UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

 

COMMISSION FILE NUMBER 001-11911

 

STEINWAY MUSICAL INSTRUMENTS, INC.

(Exact name of registrant as specified in its charter)

 

DELAWARE		35-1910745
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)
800 South Street, Suite 305 Waltham, Massachusetts		02453
(Address of Principal Executive Offices)		(Zip Code)

 

Registrant’s telephone number including area code:      (781) 894-9770

 

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 during the past 90 days.

Yes ý    No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes ý    No o

 

Number of shares of Common Stock issued and outstanding as of May 5, 2005:		Class A		477,952
		Ordinary		7,568,135
		Total		8,046,087

 

 

STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES

FORM 10-Q

INDEX

 

PART I.	UNAUDITED FINANCIAL INFORMATION
Item 1.	Consolidated and Condensed Consolidated Financial Statements:
	Consolidated Statements of Income Three months ended March 31, 2005 and March 31, 2004
	Condensed Consolidated Balance Sheets March 31, 2005 and December 31, 2004
	Consolidated Statements of Cash Flows Three months ended March 31, 2005 and March 31, 2004
	Consolidated Statement of Stockholders’ Equity Three months ended March 31, 2005
	Notes to Consolidated and Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures about Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 6.	Exhibits and Reports on Form 8-K
	Signatures

 

2

 

ITEM 1                   CONSOLIDATED AND CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

Unaudited

(In Thousands Except Share and Per Share Amounts)

 

		Three Months Ended
		March 31, 2005			March 31, 2004
Net sales		$	91,342		$	90,061
Cost of sales		65,645			64,336
Gross profit		25,697			25,725
Operating expenses:
Sales and marketing		11,272			11,294
General and administrative		6,975			6,014
Amortization		282			291
Other operating expenses		110			28
Total operating expenses		18,639			17,627
Income from operations		7,058			8,098
Other income, net		(439		)	(612		)
Interest income		(970		)	(637		)
Interest expense		4,139			3,778
Income before income taxes		4,328			5,569
Income tax provision		1,730			2,225
Net income		$	2,598		$	3,344
Earnings per share:
Basic		$	0.32		$	0.41
Diluted		$	0.32		$	0.39
Weighted average shares:
Basic		8,030,879			8,210,407
Diluted		8,241,196			8,519,707

 

See notes to consolidated and condensed consolidated financial statements.

 

3

 

STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

Unaudited

(In Thousands)

 

		March 31, 2005			December 31, 2004
Assets
Current assets:
Cash		$	24,721		$	27,372
Accounts, notes and other receivables, net of allowances of $11,836 and $13,271 in 2005 and 2004, respectively		88,407			88,059
Inventories		177,264			172,346
Prepaid expenses and other current assets		4,618			5,937
Deferred tax assets		14,883			15,047
Total current assets		309,893			308,761
Property, plant and equipment, net of accumulated depreciation of $72,463 and $70,473 in 2005 and 2004, respectively		100,216			102,944
Trademarks		12,058			12,325
Goodwill		31,236			31,854
Other intangibles, net		5,101			5,290
Other assets		16,632			16,371
Total assets		$	475,136		$	477,545
Liabilities and stockholders’ equity
Current liabilities:
Current portion of long-term debt		$	15,005		$	14,212
Accounts payable		14,220			14,789
Other current liabilities		44,029			43,892
Total current liabilities		73,254			72,893
Long-term debt		206,570			208,580
Deferred tax liabilities		25,687			26,240
Other non-current liabilities		23,713			24,279
Total liabilities		329,224			331,992
Commitments and contingent liabilities
Stockholders’ equity:
Common stock		10			10
Additional paid-in capital		81,413			81,129
Retained earnings		115,185			112,587
Accumulated other comprehensive loss		(3,260		)	(737		)
Treasury stock, at cost		(47,436		)	(47,436		)
Total stockholders’ equity		145,912			145,553
Total liabilities and stockholders’ equity		$	475,136		$	477,545

 

See notes to consolidated and condensed consolidated financial statements.

 

4

 

STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Unaudited

(In Thousands)

 

		Three months ended
		March 31, 2005			March 31, 2004
Cash flows from operating activities:
Net income		$	2,598		$	3,344
Adjustments to reconcile net income to cash flows from operating activities:
Depreciation and amortization		2,839			2,703
Amortization of bond premium		(63		)	(42		)
Deferred tax benefit		(159		)	(127		)
Tax benefit from stock option exercises		32			642
Other		131			31
Changes in operating assets and liabilities:
Accounts, notes and other receivables		(882		)	(7,706		)
Inventories		(7,179		)	(3,955		)
Prepaid expenses and other assets		1,548			(494		)
Accounts payable		(394		)	517
Other liabilities		1,151			6,177
Cash flows from operating activities		(378		)	1,090
Cash flows from investing activities:
Capital expenditures		(1,212		)	(904		)
Proceeds from disposals of fixed assets		304			76
Cash flows from investing activities		(908		)	(828		)
Cash flows from financing activities:
Borrowings under lines of credit		1,349			8,230
Repayments under lines of credit		(658		)	(7,896		)
Debt issuance costs		—			(105		)
Repayments of long-term debt		(1,595		)	(1,640		)
Proceeds from issuance of common stock		252			4,257
Cash flows from financing activities		(652		)	2,846
Effect of foreign exchange rate changes on cash		(713		)	(341		)
Increase (decrease) in cash		(2,651		)	2,767
Cash, beginning of period		27,372			42,283
Cash, end of period		$	24,721		$	45,050
Supplemental Cash Flow Information
Interest paid		$	815		$	316
Taxes paid		$	3,685		$	2,760
Non-cash transaction:
Purchase of common stock by issuance of bonds		$	—		$	31,583

 

See notes to consolidated and condensed consolidated financial statements.

 

5

 

STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

Unaudited

(In Thousands Except Share Data)

 

		Common Stock			Additional Paid-In Capital			Retained Earnings			Accumulated Other Comprehensive Loss			Treasury Stock			Total Stockholders’ Equity
Balance, January 1, 2005		$	10		$	81,129		$	112,587		$	(737	)	$	(47,436	)	$	145,553
Comprehensive income:
Net income								2,598									2,598
Foreign currency translation adjustment											(2,497		)				(2,497		)
Unrealized holding loss on marketable securities, net											(26		)				(26		)
Total comprehensive income																	75
Exercise of 12,440 options for shares of common stock					252												252
Tax benefit of options exercised					32												32
Balance, March 31, 2005		$	10		$	81,413		$	115,185		$	(3,260	)	$	(47,436	)	$	145,912

 

See notes to consolidated and condensed consolidated financial statements.

 

6

 

STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED AND CONDENSED CONSOLIDATED

FINANCIAL STATEMENTS

MARCH 31, 2005

 

Unaudited

(Tabular Amounts In Thousands Except Share and Per Share Data)

 

(1)   Basis of Presentation

 

The accompanying consolidated and condensed consolidated financial statements of Steinway Musical Instruments, Inc. and subsidiaries (the “Company”) for the three months ended March 31, 2005 and 2004 are unaudited.  In the opinion of management, these statements have been prepared on the same basis as the audited consolidated financial statements as of and for the year ended December 31, 2004, and include all adjustments which are of a normal and recurring nature, necessary for the fair presentation of financial position, results of operations and cash flows for the interim periods.  You should read the consolidated and condensed consolidated financial statements in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission (“SEC”).  The results of operations for the three months ended March 31, 2005 are not necessarily indicative of the results that may be expected for the entire year.

 

Throughout this report “we,” “us,” and “our” refer to Steinway Musical Instruments, Inc. and subsidiaries taken as a whole.

 

(2)   Summary of Significant Accounting Policies

 

Principles of Consolidation - Our consolidated financial statements include the accounts of all direct and indirect subsidiaries, all of which are wholly-owned, including The Steinway Piano Company, Inc. (“Steinway”) and Conn-Selmer. Inc. (“Conn-Selmer”).  Significant intercompany balances have been eliminated in consolidation.

 

Stock-based Compensation - We have an employee stock purchase plan (“Purchase Plan”) and a stock option plan (“Stock Plan”).  As permitted under accounting principles generally accepted in the United States of America, we have elected to continue to follow the intrinsic value method in accounting for our stock-based employee compensation arrangements.

 

7

 

The following table illustrates the effect on net income and earnings per share as if we had applied the fair value method to measure stock-based employee compensation:

 

		Three Months Ended
		March 31, 2005			March 31, 2004
Net income, as reported		$	2,598		$	3,344
Deduct: Total stock-based employee compensation expense determined under fair-value based method for all awards, net of related tax effects		(252		)	(254		)
Pro forma net income		$	2,346		$	3,090
Earnings per share:
Basic - as reported		$	0.32		$	0.41
Basic - pro forma		$	0.29		$	0.38
Diluted - as reported		$	0.32		$	0.39
Diluted - pro forma		$	0.28		$	0.36

 

We measured the fair value of options on their grant date, including the valuation of the option feature implicit in our Purchase Plan, using the Black-Scholes option-pricing model.  There were no stock option awards during the three months ended March 31, 2005 and 2004.  Key assumptions used to apply this pricing model to the option feature in the Purchase Plan are as follows:

 

		Three Months Ended March 31,
		2005		2004
Weighted-average interest rates		2.04%		1.26%
Weighted-average expected life of option feature in the Purchase Plan (in years)		1.00		1.00
Weighted-average expected life of option grants (in years)		—		—
Expected volatility of underlying stock		27%		27%

 

The weighted-average fair value of options on their grant date is as follows:

 

		Three Months Ended March 31,
		2005			2004
Option feature in Purchase Plan		$	7.33		$	4.09

 

It should be noted that the Black-Scholes option-pricing model was designed to value readily tradable options with relatively short lives and no vesting restrictions.  In addition, option valuation models require the input of highly subjective assumptions including the expected price volatility.  Because the options granted are not tradable and have contractual lives of up to ten years, and because changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the existing models do not

 

8

 

provide a reliable measure of the fair value of the options issued under either the Stock Plan or Purchase Plan.

 

Earnings per Common Share – We compute basic earnings per share using the weighted-average number of common shares outstanding during each period.  Diluted earnings per common share reflects the effect of our outstanding options using the treasury stock method, except when such options would be antidilutive.

 

A reconciliation of the weighted-average shares used for the basic and diluted computations is as follows:

 

		Three Months Ended March 31,
		2005		2004
Weighted-average shares:
For basic earnings per share		8,030,879		8,210,407
Dilutive effect of stock options		210,317		309,300
For diluted earnings per share		8,241,196		8,519,707

 

All outstanding options were included in the computation of diluted net earnings per common share for the three months ended March 31, 2005 and 2004 because the exercise prices of the options were less than the average market price of the common shares.

 

Accumulated Other Comprehensive Income(Loss) – Accumulated other comprehensive income (loss) is comprised of net income, foreign currency translation adjustments, additional minimum pension liabilities, and unrealized gains and losses on available-for-sale (“AFS”) marketable securities.  The components of accumulated other comprehensive loss are as follows:

 

		Foreign Currency Translation Adjustment				Unrealized Holding Gain/(Loss) on AFS Securities				Tax Impact of Unrealized Holding Gain/(Loss) on AFS Securities				Additional Minimum Pension Liability				Tax Impact of Additional Minimum Pension Liability				Accumulated Other Comprehensive Loss
Balance, January 1, 2005		$	5,746			$	157			$	(63		)	$		(10,802	)	$	4,225			$	(737	)
Activity		(2,497			)	(44			)	18				—				—				(2,523		)
Balance, March 31, 2005		$		3,249		$		113		$		(45	)	$	(10,802		)	$		4,225		$	(3,260	)

 

Recent Accounting Pronouncements – In December 2004, the Financial Accounting Standards Board (“FASB”) revised Statement of Financial Accounting Standards (“SFAS”) No. 123, “Share-Based Payments” (SFAS No. 123R). This accounting standard, which was originally effective for interim and annual periods beginning after June 15, 2005, requires the recognition of compensation expense related to stock options using the fair value method.  In April 2005, the SEC revised the compliance date to fiscal years beginning after June 15, 2005.  We plan to adopt SFAS No. 123R in the first quarter of 2006 using the modified prospective application method. Based on current outstanding awards, expected participation in the Purchase Plan consistent with past patterns, and no significant changes in the number of shares of outstanding stock, we anticipate an impact on earnings of approximately $0.11 per share in additional stock compensation expense in 2006.

 

9

 

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (SFAS No. 151). This accounting standard, which is effective for annual periods beginning after June 15, 2005, requires that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. The adoption of SFAS No. 151 is not expected to have a material effect on our financial position or results of operations.

 

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets,” which amends Accounting Principles Board (“APB”) Opinion No. 29, “Accounting for Nonmonetary Transactions.”  The guidance in APB Opinion 29 is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The guidance in APB Opinion 29, however, included certain exceptions to that principle. SFAS No. 153 amends APB Opinion 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS No. 153 is effective for fiscal periods beginning after June 15, 2005.  We do not expect the adoption of SFAS No. 153 to have a material impact on our financial position or results of operations.

 

FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (FIN 47) an interpretation of FASB Statement No. 143, “Accounting for Asset Retirement Obligations” (SFAS No. 143), clarifies the term conditional asset retirement obligation as used in SFAS No. 143. FIN 47 requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated. The fair value of a liability for the conditional asset retirement obligation should be recognized when incurred – generally upon acquisition, construction, or development and (or) through the normal operation of the asset. FIN 47 is effective for fiscal years ending after December 15, 2005. We do not expect the adoption of FIN 47 to have a material effect on our financial position or results of operations.

 

Reclassifications – Certain prior year amounts have been reclassified to conform to the current year presentation.

 

(3)   Acquisitions

 

On August 12, 2004, we acquired substantially all of the assets and assumed the operating liabilities of G. Leblanc Corporation (“Leblanc”) of Wisconsin, a high-quality band instrument manufacturer.  We have included the operating results and net assets of Leblanc in our financial statements since the date of acquisition.

 

We acquired Leblanc because its line of instruments and accessories is complementary to our existing product lines, enabling us to gain or strengthen market share in certain instrument categories.  Under terms of the assets purchase agreement, the Company provisionally disbursed $37.6 million for the purchase price, of which $4.5 million is being held in escrow pending expiration of the indemnification period.  The final purchase price is dependent upon a calculation derived from the closing balance sheet which, when finalized, may result in a recovery of a portion of the initial payment, or may require an additional payment to be made.  At March 31, 2005, the Company recognized an expected recovery of $0.8 million of the provisional purchase price based on current information.  We are still accumulating certain information relative to the valuation of property and other assets that may impact the final purchase price allocation.  Accordingly, the final purchase price allocation may differ from amounts previously disclosed.

 

10

 

(4)   Inventories

 

		March 31, 2005			December 31, 2004
Raw materials		$	22,365		$	23,439
Work in process		54,787			54,612
Finished goods		100,112			94,295
Total		$	177,264		$	172,346

 

5)    Goodwill, Trademarks, and Other Intangible Assets

 

Intangible assets other than goodwill and indefinite-lived trademarks are amortized on a straight-line basis over their estimated useful lives.  Deferred financing costs are amortized over the repayment periods of the underlying debt.  We test our goodwill and indefinite-lived trademark assets for impairment annually, or on an interim basis if events or circumstances indicate that the fair value of an asset has decreased below its carrying value.  Our annual impairment assessment is in July.The changes in net carrying amounts of goodwill and trademarks are as follows:

 

		Piano Segment			Band Segment			Total
Goodwill:
Balance, January 1, 2005		$	23,299		$	8,555		$	31,854
Foreign currency translation impact		(618		)	—			(618		)
Balance, March 31, 2005		$	22,681		$	8,555		$	31,236
Trademarks:
Balance, January 1, 2005		$	7,964		$	4,361		$	12,325
Foreign currency translation impact		(195		)	(72		)	(267		)
Balance, March 31, 2005		$	7,769		$	4,289		$	12,058

 

11

 

We also carry certain intangible assets that are amortized.  Once fully amortized, these assets are removed from both the gross and accumulated amortization balance.  These assets consist of the following:

 

		March 31, 2005			December 31, 2004
Gross deferred financing costs		$	8,720		$	8,627
Accumulated amortization		(4,079		)	(3,834		)
Deferred financing costs, net		$	4,641		$	4,793
Gross covenants not to compete		$	750		$	750
Accumulated amortization		(290		)	(253		)
Covenants not to compete, net		$	460		$	497

 

The weighted-average amortization period for deferred financing costs is 9 years, and the weighted-average amortization period of covenants not to compete is 5 years.  Total amortization expense is as follows:

 

		Three Months Ended March 31,
		2005			2004
Amortization expense		$	282		$	291

 

12

 

The following table shows the total estimated amortization expense for 2005 and the next five succeeding fiscal years:

 

Estimated amortization expense:

 

2005		$	1,117
2006		1,085
2007		1,084
2008		940
2009		549
2010		466

 

(6)   Other Current Liabilities

 

		March 31, 2005			December 31, 2004
Accrued payroll and related benefits		$	19,691		$	18,072
Current portion of pension liability		2,858			2,811
Accrued warranty expense		2,126			2,139
Accrued interest		7,071			3,257
Deferred income		4,906			4,468
Other accrued expenses		7,377			13,145
Total		$	44,029		$	43,892

 

Accrued warranty expense is recorded at the time of sale for instruments that have a warranty period ranging from one to ten years.  The accrued expense recorded is generally based on a percentage of sales and is adjusted periodically following an analysis of historical warranty activity.

 

The accrued warranty expense activity for the three months ended March 31, 2005 and 2004, and the year ended December 31, 2004 is as follows:

 

		March 31, 2005			March 31, 2004			December 31, 2004
Beginning balance		$	2,139		$	2,602		2,602
Additions		235			290			932
Claims and reversals		(215		)	(321		)	(1,455	)
Foreign currency translation impact		(33		)	(12		)	60
Ending balance		$	2,126		$	2,559		2,139

 

13

 

(7)   Long-Term Debt

 

Long-term debt consists of the following:

 

		March 31, 2005
Term loans		$	38,028
8.75% Senior Notes		174,345
Unamortized bond premium		1,521
Open account loans, payable on demand		7,681
Total		221,575
Less current portion		15,005
Long-term debt		$	206,570

 

Scheduled payments of long-term debt are as follows:

 

		March 31, 2005
Remainder of 2005		$	12,993
2006		8,073
2007		8,135
2008		16,508
2009		—
Thereafter		174,345
Total		$	220,054

 

14

 

(8)   Stockholders’ Equity

 

Our common stock is comprised of two classes: Class A and Ordinary.  With the exception of disparate voting power, both classes are substantially identical.  Each share of Class A common stock entitles the holder to 98 votes.  Holders of Ordinary common stock are entitled to one vote per share.  Class A common stock shall automatically convert to Ordinary common stock if, at any time, the Class A common stock is not owned by an original Class A holder.  At March 31, 2005 the Chairman and Chief Executive Officer own 100% of the Class A common shares, representing approximately 86% of the combined voting power of the Class A common stock and Ordinary common stock.

 

(9)   Facility Rationalization – Band

 

In 2003, we began a facility rationalization project to reduce excess manufacturing capacity in our band segment.  As part of this project, we closed our woodwind manufacturing facilities in Nogales, Arizona in November 2003.

 

In October 2003, we announced the closure of one of our woodwind manufacturing facilities in Elkhart, Indiana and our intent to transfer that plant’s production to other company-owned facilities.  In 2004, we recorded $1.4 million in severance expenses, and ceased operating this facility in April 2004.  All costs associated with this closure were paid out by December 31, 2004.

 

The accrued severance liability activity associated with the band segment’s facility rationalization project for the three months ended March 31, 2004 was as follows:

 

Facility rationalization severance liability:
Balance at January 1, 2004		$	1,158
Additions charged to cost of sales		1,412
Payments		(323		)
Reversals		—
Ending balance March 31, 2004		$	2,247

 

We acquired a manufacturing facility via the acquisition in August 2004 (see Note 3) that had been scheduled for closure by the predecessor owner.  We ramped down manufacturing at this facility from the date of acquisition until the end of 2004 and vacated this facility in the first quarter of 2005.  We incurred no significant costs as a result of this closure.  This facility, which had a book value of $0.8 million, was classified as held for sale in the first quarter of 2005 and included as a component of other assets.  This facility, and the Elkhart, Indiana facility closed in 2004 were sold subsequent to quarter-end for combined net expected proceeds of $0.9 million.  The gain on the sales is not expected to be significant.

 

15

 

(10)    Other Income, Net

 

		Three Months Ended March 31,
		2005			2004
West 57th building income		$	(1,163	)	$	(1,163	)
West 57th building expenses		814			814
Foreign exchange (gains) losses, net		(15		)	(258		)
Miscellaneous		(75		)	(5		)
Other income, net		$	(439	)	$	(612	)

 

(11)    Commitments and Contingent Liabilities

 

We are involved in certain legal proceedings regarding environmental matters, which are described below.  Further, in the ordinary course of business, we are party to various legal actions that we believe are routine in nature and incidental to the operation of our business.  While the outcome of such actions cannot be predicted with certainty, we believe that, based on our experience in dealing with these matters, their ultimate resolution will not have a material adverse impact on our business, financial condition, or results of operations.

 

We operated manufacturing facilities at certain locations where hazardous substances (including chlorinated solvents) were used.  We believe that an entity that formerly operated one such facility may have released hazardous substances at such location, which we leased through July 2001.  We did not contribute to the release.  Further, we have a contractual indemnity from certain stockholders of this entity.  This facility is not the subject of a legal proceeding that involves us, nor, to our knowledge, is the facility subject to investigation.  However, no assurance can be given that legal proceedings will not arise in the future and that such indemnitors would make the payments described in the indemnity.

 

We operate other manufacturing facilities which were previously owned by Philips Electronics North America Corporation (“Philips”).  Philips agreed to indemnify us for any and all losses, damages, liabilities and claims relating to environmental matters resulting from certain activities of Philips occurring prior to December 29, 1988 (the “Environmental Indemnity Agreement”).  Philips has fully performed its obligations under the Environmental Indemnity Agreement, which terminates on December 29, 2008.  Four matters covered by the Environmental Indemnity Agreement are currently pending.  Philips has entered into Consent Orders with the Environmental Protection Agency (“EPA”) for one site and the North Carolina Department of Environment, Health and Natural Resources for a second site, whereby Philips has agreed to pay required response costs.  On October 22, 1998, we were joined as defendant in an action involving a site

 

16

 

formerly occupied by a business we acquired in Illinois.  Philips has accepted the defense of this action pursuant to the terms of the Environmental Indemnity Agreement.  For the fourth site, the EPA has notified us it intends to carry out the final remediation itself.  The EPA estimates that this remedy has a present net cost of approximately $14.5 million. The EPA has named over 40 persons or entities as potentially responsible parties at this Elkhart, Indiana site, including four Conn-Selmer predecessor entities.  For two of these entities, which were previously owned by Philips, this matter has been tendered to Philips pursuant to the Environmental Indemnity Agreement.  Our potential liability at any of these sites is affected by several factors including, but not limited to, the method of remediation, our portion of the materials in the site relative to that of the other named parties, the number of parties participating, and the financial capabilities of the other potentially responsible parties once the relative share has been determined.  No assurance can be given, however, that additional environmental issues will not require additional, currently unanticipated investigation, assessment or remediation expenditures or that Philips will make payments that it is obligated to make under the Environmental Indemnity Agreement.

 

We are continuing an existing environmental remediation program at a facility we acquired in 2000.  We currently estimate that this project will take eighteen years to complete, at a total cost of approximately $0.9 million.  We have accrued approximately $0.7 million for the estimated remaining cost of this remediation program, which represents the present value total cost using a discount rate of 4.7%.  A summary of expected payments associated with this project is as follows:

 

		Environmental Payments
2005		140
2006		75
2007		54
2008		47
2009		47
Thereafter		513
Total		$	876

 

In 2004, we acquired manufacturing facilities for which environmental remediation programs had already been established.  Based on our current assessment, we have accrued approximately $0.7 million for the cost of these remediation programs.

 

The matters described above and our other liabilities and compliance costs arising under environmental laws are not expected to have a material impact on our capital expenditures, earnings, or competitive position in any individual year.  However, some risk of environmental liability is inherent in the nature of our current and former business and we might, in the future, incur material costs to meet current or more stringent compliance, cleanup, or other obligations pursuant to environmental laws.

 

17

 

(12)    Retirement Plans

 

We have defined benefit pension plans covering the majority of our employees, including certain employees in Germany and the U.K.  The components of net periodic pension cost for these plans are as follows:

 

		Domestic Plans						Foreign Plans
		Three Months Ended						Three Months Ended
		March 31, 2005			March 31, 2004			March 31, 2005			March 31, 2004
Service cost		$	126		$	286		$	168		$	167
Interest cost		566			1,033			325			322
Expected return on plan assets		(782		)	(1,401		)	(75		)	(68		)
Amortization of prior service cost		76			212			—			—
Amortization of net loss		114			88			—			19
Net periodic benefit cost		$	100		$	218		$	418		$	440

 

We provide postretirement health care and life insurance benefits to eligible hourly retirees and their dependents.  The components of net periodic pension cost for these benefits are as follows:

 

		Three Months Ended March 31,
		2005			2004
Service cost		$	11		$	19
Interest cost		36			38
Amortization of transition obligation		13			13
Amortization of net loss		—			5
Net postretirement benefit cost		$	60		$	75

 

We anticipate domestic pension plan contributions of approximately $1.5 million for the current year.  As of March 31, 2005 we have not yet made a contribution to this plan.  Our anticipated contributions to our U.K. pension plan approximate $0.2 million for the current year.  As of March 31, 2005, we have made contributions of less than $0.1 million to this plan.  Our German plans do not hold any assets and pay participant benefits as incurred.  Expected 2005 benefit payments under these plans are $1.1 million.  For the three months ended March 31, 2005, we have made benefit payments of $0.2 million under these plans.

 

18

 

(13)    Segment Information

 

We have identified two reportable segments: the piano segment and the band and orchestral instrument segment.  We consider these two segments reportable as they are managed separately and the operating results of each segment are separately reviewed and evaluated by our senior management on a regular basis.  Management and the chief operating decision maker use income from operations as a meaningful measurement of profit or loss for the segments.  Income from operations for the reportable segments includes certain corporate costs allocated to the segments based primarily on revenue, as well as intercompany profit.  Amounts reported as “Other & Elim” include those corporate costs that were not allocated to the reportable segments and the remaining intercompany profit elimination.

 

The following tables present information about our operating segments for the three-month periods ended March 31, 2005 and 2004:

 

		Piano Segment												Band Segment									Other			Consol
Three months ended 2005		U.S.			Germany			Other			Total			U.S.			Other			Total			& Elim			Total
Net sales to external customers		$	25,917		$	10,314		$	7,544		$	43,775		$	45,751		$	1,816		$	47,567		$	—		$	91,342
Income (loss) from operations		2,478			2,206			551			5,235			2,714			(54		)	2,660			(837		)	7,058

 

		Piano Segment												Band Segment									Other			Consol
Three months ended 2004		U.S.			Germany			Other			Total			U.S.			Other			Total			& Elim			Total
Net sales to external customers		$	26,741		$	10,388		$	8,588		$	45,717		$	43,181		$	1,163		$	44,344		$	—		$	90,061
Income (loss) from operations		2,252			1,556			1,152			4,960			3,789			35			3,824			(686		)	8,098

 

19

 

(14)    Summary of Guarantees

 

Our payment obligations under our 8.75% Senior Notes are fully and unconditionally guaranteed on a joint and several basis by Conn-Selmer, Steinway, and certain other of our direct and indirect wholly-owned subsidiaries, each a Guarantor (the “Guarantor Subsidiaries”).  These subsidiaries represent all of our (the “Issuer”) operations conducted in the United States.  The remaining subsidiaries, which do not guarantee the 8.75% Senior Notes, represent non-U.S. operations (the “Non Guarantor Subsidiaries”).

 

The following condensed consolidating supplementary data illustrates the financial position, results of operations, and cash flows of the Guarantor Subsidiaries and the Non Guarantor Subsidiaries.  Separate complete financial statements of the respective Guarantors would not provide additional material information that would be useful in assessing the financial composition of the Guarantor Subsidiaries.  No single Guarantor Subsidiary has any significant legal restrictions on the ability of investors or creditors to obtain access to its assets in event of default on the guarantee other than its subordination to senior indebtedness.

 

We record investments in subsidiaries on the cost method for purposes of the supplemental consolidating presentation.  Earnings of subsidiaries are therefore not reflected in the parent company’s investment accounts and earnings.  The principal elimination entries eliminate investments in subsidiaries and intercompany balances and transactions.

 

20

 

STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES

CONSOLIDATING STATEMENTS OF INCOME

THREE MONTHS ENDED MARCH 31, 2005

Unaudited

(In Thousands)

 

		Issuer of Notes			Guarantor Subsidiaries			Non Guarantor Subsidiaries			Reclass/ Eliminations			Consolidated
Net sales		$	—		$	74,603		$	20,963		$	(4,224	)	$	91,342
Cost of sales		—			56,567			13,371			(4,293		)	65,645
Gross profit		—			18,036			7,592			69			25,697
Operating expenses:
Sales and marketing		—			8,318			2,954			—			11,272
General and administrative		1,771			3,612			1,592			—			6,975
Amortization		117			162			3			—			282
Other operating (income) expense		(1,051		)	825			336			—			110
Total operating expenses		837			12,917			4,885			—			18,639
Income (loss) from operations		(837		)	5,119			2,707			69			7,058
Other income, net		(8		)	(416		)	(15		)	—			(439		)
Interest income		(3,665		)	(5,950		)	(90		)	8,735			(970		)
Interest expense		3,858			8,942			74			(8,735		)	4,139
Income (loss) before income taxes		(1,022		)	2,543			2,738			69			4,328
Income tax provision (benefit)		537			(30		)	1,165			58			1,730
Net income (loss)		$	(1,559	)	$	2,573		$	1,573		$	11		$	2,598

 

21