For the quarterly period ended: MARCH 31, 2005
OR
For the transition period from _________________ to _________________
Commission File Number: 0-13646
DREW INDUSTRIES INCORPORATED(Exact name of registrant as specified in its charter)
200 Mamaroneck Avenue, White Plains, NY 10601(Address of principal executive offices)(Zip Code)
(914) 428-9098(Registrant’s telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report) N/A
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1. Basis of Presentation
The Condensed Consolidated Financial Statements include the accounts of Drew Industries Incorporated and its subsidiaries (“Drew” or the “Company”). Drew has no unconsolidated subsidiaries. Drew’s wholly-owned active subsidiaries are Kinro, Inc. and its subsidiaries (“Kinro”), and Lippert Components, Inc. and its subsidiaries (“Lippert”). Drew, through its wholly-owned subsidiaries, supplies a broad array of components for recreational vehicles (“RVs”) and manufactured homes (“MHs”), and to a lesser extent specialty trailers for marine and leisure products. All significant intercompany balances and transactions have been eliminated. Certain prior year balances have been reclassified to conform to current year presentation.
The Condensed Consolidated Financial Statements presented herein have been prepared by the Company in accordance with the accounting policies described in its December 31, 2004 Annual Report on Form 10-K and should be read in conjunction with the Notes to Consolidated Financial Statements which appear in that report.
In the opinion of management, the information furnished in this Form 10-Q reflects all adjustments necessary for a fair statement of the financial position and results of operations as of and for the three month periods ended March 31, 2005 and 2004. All such adjustments are of a normal recurring nature. The Condensed Consolidated Financial Statements have been prepared in accordance with the instructions to Form 10-Q and therefore do not include some information and notes necessary to conform with annual reporting requirements.
2. Segment Reporting
The Company has two reportable operating segments, the recreational vehicle products segment (the “RV segment”) and the manufactured housing products segment (the “MH segment”). The RV segment, which accounted for 68 percent of consolidated net sales for each of the three month periods ended March 31, 2005 and 2004, manufactures a variety of products used in the production of recreational vehicles, including windows, doors, chassis, chassis parts, slide-out mechanisms and related power units, and electric stabilizer jacks. The RV segment also manufactures specialty trailers for equipment hauling, boats, personal watercraft and snowmobiles. The MH segment, which accounted for 32 percent of consolidated net sales for each of the three month periods ended March 31, 2005 and 2004, manufactures a variety of products used in the construction of manufactured homes and to a lesser extent, modular housing and office units, including vinyl and aluminum windows, chassis, chassis parts, and thermo-formed bath and shower units. Intersegment sales are insignificant. Until the second quarter of 2004, the Company’s RV segment included only recreational vehicle products, however, with the Company’s acquisition of Zieman Manufacturing Company (“Zieman”), the specialty trailer business of Zieman has been added to the RV segment. Other than sales of specialty trailers, which aggregated approximately $7 million in the first quarter of 2005 and $17 million in all of 2004, sales to industries other than manufacturers of RVs and MHs are not significant.
Decisions concerning the allocation of the Company’s resources are made by the Company’s key executives. This group evaluates the performance of each segment based upon segment profit or loss, defined as income before interest, amortization of intangibles and income taxes. Management of debt is considered a corporate function. The accounting policies of the RV and MH segments are the same as those described in Note 1 of Notes to Consolidated Financial Statements, of the Company’s December 31, 2004 Annual Report on Form 10-K.
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3. Inventories
Inventories are stated at the lower of cost (using the first-in, first-out method) or market. Cost includes material, labor and overhead; market is replacement cost or realizable value after allowance for costs of distribution.
Inventories consist of the following (in thousands):
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4. Long-term Indebtedness
Long-term indebtedness consists of the following (dollars in thousands):
Pursuant to the credit agreement, and certain of the other loan agreements, the Company is required to maintain minimum net worth and interest and fixed charge coverages and to meet certain other financial requirements. At March 31, 2005, the Company was in compliance with all such requirements. Certain of the Company’s loan agreements contain prepayment penalties. Borrowings under the credit agreement are secured only by capital stock of the Company’s subsidiaries.
On February 11, 2005, the Company consummated the refinancing of its line of credit with JPMorgan Chase Bank, N.A., Key Bank National Association and HSBC Bank USA, National Association (collectively, the “Lenders”). The maximum borrowings under the credit agreement were increased to $60 million and can be increased by an additional $30 million, upon approval of the Lenders. Interest on borrowings from the credit agreement is designated from time to time by the Company as either the Prime Rate, or LIBOR plus additional
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interest from 1 percent to 1.80 percent, currently 1.25 percent, depending on the Company’s performance and financial condition. This credit agreement expires June 30, 2009.
Simultaneous with the refinancing of the Company’s line of credit, the Company consummated a three-year “shelf-loan” facility with Prudential Investment Management, Inc. (“Prudential”), pursuant to which the Company can issue, and Prudential’s affiliates may, in their sole discretion, consider purchasing in one or a series of transactions, senior promissory notes (the “Senior Promissory Notes”) of the Company in the aggregate principal amount of up to $60 million, to mature no more than seven years after the date of original issue of each transaction. Prudential and its affiliates have no obligation to purchase the Senior Promissory Notes. Interest payable on the principal of the Senior Promissory Notes will be at rates determined within five business days after the Company gives Prudential a request for purchase of Senior Promissory Notes.
On April 29, 2005, the Company issued $20 million of Senior Promissory Notes under the “shelf-loan” facility with Prudential for a term of five years, at a fixed interest rate of 5.01 percent per annum, payable at the rate of $1 million per quarter plus interest. These funds are anticipated to be used for the acquisition of Venture as further described in Footnote 10.
5. Weighted Average Common Shares Outstanding
Net income per diluted common share reflects the dilution of the weighted average common shares by the assumed issuance of common stock pertaining to stock options. The numerator, which is equal to net income, is constant for both the basic and diluted earnings per share calculations. Weighted average common shares outstanding - diluted is calculated as follows (in thousands):
6. Stock Options
In 2002, the Company adopted the fair value method of accounting for stock options as contained in Statement of Financial Standards No. 123 (“SFAS No. 123”) “Accounting for Stock-Based Compensation,” which is considered the preferable method of accounting for stock-based employee compensation. During the transition period, the Company is utilizing the prospective method under SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosures.” All employee stock options granted after January 1, 2002 are being expensed on a straight line basis over the stock option vesting period based on fair value, determined using the Black-Scholes option-pricing method, at the date the options were granted. This resulted in charges to operations of $254,000 and $212,000 for the three months ended March 31, 2005 and 2004, respectively.
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Historically, the Company had applied the “disclosure only” option of SFAS No.123. Accordingly, no compensation cost has been recognized for stock options granted prior to January 1, 2002.
The following table illustrates the effect on net income and net income per common share as if the fair value method had been applied to all outstanding and unvested awards in each period (dollars in thousands):
7. Commitments and Contingencies
Lippert is a defendant in an action entitled SteelCo., Inc. vs. Lippert Components, Inc. and DOES 1 though 20, inclusive, commenced in Superior Court of the State of California, County of San Bernardino District, on July 16, 2002. On motion of Lippert, the case was removed to the U.S. District Court, Central District of California, Riverside Division.
Plaintiff alleges that Lippert violated certain provisions of the California Business and Professions Code (Sec. 17000 et. seq.) by allegedly selling chassis and component parts below Lippert’s costs, engaging in acts intended to destroy competition, wrongfully interfering with plaintiff’s economic advantage, and engaging in unfair competition. Plaintiff seeks compensatory damages of $8.2 million, treble damages, punitive damages, costs and expenses incurred in the proceeding, and injunction relief.
Management believes that the case has no merit, and Lippert is vigorously defending against the allegations in the complaint. In addition, Lippert asserted counterclaims against Plaintiff.
Court-ordered mediation did not result in settlement. On February 22, 2005, the court granted Lippert’s motion for partial summary judgment limiting plaintiff’s damages to those incurred prior to December 31, 2002, thereby reducing plaintiff’s damage claim from over $8 million (before trebling) to an amount which the Company believes could be less than $1 million based on counsel’s analysis of the testimony of plaintiff’s and Lippert’s
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damage experts, although there can be no assurance of the outcome. The court also granted Lippert’s motions for partial summary judgment as to all aspects of plaintiff’s unfair competition claim and plaintiff’s claim for an injunction. The court denied Lippert’s attempt to limit damages to those incurred prior to May 10, 2002, and certain other aspects of Lippert’s defense. Lippert’s $500,000 settlement offer to Plaintiff, which was recorded as a charge in the first quarter of 2005, was rejected. It is anticipated that a trial will be held in early 2006.
Lippert is a defendant in an action entitled Marlon Harris vs. Lippert Components, Inc. commenced in the Superior Court of the State of California, County of San Bernardino District. Plaintiff was injured on a press brake machine while working at Lippert’s Rialto, California division. The machine was purchased used and was not fitted with a guard. The claimant pursued a workers compensation claim and a third party action against Lippert and other defendants, including the manufacturer and the vendor of the subject machine. The third party suit involved allegations of willful and wanton actions and seeks compensatory and punitive damages. At trial, the jury found in favor of Plaintiff for compensatory and punitive damages.
The verdict was comprised of compensatory damages of $464,000, most of which had been previously paid or accrued by Lippert, and punitive damages of $4 million. Counsel for Lippert advised the Company that, under California law, the award for punitive damages would most likely be reduced to not in excess of four times the compensatory damages, or a maximum of $1.9 million. Accordingly, at December 31, 2004, the Company recorded a charge of $1.9 million ($945,000 after taxes and the direct impact on incentive compensation) related to the punitive damages awarded in this case. On March 17, 2005, the trial court denied Lippert’s motion to reduce the punitive damage award. Subsequent settlement discussions were unsuccessful. Accordingly, in the first quarter of 2005, the Company recorded a charge of $2.1 million ($1,050,000 after taxes and the direct impact on incentive compensation) related to the punitive damages awarded in this case. Lippert intends to appeal the verdict as well as the punitive damage award, as counsel for Lippert asserts that the verdict is unsupported by the evidence, and the punitive damage award exceeds the limit generally permitted in California. There can be no assurance of the outcome of the appeal.
On August 6, 2004, Keystone RV Company, Inc. filed a third-party petition against Lippert in an action entitled Feagins, et. al. v. D.A.R., Inc. d/b/a Fun Time RV, et. al. pending in the Probate Court, Denton County, State of Texas. Plaintiffs brought an action for wrongful death allegedly caused by an RV manufactured by defendant Keystone RV Company, Inc. (“Keystone”) seeking compensatory, future and exemplary damages. Keystone filed a third-party petition against Lippert for proportionate contribution from Lippert as the alleged manufacturer, designer and supplier of certain components of the RV. Neither plaintiffs nor any of the other five defendants filed claims against Lippert. Lippert’s counsel has advised that, at this stage of the case, based on the current theories of plaintiff’s expert, Lippert did not commit any act or omission that contributed to or caused the accident; however, there can be no assurance that plaintiff’s or other defendant’s theories will not in the future focus on an alleged act or omission by Lippert. Plaintiffs seek compensatory damages in excess of $130 million and each of the five Plaintiffs seeks $25 million in exemplary damages from each defendant. Lippert maintains product liability insurance but certain of such insurance may not cover exemplary damages. The trial is in the discovery stage, and there has been no determination of liability. Lippert’s liability insurer has assigned counsel to defend Keystone’s claim against Lippert.
Lippert and Kinro sell products to Oakwood Homes, Inc. (“Oakwood”), which filed for relief under Chapter 11 of the United States Bankruptcy Code in November 2002. Proofs of claim filed by Lippert and Kinro are pending. Lippert and Kinro have been advised that the OCH Liquidation Trust (the “Trust”) intends to file preference claims against them with respect to payments made to them by Oakwood prior to the bankruptcy filing. The preference claims are in the aggregate amount of approximately $4 million. The Company believes that
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Lippert and Kinro have valid defenses to the preference claims and that there should be no material liability to the Trust. In this connection, the Trust has indicated that, as an alternative to preference claims, the Trust might assert that payments by Oakwood constituted fraudulent transfers under sections 544 and 548 of the Bankruptcy Code. If the Trust pursues this claim, Lippert and Kinro, as well as several other creditors similarly situated, intend to vigorously defend against it.
In the normal course of business, the Company is subject to proceedings, lawsuits and other claims. All such matters are subject to many uncertainties and outcomes that are not predictable with assurance. While these matters could materially affect operating results when resolved in future periods, it is management’s opinion that after final disposition, including anticipated insurance recoveries, any monetary liability or financial impact to the Company beyond that provided in the consolidated balance sheet as of March 31, 2005, would not be material to the Company’s financial position or annual results of operations.
8. Other Income
In February 2004, the Company sold certain intellectual property rights relating to a process used to manufacture a new composite material. The sale price for the intellectual property rights was $4.0 million, consisting of cash of $100,000 at closing and a note of $3.9 million, payable over five years. In 2004, the Company received payments aggregating approximately $.5 million, and recorded a pre-tax gain on sale of $428,000. In January 2005, the Company received the second payment under the note for $570,000, including interest, which had been previously fully reserved, and the Company therefore recorded a gain on the $570,000 recovery in the first quarter. The balance of the note is now $3 million, which continues to be fully reserved.
Simultaneously with the sale, the Company entered into an equipment lease and a license agreement with the buyer. In March 2005, the owner of the manufacturing process related to this intellectual property informed the Company that it may not be able to perfect the technology required for the Company to produce bath products using this new composite material. Therefore, the lease for the production equipment has not become effective. As a result, in the first quarter of 2005, the Company wrote-off related capitalized project costs which had a book value exceeding $500,000, largely offsetting the gain on the collection of the note.
9. New Accounting Standards
In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment,” a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” and superseding APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 123R requires the Company to expense grants made under the stock option plan. SFAS No. 123R is effective for the first annual period beginning after June 15, 2005. Upon adoption of SFAS No. 123R, amounts previously disclosed under SFAS No. 123 for grants prior to January 1, 2002 will be recorded in the consolidated income statement. The implementation of SFAS No. 123R is expected to have an impact on net income of less than $75,000 in 2006 for options granted prior to January 1, 2002, and no impact in 2007 and beyond.
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10. Subsequent Event
On May 10, 2005, the Company entered into an agreement to acquire the business and certain assets and liabilities of Venture Welding (“Venture”), a division of Indiana-based Banks Corporation for approximately $19.6 million in cash. Venture Welding had annualized sales prior to the acquisition of approximately $18 million. Venture manufactures chassis and chassis parts for manufactured homes, modular homes and office units. It is anticipated that the acquisition will close within 30 days, subject to due diligence. The acquisition was funded with $20 million of Senior Promissory Notes issued on April 29, 2005 pursuant to the Company’s “shelf-loan” facility with Prudential Investment Management, Inc. (“Prudential”) for a term of five years at a fixed interest rate 5.01 percent per annum, payable at the rate of $1 million per quarter plus interest.
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The Company has two reportable operating segments, the recreational vehicle products segment (the “RV segment”) and the manufactured housing products segment (the “MH segment”). The Company’s operations are conducted through its operating subsidiaries. Its two primary operating subsidiaries, Kinro, Inc. and its subsidiaries (“Kinro”) and Lippert Components, Inc. and its subsidiaries (“Lippert”) have operations in both the MH and RV segments. At March 31, 2005, the Company’s subsidiaries operated 48 plants in the United States and one in Canada.
The RV segment accounted for 68 percent of consolidated net sales for the three months ended March 31, 2005 and 65 percent of the annual consolidated net sales for calendar 2004. The RV segment manufactures a variety of products used primarily in the production of recreational vehicles, including windows, doors, chassis, chassis parts, slide-out mechanisms and related power units, and electric stabilizer jacks. The Company’s RV products are used primarily in travel trailers and fifth wheel RVs. Travel trailers and fifth wheel RVs accounted for 69 percent of all RVs shipped by the industry in 2004, up from 61 percent in 2001. In recent months, the Company has begun to focus its efforts on expanding its market share for products used in motorhomes, and began selling slide-out mechanisms for motorhomes in the second quarter of 2004. The Company has also recently introduced leveling devices, axles, steps and bath products for RVs. Until the second quarter of 2004, the Company’s RV segment included only recreational vehicle products, however, with the Company’s acquisition of Zieman, the specialty trailer business of Zieman, including trailers for equipment hauling, boats, personal watercraft and snowmobiles, has been added to the RV segment.
The MH segment, which accounted for 32 percent of consolidated net sales for the three months ended March 31, 2005 and 35 percent of the annual consolidated net sales for calendar 2004, manufactures a variety of products used in the construction of manufactured homes, and to a lesser extent, modular housing and office units, including vinyl and aluminum windows and screens, chassis, chassis parts and thermo-formed bath and shower units.
Other than sales of specialty trailers, which aggregated approximately $7 million in the first quarter of 2005 and $17 million in all of 2004, sales to industries other than manufacturers of RVs and MHs are not significant.
BACKGROUND
Recreational Vehicle Industry
The Recreational Vehicle Industrial Association (“RVIA”) reported a 6 percent increase in total industry shipments in the first quarter of 2005, compared to the first quarter of 2004. Shipments of travel trailers and fifth wheel RVs, the Company’s primary market, increased 12 percent for the quarter, while motorhome sales declined 9.7 percent for the quarter. The RVIA is projecting a 2.5 percent decline in wholesale shipments of all types of RVs in 2005, but they are forecasting that shipments of travel trailers and fifth wheel RVs will be approximately the same as in 2004. In 2004, the RVIA reported an increase of 15 percent in total RV shipments to 370,100 units, while shipments of travel trailers and fifth wheel RVs increased 19 percent for the year to 254,600 units.
In the long-term, increasing industry RV sales are expected to continue to be driven by positive demographics, as demand for RVs is strongest from the over 50 age group, which is the fastest growing segment of the population. According to U.S. Census Bureau projections, 10 years from now there will be in excess of 20 million more people over the age of 50. In recent years, the RVIA has employed an advertising
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campaign to attract customers in the 35 to 54 age group, and the number of RV’s owned by those 35 to 54 grew faster than all other age groups. Industry growth also appears to continue to be bolstered by a preference for domestic vacations, rather than foreign travel, and low interest rates.
Manufactured Housing Industry
As a result of (i) limited credit availability for purchases of manufactured homes, (ii) high interest rate spreads between conventional mortgages on site built homes and chattel loans for manufactured homes (chattel loans were used to finance approximately 30 percent of manufactured homes purchased in 2004), and (iii) unusually high repossessions of manufactured homes, industry production declined approximately 65 percent since 1998, to 131,000 homes in both 2003 and 2004, the lowest production levels in 40 years. However, based upon industry reports, retail sales of manufactured homes have declined much less severely than industry production in recent years. Almost 50 percent of retail sales of manufactured homes in the last several years have apparently been filled by inventory reductions by dealers and manufacturers, and the resale of repossessed homes, rather than new production. It has been estimated that approximately 90,000 to 100,000 manufactured homes were repossessed in each of 2001, 2002 and 2003, far in excess of historical repossession levels. It has been reported that the level of repossessions of manufactured homes declined to between 80,000 and 85,000 homes in 2004.
The Manufactured Housing Institute (“MHI”) reported that for the quarter ended March 31, 2005, industry wholesale shipments of manufactured homes increased 7 percent over the prior year’s first quarter, including a 3 percent increase in shipments of the smaller, single section homes, and a 9 percent increase in shipments of the larger, multi-section homes, although total wholesale shipments in March 2005 were flat with March 2004. The availability of financing for manufactured homes has apparently improved somewhat. In September 2003 Berkshire Hathaway Inc. acquired Clayton Homes and Oakwood Homes, two of the leading producers of manufactured homes, as well as 21st Mortgage. Since then, Berkshire has helped Clayton raise substantial funds ($4 billion) for its mortgage operations. Further, the level of dealer inventory is low, and, as noted above, the level of repossessions of manufactured homes has reportedly declined this year. Long-term prospects for manufactured housing are favorable because manufactured homes provide quality, affordable housing.
Raw Material Prices
Steel is one of the Company’s primary raw materials in both segments, representing about 50 percent of the Company’s raw material costs. In mid December 2003 and continuing during 2004, the Company was notified by its steel suppliers of unprecedented steel cost increases. The prices the Company pays for steel, depending on the type of steel purchased, are currently double to triple the levels they were at the beginning of 2004. To offset the impact of higher steel costs, the Company implemented surcharges and sales price increases to its customers. The Company estimates that substantially all steel cost increases received through the first quarter of 2005 were passed on to customers, essentially without markup, by early 2005. Steel costs appear to have stabilized and further cost increases are not projected for 2005. In 2004 and continuing into 2005, the Company has also received cost increases from suppliers of aluminum, vinyl and ABS resin.
The Company does not expect to earn additional profit from the sales price increases implemented in response to rising raw material costs. As a result, the Company’s material cost as a percent of sales has increased, particularly for products which are made primarily from steel. However, if raw material costs
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remain stable, the raw material cost increases experienced to date, are not expected to have a significant effect on operating profit in 2005 because they have been substantially offset by the sales price increases which have been implemented. While the Company has historically been able to obtain sales price increases to offset raw material cost increases, there can be no assurance that future raw material cost increases can be passed on to customers in the form of sales price increases. The aggregate cost of the Company’s inventories has increased substantially because of the raw material cost increases and higher quantities of raw materials on hand due to the increase in sales volume.
RESULTS OF OPERATIONS
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RV Segment
Net sales of the RV segment increased 44 percent to $105 million in the first quarter of 2005. Excluding net sales of newly-acquired Zieman (approximately $10 million) and sales price increases (approximately $11 million), organic sales growth of this segment was approximately 16 percent compared to 2004, significantly greater than the 6 percent industry-wide increase in shipments of RVs this quarter. The organic sales growth of the RV segment exceeded industry growth largely due to increases in the Company’s market share of all primary product lines in this segment, including an increase of $6 million, or nearly 40 percent, in sales of slide-out mechanisms and related power units. Such increase in sales of slide-out mechanisms includes $3 million in sales of slide-out mechanisms for motorhomes, which the Company began selling in the second quarter of 2004. The Company now has a very substantial share of the market for slide-out mechanisms for towable RVs, and expects future growth in sales of its slide-out products to come largely from slide-out products for motorhomes.
The RV segment results for the first quarter of 2005 included sales by newly-acquired Zieman of approximately $4 million of RV chassis and chassis parts and nearly $6 million of specialty trailers. Operating results of the specialty trailer business are included in the RV segment. Zieman previously sold these specialty trailers only on the West Coast, however, the Company recently opened a facility in Indiana to manufacture these products for sale in other regions of the country. During the first quarter of 2005, the Company incurred start-up losses of approximately $400,000 at this new facility. Over the next few quarters, the Company may incur additional start up losses at this facility, and in the production of other newly introduced products.
Operating profit of the RV segment increased 7 percent to $8.4 million in the first quarter of 2005. The operating profit margin of this segment declined to 8.0 percent of sales in 2005 from 10.7 percent last year. Excluding $500,000 of charges related to legal proceedings, less the related reduction in incentive compensation, the operating profit margin of the RV segment would have been 8.4 percent of sales. The operating profit margin primarily declined because raw material cost increases were passed on to customers largely without margins, partially offset by improved efficiencies due to the spreading of fixed costs over increased sales volume. The charges recorded in the segment related to legal proceedings result from a
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settlement offer made by the Company in the action entitled SteelCo., Inc. vs. Lippert Components, Inc., et al, which is described in Part II, Item 1 – Legal Proceedings.
Excluding the impact of the sales price increases described above, labor and manufacturing overhead costs as a percent of sales remained stable in 2005, as higher warranty, quality control and research and development costs offset the benefit of spreading fixed production costs over a larger sales base. The Company has augmented its quality control effort to help minimize future warranty costs. In the first quarter of 2005, for the Company’s RV and MH segments combined, expenditures for quality control and research and development increased by more than $800,000 over the same period in 2004.
MH Segment
Net sales of the MH segment increased 41 percent to $49 million in the first quarter of 2005. Excluding net sales by newly-acquired Zieman (approximately $5 million) and sales price increases (approximately $5 million), organic sales growth of this segment in 2004 was approximately 11 percent, greater than the 8 percent increase in industry-wide wholesale shipments of manufactured homes this quarter. Organic sales growth by this segment exceeded industry growth primarily because of market share gains.
Operating profit of the MH segment increased 7 percent to $3.9 million in the first quarter of 2005. The operating profit margin of this segment declined to 7.9 percent of sales in the first quarter of 2005, from 10.4 percent in the first quarter of 2004, because of i) $2.1 million of charges related to legal proceedings ii) raw material cost increases passed on to customers largely without margins, and iii) partially offset by improved efficiencies due to the spreading of fixed costs over increased sales volume. Excluding the $2.1 charge related to legal proceedings, less the related reduction in incentive compensation, the operating profit margin of this segment would have increased to 11.4 percent in the first quarter of 2005. The charges recorded in the segment related to legal proceedings result from an adverse ruling in the action entitled Marlon Harris vs. Lippert Components, Inc., which is described in Part II, Item 1 – Legal Proceedings.
Corporate and Other
Corporate and other expenses for the first quarter of 2005 increased $0.3 million compared to the first quarter of 2004, of which $0.2 million is due to higher audit fees and other costs related to compliance with Section 404 of Sarbanes-Oxley.
Other Income
Simultaneously with the sale, the Company entered into an equipment lease and a license agreement with the buyer. In March 2005, the owner of the manufacturing process related to this intellectual property
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informed the Company that it may not be able to perfect the technology required for the Company to produce bath products using this new composite material. Therefore, the lease for the production equipment has not become effective. As a result, in the first quarter of 2005, the Company wrote-off related capitalized project costs which had a book value exceeding $500,000, largely offsetting the gain on the collection of the note.
Taxes
The effective tax rate for the first three months of 2005 was 38.8 percent as compared to 39.0 percent for the first quarter of 2004. The effective tax rate for the full year 2004 was 38.5 percent. The decrease in the effective tax rate in 2005 is due to the provisions of the Jobs Creation Act of 2004 which gives a small federal tax break on manufacturing activities, offset by a change in the composition of pre-tax income for state tax purposes.
Interest Expense, Net
Interest expense, net, increased $0.3 million from the first quarter of 2004, as a result of the increase in average debt levels, offset by savings resulting from a reduction in the average interest rate and $135,000 of interest costs capitalized in connection with capital projects.
LIQUIDITY AND CAPITAL RESOURCES
The Statements of Cash Flows reflect the following (in thousands):
Cash Flow from Operations
Despite a $0.2 million decrease in net income during the current quarter, net cash flows from operating activities increased approximately $14.2 million in the first quarter of 2005 compared to the first quarter of 2004 due to:
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Cash Flows from Investing Activities:
Cash flows used for investing activities of $3.9 million in the first quarter of 2005 consist primarily of capital expenditures, offset by the proceeds received from the sale of certain fixed assets and a reduction in the purchase price for the 2004 acquisition of Zieman. Capital expenditures for 2005 are anticipated to be approximately $12 - $15 million and are expected to be funded by cash flows from operations and a $2 million real estate mortgage.
Cash flows used for investing activities of $3.1 million in the first quarter of 2004 consisted primarily of capital expenditures.
Cash Flows from Financing Activities
Cash flows used for financing activities for the first quarter of 2005 include a net decrease in debt of $3.6 million, partially funded by $1.1 million received from the exercise of employee stock options. Total debt has been reduced by $3.6 million since December 31, 2004.
On February 11, 2005, the Company consummated the refinancing of its line of credit with JPMorgan Chase Bank, N.A., Key Bank National Association and HSBC Bank USA, National Association (collectively, the “Lenders”). The maximum borrowings under the credit agreement were increased to $60 million and can be increased by an additional $30 million, upon approval of the Lenders. Interest on borrowings from the credit agreement is designated from time to time by the Company as either the Prime Rate, or LIBOR plus additional interest from 1 percent to 1.80 percent, currently 1.25 percent, depending on the Company’s performance and financial condition. This credit agreement expires June 30, 2009.
Borrowings under the Company’s $60 million credit agreement at March 31, 2005 were $41 million. In addition, the Company had $5.2 million in outstanding letters of credit. Availability under the Company’s line of credit was $13.8 million at March 31, 2005. Such availability, along with anticipated cash flows from operations, is adequate to finance the Company’s working capital and anticipated capital expenditure requirements. The Company is in compliance with all of its debt covenants and expects to remain in compliance for the next twelve months. Certain of the Company’s loan agreements contain prepayment penalties.
Simultaneous with the refinancing of the Company’s line of credit, the Company consummated a three-year “shelf-loan” facility with Prudential Investment Management, Inc. (“Prudential”), pursuant to which the Company can issue, and Prudential’s affiliates may, in their sole discretion, consider purchasing in one or a series of transactions, senior promissory notes (the “Senior Promissory Notes”) of the Company in the aggregate
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principal amount of up to $60 million, to mature no more than seven years after the date of original issue of each transaction. Prudential and its affiliates have no obligation to purchase the Senior Promissory Notes. Interest payable on the principal of the Senior Promissory Notes will be at rates determined within five business days after the Company gives Prudential a request for purchase of Senior Promissory Notes.
SUBSEQUENT EVENT
CORPORATE GOVERNANCE
The Company is in compliance with the corporate governance requirements of the Securities and Exchange Commission and the New York Stock Exchange. The Company’s governance documents and committee charters and key practices have been posted to the Company’s website (www.drewindustries.com) and are updated periodically. The website also contains, or provides direct links to all SEC filings, press releases and investor presentations. The Company has also established a toll-free hotline (877-373-9123) to report complaints about the Company’s accounting, internal controls, auditing matters or other concerns.
The Company received notification in May 2005 from Institutional Stockholders Services, Inc. (“ISS”), a Rockville, Maryland-based independent research firm that advises institutional investors, that Drew’s corporate governance policies outranked 99.9 percent of all companies listed in the Russell 3000 index. Drew has no business relationships with ISS.
CONTINGENCIES
Additional information required by this item is included under Item 1 of Part II of this quarterly report on Form 10-Q.
INFLATION
The prices of raw materials, consisting primarily of steel, vinyl, aluminum, glass and ABS resin are influenced by demand and other factors specific to these commodities rather than being directly affected by inflationary pressures. Prices of certain commodities have historically been volatile. In mid December 2003 and during 2004, the Company was notified by its steel suppliers of unprecedented steel cost increases. Depending upon the type of steel purchased, steel costs are currently double or triple the levels they were prior to December 2003. Steel costs appear to have stabilized and further cost increases are not projected for 2005. In 2004 and continuing into 2005, the Company has also received cost increases from suppliers of aluminum, vinyl and ABS resin. The Company experienced modest increases in its labor costs in 2005 and 2004 related to
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inflation.
USE OF ESTIMATES
The preparation of these financial statements in conformity with US generally accepted accounting principles requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, the Company evaluates its estimates, including those related to product returns, doubtful accounts, inventories, goodwill and other intangible assets, income taxes, warranty obligations, self insurance obligations, lease terminations, asset retirement obligations, long-lived assets, post-retirement benefits, and contingencies and litigation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other resources. Actual results may differ from these estimates under different assumptions or conditions.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
This Form 10-Q contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 with respect to financial condition, results of operations, business strategies, operating efficiencies or synergies, competitive position, growth opportunities for existing products, plans and objectives of management, markets for Drew Industries Incorporated (“Drew” or the “Company”) common stock and other matters. Statements in this Form 10-Q that are not historical facts are “forward-looking statements” for the purpose of the safe harbor provided by Section 21E of the Exchange Act and Section 27A of the Securities Act. Forward-looking statements, including, without limitation, those relating to the Company’s future business prospects, revenues and income, wherever they occur in this Form 10-Q, are necessarily estimates reflecting the best judgment of the Company’s senior management, at the time such statements were made, and involve a number of risks and uncertainties that could cause actual results to differ materially from those suggested by forward-looking statements. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made. You should consider forward-looking statements, therefore, in light of various important factors, including those set forth in this Form 10-Q.
There are a number of factors, many of which are beyond the Company’s control, which could cause actual results and events to differ materially from those described in the forward-looking statements. These factors include pricing pressures due to competition, raw material costs (particularly steel, vinyl, aluminum, glass, and ABS resin), availability of retail and wholesale financing for manufactured homes, availability and costs of labor, inventory levels of retailers and manufacturers, levels of repossessed manufactured homes, the financial condition of our customers, interest rates, oil prices, the outcome of litigation, and adverse weather conditions impacting retail sales. In addition, national and regional economic conditions and consumer confidence may affect the retail sale of recreational vehicles and manufactured homes.
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DREW INDUSTRIES INCORPORATED
The Company is exposed to changes in interest rates primarily as a result of its financing activities.
On October 18, 2004, the Company entered into a five-year interest rate swap with KeyBank National Association (the “Interest Rate Swap”) with a notional amount of $20,000,000 from which it will receive periodic payments at the 3 month LIBOR rate (2.79438 percent at March 31, 2005 based upon the February 15, 2005 reset date) plus the Company’s applicable spread and make periodic payments at a fixed rate of 3.3525 percent plus the Company’s applicable spread, with settlement and rate reset dates every November 15, February 15, May 15 and August 15. The notional amount of the interest rate swap decreases by $1,000,000 on each reset date. At March 31, 2005, the notional amount was $19,000,000. The fair value of the swap was zero at inception. At March 31, 2005 the fair value of the interest rate swap was $378,000.
At March 31, 2005, the Company had $20.3 million of fixed rate debt plus $19 million outstanding under the Interest Rate Swap. Assuming there is a decrease of 100 basis points in the interest rate for borrowings of a similar nature subsequent to March 31, 2005, which the Company becomes unable to capitalize on in the short-term as a result of the structure of its fixed rate financing, future cash flows would be approximately $393,000 lower per annum than if the fixed rate financing could be obtained at current market rates.
At March 31, 2005, the Company had $28.6 million of variable rate debt, excluding the $19 million outstanding under the Interest Rate Swap. Assuming there is an increase of 100 basis points in the interest rate for borrowings under these variable rate loans subsequent to March 31, 2005, and outstanding borrowings of $28.6 million, future cash flows would be affected by $286,000 per annum.
In addition, the Company is periodically exposed to changes in interest rates as a result of temporary investments in money market funds; however, such investing activity is not material to the Company’s financial position, results of operations, or cash flow.
If the actual change in interest rates is substantially different than 100 basis points, the net impact of interest rate risk on the Company’s cash flow may be materially different than that disclosed above.
Additional information required by this item is included under the caption “Inflation” in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of this Report.
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The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Securities Exchange Act of 1934 (“The Exchange Act”) reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure, in accordance with the definition of “disclosure controls and procedures” in Rule 13a – 14(c) under the Exchange Act. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, cannot provide absolute assurance of achieving the desired control objectives. Management included in its evaluation the cost-benefit relationship of possible controls and procedures. The Company continually evaluates its system of internal controls over financial reporting to determine if changes are appropriate based upon changes in the Company’s operations or the business environment in which it operates.
As of the end of the period covered by this Form 10-Q, the Company performed an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective.
There were no changes in the Company’s internal control over financial reporting during the quarter ended March 31, 2005, or subsequent to the date the Company completed its evaluation, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II – OTHER INFORMATION
Item 1 – Legal Proceedings
Court-ordered mediation did not result in settlement. On February 22, 2005, the court granted Lippert’s motion for partial summary judgment limiting plaintiff’s damages to those incurred prior to December 31, 2002, thereby reducing plaintiff’s damage claim from over $8 million (before trebling) to an amount which the Company believes could be less than $1 million based on counsel’s analysis of the testimony of plaintiff’s and Lippert’s damage experts, although there can be no assurance of the outcome. The court also granted Lippert’s motions for partial summary judgment as to all aspects of plaintiff’s unfair competition claim and plaintiff’s claim for an injunction. The court denied Lippert’s attempt to limit damages to those incurred prior to May 10, 2002, and certain other aspects of Lippert’s defense. Lippert’s $500,000 settlement offer to Plaintiff, which was recorded as a charge in the first quarter of 2005, was rejected. It is anticipated that a trial will be held in early 2006.
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Lippert and Kinro sell products to Oakwood Homes, Inc. (“Oakwood”), which filed for relief under Chapter 11 of the United States Bankruptcy Code in November 2002. Proofs of claim filed by Lippert and Kinro are pending. Lippert and Kinro have been advised that the OCH Liquidation Trust (the “Trust”) intends to file preference claims against them with respect to payments made to them by Oakwood prior to the bankruptcy filing. The preference claims are in the aggregate amount of approximately $4 million. The Company believes that Lippert and Kinro have valid defenses to the preference claims and that there should be no material liability to the Trust. In this connection, the Trust has indicated that, as an alternative to preference claims, the Trust might assert that payments by Oakwood constituted fraudulent transfers under sections 544 and 548 of the Bankruptcy Code. If the Trust pursues this claim, Lippert and Kinro, as well as several other creditors similarly situated, intend to vigorously defend against it.
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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.
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