XNYS:CFI Culp Inc Quarterly Report 10-Q Filing - 1/29/2012

Effective Date 1/29/2012

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549
FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended January 29, 2012
Commission File No. 1-12597

CULP, INC.
(Exact name of registrant as specified in its charter)
 
NORTH CAROLINA 56-1001967
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or other organization)
 
   
1823 Eastchester Drive
 
High Point, North Carolina 27265-1402
(Address of principal executive offices) (zip code)
 
(336) 889-5161
(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 the filing requirements for at least the past 90 days.  x YES    NO o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period after the registrant was required to submit and post such files).  x YES    NO o

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 definitions of “accelerated filer, large accelerated filer, and smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one);
 
Large accelerated filero Accelerated filer x Non-accelerated filer o
     
 
Smaller Reporting Company o
 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o 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:

Common shares outstanding at January 29, 2012:  12,692,574
Par Value: $0.05 per share
 
 
 

 
 
INDEX TO FORM 10-Q
For the period ended January 29, 2012

   
Page
 
       
       
     
       
    I-1  
         
    I-2  
         
    I-3  
         
    I-4  
         
    I-5  
         
    I-24  
         
    I-25  
         
    I-39  
         
    I-40  
         
         
 
II-1
 
         
 
II-1
 
         
 
II-1
 
         
 
II-2
 
         
 
II-3
 
 
 
 
 

 
 
             
             
CONSOLIDATED STATEMENTS OF NET INCOME
FOR THE THREE AND NINE MONTHS ENDED JANUARY 29, 2012 AND JANUARY 30, 2011
UNAUDITED
(Amounts in Thousands, Except for Per Share Data)
 
     
THREE MONTHS ENDED
               
               
     
January 29,
 
January 30,
     
2012
 
2011
               
Net sales
    $ 60,450       51,652  
Cost of sales
    51,939       43,413  
 
Gross profit
    8,511       8,239  
                   
Selling, general and
               
  administrative expenses
    5,518       5,129  
Restructuring expense
    -       7  
 
Income from operations
    2,993       3,103  
                   
Interest expense
    181       224  
Interest income
    (148 )     (57 )
Other expense
    83       28  
 
Income before income taxes
    2,877       2,908  
                   
Income taxes
    1,075       483  
 
Net income
  $ 1,802       2,425  
                   
Net income per share, basic
  $ 0.14       0.19  
Net income per share, diluted
    0.14       0.18  
Average shares outstanding, basic
    12,536       13,005  
Average shares outstanding, diluted
    12,677       13,228  
                   
                   
     
NINE MONTHS ENDED
                   
                   
     
January 29,
 
January 30,
      2012   2011
                   
Net sales
    $ 178,733       156,443  
Cost of sales
    152,698       130,886  
 
Gross profit
    26,035       25,557  
                   
Selling, general and
               
  administrative expenses
    16,995       14,544  
 
Income from operations
    9,040       11,013  
                   
Interest expense
    590       659  
Interest income
    (387 )     (144 )
Other expense
    132       111  
 
Income before income taxes
    8,705       10,387  
                   
Income taxes
    (1,168 )     213  
 
Net income
  $ 9,873       10,174  
                   
Net income per share, basic
  $ 0.77       0.79  
Net income per share, diluted
    0.76       0.77  
Average shares outstanding, basic
    12,777       12,936  
Average shares outstanding, diluted
    12,918       13,218  
                   
                   
See accompanying notes to consolidated financial statements.
         
 
 
I-1

 
 
CONSOLIDATED BALANCE SHEETS
JANUARY 29, 2012, JANUARY 30, 2011 AND MAY 1, 2011
UNAUDITED
(Amounts in Thousands)
 
                   
   
January 29,
 
January 30,
 
* May 1,
   
2012
 
2011
 
2011
                   
Current assets:
                 
Cash and cash equivalents
  $ 15,096       17,259       23,181  
Short-term investments
    8,511       5,518       7,699  
Accounts receivable, net
    22,012       16,909       20,209  
Inventories
    32,910       26,407       28,723  
Deferred income taxes
    2,767       296       293  
Assets held for sale
    45       112       75  
Income taxes receivable
    -       407       79  
Other current assets
    2,522       1,521       2,376  
Total current assets
    83,863       68,429       82,635  
                         
Property, plant and equipment, net
    30,285       30,571       30,296  
Goodwill
    11,462       11,462       11,462  
Deferred income taxes
    3,903       1,322       3,606  
Other assets
    1,944       2,093       2,052  
                         
Total assets
  $ 131,457       113,877       130,051  
                         
                         
                         
Current liabilities:
                       
Current maturities of long-term debt
  $ 2,400       2,400       2,412  
Line of credit
    875       -       -  
Accounts payable-trade
    23,489       17,121       24,871  
Accounts payable - capital expenditures
    15       203       140  
Accrued expenses
    7,594       5,971       7,617  
Accrued restructuring costs
    40       71       44  
Deferred income taxes
    -       -       82  
Income taxes payable - current
    208       289       646  
Total current liabilities
    34,621       26,055       35,812  
                         
Income taxes payable - long-term
    4,040       3,934       4,167  
Deferred income taxes
    659       622       596  
Long-term debt, less current maturities
    6,766       9,166       9,135  
                         
Total liabilities
    46,086       39,777       49,710  
                         
Commitments and Contingencies (Note 17)
                       
                         
Shareholders' equity
    85,371       74,100       80,341  
                         
Total liabilities and
                       
shareholders' equity
  $ 131,457       113,877       130,051  
                         
Shares outstanding
    12,693       13,214       13,264  
                         
                         
*  Derived from audited financial statements.
                       
                         
See accompanying notes to consolidated financial statements.
 
 
I-2

 
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED JANUARY 29, 2012 AND JANUARY 30, 2011
UNAUDITED
(Amounts in Thousands)
 
   
NINE MONTHS ENDED
             
             
   
January 29,
 
January 30,
   
2012
 
2011
             
Cash flows from operating activities:
           
Net income
  $ 9,873       10,174  
Adjustments to reconcile net income to net cash
               
provided by operating activities:
               
Depreciation
    3,600       3,205  
Amortization of other assets
    183       385  
Stock-based compensation
    258       280  
Excess tax benefit related to stock-based compensation
    (39 )     (285 )
Deferred income taxes
    (2,751 )     (1,219 )
(Gain) loss on sale of equipment
    (157 )     15  
Foreign currency exchange (gains) losses
    (196 )     33  
Changes in assets and liabilities:
               
Accounts receivable
    (1,769 )     3,053  
Inventories
    (4,045 )     (291 )
Other current assets
    (159 )     204  
Other assets
    (49 )     13  
Accounts payable - trade
    (1,709 )     (5,459 )
Accrued expenses
    (1 )     (3,822 )
Accrued restructuring
    (4 )     (253 )
Income taxes
    (305 )     379  
Net cash provided by operating activities
    2,730       6,412  
                 
Cash flows from investing activities:
               
Capital expenditures
    (3,715 )     (5,580 )
Proceeds from the sale of equipment
    188       27  
Purchase of short-term investments
    (4,821 )     (4,532 )
Proceeds from the sale of short-term investments
    4,096       2,037  
Net cash used in investing activities
    (4,252 )     (8,048 )
                 
Cash flows from financing activities:
               
Proceeds from lines of credit
    6,323       -  
Payments on lines of credit
    (5,500 )     -  
Payments on long-term debt
    (2,354 )     (129 )
Payments on vendor-financed capital expenditures
    -       (188 )
Proceeds from common stock issued
    237       591  
Common stock repurchased
    (5,384 )     -  
Debt issuance costs
    (26 )     (27 )
Excess tax benefit related to stock-based compensation
    39       285  
Net cash (used in) provided by financing activities
    (6,665 )     532  
                 
Effect of exchange rate changes on cash and cash equivalents
    102       68  
                 
Decrease in cash and cash equivalents
    (8,085 )     (1,036 )
                 
Cash and cash equivalents at beginning of period
    23,181       18,295  
                 
Cash and cash equivalents at end of period
  $ 15,096       17,259  
                 
See accompanying notes to consolidated financial statements.
 
 
I-3

 
 
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
UNAUDITED
(Dollars in thousands, except share data)
                                     
                                     
               
Capital
       
Accumulated
     
               
Contributed
       
Other
 
Total
   
Common Stock
 
in Excess
 
Accumulated
 
Comprehensive
 
Shareholders’
   
Shares
 
Amount
 
of Par Value
 
Earnings
 
Income
 
Equity
Balance,  May 2, 2010
    13,051,785     $ 652       49,459       12,833       103     $ 63,047  
Net income
    -       -       -       16,164       -       16,164  
Stock-based compensation
    -       -       360       -       -       360  
Loss on cash flow hedge, net of taxes
    -       -       -       -       (103 )     (103 )
Common stock issuable in connection
                                         
with performance based units
    40,000       2       (2 )     -       -       -  
Common stock withheld for withholding taxes
                                         
payable and cost of option exercises
    (60,415 )     (3 )     (560 )     -       -       (563 )
Excess tax benefit related to stock
                                               
based compensation
    -       -       339       -       -       339  
Fully vested common stock award
    3,114       -       -       -       -       -  
Common stock issuable in connection
                              .          
with stock option plans
    229,974       12       1,085       -       -       1,097  
Balance,  May 1, 2011
    13,264,458       663       50,681       28,997       -       80,341  
    Net income
    -       -       -       9,873       -       9,873  
    Stock-based compensation
    -       -       258       -       -       258  
    Unrealized gain on short-term investments
    -       -       -       -       7       7  
    Excess tax benefit related to stock
                                               
       based compensation
    -       -       39       -       -       39  
    Common stock repurchased
    (624,459 )     (31 )     (5,353 )     -       -       (5,384 )
    Fully vested common stock award
    3,075       -       -                       -  
Common stock issued in connection
                                         
       with stock option plans
    49,500       2       235       -       -       237  
Balance,  January 29, 2012
    12,692,574     $ 634       45,860       38,870       7     $ 85,371  
                                                 
                                                 
See accompanying notes to consolidated financial statements.
 
 
I-4

 
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
1.  Basis of Presentation
 
The accompanying unaudited consolidated financial statements of Culp, Inc. and subsidiaries (the “company”) include all adjustments, which are, in the opinion of management, necessary for fair presentation of the results of operations and financial position in accordance with accounting principles generally accepted in the U.S.  All of these adjustments are of a normal recurring nature.  Results of operations for interim periods may not be indicative of future results.  The unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements, which are included in the company’s annual report on Form 10-K filed with the Securities and Exchange Commission on July 15, 2011 for the fiscal year ended May 1, 2011.
 
The company’s nine-months ended January 29, 2012 and January 30, 2011, represent 39 week periods, respectively.
 
2. Significant Accounting Policies
 
As of January 29, 2012, there were no changes in the nature of our significant accounting policies or the application of those policies from those reported in our annual report on Form 10-K for the year then ended May 1, 2011.
 
Recently Adopted Accounting Pronouncements
 
ASC Topic 605
 
In October 2009, the FASB issued ASU 2009-13, which amends ASC Topic 605, “Revenue Recognition”, to revise accounting guidance related to revenue arrangements with multiple deliverables. The guidance relates to the determination of when the individual deliverables included in a multiple-element arrangement may be treated as separate units of accounting and modifies the manner in which the transaction consideration is allocated across the individual deliverables. Also, this guidance expands the disclosure requirements for revenue arrangements with multiple deliverables. This guidance was effective as of May 2, 2011 (the beginning of our fiscal 2012) and did not have an impact on our consolidated results of operations and financial condition.
 
Recently Issued Accounting Pronouncements
 
ASC Topic 220
 
In June of 2011, the FASB issued ASU No. 2011-05, which amends ASC Topic 220, “Comprehensive Income”, to revise accounting guidance related to the presentation of comprehensive income in an entity’s financial statements. The guidance allows an entity the option to present the total comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with a total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount of comprehensive income. ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity or notes to the financial statements. This revised guidance does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. As a result, this guidance is effective for our first quarter of fiscal 2013. The FASB amended this guidance in December 2011 to postpone a requirement to present items that are reclassified from other comprehensive income to net income on the face of the financial statement where the components of net income and other comprehensive income are presented and reinstate previous guidance related to such reclassifications. This guidance will change how we present comprehensive income in our consolidated financial statements as we currently present the components of other comprehensive income and total comprehensive income as part of our notes to the consolidated financial statements (see Note 13).
 
 
I-5

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
In September 2011, the FASB issued amended guidance that permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the current two-step goodwill impairment test. If an entity concludes that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it would not be required to perform the two-step impairment test for that reporting unit. This guidance is effective for interim and annual reporting periods beginning April 30, 2012, with early adoption permitted, and will not have a material impact on our results of operations, cash flows or financial position.

3.  Stock-Based Compensation

Common Stock Award

On October 1, 2011, we granted a total of 3,075 shares of common stock to our board of directors. These shares of common stock vested immediately and were measured at $8.45 per share, which represents the closing price of the company’s common stock at the date of grant.

On October 1, 2010, we granted a total of 3,114 shares of common stock to our board of directors. These shares of common stock vested immediately and were measured at $10.02 per share, which represents the closing price of the company’s common stock at the date of grant.

We recorded $26,000 and $31,000 of compensation expense within selling, general, and administrative expense for these common stock awards for the nine-month period ending January 29, 2012 and January 30, 2011, respectively.

Incentive Stock Option Awards

We did not grant any incentive stock option awards during the first nine months of fiscal 2012.

At January 29, 2012, options to purchase 219,375 shares of common stock were outstanding, had a weighted average exercise price of $7.26 per share, and a weighted average contractual term of 5.3 years. At January 29, 2012, the aggregate intrinsic value for options outstanding was $403,000.

At January 29, 2012, outstanding options to purchase 168,175 shares of common stock were exercisable, had a weighted average exercise price of $7.56 per share, and a weighted average contractual term of 5.1 years. At January 29, 2012, the aggregate intrinsic value for options exercisable was $259,000.

The aggregate intrinsic value for options exercised during nine-month periods ended January 29, 2012 and January 30, 2011, were $196,000 and $820,000, respectively.

The remaining unrecognized compensation cost related to incentive stock option awards at January 29, 2012, was $96,000 which is expected to be recognized over a weighted average period of 1.1 years.

 
I-6

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
We recorded $101,000 and $111,000 of compensation expense on incentive stock option grants within selling, general, and administrative expense for the nine-month periods ended January 29, 2012, and January 30, 2011, respectively.
 
Time Vested Restricted Stock Awards

We did not grant any time vested restricted stock awards during the first nine months of fiscal 2012.
 
We recorded $131,000 and $126,000 of compensation expense within selling, general, and administrative expense for time vested restricted stock awards for the nine-month periods ending January 29, 2012 and January 30, 2011, respectively.
 
At January 29, 2012, there were 185,000 shares of time vested restricted stock outstanding and unvested. Of the 185,000 shares outstanding and unvested, 105,000 shares (granted on January 7, 2009) vest in equal one-third installments on May 1, 2012, 2013, and 2014, respectively. The remaining 80,000 shares (granted on July 1, 2009) vest in equal one-third installments on July 1, 2012, 2013, and 2014, respectively. At January 29, 2012, the weighted average fair value of these outstanding and unvested shares was $3.65 per share.
 
During the nine-month period ending January 29, 2012, 10,000 shares of time vested restricted stock vested and had a weighted average fair value of $18,800 or $1.88 per share.
 
At January 29, 2012, the remaining unrecognized compensation cost related to the unvested restricted stock awards was $203,000, which is expected to be recognized over a weighted average vesting period of 1.7 years.
 
Performance Based Restricted Stock Units
 
We did not grant any performance based restricted stock units during the first nine months of fiscal 2012.
 
On January 7, 2009 (fiscal 2009), certain key management employees and a non-employee were granted 120,000 shares of performance based restricted stock units. This award contingently vested in one-third increments, if in any discrete period of two consecutive quarters from February 2, 2009 through April 30, 2012, certain performance goals are met. As of August 1, 2010 (fiscal 2011), the performance goals as defined in the agreement were met and as a result, all of the performance based restricted stock units have vested.

No compensation cost was recorded for performance based restricted stock units for the nine-month period ended January 29, 2012, as all performance based restricted stock units that have been granted by the company were fully vested at the end of fiscal 2011. We recorded $12,000 within selling, general, and administrative expense for performance based restricted stock units for the nine-month period ended January 30, 2011.
 
Other Share-Based Arrangements

Effective May 2, 2011, we entered into an agreement in which we granted a non-employee a stock appreciation right that is indexed on 70,000 shares of our common stock. This agreement requires us to settle in cash an amount equal to $35,000, plus the excess, if any, over a stock appreciation right value of $700,000 at May 2, 2011. This stock appreciation right value of $700,000 represents the 70,000 indexed shares of common stock noted above measured at the closing price per share of $10 at May 2, 2011. The cash settlement in connection with the stock appreciation right value would represent the difference between a stock appreciation right value that is indexed on the 70,000 shares of common stock noted above and based on the highest closing price per share of our common stock for the period May 2, 2011 through June 30, 2012 (limited to $12 per share) and the $700,000 stock appreciation right value at May 2, 2011. This award will vest over the period May 2, 2011 through June 30, 2012 as this represents the non-employee’s required service period.
 
 
I-7

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Compensation expense associated with this agreement was $44,000 for the nine-months ended January 29, 2012.

4.  Accounts Receivable

A summary of accounts receivable follows:
 
             
(dollars in thousands)
 
January 29, 2012
 
May 1, 2011
Customers   $ 23,113     $ 21,562  
Allowance for doubtful accounts
    (561     (776
Reserve for returns and allowances and discounts
    (540     (577
    $ 22,012     $ 20,209  
 
A summary of the activity in the allowance for doubtful accounts follows:
 
 
 
Nine months ended
(dollars in thousands)
  January 29, 2012   January 30, 2011
Beginning balance
  $ (776 )   $ (1,322 )
Provision for bad debts
    18       295  
Net write-offs, net of recoveries
    197       (19
Ending balance
  $ (561 )   $ (1,046 )
 
A summary of the activity in the allowance for returns and allowances and discounts accounts follows:
 
    Nine months ended
(dollars in thousands)
  January 29, 2012   January 30, 2011
Beginning balance   $ (577   $ (534
Provision for returns, allowances and discounts
    (1,929 )     (1,606
Credits issued     1,966       1,550  
Ending balance
  $ (540 )   $ (590 )

 
I-8

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
5.  Inventories

Inventories are carried at the lower of cost or market.  Cost is determined using the FIFO (first-in, first-out) method.

A summary of inventories follows:
 
(dollars in thousands)
 
January 29, 2012
 
May 1, 2011
Raw materials
  $ 5,032     $ 6,130  
Work-in-process     2,475       2,421  
Finished goods
    25,403       20,172  
    $ 32,910     $ 28,723  
 
6. Other Assets
 
A summary of other assets follows:
 
(dollars in thousands)
 
January 29, 2012
 
May 1, 2011
Cash surrender value – life insurance   $ 1,327     $ 1,323  
Non-compete agreements, net
    369       480  
Other
    248       249  
    $ 1,944     $ 2,052  

We recorded non-compete agreements in connection with our asset purchase agreements with International Textile Group, Inc. (ITG) and Bodet & Horst at their fair values based on valuation techniques. The non-compete agreement associated with ITG was amortized on a straight line basis over the four year life of the agreement and expired at the end of the third quarter of fiscal 2011. The non-compete agreement associated with Bodet & Horst is amortized on a straight line basis over the six year life of the agreement and requires quarterly payments of $12,500 over the life of the agreement. As of January 29, 2012, the total remaining non-compete payments were $125,000.

The gross carrying amount of these non-compete agreements was $1.0 million at January 29, 2012 and May 1, 2011, respectively. At January 29, 2012 and May 1, 2011, accumulated amortization for these non-compete agreements was $692,000 and $544,000, respectively. Amortization expense for these non-compete agreements was $148,000 and $363,000 for the nine month periods ended January 29, 2012 and January 30, 2011, respectively. The remaining amortization expense (which includes the total remaining Bodet & Horst non-compete payments of $125,000) for the next four fiscal years follows: FY 2012 - $49,000; FY 2013 - $198,000; FY 2014 - $198,000; and FY 2015 - $49,000. The weighted average amortization period for these non-compete agreements is 2.5 years as of January 29, 2012.

At January 29, 2012 and May 1, 2011, we had four life insurance contracts with death benefits to the respective insured totaling $12.9 million. Our cash surrender value – life insurance balances of $1.3 million at January 29, 2012 and May 1, 2011, respectively, are collectible upon death of the respective insured.
 
 
I-9

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
7.  Accrued Expenses

A summary of accrued expenses follows:
 
(dollars in thousands)
 
January 29, 2012
 
May 1, 2011
Compensation, commissions and related benefits
  $ 4,480     $ 6,032  
Interest     324       184  
Other accrued expenses
    2,790       1,401  
    $ 7,594     $ 7,617  
 
8.  Long-Term Debt and Lines of Credit

A summary of long-term debt follows:
 
(dollars in thousands)
 
January 29, 2012
 
May 1, 2011
Unsecured senior term notes
  $ 8,800     $ 11,000  
Canadian government loan
    366       547  
      9,166       11,547  
Current maturities of long-term debt
    (2,400     (2,412
Long-term debt, less current maturities of long-term debt
  $ 6,766     $ 9,135  
 
Unsecured Term Notes

In connection with the Bodet & Horst acquisition in 2008, we entered into a note agreement dated August 11, 2008. This agreement provided for the issuance of $11.0 million of unsecured term notes with a fixed interest rate of 8.01% and a term of seven years. Principal payments of $2.2 million per year are due on the notes beginning August 11, 2011. The principal payments are payable over an average term of 3.5 years through August 11, 2015. Any principal prepayments will be assessed a penalty as defined in the agreement. This agreement contains customary financial and other covenants as defined in the agreement.

We made our first principal payment of $2.2 million associated with this note agreement on August 11, 2011.

Government of Quebec Loan

We have an agreement with the Government of Quebec for a term loan that is non-interest bearing and is payable in 48 equal monthly installments (denominated in Canadian dollars) commencing December 1, 2009. The proceeds were used to partially finance capital expenditures at our Rayonese facility located in Quebec, Canada.

Revolving Credit Agreement – United States

At May 1, 2011, we had an unsecured Amended and Restated Credit Agreement that provided for a revolving loan commitment of $6.5 million, including letters of credit up to $3.0 million. This agreement was set to expire August 15, 2012. On August 25, 2011, we entered into a seventeenth amendment to the Amended and Restated Credit Agreement, amending the agreement effective May 1, 2011 (the end of our fiscal 2011). This amendment extends the expiration date of the line of credit through August 25, 2013, increases the revolving loan commitment from $6.5 million to $10.0 million, and decreases the capital expenditure limit for fiscal years 2012 and 2013 from $10.0 million to $6.0 million. On January 17, 2012, and in connection with the Culp Europe Credit Agreement discussed below, we entered into an eighteenth amendment to decrease our revolving loan commitment from $10.0 million to $7.6 million.
 
 
I-10

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The amended agreement provides for a pricing matrix to determine the interest rate payable on loans made under the agreement (applicable interest rate of 1.88% at January 29, 2012). As of January 29, 2012, there were $50,000 in outstanding letters of credit (all of which related to workers compensation). At January 29, 2012 and May 1, 2011, there were no borrowings outstanding under the agreement.

Revolving Credit Agreement – China

At January 29, 2012, we had an unsecured credit agreement associated with our operations in China that provides for a line of credit of up to 40 million RMB (approximately $6.3 million USD at January 29, 2012). This agreement expires on September 2, 2012 and has an interest rate determined by the Chinese government. There were no borrowings outstanding under the agreement as of January 29, 2012 and May 1, 2011.

Revolving Credit Agreement - Europe

On January 17, 2012, we entered into an unsecured credit agreement associated with our operations in Poland that provides for a line of credit up to 6.8 million Polish Zloty (approximately $2.1 million USD at January 29, 2012). This agreement expires on January 15, 2013 and bears interest at WIBOR (Warsaw Interbank Offered Rate) plus 2% (applicable interest rate of 6.89% at January 29, 2012). At January 29, 2012, $875,000 (2.8 million Polish Zloty) was outstanding under this agreement.

Overall

Our loan agreements require, among other things, that we maintain compliance with certain financial covenants. At January 29, 2012, the company was in compliance with these financial covenants.

At January 29, 2012, the principal payment requirements of long-term debt during the next four years are: Year 1 – $2.4 million; Year 2 - $2.4 million; Year 3 - $2.2 million; and Year 4 - $2.2 million.

The fair value of the company’s long-term debt is estimated by discounting the future cash flows at rates currently offered to the company for similar debt instruments of comparable maturities.  At January 29, 2012, the carrying value of the company’s long-term debt was $9.2 million and the fair value was $8.2 million. At May 1, 2011, the carrying value of the company’s long-term debt was $11.5 million and the fair value was $10.2 million.

9. Fair Value of Financial Instruments

ASC Topic 820 establishes a fair value hierarchy that distinguishes between assumptions based on market data (observable inputs) and the company’s assumptions (unobservable inputs). Determining where an asset or liability falls within that hierarchy depends on the lowest level input that is significant to the fair value measurement as a whole. An adjustment to the pricing method used within either level 1 or level 2 inputs could generate a fair value measurement that effectively falls in a lower level in the hierarchy. The hierarchy consists of three broad levels as follows:
 
 
I-11

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Level 1 – Quoted market prices in active markets for identical assets or liabilities;

Level 2 – Inputs other than level 1 inputs that are either directly or indirectly observable, and

Level 3 – Unobservable inputs developed using the company’s estimates and assumptions, which reflect those that market participants would use.

The following table presents information about assets and liabilities measured at fair value on a recurring basis:
 
   
Fair value measurements at January 29, 2012 using:
       
   
Quoted prices in
active markets
for identical
assets
 
Significant other
observable inputs
 
Significant
unobservable
inputs
   
                         
(amounts in thousands) 
 
Level 1
 
Level 2
 
Level 3
 
Total
                         
Assets:
                       
Low Duration Bond Fund
  $ 2,021     N/A     N/A     $ 2,021  
Limited Term Bond Fund
    2,042     N/A     N/A       2,042  
Intermediate Term Bond Fund
    1,045     N/A     N/A       1,045  
                                 
    Fair value measurements at May 1, 2011 using:
                                 
   
Quoted prices in
active markets
for identical
assets
 
Significant other
observable inputs
 
Significant
unobservable
inputs
       
                                 
(amounts in thousands)   Level 1  
Level 2
 
Level 3
  Total
                                 
Assets:
                               
Low Duration Bond Fund
 
$
1,003     N/A     N/A     $ 1,003  
                                 
 
The determination of where an asset or liability falls in the hierarchy requires significant judgment. We evaluate our hierarchy disclosures each quarter based on various factors and it is possible that an asset or liability may be classified differently from quarter to quarter. However, we expect that changes in classifications between different levels will be rare.

Short-term investments include short-term bond funds and deposit accounts that have maturities of less than one year. Our short-term bond funds are classified as available-for-sale and their unrealized gains or losses are included in other comprehensive income. Our short-term bond funds were recorded at their fair value of $5.1 million and $1.0 million at January 29, 2012 and May 1, 2011, respectively. At January 29, 2012 and May 1, 2011, the fair value of our short-term bond funds approximates its cost basis.
 
The carrying amount of cash and cash equivalents, short-term investments that pertain to interest bearing deposit accounts, accounts receivable, other current assets, accounts payable and accrued expenses approximates fair value because of the short maturity of these financial instruments.
 
 
I-12

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
10. Derivatives
 
In accordance with the provisions ASC Topic 815, Derivatives and Hedging, our Canadian dollar foreign exchange contract was designated as a cash flow hedge, with the fair value of this financial instrument recorded in other assets and changes in fair value recorded in accumulated other comprehensive income. ASC Topic 815 requires disclosure of gains and losses on derivative instruments in the following tabular format.
 
 
(Amounts in Thousands)
 
Fair Values of Derivative Instruments As of,
 
January 29,2012
 
May 1, 2011
         
Derivatives designated as hedging instruments under ASC Topic 815
Balance
 Sheet
 Location
 
Fair
 Value
 
Balance
 Sheet
 Location
 
Fair
 Value
 
                 
Canadian dollar foreign exchange contract
Other assets
  $
-
 
Other assets
  $
-
 
                     
 

Derivatives in
 ASC Topic 815
 Net
 Investment
 Hedging
 Relationships
 
Amt of Gain (Loss)
 (net of tax)
 Recognized in OCI on
 Derivative (Effective
 Portion) and recorded
 in Other assets
 and Accrued Expenses
 at Fair Value
   
Location of
 Gain or (Loss)
 Reclassified
 from
 Accumulated
 OCI into
 Income
 (Effective
 Portion)
 
Amount of Gain or
 (Loss) Reclassified
 from Accumulated
 OCI into Income
 (Effective Portion)
 
Location of
 Gain or (Loss)
 Recognized in
 Income on
 Derivative
 (Ineffective
 Portion and
 Amount
 Excluded from
 Effectiveness
 Testing)
 
Amount of Gain (net
 of tax) or (Loss)
 Recognized in Income
 on Derivative
 (Ineffective Portion
 and Amount Excluded
 from Effectiveness
 Testing)
   
2012
 
2011
     
2012
 
2011
     
2012
 
2011
                                             
Canadian Dollar Foreign Exchange Contract
  $ -     $ (103 )  
Other Expense
  $ -     $ 5    
Other Expense
  $ -     $ 79  
 
On January 21, 2009, we entered into a Canadian dollar foreign exchange rate contract to mitigate the risk of foreign exchange rate fluctuations associated with our loan from the Government of Quebec. This agreement effectively converted the Canadian dollar principal payments at a fixed Canadian dollar foreign exchange rate compared with the United States dollar of 1.218 and was due to expire on November 1, 2013. During the first quarter of fiscal 2011, we elected to terminate this contract due to the favorable Canadian dollar foreign changes rates in comparison to the fixed contractual rate noted above.

During the fourth quarter of fiscal 2012, we entered into an agreement to enter foreign exchange contracts that mitigate the risk of foreign exchange rate fluctuations for inventory purchases associated with our operations located in Poland. These contracts effectively convert USD inventory payments at a fixed USD foreign exchange rate compared with the Polish Zloty.

11.  Cash Flow Information

Payments for interest and income taxes follows:
 
   
Nine months ended
(dollars in thousands)
 
January 29, 2012
 
January 30, 2011
Interest   $ 449     $ 454  
Net income tax payments
    1,886       1,054  
 
 
I-13

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
No interest costs were capitalized for the nine months ending January 29, 2012. Interest costs of $17,000 for the construction of qualifying property, plant, and equipment were capitalized for the nine months ending January 30, 2011.

During the nine-month period ending January 29, 2012, no shares of common stock were withheld to satisfy withholding tax liabilities and other costs incurred in connection with vesting of performance based restricted stock units or the exercise of options to purchase common stock. During the nine-month period ending January 30, 2011, 33,835 shares of common stock were withheld to satisfy withholding tax liabilities and other costs incurred in connection with 40,000 shares of common stock issued and related to the vesting of performance based restricted stock units and the exercise of 72,000 options to purchase of common stock. The total withholding tax liabilities and other costs incurred totaled $329,000.

12.  Net Income Per Share

Basic net income per share is computed using the weighted-average number of shares outstanding during the period.  Diluted net income per share uses the weighted-average number of shares outstanding during the period plus the dilutive effect of stock-based compensation calculated using the treasury stock method.  Weighted average shares used in the computation of basic and diluted net income per share follows:
 
   
Three months ended
(amounts in thousands)
 
January 29, 2012
 
January 30, 2011
Weighted average common shares outstanding, basic
    12,536       13,005  
Dilutive effect of stock-based compensation
    141       223  
Weighted average common shares outstanding, diluted
    12,677       13,228  
 
Options to purchase 142,750 shares of common stock were not included in the computation of diluted net income per share for the three months ended January 29, 2012, as the exercise price of the options was greater than the average market price of the common shares. All options of common stock were included in the computation of diluted net income per share as the exercise price of the options was less than average market price of the common shares for the three months ended January 30, 2011.

The computations of basic net income per share did not include 185,000 and 195,000 shares of time vested restricted common stock as these shares were unvested for the three months ending January 29, 2012 and January 30, 2011, respectively.
 
   
Nine months ended
(amounts in thousands)
 
January 29, 2012
 
January 30, 2011
Weighted average common shares outstanding, basic
    12,777       12,936  
Dilutive effect of stock-based compensation
    141       282  
Weighted average common shares outstanding, diluted
    12,918       13,218  
 
 
1-14

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Options to purchase 142,750 shares of common stock were not included in the computation of diluted net income per share for the nine months ended January 29, 2012, as the exercise price of the options was greater than the average market price of the common shares. All options of common stock were included in the computation of diluted net income for the nine months ended January 30, 2011, as the exercise price of the options was less than the average market price of the common shares.

The computations of basic net income per share did not include 185,000 and 195,000 shares of time vested restricted common stock as these shares were unvested for the nine months ending January 29, 2012 and January 30, 2011, respectively.

13.  Comprehensive Income

Comprehensive income is the total income and other changes in shareholders’ equity, except those resulting from investments by shareholders and distributions to shareholders not reflected in net income.

A summary of comprehensive income follows:
 
   
Nine months ended
(dollars in thousands)
 
January 29, 2012
 
January 30, 2011
Net income
  $
9,873
    $
10,174
 
Unrealized gains on short-term investments
   
7
     
-
 
Loss on cash flow hedge, net of income taxes
   
-
     
(103
)
Comprehensive income
   
9,880
    $
10,071
 
 
14.  Segment Information

Our operations are classified into two business segments: mattress fabrics and upholstery fabrics.  The mattress fabrics segment manufactures and sells fabrics to bedding manufacturers.  The upholstery fabrics segment manufactures and sells fabrics primarily to residential and commercial (contract) furniture manufacturers.

We evaluate the operating performance of our segments based upon income (loss) from operations before restructuring and related charges or (credits), certain unallocated corporate expenses, and other non-recurring items. Cost of sales in both segments include costs to manufacture or source our products, including costs such as raw material and finished goods purchases, direct and indirect labor, overhead and incoming freight charges.  Unallocated corporate expenses primarily represent compensation and benefits for certain executive officers and all costs related to being a public company.  Segment assets include assets used in the operations of each segment and primarily consist of accounts receivable, inventories, and property, plant and equipment.  The mattress fabrics segment also includes in segment assets, assets held for sale, goodwill and non-compete agreements associated with certain acquisitions.  The upholstery fabrics segment also includes assets held for sale in segment assets.
 
Financial information for the company’s operating segments follows:
 
 
I-15

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
   
Three months ended
(dollars in thousands)
  January 29, 2012   January 30, 2011
Net sales:
             
Mattress Fabrics
  $ 34,719     $ 27,991    
Upholstery Fabrics
    25,731       23,661    
    $ 60,450     $ 51,652    
Gross profit:
                 
Mattress Fabrics
  $ 5,104     $ 4,596    
Upholstery Fabrics
    3,407       3,643    
    $ 8,511     $ 8,239    
Selling, general, and administrative expenses:
                 
Mattress Fabrics
  $ 1,970     $ 1,780    
Upholstery Fabrics
    2,653       2,517    
Total segment selling, general, and administrative expenses
    4,623       4,297    
Unallocated corporate expenses
    895       832    
    $ 5,518     $ 5,129    
Income from operations:
                 
Mattress Fabrics
  $ 3,134     $ 2,816    
Upholstery Fabrics
    754       1,126    
Total segment income from operations
    3,888       3,942    
Unallocated corporate expenses
    (895 )     (832 )  
Restructuring expense
    -       (7 ) (1)
Total income from operations
    2,993       3,103    
Interest expense
    (181     (224 )  
Interest income     148       57    
Other expense     (83     (28 )  
Income before income taxes
  $ 2,877     $ 2,908    
 
(1)
The $7 restructuring charge represents $17 for lease termination and other exit costs offset by a credit of $10 for sales proceeds received on equipment with no carrying value. This restructuring charge relates to the Upholstery Fabrics segment.
 
   
Nine months ended
(dollars in thousands)
  January 29, 2012   January 30, 2011
Net sales:
               
Mattress Fabrics
  $ 102,130       $ 87,244    
Upholstery Fabrics
    76,603         69,199    
    $ 178,733       $ 156,443    
Gross profit:
                   
Mattress Fabrics
  $ 16,180       $ 15,616    
Upholstery Fabrics
    9,932         9,941    
Total segment gross profit
  $ 26,112       $ 25,557    
Other non-recurring charges
   
(77
) (2)    
-
   
    $
26,035
      $
25,557
   
Selling, general, and administrative expenses:
                   
Mattress Fabrics
  $ 6,094       $ 5,480    
Upholstery Fabrics
    8,186         6,394    
Total segment selling, general, and administrative expenses
    14,280         11,874    
Unallocated corporate expenses
    2,715         2,670    
    $ 16,995       $ 14,544    
Income from operations:
                   
Mattress Fabrics
  $ 10,087       $ 10,136    
Upholstery Fabrics
    1,745         3,547    
Total segment income from operations
    11,832         13,683    
Unallocated corporate expenses
    (2,715 )       (2,670 )  
Other non-recurring charges
    (77 (2)     -    
Total income from operations
    9,040         11,013    
Interest expense
    (590       (659 )  
Interest income     387         144    
Other expense     (132       (111 )  
Income before income taxes
  $ 8,705       $ 10,387    
 
(2)
The $77 other non-recurring charge represents employee termination benefits associated with our Anderson, SC plant facility. This non-recurring charge relates to the Upholstery Fabrics segment.
 
 
I-16

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Balance sheet information for the company’s operating segments follow:
 
(dollars in thousands)
 
January 29, 2012
 
May 1, 2011
Segment assets:
           
Mattress Fabrics
           
Current assets (3)
  $ 28,638     $ 25,456  
Assets held for sale
    14       14  
Non-compete agreements, net
    369       480  
Goodwill
    11,462       11,462  
Property, plant and equipment (4)
    28,210       28,581  
Total mattress fabrics assets
    68,693       65,993  
Upholstery Fabrics
               
Current assets (3)
    26,284       23,476  
Assets held for sale
    31       61  
Property, plant and equipment (5)
    1,246       967  
Total upholstery fabrics assets
    27,561       24,504  
Total segment assets
    96,254       90,497  
Non-segment assets:
               
Cash and cash equivalents
    15,096       23,181  
Short-term investments
    8,511       7,699  
Income taxes receivable
    -       79  
Deferred income taxes
    6,670       3,899  
Other current assets
    2,522       2,376  
Property, plant and equipment (6)
    829       748  
Other assets
    1,575       1,572  
Total assets
  $ 131,457     $ 130,051  
 
    Nine months ended
(dollars in thousands)
  January 29, 2012   January 30, 2011
Capital expenditures (7):
           
Mattress Fabrics
  $ 2,761     $ 5,040  
Upholstery Fabrics
    481       170  
Unallocated Corporate
    351       193  
Total capital expenditures
  $ 3,593     $ 5,403  
Depreciation expense:
               
Mattress Fabrics
  $ 3,163     $ 2,795  
Upholstery Fabrics
    437       410  
Total depreciation expense
  $ 3,600     $ 3,205  
 
 
I-17

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
(3)  
Current assets represent accounts receivable and inventory for the respective segment.

(4)  
The $28.2 million at January 29, 2012, represents property, plant, and equipment of $19.8 million and $8.4 million located in the U.S. and Canada, respectively. The $28.6 million at May 1, 2011, represents property, plant, and equipment of $20.0 million and $8.6 million located in the U.S. and Canada, respectively.

(5)  
The $1.2 million at January 29, 2012, represents property, plant, and equipment located in the U.S. of $957, located in China of $179, and located in Poland of $110. The $967 at May 1, 2011, represents property, plant, and equipment located in the U.S. of $727, located in China of $184, and located in Poland of $56.

(6)  
The $829 and $748 at January 29, 2012 and May 1, 2011, respectively, represent property, plant, and equipment associated with unallocated corporate departments and corporate departments shared by both the mattress and upholstery fabric segments. Property, plant, and equipment associated with corporate are located in the U.S.

(7)  
Capital expenditure amounts are stated on the accrual basis. See Consolidated Statement of Cash Flows for capital expenditure amounts on a cash basis.

15.  Income Taxes

Effective Income Tax Rate

We recorded an income tax benefit of $1.2 million, or (13.4)% of income before income tax expense, for the nine month period ended January 29, 2012, compared to income tax expense of $213,000, or 2.1% of income before income tax expense, for the nine month period ended January 30, 2011. Our effective income tax rates for the nine month periods ended January 29, 2012, and January 30, 2011, were based upon the estimated effective income tax rate applicable for the full year after giving effect to any significant items related specifically to interim periods. The effective income tax rate can be affected over the fiscal year by the mix and timing of actual earnings from our U.S. operations and foreign sources versus annual projections and changes in foreign currencies in relation to the U.S. dollar.
 
 
I-18

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
The effective income tax rate of (13.4)% for the nine month period ended January 29, 2012 is different from the amount obtained by applying our statutory rate of 34% to income before income taxes for the following reasons:

  
The effective income tax rate was reduced by 50% for a reduction in our valuation allowance associated with our U.S. net deferred income tax assets. This 50% reduction in our effective income tax rate is due to a change in judgment about the realization of our U.S. net deferred income tax assets in future years. Since the realization of our U.S. net deferred income tax assets is a result of a change in judgment about future years, we recorded an income tax benefit of $4.4 million that represents a discrete event in which the full tax effects were recorded for the nine month period ending January 29, 2012.

  
The effective income tax rate was reduced by 7% for taxable income subject to lower statutory income tax rates in foreign jurisdictions (Canada and China) compared with the statutory income tax rate of 34% for the United States.

  
The effective income tax rate was increased 7% for an increase in unrecognized tax benefits.

  
The effective income tax rate was increased by 2.6% for stock-based compensation and other miscellaneous items.

The effective income tax rate of 2.1% for the nine month period ended January 30, 2011 is different from the amount obtained by applying our statutory rate of 34% to income before income taxes for the following reasons:

  
The effective income tax rate was reduced by 31% for a reduction in our valuation allowance recorded against our net deferred income tax assets. Of this 31% reduction in our effective income tax rate, 19% and 12% pertain to our operations located in the U.S. and China, respectively. The 19% reduction in our effective income tax rate from our U.S. operations is due to the realization of our U.S. net deferred income tax assets from ordinary taxable income projected for fiscal 2011. Since the realization of our U.S. net deferred income tax assets were from ordinary taxable income in the current fiscal year, its tax effects are included in the computation of the annual effective tax rate for fiscal 2011. The 12% reduction in our effective income tax rate from our China operations is due to a change in judgment about the realization of our China net deferred income tax assets in future years. Since the realization of our China net deferred income tax assets is a result of a change in judgment about future years, we recorded an income tax benefit of $1.3 million that represents a discrete event in which the full tax effects were recorded for the nine month period ended January 30, 2011.

  
The income tax rate was reduced by 7% for taxable income subject to lower statutory income tax rates in foreign jurisdictions (Canada and China) compared with the statutory income tax rate of 34% for the United States.

  
The income tax rate was reduced by 3% for adjustments made to our Canadian deferred income tax liabilities and associated with our election to file our Canadian income tax returns in U.S. dollars commencing with our fiscal 2011 tax year. Our Canadian income tax returns were filed in Canadian dollars for fiscal years prior to fiscal 2011. This adjustment totaled $315,000 and represented a discrete event in which the full tax effects were recorded during the nine-month period ended January 30, 2011.
 
 
I-19

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
  
The income tax rate increased 9% for an increase in unrecognized tax benefits. This 9% increase in the income tax rate also includes an income tax benefit of $107,000 or a reduction in the income tax rate of 1% for the subsequent recognition of unrecognized tax benefits. This adjustment of $107,000 represents a discrete event in which the full tax effects were recorded during the nine month period ended January 30, 2011.

  
The income tax rate was increased by 0.1% for stock-based compensation and other miscellaneous items.

Deferred Income Taxes
 
Summary
 
In accordance with ASC Topic 740, we evaluate our deferred income taxes to determine if a valuation allowance is required. ASC Topic 740 requires that companies assess whether a valuation allowance should be established based on the consideration of all available evidence using a “more likely than not” standard, with significant weight being given to evidence that can be objectively verified. Since the company operates in multiple jurisdictions, we assess the need for a valuation allowance on a jurisdiction-by-jurisdiction basis, taking into account the effects of local tax law. Based on our assessments, we recorded a partial valuation allowance of $12.1 million and $16.4 million against our net deferred income tax assets associated with our U.S. operations at January 29, 2012, and May 1, 2011, respectively. No valuation allowance has been recorded against our net deferred income tax assets associated with our operations located in China, Canada, and Europe.
 
United States
 
Our net deferred income tax asset regarding our U.S. operations primarily pertains to incurring significant U.S. pre-tax losses over prior fiscal years, with U.S. loss carryforwards totaling $60.0 million at May 1, 2011. Due to the favorable results of our multi-year restructuring process in our upholstery fabric operations and key acquisitions and capital investments made for our mattress fabric segment, on a cumulative three-year basis ending May 1, 2011 (the end of our fiscal 2011), our U.S. operations earned a pre-tax income of $4.2 million. In addition, our U.S. operations reported a pre-tax income over fiscal years 2011 and 2010 totaling $8.2 million. We believe that fiscal years 2011 and 2010 are a more indicative measure of future pre-tax income as these fiscal years reflect operating performance after the cost savings of recent profit-improvement and restructuring plans were realized, as well as the full operational effects of the acquisitions associated with the company’s mattress fabric operations located in the U.S.
 
This improvement continued through the second quarter of fiscal 2012, as our U.S. operations earned a cumulative pretax income through the second quarter of fiscal 2012 and fiscal years 2011 and 2010 totaling $10.0 million. This continued earnings improvement from our U.S. operations was driven by our mattress fabric operations (which primarily resides in the U.S.). During the second quarter of fiscal 2012, our mattress fabric operations had net sales totaling $35.2 million compared with $28.3 million in the second quarter of fiscal 2011. In addition, our mattress fabric operations had operating income totaling $3.8 million in the second quarter of fiscal 2012 compared with $3.3 million in the second quarter of fiscal 2011. These improved results in the second quarter of fiscal 2012, which were better than expected, can be attributed to increased sales from our sales and marketing initiatives and new programs with customers who are leading suppliers in the bedding industry.  Collectively, these developments increased our confidence in forecasting U.S. taxable income through fiscal 2014 in the second quarter of fiscal 2012. Based on the continuation of these trends in the third quarter of fiscal 2012, we maintain our position that we can forecast U.S. taxable income through 2014. During the third quarter of fiscal 2012, our mattress fabric operations had net sales totaling $34.7 million compared with $28.0 million in the third quarter of fiscal 2011. In addition, our mattress fabric operations had operating income totaling $3.1 million in the third quarter of fiscal 2012 compared with $2.8 million in the third quarter of fiscal 2011.
 
 
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Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Although our U.S. operations have reported pre-tax income on a cumulative three-year basis, the significant uncertainty in the overall economic climate, has made it very difficult to forecast medium and long-term financial results associated with our U.S. operations. Since it will take a significant period of time for our U.S. operations to realize its U.S. net deferred income tax assets based on earned and forecasted U.S. pre-tax income levels, we believe it is too uncertain to project U.S. pre-tax income levels associated with our U.S. operations after fiscal 2014 that support a “more likely than not” assertion at the end of our third quarter of fiscal 2012.
 
Based on the positive and negative evidence noted above, we recorded a partial valuation allowance of $12.1 million at January 29, 2012, against the net deferred income tax assets associated with our U.S. operations that are expected to reverse beyond fiscal 2014 and we recognized an income tax benefit of $4.4 million in the second quarter of fiscal 2012 for the reduction in this valuation allowance for projected U.S. taxable income in fiscal years 2013 and 2014 to reduce our U.S. loss carryforwards.
 
Overall
 
The recorded valuation allowance of $12.1 million has no effect on our operations, loan covenant compliance, or the possible realization of the U.S. income tax loss carryforwards in the future. If it is determined that it is “more likely than not” that we will realize any of these U.S. income tax loss carryforwards, an income tax benefit would be recognized at that time.
 
At January 29, 2012, the current deferred income tax asset of $2.8 million represents $2.5 million and $256,000 from our operations located in the U.S. and China, respectively. At May 1, 2011, the current deferred income tax asset of $293,000 pertains to our operations located in China. At May 1, 2011, the current deferred income tax liability of $82,000 pertains to our operations located in Canada. At January 29, 2012, the non-current deferred income tax asset of $3.9 million represents $2.8 million and $1.1 million from our operations located in the U.S. and China, respectively. At May 1, 2011, the non-current deferred income tax asset of $3.6 million represents $2.3 million and $1.3 million from our operations located in the U.S. and China, respectively. At January 29, 2012 and May 1, 2011, the non-current deferred income tax liability of $659,000 and $596,000 pertains to our operations located in Canada.

Uncertainty In Income Taxes

At January 29, 2012, we had $12.3 million of total gross unrecognized tax benefits, of which $4.0 million represents the amount of gross unrecognized tax benefits that, if recognized would favorably affect the income tax rate in future periods. Of the $12.3 million in gross unrecognized tax benefits as of January 29, 2012, $8.3 million were classified as net non-current deferred income taxes and $4.0 million were classified as income taxes payable –long-term in the accompanying consolidated balance sheets.
 
 
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Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
At May 1, 2011, we had $11.7 million of total gross unrecognized tax benefits, of which $4.2 million would favorably affect the income tax rate in future periods. Of the $11.7 million in total gross unrecognized tax benefits as of May 1, 2011, $7.5 million were classified as net non-current deferred income taxes and $4.2 million were classified as income taxes payable – long-term in the accompanying consolidated balance sheets.

We estimate that the amount of gross unrecognized tax benefits will increase by approximately $1.0 million for fiscal 2012. This increase primarily relates to double taxation under applicable tax treaties with foreign tax jurisdictions.

16.  Statutory Reserves
 
Our subsidiaries located in China are required to transfer 10% of their net income, as determined in accordance with the People’s Republic of China (PRC) accounting rules and regulations, to a statutory surplus reserve fund until such reserve balance reaches 50% of the company’s registered capital.
 
The transfer to this reserve must be made before distributions of any dividend to shareholders. As of January 29, 2012, the company’s statutory surplus reserve was $2.9 million, representing 10% of accumulated earnings and profits determined in accordance with PRC accounting rules and regulations. The surplus reserve fund is non-distributable other than during liquidation and can be used to fund previous years’ losses, if any, and may be utilized for business expansion or converted into share capital by issuing new shares to existing shareholders in proportion to their shareholding or by increasing the par value of the shares currently held by them provided that the remaining reserve balance after such issue is not less than 25% of the registered capital.
 
Our subsidiaries located in China can transfer funds to the parent company with the exception of the statutory surplus reserve of $2.9 million to assist with debt repayment, capital expenditures, and other expenses of the company’s business.

17.  Commitments and Contingencies
 
Chromatex Environmental Claim
 
A lawsuit was filed against us and other defendants (Chromatex, Inc., Rossville Industries, Inc., Rossville Companies, Inc. and Rossville Investments, Inc.) on February 5, 2008 in United States District Court for the Middle District of Pennsylvania. The plaintiffs are Alan Shulman, Stanley Siegel, Ruth Cherenson as Personal Representative of Estate of Alan Cherenson, and Adrienne Rolla and M.F. Rolla as Executors of the Estate of Joseph Byrnes. The plaintiffs were partners in a general partnership that formerly owned a manufacturing plant in West Hazleton, Pennsylvania (the “Site”). Approximately two years after this general partnership sold the Site to defendants Chromatex, Inc. and Rossville Industries, Inc., we leased and operated the Site as part of our Rossville/Chromatex division. The lawsuit involves court judgments that have been entered against the plaintiffs and against defendant Chromatex, Inc. requiring them to pay costs incurred by the United States Environmental Protection Agency (“USEPA”) responding to environmental contamination at the Site, in amounts approximating  $8.6 million, plus unspecified future environmental costs. Neither USEPA nor any other governmental authority has asserted any claim against us on account of these matters. The plaintiffs seek contribution from us and other defendants and a declaration that the company and the other defendants are responsible for environmental response costs under environmental laws and certain agreements. The plaintiffs also assert that we tortiously interfered with contracts between them and other defendants in the case and diverted assets to prevent the plaintiffs from being paid monies owed to them. We do not believe we have any liability for the matters described in this litigation and intend to defend ourselves vigorously. In addition, we have an indemnification agreement with certain other defendants in the litigation pursuant to which the other defendants agreed to indemnify us for any damages we incur as a result of the environmental matters that are the subject of this litigation, although it is unclear whether the indemnitors have significant assets at this time. Since the loss is not probable and cannot be estimated, no reserve has been recorded.
 
 
I-22

 
 
Culp, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
Other Litigation
 
The company is involved in legal proceedings and claims which have arisen in the ordinary course of business. These actions, when ultimately concluded and settled, will not, in the opinion of management, have a material adverse effect upon the financial position, results of operations or cash flows of the company.
 
Purchase Commitments
 
At January 29, 2012, and May 1, 2011, we had open purchase commitments to acquire equipment for our mattress fabrics segment totaling $1.4 million and $980,000, respectively.

18.   Common Stock Repurchase Program

On June 16, 2011, our board of directors authorized the expenditure of up to $5.0 million for the repurchase of shares of our common stock. Under the common stock repurchase program, shares may be purchased from time to time in open market transactions, block trades, and through plans established under Securities Exchange Act Rule 10b5-1. The amount of shares purchased and the timing of such purchases will be based on working capital requirements, market and general business conditions and other factors including alternative investment opportunities. On August 29, 2011, our board of directors authorized the expenditure of an additional $2.0 million, for a total authorization of $7.0 million, for the repurchase of shares of our common stock.

We purchased 624,459 shares of our common stock at a cost of $5.4 million for the nine-month period ending January 29, 2012.
 
 
I-23

 
 
 
This report and the exhibits attached hereto contain “forward-looking statements” within the meaning of the federal securities laws, including the Private Securities Litigation Reform Act of 1995 (Section 27A of the Securities Act of 1933 and Section 27A of the Securities and Exchange Act of 1934).  Such statements are inherently subject to risks and uncertainties.  Further, forward looking statements are intended to speak only as of the date on which they are made, and we disclaim any duty to update such statements.  Forward-looking statements are statements that include projections, expectations or beliefs about future events or results or otherwise are not statements of historical fact.  Such statements are often but not always characterized by qualifying words such as “expect,” “believe,” “estimate,” “plan” and “project” and their derivatives, and include but are not limited to statements about expectations for our future operations, production levels, sales, gross profit margins, operating income, SG&A or other expenses, earnings, and other performance or liquidity measures, as well as any statements regarding future economic or industry trends or future developments. Factors that could influence the matters discussed in such statements include the level of housing starts and sales of existing homes, consumer confidence, trends in disposable income, and general economic conditions.  Decreases in these economic indicators could have a negative effect on our business and prospects.  Likewise, increases in interest rates, particularly home mortgage rates, and increases in consumer debt or the general rate of inflation, could affect us adversely. Changes in consumer tastes or preferences toward products not produced by us could erode demand for our products. Changes in the value of the U.S. dollar versus other currencies could affect our financial results because a significant portion of our operations are located outside the United States. Strengthening of the U.S. dollar against other currencies could make our products less competitive on the basis of price in markets outside the United States, and strengthening of currencies in Canada, China, and Europe can have a negative impact on our sales of products produced in those places. Also, economic and political instability in international areas could affect our operations or sources of goods in those areas, as well as demand for our products in international markets. Further information about these factors, as well as other factors that could affect our future operations or financial results and the matters discussed in forward-looking statements are included in Item 1A “Risk Factors” section in our Form 10-K filed with the Securities and Exchange Commission on July 15, 2011 for the fiscal year ended May 1, 2011.

 
I-24

 
 

Results of Operations

The following analysis of financial condition and results of operations should be read in conjunction with the Financial Statements and Notes and other exhibits included elsewhere in this report.

General

Our fiscal year is the 52 or 53 week period ending on the Sunday closest to April 30. The nine months ended January 29, 2012, and January 30, 2011, represent 39 week periods, respectively. Our operations are classified into two business segments: mattress fabrics and upholstery fabrics. The mattress fabrics segment manufactures, sources and sells fabrics to bedding manufacturers. The upholstery fabrics segment sources, manufactures and sells fabrics primarily to residential and commercial (contract) furniture manufacturers.

We evaluate the operating performance of our segments based upon income (loss) from operations before restructuring and related charges or credits, certain unallocated corporate expenses, and other non-recurring items. Cost of sales in both segments include costs to manufacture or source our products, including costs such as raw material and finished goods purchases, direct and indirect labor, overhead and incoming freight charges. Unallocated corporate expenses represent primarily compensation and benefits for certain executive officers and all costs related to being a public company.

Executive Summary

Net sales were $60.5 million for the third quarter of fiscal 2012, an increase of 17% compared with $51.7 million for the third quarter of fiscal 2011. Net sales were $178.7 million for the nine months ended January 29, 2012, an increase of 14% compared with $156.4 million for the nine months ended January 30, 2011.  Both of our business segments had sales gains, in spite of an uncertain global economic environment. In addition, our third quarter is typically a slower quarterly period due to the scheduled holiday plant shutdowns. We believe these trends reflect the success of our various sales and marketing initiatives along with the benefits of our design capabilities and global manufacturing platform.

Income before income taxes was $2.9 million in the third quarter of fiscal 2012 and the third quarter of fiscal 2011. Income before income taxes was $8.7 million for the nine months ended January 29, 2012, a decrease of 16% compared with $10.4 million for the nine months ended January 30, 2011. Despite the increase in net sales, income before income taxes declined primarily because of significant increases in our raw material costs in both business segments and higher selling, general, and administrative expenses (SG&A) primarily in the upholstery fabrics segment. To help offset the increased raw material costs, we have implemented customer price increases in both business segments. These price increases, however, are not expected to fully restore our reduced operating profit margins. While the increased raw material costs affected our operating margins for year to date fiscal 2012, we are encouraged that raw material prices have recently stabilized for both of our business segments.

We reported net income of $1.8 million, or $0.14 per diluted share in the third quarter of fiscal 2012 compared with net income of $2.4 million, or $0.18 per diluted share in the third quarter of fiscal 2011. Net income for the third quarter of fiscal 2012 includes income tax expense of $1.1 million and net income for the third quarter of fiscal 2011 includes income tax expense of $483,000. Net income was $9.9 million, or $0.76 per diluted share, for the nine months ended January 29, 2012, compared with $10.2 million, or $0.77 per diluted share, for the nine months ended January 30, 2011. Net income for the nine months ended January 29, 2012 includes an income tax benefit of $1.2 million and net income for the nine months ended January 30, 2011 includes income tax expense of $213,000. The income tax benefit of $1.2 million for the nine months ended January 29, 2012, includes a $4.4 million non-cash reversal during the second quarter of fiscal 2012 for a portion of the valuation allowance associated with our U.S. operations. The income tax expense of $213,000 for the nine months ended January 30, 2011 includes a $1.3 million non-cash reversal during the second quarter of fiscal 2011 for the entire valuation allowance associated with our China operations.

 
I-25

 
 
At January 29, 2012, our cash and cash equivalents and short-term investments totaled $23.6 million, exceeding our total debt (current maturities of long-term debt, long-term debt, and line of credit) of $10.1 million. We made our first $2.2 million scheduled principal payment on our long-term debt during the second quarter of fiscal 2012. Our next scheduled principal payment of $2.2 million is due in August 2012.

On January 17, 2012, we entered into an unsecured credit agreement associated with our operations in Poland that provides for a line of credit up to 6.8 million Polish Zloty (approximately $2.1 million USD at January 29, 2012). This agreement expires on January 15, 2013 and bears interest at the Warsaw Interbank Offered Rate (“WIBOR”) plus 2% (applicable interest rate of 6.89% at January 29, 2012). At January 29, 2012, $875,000 (2.8 million Polish Zloty) was outstanding under this agreement.  In connection with the unsecured credit agreement associated with our operations in Poland, we entered into an eighteenth amendment of our U.S. unsecured credit agreement to decrease our revolving loan commitment from $10.0 million to $7.6 million.

Our board of directors has authorized the expenditure of up to $7.0 million for the repurchase of shares of our common stock.  Under the common stock repurchase program, shares may be purchased from time to time in open market transactions, block trades, and through plans established under the Securities Exchange Act Rule 10b5-1. The amount of shares purchased and the timing of such purchases will be based on working capital requirements, market and general business conditions and other factors including alternative investment opportunities. Since the initial authorization of this program on June 16, 2011, we have repurchased 624,459 shares of our common stock at a cost of $5.4 million, through the third quarter of fiscal 2012.

Segment Analysis

The following tables set forth the company’s statement of operations by segment for the three and nine months ended January 29, 2012, and January 30, 2011.

 
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CULP, INC.
STATEMENTS OF OPERATIONS BY SEGMENT
           FOR THE THREE MONTHS ENDED JANUARY 29, 2012 AND JANUARY 30, 2011
        (Unaudited)
   
           (Amounts in thousands)
 
    THREE MONTHS ENDED
                                       
   
Amounts
             
Percent of Total Sales
   
January 29,
     
January 30,
       
% Over
 
January 29,
 
January 30,
Net Sales by Segment
 
2012
     
2011
       
(Under)
 
2012
 
2011
                                       
Mattress Fabrics
  $ 34,719         27,991           24.0   %     57.4  
%
    54.2   %
Upholstery Fabrics
    25,731         23,661           8.7   %     42.6  
%
    45.8   %
                                                 
     Net Sales
  $ 60,450         51,652           17.0   %     100.0  
%
    100.0   %
                                                 
                                                 
                                                 
                                                 
Gross Profit by Segment
                               
Gross Profit Margin
                                                 
Mattress Fabrics
  $ 5,104         4,596           11.1   %     14.7  
%
    16.4   %
Upholstery Fabrics
    3,407         3,643           (6.5 ) %     13.2  
%
    15.4   %
                                                 
    Gross Profit
    8,511         8,239           3.3   %     14.1  
%
    16.0   %