDITED)

   
Three Months Ended March 31,
 
   
2008
   
2007
 
Revenues:
           
Product sales
  $ 22,401     $ 20,995  
Equipment rentals
    11,974       10,919  
                 
Total revenues
    34,375       31,914  
                 
Costs and expenses:
               
Cost of products sold, excluding depreciation and amortization
    15,101       13,728  
Cost of equipment rentals, excluding depreciation
               
   and amortization
    2,447       1,999  
Selling, general and administrative expenses
    7,108       7,952  
Depreciation and amortization
    5,077       5,158  
Loss on asset disposal
    676       522  
      30,409       29,359  
                 
Operating income
    3,966       2,555  
Interest expense
    410       509  
                 
Income before provision for income taxes
    3,556       2,046  
Provision for income taxes
    1,615       935  
                 
Net income
  $ 1,941     $ 1,111  
                 
Weighted average outstanding shares of common stock:
               
Basic
    14,797       15,680  
Diluted
    15,191       15,896  
                 
Net income per basic share
  $ 0.13     $ 0.07  
Net income per diluted share
  $ 0.13     $ 0.07  
                 
 
 
See accompanying notes to financial statements.
 
 

NUCO 2 INC.
ST ATE MENTS OF INCOME
(In thousands, except per share amounts)
(UNAUDITED)

   
Nine Months Ended March 31,
 
   
2008
   
2007
 
Revenues:
           
Product sales
  $ 68,249     $ 63,865  
Equipment rentals
    35,144       32,366  
                 
Total revenues
    103,393       96,231  
                 
Costs and expenses:
               
Cost of products sold, excluding depreciation and amortization
    44,392       41,648  
Cost of equipment rentals, excluding depreciation
               
   and amortization
    7,032       4,603  
Selling, general and administrative expenses
    20,427       22,343  
Depreciation and amortization
    15,124       14,900  
Loss on asset disposal
    2,416       1,506  
      89,391       85,000  
                 
Operating income
    14,002       11,231  
Interest expense
    1,502       1,635  
                 
Income before provision for income taxes
    12,500       9,596  
Provision for income taxes
    5,513       4,584  
                 
Net income
  $ 6,987     $ 5,012  
                 
Weighted average outstanding shares of common stock:
               
Basic
    14,803       15,711  
Diluted
    15,182       15,979  
                 
Net income per basic share
  $ 0.47     $ 0.32  
Net income per diluted share
  $ 0.46     $ 0.31  
 

See accompanying notes to financial statements.
 
 

NUCO 2 INC.
STAT EME NT OF SHAREHOLDERS’ EQUITY
(In thousands, except share amounts)
(UNAUDITED)

   
Common Stock
    Additional Paid-In Capital    
Treasury Stock
 
   
Shares
   
Amount
       
Shares
   
Amount
 
                                         
Balance, June 30, 2007
    15,921,066     $ 16     $ 174,831       921,409     $ (22,937 )
Comprehensive income:
                                       
  Net income
    -       -       -       -       -  
  Other comprehensive income (loss):
                                       
    Change in fair value of hedging instruments
    -       -       -       -       -  
Total comprehensive income
                                       
Share-based compensation
    -       -       2,511       -       -  
Excess tax benefits from share-based arrangements
    -       -       170       -       -  
Issuance of 87,570 shares of common stock -
                                       
exercise of options
    87,570       -       1,398       -       -  
Purchase of treasury stock
    -       -       -       274,195       (7,081 )
Balance, March 31, 2008
    16,008,636     $ 16     $ 178,910       1,195,604     $ (30,018 )
 

See accompanying notes to financial statements.
 
 

NUCO 2 INC.
STATEMENT OF SHAREHOLDERS’ EQUITY
(In thousands, except share amounts)
(UNAUDITED)
 
   
Accumulated Deficit
   
Accumulated Other Comprehensive Income (Loss)
   
Total Shareholders' Equity
 
                         
Balance, June 30, 2007
  $ (12,126 )   $ 108     $ 139,892  
Comprehensive income:
                       
  Net income
    6,987       -       6,987  
  Other comprehensive income (loss):
                       
Change in fair value of hedging instruments
    -       (3,085 )     (3,085 )
Total comprehensive income
                    3,902  
Share-based compensation
    -       -       2,511  
Excess tax benefits from share-based arrangements
    -       -       170  
Issuance of 87,570 shares of common stock - exercise of options
    -       -       1,398  
Purchase of treasury stock
    -       -       (7,081 )
Balance, March 31, 2008
  $ (5,139 )   $ (2,977 )   $ 140,792  
 
 
See accompanying notes to financial statements.
 
 


NUCO 2 INC.
STATEM ENTS OF CASH FLOWS
(In thousands)
(UNAUDITED)

   
Nine Months Ended March 31,
 
   
2008
   
2007
 
             
Cash flows from operating activities:
           
Net income
  $ 6,987     $ 5,012  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization of property and equipment
    12,680       12,380  
Bad debt expense
    806       1,990  
Amortization of other assets
    2,444       2,520  
Loss on asset disposal
    2,416       1,506  
Change in net deferred tax asset
    5,039       4,156  
Share-based compensation
    2,511       3,245  
Excess tax benefits from share-based arrangements
    (170 )     (1,370 )
Changes in operating assets and liabilities:
               
Decrease (increase) in:
               
Trade accounts receivable
    2,154       (1,036 )
Inventories
    (15 )     (3 )
Prepaid insurance expense and deposits
    (622 )     1,712  
Prepaid expenses and other current assets
    (391 )     62  
Increase (decrease) in:
               
Accounts payable
    2,132       (2,794 )
Accrued expenses
    705       339  
Accrued insurance
    671       (2,488 )
Accrued payroll
    479       1,762  
Accrued interest
    158       9  
Other current liabilities
    318       39  
Customer deposits
    86       407  
                 
Net cash provided by operating activities
    38,388       27,448  
                 
Cash flows from investing activities:
               
Proceeds on sale of assets
    38       -  
Purchase of property and equipment
    (13,951 )     (17,582 )
Increase in deferred lease acquisition costs
    (1,865 )     (1,722 )
Increase in other assets
    (11 )     (21 )
                 
Net cash used in investing activities
  $ (15,789 )   $ (19,325 )
 
 
See accompanying notes to financial statements.
 
 


NUCO 2 INC.
STATEMENTS OF CASH FLOWS
(In thousands)
(UNAUDITED)


(Continued)

   
Nine Months Ended March 31,
 
   
2008
   
2007
 
Cash flows from financing activities:
           
Capitalized debt issuance costs
  $ (2,796 )   $ -  
Treasury Shares repurchased
    (7,081 )     (12,514 )
Purchase of swaption
    (4,900 )     -  
Exercise of options and warrants
    1,398       2,070  
Excess tax benefits from share-based payment arrangements
    170       1,370  
Repayment of long-term debt
    (18,201 )     (9,400 )
Proceeds from issuance of long-term debt
    8,800       10,250  
                 
Net cash used in financing activities
  $ (22,610 )   $ (8,224 )
                 
Decrease in cash and cash equivalents
    (11 )     (101 )
Cash and cash equivalents, beginning of period
    343       341  
                 
Cash and cash equivalents, end of period
  $ 332     $ 240  
                 
                 
                 
                 
Supplemental Cash Flow information:
               
Cash paid during the period for:
               
                 
Interest
  $ 1,551     $ 1,626  
Income taxes
  $ 258     $ 269  


See accompanying notes to financial statements.
 
During the nine months ended March 31, 2007, a certain officer exercised
stock options in a non-cash transaction.  The officer surrendered 6,800 shares of
previously acquired common stock in exchange for 25,366 newly issued shares. The
company recorded $171, the market value of the surrendered shares, as treasury stock.
 
 
9
 
NUCO 2 INC.

NOTES TO FI NANCIAL STATEMENTS
(UNAUDITED )

NOTE 1 – BASIS OF PRESENTATION

The accompanying unaudited financial statements have been prepared in accordance with the instructions to Form 10-Q used for quarterly reports under Section 13 or 15(d) of the Securities Exchange Act of 1934, and therefore, do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with generally accepted accounting principles.

The financial information included in this report has been prepared in conformity with the accounting principles, and methods of applying those accounting principles, reflected in the audited financial statements for the fiscal year ended June 30, 2007 of NuCO 2 Inc. (the “Company”) included in Form 10-K (“Form 10-K”), filed with the Securities and Exchange Commission (“SEC”).

All adjustments (consisting of normal recurring adjustments) necessary for a fair statement of the results for the interim periods presented have been recorded.  This quarterly report on Form 10-Q should be read in conjunction with the Company's audited financial statements for the fiscal year ended June 30, 2007.  The results of operations for the periods presented are not necessarily indicative of the results to be expected for the full fiscal year.  The Company anticipates that reported revenue will fluctuate on a quarterly basis due to seasonal variations.  Based on historical data and expected trends, the Company anticipates that demand for the delivery of CO 2 will be highest in the first fiscal quarter and lowest in the third fiscal quarter.

Certain prior period amounts have been reclassified to conform with the current year presentation.

NOTE 2 – RECENT ACCOUNTING PRONOUNCEMENTS

In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 141R, “ Business Combinations ” (“SFAS No. 141R”). SFAS No. 141R will require, among other things, the expensing of direct transaction costs, including deal costs and restructuring costs as incurred, acquired in process research and development assets to be capitalized, certain contingent assets and liabilities to be recognized at fair value and earn-out arrangements, including contingent consideration, may be required to be measured at fair value until settled, with changes in fair value recognized each period into earnings.   SFAS No. 141R will become effective for the Company on a prospective basis for transactions occurring in fiscal 2010 and early adoption is not permitted.  SFAS No. 141R may have a material impact on the Company’s financial position, results of operations and cash flows if it enters into a material business combination after the standard’s effective date.

In December 2007, the FASB issued SFAS No. 160, “ Noncontrolling Interests in Consolidated Financial Statements ” (“SFAS No. 160”).  SFAS No. 160 will change the accounting for and reporting of minority interests. Under the new standard, minority interests, will be referred to as noncontrolling interests and will be reported as equity in the parent company’s consolidated financial statements. Transactions between the parent company and the noncontrolling interests will be treated as transactions between shareholders provided that the transactions do not create a change in control. Gains and losses will be recognized in earnings for transactions between the parent company and the noncontrolling interests, unless control is achieved or lost.  SFAS No. 160 requires retrospective adoption of the presentation and disclosure requirements for existing minority interests. All other requirements of SFAS No. 160 shall be applied prospectively. SFAS No. 160 is effective for the Company beginning in the first quarter of fiscal year 2010 and earlier adoption is not permitted.  SFAS No. 160 may have a material impact on the Company’s financial position, results of operations and cash flows if it enters into material transactions or acquires a noncontrolling interest after the standard’s effective date.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115” (“SFAS No. 159”), which provides companies with an option to report selected financial assets and liabilities at their fair values. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 is expected to expand the use of fair value measurement, which is consistent with the FASB’s long-term measurement objectives for accounting for financial instruments. SFAS No. 159 will become effective for the Company on July 1, 2008.  The Company is currently evaluating the impact, if any, that the adoption of  SFAS No. 159 will have on its financial condition, results of operations or cash flows.
 
 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”), which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating what impact, if any, the adoption of SFAS No. 157 will have on its financial condition, results of operations or cash flows.

Please see the Company's Form 10-K for a discussion of other significant accounting policies.

NOTE 3 – AGREEMENT AND PLAN OF MERGER

On January 29, 2008, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with NuCO2 Acquisition Corp., a Delaware corporation (“Parent”), and NuCO2 Merger Co., a Florida corporation and a wholly owned subsidiary of Parent (“Merger Sub”).  Subject to the terms and conditions of the Merger Agreement, Merger Sub will merge with and into the Company (the “Merger”) with the Company being the surviving corporation in the Merger and, at the effective time of the Merger, each issued and outstanding share of common stock, par value $0.001 per share (the “Common Stock”), of the Company (other than treasury shares, shares owned by Parent, Merger Sub or any direct or indirect wholly owned subsidiary of Parent and shares owned by stockholders who perfect their appraisal rights under Florida law) will be converted automatically into the right to receive $30.00 in cash, without interest.  Merger Sub and Parent are affiliates of Aurora Capital Group, a Los Angeles-based private equity firm (“Aurora”).  
 
In order to reduce the Company’s exposure to increases in interest rates in connection with the debt financing for the Merger (the “Merger Financing”), on January 30, 2008, the Company purchased an option, for a premium of $4.9 million, to enter into a pay fixed rate swap (“Swaption I”) that grants the Company the right (but not the obligation) to enter into a pay fixed swap at the effective time of the Merger with respect to amounts to be borrowed under the Merger Financing.  The underlying swap is in the notional amount of $335.0 million, and the option expires on June 30, 2008. Under the Merger Agreement, Parent will reimburse the Company for its unrecouped costs associated with Swaption I in the event that the Merger Agreement is terminated and, upon such reimbursement, the Company will assign Swaption I to Parent.  Swaption I meets the requirements to be designated as a cash flow hedge and is deemed a highly effective transaction.  Accordingly, changes in the fair value of Swaption I are recorded as other comprehensive income (loss).  At March 31, 2008, the Company recorded a loss of $2.8 million, representing the change in fair value of Swaption I from January 30, 2008 through March 31, 2008, as other comprehensive loss.
 
The Company has incurred approximately $2.8 million in capitalized debt issuance costs associated with the Merger Financing, which are included in prepaid expenses and other current assets at March 31, 2008.
 
NOTE 4 - EARNINGS PER SHARE AND OTHER COMPREHENSIVE INCOME (LOSS)

(a) Earnings per Share

The Company calculates earnings per share in accordance with the requirements of SFAS No. 128, "Earnings Per Share." The weighted average shares outstanding used to calculate basic and diluted earnings per share were calculated as follows (in thousands):
 
   
Three Months Ended March 31,
   
Nine Months Ended March 31,
 
   
2008
   
2007
   
2008
   
2007
 
                         
Weighted average shares outstanding - basic
    14,797       15,680       14,803       15,711  
                                 
                                 
                                 
Outstanding options and warrants to purchase  shares of common stock - remaining shares after  assuming repurchase with proceeds  from exercise
    394       216       379       268  
                                 
Weighted average shares outstanding - diluted
    15,191       15,896       15,182       15,979  
 
11
 
(b) Other Comprehensive Income (Loss)

Comprehensive income (loss) is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from non-owner sources, and is comprised of net income and “other comprehensive income (loss).” The components of other comprehensive income (loss) are as follows for the periods presented (in thousands):

   
Three Months Ended March 31,
   
Nine Months Ended March 31,
 
   
2008
   
2007
   
2008
   
2007
 
Net income
  $ 1,941     $ 1,111     $ 6,987     $ 5,012  
Interest rate swap transaction (Note 4)
    (2,909 )     (48 )     (3,085 )     (225 )
                                 
Comprehensive income (loss)
  $ (968 )   $ 1,063     $ 3,902     $ 4,787  
 
NOTE 5 – LONG TERM DEBT

(a) Revolving Credit Facility

On May 27, 2005, the Company terminated its previous credit facility and entered into a $60.0 million revolving credit facility with Bank of America, N.A. (the “2005 Credit Facility”), maturing on May 27, 2010. The Company is entitled to select either Base Rate Loans (as defined) or Eurodollar Rate Loans (as defined), plus applicable margin, for principal borrowings under the 2005 Credit Facility. Applicable margin is determined by a pricing grid, as amended in March 2006, based on the Company’s Consolidated Leverage Ratio (as defined) as follows:
 
Pricing
Level
 
 
Consolidated Leverage Ratio
Eurodollar Rate
Loans
Base Rate
Loans
I
 
Greater than or equal to 2.50x
2.000%
0.500%
II
 
Less than 2.50x but greater than or equal to 2.00x
1.750%
0.250%
III
 
Less than 2.00x but greater than or equal to 1.50x
1.500%
0.000%
IV
 
Less than 1.50x but greater than or equal to 0.50x
1.250%
0.000%
V
 
Less than 0.50x
1.000%
0.000%

Interest is payable periodically on borrowings under the 2005 Credit Facility. The 2005 Credit Facility is uncollateralized. The Company is required, on a quarterly basis, to assess and meet certain affirmative and negative covenants, including financial covenants. These financial covenants are based on a measure that is not consistent with accounting principles generally accepted in the United States of America. Such measure is EBITDA (as defined), which represents earnings before interest, taxes, depreciation and amortization, as further modified by certain defined adjustments. The failure to meet these covenants, absent a waiver or amendment, would place the Company in default and cause the debt outstanding under the 2005 Credit Facility to immediately become due and payable. In connection with the Company’s share repurchase program announced during the quarter ended March 31, 2007, the 2005 Credit Facility was amended to modify certain covenants.  The Company was in compliance with all covenants under the 2005 Credit Facility as of the first assessment date on June 30, 2005 and through March 31, 2008.

As of March 31, 2008, a total of $25.4 million was outstanding under the 2005 Credit Facility, primarily consisting of Libor (Eurodollar Rate) loans, with a weighted average interest rate of 4.33% per annum.
 
 

(b)  
Hedging Activities

Effective July 1, 2000, the Company adopted SFAS No. 133, “ Accounting for Derivative Instruments and Hedging Activities,” as amended, which, among other things, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities.  All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value.  For a derivative designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded as other comprehensive income and are recognized in the statement of operations when the hedged item affects earnings.  Ineffective portions of changes in the fair value of cash flow hedges (if any) are recognized in earnings.

The Company uses derivative instruments to manage exposure to interest rate risks.  The Company’s objectives for holding derivatives are to minimize the risks using the most effective methods to eliminate or reduce the impact of this exposure.

In order to reduce the Company’s exposure to increases in Eurodollar rates, and consequently to increases in interest payments, the Company entered into an interest rate swap transaction (the “2005 Swap”), comprised of two instruments (“Swap A” and “Swap B”), on September 28, 2005, with an effective date of October 3, 2005.  Swap A, in the amount of $15.0 million (the “A Notional Amount”), matures on October 3, 2008 and Swap B, in the amount of $5.0 million (the “B Notional Amount”), matured on April 3, 2007.  Pursuant to Swap A, the Company currently pays a fixed interest rate of 4.69% per annum and receives a Eurodollar-based floating rate.  The effect of Swap A is to neutralize any changes in Eurodollar rates on the A Notional Amount.  The 2005 Swap meets the requirements to be designated as a cash flow hedge and is deemed a highly effective transaction.  Accordingly, changes in the fair value of Swap A are recorded as other comprehensive income (loss).  During the nine months ended March 31, 2008, the Company recorded a loss of $0.3 million, representing the change in fair value of Swap A from June 30, 2007 through March 31, 2008, as other comprehensive loss (see Note 4(b)).
 
NOTE 6 – SHAREHOLDERS’ EQUITY

(a)  Stock Option Plans

The Company recognized $0.9 million and $2.5 million ($0.6 million and $1.8 million, net of income taxes) in stock option compensation during the three and nine months ended March 31, 2008 as compared to $1.3 million and $3.2 million ($0.9 million and $2.3 million, net of income taxes) during the three and nine months ended March 31, 2007.

NOTE 7 – INCOME TAXES

The Company accounts for income taxes under SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”).  Deferred income taxes reflect the net tax effects of net operating loss carryforwards and temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.

As of June 30, 2007, the Company had net operating loss carryforwards for federal income tax purposes of approximately $91 million and for state purposes in varying amounts, expiring through June 2025.  The Company’s effective rate, exclusive of the impact of the net operating loss carryforwards for the three and nine months ended March 31, 2008, was approximately 45.4% and 44.1%, respectively.  If an “ownership change” for federal income tax purposes were to occur in the future, the Company’s ability to use its pre-ownership change federal and state net operating loss carryforwards (and certain built-in losses, if any) would be subject to an annual usage limitation, which under certain circumstances may prevent the Company from being able to utilize a portion of such loss carryforwards in future tax periods and may reduce its after-tax cash flow.

In July 2006, the FASB issued Interpretation 48 (“FIN No. 48”), “ Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109 .” FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS 109. FIN No. 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  FIN No. 48 also provides guidance on derecognition, classification, interest and penalties.

Effective July 1, 2007, the Company adopted the provisions of FIN No. 48. The implementation of FIN No. 48 did not have a material impact on the Company, as it had no uncertain tax positions recorded at June 30, 2007 or December 31, 2007.  The Company recognizes interest accrued related to unrecognized tax benefits in interest expense and penalties in operating expense. The Company does not currently anticipate that the total amount of unrecognized tax benefits will significantly increase or decrease by the end of Fiscal 2008. The Company is no longer subject to tax examinations by tax authorities for fiscal years ended on or prior to June 30, 2004.
 
 

NOTE 8 – COMMITMENTS AND CONTINGENCIES

The Company is a defendant in legal actions which arise in the normal course of business.  In the opinion of management, the outcome of these matters will not have a material effect on the Company’s financial position or results of operations.

NOTE 9 – SUBSEQUENT EVENTS

On April 10, 2008, the Company sold Swaption I (refer to Note 3) and purchased a new option to enter into a pay fixed rate swap (“Swaption II”) that grants the Company the right (but not the obligation) to enter into a pay fixed swap at the effective time of the Merger with respect to amounts to be borrowed under the Merger Financing, for a net cost of $3.64 million.  The underlying swap is in the notional amount of $355.0 million, due to an anticipated increase in the principal amount of the Merger Financing, and the option expires on June 30, 2008. Parent will reimburse the Company for its unrecouped costs associated with Swaptions I and II in the event that the Merger Agreement is terminated and, upon such reimbursement, the Company will assign Swaption II to Parent. Swaption II meets the requirements to be designated as a cash flow hedge and is deemed a highly effective transaction.  Accordingly, changes in the fair value of Swaption II are recorded as other comprehensive income (loss).  The Company will evaluate the fair value of Swaption II in accordance with SFAS No. 133, “ Accounting for Derivative Instruments and Hedging Activities,” on a quarterly basis.

On May 8, 2008, the Company’s shareholders approved the Merger Agreement with affiliates of Aurora Capital Group. The transaction is expected to close by the end of May 2008.
 
 

ITE M 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

THIS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTAINS FORWARD-LOOKING STATEMENTS REGARDING FUTURE EVENTS AND OUR FUTURE RESULTS THAT ARE BASED ON CURRENT EXPECTATIONS, ESTIMATES, FORECASTS, AND PROJECTIONS ABOUT THE INDUSTRY IN WHICH WE OPERATE AND THE BELIEFS AND ASSUMPTIONS OF OUR MANAGEMENT.  WORDS SUCH AS “EXPECTS,” “ANTICIPATES,” “TARGETS,” “GOALS,” “PROJECTS,” “INTENDS,” “PLANS,” “BELIEVES,” “SEEKS,” “ESTIMATES,” VARIATIONS OF SUCH WORDS AND SIMILAR EXPRESSIONS ARE INTENDED TO IDENTIFY SUCH FORWARD-LOOKING STATEMENTS.  IN ADDITION, ANY STATEMENTS THAT REFER TO PROJECTIONS OF OUR FUTURE FINANCIAL PERFORMANCE, OUR ANTICIPATED GROWTH AND TRENDS IN OUR BUSINESS, AND OTHER CHARACTERIZATIONS OF FUTURE EVENTS OR CIRCUMSTANCES, ARE FORWARD-LOOKING STATEMENTS.  READERS ARE CAUTIONED THAT THESE FORWARD-LOOKING STATEMENTS ARE ONLY PREDICTIONS AND ARE SUBJECT TO RISKS, UNCERTAINTIES, AND ASSUMPTIONS THAT ARE DIFFICULT TO PREDICT.  THEREFORE, ACTUAL RESULTS MAY DIFFER MATERIALLY AND ADVERSELY FROM THOSE EXPRESSED IN ANY FORWARD-LOOKING STATEMENTS.

Overview

We believe we are the leading supplier of bulk CO 2 systems and bulk CO 2 for carbonating fountain beverages in the United States based on the number of bulk CO 2 systems leased to customers and the only company in our industry to operate a national network of bulk CO 2 service locations. As of March 31, 2008, we operated a national network of 129 service locations (117 stationary and 12 mobile) servicing approximately 116,400 customer locations in 43 states.  Currently, virtually all fountain beverage users in the continental United States are within our present service area.

We market our bulk CO 2 products and services to large customers such as restaurant and convenience store chains, movie theater operators, theme parks, resorts and sports venues. Our customers include many of the major national and regional chains throughout the United States.  Our success in reaching multi-unit placement agreements is due in part to our national delivery system.  We typically approach large chains on a corporate or regional level for approval to become the exclusive supplier of bulk CO 2 products and services on a national basis or within a designated territory. We then direct our sales efforts to the managers or owners of the individual or franchised operating units. Our relationships with chain customers in one geographic market frequently help us to establish service with these same chains when we expand into new markets. After accessing the chain accounts in a new market, we attempt to rapidly build route density by leasing bulk CO 2 systems to independent restaurants, convenience stores and theaters.

We have entered into master service agreements which include 102 restaurant and convenience store concepts that provide fountain beverages. These master service agreements generally provide for a commitment on the part of the operator for all of its currently owned locations and may also include future locations. We currently service approximately 59,300 chain and franchisee locations with chains that have signed master service agreements.  We are actively working on expanding the number of master service agreements with numerous restaurant chains.

We believe that our future revenue growth, gains in gross margin and profitability will be dependent upon (1) increases in route density in our existing markets and the expansion and penetration of bulk CO 2 system installations in new market regions, both resulting from successful ongoing marketing, (2) improved operating efficiencies and (3) price increases.  New multi-unit placement agreements combined with single-unit placements will drive improvements in achieving route density.  We maintain a highly efficient route structure and establish additional service locations as service areas expand through geographic growth. Our entry into many states was accomplished largely through the acquisition of businesses having thinly developed route networks.  We expect to benefit from route efficiencies and other economies of scale as we build our customer base in these states through intensive regional and local marketing initiatives. Greater density should also lead to enhanced utilization of vehicles and other fixed assets and the ability to spread fixed marketing and administrative costs over a broader revenue base.
 
 

Generally, our experience has been that as our service locations mature their gross profit margins improve as a result of business volume growth while fixed costs remain essentially unchanged.  New service locations typically operate at low or negative gross margins in the early stages and detract from our highly profitable service locations in more mature markets.  Accordingly, we believe that we are in position to build our customer base while maintaining and improving upon our superior levels of customer service, with minimal changes required to support our infrastructure.  However, while the past several years have been years of strong growth, for the foreseeable future, we plan to increase our focus on improving operating effectiveness, pricing for our services and strengthening our workforce.

General

Substantially all of our revenues have been derived from the rental of bulk CO 2 systems installed at customers’ sites, the sale of bulk CO 2 and high pressure cylinder revenues.  Revenues have grown from $72.3 million in fiscal 2002 to $130.1 million in fiscal 2007.  We believe that our revenue base is stable due to the existence of long-term contracts with our customers, which generally rollover with a limited number expiring without renewal in any one year.  Revenue growth is largely dependent on (1) the rate of new bulk CO 2 system installations, (2) the growth in bulk CO 2 sales and (3) price increases.

Cost of products sold is comprised of purchased CO 2 and vehicle and service location costs associated with the storage and delivery of CO 2 .  As of March 31, 2008, we operated a total of 359 specialized bulk CO 2 delivery vehicles and technical service vehicles that logged approximately 14.6 million miles over the last twelve months.  While significant fluctuations in fuel prices impact our operating costs, such impact is largely offset by fuel surcharges billed to the majority of our customers.  Consequently, while the impact on our gross profit and operating income is substantially mitigated, rising fuel prices do result in lower gross profit margins.  Cost of equipment rentals is comprised of costs associated with customer equipment leases, including the repair and refurbishment of leased assets.  Selling, general and administrative expenses consist of wages and benefits, dispatch and communications costs, as well as expenses associated with marketing, administration, accounting and employee training.  Consistent with the capital intensive nature of our business, we incur significant depreciation and amortization expenses.  These stem from the depreciation of our bulk CO 2 systems and related installation costs, amortization of deferred lease acquisition costs, and amortization of deferred financing costs and other intangible assets.  With respect to company-owned bulk CO 2 systems, we capitalize direct installation costs associated with installation of such systems with customers under non-cancelable contracts and which would not be incurred but for a successful placement.  All other service, marketing and administrative costs are expensed as incurred.

Since 1990, we have devoted significant resources to building a sales and marketing organization, adding administrative personnel and developing a national infrastructure to support the rapid growth in the number of our installed base of bulk CO 2 systems.  The costs of  this  expansion  and the significant  depreciation  expense  recognized  on our  installed  network  have resulted in an accumulated deficit of $5.1 million at March 31, 2008.

Results of Operations

The following table sets forth, for the periods indicated, the percentage relationship which the various items bear to total revenues:
 
 

 
Three Months Ended March 31,
   
Nine Months Ended March 31,
Income Statement Data:
2008
   
2007
   
2008
     
2007
 
                         
Product sales
      65.2
%
 
      65.8
%
 
    66.0
%
   
      66.4
%
Equipment rentals
      34.8
   
      34.2
   
      34.0
     
      33.6
 
Total revenues
    100.0
   
    100.0
   
    100.0
     
    100.0
 
Cost of products sold, excluding
                       
    Depreciation and amortization
      43.9
   
      43.0
   
      42.9
     
      43.3
 
Cost of equipment rentals, excluding
                       
    Depreciation and amortization
        7.1
   
        6.3
   
        6.8
     
        4.8
 
Selling, general and administrative expenses
20.7
   
      24.9
   
      19.8
     
      23.2
 
Depreciation and amortization
      14.8
   
      16.2
   
      14.6
     
      15.5
 
Loss on asset disposal
        2.0
   
        1.6
   
        2.3
     
        1.5
 
Operating income
        11.5
   
        8.0
   
        13.6
     
      11.7
 
Interest expense
        1.2
   
        1.6
   
        1.5
     
        1.7
 
Income before income taxes
        10.3
   
        6.4
   
        12.1
     
      10.0
 
Provision for income taxes
        4.7
   
        2.9
   
        5.3
     
        4.8
 
Net income
        5.6
%
 
        3.5
%
 
        6.8
%
   
        5.2
%

Three Months Ended March 31, 2008 Compared to the Three Months Ended March 31, 2007

Total Revenues

Total revenues increased by $2.5 million, or 7.7%, from $31.9 million in 2007 to $34.4 million in 2008.  Revenues derived from our bulk CO 2 service plans increased by $1.6 million, primarily due to pricing initiatives and an increase in the number of customer locations serviced.  Revenues derived from the sale of high pressure cylinder products, fuel surcharges, and equipment sales increased by $0.9 million.  The number of customer locations utilizing our products and services increased from approximately 116,000 at March 31, 2007 to approximately 116,400 at March 31, 2008, due primarily to organic growth.

The following table sets forth, for the periods indicated, the percentage of total revenues by service plan:

     
Three Months Ended March 31,
 
Service Plan
 
2008
   
2007
 
 
Bulk budget plan 1
    47.9 %     51.0 %
 
Equipment lease/product purchase plan 2
    20.7       18.1  
 
Product purchase plan 3
    10.7       10.5  
 
High pressure cylinder 4
    5.3       5.7  
 
Other revenues 5
    15.4       14.7  
        100.0 %     100.0 %
                   
 
 
1 Combined fee for bulk CO 2 tank and bulk CO 2.
         
 
2 Fee for bulk CO 2 tank and, separately, bulk CO 2 usage.
         
 
3 Bulk CO 2 only.
         
 
4 High pressure CO 2 cylinders and non-CO 2 gases.
         
 
5 Surcharges and other charges.
         
 
Product Sales - Revenues derived from the product sales portion of our service plans increased by $1.4 million, or 6.7%, from $21.0 million in 2007 to $22.4 million in 2008.  The increase in revenues is primarily due to a slight increase in the average number of customer locations serviced, a 1.6% increase in product usage, and pricing initiatives.  In addition, sales of products and services other than bulk CO 2 increased by $0.7 million due in large part to an increase in revenues derived from cylinder products, fuel surcharges, equipment sales, and other revenues.
 
 

Equipment Rentals - Revenues derived from the lease portion of our service plans increased by $1.1 million, or 9.7%, from $10.9 million in 2007 to $12.0 million in 2008, primarily due to a 0.7% increase in the average number of customer locations leasing equipment from us, including the impact of price increases to a significant number of our customers consistent with the Consumer Price Index, partially offset by incentive pricing provided to multiple national restaurant organizations utilizing our equipment under the bulk budget plan and equipment lease/product purchase plans pursuant to master service agreements.  The number of customer locations renting equipment from us increased slightly from 96,000 at March 31, 2007 to 97,000 at March 31, 2008.

Cost of Products Sold, Excluding Depreciation and Amortization

Cost of products sold, excluding depreciation and amortization, increased from $13.7 million in 2007 to $15.1 million in 2008, while increasing as a percentage of product sales revenue from 65.4% to 67.4%.

Raw product costs increased by $0.4 million, from $5.1 million in 2007 to $5.5 million in 2008, due in large part to a $0.3 million increase in CO 2 costs.  The volume of CO 2 sold by us increased 2.4%, primarily due to a 0.2% increase in our average customer base, and an increase in usage of 1.6%.

Operational costs, primarily wages and benefits related to cost of products sold, increased from $5.6 million in 2007 to $6.0 million in 2008.

Truck delivery expenses increased from $2.1 million in 2007 to $2.6 million in 2008 primarily due to the increased customer base and fuel costs.  We have been able to continue to minimize the impact of increased fuel costs and variable lease costs associated with truck usage by continuing to improve efficiencies in the timing and routing of deliveries.  During the last six months of fiscal 2007, we implemented a new routing routine at select locations across the country.  The full implementation of “alpha routing” will be systematically implemented through the end of fiscal 2008.

Occupancy and shop costs related to cost of products sold increased from $0.9 million in at March 31, 2007 to $1.0 million at March 31, 2008.

Cost of Equipment Rentals, Excluding Depreciation and Amortization

Cost of equipment rentals, excluding depreciation and amortization, increased from $2.0 million in 2007 to $2.4 million in 2008, while increasing as a percentage of equipment rentals revenue from 18.3% to 20.4%.  During the second fiscal quarter of 2007, we made a strategic decision to be more selective with customer activations on a going forward basis, while improving both operating and customer service metrics.  As part of this decision, rather than reducing the number of technicians, we have increased our emphasis on the assessment, upgrade and service of our bulk CO 2 tanks at customer sites.  To the degree that our installers and other personnel are involved in such activities, as compared to initial installation of tanks at customer sites, which consumed the substantial majority of our technicians’ efforts over the past several years, the related expense is recognized in our statement of income as incurred.  We are continuing to increase capacity to repair and service tanks, which is expected to reduce our need to purchase new tanks.  Tank repair and service costs are expensed as incurred as compared to the purchase of a tank, which is capitalized at cost.

Selling, General and Administrative Expenses

Selling, general and administrative expenses decreased by $0.9 million from $8.0 million in 2007 to $7.1 million in 2008, while decreasing as a percentage of total revenues from 24.9% in 2007 to 20.7% in 2008.

Selling related expenses decreased by $0.1 million, from $1.1 million in 2007 to $1.0 million in 2008.  In January 2007, as part of our new strategic growth plan, we reduced our sales force by 14 associates.  We expect the full impact of this reduction to be fully seen throughout fiscal 2008.

General and administrative expenses decreased by $0.7 million, or 10.3%, from $6.8 million in 2007 to $6.1 million in 2008.  This decrease is primarily due to a decrease in bad debt expense of $0.2 million due to improved collections experience over the last year, and a decrease in stock compensation expense of $0.4 million attributable to fewer stock options granted in the quarter ended March 31, 2008 as compared to 2007, and a decrease in professional fees of $0.3 million. Additionally, included in 2007 is approximately $0.3 million for severance paid to a former executive consistent with the requirements of his employment agreement and wages and related costs who were separated as part of our strategic plan announced in January 2007.  These amounts were offset by an increase of approximately $0.5 million in costs associated with the Merger Transaction, which were not incurred in the prior year.
 
 

Depreciation and Amortization

Depreciation and amortization decreased from $5.2 million in 2007 to $5.1 million in 2008.   As a percentage of total revenues, depreciation and amortization expense decreased from 16.2% in 2007 to 14.8% in 2008.

Depreciation expense remained consistent at $4.3 million for the three months ended both March 31, 2007 and 2008.

Amortization expense decreased slightly from $0.9 million for the three months ended March 31, 2007, to $0.8 million for the three months ended March 31, 2008.

Loss on Asset Disposal

Loss on asset disposal increased from $0.5 million in 2007 to $0.7 million in 2008, increasing as a percentage of total revenues from 1.6% to 2.0%.  This increase is primarily due to the write-off of deferred lease acquisition costs and unamortized initial installation costs associated with customer attrition.

Operating Income

For the reasons previously discussed, operating income increased by $1.4 million from $2.6 million in 2007 to $4.0 million in 2008.  As a percentage of total revenues, operating income increased from 8.0% to 11.5%.

Interest Expense

Interest expense decreased from $0.5 million in 2007 to $0.4 million in 2008, while the effective interest rate of our debt decreased from 6.5% to 6.2% for the three months ended March 31, 2007 and March 31, 2008, respectively.  See “Quantitative and Qualitative Disclosures About Market Risk.”

Income Before Provision for Income Taxes

Primarily, for the reasons described above, income before provision for income taxes increased by $1.6 million, or 74.0%, from $2.0 million in 2007 to $3.6 million in 2008.

Provision for Income Taxes

During the three months ended March 31, 2007 and 2008, we recognized a tax provision consistent with our effective tax rate.  However, while we anticipate continuing to recognize a full tax provision in future periods, we expect to pay only AMT and state/local taxes until such time that our net operating loss carryforwards are fully utilized.  Our effective rate for the three months ended March 31, 2008 was 45.4%, as compared to 45.7% for the three months ended March 31, 2007.

As of June 30, 2007, we had net operating loss carryforwards for federal income tax purposes of $91 million and for state purposes in varying amounts, expiring through June 2025.  If an “ownership change” for federal income tax purposes were to occur in the future, our ability to use our pre-ownership change federal and state net operating loss carryforwards (and certain built in losses, if any) would be subject to an annual usage limitation, which under certain circumstances may prevent us from being able to utilize a portion of such loss carryforwards in future tax periods and may reduce our after-tax cash flow.

Net Income

For the reasons described above, net income increased from $1.1 million in 2007 to $1.9 million in 2008.
 
 

Non-GAAP Measures EBITDA and EBITDA Excluding Option Compensation

Earnings before interest, taxes, depreciation and amortization ("EBITDA") is one of the principal financial measures by which we measure our financial performance. EBITDA is a widely accepted financial indicator used by many investors, lenders and analysts to analyze and compare companies on the basis of operating performance, and we believe that EBITDA provides useful information regarding our ability to service our debt and other obligations. However, EBITDA does not represent cash flow from operations, nor has it been presented as a substitute to operating income or net income as indicators of our operating performance. EBITDA excludes significant costs of doing business and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with accounting principles generally accepted in the United States of America. In addition, our calculation of EBITDA may be different from the calculation used by our competitors, and therefore comparability may be affected. In addition, our lender also uses EBITDA to assess our compliance with debt covenants. These financial covenants are based on a measure that is not consistent with accounting principles generally accepted in the United States of America. Such measure is EBITDA (as defined) as modified by certain defined adjustments.

   
Three Months Ended March 31,
 
   
2008
   
2007
 
Net income
  $ 1,941     $ 1,111  
Interest expense
    410       509  
Depreciation and amortization
    5,077       5,158  
Provision for income taxes
    1,615       935  
EBITDA
    9,043       7,713  
Noncash option compensation
    870       1,301  
EBITDA excluding the impact of option compensation
  $ 9,913     $ 9,014  
                 
Cash flows provided by (used in):
               
  Operating activities
  $ 14,520     $ 9,495  
  Investing activities
  $ (5,588 )   $ (3,554 )
  Financing activities
  $ (8,984 )   $ (5,888 )
 
 
Nine Months Ended March 31, 2008 Compared to the Nine Months Ended March 31, 2007

Total Revenues

Total revenues increased by $7.2 million, or 7.4%, from $96.2 million in 2007 to $103.4 million in 2008.  Revenues derived from our bulk CO 2 service plans increased by $5.0 million, primarily due to an increase in the number of customer locations, while revenues derived from the sale of high pressure cylinder products, fuel surcharges, equipment sales and other revenues increased by $2.2 million. The $2.2 million increase in other sales is primarily due to a $0.6 million increase in nitrogen generator lease revenues in the nine months ended March 31, 2008, as compared to 2007, as customer demand for this product has increased over the prior year.  In addition, fuel surcharges to customers have steadily increased in the last nine months as fuel costs have risen. The number of customer locations utilizing our products and services increased from approximately 116,000 customers at March 31, 2007 to approximately 116,400 customers at March 31, 2008, due primarily to organic growth.
 
 
 
The following table sets forth, for the periods indicated, the percentage of total revenues by service plan:

     
Nine Months Ended March 31,
 
Service Plan
 
2008
   
2007
 
 
Bulk budget plan 1
    48.4 %     51.4 %
 
Equipment lease/product purchase plan 2
    20.4       18.0  
 
Product purchase plan 3
    10.8       10.6  
 
High pressure cylinder 4
    5.4       5.5  
 
Other revenues 5
    15.0       14.5  
        100.0 %     100.0 %
 
 
1 Combined fee for bulk CO 2 tank and bulk CO 2.
               
 
2 Fee for bulk CO 2 tank and, separately, bulk CO 2 usage.
               
 
3 Bulk CO 2 only.
               
 
4 High pressure CO 2 cylinders and non-CO 2 gases.
               
 
5 Surcharges and other charges.
               
 
Product Sales - Revenues derived from the product sales portion of our service plans increased by $4.3 million, or 6.9%, from $63.9 million in 2007 to $68.2 million in 2008.  The increase in revenues is primarily due to a slight increase in the average number of customer locations serviced, a 1.7% increase in product usage, and pricing initiatives.  In addition, sales of products and services other than bulk CO 2 increased by $1.5 million due in large part to an increase in revenues derived from cylinder products, fuel surcharges, equipment sales, and other revenues.

Equipment Rentals - Revenues derived from the lease portion of our service plans increased by $2.7 million, or 8.6%, from $32.4 million in 2007 to $35.1 million in 2008, primarily due to a 1.8% increase in the average number of customer locations leasing equipment from us, including the impact of price increases to a significant number of our customers consistent with the Consumer Price Index, offset by incentive pricing provided to multiple national restaurant organizations utilizing our equipment under the bulk budget plan and equipment lease/product purchase plans pursuant to master service agreements.   The number of customer locations renting equipment from us increased from 96,000 for the nine months ended March 31, 2007, to 97,000 for the nine months ended March 31, 2008. Additionally, nitrogen generator lease revenues increased by $0.6 million in the nine months ended march 31, 2008 due to increased customer demand.
 
Cost of Products Sold, Excluding Depreciation and Amortization

Cost of products sold, excluding depreciation and amortization, increased from $41.6 million in 2007 to $44.4 million in 2008, while decreasing as a percentage of product sales revenue from 65.2% to 65.0%.

Raw product costs increased by $1.4 million, from $15.9 million in 2007 to $17.3 million in 2008, due in large part to a $0.9 million increase in CO 2 costs.    The volume of CO 2 sold by us increased 3.5%, primarily due to the 1.1% increase in our average customer base and an increase in usage of 1.7%.

Operational costs, primarily wages and benefits related to cost of products sold, increased from $16.6 million for the nine months ended March 31, 2007 to $17.0 million for the nine months ended March 31, 2008. This increase was primarily due to increased delivery personnel wages of $0.4 million.

Truck delivery expenses increased from $6.4 million in 2007 to $7.2 million in 2008. The increase in expenses is due to the rising costs of fuel over the last nine months.  Despite rising fuel costs, we have been able to continue to partially minimize the impact of increased fuel costs and variable lease costs associated with truck usage by continuing to improve efficiencies in the timing and routing of deliveries.   During the last year, we have implemented a new routing routine at select locations across the country.  The full implantation of “alpha routing” will be systematically implemented through the end of fiscal 2008.

Occupancy and shop costs related to cost of products sold increased slightly from $2.8 million in 2007 to $2.9 million in 2008.
 
 

Cost of Equipment Rentals, Excluding Depreciation and Amortization

Cost of equipment rentals, excluding depreciation and amortization, increased from $4.6 million in 2007 to $7.0 million in 2008 while increasing as a percentage of equipment rentals revenue from 14.2% to 20.0%.  During fiscal 2007, we made a strategic decision to be more selective with our customer activations on a going forward basis, while improving both operating and customer service metrics.  As part of this decision, rather than reducing the number of technicians, we are increasing our emphasis on the assessment, upgrade and service of our bulk CO 2 tanks at customer sites.  To the degree that our installers and other personnel are involved in such activities, as compared to initial installation of tanks at customer sites, which consumed the substantial majority of our technicians’ efforts over the past several years, the related expense is recognized in our statement of operations as incurred.  We are increasing capacity to repair and service tanks, which is and will continue to reduce our need to purchase new tanks.  Tank repair and service costs are expensed as incurred as compared to the purchase of a tank, which is capitalized at cost.

Selling, General and Administrative Expenses

Selling, general and administrative expenses decreased by $1.9 million from $22.3 million in 2007 to $20.4 million in 2008, while decreasing as a percentage of total revenues from 23.2% in 2007 to 19.8% in 2008.  This decrease is primarily due to an overall reduction in salary expense of $0.7 million, which is consistent with our reduction in the sales force by 28 sales personnel from October 2006 through January 2007, along with a decrease of $1.2 million in bad debt expense, which is due to our increased collection activity for the nine months ended March 31, 2008 as compared to the nine months ended March 31, 2007.

Selling related expenses decreased by $0.7 million, from $3.8 million in 2007 to $3.1 million in 2008, primarily the result of the planned conversion of select independent sales representatives to salaried employees and expenses directed towards training, marketing and growth opportunities.

General and administrative expenses decreased by $1.1 million, or 6.2%, from $18.5 million in 2007 to $17.4 million in 2008, primarily due to a decrease in bad debt expense of $1.2 million due to improved collections on outstanding accounts receivable in 2008 as compared to 2007, and approximately $0.8 million in expenses related to the Merger Transaction.
 
Depreciation and Amortization

Depreciation and amortization increased from $14.9 million in 2007 to $15.1 million in 2008.   As a percentage of total revenues, depreciation and amortization expense decreased from 15.5% in 2007 to 14.6% in 2008.

Depreciation expense increased from $12.4 million in 2007 to $12.7 million in 2008.  The increase was due in large part to the purchase and placement of additional bulk CO 2 tanks at customer sites.

Amortization expense decreased slightly from $2.5 million for the nine months ended March 31, 2007, to $2.4 million for the nine months ended March 31, 2008.

Loss on Asset Disposal

Loss on asset disposal increased from $1.5 million in 2007 to $2.4 million in 2008, increasing as a percentage of total revenues from 1.6% to 2.3%.   This increase is primarily due to the write-off of deferred lease acquisition costs and unamoritzed initial installation costs associated with customer attrition.

Operating Income

For the reasons previously discussed, operating income increased by $2.8 million from $11.2 million in 2007 to $14.0 million in 2008.  As a percentage of total revenues, operating income increased from 11.7% to 13.5%.
 
 

Interest Expense

Interest expense decreased from $1.6 million in 2007 to $1.5 million in 2008, which is consistent with the reduction in our outstanding debt balance over the last nine months.  The effective interest rate of our debt increased from 6.5% in 2007 to 6.6% in 2008.  See “Quantitative and Qualitative Disclosures About Market Risk.”


Income Before Provision for Income Taxes

Primarily for the reasons described above, income before provision for income taxes increased by $2.9 million, or 30.3%, from $9.6 million in 2007 to $12.5 million in 2008.

Provision for Income Taxes

During the six months ended March 31, 2007 and 2008, we recognized a tax provision consistent with our effective tax rate.  However, while we anticipate continuing to recognize a full tax provision in future periods, we expect to pay only AMT and state/local taxes until such time that our net operating loss carryforwards are fully utilized.  Our effective rate for the nine months ended March 31, 2008 was 44.1%, as compared to 47.8% for the nine months ended March 31, 2007.

As of June 30, 2007, we had net operating loss carryforwards for federal income tax purposes of $91 million and for state purposes in varying amounts, expiring through June 2025.  If an “ownership change” for federal income tax purposes were to occur in the future, our ability to use our pre-ownership change federal and state net operating loss carryforwards (and certain built in losses, if any) would be subject to an annual usage limitation, which under certain circumstances may prevent us from being able to utilize a portion of such loss carryforwards in future tax periods and may reduce our after-tax cash flow.

Net Income

For the reasons described above, net income increased from $5.0 million 2007 to $7.0 million in 2008.

Non-GAAP Measures EBITDA and EBITDA Excluding Option Compensation

Earnings before interest, taxes, depreciation and amortization ("EBITDA") is one of the principal financial measures by which we measure our financial performance. EBITDA is a widely accepted financial indicator used by many investors, lenders and analysts to analyze and compare companies on the basis of operating performance, and we believe that EBITDA provides useful information regarding our ability to service our debt and other obligations. However, EBITDA does not represent cash flow from operations, nor has it been presented as a substitute to operating income or net income as indicators of our operating performance. EBITDA excludes significant costs of doing business and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with accounting principles generally accepted in the United States of America. In addition, our calculation of EBITDA may be different from the calculation used by our competitors, and therefore comparability may be affected. In addition, our lender also uses EBITDA to assess our compliance with debt covenants. These financial covenants are based on a measure that is not consistent with accounting principles generally accepted in the United States of America. Such measure is EBITDA (as defined) as modified by certain defined adjustments.
 
 
 
   
Nine Months Ended March 31
 
   
2008
   
2007
 
Net income
  $ 6,987     $ 5,012  
Interest expense
    1,502       1,635  
Depreciation and amortization
    15,124       14,900  
Provision for income taxes
    5,513       4,584  
EBITDA
    29,126       26,131  
Noncash option compensation
    2,511       3,245  
EBITDA excluding the impact of option compensation
  $ 31,637     $ 29,376  
                 
Cash flows provided by (used in):
               
  Operating activities
  $ 38,388     $ 27,448  
  Investing activities
  $ (15,789 )   $ (19,325 )
  Financing activities
  $ (22,610 )   $ (8,224 )
 
Liquidity and Capital Resources

Our cash requirements consist principally of (1) capital expenditures associated with purchasing and placing new bulk CO 2 systems into service at customers' sites; (2) payments of principal and interest on outstanding indebtedness; and (3) working capital.  Whenever possible, we seek to obtain the use of vehicles, land, buildings, and other office and service equipment under operating leases as a means of conserving capital.  We anticipate making cash capital expenditures of approximately $23.1 million for internal growth over the next twelve months, primarily for purchases of bulk CO 2 systems and utilization of existing bulk CO 2 systems for new customers.
 
Long Term Debt

On May 27, 2005, we terminated our previous credit facility and entered into a $60.0 million revolving credit facility with Bank of America, N.A. (the “2005 Credit Facility”). The 2005 Credit Facility matures on May 27, 2010. We are entitled to select either Base Rate Loans (as defined) or Eurodollar Rate Loans (as defined), plus applicable margin, for principal borrowings under the 2005 Credit Facility. Applicable margin is determined by a pricing grid, as amended March 2006, based on our Consolidated Leverage Ratio (as defined) as follows:

Pricing
Level
 
Consolidated Leverage
Ratio
Eurodollar Rate
Loans
Base Rate
Loans
I
 
Greater than or equal to
2.50x
2.000%
0.500%
II
 
Less than 2.50x but greater
than or equal to 2.00x
1.750%
0.250%
III
 
Less than 2.00x but greater
than or equal to 1.50x
1.500%
0.000%
IV
 
Less than 1.50x but greater
than or equal to 0.50x
1.250%
0.000%
V
 
Less than 0.50x
1.000%
0.000%

Interest is payable periodically on borrowings under the 2005 Credit Facility. The 2005 Credit Facility is uncollateralized. We are required to meet certain affirmative and negative covenants, including financial covenants. We are required to assess our compliance with these financial covenants under the 2005 Credit Facility on a quarterly basis. These financial covenants are based on a measure that is not consistent with accounting principles generally accepted in the United States of America. Such measure is EBITDA (as defined), which represents earnings before interest, taxes, depreciation and amortization, as further modified by certain defined adjustments. The failure to meet these covenants, absent a waiver or amendment, would place us in default and cause the debt outstanding under the 2005 Credit Agreement to immediately become due and payable.  In connection with our share repurchase program announced during the quarter ended March 31, 2007, the 2005 Credit Facility was amended to modify certain covenants.  We were in compliance with all covenants under the 2005 Credit Facility as of June 30, 2005 and all subsequent periods through March 31, 2008.
 
 

As of March 31, 2008, a total of $25.4 million was outstanding pursuant to the 2005 Credit Facility, primarily consisting of Libor (Eurodollar Rate) loans with a weighted average interest rate of 4.33% per annum.

Other

During the nine months ended March 31, 2008, our capital resources included cash flows from operations and available borrowing capacity under the 2005 Credit Facility.  We believe that cash flows from operations and available borrowings under the 2005 Credit Facility will be sufficient to fund proposed operations for at least the next twelve months.

Working Capital .  As of March 31, 2008 and June 30, 2007, we had working capital of $10.0 million and $13.3 million, respectively.

Cash Flows from Operating Activities: During 2007 and 2008, net cash generated by operating activities was $27.4 million and $38.4 million, respectively.  Cash used by our working capital assets improved by $7.7 million, partially offset by the cash generated from our results of operations.  This increase is due in part to increased collection activity on outstanding customer accounts.

Cash Flows from Investing Activities.   During 2007 and 2008, net cash used in investing activities was $19.3 million and $15.8 million, respectively.  Investing activities in 2008 included $14.0 million associated with the purchase and installation of tanks at customer sites as compared with $17.6 million last year. As previously noted, we have increased our capacity to repair and service tanks resulting in a reduction in the number of tanks purchased.

Cash Flows from Financing Activities.   During 2008, cash flows used in financing activities was $22.6 million, compared to $8.2 million used in financing activities in 2007.  During 2008, we made net repayments on outstanding debt of $9.4 million.  Additionally, as previously discussed, in January 2008, we purchased a swaption for $4.9 million to hedge against rising interest rates in relation to the Company’s anticipated financing transaction related to the merger with Aurora Capital Group (“Aurora”). Pursuant to the anticipated merger, we entered into an interest rate swap to hedge the risk rising interest rates between the date of the merger agreement and the expected closing date of the transaction.  Additionally, we incurred approximately $2.8 million in deferred debt issuance costs associated with the anticipated Merger Financing.  This year, we also incurred approximately $7.1 million associated with the repurchase of outstanding shares of our common stock as compared to $12.5 million during the same period lat year.
 

Inflation

The modest levels of inflation in the general economy have not affected our results of operations.  Additionally, our customer contracts generally provide for annual increases in the monthly rental rate based on increases in the consumer price index.  We believe that inflation will not have a material adverse effect on our future results of operations.

Our bulk CO 2 exclusive requirements contract with The BOC Group, Inc. (“BOC”) provides for annual adjustments in the purchase price for bulk CO 2 based upon increases or decreases in the Producer Price Index for Chemical and Allied Products or the average percentage increase in the selling price of bulk merchant carbon dioxide purchased by BOC’s large, multi-location beverage customers in the United States, whichever is less.

As of March 31, 2008, we operated a total of 359 specialized bulk CO 2 delivery vehicles and technical service vehicles that logged approximately 14.6 million miles over the last twelve months.  While significant increases in fuel prices impact our operating costs, such impact is largely offset by fuel surcharges billed to the majority of our customers.
 
 

Recent Accounting Pronouncements

In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 141R, “ Business Combinations ” (“SFAS No. 141R”). SFAS No. 141R will require, among other things, the expensing of direct transaction costs, including deal costs and restructuring costs as incurred, acquired in process research and development assets to be capitalized, certain contingent assets and liabilities to be recognized at fair value and earn-out arrangements, including contingent consideration, may be required to be measured at fair value until settled, with changes in fair value recognized each period into earnings.  In addition, material adjustments made to the initial acquisition purchase accounting will be required to be recorded back to the acquisition date. This will cause companies to revise previously reported results when reporting comparative financial information in subsequent filings. SFAS No. 141R will become effective for us on a prospective basis for transactions occurring in 2009 and earlier adoption is not permitted.  We are currently evaluating the impact, if any, that the adoption of SFAS No. 141R will have on our financial condition results of operations or cash flows.

In December 2007, the FASB issued SFAS No. 160, “ Noncontrolling Interests in Consolidated Financial Statements ” (“SFAS No. 160”). SFAS No. 160 will change the accounting for and reporting of minority interests. Under the new standard, minority interests, will be referred to as noncontrolling interests and will be reported as equity in the parent company’s consolidated financial statements. Transactions between the parent company and the noncontrolling interests will be treated as transactions between shareholders provided that the transactions do not create a change in control. Gains and losses will be recognized in earnings for transactions between the parent company and the noncontrolling interests, unless control is achieved or lost. SFAS No. 160 requires retrospective adoption of the presentation and disclosure requirements for existing minority interests. All other requirements of SFAS No. 160 shall be applied prospectively. SFAS No. 160 is effective for us beginning in the first quarter of fiscal year 2009 and earlier adoption is not permitted. We are currently evaluating the impact, if any, that the adoption of SFAS No. 160 will have on our financial condition, results of operations or cash flows.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115” (“SFAS No. 159”), which provides companies with an option to report selected financial assets and liabilities at their fair values. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 is expected to expand the use of fair value measurement, which is consistent with the FASB’s long-term measurement objectives for accounting for financial instruments. SFAS No. 159 will become effective for us on July 1, 2008.  We are currently evaluating the impact, if any, that the adoption of SFAS No. 159 will have on our financial condition, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”), which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating what impact, if any, the adoption of SFAS No. 157 will have on our financial condition, results of operations or cash flows.


ITEM 3.                            QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
As discussed under “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources” above, as of March 31, 2008, a total of $25.4 million was outstanding under the 2005 Credit Facility with a weighted average interest rate of 4.33% per annum.  Based upon the $25.4 million outstanding under the 2005 Credit Facility at December 31, 2007, our annual interest cost under the 2005 Credit Facility would increase by $0.3 million for each 1% increase in Eurodollar interest rates.
 
 

On January 29, 2008, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with NuCO 2 Acquisition Corp., a Delaware corporation (“Parent”), and NuCO2 Merger Co., a Florida corporation and a wholly owned subsidiary of Parent (“Merger Sub”).  Subject to the terms and conditions of the Merger Agreement, Merger Sub will merge with and into the Company (the “Merger”) with the Company being the surviving corporation in the Merger and, at the effective time of the Merger, each issued and outstanding share of common stock, par value $0.001 per share (the “Common Stock”), of the Company (other than treasury shares, shares owned by Parent, Merger Sub or any direct or indirect wholly owned subsidiary of Parent and shares owned by stockholders who perfect their appraisal rights under Florida law) will be converted automatically into the right to receive $30.00 in cash, without interest.   
 
In order to reduce the Company’s exposure to increases in interest rates in connection with the debt financing for the Merger (the “Merger Financing”), on January 30, 2008, the Company purchased an option, for a premium of $4.9 million, to enter into a pay fixed rate swap (“Swaption I”) that grants the Company the right (but not the obligation) to enter into a pay fixed swap at the effective time of the Merger with respect to amounts to be borrowed under the Merger Financing.  The underlying swap is in the notional amount of $335.0 million, and the option expires on June 30, 2008. Under the Merger Agreement, Parent will reimburse the Company for its unrecouped costs associated with Swaption I in the event that the Merger Agreement is terminated and, upon such reimbursement, the Company will assign Swaption I to Parent.  Swaption I meets the requirements to be designated as a cash flow hedge and is deemed a highly effective transaction.  Accordingly, changes in the fair value of Swaption I are recorded as other comprehensive income (loss).  At March 31, 2008, the Company recorded a loss of $2.8 million, representing the change in fair value of Swaption I from January 30, 2008 through March 31, 2008, as other comprehensive loss.
 
In order to reduce our exposure to increases in Eurodollar rates, and consequently to increases in interest payments, we entered into an interest rate swap transaction (the “2005 Swap”) comprised of two instruments (“Swap A” and “Swap B”) on September 28, 2005, with an effective date of October, 3, 2005.  Swap A, in the amount of $15.0 million (the “A Notional Amount”), matures on October 3, 2008 and Swap B, in the amount of $5.0 million (the “B Notional Amount”), matured on April 3, 2007.  Pursuant to Swap A, we currently pay a fixed interest rate of 4.69% per annum and receive a Eurodollar-based floating rate.  The effect of Swap A is to neutralize any changes in Eurodollar rates on the A Notional Amount.  The 2005 Swap meets the requirements to be designated as a cash flow hedge and is deemed a highly effective transaction.  Accordingly, changes in the fair value of Swap A are recorded as other comprehensive income (loss).  During the nine months ended March 31, 2008, we recorded a loss of $0.3 million, representing the change in fair value of Swap A from June 30, 2007 through March 31, 2008, as other comprehensive loss.


ITE M 4.                      CONTROLS AND PROCEDURES

 
Evaluation of disclosure controls and procedures .   Based on our management’s evaluation (with the participation of our principal executive officer and principal financial officer), as of the end of the period covered by this report, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
 
Changes in internal control over financial reporting . There have been no changes in our internal control over financial reporting during the quarter ended March 31, 2008 that have materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PAR T II.                      OTHER INFORMATION.

ITEM 6.                      EXHIBITS.


Exhibit No.
Exhibit
   
31.1
Section 302 Certification of Principal Executive Officer.
31.2
Section 302 Certification of Principal Financial Officer.
32.1
Section 906 Certification of Principal Executive Officer.
32.2
Section 906 Certification of Principal Financial Officer.


S IGNA TURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
NuCO 2 Inc.
   
   
Dated:  May 12, 2008
By:
/s/ Robert R. Galvin
   
Robert R. Galvin
   
Chief Financial Officer
     
 

 
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