Overview

Over the last five years the market for residential wood furniture has been significantly impacted by declines in housing activity, consumer confidence and disposable income. In response to these deteriorating industry conditions we took a number of steps during this time to reposition our company to align our cost structure and operating models with the lower sales volume and the changing marketplace. Major restructuring action was taken to consolidate facilities and ultimately reduce our domestic manufacturing footprint to improve asset utilization and production efficiencies. At the same time we shifted our operation strategy for each brand so that we could respond to the demands of a new marketplace and position our company for growth. Accordingly, we transitioned the manufacturing of the Stanley Furniture product line to a fully overseas sourced model and ceased domestic manufacturing operations for this brand in late 2010. This transition of our Stanley Furniture product line was successfully completed in 2011. For our Young America product line we implemented a strategy to differentiate this line by controlling the production to ensure safety, quality, selection and service. This led us to shift the production of sourced Young America items from overseas to our domestic operation. Over the past two years we have invested approximately $8.0 million in the modernization of our Young America manufacturing facility in Robbinsville, North Carolina to allow us to compete as a domestic producer of this product. We completed this major modernization and the transition of the entire product line to higher quality standards in December 2012. All these actions resulted in significant losses in 2009 and 2010 and to a lesser extent in 2011 and 2012. The strength of our Balance Sheet during this transition has allowed us to act on strategic decisions that we believe have positioned us for growth in both product lines.

Results of Operations

The following table sets forth the percentage relationship to net sales of certain items included in the Consolidated Statements of Income:

                                                    For the Years Ended
                                                        December 31,
                                              2012        2011         2010
Net sales                                      100.0 %     100.0 %      100.0 %
Cost of sales                                   87.6        88.1        111.7
Gross profit (loss)                             12.4        11.9       (11.7)
Selling, general and administrative expenses    18.6        18.4         15.1
Goodwill impairment charge                                                6.6
Operating loss                                 (6.2)       (6.5)       (33.4)
CDSOA income, net                               39.9         3.8          1.1
Other income, net                                 .1          .1
Interest expense, net                            2.3         2.2          2.6
Income before income taxes                      31.5       (4.8)       (34.9)
Income taxes (benefit)                            .7                    (2.9)
Net income (loss)                               30.8 %     (4.8) %     (32.0) %

2012 Compared to 2011

Net sales decreased $6.1 million, or 5.8%, in 2012 compared to 2011. The decrease was primarily due to lower unit volume for our Young America product line as we completed the modernization efforts in our factory and transitioned the entire product line to higher quality standards. Partially offsetting the volume declines on the Young America product line was increased sales and unit volume on the Stanley Furniture product line, as we believe we are regaining market share lost during our transition to a sourced model in early 2011.

Gross profit as a percentage of net sales improved to 12.4% in 2012 from 11.9% in 2011. The improvement in gross profit for 2012 compared to 2011 resulted from higher sales volume on the Stanley Furniture product line and operational improvements from our Young America product line. Included in gross profit in 2012 and 2011 is $474,000 and $416,000, respectively, in restructuring and related charges. During 2011, we began evaluating our overall warehousing and distribution requirements for our Stanley Furniture product line and concluded that only a portion of the leased warehouse space in Stanleytown, Virginia would be required. As a result, a restructuring charge against future lease obligations of $418,000 and $499,000 was taken in 2012 and 2011, respectively.

Selling, general and administrative expenses for 2012 were $18.3 million, or 18.6% of net sales, compared to $19.3 million, or 18.4% of net sales, in 2011.
The decline in this expense is primarily due to the impact that lower sales has on variable selling expenses, lower spending on marketing related expenses and a decrease in bad debt expense.

As a result of the above, operating loss improved to $6.1 million in 2012 compared with an operating loss of $6.8 million in 2011.

We recorded income, net of legal expenses, of $39.3 million in 2012 from the receipt of funds under the Continued Dumping and Subsidy Offset Act of 2000 (CDSOA) involving wooden bedroom furniture imported from China and other related payments compared to $4.0 million in 2011.

Interest expense in 2012 remained flat with 2011. Interest expense for both periods is composed of interest on insurance policy loans from a legacy deferred compensation plan and imputed interest on a lease related obligation in 2011.

Our effective tax rate for 2012 was 2.1%. The tax expense in 2012 is primarily the result of federal alternative minimum tax on the receipt of proceeds from the CDSOA distributed by U.S. Customs and Border Protection. Federal alternative minimum tax regulations limit the ability to offset all of the income generated in the period with net operating loss carry forwards. Our 2011 effective tax rate was essentially zero since we had established a valuation allowance for our deferred tax assets in excess of our deferred tax liabilities.

2011 Compared to 2010

Net sales decreased $32.4 million, or 23.6%, in 2011 compared to 2010. The decrease was due primarily to lower unit volume. We believe the overall decline was the result of loss of market share and continued weakness in demand for residential wood furniture in the premium segment. We believe the loss of market share resulted from the transition caused by the major restructuring of our business. Partially offsetting the unit decline was higher average selling prices for our Young America products.

Gross profit in 2011 increased to $12.5 million, or 11.9% of net sales, from a loss of $16.1 million in 2010. Included in gross profit in 2011 and 2010 is $416,000 and $10.4 million, respectively, in restructuring and related charges.
See Note 8 of the Notes to the Consolidated Financial Statements for further details on restructuring and related charges. The remaining improvement in gross profit for 2011 compared to 2010 resulted primarily from the Stanley product line operating with a globally sourced model with little fixed cost burden. Also contributing to the improved margins was the progression of operational improvements throughout the year in Robbinsville combined with higher average selling prices for Young America.

Selling, general and administrative expenses for 2011 were $19.3 million, or 18.4% of net sales, compared to $20.6 million, or 15.1% of net sales, in 2010. The decline in this expense is primarily due to the impact that lower sales has on variable selling expenses. Partially offsetting these lower costs were increased spending on marketing related expenses to educate the consumer on the reinvention of our product lines and increased bad debt expense. The higher percentage in 2011 is primarily due to lower sales.

During the first quarter of 2010, we completed an impairment analysis of goodwill and recognized a charge of $9.1 million, the entire amount of goodwill at the time.

As a result of the above, operating loss improved to $6.8 million in 2011 compared with an operating loss of $45.8 million in 2010.

We recorded income, net of legal expenses, of $4.0 million in 2011 from the receipt of funds under the Continued Dumping and Subsidy Offset Act of 2000 (CDSOA) involving wooden bedroom furniture imported from China and other related payments compared to $1.6 million in 2010.

Interest expense in 2011 declined from 2010 due to the repayment of all outstanding debt in December 2010. Interest expense in the current year is composed of interest on insurance policy loans from a legacy deferred compensation plan and imputed interest on a lease related obligation.

Our effective tax rate for 2011 was essentially zero compared to a tax benefit rate of 8.3% in 2010. The 2011 rate is the result of using all available carry-back income and maintaining a full valuation allowance for our deferred tax assets in excess of our deferred tax liabilities. The effective tax benefit rate for 2010 was 8.3% which differs from the U.S. federal statutory rate of 35% because of the establishment of a deferred tax valuation allowance and to a lesser extent the goodwill impairment charge.

Financial Condition, Liquidity and Capital Resources

Sources of liquidity include cash on hand and cash generated from operations. While we believe that our business strategy and restructuring efforts will be successful, we cannot predict with certainty the ultimate impact on our revenues, operating costs and cash flows from operations. The CDSOA proceeds of $39.9 million have strengthened our balance sheet and allowed us to focus on the execution of our strategy. We expect cash on hand to be adequate for ongoing expenditures and capital expenditures for the foreseeable future.
At December 31, 2012 we had $10.9 million in cash, $1.7 million in restricted cash and $25.0 million of short-term investments.

Working capital, excluding cash, restricted cash and short-term investments, increased during 2012 to $34.6 million from $28.8 million on December 31, 2011.
The increase was primarily the result of a build in inventories and a reduction in accounts payable.

Cash provided by operations was $25.4 million in 2012 compared to cash used of $7.3 million in 2011 and $9.4 million in 2010. The cash provided by operations during 2012 was from the receipt of $39.9 million in proceeds from the CDSOA compared to $4.6 million in 2011 and $2.2 million in 2010. Also during the current year, we paid income taxes of $768,000, largely driven by the income related to the CDSOA proceeds compared to income tax refunds of $3.6 million in 2011 and $8.2 million in 2010. The increase in cash used by operations in 2012, excluding the CDSOA receipts, was primarily due to lower sales, partially offset by a decrease in cash paid to suppliers and employees resulting from savings related to operational improvements on our Young America product line .

Net cash used by investing activities was $31.6 million in 2012 compared to $4.4 million in 2011 and cash provided of $4.8 million in 2010. During 2012 we invested $25.0 million of our CDSOA proceeds in short-term investments. In addition, we invested $3.8 million in 2012, $4.4 million in 2011 and $857,000 in 2010 in capital expenditures a majority of which was for the modernization of our Young America manufacturing operation in Robbinsville, North Carolina. We also began to improve our systems and website during 2012 with an investment of $2.7 million and project to spend another $2.0 million in 2013 to finalize the project. Included in 2011 investing activities was a $1.6 million transfer of cash to restricted cash to secure letters of credit. Sale of assets provided cash of $81,000, $1.6 million and $5.7 million in 2012, 2011 and 2010, respectively. Capital expenditures for 2013 should return back to normal maintenance capital at approximately $1.0 million, with most occurring in the later part of the year. In addition, we expect to invest $1.7 million in leasehold improvements on the consolidation of our showroom and corporate offices in High Point, North Carolina. Approximately $178,000 has been invested in 2012 and the remainder will be invested in the first half of 2013.

Net cash provided by financing activities was $1.5 million in 2012 compared to $1.9 million in 2011 and cash used of $11.7 million in 2010. In 2012, funds were used for the purchase and retirement of $661,000 of our common stock. In 2012, 2011 and 2010, proceeds from insurance policy loans provided cash of $2.2 million, $2.0 million and $1.8 million, respectively. In 2010, cash of $27.9 million was used to retire outstanding debt, proceeds of $11.8 million (net of expenses) were received from the issuance of 4 million shares of our common stock and proceeds of $2.4 million were received from the sale of our Martinsville, Virginia facility which was accounted for as a financing obligation.

In the first quarter of 2012, we entered into a lease agreement for a new corporate office and showroom location that will allow for the consolidation of our corporate offices and our High Point Market showroom into a single, multi-purpose location in High Point, North Carolina. As a result of this consolidation, we expect to record approximately $600,000 in restructuring charges for severance and relocation cost in the first quarter of 2013. In addition, we entered into a lease agreement to open a new showroom within the Las Vegas Design Center located within the World Market Center Las Vegas in January 2013. With the addition of these leases, our future minimum operating lease payments will be $1.5 million in 2013 and 2014, $1.6 million in 2015, $1.2 million in 2016, $800,000 in 2017 and $3.7 million for the years thereafter.

The following table sets forth our contractual cash obligations and other commercial commitments at December 31, 2012 (in thousands):

                                            Payment due or commitment expiration
                                            Less Than                                   Over
                                Total        1 year       1-3 years     4-5 years     5 years
Contractual cash obligations:
Postretirement benefits other
than pensions(1)              $    3,562   $       346   $       599   $       540   $    2,077
Operating leases                  10,207         1,454         3,074         2,016        3,663
Capital lease                        747           147           294           294           12
Total contractual cash
obligations                   $   14,516   $     1,947   $     3,967   $     2,850   $    5,752
Other commercial commitments:
Letters of credit             $    1,737   $     1,737

(1) The RP-2000 Combined Health Mortality Table with generational mortality improvements were used in estimating future benefit payments, and the health care cost trend rate for determining payments is 8.5% for 2012 and gradually declines to 5.5% in 2018 where it is assumed to remain constant for the remaining years.

Not included in the above table are unrecognized tax benefits of $678,000, due to the uncertainty of the date of occurrence.

Continued Dumping and Subsidy Offset Act (CDSOA)

The CDSOA provides for distribution of monies collected by U.S. Customs and Border Protection ("Customs") for imports covered by antidumping duty orders entering the United States through September 30, 2007 to eligible domestic producers that supported a successful antidumping petition ("Supporting Producers") concerning wooden bedroom furniture imported from China. We received CDSOA proceeds in the amount of $39.9 million, $4.0 million and $1.6 million in 2012, 2011 and 2010. Antidumping duties for merchandise entering the U.S. after September 30, 2007 have remained with the U.S. Treasury.

Certain manufacturers who did not support the antidumping petition ("Non-Supporting Producers") filed actions in the United States Court of International Trade, challenging the CDSOA's "support requirement" and seeking to share in the distributions. As a result, Customs held back a portion of those distributions (the "Holdback") pending resolution of the Non-Supporting Producers' claims. The Court of International Trade dismissed all of the actions of the Non-Supporting Producers, who appealed to the United States Court of Appeals for the Federal Circuit. Customs advised that it expected to distribute the Holdback to the Supporting Producers after March 9, 2012. The Non-Supporting Producers sought injunctions first from the Court of International Trade and, when those efforts were unsuccessful, from the Federal Circuit directing Customs to retain the Holdback until the Non-Supporting Producers' appeals were resolved.

On March 5, 2012, the Federal Circuit denied the motions for injunction, "without prejudicing the ultimate disposition of these cases." As a result, we received a CDSOA distribution in the amount of $39.9 million in April 2012. If the Federal Circuit were to reverse the decisions of the Court of International Trade and determine that the Non-Supporting Producers were entitled to CDSOA distributions, it is possible that Customs may seek to have us return all or a portion of our share of this most recent distribution. The Federal Circuit has scheduled oral arguments for March 8, 2013 concerning the appeals of the Non-Supporting Producers. Based on what we know today, we believe that the chance Customs will seek and be entitled to obtain a return is remote. We therefore recorded income, net of expenses, of $39.4 million in April 2012 as a result of the receipt of these funds.

In addition, according to Customs, as of October 1, 2012, approximately $8.9 million in duties had been secured by cash deposits and bonds on unliquidated entries of wooden bedroom furniture that are subject to the CDSOA, and this amount is potentially available for distribution under the CDSOA to eligible domestic producers in connection with the case involving wooden bedroom furniture imported from China. The amount ultimately distributed will be impacted by appeals concerning the results of the annual administrative review process, which can retroactively increase or decrease the actual duties owed on entries secured by cash deposits and bonds, by collection efforts concerning duties that may be owed, and by any applicable legislation and Custom's interpretation of that legislation. Assuming that such funds are distributed and that our percentage allocation in future years is the same as it was for the 2011 distribution (approximately 30% of the funds distributed) and the $8.9 million in estimated antidumping duties secured by antidumping duty cash deposits and bonds does not change as a result of the annual administrative review process or otherwise, we could receive approximately $2.7 million more in CDSOA funds.

In November 2012, Customs disclosed that it has again withheld funds from any available distribution associated with any cases involved in ongoing litigation until the amounts at issue in the pending litigation have been resolved. It is expected that Customs will continue withholding such funds until a final decision is reached in the pending litigation. Therefore, no distributions were made in December 2012 for the case involving wooden bedroom furniture imported from China.

Due to the uncertainty of the various legal and administrative processes, we cannot provide assurances as to the amount of additional CDSOA funds that ultimately will be received, if any, and we cannot predict when we may receive any additional CDSOA funds.

Critical Accounting Policies

We have chosen accounting policies that are necessary to accurately and fairly report our operational and financial position. Below are the critical accounting policies that involve the most significant judgments and estimates used in the preparation of our consolidated financial statements.

Cash and equivalents - We consider highly liquid investments with maturities of 90 days or less when purchased to be cash equivalents. Cash equivalents are stated at cost, which approximates fair market value. Our cash and cash equivalents are primarily in bank deposits, money market funds and certificate of deposits.

Short-term investments - We consider investments with maturities of greater than three months and less than one year at the time of purchase as short-term investments. Our investments are in certificates of deposits, which we intend to hold until maturity. We report the investments at cost with earnings recognized through interest income.

Allowance for doubtful accounts - We maintain an allowance for doubtful accounts for estimated losses resulting from the failure of our customers to make required payments. We perform ongoing credit evaluations of our customers and monitor their payment patterns. Should the financial condition of our customers deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required which would reduce our earnings.

Inventory valuation - Inventory is valued at the lower of cost or market. Cost for all inventories is determined using the first-in, first-out (FIFO) method.
We evaluate our inventory to determine excess or slow moving items based on current order activity and projections of future demand. For those items identified, we estimate our market value based on current trends. Those items having a market value less than cost are written down to their market value. If we fail to forecast demand accurately, we could be required to write off additional non-saleable inventory, which would also reduce our earnings.

Deferred Taxes -- We recognize deferred tax assets and liabilities based on the estimated future tax effects of differences between the financial statements and the tax basis of assets and liabilities given the enacted tax laws. We evaluate the need for a deferred tax asset valuation allowance by assessing whether it is more likely than not that the company will realize its deferred tax assets in the future. The assessment of whether or not a valuation allowance is required often requires significant judgment, including the forecast of future taxable income. Adjustments to the deferred tax valuation allowance are made to earnings in the period when such assessment is made.

In preparation of the company's financial statements, management exercises judgments in estimating the potential exposure to unresolved tax matters and applies a more likely than not criteria approach for recording tax benefits related to uncertain tax positions. While actual results could vary, in management's judgment, the company has adequate tax accruals with respect to the ultimate outcome of such unresolved tax matters.

Long-lived assets - Property, plant and equipment is reviewed for possible impairment when events indicate that the carrying amount of an asset may not be recoverable. Assumptions and estimates used in the evaluation of impairment may affect the carrying value of long-lived assets, which could result in impairment charges in future periods that would lower our earnings. Our depreciation policy reflects judgments on the estimated remaining useful lives of assets.

Off-Balance Sheet Arrangements

We do not have transactions or relationships with "special purpose" entities, and we do not have any off-balance sheet financing other than normal operating leases primarily for warehousing, showroom and office space, and certain technology equipment.