UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended February 26, 2005
or
For the transition period from to
Commission File Number 001-09225
H.B. FULLER COMPANY
(Exact name of Registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
(651) 236-5900
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). x
The number of shares outstanding of the Registrant’s Common Stock, par value $1.00 per share, was 28,799,443 as of March 31, 2005.
H.B. FULLER COMPANY AND SUBSIDIARIES
Consolidated Statement of Income
(In thousands, except per share amounts)
(Unaudited)
Net revenue
Cost of sales
Gross profit
Selling, general and administrative expenses
Gains from sales of property, plant and equipment
Other expense, net
Interest expense
Income before income taxes, minority interests, and income from equity investments
Income taxes
Minority interests in consolidated income
Income from equity investments
Net income
Basic income per common share
Diluted income per common share
Weighted-average common shares outstanding:
Basic
Diluted
Dividends declared per common share
See accompanying notes to consolidated financial statements.
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Consolidated Balance Sheet
(In thousands, except share and per share amounts)
November 27,
2004
Assets
Current assets:
Cash and cash equivalents
Trade receivables
Allowance for doubtful accounts
Inventories
Other current assets
Total current assets
Property, plant and equipment, net
Other assets
Goodwill
Other intangibles, net
Total assets
Liabilities and Stockholders’ Equity
Current liabilities:
Notes payable
Current installments of long-term debt
Trade payables
Accrued payroll and employee benefits
Other accrued expenses
Income taxes payable
Total current liabilities
Long-term debt, excluding current installments
Accrued pensions
Other liabilities
Minority interests in consolidated subsidiaries
Total liabilities
Commitments and contingencies
Stockholders’ equity:
Preferred stock (no shares outstanding) Shares authorized – 10,045,900
Common stock, par value $1.00 per share, Shares authorized – 80,000,000, Shares issued and outstanding – 28,787,157 and 28,641,037, respectively
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income
Unearned compensation - restricted stock
Total stockholders’ equity
Total liabilities and stockholders’ equity
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Consolidated Statement of Cash Flows
(In thousands)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation and amortization
Deferred income taxes
Change in assets and liabilities:
Accounts receivables, net
Accounts payables
Accrued payroll / employee benefits
Restructuring liability
Other
Net cash used in operating activities
Cash flows from investing activities:
Purchased property, plant and equipment
Purchased investment
Proceeds from sale of investment
Proceeds from sale of property, plant and equipment
Net cash provided by (used in) investing activities
Cash flows from financing activities:
Repayment of long-term debt
Net (payments) proceeds (on) from notes payable
Dividends paid
Net cash (used in) provided by financing activities
Effect of exchange rate changes
Net change in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental disclosure of cash flow information:
Cash paid for interest
Cash paid for income taxes
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Notes to Consolidated Financial Statements
(Amounts in thousands, except share and per share amounts)
The company has made certain reclassifications to the fiscal 2004 consolidated financial statements, as previously reported, to conform to current classification. These reclassifications did not change net income or stockholders’ equity as previously reported.
Net income, as reported
Add back: Stock-based compensation expense recorded, net of related tax effects
Net income excluding stock-based compensation
Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects
Pro forma net income
Basic income per share:
As reported
Pro forma
Diluted income per share:
Compensation expense for pro forma purposes is reflected on a straight-line basis over the vesting period.
Weighted-average common shares – basic
Equivalent shares – stock-based compensation plans
Weighted-average common shares – diluted
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The computations of diluted income per common share do not include stock options with exercise prices greater than the average market price of the common shares of 23,675 and 2,755 for the three-month periods ended February 26, 2005 and February 28, 2004, respectively, as the results would have been anti-dilutive.
Other comprehensive income
Foreign currency translation, net
Total comprehensive income
Components of accumulated other comprehensive income follows:
Accumulated Other Comprehensive Income
Foreign currency translation adjustment
Minimum pension liability
Total accumulated other comprehensive income
Raw materials
Finished goods
LIFO reserve
Total liabilities at November 27, 2004
Currency change effect
Cash payments
Total liabilities at February 26, 2005
Long-term portion of liabilities
Current liabilities at February 26, 2005
The long-term portion of the restructuring liability relates to adverse lease commitments that are expected to be paid beyond one year. The largest cash payment made in 2005 related to $1,884 of lease termination costs for one facility. In the first quarter of 2005, a gain of $1,692 was recognized from the sale of one facility closed as part of the restructuring plan.
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As of February 26, 2005, the company had forward foreign currency contracts maturing between March 7, 2005 and December 15, 2005. The mark-to-market effect associated with these contracts was net losses of $730 at February 26, 2005.
Trade
Revenue
Inter-
Segment
Operating
Income
Global Adhesives
Full-Valu/Specialty
Total
Reconciliation of Operating Income to Income before Income Taxes, Minority Interests and Income from Equity Investments:
Operating income
Income before income taxes, minority interests and income from equity investments
Environmental: The company is party to various lawsuits and governmental proceedings. In particular, the company is currently deemed a potentially responsible party (PRP) or defendant, generally in conjunction with numerous other parties, in a number of government enforcement and private actions associated with hazardous waste sites. As a PRP or defendant, the company may be required to pay a share of the costs of investigation and cleanup of these sites. In addition, the company is currently investigating soil contamination at its Sorocaba, Brazil facility. The company is working with Brazilian regulatory authorities to determine the necessary scope of remediation at the facility. As of February 26, 2005, $1,034 was recorded as a liability for expected investigation and remediation expenses for this site. Once the scope of any necessary remediation is determined, the company may be required to record additional liabilities related to investigation and remediation costs at the Sorocaba facility.
As of February 26, 2005, the company had recorded $2,729 as its best probable estimates of aggregate liability of costs of environmental investigation and remediation, inclusive of the accrual related to Brazil above. These estimates are based primarily upon internal or third party environmental studies, assessments as to the company’s responsibility, the extent of the contamination and the nature of required remedial actions. The company’s current assessment of the probable liabilities and associated expenses related to environmental matters is based on the facts and circumstances known at this time. Recorded liabilities are adjusted as further information develops or circumstances change. Based upon currently available information, management does not believe the effect, in aggregate, of all such lawsuits, proceedings and investigations will have a material adverse impact on the company’s financial condition, results of operations or cash flows. However, adverse developments could negatively impact earnings or cash flows in a particular future period.
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Product Liability: As a participant in the chemical and construction products industries, the company faces an inherent risk of exposure to claims in the event that the failure, use or misuse of its products results in, or is alleged to result in property damage and/or bodily injury. From time to time and in the ordinary course of business, the company is a party to, or a target of, lawsuits, claims, investigations and proceedings, including product liability, contract, patent and intellectual property, antitrust and employment matters.
A subsidiary of the company is a defendant or co-defendant in numerous exterior insulated finish systems (“EIFS”) related lawsuits. As of February 26, 2005, the company’s subsidiary was a defendant or co-defendant in approximately 82 lawsuits and 7 claims related primarily to single-family homes. The EIFS product was used primarily in the residential construction market in the southeastern United States. Claims and lawsuits related to this product seek monetary relief for water intrusion related property damages. One of the lawsuits is a class action lawsuit purportedly involving 186 members, and some of the lawsuits involve EIFS in commercial or multi-family structures. As of February 26, 2005, the company had recorded $3,607 for the probable liabilities and $1,287 for insurance recoveries for all such matters. The company has insurance coverage for certain years with respect to this product. The company continually reevaluates these amounts. Management does not believe that the ultimate outcome of any pending legal proceedings and claims related to this product line, individually or in aggregate, will have a material adverse effect on its financial condition, results of operations or cash flows. However, projecting future events, such as the number of new claims to be filed each year, the average cost of disposing of each such claim, as well as the numerous uncertainties surrounding litigation in the United States, could cause the actual costs to be higher or lower than the current estimated reserves or insurance recoveries.
From time to time, the company or its subsidiaries are named in asbestos-related lawsuits in various state courts involving alleged exposure to products manufactured 20 to 30 years ago. These lawsuits frequently seek both actual and punitive damages, often in very large amounts. In many cases, plaintiffs are unable to demonstrate that they have suffered any compensable loss as a result of such exposure, or they are unable to demonstrate that injuries incurred in fact resulted from exposure to products manufactured by the company or its subsidiaries. In such cases, the company is generally dismissed without payment. With respect to those cases where compensable disease, exposure and causation are established with respect to one of the company’s products, the company generally settles for amounts that reflect the confirmed disease, the seriousness of the case, the particular jurisdiction and the number and solvency of other parties in the case. Prior to 2003, insurance and/or indemnification from solvent third parties paid substantially all of the indemnity and defense costs associated with most of the asbestos litigation applicable to the company.
During 2003, the company’s insurers replaced the cost sharing agreement that had previously provided for the allocation of settlement payments among the insurers with an interim allocation formula. Under this formula the company has funded amounts allocable to years in which the responsible insurer is insolvent. As previously reported and accounted for during the third quarter of 2004, the company and a group of other defendants entered into negotiations with a group of plaintiffs to settle a number of asbestos related lawsuits. Subject to finalization of certain terms and conditions of settlement, the company has agreed to contribute $3,520 towards the settlement amount to be paid to the plaintiffs in exchange for a full release of claims by the plaintiffs. Of this amount, the company’s insurers have agreed to pay approximately $1,211. During the first quarter of 2005, the company settled one asbestos-related lawsuit for an amount of $40. To the extent the company can reasonably estimate the amount of its probable liability for asbestos-related claims, the company establishes a financial reserve and a corresponding amount for insurance coverage.
In addition to product liability claims discussed above, the company and its subsidiaries are involved in claims or legal proceedings related to its products, which it believes are not out of the ordinary in a business of the type and size in which it is engaged.
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With respect to EIFS and asbestos claims, as well as all other litigation, the company cannot always definitively estimate its potential liabilities. While the company is unable to predict the outcome of these matters, it does not believe, based upon currently available facts, that the ultimate resolution of any pending matter, including the EIFS and asbestos litigation described above, will have a material adverse effect on its financial condition, results of operations or cash flows. However, adverse developments could negatively impact earnings or cash flows in a particular future period.
Guarantees: In July 2000, the Board of Directors adopted the Executive Stock Purchase Loan Program, designed to facilitate immediate and significant stock ownership by executives, especially new management employees. During certain designated periods between September 2000 and August 2001, eligible employees were allowed to purchase shares of company common stock in the open market. Under the program, the company arranged for a bank to provide full-recourse, personal loans to eligible employees electing to participate in the program. The loans bear interest at the Applicable Federal Rate and mature in five years, with principal and interest due at that time. The loans are guaranteed by the company only in the event of the participant’s default. The aggregate amount outstanding was $7,396 and $7,388 at February 26, 2005 and November 27, 2004, respectively.
In May 2004, the FASB issued FASB Staff Position No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP No. 106-2”). FSP No. 106-2, which replaced the same titled FSP No. 106-1, provides guidance on the accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“Act”) that was signed into law in December 2003. Under FSP No. 106-1, the company elected to defer the accounting for the effects of the Act. The company adopted FSP No. 106-2 in the third quarter of 2004 using the prospective method, which means the reduction of the Accumulated Other Postretirement Benefits obligation (APBO) is recognized over future periods. This reduction in the APBO is due to a subsidy available on benefits provided to plan participants determined to be actuarially equivalent to the Act. Based on the current guidance of determining actuarial equivalence, the company has only been able to determine that some of the plan participants qualify the company for the subsidy. As required by FSP No. 106-2, the company’s actuaries, performed a remeasurement on the plan on February 29, 2004, which used a revised discount rate, and determined that after taking the subsidy into consideration on these participants, there is a reduction in the APBO of approximately $3,049. It is possible that after additional guidance on determining actuarial equivalence is issued, the company may be able to recognize an additional reduction to the APBO due to additional plan participants qualifying the company for the subsidy.
In November 2004 the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing”, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and spoilage. This statement requires that those items be recognized as current period charges regardless of whether they meet the criterion of “so abnormal” which was the criterion specified in ARB No. 43. In addition, this Statement requires that allocation of fixed production overheads to the cost of production be based on normal capacity of the production facilities. This pronouncement is effective for the company beginning December 4, 2005. The company is in the process of evaluating whether the adoption of SFAS 151 will have a significant impact on the company’s overall results of operations, financial position or cash flows, however, it is unlikely the impact will be material.
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In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.” The amendments made by Statement 153 are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. Further, the amendments eliminate the narrow exception for nonmonetary exchanges of similar productive assets and replace it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. The Statement is effective for the company relative to nonmonetary asset exchanges beginning December 4, 2005. The provisions of this Statement shall be applied prospectively.
In December 2004, the FASB issued SFAS No. 123(R) “Share-Based Payment.” SFAS 123(R) requires the recognition of compensation cost relating to share-based payment transactions in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued as of the grant date, based on the estimated number of awards that are expected to vest. SFAS 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Statement 123(R) replaces FASB Statement No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Statement 123(R) is effective for the company beginning August 28, 2005. The company is in the process of evaluating the impact of SFAS 123(R) on its financial condition, results of operations and cash flows. Refer to pro forma disclosure under “Accounting for Stock-Based Compensation” in Note 2 above for indication of ongoing expense that will be included in the income statement beginning in the fourth quarter of 2005.
In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004”, which provides guidance under SFAS No. 109, “Accounting for Income Taxes,” with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the Jobs Act) on enterprises’ income tax expense and deferred tax liability. The Jobs Act was enacted on October 22, 2004. The Jobs Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by providing an 85% dividends received deduction for certain dividends from controlled foreign corporations. FSP No. 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS No. 109. As a result of this Act, the company has the opportunity to repatriate approximately $24,000 of cash in 2005 that has been generated over time by its foreign operations, resulting in an estimated increase in the company’s tax provision in 2005 of approximately $1,000. The company has identified this amount as being distributable and as being financially beneficial given the company’s tax position. At present, management has not drawn any conclusion regarding this opportunity to the company’s overall strategy. Management expects to complete the evaluation of the opportunity by May 28, 2005.
The company determined that Autotek met the definition of a variable interest entity under FIN 46R and that the company’s automotive joint venture is the primary beneficiary.
The investment was accounted for under the equity method through the second quarter of fiscal year 2004. Beginning May 30, 2004, the operating results were reflected broadly across the statement of consolidated income with minority interest representing the portion of the operating results applicable to the minority interest holders. Had the company consolidated Autotek results of operations beginning November 30, 2003, the company’s pro forma unaudited net revenue would have been reported as $319,439 for the three months ended February 28, 2004. As the company had previously accounted for its investment under the equity method, no adjustments were made to the company’s net income or earnings per share for the period presented.
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Net income per share:
PostretirementBenefits
Net periodic cost (benefit):
Service cost
Interest cost
Expected return on assets
Amortization:
Prior service cost
Actuarial (gain)/ loss
Transition amount
Net periodic benefit cost (benefit)
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
Raw material costs continued to increase during the first quarter of 2005. Tight supply was the predominant reason for the increasing prices as global demand continued to grow. Higher energy prices also contributed to the company’s increased raw material costs. Passing these cost increases on to the customer can be challenging, but in the first quarter of 2005 the company was able to achieve a 4.4 percent average selling price increase as compared to the first quarter of 2004. As the increase in raw material costs is not expected to slow down in the near term, raising selling prices will continue to be a critical factor in the 2005 financial performance.
Net income increased more than 40 percent as compared to the first quarter of 2004. Earnings per diluted share increased from $0.16 in the first quarter of 2004 to $0.22 in the first quarter of 2005. The following items were included in the first quarter 2005 income statement on a pre-tax basis:
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Another item to consider when comparing the operating results of the first quarter of 2005 to the first quarter of 2004 was $1.8 million of costs associated with the closure of a manufacturing facility and other capacity-reduction costs in the Full-Valu/Specialty operating segment recorded in the first quarter of 2004.
In looking forward to the remainder of 2005, the overriding issue will be maintaining and restoring the gross profit margin in an environment of rapidly rising raw material costs.
Results of Operations
Net Revenue: Net revenue in the first quarter of 2005 of $353.0 million increased $34.4 million or 10.8 percent from the 2004 first quarter net revenue of $318.6 million. Management reviews variances in net revenue in terms of changes related to product pricing, sales volume, acquisitions/divestitures and changes in foreign currency exchange rates. The following table shows the net revenue variance analysis for the first quarter of 2005 as compared to the first quarter of 2004:
1st Qtr 2005vs
1st Qtr 2004
Product Pricing
Sales Volume
Acquisitions
Currency
The net revenue increase of 4.4 percent attributed to increases in average selling prices reflected management’s continuing efforts to address the effects of rising raw material costs. The net revenue increase due to acquisitions of 2.7 percent resulted from the Probos acquisition in the second quarter of 2004. Beginning in the second quarter of 2005 net revenue from the Probos acquisition will be comparable on a year-over-year basis. The net revenue increase attributed to currency effects was primarily the result of a stronger euro in the first quarter of 2005 as compared to the first quarter of 2004. The average exchange rate of the euro in the first quarter of 2005 was $1.33 as compared to an average rate of $1.23 in the first quarter of 2004.
On an operating segment basis, net revenue increases in the first quarter of 2005 as compared to the first quarter of 2004 were 12.8 percent and 6.2 percent in Global Adhesives and Full-Valu/Specialty, respectively.
Cost of Sales: The cost of sales of $262.3 million in the first quarter of 2005 were $29.5 million or 12.7 percent higher than the first quarter of 2004 cost of sales of $232.8 million. Raw material cost increases were the most significant factor in the cost of sales increase in 2005 as compared to 2004. Although the prices of natural gas and crude oil were significantly higher in the first quarter of 2005 as compared to the first quarter of 2004, tight supply continued to be the primary driver of the company’s raw material cost increases. The effects from currency fluctuations increased the 2005 cost of sales by approximately $5 million as compared to last year. Other increases in cost of sales were realized as a result of increased sales volume, higher transportation costs and the Probos acquisition in 2004. The first quarter 2005 cost of sales included a gain of $1.0 million from an insurance settlement related to a fire at the company’s Austrian facility in 2004. Cost of sales reductions were realized in the first quarter of 2005 as part of the Lean Six SigmaSM initiative that was deployed in 2004. The cost of sales in the first quarter of 2004 included $1.5 million of expenses related to the closure of a manufacturing facility and other capacity reduction initiatives in the Full-Valu/Specialty operating segment.
As a percent of net revenue, the first quarter 2005 cost of sales were 74.3 percent as compared to 73.1 percent in the first quarter of 2004.
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Gross Profit Margin: The gross profit margin was 25.7 percent in the first quarter of 2005 as compared to 26.9 percent in the first quarter of 2004. The decrease in the gross profit margin resulted primarily from the rate of increase in the company’s cost of raw materials exceeding the rate in which selling prices were passed on to the customers.
Selling, General and Administrative (SG&A) Expenses: SG&A expenses of $80.3 million in the first quarter of 2005 were $4.9 million or 6.5 percent higher than the expenses in the first quarter of 2004. The effects of stronger foreign currencies versus the U.S. dollar added approximately $1.4 million to the SG&A expenses in the first quarter of 2005 as compared to the first quarter of 2004. SG&A expenses resulting from the 2004 Probos acquisition were $1.5 million in the first quarter of 2005. The 2005 expenses included $1.0 million related to the investigation of the company’s Chilean operations. The Chilean matter was discussed in detail in the company’s 2004 annual report filed on Form 10-K on February 25, 2005. Severance and other related costs associated with the departure of a number of managers and executives amounted to $1.1 million in the first quarter of 2005. SG&A expense decreases were realized in the quarter as a result of census reductions.
As a percent of net revenue, SG&A expenses were 22.8 percent in the first quarter of 2005 and 23.7 percent in the first quarter of 2004.
Gains from Sales of Property, Plant and Equipment: The first quarter of 2005 included gains from sales of property, plant and equipment of $1.8 million. The sale of one facility in Europe, that was closed as part of the company’s 2002 restructuring initiative, accounted for a gain of $1.7 million in the first quarter of 2005. This facility was reported in assets held for sale in the November 27, 2004 consolidated balance sheet. There were no significant gains or losses on sales of fixed assets in the first quarter of 2004.
Other Expense, Net: Other expense, net was $0.4 million in the first quarter of 2005 as compared to $1.0 million in the first quarter of 2004. The most significant component of other expense, net was foreign currency transaction and remeasurement gains and losses, which were losses of $0.3 million in the first quarter of 2005 and losses of $0.7 million in the first quarter of 2004.
Interest Expense:Interest expense of $3.3 million in the first quarter of 2005 was $0.2 million less than the interest expense in the first quarter of 2004. The repayment in the first quarter of 2005 of $22 million relating to the company’s 1994 private placement was the primary reason for the lower interest expense in the first quarter of 2005 as compared to the first quarter of 2004.
Income Taxes: The effective income tax rate was 32 percent in both the first quarter of 2005 and the first quarter of 2004.
Minority Interests (Expense)/Income: Minority interests was income of $0.2 million in the first quarter of 2005 and $0.1 million of income in the first quarter of 2004. These results were mainly from the company’s North American automotive joint venture, of which the company owns 70 percent.
Income from Equity Investments: Income from equity investments was $0.5 million in the first quarter of both 2005 and 2004. The source of this income is the company’s 30 percent ownership interest in an automotive joint venture with a European company.
Net Income: Net income of $6.5 million in the first quarter of 2005 was 41 percent more than the net income of $4.6 million in the first quarter of 2004. The income per diluted share was $0.22 in the first quarter of 2005 and $0.16 in the first quarter of 2004.
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Operating Segment Results
Note: Management evaluates the performance of its operating segments based on operating income which is defined as gross profit less SG&A expenses and excluding the gains/(losses) on sales of property, plant and equipment. Corporate expenses are fully allocated to the operating segments.
Global Adhesives: Net revenue in the Global Adhesives operating segment of $250.5 million in the first quarter of 2005 was 12.8 percent higher than the net revenue of $222.1 million in the first quarter of 2004. The following table shows the net revenue variance analysis:
The net revenue results reflected management’s focus on increasing selling prices in response to the escalating pace of raw material cost increases. The raw material cost increases did outpace the selling price increases and therefore, the gross profit margin in Global Adhesives decreased 1.4 percentage points as compared to the first quarter of 2004. SG&A expenses in the first quarter of 2005 were 9.7 percent higher than the first quarter of 2004. The Probos acquisition and currency effects accounted for 60 percent of that increase. Other increases related to costs associated with the departures of certain managers and executives as well as costs related to the investigation of the Chilean operations. The resulting operating income of $5.7 million was 18.7 percent less than the $7.0 million achieved in the first quarter of 2004. As a percent of net revenue, operating income in the Global Adhesives segment was 2.3 percent as compared to 3.1 percent in the first quarter of 2004.
Full-Valu/Specialty: Net revenue in the first quarter of 2005 for the Full-Valu/Specialty segment of $102.5 million was 6.2 percent above the net revenue recorded in the first quarter of 2004 of $96.5 million. The variance analysis is shown in the following table:
As with Global Adhesives, selling price increases continue to be a key area of focus. The window adhesives and ceramic tile installation product lines had particularly strong performance in the first quarter of 2005 in terms of net revenue increases as compared to the first quarter of 2004. The gross profit margin in Full-Valu/Specialty declined 0.3 percentage points in the first quarter of 2005 as compared to the same period last year. Raw material cost increases were the primary reason for the reduced gross profit margin. The gross profit margin in the first quarter of 2004 included a negative 1.5 percentage point impact resulting from $1.5 million of costs associated with the closure of a North American manufacturing facility. SG&A expenses in the first quarter of 2005 approximated last year’s level. Operating income of $4.7 million in the first quarter of 2005 was 38.8 percent above last year’s first quarter operating income of $3.4 million. As a percent of net revenue, operating income was 4.6 percent in the first quarter of 2005 and 3.5 percent in the first quarter of 2004.
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Restructuring and other Related Costs
The remaining liabilities accrued as part of the 2002 restructuring plan were $1.2 million and $3.1 million as of February 26, 2005 and November 27, 2004, respectively. Details of the activity for fiscal 2005 are as follows:
(in thousands)
The long-term portion of the restructuring liability relates to adverse lease commitments that are expected to be paid beyond one year. The largest cash payment made in 2005 related to $1.8 million of lease termination costs for one facility. In the first quarter of 2005, a gain of $1.7 million was recognized from the sale of one facility closed as part of the restructuring plan.
Liquidity and Capital Resources
Cash Flows from Operating Activities: Net cash used in operating activities was $7.5 million in the first quarter of 2005 and $5.0 million in the first quarter of 2004. The first quarter of 2005 included a payment of $9.5 million, recorded in other accrued expenses, associated with the conversion of a portion of the company’s pension plan in Austria from a defined benefit plan to a defined contribution plan. The conversion was made in the fourth quarter of 2004 however the funding did not occur until the first quarter of 2005. Changes in net working capital, defined as net trade accounts receivable plus inventory minus trade accounts payable, resulted in a use of cash of $1.4 million in the first quarter of 2005 as compared to a use of cash of $12.0 million in the first quarter of 2004. Management continues to emphasize the importance of net working capital management throughout the company. As a percent of annualized net revenue (current quarter net revenue X 4), net working capital was 18.5 percent as of February 26, 2005 as compared to 22.3 percent at February 28, 2004.
Cash Flows from Investing Activities: Cash of $3.5 million was provided by investing activities in the first quarter of 2005 as compared to cash used in investing activities in the first quarter of 2004 of $5.3 million. The major item in the first quarter of 2005 was over $10 million of proceeds received from the sale of a facility in Europe. This sale resulted in a $1.7 million gain as discussed earlier in this report. Capital spending was $6.9 million in the first quarter of 2005 and $6.3 million in the first quarter of 2004.
Cash Flows from Financing Activities: Financing activities resulted in a use of cash of $26.7 million in the first quarter of 2005 as compared to cash provided by financing activities in the first quarter of 2004 of $8.0 million. Financing activity in the first quarter of 2005 included the repayment of $22 million related to the company’s 1994 private placement. Total debt decreased $24.1 million during the first quarter of 2005 to $150.3 million. During the first quarter of 2004 total debt increased $10.8 million to $184.8 million. The company’s capitalization ratio, defined as total debt divided by total debt plus equity, was 21.3 percent at February 26, 2005 as compared to 24.0 percent at November 27, 2004 and 26.3 percent at February 28, 2004.
Cash dividends paid were $3.3 million in the first quarter of 2005 and $3.2 million in the first quarter of 2004.
Forward-Looking Statements and Risk Factors
Certain statements in this document may be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are subject to various risks and uncertainties, including but not limited to the following: political and economic conditions; product demand;
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competitive products and pricing; costs of and savings from restructuring initiatives; product mix; availability and price of raw materials; the Company’s relationships with its major customers and suppliers; changes in tax laws and tariffs; devaluations and other foreign exchange rate fluctuations (particularly with respect to the euro, the British pound, the Japanese yen, the Australian and Canadian dollars, the Argentine peso and the Brazilian real); the effect of new accounting pronouncements and accounting charges and credits; and similar matters. Further information about the various risks and uncertainties can be found in the Company’s SEC 10-K filing of February 25, 2005. All forward-looking information represents management’s best judgment as of this date based on information currently available that in the future may prove to have been inaccurate. Additionally, the variety of products sold by the Company and the regions where the Company does business make it difficult to determine with certainty the increases or decreases in sales resulting from changes in the volume of products sold, currency impact, changes in product mix and selling prices. However, management’s best estimates of these changes as well as changes in other factors have been included. References to volume changes include volume, product mix, and delivery charges, combined.
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The company may refer to this section of the Form 10-Q to identify risk factors related to other forward looking statements made in oral presentations, including investor conferences and/or webcasts open to the public.
The foregoing list of important factors does not include all such factors nor necessarily present them in order of importance. This disclosure, including that under “Forward-Looking Statements and Risk Factors,” and other forward-looking statements and related disclosures made by the company in this report and elsewhere from time to time, represents management’s best judgment as of the date the information is given. The company does not undertake responsibility for updating any of such information, whether as a result of new information, future events, or otherwise, except as required by law. Investors are advised, however, to consult any further public company disclosures (such as in filings with the Securities and Exchange Commission or in company press releases) on related subjects.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market Risk: The company is exposed to various market risks, including changes in interest rates, foreign currency rates and prices of raw materials. Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates and foreign currency exchange rates.
Interest Rate Risk: Exposure to changes in interest rates result primarily from borrowing activities used to fund operations. Committed floating rate credit facilities are used to fund a portion of operations.
Management believes that probable near-term changes in interest rates would not materially affect financial condition, results of operations or cash flows. The annual impact on net income of a one-percentage point interest rate change on the outstanding balance of its variable rate debt as of February 26, 2005 would be approximately $0.1 million.
Foreign Exchange Risk: As a result of being a global enterprise, there is exposure to market risks from changes in foreign currency exchange rates, which may adversely affect operating results and financial condition. Approximately 53 percent of net revenue was generated outside of the United States in the first three months of 2005. Principal foreign currency exposures relate to the euro, British pound sterling, Japanese yen, Australian dollar, Canadian dollar, Argentine peso and Brazilian real.
Management’s objective is to balance, where possible, local currency denominated assets to local currency denominated liabilities to have a natural hedge and minimize foreign exchange impacts. The company enters into cross border transactions through importing and exporting goods to and from different countries and locations. These transactions generate foreign exchange risk as they create assets, liabilities and cash flows in currencies other than the local currency. This also applies to services provided and other cross border agreements among subsidiaries.
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Management takes steps to minimize risks from foreign currency exchange rate fluctuations through normal operating and financing activities and, when deemed appropriate, through the use of derivative instruments. Management does not enter into any speculative positions with regard to derivative instruments.
From a sensitivity analysis viewpoint, based on the financial results of the first quarter of 2005, a hypothetical overall 10 percent change in the U.S. dollar would have resulted in a change in net income of approximately $0.7 million.
Raw Materials: The principal raw materials used to manufacture products include resins, polymers, synthetic rubbers, vinyl acetate monomer and plasticizers. The company generally avoids sole source supplier arrangements for raw materials. While alternate sources for most key raw materials are available, if worldwide supplies were disrupted due to unforeseen events, or if unusual demand causes products to be subject to allocation, shortages could occur.
Management’s objective is to purchase raw materials that meet both its quality standards and production needs at the lowest total cost. Most raw materials are purchased on the open market or under contracts that limit the frequency but rarely limit the magnitude of price increases. In some cases, however, the risk of raw material price changes is managed by strategic sourcing agreements which limit price increases to increases in supplier feedstock costs, while requiring decreases as feedstock costs decline. The leverage of having substitute raw materials approved for use wherever possible is used to minimize the impact of possible price increases.
Item 4. Controls and Procedures
(a) Disclosure controls and procedures
As of the end of the period covered by this report, the company conducted an evaluation, under the supervision and with the participation of the company’s chief executive officer and chief financial officer, of the company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on this evaluation, and due to the material weakness in the company’s internal control over financial reporting in the company’s Chilean accounting operations as discussed below and as reported in the company’s Annual Report on Form 10-K for the year ended November 27, 2004, the chief executive officer and chief financial officer concluded that, as of February 26, 2005, the company’s disclosure controls and procedures were not effective to ensure that information required to be disclosed by the company in reports that it files or submits under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
(b) Change in internal control over financial reporting
The company is responsible for establishing and maintaining adequate internal control over financial reporting. The company’s internal control system was designed to provide reasonable assurance to the company’s management and the board of directors regarding the preparation and fair presentation of published financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
As of November 27, 2004 the company’s assessment of the effectiveness of its internal control over financial reporting identified a material weakness in the company’s internal control over financial reporting in the company’s Chilean accounting operations due to insufficient supervision and oversight of certain local accounting personnel. Specifically, there was no review of the local books and records of the smaller locations within the Latin America region, which includes the Chilean operations, by regional financial
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management or internal audit. As a result of the material weakness in internal control, the company’s financial statements were misstated due to the intentional recording of incorrect accounting entries by local accounting personnel under the supervision of the Chilean financial controller. This material weakness is discussed in greater detail in the company’s Annual Report on Form 10-K for the year ended November 27, 2004.
During the first quarter of 2005 the company has implemented, or is in the process of implementing, the following remediation steps to address the material weakness discussed above:
The company believes that, once fully implemented, these remediation steps will correct the material weakness discussed above.
Except as discussed above, there were no changes in the company’s internal control over financial reporting during its most recently completed fiscal quarter that have materially affected or are reasonably likely to materially affect its internal control over financial reporting, as defined in Rule 13a-15(f) under the Exchange Act.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Environmental Matters. From time to time, the company is identified as a “potentially responsible party” under the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) and similar state laws that impose liability for costs relating to the cleanup of contamination resulting from past spills, disposal or other release of hazardous substances. The company is also subject to similar laws in some of the countries where current and former plants are located. The company’s environmental, health and safety department monitors compliance with all applicable laws on a global basis.
Currently the company is involved in administrative proceedings or lawsuits relating to 35 sites. This number includes contaminated sites where the company’s sole involvement to date has been responding to a formal request for information. At many of these sites, the company has entered into participation agreements and consent decrees, tolling agreements exist, or the company has received no further communication after submitting its response for a request for information and/or its denial of liability. In addition, the company is currently investigating soil contamination at its Sorocaba, Brazil facility. The company is working with Brazilian regulatory authorities to determine the necessary scope of remediation at the facility. As of February 26, 2005, $1.0 million was recorded as a liability for expected investigation and remediation expenses for this site. Once the full scope of any necessary remediation is determined, the company may be required to record additional liabilities related to investigation and remediation costs at the Sorocaba facility.
The company’s management reviews each individual site, considering the number of parties involved, the level of potential liability or contribution of the company relative to the other parties, the nature and magnitude of the hazardous wastes involved, the method and extent of remediation, the estimated legal and consulting expense with respect to each site and the time period over which any costs would likely be incurred. The company accrues appropriate reserves for potential environmental liabilities, which are continuously reviewed and adjusted as additional information becomes available. As of February 26, 2005, the company had reserved $2.7 million, which represents its best estimate of probable liabilities with respect to environmental matters, inclusive of the accrual related to Brazil above. However, the full extent of the company’s future liability for environmental matters is difficult to predict because of uncertainty as to the cost of investigation and cleanup of the sites, the company’s responsibility for such hazardous waste and the number of and financial condition of other potentially responsible parties.
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From time to time management becomes aware of compliance matters relating to, or receives notices from federal, state or local entities regarding possible or alleged violations of environmental, health or safety laws and regulations. In some instances, these matters may become the subject of administrative proceedings or lawsuits and may involve monetary sanctions of $0.1 million or more (exclusive of interest and litigation costs).
While uncertainties exist with respect to the amounts and timing of the company’s ultimate environmental liabilities, based on currently available information, management does not believe that these matters, individually or in the aggregate, will have a material adverse effect on the company’s financial condition, results of operations or cash flows. However, adverse developments could negatively impact earnings or cash flows in a particular future period.
Other Legal Proceedings. From time to time and in the ordinary course of business, the company is a party to, or a target of, lawsuits, claims, investigations and proceedings, including product liability, contract, patent and intellectual property, antitrust and employment matters. While the company is unable to predict the outcome of these matters, it does not believe, based upon currently available facts, that the ultimate resolution of any pending matter, including the EIFS and asbestos litigation described in the following paragraphs, will have a material adverse effect on its overall financial condition, results of operations or cash flows. However, adverse developments could negatively impact earnings or cash flows in a particular future period.
As disclosed in prior filings, a subsidiary of the company is a defendant or co-defendant in numerous exterior insulated finish systems (“EIFS”) related lawsuits. As of February 26, 2005, the company’s subsidiary was a defendant or co-defendant in approximately 82 lawsuits and 7 claims related primarily to single-family homes. The EIFS product was used primarily in the residential construction market in the southeastern United States. Claims and lawsuits related to this product seek monetary relief for water intrusion related property damages. One of the lawsuits is a class action lawsuit purportedly involving 186 members, and some of the lawsuits involve EIFS in commercial or multi-family structures. As of February 26, 2005, the company had recorded $3.6 million for the probable liabilities and $1.3 million for insurance recoveries for all such matters. The company has insurance coverage for certain years with respect to this product. The company continually reevaluates these amounts. Management does not believe that the ultimate outcome of any pending legal proceedings and claims related to this product line, individually or in aggregate, will have a material adverse effect on its financial condition, results of operations or cash flows. However, projecting future events, such as the number of new claims to be filed each year, the average cost of disposing of each such claim, as well as the numerous uncertainties surrounding litigation in the United States, could cause the actual costs to be higher or lower than the current estimated reserves or insurance recoveries.
As previously reported, over the years, the company has been named as a defendant, in lawsuits in various state courts in which plaintiffs alleged injury due to exposure to products manufactured by the company 20 to 30 years ago that contained asbestos. These cases generally seek unspecified damages for asbestos-related diseases. These lawsuits frequently seek both actual and punitive damages, often in very large amounts. In many cases, plaintiffs are unable to demonstrate that they have suffered any compensable loss as a result of such exposure, or they are unable to demonstrate that injuries incurred in fact resulted from exposure to products manufactured by the company or its subsidiaries. In such cases, the company is generally dismissed without payment. With respect to those cases where compensable disease, exposure and causation are established with respect to one of the company’s products, the company generally settles for amounts that reflect the confirmed disease, the seriousness of the case, the particular jurisdiction and the number and solvency of other parties in the case. Substantially all of these cases have involved multiple co-defendants and the company is typically a de minimis party.
During fiscal year 2004, insurance or indemnification from solvent third parties in accordance with applicable policies or contracts paid virtually all of the defense costs associated with the company’s asbestos litigation. As previously reported, during 2003, the company’s insurers replaced the cost sharing agreement, which had previously provided for the allocation of settlement payments among the insurers
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with an interim allocation formula. Under this formula the company has funded settlement amounts allocable to years in which the responsible insurer is insolvent. As previously reported and accounted for during the third quarter of 2004, the company and a group of other defendants entered into negotiations with a group of plaintiffs to settle a number of asbestos-related lawsuits. Subject to finalization of certain terms and conditions of settlement, the company has agreed to contribute $3.5 million towards the settlement amount to be paid to the plaintiffs in exchange for a full release of claims by the plaintiffs. Of this amount, the company’s insurers have agreed to pay approximately $1.2 million. During the first quarter of 2005, the company settled one asbestos-related lawsuit for an amount of less than $0.1 million. The company and its insurers have also engaged in negotiations with respect to the terms of a new cost sharing arrangement which may result in a continuation or alteration of the interim allocation formula. To the extent the company can reasonably estimate the amount of its probable liability, the company will establish a financial reserve in an amount that it deems to be adequate and a corresponding amount for insurance coverage.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
Upon vesting of restricted stock awarded by the company to employees, shares are withheld to cover the employees’ withholding taxes. Information on the company’s purchases of equity securities during the first quarter follows:
Period
(a)
TotalNumber
of Shares
Purchased
(b)
Average
PricePaid
per Share
(c)
Total Number
Purchased as
Part of Publicly
Announced
Plans or
Programs
(d)
Maximum
Number of
Shares that
May Yet Be
Under thePlans orPrograms (atend of period)
November 28, 2004 – January 1, 2005
January 2, 2005 – January 29, 2005
January 30, 2005 – February 26, 2005
Item 6.
Exhibits
Lean Six SigmaSM is a registered service mark of The George Group Incorporated.
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SIGNATURES
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.
Dated: April 4, 2005
/s/ John A. Feenan
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Exhibit Index