Worthington Industries 10-K 2006
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended May 31, 2006
For the transition period from to
Commission File Number 1-8399
WORTHINGTON INDUSTRIES, INC.
(Exact name of Registrant as specified in its charter)
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
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 ¨
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 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 Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
YES ¨ NO x
The aggregate market value of the Common Shares (the only common equity) of the Registrant held by non-affiliates of the Registrant, based on the closing price on the New York Stock Exchange on November 30, 2005 was approximately $1,757,447,872.
The number of Registrants Common Shares issued and outstanding as of August 1, 2006, was 88,807,354.
DOCUMENT INCORPORATED BY REFERENCE
Selected portions of the Registrants Proxy Statement to be furnished to shareholders of the Registrant in connection with the Annual Meeting of Shareholders to be held on September 27, 2006, are incorporated by reference into Part III of this Form 10-K to the extent provided herein.
TABLE OF CONTENTS
SAFE HARBOR STATEMENT
Selected statements contained in this Annual Report on Form 10-K, including, without limitation, in PART I Item 1. Business and PART II Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, constitute forward-looking statements as that term is used in the Private Securities Litigation Reform Act of 1995 (the Act). These forward-looking statements include, without limitation, statements relating to:
Because they are based on beliefs, estimates and assumptions, forward-looking statements are inherently subject to risks and uncertainties that could cause actual results to differ materially from those projected. Any number of factors could affect actual results, including, without limitation:
Any forward-looking statements in this Annual Report on Form 10-K are based on current information as of the date of this Form 10-K, and we assume no obligation to correct or update any such statements in the future, except as required by applicable law.
Item 1. Business
Worthington Industries, Inc., an Ohio corporation (individually, the Registrant or Worthington Industries or, together with its subsidiaries, Worthington), is primarily a diversified metal processing company, focused on value-added steel processing and manufactured metal products, such as metal framing, pressure cylinders, automotive past-model service stampings and, through joint ventures, metal ceiling grid systems and laser-welded blanks.
Worthington was founded in 1955 and as of August 1, 2006, operates 46 manufacturing facilities worldwide and holds equity positions in seven joint ventures, which operate an additional 15 manufacturing facilities worldwide.
Worthington is headquartered at 200 Old Wilson Bridge Road, Columbus, Ohio 43085, telephone (614) 438-3210. The common shares of Worthington Industries are traded on the New York Stock Exchange under the symbol WOR.
Worthington made changes during the second quarter of the fiscal year ended May 31, 2006 (fiscal 2006) to the internal organizational and reporting structure, affecting the composition of its business segments. The Automotive Body Panels reporting segment, consisting of The Gerstenslager Company, which was previously combined with Steel Processing in the Processed Steel Products reportable segment, was moved to the Other category and the Processed Steel Products reportable segment was renamed Steel Processing. Dietrich Construction Group was formed and includes Dietrich Building Systems, which was previously included in the Metal Framing reportable segment, Dietrich Residential Construction, and a research and development project in China. Dietrich Construction Group is now included in the Construction Services reporting segment, and is reported in the Other category. All segment financial information for the prior periods has been reclassified to reflect these changes.
Operations are currently reported in three principal reportable segments: Steel Processing, Metal Framing and Pressure Cylinders. All financial information included in this Annual Report on Form 10-K for periods prior to the second quarter of fiscal 2006 has been reclassified to reflect the segment changes discussed in the immediately preceding paragraph. The Steel Processing segment consists of the Worthington Steel business unit (Worthington Steel). The Metal Framing segment consists of the Dietrich Metal Framing business unit (Dietrich). The Pressure Cylinders segment consists of the Worthington Cylinder business unit (Worthington Cylinders). The Other category includes the Automotive Body Panels, Construction Services and Steel Packaging operating segments and also includes income and expense items not allocated to the reportable segments.
Worthington holds equity positions in seven joint ventures, further discussed below under the subheading Joint Ventures. One joint venture is consolidated while the remaining six joint ventures are unconsolidated.
During fiscal 2006, the Steel Processing, Metal Framing and Pressure Cylinders segments served approximately 1,050, 2,075 and 2,325 customers, respectively, located primarily in the United States. Foreign sales account for less than 10% of consolidated net sales and are comprised primarily of sales to customers in Canada and Europe. No single customer accounts for over 5% of consolidated net sales.
Worthington Industries maintains an Internet web site at www.worthingtonindustries.com. This uniform resource locator, or URL, is an inactive textual reference only and is not intended to incorporate Worthington Industries web site into this Annual Report on Form 10-K. Annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports, filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the Exchange Act), are available free of charge, on or through the web site, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (the SEC).
On June 13, 2005, Worthington Industries announced that its board of directors had authorized the repurchase of up to 10.0 million of the outstanding common shares of Worthington Industries. The purchases may be made from time to time, on the open market or in private transactions, with consideration given to the market price of the common shares, the nature of other investment opportunities, cash flows from operations and general economic conditions. No repurchases of common shares pursuant to this authorization occurred during fiscal 2006.
On September 27, 2005, Dietrich entered into a joint development agreement with NOVA Chemicals Corporation to evaluate and commercialize novel construction products that combine the structural benefits of light-gauge steel framing with the thermal and moisture retardant properties of expandable polystyrene. On July 20, 2006, Worthington announced that Dietrich had formed a 50:50 joint venture with NOVA Chemicals Corporation that is intended to develop and manufacture durable, energy-saving composite construction products and systems. The joint ventures current focus is on developing cost-effective insulated metal framing panels intended to remove significant obstacles to using steel framing products for exterior walls in areas where interior/exterior temperature variations may cause condensation.
On September 29, 2005, Worthington Industries amended and restated its $435,000,000 long-term unsecured revolving credit facility. The amended and restated facility provides for an extension of the revolving credit commitments to September 2010; replaces the leverage ratio (debt-to-EBITDA) financial covenant with an interest coverage ratio (EBITDA-to-interest expense) financial covenant; and reduces the facility fees payable. Borrowings under the amended and restated facility may be used to fund general corporate purposes including working capital, capital expenditures, acquisitions and dividends. The facility was unused at May 31, 2006.
On October 17, 2005, Worthington acquired the remaining 50% interest in Dietrich Residential Construction, LLC from its partner, Pacific Steel Construction, for $3,773,000 cash and debt assumption of $4,153,000. This acquisition provides panelizing capabilities and further opens the door to United States military housing and residential housing markets.
In November 2005, Dietrich launched the UltraSTEEL drywall metal framing line in Florida. As of May 31, 2006, the UltraSTEEL product line had been introduced into markets in the Southeast and Northeast and machinery conversions were underway to make UltraSTEEL products in the Midwest and Southwest. A license from Hadley Industries PLC (Hadley) grants Dietrich the exclusive rights to manufacture and sell metal framing using Hadleys patented UltraSTEEL technology in North America. In February 2006, Dietrich entered into an exclusive sublicensing arrangement with Clark-Western, which will become the only other producer of UltraSTEEL metal framing products for the North American market.
On November 30, 2005, Worthington acquired the remaining 40% interest in Dietrich Metal Framing Canada, Inc. from the minority shareholder, Encore Coils Holdings Ltd., for $3,003,000 cash.
On April 25, 2006, Worthington Steel sold its 50% equity interest in Acerex, S.A. de C.V., a joint venture operating a steel processing facility in Monterrey, Mexico, to its partner Ternium, S.A. for $44,604,000 cash.
The Steel Processing reportable segment consists of the Worthington Steel business unit. For fiscal 2006, the fiscal year ended May 31, 2005 (fiscal 2005), and the fiscal year ended May 31, 2004 (fiscal 2004), the percentage of consolidated net sales generated by the Steel Processing segment was 51.3%, 58.8%, and 53.2%, respectively.
Worthington Steel is one of Americas largest independent intermediate processors of flat-rolled steel. It occupies a niche in the steel industry by focusing on products requiring exact specifications. These products typically cannot be supplied as efficiently by steel mills or steel end-users.
The Steel Processing segment owns and operates eight manufacturing facilities, one each located in Alabama, Indiana, Kentucky, Maryland and Michigan, and three located in Ohio. The consolidated joint venture, Spartan Steel Coating, LLC (Spartan), owns and operates a manufacturing facility in Michigan.
Worthington Steel serves approximately 1,050 customers from these facilities, principally in the automotive, construction, lawn and garden, hardware, furniture, office equipment, electrical control, leisure and recreation, appliance, farm implements, HVAC, container, and aerospace markets. No single customer represented greater than 8% of net sales for the Steel Processing segment during fiscal 2006.
Worthington Steel buys coils of steel from major integrated steel mills and mini-mills and processes them to the precise type, thickness, length, width, shape, temper and surface quality required by customer specifications. Computer-aided processing capabilities include, among others:
Worthington Steel also toll processes steel for steel mills, large end-users, service centers, and other processors. Toll processing is different from typical steel processing because the mill, end-user, or other party retains title to the steel and has the responsibility for selling the end product. Toll processing enhances Worthington Steels participation in the market for wide sheet steel and large standard orders, which is a market generally served by steel mills rather than by intermediate steel processors.
The steel processing industry is fragmented and highly competitive. There are many competitors, including other independent intermediate processors. Competition is primarily on the basis of product quality, ability to meet delivery requirements, and price. Technical service and support for material testing and customer-specific applications enhance the quality of products (See Item 1. Business Technical Services). However, the extent to which technical service capability has improved Worthington Steels competitive position has not been quantified. Worthington Steels ability to meet tight delivery schedules is, in part, based on the proximity of facilities to customers, suppliers, and one another. The extent to which plant location has impacted Worthington Steels competitive position has not been quantified. Processed steel products are priced competitively, primarily based on market factors, including, among other things, the cost and availability of raw materials, transportation and shipping costs, and overall economic conditions in the United States and abroad.
The Metal Framing reportable segment, consisting of the Dietrich Metal Framing business unit, designs and produces metal framing components and systems and related accessories for the commercial and residential construction markets within the United States and Canada. For fiscal 2006, fiscal 2005, and fiscal 2004, the percentage of consolidated net sales generated by the Metal Framing segment was 27.5%, 27.4%, and 27.4%, respectively.
Metal Framing products include steel studs and track, floor and wall system components, roof trusses and other building product accessories, such as metal corner bead, lath, lath accessories, clips, fasteners and vinyl beads and trim.
In November 2005, Dietrich successfully launched its UltraSTEEL drywall metal framing product line in Florida. The UltraSTEEL product line is being readily accepted by architects, engineers and material specifiers for its performance capabilities and by contractors for its ease of use. As of May 31, 2006, UltraSTEEL had also been introduced into additional markets in the Southeast and Northeast and machinery conversions were underway to make UltraSTEEL products in the Midwest and Southwest for sales in those markets. In February 2006, Dietrich entered into an exclusive sublicensing agreement with Clark-Western, which will become the only other producer of UltraSTEEL metal framing products for the North American market.
The Metal Framing segment has 23 operating facilities located throughout the United States: one each in Colorado, Georgia, Hawaii, Illinois, Kansas, Maryland, Massachusetts, New Jersey, South Carolina and Washington; two each in Arizona, California, Indiana, Ohio and Texas; and three in Florida. This segment also has three operating facilities in Canada: one each in British Columbia, Ontario and Quebec.
Dietrich is the largest metal framing manufacturer in the United States, supplying between 40% and 45% of the metal framing products and accessories sold in the United States. Dietrich is the second largest metal framing manufacturer in Canada with a market share of between 15% and 20%. Dietrich serves approximately 2,075 customers, primarily consisting of wholesale distributors, commercial and residential building contractors, and mass merchandisers. During fiscal 2006, Dietrichs two largest customers represented approximately 15% and 12%, respectively, of the net sales for the segment, while no other customer represented more than 5% of net sales for the segment.
The light-gauge metal framing industry is very competitive. Dietrich competes with seven large regional or national competitors and numerous small, more localized competitors, primarily on the basis of quality, service and price. As is the case in the Steel Processing segment, the proximity of facilities to customers and their project sites provides a service advantage and impacts freight and shipping costs. The products sold are transported by both common and dedicated carriers. The extent to which facility location has impacted Dietrichs competitive position has not been quantified.
Dietrich uses numerous trademarks and patents in its business. Dietrich licenses from Hadley the UltraSTEEL trademark and the United States and Canadian patents to manufacture UltraSTEEL metal framing and accessory products. The Spazzer® trademark is used in connection with wall component products that are the subject of four United States patents, one foreign patent, one pending United States patent application, and several pending foreign patent applications. The trademark TradeReady® is used in connection with floor-system products that are the subject of four United States patents, seventeen foreign patents, one pending United States patent application, and five pending foreign patent applications. The Clinch-On® trademark is used east of the Rockies in connection with corner bead and metal trim products for gypsum wallboard. Dietrich licenses the SLP-TRK® trademark as well as the patent to manufacture SLP-TRK® slotted track in the United States from Brady Construction Innovations, Inc. Aegis Metal Framing, LLC, an unconsolidated joint venture, uses the Ultra-Span® registered trademark in connection with certain patents for proprietary roof trusses. Dietrich intends to continue to use and renew these registered trademarks. Dietrich also has a number of other patents and trade names relating to specialized products.
The Pressure Cylinders segment consists of the Worthington Cylinders business unit. For fiscal 2006, fiscal 2005, and fiscal 2004, the percentage of consolidated net sales generated by Worthington Cylinders was 15.9%, 13.3%, and 13.8%, respectively.
Worthington Cylinders operates eight manufacturing facilities: three in Ohio, one in Wisconsin, and one each in Austria, Canada, the Czech Republic, and Portugal.
The Pressure Cylinders segment produces a diversified line of pressure cylinders, including low-pressure liquefied petroleum gas (LPG) and refrigerant gas cylinders and high-pressure and industrial/specialty gas cylinders. LPG cylinders are sold to manufacturers, distributors and mass merchandisers and are used for gas barbecue grills, recreational vehicle equipment, residential heating systems, industrial forklifts, propane-fueled camping equipment, hand torches, and commercial/residential cooking (the latter, generally outside North America).
Refrigerant gas cylinders are sold primarily to major refrigerant gas producers and distributors and are used to hold refrigerant gases for commercial and residential air conditioning and refrigeration systems and for automotive air conditioning systems. High-pressure industrial/specialty gas cylinders are sold primarily to gas producers and distributors as containers for gases used in: cutting and welding metals; breathing (medical, diving and firefighting); semiconductor production; beverage delivery; and compressed natural gas systems. Worthington Cylinders also produces recovery tanks for refrigerant gases, air reservoirs for truck and trailer original equipment manufacturers, and Balloon Time® helium kits which include non-refillable cylinders. While a large percentage of cylinder sales are made to major accounts, Worthington Cylinders has approximately 2,325 customers. During fiscal 2006, no single customer represented more than 9% of net sales for the segment.
Worthington Cylinders produces low-pressure steel cylinders with refrigerant capacities of 15 to 1,000 lbs. and steel and aluminum cylinders with LPG capacities of 14.1 oz. to 420 lbs. Low-pressure cylinders are produced by precision stamping, drawing, welding and/or brazing component parts to customer specifications. They are then tested, painted and packaged, as required. High-pressure steel cylinders are manufactured by several processes, including deep drawing, tube spinning and billet piercing. In the United States and Canada, high-pressure and low-pressure cylinders are primarily manufactured in accordance with U.S. Department of Transportation and Transport Canada specifications. Outside the United States and Canada, cylinders are manufactured according to European norm specifications, as well as various other international standards.
In the United States and Canada, Worthington Cylinders has one principal domestic competitor in the low-pressure non-refillable refrigerant market, one principal domestic competitor in the low-pressure LPG cylinder market, and two principal domestic competitors in the high-pressure cylinder market. There are also several smaller foreign competitors in these markets. Worthington Cylinders believes that it has the largest domestic market share in both low-pressure cylinder markets. In the European high-pressure cylinder market, there are several competitors. Worthington Cylinders believes that it is a leading producer in both the high-pressure cylinder and low-pressure non-refillable cylinder markets in Europe. As with Worthingtons other segments, competition is on the basis of service, price and quality.
The Pressure Cylinders segment uses the trade name Worthington Cylinders to conduct business and the registered trademark Balloon Time® to market low-pressure helium balloon kits and intends to continue to use and renew this registered trademark. This intellectual property is important to the Pressure Cylinders segment but is not considered material.
The Other category consists of reporting segments that do not meet the materiality tests for purposes of separate disclosure and other corporate related entities. These reporting segments are Automotive Body Panels, Construction Services and Steel Packaging, which includes the Worthington Steelpac business unit (Steelpac).
The Automotive Body Panels reporting segment, consisting of the Gerstenslager business unit, provides stamping, blanking, assembly, painting, packaging, die management, warehousing, distribution management and other services to customers, primarily in the automotive industry. Gerstenslager is a major supplier to the automotive past-model market and manages more than 3,000 finished good part numbers and more than 11,000 stamping dies/fixture sets for the past- and current-model year automotive and truck manufacturers, both domestic and transplant.
The Construction Services reporting segment consists of Dietrich Building Systems, which designs and builds mid-rise light-gauge steel framed commercial structures and multi-family housing units; Dietrich Residential Construction, which is involved in the supply and construction of metal framing products for, and in the framing of, single family housing, with a focus on military; and a mid-rise light-gauge steel framed construction project in China entered into primarily for research and development purposes.
Steel Packaging consists of Steelpac, which is an ISO-9001: 2000 certified manufacturer of engineered, recyclable steel shipping solutions, designs and manufactures reusable custom crates, racks, and pallets made of steel for supporting, protecting and handling products throughout the shipping process for industries such as automotive, lawn and garden and recreational vehicles.
Segment Financial Data
Financial information for the reportable segments is provided in Item 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Note H Industry Segment Data.
Financial Information About Geographic Areas
Foreign operations and exports represent less than 10% of production and consolidated net sales. Summary information about our foreign operations is set forth in Item 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Note A Summary of Significant Accounting Policies Risks and Uncertainties. For fiscal 2006 and fiscal 2005, Worthington had operations in North America and Europe, while prior years included operations in South America. Net sales by geographic region are provided in Item 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Note H Industry Segment Data.
In fiscal 2006, Worthington purchased approximately four million tons of steel on a consolidated basis. Steel is purchased in large quantities at regular intervals from major primary producers, both domestic and foreign. In the Steel Processing segment, steel is primarily purchased and processed based on specific customer orders. The Metal Framing and Pressure Cylinders segments purchase steel to meet production schedules. Raw materials are generally purchased in the open market on a negotiated spot-market basis at prevailing market prices. Supply contracts are also entered into, some of which have fixed pricing. During fiscal 2006, major suppliers of steel were, in alphabetical order: Gallatin Steel Company; Mittal Steel; North Star BlueScope Steel LLC; Nucor Corporation; SeverStal North America, US Steel Corporation; and WCI Steel, Inc. Alcoa, Inc. was the primary aluminum supplier for the Pressure Cylinders segment in fiscal 2006. Worthington believes its supplier relationships are good.
Worthington employs a staff of engineers and other technical personnel and maintains fully-equipped modern laboratories to support operations. These facilities enable verification, analysis and documentation of the physical, chemical, metallurgical, and mechanical properties of raw materials and products. Technical service personnel also work in conjunction with the sales force to determine the types of flat-rolled steel required for customer needs. Additionally, technical service personnel design and engineer metal framing structures and provide sealed shop drawings to the building construction markets. To provide these services, Worthington maintains a continuing program of developmental engineering with respect to product characteristics and performance under varying conditions. Laboratory facilities also perform metallurgical and chemical testing as dictated by the regulations of the U.S. Department of Transportation, Transport Canada, and other associated agencies, along with International Organization for Standardization (ISO) and customer requirements. All design work complies with current local and national building code requirements. IAS (International Accreditations Service, Incorporated) accredited product-testing laboratory supports these design efforts.
Our financial results are generally lower in the third quarter of our fiscal year, primarily due to reduced activity in the building and construction industry as a result of the weather, as well as customer plant shutdowns in the automotive industry due to holidays.
As of May 31, 2006, Worthington employed approximately 8,200 employees in its operations, excluding the unconsolidated joint ventures, approximately 11% of whom were covered by collective bargaining agreements, including those at the Hammond facility as discussed below. Worthington believes it has good relationships with its employees in general, including those covered by collective bargaining agreements. However, the union employees at the Dietrich facility in Hammond, Indiana have been on strike since May 5, 2006, as the parties have not reached
agreement on a new contract covering the facility. The Hammond facility has continued to operate during this time period at approximately 90% of pre-strike production levels.
As part of a strategy to selectively develop new products, markets, and technological capabilities and to expand an international presence, while mitigating the risks and costs associated with those activities, Worthington participates in one consolidated and six unconsolidated joint ventures.
See Item 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Note J Investments in Unconsolidated Affiliates for further information about Worthingtons participation in unconsolidated joint ventures.
Worthingtons manufacturing facilities, generally in common with those of similar industries making similar products, are subject to many federal, state and local requirements relating to the protection of the environment. Worthington continually examines ways to reduce emissions and waste and to decrease costs related to environmental compliance. The cost of compliance or capital expenditures for environmental control facilities required to meet environmental requirements are not anticipated to be material when compared with overall costs and capital expenditures and, accordingly, are not anticipated to have a material effect on our financial position, results of operations or cash flows, or the competitive position of the Company.
Item 1A. Risk Factors
Future results and the market price for Worthington Industries common shares are subject to numerous risks, many of which are driven by factors that cannot be controlled or predicted. The following discussion, as well as other sections of this Annual Report on Form 10-K, including Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations, describe certain business risks. Consideration should be given to the risk factors described below as well as those in the Safe Harbor Statement at the beginning of this Form 10-K, in conjunction with reviewing the forward-looking statements and other information contained in this Form 10-K.
Raw Material Prices
Our future operating results may be affected by fluctuations in raw material prices. Our principal raw material is flat-rolled steel, which we purchase from multiple primary steel producers. The steel industry as a whole is very cyclical, and at times availability and pricing can be volatile due to a number of factors beyond our control. These factors include general economic conditions, domestic and worldwide demand, curtailed production at major mills due to factors such as equipment breakdowns, repairs or catastrophic events, labor costs or problems, competition, import duties, tariffs, energy costs, availability and cost of steel inputs (e.g. ore, scrap, coke, energy, etc.), currency exchange rates and those other factors described under Raw Material Availability. This volatility can significantly affect our steel costs. In an environment of increasing prices for steel and other raw materials, competitive conditions may impact how much of the price increases we can pass on to our customers and to the extent we are unable to pass on future price increases in our raw materials to our customers, our financial results could be adversely affected. Also, if steel prices in general decrease, competitive conditions may impact how quickly we must reduce our prices to our customers and we could be forced to use higher-priced raw materials to complete orders for which the sales prices have decreased.
Raw Material Availability
The costs of manufacturing our products and the ability to supply our customers could be negatively impacted if we experience interruptions in deliveries of needed raw materials or supplies. If for any reason our supply of flat-rolled steel or other key raw materials, such as aluminum and zinc, is curtailed or we are otherwise unable to obtain the quantities we need at competitive prices, our business could suffer and our financial results could be adversely affected. Such interruptions might result from a number of factors including events such as a shortage of capacity in the supplier base or of the raw materials, energy or the inputs needed to make steel or other supplies, financial difficulties of suppliers, significant events affecting their facilities, significant weather events, those factors listed under Raw Material Prices or other factors beyond our control. Further, the number of suppliers has decreased in recent years due to industry consolidation and the financial difficulties of certain suppliers, and consolidation may continue. Accordingly, if delivery from a major supplier is disrupted, it may be more difficult to obtain an alternative supply than in the past.
Our business could be harmed if we fail to maintain proper inventory levels. We are required to maintain substantial inventories to accommodate the needs of our customers, including in many cases, short lead times and just-in-time delivery requirements. Although we typically have customer orders in hand prior to placement of our raw material orders for Steel Processing, we anticipate and forecast customer demand for all business segments. We purchase raw materials on a regular basis in an effort to maintain our inventory at levels that we believe are sufficient to satisfy the anticipated needs of our customers based upon orders, customers volume expectations, historic buying practices and market conditions. Inventory levels in excess of customer demand may result in the use of higher-priced inventory to fill orders reflecting lower sales prices, if steel prices have significantly decreased. These events could adversely affect our financial results. Conversely, if we underestimate demand for our products or if our suppliers fail to supply quality products in a timely manner, we may experience inventory shortages. Inventory shortages might result in unfilled orders, negatively impact customer relationships, and result in lost revenues, any of which could harm our business and adversely affect our financial results.
Economic or Industry Downturns
Downturns or weakness in the economy in general or in key industries, such as commercial construction or automotive, may adversely affect our customers, which may cause the demand for our products and services to decline and adversely affect our financial results. Many of our customers are in industries and businesses that are cyclical in nature and affected by changes in general economic conditions or conditions specific to their respective markets, such as the commercial construction and automotive industries. Product demand in our customers end markets is based on numerous factors such as interest rates, general economic conditions, consumer confidence, and other factors beyond our control. Downturns in demand from the commercial construction industry, the automotive industry or any of the other industries we serve, or a decrease in the margins that we can realize from sales of our products to customers in any of these industries, could adversely affect our financial results.
Reduced commercial construction activity, especially office building, could negatively impact our financial results. The commercial construction market is a key end market with approximately 41% of our net sales going to that market in fiscal 2006. If commercial construction activity in the United States, in general, or by one or more of our major customers, in particular, were to be reduced significantly, it could negatively affect our sales and financial results.
Reduced automotive/truck production and the financial difficulties of customers in this market could negatively impact our financial results. The automotive and truck market remains a key customer group with approximately 33% of our net sales derived from that market in fiscal 2006. Total domestic automotive production in fiscal 2006 was at a relatively high level on an historical basis. If domestic automotive production, in general, or by one or more of our major domestic customers, in particular, were to be reduced significantly, it could negatively affect our sales and financial results.
The financial difficulties and internal strategies of customers could adversely affect us. A portion of our business is highly dependent on automotive manufacturers, many of which have publicly announced plans to reduce production levels and eliminate excess manufacturing capacity including plans to eliminate jobs and reduce costs. The financial difficulties of certain customers and the efforts under way by our customers to improve their overall financial condition could result in numerous changes that are beyond our control, including additional unannounced customer plant closings, decreased production, changes in product mix or distribution patterns, volume reductions, labor disruptions, changes or disruptions in our accounts receivable, mandatory reductions or other unfavorable changes in our pricing, terms or service conditions or market share losses, as well as other changes we may not accurately anticipate. These events could adversely impact our financial results.
The loss of significant volume from key customers could adversely affect us. In fiscal 2006, our largest customer accounted for approximately 5% of our gross sales, and our ten largest customers accounted for approximately 25% of our gross sales. A significant loss of or decrease in business from customers could have an adverse effect on our sales and financial results if we cannot obtain replacement business. Also, due to consolidation in the industries we serve, including the commercial construction, automotive and retail industries, our gross sales may be increasingly sensitive to deterioration in the financial condition of, or other adverse developments with respect to, one or more of our top customers.
Our business is highly competitive, and increased competition could negatively impact our financial results. Generally, the markets in which we conduct business are highly competitive. Competition for most of our products is primarily on the basis of product quality, ability to meet delivery requirements, and price. Increased competition could cause us to lose market share, increase expenditures, lower our margins or offer additional services at a higher cost to us, which could adversely impact our financial results.
In certain applications, steel competes with other materials, such as aluminum (particularly in the automobile industry), cement and wood (particularly in the construction industry), composites, glass and plastic. Prices of all of these materials fluctuate widely and differences between them and steel prices may adversely affect
demand for our products and/or encourage substitution, which could adversely affect prices and demand for steel products.
Freight and Energy
The availability and cost of freight and energy, such as electricity, natural gas, and diesel fuel, is important in the manufacture and transport of our products. Our operating costs increase when energy costs rise. During periods of increasing freight and energy costs, we might not be able to fully recover our operating cost increases through price increases without reducing demand for our products. Our financial results could be adversely affected if we are unable to pass all of the increases on to our customers or if we are unable to obtain the necessary freight and energy.
We are subject to information system security risks and systems integration issues that could disrupt our internal operations. We are dependent upon information technology for the distribution of information internally and also to our customers and suppliers. This information technology is subject to damage or interruption from a variety of sources, including but not limited to computer viruses, security breaches and defects in design. There also could be system or network disruptions if new or upgraded business management systems are defective or are not installed properly. We are currently in the process of implementing a new software-based enterprise resource planning system (ERP). For more information related to the new ERP, see Part II Item 9A. Controls and Procedures New ERP System. Various measures have been implemented to manage our risks related to information system and network disruptions, but a system failure or failure to implement new systems properly could negatively impact our operations and financial results.
Disruptions to our business or the business of our customers or suppliers, could adversely impact our operations and financial results. Business disruptions, including increased costs for or interruptions in the supply of energy or raw materials, resulting from severe weather events such as hurricanes, floods, blizzards, from casualty events, such as fires or material equipment breakdown, from acts of terrorism, or from other events such as required maintenance shutdowns, can cause interruptions to our businesses as well as the operations of our customers and suppliers. Such interruptions can have an adverse effect on our operations and financial results.
Economic, political and other risks associated with foreign operations could adversely affect our international financial results. Although the majority of our business activity takes place in the United States, we derive a portion of our revenues and earnings from operations in foreign countries, and are subject to risks associated with doing business internationally. Our sales originating outside the United States represented approximately 10% of our consolidated net sales in fiscal 2006. We have wholly-owned facilities in Austria, Canada, the Czech Republic, and Portugal and joint venture facilities in China, France, Mexico, Spain and the United Kingdom. The risks of doing business in foreign countries include the potential for adverse changes in the local political climate, in diplomatic relations between foreign countries and the United States or in government policies, laws or regulations, terrorist activity that may cause social disruption, logistical and communications challenges, costs of complying with a variety of laws and regulations, difficulty in staffing and managing geographically diverse operations, deterioration of foreign economic conditions, currency rate fluctuations, foreign exchange restrictions, differing local business practices and cultural considerations, restrictions on imports and exports or sources of supply and changes in duties or taxes. We believe that our business activities outside of the United States involve a higher degree of risk than our domestic activities.
We may not be able to manage and integrate future acquisitions successfully. Some of our growth has been through acquisitions. We continue to seek additional businesses to acquire in the future. There are no assurances, however, that any acquisition opportunities will arise or if they do, that they will be consummated, or that any
needed additional financing will be available on satisfactory terms when required. In addition, acquisitions involve risks that the businesses acquired will not perform in accordance with expectations, that business judgments concerning the value, strengths and weaknesses of businesses acquired will prove incorrect, that the acquired businesses may not be integrated successfully and that the acquisitions may strain our management resources.
Accounting & Tax Estimates
We are required to make accounting and tax-related estimates and judgments in preparing our consolidated financial statements. In preparing our consolidated financial statements in accordance with accounting principles generally accepted in the United States, we make certain estimates and assumptions that affect the accounting for and recognition of assets, liabilities, revenues and expenses. These estimates and assumptions must be made because certain information that is used in the preparation of our consolidated financial statements is dependent on future events, cannot be calculated with a high degree of precision from data available or is not capable of being readily calculated based on generally accepted methodologies. In some cases, these estimates are particularly difficult to determine and we must exercise significant judgment. The estimates and the assumptions having the greatest amount of uncertainty, subjectivity and complexity are related to our accounting for bad debts, returns and allowances, self-insurance, derivatives, deferred income taxes, and asset impairments. Actual results could differ materially from the estimates and assumptions that we use, which could have a material adverse effect on our financial condition and results of operations.
Claims and Insurance
Adverse claims experience, to the extent not covered by insurance, may have an adverse effect on our financial results. We self-insure a significant portion of our potential liability for workers compensation costs, product liability claims and recall exposure, general liability claims, employee medical claims and casualty risks. In order to reduce risk and better manage our overall loss exposure, we purchase stop-loss or other insurance from licensed insurance carriers that covers most claims in excess of the deductible or retained amounts. We maintain an accrual for the estimated cost to resolve open claims as well as an estimate of the cost of claims that have been incurred but not reported. The occurrence of a significant claims, losses on recalls, our failure to adequately reserve for such claims, a significant cost increase to maintain our insurance, or the failure of our insurance provider to perform, could have an adverse impact on our financial results.
Our principal shareholder may have the ability to exert significant influence in matters requiring a shareholder vote and could delay, deter or prevent a change in control of Worthington Industries. Pursuant to our charter documents, certain matters such as those in which a person would attempt to acquire or take control of the Company, must be approved by the vote of 75% of Worthington Industries outstanding voting power. Approximately 15.9% of our outstanding common shares may be voted by John H. McConnell, our Founder. As a result of his voting power, John H. McConnell may have the ability to exert significant influence in these matters and other proposals which our shareholders vote upon.
Worthington Industries has no unresolved SEC staff comments.
Item 2. Properties
The principal corporate offices, as well as the corporate offices for Worthington Cylinders and Worthington Steel, are located in a leased office building in Columbus, Ohio. As of May 31, 2006, Worthington owned or leased a total of approximately 9,200,000 square feet of space for operations, of which approximately 8,800,000 square feet is devoted to manufacturing, product distribution and sales offices. Major leases contain renewal options for periods of up to ten years. For information concerning rental obligations, see the discussion of contractual obligations under
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Contractual Cash Obligations and Other Commercial Commitments as well as Item 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Note L Operating Leases. Distribution and office facilities provide adequate space for operations and are well maintained and suitable.
Excluding joint ventures, Worthington operates 46 manufacturing facilities and two warehouses. The facilities are generally well maintained and in good operating condition, and are believed to be sufficient to meet current needs.
The Steel Processing reportable segment operates eight manufacturing facilities, seven of which are owned and one of which is leased. These facilities are located in Alabama, Indiana, Kentucky, Maryland, Michigan and Ohio (3). This segment also maintains a warehouse in Columbus, Ohio. In addition, the segment includes Spartan, a consolidated joint venture which owns and operates a manufacturing facility in Michigan.
The Metal Framing segment operates 26 manufacturing facilities: 23 in the United States and three in Canada. In the United States, these facilities are located in Arizona (2), California (2), Colorado, Florida (3), Georgia, Hawaii, Illinois, Indiana (2), Kansas, Maryland, Massachusetts, New Jersey, Ohio (2), South Carolina, Texas (2), and Washington. The facilities in Canada are located in British Columbia, Ontario and Quebec. Of these facilities, 12 are leased and 14 are owned. This segment also leases administrative offices in Pittsburgh and Blairsville, Pennsylvania.
The Pressure Cylinders segment operates eight manufacturing facilities. The manufacturing facilities located in Ohio (3), Austria, Canada, and the Czech Republic are all owned, and the manufacturing facilities located in Wisconsin and Portugal are leased.
Steelpac operates one leased manufacturing facility located in Pennsylvania. Gerstenslager owns and operates two manufacturing facilities, both located in Ohio. Construction Services has administrative offices in Ohio, Tennessee and China.
The Spartan consolidated joint venture owns and operates one manufacturing facility in Michigan which is included in the Steel Processing segment. The unconsolidated joint ventures operate 14 manufacturing facilities, located in Indiana, Maryland, Michigan (3), Missouri, Nevada and Ohio, domestically, and in China, France, Mexico (2), Spain, and the United Kingdom, internationally.
Item 3. Legal Proceedings
Various legal actions, which generally have arisen in the ordinary course of business, are pending against Worthington. None of this pending litigation, individually or collectively, is expected to have a material adverse effect on our financial position, results of operation or cash flows.
Item 4. Submission of Matters to a Vote of Security Holders
Supplemental Item. Executive Officers of the Registrant.
The following table lists the names, positions held and ages of the Registrants executive officers as of August 1, 2006:
John P. McConnell has served as Worthington Industries Chief Executive Officer since June 1993, as a director of Worthington Industries continuously since 1990, and as Chairman of the Board of Worthington Industries since September 1996. Mr. McConnell also serves as the Chairman of the Executive Committee of Worthington Industries Board of Directors. Mr. McConnell has served in various positions with Worthington Industries since 1975.
John S. Christie has served as President and as a director of Worthington Industries continuously since June 1999. He became interim Chief Financial Officer of Worthington Industries in September 2003 and Chief Financial Officer in January 2004. He also served as Chief Operating Officer of Worthington Industries from June 1999 until September 2003.
Dale T. Brinkman has served as Worthington Industries Vice President-Administration since 1998 and General Counsel since 1982. He has been Secretary of Worthington Industries since 2000 and served as Assistant Secretary of Worthington Industries from 1982 to 2000.
Harry A. Goussetis has served as President of Worthington Cylinder Corporation since December 2005. He served as Vice President Human Resources for Worthington Industries from January 2001 to December 2005, and held various other positions with Worthington Industries from November 1983 to January 2001.
Joe W. Harden has served as President of The Worthington Steel Company since February 2003. From February 1999 through February 2003, Mr. Harden served as President of Buckeye Steel Castings Company in Columbus, Ohio, which filed a voluntary petition under the Federal Bankruptcy Act in December 2002.
Lester V. Hess has served Worthington Industries as Treasurer since February 2006. Prior thereto he served Worthington Industries as Assistant Treasurer from November 2003 to February 2006; and as Director of Treasury from August 2002 to November 2003. Prior to August 2002, Mr. Hess served in various accounting and finance positions with MeadWestvaco Corporation (formerly, The Mead Corporation), a $6 billion global packaging company, for more than five years.
Edmund L. Ponko, Jr. has served as President of Dietrich Industries, Inc. since June 2001. Prior thereto, Mr. Ponko served Dietrich Industries, Inc. as Executive Vice President from 1998 to 2001, as marketing manager from 1987 to 1998, and as a sales representative from 1981 to 1987.
Ralph V. Roberts has served as Senior Vice President-Marketing of Worthington Industries since January 2001. From June 1998 through January 2001, he served as President of The Worthington Steel Company. Prior to that time, Mr. Roberts served Worthington Industries since 1973 in various positions, including Vice President-Corporate Development and President of the WAVE joint venture.
George P. Stoe has served as Executive Vice President and Chief Operating Officer of Worthington Industries since December 2005 and as President of Worthington Cylinder Corporation from January 2003 to December 2005. Mr. Stoe served as President of Zinc Corporation of America, the nations largest zinc producer, located in Monaca, Pennsylvania, from November 2000 until May 2002.
Richard G. Welch has served as Controller of Worthington Industries since March 2000. He served as Assistant Controller of Worthington Industries from September 1999 to March 2000.
Virgil L. Winland has served as Senior Vice President-Manufacturing of Worthington Industries since January 2001. He has served in various positions with Worthington Industries since 1971, including President of Worthington Cylinder Corporation from June 1996 through January 2001.
Executive officers serve at the pleasure of the directors of the Registrant. There are no family relationships among any of the Registrants executive officers or directors. No arrangements or understandings exist pursuant to which any individual has been, or is to be, selected as an executive officer of the Registrant.
Item 5. Market for Registrants Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
The common shares of Worthington Industries, Inc. (Worthington Industries) trade on the New York Stock Exchange (NYSE) under the symbol WOR and are listed in most newspapers as WorthgtnInd. As of August 1, 2006, Worthington Industries had approximately 8,200 registered shareholders. The following table sets forth (i) the low and high closing prices and the closing price for Worthington Industries common shares for each quarter of fiscal 2005 and fiscal 2006, and (ii) the cash dividends per share declared on Worthington Industries common shares during each quarter of fiscal 2005 and fiscal 2006.
Dividends are declared at the discretion of the board of directors. Worthington Industries declared quarterly dividends of $0.17 per share in fiscal 2006. The board of directors reviews the dividend quarterly and establishes the dividend rate based upon Worthington Industries financial condition, results of operations, capital requirements, current and projected cash flows, business prospects, and other factors which the directors may deem relevant. While Worthington Industries has paid a dividend every quarter since becoming a public company in 1968, there is no guarantee that this will continue in the future.
The following table provides information about purchases made by, or on behalf of, Worthington Industries or any affiliated purchaser (as defined in Rule 10b 18(a) (3) under the Securities Exchange Act of 1934) of common shares of Worthington Industries during each month of the fiscal quarter ended May 31, 2006:
On June 13, 2005, Worthington Industries announced that the board of directors had authorized the repurchase of up to 10,000,000 of its outstanding common shares. The common shares may be purchased from time to time, with consideration given to the market price of the common shares, the nature of other investment opportunities, cash flows from operations and general economic conditions. Repurchases may be made on the open market or through privately negotiated transactions. During the fourth quarter of fiscal 2006, there were no repurchases of common shares.
Item 6. - Selected Financial Data
The acquisition of the Western Cylinder Assets has been included since September 2004. The disposition of certain Decatur assets has been reflected since August 2004. The acquisition of Unimast Incorporated has been included since July 2002. All financial data includes the results of The Gerstenslager Company, which was acquired in February 1997 through a pooling of interests. The acquisition of Dietrich Industries, Inc. has been included since February 1996.
* Includes $113,000 of Worthington Industries, Inc. common shares exchanged for shares of The Gerstenslager Company during fiscal year ended May 31, 1997.
** Excludes Debt Exchangeable for Common Stock of Rouge Industries, Inc. of $52,497, $75,745 and $88,494 at May 31, 1999, 1998 and 1997, respectively.
* Includes $113,000 of Worthington Industries, Inc. common shares exchanged for shares of The Gerstenslager Company during fiscal year ended May 31, 1997.
** Excludes Debt Exchangeable for Common Stock of Rouge Industries, Inc. of $52,497, $75,745 and $88,494 at May 31, 1999, 1998 and 1997, respectively.
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
Selected statements contained in this Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations constitute forward-looking statements as that term is used in the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based, in whole or in part, on managements beliefs, estimates, assumptions and currently available information. For a more detailed discussion of what constitutes a forward-looking statement and of some of the factors that could cause actual results to differ materially from such forward-looking statements, please refer to the Safe Harbor Statement in the beginning of this Annual Report on Form 10-K and Part I - Item 1A. Risk Factors of this Annual Report on Form 10-K.
Worthington Industries, Inc., together with its subsidiaries (collectively, we, our, Worthington, or the Company), is a diversified metal processing company that focuses on value-added steel processing and manufactured metal products. As of May 31, 2006, excluding our joint ventures, we operated 47 manufacturing facilities worldwide, principally in three reportable business segments: Steel Processing, Metal Framing and Pressure Cylinders. We also held equity positions in 6 joint ventures, which operated 15 manufacturing facilities worldwide as of May 31, 2006.
Several changes occurred during fiscal 2006 in our internal organizational and reporting structures. The Automotive Body Panels operating segment, consisting of The Gerstenslager Company, which was previously combined with Steel Processing in the Processed Steel Products segment, was moved to the Other category, and the Processed Steel Products segment was renamed Steel Processing. Dietrich Construction Group was formed and includes Dietrich Building Systems, Inc. (which was previously included in the Metal Framing segment), Dietrich Residential Construction, LLC (DRC), and a research and development project in China. Dietrich Construction Group is now included in the Construction Services operating segment, which is reported in the Other category. The Other category now includes the Automotive Body Panels, Construction Services and Steel Packaging operating segments and also includes income and expense items not allocated to the reportable segments. All prior period segment financial information has been restated to reflect the changes mentioned above.
The following discussion and analysis of business strategy, key economic and industry indicators, steel pricing, and the results of operations and financial condition of Worthington, should be read in conjunction with our consolidated financial statements included in Item 8. Financial Statements and Supplementary Data.
Our number one goal is to increase shareholder value. We believe that our business strategy, centered on our core competency of adding value to flat-rolled steel, provides an excellent platform to deliver that value. Our focus is to grow shareholder value by effectively managing and growing our Companys downstream, value-added capabilities. Each of our reportable business segmentsSteel Processing, Metal Framing, Pressure Cylindersand our largest joint venture holds a leadership position in its market, which we expect to leverage and grow. We have the capacity in each of our business segments to handle additional sales growth without significantly increasing capital investment.
The three primary ways we seek to accomplish our strategic goal are optimizing existing operations; developing and commercializing new products and applications; and pursuing strategic acquisitions and joint ventures. Over the last several years, this focus has resulted in investing in growth markets and products, consolidating facilities and divesting certain non-strategic assets or other assets that were not delivering appropriate returns. We will continue our efforts to optimize existing operations by improving efficiencies, consolidating operations when necessary, and reducing the costs and risks of our existing operations.
Although no individual customer provides more than five percent of our consolidated net sales, diversifying our customer base through new products and new applications for existing products is a priority. We are developing new products and services in our Steel Processing segment. We are developing and testing innovative building products and systems to expand the application of metal framing, and we have developed and acquired, and will continue to develop and acquire, new pressure cylinder products.
We have added products and operations, including joint ventures, which we believe complement our existing business and strengths. Our strong balance sheet provides the financial flexibility to acquire or invest in companies that further extend our product lines or penetrate new markets. Because of our success with joint ventures and alliances, we continue to look for additional opportunities where we can bring together complementary skill sets, manage our risk and effectively invest our capital. Some of these joint ventures and alliances have served as entry points into markets not previously served and have resulted in later buyouts of the other joint venture parties.
During fiscal 2006, we took the following actions:
Ternium. This ownership change prompted the sale of the joint venture. We remain interested in the Mexican steel processing market and are exploring opportunities to continue the success that we have enjoyed there for over a decade.
Key Economic and Industry Indicators
To better understand the markets in which each of our business segments operates and the performance of those segments, we monitor certain economic and industry data. During the fiscal year ended May 31, 2006 (fiscal 2006), Gross Domestic Product continued to expand, up 3.4% over the fiscal year ended May 31, 2005 (fiscal 2005).
Commercial construction, the end market for approximately 41% of our net sales, improved in fiscal 2006 as indicated by the U.S. Census Bureaus Index of Private Construction Spending, which was 8% above fiscal 2005. According to this same index, our largest construction market sector, office buildings, improved 11%. These improvements increased demand, which generally leads to rising prices.
The hurricanes that hit the Gulf Coast states during the first part of fiscal 2006 had no direct impact on our facilities. However, some Metal Framing customers plants, representing approximately 2-3% of Metal Framings business, were shut down temporarily. While we estimate that recovery in the region may take several years, the rebuilding effort should benefit demand. The hurricanes were also a factor in the increase in zinc, energy and transportation costs. Excluding the impact of volume, these costs were $17.4 million higher than in fiscal 2005.
The automotive end market, which represents approximately 33% of our net sales, had mixed results. Total North American vehicle production was 3% higher than last year. However, Big Three automotive (collectively, DaimlerChrysler AG, Ford Motor Co. and General Motors Corp.) production was down 2% compared to last year. While our tons shipped directly to the Big Three increased 29% over last year, our total automotive volumes decreased slightly from fiscal 2005. The financial condition of some automotive manufacturers and suppliers has deteriorated and the debt of several automotive manufacturers and automotive suppliers has been rated below investment grade. In recent years, certain automotive suppliers have filed voluntary petitions for Chapter 11 bankruptcy protection. We are concerned about the viability of several other automotive suppliers and continue to monitor their status.
During the last several fiscal years, the steel industry experienced unprecedented steel price fluctuations. Early in the fiscal year ended May 31, 2004 (fiscal 2004), the Peoples Republic of China (China) was a net importer of steel as its demand for steel exceeded its production capabilities, increasing the demand for steel in the worldwide market and reducing the availability of foreign steel in the United States of America (U.S.). A weaker U.S. dollar and higher transportation costs made foreign steel more expensive than domestic steel, further reducing the supply of imports to the U.S. As China increased its production capabilities, it required more steel-making raw materials, especially coke and scrap steel. This resulted in shortages of these key raw materials, fueling further increases in steel prices. Finally, the consolidation of the steel industry within the U.S. reduced the availability of steel. All of these factors combined during this period of time to cause an unprecedented increase in steel prices, which peaked in September 2004.
Since then, China increased steel production significantly, contributing to global supply and placing significant downward pressure on steel prices. In addition, excess inventories and lower production from automotive and other key metalworking sectors reduced demand. As a result, benchmark commodity steel prices began to weaken and continued to decline through the end of our fiscal 2006 first quarter. However, since our fiscal 2006 first quarter, steel prices have increased 23% due to improved overall demand, constrained domestic supply, and lower levels of available imports. On average, published benchmark commodity steel prices for our fiscal 2006 were lower by $119 per ton, or 18% from last fiscal year, because of generally weaker demand and greater supply.
The following graph shows the volatility of steel prices over the last four years:
The consolidation of the industry around the globe has set the stage for a more disciplined approach to production and pricing. Domestically, the concentration of steel production owned by the top three producers has doubled, along with their market share, to approximately 70%. Globally, consolidation has resulted in a significant shift in the amount of production capacity owned by the private sector. Prior to 2000, approximately 25% of steel-producing assets were privately owned versus more than 75% today. Combined with strong regional growth in Asia and Eastern Europe, industry consolidation has produced an environment which may lead to steel pricing being much less volatile than was experienced during the preceding 10 years.
Volatile steel prices combined with our first-in first-out (FIFO) inventory flow, can have a dramatic affect on the results of our operations. In a rising steel-price environment, our reported income is often favorably impacted as lower-priced inventory, acquired during the previous two to three months, flows through cost of goods sold while our selling prices increase to meet the rising cost of steel. In a decreasing steel-price environment, the inverse often occurs as higher-priced inventory on hand flows through cost of goods sold and our selling prices decrease. This results in what we refer to as inventory holding gains or losses. We strive to limit this impact by controlling inventory levels and monitoring our selling prices.
Results of Operations
Fiscal 2006 Compared to Fiscal 2005
The impact of inventory holding gains and losses continued to be a major factor when comparing our results against the prior year. Average hot-roll prices were 18% lower during fiscal 2006 versus fiscal 2005. Operating income for the twelve months ended May 31, 2006, was negatively impacted by an inventory holding loss estimated at $7.9 million, while operating income for fiscal 2005 contained an estimated inventory holding gain of $78.5 million.
A majority of our full-time employees receive a significant portion of their compensation through profit sharing and bonuses, which are tied to the performance of our Company. When earnings are up, so is profit sharing
and bonus expense, and when earnings are down, so is profit sharing and bonus expense. Because of this relationship, profit sharing and bonus expense tends to minimize the volatility of earnings.
The following table presents our consolidated operating results for the fiscal years indicated:
Net earnings decreased $33.4 million, to $146.0 million for fiscal 2006, from $179.4 million for fiscal 2005. Diluted earnings per share decreased $0.39 per share to $1.64 per share from $2.03 per share for the prior fiscal year. Net sales decreased 6%, or $181.7 million, to $2,897.2 million for fiscal 2006 from $3,078.9 million for fiscal 2005. The decrease was due to lower selling prices, reflecting the lower steel prices that prevailed during fiscal 2006 versus fiscal 2005, which reduced net sales by $228.9 million. Higher overall volumes slightly offset the negative impact of the decline in selling prices. The volume increase was primarily due to increased volumes in the Metal Framing and Pressure Cylinders segments and in Construction Services, which is included in the Other category, but the impact of these volume increases was somewhat offset by slightly lower volumes in the Steel Processing segment, due largely to the sale of the cold mill in Decatur, Alabama, in the first quarter of fiscal 2005.
Gross margin decreased 26%, or $127.3 million, to $371.6 million for fiscal 2006 from $498.9 million for fiscal 2005. The decrease was due to a $138.2 million decline in pricing spread and a $7.2 million increase in direct labor and manufacturing expenses, partially offset by an increase in overall volume of $18.1 million. The increase in direct labor and manufacturing expenses was mainly due to increases in freight, zinc, and energy expenses. Gross margin as a percentage of net sales decreased to 12.8% for fiscal 2006 compared to 16.2% for fiscal 2005.
SG&A expense, as a percentage of net sales, increased to 7.4% for fiscal 2006 compared to 7.3% of net sales for the prior year. In total, SG&A expense decreased 5%, or $11.9 million, to $214.0 million for fiscal 2006 from $225.9 million for fiscal 2005. This decrease was primarily due to a $19.6 million decrease in profit sharing and bonus expense resulting from lower earnings and a $9.7 million reduction in bad debt expense, offset by increases in professional fees of $7.4 million, wages of $7.3 million, and insurance and taxes of $1.9 million. The reduction in bad debt expense reflects the favorable settlement of our claim in a large bankruptcy case in fiscal 2006.
Miscellaneous expense decreased $6.5 million in fiscal 2006 compared to fiscal 2005. This was due to an increase in, and higher returns on, cash and short-term investments and the reduced minority interest elimination for our consolidated joint venture due to its lower earnings.
Results for fiscal 2006 include a $26.6 million pre-tax gain on the sale of our 50% equity interest in Acerex to our partner, Ternium.
Interest expense increased 6% or $1.5 million due to higher average borrowings.
Equity in net income of unconsolidated affiliates increased to $56.3 million for fiscal 2006 from $53.9 million for fiscal 2005, primarily due to increased earnings of the WAVE joint venture, partially offset by a $6.0 million adjustment for the under-accrual of income taxes over the last five years at our Acerex joint venture. The unconsolidated joint ventures generated $810.3 million in sales and net income of $108.7 million during fiscal 2006. Joint venture income has been a consistent and significant contributor to our profitability over the last several years. Our aggregate annual return on the investment in these joint ventures has averaged 43%. The joint ventures are also a source of cash to us, and aggregate annual distributions have ranged from $12 to $57 million.
Income tax expense decreased 39%, or $42.4 million, mainly due to lower earnings. However, the effective tax rate also decreased to 31.4% for fiscal 2006 from 37.8% for fiscal 2005. The rate decrease was due to higher foreign earnings that were taxed at a lower rate, modifications to the corporate tax laws for the state of Ohio that reduced tax expense, deferred tax adjustments for foreign earnings, offset by special taxes on foreign earnings repatriations and the sale of Acerex. The rate was further reduced by the elimination of the reserves established for the disallowance of investment tax credits in the State of Ohio when the program was ruled unconstitutional by the Sixth Circuit Court of Appeals in fiscal 2005. This reserve became unnecessary due to the recent ruling by the U.S. Supreme Court, which vacated the Sixth Circuits ruling.
Our Steel Processing segment represented approximately 51% of consolidated net sales in fiscal 2006. The steel-pricing environment and the automotive industry, which accounts for approximately 60% of this segments net sales, significantly impacted the results of this segment. After having risen steadily for the first four months of fiscal 2005 to an all time high in September 2004, steel prices declined significantly for the next twelve months. As a result, average steel prices were significantly lower in fiscal 2006 than in fiscal 2005, which led to a reduced spread between our average selling price and material cost. In addition, sales to the automotive market in fiscal 2006 were 8% lower than in fiscal 2005.
Effective August 1, 2004, we sold our Decatur, Alabama, steel-processing facility and its cold-rolling assets (Decatur) to Nucor Corporation (Nucor) for $80.4 million cash. The assets sold at Decatur included the land and buildings, the four-stand tandem cold mill, the temper mill, the pickle line and the annealing furnaces. The sale excluded the slitting and cut-to-length assets and net working capital. The retained assets provide basic steel-processing services to our customers at the Decatur site, which is leased from Nucor. A pre-tax charge of $5.6 million, mainly related to contract termination costs, was recognized during the first quarter of fiscal 2005.
The following table presents a summary of operating results for the Steel Processing segment for the fiscal years indicated:
Operating income decreased 51%, or $65.3 million, to $61.8 million, or 4.2% of net sales, in fiscal 2006 from $127.1 million, or 7.4% of net sales, for fiscal 2005. Net sales decreased 14%, or $233.1 million, to $1,486.2 million from $1,719.3 million, due to a decrease in pricing of $144.5 million and a decrease in volume of $88.6 million, of which $79.6 million was due to the sale of certain Decatur assets. Gross margin declined 39%, or $88.5 million, to $138.6 million, or 9.3% of net sales, for fiscal 2006 versus $227.1 million, or 13.2% of net sales, for fiscal 2005. A narrower spread between average selling price and material cost, and a decrease in volume, reduced gross margin by $81.5 million and $12.3 million, respectively. Gross margin was favorably impacted by a $13.7 million decrease in profit sharing and bonus expense due to lower earnings and a $3.8 million reduction in manufacturing expenses at our Decatur facility, partially offset by increases for freight, zinc and natural gas expense. SG&A expense decreased $17.6 million, to 5.2% of net sales in fiscal 2006, down from 5.5% of net sales for fiscal 2005. The decline in SG&A expense was largely due to a decrease of $13.1 million in profit sharing and bonus expense, resulting from lower earnings, and a $9.4 million decrease in bad debt expense compared to the prior year. The reduction in bad debt expense reflects the favorable settlement of our claim in a large bankruptcy case in fiscal 2006.
Our Metal Framing segment represented approximately 28% of consolidated net sales during fiscal 2006. Volumes for fiscal 2006 increased 7% compared to fiscal 2005. We believe the improved demand reflects a combination of factors including a general increase in commercial construction, rebuilding in Florida after the hurricanes of fiscal 2005, and an expansion into Canada.
The following table presents a summary of operating results for the Metal Framing segment for the fiscal years indicated:
Operating income decreased $67.1 million to $46.7 million, or 5.9% of net sales, in fiscal 2006 from $113.8 million, or 13.5% of net sales, for fiscal 2005. The primary driver of the decrease was the narrower spread between average selling price and material cost of $84.9 million, partially offset by an increase in volume of $20.5 million. Net sales decreased 6%, or $47.6 million, to $796.3 million in fiscal 2006 from $843.9 million for fiscal 2005 due to the impact of lower pricing of $117.0 million, partially offset by the impact of an increase in volume of $69.4 million. Gross margin decreased $72.5 million from $195.5 million to $123.0 million and, as a percentage of net sales, was 15.4% compared to 23.2% for the comparable period in the prior year. SG&A expense decreased because of a reduction in profit sharing and bonus expense of $10.6 million resulting from lower earnings.
Our Pressure Cylinders segment represented approximately 16% of consolidated net sales during fiscal 2006. This segment had an increase in net sales and record operating income in fiscal 2006.
The following table presents a summary of operating results for the Pressure Cylinders segment for the fiscal years indicated:
Operating income increased 47%, or $15.7 million, to $49.3 million, or 10.7% of net sales, in fiscal 2006 from $33.6 million, or 8.2% of net sales, for fiscal 2005. Net sales increased 13%, or $53.6 million, to $461.9 million in fiscal 2006 from $408.3 million for fiscal 2005. The full-year impact of the September 2004 acquisition of the net assets of the propane and specialty gas cylinder business of Western Industries, Inc. (Western Cylinder Assets) contributed $23.0 million to this increase, other North American net sales contributed $12.6 million and improved European sales contributed $18.0 million. Unit volumes were flat, excluding units from the Western Cylinder Assets. Gross margin was 20.5% of net sales in fiscal 2006 compared to 18.2% for fiscal 2005. The
improved gross margin was primarily due to the full-year contribution of the Western Cylinder Assets and improved operating results of our European operations. The Austrian facility experienced increased unit volumes and expanded operating margins compared to fiscal 2005. The Portugal facility ceased production of its unprofitable liquefied petroleum gas cylinders in the first quarter of fiscal 2005, resulting in significantly improved gross margin in fiscal 2006 as a percentage of net sales. The Czech Republic facility expanded its air tank production in fiscal 2005, but incurred high labor and manufacturing expense during the expansion start-up in fiscal 2005. SG&A expense increased $4.8 million in fiscal 2006 from the prior year due the settlement of two product liability claims totaling $2.4 million and a $2.1 million increase in costs related to the full-year operation of the acquired Western Cylinder Assets.
The Other category includes the Automotive Body Panels, Construction Services and Steel Packaging operating segments, which are immaterial for separate disclosure, and also includes income and expense items not allocated to the operating segments.
The following table presents a summary of operating results for the Other category for the fiscal years indicated:
Operating loss decreased by $6.9 million to $0.2 million in fiscal 2006 from an operating loss of $7.1 million in fiscal 2005 for all three operating segments in the Other category, primarily due to an improvement in results for Auto Body Panels, which offset losses in Construction Services. Net sales increased 42%, or $45.5 million, to $152.9 million in fiscal 2006 from $107.4 million in fiscal 2005 due primarily to increased sales in the Construction Services operating segment. Gross margin was 10.1% of net sales in fiscal 2006 compared to 2.0% in fiscal 2005. SG&A expense increased $6.5 million from the prior year due to sales growth in the Construction Services operating segment.
Fiscal 2005 Compared to Fiscal 2004
The following table presents our consolidated operating results for the fiscal years indicated:
Net earnings increased $92.6 million to $179.4 million for fiscal 2005, from $86.8 million for fiscal 2004. Fiscal 2005 diluted earnings per share increased $1.03 to $2.03 per share from $1.00 per share in fiscal 2004.
Net sales increased 29%, or $699.8 million, to $3,078.9 million in fiscal 2005 from $2,379.1 million for fiscal 2004. Virtually all of the increase in net sales was due to higher pricing, as volumes, excluding acquisitions and divestitures, were down on a comparative year-over-year basis for Metal Framing and Pressure Cylinders and up slightly for Steel Processing.
Gross margin increased 33%, or $123.5 million, to $498.9 million for fiscal 2005 from $375.4 million for fiscal 2004. A favorable pricing spread accounted for $127.6 million of the increase, offset by a $5.3 million increase in direct labor and manufacturing expenses. Collectively, these factors increased gross margin as a percentage of net sales to 16.2% in fiscal 2005 from 15.8% in fiscal 2004.
SG&A expense decreased to 7.3% of net sales in fiscal 2005 compared to 8.2% of net sales in fiscal 2004. In total, SG&A expense increased $30.1 million, to $225.9 million in fiscal 2005 from $195.8 million in fiscal 2004. This was mainly due to a $16.6 million increase in profit sharing expense, which was up significantly due to record earnings; a $9.9 million increase in professional fees; and a $2.7 million increase in bad debt expense. The increase in professional fees was due to $5.5 million of additional expenses associated with meeting the requirements of the Sarbanes-Oxley Act of 2002 (SOX) and $5.3 million was due to the ongoing implementation of our enterprise resource planning system (ERP). The increase in bad debt expense was a result of the increased collection risk of certain customers.
Impairment charges and other for fiscal 2004 included a $67.4 million pre-tax charge for the impairment of certain assets and other related costs at the Decatur, Alabama, steel-processing facility and a $2.0 million pre-tax charge for the impairment of certain assets related to the European operations of Pressure Cylinders. An additional pre-tax charge of $5.6 million, mainly due to contract termination costs related to the sale of the Decatur facility,
was recognized during the first quarter of fiscal 2005. Refer to Item 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Note N Impairment Charges and Restructuring Expense for more information.
Miscellaneous expense in fiscal 2005 increased $6.4 million from fiscal 2004, largely due to a $4.3 million higher elimination for the minority shareholders interest in the net earnings of our consolidated joint ventures. Fiscal 2004 included a $3.6 million gain from the settlement of a hedge position with the Enron bankruptcy estate while fiscal 2005 also included a $1.1 million increase in interest income.
Interest expense increased 12%, or $2.6 million, to $24.8 million in fiscal 2005 from $22.2 million in fiscal 2004, due to higher average debt balances.
Equity in net income of unconsolidated affiliates increased 31%, or $12.8 million, to $53.9 million in fiscal 2005 from $41.1 million in fiscal 2004. Five of our seven unconsolidated joint ventures had strong double-digit increases in earnings. Collectively, the unconsolidated joint ventures generated approximately $767.0 million in sales in fiscal 2005, which were not reflected in consolidated net sales.
Income tax expense increased in fiscal 2005 compared to fiscal 2004 due to a higher level of income and various tax adjustments. Our effective tax rate was 37.8% for fiscal 2005 and 31.9% for fiscal 2004. The rate change was mainly due to a net unfavorable adjustment of $2.6 million in fiscal 2005 compared to favorable adjustments of $7.7 million recorded in fiscal 2004. The fiscal 2005 net adjustment was comprised of an unfavorable $4.3 million adjustment due to a ruling by the Sixth Circuit Court of Appeals that the state of Ohios investment tax credit program was unconstitutional and was partially offset by a $1.7 million favorable adjustment for the revision of estimated tax liabilities resulting from tax audit settlements and related developments. The $7.7 million favorable adjustments in fiscal 2004 were comprised of a $6.3 million credit for the favorable resolution of certain tax audits and a $1.4 million credit for an adjustment to deferred taxes.
Our Steel Processing segment represented 56% of consolidated net sales in fiscal 2005. The steel pricing environment and the automotive industry significantly impacted this segments results. After rising steadily in early fiscal 2005, steel prices declined from their peak in September of 2004. Overall, the price of steel in fiscal 2005 was significantly higher than in fiscal 2004. Our ability to raise prices to our customers contributed to an improved spread between our average selling price and material cost. Sales volume to the automotive market for fiscal 2005 was 3% higher than for fiscal 2004, due to market share gains and involvement in better selling product lines. Big Three automotive production volumes were down about 4% for the same period, while North American vehicle production for all manufacturers stayed relatively flat.
Effective August 1, 2004, we sold our Decatur, Alabama, steel-processing facility and its cold-rolling assets to Nucor for $80.4 million in cash. The assets sold at Decatur included the land and buildings, the four-stand tandem cold mill, the temper mill, the pickle line and the annealing furnaces. The sale excluded the slitting and cut-to-length assets and net working capital. We continue to serve customers by providing steel-processing services at the Decatur site under a long-term building lease with Nucor.
As a result of the sale, we recorded a $67.4 million pre-tax charge during the fourth quarter of fiscal 2004, primarily for the impairment of assets at the Decatur, Alabama, facility. All but an estimated $0.8 million of the pre-tax charge was non-cash. An additional pre-tax charge of $5.6 million, mainly relating to contract termination costs, was recognized during the first quarter of fiscal 2005.
The following table presents a summary of operating results for the Steel Processing segment for the fiscal years indicated:
Operating income increased $111.3 million, to $127.1 million in fiscal 2005 from $15.8 million in fiscal 2004. Excluding the effect of the impairment charges and other line item from each year, operating income increased $49.5 million, to $132.7 million, or 7.7% of net sales, in fiscal 2005 from $83.2 million, or 6.6% of net sales, in fiscal 2004. This increase was due to a larger spread of $51.2 million between average selling price and material cost and a decrease in expenses largely due to the sale of the Decatur assets. Net sales increased 36%, or $454.0 million, to $1,719.3 million from $1,265.3 million because of increased pricing. Volumes declined slightly compared to the prior fiscal year, but excluding the volumes associated with the assets sold at Decatur in each year, tons shipped increased 3.7% compared to the prior period. SG&A expense for fiscal 2005 was $94.4 million, an increase of $11.3 million from $83.1 million for fiscal 2004; however, as a percentage of net sales, SG&A declined due to the significant increase in net sales. The increase in SG&A was largely due to an increase in profit sharing and bonus expense of $6.5 million; higher bad debt expense of $3.4 million resulting from the increased collection risk of certain customers, including Tower Automotive; and additional expenses of $2.7 million associated with meeting SOX requirements.
Fiscal 2005 represented the best year in the history of the Metal Framing segment. This was primarily due to the wider spread between average selling price and material cost. During fiscal 2005, as spread continued to drive profitability, volumes slowed due to the weak commercial and office construction market. Even though volumes declined in fiscal 2005 compared to fiscal 2004, there were signs that the commercial construction market was improving late in the year. Certain commercial construction indices generally trended higher in fiscal 2005 compared to fiscal 2004, while our largest market, office buildings, declined in activity. In general, commercial construction activity had been depressed for over three years.
During the second quarter of fiscal 2005, we entered into an unconsolidated joint venture with Pacific. The focus of this joint venture was on the military housing construction market. Our Metal Framing segment sold steel framing products to the joint venture for its projects. The operating results of the joint venture were included in Equity in net income of unconsolidated affiliates on the Consolidated Statement of Earnings for fiscal 2005. During the second quarter of fiscal 2006, we purchased the interest of Pacific (see Item 8 Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements Note Q-Acquisitions and Business Strategy above).
Also during the second quarter of fiscal 2005, we formed a consolidated joint venture with Encore, operating under the name Dietrich Metal Framing Canada. This joint venture was formed to manufacture steel framing products for the Canadian market and to offer a variety of proprietary products supplied by our Metal Framing facilities in the U. S. During fiscal 2005, this joint venture was a 60%-owned Canadian limited liability company for which the assets and results of operations were consolidated in our Metal Framing segment.
The following table presents a summary of operating results for the Metal Framing segment for the fiscal years indicated:
Operating income increased $45.0 million, to a record $113.8 million in fiscal 2005 from $68.8 million in fiscal 2004. The primary driver for the increase was a $95.1 million expansion in the spread between average selling price and material cost. Net sales increased 30%, or $192.3 million, to $843.9 million in fiscal 2005 from $651.6 million in fiscal 2004. This increase was due to a 54% increase in average selling price, which increased net sales by $286.0 million, offset by a 16% volume decrease, which reduced net sales by $93.8 million. Gross margin increased 44% to $195.5 million from $135.9 million in fiscal 2004, mostly due to an increase in the spread between average selling price and material cost, partially offset by a $41.2 million impact due to lower sales volume. Even though SG&A expense increased $14.6 million, it decreased as a percentage of net sales to 9.7% in fiscal 2005 from 10.3% in fiscal 2004 due to the significant increase in net sales. SG&A expense increased primarily due to a $9.2 million increase in profit sharing and bonus expense, additional expenses of $3.7 million for professional fees mainly due to the ERP implementation and $1.3 million associated with meeting SOX requirements. The combined impact of the factors discussed above was an increase in operating income as a percentage of net sales to 13.5% in fiscal 2005 from 10.6% in fiscal 2004.
We acquired the Western Cylinder Assets on September 17, 2004. This business manufactures 14.1 oz. and 16.4 oz. disposable cylinders for products such as hand torches, propane-fueled camping equipment, portable heaters and tabletop grills. These new product lines generated $45.8 million of net sales for us in fiscal 2005 after the acquisition.
In Europe, we have been successful with high-pressure and refrigerant cylinders, but struggled with the liquefied petroleum gas (LPG) cylinders due to market overcapacity and declining demand. As a result, an impairment charge on certain of our Portugal LPG assets was recorded in the fourth quarter of fiscal 2004 and production of the LPG cylinders at the Portugal facility ceased during the first quarter of fiscal 2005.
On October 13, 2004, we purchased the 49% interest of our minority partner in the joint venture that operates a pressure cylinder manufacturing facility in Hustopece, Czech Republic.
The following table presents a summary of operating results for the Pressure Cylinders segment for the fiscal years indicated:
Operating income increased 14%, or $4.2 million, to $33.6 million in fiscal 2005 from $29.4 million in fiscal 2004. The increase was due to higher volumes of $19.6 million, partially offset by a decline in the spread between average selling price and material cost of $11.6 million. Net sales increased 24%, or $79.6 million, to $408.3 million due to higher sales volumes, with $45.8 million of this increase attributable to the purchase of the Western Cylinder Assets. The strength of foreign currencies against the U.S. dollar also contributed $10.2 million to net sales. Gross margin increased $8.1 million to $74.2 million for fiscal 2005 from $66.1 million for fiscal 2004. Although SG&A expense decreased slightly as a percentage of net sales, the dollar expense increased $5.9 million primarily due to $2.9 million of expenses related to the purchase of the Western Cylinder Assets (which included $1.7 million of amortization expense of customer list intangible assets), an increase in profit sharing and bonus expense of $1.7 million, and additional expenses of $0.6 million associated with meeting SOX requirements.
The Other category includes the Automotive Body Panels, Construction Services and Steel Packaging reporting segments, which are immaterial for purposes of separate disclosure, and also includes income and expense items not allocated to the operating segments.
The following table presents a summary of operating results for the Other category for the fiscal years indicated:
Operating loss increased $3.3 million to $7.1 million, or 6.6% of net sales, for the year from $3.8 million, or 2.8% of net sales, for fiscal 2004. Net sales were $107.4 million for the year compared to $133.5 million in fiscal 2004 due to the impact of lower volume of $25.8 million. Gross margin decreased $5.0 million, to $2.1 million, from $7.1 million and, as a percentage of net sales, was 2.0% compared to 5.3% in the prior year, primarily due to a narrower spread between average selling price and material cost and the decrease in volume. SG&A expense decreased from $10.9 million in fiscal 2004 to $9.2 million in fiscal 2005, but increased as a percentage of net sales from 8.2% in fiscal 2004 to 8.6% in fiscal 2005.
Liquidity and Capital Resources
During fiscal 2006, we generated $227.1 million in cash from operating activities. This was primarily the result of $146.0 million in net earnings, an $11.6 million increase in accounts receivable and an $81.7 million increase of in accounts payable during the period. The difference between the net cash provided by operating activities in fiscal 2006 compared to fiscal 2005 was primarily the result of changes in accounts receivable and inventory, which were reflective of the decline of steel prices, discussed above, and increased accounts payable.
Consolidated net working capital was $505.5 million at May 31, 2006, compared to $392.9 million at May 31, 2005. The $112.6 million increase was mainly attributable to an increase in inventory of $33.6 million and a decrease in current maturities of long-term debt of $143.4 million, partially offset by an increase in accounts payable of $82.7 million.
Our primary investing and financing activities included distributing $60.0 million in dividends to shareholders, and spending $60.1 million on capital projects, including $14.3 million for our ERP system, $7.4 million for a furnace upgrade at our Spartan joint venture galvanizing facility and $5.5 million for the UltraSTEELTM conversion project. We also invested $16.4 million in a new aircraft which represented progress payments on an estimated purchase price of $l9.3 million. This investment is recorded in assets held for sale as the aircraft will be sold and leased back during fiscal 2007. It will replace an existing leased aircraft.
We generated $9.1 million in cash from the issuance of common shares through option exercises and $47.8 million from the sale of assets, including the sale of our interest in Acerex. Major ongoing projects include our ERP project, the furnace upgrade at Spartan, and the conversion to UltraSTEELTM production for our Metal Framing segment.
Our short-term liquidity needs are primarily met by a $435.0 million long-term revolving credit facility; a $100.0 million trade accounts receivable securitization facility and $40.0 million in uncommitted discretionary credit lines. During the third quarter of fiscal 2006, a $20.0 million discretionary credit line was terminated. All credit facilities and lines were unused as of May 31, 2006 and May 31, 2005. Our 7 1/8% Senior Notes matured on May 15, 2006, and were fully paid.
On September 29, 2005, we amended and restated our $435.0 million long-term revolving credit facility to extend the maturity to September 2010 and to replace the leverage ratio (debt-to-EBITDA) financial covenant with an interest coverage ratio (EBITDA-to-interest expense) financial covenant of not less than 3.25 times. The amended and restated facility also reduces the facility fees payable and provides liquidity beyond the maturity of our 6.70% Notes due in December 2009. The proceeds of the amended and restated facility may be used for general corporate purposes including working capital, capital expenditures, acquisitions and dividends.
Uncommitted lines of credit are extended to us on a discretionary basis. Because the outstanding principal amounts can be adjusted daily, these uncommitted lines typically provide us with the greatest amount of funding flexibility compared to our other sources of short-term capital.
At May 31, 2006, our total debt was $252.7 million compared to $388.4 million at May 31, 2005. Our debt to total capitalization ratio was 21.1% at May 31, 2006, down from 32.1% at May 31, 2005.
On June 13, 2005, we announced that our board of directors authorized the repurchase of up to 10.0 million of our outstanding common shares. The purchases may be made from time to time, on the open market or in private transactions, with consideration given to the market price of the common shares, the nature of other investment opportunities, cash flows from operations and general economic conditions. During fiscal 2006, there were no repurchases of common shares.
We assess acquisition opportunities as they arise. Additional financing may be required if we decide to make additional acquisitions. There can be no assurance, however, that any such opportunities will arise, that any such acquisitions will be consummated, or that any needed additional financing will be available on satisfactory terms when required. Absent any new acquisitions, we anticipate that cash, short-term investments, cash provided
by operating activities and unused borrowing capacity should be sufficient to fund expected normal operating costs, dividends, working capital, and capital expenditures for our existing businesses.
Dividends are declared at the discretion of our board of directors. Our board of directors reviews the dividend quarterly and establishes the dividend rate based upon our financial condition, results of operations, capital requirements, current and projected cash flows, business prospects and other factors which are deemed relevant. While we have paid a dividend every quarter since becoming a public company in 1968, there is no guarantee that this will continue in the future.
Contractual Cash Obligations and Other Commercial Commitments
The following table summarizes our contractual cash obligations as of May 31, 2006. Certain of these contractual obligations are reflected on our consolidated balance sheet, while others are disclosed as future obligations under accounting principles generally accepted in the U.S.
The interest expense on long-term debt is computed by using the fixed rates of the debt including the interest rate swap hedge. The unconditional purchase obligations are to secure access to a facility used to regenerate acid used in three steel processing facilities. These three facilities are to deliver their spent acid for processing annually through fiscal 2019.
The following table summarizes our other commercial commitments as of May 31, 2006. These commercial commitments are not reflected on our consolidated balance sheet.
Off Balance Sheet Arrangements
We had no material off balance sheet arrangements at May 31, 2006.
Recently Issued Accounting Standards
In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4 (SFAS 151).
SFAS 151 amends the guidance in Accounting Research Bulletin No. 43, Chapter 4, Inventory Pricing to clarify the accounting for abnormal amounts of idle facility expense, freight, handling cost and wasted material (spoilage). In addition, SFAS 151 requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred beginning June 1, 2006. We do not expect the adoption of SFAS 151 to have a material impact on our financial position or results of operations.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)). SFAS 123(R) is a revision of SFAS 123 and it supercedes APB No. 25 and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Proforma disclosure will not be an alternative. SFAS 123(R) is effective for all fiscal years beginning after June 15, 2005, and thus will become effective for us beginning in the fiscal year ending May 31, 2007 (fiscal 2007). The adoption of SFAS 123(R)s fair value method will have an impact on results of operations, although it will have no impact on the Companys overall financial position. Stock option expense after the adoption of SFAS 123(R) is not expected to be materially different than the expense reported in Item 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Note A Summary of Significant Accounting Policies, but this will not be known until a full analysis of the impact of SFAS 123(R) is completed. The impact will largely depend on levels of share-based payments granted in the future.
In July 2006, FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that we recognize in our financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of our 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our financial statements.
We believe environmental issues will not have a material effect on capital expenditures, future results of operations or financial position.
The effects of inflation on our operations were not significant during the periods presented in the consolidated financial statements.
Critical Accounting Policies
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. We continually evaluate our estimates, including those related to our valuation of receivables, intangible assets, accrued liabilities, income and other tax accruals, and contingencies and litigation. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances. These results form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Critical accounting policies are defined as those that reflect our significant judgments and uncertainties that could potentially result in materially different results under different assumptions and conditions. Although actual results historically have not deviated significantly from those determined using our estimates, as discussed below, our financial position or results of operations could be materially different if we were to report under different conditions or to use different assumptions in the application of such policies. We believe the following accounting policies are the most critical to us since these are the primary
areas where financial information is subject to our estimates, assumptions and judgment in the preparation of our consolidated financial statements.
Revenue Recognition: We recognize revenue upon transfer of title and risk of loss provided evidence of an arrangement exists, pricing is fixed and determinable, and collectibility is probable. In circumstances where the collection of payment is highly questionable at the time of shipment, we defer recognition of revenue until payment is collected. We provide an allowance for returns based on experience and current customer activities. Within Construction Services, we recognize revenue on a percentage-of-completion method.
Receivables: We review our receivables on a monthly basis to ensure that they are properly valued and collectible. This is accomplished through two contra-receivable accounts: returns and allowances and allowance for doubtful accounts. Returns and allowances are used to record estimates of returns or other allowances resulting from quality, delivery, discounts or other issues affecting the value of receivables. This account is estimated based on historical trends and current market conditions, with the offset to net sales.
The allowance for doubtful accounts is used to record the estimated risk of loss related to the customers ability to pay. This allowance is maintained at a level that we consider appropriate based on factors that affect collectibility, such as the financial health of the customer, historical trends of charge-offs and recoveries, and current and projected economic and market conditions. As we monitor our receivables, we identify customers that may have a problem paying, and we adjust the allowance accordingly, with the offset to SG&A expense.
While we believe these allowances are adequate, changes in economic conditions, the financial health of customers, and bankruptcy settlements could impact our future earnings.
Impairment of Long-Lived Assets: We review the carrying value of our long-lived assets, including intangible assets, whenever events or changes in circumstances indicate that the carrying value of an asset or a group of assets may not be recoverable. Accounting standards require an impairment charge to be recognized in the financial statements if the carrying amount of an asset or group of assets exceeds the undiscounted cash flows generated by that asset or group of assets. The loss recognized would be the difference between the fair value and the carrying amount of the asset or group of assets.
Annually at the end of our fiscal third quarter, we review goodwill for impairment using the present value technique to determine the estimated fair value of goodwill associated with each reporting entity. There are three significant sets of values used to determine the fair value: estimated future discounted cash flows, capitalization rate and tax rates. The estimated future discounted cash flows used in the model are based on planned growth with an assumed perpetual growth rate. The capitalization rate is based on our current cost of debt and equity capital. Tax rates are maintained at current levels.
Accounting for Derivatives and Other Contracts at Fair Value: We use derivatives in the normal course of business to manage our exposure to fluctuations in commodity prices, foreign currency and interest rates. These derivatives are based on quoted market values. These estimates are based upon valuation methodologies deemed appropriate in the circumstances; however, the use of different assumptions could affect the estimated fair values.
Stock-Based Compensation: We currently account for employee and non-employee stock option plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and the related interpretations. No stock-based employee compensation cost is reflected in net earnings, as all options granted under our plans had an exercise price equal to the fair market value of the underlying common shares on the grant date. Beginning in fiscal 2007, we will be required to record an expense for our stock-based compensation plans using the fair value method prescribed in SFAS No. 123(R). Had we accounted for stock-based compensation plans using this fair value method, we estimate that diluted earnings per share would have been reduced by $0.03 per share in fiscal 2006, $0.03 in fiscal 2005 and $0.02 in fiscal 2004.
Income Taxes: In accordance with the provisions of SFAS No. 109, Accounting for Income Taxes, we account for income taxes using the asset and liability method. The asset and liability method requires the recognition of deferred tax assets and liabilities for expected future tax consequences of temporary differences that currently exist between the tax basis and financial reporting basis of our assets and liabilities. In assessing the
realizability of deferred tax assets, we consider whether it is more likely than not that some or a portion of the deferred tax assets will not be realized. We provide a valuation allowance for deferred income tax assets when, in our judgment, based upon currently available information and other factors, it is more likely than not that a portion of such deferred income tax assets will not be realized. The determination of the need for a valuation allowance is based on an on-going evaluation of current information including, among other things, estimates of future earnings in different tax jurisdictions and the expected timing of deferred income tax asset reversals. We believe that the determination to record a valuation allowance to reduce deferred income tax assets is a critical accounting estimate because it is based on an estimate of future taxable income in the various tax jurisdictions in which we do business, which is susceptible to change and may or may not occur, and because the impact of adjusting a valuation allowance may be material.
We have a reserve for taxes and associated interest and penalties that may become payable in future years as a result of audits by taxing authorities. While we believe the positions taken on previously filed tax returns are appropriate, we have established the tax and interest reserves in recognition that various taxing authorities may challenge our positions. The tax reserves are analyzed periodically and adjustments are made, as events occur to warrant adjustment to the reserve, such as lapsing of applicable statutes of limitations, conclusion of tax audits, additional exposure based on current calculations, identification of new issues, release of administrative guidance or court decisions affecting a particular tax issue.
Self-Insurance Reserves: We are largely self-insured with respect to workers compensation, general liability, property damage, employee medical claims and other potential losses. In order to reduce risk and better manage overall loss exposure, we purchase stop-loss insurance that covers individual claims in excess of the deductible amounts. We maintain reserves for the estimated cost to settle open claims as well as an estimate of the cost of claims that have been incurred but not reported. These estimates are based on third-party actuarial valuations that take into consideration the historical average claim volume, the average cost for settled claims, current trends in claim costs, changes in our business and workforce, general economic factors and other assumptions believed to be reasonable under the circumstances. The estimated reserves for these liabilities could be affected if future occurrences and claims differ from assumptions used and historical trends. Facility consolidations, focus on and investment in safety initiatives, and an emphasis on property loss prevention and product quality has resulted in an improvement in our loss history and the related assumptions used to analyze these reserves. This improvement resulted in a $5.3 million reduction to these insurance reserves that was recorded during the second quarter of fiscal 2006. We will continue to review these reserves on a quarterly basis, or more frequently if factors dictate a more frequent review is warranted.
The critical accounting policies discussed herein are not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for our judgment in their application. There are also areas in which our judgment in selecting an available alternative would not produce a materially different result.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
In the normal course of business, we are exposed to various market risks. We continually monitor these risks and regularly develop appropriate strategies to manage them. Accordingly, from time to time, we may enter into certain derivative financial and commodity instruments. These instruments are used solely to mitigate market exposure and are not used for trading or speculative purposes.
Interest Rate Risk
We entered into an interest rate swap in October 2004, which was amended December 17, 2004. The swap had a notional amount of $100 million to hedge changes in cash flows attributable to changes in the LIBOR rate associated with the December 17, 2004, issuance of the unsecured Floating Rate Senior Notes due December 2014. See Item 8 Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Note C Debt. The critical terms of the derivative correspond with the critical terms of the underlying exposure. The interest rate swap was executed with a highly rated financial institution. We pay a fixed rate of 4.46% and receive a variable rate based on six-month LIBOR. A sensitivity analysis of changes in the interest rate yield curve associated
with our interest rate swap indicates that a 10% decline in the yield curve would reduce the fair value of our interest rate swap by $3.2 million.
Foreign Currency Risk
The translation of foreign currencies into U.S. dollars subjects the Company to exposure related to fluctuating exchange rates. Derivative instruments are not used to manage this risk. However, the Company does make limited use of forward contracts to manage exposure to certain intercompany loans with our foreign affiliates. Such contracts limit exposure to both favorable and unfavorable currency fluctuations. At May 31, 2006, the difference between the contract and book value was not material to the Companys financial position, results of operations or cash flows. A 10% change in the exchange rate to the U.S. dollar forward rate is not expected to materially impact the financial position, results of operations, or cash flows. A sensitivity analysis of changes in the U.S. dollar on these foreign currency-denominated contracts indicates that if the U.S. dollar uniformly weakened by 10% against all of these currency exposures, the fair value of these instruments would decrease by $4.7 million. Any resulting changes in fair value would be offset by changes in the underlying hedged balance sheet position. The sensitivity analysis assumes a parallel shift in foreign currency exchange rates. The assumption that exchange rates change in parallel may overstate the impact of changing exchange rates on assets and liabilities denominated in a foreign currency.
Commodity Price Risk
We are exposed to market risk for price fluctuations on purchases of steel, natural gas, zinc (see additional information below regarding natural gas and zinc) and other raw materials and utility requirements. The Company attempts to negotiate the best prices for commodities and to competitively price products and services to reflect the fluctuations in market prices.
Derivative financial instruments are selectively used to manage exposure to fluctuations in the cost of natural gas and zinc. These contracts cover periods commensurate with known or expected exposures through 2008. No derivatives are held for trading purposes. No credit loss is anticipated, as the counterparties to these agreements are major financial institutions that are highly rated. The derivatives are classified as cash flow hedges. The effective portions of the changes in the fair values of these derivatives are recorded in other comprehensive income and are reclassified to cost of goods sold in the period in which earnings are impacted by the hedged items or in the period that the transaction no longer qualifies as a cash flow hedge. There were no transactions that ceased to qualify as a cash flow hedge in fiscal 2006.
A sensitivity analysis of changes in the price of hedged commodities indicates that a 10% decline in zinc prices would reduce the fair value of our hedge position by $4.0 million. A similar 10% decline in natural gas prices would reduce the fair value of the natural gas hedge position by $1.0 million. Any resulting changes in fair value would be recorded as adjustments to other comprehensive income.
Notional transaction amounts and fair values for the outstanding derivative positions as of May 31, 2006 and 2005 are summarized below. Fair values of the derivatives do not consider the offsetting underlying hedged item.
Quantitative and qualitative disclosures about market risk include forward-looking statements with respect to managements opinion about risks associated with our use of derivative instruments. These statements are based on certain assumptions with respect to market prices and industry supply of, and demand for, steel products and certain raw materials. To the extent these assumptions prove to be inaccurate, future outcomes with respect to hedging programs may differ materially from those discussed in the forward-looking statements.
Item 8. Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Worthington Industries, Inc.:
We have audited the accompanying consolidated balance sheets of Worthington Industries, Inc. and subsidiaries as of May 31, 2006 and 2005, and the related consolidated statements of earnings, shareholders equity, and cash flows for each of the years in the three-year period ended May 31, 2006. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule of valuation and qualifying accounts. These consolidated financial statements and financial statement schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated 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 Worthington Industries, Inc. and subsidiaries as of May 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended May 31, 2006, in conformity with U.S. generally accepted accounting principles. 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.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Worthington Industries, Inc. and subsidiaries internal control over financial reporting as of May 31, 2006, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated August 11, 2006, expressed an unqualified opinion on managements assessment of, and the effective operation of, internal control over financial reporting.
August 11, 2006
WORTHINGTON INDUSTRIES, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
See notes to consolidated financial statements
WORTHINGTON INDUSTRIES, INC.
CONSOLIDATED STATEMENTS OF EARNINGS
(In thousands, except per share)
See notes to consolidated financial statements.
WORTHINGTON INDUSTRIES, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
(Dollars in thousands, except per share)
See notes to consolidated financial statements
WORTHINGTON INDUSTRIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
See notes to consolidated financial statements.
WORTHINGTON INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Fiscal Years Ended May 31, 2006, 2005 and 2004
Note A Summary of Significant Accounting Policies
Consolidation: The consolidated financial statements include the accounts of Worthington Industries, Inc. and consolidated subsidiaries (the Company). Spartan Steel Coating, LLC (owned 52%) is fully consolidated with the equity owned by the partner shown as minority interest on the balance sheet, and its portion of net income or loss is included in miscellaneous income or expense. Investments in unconsolidated affiliates are accounted for using the equity method. Significant intercompany accounts and transactions are eliminated.
Use of Estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Cash and Cash Equivalents: The Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents.
Inventories: Inventories are valued at the lower of cost or market. Cost is determined using the first-in, first-out method for all inventories.
Derivative Financial Instruments: The Company does not engage in currency or commodity speculation and generally enters into derivatives only to hedge specific interest, foreign currency or commodity transactions. All derivatives are accounted for using mark-to-market accounting. Gains or losses from these transactions offset gains or losses of the assets, liabilities or transactions being hedged. Current assets and other assets include derivative fair values at May 31, 2006 of $13,868,000 and $25,307,000, respectively. If a cash flow derivative is terminated and the cash flows remain probable, the amount in other comprehensive income remains and will be reclassified to net earnings when the hedged cash flow occurs. Ineffectiveness of the hedges during the fiscal year ended May 31, 2006 (fiscal 2006), the fiscal year ended May 31, 2005 (fiscal 2005) and the fiscal year ended May 31, 2004 (fiscal 2004) was immaterial and was reported in other income (expense). The commodity derivatives hedge exposure through 2008.
Fair Value of Financial Instruments: The non-derivative financial instruments included in the carrying amounts of cash and cash equivalents, short-term investments, account and note receivables, other assets and account and note payables, approximate fair values. The fair value of long-term debt, including current maturities, based upon quoted market prices was $250,206,000 and $408,101,000 at May 31, 2006 and 2005, respectively.
Risks and Uncertainties: As of May 31, 2006, the Company, including unconsolidated affiliates, operated 62 production facilities in 23 states and 10 countries. The Companys largest markets are the construction and the automotive and automotive supply markets, which comprise approximately 41% and 33%, respectively, of the Companys net sales. Foreign operations and exports represent less than 10% of the Companys production, consolidated net sales and consolidated net assets. Approximately 11% of the Companys consolidated labor force is covered by collective bargaining agreements. These numbers include 95 employees who were covered by a contract that expired on May 5, 2006 that is currently being renegotiated. Of the remaining labor contracts, none expire within one year from May 31, 2006. The concentration of credit risks from financial instruments related to the markets served by the Company is not expected to have a material adverse effect on the Companys consolidated financial position, cash flows or future results of operations.
Property and Depreciation: Property, plant and equipment are carried at cost and depreciated using the straight-line method. Buildings and improvements are depreciated over 10 to 40 years and machinery and equipment over 3 to 20 years. Depreciation expense was $56,769,000 for fiscal 2006, $55,409,000 for fiscal 2005, and $66,545,000 for fiscal 2004. Accelerated depreciation methods are used for income tax purposes.
Planned Maintenance Activities: The Company uses the deferral method to account for costs of planned maintenance shutdowns. Under this method the costs of a qualifying shutdown are capitalized and amortized on a straight-line basis, into maintenance expense, until the next anticipated shutdown. In no case will the amortization period exceed twelve months.
Leases: Certain lease agreements contain fluctuating or escalating payments and rent holiday periods. The related rent expense is recorded on a straight-line basis over the length of the lease term. Leasehold improvements made by the lessee that are funded by landlord allowances or incentives are recorded as leasehold improvement assets and will be amortized over the shorter of the economic life or the lease term. These incentives are also recorded as deferred rent and amortized as reductions in rent expense over the lease term.
Capitalized Interest: The Company capitalizes interest in connection with the construction of qualified assets. Under this policy, the Company capitalized interest of $638,000 in fiscal 2006, $158,000 in fiscal 2005 and $22,000 in fiscal 2004.
Stock-Based Compensation: At May 31, 2006, the Company had stock option plans for employees and non-employee directors which are described more fully in Note F Stock-Based Compensation. The Company accounts for these plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and the related interpretations. No stock-based employee compensation cost is reflected in net earnings, as all options granted under the plans had an exercise price equal to the fair market value of the underlying common shares on the date of the grant. Pro forma information regarding net earnings and earnings per share is required by Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation Transition and Disclosure. This information is required to be determined as if the Company had accounted for its options granted after December 31, 1994, under the fair value method prescribed by that Statement.
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)). SFAS 123(R) is a revision of SFAS 123 and it supercedes APB No. 25 and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee options, to be recognized in the income statement based on their fair values. Pro forma disclosure will not be an alternative. SFAS 123(R) is effective for all fiscal years beginning after June 15, 2005, and thus will become effective for the Company beginning in fiscal 2007.
The adoption of SFAS 123(R)s fair value method will not materially impact the Companys results of operations or overall financial position. Stock option expense after the adoption of SFAS 123(R) is not expected to be materially different than the expense reported in the table below, but this will not be known until a full analysis of the impact of SFAS 123(R) is completed. The impact will largely depend on levels of share-based payments granted in the future.
On March 29, 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107). SAB 107 provides interpretations expressing the views of the SEC staff regarding the interaction between SFAS 123(R) and certain SEC rules and regulations, and provides the staffs views regarding the valuation of share-based payment arrangements for public companies. SAB 107 does not modify any of SFAS 123(R)s conclusions or requirements.
The weighted average fair value of stock options granted in fiscal 2006, fiscal 2005 and fiscal 2004 was $3.62, $3.14, and $2.82, respectively, based on the Black Scholes option pricing model with the following weighted average assumptions:
The following table illustrates the effect on net earnings and earnings per share if the Company had accounted for the stock option plans under the fair value method of accounting, as required by SFAS 123, for the years ended May 31:
Revenue Recognition: The Company recognizes revenue upon transfer of title and risk of loss provided evidence of an arrangement exists, pricing is fixed and determinable, and collectibility is probable. In circumstances where the collection of payment is highly questionable at the time of shipment, the Company defers recognition of revenue until payment is collected. The Company provides an allowance for expected returns based on experience and current customer activities. Within the Construction Services operating segment, revenue is recognized on a percentage-of-completion method.
Advertising Expense: The Company expenses advertising costs as incurred. Advertising expense was $3,571,000, $3,924,000 and $3,024,000 for fiscal 2006, fiscal 2005 and fiscal 2004, respectively.
Shipping and Handling Fees and Costs: Shipping and handling fees billed to customers are included in net sales and shipping and handling costs incurred by the Company are included in cost of goods sold.
Environmental Costs: Environmental costs are capitalized if the costs extend the life of the property, increase its capacity, and/or mitigate or prevent contamination from future operations. Costs related to environmental contamination treatment and clean-up are charged to expense.
Statements of Cash Flows: Supplemental cash flow information for the years ended May 31 is as follows: