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SCHNITZER STEEL INDUSTRIES, INC.
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the quarterly period ended May 31, 2004
or
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from ________ to ________.
Commission files number 0-22496
SCHNITZER STEEL INDUSTRIES, INC.
--------------------------------
(Exact name of registrant as specified in its charter)
OREGON 93-0341923
------ ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3200 N.W. Yeon Ave.
P.O Box 10047
Portland, OR 97296-0047
------------- ----------
(Address of principal executive offices) (Zip Code)
(503) 224-9900
--------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes [X] No [ ]
The Registrant had 21,582,541 shares of Class A Common Stock, par value of $1.00
per share, and 8,548,515 shares of Class B Common Stock, par value of $1.00 per
share, outstanding at June 30, 2004.
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INDEX
PAGE NO.
--------
PART I. FINANCIAL INFORMATION
Condensed Consolidated Balance Sheets at May 31, 2004
and August 31, 2003........................................................3
Condensed Consolidated Statement of Operations for the
Three Months and Nine Months Ended May 31, 2004 and 2003...................4
Condensed Consolidated Statement of Shareholders' Equity for the
Year Ended August 31, 2003 and the Nine Months
Ended May 31, 2004.........................................................5
Condensed Consolidated Statement of Cash Flows for the
Nine Months Ended May 31, 2004 and 2003....................................6
Notes to Condensed Consolidated Financial Statements...........................7
Management's Discussion and Analysis of
Financial Condition and Results of Operations..............................15
Quantitative and Qualitative Disclosures about Market Risk....................29
Controls and Procedures.......................................................29
PART II. OTHER INFORMATION
Exhibits and Reports on Form 8-K..............................................30
SIGNATURE PAGE................................................................31
2
SCHNITZER STEEL INDUSTRIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except per share amounts)
MAY 31, 2004 AUG. 31, 2003
------------ -------------
ASSETS
------
Current Assets:
Cash and equivalents $ 3,621 $ 1,687
Accounts receivable, less allowance for doubtful accounts
of $1,045 and $712 68,126 38,428
Accounts receivable from related parties 265 555
Inventories (Note 2) 87,971 61,143
Deferred income taxes 4,595 4,524
Prepaid expenses and other 8,269 7,400
------------ ------------
Total current assets 172,847 113,737
Net property, plant and equipment 142,615 141,224
Other assets:
Investment in and advances to joint venture partnerships 163,711 119,066
Goodwill 131,178 107,209
Intangibles and other 7,289 6,658
------------ ------------
$ 617,640 $ 487,894
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
Current liabilities:
Current portion of long-term debt $ 229 $ 220
Accounts payable 31,402 21,537
Accrued payroll liabilities 14,252 8,896
Accrued income taxes 16,386 31
Current portion of environmental liabilities 14,750 4,639
Other accrued liabilities 7,768 5,973
------------ ------------
Total current liabilities 84,787 41,296
Deferred income taxes 22,487 33,093
Long-term debt, less current portion 112,857 87,045
Environmental liabilities, net of current portion 9,100 17,139
Other long-term liabilities 2,726 2,704
Minority interests 5,653 3,620
Commitments and contingencies -- --
Shareholders' equity:
Preferred stock--20,000 shares authorized, none issued -- --
Class A common stock-75,000 shares $1 par value authorized,
21,544 and 12,445 shares issued and outstanding 21,544 12,445
Class B common stock--25,000 shares $1 par value authorized,
8,584 and 7,061 shares issued and outstanding 8,584 7,061
Additional paid-in capital 108,980 104,249
Retained earnings 240,949 179,242
Accumulated other comprehensive loss:
Foreign currency translation adjustment (27) --
------------ ------------
Total shareholders' equity 380,030 302,997
------------ ------------
$ 617,640 $ 487,894
============ ============
The accompanying notes are an integral part of this statement.
3
SCHNITZER STEEL INDUSTRIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(Unaudited, in thousands, except per share amounts)
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
------------------------------ ------------------------------
MAY 31, 2004 MAY 31, 2003 MAY 31, 2004 MAY 31, 2003
------------ ------------ ------------ ------------
Revenues $ 193,750 $ 127,944 $ 483,729 $ 343,270
Cost and expenses:
Cost of goods sold 139,339 105,051 381,667 288,000
Impairment and other non-recurring charges -- -- -- 2,100
Selling and commission expenses 1,903 1,369 4,287 3,811
General and administrative expenses 13,206 8,337 30,771 23,484
------------ ------------ ------------ ------------
Income from consolidated operations 39,302 13,187 67,004 25,875
Income from joint ventures 28,013 8,840 42,634 18,209
------------ ------------ ------------ ------------
Income from operations 67,315 22,027 109,638 44,084
Other expense:
Interest expense (562) (444) (1,488) (1,134)
Other expense (315) (61) (161) (277)
------------ ------------ ------------ ------------
(877) (505) (1,649) (1,411)
Income before cumulative effect of change in
accounting principle, income taxes, minority
interests and pre-acquisition interests 66,438 21,522 107,989 42,673
Income tax provision (23,187) (5,945) (32,951) (11,462)
------------ ------------ ------------ ------------
Income before cumulative effect of change in
accounting principle, minority interests,
and pre-acquisition interests 43,251 15,577 75,038 31,211
Minority interests, net of tax (737) (549) (1,797) (1,350)
Pre-acquisition interests, net of tax -- -- -- (2,547)
------------ ------------ ------------ ------------
Income before cumulative effect of change in
accounting principle 42,514 15,028 73,241 27,314
Cumulative effect of change in accounting
principle -- -- -- (983)
------------ ------------ ------------ ------------
Net Income $ 42,514 $ 15,028 $ 73,241 $ 26,331
============ ============ ============ ============
Net Income per share - basic:
Income before cumulative effect of change
in accounting principle $ 1.41 $ 0.54 $ 2.45 $ 0.99
Cumulative effect of change in accounting
principle -- -- -- (0.04)
------------ ------------ ------------ ------------
Net Income per share - basic $ 1.41 $ 0.54 $ 2.45 $ 0.95
============ ============ ============ ============
Net Income per share - diluted:
Income before cumulative effect of change
in accounting principle $ 1.37 $ 0.52 $ 2.36 $ 0.96
Cumulative effect of change in accounting
principle -- -- -- (0.04)
------------ ------------ ------------ ------------
Net Income per share - diluted $ 1.37 $ 0.52 $ 2.36 $ 0.92
============ ============ ============ ============
The accompanying notes are an integral part of this statement.
4
SCHNITZER STEEL INDUSTRIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(in thousands, unaudited)
Class A Class B Accumulated
Common Stock Common Stock Additional Other
------------------- ------------------- Paid-in Retained Comprehensive
Shares Amount Shares Amount Capital Earnings Loss Total
-------- -------- -------- -------- --------- -------- --------- --------
Balance at August 31, 2002 5,025 $ 5,025 4,180 $ 4,180 $ 96,074 $147,669 $ -- $252,948
Class B common stock converted to Class A
common stock 635 635 (635) (635) --
Class A common stock issued 547 547 8,175 8,722
Net income 43,201 43,201
Stock dividend 6,238 6,238 3,516 3,516 (9,754) --
Cash dividends - common ($0.10 per share) (1,874) (1,874)
-------- -------- -------- -------- --------- -------- --------- --------
Balance at August 31, 2003 12,445 12,445 7,061 7,061 104,249 179,242 -- 302,997
Net income 73,241 73,241
Foreign currency translation adjustments (27) (27)
--------
Comprehensive income 73,214
Class B common stock converted to Class A
common stock 1,465 1,465 (1,465) (1,465) --
Class A common stock issued 602 602 4,731 5,333
Stock dividend 7,032 7,032 2,988 2,988 (10,020) --
Cash dividends - common ($0.05 per share) (1,514) (1,514)
-------- -------- -------- -------- --------- -------- --------- --------
Balance at May 31, 2004 21,544 $ 21,544 8,584 $ 8,584 $ 108,980 $240,949 $ (27) $380,030
======== ======== ======== ======== ========= ======== ========= ========
The accompanying notes are an integral part of this statement.
5
SCHNITZER STEEL INDUSTRIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands, unaudited)
FOR THE NINE MONTHS ENDED
------------------------------
MAY 31, 2004 MAY 31, 2003
------------ ------------
Operations:
Net income $ 73,241 $ 26,331
Noncash items included in income:
Cumulative effect of change in accounting principle -- 983
Depreciation and amortization 15,020 14,709
Minority and pre-acquisition interests 2,514 5,267
Equity in income of joint ventures (42,634) (18,209)
Deferred income tax (10,677) (33)
Gain on disposal of assets (212) (106)
Cash provided (used) by changes in working capital:
Accounts receivable (29,408) 1,378
Inventories (26,828) (10,607)
Prepaid expenses and other 2,631 (3,426)
Accounts payable 9,865 1,538
Accrued liabilities 23,243 725
Environmental liabilities, net of recoveries (1,428) 885
Other assets and liabilities 195 1,427
------------ ------------
Net cash provided by operations 15,522 20,862
------------ ------------
Investing:
Capital expenditures (17,046) (14,810)
Investment in subsidiaries (23,861) (64,923)
Cash received from joint ventures 470 260
Cash paid to joint ventures (2,595) (2,842)
Proceeds from sale of assets 1,628 577
------------ ------------
Net cash used by investments (41,404) (81,738)
------------ ------------
Financing:
Issuance of Class A common stock 5,333 2,910
Distributions to minority and pre-acquisition interests (1,824) (3,901)
Dividends declared and paid (1,514) (1,389)
Increase in long-term debt 25,821 31,414
------------ ------------
Net cash provided by financing 27,816 29,034
------------ ------------
Net increase (decrease) in cash 1,934 (31,842)
Cash at beginning of period 1,687 32,974
------------ ------------
Cash at end of period $ 3,621 $ 1,132
============ ============
The accompanying notes are an integral part of this statement.
5
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED MAY 31, 2004 AND 2003
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
BASIS OF PRESENTATION
- ---------------------
The accompanying unaudited condensed interim financial statements of Schnitzer
Steel Industries, Inc. (the Company) have been prepared pursuant to the rules
and regulations of the Securities and Exchange Commission (SEC). Certain
information and note disclosures normally included in annual financial
statements have been condensed or omitted pursuant to those rules and
regulations. The condensed unaudited balance sheet for the year ended August 31,
2003 is derived from the audited balance sheet for the year ended August 31,
2003. In the opinion of management, all adjustments, consisting only of normal,
recurring adjustments considered necessary for a fair presentation, have been
included. Although management believes that the disclosures made are adequate to
ensure that the information presented is not misleading, management suggests
that these financial statements be read in conjunction with the financial
statements and notes thereto included in the Company's annual report for the
fiscal year ended August 31, 2003. The results for the three and nine months
ended May 31, 2004 and 2003 are not necessarily indicative of the results of
operations for the entire year.
Note 3 of the Notes to the Condensed Consolidated Financial Statements describes
an acquisition that occurred on February 14, 2003. Under Statement of Financial
Accounting Standards No. 141 ("SFAS 141"), "Business Combinations," the
acquisition is considered a "step" acquisition due to the fact that the Company
had a significant joint venture interest in the acquired business for a number
of years. Additionally, since the acquisition occurred during the year, the
Company elected to include it in the consolidated results as though it had
occurred at the beginning of fiscal 2003. Thus, the 2003 statement of
operations, balance sheet and statement of cash flows have been adjusted to
consolidate the acquisition as of September 1, 2002. For the period from
September 1, 2002 through February 14, 2003, net income was reduced by $2.5
million of pre-acquisition interests, net of income taxes, representing the
share of income attributable to the former joint venture partner prior to the
acquisition.
RECLASSIFICATIONS
- -----------------
Certain prior year amounts have been reclassified to conform to the fiscal 2004
presentation. These changes had no impact on previously reported results of
operations or shareholders' equity.
EARNINGS AND DIVIDENDS PER SHARE
- --------------------------------
Basic earnings per share (EPS) are computed based upon the weighted average
number of common shares outstanding during the period. Diluted EPS reflects the
potential dilution that would occur if securities or other contracts to issue
common stock were exercised or converted into common stock.
7
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED MAY 31, 2004 AND 2003
The following represents reconciliation from basic EPS to diluted EPS (in
thousands, except per share amounts):
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
(Unaudited)
Income before cumulative effect
of change in accounting principle $ 42,514 $ 15,028 $ 73,241 $ 27,314
Cumulative effect of change in accounting
principle -- -- -- (983)
------------ ------------ ------------ ------------
NetIncome $ 42,514 $ 15,028 $ 73,241 $ 26,331
============ ============ ============ ============
Computation of shares (1):
Average common shares outstanding 30,088 27,825 29,897 27,687
Stock options 971 1,167 1,152 789
------------ ------------ ------------ ------------
Diluted average common shares outstanding 31,059 28,992 31,049 28,476
============ ============ ============ ============
Basic EPS:
Income before cumulative effect
of change in accounting principle $ 1.41 $ 0.54 $ 2.45 $ 0.99
Cumulative effect of change in accounting
principle -- -- -- (0.04)
------------ ------------ ------------ ------------
Net Income per share - basic $ 1.41 $ 0.54 $ 2.45 $ 0.95
============ ============ ============ ============
Diluted EPS:
Income before cumulative effect
of change in accounting principle $ 1.37 $ 0.52 $ 2.36 $ 0.96
Cumulative effect of change in accounting
principle -- -- -- (0.04)
------------ ------------ ------------ ------------
Net Income per share - diluted $ 1.37 $ 0.52 $ 2.36 $ 0.92
============ ============ ============ ============
Dividend per share(1) $ 0.017 $ 0.017 $ 0.05 $ 0.05
============ ============ ============ ============
(1) Basic and diluted earnings per share and dividends per common share for
the three and nine months ended May 31, 2003, have been adjusted to
reflect the one-for-one share dividend paid on August 14, 2003, to
shareholders of record on July 24, 2003. Additionally, the per share data
for all periods have been adjusted to reflect the three-for-two stock
split effected as a stock dividend and paid March 25, 2004, to
shareholders of record on March 4, 2004.
Options to purchase 804,000 shares were outstanding for the three and nine month
period ended May 31, 2003, but are not included in the computation of diluted
earnings per share because the options' exercise prices were greater than the
average market price of the common shares and, therefore, the effect would be
anti-dilutive. All of the options for fiscal 2004 are considered to be dilutive
and are reflected in the above table.
STOCK INCENTIVE PLAN
- --------------------
The Company's compensation expense for its stock incentive plans is determined
using the intrinsic value method. Accordingly, because the exercise price
generally equals the market price on the date of the grant, no compensation
expense is recognized by the Company for stock options issued to employees and
directors. If the fair value based method had been applied in measuring stock
compensation expense, the pro forma effect on net income per share would have
been as follows (in thousands, except earnings per share):
8
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED MAY 31, 2004 AND 2003
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
(Unaudited)
Reported net income $ 42,514 $ 15,028 $ 73,241 $ 26,331
Stock compensation expense, net of tax (139) (351) (405) (646)
------------ ------------ ------------ ------------
Pro forma net income $ 42,375 $ 14,677 $ 72,836 $ 25,685
============ ============ ============ ============
Reported basic income per share $ 1.41 $ 0.54 $ 2.45 $ 0.95
Pro forma basic income per share $ 1.41 $ 0.53 $ 2.44 $ 0.93
Reported diluted income per share $ 1.37 $ 0.52 $ 2.36 $ 0.92
Pro forma diluted income per share $ 1.36 $ 0.51 $ 2.35 $ 0.90
Pro forma diluted net income per share for the three and nine months ended May
31, 2003 is computed excluding potential common shares of 804,000, as their
effect is anti-dilutive. All of the options for fiscal 2004 are considered to be
dilutive and are reflected in the above table.
GOODWILL
- --------
The changes in the carrying amount of goodwill for the nine months ended May 31,
2004, are as follows (in thousands):
Metals
Recycling Auto Parts
Business Business Total
---------- ---------- ----------
Balance as of August 31, 2003,
audited $ 34,771 $ 72,438 $ 107,209
Pick-N-Pull Business -- 10,812 10,812
Combination (Note 3)
Canadian Acquisition (Note 3) -- 13,157 13,157
---------- ---------- ----------
Balance as of May 31, 2004,
unaudited $ 34,771 $ 96,407 $ 131,178
========== ========== ==========
The Company performs impairments tests annually and whenever events and
circumstances indicate that the value of goodwill and other indefinite-lived
intangible assets might be impaired. As of May 31, 2004, based on the results of
the above business segments and the impairment tests performed, none of the
above balances were impaired.
PENSION PLAN
- ------------
For certain nonunion employees (excluding Cascade Steel Rolling Mills), the
Company maintains a defined benefit pension plan. The components of net periodic
pension benefit cost are (in thousands):
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
(Unaudited)
Service cost $ 260 $ 177 $ 691 $ 584
Interest cost 169 123 448 405
Expected return on plan assets (192) (115) (511) (379)
Amortization of past service cost 1 1 3 3
Recognized actuarial loss 48 22 127 73
------------ ------------ ------------ ------------
Net periodic pension benefit cost $ 286 $ 208 $ 758 $ 686
============ ============ ============ ============
9
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED MAY 31, 2004 AND 2003
For the year ended August 31, 2004, the Company expects to contribute $1.0
million to its defined benefit pension plan. As of May 31, 2004, the Company has
contributed approximately $0.3 million to this plan.
For Cascade Steel Rolling Mills nonunion employees, the Company maintains a
defined contribution pension plan. The total plan costs are (in thousands):
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
(Unaudited)
Plan costs $ 305 $ 265 $ 915 $ 767
For certain union employees, the Company contributes funds to a multiemployer
pension plan. The total plan contributions are (in thousands):
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
(Unaudited)
Plan contributions $ 832 $ 607 $ 2,322 $ 1,946
NOTE 2 - INVENTORIES:
Inventories consisted of the following (in thousands):
May 31, August 31,
2004 2003
-------- --------
(Unaudited) (Audited)
Recycled metals $ 46,146 $ 21,115
Work in process 5,803 8,254
Finished goods 23,973 19,912
Supplies 12,049 11,862
-------- --------
$ 87,971 $ 61,143
======== ========
NOTE 3 - BUSINESS COMBINATIONS AND ACQUISITIONS:
CANADIAN ACQUISITION
- --------------------
On March 8, 2004, the Company, through its wholly owned subsidiary, PNP Auto
Parts Canada Co., acquired the assets and leased the sites of three self-service
used auto parts stores in Calgary and Edmonton, Alberta and Kelowna, British
Columbia from Sheppard Holdings Ltd. of Calgary, Alberta, Canada, or its
affiliates. The three stores currently operate under the name of Pick Your Part.
This acquisition expands the geographic scope of our auto parts business into
the Canadian market as part of our strategy to grow the business in North
America. The acquisition was completed in the third quarter of fiscal 2004. The
purchase price ($13.7 million) and the results of operations for these three
stores are reflected in the consolidated results of the Company beginning with
the third fiscal 2004 quarter ended May 31, 2004. Of the total purchase price,
$13.2 million was related to goodwill. For further information related to
goodwill, refer to Note 1 of the Consolidated Financial Statements.
PICK-N-PULL BUSINESS COMBINATION
- --------------------------------
On February 14, 2003, the Company's wholly owned subsidiary, Norprop, Inc.
("Norprop") closed its acquisition (the "Acquisition") of all of the stock of
Pick and Pull Auto Dismantling, Inc., which was the Company's 50% partner in
Pick-N-Pull Auto Dismantlers, a California general partnership (the "Joint
Venture") and all of the
10
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED MAY 31, 2004 AND 2003
membership interests in Pick-N-Pull Auto Dismantlers, Stockton, LLC
("Stockton"). The cost of the Acquisition consisted of $71.4 million of cash
paid to the seller at closing, $3.3 million of debt assumed and immediately paid
off, $0.6 million of acquisition costs and $0.5 million of tax related expenses.
In addition, Norprop assumed approximately $12.5 million of debt owed by the
Joint Venture to the Company. Two additional payments have been made during
fiscal 2004. The first payment of $4.7 million was made during the fiscal
quarter ended November 30, 2003, as a result of an amendment to the Purchase
Agreement. The second and final payment of $7.1 million was made during the
fiscal quarter ended February 29, 2004, and related to a purchase price
adjustment one year after closing based upon calendar year 2002 and 2003
earnings before interest, taxes, depreciation and amortization (EBITDA) of the
acquired Auto Parts Business. The total purchase price was $100.1 million (or
$96.5 million net of the seller's $3.6 million share of the Joint Venture's cash
on hand at closing). The Joint Venture stores together with the Stockton store
are one of the country's leading self-service used auto parts network. At the
time of this acquisition, there were 23 store locations, 17 in northern
California, two in Nevada, and one in each of Texas, Utah, Illinois and Indiana.
During the nine months ended May 31, 2004, the Company has expanded its
operations into Canada, with the purchase of three stores in an unrelated
transaction bringing the total number of stores to 26.
The following is a summary of the estimated fair values of the assets acquired
and liabilities assumed as of the date of the acquisition (in millions):
Property, plant and equipment $ 13.3
Identified intangible assets 3.7
Other assets 5.4
Liabilities (3.8)
Goodwill 81.5
-------
Total $ 100.1
=======
Goodwill of $81.5 million represents the excess of purchase price over the fair
value of the net tangible and identified intangible assets acquired, and, as a
result of a tax election filed jointly by the Company and seller, substantially
all of it will be deductible for tax purposes over a 15-year period. Also,
approximately $1.8 million of goodwill existed on the Joint Venture's balance
sheet prior to the Acquisition but was not shown separately in accordance with
the equity method of accounting. Therefore, the total increase to goodwill
related to the Acquisition was $83.3 million. In accordance with Statement of
Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets,"
goodwill is not amortized and will be tested for impairment at least annually.
NOTE 4 - SEGMENT INFORMATION:
The Company operates in three industry segments: metal processing and recycling
(Metals Recycling Business), mini-mill steel manufacturing (Steel Manufacturing
Business) and self-service used retail auto parts (Auto Parts Business).
Additionally, the Company is a non-controlling partner in joint ventures, which
are either in the metals recycling business or suppliers of unprocessed metals.
The Joint Ventures in the Metals Recycling Business sell recycled metals that
have been processed at their facilities (Processing) and also buy and sell third
parties' processed metals (Brokering). The Company considers these joint
ventures to be separate segments because they are managed separately. These
joint ventures are accounted for using the equity method. As such, the operating
information related to the joint ventures is shown separately from consolidated
information, except for the Company's equity in the net income of, investments
in and advances to the joint ventures. Additionally, assets and capital
expenditures are not shown for the joint ventures as management does not use
that information to allocate resources or assess performance. The Company does
not allocate corporate interest income and expense, income taxes or other income
and expenses related to corporate activity to its operating segments.
11
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED MAY 31, 2004 AND 2003
Revenues from external customers for the Company's consolidated operations are
as follows (in thousands):
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
Metals Recycling Business $ 137,997 $ 79,318 $ 326,926 $ 210,608
Steel Manufacturing Business 72,048 51,076 185,128 135,177
Auto Parts Business 23,294 17,311 58,199 48,205
Intersegment revenues (39,589) (19,761) (86,524) (50,720)
------------ ------------ ------------ ------------
Consolidated revenues $ 193,750 $ 127,944 $ 483,729 $ 343,270
============ ============ ============ ============
The joint ventures' revenues from external customers are as follows (in
thousands):
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
Joint Ventures in the Metals
Recycling Business:
Processing $ 343,625 $ 174,732 $ 729,840 $ 430,249
Brokering 193,946 58,088 424,406 151,292
Joint Venture Suppliers of Metals 4,128 1,642 8,573 6,151
------------ ------------ ------------ ------------
Total revenues $ 541,699 $ 227,305 $ 1,163,319 $ 569,138
============ ============ ============ ============
The Company's income (loss) from operations is as follows (in thousands):
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
Metals Recycling Business $ 32,462 $ 10,114 $ 55,547 $ 21,679
Auto Parts Business 8,554 6,005 19,537 16,236
Steel Manufacturing Business 6,956 (283) 9,506 (2,898)
Joint Ventures in the Metals Recycling Business 27,888 9,117 42,964 18,659
Joint Venture Suppliers of Metals 125 (277) (330) (450)
Corporate expense (6,053) (2,445) (11,717) (6,998)
Eliminations (2,617) (204) (5,869) (44)
Impairment and other non-recurring charges -- -- -- (2,100)
------------ ------------ ------------ ------------
Consolidated income from operations $ 67,315 $ 22,027 $ 109,638 $ 44,084
============ ============ ============ ============
Income from operations generated by the joint ventures represents the Company's
equity in the income or loss of these entities.
The Company's share of depreciation and amortization expense included in the
determination of joint ventures' income from operations is as follows (in
thousands):
12
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED MAY 31, 2004 AND 2003
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
Joint Ventures in the Metals
Recycling Business $ 1,935 $ 1,488 $ 5,160 $ 4,748
Joint Venture Suppliers of Metals 65 70 199 219
------------ ------------ ------------ ------------
Total $ 2,000 $ 1,558 $ 5,359 $ 4,967
============ ============ ============ ============
NOTE 5 - INCOME TAX PROVISION:
As part of the 1996 acquisition of Proler International, Inc., the Company
succeeded to federal income tax Net Operating Loss carryforwards ("NOLs"). In
accordance with generally accepted accounting principles (GAAP), valuation
reserves were then established against the NOLs because management was uncertain
whether the Company's future taxable income would be sufficient to use the NOLs.
Part of the uncertainty stemmed from two Federal tax law constraints, one an
annual dollar limit and the other a time limit: With respect to the NOLs, the
Company could only offset taxable income by $2.4 million a year, and they would
expire if not used by 2016. Management would assess the continuing need for the
valuation reserves each fiscal quarter, and would release them only to the
extent that the uncertainty regarding their use was judged to be mitigated.
During the second quarter of fiscal 2004, management assessed those reserves and
determined that it was more likely than not that future taxable income would be
sufficient to absorb the remaining NOLs of $15.3 million. Accordingly, the $6.1
million deferred tax asset valuation allowance associated with the NOLs was
reversed and income tax expense was reduced by that amount. This determination
was based upon a number of factors including profitability trends, industry
fundamentals and recent profitable acquisitions. The reversal of the valuation
allowance, offset in part by an unrelated change in estimated Extraterritorial
Income Exclusion (EIE) tax benefits on export sales, reduced the Company's
second quarter tax rate from 29% to 19%. The reversal had no effect on cash
flows, as those are only affected by the present and future use of the NOLs
against taxable income.
For the nine months ended May 31, 2004, the tax rate was 31%, which includes an
EIE benefit of approximately 3%.
NOTE 6 - ENVIRONMENTAL LIABILITIES:
PROLER
- ------
Metals Recycling L.L.C. (Metals) is a scrap metals processing business with
locations in Rhode Island and Massachusetts. The members of Metals are one of
the Company's joint ventures, Proler International Corp. (Proler) and Izzo
Group, Inc. On June 9, 1999, the Rhode Island Department of Environmental
Management (DEM) issued a Notice of Violation (NOV) against Metals, alleging
Metals had violated federal and state regulations relating to the storage,
management and transportation of hazardous waste and seeking to impose an
administrative penalty of $0.7 million. Metals filed an answer to the NOV in
which it denied the allegations and requested an adjudicatory hearing. In
January of 1999, federal and state officials searched Metals' Johnston, Rhode
Island and Worcester, Massachusetts facilities. Metals was advised that the
search was part of a state criminal investigation into possible violations of
state and federal hazardous waste programs and a Rhode Island statute that
prohibits the disposal of out-of-state solid waste at the landfill operated by
Rhode Island Resource Recovery Corporation (RIRRC). A grand jury was empanelled
to consider the allegations and issued an indictment on August 30, 2002 against
Metals for storing hazardous waste without a permit, operating a hazardous waste
disposal facility without a permit, causing transportation of hazardous waste
without a permit,
13
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED MAY 31, 2004 AND 2003
causing transportation of hazardous waste without a manifest and operating a
solid waste management facility without a license. Metals pleaded not guilty on
all counts and vigorously contested the state's allegations. Settlement
discussions with DEM and the Rhode Island Attorney General's Office resulted in
the dismissal with prejudice of the criminal charges and Metals' settlement of
the DEM's civil NOV by payment of $250,000 pursuant to a Consent Agreement
entered into on December 4, 2003.
AUTO PARTS BUSINESS
- -------------------
On January 6, 2004, Pick-N-Pull Auto Dismantlers (PNP), one of the Company's
subsidiaries in the Auto Parts Business segment, was served with a Notice of
Violation (NOV) of the general permit requirements on its diesel powered car
crushers at the Rancho Cordova and Sacramento locations from the Sacramento
Metropolitan Air Quality Management District (SMAQMD). The NOV required PNP to
cease operation of the car crushers at these locations. Since receiving this
notification, the Sacramento location has converted its diesel powered car
crusher to electric powered, and the Rancho Cordova location has received an
interim permit from SMAQMD to operate its diesel powered car crusher, with
modifications, for one year. The Company is engaged in an ongoing evaluation of
its car crushing systems and discussions with the SMAQMD to assure compliance
and address the potential regulatory enforcement penalties. The Company is
cooperating with the SMAQMD, but, as this is a new enforcement initiative and a
first time violation, it is difficult to reasonably estimate the amount, if any,
of the penalties. However, the Company's financial statements include an amount
to cover what it currently believes is the potential exposure.
MANUFACTURING MANAGEMENT, INC.
- ------------------------------
In 1994, Manufacturing Management, Inc. (MMI) recorded a reserve for the
estimated cost to cure certain environmental liabilities. This reserve was
carried over to the Company's financial statements when MMI was acquired in
1995, and at May 31, 2004 aggregated $17.4 million.
General Metals of Tacoma (GMT), a subsidiary of MMI, owns and operates a metals
recycling facility located in the State of Washington on the Hylebos Waterway, a
part of Commencement Bay, which is the subject of an ongoing remediation project
by the United States Environmental Protection Agency (EPA) under the
Comprehensive Environmental Response, Compensation and Liability Act (CERCLA).
GMT and more than 60 other parties were named potentially responsible parties
(PRPs) for the investigation and clean-up of contaminated sediment along the
Hylebos Waterway. On March 25, 2002, the EPA issued Unilateral Administrative
Orders (UAOs) to GMT and another party (Other Party) to proceed with Remedial
Design and Remedial Action (RD/RA) for the head of the Hylebos Waterway and to
two other parties to proceed with the RD/RA for the balance of the waterway. The
issuance of the UAOs did not require the Company to change its previously
recorded estimate of environmental liabilities for this site. The UAO for the
head of the Hylebos Waterway was converted to a voluntary consent decree in May
2004, pursuant to which GMT and the Other Party agreed to remediate the head of
the Hylebos Waterway. Notice of the consent decree was published in the Federal
Register on June 17, 2004. The public comment period on the consent decree will
end July 19, 2004, unless extended by the United States Department of Justice.
Upon the final entry of the consent decree, approximately $7 million in
settlement funds previously collected by EPA from other PRPs will be available
for reimbursement of remediation costs incurred by GMT and the Other Party.
Accordingly, as of May 31, 2004, the Company recorded $3.5 million in other
current assets representing the Company's share of the expected EPA
reimbursements and, because the expectation of contribution from other PRPs in
this amount had previously been taken into account as a reduction in the
Company's reserve for environmental liabilities, the Company also recorded a
$3.5 million increase in environmental liabilities. GMT and the Other Party may
pursue legal actions against other non-settling, non-performing PRPs to recover
additional amounts that may be applied against the head of the Hylebos
remediation costs. Significant uncertainties continue to exist regarding the
total cost to remediate this site as well as the Company's share of those costs;
nevertheless, the Company's estimate of its liabilities related to this site is
based on information currently available.
14
SCHNITZER STEEL INDUSTRIES, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The Company operates in three industry segments. The Company's Metals Recycling
Business collects, processes and recycles steel and other metals through its
facilities. The Company's Steel Manufacturing Business operates a mini-mill near
Portland, Oregon, which melts recycled metal, produces finished steel products
and maintains one mill depot in Southern California and a third party depot in
Central California. The Company's Auto Parts Business purchases used and wrecked
automobiles and allows retail customers the opportunity of extracting parts for
purchase in its self-service auto parts stores, with 17 located in California,
three in Canada, two in Nevada, and one store in each of Texas, Utah, Illinois
and Indiana. Additionally, the Company is a non-controlling partner in joint
ventures that are either in the metals recycling business or are suppliers of
unprocessed metals. The Joint Ventures in the Metals Recycling Business sell
recycled metals that have been processed at their facilities (Processing) and
also buy and sell third parties' processed metals (Brokering).
RESULTS OF OPERATIONS
The Company's revenues and operating results by business segment are summarized
below (in thousands):
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
(Unaudited)
REVENUES:
Metals Recycling Business:
Ferrous sales $ 121,086 $ 65,172 $ 282,526 $ 171,732
Nonferrous sales 15,174 12,764 39,661 34,548
Other sales 1,737 1,382 4,739 4,328
------------ ------------ ------------ ------------
Total sales 137,997 79,318 326,926 210,608
Auto Parts Business 23,294 17,311 58,199 48,205
Steel Manufacturing Business 72,048 51,076 185,128 135,177
Intercompany sales eliminations (39,589) (19,761) (86,524) (50,720)
------------ ------------ ------------ ------------
Total $ 193,750 $ 127,944 $ 483,729 $ 343,270
============ ============ ============ ============
INCOME (LOSS) FROM OPERATIONS:
Metals Recycling Business $ 32,462 $ 10,114 $ 55,547 $ 21,679
Auto Parts Business 8,554 6,005 19,537 16,236
Steel Manufacturing Business 6,956 (283) 9,506 (2,898)
Joint Ventures in the Metals Recycling Business 27,888 9,117 42,964 18,659
Joint Venture Suppliers of Metals 125 (277) (330) (450)
Corporate expense (6,053) (2,445) (11,717) (6,998)
Intercompany eliminations (2,617) (204) (5,869) (44)
Impairment and other non-recurring charges -- -- -- (2,100)
------------ ------------ ------------ ------------
Total $ 67,315 $ 22,027 $ 109,638 $ 44,084
============ ============ ============ ============
NET INCOME $ 42,514 $ 15,028 $ 73,241 $ 26,331
============ ============ ============ ============
15
SCHNITZER STEEL INDUSTRIES, INC.
The Joint Ventures' revenues and results of operations were as follows (in
thousands):
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
(Unaudited)
Total revenues from external customers recognized by:
Joint Ventures in the Metals Recycling Business
Processing $ 342,792 $ 167,250 $ 729,006 $ 414,252
Brokering 181,690 58,088 412,190 151,292
Joint Venture Suppliers of Metals 3,929 1,130 8,498 8,876
------------ ------------ ------------ ------------
$ 528,411 $ 226,468 $ 1,149,694 $ 574,420
============ ============ ============ ============
Income (loss) from joint ventures recognized by the Company from:
Joint Ventures in the Metals Recycling Business $ 27,888 $ 9,117 $ 42,964 $ 18,659
Joint Venture Suppliers of Metals 125 (277) (330) (450)
------------ ------------ ------------ ------------
$ 28,013 $ 8,840 $ 42,634 $ 18,209
============ ============ ============ ============
The following table summarizes certain selected operating data for the Company
and its joint venture businesses:
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
(Unaudited)
METALS RECYCLING BUSINESS:
Ferrous Recycled Metal Sales Prices ($/ton) (1,2)
Domestic $ 228 $ 125 $ 177 $ 112
Export $ 243 $ 140 $ 180 $ 119
Average $ 237 $ 133 $ 179 $ 117
Ferrous recycled metal shipments (tons in thousands) (2)
To Steel Manufacturing Business 158 144 448 400
To other unaffiliated domestic customers 7 48 36 98
To export customers 280 240 871 784
------------ ------------ ------------ ------------
Total ferrous recycled metal 445 432 1,355 1,282
============ ============ ============ ============
Nonferrous metal shipments (pounds in thousands) 28,100 29,100 81,300 82,800
============ ============ ============ ============
16
SCHNITZER STEEL INDUSTRIES, INC.
For the Three Months Ended For the Nine Months Ended
----------------------------- -----------------------------
May 31, 2004 May 31, 2003 May 31, 2004 May 31, 2003
------------ ------------ ------------ ------------
(Unaudited)
STEEL MANUFACTURING BUSINESS:
Sales Prices ($/ton) (1,2)
Rebar $ 460 $ 282 $ 367 $ 275
Other $ 438 $ 305 $ 369 $ 299
Average $ 448 $ 293 $ 368 $ 287
Finished steel products (tons in thousands) (2) 155 164 480 444
============ ============ ============ ============
JOINT VENTURES IN THE METALS RECYCLING BUSINESS:
Ferrous recycled metal shipments (tons in thousands) (2)
Processed 1,086 880 2,588 2,457
Brokered 710 387 2,011 1,162
------------ ------------ ------------ ------------
1,796 1,267 4,599 3,619
============ ============ ============ ============
(1) The Company reports revenues that include shipping costs billed to
customers. However, average net selling prices are shown net of shipping
costs.
(2) Tons for ferrous recycled metals are long tons (2,240 pounds) and for
finished steel products are short tons (2,000 pounds).
THIRD QUARTER FISCAL 2004 COMPARED TO THIRD QUARTER FISCAL 2003
GENERAL. During the third quarter of fiscal 2004, the Metals Recycling Business
and related Joint Ventures continued to experience improved market conditions.
Global demand for ferrous recycled metal has increased primarily due to the
improving U.S. economy, growing Asian economies, in particular China and
worldwide economic improvements. Throughout fiscal 2003 and into the third
quarter of fiscal 2004, selling prices continued to rise primarily due to strong
Asian demand, the tight supply of ferrous metal available in the export market,
rising domestic demand and the weakness of the U.S. dollar relative to other
foreign currencies. Demand, which is being fueled primarily by China, continues
to remain strong. In 2000, China produced an estimated 129 million tons of steel
representing 16% of the world's production. By the end of 2003, China produced
an estimated 220 million tons of crude steel representing 23% of the world's
total production. This growing steel production is directly increasing demand
and prices for recycled ferrous metal. Although China is the main driving force
behind the recent strong export demand, the Company is also seeing indications
of growing demand from other customers located in Mexico and other Southeast
Asian countries.
Demand for nonferrous recycled metal, particularly from China, was strong and
boosted nonferrous metals selling prices. During the same period, the cost of
unprocessed metal rose as well, which, combined with rising shipping costs,
partially offset the increase in selling prices. Average export sales shipping
costs rose 80% from the third quarter of last year, due to the combination of an
increase in Asian demand for bulk cargo vessels that traditionally ship scrap
metal and other bulk commodity products and higher fuel prices.
The Joint Ventures in the Metals Recycling Business reported increased profit
primarily as a result of margin improvement in the Processing Joint Ventures
that experienced similar market dynamics as the Company's wholly owned Metals
Recycling business segment. Sales volumes rose to record levels during the
quarter and totaled 1.8 million tons representing a 42% increase over the prior
year quarter. The majority of the volume improvement came from the Brokering
Joint Venture, which has continued to grow its market share. In addition, the
Processing Joint Ventures shipped a record 1.1 million tons in the third quarter
of 2004,
17
SCHNITZER STEEL INDUSTRIES, INC.
representing a 23% increase over the 2003 quarter. The higher sales volumes
shipped by the Processing Joint Ventures were caused in part by the sale of
inventory that temporarily built up during the first half of the year and was
sold during the recent quarter.
The Steel Manufacturing Business saw higher average selling prices and slightly
lower sales volumes during the third quarter of fiscal 2004 compared with the
third quarter of fiscal 2003. Domestic steel producers continued to raise
selling prices in an attempt to offset the rise in raw material and energy costs
as well as due to strong demand for finished products along the West Coast of
the United States. Sales prices and volumes also benefited from improvements in
the U.S. economy, lower steel imports, which is partially attributed to the
weakness of the U.S. dollar and higher ocean freight rates. Partially offsetting
the higher selling prices was an increase in the cost of raw materials resulting
from increases in worldwide demand for recycled ferrous metal. Third quarter
2004 sales volumes have decreased compared to last year's third quarter due to a
significant increase in sales volumes during the second quarter of 2004 as
customers bought ahead of announced price increases.
The Auto Parts Business continues to experience strong growth in wholesale
revenues, which originate from the sale of scrap metal ("scrap sales") and other
parts wholesale ("core sales"). Scrap sales benefited from rising prices caused
by many of the factors experienced by the Metals Recycling Business. Core sales
also benefited from rising prices which are due to both increased demand and
operational improvements. This increased revenue was partially offset by
increased vehicle purchasing costs and higher labor costs. Retail revenues also
increased from the third fiscal 2003 quarter due to increased retail pricing and
successful store promotions while admissions were relatively flat with the prior
year During the third fiscal 2004 quarter, the original 23 stores showed revenue
growth of 23% over the same period last year. On March 8, 2004, the Company
acquired three stores in Calgary, Edmonton and Kelowna, Canada, forming a new
Canadian subsidiary, and increasing the number of stores in the Auto Parts
Business segment to 26.
Net income for the third quarter of fiscal 2004 compared with the same quarter
in the previous fiscal year benefited from improvements in all of the Company's
business segments. The Metals Recycling Business and the Steel Manufacturing
Business experienced higher operating income due to significantly higher average
selling prices. Volumes for the Metals Recycling Business increased slightly
while the Steel Manufacturing Business saw a slight decline. The Auto Parts
Business saw an increase in operating income resulting from higher revenues
partially offset by slightly higher operating expenses, which expanded margins.
The joint ventures in the metals recycling business also saw higher income
primarily due to similar market dynamics experienced by the Metals Recycling
Business.
REVENUES. Consolidated revenues for the quarter ended May 31, 2004 increased 51%
from $127.9 million to $193.8 million compared with the third quarter of fiscal
2003. The increase was primarily a result of a significant rise in net selling
prices for both the Metals Recycling Business and the Steel Manufacturing
Business. Also, the Auto Parts Business revenues also rose significantly
primarily due to increased retail, scrap and core revenues.
Revenues for the Metals Recycling Business for the quarter ended May 31, 2004,
before intercompany eliminations, increased $58.7 million (74%) compared with
the fiscal 2003 quarter primarily due to higher average net selling prices per
ton, higher volumes and higher shipping costs billed to customers. The average
sales price, net of shipping costs (average net sales price), for ferrous metals
increased $104 per ton (78%) to $237 per ton from the third quarter of fiscal
2003 resulting in a $44.9 million increase in revenue. This price increase was
due to the lower supplies of competing metal in global markets, strong demand in
Asia and increased demand domestically. Additionally, many of the sales reported
in the third quarter of fiscal 2004 were the result of orders taken late in the
second quarter when market selling prices for ferrous metals rose to record
levels. Volumes saw a modest increase of 3% and resulted in a revenue increase
of $1.7 million. Average export sales shipping costs have increased 80% over the
prior year's quarter and represented $7.9 million of the revenue increase.
Nonferrous selling price per pound increased 24% in the current quarter versus a
year ago,
18
SCHNITZER STEEL INDUSTRIES, INC.
and was primarily attributable to strong demand from China and Korea. Nonferrous
sales volumes declined 4% due to lower beginning inventory levels this quarter
compared to last year's quarter. The high demand for nonferrous metal during
last year's third quarter enabled the Company to decrease its inventory levels.
Nonferrous inventory levels continued to remain low during the third quarter of
2004 and this, coupled with reduced availability of raw materials, caused
nonferrous volumes to decline.
The Steel Manufacturing Business' revenues for the quarter ended May 31, 2004
increased $21.0 million (41%), to $72.0 million compared with the prior year
quarter, reflecting higher average sales prices. The average finished steel net
selling price increased $155 per ton (53%) to $448 per ton compared with the
same quarter last year resulting in a revenue increase of $25.4 million. This
revenue increase was partially offset by a $2.7 million revenue decrease
relating to a 6% reduction in sales volumes. Third quarter 2004 sales volumes
have decreased compared to last year's third quarter due to a significant
increase in sales volumes during the second quarter of 2004 as customers bought
ahead of announced price increases. The price increases were primarily caused by
improved demand, a shift in sales mix towards higher priced products, and steel
producers' attempts to offset the sharp rise in raw material and energy costs.
Revenues for the Auto Parts Business for the third quarter ended May 31, 2004,
before intercompany eliminations, increased $6.0 million (35%) compared with the
fiscal 2003 quarter primarily due to an increase in wholesale revenues driven by
higher sales prices for scrapped auto bodies caused by rising ferrous recycled
metal prices and the addition of the three Canadian stores. Wholesale prices
also benefited from the implementation of improved efficiencies and changes in
work practices, which were caused in part by a new distribution center. This,
coupled with strong pricing, resulted in increased sales volumes. Retail
revenues increased slightly due to increased pricing and successful store
promotions, while admissions were flat with the fiscal 2003 quarter.
COST OF GOODS SOLD. Consolidated cost of goods sold increased $34.3 million
(33%) for the third quarter ended May 31, 2004, compared with the same period
last year. Cost of goods sold decreased as a percentage of revenues from 82% to
72%. Gross profit increased $31.5 million to $54.4 million during the latest
quarter compared to the prior year quarter driven by profit margin improvements
at all of the Company's wholly owned business segments.
For the Metal Recycling Business, the cost of goods sold as a percentage of
revenues decreased compared with the third quarter of fiscal 2003 from 82% to
73%. Gross profit increased by $23.5 million to $37.9 million. The increase in
gross profit was attributable to higher average net selling prices per ton.
Compared with the third quarter of last year, the average ferrous metals cost of
sales per ton increased 53% due primarily to higher purchase costs for
unprocessed ferrous metals and higher export sales shipping costs. Generally,
the change in the cost of unprocessed metal has a strong correlation to changes
in the average selling price; however there is generally a delay in the timing
between changes in net selling prices and the change in the cost of unprocessed
metal. Thus, as selling prices rose compared with last year's quarter, so did
the cost of unprocessed metal. However, since purchase costs did not increase at
the same rate as selling prices, and purchase costs began to decline after the
Company locked in favorable export contracts at record prices early in the third
quarter, the Company experienced a significant increase in margins in the
quarter.
For the third quarter of fiscal 2004, cost of goods sold for the Steel
Manufacturing Business increased $13.4 million (27%) compared to the same period
last year. Cost of goods sold per ton increased 37% primarily due to higher raw
material costs partially offset by lower rolling mill conversion costs. As a
percentage of revenues, cost of goods sold decreased from 99% to 89%. In the
third quarter of fiscal 2004, the gross profit was $8.2 million compared with
$0.6 million in the third quarter of last year. This improvement was primarily
attributable to higher selling prices.
The Auto Parts Business' cost of sales was $3.1 million higher (33%) during the
third quarter of fiscal 2004 compared to the cost of sales for the fiscal 2003
quarter. As a percentage of revenues, the cost of sales decreased from 54% to
53% for the fiscal 2003 quarter. The improvement was due to higher revenues.
19
SCHNITZER STEEL INDUSTRIES, INC.
JOINT VENTURES. The Joint Ventures in the Metals Recycling Business
predominantly sell recycled ferrous metal. Revenues for this segment in the
third quarter of fiscal 2004 increased $301.9 million (133%) compared with the
prior year quarter primarily due to higher average net selling prices per ton
and higher volumes. The Brokering Joint Venture's volumes nearly doubled
compared with the prior year quarter. The Processing Joint Ventures' volumes and
average net selling price per ton for ferrous recycled metals increased due to
the same supply and demand circumstances described earlier for the Company's
wholly owned businesses.
Income from Joint Ventures amounted to $28.0 million for the third quarter of
fiscal 2004 compared to $8.8 million in last year's third quarter. The increase
of $19.2 million was primarily a result of higher prices and volumes of the
Processing Joint Ventures. Additionally, profitability more than doubled in the
Brokering Joint Venture due to volume increases of over 90% and increased
margins from record high scrap metal pricing.
GENERAL AND ADMINISTRATIVE EXPENSE. Compared with the third quarter of fiscal
2003, general and administrative expense for the same quarter this fiscal year
increased $4.9 million primarily due to higher bonus accruals. The Company's
bonus plan is based upon the principles of Economic Value Added (EVA(R)) and is
directly tied to the financial performance of the Company. Given the Company's
recent record financial performance, bonus expense is significantly higher in
fiscal 2004. As a percentage of revenues, general and administrative expenses
are consistent with the prior year's quarter.
INTEREST EXPENSE. Interest expense for the third quarter of fiscal 2004
increased $0.1 million to $0.6 million compared with the third quarter of fiscal
2003. The increase was primarily a result of higher average debt balances during
the fiscal 2004 quarter compared with the fiscal 2003 quarter.
INCOME TAX PROVISION. The 35% tax rate for the third quarter of fiscal 2004
compares with 28% for the third quarter of fiscal 2003. The increase is
primarily attributable to a reduction in estimated Extraterritorial Income
Exclusion tax benefits on export sales.
MINORITY INTERESTS. Minority interests, net of tax, represent the share of
income attributable to various continuing minority partners within the Auto
Parts Business segment. During the three month period ended May 31, 2004,
minority interests increased $0.2 million due to improved operating performance
at locations which have minority partners.
FIRST NINE MONTHS OF FISCAL 2004 VS. FIRST NINE MONTHS OF FISCAL 2003
- ---------------------------------------------------------------------
REVENUES. Consolidated revenues for the nine months ended May 31, 2004 increased
$140.5 million (41%) from the same period last year. The higher revenues were
primarily attributed to increased sales volumes and higher average selling
prices for the Metals Recycling Business and the Steel Manufacturing Business,
and higher revenues for the Auto Parts Business.
During the nine months ended May 31, 2004, revenues for the Metals Recycling
Business, before intercompany eliminations, increased $116.3 million (55%),
compared to the first nine months of fiscal 2003 primarily as a result of higher
average ferrous recycled metals selling prices, higher ferrous sales volumes,
and higher shipping costs billed to customers. Ferrous sales volumes increased
by 6% over the 2003 period resulting in a revenue increase of $8.6 million.
Average net selling prices for ferrous metals were up 53% and added $79.5
million to revenues. Nonferrous metals prices were up 17% compared with the
first nine months of fiscal 2003 on slightly lower volumes and contributed $5.1
million towards the revenue increase. The higher prices were caused by continued
strong demand from Asian countries, improvements in demand domestically, and a
decrease in supply available in the global market. Shipping rates have also
increased year over year and resulted in an $18.2 million increase to revenues.
20
SCHNITZER STEEL INDUSTRIES, INC.
The Steel Manufacturing Business' revenues for the nine months ended May 31,
2004 increased $50.0 million (37%), to $185.1 million, from the first nine
months of the prior year. Approximately $10.4 million of the increase in
revenues was a result of a 36,000 ton increase (8%) in volume during the first
nine months of fiscal 2004 compared to the prior year due to increasing demand
and industry consolidation all of which were the result of increases in steel
consumption. Average net selling prices increased 28%, contributing $36.1
million of the increase in revenues and were due primarily to improved demand, a
higher-priced sales mix and higher prices as steel producers' raised prices to
offset the sharp rise in raw material and energy costs.
Revenues for the Auto Parts Business increased by $10.0 million (21%) for the
first nine months of fiscal 2004 compared to the same period in 2003. The higher
revenues were primarily caused by an increase in wholesale revenues driven by
rising prices for recycled car bodies sold for scrap metal, increasing volumes,
increasing prices for cores and the Canadian acquisition.
COST OF GOODS SOLD. Consolidated cost of goods sold increased by $93.7 million
(32%) for the nine months ended May 31, 2004, compared with the same period last
year. Cost of goods sold decreased as a percentage of revenues from 84% to 79%,
which contributed to a $46.8 million increase in gross profit for the first nine
months of fiscal 2004 as compared to the prior year. The higher gross profit
reflected the increased volumes and selling prices for the Metals Recycling
Business and the Steel Manufacturing Business and higher wholesale prices for
the Auto Parts Business.
During the first nine months of fiscal 2004, the Metals Recycling Business' cost
of goods sold increased $80.5 million over the prior year. The cost of goods
sold as a percentage of revenues decreased from 84% for the first nine months of
fiscal 2003 to 79% during the first nine months of fiscal 2004. As a result,
gross profit increased by $35.9 million to $70.3 million. The increase in gross
margin in the first nine months of fiscal 2004 is attributable to higher average
selling prices per ton and higher sales volumes partially offset by higher
average amounts paid for unprocessed metal and higher export sales shipping
costs compared with the first nine months of fiscal 2003.
During the first nine months of fiscal 2004, cost of goods sold for the Steel
Manufacturing Business increased $37.1 million compared to the same period last
year and decreased as a percentage of revenues from 100% to 93%. This decrease
is attributable to higher average selling prices, higher sales volumes and the
receipt of the final $1.8 million electrode price fixing settlement during the
second quarter ended February 29, 2004. Gross margin improved from a loss of
$0.5 million to a profit of $12.4 million compared with the first nine months of
last year primarily due to higher average selling prices, higher sales volumes
and the electrode price fixing settlement. This improvement was partially offset
by higher raw material and conversion costs compared with the first nine months
of fiscal 2003.
The Auto Parts Business' cost of sales as a percentage of revenues decreased to
57% from 60% during the first nine months of fiscal 2004 as compared to the
fiscal 2003 period due primarily to higher revenues offset by higher labor and
car purchase costs.
JOINT VENTURES. For the nine months ended May 31, 2004, revenues for Joint
Ventures in the Metals Recycling Business increased by $575.3 million from the
first nine months of last year. The increase was primarily due to higher average
net sales prices for ferrous metals and higher ferrous sales volumes for the
Brokering Joint Venture. These higher average sales prices were caused by the
same market conditions as described for the Metals Recycling Business. The
higher sales volumes are a result of increased market share at the Brokering
Joint Venture. For the first nine months of fiscal 2004, income recognized from
these joint ventures increased by $24.4 million over the first nine months of
fiscal 2003 to $42.6 million. The improved operating results were primarily
caused by higher average net selling prices per ton and higher sales volumes.
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SCHNITZER STEEL INDUSTRIES, INC.
GENERAL AND ADMINISTRATIVE EXPENSE. For the nine months ended May 31, 2004,
general and administrative expense increased $7.3 million over the same period
last year primarily driven by an increase in the Company's bonus accrual. The
Company bonus plan is based upon the principles of Economic Value Added (EVA(R))
and covers nearly 400 of the Company's employees. The bonus plan is directly
tied to the financial performance of the Company. As such, the recent record
financial performance of the Company has resulted in significantly higher bonus
expense in the fiscal 2004 period. Additionally, costs associated with the
Company's compliance with Section 404 of the Sarbanes-Oxley Act also contributed
to the increase. As a percentage of revenues, general and administrative expense
has decreased from 6.8% to 6.4% due to spreading fixed costs over higher
revenues.
INTEREST EXPENSE. For the nine months ended May 31, 2004, interest expense
increased $0.4 million to $1.5 million compared to the same period last year.
The increase was primarily a result of higher average borrowings year over year.
INCOME TAX PROVISION. The 31% tax rate for the first nine months of fiscal 2004
compares with a tax rate of 27% for the first nine months of fiscal 2003. The
increase is primarily attributable to a reduction in estimated Extraterritorial
Income Exclusion (EIE) tax benefits on export sales, an increase partially
offset by the second quarter fiscal 2004 reversal of the $6.1 million deferred
tax valuation allowance associated with Net Operating Loss carryforwards (NOLs).
It is anticipated that the rate will be approximately 35% in the fourth quarter
of fiscal 2004, reflecting the decrease in estimated EIE tax benefits and the
fact that no further reversals of the deferred tax valuation allowance are
possible. For further information regarding the tax provision, refer to Note 5 -
Income Tax Provision in the Notes to the Condensed Consolidated Financial
Statements.
PRE-ACQUISITION INTERESTS. For the nine months ended May 31, 2003,
pre-acquisition interests of $2.5 million, which are net of tax, represent the
share of income attributable to the former joint venture partner prior to the
acquisition. See Note 3 of the Notes to the Condensed Consolidated Financial
Statements.
MINORITY INTERESTS. Minority interests, net of tax, represent the share of
income attributable to various continuing minority partners within the Auto
Parts Business segment. During the nine month period ended May 31, 2004,
minority interests increased $0.4 million due to improved operating performance
at locations which have minority partners.
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE. The Company performed a
transitional impairment test of its goodwill and intangible assets during the
third quarter of fiscal 2003. As a result of this test, the Company recorded a
non-cash impairment charge of $983,000, effective September 1, 2002, and
reported it as a "Cumulative effect of change in accounting principle" on the
Consolidated Statement of Operations.
LIQUIDITY AND CAPITAL RESOURCES. Cash provided by operations for the nine months
ended May 31, 2004 was $15.5 million compared with $20.9 million for the same
period in the prior fiscal year, notwithstanding the $46.9 million increase in
net income in the 2004 period. The reduced cash flow was primarily due to
reinvestment of cash flow by our Joint Ventures, temporary increases in
receivables due to the volume of late-quarter shipments, and temporary increases
in inventory as a result of export shipments scheduled for early in the fourth
quarter of fiscal 2004. The receivables were collected in early June.
Capital expenditures for the nine months ended May 31, 2004 were $17.0 million
compared with $14.8 million during the first nine months of fiscal 2003. The
increase was primarily due to production improvement projects at the Company's
Oakland, California recycling facility and its steel mill. The Company initially
estimated that the electric arc furnace in the steel mill's melt shop would be
replaced by the end of fiscal 2004. The Company has revised that estimated
completion date and is now targeting an installation date closer to the end of
calendar year 2004. The Company expects to spend approximately $10.8 million on
capital projects during the remainder of fiscal 2004.
22
SCHNITZER STEEL INDUSTRIES, INC.
As a result of acquisitions completed in prior years the Company had $23.9
million of accrued environmental liabilities as of May 31, 2004. Over the next
twelve months, the Company expects to pay approximately $12.7 million relating
to a previously accrued remediation project in connection with one of its metals
recycling facilities located in the State of Washington on the Hylebos Waterway.
Additionally, it expects to receive $3.5 million of reimbursements from the EPA
to partially offset this amount. For further information regarding environmental
matters, refer to Note 6 - Environmental Liabilities. Additionally, the Company
expects to require significant future cash outlays as it incurs the actual costs
relating to the remediation of other such environmental liabilities.
As of May 31, 2004, the Company had a committed unsecured bank credit facility
totaling $150 million that matures in May 2006. The Company also had an
additional unsecured line of credit of $10 million, which is uncommitted. The
Company's debt agreements have certain restrictive covenants. As of May 31,
2004, the Company was in compliance with such covenants and had aggregate bank
borrowings outstanding of $105 million.
In July 2002, the Company's metals recycling joint ventures with Hugo Neu
Corporation entered into a $70 million revolving credit facility ("JV Credit
Facility") with a group of banks for working capital and general corporate
purposes. Prior to that time, the joint ventures' working capital and other cash
needs had been met by advances provided equally by the Company and its partner,
Hugo Neu Corporation. During February 2004, the facility was increased to $110
million. The JV Credit Facility expires in December 2004 and is secured by the
inventory and receivables of the joint venture businesses. The Company is not a
guarantor of the JV Credit Facility. The JV Credit Facility has a number of
covenants and restrictions, including restrictions on the level of distributions
to the joint venture partners. As of May 31, 2004, the joint ventures were in
compliance with such covenants. Borrowings under the JV Credit Facility totaled
$56.5 million at May 31, 2004, up from $30.0 million at August 31, 2003, but
down from $79.0 million at February 29, 2004. The increased borrowing levels
since August 31, 2003 were primarily caused by additional working capital
requirements resulting from carrying higher levels of inventory for the
Brokering Joint Venture. As previously reported, the Joint Venture was expecting
to obtain an additional $36 million in secured financing to purchase three new
automobile shredders. Currently, the financing arrangements have been placed on
hold while the JVs assess other alternatives.
The JV Credit facility mentioned above includes restrictions on the level of
distributions to the joint venture partners. Over the last 21 months, the
Company has recorded $67.4 million of operating income representing its share in
the earnings of the joint ventures. However, the Company has not received cash
distributions. Instead, the Hugo-Neu joint ventures have been utilizing all of
their available cash to fund expansion of working capital, business growth and
investment in state-of-the-art equipment to improve the efficiencies and
capabilities of their businesses.
Pursuant to a stock repurchase program which began October 2000, the Company is
authorized to repurchase up to 3.0 million shares of its stock when the market
price of the Company's stock is not reflective of management's opinion of an
appropriate valuation of the stock. Management believes that repurchasing shares
under these conditions enhances shareholder value. During the first nine months
of fiscal 2004, the Company made no share repurchases. As of May 31, 2004, the
Company had repurchased a total of 1.3 million shares under this program.
The Company believes that its current cash balance, internally generated funds
and existing credit facilities will provide adequate financing for capital
expenditures, working capital, joint ventures, stock repurchases, debt service
requirements and future environmental obligations for the next twelve months. In
the longer term, the Company may seek to finance business expansion with
additional borrowing arrangements or additional equity financing.
23
SCHNITZER STEEL INDUSTRIES, INC.
OUTLOOK. During the third quarter of fiscal 2004 ferrous recycled metal selling
prices began to ease from the record highs that were achieved for orders
received in early March 2004. The Company believes that the decline was caused
by a number of factors, including concerns over the impact of the Chinese
government's recent attempt to slow its economy coupled with Asian steel mills
buying metal ahead in anticipation of higher prices. Today, the uncertainty
continues; however, market prices for ferrous metal have recently firmed and
remain high from an historical perspective. The Metals Recycling Business
normally accepts export orders 60 to 90 days before shipment. Based upon the
Metals Recycling Businesses' current order backlog, contracted selling prices
that are expected to be shipped in the fourth quarter are, on average, above the
average realized in the first nine months of fiscal 2004, but below the record
average prices in the third quarter of fiscal 2004. Fourth quarter 2004 ferrous
metal sales volumes are anticipated to be in the 475,000 to 500,000 ton range.
Ocean freight rates also remain relatively high; however, rates have receded
from levels incurred by the Company in the third quarter of fiscal 2004. The
cost of unprocessed ferrous metal remains very competitive and volatile. The
Company anticipates the cost of unprocessed metal to generally follow the trend
of market selling prices.
The joint venture processors in the metals recycling business are anticipated to
experience similar market trends as the Company's wholly owned Metals Recycling
Business; however, their financial results may vary depending on geographical
locations, competition and other factors. Fourth quarter 2004 sales volumes
should approximate a more normal quarterly shipment rate. Two of the joint
venture businesses use last-in first-out (LIFO) to value their inventory and
record a LIFO adjustment during the fourth quarter of each fiscal year. During
last year's fourth quarter, the LIFO adjustment resulted in a $2.2 million
charge that reduced income from operations. It is difficult to predict the
ultimate impact of LIFO on the Company's fourth quarter 2004 earnings.
Due to the timing of when finished steel price increases took effect in the
third quarter of fiscal 2004 as well as recently announced new price increases,
the Company anticipates that the Steel Manufacturing Business's average selling
price will rise in the fourth quarter of fiscal 2004. Fourth quarter sales
volumes are expected to be modestly above third quarter 2004 levels, which
approximates the mill's current production rate. Compared to the third quarter
of fiscal 2004, fourth quarter raw material costs should be modestly lower due
to anticipated declines in recycled metal selling prices.
The Auto Parts Business typically experiences a modest reduction in retail
demand in the fourth quarter of each year as customer admissions decrease due to
hot weather conditions. Wholesale revenues are anticipated to decline from the
third quarter 2004 levels due to lower recycled metal pricing, but remain ahead
of last year's levels. The Auto Parts Business's operating profits should
continue to benefit from the addition of the three new Canadian stores, where
retail sales tend to be seasonably strong during the summer months.
Assuming no LIFO inventory valuation adjustments at the Company's joint venture
businesses, the Company estimates its fourth quarter 2004 income from operations
to be in the $45 million to $52 million range. This amount compares to income
from operations of $24.8 million reported for the fourth quarter of fiscal 2003,
which includes the aforementioned $2.2 million LIFO charge that was recorded in
the 2003 fourth quarter.
The Company's effective tax rate for the fourth quarter of fiscal 2004 should
continue to benefit from Extraterritorial Income Exclusion benefits associated
with certain export sales. These, as well as other factors, including increased
profitability, should result in a fourth quarter 2004 effective tax rate of
approximately 35%.
FACTORS THAT COULD AFFECT FUTURE RESULTS. Management's Discussion and Analysis
of Financial Condition and Results of Operations, particularly "Outlook" above,
contains forward-looking statements, within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Act of 1934, that are
made pursuant to the safe harbor provisions of the Private Securities Litigation
Reform Act of 1995. One can generally identify these forward-looking statements
because they contain "expect", "believe" "anticipate", "estimate" and other
words which convey a similar meaning. One can also identify these statements as
they do
24
SCHNITZER STEEL INDUSTRIES, INC.
not relate strictly to historical or current facts. Examples of factors
affecting Schnitzer Steel Industries, Inc.'s consolidated operations and its
joint ventures (the Company) that could cause actual results to differ
materially are the following:
CYCLICALITY AND GENERAL MARKET CONSIDERATIONS: Purchase and selling prices for
recycled metals are highly cyclical in nature and subject to worldwide economic
conditions. In addition, the cost and availability of recycled metals are
subject to global supply and demand conditions which are volatile and beyond the
Company's control, resulting in periodic fluctuations in recycled metals prices
and working capital requirements. While the Company attempts to maintain and
grow margins by responding to changing recycled metals selling prices through
adjustments to its metals purchase prices, the Company's ability to do so is
limited by competitive and other market factors. Additionally, changing prices
could potentially impact the volume of recycled metal available to the Company,
the subsequent volume of processed metal sold by the Company, inventory levels
and the timing of collections and levels relating to the Company's accounts
receivable balances. Moreover, increases in recycled metals prices can adversely
affect the operating results of the Company's Steel Manufacturing Business
because increases in steel prices generally lag increases in ferrous recycled
metals prices.
The steel industry is also highly cyclical in nature and sensitive to general
economic conditions. Future economic downturns or a stagnant economy may
adversely affect the performance of the Company.
The Company expects to continue to experience seasonal fluctuations in its
revenues and net income. Revenues can fluctuate significantly quarter-to-quarter
due to factors such as the seasonal slowdown in the construction industry, which
is an important consumer of both the Company's finished steel products and other
customers who buy recycled metal. The timing and extent of the slowdown is also
dependent on the weather.
Another factor, which may affect revenues, relates to the seasonal reduction in
demand for recycled metal from foreign customers who tend to reduce their
finished steel production during the summer months to offset higher energy
costs. Also, severe weather conditions may affect the Company's global market
conditions.
The Company makes a number of large ferrous recycled metals shipments to foreign
steel producers each year. Customer requirements, shipping schedules and other
factors limit the Company's control over the timing of these shipments.
Variations in the number of foreign shipments from quarter to quarter will
result in fluctuations in quarterly revenues and earnings. The Company's
expectations regarding ferrous metal sales prices and volumes, as well as
earnings, are based in part on a number of assumptions which are difficult to
predict (for example, uncertainties relating to customer orders, metal
availability, estimated freight rates, ship availability, cost and volume of
inventory yet to be processed, and production output, etc.).
The Auto Parts Business experiences modest seasonal fluctuations in demand. The
retail stores are open to the natural elements. During periods of extreme
temperatures and precipitation, customers tend to delay their purchases and wait
for milder conditions. As a result, retail sales are generally higher during the
spring and fall of each calendar year and lower in the winter and summer months.
Additionally, the Auto Parts Business is subject to a number of other risks that
could prevent it from maintaining or exceeding its current levels of
profitability, such as volatile supply and demand conditions affecting prices
and volumes in the markets for its products, services and raw materials;
environmental issues; local and worldwide economic conditions; increased
competition; and business integration and management transition issues.
COMPETITION: The recycled metals industry is highly competitive, with the volume
of purchases and sales subject to a number of competitive factors, principally
price. The Company competes with both large and numerous smaller companies in
its markets for the purchase of recyclable metals. The Company also competes
with a number of domestic and foreign recycled metals processors and brokers for
processed and unprocessed metal as well as for
25
SCHNITZER STEEL INDUSTRIES, INC.
sales to domestic and foreign customers. For example, in 2001 and 2002, lower
cost ferrous recycled metals supplies from certain foreign countries adversely
affected market selling prices for ferrous recycled metals. Since then, many of
these countries have imposed export restrictions which have significantly
reduced their export volumes and lowered the worldwide supply of ferrous
recycled metals. These restrictions are believed to have had a positive effect
on the Company's selling prices. Given the intricacies in which the global
markets operate, the Company cannot predict when or if foreign countries will
change their trading policies and what effect, if any, such changes might have
on the Company's operating results.
From time to time, both the United States and foreign governments impose
regulations and restrictions on trade in the markets in which the Company
operates. Also, it is not unusual for various constituencies to petition
government entities to impose new restrictions or change current laws. If
imposed, these restrictions could affect the Company's margins as well as its
ability to ship goods to foreign customers. Alternatively, restrictions could
also affect the global availability of ferrous recycled metals, thereby
affecting the Company's volumes and margins. As a result, it is difficult to
predict what, if any, impact pending or future trade restrictions will have on
the operations of the Company.
Some of the more significant domestic competitors include regional steel mills
and their brokers who compete for recycled metal for the purpose of providing
the mill with feedstock to produce finished steel. During periods when market
supplies of metal are in short supply, these buyers may, at times, react by
raising buying prices to levels that are not reasonable in relation to more
normal market conditions. As a result, the Company may have to raise its buying
prices to maintain its production levels which may result in compressed margins.
The domestic steel industry also is highly competitive. Steel prices can be
highly volatile and price is a significant competitive factor. The Company
competes domestically with several steel producers in the Western United States
for sales of its products. In recent years, the Company has experienced
significant foreign competition, which is sometimes subsidized by large foreign
government agencies. There can be no assurance that such competition will not
increase in the future. In March and April 2002, the International Trade
Commission imposed tariffs on imported steel, under Section 201 of the 1974
Trade Act, to temporarily aid the domestic steel industry. On December 4, 2003,
President Bush, in response to pressure by the World Trade Organization,
terminated these tariffs. However, management is of the belief that the tariffs
did not significantly benefit selling prices for finished steel products on the
West Coast of the United States. In the spring of 2002, the U.S. Government
imposed anti-dumping and countervailing duties against wire rod products from
eight foreign countries. These duties have assisted the Company in increasing
sales of wire rod products; any expiration or termination of the duties could
have a corresponding adverse effect.
In December 2002, Nucor Corporation ("Nucor") assumed ownership of the assets of
Birmingham Steel Corp., and acquired a steel manufacturing business in Seattle,
Washington. Nucor Corporation, the leader in setting finished steel prices in
the Company's finished steel markets, has a significant share of the West Coast
steel market and is considered an aggressive competitor. The long term impact,
if any, which Nucor's ownership and operation of Birmingham Steel's Seattle
facility will have on the Steel Manufacturing Business' and the Metals Recycling
Business' operating results cannot be determined at this time. Additionally,
until recently the Steel Manufacturing Business also competed with the North
Star steel mill in Kingman, Arizona, a producer of wire rod and rebar products,
which was sold to Nucor. That facility is currently idle, but any future
start-up of its operations could negatively impact the Company's recycled metal
and finished steel markets, prices, margins and, potentially, cash flow.
The Auto Parts Business competes with both full-service and self-service auto
dismantlers as well as larger well financed retail auto parts chains for retail
customers. Periodically, the Auto Parts Business increases prices, which may
affect customer flow and buying patterns. Additionally, in markets where the
Company has only a few stores, it does not have the same pricing power it
experiences in markets where it has more than one store in which it operates. As
this segment expands, the Company may experience new competition from others
attempting to replicate the Company's business model. The ultimate impact of
these dynamics cannot be predicted. Also, the
26
SCHNITZER STEEL INDUSTRIES, INC.
business competes for its automobile inventory with other dismantlers, used car
dealers, auto auctions and metal recyclers. Inventory costs can fluctuate
significantly depending on market conditions and prices for recycled metal.
GEOGRAPHICAL CONCENTRATION: The Company competes in the scrap metal business
through its wholly-owned Metals Recycling Business as well as through its joint
venture businesses. Over the last few years, a significant portion of the
revenues and operating profits earned in these segments have been generated from
sales to Asian countries, principally China and South Korea. In addition, the
Company's sales in these countries are also concentrated with relatively few
customers that vary depending on buying cycles and general market conditions.
Due to the concentration of sales in these countries and to a relatively small
customer base, a significant change in buying patterns, change in political
events, change in regulatory requirements, tariffs and other export restrictions
within the United States or these foreign countries, severe weather conditions
or general changes in economic conditions could adversely affect the financial
results of the Company.
JOINT VENTURES: The Company has significant investments in joint venture
companies. The Company does not manage the day-to-day activities of these
businesses. As a result, it does not have the same ability to control the
operations, cash flow, expenditures, debt, and related financial results as it
does with its consolidated businesses. These businesses are, however, affected
by many of the same risk factors mentioned in this document. Therefore, it is
difficult to predict the financial results of these businesses. Additionally,
two of these joint ventures continue to use LIFO inventory accounting, which
tends to defer income taxes. Historically, the effects of LIFO adjustments,
which are recorded during the fourth quarter of each fiscal year, have been
difficult to predict.
ENERGY SUPPLY: The Company and its joint ventures utilize various energy sources
to operate their facilities. In particular, electricity and natural gas
currently represent approximately 9% of the cost of steel manufactured for the
Company's Steel Manufacturing Business. The Steel Manufacturing Business
purchases electric power under a long-term contract from McMinnville Water &
Light (McMinnville), which in turn purchases the power from the Bonneville Power
Administration (BPA). Historically, these contracts have had favorable prices
and are long-term in nature. The Company has a five-year contract that expires
in September 2006. On October 1, 2001, the BPA increased its electricity rates
due to increased demand on the West Coast and lower supplies. This increase was
in the form of a Cost Recovery Adjustment Clause (CRAC) added to BPA's contract
with McMinnville. The CRAC is an additional monthly surcharge on selected power
charges to recover costs associated with buying higher priced power during the
West Coast power shortage. Because the BPA can adjust the CRAC every six months,
it is not possible to predict future rate changes.
The Steel Manufacturing Business also has a two year contract for natural gas.
The current contract expires on October 31, 2005 and reflects a 15% increase
over the previous contract.
If the Company is unable to negotiate favorable terms of electricity, natural
gas and other energy sources, this could adversely affect the performance of the
Company.
TAX LAWS: The Company has been able to reduce its effective tax rate below the
federal statutory tax rate for each of the last three years by using a
combination of Net Operating Loss carryforwards (NOLs), tax credits in State of
California Enterprise Zones, and tax benefits associated with making foreign
sales. However, in fiscal 2003, the World Trade Organization determined that the
Extraterritorial Income Exclusion, or EIE, as provided for in the U.S. Internal
Revenue Code, is an illegal export subsidy. Accordingly, the Company anticipates
that the United States may repeal the EIE during fiscal 2004. The Senate has
approved its legislative proposals in S. 1637 (the JOBS Act), and the House has
passed H.R. 4520 (the American Jobs Creation Act of 2004). Differences between
Senate and House versions will have to be resolved in conference negotiations.
It is possible that the Company's worldwide tax rate may increase in fiscal 2004
and beyond, pending the outcome of these potential changes in the law. The
Company is presently unable to determine the effect of the potential tax law
changes and there is no assurance that such changes will not adversely affect
its results of operations in future periods. Additionally, the Company cannot
predict the likelihood of enactment of this or any other
27
SCHNITZER STEEL INDUSTRIES, INC.
proposed legislation. Future tax rates are apt to be higher, though, because the
NOLs have been fully used for GAAP purposes and discovery of a significant
amount of further credits is not anticipated.
CURRENCY FLUCTUATIONS: Demand from the Company's foreign customers is partially
driven by foreign currency fluctuations relative to the U.S. dollar. Recent
weakness of the U.S. dollar relative to foreign currencies is believed to have
had a significant effect in the increases in recycled metals prices over the
last year, as well as resulted in increasing the cost of certain finished steel
imports. Strengthening of the U.S. dollar could adversely affect the
competitiveness of the Company's products in the markets in which the Company
competes. Additionally, global economic forces can cause fluctuations in the
currency of the foreign countries in which the Company competes as well as
trigger a revaluation of that currency. The Company has no control over such
fluctuations and, as such, these dynamics could affect the Company's revenues
and earnings.
SHIPPING AND HANDLING: Both the Metals Recycling Business and the Steel
Manufacturing Business often rely on third parties to handle and transport their
products to end users in a timely manner. The cost to transport the products, in
particular by ocean freight, can be affected by circumstances over which the
Company has no control such as fuel prices, political events, governmental
regulations on transportation and changes in market rates due to carrier
availability. In estimating future operating results, the Company makes certain
assumptions regarding shipping costs. Given the recent tightness in the ocean
freight market, the Company has experienced significant increases in its
shipping costs which have adversely affected operating income. Since it is
difficult to predict the future costs for shipping the Company's products,
actual results could differ materially from forecasts.
In estimating quarterly volumes of ferrous metal exports, the Company makes
assumptions regarding the anticipated timing of ship arrival into loading ports
and the estimated time to load the ships. The actual timing of ship departure,
and thus the ultimate revenue recognition, can vary due to ship availability,
weather, mechanical delays, and governmental regulatory delays. One export
ferrous shipment can range from 25,000 to 40,000 tons representing a significant
portion of the Company's quarterly revenue and profit. Thus, the delay of one
shipment into the next quarter can significantly affect the quarterly financial
results.
INSURANCE: The cost of the Company's insurance is affected not only by its own
loss experience but also by cycles in the insurance market. The Company cannot
predict future events and circumstances which could cause rates or claims to
materially change such as war, terrorist activities or natural disasters.
ASSET ACQUISITION AND DISPOSITION: Throughout the Company's history, it has made
a number of acquisitions and divestures as management attempts to improve the
value of the Company for its shareholders. Over the last few years this activity
has principally been limited to acquisitions related to the Auto Parts Business,
the most recent of which was the March 8, 2004 purchase of three stores in
Canada. It is anticipated that the Company will continue to pursue additional
expansion of the Auto Parts Business as well as other business segments. Each
acquisition comes with its own inherent risks that make it difficult to predict
the ultimate success of the transaction. The Company may make estimates
regarding its opinion about the future success of a transaction, but gives no
assurance regarding the accuracy of these estimates.
On May 5, 2004, the Company announced its intention to explore various strategic
alternatives, including the possible sale or merger of its Steel Manufacturing
Business. To date there has not been any decision made to change the direction
of the Steel Manufacturing Business and it continues to be managed as an ongoing
business segment of the Company.
INTERCOMPANY SALES: The Auto Parts Business sells autobodies to the Metals
Recycling Business, and the Metals Recycling Business sells ferrous recycled
metal to the Steel Manufacturing Business, at prices that are intended to
approximate market. When the Company consolidates its results in accordance with
generally accepted accounting principles, the Company eliminates the
intercompany sales and purchases and also eliminates the estimated profit
remaining in inventory ("Profit Elimination") at the end of each reporting
period. In estimating future operating
28
SCHNITZER STEEL INDUSTRIES, INC.
and financial performance, the Company makes assumptions regarding the
forecasted Profit Elimination computation and its impact on the quarterly
financial results of the Company. Small variations in price, sales volume,
production volume, and purchase prices and volumes from both within the Company
and from third parties can result in significant differences between forecasted
Profit Elimination and actual results.
One should understand that it is not possible to predict or identify all factors
that could cause actual results to differ from the Company's forward-looking
statements. Consequently, the reader should not consider any such list to be a
complete statement of all potential risks or uncertainties. Further, the Company
does not assume any obligation to update any forward-looking statement.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company periodically uses derivative financial instruments to limit exposure
to changes in interest rates. Because such derivative instruments are used
solely as hedges and not for speculative trading purposes, they do not represent
incremental risk to the Company. For further discussion of derivative financial
instruments, refer to "FAIR VALUE OF FINANCIAL INSTRUMENTS" in the consolidated
Financial Statements included in Item 8 of Form 10-K for the fiscal year ended
August 31, 2003.
ITEM 4. CONTROLS AND PROCEDURES
Schnitzer Steel Industries, Inc. management, under supervision of the Chief
Executive Officer and Chief Financial Officer, is responsible for establishing
and maintaining disclosure controls and procedures for Schnitzer Steel
Industries, Inc. and its subsidiaries. As of May 31, 2004, with the
participation of the Chief Executive Officer and the Chief Financial Officer,
management completed an evaluation of the Company's disclosure controls and
procedures. Based upon this evaluation, the Company's Chief Executive Officer
and Chief Financial Officer have concluded that the disclosure controls and
procedures are effective to ensure that all material information relating to
Schnitzer Steel Industries, Inc. and its subsidiaries is made known to them by
others within the organization as appropriate to allow timely decisions
regarding required disclosures.
There were no changes in the Company's internal control over financial reporting
during the third fiscal quarter that have materially affected, or are reasonably
likely to materially affect, the internal control over financial reporting.
29
SCHNITZER STEEL INDUSTRIES, INC.
PART II
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
31.1 Certification of Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350 as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350 as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
(b) REPORTS ON FORM 8-K
The following reports were filed on Form 8-K during the fiscal quarter ended May
31, 2004:
On April 1, 2004, the Company filed a Current Report on Form 8-K, to
report under Item 12 the issuance of a press release announcing
financial results for the Company's quarter and six months ended
February 29, 2004.
On April 30, 2004, the Company filed a Current Report on Form 8-K,
to report under Item 12 the issuance of a press release announcing
improved quarter earnings guidance for the quarter ended May 31,
2004.
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SCHNITZER STEEL INDUSTRIES, INC.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SCHNITZER STEEL INDUSTRIES, INC.
(Registrant)
Date July 12, 2004 By: /s/ Barry A. Rosen
--------------- -------------------------------------
Barry A. Rosen
Vice President, Finance and Chief
Financial Officer
31