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SCX > SEC Filings for SCX > Form 10-K on 5-Sep-2013All Recent SEC Filings

Show all filings for STARRETT L S CO

Form 10-K for STARRETT L S CO


5-Sep-2013

Annual Report

Items 7 and 7A- Management's Discussion and Analysis of Financial Condition and Results of Operations and Quantitative and Qualitative Disclosure about Market Risk

RESULTS OF OPERATIONS

Fiscal 2013 Compared to Fiscal 2012

Overview

Starrett is a global manufacturing company with approximately one-half of consolidated net sales derived outside of North America, predominantly through multiple distribution channels. The Company is exposed to volatility in the markets that it serves. In North America, economic uncertainty and political turmoil dampened manufacturing investment which adversely impacted sales for capital equipment and discouraged our distribution network customers to stock inventory at historical levels. Internationally, sales declined due to a continued recession in the European economies and a significant exchange rate decline in the Brazilian Real against the U.S. dollar.

Net sales for fiscal 2013 declined $16.3 million or 6.3% compared to fiscal 2012, due principally to unfavorable foreign currency exchange rates. Gross margins declined $6.3 million from $78.1 million or 30.0 % of sales in fiscal 2012 to $71.8 million or 29.5% of sales in fiscal 2013 as the savings related to lower pension costs was offset by unfavorable foreign currency exchange rates, reduced sales and higher unabsorbed fixed manufacturing costs. Selling, general and administrative expenses decreased $6.8 million or 9% from $79.9 million in fiscal 2012 to $73.1 million in fiscal 2013 principally due to lower international expenses translated to U. S. dollars and reduced pension expense. Operating income (loss) improved $0.6 million from a loss of $1.9 million in fiscal 2012 to a loss of $1.3 million in fiscal 2013.

Net Sales

Net sales in North America declined $5.6 million or 4% from $129.1 million in fiscal 2012 to $123.5 million in fiscal 2013. The principal factors contributing to the drop in sales were a combined reduction in precision tools and custom granite of $7.8 million, which was partially offset by a $3.3 million increase due to a full year of operations for Bytewise. International sales decreased $10.7 million or 8% from $131.0 million in fiscal 2012 to $120.3 million in fiscal 2013. Foreign currency exchange rate fluctuations represented an unfavorable impact of $16.2 million, while Brazilian sales denominated in local currency increased 6% or $5.5 million.

Gross Margin

Gross margin in North America increased $3.1 million or 10% from $29.8 million in fiscal 2012 to $33.0 million in fiscal 2013 and improved as a percentage of sales from 23% in fiscal 2012 to 27% in fiscal 2013. The improvement was due to lower pension expenses which more than offset inventory production inefficiencies. International gross margins decreased $9.4 million or 20% from $48.3 million in fiscal 2012 to $38.8 million in fiscal 2013 with foreign exchange fluctuations representing $5.1 million or 55% of the shortfall. Reduced sales and manufacturing inefficiencies represented the remaining $4.3 million decrease.

Selling, General and Administrative Expenses

Selling, general and administrative expenses in North American decreased $4.1 million or 10%. Lower pension expense represented $3.0 million of the decrease, while reduced headcount and management bonuses accounted for the remaining $1.1 million in savings. International selling, general and administrative expenses decreased $2.7 million or 7.0% with a $4.3 million savings due to the stronger U. S. dollar offsetting higher employee benefit expenses.

Other Income, Net

Other income, net improved $0.2 million due to the Company's equity share in higher profits of a private software development company. Internationally, a $0.5 million settlement gain related to a lawsuit was offset by a $0.5 million decline in foreign exchange gains as compared to the prior year.

Income Taxes

The Company recorded tax expense of $1.0 million in fiscal 2013 which represented 120% of pre-tax income. The principal reasons the effective tax rate exceeded the U.S. normalized combined federal and state statutory tax rate of approximately 40% was due to losses in two foreign operations which did not receive any tax benefit because of the uncertainty of recovery in the future and a reduction in deferred state tax assets due to a change in the expected effective state tax rate.


There were no significant changes in valuation allowances relating to carryforwards for foreign NOL's, foreign tax credits and certain state NOL's. The Company continues to believe that it is more likely than not that it will be able to utilize its domestic federal net operating loss carryforward of approximately $20.0 million.

Fiscal 2012 Compared to Fiscal 2011

Overview

Solid revenue growth continued in fiscal 2012 as sales increased over a strong fiscal 2011. The Company was not immune to the financial volatility over the past twelve months. Lower long-term interest rates driven by Federal Reserve policy led to the discount rate falling to historic lows. As a result the Company recognized a significantly higher pension liability, and a $17.2 million non-cash pension expense, of which $15.2 million was recorded in the fourth quarter of fiscal 2012. The eight fold increase over normal pension expense negatively impacted gross margin and selling, general and administrative expenses and was the prime driver in a net loss in the fourth quarter and near breakeven results for the year. The Company closed its Dominican Republic facility in December 2011 and added advanced metrology technology through its acquisition of Bytewise in November 2011.

Net sales for fiscal 2012 increased $15.3 million or 6.3% compared to fiscal 2011 due to a recovering manufacturing sector and increased market penetration. Gross margins declined $3.7 million from $81.8 million or 33 % of sales in fiscal 2011 to $78.1million or 30% of sales in fiscal 2012. Selling, general and administrative expenses increased $9.2 million or 13% from $70.8 million in fiscal 2011 to $79.9 million in fiscal 2012. Operating income declined $14.3 million from a profit of $12.4 million in fiscal 2011 to a loss of $1.9 million in fiscal 2012. All of these changes, as more fully described below, were significantly affected by the pension expense noted above.

Net Sales

Net sales in North America increased $9.4 million or 8% from $119.7 million in fiscal 2011 to $129.1 million in fiscal 2012. All divisions, excluding Tru Stone, posted gains led by precision tools. The Bytewise acquisition represented $6.1 million of the gain. International sales increased $5.9 million or 5% from $125.1 million in fiscal 2011 to $131.0 million in fiscal 2012. Foreign currency exchange rate fluctuations represented a marginal unfavorable impact of $0.9 million.. All international subsidiaries achieved sales increases and account for over 50% of the Company's global revenues.

Gross Margin

Gross margin in North America decreased $5.4 million or 15% from $35.2 million in fiscal 2011 to $29.8 million in fiscal 2012 and declined as a percentage of sales from 29% in fiscal 2011 to 23% in fiscal 2012. Higher sales and improved efficiencies contributed $1.2 million and $6.8 million, respectively. However, these gains were offset by an increase in non-cash pension expense of $13.4 million. Higher production levels for precision tools and saws were the primary factor influencing the improvement in efficiencies coupled with the contribution of the newly acquired higher margin Bytewise business. International gross margins increased $1.7 million or 4% from $46.6 million in fiscal 2011 to $48.3 million in fiscal 2012 and remained level as a percentage of sales at 37% in both fiscal 2011 and 2012. Foreign exchange rate fluctuations represented an unfavorable charge of $0.3.million. Improvements in China were offset by declines in Europe.

Selling, General and Administrative Expenses

North American selling, general and administrative expenses increased $4.7 million or 13%. Employee benefits increased $4.7 million principally due to a $3.0 million increase in non-cash pension expense, all of which was related to a decrease in the discount rate used to measure the pension benefit obligation. Salaries and insurance expenses increased $0.4 and $0.2 million, respectively. International selling, general and administrative expenses increased $4.5 million or 13% due to a $0.8 million bad debt; a $0.6 million increase in research and development expenses; and increased selling expenses, particularly in South America, related to increased competition including: $0.6 for advertising and marketing, $0.4 million in commissions and $0.3 travel and entertainment. International salaries and benefits also increased $0.7 million.

Operating Loss

Higher sales and improved gross margins were more than offset by a $16.4 million increase in North American non-cash pension expense resulting in a $1.9 million operating loss. The discount rate used for valuing the pension liability declined from 5.44% as of June 30, 2011 to 3.92% as of June 30, 2012 and increased the pension liability by $21.0 million, which was the prime driver behind the increase in pension expense.


Other Income, Net

Other income, net increased $1.1 million from $0.8 in fiscal 2011 to $1.9 million in fiscal 2012 primarily due to foreign currency exchange rate changes.

Income Taxes

The effective tax rate was a benefit of 700% for fiscal 2012. The rate reflects federal, state and foreign adjustments for permanent book tax differences. The principal reason for the rate significantly greater than the US normalized combined federal and state tax rate of approximately 40% includes the very low book income which causes even small dollar adjustments to have a very large impact on the tax rate. One significant item which reduced tax expense is income earned in foreign countries taxed at rates lower than the US tax rate.

There were no significant changes in valuation allowances relating to carryforwards for foreign NOL's, foreign tax credits and certain state NOL's. The Company continues to believe that it is more likely than not that it will be able to utilize its domestic federal net operating loss carryforward of approximately $16.8 million.

FINANCIAL INSTRUMENT MARKET RISK

Market risk is the potential change in a financial instrument's value caused by fluctuations in interest and currency exchange rates, and equity and commodity prices. The Company's operating activities expose it to risks that are continually monitored, evaluated and managed. Proper management of these risks helps reduce the likelihood of earnings volatility.

The Company does not engage in tracking, market-making or other speculative activities in derivatives markets. The Company does not enter into long-term supply contracts with either fixed prices or quantities. The Company engages in an immaterial amount of hedging activity to minimize the impact of foreign currency fluctuations and had $1.0 million in forward currency contracts outstanding at June 30, 2013. Net foreign monetary assets are approximately $37.5 million as of June 30, 2013.

A 10% change in interest rates would not have a significant impact on the aggregate net fair value of the Company's interest rate sensitive financial instruments or the cash flows or future earnings associated with those financial instruments. A 10% increase in interest rates would not have a material impact on our borrowing costs. See Note 13 to the Consolidated Financial Statements for details concerning the Company's long-term debt outstanding of $24.3 million.

LIQUIDITY AND CAPITAL RESOURCES

                                                       Years ended June 30 ($000)
                                                    2013         2012          2011
Cash provided by operating activities             $ 20,331     $   3,524     $   5,189
Cash used in investing activities                   (9,476 )     (25,870 )     (10,141 )
Cash provided by (used in) financing activities     (7,558 )      20,050         3,860

The Company has a working capital ratio of 5.6:1 as of June 30, 2013 as compared to 5.0:1 as of June 30, 2012. Cash, short-term investments, accounts receivable and inventories represent 91% and 90% of current assets in fiscal 2013 and fiscal 2012, respectively. The Company had accounts receivable turnover of 6 in fiscal 2013 compared to 6 in fiscal 2012 and an inventory turnover ratio of 2.7 in fiscal 2013 compared to 2.8 in fiscal 2012.

Net cash provided by operating activities of $20.3 million in fiscal 2013 is principally due to a reduction in inventory levels partially offset by a decline in operating performance.

The Company invested $9.5 million in fiscal 2013 with investments in plant and equipment representing $ 7.8 million and the remaining amount being attributable to the net increase in short-term investments.

The Company repaid $6.7 million of its long-term debt in fiscal 2013 accounting for most of its $7.6 million of cash used in financing activities. Effects of translation rate changes on cash primarily result from the movement of the U.S. dollar against the British Pound, the Euro and the Brazilian Real. The Company uses a limited number of forward contracts to hedge some of this activity and a natural hedge strategy of paying for foreign purchases in local currency when economically advantageous.

Liquidity and Credit Arrangements

The Company believes it maintains sufficient liquidity and has the resources to fund its operations in the near term. In addition to its cash and short-term investments, the Company has maintained a $23.0 million line of credit, of which $0.6 million is reserved for letters of credit and $11.9 million was outstanding as of June 30, 2013.


On June 30, 2009, the Company and certain subsidiaries entered into a Loan and Security Agreement (the "Credit Facility") with TD Bank, N.A.. The amended Credit Facility is scheduled to mature on April 30, 2015 and bears interest at LIBOR plus 1.50%.

The obligations under the Credit Facility are unsecured. However, in the event of certain triggering events, the obligations under the Credit Facility will become secured by the assets of the Company and the subsidiaries party to the Credit Facility. Triggering events are two consecutive quarters of failure to achieve the financial covenants outlined in Note 13 of the Notes to Consolidated Financial Statements.

Availability under the Credit Facility is subject to a borrowing base comprised of accounts receivable and inventory. The Company believes that the borrowing base will consistently produce availability under the Credit Facility in excess of $23.0 million. As of August 31, 2013, the Company had borrowings of $11.9 million under the line of credit.

The Credit Facility contains financial covenants with respect to leverage, tangible net worth, and interest coverage, and also contains customary affirmative and negative covenants, including limitations on indebtedness, liens, acquisitions, asset dispositions, and fundamental corporate changes, and certain customary events of default. Upon the occurrence and continuation of an event of default, the lender may terminate the revolving credit commitment and require immediate payment of the entire unpaid principal amount of the Credit Facility, accrued interest and all other obligations. As of June 30, 2013, the Company was in compliance with the financial covenants under the Credit Facility.

OFF-BALANCE SHEET ARRANGEMENTS

The Company does not have any material off-balance sheet arrangements as defined under the Securities and Exchange Commission rules.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. The second footnote to the Company's Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the consolidated financial statements.

Judgments, assumptions, and estimates are used for, but not limited to, the allowance for doubtful accounts receivable and returned goods; inventory allowances; income tax reserves; long lived assets; goodwill; and employee turnover, discount and return rates used to calculate pension obligations.

Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the Company's Consolidated Financial Statements. The following sections describe the Company's critical accounting policies.

Revenue Recognition and Accounts Receivable: Sales of merchandise and freight billed to customers are recognized when products are delivered, title and risk of loss has passed to the customer, no significant post-delivery obligations remain and collection of the resulting receivable is reasonably assured. Sales are net of provisions for cash discounts, returns, customer discounts (such as volume or trade discounts), cooperative advertising and other sales related discounts. Cooperative advertising payments made to customers are included as advertising expense in selling, general and administrative in the Consolidated Statements of Operations. While the Company does allow its customers the right to return in certain circumstances, revenue is not deferred, but rather a reserve for sales returns is provided based on experience, which historically has not been significant.

The allowance for doubtful accounts of $0.7 million and $1.0 million at the end of fiscal 2013 and 2012, respectively, is based on our assessment of the collectability of specific customer accounts and the aging of our accounts receivable. While the Company believes that the allowance for doubtful accounts is adequate, if there is a deterioration of a major customer's credit worthiness, actual write-offs are higher than our previous experience, or actual future returns do not reflect historical trends, the estimates of the recoverability of the amounts due the Company and net sales could be adversely affected.

Inventory Valuation: Inventory purchases and commitments are based upon future demand forecasts. If there is a sudden and significant decrease in demand for our products the Company may be required to increase the inventory reserve and, as a result, gross profit margin could be adversely affected.

Long-lived Assets and Goodwill: The Company accounts for property, plant and equipment (PP&E) at historical cost less accumulated depreciation. Impairment losses are recorded when indicators of impairment, such as plant closures, are present and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount. The Company continually reviews for such impairment and believes that PP&E is being carried at its appropriate value.


The Company assesses the fair value of its goodwill generally based upon a discounted cash flow methodology. The discounted cash flows are estimated utilizing various assumptions regarding future revenue and expenses, working capital, terminal value, and market discount rates. If the carrying amount of the goodwill is greater than the fair value, an impairment charge is recognized to the extent the recorded goodwill exceeds the implied fair value of goodwill.

The Company performed a qualitative analysis in accordance with ASU 2011-08 for its Bytewise reporting unit for its October 1, 2012 annual assessment of goodwill (commonly referred to as "Step Zero"). From a qualitative perspective, in evaluating whether it is more likely than not that the fair value of the reporting unit is not less than its carrying amount, relevant events and circumstances were taken into account, with greater weight assigned to events and circumstances that most affect the fair value of Bytewise or the carrying amounts of its assets. Items that were considered included, but were not limited to, the following: macroeconomic conditions, industry and market conditions, cost factors, overall financial performance, changes in management or key personnel, and other Bytewise specific events. After assessing these and other factors the Company determined that it was more likely than not that the fair value of the Bytewise reporting unit was not less than the carrying amount as of October 1, 2012.

Our long-lived assets consist primarily of property, plant and equipment. The Company groups long-lived assets for impairment analysis by division and/or product line. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of such an asset may not be recoverable. Such events or circumstances include, but are not limited to, a significant decrease in the fair value of the underlying business or change in utilization of property and equipment.

Recoverability of the net book value of property, plant and equipment is determined by comparison of the carrying amount to estimated future undiscounted net cash flows the assets are expected to generate. Those cash flows include an estimated terminal value based on a hypothetical sale at the end of the assets' depreciation period. Estimating these cash flows and terminal values requires management to make judgments about the growth in demand for our products, sustainability of gross margins, and our ability to achieve economies of scale. If assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the long-lived asset exceeds its fair value. No events or circumstances arose in fiscal 2013 which required management to perform an impairment analysis.

Depreciation is included in cost of goods sold or selling, general and administrative expenses in the Consolidated Statement of Operations based upon where the assets are contributing to the measurement of cost or expense by functional area. Depreciation of equipment used in the manufacturing process is a component of inventory and included in costs of goods sold. Depreciation of equipment used for office and administrative functions is an expense in selling, general and administrative expenses.

Income Taxes: Accounting for income taxes requires estimates of future benefits and tax liabilities. Due to temporary differences in the timing of recognition of items included in income for accounting and tax purposes, deferred tax assets or liabilities are recorded to reflect the impact arising from these differences on future tax payments. With respect to recorded tax assets, the Company assesses the likelihood that the asset will be realized. If realization is in doubt because of uncertainty regarding future profitability, the Company provides a valuation allowance related to the asset. Should any significant changes in the tax law or the estimate of the necessary valuation allowance occur, the Company would record the impact of the change, which could have a material effect on our financial position or results of operations.

Defined Benefit Pension Plans: The Company has two defined benefit pension plans, one for U.S. employees and another for U.K. employees.

In 2011, we elected to retrospectively change our method of recognizing certain actuarial gains and losses. Previously, the market related value of plan assets for the U.S. plan was equal to fair value, and the market-related value of plan assets for the U.K. plan, was based on a calculated five-year moving average of market value. Actuarial gains and losses were recognized in other comprehensive income as of the measurement date. Net actuarial gains or losses in excess of ten percent (10%) of the greater of the market-related value of plan assets or of the plans' projected benefit obligation (the corridor) were amortized in net periodic benefit cost over the average remaining service period (fourteen-years). The primary factors contributing to actuarial gains and losses are changes in the discount rate used to value pension obligations as of the measurement date each year and the differences between expected and actual returns on plan assets.

Under our current accounting method, both plans use fair value as the market-related value of plan assets and continue to recognize actuarial gains or losses within the corridor in other comprehensive income but instead of amortizing net actuarial gains or losses in excess of the corridor in future periods, excess gains and losses are recognized in net periodic benefit cost as of the plan measurement date, which is the same as the fiscal year end of the Company (MTM adjustment). This accounting method is a permitted option which results in immediate recognition of excess net actuarial gains and losses in net periodic benefit cost instead of in other comprehensive income. Immediate recognition in net periodic benefit cost could potentially increase the volatility of net periodic benefit cost. The MTM adjustments to net periodic benefit cost for 2013, 2012 and 2011 were $0.0, $15.3, and $0.0 million, respectively.


Calculation of pension and postretirement medical costs and obligations are dependent on actuarial assumptions. These assumptions include discount rates, healthcare cost trends, inflation, salary growth, long-term return on plan assets, employee turnover rates, retirement rates, mortality and other factors. These assumptions are made based on a combination of external market factors, actual historical experience, long-term trend analysis, and an analysis of the assumptions being used by other companies with similar plans. Significant differences in actual experience or significant changes in assumptions would affect pension and other postretirement benefit costs and obligations. See also Employee Benefit Plans (Note 12 to the Consolidated Financial Statements).

Cost of Goods Sold: The Company includes material direct and indirect labor and manufacturing overhead in cost of goods sold. Included in these costs are inbound freight, personnel (manufacturing plants only), receiving costs, internal transferring, employee benefits (including pension expense) and inspection costs.

Selling General and Administrative Expenses: The Company includes distribution expenses in selling, general and administrative expenses. Distribution expenses include shipping labor and warehousing costs associated with the storage of finished goods at each manufacturing facility. The Company also includes costs for our dedicated distribution centers as selling expenses. Employee benefits, including pension expense attributable to personnel not involved in the manufacturing process, are also included in selling, general and administrative expenses.

CONTRACTUAL OBLIGATIONS



The following table summarizes future estimated payment obligations by period.



                                           Payments due by period (in millions)
                               Total          <1yr.       1-3yrs.       3-5yrs.       >5yrs.
Debt obligations              $   25.8       $   1.6     $    15.0     $     3.1     $    6.1
Capital lease obligations          0.3           0.2           0.1             -            -
Operating lease obligations        2.1           1.6           0.5             -            -
Purchase obligations              11.1          10.8           0.2           0.1            -
Total                         $   39.3       $  14.2     $    15.8     $     3.2     $    6.1

While our purchase obligations are generally cancellable without penalty, . . .

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