1998 ANNUAL REPORT
Management's Discussion and Analysis of Financial
Condition and Results of Operations
Introduction
Sales and net earnings have continued to improve over the last three years. The
improvement in operating results is primarily the result of increased sales of
aerospace fasteners and superalloys and the inclusion of the operating results
of the businesses acquired in the past three years. The Company's capital
expenditure program over the last five years has increased capacity and reduced
manufacturing costs. During the past three years, net cash provided by
operating activities has funded 59 percent of the $321.4 million cost incurred
by the aggressive capital expenditure and "bolt on" acquisition programs that
are driving the Company's growth.
1998 Compared to 1997
Net Sales
Fasteners segment sales increased $43.0 million, or 11.2 percent, in 1998. The
increase in fastener sales is due principally to two factors: an increase in
aerospace fastener sales and the acquisition of fastener companies in 1998. The
segment's aerospace fasteners sales increased $29.7 million, or 14.0 percent,
to $241.1 million as sales increased in North America and Europe. Although
sales in North America increased in 1998, the Company experienced a decline in
aerospace fastener orders in North America in 1998. This decline is attributed
to a forecasted drop in Boeing aircraft deliveries in the year 2000 and current
reductions in Boeing inventories. The Company's North American aerospace
facilities did secure important long-term contracts with Boeing, Pratt &
Whitney and General Electric which are expected to increase market share with
these customers. The recent success of Airbus in winning new aircraft orders
has increased the overall demand for aerospace products in Europe. To further
participate in the expanding European aerospace market, the Company has
committed to a $4.3 million expansion project for its European aerospace
fastener manufacturing facility. This expansion will be completed in 1999 and
is expected to increase manufacturing capacity by 25 percent. For 1999, the
Company believes that the overall aerospace fastener production volume should
remain at a level that will continue to generate reasonable profits and
significant free cash flow.
Sales of automotive and industrial fasteners by Terry Machine Company (acquired
on June 30, 1998) and Non-Ferrous Bolt & Mfg. Co. (acquired on July 31, 1998)
increased Fasteners segment sales by $23.7 million. Excluding the sales from
these acquired businesses, the Company's automotive and industrial fastener
sales decreased $6.1 million, or 3.8 percent. The decrease in sales of
fasteners manufactured in Brazil and Australia exceeded the modest growth in
sales of fasteners manufactured in North America and Europe. The overall
weakness of the Brazilian economy and increased fastener industry capacity has
adversely affected the Company's Brazilian operation. The Company's Australian
operation was adversely affected by weak demand from the automotive industry as
a result of the Asian economic slowdown.
Specialty Materials and Alloys segment sales increased $30.0 million, or 36.2
percent. This increase is due primarily to the 1998 acquisition of Greenville
Metals, Inc. ($14.0 million) and to an increase in superalloy sales ($13.4
million) by the Cannon-Muskegon Corporation (Cannon). Superalloy sales
benefited from strong demand from the aerospace and industrial gas turbine
markets. In December 1998, the Company signed a five year supply agreement to
deliver in excess of three million pounds annually of superalloy material to
Precision Castparts for use in industrial gas turbines and airplane jet
engines. The Company has committed to a $6.75 million investment at Cannon for
a building addition, a new five ton vacuum furnace and other equipment in order
to increase capacity to meet the requirements of this new contract.
Excluding the $32.1 million of sales by two companies acquired at the end of
1997 (Magnetic Technologies Corporation and National-Arnold Magnetics Company),
Magnetic Materials segment sales decreased by $2.6 million, or 2.4 percent. The
decrease is attributed to a decline in demand from ad-specialty customers and
the General Motors strike.
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SPS TECHNOLOGIES, INC. AND SUBSIDIARIES
Management's Discussion and Analysis of Financial
Condition and Results of Operations (continued)
As described in Note 18 to the financial statements, the Company's Other
segment consists of the Precision Tool Group and the Chevron Aerospace Group.
The Precision Tool Group was formed to build a full service, global tool
business focusing on precision consumable tools used for metal forming and
cutting. Due primarily to the acquisition of Mohawk Europa Limited (Mohawk) on
September 23, 1997 and Howell Penncraft, Inc. on June 30, 1998, the Precision
Tool Group increased sales by $15.4 million, or 125 percent. The acquisition of
the Chevron Aerospace Group on October 28, 1998 marked the Company's expansion
into the production of aerospace structural components. While contributing
$10.1 million of sales in 1998, this acquisition is expected to have a more
material impact on sales in 1999.
Sales originating in the United States, as presented in the geographic area
information in Note 18 to the financial statements, increased $104.5 million,
or 25.3 percent, in 1998. This increase is primarily due to increased domestic
aerospace sales ($15.1 million) and sales from acquisitions made in the last
two years located in the United States ($79.2 million). Sales originating in
England and Ireland increased $34.5 million, or 31.0 percent, due to higher
sales of aerospace fasteners manufactured in England ($7.5 million), increased
sales from Mohawk, which was acquired in September of 1997 ($9.1 million) and
sales from Chevron noted above. The decrease in sales originating in Other
areas is attributed to the decrease in sales of fasteners manufactured in
Australia described above.
Operating Earnings
Operating earnings of the Fasteners segment improved from $41.1 million, or
10.7 percent of sales, in 1997, to $52.2 million, or 12.3 percent of sales. The
improvement in earnings is attributed to increased sales of aerospace fasteners
and further improvements in manufacturing efficiencies of all fastener
businesses. New production equipment, new plant layouts and process
simplification have resulted in improved margins in the Fasteners segment.
In 1998, the Company announced further downsizing of its manufacturing
operation in Coventry, England. This facility lost $3.4 million in 1998 which
included operating losses of $860 thousand, cost of employee separations of
$1.7 million, inventory write-offs of $600 thousand and other costs of $240
thousand. The headcount at this facility is expected to be approximately 50
employees by March, 1999 compared to 154 employees at January 1, 1998 and 82
employees at December 31, 1998. Certain equipment at Coventry will be relocated
to other facilities owned by the Company or sold to third parties. In 1998, the
Fasteners segment incurred the cost of other employee separations (primarily
related to automotive and industrial manufacturing operations) of $3.0 million.
Operating earnings of the Specialty Materials and Alloys segment improved from
$11.0 million, or 13.3 percent of sales, to $15.1 million, or 13.4 percent of
sales. The increase in earnings is attributed to increased sales of superalloys
and earnings contributed by the 1998 acquisition of Greenville Metals, Inc.
Partially offsetting these increases were operating losses incurred by Lake
Erie Design where technical problems were experienced in ramping up production
of very complex cores in the new 38,000 square foot industrial gas turbine core
facility. The Company expects to resolve these problems and return this
facility to profitability in 1999.
The magnetic material acquisitions completed at the end of 1997 discussed above
contributed $3.2 million of the $3.4 million increase in operating earnings in
the Magnetic Materials segment. Acquisitions in the Other segment (Chevron
Aerospace Group and the Precision Tool Group companies discussed above)
contributed $2.9 million of the $3.2 million increase in operating earnings
from the Other segment.
Other Income (Expenses)
Interest expense increased from $9.0 million in 1997 to $10.9 million in 1998
due primarily to a higher level of average debt during 1998. The 1998 loss from
equity in affiliates was $2.7 million worse than the 1997 income amount. The
Company's affiliates in India and China incurred significant losses in 1998.
The Company's
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1998 ANNUAL REPORT
Management's Discussion and Analysis of Financial
Condition and Results of Operations (continued)
share of these losses was $1.4 million for the Indian affiliate and $1.0
million for the China joint venture. Decreasing export sales, manufacturing
inefficiencies and weak economic conditions in Asia were the major factors in
these losses.
Orders and Backlog
Incoming orders in 1998 were $704.2 million compared to $648.6 million in 1997,
an 8.6 percent increase. The acquisitions made in the last two years increased
orders by $95.8 million. In addition to the acquisition impact, the Company's
orders increased for aerospace fasteners manufactured in England ($9.1 million)
and superalloys manufactured by Cannon ($16.7 million). Partially offsetting
these increases were decreases for aerospace fasteners manufactured in North
America ($49.0 million) and magnetic materials manufactured in North America
($13.9 million). The backlog of orders, which represent firm orders with
delivery scheduled within 12 months, at December 31, 1998 was $296.1 million,
compared to $251.1 million at the end of 1997 and $181.0 million at December
31, 1996.
Environmental
The Company has been identified as a potentially responsible party by various
federal and state authorities for clean up or removal of waste from various
disposal sites. The cost of remediation will depend upon numerous factors,
including the number of parties found liable at each environmental site and
their ability to pay, the outcome of negotiations with regulatory authorities
and the years of remedial activity required.
At December 31, 1998, the accrued liability for environmental remediation
represents management's best estimate of the probable and reasonably estimable
costs related to environmental remediation. The measurement of the liability is
evaluated quarterly based on currently available information.
Acquisitions
As discussed in Note 2 to the financial statements, the Company acquired five
businesses in 1998. On March 23, 1998, the Company acquired all of the
outstanding shares of Greenville Metals, Inc. (Greenville) located in Transfer,
Pennsylvania, for $15.9 million. Greenville manufactures master alloy ingot and
shot, foundry additive products, miscellaneous induction alloys and refines and
converts scrap for a wide variety of customers. In 1998, Greenville had sales
of approximately $19.2 million. Greenville's capabilities complement and expand
those of Cannon and the Company expects to realize future benefits from the
operational synergies that can be achieved between Cannon and Greenville. On
June 30, 1998, the Company acquired all of the outstanding shares of Terry
Machine Company (Terry) located in Waterford, Michigan, for $22.1 million.
Terry manufactures specialty cold headed fasteners for the automotive industry
and had 1998 sales of approximately $36.1 million. This acquisition expands the
Company's automotive product offering which complements auto makers' on-going
vendor reduction strategy. On June 30, 1998, the Company purchased the
operating assets of Howell Penncraft, Inc. (Penncraft) located in Howell,
Michigan, for $3.5 million. Penncraft is a manufacturer of high-speed tool
steel and carbide products used in metal forming. Penncraft had 1998 sales of
approximately $8.6 million. This acquisition expands the product range and
geographic sales coverage of the Company's Precision Tool Group. On July 31,
1998, the Company acquired all of the outstanding shares of Nevada Bolt & Mfg.
Co. doing business as Non-Ferrous Bolt & Mfg. Co. (Non-Ferrous) located in Las
Vegas, Nevada for $11.9 million. Non-Ferrous manufactures non-standard,
hot-forged bolts and nuts from stainless steel and specialty alloy materials.
Non-Ferrous had 1998 sales of approximately $16.0 million. This acquisition
expands the product range of the Company's industrial fastener products and
extends their penetration into the industrial market. On October 28, 1998 the
Company acquired all of the outstanding shares of Chevron Aerospace Group
Limited (Chevron) based in Nottingham, England for $54.9 million. Chevron is a
manufacturer of aircraft structural assemblies, precision machined components,
avionic panels, wiring harnesses and turbine lockplates. In 1998, Chevron had
sales of approximately $44.4 million.
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SPS TECHNOLOGIES, INC. AND SUBSIDIARIES
Management's Discussion and Analysis of Financial
Condition and Results of Operations (continued)
The acquisition of Chevron expands SPS' product offering to the European
aerospace market, which is growing rapidly due to the continued success of
Airbus in securing new aircraft orders.
The Company also acquired three smaller sized businesses, at a cost of $2.9
million, intended to add specific product line capabilities and enhance the
competitive position of the Company's current businesses. The company acquired
the assets of Premier Microwave Corporation's solenoid business, certain assets
of Robertson Tooling Limited (a manufacturer of planetary thread roll dies) and
the assets of KSS Socket Screw, Inc. (a manufacturer of small diameter headed
socket screws). The combined annual sales of these three businesses is
approximately $3.5 million and all assets were or will be relocated to
facilities owned by the Company.
1997 Compared to 1996
Net Sales
Fasteners segment sales increased $55.3 million, or 16.9 percent, in 1997. The
increase in fastener sales is attributed to an increase in aerospace fastener
sales and the 1997 acquisition of Greer Stop Nut, Inc. (Greer). The segment's
aerospace fastener sales increased $51.0 million, or 31.8 percent, to $211.4
million due to the buoyant aerospace market. The strong demand for aerospace
fasteners was attributed to the build rates for new aircraft and the ongoing
need for maintenance and repair parts for the aging fleet of commercial and
military aircraft. The Company spent approximately $23.9 million on capital
equipment over the past three years (1995 to 1997) to increase aerospace
capacity and lower costs to enhance its competitive position. Sales of
industrial fasteners by Greer (acquired in February, 1997) increased Fasteners
segment sales by $10.5 million. Excluding the sales from this business, the
Company's automotive and industrial fastener sales increased $2.1 million, or
1.4 percent, due primarily to increased sales by the Company's Brazilian
operation. Increased sales of UNBRAKO fasteners in the North American market
(approximately $2.0 million) were offset by lower sales of UNBRAKO fasteners in
Europe.
Specialty Materials and Alloy segment sales increased $16.1 million, or 24.1
percent, due to an increase in superalloy sales by the Cannon-Muskegon
Corporation ($10.5 million) and to the 1997 acquisition of Lake Erie Design
($5.6 million). The capital expenditures made over the past four years (1994 to
1997) have increased superalloy production capacity and allowed Cannon-Muskegon
to further participate in the expanding aerospace and land-based industrial gas
turbine markets. The acquisitions made in 1997 and 1996 in the Magnetic
Materials segment contributed $25.5 million of the $26.5 million increase in
this segment's sales.
Sales originating in the United States, as presented in the geographic area
information in Note 18 to the financial statements, increased $77.7 million, or
23.2 percent, in 1997. This increase is primarily due to increased domestic
aerospace fastener sales ($34.5 million) and sales from acquisitions made in
the last two years ($32.1 million) located in the United States. Sales
originating in England and Ireland increased $21.2 million, or 23.5 percent,
due to higher sales of aerospace fasteners manufactured in England ($9.0
million) and increased sales from the magnetic material company located in
England that was acquired in June, 1996 ($9.6 million). Sales originating in
Other areas include sales into the troubled Asia market; however, these sales
are not a significant part of our business and our net exposure in the affected
economies is not material to the Company's consolidated financial position or
results of operations.
Operating Earnings
Operating earnings of the Fasteners segment improved from $26.6 million, or 8.1
percent of sales, in 1996, to $41.1 million, or 10.7 percent of sales, in 1997.
The improvement in earnings is primarily the result of increased sales of
aerospace fasteners, aggressive capital expenditure programs and incorporating
design changes on certain programs to manufacture products on a more cost
effective basis. The fastener acquisitions made in 1997 and 1996 contributed
$2.9 million of the $14.5 million increase in operating earnings from the
Fasteners segment. Partially offsetting this
52
1998 ANNUAL REPORT
Management's Discussion and Analysis of Financial
Condition and Results of Operations (continued)
increase was the operating loss incurred by the Company's manufacturing
facility in Coventry, England. In 1997, the Coventry facility lost $3.2 million
which included operating losses of $2.4 million and cost of employee
separations of $800 thousand.
Operating earnings of the Specialty Materials and Alloys segment improved from
$8.6 million, or 12.9 percent of sales, in 1996 to $11.0 million, or 13.3
percent of sales, in 1997. The improvement in earnings is the result of the
1997 acquisition of Lake Erie Design and an increase in superalloy sales by the
Cannon-Muskegon Corporation as described above. The acquisitions made in 1997
and 1996 in the Magnetic Materials segment contributed $3.1 million of the $3.4
million increase in operating earnings in this segment.
Other Income (Expenses)
Interest expense increased from $8.0 million in 1996 to $9.0 million in 1997
due primarily to a higher level of average debt during 1997. Income from the
equity in earnings of affiliates decreased from $853 thousand in 1996 to $230
thousand in 1997 due primarily to the loss incurred by the Company's joint
venture in China. The loss by the China joint venture is primarily due to a
significant decrease in sales (28 percent or $3.5 million) as a result of
competitive pricing conditions and decreased demand from European markets. The
Company's share of the joint venture loss in 1997 was approximately $800
thousand.
Liquidity and Capital Resources
Management considers liquidity to be the ability to generate adequate amounts
of cash to meet its needs and capital resources to be the resources from which
such cash can be obtained, principally from operating and external sources. The
Company believes that capital resources available to it will be sufficient to
meet the needs of its business, both on a short-term and long-term basis.
Cash flow provided by or used in operating activities, investing activities and
financing activities is summarized in the statements of consolidated cash
flows. Net cash provided by operating activities was $70.2 million in 1998 and
1997. The improvement in net earnings ($12.1 million) and higher non-cash
charges of depreciation, amortization, loss from equity in affiliates and
deferred income taxes ($5.4 million) were offset by an increase in cash used to
fund working capital ($18.8 million).
The increase in cash used in investing activities is attributed to 1998
payments for Greenville ($10.1 million), Terry ($8.4 million), Penncraft ($3.5
million) and Chevron ($32.6 million) compared to 1997 payments for Greer ($10.0
million), RJF's Bonded Magnet Business ($9.2 million), LED ($7.8 million),
Mohawk ($8.9 million) and MTC ($9.6 million) compared to 1996 payments for
Flexmag ($21.3 million), Swift Levick ($10.4 million) and Mecair ($5.6
million). Capital expenditures in 1998 ($32.1 million) and in 1997 ($37.5
million) were spent primarily to increase capacity in the Company's aerospace
fastener, superalloy, ceramic core and bonded magnet businesses and to upgrade
equipment in the automotive and industrial fastener manufacturing operations.
Capital spending of $38.0 million is budgeted for 1999, excluding capital
spending for companies acquired in 1999.
The Company's total debt to equity ratio was 65 percent at December 31, 1998,
52 percent at December 31, 1997 and 65 percent at December 31, 1996. Total debt
was $172.2 million at December 31, 1998 compared to $110.7 million at December
31, 1997 and $115.3 million at December 31, 1996. As of December 31, 1998,
under the terms of the existing credit agreements, the Company is permitted to
incur an additional $94.6 million in debt. Additional details of the long-term
Note Purchase Agreement, the credit agreements with commercial banks and other
debt are provided in Note 9 to the financial statements.
Market Risk
The Company's primary market risk exposures are foreign currency exchange rate
and interest rate risk. Fluctuations in foreign currency exchange rates affect
the Company's results of operations and financial position. As discussed in
Note 1 to
53
SPS TECHNOLOGIES, INC. AND SUBSIDIARIES
Management's Discussion and Analysis of Financial
Condition and Results of Operations (continued)
the financial statements, the Company uses forward exchange contracts and one
currency swap agreement to minimize exposure and reduce risk from exchange rate
fluctuations affecting the results of operations. Because the largest portion
of the Company's foreign operations are in countries with relatively stable
currencies, namely, England, Ireland and Canada, the foreign currency exchange
rate risk to the Company's financial position is not material. However, the
Company has expanded into Brazil, China and other foreign countries which
increases its exposure to foreign currency fluctuations. Fluctuations in
interest rates primarily affect the Company's results of operations. Because a
majority of the Company's debt is in fixed rate obligations (as disclosed in
Note 9 to the financial statements), the Company has effectively limited its
interest expense exposure to fluctuations in interest rates.
The status of the Company's financial instruments as of December 31, 1998 and
1997 is provided in Note 16 to the financial statements. Assuming an
instantaneous 10 percent strengthening of the United States dollar versus
foreign currencies for which forward exchange contracts and currency rate swap
agreements existed and a 10 percent change in interest rate on the Company's
debt had all occurred on December 31, 1998, the Company's results of
operations, cash flow and financial position would not have been materially
affected.
Year 2000 Readiness Disclosures
The following statements include "Year 2000 Readiness Disclosure" within the
meaning of the Year 2000 Information and Readiness Disclosure Act of 1998. The
Company is identifying, evaluating and implementing changes to computer systems
and applications necessary to achieve a year 2000 (Y2K) date conversion with no
material effect on customers or disruption to business operations. These
actions are necessary to ensure that information technology (IT) and non-IT
systems and applications will recognize and process the year 2000 and beyond.
Major areas of potential business impact have been identified and conversion
efforts are underway. All mainframe based IT systems have been assessed, plans
have been put into place and required Y2K conversion of mainframe computer
programs is 90 percent completed. Converted programs have been tested and
placed into operation. Conversion is expected to be complete by April, 1999.
The process of assessing the various PC and LAN based IT systems and non-IT
systems is substantially complete. The Company has converted and tested many of
these systems and expects that the balance of testing and any necessary
remediation will be completed by September 30, 1999. The Company is
communicating with suppliers, customers, financial institutions and others it
does business with to coordinate Y2K conversion. The Company has not completed
its assessment and evaluation of the state of readiness of its customers and
vendors, although major customers have requested from the Company information
regarding its Y2K readiness and certain key suppliers have confirmed their own
internal Y2K readiness.
The cost specifically associated with addressing Y2K issues incurred in 1998
were capitalizable costs of $500 thousand and costs expensed as incurred of
$1.0 million. The Company's cost to complete its Y2K readiness actions is
estimated to be additional capitalizable costs of $1.2 million and costs
expensed as incurred of $600 thousand. Costs expensed as incurred include the
cost of resources within the Company and external resources which have been
directed toward Y2K activities. Total Y2K readiness costs are estimated to be
$3.4 million.
The most reasonably likely worst case Y2K scenario would be the failure of
either the Company or a third party to correct a material Y2K problem that
would cause an interruption in, or failure of, normal business activities or
operations. In the event that the worst case scenario occurs, the impact on the
Company's financial position or results of operations cannot be estimated.
While the Company believes that all internal IT and non-IT systems will be
converted prior to January 1, 2000, the Company is in the process of generating
contingency plans and
54
1998 ANNUAL REPORT
Management's Discussion and Analysis of Financial
Condition and Results of Operations (continued)
identifying additional actions which would be implemented in the event of a Y2K
failure, including but not limited to: utilization of outside (third-party)
mainframe processing resources, identifying backup capacity within the
operating groups, development of manual procedures to process critical
transactions and other appropriate measures. To the extent that the Company
experiences a Y2K failure related to a third party's lack of readiness,
alternate sources of supply are being identified, however, certain resources
are not easily replaceable and there are limited contingency planning options
for such resources. At this time, the Company has not identified a Y2K problem
that it believes cannot be remediated prior to it having a material impact on
operations. The Company will continue to assess the readiness of its own
systems and, if a problem is identified that cannot be remediated in the
appropriate time period, a specific plan to address that issue will be
developed.
Forward-Looking Statements
Certain statements in Management's Discussion and Analysis of Financial
Condition and Results of Operations contain "forward-looking" information,
within the meaning of the Private Securities Litigation Reform Act of 1995,
that involve risk and uncertainty. The Company's expectations of demand for
aerospace fasteners and its effect on the Company's aerospace operations, the
market share gains as a result of the aerospace and superalloy long-term
contracts, resolution of manufacturing problems at Lake Erie Design, future
benefits from operational synergies with newly acquired companies, the relative
stability of certain foreign currencies and completing the Year 2000 date
conversion with no material adverse effect on operations and at no material
cost to the Company's results of operations are "forward looking" statements
contained in Management's Discussion and Analysis of Financial Condition and
Results of Operations. Actual future results may differ materially depending on
a variety of factors, such as: the effects of competition on products and
pricing, customer satisfaction and qualification issues, labor disputes,
worldwide political and economic stability and changes in fiscal policies, laws
and regulations on a national and international basis. The Company undertakes
no obligation to publicly release any forward-looking information to reflect
anticipated or unanticipated events or circumstances after the date of this
document.
55