STARRETT L S CO 10-K 2011
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission File No. 1-367
THE L.S. STARRETT COMPANY
(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code 978-249-3551
Securities registered pursuant to Section 12(b) of the Act:
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ 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 for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or amendment to this Form 10-K. x
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one)
Large Accelerated Filer ¨ Accelerated Filer x
Non-Accelerated Filer ¨ Smaller Reporting Company ¨
(Do not check if a smaller reporting company)
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
The Registrant had 5,890,309 and 803,913 shares, respectively, of its $1.00 par value Class A and B common stock outstanding on December 25, 2010. On December 25, 2010, the last business day of the Registrant’s second fiscal quarter, the aggregate market value of the common stock held by nonaffiliates was approximately $67,904,014.
There were 5,942,689 and 797,764 shares, respectively, of the Registrant’s $1.00 par value Class A and Class B common stock outstanding as of August 31, 2011.
The exhibit index is located on pages 57-58.
DOCUMENTS INCORPORATED BY REFERENCE
The Registrant intends to file a definitive Proxy Statement for the Company’s 2011 Annual Meeting of Stockholders within 120 days of the end of the fiscal year ended June 30, 2011. Portions of such Proxy Statement are incorporated by reference in Part III.
THE L.S. STARRETT COMPANY
FOR THE PERIOD ENDED JUNE 30, 2011
TABLE OF CONTENTS
All references in this Annual Report to “Starrett”, the “Company”, “we”, “our” and “us” means The L.S. Starrett Company and its subsidiaries.
Item 1 - Business
Founded in 1880 by Laroy S. Starrett and incorporated in 1929, the Company is engaged in the business of manufacturing over 5,000 different products for industrial, professional and consumer markets. As a global manufacturer with major subsidiaries in Brazil (1956), Scotland (1958) and China (1997), the Company offers its broad array of products to the market through multiple channels of distribution throughout the world. The Company’s products include precision tools, electronic gages, gage blocks, optical and vision measuring equipment, custom engineered granite solutions, tape measures, levels, chalk products, squares, band saw blades, hole saws, hacksaw blades, jig saw blades, reciprocating saw blades, M1® lubricant and precision ground flat stock. The Company’s financial reporting is based upon one business segment.
Starrett® is brand recognized around the world for precision, quality and innovation.
The Company’s tools and instruments are sold throughout North America and in over 100 foreign countries. By far the largest consumer of these products is the metalworking industry including aerospace, medical, and automotive but other important consumers are marine and farm equipment shops, do-it-yourselfers and tradesmen such as builders, carpenters, plumbers and electricians.
For 131 years the Company has been a recognized leader in providing measurement solutions consisting of hand measuring tools and precision instruments such as micrometers, vernier calipers, height gages, depth gages, electronic gages, dial indicators, steel rules, combination squares, custom and non contact gaging and many other items. Skilled personnel, superior products, manufacturing expertise, innovation and unmatched service has earned the Company its reputation as the “Best in Class” provider of measuring application solutions for industry. During fiscal 2008, the Company enhanced its wireless data collection solutions, making them more customer-friendly and more software-compatible.
The Company’s saw product lines enjoy strong global brand recognition and market share. These products encompass a breadth of uses. During 2009, the Company introduced several new products including its ADVANZ carbide tipped products and its VERSATIX products with a patent pending tooth geometry designed for the cutting of structurals and small solids. This launch was further enhanced through the global introduction of new support programs and marketing collateral. These actions are aimed at positioning Starrett for global growth in wide band products for production applications as well as product range expansions for shop applications. A full line of complementary saw products, including hack, jig, reciprocating saw blades and hole saws provide cutting solutions for the building trades and are offered primarily through construction, electrical, plumbing and retail distributors.
At June 30, 2011, the Company had 1,951 employees, approximately 51% of whom were domestic. This represents a net increase from June 26, 2010 of 207 employees. The headcount increase was 96 domestically and 111 internationally.
None of the Company’s operations are subject to collective bargaining agreements. In general, the Company considers relations with its employees to be excellent. Domestic employees hold a large share of Company stock resulting from various stock purchase plans. The Company believes that this dual role of owner-employee has strengthened employee morale over the years.
The Company is competing on the basis of its reputation as the best in class for quality, precision and innovation combined with its commitment to customer service and strong customer relationships. To that end, Starrett is increasingly focusing on providing customer centric solutions. Although the Company is generally operating in highly competitive markets, the Company’s competitive position cannot be determined accurately in the aggregate or by specific market since none of its competitors offer all of the same product lines offered by the Company or serve all of the markets served by the Company.
The Company is one of the largest producers of mechanics’ hand measuring tools and precision instruments. In the United States, there are three other major companies and numerous small competitors in the field, including direct foreign competitors. As a result, the industry is highly competitive. During fiscal 2011, there were no material changes in the Company’s competitive position. The Company’s products for the building trades, such as tape measures and levels, are under constant margin pressure due to a channel shift to large national home and hardware retailers. The Company is responding to such challenges by expanding its manufacturing operations in China. Certain large customers offer private labels (“own brand”) that compete with Starrett branded products. These products are often sourced directly from low cost countries.
Saw products encounter competition from several domestic and international sources. The Company’s competitive position varies by market segment and country. Continued research and development, new patented products and processes, and strong customer support have enabled the Company to compete successfully in both general and performance oriented applications.
The operations of the Company’s foreign subsidiaries are consolidated in its financial statements. The subsidiaries located in Brazil, Scotland and China are actively engaged in the manufacturing and distribution of precision measuring tools, saw blades, optical and vision measuring equipment and hand tools. Subsidiaries in Canada, Argentina, Australia, New Zealand, Mexico and Germany are engaged in distribution of the Company’s products. The Company expects its foreign subsidiaries to continue to play a significant role in its overall operations. A summary of the Company’s foreign operations is contained in Note 15 to the Company’s fiscal 2011 financial statements under the caption “OPERATING DATA” found in Item 8 of this Form 10-K.
Orders and Backlog
The Company generally fills orders from finished goods inventories on hand. Sales order backlog of the Company at any point in time is not significant. Total inventories amounted to $58.8 million at June 30, 2011 and $46.2 million at June 26, 2010.
When appropriate, the Company applies for patent protection on new inventions and currently owns a number of patents. Its patents are considered important in the operation of the business, but no single patent is of material importance when viewed from the standpoint of its overall business. The Company relies on its continuing product research and development efforts, with less dependence on its current patent position. It has for many years maintained engineers and supporting personnel engaged in research, product development and related activities. The expenditures for these activities during fiscal years 2011, 2010 and 2009 were approximately $1.5 million, $0.9 million and $1.6 million respectively, all of which were expensed in the Company’s financial statements.
The Company uses trademarks with respect to its products and considers its trademark portfolio as one of its most valuable assets. All of the Company’s important trademarks are registered and rigorously enforced.
Compliance with federal, state, local, and foreign provisions that have been enacted or adopted regulating the discharge of materials into the environment or otherwise relating to protection of the environment is not expected to have a material effect on the capital expenditures, earnings and competitive position of the Company. Specifically, the Company has taken steps to reduce, control and treat water discharges and air emissions. The Company takes seriously its responsibility to the environment, has embraced renewable energy alternatives and is ready to bring a new hydro – generation facility on line at its Athol, MA plant to reduce its carbon foot print and energy costs, an investment in excess of $1.0 million.
Globalization has had a profound impact on product offerings and buying behaviors of industry and consumers in North America and around the world, forcing the Company to adapt to this new, highly competitive business environment. The Company continuously evaluates most aspects of its business, aiming for new world-class ideas to set itself apart from its competition.
Our strategic concentration is on global brand building and providing unique customer value propositions through technically supported application solutions for our customers. Our job is to recommend and produce the best suited standard product or to design and build custom solutions. The combination of the right tool for the job with value added service gives us a competitive advantage. The Company continues its focus on lean manufacturing, plant consolidations, global sourcing and improved logistics to optimize its value chain.
The execution of these strategic initiatives has expanded the Company’s manufacturing and distribution in developing economies, increasing its international sales revenues to 56% of its consolidated sales for fiscal 2011.
SEC Filings and Certifications
The Company makes its public filings with the Securities and Exchange Commission (“SEC”), including its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all exhibits and amendments to these reports, available free of charge at its website, www.starrett.com, as soon as reasonably practicable after the Company files such material with the SEC. Information contained on the Company’s website is not part of this Annual Report on Form 10-K.
Item 1A – Risk Factors
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
This Annual Report on Form 10-K and the Company’s 2011 Annual Report to Stockholders, including the President’s letter, contains forward-looking statements about the Company’s business, competition, sales, gross margins, expenditures, foreign operations, plans for reorganization, interest rate sensitivity, debt service, liquidity and capital resources, and other operating and capital requirements. In addition, forward-looking statements may be included in future Company documents and in oral statements by Company representatives to security analysts and investors. The Company is subject to risks that could cause actual events to vary materially from such forward-looking statements, including the following risk factors:
Risks Related to Financial Reporting: >If the Company or its independent registered public accounting firm are unable to affirm the effectiveness of internal control over financial reporting in future years, the market value of the Company’s common stock could be adversely affected. The Company’s independent registered public accounting firm did audit and report on internal controls over financial reporting as of June 30, 2011 and June 26, 2010. For the year ended June 26, 2010, material weaknesses in internal controls over financial reporting were identified. Management has implemented the remediation steps outlined in the Annual Report on Form 10-K for fiscal 2010, but these steps have yet to fully resolve all the financial reporting issues, as the controls around tax reporting have not met the criteria required to be considered fully functioning. The Company is in the process of implementing new remediation steps to address this control failure.
Risks Related to the Economy:> The Company’s results of operations are materially affected by the conditions in the global economy. As a result of the global economic recession, U.S. and foreign economies have experienced significant declines in employment, household wealth, consumer spending, and lending. Businesses, including the Company and its customers, have faced weakened demand for their products and services, difficulty obtaining access to financing, increased funding costs, and barriers to expanding operations. The Company’s results of operations in fiscal 2010 were negatively impacted by the global economic recession; however, business activity improved for the Company in fiscal 2011. The Company can provide no assurance that its improvement in fiscal 2011 will continue or that its future results of operations will improve.
Risks Related to Reorganization:> The Company continues to evaluate consolidation and reorganization of some of its manufacturing and distribution operations. There can be no assurance that the Company will be successful in these efforts or that any consolidation or reorganization will result in revenue increases or cost savings to the Company. The implementation of these reorganization measures may disrupt the Company’s manufacturing and distribution activities, could adversely affect operations, and could result in asset impairment charges and other costs that will be recognized if and when reorganization or restructuring plans are implemented or obligations are incurred.
Risks Related to Technology:> Although the Company’s strategy includes investment in research and development of new and innovative products to meet technology advances, there can be no assurance that the Company will be successful in competing against new technologies developed by competitors.
Risks Related to Foreign Operations:> Approximately 56% of the Company’s sales and 62% of net assets related to foreign operations for fiscal 2011. Foreign operations are subject to special risks that can materially affect the sales, profits, cash flows and financial position of the Company, including taxes and other restrictions on distributions and payments, currency exchange rate fluctuations, political and economic instability, inflation, minimum capital requirements and exchange controls. The Company’s Brazilian operations can be very volatile, changing from year to year due to the political situation, currency risk and the economy. As a result, the future performance of the Brazilian operations may be difficult to forecast.
Risks Related to Industrial Manufacturing Sector:> The market for most of the Company’s products is subject to economic conditions affecting the industrial manufacturing sector, including the level of capital spending by industrial companies and the general movement of manufacturing to low cost foreign countries where the Company does not have a substantial market presence. Accordingly, economic weakness in the industrial manufacturing sector may, and in some cases has, resulted in decreased demand for certain of the Company’s products, which adversely affects sales and performance. Economic weakness in the consumer market will also adversely impact the Company’s performance. In the event that demand for any of the Company’s products declines significantly, the Company could be required to recognize certain costs as well as asset impairment charges on long-lived assets related to those products.
Risks Related to Competition:> The Company’s business is subject to direct and indirect competition from both domestic and foreign firms. In particular, low cost foreign sources have created severe competitive pricing pressures. Under certain circumstances, including significant changes in U.S. and foreign currency relationships, such pricing pressures tend to reduce unit sales and/or adversely affect the Company’s margins.
Risks Related to Insurance Coverage:> The Company carries liability, property damage, workers’ compensation, medical and other insurance policies that management considers adequate for the protection of its assets and operations. There can be no assurance, however, that the coverage limits of such policies will be adequate to cover all claims and losses. Such uncovered claims and losses could have a material adverse effect on the Company. Depending on the risk, deductibles can be as high as 5% of the loss or $500,000.
Risks Related to Raw Material and Energy Costs:> Steel is the principal raw material used in the manufacture of the Company’s products. The price of steel has historically fluctuated on a cyclical basis and has often depended on a variety of factors over which the Company has no control. The cost of producing the Company’s products is also sensitive to the price of energy. The selling prices of the Company’s products have not always increased in response to raw material, energy or other cost increases, and the Company is unable to determine to what extent, if any, it will be able to pass future cost increases through to its customers. The Company’s inability to pass increased costs through to its customers could materially and adversely affect its financial condition or results of operations.
Risks Related to Stock Market Performance:> Currently, the Company’s U.S. defined benefit pension plan is underfunded. The Company is not required to provide additional funds to the domestic pension fund; however, the estimated future return on pension assets is insufficient to cover future obligations, creating an actuarially underfunded status. The Company could be required to fund the domestic plan in the future. The Company’s UK plan, which was underfunded, required Company contributions during fiscal 2009, 2010 and 2011.
Risks Related to Acquisitions: >Acquisitions involve special risks, including the potential assumption of unanticipated liabilities and contingencies, difficulty in assimilating the operations and personnel of the acquired businesses, disruption of the Company’s existing business, dissipation of the Company’s limited management resources, and impairment of relationships with employees and customers of the acquired business as a result of changes in ownership and management. While the Company believes that strategic acquisitions can improve its competitiveness and profitability, the failure to successfully integrate and realize the expected benefits of such acquisitions could have an adverse effect on the Company’s business, financial condition and operating results.
Risks Related to Investor Expectations:> The Company’s share price suffered a significant decline in fiscal 2009 then remained relatively stable in fiscal 2010. The price rose steadily through the first three quarters of fiscal 2011 before declining in the fourth quarter. The Company's earnings may not continue to grow at rates similar to the growth rates achieved in recent years and may fall short of either a prior quarter or investors’ expectations. If the Company fails to meet the expectations of securities analysts or investors, the Company's share price may decline.
Risks Related to the Company’s Credit Facility:> Under the Company’s credit facility with TD Bank, N.A., the Company is required to comply with certain financial covenants. While the Company believes that it will be able to comply with the financial covenants in future periods, its failure to do so would result in defaults under the credit facility unless the covenants are amended or waived. An event of default under the credit facility, if not waived, could prevent additional borrowing and could result in the acceleration of the Company’s indebtedness. The Credit Facility matures on April 30, 2012. The Company plans to extend the Credit Facility before maturity, however, there are no assurances the extension will be available to the Company. This could have an impact on the Company’s ability to operate its business.
Risks Related to Information Systems:> The efficient operation of the Company's business is dependent on its information systems, including its ability to operate them effectively and to successfully implement new technologies, systems, controls and adequate disaster recovery systems. In addition, the Company must protect the confidentiality of data of its business, employees, customers and other third parties. The failure of the Company's information systems to perform as designed or its failure to implement and operate them effectively could disrupt the Company's business or subject it to liability and thereby harm its profitability. For those reasons, the Company implemented a new Enterprise Resource Planning (ERP) system in fiscal 2010 at its principal North American locations.
Risks Related to Litigation and Changes in Laws, Regulations and Accounting Rules: >Various aspects of the Company's operations are subject to federal, state, local or foreign laws, rules and regulations, any of which may change from time to time. Generally accepted accounting principles may change from time to time, as well. In addition, the Company is regularly involved in various litigation matters that arise in the ordinary course of business. Litigation, regulatory developments and changes in accounting rules and principles could adversely affect the Company's business operations and financial performance.
Item 1B – Unresolved Staff Comments
Item 2 - Properties
The Company’s principal plant and its corporate headquarters are located in Athol, MA on approximately 15 acres of Company-owned land. The plant consists of 25 buildings, mostly of brick construction of varying dates, with approximately 535,000 square feet.
The Company’s Webber Gage Division in Cleveland, OH, owns and occupies two buildings totaling approximately 50,000 square feet.
The Company-owned facility in Mt. Airy, NC consists of one building totaling approximately 320,000 square feet. It is occupied by the Company’s Saw Division, Ground Flat Stock Division and a distribution center. A separate 36,000 square foot building which formerly housed the distribution center was vacated in November 2008 and is currently listed for sale.
A manufacturing and warehousing facility in North Charleston encompassing 173,000 square feet was closed in fiscal 2005 and the building was sold in fiscal 2011.
The Company’s subsidiary in Itu, Brazil owns and occupies several buildings totaling 209,000 square feet. The Company’s subsidiary in Jedburgh, Scotland owns and occupies a 175,000 square foot building. A wholly owned manufacturing subsidiary in The People’s Republic of China leases a 133,000 square foot building in Suzhou. In fiscal 2011, we closed a 5,000 square foot Shanghai distribution center and sales office, consolidated the distribution into the Suzhou facility and leased a new sales office in Shanghai.
In addition, the Company operates warehouses and/or sales-support offices in the U.S., Canada, Australia, New Zealand, Mexico, Germany, Japan and Argentina. In fiscal 2011, the company opened a new sales and distribution center in Singapore.
The Tru-Stone Division owns and occupies a 90,000 square foot facility in Waite Park, MN.
The Kinemetric Engineering Division occupies a 14,000 square foot leased facility in Laguna Hills, CA.
In the Company’s opinion, all of its property, plants and equipment are in good operating condition, well maintained and adequate for its needs.
Item 3 - Legal Proceedings
The Company is, in the ordinary course of business, from time to time involved in litigation that is not considered material to its financial condition or operations.
Item 4 – Removed and Reserved
Item 5 - Market for the Company’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company’s Class A common stock is traded on the New York Stock Exchange. Quarterly dividend and high/low closing market price information is presented in the table below. The Company’s Class B common stock is generally nontransferable, except to lineal descendants, and thus has no established trading market, but it can be converted into Class A common stock at any time. The Class B common stock was issued on October 5, 1988, and the Company has paid the same dividends thereon as have been paid on the Class A common stock since that date. On June 30, 2011, there were approximately 1,488 registered holders of Class A common stock and approximately 1,227 registered holders of Class B common stock.
The Company’s dividend policy is subject to periodic review by the Board of Directors. Based upon economic conditions, the Board of Directors decided to increase the quarterly dividend from $0.06 to $0.08 per share in the second quarter and from $0.08 to $0.10 per share in the fourth quarter of fiscal 2011.
ISSUER PURCHASES OF EQUITY SECURITIES
Summary of Stock Repurchases:
A summary of the Company’s repurchases of shares of its common stock for the fourth quarter fiscal 2011 is as follows:
The following graph sets forth information comparing the cumulative total return to holders of the Company’s Class A common stock over the last five fiscal years with (1) the cumulative total return of the Russell 2000 Index (“Russell 2000”) and (2) a peer group index (the “Peer Group”) reflecting the cumulative total returns of certain small cap manufacturing companies as described below. The peer group is comprised of the following companies: Acme United, Q.E.P. Co. Inc., Badger Meter, Federal Screw Works, National Presto Industries, Regal-Beloit Corp., Tecumseh Products Co., Tennant Company, The Eastern Company and WD-40.
Item 6 - Selected Financial Data
The following selected condensed financial data has been derived from and should be read in conjunction with “Management Discussion and Analysis of Financial Condition and Results of Operations” and our Consolidated Financial Statements and notes thereto, included elsewhere in this report on Form 10K and incorporated herein by reference. The table below reflects the change in pension accounting, described in Note 2, for all five fiscal years.
Items 7 and 7A- Management’s Discussion and Analysis of Financial Condition and Results of Operations and Quantitative and Qualitative Disclosure about Market Risk
RESULTS OF OPERATIONS
Fiscal 2011 Compared to Fiscal 2010
As further explained in Note 2 to the consolidated financial statements in fiscal 2011, the Company changed its fiscal year end from the last Saturday in June to June 30. This change facilitated an improved closing process and conformed North American to International subsidiaries’ year end. In fiscal 2010, the Company changed the fiscal year end of its International subsidiaries to that of the Company. Those subsidiaries previously reported on a one-month lag. Management has concluded that the effects of the change from a fiscal to a calendar year end and the inclusion of the additional month for its International subsidiaries in fiscal 2010 are immaterial to the consolidated financial statements.
The Company changed its method of accounting for pensions in fiscal 2011. The impact of this change is described in Note 2.
The Company began to experience an economic upturn in the second quarter of fiscal 2010. To service higher demand the Company began to increase manufacturing output, inventory raw material purchases, and selling, general, and administrative expenses globally in the third quarter of fiscal 2010. Sales increased $21.5 million or 24% in the second half of fiscal 2011 compared to the first half of fiscal 2010. Sales in the first half of 2011 were $23.7 million or 26% higher than in the first half of 2010. The Company experienced higher backorder levels in the first half of fiscal 2011 as a result of the inability to quickly adjust inventory and manufacturing staffing levels to match demand, however, this backorder position decreased in the second half of fiscal 2011.
Net sales for fiscal 2011 increased $41.1 million or 20% compared to fiscal 2010 due to global economic recovery and increased market penetration. Gross margins improved $25.4 million from $56.4 million or 28% of sales in fiscal 2010 to $81.8 million or 33% of sales in fiscal 2011. Selling, general and administrative expenses increased $6.7 million or 10% from $64.1 million in fiscal 2010 to $70.8 million in fiscal 2011. Operating income increased $21.8 million from a loss of $9.4 million in fiscal 2010 to a profit of $12.4 million in fiscal 2011.
Net sales in North America increased $22.6 million or 23% from $97.1 million in fiscal 2010 to $119.7 million in fiscal 2011. All divisions posted gains except Evans Rule, which lost the Sears contract in the fourth quarter of fiscal 2010. Tru-Stone and Kinemetric benefited from renewed capital equipment markets registering sales increases in fiscal 2011 of 64% and 71%, respectively, as our customers reinvested in their businesses. International sales, excluding U.S. exports, increased $18.5 million or 17% from $106.6 million in fiscal 2010 to $125.1 million in fiscal 2011. Foreign currency exchange rate fluctuations represented $8.1 million of the sales gain principally due to a weaker U.S. dollar. All International subsidiaries achieved double digit sales increases and account for over 50% of the Company’s global revenues. The Company is cautiously optimistic about fiscal 2012 based upon orders through August of fiscal 2012; however, recent unfavorable economic news could have a negative impact on the year.
Gross margin in North America increased $10.8 million or 44% from $24.5 million in fiscal 2010 to $35.3 million in fiscal 2011 and improved as a percentage of sales from 25.3% in fiscal 2010 to 29.5% in fiscal 2011. Higher sales, improved manufacturing efficiencies, and a reduction in pension cost were the key drivers in the improved margin performance. In addition, the gross margin improvement overcame an unfavorable LIFO swing of $9.5 million based upon a reduction in cost of sales of $8.5 million in fiscal 2010 to an increase in cost of sales of $1.0 million in fiscal 2011. The change in LIFO was the result of lower inventories during the recession in fiscal 2010 compared to an increase in inventories in conjunction with the economic recovery in fiscal 2011. International gross margins increased $14.6 million or 46% from $31.9 million in fiscal 2010 to $46.5 million in fiscal 2011 and improved as a percentage of sales from 30% in fiscal 2010 to 37% in fiscal 2011. Higher sales, improved manufacturing efficiencies, lower pension expense and favorable foreign exchange rates all contributed to the improved international gross margins.
Selling, General and Administrative Expenses
North American selling, general and administrative expenses increased $3.6 million or 11% but declined as a percentage of sales from 33% in fiscal 2010 to 30% in fiscal 2011. Salaries and benefits in North America increased $2.2 million in fiscal 2011 compared to fiscal 2010, principally due to the restoration of previous salary reductions, a 3% salary increase and higher medical costs. Higher sales also resulted in a $0.9 million increase in travel and commission expenses. International selling, general and administrative expenses increased $3.1 million or 10% and declined from 30% to 28% of sales. Salaries and benefits increased $2.5 million due to restoration of previous salary reductions, while increased sales resulted in a $1.3 million increase in travel and commission expenses. These expense increases were partially offset by a $2.2 million reduction in pension expense.
Operating income in fiscal 2011 of $12.4 million represented a $21.8 million improvement from an operating loss of $9.4 million in fiscal 2010. Higher sales and improved margins accounted for $11.4 and $14.0 million, respectively of the $25.4 million gross margin improvement and offset the selling, general and administrative increase of $6.7 million, resulting in an $18.7 gain in operating income from operations. The net impact of combined losses related to restructuring costs and goodwill impairment of $1.7 million in fiscal 2010 compared to a $1.3 million gain on the sale of a building in fiscal 2011 represents the incremental operating profit improvement of $3.0 million.
Other Operating Income
Higher interest income was the primary factor for the $0.8 million improvement in other operating income.
Significant Fourth Quarter Activity
As shown in Note 15, the Company recorded a $4.5 million profit before taxes in the fourth quarter of fiscal 2011 compared to a comparable $1.5 million loss in fiscal 2010.
Consolidated sales increased $7.4 million or 12 % from $63.9 million in fiscal 2010 to $71.3 million in fiscal 2011 with North America representing $7.3 million of the increase. International sales increase was modest due to three months of sales in fiscal 2011 compared to four months in fiscal 2010. The four months in fiscal 2010 for International was a result of dropping the one month lag. Higher sales and improved margins generated a $5.3 million increase in gross margins which more than offset a $0.6 million increase in selling, general and administrative expenses resulting in a $4.7 million net contribution to profits. The remaining $1.5 comparative profit improvement was principally due to losses of $1.7 million related to restructuring and impairment charges in fiscal 2010 compared to no similar costs in fiscal 2011.
The effective tax rate was 48% for fiscal 2011. The rate reflects federal, state and foreign adjustments for permanent book tax differences. The principal reason for the 8% increase over a normalized combined federal and state statutory tax rate of approximately 40% is book losses not tax benefited principally in China and the Dominican Republic as well as provisions for valuation allowances.
The effective tax rate for fiscal 2010 was 14%. The Brazilian audit settlement and losses not benefited principally in China and the Dominican Republic were the principal factors reducing the normalized benefit of 40% to 14%.
There was a $0.9 million increase in valuation allowances relating primarily to carryforwards for foreign NOL’s. The Company continues to believe that it is more likely than not that it will be able to realize its domestic tax operating loss carryforward assets of approximately $8.5 million reflected on the Balance Sheet.
Fiscal 2010 Compared to Fiscal 2009
The Company began to experience the economic downturn in the second quarter of fiscal 2009 and significantly reduced its manufacturing and selling, general administrative expenses in the third quarter of fiscal 2009. These cost reductions remained in place for one year until the third quarter of fiscal 2010, when an uptick in orders resulted in restoring reduced hours to normal hours for both the factory and office personnel. The economy’s cycle created significant problems in managing costs and inventory levels in fiscal 2010 compared to fiscal 2009 as first half fiscal 2010 sales declined $31.0 million, or 25%, compared to $31.1 million, or 38%, increase in the second half.
Net sales for fiscal 2010 remained level with fiscal 2009 at $203.6 million. Gross margins improved $22.5 million from $33.9 million or 16.7% of sales in fiscal 2009 to $56.4 million or 27.7% of sales in fiscal 2010. Selling, general and administrative expenses decreased $2.7 million of 4.0% from $66.8 million in fiscal 2009 to $64.1 million in fiscal 2010. The operating loss declined $28.8 million principally due to a change in accounting for pension expense which reduced cost of sales and selling, general and administrative expenses $25.3 million from $32.5 million in fiscal 2009 to $7.2 million in fiscal 2010.
Net sales in North America declined $5.8 million, or 5.7%, from $102.9 million in fiscal 2009 to $97.1 million in fiscal 2010. With the exception of Tru-Stone, all divisions posted declines as reduced volume from Sears impacting the Evans Rule division and the significant decline in customer capital expenditures adversely affecting the demand for Kinemetric’s products. International sales increased $5.9 million, or 5.9%, from $100.7 million in fiscal 2009 to $106.6 million in fiscal 2010. Foreign currency exchange rate fluctuations represented a $4.1 million of the sales gain with a stronger Brazilian Real accounting for $5.2 million and a weaker Pound Sterling posing a $1.1 million decline.
Gross margin in North America increased $29.0 million, from a negative $4.5 million in fiscal 2009 to $24.5 million in fiscal 2010. A reduction in pension expense represented $21.0 or 72% of the change. In addition, cost reductions and reduced manufacturing hours implemented in February of 2009 coupled with increased volume, particularly in the second half of fiscal 2010, represented $1.0 million while inventory reductions resulted in an additional net $4.3 million LIFO liquidation. International gross margins declined $6.5 million, from $38.4 million in fiscal 2009 to $31.9 million in fiscal 2010. A $2.2 million increase in pension expense coupled with higher fixed manufacturing costs and under absorbed overhead as a result of lower production were the prime factors influencing the gross margin decline.
Selling, General & Administrative Expenses
Selling, general and administrative expenses decreased $2.7 million, or 4.0%, from $66.8 million in fiscal 2009 to $64.1 million in fiscal 2010. North American expenses decreased $5.5 million, due to a $4.3 million reduction in pension expense as well as savings related to reduced salaries, travel and advertising costs of $0.9 million. International expenses increased $2.8 million, due to a $2.2 million increase in pension expense as well as higher salaries and benefits.
The operating loss decreased $28.8 million from a loss of $38.2 million in fiscal 2009 to a loss of $9.4 million in fiscal 2010 principally due to a $25.3 million reduction in pension expense.
FINANCIAL INSTRUMENT MARKET RISK
Market risk is the potential change in a financial instrument’s value caused by fluctuations in interest and currency exchange rates, and equity and commodity prices. The Company’s operating activities expose it to risks that are continually monitored, evaluated and managed. Proper management of these risks helps reduce the likelihood of earnings volatility.
As of June 30, 2011, the Company’s Scottish subsidiary held a $6.4 million six month fixed rate deposit.
The Company does not engage in tracking, market-making or other speculative activities in derivatives markets. The Company does not enter into long-term supply contracts with either fixed prices or quantities. The Company engages in an immaterial amount of hedging activity to minimize the impact of foreign currency fluctuations. Net foreign monetary assets are approximately $24.6 million as of June 30, 2011.
A 10% change in interest rates would not have a significant impact on the aggregate net fair value of the Company’s interest rate sensitive financial instruments or the cash flows or future earnings associated with those financial instruments. A 10% change in interest rates would impact the fair value of the Company’s fixed rate investments of $6.4 million by an immaterial amount. A 10% increase in interest rates would not have a material impact on our short-term borrowing costs. See Note 12 to the Consolidated Financial Statements for details concerning the Company’s long-term debt outstanding of $0.7 million.
LIQUIDITY AND CAPITAL RESOURCES
The Company has a working capital ratio of 3.9 in fiscal 2011 and 4.3 in fiscal 2010. Cash, investments, accounts receivable and inventory represent 92% of current assets in both fiscal 2011 and fiscal 2010. The Company had accounts receivable turnover of 6.3 in fiscal 2011 compared to 6.7 in fiscal 2010 and an inventory turnover ratio of 3.2 in fiscal 2011 compared to 2.7 in fiscal 2010.
Net cash provided by operations of $5.2 million in fiscal 2011 declined $24.5 million compared to fiscal 2010 due to a $24.9 million net change in inventory reflecting the economic recession in fiscal 2010 and the recovery in fiscal 2011.
The Company has invested $10.1 million in fiscal 2011. Plant and equipment and short-term investments represented a combined $12.2 million, which was partially offset by proceeds of $3.3 million from the sale of a building.
The Company increased short-term debt $5.5 million in fiscal 2011 compared to fiscal 2010 principally to finance higher working capital requirements.
Effects of translation rate changes on cash primarily result from the movement of the U.S. dollar against the British Pound, the Euro and the Brazilian Real. The Company uses a limited number of forward contracts to hedge some of this activity and a natural hedge strategy of paying for foreign purchases in local currency when economically advantageous.
Liquidity and Credit Arrangements
The Company believes it maintains sufficient liquidity and has the resources to fund its operations in the near term. In addition to its cash and investments, the Company has maintained a $23.0 million line of credit, of which, $0.4 million is reserved for letters of credit and $8.0 million was outstanding as of June 30, 2011.
On June 30, 2009, The L.S. Starrett Company (the “Company”) and certain subsidiaries of the Company subsidiaries (the “Subsidiaries”) entered into a Loan and Security Agreement (the “Credit Facility”) with TD Bank, N.A., as lender.
The Credit Facility replaced the Company’s previous Bank of America facility with a $23.0 million line of credit. On June 30, 2009, the Company utilized this line of credit to pay off the remaining balances on the Bank of America Reducing Revolver and Line of Credit. The interest rate under the Credit Facility is based on a grid which uses the ratio of Funded Debt/EBITDA to determine the floating margin that will be added to one-month LIBOR. The initial rate was one-month LIBOR plus 1.75%, and is currently one-month LIBOR plus 1.50%. The Credit Facility matures on April 30, 2012. The Company plans to extend this credit facility before maturity, however, there are no assurances the extension will be available to the Company.
The obligations under the Credit Facility are unsecured. However, in the event of certain triggering events, the obligations under the Credit Facility will become secured by the assets of the Company and the subsidiaries party to the Credit Facility. Triggering events are two consecutive quarters of failure to achieve the financial covenants outlined in Note 12.
Availability under the Credit Facility is subject to a borrowing base comprised of accounts receivable and inventory. The Company believes that the borrowing base will consistently produce availability under the Credit Facility in excess of $23.0 million. In addition, the Company anticipates that it will not need to fully utilize the amounts available to the Company and its subsidiaries under the Credit Facility. As of August 31, 2011, the Company had borrowings of $9.6 million under the Credit Facility.
The Credit Facility contains financial covenants with respect to leverage, tangible net worth, and interest coverage, and also contains customary affirmative and negative covenants, including limitations on indebtedness, liens, acquisitions, asset dispositions, and fundamental corporate changes, and certain customary events of default. Upon the occurrence and continuation of an event of default, the lender may terminate the revolving credit commitment and require immediate payment of the entire unpaid principal amount of the Credit Facility, accrued interest and all other obligations. As of June 30, 2011, the Company was in compliance with the financial covenants required for testing at that time under the Credit Facility.
OFF-BALANCE SHEET ARRANGEMENTS
The Company does not have any material off-balance sheet arrangements as defined under the Securities and Exchange Commission rules.
CRITICAL ACCOUNTING POLICIES and ESTIMATES
The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. The second footnote to the Company’s Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the consolidated financial statements.
Judgments, assumptions, and estimates are used for, but not limited to, the allowance for doubtful accounts receivable and returned goods; inventory allowances; income tax reserves; employee turnover, discount, and return rates used to calculate pension obligations.
Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the Company’s Consolidated Financial Statements. The following sections describe the Company’s critical accounting policies.
Revenue Recognition and Accounts Receivable: Sales of merchandise and freight billed to customers are recognized when products are delivered, title and risk of loss has passed to the customer, no significant post delivery obligations remain and collection of the resulting receivable is reasonably assured. Sales are net of provisions for cash discounts, returns, customer discounts (such as volume or trade discounts), cooperative advertising and other sales related discounts. Cooperative advertising payments made to customers are included as advertising expense in selling, general and administrative in the Consolidated Statements of Operations. While the Company does allow its customers the right to return in certain circumstances, revenue is not deferred, but rather a reserve for sales returns is provided based on experience, which historically has not been significant.
The allowance for doubtful accounts of $0.4 million and $0.6 million at the end of fiscal 2011 and 2010, respectively, is based on our assessment of the collectability of specific customer accounts and the aging of our accounts receivable. While the Company believes that the allowance for doubtful accounts is adequate, if there is a deterioration of a major customer’s credit worthiness, actual defaults are higher than our previous experience, or actual future returns do not reflect historical trends, the estimates of the recoverability of the amounts due the Company and sales could be adversely affected.
Inventory Valuation: Inventory purchases and commitments are based upon future demand forecasts. If there is a sudden and significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and requirements, the Company may be required to increase the inventory reserve and, as a result, gross profit margin could be adversely affected.
Long-lived Assets and Goodwill: The Company values property, plant and equipment (PP&E) at historical cost less accumulated depreciation. Impairment losses are recorded when indicators of impairment, such as plant closures, are present and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount. The Company continually reviews for such impairment and believes that PP&E is being carried at its appropriate value.
The Company assesses the fair value of its goodwill generally based upon a discounted cash flow methodology. The discounted cash flows are estimated utilizing various assumptions regarding future revenue and expenses, working capital, terminal value, and market discount rates. If the carrying amount of the goodwill is greater than the fair value, an impairment charge is recognized to the extent the recorded goodwill exceeds the implied fair value of goodwill.
Our long-lived assets consist primarily of property, plant and equipment. The Company groups long-lived assets for impairment analysis by division and/or product line. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of such an asset may not be recoverable. Such events or circumstances include, but are not limited to, a significant decrease in the fair value of the underlying business or change in utilization of property and equipment.
Recoverability of the undepreciated cost of property, plant and equipment is measured by comparison of the carrying amount to estimated future undiscounted net cash flows the assets are expected to generate. Those cash flows include an estimated terminal value based on a hypothetical sale at the end of the assets' depreciation period. Estimating these cash flows and terminal values requires management to make judgments about the growth in demand for our products, sustainability of gross margins, and our ability to achieve economies of scale. If assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the long-lived asset exceeds its fair value.
Depreciation is included in cost of goods sold and selling, general and administrative expenses in the Consolidated Statement of Operations based upon where the assets are contributing to the measurement of cost or expense by functional area. Depreciation of equipment used in the manufacturing process is a component of inventory and included in costs of goods sold. Depreciation of equipment used for office and administrative functions is an expense in selling, general and administrative expenses.
Income Taxes: Accounting for income taxes requires estimates of future benefits and tax liabilities. Due to temporary differences in the timing of recognition of items included in income for accounting and tax purposes, deferred tax assets or liabilities are recorded to reflect the impact arising from these differences on future tax payments. With respect to recorded tax assets, the Company assesses the likelihood that the asset will be realized. If realization is in doubt because of uncertainty regarding future profitability or enacted tax rates, the Company provides a valuation allowance related to the asset. Should any significant changes in the tax law or the estimate of the necessary valuation allowance occur, the Company would record the impact of the change, which could have a material effect on our financial position or results of operations.
Defined Benefit Pension Plans: The Company has two defined benefit pension plans, one for U.S. employees and another for U.K. employees.
In 2011, we elected to retrospectively change our method of recognizing certain actuarial gains and losses. Previously, the market related value of plan assets for the U.S. plan was equal to fair value, and the market-related value of plan assets for the U.K. plan, was based on a calculated five-year moving average of market value. Actuarial gains and losses were recognized in other comprehensive income as of the measurement date. Net actuarial gains or losses in excess of ten percent (10%) of the greater of the market-related value of plan assets or of the plans’ projected benefit obligation (the corridor) were amortized in net periodic benefit cost over the average remaining service period (fourteen-years). The primary factors contributing to actuarial gains and losses are changes in the discount rate used to value pension obligations as of the measurement date each year and the differences between expected and actual returns on plan assets.
Under our new accounting method, both plans will use fair value as the market-related value of plan assets and continue to recognize actuarial gains or losses within the corridor in other comprehensive income but instead of amortizing net actuarial gains or losses in excess of the corridor in future periods, excess gains and losses will be recognized in net periodic (benefit) cost as of the plan measurement date, which is the same as the fiscal year end of the Company (MTM adjustment). This change in accounting method is a permitted option which results in immediate recognition of excess net actuarial gains and losses in net periodic benefit cost instead of in other comprehensive income. Immediate recognition in net periodic benefit cost could potentially increase the volatility of net periodic benefit cost. The MTM adjustments to net periodic benefit cost for 2011, 2010 and 2009 were $0.0, $9.4, and $32.5 million, respectively. The accounting for the remaining components of net periodic pension cost, primarily service, interest costs and expected return on plan assets will be unchanged (On-going Pension Expense). See Note 2 to the financial statements for further details of the change and the impact of our retrospective application of the new policy.
Calculation of pension and postretirement medical costs and obligations are dependent on actuarial assumptions. These assumptions include discount rates, healthcare cost trends, inflation, salary growth, long-term return on plan assets, employee turnover rates, retirement rates, mortality and other factors. These assumptions are made based on a combination of external market factors, actual historical experience, long-term trend analysis, and an analysis of the assumptions being used by other companies with similar plans. Significant differences in actual experience or significant changes in assumptions would affect pension and other postretirement benefit costs and obligations. See also Employee Benefit Plans (Note 11 to the Consolidated Financial Statements).
Cost of Goods Sold: The Company includes material, direct and indirect labor and manufacturing overhead in cost of goods sold. Included in these costs are inbound freight, personnel (manufacturing plants only), receiving costs, internal transferring, employee benefits (including pension expense) and inspections costs.
Selling, General and Administrative Expenses: The Company includes distribution expenses in selling, general and administrative expenses. Distribution expenses include shipping labor and warehousing costs associated with the storage of finished goods at each manufacturing facility. The Company also includes costs for our dedicated distribution centers as selling expenses. Employee benefits, including pension expense, are also included in selling, general and administrative expenses.
The following table summarizes future estimated payment obligations by period. The majority of the obligations represent commitments for production needs in the normal course of business.
ANNUAL NYSE CEO CERTIFICATION AND SARBANES-OXLEY SECTION 302 CERTIFICATIONS
In fiscal 2011, the Company submitted an unqualified “Annual CEO Certification” to the New York Stock Exchange as required by Section 303A.12(a) of the New York Stock Exchange Listed Company Manual. Further, the Company is filing with the Securities and Exchange Commission the certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 as exhibits to the Company’s Annual Report on Form 10-K.
Item 8 - Financial Statements and Supplementary Data
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCONTING FIRM
Board of Directors and Stockholders
The L.S. Starrett Company
We have audited the accompanying consolidated balance sheets of The L.S. Starrett Company and subsidiaries (“the Company”) as of June 30, 2011 and June 26, 2010, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended June 30, 2011. Our audits of the basic consolidated financial statements included the financial statement schedule listed in the index appearing under Item 15(a)(2). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The L.S. Starrett Company and subsidiaries as of June 30, 2011 and June 26, 2010, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2011 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
As discussed in Note 2 to the consolidated financial statements, in fiscal year 2011 the Company changed its method of accounting for defined benefit pension costs. All periods presented have been retroactively adjusted for this accounting change.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), The L.S. Starrett Company’s internal control over financial reporting as of June 30, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our accompanying report dated September 13, 2011 expressed an adverse opinion on the effectiveness of the Company’s internal control over financial reporting.
/s/ Grant Thornton LLP
September 13, 2011
THE L.S. STARRETT COMPANY
Consolidated Balance Sheets
(in thousands except share data)
THE L.S. STARRETT COMPANY
Consolidated Statements of Operations
For the three years ended June 30, 2011
(in thousands except per share data)
See notes to consolidated audited financial statements
THE L. S. STARRETT COMPANY
For the three years ended June 30, 2011
Consolidated Statements of Cash Flows
See notes to consolidated audited financial statements
THE L.S. STARRETT COMPANY
For the three years ended June 30, 2011
Consolidated Statements of Stockholders’ Equity
See notes to consolidated audited financial statements
THE L.S. STARRETT COMPANY
Notes to Consolidated Financial Statements
1. DESCRIPTION OF BUSINESS
The L. S. Starrett Company (the “Company”) is in the business of manufacturing industrial, professional and consumer measuring and cutting tools and related products. The largest consumer of these products is the metalworking industry, but others include automotive, aviation, marine, farm, do-it-yourselfers and tradesmen such as builders, carpenters, plumbers and electricians.
2. SIGNIFICANT ACCOUNTING POLICIES
Principles of consolidation: The consolidated financial statements include the accounts of The L. S. Starrett Company and its subsidiaries, all of which are wholly-owned. All significant intercompany items have been eliminated. The Company’s fiscal year ends on June 30 but previously ended on the last Saturday in June. Fiscal years 2011, 2010 and 2009 represent 52 week years. The fiscal years of the Company’s major foreign subsidiaries previously ended in May for fiscal 2009 and prior. Based upon technology improvements related to the Company’s new ERP system as well as management’s desire for a common financial reporting schedule, the Company eliminated the one month lag in fiscal 2010. The change in reporting for the international subsidiaries was not considered material to the Company’s results of operations, therefore prior periods have not been restated.
Financial instruments and derivatives: The Company’s financial instruments consist primarily of cash, investments and receivables, current liabilities and long term debt. Current assets and liabilities, except investments, are stated at cost, which approximates fair market value. Long-term debts, which are at current market interest rates, also approximate fair market value. On June 30, 2009, the Company entered into a new Loan and Security Agreement with TD Bank, N.A. and paid off its Reducing Revolver with Bank of America. The Company’s U.K. subsidiary entered into various forward exchange contracts during fiscal 2011. The amount of contracts outstanding as of June 30, 2011 and June 30, 2010 (foreign subsidiary year-end) amounted to $10.7 million and $11.8 million (dollar equivalent), respectively. The values of these contracts do not differ materially from the corresponding payables.
Accounts receivable: Accounts receivable consist of trade receivables from customers. The expense for bad debts amounted to $0.3, $0.1, and $0.5 million in fiscal 2011, 2010 and 2009, respectively. In establishing the allowance for doubtful accounts, management considers historical losses, the aging of receivables and existing economic conditions.
Inventories: Inventories are stated at the lower of cost or market. Substantially, all United States inventories are valued using the LIFO method of accounting. All non-U.S. subsidiaries use the FIFO method or the average cost method, as LIFO is not an accepted method of inventory valuation outside the U.S.
Long-lived assets: Buildings and equipment are depreciated using straight-line and accelerated methods over estimated useful lives as follows: buildings and building improvements 10 to 50 years, machinery and equipment 3 to 12 years. Leases are capitalized under the criteria set forth in ASC 840, “Leases” which establishes the four criteria of a capital lease. At least one of the four following criteria must be met for a lease to be considered a capital lease: a transfer of ownership of the property to the lessee by the end of the lease term; a bargain purchase option; a lease term that is greater than or equal to 75 percent of the economic life of the leased property; present value of the future minimum lease payments equals or exceeds 90 percent of the fair market value of the leased property. If none of the aforementioned criteria are met, the lease will be an operating lease. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less cost to sell. A gain or loss is recorded on individual fixed assets when retired or disposed of. Included in buildings and building improvements and machinery and equipment at June 30, 2011 and June 26, 2010 were $5.0 million and $4.3 million, respectively, of construction in progress. Also included in machinery and equipment at June 30, 2011 and June 26, 2010 were $0.5 million and $0.5, respectively, of capitalized interest cost. Repairs and maintenance of equipment are expensed as incurred.
Intangible assets and goodwill: Intangibles are recorded at cost and are amortized on a straight-line basis over a 5 year period. Patents are amortized over a 15 year basis. Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired businesses. Goodwill is not subject to amortization but is tested for impairment annually and at any time when events suggest impairment may have occurred. The Company assesses the fair value of its goodwill using impairment tests, generally based upon a discounted cash flow methodology. The discounted cash flows are estimated utilizing various assumptions regarding future revenue and expenses, working capital, terminal value and market discount rates. In the event that the carrying value of goodwill exceeds the fair value of the goodwill, an impairment loss would be recorded for the amount of that excess. There was no goodwill recorded as of June 30, 2011 and June 26, 2010.
Revenue recognition: Sales of merchandise and freight billed to customers are recognized when title and risk of loss has passed to the customer, no significant post delivery obligations remain and collection of the resulting receivable is reasonably assured. Sales are presented net of provisions for cash discounts, returns, customer discounts (such as volume or trade discounts), cooperative advertising and other sales related discounts. Cooperative advertising payments made to customers are included as advertising expense in selling, general and administrative in the Consolidated Statements of Operations. While the Company does allow its customers the right to return in certain circumstances, revenue is not deferred, but rather a reserve for sales returns is provided based on experience, which historically has not been significant.
Advertising costs: The Company’s policy is to generally expense advertising costs as incurred, except catalogs costs, which are deferred until mailed. Advertising costs were expensed as follows: $5.1 million in fiscal 2011, $5.0 million in fiscal 2010 and $4.6 million in fiscal 2009.
Freight costs: The cost of outbound freight absorbed by the Company for customers or the cost for inbound freight included in material purchase cost are both included in cost of sales.
Warranty expense: The Company’s warranty obligation is generally one year from shipment to the end user and is affected by product failure rates, material usage, and service delivery costs incurred in correcting a product failure. Any such failures tend to occur soon after shipment. Historically, the Company has not incurred significant warranty expense and consequently its warranty reserves are not material. In the event a material warranty liability is deemed probable, a reserve will be established for the event.
Pension and Other Postretirement Benefits:
The Company has two defined benefit pension plans, one for U.S. employees and another for U.K. employees. The Company also has defined contribution plans. In addition, certain U.S. employees participate in an Employee Stock Ownership Plan (ESOP).
The Company sponsors both funded and unfunded U.S. and non-U.S. defined benefit pension plans covering the majority of our U.S. employees and U.K. retirees. The Company also sponsors postretirement benefit plans that provide health care benefits and life insurance coverage to eligible U.S. retirees. In 2011, the Company elected to change our method of recognizing certain actuarial gains and losses. Previously, the market related value of plan assets for the U.S. plan was equal to fair value, and the market-related value of plan assets for the U.K. plan, was based on a calculated five-year moving average of market value. Actuarial gains and losses were recognized in other comprehensive income as of the measurement date. Net actuarial gains or losses in excess of ten percent (10%) of the greater of the market-related value of plan assets or of the plans’ projected benefit obligation (the corridor) were amortized in net periodic benefit cost over the average remaining service period (currently fourteen-years). The primary factors contributing to actuarial gains and losses are changes in the discount rate used to value pension obligations as of the measurement date each year and the differences between expected and actual returns on plan assets.
Under the Company’s new accounting method, both plans will use fair value as the market-related value of plan assets and continue to recognize actuarial gains or losses within the corridor in other comprehensive income but instead of amortizing net actuarial gains or losses in excess of the corridor in future periods, excess gains and losses will be recognized in net periodic (benefit) cost as of the plan measurement date, which is the same as the fiscal year end of the Company (MTM adjustment). This change in accounting method is a permitted option which results in immediate recognition of excess net actuarial gains and losses in net periodic benefit cost instead of in other comprehensive income. Immediate recognition in net periodic benefit cost could potentially increase the volatility of net periodic benefit cost. The MTM adjustments to net periodic benefit cost for 2011, 2010 and 2009 were $0.0, $9.4, and $32.5 million, respectively. The accounting for the remaining components of net periodic pension cost, primarily service, interest costs and expected return on plan assets will be unchanged (On-going Pension Expense).
This change has been reported through retrospective application of the new policy to all periods presented. The impacts of all adjustments made to the consolidated financial statements are summarized below (in thousands, except per share):
Income taxes: Deferred tax expense results from differences in the timing of certain transactions for financial reporting and tax purposes. Deferred taxes have not been recorded on approximately $67.1 million of undistributed earnings of foreign subsidiaries as of June 30, 2011 or the related unrealized translation adjustments because such amounts are considered permanently invested. In addition, it is possible that remittance taxes, if any, would be reduced by U.S. foreign tax credits. Valuation allowances are recognized if, based on the available evidence, it is more likely than not that some portion of the deferred tax assets will not be realized.
Sales and use tax: Sales and use tax is recorded as incurred and represents a cost of certain purchased materials.
Research and development: Research and development costs were expensed as follows: $1.5 million in fiscal 2011, $0.9 million in fiscal 2010 and $1.6 million in fiscal 2009.
Earnings per share (EPS): Basic EPS excludes dilution and is computed by dividing earnings available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution by securities that could share in the earnings. The Company had 19,236, 12,687, and 5,501 of potentially dilutive common shares in fiscal 2011, 2010 and 2009, respectively, resulting from shares issuable under its stock option plan. For fiscal year 2011, these shares had no impact on the calculated per share amounts due to their magnitude. These additional shares are not used for the diluted EPS calculation in loss years.
Translation of foreign currencies: Assets and liabilities are translated at exchange rates in effect on reporting dates, and income and expense items are translated at average rates or rates in effect on transaction dates as appropriate. The resulting differences of translating assets and liabilities due to changing exchange rates are charged or credited directly to the “Accumulated Other Comprehensive Loss” account included as part of stockholders’ equity.
Use of accounting estimates: The preparation of the financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of sales and expenses during the reporting period. Judgments, assumptions and estimates are used for, but not limited to, the allowance for doubtful accounts receivable and returned goods; inventory allowances; income tax reserves; employee turnover, discount, and return rates used to calculate pension obligations; normal expense accruals such as workers compensation and employee medical expenses. Amounts ultimately realized could differ from those estimates.
Treasury stock: Treasury stock is accounted for using the par value method. The number of treasury shares held by the Company at June 30, 2011 and June 26, 2010 was 1,668,945 and 1,689,870 respectively.
Other: Accounts payable and accrued expenses at June 30, 2011 and June 26, 2010 consist primarily of accounts payable ($13.1 million and $13.0 million), accrued benefits ($0.9 million and $1.2 million) and accrued taxes other than income ($3.1 million and $1.2 million) and accrued expenses and other ($4.9 million and $2.3 million).
Reclassifications: Certain reclassifications have been made to the prior periods as a result of the current year presentation with no effect on net earnings.
3. CASH AND INVESTMENTS
As of June 30, 2011, the company’s U.K. subsidiary held a $6.4 million six month fixed rate deposit.
The investments at June 26, 2010 are AAA rated Puerto Rico debt obligations that had maturities less than one year. On July 1, 2010, these bonds were redeemed at face value. Cash and investments held in foreign locations amounted to $18.9 million and $16.2 million at June 30, 2011 and June 26, 2010, respectively. Of this amount, $4.1 million in U.S. dollar equivalents were held in British Pound Sterling and $10.5 million in U.S. dollar equivalents were held in Brazilian Real.
On October 1, 2008, the Company adopted ASC 820 “Fair Value Measurements”, which defines and establishes a framework for measuring fair value and expands disclosures about fair value instruments. In accordance with ASC 820, the Company has categorized its financial assets, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy as set forth below. The Company does not have any financial liabilities that are required to be measured at fair value on a recurring basis. If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.
Financial assets recorded on the balance sheets are categorized based on the inputs to the valuation techniques as follows:
As of June 30, 2011 and June 26, 2010, the Company’s Level 1 financial assets were as follows (in thousands):
Inventory consists of the following (in thousands):