Olympic Steel - 10-Q quarterly report FY

 

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 þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes þ No o

Indicate the number of shares of each of the issuer’s classes of common stock, as of the latest practicable date:

The accompanying consolidated financial statements have been prepared from the financial records of Olympic Steel, Inc. and its wholly-owned subsidiaries (collectively Olympic or the Company), without audit and reflect all normal and recurring adjustments which are, in the opinion of management, necessary to fairly present the results of the interim periods covered by this report. Year-to-date results are not necessarily indicative of 2005 annual results and these financial statements should be read in conjunction with the Company’s 2004 Annual Report on Form 10-K. All significant intercompany transactions and balances have been eliminated in consolidation. Investments in the Company’s joint ventures are accounted for under the equity method.

The Company maintained allowances for doubtful accounts and unissued credits of $4.1 million and $4.3 million at June 30, 2005 and December 31, 2004, respectively. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific customer collection issues that have been identified. Estimations are based upon a calculated percentage of accounts receivable, which remains fairly level from year to year, and judgments about the probable effects of economic conditions on certain customers, which can fluctuate significantly from year to year. The Company cannot guarantee that the rate of future credit losses will be similar to past experience. The Company considers all available information when assessing each quarter the adequacy of its allowance for doubtful accounts.

Steel inventories consist of the following:

The Company’s two joint ventures are Olympic Laser Processing, LLC (OLP), a company that processes laser welded steel sheet blanks for the automotive industry, and G.S.P., LLC (GSP), a certified Minority Business Enterprise company supporting the flat-rolled steel requirements of the automotive industry. As of June 30, 2005, Olympic guaranteed 50% of OLP’s $14.5 million and 49% of GSP’s $4.1 million of outstanding debt on a several basis.

The following table sets forth selected data for the Company’s OLP joint venture:

The Company records 50% of OLP’s net income or loss to its Consolidated Statements of Operations as “Income from Joint Ventures.”

The following table sets forth selected data for the Company’s GSP joint venture:

The Company records 49% of GSP’s net income or loss to its Consolidated Statements of Operations as “Income from Joint Ventures.”

The Company’s secured bank-financing agreement (the Credit Facility) is comprised of a revolver and two term loan components. The Credit Facility is collateralized by the Company’s accounts receivable, inventories, and substantially all of the property and equipment. Revolver borrowings are limited to the lesser of a borrowing base, comprised of eligible receivables and inventories, or $110 million in the aggregate. In June 2005, the Company entered into an amendment of the Credit Facility which: (i) extended the maturity date of the existing Credit Facility from December 15, 2006 to December 15, 2008; and (ii) added a $25 million accordion feature to the revolver portion of the Credit Facility which allows the Company to add up to $25 million of availability at a future date. The Company has the option to borrow based on the agent’s base rate or Eurodollar Rates (EURO) plus a premium.

In December 2002, the Company incurred $2.2 million of closing fees and expenses in connection with the origination of this Credit Facility and also incurred $1 million of subsequent bank amendment and waiver fees, all of which have been capitalized and included in “Deferred Financing Fees, Net” on the accompanying consolidated balance sheets. These fees and expenses are being amortized to “Interest and Other Expense on Debt.”

The Company’s effective borrowing rate, inclusive of deferred financing fees, for the first six months of 2005 was 5.6% compared to 5.8% for the comparable period in 2004.

The Credit Facility requires the Company to comply with various covenants, the most significant of which include: (i) minimum availability of $10 million, tested monthly, (ii) a minimum fixed charge coverage ratio of 1.25, and a maximum leverage ratio of 1.75, which are tested quarterly, (iii) restrictions on additional indebtedness, and (iv) limitations on capital expenditures. At June 30, 2005, the Company had $61.0 million of availability under its Credit Facility and was in compliance with its covenants.

Included in the Credit Facility revolver balances on the accompanying consolidated balance sheets are $8.6 million and $9.1 million of checks issued by the Company that have not cleared the bank as of June 30, 2005 and December 31, 2004, respectively.

In 2002, the Company closed its unprofitable tube processing operation (Tubing) in Cleveland, Ohio. In accordance with Statement of Financial Accounting Standards No. 144 (SFAS No. 144), “Accounting for the Impairment or Disposal of Long-Lived Assets,” Tubing was accounted for as a discontinued operation and its assets were written down to their estimated fair value less costs to sell. The accompanying Consolidated Statements of Operations reflects a $487 thousand asset impairment charge in 2004 which reduced the carrying value of the assets held for sale to its then estimated fair value of $150 thousand. The assets were sold in the third quarter of 2004 for $150 thousand.

Earnings per share have been calculated based on the weighted average number of shares outstanding as set forth below:

At June 30, 2005, stock options to purchase 756,512 shares were outstanding, of which 637,179 were exercisable at prices ranging from $1.97 to $15.50 per share, none of which were anti-dilutive.

Statement of Financial Accounting Standards No. 123 (SFAS No. 123), “Accounting for Stock-Based Compensation,” encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company’s stock at the date of the grant over the amount an employee must pay to acquire the stock.

If the Company had elected to recognize compensation cost based on the fair value of the options granted at the grant date under SFAS No. 123, net income and earnings per share would have been reduced by the amounts shown below:

Interest paid during the first six months of 2005 and 2004 totaled $2.1 million and $2.0 million, respectively. Taxes paid during the first six months of 2005 and 2004 totaled $10.0 million and $4.2 million, respectively.

In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 151 (SFAS No. 151), “Inventory Costs – an amendment of ARB No. 43, Chapter 4” which clarifies that abnormal amounts of idle facility expenses, freight, handling costs and wasted materials (spoilage) should be recognized as current period charges. In addition, SFAS No. 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of SFAS No. 151 are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS No. 151 is not expected to have a material impact on our financial statements.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123-R (SFAS No. 123-R). SFAS No. 123-R establishes standards for accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those securities. SFAS No. 123-R also requires an entity to recognize the cost of employee services received in share-based payment transactions, thereby reflecting the economic consequences of those transactions in the financial statements. SFAS No. 123-R applies to all awards granted on or after July 1, 2005, and to awards modified, vested, repurchased, or canceled after that date. In April 2005, the FASB delayed the effective date of SFAS No. 123-R, so that it applies to our annual period beginning on January 1, 2006. Due to the relatively few number of stock options vesting after the effective date, SFAS No. 123-R is not expected to have a significant impact on our financial statements.

The following discussion and analysis of our financial conditions and results are based upon the consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results could differ from these estimates under different assumptions or conditions. On an ongoing basis, we monitor and evaluate our estimates and assumptions.

For further information regarding the accounting policies that we believe to be critical accounting policies and that affect our more significant judgments and estimates used in preparing our consolidated financials statements, see our Annual Report on Form 10-K for the period ended December 31, 2004.

Our results of operations are affected by numerous external factors, such as general and global business, economic and political conditions, competition, steel pricing and availability, energy prices, pricing and availability of raw materials used in the production of steel, customer demand for steel and their ability to manage their credit line availability and layoffs or work stoppages by our own, our suppliers’ or our customers’ personnel.

We sell a broad range of products, many of which have different gross profits and margins. Products that have more value-added processing generally have a greater gross profit and higher margins. Accordingly, our overall gross profit is affected by, among other things, product mix, the amount of processing performed, the availability of steel, volatility in selling prices and material purchase costs. We also perform toll processing of customer-owned steel, the majority of which is performed in our Detroit and Georgia operations.

Our two joint ventures are Olympic Laser Processing, LLC (OLP), a company that processes laser welded sheet steel blanks for the automotive industry, and G.S.P., LLC (GSP), a certified Minority Business Enterprise company supporting the flat-rolled steel requirements of the

automotive industry. Our 50% interest in OLP and 49% interest in GSP are accounted for under the equity method.

Financing costs include interest expense on debt and deferred financing and bank amendment fees amortized to expense.

We sell certain products internationally. All international sales and payments are made in United States dollars. Recent international sales have been immaterial to our consolidated financial results.

In 2002, we closed our unprofitable tube processing operation (Tubing) in Cleveland, Ohio. In accordance with Statement of Financial Accounting Standards No. 144 (SFAS No. 144), “Accounting for the Impairment or Disposal of Long-Lived Assets,” Tubing was accounted for as a discontinued operation and its assets were written down to their estimated fair value less costs to sell. The accompanying Consolidated Statements of Operations reflects a $487 thousand asset impairment charge which reduced the carrying value of the assets held for sale to its then estimated fair value of $150 thousand. The assets were sold in the third quarter of 2004 for $150 thousand.

We have four collective bargaining agreements covering approximately 185 employees at our Minneapolis and Detroit facilities. A collective bargaining agreement for employees at our Minneapolis coil facility expires on September 30, 2005 and agreements covering other Detroit and Minneapolis employees expire in 2006 and subsequent years. We have never experienced a work stoppage and we believe that our relationship with our employees is good. However, any prolonged work stoppages by our personnel represented by collective bargaining units could have a material adverse effect on our business, financial condition, results of operations or cash flows.

Tons sold decreased 7.4% to 319 thousand in the second quarter of 2005 from 344 thousand in the second quarter of 2004. Tons sold in the second quarter of 2005 included 271 thousand from direct sales and 48 thousand from toll processing, compared with 293 thousand direct tons and 51 thousand toll tons in the comparable period of last year. Tons sold in the first six months of 2005 decreased 7.0% to 679 thousand from 729 thousand last year. Tons sold in the first six

months included 585 thousand from direct sales and 94 thousand from toll processing, compared with 623 thousand direct tons and 106 thousand toll tons in the comparable period of last year. The decreases in tons sold for the 2005 periods were primarily attributable to reduced sales to automotive customers, reduced sales to other service centers and lower overall demand across most sectors in 2005 when compared to 2004. We expect third quarter tons sold to be less than second quarter tons sold due to normal seasonal closings and production declines of certain automotive and manufacturing customers.

Net sales increased 8.4% to $241.5 million in the second quarter of 2005 from $222.8 million in the second quarter of 2004. For the first six months of 2005, net sales increased 28.4% to $526.0 million from $409.8 million. Average selling prices for the second quarter of 2005 increased 17.1% from last year’s second quarter, but decreased 4.2% from the first quarter of 2005. Higher levels of inventory held by steel service centers and end-use customers have led to competitive pressures and have reduced selling prices during the second quarter of 2005. We expect competitive pressures on selling price to continue in the third quarter of 2005.

As a percentage of net sales, gross profit (exclusive of depreciation) decreased to 14.9% in the second quarter of 2005 from 31.7% in the second quarter of 2004. For the first six months of 2005, gross profit decreased to 16.2% from 30.3% in the comparable 2004 period. As the base price of steel declined, competitive pressures resulted in lower current selling prices and gross margin percentages during the first six months of 2005. We expect gross margin levels in the third quarter of 2005 to be comparable to the second quarter of 2005.

Operating expenses in the second quarter of 2005 decreased 22.5% to $30.1 million from $38.8 million in last year’s second quarter. For the first six months of 2005, operating expenses decreased 14.7% to $62.7 million from $73.4 million in the comparable 2004 period. The decrease in operating expenses is primarily the result of lower variable compensation for the first six months of 2005. As a percentage of net sales, operating expenses decreased to 12.4% for the second quarter of 2005 from 17.4% in the comparable 2004 period. For the first six months of 2005, operating expenses decreased to 11.9% of net sales from 17.9% in the last year’s comparable period. Our 2005 second quarter results included an after-tax bad debt charge of $1.1 million, or $.10 per diluted share, related to receivables from two customers that filed for bankruptcy protection in June 2005.

Income from joint ventures totaled $200 thousand in the second quarter of 2005, compared to $94 thousand in the second quarter of 2004. For the first six months of 2005, income from joint ventures totaled $443 thousand compared to $172 thousand in 2004.

Financing costs totaled $1.4 million for the second quarter of 2005 compared to $1.0 million for the second quarter of 2004. For the first six months of 2005, financing costs increased to $2.7 million from $2.4 million in 2004. Our effective borrowing rate, inclusive of deferred financing fees, for the first six months of 2005 was 5.6% compared to 5.8% in 2004. We have the option to borrow based on the agent bank’s base rate or Eurodollar Rate (EURO) plus a premium. We expect market interest rates to increase during the remainder of 2005.

For the second quarter of 2005, income before income taxes totaled $4.8 million compared to $30.8 million in the second quarter of 2004. An income tax provision of 36.9% was recorded for the second quarter of 2005, compared to a provision of 40% for the second quarter of 2004. For the first six months of 2005, we reported income before taxes of $20.5 million compared to $48.3 million for the first six months of 2004. An income tax provision of 38.5% was recorded during the first six months of 2005 compared to a 39.3% provision recorded during the comparable 2004 period. The effective tax rate decreased in 2005 due to our estimated benefit of the manufacturing deduction provided by The American Jobs Creation Act of 2004. We expect the effective tax rate to approximate 38.5% for the remainder of 2005. Taxes paid totaled $7.8 million and $4.1 million for the second quarter of 2005 and 2004, respectively. Taxes paid during the first six months of 2005 totaled $10.0 million compared to $4.1 million for the comparable 2004 period. Taxes paid in 2005 are higher than 2004 as substantially all net operating loss carryforwards were utilized during the first six months of 2004.

Net income for the second quarter of 2005 totaled $3.0 million or $.29 per diluted share, compared to net income of $18.5 million or $1.82 per diluted share for the second quarter of 2004. Net income for the first six months of 2005 totaled $12.6 million or $1.21 per diluted share, compared to $29.3 million or $2.90 per diluted share in the first six months of 2004.

Our principal capital requirements include funding working capital needs, purchasing and upgrading processing equipment and facilities, and investing in joint ventures. We use cash generated from operations, leasing transactions, and our credit facility to fund these requirements.

Working capital at June 30, 2005 increased $3.9 million from the end of the prior year. Significant working capital changes included a $42.3 million decrease in inventories from December 31, 2004, a $11.6 million increase in accounts receivable, and decreases of $20.7 million in accounts payable and $13.3 million in accrued payroll and accrued liabilities.

Net cash from operating activities totaled $12.6 million for the six months ended June 30, 2005. Cash generated from earnings before non-cash items totaled $16.5 million, while cash used for working capital components totaled $3.9 million. Decreases in steel pricing and the reduction in our inventory levels have resulted in significant decreases in inventories and accounts payable. We expect working capital levels to further decline during the third quarter of 2005, as lower pricing will result in further reductions of accounts receivable, inventories and accounts payable.

During the first six months of 2005, net cash used for investing activities totaled $0.9 million, which consisted of capital spending. We do not expect to make significant capital expenditures during the remainder of the year. We anticipate adding new laser processing equipment during the remainder of 2005, which we expect will be financed through operating leases.

Net cash used for financing activities during the first six months of 2005 totaled $12.4 million and primarily consisted of scheduled principal repayments under our debt agreements and reduced borrowings under our revolving credit line, offset by proceeds from the exercise of stock options. We expect our total borrowings to further decline during the third quarter of 2005.

Our secured bank-financing agreement (the Credit Facility) is comprised of a revolver and two term loan components. The Credit Facility is collateralized by our accounts receivable, inventories, and substantially all of our property and equipment. Revolver borrowings are limited to the lesser of a borrowing base, comprised of eligible receivables and inventories, or $110 million in the aggregate. In June 2005, we entered into an amendment of the Credit Facility which: (i) extended the maturity of the existing Credit Facility from December 15, 2006 to

December 15, 2008; and (ii) added a $25 million accordion feature to the revolver portion of the Credit Facility which allows us to add up to $25 million of availability at a future date.

In December 2002, we incurred $2.2 million of closing fees and expenses in connection with the origination of the Credit Facility and also incurred $1 million of subsequent bank amendment and waiver fees, all of which have been capitalized and included in “Deferred Financing Fees, Net” on the accompanying consolidated balance sheets. These fees and expenses are being amortized to interest and other expense on debt. Monthly principal payments of $367 thousand commenced on February 1, 2003 for the term loan components of the Credit Facility.

The Credit Facility requires us to comply with various covenants, the most significant of which include: (i) minimum availability of $10 million, tested monthly, (ii) a minimum fixed charge coverage ratio of 1.25, and a maximum leverage ratio of 1.75, which are tested quarterly, (iii) restrictions on additional indebtedness, and (iv) limitations on capital expenditures. At June 30, 2005, we had $61.0 million of availability under our Credit Facility and we were in compliance with our covenants.

We believe that funds available under our Credit Facility, together with funds generated from operations, will be sufficient to provide us with the liquidity necessary to fund anticipated working capital requirements, capital expenditure requirements, and scheduled debt maturities over the next 12 months. Capital requirements are subject to change as business conditions warrant and opportunities arise.

This document contains various forward-looking statements and information that are based on management’s beliefs as well as assumptions made by and information currently available to management. When used in this documents, the words “anticipate,” “expect,” “believe,” “estimate,” “project,” “plan” and similar expressions are intended to identify forward-looking statements, which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks, uncertainties and assumptions including, but not limited to:

Should one or more of these or other risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, expected, believed, estimated, projected or planned. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to republish revised forward-looking statements to reflect the occurrence of unanticipated events or circumstances after the date hereof.

During 2004, steel producers were significantly impacted by a shortage of raw materials, rising raw material prices, increased product demand, producer consolidation and longer lead time requirements. These conditions resulted in unprecedented cost increases and translated into higher gross profit dollars and margin percentages. During 2004, we were able to pass producers’ price increases and surcharges on to our customers. The base price of carbon flat-rolled steel has been declining since September 2004. This decline has reduced our gross profit margin percentages to levels which are lower than our historical levels. Higher levels of inventory at steel service centers and end-use customers have caused competitive pressures which have compressed gross margin percentages in the first half of 2005. Based on industry statistics, there was a meaningful decrease in service center inventory levels in June 2005. We believe that the continuation of this inventory correction may allow margin pressures to subside by later this year.

Approximately 12% of our net sales in the first half of 2005 were directly to automotive manufacturers or manufacturers of automotive components and parts. The automotive industry experiences significant fluctuations in demand based on numerous factors such as general economic conditions and consumer confidence. The automotive industry is also subject, from time to time, to labor work stoppages. Certain customers in this industry also represent an increasing credit risk.

We are exposed to the impact of interest rate changes and fluctuating steel prices. We have not entered into any interest rate or steel commodity hedge transactions for speculative purposes or otherwise.

Inflation generally affects us by increasing the cost of employee wages and benefits, transportation services, processing equipment, purchased steel, energy and borrowings under our credit facility. General inflation has not had a material effect on our financial results during the past two years. When raw material prices increase, competitive conditions will influence how much of the steel price increase can be passed on to our customers. When raw material prices decline, customer demands for lower costed product result in lower selling prices. Declining steel prices have generally adversely affected our net sales and net income, while increasing steel prices favorably affect net sales and net income.

Our primary interest rate risk exposure results from variable rate debt. If interest rates in the future were to increase 100 basis points (1.0%) from June 30, 2005 rates, and assuming no changes in total debt from June 30, 2005 levels, the additional annual interest expense to us would be approximately $792 thousand. We currently do not hedge our exposure to variable interest rate risk. However, we have the option to enter into 30 to 180 day fixed base rate EURO loans under the credit facility.

We have evaluated the effectiveness of the design and operations of our disclosure controls and procedures as of June 30, 2005. These disclosure controls and procedures are the controls and other procedures that were designed to ensure that information required to be disclosed in reports that are filed with or submitted to the SEC is: (i) accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures; and (ii) recorded, processed, summarized and reported within the time periods specified in applicable law and regulations. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2005, our disclosure controls and procedures were effective.

There were no changes in our internal controls over financial reporting that occurred during the second quarter of 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

The Company’s annual meeting of shareholders was held on April 28, 2005.

At the annual meeting, the Company’s shareholders elected Michael D. Siegal, Thomas M. Forman and James B. Meathe as Directors for a two-year term, which expires at the annual meeting of shareholders in 2007.

The following tabulation represents voting for the Directors:

On August 5, 2005, the Company entered into Management Retention Agreements (the “Agreements”) in substantially the same form as included in Exhibit 10.16, with Richard A. Manson, Treasurer & Corporate Controller, and Heber MacWilliams, Chief Information Officer. Under the Agreements which do not become operative unless there is a Change-in-Control of the Company (as defined in the Agreements), the Company agrees to continue the employment of the Officer for one year following the Change-in-Control in the same position with the same duties and responsibilities and at the same compensation level as existed prior to the Change-in-Control. If during the one year period following the Change-in-Control, the Officer’s employment is terminated without cause, or the Officer terminates his employment for “good reason,” the Officer shall receive a lump-sum severance payment equal to one times the average of his last three years’ compensation. The Agreement also includes a one-year non-competition prohibition.

Exhibit 10.16 – Form of Management Retention Agreement for Richard A. Manson and Heber MacWilliams.

Exhibit 31.1 – Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 31.2 – Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 32.1 – Certification of the Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Exhibit 32.2 – Certification of the Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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