UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED] For the fiscal year ended December 31, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the transition period from to Commission file number 0-14938 STANLEY FURNITURE COMPANY, INC. (Exact name of Registrant as specified in its Charter) Delaware 54-1272589 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 1641 Fairystone Park Highway, Stanleytown, VA 24168 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (540) 627-2000 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.02 per share (Title of Class) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days: Yes (x) No ( ) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.[ ] Aggregate market value of the voting stock held by non-affiliates of the registrant based on the closing price on January 20, 1998: $95.1 million Indicate the number of shares outstanding of each of the Registrant's classes of common stock as of January 27, 1998: Common Stock, par value $.02 per share 3,432,759 (Class of Common Stock) Number of Shares Documents incorporated by reference: Portions of the Registrant's Proxy Statement for its Annual Meeting of Stockholders scheduled for April 30, 1998 are incorporated by reference into Part III. TABLE OF CONTENTS Part I Page Item 1 Business............................. 3 Item 2 Properties........................... 8 Item 3 Legal Proceedings.................... 8 Item 4 Submission of Matters to a Vote of Security Holders................ 8 Part II Item 5 Market for Registrant's Common Equity and Related Stockholder Matters.... 11 Item 6 Selected Financial Data.............. 12 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations...................... 14 Item 8 Financial Statements and Supplementary Data................. 17 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure............... 17 Part III Items 10 through 13.............................. 18 Part IV Item 14 Exhibits, Financial Statement Schedule and Reports on Form 8-K... 18 Signatures....................................... 24 Index to Financial Statements and Schedule....... F-1 Stanley Furniture Company, Inc. PART I Item 1. Business General The Company is a leading designer and manufacturer of residential furniture exclusively targeted at the upper-medium price range. The Company offers diversified product lines across all major style and product categories within this price range. Its product depth and extensive style selections make the Company a complete furniture resource for retailers in its price range and allow the Company to respond more quickly to shifting consumer preferences. The Company has established a broad distribution network that includes independent furniture stores, department stores, and national and regional furniture chains. To produce its products and support its broad distribution network, the Company has developed efficient and flexible manufacturing processes that it believes are unique in the furniture industry. The Company emphasizes continuous improvement in its manufacturing processes to enable it to continue providing competitive advantages to its customers, such as quick delivery, reduced inventory investment, high quality, and value. Products and Styles The Company's product lines cover all major design categories, and include bedroom, dining room, youth bedroom (Young AmericaTM), living room tables, entertainment centers, home office (The OfficeTM), and upholstery. The Company believes that the diversity of its product lines enables it to anticipate and respond quickly to changing consumer preferences and provides retailers a complete furniture resource in the upper-medium price range. The Company intends to continue expanding its product styles with particular emphasis on upholstery, home office, and youth bedroom. The Company believes that its products represent good value and that the quality and style of its furniture compare favorably with more premium-priced products. To emphasize this comparison the Company uses the marketing theme, "We Just Look Expensive." The Company provides wood products in a variety of woods, veneers, and finishes. The number of styles by product line currently marketed by the Company is set forth in the following table: Number of Styles Bedroom....................................... 25 Dining room................................... 22 Youth bedroom (Young America)................. 16 Occasional: Living room tables......................... 19 Entertainment centers...................... 13 Home office (The Office)................... 5 These product lines cover all major design categories including European traditional, contemporary/transitional, American traditional, and country/casual designs. The Company introduced upholstered furniture products in the fall of 1994, allowing the Company to expand its product offerings in the upper-medium price range. The Company's entry into the upholstery business takes advantage of its existing distribution network without requiring a significant capital investment. The Company's upholstered products consist mainly of stationary sofas, sleepers, love seats, and chairs. Since initial introduction, the Company has expanded its upholstered products and currently offers a variety of frames and approximately 500 fabric selections. The Company designs and develops new product styles each year to replace discontinued items or styles and, if desired, expand product lines. The Company's product design process begins with marketing personnel identifying customer needs and conceptualizing product ideas, which generally consist of a group of related furniture pieces. A variety of sketches are produced, usually by Company designers, from which prototype furniture pieces are built. The Company's engineering department then prepares the prototype for actual full-scale production. The Company consults with its marketing personnel, sales representatives, and selected customers throughout this process and introduces its new product styles at the fall and spring international furniture markets. Distribution The Company has developed a broad domestic and international customer base and sells its furniture through approximately 70 independent sales representatives to independent furniture retailers and national and regional chain stores. Representative customers include Sears, J.C. Penney, Rhodes, Rooms To Go, Breuners Home Furnishings, Robb & Stucky, Nebraska Furniture Mart, Furnitureland South, and Haverty's. The Company believes this broad network reduces its exposure to regional recessions, and allows it to capitalize on emerging channels of distribution. The Company offers tailored merchandising programs to address each channel of distribution. The general marketing practice followed in the furniture industry is to exhibit products at international and regional furniture markets. In the spring and fall of each year, a nine-day furniture market is held in High Point, North Carolina, which is attended by most buyers and is regarded by the industry as the international market. The Company utilizes approximately 60,000 square feet of showroom space at the High Point market to introduce new products, increase sales of its existing products, and test ideas for future products. The Company has sold to over 3,600 customers during the past twelve months, and approximately 8% of the Company's sales in 1997 were to international customers. No single customer accounted for more than ten percent of the Company's sales in 1997. No material part of the Company's business is dependent upon a single customer, the loss of which would have a material effect on the business of the Company. The loss of several of the Company's major customers could have a material impact on the business of the Company. Manufacturing The Company's manufacturing operations complement its product and distribution strategy by emphasizing continuous improvement in quality and customer responsiveness while reducing costs. The Company's manufacturing processes produce smaller, more frequent and cost effective runs. The Company focuses on identifying and eliminating manufacturing bottlenecks and waste, employing statistical process control and, in turn, adjusting manufacturing schedules on a daily basis, using cellular manufacturing in the production of components, and improving its relationships with suppliers by establishing primary supplier relationships. In addition, a key element of the Company's manufacturing processes is to involve all Company personnel, from hourly associates to management, in the improvement of the manufacturing processes by encouraging and responding to ideas to improve quality and to reduce manufacturing lead times. The Company operates manufacturing facilities in North Carolina and Virginia consisting of an aggregate of more than three million square feet. The Company considers its present equipment to be generally modern, adequate and well maintained. The Company schedules production of its various styles based upon actual and anticipated orders. The Company's manufacturing processes enable it to fill orders through manufacturing rather than inventory. As a result, the Company shipped customer orders within 16.3 days on average during 1997 with average finished goods inventory turns of 6.2. Since the Company ships customer orders on average in less than three weeks, management believes that the size of its backlog is not necessarily indicative of its long-term operations. The Company's backlog of unshipped orders was $34.9 million at December 31, 1997 and $23.6 million at December 31, 1996. Raw Materials The principal materials used by the Company in manufacturing its products include lumber, veneers, plywood, particle board, hardware, glue, finishing materials, glass products, laminates, fabrics, metals, frames, filling, and cushioning materials. The Company uses a variety of species of lumber, including cherry, oak, ash, poplar, pine, maple, and mahogany. The Company's five largest suppliers accounted for approximately 21% of its purchases in 1997. The Company believes that its sources of supply for these materials are adequate and that it is not dependent on any one supplier. Competition The Company is the fourteenth largest furniture manufacturer in North America based on 1996 sales, according to Furniture/Today, a trade publication. The furniture industry is highly competitive and includes a large number of foreign and domestic manufacturers, none of which dominates the market. The markets in which the Company competes include a large number of relatively small manufacturers; however, certain competitors of the Company have substantially greater sales volumes and financial resources than the Company. Competitive factors in the upper-medium price range include style, price, quality, delivery, design, service, and durability. The Company believes that its manufacturing processes, its long-standing customer relationships and customer responsiveness, its consistent support of existing diverse product lines that are high quality and good value, and its experienced management are competitive advantages. Associates At December 31, 1997, the Company employed approximately 2,800 associates. None of the Company's associates is represented by a labor union. The Company considers its relations with its associates to be good. Patents and Trademarks The trade names of the Company represent many years of continued business, and the Company believes such names are well recognized and associated with quality in the furniture industry. The Company owns a number of patents, trademarks, and licenses, none of which is considered to be material to the Company. Governmental Regulations The Company is subject to federal, state, and local laws and regulations in the areas of safety, health, and environmental pollution controls. Compliance with these laws and regulations has not in the past had any material effect on the Company's earnings, capital expenditures, or competitive position; however, the effect of such compliance in the future cannot be predicted. Management believes that the Company is in material compliance with applicable federal, state, and local environmental regulations. Regulations issued in December 1995 under the Clean Air Act Amendments of 1990 as part of the National Emission Standards for Hazardous Air Pollutants program and negotiated into the Furniture Maximum Achievable Control Technology Standard, requires the Company to reformulate certain furniture finishes and institute process and administrative changes to reduce emissions of hazardous air pollutants. The Company believes it is in compliance with these regulations by its use of compliant coatings and by training its associates in work practice standards. The Company cannot at this time estimate the future impact of these standards on the Company's operations and capital expenditure requirements. Forward-Looking Statements Certain statements made in this Annual Report on Form 10-K are not based on historical facts, but are forward-looking statements. These statements can be identified by the use of forward-looking terminology such as "believes," "expects," "may," "will," "should," or "anticipates" or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy. These statements reflect the Company's reasonable judgment with respect to future events and are subject to risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include the cyclical nature of the furniture industry, fluctuations in the price for lumber which is the most significant raw material used by the Company, competition in the furniture industry, capital costs and general economic conditions. Item 2. Properties Set forth below is certain information with respect to the Company's principal properties. The Company believes that all these properties are well maintained and in good condition. The Company believes its manufacturing facilities are being efficiently utilized and that it could increase production at its facilities if required by customer demand. Each facility is focused on specific product lines to optimize efficiency. The Company estimates that its facilities are presently operating at approximately 90% of capacity, principally on a one-shift basis. All Company plants are equipped with automatic sprinkler systems and modern fire protection equipment, which management believes are adequate. All facilities set forth below are active and operational. Approximate Owned Facility Size or Location Primary Use (Square Feet) Leased Stanleytown, VA Manufacturing 1,660,000 Owned and Corporate Headquarters 61,000 Owned West End, NC Manufacturing 470,000 Owned West End, NC Lumber Yard Leased(1) Lexington, NC Manufacturing 635,000 Owned Robbinsville, NC Manufacturing 540,000 Owned High Point, NC Showroom 80,000 Leased(2) (1) Lease expires May 31, 2007. (2) Lease expires October 31, 1999. Approximately 17,500 square feet is subleased. Item 3. Legal Proceedings None. Item 4. Submission of Matters to a Vote of Security Holders None. Executive Officers of the Registrant The Company's executive officers and their ages as of January 1, 1998 are as follows: Name Age Position Albert L. Prillaman........ 52 Chairman, President and Chief Executive Officer Bobby I. Hodges............ 60 Senior Vice President- Manufacturing Douglas I. Payne........... 39 Senior Vice President- Finance and Administration, Treasurer and Secretary William A. Sibbick......... 41 Senior Vice President- Sales Kelly S. Cain.............. 43 Senior Vice President-Product Development and Merchandising Albert L. Prillaman has been President and Chief Executive Officer of the Company since December 1985 and Chairman of the Board of Directors since September 1988. Prior thereto, Mr. Prillaman had served as a Vice President of the Company and President of the Stanley Furniture division of the Company's predecessor since 1983, and in various executive and other capacities with the Stanley Furniture division of the predecessors of the Company since 1969. Mr. Prillaman is a director of Main Street BankGroup Incorporated and First Alert, Inc. Bobby I. Hodges has been Senior Vice President-Manufacturing of the Company since April 1995. He has been a Vice President since June 1993. He was Senior Vice President-Manufacturing of the Stanley Furniture division from January 1986 until June 1993. Prior to that time, Mr. Hodges held various positions related to manufacturing management since his employment in 1967. Douglas I. Payne has been Senior Vice President-Finance and Administration since December 1996. He was Vice President of Finance and Treasurer of the Company from September 1993 to December 1996. He was Vice President-Treasurer of the Company from December 1989 to September 1993. Prior to that time, Mr. Payne held various financial management positions since his employment in 1983. Mr. Payne has been Secretary of the Company since 1988. William A. Sibbick has been Senior Vice President-Sales since December 1997. He was Vice President-Product Development and Merchandising-Dining Room and Occasional from December 1996 to December 1997. He was Vice President - Product Development and Merchandising from April 1995 until December 1996. He was Vice President - Product Development from June 1993 until April 1995. He was Vice President-Senior Product Manager of the Stanley Furniture division from January 1992 until June 1993. Prior to that time, Mr. Sibbick was Vice President-Product Manager since his employment in 1989. Kelly S. Cain has been Senior Vice President-Product Development and Merchandising since December 1997. He was Vice President-Product Development and Merchandising for bedroom product lines from December 1996 to December 1997. Prior to that time, Mr. Cain held various management positions in sales and marketing since his employment in 1985. PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The Company's common stock is quoted on The Nasdaq Stock Market ("Nasdaq") under the symbol STLY. The table below sets forth the high and low sales prices per share as reported by Nasdaq. High Low 1997 First Quarter.......................... $26.00 $18.25 Second Quarter......................... 23.50 17.00 Third Quarter.......................... 29.75 22.75 Fourth Quarter......................... 29.00 22.75 1996 First Quarter.......................... $10.75 $ 8.00 Second Quarter......................... 12.13 10.00 Third Quarter.......................... 17.50 10.25 Fourth Quarter......................... 20.75 14.00 The quotations reflect interdealer prices, without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions. As of January 20, 1998, there were approximately 1,600 beneficial stockholders. The Company currently retains all earnings to finance the growth and development of its business. However, the Company will continue to evaluate its dividend policy, and any future payments will depend upon the financial condition, capital requirements, and earnings of the Company, as well as other factors that the Board of Directors may deem relevant. The Company's ability to pay dividends with respect to the Common Stock is restricted, under certain loan covenants, to $25.0 million plus 50% of the Company's consolidated net earnings, adjusted for net cash proceeds received by the Company from the sale of its stock and the amount of payments for redemption, purchase or other acquisition of its capital stock, subsequent to January 1, 1997. As of December 31, 1997, $5.6 million was available for the payment of dividends under these restrictions. Item 6. Selected Financial Data Years Ended December 31, 1997 1996 1995 1994 1993 (in thousands, except per share data) Income Statement Data: Net sales..............$211,905 $201,905 $174,179 $184,342 $167,091 Cost of sales: From products sold....159,453 153,332 137,621 148,453 134,972 Business interruption insurance (1)....... (5,036) Gross profit...... 52,452 48,573 36,558 35,889 37,155 Selling, general and admin- istrative expenses.....29,949 30,403 26,454 26,483 25,976 Unusual items, net(2).... (136) Operating income.....22,503 18,170 10,240 9,406 11,179 Other expense, net....... 276 616 433 444 1,346 Gain on insurance settlement(3) (2,379) (2,186) Interest expense......... 3,538 3,344 3,534 2,969 3,048 Income from continuing operations before income taxes................18,689 14,210 6,273 8,372 8,971 Income taxes............. 7,102 5,470 2,384 3,256 3,691 Income from continuing operations..........$11,587 $ 8,740 $ 3,889 $ 5,116 $ 5,280 Basic Earnings Per Share: Income from continuing operations..........$ 2.76 $ 1.85 $ .82 $ 1.08 $ 1.39 Weighted average shares (4)(5)................ 4,197 4,722 4,727 4,725 3,792 Diluted Earnings Per Share: Income from continuing operations............$ 2.50 $ 1.77 $ .82 $ 1.08 $ 1.39 Weighted average shares (4)(5)................ 4,639 4,945 4,727 4,744 3,792 Supplementary Income From Con- tinuing Operations Per Share Data-Diluted: Before non-recurring gain(6)...............$ 2.50 $ 1.77 $ .82 $ .77 $ .90 Non-recurring gain on insurance............. .31 .29 As reported...........$ 2.50 $ 1.77 $ .82 $ 1.08 $ 1.19 Weighted average shares (7)................... 4,639 4,945 4,727 4,744 4,725 Item 6. Selected Financial Data (continued) Years Ended December 31, 1997 1996 1995 1994 1993 (in thousands, except per share data) Balance Sheet Data: Cash.................... $ 756 $ 8,126 $ 298 $ 301 $ 200 Inventories............. 45,730 40,239 40,167 39,905 37,684 Working capital......... 41,440 46,225 42,422 42,912 40,833 Total assets............ 143,225 141,510 134,551 124,519 124,859 Long-term debt including current maturities(5). 52,577 39,350 41,067 33,395 32,647 Stockholders' equity (4)(5)(8)............. 48,247 61,617 54,739 50,830 47,204 (1) In 1993, the Company recorded $5.0 million of business interruption insurance replacing the gross profit on lost sales due to a fire. (2) In 1995, the Company recognized a pretax credit of $1.1 million after it was released from a lease obligation at a previously closed manufacturing facility. Also included is a pretax charge for a severance accrual. (3) In 1993, a $2.2 million pretax gain was recorded since insurance proceeds exceeded the book value of leasehold improvements and equipment destroyed in a fire. In 1994, the Company recorded a pretax gain of $2.4 million as part of the final insurance settlement. (4) In July 1993, the Company completed a public offering of 1,725,000 shares of common stock at $8.50 per share. The net proceeds of $13.1 million were used to reduce debt. (5) In 1997, the Company purchased 1,163,201 million shares of its common stock for a total consideration of $25.3 million. See Note 5 of the Notes to Financial Statements. (6) Income from continuing operations before insurance related gains was $3.7 million in 1994 and $4.3 million in 1993. (7) The 1993 period includes the effect of pro forma adjustments assuming the July 1993 public offering of 1,725,000 shares of common stock occurred at the beginning of the year. (8) No dividends have been paid on the Company's common stock during any of the years presented. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the Selected Financial Data and the Financial Statements and Notes thereto contained elsewhere herein. Results of Operations The following table sets forth the percentage relationship to net sales of certain items included in the Statements of Income: For the Years Ended December 31, 1997 1996 1995 Net sales...............................100.0% 100.0% 100.0% Cost of sales........................... 75.3 75.9 79.0 Gross profit.......................... 24.7 24.1 21.0 Selling, general and administrative expenses...............................14.1 15.1 15.2 Unusual items, net....................... (.1) Operating income.......................10.6 9.0 5.9 Other expenses, net...................... .1 .3 .3 Interest expense......................... 1.6 1.7 2.0 Income from continuing operations before income taxes.................. 8.9 7.0 3.6 Income taxes............................. 3.4 2.7 1.4 Income from continuing operations...... 5.5% 4.3% 2.2% 1997 Compared to 1996 Net sales increased $10.0 million, or 5.0%, for 1997 compared to 1996. The increase was due primarily to higher average selling prices and to a lesser extent higher unit volume. Gross profit margin for 1997 increased to 24.7% from 24.1% for the comparable 1996 period. The higher gross profit margin was due primarily to lower raw material costs as a percentage of net sales and improved operating efficiencies. However, gross profit margin declined from 25.2% for the first half of 1997 to 24.4% for the second half of 1997, due primarily to increased lumber cost. Management expects this trend to continue into 1998. Selling, general and administrative expenses as a percentage of net sales were 14.1% and 15.1% for 1997 and 1996, respectively. These expenses were lower in 1997 due primarily to lower selling expenses and a reduced provision for bad debts. As a result of the above, operating income increased to $22.5 million, or 10.6% of net sales, from $18.2 million, or 9.0% of net sales, in 1996. Interest expense for the 1997 period increased due to higher debt levels resulting from the Company's June and November 1997 repurchases of its common stock. Including the December 1996 purchase of 150,000 shares, the Company acquired a total of 1,313,201 shares of its common stock for a total consideration of $27.6 million. The Company's effective income tax rate was 38.0% and 38.5% for 1997 and 1996, respectively. 1996 Compared to 1995 Net sales increased $27.7 million, or 15.9%, for 1996 compared to 1995. The increase was due principally to higher unit volume. Gross profit margin for 1996 increased to 24.1% from 21.0% for the comparable 1995 period. The higher gross profit margin was due primarily to stabilizing raw material costs, improved operating efficiencies, and the leveraging of fixed costs due to increased production levels. Selling, general and administrative expenses as a percentage of net sales were 15.1% and 15.2% for 1996 and 1995, respectively. These expenses increased for the 1996 period due principally to (i) higher selling cost resulting from increased sales and increased merchandising expenses, (ii) increased compensation expense pursuant to the Company's incentive compensation plan for key employees, and (iii) increased provision for bad debts. During the second quarter of 1995, the Company recognized an unusual item consisting of the net effect of (i) an accrual reversal as a result of being released from a lease obligation at its previously closed Waynesboro, Virginia facility and (ii) a charge for severance resulting from the resignation of a former officer. As a result of the above, operating income for 1996 increased to $18.2 million, or 9.0% of net sales, from $10.2 million, or 5.9% of net sales, in 1995. The Company's effective income tax rate was 38.5% and 38.0% for 1996 and 1995, respectively. Financial Condition, Liquidity and Capital Resources In November 1997, the Company issued $10.0 million of 7.43% senior notes due 2007 in a private placement of debt. The proceeds were used to purchase 413,201 shares of its common stock from the ML-Lee Acquisition Fund, L.P. and its affiliates. In June 1995, the Company issued a $10.0 million 7.57% senior note due 2005 in a private placement of debt. The proceeds were used to purchase two previously leased manufacturing facilities. At December 31, 1997, long-term debt including current maturities was $52.6 million. Approximately $19.1 million of additional borrowing capacity was available under a revolving credit facility. However, current loan covenants restrict borrowings to an additional $6.4 million at December 31, 1997, without obtaining lender consent. Annual debt service requirements are $5.1 million in 1998, $9.1 million in 1999, $5.2 million in 2000, $6.7 million in 2001, and $6.8 million in 2002. The Company believes that its financial resources are adequate to support its capital needs and debt service requirements. The Company has and will continue to make certain investments in its software systems and applications to ensure the Company is year 2000 compliant. The financial impact to the Company has not been and is not anticipated to be material to its financial position or results of operations in any given year. Operating Cash Flows The Company generated cash from operations of $8.3 million in 1997 compared to $15.3 million in 1996. The decrease in cash generated from operations was due primarily to higher payments to suppliers and employees due to increased production. Also, cash was required to fund higher tax payments resulting from higher taxable income in 1997. The Company used the cash generated from operations in 1997 and 1996 to fund capital expenditures, reduce borrowings and repurchase its common stock. During 1995, cash generated from operations of $6.6 million was used to reduce borrowings under the revolving credit facility and to fund capital expenditures. Investing Activities Net cash used by investing activities was $4.2 million in 1997 compared to $4.0 million and $14.7 million in 1996 and 1995, respectively. In the 1995 period, proceeds from the issuance of senior notes and additional borrowings from the revolving credit facility were used to purchase two previously leased plant facilities for $10.5 million. The 1997 and 1996 expenditures, and the remaining expenditures for 1995, were primarily for plant and equipment and other assets in the normal course of business. Financing Activities Net cash used by financing activities was $11.5 million and $3.5 million in 1997 and 1996, respectively, compared to cash provided by financing activities of $8.1 million in 1995. In 1997, the purchase of common stock was financed by the private placement of debt, the revolving credit facility and cash generated from operations. In 1996, the purchase of common stock and the reduction in borrowings were financed by cash generated from operations. The 1995 borrowings provided cash for the purchase of the two previously leased plant facilities and other capital expenditures. Discontinued Operations In 1996, the Company was released from a lease obligation resulting from the purchase and concurrent resale of certain facilities at a former division, which ceased operations in 1994. Accordingly, the Company recorded an after tax gain of $246,000, or $.05 per share, as a partial reversal of a previous accrual, representing the final adjustment for the cost of the closure. Item 8. Financial Statements and Supplementary Data The financial statements and schedule listed in Items 14(a)(1) and (a)(2) hereof are incorporated herein by reference and are filed as part of this report. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III In accordance with general instruction G(3) of Form 10-K, the information called for by items 10, 11, 12, and 13 of Part III is incorporated by reference to the Registrant's definitive Proxy Statement for its Annual Meeting of Stockholders scheduled for April 30, 1998, except for information concerning the executive officers of the registrant which is included in Part I of this report under the caption "Executive Officers of the Registrant." PART IV Item 14. Exhibits, Financial Statement Schedule and Reports on Form 8-K (a) Documents filed as a part of this Report: (1) The following financial statements are included in this report on Form 10-K: Report of Independent Accountants Balance Sheets - as of December 31, 1997 and 1996 Statements of Income - for each of the three years in the period ended December 31, 1997 Statements of Changes in Stockholders' Equity for each of the three years in the period ended December 31, 1997 Statements of Cash Flows - for each of the three years in the period ended December 31, 1997 Notes to Financial Statements (2) Financial Statement Schedule: Schedule II - Valuation of Qualifying Accounts - for each of the three years in the period ended December 31, 1997 (b) The following reports on Form 8-K were filed by the Registrant during the last quarter of the period covered by this report: A report on Form 8-K was filed on December 2, 1997, to disclose the repurchase of 413,201 shares of the Company's common stock from the ML-Lee Acquisition Fund, L.P. and its affiliates. (c) Exhibits: 3.1 The Certificate of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to the Registrant's Registration Statement on Form S-1, No. 33-7300). 3.2 The By-laws of the Registrant (incorporated by reference to Exhibit 3.2 to the Registrant's Registration Statement on Form S-1, No. 33-7300). 3.3 Amendment adopted March 21, 1988 to the By-laws of the Registrant (incorporated by reference to Exhibit 3.3 to the Registrant's Form 10-K (Commission File No. 0-14938) for the year ended December 31, 1987). 3.4 Amendments adopted February 8, 1993 to the By-laws of the Registrant (incorporated by reference to Exhibit 3.4 to the Registrant's Registration Statement on Form S-1 No. 33-57432). 3.5 Certificate of Stock Designation dated May 1, 1991 of the Registrant as modified by an Amendment to Certificate of Designation dated May 31, 1991 (incorporated by reference to Exhibit 3.6 to the Registrant's Form 10-K for the year ended December 31, 1991). 3.6 Certificate of Merger dated as of November 9, 1992 (incorporated by reference to Exhibit 3.6 to the Registrant's Statement on Form S-1 No. 33-57432). 3.7 Certificate of Amendment dated June 30, 1993. (incorporated by reference to Exhibit 3.7 to the Registrant's Form 10-K for the year ended December 31, 1994). 4.1 The Certificate of Incorporation and By-laws of the Registrant as currently in effect (incorporated by reference to Exhibits 3.1 through 3.7 hereto). 4.2 Note Agreement dated February 15, 1994 between the Registrant and the Prudential Insurance Company of America. (incorporated by reference to Exhibit 4.6 to the Registrant's Form 10-K for the year ended December 31, 1993). 4.3 Letter Amendment, dated October 14, 1996, to Note Agreements, dated February 15, 1994 and June 29, 1995, between the Registrant and The Prudential Insurance Company of America (incorporated by reference to Exhibit 4.1 to the Registrant's Form 10-Q for the quarter ended September 29, 1996). 4.4 Letter Amendment, dated June 16, 1997, to Note Agreements, dated February 15, 1994 and June 29, 1995, between the Registrant and The Prudential Insurance Company of America (incorporated by reference to Exhibit 4.1 to the Registrant's Statement on Form 8-K filed July 9, 1997). 4.5 Note Purchase and Private Shelf Agreement, dated as of June 29, 1995, among the Company, The Prudential Insurance Company of America and the affiliates of Prudential who become Purchasers as defined therein (incorporated by reference to Exhibit 4.1 to the Registrant's Form 8-K filed December 2, 1997). Pursuant to Regulation S-K, Item 601(b)(4)(iii), instruments evidencing long term debt less than 10% of the Registrant's total assets have been omitted and will be furnished to the Securities and Exchange Commission upon request. 10.1 Employment Agreement made as of January 1, 1991 between Albert L. Prillaman and the Company (incorporated by reference to Exhibit 10.1 to the Registrant's Form 10-K for the year ended December 31, 1991).(2) 10.2 Lease dated February 23, 1987 between Stanley Interiors Corporation and Southern Furniture Exposition Building, Inc. d/b/a Southern Furniture Market Center (incorporated by reference to Exhibit 10.10 to the Registrant's Form 10-K for the year ended December 31, 1987). 10.3 Lease dated June 30, 1987 between A. Allan McDonald, Virginia Cary McDonald, C. R. McDonald, Dorothy V. McDonald, and Lillian S. McDonald, as lessor, and Stanley Interiors Corporation, as lessee (incorporated by reference to Exhibit 10.14 to the Registrant's Form 10-K for the year ended December 31, 1987). 10.4 The Stanley Retirement Plan, as restated effective January 1, 1989, adopted April 20, 1995 (incorporated by reference to Exhibit 10.4 to the Registrant's Form 10-K for the year ended December 31, 1995).(2) 10.5 Amendment No. 1, The Stanley Retirement Plan, effective December 31, 1995, adopted December 15, 1995 (incorporated by reference to Exhibit 10.5 to the Registrant's Form 10-K for the year ended December 31, 1995).(2) (2) Management contract or compensatory plan 10.6 Supplemental Retirement Plan of Stanley Furniture Company, Inc., as restated effective January 1, 1993. (incorporated by reference to Exhibit 10.8 to the Registrant's Form 10-K for the year ended December 31, 1993).(2) 10.7 First Amendment to Supplemental Retirement Plan of Stanley Furniture Company, Inc., effective December 31, 1995, adopted December 15, 1995 (incorporated by reference to Exhibit 10.7 to the Registrant's Form 10-K for the year ended December 31, 1995).(2) 10.8 Stanley Interiors Corporation Deferred Compensation Capital Enhancement Plan, effective January 1, 1986, as amended and restated effective August 1, 1987 (incorporated by reference to Exhibit 10.12 to the Registrant's Registration Statement on Form S-1, No. 33-7300).(2) 10.9 Stanley 401(k) Retirement Savings Plan, as amended and restated effective January 1, 1996 (incorporated by reference to Exhibit 10.9 to the Registrant's Form 10-K for the year ended December 31, 1995).(2) 10.10 Employment Agreement made as of January 1, 1991 between William Cubberley, Jr. and the Registrant (incorporated by reference to Exhibit 10.42 to the Registrant's Form 10-K for the year ended December 31, 1991).(2) 10.11 Split Dollar Insurance Agreement dated as of March 21, 1991 between Albert L. Prillaman and the Registrant (incorporated by reference to Exhibit 10.43 to the Registrant's Form 10-K for the year ended December 31, 1991).(2) 10.12 Second Amended and Restated Revolving Credit Facility and Term Loan Agreement dated February 15, 1994 (the "Second Amended and Restated Credit Facility") between the Registrant, National Canada Finance Corp., and the National Bank of Canada (incorporated by reference to Exhibit 10.17 to Registrant's Form 10-K for the year ended December 31, 1994). 10.13 First Amendment to Second Amended and Restated Credit Facility dated as of August 21, 1995 (incorporated by reference to Exhibit 10.14 to Registrant's Form 10-K for the year ended December 31, 1995). 10.14 1992 Stock Option Plan (incorporated by reference to Registrant's Registration Statement on Form S-8, No. 33- 58396).(2) (2) Management contract or compensatory plan 10.15 1994 Stock Option Plan. (incorporated by reference to Exhibit 10.18 to the Registrant's Form 10-K for the year ended December 31, 1994).(2) 10.16 1994 Executive Loan Plan. (incorporated by reference to Exhibit 10.19 to the Registrant's Form 10-K for the year ended December 31, 1994).(2) 10.17 Loan and Stock Purchase Agreement dated as of December 2, 1994 by Albert L. Prillaman. (incorporated by reference to Exhibit 10.20 to the Registrant's Form 10-K for the year ended December 31, 1994).(2) 10.18 Employment agreement dated as of June 1, 1996, between Douglas I. Payne and the Registrant (incorporated by reference to Exhibit 10.1 to the Registrant's Form 10-Q for the quarter ended June 30, 1996).(2) 10.19 Amendment No. 1 to Employment Agreement between C. William Cubberley, Jr. and the Registrant, dated as of June 1, 1996 (incorporated by reference to Exhibit 10.2 to the Registrant's Form 10-Q for the quarter ended June 30, 1996).(2) 10.20 Amendment No. 1, dated as of October 1, 1996, to the Employment Agreement, dated as of January 1, 1991, between the Registrant and Albert L. Prillaman (incorporated by reference to Exhibit 10.4 to the Registrant's Form 10-Q for the quarter ended September 29, 1996). 10.21 Assignment and Transfer Agreement, dated as of October 8, 1996, between National Canada Finance Corp. and National Bank of Canada relating to the Second Amended and Restated Revolving Credit Facility (incorporated by reference to Exhibit 10.1 to the Registrant's Form 10-Q for the quarter ended September 29, 1996). 10.22 Second Amendment, dated as of October 14, 1996, to the Second Amended and Restated Revolving Credit Facility (incorporated by reference to Exhibit 10.2 to the Registrant's Form 10-Q for the quarter ended September 29, 1996). 10.23 Stock Purchase Agreement, dated as of November 13, 1996, between the Registrant and the Selling Stockholders listed on Schedule 1 thereto (incorporated by reference to Exhibit 99.1 to the Registrant's Registration Statement on Form S-3 No. 333-14063). (2) Management contract or compensatory plan 10.24 First Amendment to Loan and Stock Pledge Agreement, dated December 31, 1996, by Albert L. Prillaman (incorporated by reference to Exhibit 10.27 to the Registrant's Form 10-K for the year ended December 31, 1996). 10.25 Stock Purchase Agreement, dated as of June 27, 1997 among the Registrant and the Selling Stockholders named therein (incorporated by reference to Exhibit 99.1 to the Registrant's Form 8-K filed July 9, 1997). 10.26 Registration Rights Agreement dated as of November 9, 1992 by and among the Registrant, ML-Lee Acquisition Fund, L.P., ML- Lee Acquisition Fund II, L.P., ML-Lee Acquisition Fund (Retirement Accounts) II, L.P., Lee Stockholders (as defined therein) and Management Stockholders (as defined therein) (incorporated by reference to Exhibit 4.3 to the Registrant's Statement on Form S-1 No. 33-57432). 10.27 Amendment No. 1, dated as of June 27, 1997, to Registration Rights Agreement, dated as of November 9, 1992, by and among the Registrant, ML-Lee Acquisition Fund, L.P., ML-Lee Acquisition Fund II, L.P., ML-Lee Acquisition Fund (Retirement Accounts) II, L.P., Lee Stockholders and Manage- ment Stockholders (incorporated by reference to Exhibit 99.2 to the Registrant's Form 8-K filed July 9, 1997). 10.28 Stock Purchase Agreement, dated as of November 11, 1997, among the Company and the Selling Stockholders named therein (incorporated by reference to Exhibit 99.2 to the Registrant's Form 8-K filed December 2, 1997). 10.29 Third Amendment, dated as of June 24, 1997, to the Second Amended and Restated Revolving Credit Facility and Term Loan Agreement dated February 15, 1994 between the Registrant, National Canada Finance Corp., and the National Bank of Canada (incorporated by reference to Exhibit 99.4 to the Registrant's Form 8-K filed July 9, 1997). 11 Schedule of Computation of Earnings Per Share.(1) 21 Listing of Subsidiaries: Charter Stanley Foreign Sales Corporation, a United States Virgin Islands Corporation. 23 Consent of Coopers & Lybrand L.L.P.(1) 27 Financial Data Schedule.(1) (1) Filed herewith SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. STANLEY FURNITURE COMPANY, INC. February 6, 1998 By: /s/Albert L. Prillaman Albert L. Prillaman Chariman, President, and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date /s/Albert L. Prillaman Chairman, President, February 6, 1998 (Albert L. Prillaman) and Chief Executive Officer, and Director (Principal Executive Officer) /s/Douglas I. Payne Senior Vice President February 6, 1998 (Douglas I. Payne) -Finance and Administration, Treasurer and Secretary (Principal Financial and Accounting Officer) /s/David V. Harkins Director February 6, 1998 (David V. Harkins /s/C. Hunter Boll Director February 6, 1998 (C. Hunter Boll) /s/Edward J. Mack Director February 6, 1998 (Edward J. Mack) /s/T.Scott McIlhenny,Jr. Director February 6, 1998 (T.Scott McIlhenny, Jr.) STANLEY FURNITURE COMPANY, INC. ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997 INDEX TO FINANCIAL STATEMENTS AND SCHEDULE Financial Statements Page Report of Independent Accountants......................... F-2 Balance Sheets as of December 31, 1997 and 1996........... F-3 Statements of Income for each of the three years in the period ended December 31, 1997................... F-4 Statements of Changes in Stockholders' Equity for each of the three years in the period ended December 31, 1997...................................... F-5 Statements of Cash Flows for each of the three years in the period ended December 31, 1997................... F-6 Notes to Financial Statements............................. F-7 Financial Statement Schedule Schedule II - Valuation and Qualifying Accounts for each of the three years in the period ended December 31, 1997....................................... S-1 F-1 To The Board of Directors and Stockholders Of Stanley Furniture Company, Inc. We have audited the financial statements and financial statement schedule of Stanley Furniture Company, Inc. listed in the index on page F-1. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Stanley Furniture Company, Inc. as of December 31, 1997 and 1996, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information required to be included therein. Coopers & Lybrand L.L.P. Richmond, Virginia January 23, 1998 F-2 STANLEY FURNITURE COMPANY, INC BALANCE SHEETS (in thousands, except share data) December 31, 1997 1996 ASSETS Current assets: Cash.......................................$ 756 $ 8,126 Accounts receivable, less allowances of $1,895 and $1,945........................ 27,427 23,096 Inventories: Finished goods........................... 21,220 20,953 Work-in-process.......................... 6,997 6,142 Raw materials............................ 17,513 13,144 45,730 40,239 Prepaid expenses and other current assets........................... 1,571 486 Deferred income taxes...................... 770 1,886 Total current assets..................... 76,254 73,833 Property, plant and equipment, at cost....... 84,545 80,737 Less accumulated depreciation.............. 32,831 28,024 51,714 52,713 Goodwill, less accumulated amortization of $3,024 and $2,688....................... 10,416 10,752 Other assets................................. 4,841 4,212 $143,225 $141,510 LIABILITIES Current liabilities: Current maturities of long-term debt.......$ 5,086 $ 725 Accounts payable........................... 18,164 14,630 Accrued salaries, wages and benefits....... 9,687 9,584 Other accrued expenses..................... 1,877 2,669 Total current liabilities................ 34,814 27,608 Long-term debt, exclusive of current maturities................................. 47,491 38,625 Deferred income taxes........................ 10,448 11,673 Other long-term liabilities.................. 2,225 1,987 Total liabilities.......................... 94,978 79,893 STOCKHOLDERS' EQUITY Common stock, $.02 par value, 10,000,000 shares authorized, 3,432,759 and 4,579,042 shares issued and outstanding.... 68 91 Capital in excess of par value............... 37,508 62,442 Retained earnings (deficit).................. 10,671 (916) Total stockholders' equity................. 48,247 61,617 $143,225 $141,510 The accompanying notes are an integral part of the financial statements. F-3 STANLEY FURNITURE COMPANY, INC. STATEMENTS OF INCOME (in thousands, except per share data) For the Years Ended December 31, 1997 1996 1995 Net sales........................... $211,905 $201,905 $174,179 Cost of sales....................... 159,453 153,332 137,621 Gross profit...................... 52,452 48,573 36,558 Selling, general and administrative expenses.......................... 29,949 30,403 26,454 Unusual items, net.................. (136) Operating income ................. 22,503 18,170 10,240 Other expense, net.................. 276 616 433 Interest expense.................... 3,538 3,344 3,534 Income from continuing operations before income taxes............. 18,689 14,210 6,273 Income taxes........................ 7,102 5,470 2,384 Income from continuing operations... 11,587 8,740 3,889 Gain from discontinued operations, net of taxes...................... 246 Net income.................... $ 11,587 $ 8,986 $ 3,889 Basic earnings per share: Continuing operations............. $ 2.76 $ 1.85 $ .82 Discontinued operations........... .05 Net income...................... $ 2.76 $ 1.90 $ .82 Weighted average shares outstanding. 4,197 4,722 4,727 Diluted earnings per share: Continuing operations............. $ 2.50 $ 1.77 $ .82 Discontinued operations........... .05 Net income...................... $ 2.50 $ 1.82 $ .82 Weighted average shares outstanding. 4,639 4,945 4,727 The accompanying notes are an integral part of the financial statements. F-4 STANLEY FURNITURE COMPANY, INC. STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY For each of the three years in the period ended December 31, 1997 (in thousands) Capital in Retained Common Stock Excess of Earnings Shares Amount Par Value (Deficit) Balance at January 1, 1995...................... 4,727 $94 $64,527 $(13,791) Compensation expense for executive loan plan, net.. 20 Net income.................. 3,889 Balance at December 31, 1995.................... 4,727 94 64,547 (9,902) Purchase and retirement of common stock........... (150) (3) (2,265) Compensation expense for executive loan plan, net.. 133 Other....................... 2 27 Net income.................. 8,986 Balance at December 31, 1996.................... 4,579 91 62,442 (916) Purchase and retirement of common stock........... (1,163) (23) (25,306) Compensation expense for executive loan plan, net.. 133 Exercise of stock options... 17 239 Net income.................. 11,587 Balance at December 31, 1997.................... 3,433 $68 $37,508 $10,671 The accompanying notes are an integral part of the financial statements. F-5 STANLEY FURNITURE COMPANY, INC. STATEMENTS OF CASH FLOWS (in thousands) For the Years Ended December 31, 1997 1996 1995 Cash flows from operating activities: Cash received from customers...... $207,590 $200,793 $175,189 Cash paid to suppliers and employees....................... (187,346) (176,739) (164,022) Interest paid..................... (3,403) (3,483) (3,535) Income taxes paid, net............ (8,529) (5,259) (1,033) Net cash provided by operating activities.................... 8,312 15,312 6,599 Cash flows from investing activities: Capital expenditures.............. (4,076) (3,599) (14,225) Purchase of other assets.......... (143) (370) (467) Proceeds from sale of assets...... 13 25 Net cash used by investing activities.................... (4,219) (3,956) (14,667) Cash flows from financing activities: Purchase and retirement of common stock........................... (25,329) (2,268) Issuance of senior notes.......... 10,000 10,000 Repayment of senior note.......... (725) (650) Proceeds from (repayment of) revolving credit facility, net............. 3,952 (914) (2,320) Other, net......................... 639 304 385 Net cash (used) provided by financing activities........... (11,463) (3,528) 8,065 Net (decrease) increase in cash...... (7,370) 7,828 (3) Cash at beginning of year............ 8,126 298 301 Cash at end of year................ $ 756 $ 8,126 $ 298 The accompanying notes are an integral part of the financial statements. F-6 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies Organization and Basis of Presentation Stanley Furniture Company, Inc. (the "Company") is a leading designer and manufacturer of furniture exclusively targeted at the upper-medium price range of the residential market. The Company operates predominantly in one business segment. Substantially all revenues result from the sale of residential furniture products. Substantially all of the Company's trade accounts receivable are due from retailers in this market, which consists of a large number of entities with a broad geographical dispersion. Inventories Inventories are valued at the lower of cost or market. Cost for all inventories is determined using the first-in, first-out (FIFO) method. Property, Plant and Equipment Depreciation of property, plant and equipment is computed using the straight-line method based upon the estimated useful lives. Gains and losses related to dispositions and retirements are included in income. Maintenance and repairs are charged to income as incurred; renewals and betterments are capitalized. Capitalized Software Cost The Company amortizes certain purchased computer software costs using the straight-line method over the economic lives of the related products not to exceed five years. Unamortized cost at December 31, 1997 and 1996 was $838,000 and $720,000, respectively. Goodwill and Long-lived Assets Goodwill is being amortized on a straight-line basis over 40 years. The Company continually evaluates the existence of impairment of long-lived assets, including goodwill, on the basis of whether it is fully recoverable from projected, undiscounted net cash flows. Income Taxes Deferred income taxes are determined based on the difference between the financial statement and income tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse. Deferred tax expense represents the change in the deferred tax asset/liability balance. Income tax credits are reported as a reduction of income tax expense in the year in which the credits are generated. F-7 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 1. Summary of Significant Accounting Policies (continued) Fair Value of Financial Instruments The fair value of the Company's long-term debt is estimated using discounted cash flow analysis based on the incremental borrowing rates currently available to the Company for loans with similar terms and maturities. At December 31, 1997, the fair value approximated the carrying amount. The fair value of trade receivables, trade payables and letters of credit approximate the carrying amount because of the short maturity of these instruments. Pension Plans The Company's funding policy is to contribute to all qualified plans annually an amount equal to the normal cost and a portion of the unfunded liability, but not to exceed the maximum amount that can be deducted for federal income tax purposes. Earnings per Common Share The Company has adopted Statement of Financial Accounting Standards No. 128, "Earnings Per Share", resulting in the restatement of earnings per share for all prior periods. Basic earnings per common share are based upon the weighted average shares outstanding. Outstanding stock options are treated as common stock equivalents for purposes of computing diluted earnings per share and represent the difference between basic and diluted weighted average shares outstanding. Stock Options The Company applies Accounting Principles Board Opinion No. 25 in accounting for stock options and discloses the fair value of options granted as permitted by Statement of Financial Accounting Standards No. 123. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. F-8 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 2. Property, Plant and Equipment at December 31 Depreciable lives (in thousands) (in years) 1997 1996 Land and buildings............. 20 to 50 $33,941 $33,694 Machinery and equipment........ 5 to 12 48,180 45,120 Office furniture and equipment. 3 to 10 1,836 1,794 Construction in progress....... 588 129 $84,545 $80,737 3. Long-Term Debt at December 31 (in thousands) 1997 1996 7.28% Senior notes due March 15, 2004........$30,000 $30,000 7.57% Senior note due June 30, 2005.......... 8,625 9,350 7.43% Senior notes due November 18, 2007..... 10,000 Revolving credit facility.................... 3,952 Total.................................... 52,577 39,350 Less current maturities...................... 5,086 725 $47,491 $38,625 In November 1997, the Company issued $10.0 million of 7.43% senior notes due 2007 in a private placement of debt, which was used to purchase 413,201 shares of its common stock from the ML-Lee Acquisition Fund, L.P. and its affiliates. The revolving credit facility provides for borrowings of up to $25.0 million through June 1999, automatically renewable thereafter for one year periods unless terminated by either party. Interest under the facility is payable monthly at prime (8.50% on December 31, 1997) or, at the Company's option, the reserve adjusted LIBOR plus 1.0% per annum (6.60% on December 31, 1997). The above loan agreements require the Company to maintain certain financial covenants. As of December 31, 1997, these covenants limit additional borrowings to $6.4 million and limit funds available to pay dividends and repurchase its common stock to $5.6 million. Annual debt service requirements are $5.1 million in 1998, $9.1 million in 1999, $5.2 million in 2000, $6.7 million in 2001 and $6.8 million in 2002. The Company utilizes letters of credit to collateralize certain insurance policies and inventory purchases. Outstanding letters of credit at December 31, 1997 were $1.9 million. F-9 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 4. Income Taxes The provision for income taxes on income from continuing operations consists of (in thousands): 1997 1996 1995 Current: Federal......................... $6,454 $5,217 $1,750 State........................... 757 952 412 Total current................. 7,211 6,169 2,162 Deferred: Federal......................... (96) (567) 156 State........................... (13) (132) 66 Total deferred................ (109) (699) 222 Income taxes................ $7,102 $5,470 $2,384 A reconciliation of the difference between the federal statutory income tax rate and the effective income tax rate on income from continuing operations follows: 1997 1996 1995 Federal statutory rate.......... 35.0% 35.0% 35.0% State taxes, net of federal benefit....................... 2.6 3.8 5.0 Goodwill........................ .6 .8 1.9 Life insurance.................. (.7) (.7) (1.5) Tax savings from foreign sales corporation................... (.5) (1.4) (.8) Tax credits..................... (.2) Other, net...................... 1.0 1.0 (1.4) Effective income tax rate..... 38.0% 38.5% 38.0% The income tax effects of temporary differences that comprise deferred tax assets and liabilities at December 31 follow (in thousands): 1997 1996 Current deferred tax assets (liabilities): Accounts receivable............... $ (180) $ 618 Inventory......................... (18) (521) Employee benefits................. 901 1,692 Other accrued expenses............ 67 97 Net current deferred tax asset.. $ 770 $ 1,886 Noncurrent deferred tax liabilities: Property, plant and equipment..... $10,236 $11,229 Employee benefits................. 212 444 Net noncurrent deferred tax liability..................... $10,448 $11,673 F-10 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 5. Stockholders' Equity, Stock Options and Related Matters The Company's stock option plans provide for the granting of stock options up to an aggregate of 700,000 shares of common stock to key employees. The exercise price may not be less than the fair market value of the Company's common stock on the grant date. Granted options vest 20% annually. At December 31, 1997 and 1996, options to purchase 496,188 and 385,443 shares, were exercisable with a weighted-average exercise price of $9.74 and $9.66, respectively. At December 31, 1997, 3,651 shares were available for grant. Activity for the three years ended December 31, 1997 follows: Number Weighted-Average of shares Exercise Price Outstanding at January 1, 1995.... 670,000 $ 9.86 Cancelled or Lapsed.............(162,047) 9.84 Granted......................... 170,000 8.75 Outstanding at December 31, 1995...677,953 9.59 Lapsed...........................(15,216) 9.80 Exercised........................ (2,500) 9.75 Granted.......................... 20,000 14.78 Outstanding at December 31, 1996...680,237 9.74 Lapsed........................... (9,000) 9.17 Exercised........................(16,902) 9.48 Granted.......................... 17,500 20.11 Outstanding at December 31, 1997...671,835 $ 9.89 Options outstanding at December 31, 1997, include 634,335 shares with an exercise price ranging from $8.50 to $10.00 and a weighted-average remaining contractual life of 7.2 years. The remaining options have an exercise price ranging from $12.13 to $28.00 with a weighted-average remaining contractual life of 9.1 years. The estimated per share weighted-average fair value of stock options granted during 1997, 1996, and 1995 was $14.50, $8.00 and $6.00 respectively, on the date of grant. A risk-free interest rate of 5.4%, 6.8% and 6.2% for 1997, 1996, and 1995 respectively, and a 50% volatility rate with an expected life of 10 years was assumed in estimating the fair value. F-11 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 5. Stockholders' Equity, Stock Options, and Related Matters (continued) The following table summarizes the pro forma effects assuming compensation cost for such awards had been recorded based upon the estimated fair value (in thousands, except per share data): 1997 1996 1995 As Pro As Pro As Pro Reported Forma Reported Forma Reported Forma Net income...........$11,587 $11,326 $8,986 $8,754 $3,889 $3,685 Basic earnings per share.............. 2.76 2.70 1.90 1.85 .82 .78 Diluted earnings per share.............. 2.50 2.45 1.82 1.79 .82 .78 During 1994, the Company entered into a contractual agreement to issue 50,000 shares of common stock to the chief executive officer at $10.00 per share (the market price on the date of the agreement) in exchange for a non-recourse 7.6% note receivable. One tenth of the principal amount plus accrued interest is due each December 31 until 1998 and the remaining principal is due January 2, 1999. The Company agreed to forgive the accrued interest plus one tenth of the initial principal amount each December 31, if the executive remains employed by the Company. During 1996, the Company agreed to forgive the outstanding loan balance over the remaining three years, subject to the executive's continued employment. Compensation expense was $285,000, $308,000 and $98,000 for 1997, 1996 and 1995, respectively. During 1996, a secondary offering of 1,000,000 shares of the Company's common stock owned by the ML-Lee Acquisition Fund, L.P. (the "Lee Fund") and its affiliates was completed. In connection with the offering, the Company incurred approximately $325,000 of expenses. The Company also purchased 150,000 shares of its common stock, which were subject to the over-allotment option from the secondary offering, for an aggregate consideration of $2.3 million. In 1997, the Company completed two transactions for the purchase of its common stock owned by the Lee Fund and its affiliates. In June 1997, 750,000 shares were purchased for an aggregate purchase price of $15.0 million and in November 1997, 413,201 shares were purchased for an aggregate purchase price of $10.3 million. Assuming the shares were repurchased at the beginning of the year and financed entirely by borrowings under the revolving credit facility at an assumed rate of 7.25%, the pro forma diluted earnings per share would have been $2.77 for 1997. F-12 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) In addition to its common stock, the Company's authorized capital includes 1,000,000 shares of "blank check" preferred stock. None was outstanding during the three years ended December 31, 1997. The Board of Directors is authorized to issue such stock in series and to fix the designation, powers, preferences, rights, limitations and restrictions with respect to any series of such shares. Such "blank check" preferred stock may rank prior to common stock as to dividend rights, liquidation preferences or both, may have full or limited voting rights and may be convertible into shares of common stock. 6. Employee Benefit Plans Defined Contribution Plan The Company maintains a defined contribution plan covering substantially all of its employees. Discretionary matching and profit sharing contributions for 1997 and 1996 totaled $1.2 million and $856,000, respectively. Prior to 1996, the Company made no contributions. Pension Plans Benefits were accrued under the Company's pension plans through 1995. The Stanley Retirement Plan covers substantially all employees hired prior to 1995. The Supplemental Plan is unfunded and covers certain key employees hired prior to 1989. Stanley Retirement Plan assets are invested in fixed income and equity securities. Benefits under both plans are based on average compensation and service through 1995. The financial status of the plans at December 31 follows (in thousands): 1997 1996 Stanley Supple- Stanley Supple- Retirement mental Retirement mental Plan Plan Plan Plan Accumulated benefit obligation: Vested.....................$(15,361) $(1,210) $(14,334) $ (990) Nonvested.................. (1,785) (1,636) Accumulated benefit obliga- tion.......................$(17,146) $(1,210) $(15,970) $ (990) Projected benefit obligation.$(17,146) $(1,210) $(15,970) $ (990) Plan assets at fair value.... 17,170 16,116 Plan assets more than (less than) projected benefit obligation................. 24 (1,210) 146 (990) Unrecognized (gain) loss..... 4,776 (5) 3,994 (62) Prepaid (accrued) pension costs....................$ 4,800 $(1,215) $ 4,140 $(1,052) F-13 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 6. Employee Benefit Plans (continued) Components of net periodic pension cost follow (in thousands): 1997 1996 1995 Service cost.................... $ 774 Interest cost................... $1,279 $1,295 1,256 Actual return on assets......... (1,587) (618) (1,320) Net amortization and deferral... 550 (55) 965 Loss on curtailment............. 31 $ 242 $ 622 $1,706 The assumptions used as of December 31 to determine the plans' financial status and pension cost were: 1997 1996 1995 Discount rate for funded status.. 7.00% 7.75% 7.67% Discount rate for pension cost... 7.75% 7.67% 9.00% Salary progression............... N/A N/A 5.00% Return on assets................. 7.50% 7.50% 7.75% A reduction in the discount rate of 0.25% would create an additional minimum pension liability of $5.4 million and would result in a charge to stockholders' equity of $3.3 million, net of deferred taxes, at December 31, 1997. Postretirement Benefits Other Than Pensions The Company provides health care benefits to eligible retired employees between the ages of 55 and 65 and provides life insurance benefits to eligible retired employees from age 55 until death. Substantially all of the Company's employees are eligible for these benefits after satisfying service and age provisions. Employees who elect benefits at retirement contribute to the cost of coverage. The plan is unfunded. F-14 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 6. Employee Benefit Plans (continued) The plan's financial status at December 31 follows (in thousands): 1997 1996 Accumulated postretirement benefit obligation: Retirees............................. $(2,963) $(3,049) Fully eligible active plan participants....................... (285) (254) Other active plan participants....... (393) (300) Accumulated postretirement benefit obligation................... (3,641) (3,603) Unrecognized net loss.................. 895 741 Unrecognized transition obligation..... 1,954 2,084 Accrued postretirement benefit cost.. $ (792) $ (778) Components of net periodic postretirement benefit cost were (in thousands): 1997 1996 1995 Service cost............... $ 36 $ 35 $ 93 Interest cost.............. 261 274 510 Amortization of transition obligation............... 131 130 134 Amortization and deferral.. 29 33 182 $ 457 $ 472 $919 The weighted-average discount rates used in determining the actuarial present value of the projected benefit obligation were 7.00%, 7.75% and 7.67% for 1997, 1996 and 1995, respectively. The rate of increase in future health care benefit cost used in determining the obligation for 1997 was 9% gradually decreasing to 5.5% beginning in 2004; for 1996 was 10% gradually decreasing to 5.5% beginning in 2003; and, for 1995 was 12% gradually decreasing to 6% beginning in 2002. Increasing the assumed health care cost trend rate by one percentage point in each future year would increase the accumulated postretirement benefit obligation at December 31, 1997, by $101,000 and the annual postretirement benefit cost by $12,000. Deferred Compensation The Company has a deferred compensation plan, funded with life insurance policies, which permits certain management employees to defer portions of their compensation and earn a fixed rate of return. The accrued liabilities relating to this plan of $1.4 million at December 31, 1997 and 1996, are included in accrued salaries, wages and benefits and other long-term liabilities. The cash surrender value, net of policy loans, is included in other assets. F-15 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 7. Leases The Company leased a substantial portion of its facilities under operating leases through June 1995, at which time the Company purchased these facilities. The Company continues to lease showroom space and certain other equipment. Rental expenses charged to operations were $1.1 million, $970,000, and $1.4 million in 1997, 1996 and 1995, respectively. Future minimum lease payments, net of subleases, are approximately as follows: 1998 - $913,000; 1999 - $728,000; 2000 -$54,000; and thereafter - $45,000. 8. Discontinued Operations In 1996, the Company was released from a lease obligation resulting from the purchase and concurrent resale of certain facilities at a former division, which ceased operations in 1994. Accordingly, the Company recorded an after tax gain of $246,000, or $.05 per share, as a partial reversal of a previous accrual, representing the final adjustment for the cost of the closure. 9. Related Party Transactions During 1996 and 1997, the Company completed three purchases of its common stock from the ML-Lee Acquisition Fund, L.P. and its affiliates (the "Lee Fund") totaling 1.3 million shares for a total consideration of $27.6 million. The Lee Fund sold to public investors its remaining ownership in January 1998. The Company maintained a management agreement with an affiliate of the Lee Fund which was terminated in November 1997. Fees paid pursuant to this agreement amounted to $125,000 in 1997, $241,000 in 1996, and $250,000 in 1995. 10. Unusual Items During 1995, the Company was released from a lease obligation at its previously closed Waynesboro, Virginia manufacturing facility. Accordingly, the Company recognized a pretax credit of $1.1 million related to the reversal of an accrual provided in 1991 for the closing of the facility. Unusual items also included a pretax charge for severance resulting from the resignation of a former officer of the Company. F-16 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 11. Supplemental Cash Flow Information (in thousands) 1997 1996 1995 Net income......................... $11,587 $ 8,986 $ 3,889 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation................... 5,000 4,774 4,503 Amortization................... 432 426 416 Other, net..................... 340 463 118 Loss on disposal of fabric division..................... (246) Changes in assets and liabilities: Accounts receivable.......... (4,331) (364) 1,028 Inventories................... (5,491) (72) (262) Prepaid expenses and other current assets............. (2,180) (1,347) (1,030) Accounts payable............. 3,534 993 (1,022) Accrued salaries, wages and benefits................... (27) 2,965 (500) Other accrued expenses....... (713) (479) 137 Deferred income taxes........ (109) (134) 222 Other assets................. 32 29 25 Other long-term liabilities.. 238 (682) (925) Net cash provided by operating activities..... $ 8,312 $15,312 $ 6,599 F-17 STANLEY FURNITURE COMPANY, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 12. Quarterly Results of Operations (Unaudited) The Company's unaudited quarterly results of operations were as follows (in thousands, except per share data): First Second Third Fourth 1997 Quarters: Net sales............... $49,631 $49,469 $54,270 $58,534 Gross profit............ 12,461 12,488 13,288 14,214 Net income.............. 2,772 2,756 2,935 3,125 Net income per share: Basic................. $ .60 $ .60 $ .76 $ .85 Diluted............... .55 .55 .68 .75 1996 Quarters: Net sales............... $48,190 $47,282 $52,550 $53,882 Gross profit............ 10,769 11,087 12,778 13,939 Net income from continuing operations............ 1,583 1,704 2,615 2,839 Net income from continuing operations per share: Basic................. $ .33 $ .36 $ .55 $ .60 Diluted............... .33 .35 .53 .56 F-18 STANLEY FURNITURE COMPANY, INC. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS For each of the Three Years in the Period Ended December 31, 1997 (In thousands) Column A Column B Column C Column D Column E Charged Balance at (Credited) Balance Beginning to Costs & at End of Descriptions of Period Expenses Deductions Period 1997 Doubtful receivables. $1,332 $ 20 $236(a) $1,116 Discounts, returns, and allowances.. 613 166(b) 779 $1,945 $186 $236 $1,895 1996 Doubtful receivables. $ 600 $860 $128(a) $1,332 Discounts, returns, and allowances.. 557 56(b) 613 $1,157 $916 $128 $1,945 1995 Doubtful receivables. $ 528 $302 $230(a) $ 600 Discounts, returns, and allowances.. 405 152(b) 557 $ 933 $454 $230 $1,157 (a) Uncollectible receivables written off, net of recoveries. (b) Represents net increase in the reserve. S-1