Gerdau S.A. 20-F 2006
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission file number 1-14878
(Exact Name of Registrant as Specified in its Charter)
Av. Farrapos 1811
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
The total number of issued shares of each class of stock of GERDAU S.A. as of December 31, 2005 was:
Shares, no par value per share
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No o
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. Yes o No x
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 such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
Indicate by check mark which financial statement item the Registrant has elected to follow Item 17 o Item 18 x.
TABLE OF CONTENTS
Unless otherwise indicated, all references herein to:
(i) the Company or to Gerdau are references to Gerdau S.A., a corporation organized under the laws of the Federative Republic of Brazil (Brazil) and its consolidated subsidiaries,
(ii) Açominas are references to Aço Minas Gerais S.A. Açominas prior to November 2003 whose business was to operate the Ouro Branco steel mill. In November 2003 the company underwent a corporate reorganization, receiving all of Gerdaus Brazilian operating assets and liabilities and being renamed Gerdau Açominas S.A.,
(iii) Gerdau Açominas are references to Gerdau Açominas S.A. after November 2003 and to Açominas before such date, between November 2003 and July 2005 Gerdau Açominas hold all operating assets and liabilities of the Company in Brazil. In July 2005, certain assets and liabilities of Gerdau Açominas were spun-off to other four newly created entities: Gerdau Aços Longos, Gerdau Aços Especiais, Gerdau Comercial de Aços and Gerdau América do Sul Participações. As a result of such spin-off as from July 2005 the activities of Gerdau Açominas only comprise the operation of the Ouro Branco steel mill,
(iv) Preferred Shares and Common Shares refer to the Companys authorized and outstanding preferred stock and common stock, designated as ações preferenciais and ações ordinárias, respectively, all without par value. All references herein to the real, reais or R$ are to the Brazilian real, the official currency of Brazil. All references to (i) U.S., dollars, U.S.$ or $ are to United States dollars, (ii) Canadian dollars or Cdn$ are to Canadian dollars (iii) billions are to thousands of millions, (iv) km are to kilometers, and (v) tonnes are to metric tonnes.
The Company has prepared the consolidated financial statements included herein in accordance with accounting principles generally accepted in the United States (U.S. GAAP). The investments in Gallatin Steel Co. (Gallatin), Bradley Steel Processor and MRM Guide Rail, all in North America, of which Gerdau Ameristeel holds 50% of the total capital, the investments in Armacero Industrial y Comercial Limitada, in Chile, in which the Company holds a 50% stake and the investment in Dona Francisca Energética S.A, in Brazil, in which the Company holds a 51.82% stake, are accounted for using the equity accounting method.
Unless otherwise indicated, all information in this Annual Report is stated for December 31, 2005. Subsequent developments are discussed in Item 8 - Financial Information - Significant Changes.
CAUTIONARY STATEMENT WITH RESPECT TO FORWARD-LOOKING STATEMENTS
Statements made in this Annual Report with respect to the Companys current plans, estimates, strategies, beliefs and other statements that are not historical facts are forward-looking statements about the Companys future performance. Forward-looking statements include but are not limited to those using words such as believe, expect, plans, strategy, prospects, forecast, estimate, project, anticipate, may or might and words of similar meaning in connection with a discussion of future operations or financial performance. From time to time, oral or written forward-looking statements may also be included in other materials released to the public. These statements are based on managements assumptions and beliefs in the light of the information currently available to it. The Company cautions potential investors that a number of important risks and uncertainties could cause actual results to differ materially from those discussed in the forward-looking statements. Investors should not thus place undue reliance on the forward-looking statements. The Company expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in the Companys expectations or to reflect any change in events, conditions or circumstances on which any such forward-looking statements is based, in whole or in part. Risks and uncertainties that might affect the Company include, but are not limited to: (i) general economic conditions in the Companys markets, particularly levels of spending; (ii) exchange rates, particularly between the real and the U.S. dollar, and other currencies in which the Company realizes significant sales or in which its assets and liabilities are denominated; and (iii) the outcome of contingencies.
Not applicable, as the Company is filing this Form 20-F as an annual report.
Not applicable, as the Company is filing this Form 20-F as an annual report.
A. SELECTED FINANCIAL DATA
The selected financial information for the Company included in the following table should be read in conjunction with, and is qualified in its entirety by, the U.S. GAAP financial statements of the Company and Operating and Financial Review and Prospects appearing elsewhere in this Annual Report. The consolidated financial data for the Company on December 31, 2005, 2004, 2003, 2002 and 2001 are derived from the financial statements prepared in accordance with U.S. GAAP.
(i) Per share information has been retroactively restated for all periods to reflect the effect of:, (a) the stock bonus of ten shares for three shares held, approved in April 2003, (b) the reverse stock split of one share for 1,000 shares held, approved in April 2003, (c) the stock bonus of one share for every share held approved in April 2004, (d) the stock bonus of one share for two shares held approved in March 2005 and (e) the stock bonus of one share for two shares held approved in March 2006. Earnings per share has been computed on whighted average share outstanding during each year.
(ii) The information on the numbers of shares presented above relates to the end of each year, and is retroactively restated to reflect changes in numbers of shares due to the transactions described in (i) above.
(1) Total current assets less total current liabilities
The Companys total authorized capital stock is composed of common and preferred shares. As of April 30, 2006, the Company had 231,607,008 common shares and 433,122,385 non-voting preferred shares outstanding (excluding treasury stock), adjusted to reflect the stock bonus effective approved in March 2006.
The following table details dividends paid to holders of common shares and preferred shares since 2001. The figures are expressed in Brazilian reais and converted into U.S. dollars on the date of deliberation of the dividend. Dividend per share figures have been retroactively adjusted for all periods to reflect: (a) the stock bonus of ten shares for three shares held, approved in April 2003, (b) the reverse stock split of one share for 1,000 shares held, approved in April 2003, (c) the stock bonus of one share for every share held approved in April 2004, (d) the stock bonus of one for two shares held approved in March 2005 and (e) a stock bonus of one share for two shares approved in March 2006.
Dividend per share information has been computed by dividing dividends and interest on capital stock by the quantity of shares outstanding, which excludes treasury stock.
(1) Payment of interest on capital stock.
(2) Payment of both dividends and interest on capital stock.
(3) As of April 2003 and as result of the reverse stock split of one share for 1,000 shares held approved in this same month, dividends are paid on a per share basis (rather than a per thousand shares basis, as was the case prior to this date).
Law 9,249, of December 1995, states that a company may, at its sole discretion, pay interest on capital stock in addition to or instead of dividends (See Item 8 Financial Information - Interest on Capital Stock). A Brazilian corporation is entitled to pay its shareholders (considering such payment as part of the mandatory dividend required by Brazilian Corporate Law for each fiscal year) interest on capital stock up to the limit calculated as the TJLP rate (Long-Term Interest Rate) on its shareholders equity or 50% of the income for the fiscal year, whichever is the greater. The payment of interest on capital stock as described herein is subject to a 15% withholding income tax. See Item 10. Additional Information - Taxation.
B. CAPITALIZATION AND INDEBTEDNESS
C. REASONS FOR THE OFFER AND USE OF PROCEEDS
D. RISK FACTORS
Risks Relating to Brazil
Brazilian Political and Economic Conditions, and the Brazilian Governments Economic and Other Policies May Negatively Affect Demand for the Companys Products as Well as Net Sales and Overall Financial Performance.
The Brazilian economy has been characterized by frequent and occasionally extensive intervention by the Brazilian government. The Brazilian government has often changed monetary, taxation, credit, tariff and other policies to influence the course of Brazils economy. The Brazilian governments actions to control inflation and implement other policies have involved interest rate increases, wage and price controls and currency devaluations, freezing of bank accounts, capital controls and restrictions on imports.
The Companys operational results and financial condition may be adversely affected by the following factors and governmental reaction to them:
· fluctuations in exchange rates;
· interest rates;
· tax policies;
· exchange controls;
· energy shortages;
· liquidity of domestic capital and lending markets; and
· other political, diplomatic, social and economic developments in or affecting Brazil.
Uncertainty over whether the Brazilian government will change policies or regulations affecting these or other factors may contribute to economic uncertainty in Brazil and to heightened volatility in the Brazilian securities markets and securities issued abroad by Brazilian issuers. These and other developments in the Brazilian economy and governmental policies may adversely affect the Company and its business.
In recent months, government figures, legislators and political party officials, especially those of the Presidents party, have been the subject of a variety of allegations of unethical or illegal conduct. These accusations, which are currently being investigated by the Brazilian Congress, involve campaign financing and election law violations, influencing of government officials and Congressmen in exchange for political support. Several members of the Presidents party and of the federal government, including the Presidents chief of staff and the Minister of Finance, have resigned. The Company cannot predict what effects these accusations and investigations may have on the Brazilian economy and the market for securities of Brazilian issuers.
Inflation and Government Actions to Combat Inflation May Contribute Significantly to Economic Uncertainty in Brazil and Could Adversely Affect the Companys Business.
Throughout its history, Brazil has experienced high rates of inflation. Inflation, as well as certain government efforts to combat it, has had significant negative effects on the Brazilian economy. Inflation rates were 8.69% in 2003, 12.42% in 2004 and 1.20% in 2005, as measured by the Índice Geral de Preços-Mercado, or the IGP-M. The Brazilian governments adopted measures to control inflation have often included maintaining a tight monetary policy with high interest rates, thereby restricting availability of credit and reducing economic growth. Inflation, actions to combat inflation and public speculation about possible additional actions also contributed materially to economic uncertainty in Brazil and to heightened volatility of securities of Brazilian issuers.
If Brazil experiences high levels of inflation in the future, the rate of growth of the economy may be slowed, which would lead to reduced demand for the Companys products in Brazil. Inflation is also likely to increase some costs and expenses which the Company may not be able to pass on to its customers and, as a result, may reduce its profit margins and net income. In addition, high inflation generally leads to higher domestic interest rates, and, as a consequence, the costs of servicing its real-denominated debt may increase. Inflation may, in addition, hinder its access to capital markets, which could adversely affect its ability to refinance its indebtedness. Inflationary pressures may also lead to the imposition of government policies to combat inflation that could adversely affect its business.
Foreign Exchange Variations Between the U.S. Dollar and the Currencies of the Countries in Which the Company Operates May Raise the Cost of Servicing Its Foreign Currency-Denominated Debt and Adversely Affect Its Overall Financial Performance.
The Companys operating results are affected by foreign exchange-rate fluctuations between the U.S. dollar, the currency in which the Company prepares its financial statements, and the currencies of the countries in which it operates.
For example, Gerdau Ameristeel reports results in U.S. dollars, while a portion of its net sales and operating costs are in Canadian dollars. As a result, fluctuations in the exchange rate between these two currencies may affect operating results. The same happens with all the other businesses located outside the United States with respect to the exchange rate between the local currency of the respective subsidiary and the U.S. dollar, as the Company reports its financial position and results of operations in U.S. dollars.
The real appreciated by 18.3% in 2003, 8.1% in 2004 and 11.8% in 2005 against the dollar, the real may depreciate again. On April 28 2006, the U.S. dollar/real exchange rate was US$1.00 per R$2.0892.
Devaluation of the real relative to the U.S. dollar also could result in additional inflationary pressures in Brazil by generally increasing the price of imported products and services and requiring recessionary government policies to curb demand. In addition, a devaluation of the real could weaken investor confidence in Brazil. On the other hand, appreciation of the real against the U.S. dollar may lead to a deterioration of the countrys current account and the balance of payments and may dampen export-driven growth.
The Company had total foreign currency-denominated debt obligations in an aggregate amount of $2,481.5 million at December 31 2005, representing 77.2% of its indebtedness on a consolidated basis. On December 31, 2005, the Company had $469.3 million in U.S. dollar-denominated cash equivalents and $479.7 million in U.S. dollar-denominated short-term investments. A significant devaluation of the real in relation to the U.S. dollar or other
currencies could reduce the Companys ability to meet debt service requirements of foreign currency-denominated obligations, particularly as a significant part of net sales revenue denominated in reais.
Export revenues and margins are also affected by the reals fluctuations in relation to the U.S. dollar. The Companys production costs are denominated in local currency but its export sales are denominated in U.S. dollars. Financial revenues generated by exports are reduced when they are translated to reais in the periods in which the Brazilian currency appreciates in relation to the U.S. currency. On the other hand, when the real depreciates the translation impact is favorable and the same amount of dollars translates to a greater amount of reais.
Developments in Other Emerging Markets May Adversely Affect The Companys Operating Results.
Political, economic, social and other developments in other countries, particularly Latin American and emerging-market countries, may have an adverse effect on the market value of the Company. Although conditions in these countries may be quite different from those in Brazil, investors reactions to developments in these countries may affect the Brazilian securities markets and reduce investor interest in securities of Brazilian issuers. Brazil has experienced periods with a significant outflow of U.S dollars, and Brazilian companies have faced higher costs for raising funds, both domestically and abroad and have been impeded from accessing international capital markets. The Company cannot assure that international capital markets will remain open to Brazilian companies or that prevailing interest rates in these markets will be advantageous to the Company, which may limit the ability to refinance its indebtedness.
Risks Relating to Gerdau and the Steel Sector
The Demand for Steel Is Cyclical and a Reduction in the Prevailing World Prices for Steel Could Adversely Affect The Companys Operating Results.
The steel industry is highly cyclical both in Brazil and abroad. Consequently, the Company is exposed to substantial swings in the demand for steel products which in turn causes volatility in the prices of its products, mainly for exports and for products that face competition from imports. Additionally, as the Brazilian steel industry produces substantially more steel than the domestic economy is able to consume, the sector is heavily dependent on export markets. The demand for steel products and, thus, the financial condition and results of operations of companies in the steel industry, including the Company itself, are generally affected by macroeconomic fluctuations in the world economy and the domestic economies of steel-producing countries, including trends in the construction sector and the automotive sector in general. Since 2003, demand for steel products from developing countries (particularly China), the strength of the Euro and overall worldwide economic growth have contributed to a historically new high level of prices for the Companys steel products, but these relatively high prices may not endure, especially due to the worldwide expansion in installed capacity. Any material decrease in demand for steel or exporting by countries not able to consume their production could have a material adverse effect on Company operations and prospects.
Increases in Steel Scrap Prices or a Reduction in Supply Could Adversely Affect Production Costs and Operating Margins.
The main metallic input for the Companys mini-mills, which corresponded to 66.9% of total crude steel output in 2005, is steel scrap. Although international steel scrap prices are determined essentially by scrap prices in the U.S. domestic market, the United States being the main exporter of scrap, scrap prices in the Brazilian market are set by domestic supply and demand. The price of steel scrap in Brazil varies from region to region and reflects demand and transportation costs. Should scrap prices increase significantly without a commensurate increase in finished steel sale prices, the Companys profits and margins could be reduced. An increase in steel scrap prices or shortage in the supply of scrap to its units would affect production costs and potentially reduce operating margins.
Increases in Iron Ore and Coal Prices or a Reduction in Market Supply Could Adversely Affect the Production Costs and Operating Margins of the Companys Integrated Mills.
When the prices of raw materials that the Company needs to produce steel in its integrated facilities, particularly iron ore and coking coal, increase, the production costs in its integrated facilities also increase. The Company uses iron ore to produce liquid pig iron at its Ouro Branco mill and at its Gerdau Barão de Cocais and Gerdau Divinópolis units, in the state of Minas Gerais. Iron ore is also used to produce sponge iron at the Gerdau Usiba unit, in the state of Bahia. These four units represent 33.1% of its consolidated crude steel output.
The Ouro Branco unit is the Companys biggest mill in Brazil, and its main metallic input for the production of steel is iron ore. This unit represents 42.0% of the total crude steel output of its Brazilian operations. A shortage of iron ore in the domestic market would adversely affect the steel producing capacity of its Brazilian units, and an increase in iron ore prices could reduce profit margins.
All of the Companys coking coal requirements for its Brazilian units are imported due to the low quality of Brazilian coal. Coking coal is the main energy input in the Ouro Branco mill, and it is used in the coking facility. Although this mill is not dependent on supplies of coke, a contraction in the supply of coking coal could adversely affect the integrated operation at this site, since the Ouro Branco mill requires coking coal to produce coke in its coking facility. All the coking coal used in Ouro Branco is imported from Canada, the United States and Australia. A shortage of coking coal in the international market would adversely affect the steel producing capacity of the Ouro Branco mill, and an increase in prices could reduce profit margins. The Company does not have long-term supply contracts for certain raw materials it uses.
The Company Operations Are Energy-Intensive, and Energy Shortages or Price Increases May Adversely Affect It.
Steel production is an energy-intensive process, especially in melt shops with electric arc furnaces. Electricity represents a significant cost component at these units, as does natural gas, to a lesser extent. Electricity cannot be replaced in the Companys melt shops and rationing or a power shortage such as those that occurred in Brazil in 2001 could adversely affect production in those units.
Natural gas is used in the reheating furnaces at the Companys rolling mills. In the case of shortages in the supply of natural gas, the Company could in some instances change to fuel oil as an energy source. However, these measures could increase its production costs and consequently reduce its operating margins.
Restrictive Measures on Trade in Steel Products May Affect the Companys Business by Increasing the Price of Its Products or Reducing Its Ability to Export.
The Company is a steel producer that supplies both the domestic market in Brazil and a number of international markets. The Companys exports face competition from other steel producers, as well as restrictions imposed by importing countries in the form of quotas, ad valorem taxes, tariffs or increases in import duties, any of which could increase the costs of products and make them less competitive or prevent the Company from selling in these markets. There can be no assurance that importing countries will not impose quotas, ad valorem taxes, tariffs or increase import duties.
Less Expensive Imports from Other Countries in North America May Adversely Affect the Companys Business.
Steel imports into North America have caused downward pressure on steel prices in recent years, adversely affecting sales and profit margins. Competition from foreign steel producers is strong and may grow due to increases in foreign installed steel capacity, devaluation of the U.S. dollar and a reduction in domestic steel demand in other markets. These factors lead to higher levels of steel exports to North America at lower prices. In the past, the U.S. government has taken temporary protective measures to regulate steel imports by means of quotas and tariffs. Protective measures may not be taken in the future and, despite trade regulation efforts, unfairly priced imports could enter into the North American markets in the future, resulting in price pressure that could adversely affect its business.
Compliance Costs Related to Environmental Regulation May Increase if Requirements Become More Stringent. Such Increased Costs May Adversely Affect the Company Operating Results.
The Companys industrial plants are required to comply with a number of federal, state, and municipal environmental laws and regulations with respect to the environment and the operation of mills in every country in which the Company operates. These regulations include those governing air emissions, waste and water discharges and solid and hazardous waste handling and disposal. Non-compliance with these laws and regulations may result in civil penalties, criminal sanctions or closure orders, and under various circumstances requires the cleanup of contamination associated with previous operations under less conditions. If existing laws or future legislation become more demanding, expenditure on fixed assets and the costs of compliance may rise, adversely affecting its financial condition. Furthermore, the Company may be subject to additional expenditures and costs with environmental compliance as a result of future acquisitions.
The Company May Not Successfully Integrate Its Businesses, Management, Operations, or Products or Realize Any of the Anticipated Benefits of Future Acquisitions.
During the last few years, the Company has expanded its operations, through significant acquisitions such as that of Ameristeel in 1999, the stake in Açominas, the reverse takeover of Co-Steel at the end of 2002, the acquisition of the assets of North Star in 2004 and, more recently, the acquisition of the units in Colombia, and the acquisition of an additional stake in Sipar and a strategic shareholding in Corporación Sidenor (Spain). The integration of the business and opportunities stemming from entities acquired by the Company in the future may involve risks. The Company may not successfully integrate future acquired business, management, operations, products, and services with its current operations. Diversion of managements attention from its existing businesses, as well as problems that can arise in connection with the integration of the new operations, may have an impact on revenues and the results of operations. Integration of future acquisitions may result in additional expenses which could reduce profitability. The Company may not succeed in addressing these risks or any other problems encountered in connection with future acquisitions. The Company may not successfully integrate the businesses, management, operations, or product or realize any of the anticipated benefits of future acquisitions.
A. HISTORY AND DEVELOPMENT
Gerdau S.A. is a Brazilian corporation (Sociedade Anônima) that was incorporated on November 11, 1961. Its main registered office is located at Av. Farrapos, 1811, Porto Alegre RS Brazil. Its telephone number is xx 55 (51) 3323 2000.
Gerdau began operating in 1901 as the Pontas de Paris nail factory in Porto Alegre, Brazil. In 1969, the Company changed its name to Metalúrgica Gerdau S.A., today a holding company that controls Gerdau S.A. In 105 years of activity, the Gerdau Group has made a seminal contribution to the Brazilian industry.
Important Events in the Development of the Companys Business
At the end of World War II, Gerdau acquired Siderúrgica Riograndense S.A.(Riograndense), a steel mill also located in Porto Alegre, for mitigating possible raw material shortages. In February 1948, Gerdau initiated its steel operations, foreshadowing the successful mini-mill model of producing steel in electric arc furnaces (EAF), using steel scrap as the main raw material. The Company also adopted a regional sales strategy to ensure more competitive operating costs. Growth resulted in the Company installing a second Riograndense unit in the city of Sapucaia do Sul (state of Rio Grande do Sul) in 1957, consolidating the Groups vocation as a steel producer. In 1962, the steady growth in the production of nails led to the construction of a larger and more advanced factory in Passo Fundo (state of Rio Grande do Sul). Although the factory in Passo Fundo is no longer in operation, Gerdau still produces nails at some of its existing mills and the Company believes that it is currently the worlds largest nail manufacturer with more than 1,000 items available to customers from 100,000 sales outlets.
In 1967, the Company expanded into the state of São Paulo, in the Southeast region of Brazil, by purchasing Fábrica de Arames São Judas Tadeu, a producer of nails and wires. It was later renamed Comercial Gerdau and became the Brazilian distribution channel for the Companys steel products, with 74 branches including 6 flat steel service centers strategically located throughout the country.
In June 1969, Gerdau expanded into the Northeast of Brazil, producing steel at Siderúrgica Açonorte in the state of Pernambuco. In 1971, Gerdau began the construction of the Cosigua mill in Rio de Janeiro, initially as a joint venture with the German group, August Thyssen Huette. Eight years later, Gerdau became the majority shareholder of Cosigua, which currently operates the largest mini-mill in Latin America. In December 1971, Gerdau acquired the control of Siderúrgica Guaíra, a pioneer steel producer in the state of Paraná. Since then, Gerdau has expanded throughout Brazil with a series of acquisitions and new operations, currently owning 11 steel mills in the country.
On November 28, 2003, Gerdau S.A. transferred its directly and indirectly controlled operations in Brazil to Açominas, which was renamed Gerdau Açominas S.A., while remaining headquartered in Ouro Branco (in the state of Minas Gerais).
In 1980, Gerdau began to expand internationally first with the acquisition of Gerdau Laisa in Uruguay, followed in 1989 with the purchase of the Canadian company, Gerdau Ameristeel Cambridge, located in Cambridge, Ontario. In 1992, Gerdau acquired control of Gerdau AZA, Chile. Over time, Gerdau increased its international presence by acquiring a minority interest in units in Argentina, and most notably, in North America where it acquired interests in Gerdau Ameristeel MRM Special Sections and the former Ameristeel Corp. In October 2002, Gerdau
carried out a reverse takeover, merging its North American assets with those of the Canadian company Co-Steel to create Gerdau Ameristeel, currently the second largest long steel producer in North America. Through its Gerdau Ameristeel subsidiary, Gerdau acquired the assets of North Star Steel in November 2004.
Gerdau signed an agreement in September, 2005, for the acquisition of 35.98% of shares issued by Sipar Aceros S.A., a long steel rolling mill located in the Province of Santa Fé, Argentina. This stake added to the 38.46% already owned by Gerdau, and represents 74.44% of the share capital of Sipar Aceros S.A. At the end of the third quarter of 2005, Gerdau concluded the acquisition of a 57.1% stake in Diaco S.A., the largest rebar manufacturer in Colombia. Both acquisitions represent the Companys continuing process of globalization.
On January 10 2006, through its subsidiary Gerdau Hungria Holdings Limited Liability Company, the Company acquired 40% of the capital stock of Corporación Sidenor, S.A., the largest long specialty steel producer, forged parts manufacturer and foundry in Spain and one of the major producers of forged parts using the stamping process in that country.
On March 2006, the assets of two industrial units were acquired in the United States. The first one was Callaway Building Products, in Knoxville, Tennessee, a supplier of civil construction cut and bent reinforcing concrete bars. The second was Fargo Iron and Metal Company, located in Fargo, North Dakota, a storage and scrap processing facility and service provider to industries and civil construction companies.
On April 5 2006, Gerdau signed a purchase agreement for the acquisition of Sheffield Steel Corporation, of Sand Springs, Oklahoma, in the USA. Sheffield is a mini-mill producer of long common steel, namely concrete reinforcing bars and merchant bars. It has one melt shop and one rolling mill in Sand Springs, Oklahoma, one rolling mill in Joliet, Illinois, and three transformation units in Kansas City and Sand Springs.
In addition to its 25 steel mini mills, in Brazil and abroad, four Brazilian-based integrated mills, and a rolling mill in Argentina, the Company owns 11 fabricated reinforcing steel facilities (branded Armafer), 6 downstream operations, 6 service centers for flat steel, 13 fabricated reinforcing steel facilities (branded Prontofer) and 7 scrap collection and processing units in Brazil. Gerdau also owns 3 iron ore extraction areas, two facilities for the production of solid pig iron and two private maritime terminals in Brazil. In South America, it owns 8 fabricating facilities and 2 downstream operations (in Colombia). In North America, it has 30 rebar fabricating facilities, 13 downstream operations and 17 steel scrap-recycling operations.
In 1995, Gerdau began a corporate restructuring - completed in 1997 - whereby the 28 Gerdau group companies were merged with the Companys six listed companies, consolidating them into two: Gerdau S.A. and Metalúrgica Gerdau S.A., resulting in improved corporate governance and financial disclosure.
In November 2003, the integration of the operations of Gerdau S.A. in Brazil and Aço Minas Gerais S.A. - Açominas, resulted in the revamped Gerdau Açominas S.A. operation. On December 3 2004, the Board of Directors of Gerdau S.A. approved the proposal that led to the implementation of the corporate reorganization of the Gerdau companies in Brazil and in other countries in South America.
On December 29 2004, the first step in this process was taken with the capitalization of the holding company Gerdau Participações S.A. with stock from Gerdau Açominas S.A. and 22% of the capital of Gerdau Internacional Empreendimentos Ltda., owned by Gerdau S.A.
To complete a sequence of corporate operations, on July 20 2005, the shareholders of Gerdau Açominas approved the spin-off up of the net assets of Gerdau Açominas into the following companies: Gerdau Aços Longos S.A., Gerdau Aços Especiais S.A. and Gerdau Comercial de Aços S.A. These companies produce long common steels, specialty long steel and selling steel products in general, respectively. Gerdau Açominas S.A., headquartered in Ouro Branco, Minas Gerais, remains focused mainly on the production of slab, blooms and billets for export. Additionally, Gerdau América do Sul Participações S.A. was created as a holding company for the investments in the other South American operations (except for Brazil).
The shareholders of the companies listed in Brazil and abroad had not been affected by the July 2005 reorganization. The shareholders continue to maintain their existing positions in the respective companies, and all their rights have been preserved.
Gerdau S.A. has been a listed company in Brazil since 1980, with an ADR listing on the New York Stock Exchange (NYSE) since March 1999. In June 2001, Gerdau joined the São Paulo Stock Exchanges Corporate Governance Program (Level 1). In December 2002, it listed on the Latibex, a section of the Madrid Stock Exchange dedicated to Latin American companies with stocks trading in Euros. Gerdau Ameristeel is listed in Canada on the Toronto Stock Exchange and, more recently, began trading on the New York Stock Exchange as well.
From its beginning in Brazil in 1901, Gerdau has grown steadily. In 2005, it was the 14th largest world steel producer according to the International Iron and Steel Institute (IISI) and the highest ranked positioned Brazilian company.
Investment Programs 2003-2005
2003TOTAL CAPITAL EXPENDITURES: $312.5 MILLION
The Company initiated new technological upgrading programs to meet future increases in domestic demand, most notably at Gerdau Riograndense, Gerdau Aços Finos Piratini (hereinafter Gerdau Aços Especiais Piratini) and Gerdau Usiba.
In January 2003, Gerdau acquired an additional interest in Dona Francisca Energética S.A. (DFESA), for a consideration of $5.7 million, increasing its total stake in this company to 51.8%.
The main investments during the year are described below.
Modernization and Upgrading of Industrial Plants
In addition to its wire rod rolling mill, the Ouro Branco mill also invested in the production of high quality steel: the KR plant, which reduces sulfur levels in pig iron, reached full capacity in 2003, improving quality and cutting costs. The Company also implemented its dephosphorization project to reduce the level of phosphorus in its steel products as well as almost concluding the new billet guaranteeing surface quality inspection line at the Ouro Branco mills primary rolling mill. Investments at the Ouro Branco mill amounted to $80 million in 2003.
Other investments in the Brazilian units amounted to $151.9 million and included the conclusion of the modernization of Gerdau Aços Especiais Piratini medium and heavy bar rolling mill and the modernization of the melt shop and improvements at Cosigua, as well as the construction of a new blast furnace at the Gerdau Divinópolis mill.
South America (except Brazil)
The Company extended the automation of industrial processes to the profile finishing area at the Renca unit of the Chilean subsidiary. A new stock and loading warehouse also optimized product delivery during 2003. The paving of the scrap yard at the Colina unit has significantly improved the performance of trucks and equipment, with a consequent reduction in raw material unloading times. Rebar storage conditions were also improved helping to maintain product quality, reduce costs and loading time. Investments in the Chilean and Uruguayan subsidiaries amounted to $6.9 million.
Canada and the United States
Investments in Gerdaus North American subsidiaries amounted to $55.2 million in 2003. The most significant investments in North America were a new warehouse at the Cartersville mill; rolling mill electrical control system upgrades at the Knoxville and Charlotte mills; a caster upgrade at the Jackson mill and a new pollution control system at the Cambridge mill.
2004TOTAL CAPITAL EXPENDITURES: $756.7 MILLION
In 2004, the Company invested $756.7 million in acquisitions of new businesses as well as new property, plant and equipment, increases in installed capacity and in technological upgrades of its units in Brazil, Canada, Chile, United States and Uruguay. The main investments during the year are described below.
Capital expenditures amounted to $329.0 million in 2004 in Brazil. One of the major capital projects included investments of $77.9 million for the construction of the São Paulo mill melt shop which was officially inaugurated in March 2006 as well as other improvements at the same facility. Other important expenditures during the year were $100.2 million at the Ouro Branco mill which included technological upgrades of equipment and a project to increase installed capacity by 1.5 million tonnes of liquid steel, expected to come on stream in 2007. Other amounts relate to smaller improvements and technological upgrades at other facilities in Brazil.
South America (except Brazil)
The South American units spent $10.3 million on capital projects in 2004, compared to $6.9 million in 2003.
Canada and the United States
Gerdau Ameristeel spent $82.1 million on capital projects in 2004, compared to $55.2 million in 2003. Major capital projects in 2004 included caster upgrades of $10.0 million, mill control upgrades of $5.5 million, warehouse and material handling improvements of $16.0 million, sub-station upgrades of $3.5 million, reheat furnace improvements of $10.0 million and information system upgrades of $4.0 million.
2005TOTAL CAPITAL EXPENDITURES: $776.8 MILLION
In 2005, the Company invested $776.8 million in the acquisition of new businesses as well as new property, plant and equipment, increases in installed capacity and in technological upgrades of its units in Argentina, Brazil, Canada, Chile, Colombia, United States and Uruguay. The main investments during the year are described below.
Capital expenditures at the Brazilian units amounted to $527.8 million in 2005. A total of $91.2 million was invested in the completion of the São Paulo mill melt shop that started operating in December 2005 as well as other improvements at the same facility. The Company invested $227.0 million at the Ouro Branco mill, mainly the project to increase installed capacity by 1.5 million tonnes of liquid steel and expected to come on stream in 2007 together with technological upgrades of equipment. Another important investment of $48.0 million was made in the Cosigua mill the modernization of equipment. Other amounts relate to smaller improvements and technological upgrades at other facilities in Brazil.
South America (except Brazil)
The South American units spent $63.4 million on capital expenditures in 2005, compared to $10.3 million in 2004. The Company paid $13.0 million for the acquisition of Diaco and Sidelpa, in Colombia, and $16.7 million for an additional stake in Sipar, Argentina.
Canada and the United States
Gerdau Ameristeel spent $185.5 million on capital projects and acquisitions in 2005, compared to $82.1 million in 2004. Major capital investments in 2005 included improved warehouse facilities at the Whitby, Ontario facility ($10.8 million), a new reheat furnace at the Sayreville, New Jersey facility ($10.0 million), and the purchase of shredders at the Jacksonville, Florida ($5.0 million) and the Jackson, Tennessee ($6.1 million) facilities.
Complementary information regarding these investments is available under the following topics Principal Capital Expenditure Currently in Progress and Acquisitions.
Principal Capital Expenditure Currently in Progress
Technological Update at the Ouro Branco Mill
In September 2004, Gerdau Açominas announced a technological upgrading program at its Ouro Branco mill in the state of Minas Gerais. This modernization program is part of a project to increase the mills installed capacity from 3 to 6 million tonnes of liquid steel in two phases. The first phase, already underway, will require investments of roughly $1.3 billion to increase installed capacity from 3 to 4.5 million tonnes with the installation of a new blast furnace with 1.5 million tonnes of annual installed capacity. Besides the new blast furnace, Gerdau installed a continuous blooms and beam blanks caster, a dephosphorization system and other additional improvements.
Part of the project will be financed by a $240 million financing agreement guaranteed by Nippon Export and Investment Insurance (NEXI), a credit insurance agency linked to the Japanese government, covering 97.5% of the political risk and 95% of the commercial risk.
On March 24 2006, Gerdau Açominas signed a $267.0 million Yen Equivalent Term Loan Facility with Citibank, N.A., Tokyo Branch. The term loan is insured by NEXI under its Overseas Untied Loan Insurance facility, and is guaranteed by Gerdau S.A. The facility is to cover part of Gerdau Açominas production capacity expansion plan through 2007.
On October 14, 2005, Gerdau Açominas signed a $201.0 million Buyers Credit Facility insured by China Export & Credit Insurance Corporation (Sinosure). The facility was funded by BNP Paribas and Industrial and Commercial Bank of China (ICBC) and is to finance 85% of the commercial contracts signed between Gerdau Açominas and the equipment suppliers. In connection with the Sinosure financing, a $50 million Commercial Loan Facility was entered into by Gerdau Açominas and BNP Paribas on June 15 2005, to finance the outstanding 15% of the amount of the commercial contracts and 100% of the Sinosure Insurance Premium.
Other sources of funding have not yet been negotiated but Gerdau expects these to be a mix of internal cash generation and other financing currently under consideration.
Rolling Mill in São Paulo
A rolling mill with an annual capacity of 600,000 tonnes is being built at the Gerdau Araçariguama plant in the state of São Paulo. The Company is to invest $68 million by the end of the third quarter of 2006. Of the total amount invested, approximately one-third will be financed from internal cash flow, one-third by domestic financial institutions and the remaining third by foreign financial institutions.
Enhancement of Installed Capacity at Gerdau Cosigua
The Company is investing $164.0 million by the end of 2007 in the expansion of its Gerdau Cosigua mill in the state of Rio de Janeiro. Gerdau Cosiguas annual crude steel capacity is to be increased from 1.4 to 2.2 million ton, and rolled products, from 1.3 to 2.0 million tonnes. With this investment, the Gerdau Cosigua mill will enlarge its capability to supply the metallurgical and the civil construction industries as well as the agriculture and ranching sectors.
Capacity Increase at the Jacksonville mill
During the year 2005 the Company, through its subsidiary Gerdau Ameristeel, approved the construction of a new melt shop that will increase the annual crude steel capacity from 581,000 to 901,000 tonnes and will provide operational improvements in the steel-making process. Gerdau will invest $133.0 million by the end of 2008.
Acquisitions during 2005
Diaco S.A. and Siderúrgica del Pacífico S.A. Sidelpa
On December 23, 2004, the Company reached an agreement with the Mayaguez Group and Latin American Enterprise Steel Holding (LAESH), majority shareholders of Diaco S.A. (Diaco) and Siderurgia del Pacifico S.A. (Sidelpa) to buy shares owned by those investors in Diaco and Sidelpa. Diaco is the largest producer of steel and rebar in Colombia, while Sidelpa is the only Colombian producer of specialty steel.
The transactions were subject to several conditions precedent. Upon entering into the agreement, the Company made a deposit of $68.5 million in favor of certain trusts set up for this transaction. Gerdau also has committed to acquire additional shares of Diaco within an eight-year period.
During September 2005, the conditions precedent for the Diaco acquisition were met, including Diacos public offer in the Colombian market to acquire shares owned by minority shareholders and its delisting from the stock exchange in Colombia. On September 30 2005, the Company concluded all the steps required to obtain a 57.1% voting and total interest in Diaco, and therefore, a controlling interest. As a result, Diaco shares acquired by the Company and held in the trusts were transferred to the Company, and the amount of $49.2 million was transferred from the trust to the sellers, while the Company paid an additional amount of $6.8 million in cash.
On November 19 2005, the Company met all the conditions precedent related to the acquisition of a 97.01% interest in Sidelpa, obtaining control of this company. As a result of this transaction, an amount of $4.4 million was transferred from the trusts to the former owners of Sidelpa, and an additional $6.2 million was paid in cash.
Gerdau is also obligated to purchase an additional 40.27% interest in Diaco in 2013, but has the option to anticipate such a purchase by acquiring 50% of the additional interest in March 2008 and the other 50% in March 2009. Settlement of the acquisition of the additional interest can be made in cash or in Gerdaus shares of at the option of the sellers. The terms of the agreement establish a formula to determine the purchase price, which is based on a minimum amount plus interest over the period from December 2004 to the date of the acquisition, and an additional price based on changes in Diacos net equity.
Sipar Aceros S.A - Sipar
On September 15 2005, the Company entered into an agreement to acquire an additional interest of 35.98% of Sipar Aceros S.A (Sipar Aceros), a rolling steel mill located in Santa Fé, Argentina, in which the Company already had a 38.46% interest. The Company paid $16.7 million in cash on September 15 2005 and will pay an additional amount of $23.9 million during the next three years without interest on those additional payments. The total amount of the purchase of such an interest, considering the financed portion of the purchase price discounted to fair value, amounts to $37.3 million.
As a result of this acquisition, the Company obtained a controlling interest of 74.44%, and therefore Sipar Aceros has been consolidated as of September 15 2005. Previous to this date, this investment was accounted for using the equity method.
Two groups of Sipar Aceros shareholders have options to sell additional shares in Gerdau Sipar Inversiones S.A. (parent company of Sipar Aceros) to the Company at a fixed amount, until September 2007. Settlement of the acquisition of the additional interest can be made in cash or in Gerdaus shares at the option of the sellers in the case of one group and at the option of the Company with respect to the other group.
Additional information regarding acquisitions during 2005 is set forth in Item 18. Financial Statements Note 4.
B. BUSINESS OVERVIEW
Gerdaus strategy focuses on the decentralized production of long steel using electric arc furnace (EAF) mini-mills and integrated mills with blast furnaces, and continuous casting technology being used in both processes. The Ouro Branco mill also uses the conventional casting technology. Plants are sized and located to meet the needs of local markets and provide efficient access to customers. This strategy is a response to the geographical dimensions of Brazil and the United States given both countries high transportation and freight costs. Gerdau is therefore able to supply its customers and source raw materials locally. From 1970 to 1990, Gerdau concentrated on building market share in Brazil by increasing its installed capacity and by acquiring existing mills, typically seeking those with management problems where the Companys main contribution would be its management skills rather than capital. Gerdaus Brazilian operations constitute currently the third largest crude steel producer in Brazil, according to the IBS (Brazilian Steel Institute).
Outside Brazil, and notably in North America, Gerdau Ameristeel has increased its market share by acquiring mills, which, like their Brazilian counterparts, required management restructuring rather than capital. Gerdau has progressively increased its share of the North American market and is currently the second largest North American long steel producer with annual nominal capacities of 7.6 million tonnes of crude steel and 6.9 million tonnes of rolled products according to Company statistics. Gerdaus industrial units are distributed across North America to supply local markets along the east coast of the United States and the east and central regions of Canada. Following the acquisition of North Stars assets, completed in November 2004, Gerdau Ameristeel has 14 long steel units and a strategic shareholding of 50% in Gallatin.
Gerdau also owns steel units in Argentina (rolling mill), Chile, Colombia and Uruguay. The steel units have a combined annual installed capacity of 1.0 million tonnes of crude steel. Although these units make only a minor contribution to consolidated results, they are highly profitable and efficient.
On November 14 2005, the Company entered into an agreement to acquire 40% of Corporación Sidenor S.A., a Spanish steel producer with operations in Spain and Brazil. The operation was concluded in January 2006, when the transfer of Sidenor shares to the Company took place and the purchase price amounting to Euro 165.8 million was paid. This represents a significant investment in the industrial segment where Gerdau has consolidated experience. This investment opens the way to enter the strategic European Union market. Furthermore, this acquisition allows the Company to open an important channel with the large international carmakers as well as provides access to production, administrative, and industrial management know-how of one of the largest suppliers of this sector in the world consistent with the Companys long-term growth and globalization plan.
List of Products
Gerdau produces steel products throughout its units located in Brazil, North America and South America (excluding Brazil). Please find below the list of products:
Principal Markets in which the Company competes
The three main markets in which Gerdau operates are: (i) construction, to which it supplies rebars, merchant bars, nails and meshes; (ii) manufacturing, to which it supplies products for machinery and agricultural implements, tools and other industrial products; and (iii) other markets, to which it supplies wires and posts for agricultural facilities and reforestation projects. In North America, Gerdau Ameristeel MRM Special Sections also supplies customers with special sections, including elevator guide rails and super light beams. Gerdau provides its customers with higher added value products at 49 fabricated reinforcing steel facilities fabshops - (11 Armafer service centers in Brazil, eight in South America and 30 Fabrication Shops in North America) and six flat steel service centers in Brazil.
Seasonality of the Companys Main Business
The Companys sales are not subject to significant seasonal variation. Performance is more dependent on the development of the segments that contribute directly to the Gross Domestic Product of the countries in which Gerdau operates. In Brazil, second and third quarter shipments tend to be stronger than those in the other two quarters. In North America, demand is influenced by winter conditions, when consumption of electricity and other energy sources (i.e. natural gas) for heating increases and may be exacerbated by adverse weather conditions, contributing to increased costs, decreased construction activity and hence lower Company sales.
Sources and Availability
Gerdaus production processes are mainly based on the mini-mill concept, with mills equipped with electric arc furnaces that can melt steel scrap and produce the steel product at the required specifications. The principal raw material used at these mills is essentially steel scrap and a mixture of pig iron and steel scrap in the Brazilian mills. The component proportions of this mixture may change in line with price and availability at the time of production so as to optimize raw material costs, the ratio of steel scrap to pig iron varying from 60%-40% to 90%-10%.
The main metallic input used by the Companys mills in the United States is steel scrap. In the event of steel scrap prices exceeding acceptable levels, 2004 being a case in point, the mills seek alternate input sources. These include pig iron from Margusa, a solid pig iron producer owned by Gerdau, in the Northeast of Brazil located close to the coast and port facilities, with an annual installed plant capacity of 210,000 tonnes. Gerdau uses Margusas output
to supply its plants in the Northeast of Brazil, although a smaller quantity has been exported to some of Gerdau Ameristeel plants in the United States.
The Companys Brazilian mills use scrap and pig iron purchased from local suppliers. The Company believes that this strategy minimizes transportation costs. Gerdau has a network of more than 2,500 scrap suppliers that deliver their materials to its yards in Brazil. The Company believes that it is the largest buyer of scrap in Brazil. The pig iron used in the steel-making process is produced at Gerdau Contagem in the state of Minas Gerais and Margusa, in the state of Maranhão. Part of the pig iron used at Gerdaus mills is also sourced from other companies. In 2005, Gerdau Brazils mini-mills produced 39% of its solid pig iron requirements internally.
Due to the nature of the raw materials employed, Gerdau does not use long-term supply contracts in its mini-mills operations in Brazil. The Companys mini-mills purchase their scrap directly on demand using mainly obsolescence scrap. Scrap and other raw materials are priced in Brazilian reais and input prices are not therefore directly affected by currency fluctuations.
Due to its size, Ouro Branco mill employs a different strategy to acquire its raw materials: long-term contracts to guarantee supplies. The units main raw materials include: (i) coal, imported from Canada, Australia and the United States; (ii) ferroalloys, of which 100% is purchased in the domestic market; and (iii) iron ore, which is supplied by large, medium and small sized mining companies, some of them strategically located close to the plant. These three items account for more than 44% of the total production costs of Gerdau Açominas in 2005.
South American units (excluding Brazil), do not maintain long-term contracts with suppliers and are thus exposed to market fluctuations. There are approximately 250 steel scrap suppliers in Chile, more than 190 suppliers in Uruguay and 3,455 in Colombia.
Gerdau Ameristeel has consistently obtained adequate supplies of raw materials and is not dependent on any one supplier. It believes there are an adequate number of alternative suppliers in the marketplace should it need to replace an existing one.
Gerdaus main metallic input is steel scrap, which is used in electric arc furnaces. Pig iron, iron ore (used in blast furnaces and in one DRI plant), and ferroalloys are also important. The Companys Brazilian mills use a mixture of scrap and pig iron, due to the low yield of steel scrap in Brazil. The North American mini-mills use mainly steel scrap.
Although international steel scrap prices are determined by the U.S. domestic market (since the United States is the main scrap exporter), the price of steel scrap in Brazil varies from region to region and is influenced by demand and transportation costs. Gerdau is the largest consumer of steel scrap in Brazil with more than 2,500 scrap suppliers.
There are two broad categories of steel scrap: (i) obsolescence scrap representing steel from various sources, ranging from tin foil cans to car bodies and white goods and (ii) industrial scrap representing factory steel cookie cutouts, steel turnings, and even scrap generated by the Companys production processes themselves. Gerdau uses mainly obsolescence scrap in Brazil while the North American plants use mainly industrial scrap.
In Brazil, the largest proportion of the steel scrap consumed by Gerdau is sourced in the state of São Paulo, the balance being evenly distributed among the other areas in which the Companys mills are located. Scrap dealers deliver obsolescence scrap directly to the mills. In regions where it does not have a steel mill, the Company has yards where scrap is collected and compacted for transportation by third parties. The price of scrap in Brazil varies by region, depending upon local supply and demand, and transportation costs. Each month, based on market conditions, the Companys procurement officer sets the maximum price for scrap (by type of scrap and region) to be paid by Company representatives. With the large number of consumers leading to fierce competition, prices tend to be higher in the Southeast, the most industrialized region of Brazil. Given that the Companys facilities are evenly distributed throughout Brazil, however, Gerdau is able to take advantage of lower prices in other regions without incurring high transportation costs.
Gerdau Metálicos is a division that collects and supplies scrap to the industrial units, and is the Latin American leader in steel scrap recycling. It reuses millions of tonnes of Brazilian scrap every year, accounting for significant gains through process optimization, reduced energy consumption, greater productivity and increasingly competitive operating costs. It should be noted that a ton of steel produced from scrap requires only one third of the power needed to generate one ton of steel from iron ore. Gerdau Metálicos purchases scrap directly from companies across Brazil, through a network of more than 2,500 suppliers that generate thousands of jobs. Gerdau Metálicos has stowage yards (collection points) for scrap in strategic locations throughout Brazil and uses several mobile presses that travel the country, preparing scrap for transportation to its mills. Every Gerdau Metálicos industrial unit has a recycling yard with state-of-the-art equipment to process scrap using presses and stationary and mobile shears. The Company also has two shredders, including a mega-shredder at Gerdau Cosigua in Rio de Janeiro, capable of processing 300 cars per hour.
The price of scrap in South America (excluding Brazil) varies according to demand, transportation costs and by region.
Steel scrap is Gerdau Ameristeels primary raw material and represented approximately 44% of mill production costs in 2005. Scrap is a commodity, the availability of which varies with price and is a major constraint in the companys operations. Gerdau Ameristeels Jackson and Jacksonville mills both have on-site dedicated scrap processing facilities that supply a significant proportion of their requirements. Gerdau Ameristeel MRM Special Sections receives a significant amount of its scrap from the Mandak and Porter scrap collection and processing yards. Gerdau Ameristeel has a total of 17 scrap recycling locations, although given that not all of the scrap that it consumes is sourced from its own scrap yards, it buys residual requirements in the market either directly or through dealers who source and aggregate scrap.
All of Gerdau Ameristeels production facilities in North America are mini-mills where operating results are closely linked to the cost of steel scrap and scrap substitutes, the primary mini-mill input. Steel scrap prices are relatively higher during winter months due to the impact of weather on collection and supply efforts. While realized selling prices for end products cannot always be adjusted on a short-term basis to recover the cost of increases in steel scrap prices, they generally accompany increases or decreases in these prices. Approximately half of all steel products in North America are currently made in electric arc furnaces using steel scrap. The increasing rate of consumption has pushed up the prices of steel scrap. The availability and prices of scrap are subject to market forces and government regulation that are largely beyond the companys control. This is also the case with demand from North American and international steel producers.
Pig Iron and Sponge Iron
Brazil is a net exporter of pig iron. Most Brazilian pig iron is produced in the state of Minas Gerais by a large number of small producers. Pig iron is a natural substitute for scrap, and in Brazil, mixed with scrap due to the low quality of the existing scrap supplies. Some mills in the U.S. use pig iron with steel scrap. In Brazil, the price of pig iron is related to the cost of charcoal, an important input and the most volatile cost item in the production of pig iron. When the price of charcoal is seasonally high, coking coal can be used as a substitute which, although more expensive, provides higher pig iron yields. Iron ore, the main component of pig iron, is widely available in Brazil, the country being among the worlds leading producers and exporters.
The Company produces sponge iron at its industrial plant in the state of Bahia (Gerdau Usiba), the entire production of which is used internally to manufacture steel products.
The Company does not have any Brazilian contracts for the supply of pig iron, negotiating amounts and delivery conditions directly on the spot market. The price of pig iron may fluctuate in line with its international market price, given that a large portion of production in Brazil is exported.
In Chile, Gerdau AZA sources pig iron from Compañía Siderúrgica Huachipato, located 550 km to the south of Santiago, in accordance with its needs and the specifications of the steel to be produced.
Scrap availability is a major factor in Gerdau Ameristeels ability to operate. Direct reduced iron, hot briquetted iron and pig iron can be a substitute for a limited portion of the steel scrap used in electric arc furnace steel production. Gerdau Ameristeel does not employ significant quantities of scrap substitutes in its mini-mills except for
pig iron used for its chemical properties in the Perth Amboy rod making facility and to manufacture certain special sections.
Gerdau Brazilian operations use iron ore to produce pig iron at its Barão de Cocais and Divinópolis mills, in the state of Minas Gerais, and sponge iron at its Gerdau Usiba mill in Bahia. Gerdau Contagem and Margusa also use iron ore in order to produce solid pig iron. The Company has acquired iron ore from MBR, Companhia Vale do Rio Doce and other smaller suppliers.
Gerdau Açominas uses fine grain quality iron ore, which is transformed into sinter at a sintering unit, as its main metallic input in the steel production. Lump ore and iron ore pellets are directly loaded into the blast furnace to increase productivity. Raw material suppliers located nearby the plant reduce transportation and storage costs. The molten pig iron produced in the blast furnace is the main raw material used in the melt shop. In 2005, metallic inputs were composed of 84% of molten pig iron, 12% of steel scrap and 4% of solid pig iron.
In addition to scrap, pig iron, sponge iron and iron ore, Gerdaus Brazilian operations use other inputs to produce steel such as ferroalloys, electrodes, furnace refracting materials, oxygen, nitrogen and other industrial gases and limestone, albeit in smaller amounts. All of these inputs are readily available in Brazil. Additional inputs associated with the production of pig iron are charcoal, used in blast furnace mills, and natural gas, used at the DRI unit.
Gerdau Açominas important raw materials and inputs also include coking coal, along with iron ore and pellets. Coal is used in the production of coke, the main reduction agent for sinter, iron ore and pellets, in the blast furnace. Pulverized Coal Injection (PCI) is also used to reduce consumption, increase productivity and consequently the cost of pig iron. At the steel works, ferroalloys are used for the production of special steels. Oxygen, nitrogen and argon are also used in some processes and supplied by an on-site company. The gas resulting from the production of coke, pig iron and steel, having been cleaned, is used as fuel for several processes and while also generating electric power for the plant.
In Chile and Uruguay, both energy and natural gas are provided under long-term contracts. During the year Gerdau Laisa (Uruguay) replaced fuel oil with natural gas. Due to rationing in Argentina, Gerdau AZA has had to use fuel oil in place of natural gas.
The North American operations also use additional inputs. Various domestic and foreign companies supply other important raw materials or operating supplies required for the business, including refractory materials, ferroalloys and carbon electrodes that are readily available in the open market. Gerdau Ameristeel has obtained adequate quantities of these raw materials and supplies at competitive market prices thus permitting efficient mill operations. The Company is not dependent on any one supplier as a source for any particular material and believes there are adequate alternative suppliers available in the marketplace if the need to replace an existing one arises.
Steel production is an energy intensive process, especially in EAF mills. Power and, to a lesser extent, natural gas used in some mills are significant components of steel production costs.
In Brazil, Gerdaus units hold contracts with a series of electricity suppliers and are not dependent on any single contract. Energy is currently supplied to the Companys industrial units under two types of contract:
I-Contracts in which the Company is a Captive Consumer, exist at the following units: Riograndense, Aços Especiais Piratini, Guaíra, Cosigua, Usiba and Açonorte. These contracts involve state-owned companies or holders of public concessions. Under these contracts, demand and consumption are defined between the parties and the tariffs are defined by ANEEL, the Brazilian Electricity Power Regulator. Captive consumers may purchase part of their energy on the free market.
II-Contracts in which Gerdau is a Free Consumer include Araçariguama, Cearense, Ouro Branco, Divinópolis and the Barão de Cocais units. These mills have the energy contracts with generators with rates defined and adjusted according to pre-established indices. The demand contracts are held with transmission and distribution
companies and the tariffs are revised annually by ANEEL. Ouro Branco reduces its exposure to the energy market by meeting a significant part of its energy needs through self-generation, using top-of-blast furnace-generated gases.
In terms of natural gas, all units are supplied under long-term contracts. The Barão de Cocais and Divinópolis units do not have access to natural gas.
In Chile and Uruguay, both energy and natural gas are provided under long-term contracts. During the year Gerdau Laisa (Uruguay) replaced fuel oil with natural gas. Due to rationing in Argentina, Gerdau AZA has had to use fuel oil in place of natural gas.
In North America, there are two kinds of energy markets: regulated and deregulated. In the regulated market, the contracts are held with authorized public utilities and the tariffs are defined for each region through long-term contracts. In the deregulated market, the price of power changes every 5 minutes (spot market price) to reflect the actual cost to produce power. Although deregulation of both natural gas and wholesale electricity may provide opportunities for lower costs resulting from competitive market forces, the prices of both of these energy inputs have recently become more volatile and may remain so. The Company does not have long-term natural gas supply contracts and therefore is subject to market variables and price swings.
Information on the Extent of the Companys Dependence
The Company is not dependent on patents or licenses, industrial, commercial or financial contracts (including contracts with customers or suppliers) or new manufacturing processes that are material to the Companys business or profitability.
The Company has a policy of diversifying its suppliers so that it can replace these in the event of a breach of contract without affecting the Companys operations.
Should electricity supplies be interrupted, no alternate energy options are available at most Gerdau mills due to the high volume and tension required for the operation of these plants. In such cases (as occurred in 2001, in Brazil, when the federal government set targets for reducing consumption), the events and their consequences are discussed with the respective energy concessionaires while operating capacity is kept at emergency levels to protect staff and equipment.
In the event of rationing, decisions and procedures will be implemented by the Governments regulatory agency. These may have a materially adverse impact on the Companys results, with a consequent reduction in production in the light of the availability of electricity and readjustments to delivery schedules. Although such problems are not common in Brazil, some small Gerdau units may choose, as an alternative, to use generators to compensate for the shortage of energy. During the 2001 period of electric power rationing, Gerdau overcame the crisis by reallocating production among its several industrial units and by rationalizing the use of electricity. These measures resulted in efficiency and productivity gains which were incorporated into the production process even after the critical period ended.
In terms of natural gas, the units of Rio Grande do Sul, Paraná and São Paulo are supplied by imported natural gas, through GASBOL (Brazil-Bolivia Pipeline), whereas the other units are supplied by domestic natural gas. In the event of natural gas rationing, it would be possible to adapt the equipment for use of fuel oil and LPG (Liquefied Petroleum Gas).
The Company sells its products to various markets, including construction, manufacturing and other markets. Sales by its Brazilian operations include both domestic and exports. Most of the sales of its North and South American business operations are for their respective local markets.
The Companys Brazilian operations accounted for 49.8% of overall Gerdau shipments. Brazilian sales amounted to 6.4 million tonnes, of which 3.5 million tonnes were delivered to the domestic market and 2.9 million tonnes to the export market.
The Gerdau Brazilian operations are divided into the following segments: Brazil Long Steel Products, Specialty Steel Products and Gerdau Açominas (Ouro Branco mill).
Approximately 20% of the production sold in Brazil is distributed through Comercial Gerdau, the Companys largest distribution channel with 68 stores throughout Brazil, servicing approximately 124,000 customers in 2005. Another important distribution channel is the network of 6,000 independent distributors to which Gerdau sells its products, giving it a comprehensive national coverage. Sales through its distribution network and to final industrial and construction consumers are channeled through Company employees and authorized representatives working on commission. The Company provides these representatives with product catalogs and access to Gerdaus information system as well as computers and telephones to better service their customers and expedite orders.
Gerdau Brazilian operations minimize delays by delivering its products directly to customers through third-party companies, under Gerdaus supervision. Sales trends in both the domestic and export markets are forecasted monthly based on historical data of the three preceding months. Gerdaus Brazilian operations use their own information system to remain current on market developments so that it can respond swiftly to fluctuations in demand. Gerdau considers its flexibility in shifting between markets, and its ability to monitor and optimize inventory levels in the light of changing demand, as key to its success.
Gerdau Açominas has specific operational features. The products are usually sold to rolling mills and to companies that use slabs, billets, blooms and ingots as raw material for their finishing lines such as shipbuilding, forging and mechanical. Gerdau Açominas also produces its own finished products such as high quality wire rod and sections. These products are delivered to the customers port of destination or directly to their premises.
Gerdau Aços Especiais Piratini operates in the specialty steel market and its sales force and production facilities are independent of the Brazilian long steel business unit. Gerdau Aços Especiais Piratini produces engineering steel, tool steel and stainless steel that is sold to more than 260 clients. About 80% of its sales go to the automotive industry. In order to meet the continuous need for innovation, Gerdau Aços Especiais Piratini is constantly developing new products, such as micro-alloyed steel for diesel engines with high power and low emissions, clean steels for application in bearings, steels with improved machining characteristics, which allow higher machining speeds and lower tooling replacement, among others, in partnership with its customers.
The Gerdau Brazilian operations sell its products nationwide through the Comercial Gerdau network of 74 stores including six flat steel service centers. In addition to Gerdau products, Comercial Gerdau resells flat products produced by other companies in Brazil. In 2005, domestic market sales of flat steel products amounted to 259,366 tonnes.
Since 2003, Gerdau has been exporting a larger part of its production following the consolidation of its Brazilian operations, the decline in domestic market sales and higher international prices. In 2005, exports accounted for 45.2% of the Companys Brazilian operations total shipments. Export activities are coordinated by the sales channel responsible for selling products directly to end overseas users and indirectly through trading companies. Sales are negotiated worldwide (i) primarily CFR (Cost and Freight) and (ii) guaranteed by sight letters-of-credit issued by customers through first class European and American banks.
Gerdaus Brazilian exports generated $1,225.4 million in revenues in 2005. As a result of lower economic activity throughout the year in Brazil, sales volume to Brazilian clients dropped 9.6% in the period and part of this reduction was offset by exports, which increased 2.3% in volume for the full year, reaching 2.9 million metric tonnes. The new export strategy has allowed Gerdau to develop its client base in a more evenly distributed manner throughout the world with exports going to Africa, Europe, South, Central and North America and Asia. Despite the significant portion of exports going to Asian countries - more than 40% of total exported volumes -, (mainland) China is responsible for less than 2% of Gerdaus exports.
Exports from the Companys Brazilian operations have become an even more significant portion of its sales. Consequently, Gerdau has been making efforts to improve its logistics strategies to overcome Brazilian infrastructure limitations. In 2005, exports were dispatched from 14 mills and downstream facilities to about 70 countries aboard 583 ships using the services of 19 different ports.
Although Gerdaus Brazilian operations deal primarily in commodities, it is aware of the importance of quality control. The Companys technicians conduct random visits to customers to check the quality of the products that it exports to ensure user satisfaction with products purchased indirectly from Gerdau.
Gerdaus foreign operations are divided into the following segments: North American and South American Operations (excluding Brazil).
South American units (excluding Brazil) sold 728,919 tonnes of finished products in 2005, representing a 66.4% increase compared to 2004. This is due to the consolidation of the acquisition of an additional stake in Sipar and the acquisition of Diaco, in the last quarter of 2005.
Gerdau AZA has a 51% share of the Chilean merchant bar and rebar markets. Since the end of 2000, Gerdau AZA has had a business unit known as AZAonLine, which services customers in Chile through the Internet. This was the first e-commerce initiative in the steel sector in Chile. Customers can track their orders on the Internet, together with product inventories and credit and payment status. They can also access their purchase records as well as generate quality certificates and place orders. Gerdau AZA sells its products to more than 370 clients, which are distributors and end-users.
Gerdau Laisa has an 84% share of the long steel products market in Uruguay. There are more than 580 registered customers classified as retail, wholesale and end-consumers, which distribute its products all over the country. Uruguayan customers can also use an e-business channel.
The Sipar Aceros figures were consolidated starting in the fourth quarter of 2005 as a result of the acquisition of an additional stake. Sipar has 20% of the Argentine market and has more than 1,000 clients. The company sells its products directly to end-users (construction companies and industries) or through distributors.
Diaco, acquired in September 2005, and Sidelpa, acquired in December 2005, have a 36% stake in the Colombian steel market. The companies sell their products through more than 400 distributors and have almost 1,000 clients (end-users) in the following markets: civil construction, industry and others.
Gerdaus foreign operations supply their respective domestic markets, with the exception of the Canadian operations, which sell a significant portion of their production to the United States.
Gerdau Ameristeels strategy is to have production facilities located in close proximity to customers job-sites so quick delivery times are provided to satisfy their reinforcing steel needs and construction schedules. In 2005, Gerdau Ameristeel sold products to over 1,000 customers.
As a rule, the Tampa sales office centrally manages sales of mill-finished products to U.S. customers while the Whitby sales office is responsible for sales to Canadian customers. Gerdau Ameristeel has a sales office in Selkirk, Manitoba, for managing sales of special sections. Metallurgical service representatives at the mills provide technical support to the sales group. Sales of the cold drawn and super light beam products are managed by sales representatives located at their respective facilities. Fabricated rebar and elevator guide rails are generally sold through a bidding process in which employees at the Gerdau Ameristeels facilities work closely with customers to tailor product requirements, shipping schedules and prices.
The appropriate sales offices are responsible for booking orders, mill scheduling and inventory management. Gerdau Ameristeel has about 118 employees dedicated to marketing and sales, a fifth of whom are located in the field close to the customers. Every Gerdau Ameristeel sales representative has immediate access to inventory and production schedules at all mills enabling them to provide customers with one-stop shopping, as well as to service customer needs from the most convenient and/or cost effective source within the company.
Terms of Sales
Gerdau Brazilian sales are usually made on a 21-day settlement CIF (Cost Insurance and Freight) basis. Comercial Gerdau, the retail arm of Gerdau in Brazil, sells on a 26-day settlement basis, either CIF or FOB (Free on Board).
Brazilian customers are subject to a credit approval process. The concession of credit limits is controlled by a corporate-level system (SAP R/3), which can be accessed by all sales channels. The credit and collection department is responsible for credit evaluation, definition and monitoring in accordance with the limits policy. This policy has the active participation of the client sales channels officers.
At Comercial Gerdau, in particular, the criteria for retail sales also include practices such as the use of credit cards serviced in Brazil.
Gerdau Açominas exports are guaranteed via letter of credit and/or pre-payment before the product is shipped. Exceptionally, exports to Gerdaus subsidiaries may be sold on credit at ongoing market interest rates.
As a result of the implementation of these policies, the Companys provision for doubtful accounts was an insignificant percentage of its consolidated accounts receivable (less than 0.1%) on December 31 2005. Thanks to the implementation of the Integrated Risk Management Project, Gerdau has improved its credit approval controls and enhanced the reliability of its sales process through the use of risk indicators and internal controls.
Gerdau Ameristeels credit terms to customers are generally based on customary market conditions and practices. Gerdau Ameristeels business is seasonal with orders in the second and third quarters tending to be stronger than those of the first and fourth quarters, due primarily to weather-related slowdowns in the construction industry.
Shipping, freight and demurrage costs are a major barrier to imports, and, since Gerdau operates primarily in the common long rolled product business in Brazil where profit margins are relatively small, the incentive for foreign competitors to enter the Brazilian market is low. In the Brazilian market, no single company competes against Gerdau across its entire product range. Gerdau believes that its business diversification and decentralization provide a competitive edge over its major competitors where operations are more centralized.
Gerdau is the largest Brazilian long steel producer with a 47.5% market share according to the IBS. Belgo Mineira, an Arcelor subsidiary, is the second largest producer in Brazil with roughly 35.9% of the market. Belgo Mineira was originally an integrated steel company, but now also has mini-mill plants.
In the domestic market, Gerdau Açominas is almost an exclusive supplier to well-defined and loyal customers, which have been purchasing from it regularly for more than ten years. Competition from CST (Companhia Siderúrgica de Tubarão) in the slab market is stiffer. In the international market, Gerdau Açominas faces strong competition in the commercial quality products line from Eastern Europe (CIS) and China. The main competitors in the high quality products segment are Europe and Japan. The Company is a strong player due to its great experience and the high quality of its services and products. Gerdau Açominas has a diversified list of traditional customers all over the world.
In South America (excluding Brazil), the main barriers faced by the operations are freight and transportation costs and the availability of imports. The South American units are the main players in the country where they operate with the exception of Sipar Aceros, which is the second player in the Argentine market with 19.8% of the market share.
Gerdau Ameristeels geographic market encompasses the eastern two thirds of Canada and the United States, predominantly throughout the eastern seaboard, the southeast and the Midwest U.S. The Company experiences substantial competition in the sale of each of its products from numerous competitors in its markets. Rebar, merchant bars, and structural shapes are commodity steel products, for which pricing is the primary competitive factor. Due to the high cost of freight relative to the value of steel products, competition from non-regional producers is somewhat limited. Proximity of product inventories to customers, together with competitive freight costs and low-cost manufacturing processes, are key to maintaining margins on rebar and merchant bar products. Rebar deliveries are generally concentrated within a 350-mile radius of the mills and merchant bar deliveries are generally concentrated within a 500-mile radius. Some products, such as special sections produced by the Manitoba mill, are shipped greater distances, including overseas. Except in unusual circumstances, the customers delivery expense is limited to freight charges from the nearest competitive mill, and the supplier absorbs any incremental freight charges.
Principal competitors to Gerdau Ameristeel include Mittal Inc., Stelco Inc. and Ivaco Inc. in Canada; and Bayou Steel Corporation, Commercial Metals Corporation, Nucor Corporation, and Steel Dynamics Inc. in the United States. Gallatin Steel competes with numerous other integrated and mini mill steel producers.
Despite the commodity characteristics of the rebar, merchant bar and structural markets, Gerdau Ameristeel believes it distinguishes itself from competitors due to its large product range, product quality, consistent delivery performance, capacity to service large orders and ability to fill most orders quickly from inventory. The Company believes it produces one of the largest ranges of bar products and shapes east of the Mississippi River. The Companys product diversity is an important competitive advantage in a market where many customers are looking to fulfill their requirements from a few key suppliers.
Material Effects of Government Regulations
Besides government regulations that apply to industry in general, the Company is not subject to any specific regulation that materially affects its business.
C. ORGANIZATIONAL STRUCTURE
Gerdau S.A. is a non-operational holding company (since November, 2003 when Gerdau S.A.s Brazilian assets were integrated with Açominas, creating Gerdau Açominas S.A.) controlled by a holding company, Metalúrgica Gerdau S.A. As of December 31 2005, Gerdau S.A. consolidates the results of 12 operating companies: Diaco S.A. (Colombia) Gerdau Açominas S.A. (Brazil), Gerdau Aços Longos S.A. (Brazil), Gerdau Aços Especiais S.A. (Brazil), Maranhão Gusa S.A.Margusa (Brazil), Gerdau Comercial de Aços S.A. (Brazil), Gerdau Ameristeel Corp (Canada) and its subsidiaries (United States and Canada), Gerdau AZA S.A. (Chile), Gerdau Laisa S.A. (Uruguay), Siderúrgica Del Pacifico S.A. (Colombia), Sipar Aceros S.A. (Argentina) and Seiva S.A. (Brazil) which operates in the forestry business.
The Companys investments in Gallatin, Bradley Steel Processor and MRM Guide Rail in North America, in which Gerdau Ameristeel holds a 50% stake in the total capital, the investments in Armacero Industrial y Comercial Limitada in Chile, in which the Company owns a 50% stake, and the investment in Dona Francisca Energética S.A., in which the Company owns a 51.82% stake, are accounted in the Companys financial statements using the equity method.
The table below shows the main consolidated companies and investments maintained directly or indirectly by Gerdau on December 31 2005:
The operating companies that are fully consolidated or accounted according to the equity method in the financial statements of Gerdau S.A. are described below:
Gerdau Aços Longos, Gerdau Aços Especiais and Gerdau Comercial de Aços
In order to complete a series of corporate operations, on July 29 2005, the shareholders of Gerdau Açominas S.A. approved the spin-off of its assets and liabilities into the following companies: Gerdau Aços Longos S.A., Gerdau Aços Especiais S.A. and Gerdau Comercial de Aços S.A. The operations of these companies operations consists of producing long common and specialty long steels and selling steel products in general, respectively. Gerdau Açominas S.A., headquartered in Ouro Branco, Minas Gerais, remains focused mainly in the production of slabs, blooms and billets for export. Gerdau Aços Longos has nine mills distributed throughout the country and has an annual installed capacity of 5.2 million tonnes of crude steel (including Gerdau Araçariguama that started operating in the end of 2005).
Gerdau Aços Especiais is headquartered in Charqueadas, state of Rio Grande do Sul and has an annual installed capacity of 400,000 tonnes of crude steel.
Gerdau acquired a stake in Açominas, together with NatSteel and the Açominas Employees Association in 1997. The Company increased its stake in Açominas, acquiring a controlling stake in 2001. Gerdau Açominas owns the Ouro Branco mill, located in the state of Minas Gerais. The Ouro Branco mill has an annual installed capacity of 3.0 million tonnes of crude steel and is responsible for 42.0% of Gerdaus crude steel output in Brazil.
In 1980, the Company acquired the Laisa mini-mill, in Uruguay. Gerdau Laisa is the only long steel producer in Uruguay and has an annual installed capacity of 70,000 tonnes of crude steel and 72,000 tonnes of rolled products.
In 1992, the Company acquired the AZA mini-mill in Chile with Gerdau AZAs second mill beginning operations in January 1999. The two units, Renca and Colina, have a combined annual production capacity of 440,000 tonnes of crude steel and 465,000 tonnes of rolled steel. The difference in the output of crude steel and long rolled products is due to the fact that Gerdau AZA still operates old profile rolling mill equipment at the Renca unit, which
was not decommissioned following the start-up of the new plant in 1999. Although no official statistics are available in Chile, Gerdau AZA believes its share of the domestic long steel rebar market to be about 51%.
Gerdau entered the Argentine market in December 1997. Following the financial and corporate restructuring of its operations in Argentina due to the prevailing economic environment, the Company currently holds a 72% stake in Sipar, a rolling mill with an annual installed capacity of 240,000 tonnes.
Diaco and Sidelpa
On September 30 2005, the Company concluded all steps required to obtain a 57.1% voting and total interest in Diaco, thus obtaining a controlling interest. Diaco is the largest producer of steel and rebar in Colombia.
On November 19 2005, the Company met all the conditions precedent related to the acquisition of a 97.0% controlling interest in Sidelpa. Sidelpa is the only producer of long specialty steel in Cali, Colombia.
In September 1999, Gerdau acquired 75% of Ameristeel from Kyoei Steel Ltd. of Japan. At that time, Ameristeel operated four mills on the East Coast: one unit in Florida, two in Tennessee, and one in North Carolina. In 2000, Gerdau acquired an additional 12% stake from Kyoei, increasing its overall stake in Ameristeel to 87%. In December 2001, Ameristeel acquired a steel mill located in Cartersville, Georgia.
In October 2002, Gerdau merged its North American assets with Co-Steel to create Gerdau Ameristeel. As a result of this merger, Gerdaus interest in Gerdau Ameristeel was reduced to 67%.
In November 2004, Gerdau Ameristeel acquired from Cargill Incorporated, the fixed assets and working capital of four long steel product mini mills, three wire rod processing facilities and a grinding ball facility in Duluth, Minnesota, known as North Star Steel.
Currently, Gerdau Ameristeel has a nominal annual capacity of 7.6 million tonnes of crude steel and 6.9 million tonnes of rolled products. Gerdau S.A. now holds a stake of 65% following Gerdau Ameristeels public offering in October 2004 and the exercise of the over-allotment option in November 2004. The Company is the second largest producer of long steel in North America and is listed on the Toronto Stock Exchange and the New York Stock Exchange, under the ticker symbols GNA.TO and GNA, respectively.
Dona Francisca Energética S.A. (DFESA) is an operational hydroelectric power plant with a nominal capacity of 125 MW, located in the center of the state of Rio Grande do Sul.
DFESAs corporate purpose is to operate, maintain and maximize the use of the Dona Francisca Hydroelectric Plants energy potential.
In conjunction with the state power utility, Companhia Estadual de Energia Elétrica CEEE, Dona Francisca shareholders participate in a consortium (Consórcio Dona Francisca) formed in accordance with contract CEEE/9700295 of March 13 1997. Following Gerdau S.A.s acquisition of an additional stake in early 2003, Dona Francisca Energética S.A.s shareholders are: Gerdau S.A. (51.8%), Companhia Paranaense de Energia COPEL (23.0%), Celesc (23.0%), and Desenvix (2.2%).
D. PROPERTY, PLANT AND EQUIPMENT
Material Plans to Construct, Expand or Improve Facilities
New Specialty Steel Mill in Rio de Janeiro
There are plans to invest $212.0 million through 2009 in the construction of a new specialty steel mill in Rio de Janeiro. The new unit is intended to meet demand from the automotive industry. The mills annual installed capacity is expected to be 800,000 tonnes of crude steel and 500,000 tonnes of rolled products. Of the total amount invested, approximately one-third is expected to be financed from internal cash flow, one-third from domestic financial institutions and the remaining third from foreign financial institutions.
Gerdau S.A believes it is currently in compliance with government environmental regulations. The Company believes that there are no environmental issues that might affect use of the fixed assets described below.
Material Tangible Fixed Assets
Gerdaus principal properties are for the production of steel, rolled products and drawn products. The following is a list showing the location, capacity and type of installation, as well as the types of products manufactured:
Locations of plants, capacity, equipment and products
Note (1): While EAF (electric arc furnace) mills produce crude steel from raw materials such as steel scrap or pig iron, a mill with a blast furnace or DRI (direct reduction iron) is also capable of producing pig iron or sponge iron for use in the production of crude steel, iron ore and natural gas being the main raw materials.
The Company has no unresolved comments from the staff of the U.S. Securities and Exchange Commission in respect of its periodic reports under the Exchange Act.
A. OPERATING RESULTS
In general terms the year 2005 produced excellent results for Gerdau. Consolidated gross revenues reached $10.0 billion, 28.2% greater than in 2005. Net profit was $1.1 billion, 3.5% less than that of 2004. It is worthwhile noting that these important results were obtained in spite of the weaker Brazilian domestic market and lower average international prices compared with 2004.
The Brazilian market was below expectations in 2005. There was an excessive deceleration in economic growth due to the extremely tight monetary policy. GDP increased 2.3%, which is rather low for a developing country at a time when all economies, developing and developed, have been growing at a much steadier and faster pace. As a consequence, the Brazilian long steel domestic market fell to the same levels as 2003, essentially neutralizing the important recovery seen in 2004.
In spite of an unfavorable foreign exchange rate, the Company sought to at least partially compensate the decline in domestic demand by increasing exports that reached historical highs in volumes terms.
Demand in North America permitted steel scrap price volatility to be absorbed into final product prices thus maintaining metallic spreads above the $340 per ton mark.
In 2005 the world steel output was 1.1 billion tonnes. Of this total, China contributed with approximately 350 million tonnes, 25% more than in 2004, when output reached 281 million tonnes. In 2005, China, for the first time, became a net steel product exporter of both finished and semi-finished products.
Significant Factors Materially Affecting the Companys Results
Sales in 2005 reached 12.9 million tonnes, 8.3% greater than those of 2004. This performance is due largerly to the consolidation of North Star in North America as from November 1 2004, Diaco, in Colombia as from October 1 2005 and Sipar, Argentina as from September 30 2005.
As a consequence of the reduced economic activity, Brazilian domestic sales decreased 9.6% in 2005. Part of this reduction was made up by the increase in exports, up 2.3%, reaching 2.9 million tonnes in 2005, despite the appreciation in the real and lower international prices in 2005.
North America saw sales increase 21.2% in 2005, from 4.7 up to 5.7 million tonnes. South America saw an increase of 66.4% in the full year, from 439 to 728 thousand tonnes.
The combination of sales abroad and exports from Brazil represented 72.7% of consolidated tonnage shipped in 2005.
The Companys growth objective is to consolidate its position as a leader in the Americas in the production of long steel. Recent acquisitions and agreements substantiate the Companys faith in the growth potential of the continents economies and have encouraged the search for new opportunities. Consequently, during 2005, the Company acquired operations in Colombia and an additional stake in Sipar (Argentina).
In North America, Gerdau Ameristeels acquisition of the North Star assets in November, 2004, made a significant contribution to the expansion of the Companys geographical coverage of the United States Midwest and South regions. The North American operations have a total capacity of approximately 6.9 million metric tonnes of rolled products.
The production of slabs, blooms and billets rose to 13.0 million tonnes in 2005, 1.8% more than in 2004. Rolled product output, the subsequent stage in the production chain, reached 10.0 million tonnes, a growth of 5.8% compared to the volume for the previous year. As mentioned above, this performance was due to the consolidation of the steel plants acquired at the end of 2004 and during 2005.
* The rolling process relies on raw materials produced at the melt shops such as slabs, blooms and billets. These products are partially sold directly to external customers and the remainder used in the rolling process.
The Brazilian units produced 6.9 million tonnes of steel in 2005, a volume 5.4% lower than in 2004 and corresponding to 53.1% of the consolidated output. In North America, production was 10.3% greater, reaching 5.6 million tonnes (42.8% of the total). The South American companies (excluding Brazil) produced 533,989 tonnes (4.1% of the total), posting a growth of 24.7%.
The Gerdau companies production of rolled products in Brazil amounted to 4.0 million tonnes in 2005, a decrease of 7.5%. In North America and South America (excluding Brazil), production grew 14.7% and 43.7%, respectively, to reach 5.5 million tonnes and 578,362 tonnes, reflecting the consolidation of North Star, in North America, Diaco, in Colombia, and of Sipar, in Argentina, the latter two in the 4th quarter.
Significant events affecting financial performance during 2005
In addition to increased sales, the results of the Companys operations in 2005 were negatively impacted by a series of events that resulted in only a slight a year-on-year reduction in net income. Some of the most relevant events are described below:
· During 2005, the Companys consolidated results of operations of North Star for the full year, compared to two months consolidated following the acquisition in November 2004, generating revenues of $889.0 million, compared to $154.0 million of revenues from North Star mills in 2004. Nevertheless, production costs increased during 2005 due to the increase in scrap prices, resulting in a reduction in the gross margin in North America (10.3% in 2005 against 12.4% in 2004).
· In 2005, the Company obtained a final settlement of a lawsuit in which the Company challenged payment of PIS taxes on the grounds of the unconstitutionality of executive laws 2,445/88 and 2,449/88, and, as a result, recorded a gain of $28.9 million ($19.1 million net of tax) compared to a gain for the same reason in 2004 when Gerdau Açominas also obtained a gain of $43.5 million ($28.7 million, net of taxes) for a similar claim. Such credits are expected to be used to offset other federal taxes, such as income taxes or excise taxes.
· The effective income tax rate rose to 26.4% in 2005 from 23.6% in 2004, mainly for the reversal of valuation allowance on deferred tax assets in 2004, an event that was not repeated in 2005. Since December 31, 2004, the Company has not had any valuation allowance for tax losses recorded for its Brazilian operations.
· Gains on investments accounted for under the equity method were $96.5 million in 2005 compared to $141.9 million in 2004, arising mainly from the results of the Gallatin, Bradley Steel Processors and MRM Guide Rail joint ventures. Gallatin Steel shipments were flat for the year ended December 31 2005 compared with 2004 and spreads for flat rolled steel products decreased from the levels earned in 2004, which negatively affected Gallatins net income mainly for the first nine months of 2005 with a slight recovery in the fourth quarter, supported by a stronger demand and order backlog. Gallatin paid to Gerdau cash dividends of $115.8 million during 2005 and $82.8 million during 2004.
Impact of Inflation and Fluctuations in Exchange Rates
Gerdaus results and its financial position are largely dependent on the state of the Brazilian economy, notably (i) economic growth and its impact on steel demand, (ii) financing costs and the availability of financing, and (iii) the exchange rates between the real and foreign currencies.
For many years, Brazil experienced high rates of inflation that progressively eroded the purchasing power of the vast majority of the population. During periods of high inflation, effective salaries and wages tend to fall because the frequency and size of salary and wage adjustments for inflation usually do not offset the actual rate of inflation. Since the introduction of the real in July 1994, the inflation rate in Brazil has decreased dramatically. Following the implementation of the Real Plan, the Brazilian GDP increased, rising by 1.4% in 2001, 1.5% in 2002, decreasing by 0.2% in 2003, increasing by 5.2% in 2004 and increasing again by 2.3% in 2005.
The following table presents Brazilian inflation and the performance of the real against the U.S. dollar for the periods shown. For a discussion of the foreign exchange rate in Brazil generally, see Item 10.D. Exchange Controls Exchange Rates.
In a positive economic environment, the real appreciated against the U.S. dollar throughout 2005 leading to a significant improvement in Brazilian country risk and a gradual reduction in interest rates.
A portion of Gerdaus trade accounts receivable, trade accounts payable and debt is denominated in currencies different to the respective functional currency of each subsidiary. Brazilian operating subsidiaries (Gerdau Açominas, Gerdau Aços Longos, Gerdau Aços Especiais and Gerdau Comerical de Aços) functional currency is the Brazilian real. Brazilian subsidiaries have foreign currency denominated assets and liabilities, mainly in U.S. dollars, their financial position and results being affected by changes in the exchange rate of the Brazilian real in relation to the U.S. dollar. In 2005, 2004 and 2003, Gerdaus results were affected by the appreciation of the Brazilian real against the U.S. dollar, generating losses in its U.S. dollar-denominated trade accounts receivable from exports, and generating gains in the U.S. dollar denominated trade accounts payable and also debt. The reduction of net debt balances (defined as short and long term debt less short term investments, restricted cash and cash and cash equivalents) during 2005 compared to 2004 and the appreciation of the real, together with the increase in the balance of trade accounts receivable and trade accounts payable generated a net foreign exchange gain during 2005. Gerdaus financial statements are presented in U.S. dollars with transactions in currencies other than the U.S. dollar translated into U.S. dollars in accordance with the criteria established in SFAS No. 52 Foreign Currency Translations. Changes in the exchange rate between the functional currency of the Companys operations, such as the Brazilian real and the U.S. dollar, affect the reported amounts of revenues and expenses in the consolidated statements presented in U.S. dollars.
Net income for the years ended December 31, 2005, 2004 and 2003
The table below contains information for various income statement items, expressed as a percentage of net sales for each of the respective years:
The table below contains information for various income statement items, where the years are expressed in $ millions:
Year Ended December 31, 2005 Compared with Year Ended December 31, 2004
The Companys net sales were $8,894.4 million in 2005, 27.9% more than 2004 ($6,952.1 million). Of this amount, 50.4% ($4,483.9 million) came from operations in Brazil, 43.8% ($3,897.1 million) from the North American units, and 5.8% ($513.4 million) from the South American companies (excluding Brazil). The consolidation of the steel units in North and South America was the principal reason for this growth, and to a lesser extent the improved demand in North America and in the South American countries where the Company is present.
The average net price of steel in 2005 was $691.6/ton, an 18.1% increase from $585.5/ton in 2004.
Cost of Sales and Gross Profit
Cost of sales increased from $4,838.9 million in 2004 to $6,564.2 million in 2005, representing an increase of 35.7%. This increase is due to higher volume of shipments in 2005, as well as to the appreciation of the real against the US dollar, which impacts significantly the cost of sales of the Brazilian subsidiaries when translated into U.S. dollars. The Companys gross margin reached 26.2% in 2005, compared to 30.4% in 2004. This reduction is due to the increase in costs of the main raw materials used in the production process in 2005, such as coking coal, iron ore, energy and others. Gross profit reached $2,330.2 million in 2005, compared to $2,113.2 million in 2004, representing an increase of 10.3%, principally due to higher sales volume in 2005.
Operating expenses (sales and marketing, general and administrative and other expenses) increased 39.7% in 2005, compared to 2004, and a growth of 27.9% in net sales. The ratio of operating expenses to net sales was 7.5%, and slightly above the percentage of 7.4% in 2004. This increase is mainly the result of expenses related to greater export volumes and the enhanced long term incentive program for Gerdau Ameristeels employees. In 2005, consolidated operating expenses, excluding other operating expenses, were $669.3 million against $513.7 million in 2004.
Other Operating Income (Expenses), Net
During 2005, several non-recurring items affected operating income, such as the recognition of an impairment loss on the goodwill related to the acquisition of Margusa in the amount of $13.0 million, due to a reduction in pig iron prices and the reals appreciation during the year, which reduced severely Margusas profitability. Other non-recurring items included the recognition of a provision for tax contingencies related to ICMS credits denied by the fiscal authorities and an unfavorable court ruling during the fourth quarter on this issue amounting to $12.6 million, as well as tax contingencies recorded regarding operations performed under a drawback concession which is being challenged by the fiscal authorities, and for which the Company has also had an unfavorable court ruling in the amount of $33.9 million. Nevertheless, the Company has also recorded some amounts that generated other income such as the positive fair value of the commitment to acquire 40% of Diaco shares in the amount of $7.5 million.
Operating income was $1,652.7 million in 2005, an increase of 1.5% when compared to $1,628.3 million in 2004. Operating income was substantially flat in 2005 because of lower gross margins. Bearing in mind that net sales were higher in 2005, the increase in the cost of goods and a reduction in other operating income almost offset the impact on operating income in 2005.
Financial Expenses, Financial Income, Foreign Exchange Gains and Losses, Net and Gains and Losses in Derivatives, Net
In the fiscal year 2005, net financial income (which consists of financial income, financial expenses, foreign exchange gains and losses and gains and losses from derivatives) totaled $12.6 million, against net financial expenses of $50.8 million in the previous year. This decrease in expenses is due mainly to the increase in financial investments, as a result of the stronger cash flow in the period, and to a reduction in the cost of debt.
With the goal of extending the average maturity of its indebtedness, financial transactions conducted throughout 2005 contributed substantially to meeting this objective. The average debt maturity more than doubled in the period increasing from 4 to 9 years, also generating lower financial expenses on the new debt contracted. Foreign exchange gains during 2005 amounted to $57.9 million against $30.8 million in 2004, but these gains were partially offset due to losses recorded with derivatives, mainly swaps agreements, in the amount of $22.0 million during 2005 compared to a gain of $1.2 million during 2004.
Equity in Earnings (Losses) of Unconsolidated Companies, net
During 2005, equity income from unconsolidated companies amounted to $96.5 million compared to $141.9 million recorded in 2004. Lower average selling prices for flat steel products during the year, as well as an increase in the price of scrap during the year generated lower net income at the joint ventures in the United States (Gallatin Steel, MRM Guide Rail and Bradley Steel Processors), which account for the majority of the equity income recorded on its books.
Provision for Taxes on Income
In 2005, income tax expenses were positively affected by the recognition of tax-deductible amortization of goodwill, which reduced this expense, in the amount of $76.7 million. Nevertheless, the effective tax rate has increased from 23.61% in 2004 to 26.41% in 2005 due to the recognition during 2004 of a reversal of valuation allowance, in the amount of $120.3 million for Gerdau Açominas and $48.6 million for Gerdau Ameristeel, which had reduced significantly the effective tax rate in 2004.
In 2005, consolidated net income amounted to $1,117.5 million, 3.5% lower than $1,158.4 million in 2004. This reduction reflects the smaller volume shipped to the domestic market and the impact of the foreign exchange rate on sales abroad, considering that the average US dollar rate for 2005 was lower than that of 2004. Net margin (defined as net income divided by net sales) decreased from 16.7% in 2004 to 12.6% in 2005.
Year Ended December 31, 2004 Compared with Year Ended December 31, 2003
Net sales were $6,952.1 million in 2004, 53.4% more than 2003 ($4,531.0 million). Of this amount, 52.1% ($3,623.0 million) came from operations in Brazil, 43.3% ($3,009.9 million) from the North American units, and 4.6% ($319.2 million) from Chile and Uruguay. This increase was driven by a better performance from operations outside Brazil, an increase in international market prices and a recovery in domestic demand, in addition to the consolidation of the North Star assets acquired in November 2004.
The average net price of steel in 2004 was $585.5/ton, a 48.0% increase from $395.6/ton in 2003.
Cost of Sales and Gross Profit
Cost of sales was $4,839.0 million in the year ended December 31, 2004, an increase of 40.4% compared to the cost of sales in 2003 ($3,445.6 million). The increase was mainly due to the increases in the cost of raw materials (scrap and pig iron) caused by a greater demand from steel producers, and a 3.7% increase in sales volume in metric tonnes. Gross margin reached 30.4% in 2004, against 24.0% in 2003. This reflected improved margins from the Brazilian operations following adjustments in sale prices due to higher raw material costs and increased international market prices, strongly favoring exports and the North America business. Gross profit reached $2,113.2 million in 2004, against $1,085.4 million in 2003, a growth of 94.7%.
Operating expenses (sales and marketing, general and administrative) increased 32.3% in 2004, compared to 2003, against a growth of 53.4% in net sales, with the ratio of operating expenses to net sales falling from 8.6% to 7.4%. This reduction primarily reflects lower export volumes, which reduced freight and transportation costs, and lower expenses at Gerdau Ameristeel. In 2004, consolidated operating expenses, excluding other operating expenses, were $513.7 million against $388.2 million in 2003.
Other Operating Income (Expenses), Net
Net other operating income in 2004 totaled $28.7 million, an increase of $29.5 million compared to net other operating expenses of $0.8 million reported in 2003. The increase was principally due to an irrevocable court ruling in favor of the subsidiary, Gerdau Açominas S.A. for a lawsuit brought against the payment of social contribution taxes based on the unconstitutionality of Decree-Laws 2,445/88 and 2,449/88 and totaling $43.5 million ($28.7 million net of tax).
Operating income in 2004 was $1,628.2 million, an increase of 133.8% compared to $696.3 million in 2003. The increase was mainly due to an increase in gross margin on steel products throughout the year, particularly during
the second half of 2004, as a result of increased prices and the gain of $43.5 million resulting from the final court ruling in the Companys favor in a lawsuit challenging the payment of PIS taxes.
Financial Expense, Financial Income, Foreign Exchange Gains and Losses, Net and Gains and Losses on Derivatives, Net
In the fiscal year 2004, net financial expense (which comprises financial income, financial expenses, foreign exchange gains and losses and derivative gains and losses) totaled $50.8 million, against $192.7 million in the previous year. This decrease is due mainly to the increase in financial investments, as a result of the stronger cash flow in the period, and to a reduction in the cost of debt due to a change in its debt profile, with the issuance of debt facilities such as Euro Commercial Paper and Senior Notes of Gerdau AmeriSteel, with lower financial costs to Gerdau, and repayment of debt bearing higher interest rates. Additionally, the majority of the cross-currency rate swap contracts entered into in 2003 matured in 2004 and was not replaced, resulting in the reduction of losses on derivatives in 2004.
Equity in Earnings (Losses) of Unconsolidated Companies, Net
Equity in earnings of unconsolidated companies was $141.9 million in 2004, mainly due to positive results of the 50% joint ventures in Gallatin, Bradley Steel Processors and MRM Guide Rail and reflecting the good performance of the steel making business.
Gain on Change in Interest on Gerdau Ameristeel Investment
On October 15 2004, Gerdau Ameristeel issued 70,000 new shares, which were acquired by Gerdau and other investors in a public offering. As the new shares were issued at a price higher than the average carrying amount of the shares held by Gerdau, Gerdau recorded a gain in the amount of $2.7 million presented as Gain on change of interest in the consolidated statement of income.
Provision for Taxes on Income
In 2004, provision for income tax and social contribution was affected by the recognition of deferred tax assets corresponding to tax loss carryforwards in the amounts of $120.3 million and $48.6 million by the Companys Brazilian operations and Gerdau Ameristeel, respectively. This reflects a review of the probability of realizing these tax loss carryforwards considering current levels of profitability.
In 2004, consolidated net income was $1,158.4 million, 127.1% higher than $510.2 million in 2003, due to higher gross margins generated by an increase in world steel demand, an impact of $43.5 million related to a final court ruling regarding tax claims, an increase in earnings of unconsolidated companies accounted for under the equity income method contributing $141.9 million and also the reduction of financial expense due to an increase in cash generated from operations, permitting the paying down of debt.
Year Ended December 31, 2003 Compared with Year Ended December 31, 2002
Net sales in 2003 amounted to $4,531.0 million, representing an increase of 38.8% relative to 2002 ($3,264.9 million), mainly due to increased export volume, with export revenues of $787.3 million (125.0% higher than in 2002), the acquisition of the nine North American units of Co-Steel in October 2002, and the utilization of full installed capacity of its Brazilian operations.
The average net price of steel in 2003 was $395.6/ton, which increased from $365.7/ton in 2002.
Of total net sales, the Brazilian operations accounted for $2,597.8 million, a 23.0% increase relative to the fiscal year 2002. Sales of the other South American operations increased by 22.7% to $122.0 million, while the net revenues of the Gerdau Ameristeel operation increased by 71.9% from $1,053.8 million to $1,811.2 million over the same period, following the full consolidation of its nine North American operations, a significant increase in regional prices and an improvement in market conditions.
Cost of Sales and Gross Profit
Cost of sales was $3,445.6 million in 2003, an increase of 46.6% compared to the cost of sales in 2002 ($2,349.6 million). The increase was mainly due to the acquisition of Co-Steel, which contributed to greater sales in metric tonnes and also a proportionate increase in the cost of sales for these deliveries. This result produced a decline in gross margin for 2003 to 24.0% from 28.0% in the previous year, particularly due to the increased cost of scrap and pig iron in Brazil, and of scrap, electricity and natural gas in the United States. In 2003, gross profit rose 18.6% to $1,085.4 million.
Operating expenses (sales and marketing, general and administrative expenses) rose 16.1% in 2003 to $388.2 million due primarily to the acquisition of Co-Steel. In spite of this increase, however, operating expenses fell as a percentage of net sales to 8.6% in 2003 from 10.2% in 2002, due to the consolidation in 2003 of its North American operations administrative area in Tampa, the function of which had been duplicated in Toronto (former headquarters of Co-Steel) in 2002.
Other Operating Income (Expenses), net
Net other operating expenses in 2003 totaled $0.8 million, a decrease of $17.4 million compared to net other operating expenses of $18.2 million reported in 2002. The decrease was principally due to the sale of SIPSA, an Argentine company previously held by Gerdau and sold during 2002, generating a loss of $18.0 million.
Operating income in 2003 was $696.3 million, an increase of 23.8% compared to $562.6 million in 2002. The increase was mainly due to greater gross income due to the nine new mills that started operating during 2003. The increase in cost of sales led to a fall in operating margin over the same period from 17.2% to 15.4%.
Financial Expense, Financial Income, Foreign Exchange Gains and Losses, Net and Gains and Losses on Derivatives, Net
In 2003, net financial expense (which comprises financial income, financial expenses, foreign exchange gains and losses and gains and losses on derivatives) amounted to $192.7 million, 40.5% below that of the previous year. This figure represents financial expenses of $219.4 million, foreign exchange gains of $162.2 million, loss on derivatives of $197.6 million and financial income of $62.0 million. The reduction in net financial expense in 2003 was principally due to the foreign exchange gain from the appreciation of the Brazilian real against the U.S. dollar, together with the increase in assets denominated in U.S. dollars relative to assets denominated in reais, mainly trade accounts receivable, influenced by increased exports from Brazil.
Equity in Earnings (Losses) of Unconsolidated Companies, Net
Equity in earnings of unconsolidated companies of $22.1 million in 2003 resulted from earnings from unconsolidated companies in Argentina, Chile, the United States and Brazil, most of this amount being generated by Gallatin and Dona Francisca Energética S.A., or DFESA. In 2003, equity in earnings of unconsolidated companies included Gallatins net income for the full 12 months period against a two-month period in 2002 following the integration of its North American operations. DFESA generated losses in 2002, with a material affect on equity in earnings of unconsolidated companies for that year, while in 2003, its operations generated a net income.
Provision for Taxes on Income
The Company recognized a credit of $34.1 million for the year ended December 31, 2003 due to the reversal of a valuation allowance of $137.3 million in the light of the improvement in profitability following the corporate reorganization in November 2003. This credit is related to tax losses generated in previous years at the former Açominas plant. The Company is permitted to offset these against taxable income generated by its Brazilian steel operations, which include, from November 2003, those formerly owned by Gerdau S.A. and transferred to Gerdau Açominas as a result of the corporate reorganization concluded in 2003.
Due to higher sales, lower operating expenses, lower net financial expenses and the income tax credit, net income amounted to $510.2 million in 2003, a year-on-year increase of 120.1%. Net margin rose to 11.3% from 7.1% in 2002 due to the consolidation of the nine North American units acquired from Co-Steel and the recognition of tax credits and cancellation of income tax valuation allowances, due to new profitability estimates in the light of the corporate reorganization, which took place in 2003.
B. LIQUIDITY AND CAPITAL RESOURCES
Net cash generated from operating activities amounted to $345.1 million, $1,070.6 million and $611.3 million for the years ended December 31, 2005, 2004 and 2003, respectively, with a cumulative total for the three years of $2,026.9 million. Net cash generated from operating activities was one of the Companys main sources of liquidity. Cumulative short and long-term financing amounted to $4,918.4 million for the three-year period contributing $1,630.5 million in 2005, $1,290.0 million in 2004 and $1,997.9 million in 2003 towards the Companys liquidity requirements. Disposals of fixed assets, such as obsolete machinery and scrap equipment, generated cumulative proceeds of $8.7 million for the years of 2005, 2004 and 2003.
The main uses of capital resources in 2005 were: $697.4 million for investment in fixed assets, $49.6 million for the acquisition of North Star in North America, $16.7 million for the acquisition of Sipar Aceros, $6.7 million for the acquisition of Diaco and $6.2 million for the acquisition of Sidelpa, $396.0 million for payment of dividends and $798.4 million for the repayment of debt. The acquisitions of Diaco and Sidelpa completed in 2005, also had a non-cash impact of $53.6 million resulting from the release of funds previously maintained in trusts. The payment of cash into the trusts was previously recognized as a use of resources during 2004 in the cash flow statement. In 2004, the main uses of capital resources were: $440.9 million for investments in fixed assets, $298.4 million for the acquisition of businesses in North America, $1,273.2 million for the repayment of maturing short and long-term debt and $275.6 million for the distribution of dividends. In 2003, the main uses of capital resources were $297.8 million for investment in fixed assets, $2,126.5 million for repayment of maturing short and long-term debt and $122.3 million for the distribution of dividends. Resources invested in fixed assets from 2003 to 2005 ($1,436.1 million) were used to modernize the Companys industrial plants and subsidiaries and to upgrade technology. In 2005, capital resources were primarily used for the construction of a new industrial electric arc furnace mill in São Paulo and for the expansion of the blast furnace at the Ouro Branco mill.
The Companys principal source of liquidity has traditionally consisted of cash generated from operating activities.
Between December 31, 2004 and December 31, 2005, net working capital (current assets less current liabilities) increased by $1,683.9 million, from $1,610.7 million in 2004 to $3,294.6 million in 2005. Between December 31, 2003 and December 31, 2004, net working capital increased by $1,310.0 million, from $300.7 million in 2003 to $1,610.7 million in 2004. The increase in 2005 was primarily due to (i) the increase in financial investments, as a result of the stronger cash flow in the period and due to the issuance of long term debt, mainly perpetual bonds in the amount of $600.0 million, (ii) an increase in inventory as a result of higher steel output, (iii) a decrease in accounts receivable due to lower sales, mainly in North America resulting from high inventory levels and (iv) the consolidation of assets of the North Star operations, as well as the consolidation of the South American companies acquired during 2005.
Debt and Financial Strategy
The Companys debt is intended to finance investments in fixed assets, both in the modernization and technological upgrading of its plants and in the expansion of installed capacity, as well as working capital, the purchase of stakes in other companies, and, depending on market conditions, short-term financial investments.
The Companys total debt (total debt excluding debentures, which are mainly held by related parties, and loans from the parent company) was $2,799.6 million and $1,953.7 million as of December 31 2005 and 2004, respectively. On the same dates, balances of short-term investments and cash and cash equivalents were $2,303.4 million and $659.5 million, respectively.
Total debt amounted to $3,215.0 million in 2005 and $2,299.6 million in 2004. Net debt (defined as short and long-term debt plus debentures less short-term investments, restricted cash and cash and cash equivalents) decreased from $1,640.1 million in 2004, to $911.6 million in 2005. This reduction reflects the stronger cash flow in the period, as well the appreciation of the real against the U.S. dollar, which decreased the amount translated into U.S. dollars of reais denominated debt of the portion in reais contracted by the Brazilian companies.
In 2005, net financial income (which comprises financial income, financial expenses, foreign exchange gains and losses and gains and losses on derivatives) amounted to $12.6 million against a net financial expense of $50.8 million in 2004. This improvement is due to stronger cash flow, which was mainly used to buy interest bearing short-term investments. Additionally, net financial income in 2005 reflected foreign exchange gains ($57.9 million) due to the appreciation of the real, which impacted U.S. dollar denominated assets and liabilities, most notably trade accounts receivable and debt and trade accounts payable. Derivatives generated losses of $22.0 million in 2005, caused by appreciation of the real against the U.S. dollar.
The following table profiles the Companys debt on December 31 2005 and 2004 (in thousands of U.S. dollars):
On December 31 2005, the Companys total debt plus debentures amounted to $3,215.0 million. Of this balance, $733.4 million (22.8%) was denominated in Brazilian reais and $2,481.5 million (77.2%) in foreign currency.
Short-term debt and current portion of long-term debt
As of December 31, 2005, the Companys short-term debt amounted to $311.4 million. Of this total, $7.9 million related to financing in reais and $303.5 million in foreign currencies. The current portion of the long-term debt and debentures amounted to $256.3 million, of which $39.9 million was in reais and $216.4 million in foreign currencies. In 2005, short-term debt plus the current portion of long-term debt, debentures and financing from the parent company amounted to $567.7 million, representing a reduction of 15.8% relative to 2004, resulting principally from extending the average maturity of its indebtedness.
Long-term debt including debentures amounted to $2,647.2 million as of December 31, 2005. Of this total, $2,233.0 million represented loans obtained from financial institutions and from issuance of debt in the market, of which $349.6 million was denominated in reais and $1,883.5 million in foreign currency. Of total long-term debt, $414.2 million represents debentures, of which $78.2 million was denominated in foreign currency and $336.0 million in reais.
Approximately 75.4% of the $1,883.5 million of long-term loans denominated in foreign currency, excluding the current portion of long-term debt and debentures, was contracted by the Company and its Brazilian subsidiaries and 24.6% by the Companys foreign subsidiaries.
The Company has entered into financial agreements to fund and improve its debt profile. The most significant financial agreements contracted in 2005 are described below.
On October 12 2005, Gerdau concluded its third issue of euro commercial paper for a total amount of $200.0 million, under a $300.0 million program with maturity on October 11 2006, and interest at 5.0% per annum.
On September 15 2005, Gerdau issued $600 million, 8.875% interest bearing Guaranteed Perpetual Senior Securities. The bonds are guaranteed by Gerdau Açominas, Gerdau Aços Longos, Gerdau Aços Especiais and Gerdau Comercial de Aços. The bonds do not have a stated maturity date but must be redeemed by Gerdau in the event of certain specified events of default (as defined in the terms of the bonds) which are not fully under its control. The Company has a call option to redeem these bonds at any time after September 2010. Interest payments are due on a quarterly basis.
The Company is subject to limitations on debt levels, the granting of encumbrances on its properties and the payment of dividends under certain circumstances, in accordance with the terms of its debentures and its loans from the Brazilian National Bank for Economic and Social Development (BNDES). These limitations are applicable to the Guaranteed Perpetual Senior Securities and to the refinancing agreements for Gerdau Ameristeel (Senior Notes and Senior Secured Credit Facility) as well as trade finance lines, bank loans and suppliers credits. Most of the financial agreements contracted the Company, including the NEXI operations and Export Receivables Notes, have covenants based on certain limits such as (i) Financial Debt divided by Earnings before Interest, Taxes, Depreciation and Amortization - EBITDA (defined as gross profit minus general, sales and marketing and administrative expenses plus depreciation and amortization) of less than four and (ii) EBITDA divided by Net Financial Expenses Excluding Monetary and Foreign Exchange Variations of higher than three.
Under the Export Receivables Notes Program, the Company has to maintain a Consolidated Minimum Net Worth of R$3,759.2 million.
In order to protect the Company from fluctuations of the Brazilian currency against the U.S. dollar and changes in interest rates on its foreign currency debt incurred in Brazil, Gerdau entered into cross-currency interest rate swaps whereby it receives U.S. dollars, generally accruing interest at fixed rates, and pays reais accruing interest at rates based on the CDI (Brazilian Interbank Deposit Rates). In December 2005, the total amount swapped was $7.9 million (notional amount). Part of its cash flow from operations is denominated in reais and part in U.S. dollars.
During 2005, Gerdau Açominas entered into interest rate swaps where it receives a fixed interest rate in U.S. dollars and pays a variable interest rate based on LIBOR. The agreements have a notional value of $240.0 million and expiration date of November 2011. Gerdau has also obtained financing in Brazilian reais at fixed rates, which also subject the Company to changes in the fair value of its debt as a result of changes in interest rates. As a result, the Company entered during 2005 into interest rate swaps where Gerdau receives a fixed interest rate in Brazilian reais and pays a variable interest rate based on the CDI. The agreements have a notional value of $133.5 million as of December 31, 2005 and expiration date between January 2006 and March 2006.
Also, in order to reduce its exposure to changes in the fair value of its Senior Notes, Gerdau Ameristeel entered into interest rate swaps whereby it receives a fixed interest rate and pays a variable interest rate based on LIBOR. In December 2005, the total amount swapped was $200 million. Cash flows from operations may be used to service this debt. There can, however, be no assurance that cash flows from operations will be sufficient to service foreign currency debt obligations, denominated principally in U.S. dollars. It is thus possible that exchange rate fluctuations may have a material adverse effect on the Companys business, financial condition and results of operations. See Item 3 - Risk Factors.
The maturity profile of the Companys long-term debt with financial institutions, including debentures, is as follows:
The amounts described above include the Gerdau Ameristeel convertible debentures that mature in 2007 ($78.2 million) and a further five Gerdau S.A. debenture issues ($336.0 million) with different maturity dates after 2010.
C. RESEARCH AND DEVELOPMENT, PATENTS AND LICENCES, ETC.
Due to the specialized nature of its business, Gerdau Aços Especiais Piratini is the only unit that has been investing uninterruptedly in technological upgrading and in research and development (R&D). This unit is active in the automotive segment and maintains an R&D department responsible for new products and the optimization of existing processes. These product development projects are headed by specialists who use quality tools such as 6 Sigma, statistical procedures for improving the assessment of process variables, and Quality Function Deployment, a methodology through which the technicians are able to identify the full spread of customer requirements. In the other plants, production and quality teams are responsible for developing new products to meet customer and market needs.
As is common with mini-mill steel makers, Gerdau usually acquires technology in the market, since steel-making technology is readily available for purchase.
International machinery manufacturers and steel technology companies supply most of the sophisticated production equipment used by the Company. Such suppliers generally sign technology transfer agreements with the purchaser and provide extensive technical support and staff training for the installation and commissioning of the equipment. Gerdau has technology transfer agreements with Nippon Steel, Sumitomo Steel, Thyssen, Daido Steel and BSW.
D. TREND INFORMATION
Gerdaus business focuses on the production of long steel and the distribution of steel products in general at its operations located in Brazil, North and South America. One of the Companys strategies is the development of business on a regional basis aiming at servicing its raw material requirements and the selling of its production to clients mostly located close to the operating units.
According to this concept, availability of the Companys inputs, such as scrap, pig iron, iron ore, charcoal and coal, and local demand are very important factors in the performance of the operating units, although not necessarily critical to the consolidated performance. The steel industry, especially the long steel segment, irrespective of the country in which a company operates, is strongly influenced by global and regional macroeconomic elements. The Gerdau Group prepares its performance forecasts based on these elements.
The general outlook for international markets for long common steel is positive, reflecting the balance between supply and demand and inventory levels around the world. Global discipline is yet another factor that has contributed to maintaining stability in the competitive environment. In broad terms, it is fair to assume that the world economy will continue favorable in 2006.
On the other hand, in the long run, there is the threat of excess capacity in China, which brings uncertainty not only to the American market but also to international prices. The Chinese economy should continue to grow and it is reasonable to expect that domestic demand will continue to absorb a significant portion of this added capacity.
In Brazil there are indications that the worst is over and that the country will take off in 2006 at a pace that should lead to full economic recovery. From the perspective of the domestic market with interest rates falling and perhaps an increase in government spending, confidence in the economy should improve. Civil construction is already showing signs of recovery and may play a relevant role in economic growth. The Company should see recovery in the industrial sector in such segments as agricultural equipment and power transmission towers. Iron ore costs may increase due to growing world demand. Coking coal and ferroalloys costs should remain stable.
The Brazilian GDP should grow between 3.0% and 3.5% and the Company believes that shipments to the domestic market will increase at least 5.0%.
In North America, the early months of the year suggests the overall supply and demand picture for steel products is reasonably well balanced, and normal seasonal strengthening of demand can be expected as springtime approaches. This should help maintain good metal spreads. Even with the challenges that the Company and the industry face, Gerdau believes that its North American subsidiary is prepared to take advantage of this favorable environment through the relentless execution of its core values and business strategies.
The U.S. GDP should continue to grow at healthy rates and the highway bill, along with the reconstruction efforts in the Gulf area should maintain demand for rebars, merchant bars and profiles strong. Production costs should remain stable as should the metal spread.
The South American economies should consolidate their growth in 2006. The demand for steel should be strong with improved market conditions for the civil construction sector. The International Monetary Fund (IMF) estimates a GDP growth above 4.0% for the South American countries where Gerdau has operations (excluding Brazil).
The stake in Sidenor was consolidated in the first quarter of 2006, increasing Gerdaus annual production capacity by more than 750,000 tonnes.
Overall, the trend is for higher volume shipped in 2006 and for financial results in the same level of 2005.
E. OFF-BALANCE SHEET ARRANGEMENTS
The Company does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources other than the ones described below.
The Company has guaranteed 51.82% of the debt of Dona Francisca Energética S.A., an unlisted corporation that owns and operates a hydroelectric power plant, known as Usina Hidroelétrica Dona Francisca. The debt amounts to R$90.4 million (equivalent to $38.6 million at the year-end foreign exchange rate). The percentage of this guarantee corresponds to its 51.82% stake in Dona Francisca Energética. In addition, the Company has issued guarantees to Banco Gerdau S.A. for $18.1 million relating to loans by the bank to its customers for purchasing its products.
F. DISCLOSURE OF CONTRACTUAL OBLIGATIONS
(1) Total amounts are included in the December 31, 2005 consolidated balance sheet. See Note 14 Short-term Debt, and Note 15 Long-term Debt and Debentures in the consolidated financial statements
(2) Interest payments include amounts related to the perpetual bonds, which do not have a final maturity date. For the purpose of interest calculations, interest payments on the perpetual bonds were considered for 30 years.
(3) Includes minimum lease payment obligations for equipment and real property leases in effect as of December 31, 2005.
(4) Purchase obligations for capital expenditures correspond to and are related to capital projects. The full amount relates to capital projects agreements where Gerdau has irrevocably committed with suppliers to acquire equipment. As the equipment had not been received by December 31 2005, the corresponding liability has not yet been recorded in its current financial statements.
(5) The majority of other purchase obligations are for inventory and operating supplies and expenses used in the ordinary course of business.
(6) Conditional purchase obligations are for inventory and operating supplies and expenses used in the ordinary course of business. Those purchase obligations are not considered unconditional because they can be cancelled upon payment of fines, which are not material in the full amount of the contract.
(7) Pension funding obligations are included only for 2006 as the amount of funding obligations on and after 2007 cannot be determined.
(8) During 2005, all conditions precedent related to the acquisition agreement of Diaco were met. As a consequence, Diaco is being consolidated in the Companys financial statements. Nevertheless, the Company has committed to acquire the remaining 40% of Diaco shares currently held by the former owners. Final maturity of this commitment is December 2012, and the amount disclosed includes contractual interest. Gerdau has an option to accelerate the acquisition of those shares, and if the option is exercised, payment should be made in 2008 and 2009. The fair value of this commitment is recorded in its financial statements. See Note 4.1 Acquisitions Diaco and Sidelpa in its Consolidated Audited Financial Statements.
G. SAFE HARBOR
See Cautionary Statement with Respect to Forward-Looking Statements.
H. CRITICAL ACCOUNTING POLICIES
Critical accounting policies are those that are both (1) important to the portrayal of its financial condition and results and (2) require managements most difficult, subjective or complex judgments, often as a result of the need to make estimates impacting matters that are inherently uncertain. As the number of variables and assumptions affecting the possible future resolution of the uncertainties increase, those judgments become even more subjective and complex. In connection with the preparation of the financial statements included in this annual report, its management has relied on variables and assumptions derived from historical experience and various other factors that it deems reasonable and relevant. Although these estimates and assumptions are reviewed by management in the ordinary course of business, the portrayal of its financial condition and results of the operation often requires the Company to make judgments regarding the effects of inherently uncertain matters on the carrying value of its assets and liabilities. Actual results may differ from those estimated using different variables, assumptions or conditions. In order to provide an understanding of how management forms its judgments about future events, including the variables and assumptions underlying the estimates, comments have been included that relate to each critical accounting policy, described as follows:
· deferred income taxes;
· pension and post-retirement benefits;
· environmental liabilities;
· derivative financial instruments;
· useful lives of fixed assets; and
· fair value of non quoted financial instruments.
Deferred Income Taxes
The liability method of accounting for income taxes is used for deferred income taxes generated by temporary differences between the book value of assets and liabilities and their respective tax values and for tax loss carry forwards. Deferred income tax assets and liabilities are measured using tax rates applicable to taxable income in the years in which those temporary differences are expected to be realized. A valuation allowance is recorded to the extent that the recoverability of the future income tax assets is considered more likely than not. Future taxable income may be higher or lower than estimates made when determining whether it is necessary to make a valuation allowance and when the amount of the valuation allowance was estimated.
Pension and Post-retirement Benefits
The Company accrues its obligations relating to employee benefit plans and their related costs, net of plan assets, adopting the following policies:
· The cost of pensions and other retirement benefits earned by employees is actuarially determined using the projected benefit method prorated for service and managements best estimate of expected investment performance for funded plans, growth in salaries, retirement ages of employees and expected health care costs. The discount rate used for determining the liability for future benefits is an estimate of the current interest rate on the balance sheet date on high quality fixed income investments with maturities that match the expected maturity of obligations
· Pension assets are valued at fair market value
· Past service costs from plan amendments are amortized on a straight-line basis over the average remaining service period of employees active on the date of amendment
· The net actuarial gain or loss that exceeds 10% of the greater of the benefit obligation and the fair value of plan assets is amortized over the average remaining service period of active employees
· A plan curtailment will result if there has been a significant reduction in the expected future service of present employees. A net curtailment loss is recognized when the event is probable and can be estimated, while a net curtailment gain is deferred until realized.
In accounting for pension and post-retirement benefits, several statistical and other factors, which attempt to anticipate future events, are used in calculating plan expenses and liabilities. These factors include discount rate assumptions, expected return on plan assets, future increases in health-care costs and rate of future compensation increases. In addition, actuarial consultants also use subjective factors such as withdrawal, turnover and mortality rates to estimate these factors. The actuarial assumptions used by the Company may differ materially from actual results due to changing market and economic conditions, regulatory events, judicial rulings, higher or lower withdrawal rates or longer or shorter participant life spans.
Gerdau has made provisions for potential environmental liabilities based on best estimates for potential clean-up and compensation costs for known environmental sites. The Company employs a staff of experts to manage all phases of its environmental programs, and use outside experts where needed. These professionals develop estimates of potential liabilities at these sites based on projected and known remediation costs. This analysis requires the Company to make significant estimates, with changes in facts and circumstances possibly resulting in material changes in environmental provisions.
Derivative Financial Instruments
· Gerdau applies SFAS 133Accounting for Derivative Instruments and Hedging Activities as amended and interpreted.
Derivative financial instruments include cross-currency interest rate swaps entered into by the companies operating in Brazil mainly for swapping fixed-rate debt denominated or indexed in U.S. dollars and fixed rate debt denominated in reais denominated debt into variable rate debt in reais, as well as for swapping fixed interest rates in U.S. dollars for interest rates based on LIBOR.
Derivatives are recognized on the balance sheet at fair value and adjustments to fair value for all its derivatives are recorded through income. The derivatives Gerdau has entered into are not traded derivatives and have been agreed with various financial institutions, mainly in Brazil. The Company values such instruments considering
quotations obtained from market participants and following an internally developed methodology that considers, as applicable, the forward rate of exchange of the real against the U.S. dollar and forward interest rates in reais or in U.S. dollars prevailing on the date of measurement. The Company understands that estimates of fair value obtained are reasonable when compared with information on similar financial instruments traded on the São Paulo Futures and Commodities Exchange (BM&F), that the internally developed valuation methodology is consistent with methodologies used by other participants in the derivatives market in Brazil and that its results reasonably reflect the amount that would be paid or received to settle the derivatives on the valuation date. Intense volatility in the foreign exchange and interest rate markets in Brazil observed has nevertheless in certain periods caused significant changes in forward rates and interest rates over very short periods of time, generating significant changes in the fair value of swaps over similarly short periods of time. The fair value recognized in its financial statements may not, therefore, necessarily represent the amount of cash that the Company would receive or pay, as applicable, if the Company had settled the transaction on December 31 2005. On December 31 2005, the unrealized gains on its derivative financial instruments amounted to $2.3 million and unrealized losses amounted to $8.0 million.
Useful lives of long-lived assets
Gerdau recognizes depreciation of its long-lived assets based on estimated useful lives, which are based on industry practices and prior experience and reflects economic lives of long-lived assets. Nevertheless, actual useful lives can vary based on technological update of each industrial plant. Useful lives of long-lived assets also affect impairment tests of those long-lived assets, when required.
Fair value of non-quoted financial instruments
Gerdau has entered into financial instruments in connection with some of the acquisitions conducted during 2005, which involves commitments to acquire shares from minority shareholders of the acquired companies, or grant of put options to some minority shareholders to sell to the Company their shares. Such financial instruments are recorded at fair value on the Companys balance sheet, and the determination of their fair value involves a series of estimates that can significantly impact the final outcome of such calculation. Gerdau estimates the fair value of the companies whose shares it is committed to acquire using EBITDA multiples of market traded similar companies. The Company believes such criteria is appropriate, in line with practices observed in the market and with authoritative technical literature to estimate fair market value of unquoted instruments.
A. DIRECTORS AND SENIOR MANAGEMENT
The following is a brief biography of each of the Company Directors and Executive Officers:
JORGE GERDAU JOHANNPETER (70) has worked for the Gerdau Group since 1954. Jorge Johannpeter became an Executive Officer in 1971 and a member of the Board of Directors in 1973. In 1983, he became Chairman of the Board of Directors and President of the Company. Since 2002, after the implementation of the new corporate governance structure, he also became the President of the Gerdau Executive Committee (CEG). He holds a degree in Law from the Federal University of Rio Grande do Sul.
GERMANO HUGO GERDAU JOHANNPETER (74) has worked for the Gerdau Group since 1951. He became an Executive Officer in 1971 and has been a member of the Board of Directors since 1973. In 2002, under the new corporate governance structure, he became a Vice Chairman of the Board of Directors. He holds a degree in Business Administration from the Getúlio Vargas Foundation.
KLAUS GERDAU JOHANNPETER (71) has worked for the Gerdau Group since 1954. He became an Executive Officer in 1971 and has been a member of the Board of Directors since 1973. In 2002, under the new corporate governance structure, he became a Vice Chairman of the Board of Directors. He holds a degree in Civil, Electrical and Mechanical Engineering from the Federal University of Rio Grande do Sul.
FREDERICO CARLOS GERDAU JOHANNPETER (64) has worked for the Gerdau Group since 1961. He became an Executive Officer in 1971 and has been a member of the Board of Directors since 1973. Under the new Corporate Governance structure, he also became Senior Vice President of the Gerdau Executive Committee. He holds a degree in Business Administration from the Federal University of Rio Grande do Sul and a masters degree in Business, Finance, Costs and Investments from the University of Cologne, Germany.
ANDRÉ PINHEIRO DE LARA RESENDE (55) was elected as an Independent Board Member in 2002. He graduated in Economics from the Pontifical Catholic University in Rio de Janeiro (PUC), and holds a masters degree from the Postgraduate School of Economics of the Getúlio Vargas Foundation and a PhD from the Massachusetts Institute of Technology in Cambridge, Massachusetts, USA. André Pinheiro de Lara Resende is also a member of the Board of Alps Funds. He was formerly President of the Brazilian National Bank for Economic and Social Development (BNDES), Special Advisor to the President of Brazil, Managing Partner of Banco Matrix S.A., Brazils chief foreign debt negotiator, Executive President of Companhia Siderúrgica Tubarão (CST), Executive Vice President and member of the Board of Unibanco União de Bancos Brasileiros S.A., Director of Brasil Warrant Administração de Bens e Empresas Ltda., a member of the Board of Directors of Cia. Ferro Brasileiro S.A., a member of the Board of Directors of Lojas Americanas S.A., Managing Partner of Banco de Investimento Garantia and Manager of Public Debt and Open Market of the Brazilian Central Bank.
AFFONSO CELSO PASTORE (66) was elected as an Independent Board Member in 2002. He holds a degree in Economics from the University of São Paulo and a PhD in Economics from the same University. Affonso Celso Pastore is also Professor at the Getulio Vargas Foundation in Rio de Janeiro and an independent economics advisor. He was the Secretary of the São Paulo Treasury Department and President of the Brazilian Central Bank.
OSCAR DE PAULA BERNARDES NETO (60) was elected as an Independent Board Member in 2002. He holds a degree in Chemical Engineering from the Federal University of Rio de Janeiro and a degree in Business Administration from the State University of Rio de Janeiro. Oscar de Paula Bernardes Neto is the owner and director of LID Latin America Internet Development Group and member of the consultative boards of Telesystem International Wireless (TIW) and Bunge Alimentos S.A.. in Brazil. He is also a member of the boards of RBS (media network), CheckForte, Satipel and Alcoa in Brasil, and Delphi Corp. in the United States.
ANDRÉ BIER JOHANNPETER (43) has worked for the Gerdau group since 1980. He was recently appointed executive Vice President of its executive committee, and is the Chief Operating Officer for its North American operations. He holds a degree in business administration from the Pontifical Catholic University of Rio Grande do Sul.
CLAUDIO JOHANNPETER (43) joined the Gerdau group in 1982. He became executive officer in 1997, and is currently an Executive Vice President of its executive committee, responsible for the Ouro Branco mill and specialty steel, as well as for industrial processes in Brazil and abroad. He was awarded a degree in metallurgical engineering from the Federal University of Rio Grande do Sul in 1990.
FILIPE AFFONSO FERREIRA (40) joined the Gerdau group in 2004 as Controller Executive Vice President, member of the Gerdau Executive Committee and responsible for Accounting, Audit and Information Technology. He graduated in business administration from the Pontifical Catholic University of Campinas SP. Filipe Ferreira also held positions as executive officer at Magneti Marelli, Alcoa and Mars Inc. in Brazil and other countries in Latin America.
CARLOS JOÃO PETRY (65) has worked for the Gerdau group since 1965. He became an executive officer in 1974 and was appointed to the Board of Directors in 1983. Under the new corporate governance structure, he also became Senior Vice President of the Gerdau Executive Committee. He holds a degree in Philosophy from the Federal University of Rio Grande do Sul.
OSVALDO BURGOS SCHIRMER (55) joined the Gerdau group in 1986 and was appointed Financial Executive Officer in 1987. He has also been responsible for Gerdau Bank (Banco Gerdau) since 1994 and was recently promoted to the position of Executive Vice President of its executive committee, while retaining the positions of Chief Financial Officer and Investor Relations Executive Officer of Gerdau S.A. He is also responsible for the South American operations of Gerdau S.A. Osvaldo Burgos Schirmer graduated in business administration from the Federal University of Rio Grande do Sul in 1973, and holds an MBA from Illinois University. He previously held a position as an executive officer at the Iochpe-Maxion Group, a holding company for companies in the auto parts and railroad equipment sectors.
RICARDO GEHRKE (49) joined the Gerdau group in 2004 as Executive Vice President of its executive committee, responsible for the Business Operation Long Steel Brazil. He graduated in business administration from the Pontifical Catholic University of Rio Grande do Sul. Ricardo held a position as executive officer at Exxon Company, in Brazil and in the United States.
EXPEDITO LUZ (54) has worked for Gerdau since 1976 and in 1989 became an executive officer of the Legal Department. He was appointed to the board of directors in 2001 and under the new corporate governance structure, he is now Secretary-General of the Board of Directors and the Gerdau Executive Committee. Expedito Luz graduated in Law from the Federal University of Rio Grande do Sul in 1975 and obtained a masters degree in law from the Columbia Law School in New York in 1980.
MARIO LONGHI FILHO (52) joined the Gerdau group in 2005 as Executive Vice President, member of its executive committee. Mário graduated in metallurgical engineering from Instituto Mauá de Tecnologia, São Paulo. Before joining the Gerdau group, Mário had a successful career at Alcoa, where he became Vice President, heading global operations and member of the executive committee.
PAULO FERNANDO BINS DE VASCONCELLOS (61) joined the Gerdau group in 1972. In 2002, he was appointed Executive Vice President of the Gerdau executive committee. In 2003 he was transferred to North America as Vice President of North Eastern Steel Operations. He holds a degree in metallurgical engineering.
FRANCESCO SAVÉRIO MERLINI (64) joined the Company in 1977 and became an Executive Officer in 1998. He graduated in Electromechanical Engineering from the Cuyo National University of Argentina in 1970.
NESTOR MUNDSTOCK (53) joined the Company in 1974, and became an Executive Officer in 2006. Nestor graduated in Mechanical Engineering from Federal University of Rio Grande do Sul.
MÁRCIO PINTO RAMOS (46) became an Executive Officer in 2005, Márcio gradated in Mechanical Engineering from the Federal University of Rio Grande do Sul and holds an MBA from Purdue University, USA. He has also held a position as an executive officer at Effem do Brasil (Mars Inc.) and Telet Claro Digital.
SIRLEU JOSÉ PROTTI (64) joined the Company in 1967, and became an Executive Officer in 1981. Sirleu graduated in Economics from the Pontifical Catholic University of Rio Grande do Sul in 1966.
Jorge Gerdau Johannpeter, Germano Hugo Gerdau Johannpeter, Klaus Gerdau Johannpeter and Frederico Carlos Gerdau Johannpeter are brothers. André Bier Johannpeter is Jorge Gerdau Johannpeters son and Claudio Johannpeter is Klaus Gerdau Johannpeters son.
Gerdau has no agreement of any kind with shareholders, clients, suppliers or other parties with respect to the election of its officers or directors. There are no pending legal proceedings to which any Company Board Member or Executive Officer is a party against the Company. Apart from statutory severance benefits, none of the Board Members or Executive Officers is entitled to any contractual benefits upon termination of employment.
The employees compensation system is based on two variables: a fixed salary and a variable portion linked to specific targets.
The fixed portion of the compensation is constantly monitored and compared to market benchmarks in order to maintain parity with the best market practices as adopted by other companies. The variable portion of the compensation package incorporates semi-annual and annual goals. The achievement of these goals is measured against clearly specified standards that are intended to motivate individuals and teams.
The Human Resources policy is based on the acknowledgement and recognition of co-workers as strategic to the business.
The Company conducts evaluations based on several different methodologies, including competence mapping, to track the managerial skills of its executives. Competence mapping aims to identify the degree of alignment of executives with the Companys strategies and business management and to monitor individual development.
In 2005, Gerdau S.A. paid a total of $32.1 million to its Directors and Executive Officers in salaries and variable remuneration. The variable remuneration for executives is based on the overall performance of Gerdau S.A., on the basis of actual EBITDA (as defined for the purposes of calculating variable remuneration) versus planned EBITDA (as defined for the purposes of calculating the variable remuneration), on the performance of the unit to which the executive is related, and on personal performance. Each of these factors influence one third of the variable remuneration.
The Company and other related companies in the Group co-sponsor pension plans (the Brazilian Plans) covering substantially all employees based in Brazil, including Gerdau Açominas since its consolidation. The Brazilian Plans consists of a plan for the employees of Gerdau and its subsidiaries (Gerdau Plan) and a plan for employees of the former Açominas and its subsidiaries (Gerdau Açominas Plan). The Brazilian Plans are mainly defined benefit plans with certain limited defined contributions. The Companys Canadian and American subsidiaries, including Gerdau Ameristeel, also sponsor defined benefit plans (the North American Plans) that cover the majority of their employees. Contributions to the Brazilian Plans and the North American Plans are based on actuarially determined amounts.
During 2005, Gerdaus contribution to the Gerdau Plan with respect to the executive officers amounted to $29.9 million (Basic income program) and an additional $85.7 million to the supplementary fund. This sum includes only that portion of contributions for executives who do not currently receive retirement benefits from the Company. These benefits are in no way different from those offered to the other employees of the Company.
On April 30th, 2003, Gerdau S.A.s shareholders approved a new compensation program for executives with strategic positions in the Company known as the Long Term Incentive Program. This new compensation program consists of call options on the Companys Preferred Shares, granted on an annual basis, representing 20% of the annual base salary of each executive and, for the Directors and Executive Offices, an additional entrance bonus equivalent to 30% of the annual salary (the latter was eliminated as from April 28, 2005). This program aims to attract and secure the long-term commitment of executives by allowing them to share in the growth of the Company, thereby enhancing the sense of participation in the business. (See Item 10. Additional Information B. Memorandum and Articles of Association).
Also in April 2003, for the first time, Gerdau S.A. granted stock options to Directors and Executive Officers of its companies in Brazil. This program consisted of stock options granted on 842,520 Gerdau S.A. Preferred Shares, which can be exercised from January 1, 2008 and stock options granted on 1,209,687 Preferred Shares, which can be exercised from January 1, 2006. Both stock options must be exercised by December 31, 2012.
In December 2003, the stock option program was extended to Senior Managers of Gerdau companies in Brazil. At this time, the Company granted stock options on 513,374 Gerdau S.A. Preferred Shares, which can be exercised from January 1, 2009 and stock options on 7,289 Preferred Shares, which can be exercised from January 1, 2007. Both options must be exercised by December 31, 2013.
In December 2004, in the third edition of the program, the Company granted stock options on 444,784 shares to the Directors, Executive Officers and Senior Managers eligible for the program. These options may be exercised from January 1, 2010. The Company also granted options on 27,439 shares, which can be exercised from January 1, 2008. All those options must be exercised by December 31, 2014.
Again in December 2004, the Company granted stock options on 298,390 shares, equivalent to 10% of the basic annual salary, in recognition of the positive corporate earnings for the year. This special and specific edition of the program was authorized on this occasion only, for Directors, Executive Officers, Senior Management and Managers or their equivalents, comprising 366 individuals. These options can be exercised during the period from January 1, 2008 to December 31, 2014.
The Compensation and Succession Committee approved the annual grant of stock options corresponding to the year ended December 31, 2003, 2004, 2005 and 2006, respectively.
The stock option grants distributed to the Directors and Executive Officers are as follows (see Consolidated Financial Statements Note 25.1 for a complete summary of the stock option plan):