UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X} QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 ------------------ OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to _________ Commission File Number 0-23486 NN, Inc. (Exact name of registrant as specified in its charter) Delaware 62-1096725 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 2000 Waters Edge Drive Building C, Suite 12 Johnson City, Tennessee 37604 (Address of principal executive offices, including zip code) (423) 743-9151 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] As of November 5, 2004 there were 16,772,092 shares of the registrant's common stock, par value $0.01 per share, outstanding. NN, Inc. INDEX Page No. -------- Part I. Financial Information Item 1. Financial Statements: Consolidated Statements of Income and Comprehensive Income for the three and nine months ended September 30, 2004 and 2003 (unaudited)...............................................2 Condensed Consolidated Balance Sheets at September 30, 2004 (unaudited) and December 31, 2003 .................................3 Consolidated Statements of Changes in Stockholders' Equity for the nine months ended September 30, 2004 and 2003 (unaudited)...............................................4 Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003 (unaudited)....................5 Notes to Consolidated Financial Statements (unaudited)...................6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................13 Item 3. Quantitative and Qualitative Disclosures about Market Risk.........................................................24 Item 4. Controls and Procedures.............. ...............................26 Part II. Other Information Item 1. Legal Proceedings...................................................27 Item 2. Change in Securities and Use of Proceeds............................27 Item 3. Defaults Upon Senior Securities.....................................27 Item 4. Other Information...................................................27 Item 5. Exhibits and Reports on Form 8-K....................................27 Signatures...................................................................29 -1- PART I. FINANCIAL INFORMATION Item 1. Financial Statements NN, Inc. Consolidated Statements of Income and Comprehensive Income (Unaudited) Three Months Ended Nine Months Ended September 30, September 30, Thousands of Dollars, Except Per Share Data 2004 2003 2004 2003 - ------------------------------------------------------------------------------------------------------------------ Net sales $72,917 $64,612 $225,815 $ 186,415 Cost of products sold (exclusive of depreciation shown separately below) 57,263 50,294 176,590 142,758 Selling, general and administrative 7,126 5,247 22,309 15,650 Depreciation and amortization 3,999 3,602 11,918 10,103 Restructuring and impairment costs -- (224) -- 2,498 ----------- ----------- ------------ ------------ Income from operations 4,529 5,693 14,998 15,406 Interest expense, net 1,101 921 2,925 2,325 Other (income) expense, net (177) (38) (208) 272 ----------- ----------- ------------ ------------ Income before provision for income taxes 3,605 4,810 12,281 12,809 Provision for income taxes 1,453 1,646 4,926 4,630 Minority interest in consolidated subsidiaries -- -- -- 675 ----------- ----------- ------------ ------------ Net income 2,152 3,164 7,355 7,504 Other comprehensive income: Foreign currency translation 1,184 1,292 (1,304) 5,460 ----------- ----------- ------------ ------------ Comprehensive income $ 3,336 $ 4,456 $ 6,051 $ 12,964 =========== =========== ============ ============ Basic income per common share: $ 0.13 $ 0.19 $ 0.44 $ 0.48 =========== =========== ============ ============ Weighted average shares outstanding 16,767 16,660 16,721 15,804 =========== =========== ============ ============ Diluted income per common share: $ 0.13 $ 0.18 $ 0.43 $ 0.46 =========== =========== ============ ============ Weighted average shares outstanding 17,135 17,167 17,142 16,194 =========== =========== ============ ============ Cash dividends per common share $ 0.08 $ 0.08 $ 0.24 $ 0.24 =========== =========== ============ ============ See accompanying notes. -2- NN, Inc. Condensed Consolidated Balance Sheets (Unaudited) September 30, December 31, Thousands of Dollars 2004 (Unaudited) 2003 - ----------------------------------------------------------------------------------------------------------------- Assets Current assets: Cash and cash equivalents $ 7,773 $ 4,978 Accounts receivable, net 50,656 40,864 Inventories, net 32,292 36,278 Other current assets 6,092 6,299 ------------------ ------------------ Total current assets 96,813 88,419 Property, plant and equipment, net 125,463 128,996 Assets held for sale -- 1,805 Goodwill, net 42,544 42,893 Other assets 4,871 4,304 ------------------ ------------------ Total assets $ 269,691 $ 266,417 ================== ================== Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 37,418 $ 32,867 Accrued salaries and wages 12,106 12,032 Short-term debt -- 2,000 Current maturities of long-term debt 6,523 12,725 Other current liabilities 6,519 3,070 ------------------ ------------------ Total current liabilities 62,566 62,694 Non-current deferred tax liability 14,102 13,423 Long-term debt 70,735 69,752 Accrued pension and other 13,355 14,080 ------------------ ------------------ Total liabilities 160,758 159,949 Total stockholders' equity 108,933 106,468 ------------------ ------------------ Total liabilities and stockholders' equity $ 269,691 $ 266,417 ================== ================== See accompanying notes. -3- NN, Inc. Consolidated Statements of Changes in Stockholders' Equity (Unaudited) Common Stock Accumulated Number Additional Other Of Par paid in Retained Comprehensive Shares value capital Earnings Income (Loss) Total - ------------------------------------------------------------------------------------------------------------------------------------ Balance, January 1, 2003 15,370 $154 $ 40,457 $ 38,984 $ (1,687) $ 77,908 Shares issued 1,330 14 12,421 -- -- 12,435 Net income -- -- -- 7,504 -- 7,504 Dividends declared -- -- -- (3,895) -- (3,895) Other comprehensive income -- -- -- -- 5,460 5,460 ----------- -------- ----------- ------------ ------------- ------------ Balance, September 30, 2003 16,700 $168 $ 52,878 $ 42,593 $ 3,773 $ 99,412 =========== ======== =========== ============ ============= ============ Balance, January 1, 2004 16,712 $168 $ 52,960 $ 43,931 $ 9,409 $106,468 Shares issued 60 -- 430 -- -- 430 Net income -- -- -- 7,355 -- 7,355 Dividends declared -- -- -- (4,016) -- (4,016) Other comprehensive (loss) -- -- -- -- (1,304) (1,304) ----------- ------- ---------- ----------- ------------ ----------- Balance, September 30, 2004 16,772 $168 $ 53,390 $ 47,270 $ 8,105 $108,933 =========== ======== =========== ============ ============= ============ See accompanying notes. -4- NN, Inc. Consolidated Statements of Cash Flows (Unaudited) Nine Months Ended September 30, Thousands of Dollars 2004 2003 - ------------------------------------------------------------------------------------------------------------- Operating Activities: Net income $ 7,355 $ 7,504 Adjustments to reconcile net income to net cash provided (used) by operating activities: Depreciation and amortization 11,918 10,103 Amortization of debt issue costs 106 128 Write-off of unamortized debt issue costs 260 455 Gain (loss) on disposal of property, plant and equipment 30 (145) Interest income on note receivable 77 61 Minority interest in consolidated subsidiary -- 675 Restructuring costs and impairment costs -- 2,742 Changes in operating assets and liabilities: Accounts receivable (9,609) (14,506) Inventories 3,587 (3,736) Other current assets (717) (594) Other assets (306) (3,056) Accounts payable 4,897 6,653 Income taxes payable 2,079 (128) Other liabilities 2,299 2,015 ------------ ----------- Net cash provided by operating activities 21,976 8,171 ------------ ----------- Investing Activities: Acquisition of Veenendaal, The Netherlands -- (17,933) Purchase of minority interest -- (15,583) Acquisition of property, plant, and equipment (7,999) (7,100) Proceeds from disposals of property, plant and equipment 51 145 ------------ ----------- Net cash used by investing activities (7,948) (40,471) ------------ ----------- Financing Activities: Proceeds from long-term debt 40,000 89,745 Proceeds from short-term debt -- 2,000 Book overdraft -- (37) Debt issue costs paid (771) (823) Repayment of long-term debt (44,642) (60,962) Repayment of short-term debt (2,000) -- Proceeds from issuance of stock 431 5,498 Dividends paid (4,016) (3,895) ------------ ----------- Net cash provided (used) by financing activities (10,998) 31,526 ------------ ----------- Effect of exchange rate changes on cash and cash equivalents (235) 420 Net Change in Cash and Cash Equivalents 2,795 (354) Cash and Cash Equivalents at Beginning of Period 4,978 5,144 ------------ ----------- Cash and Cash Equivalents at End of Period $ 7,773 $ 4,790 ============ =========== Supplemental schedule of non-cash investing and financing activities: Stock issued related to acquisition on Veenendaal $ -- $ 6,937 ============ =========== See accompanying notes. -5- NN, Inc. Notes To Consolidated Financial Statements (unaudited) Note 1. Interim Financial Statements The accompanying consolidated financial statements of NN, Inc. (the "Company") have not been audited by our independent registered public accounting firm, except that the balance sheet at December 31, 2003 is derived from the Company's audited financial statements. In the opinion of the Company's management, the financial statements reflect all adjustments necessary to present fairly the results of operations for the three and nine month periods ended September 30, 2004 and 2003, the Company's financial position at September 30, 2004 and December 31, 2003, and the cash flows for the nine month periods ended September 30, 2004 and 2003. These adjustments are of a normal recurring nature and are, in the opinion of management, necessary for fair presentation of the financial position and operating results for the interim periods. As used in this Quarterly Report on Form 10-Q, the terms "NN", "the Company", "we", "our", or "us" mean NN, Inc. and its subsidiaries. Certain information and footnote disclosures normally included in the financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted from the interim financial statements presented in this Quarterly Report on Form 10-Q. These Condensed, Consolidated, Unaudited Financial Statements should be read in conjunction with our audited Consolidated Financial Statements and the Notes thereto included in our most recent annual report on Form 10-K which we filed with the Securities and Exchange Commission on March 15, 2004. The results for the first, second and third quarters of 2004 are not necessarily indicative of future results. Certain 2003 amounts have been reclassified to conform with the 2004 presentation. Note 2. Derivative Financial Instruments We have an interest rate swap accounted for in accordance with Statement of Financial Accounting Standards (SFAS) No. 133, "Accounting for Derivative Instruments and Hedging Activities", effective January 1, 2001. The Company adopted SFAS No. 133 on January 1, 2001, which establishes accounting and reporting standards for derivative instruments and for hedging activities. The Standard requires the recognition of all derivative instruments on the balance sheet at fair value. The Standard allows for hedge accounting if certain requirements are met including documentation of the hedging relationship at inception and upon adoption of the Standard. In connection with a variable Euribor rate debt financing in July 2000, our subsidiary, NN Europe ApS (formerly known as NN Euroball ApS) entered into an interest rate swap with a notional amount of 12.5 million Euro for the purpose of fixing the interest rate on a portion of its debt financing. The interest rate swap provides for the Company to receive variable Euribor interest payments and pay 5.51% fixed interest. The interest rate swap agreement expires in July 2006 and the notional amount amortizes in relation to initially established principal payments on the underlying debt over the life of the swap. This original debt was repaid in May 2003, however, the swap remains pursuant to its original terms. As of September 30, 2004, the fair value of the swap was approximately $264,000, which is recorded as a component of other non-current liabilities. The change in fair value during the nine month periods ended September 30, 2004 and 2003 was a gain of approximately $73,000 and a loss of $63,000, respectively, which have been included as a component of other (income) expense. -6- Note 3. Inventories Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. Inventories are comprised of the following (in thousands): September 30, December 31, 2004 2003 ------------------ ----------------- Raw materials $ 8,392 $ 8,492 Work in process 6,160 6,808 Finished goods 19,012 22,128 Less inventory reserves (1,272) (1,150) ------------------ ----------------- $ 32,292 $ 36,278 ================== ================= Inventories on consignment at customer locations as of September 30, 2004 and December 31, 2003 were $4,341 and $3,046, respectively. Note 4. Net Income Per Share Three months ended Nine months ended September 30, September 30, Thousands of Dollars, Except Share and Per Share 2004 2003 2004 2003 Data - --------------------------------------------------- ------------- ------------- ------------- ------------ Net income $ 2,152 $ 3,164 $ 7,355 $ 7,504 ============= ============= ============= ============ Weighted average basic shares 16,767,092 16,660,350 16,720,515 15,804,069 Effect of dilutive stock options 367,414 506,293 421,633 389,831 ------------- ------------- ------------- ------------ Weighted average dilutive shares outstanding 17,134,506 17,166,643 17,142,148 16,193,900 ============= ============= ============= ============ Basic net income per share $ 0.13 $ 0.19 $ 0.44 $ 0.48 ============= ============= ============= ============ Diluted net income per share $ 0.13 $ 0.18 $ 0.43 $ 0.46 ============= ============= ============= ============ Excluded from the shares outstanding for each of the periods ended September 30, 2004 and 2003 were 438,000 and 0 antidilutive options, respectively, which had an exercise price of $12.62 as of September 30, 2004. Note 5. Segment Information During 2004 and 2003, the Company's reportable segments are based on differences in product lines and geographic locations and are divided among Domestic Ball and Roller, European operations ("NN Europe") and Plastic and Rubber Components. The Domestic Ball and Roller Segment is comprised of two manufacturing facilities in the eastern United States. The NN Europe Segment is comprised of precision ball manufacturing facilities located in Kilkenny, Ireland, Eltmann, Germany, Pinerolo, Italy, Kysucke Nove Mesto, Slovakia, which began production in the second quarter of 2004, and Veenendaal, The Netherlands ("Veenendaal") which is a tapered roller and metal cage manufacturing operation acquired in May 2003. See Note 6, "Acquisitions and Joint Ventures". All of the facilities in the Domestic Ball and Roller Segment are engaged in the production of precision balls and rollers used primarily in the bearing industry. All of the facilities in the NN Europe Segment are engaged in the production of precision balls used primarily in the bearing industry except for Veenendaal which is engaged in the production of tapered rollers and cages for use primarily in the bearing industry. The Plastic and Rubber Components Segment is comprised of the Industrial Molding Corporation ("IMC") business, located in Lubbock, Texas and The Delta Rubber Company ("Delta") business, located in Danielson, Connecticut. IMC is engaged in the production of plastic injection molded products for the bearing, automotive, instrumentation, fiber optic and general industrial markets. Delta is engaged principally in the production of engineered bearing seals used principally in automotive, industrial, agricultural, mining and aerospace applications. -7- The accounting policies of each segment are the same as those described in the summary of significant accounting policies in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2003, including those policies as discussed in Note 1. We evaluate segment performance based on profit or loss from operations before income taxes and minority interest. We account for inter-segment sales and transfers at current market prices; however, we did not have any material inter-segment transactions during the three or nine month periods ended September 30, 2004 or 2003. Three Months Ended September 30, 2004 2003 ----------------------------------------------------------------------------------------- Plastic and Domestic Plastic and Domestic Ball NN Europe Rubber Ball & NN Europe Rubber Thousands of Dollars & Roller Segment Components Roller Segment Components - ----------------------------------------------------------------------------------------------------------------------- Revenues from external customers $ 14,440 $ 45,485 $ 12,992 $ 14,414 $ 37,784 $ 12,414 Pretax profit (loss) 233 3,874 (502) 1,090 2,897 823 Assets 51,818 160,594 57,279 53,077 144,560 57,989 Nine Months Ended September 30, 2004 2003 ----------------------------------------------------------------------------------------- Plastic and Domestic Plastic and Domestic Ball NN Europe Rubber Ball & NN Europe Rubber Thousands of Dollars & Roller Segment Components Roller Segment Components - ----------------------------------------------------------------------------------------------------------------------- Revenues from external customers $ 43,417 $143,926 $ 38,472 $ 42,588 $104,829 $ 38,998 Pretax profit (loss) 862 10,752 667 3,469 9,871 (531) Assets 51,818 160,594 57,279 53,077 144,560 57,989 Note 6. Acquisitions and Joint Ventures On May 2, 2003 we acquired the 23 percent interest in NN Europe, ApS ("NN Europe") (formerly known as NN Euroball ApS) held by SKF. On March 12, 2004 we changed the name of our primary European entity from NN Euroball, ApS to NN Europe ApS. To avoid confusion between the entity and the segment, we will refer to the segment as the NN Europe Segment and the entity as NN Europe. We paid approximately 13.8 million Euros ($15.6 million) for SKF's interest in Euroball. Upon consummation of this transaction, we became the sole owner of NN Europe. On May 2, 2003 we acquired 100 percent of the tapered roller and metal cage manufacturing operations of SKF in Veenendaal, The Netherlands. The results of Veenendaal's operations have been included in the consolidated financial statements since that date. We paid consideration of approximately 23.0 million Euros ($25.7 million) and incurred other costs of approximately $1.0 million, for the Veenendaal net assets acquired from SKF. The Veenendaal operation manufactures rollers for tapered roller bearings and metal cages for both tapered roller and spherical roller bearings allowing us to expand our bearing component offering. The results of the Veenendaal operation are included in the NN Europe Segment. In connection with the acquisition of SKF's Veenendaal, The Netherlands operations, SKF purchased from us 700,000 shares of our common stock for an aggregate fair value of approximately $6.9 million which was applied to the purchase of SKF's Veenendaal, The Netherlands operations. For purposes of valuing the 700,000 common shares issued in our Consolidated Financial Statements, the value was determined based on the average market price of NN, Inc.'s common shares over the two-day period before, the day of, and the two-day period after the terms of the acquisition were agreed to, April 14, 2003. The following unaudited pro-forma summary presents the financial information for the nine month period ended September 30, 2003 as if our Veenendaal acquisition had occurred as of the beginning of the period presented. These pro forma results have been prepared for comparative purposes and do not purport to be indicative of what would have occurred had the acquisition been made as of the beginning of each of the periods presented, nor are they indicative of future results. -8- Nine months ended September 30, 2003 (In thousands, except per share data) (unaudited) ------------------------------------------------------------------------ Net sales $197,209 Net income 8,168 Basic earnings per share 0.52 Diluted earnings per share 0.50 Note 7. New Accounting Pronouncements On March 31, 2004, the FASB issued an Exposure Draft, "Share-Based Payment", that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, "Accounting for Stock Issued to Employees", and generally would require instead that such transactions be accounted for using a fair-value method. On October 13, 2004, the FASB announced the final Statement for public companies would be effective for any interim or annual period beginning after June 15, 2005. We are currently evaluating the impacts of this Exposure Draft on the Company's consolidated financial statements. On May 19, 2004, the Financial Accounting Standards Board ("FASB") issued FASB Staff Position (FSP) No. 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003", which supersedes FSP No. 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003," (the Act). FSP No. 106-2 permits a sponsor of a postretirement health care plan that provides a prescription drug benefit to make a one-time election to defer accounting for the effects of the Act until authoritative guidance on accounting for subsidies provided by the Act is issued. The Act introduces a prescription drug benefit under Medicare as well as a federal subsidy to sponsors of retiree health care benefit plans. The Company does not anticipate that the Act will have an effect on the Company's Financial Statements. In December 2003, the FASB issued Financial Interpretation No. 46(R), "Consolidation of Variable Interest Entities," ("FIN 46(R)"). This interpretation addresses consolidation by business enterprises of variable interest entities with certain defined characteristics and replaces Financial Interpretation No. 46. The interpretation was effective January 1, 2004 for variable interest entities existing prior to February 2003. FIN 46(R) did not have a significant impact on the Company's consolidated financial statements. In December 2003 the FASB issued SFAS No. 132 (revised 2003), "Employers' Disclosures about Pensions and Other Postretirement Benefits". SFAS No. 132R revises employers' disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, "Employers' Accounting for Pensions", No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pensions Plans and for Termination Benefits, and No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". SFAS No. 132R requires additional disclosures to those in the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. With certain exceptions, principally related to disclosure requirements of foreign plans, SFAS No. 132R is effective for financial statements with fiscal years ending after December 15, 2003.We have complied with the disclosure requirements of SFAS No. 132R. We have a defined benefit pension plan covering the employees at our Eltmann, Germany facility. The benefits are based on the expected years of service including the rate of compensation increase. The plan is unfunded. -9- Components of Net Periodic Pension Cost: Three months ended Nine months ended September 30, September 30, (in thousands of dollars) 2004 2003 2004 2003 - ----------------------------------------------------------- ----------- ------------ Service cost $26 $29 $ 78 $ 86 Interest cost 58 52 174 156 Amortization of net gain -- 2 -- 7 ------------ ----------- ----------- ------------ Net periodic pension cost $84 $83 $252 $249 ============ =========== =========== ============ We expect to contribute approximately $0.3 million to our pension plan in 2004. As of September 30, 2004, approximately $0.3 million of contributions have been made. -10- Note 8. Long-Term Debt and Short-Term Debt On May 1, 2003 in connection with the purchase of SKF's Veenendaal component manufacturing operations and SKF's 23 percent interest in Euroball, we entered into a $90 million syndicated credit facility with AmSouth Bank ("AmSouth") as the administrative agent and Suntrust Bank as the Euro loan agent for the lenders under which we borrowed $60.4 million and 26.3 million Euros ($29.6 million) (the "$90 million credit facility"). This financing arrangement replaced our prior credit facility with AmSouth and Hypo Vereinsbank Luxembourg, S.A. The credit facility as originally entered into consisted of a $30.0 million revolver ("$30.0 million revolver") expiring on March 15, 2005, subsequently extended to March 31, 2006 bearing interest at a floating rate equal to LIBOR (2.02% at September 30, 2004) plus an applicable margin of 1.25 to 2.0, a $30.4 million term loan expiring on May 1, 2008, bearing interest at a floating rate equal to LIBOR (2.02% at September 30, 2004) plus an applicable margin of 1.25% to 2.0% and a 26.3 million Euro ($29.6 million) term loan ("26.3 million Euro term loan") expiring on May 1, 2008 which bears interest at a floating rate equal to Euro LIBOR (2.15% at September 30, 2004) plus an applicable margin of 1.25% to 2.0%. All amounts owed under the $30.4 million term loan were paid during the second quarter of 2004 with the proceeds from our $40 million notes and we no longer have borrowing capacity under that portion of the $90 million credit facility. The terms of the $30.0 million revolver and the 26.3 million Euro term loan remain unchanged. The loan agreement contains customary financial and non-financial covenants. Such covenants specify that we must maintain certain liquidity measures. The loan agreement also contains customary restrictions on, among other things, additional indebtedness, liens on our assets, sales or transfers of assets, investments, restricted payments (including payment of dividends and stock repurchases), issuance of equity securities, and mergers, acquisitions and other fundamental changes in the Company's business. The credit agreement is un-collateralized except for the pledge of stock of certain foreign subsidiaries. We were in compliance with all such covenants as of September 30, 2004. In connection with the acquisition of KLF's operations in Slovakia, on September 23, 2003 we entered into a $2.0 million short-term unsecured promissory note (the "$2.0 million note") with AmSouth as the lender. This note bore interest at the prime rate. All amounts owed under this note were paid during the second quarter of 2004 with the proceeds from our $40 million notes. On March 23, 2004 we entered into a $2.7 million short-term promissory note (the "$2.7 million note") with AmSouth Bank ("AmSouth") as the lender. This note bore interest at the prime rate. This agreement was entered into to fund short term operating capital requirements. All amounts owed under this note were paid during the second quarter of 2004 with the proceeds from our $40 million notes. On April 26, 2004 we issued $40.0 million aggregate principal amount of senior notes in a private placement (the "$40 million notes"). These notes bear interest at a fixed rate of 4.89% and mature on April 26, 2014. Interest is paid semi-annually. As of September 30, 2004, $40.0 million remained outstanding. Annual principal payments of approximately $5.7 million begin on April 26, 2008 and extend through the date of maturity. Proceeds from this credit facility were used to repay our existing US dollar denominated term loan, $24 million, and repay a portion, of our borrowings under our US dollar denominated revolving credit facility, $13 million, which are both components of our $90 million credit facility, and to repay borrowings remaining under our $2.0 million note and our $2.7 million note of $2 million and $1 million, respectively. The agreement contains customary financial and non-financial covenants. Such covenants specify that we must maintain certain liquidity measures. The agreement also contains customary restrictions on, among other things, additional indebtedness, liens on our assets, sales or transfers of assets, investments, restricted payments (including payment of dividends and stock repurchases), issuance of equity securities, and mergers, acquisitions and other fundamental changes in our business. No event of default had occurred as of September 30, 2004. The notes are not collateralized except for the pledge of stock of certain foreign subsidiaries. We incurred $0.7 million of related costs as a result of issuing these notes which have been recorded as a component of other non-current assets and are being amortized over the term of the notes. In connection with the issuance of the $40 million notes, capitalized costs in the amount of approximately $0.3 million associated with structuring of the $90 million credit facility were written off during the three months ended June 30, 2004 and are included as a component of other (income) expense. -11- Note 9. Goodwill The changes in the carrying amount of goodwill for the twelve and nine month periods ended December 31, 2003 and September 30, 2004, respectively, are as follows: In thousands of dollars Plastic and Rubber Components Segment NN Europe Segment Total ------------------- ------------------- ---------------- Balance as of January 1, 2003 $ 26,712 $ 12,662 $ 39,374 Goodwill acquired -- 2,151 2,151 Impairment losses (1,285) -- (1,285) Currency impacts/reclassification 328 2,325 2,653 ------------------- ------------------- ---------------- Balance as of December 31, 2003 $ 25,755 $ 17,138 $ 42,893 =================== =================== ================ Plastic and Rubber In thousands of dollars Components Segment NN Europe Segment Total ------------------- ------------------- ---------------- Balance as of January 1, 2004 $ 25,755 $ 17,138 $ 42,893 Currency impacts -- (349) (349) ------------------- ------------------- ---------------- Balance as of September 30, 2004 $ 25,755 $ 16,789 $ 42,544 =================== =================== ================ Note 10. Stock Compensation We have adopted the provisions of SFAS 123, which encourages but does not require a fair value based method of accounting for stock compensation plans. We have elected to continue accounting for our stock compensation plan using the intrinsic value based method under Auditing Practices Board ("APB") Opinion No. 25 and, accordingly, have not recorded compensation expense for the three and nine month periods ended September 30, 2004 and September 30, 2003, except as related to stock options accounted for under the variable method of accounting. Had compensation cost for our stock compensation plan been determined based on the fair value at the option grant dates, our net income and earnings per share would have been changed to the pro-forma amounts indicated below: Three months ended Nine months ended September 30, September 30, In Thousands, Except per Share Data 2004 2003 2004 2003 - -------------------------------------------------- ------------ ----------- ------------ ----------- Net income - as reported $ 2,152 $ 3,164 $ 7,355 $ 7,504 Stock based compensation costs (income), net of income tax, included in net income as reported (98) (5) (86) 195 Stock based compensation costs, net of income tax, that would have been included in net income if the fair value method had been applied (388) (424) (442) (494) ------------ ----------- ------------ ----------- Net income - pro-forma $ 1,666 $ 2,735 $ 6,827 $ 7,205 ============ =========== ============ =========== Basic earnings per share - as reported $ 0.13 $ 0.19 $ 0.44 $ 0.48 Stock based compensation costs (income), net of income tax, included in net income as reported (0.01) -- -- 0.01 Stock based compensation costs, net of income tax, that would have been included in net income if the fair value method had been applied (0.02) (0.03) (0.03) (0.03) ------------ ----------- ------------ ----------- Basic earnings per share - pro-forma $ 0.10 $0.16 $ 0.41 $ 0.46 ============ =========== ============ =========== -12- Earnings per share-assuming dilution - as reported $ 0.13 $ 0.18 $ 0.43 $ 0.46 Stock based compensation costs (income), net of income tax, included in net income as reported (0.01) -- (0.01) 0.01 Stock based compensation costs, net of income tax, that would have been included in net income if the fair value method had been applied (0.02) (0.02) (0.02) (0.03) ------------ ----------- ------------ ----------- Earnings per share - assuming dilution-pro-forma $ 0.10 $ 0.16 $ 0.40 $ 0.44 ============ =========== ============ =========== The fair value of each option grant was estimated based on actual information available through September 30, 2004 and 2003 using the Black Scholes option-pricing model with the following assumptions: Term Vesting period - ---- -------------- Risk free interest rate 3.50% and 3.28% at September 30, 2004 and 2003, respectively Dividend yield 2.79% and 3.66% at September 30, 2004 and 2003, respectively Volatility 48.88% and 50.62% at September 30, 2004 and 2003, respectively Note 11. Lease Commitment On June 1, 2004, our wholly owned subsidiary, NN Precision Bearing Products Company LTD, entered into a twenty year lease agreement with Kunshan Tian Li Steel Structure Co. LTD for the lease of land and building (approximately 110,000 square feet) in the Kunshan Economic and Technology Development Zone, Jiangsu, The People's Republic of China. The building will be newly constructed and we expect to begin usage of the leased property during the second quarter of 2005. The land and building remain under the control of the lessor until such time as usage of the leased property commences. The agreement satisfies the requirements of a capital lease at June 1, 2004 and we anticipate recording the lease as a capital lease in our Consolidated Financial Statements when usage of the leased property begins. Accordingly, as of September 30, 2004, no amount has been recorded related to the asset and corresponding obligation associated with the lease agreement in our Consolidated Financial Statements. We estimate the fair value of the land and building to be approximately $2.0 million and undiscounted annual lease payments of approximately $0.2 million (approximately $4.1 million aggregate non-discounted lease payments over the twenty year term). The lease terms include fair value buy-out provisions and we maintain the option to extend the lease term. Note 12. Subsequent Event On October 27, 2004 we completed the sale of our idle warehouse in Kilkenny, Ireland for approximately 1.6 million euro ($2.0 million), net of selling costs incurred. As a result of this transaction, we anticipate recording a loss on sale of fixed assets of approximately 0.1 million euro ($0.1 million) during the fourth quarter which will be recorded as a component of Other (income) expense, net. As of December 31, 2003 and September 30, 2004 this asset has been classified as a component of Property, plant and equipment, net. Proceeds received from the sale of this asset will be used to repay a portion of our $90 million credit facility. -13- Item 2. Management's Discussion and Analysis of Financial Condition and Results Of Operations Overview and Management Focus Our strategy and management focus is based upon the following long-term objectives: o Captive growth, providing a competitive and attractive alternative to the operations of our global customers o Expansion of our bearing product offering, and o Global expansion of our manufacturing base to better address the global requirements of our customers Management generally focuses on these trends and relevant market indicators: o Global industrial growth and economics o Global automotive production rates o Costs subject to the global inflationary environment, including, but not limited to: o Raw material o Wages and benefits, including health care costs o Energy o Trends related to manufacturing's geographic migration of competitive manufacturing o Regulatory environment for United States public companies o Currency and exchange rate movements and trends o Interest rate levels and expectations Management generally focuses on the following key indicators of operating performance: o Sales growth o Cost of products sold levels o Selling, general and administrative expense levels o Net income o Cash flow from operations and capital spending Our core business is the manufacture and sale of high quality, precision steel balls and rollers. In 2003, sales of balls and rollers accounted for approximately 76% of the Company's total net sales with 63% and 13% of sales from balls and rollers, respectively. Sales of metal bearing retainers accounted for 4% and sales of precision molded plastic and rubber parts accounted for the remaining 20%. Since our formation in 1980 we have grown primarily through the displacement of captive ball manufacturing operations of domestic and international bearing manufacturers resulting in increased sales -14- of high precision balls for quiet bearing applications. Management believes that our core business sales growth since our formation has been due to our ability to capitalize on opportunities in global markets and provide precision products at competitive prices, as well as our emphasis on product quality and customer service. Results of Operations Three Months Ended September 30, 2004 Compared to the Three Months Ended September 30, 2003 Net Sales. Net Sales increased by approximately $8.3 million, or 12.9%, from $64.6 million for the third quarter of 2003 to $72.9 million for the third quarter of 2004. By segment, sales increased $7.7 million and $0.6 million for the NN Europe Segment and the Plastic and Rubber Components Segment, respectively. Within the NN Europe Segment, $4.4 million of the increase is related to increases in product demand and $3.2 million is related to the impact of currency exchange rates. Within the Plastic and Rubber Components Segment, the total increase of $0.6 million is related to increases in product demand. Net Sales remained approximately unchanged for the Domestic Ball and Roller Segment. Cost of Products Sold. Cost of products sold increased by approximately $7.0 million, or 13.9%, from $50.3 million for the third quarter of 2003 to $57.3 million for the third quarter of 2004. By segment, cost of products sold increased $5.7 million and $1.3 million for the NN Europe Segment and the Plastic and Rubber Components Segment, respectively. Within the NN Europe Segment, $3.2 million of the increase is related to increases in product demand, increased material costs and the impact of inventory reductions and $2.5 million is related to the impact of currency exchange rates. Within the Plastic and Rubber Components Segment, the total increase of $1.3 million is related to increases in product demand and the impact of inventory reductions. Cost of products sold remained approximately unchanged for the Domestic Ball and Roller Segment. As a percentage of net sales, cost of products sold increased from 77.8% during the third quarter of 2003 to 78.5% during the third quarter of 2004. The price of steel has risen over the last twelve to eighteen months with fourth quarter of 2004 and possibly 2005 prices expected to reflect even greater increases. The increase is principally due to general increases in global demand and, more recently, due to China's increased consumption of steel. This has had the impact of increasing scrap surcharges we pay in procuring our steel. Our contracts with key customers allow us to pass a majority of the steel price increases we incur on to those customers. However, by contract, material price changes in any given year are typically passed along with price adjustments in January of the following year. Until the current increases can be passed through to our customers, income from operations, net income and cash flow from operations will be adversely affected. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by approximately $1.9 million, or 35.8%, from $5.2 million for the third quarter of 2003 to $7.1 million for the third quarter of 2004. By segment, selling, general and administrative expenses increased $0.9 million, $0.6 million and $0.3 million for the NN Europe Segment, Domestic Ball and Roller Segment and the Plastic and Rubber Components Segment, respectively. Within the NN Europe Segment, $0.6 million of the increase is related to the start-up of our previously announced Level 3 program which integrates the principles of Lean Enterprise, Six Sigma and Total Productive Maintenance (the "Level 3 Program"), expenses associated with our Slovakia ball production facility and severance costs, and, $0.3 million is related to the impact of currency exchange rates. Within the Domestic Ball and Roller Segment, the increase of $0.6 million is principally related to Sarbanes-Oxley compliance efforts in the area of internal controls and the Level 3 Program. Within the Plastic and Rubber Components Segment, the $0.3 million increase is principally related to employee severance. As a percentage of net sales, selling, general and administrative expenses increased from 8.1% during the third quarter of 2003 to 9.8% during the third quarter of 2004. Depreciation and Amortization. Depreciation and amortization expenses increased by approximately $0.4 million or 11.0% from $3.6 million for the third quarter of 2003 to $4.0 million for the third quarter of 2004. Principally all of the $0.4 million increase is attributable to the NN Europe Segment. Within the NN Europe Segment, $0.2 million of the increase is related to capital investments in machinery, equipment and processes and $0.2 million of the increase is related to the impact of foreign currency exchange rates. As a percentage of net sales, depreciation and amortization expense decreased from 5.6% during the third -15- quarter of 2003 to 5.5% during the third quarter of 2004. Restructuring and Impairment Costs. Restructuring and impairment costs increased by $0.2 million from ($0.2 million) in the third quarter of 2003 to $0 in the third quarter of 2004. The increase is related to gains recorded during the third quarter of 2003 associated with the disposition of certain previously impaired NN Arte assets. Restructuring and impairment charges were (0.4%) of net sales in the third quarter of 2003 and 0% of net sales in the third quarter of 2004. Interest Expense. Interest expense increased by approximately $0.2 million from $0.9 million in the third quarter of 2003 to $1.1 million in the third quarter of 2004. The increase is principally related to our April 26, 2004 issuance of our $40.0 million aggregate principal amount of senior notes in a private placement. These notes bear interest at a fixed rate of 4.89%. See "Liquidity and Capital Resources". Net Income. Net income decreased by approximately $1.0 million, or 32.0%, from $3.2 million in the third quarter of 2003 to $2.2 million in the third quarter of 2004. As a percentage of net sales, net income decreased from 4.9% during the third quarter of 2003 to 3.0% during the third quarter of 2004. Nine Months Ended September 30, 2004 Compared to the Nine Months Ended September 30, 2003 Net Sales. Net Sales increased by approximately $39.4 million, or 21.1%, from $186.4 million for the first nine months of 2003 to $225.8 million for the first nine months of 2004. By segment, Net Sales increased $39.1 million and $0.8 million for the NN Europe Segment and the Domestic Ball and Roller Segment, respectively. Net Sales decreased by $0.5 million for the Plastic and Rubber Components Segment. Within the NN Europe Segment, $17.2 million of the increase is related to our May 2, 2003 acquisition of Veenendaal and a full nine months of its results included in 2004 versus five months of its results included in the first nine months of 2003, $11.6 million is related to the impact of currency exchange rates and $10.3 million is related to increases in product demand. Within the Domestic Ball and Roller Segment, the increase of $0.8 million is principally related to increases in product demand. The decrease of $0.5 million in the Plastic and Rubber Components Segment is principally related increases in product demand of approximately $1.1 million offset by decreased net sales of approximately $1.6 million resulting from to the closure of our Guadalajara, Mexico injection molding facility in 2003. Cost of Products Sold. Cost of products sold increased by approximately $33.8 million, or 23.7%, from $142.8 million for the first nine months of 2003 to $176.6 million for the first nine months of 2004. By segment, cost of products sold increased $32.9 million, $0.6 million and $0.3 million for the NN Europe Segment, the Domestic Ball and Roller Segmet and the Plastic and Rubber Components Segment, respectively. Within the NN Europe Segment, $14.4 million of the increase is related to our May 2, 2003 acquisition of Veenendaal and a full nine months of its results included in 2004 versus five months of its results included in the first nine months of 2003, $9.2 million is related to the impact of currency exchange rates and $9.3 million is related to increases in product demand and the impact of inventory reductions. The increase of $0.3 million in the Plastic and Rubber Components Segment is principally related increases in product demand and the impact of inventory reductions of approximately $2.3 million offset by decreased cost of products sold of approximately $2.1 million resulting from the closure of our Guadalajara, Mexico injection molding facility in 2003. As a percentage of net sales, cost of products sold increased from 76.6% during the first nine months of 2003 to 78.2% during the first nine months of 2004. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by approximately $6.7 million, or 42.6%, from $15.6 million for the first nine months of 2003 to $22.3 million for the first nine months of 2004. By segment, selling, general and administrative expenses increased $3.8 million, $2.4 million and $0.5 million for the NN Europe Segment, Domestic Ball and Roller Segment and the Plastic and Rubber Components Segment, respectively. Within the NN Europe Segment, $1.6 million of the increase is related to our May 2, 2003 acquisition of Veenendaal and a full nine months of its results included in 2004 versus five months of its results included in the first nine months of 2003, $1.3 million is related to the start-up of our Level 3 Program, expenses associated with our Slovakia ball production facility and employee severance and $0.9 million is related to the impact of currency exchange rates. Within the Domestic Ball and Roller Segment, approximately $1.4 million is principally related to Sarbanes-Oxley compliance efforts in the area of internal controls, approximately $0.7 million is related to our Level 3 Program and approximately $0.3 million is related to the start-up of our China operation. -16- Within the Plastic and Rubber Components Segment, $0.3 million of the increase is related to employee severance. As a percentage of net sales, selling, general and administrative expenses increased from 8.4% during the first nine months of 2003 to 9.9% during the first nine months of 2004. Depreciation and Amortization. Depreciation and amortization expenses increased by approximately $1.8 million or 18.0% from $10.1 million for the first nine months of 2003 to $11.9 million for the first nine months of 2004. Principally all of the $1.8 million increase is attributable to the NN Europe Segment. Within the NN Europe Segment, $1.0 million of the increase is related to our May 2, 2003 acquisition of Veenendaal and a full nine months of its results included in 2004 versus five months of its results included in the first nine months of 2003, $0.2 million of the increase is related to capital investments in machinery, equipment and processes and $0.6 million of the increase is related to the impact of foreign currency exchange rates. As a percentage of net sales, depreciation and amortization expense decreased from 5.4% during the first nine months of 2003 to 5.3% during the first nine months of 2004. Interest Expense. Interest expense increased by approximately $0.6 million from $2.3 million in the first nine months of 2003 to $2.9 million in the first nine months of 2004. Approximately $0.4 million of the increase is related to increased debt levels due to the May 2003 acquisition of Veenendaal and the May 2003 purchase of the 23% interest in NN Europe held by SKF. Effective with the completion of this transaction, we own 100% of NN Europe. Additionally, approximately $0.2 million of the increase is related to our April 26, 2004 issuance of $40.0 million aggregate principal amount of senior notes in a private placement. These notes bear interest at a fixed rate of 4.89%. See "Liquidity and Capital Resources". Net Income. Net income decreased by approximately $0.1 million, or 2.0%, from $7.5 million in the first nine months of 2003 to $7.4 million in the first nine months of 2004. As a percentage of net sales, net income decreased from 4.0% during the first nine months of 2003 to 3.3% during the first nine months of 2004. Liquidity and Capital Resources On May 1, 2003 in connection with the purchase of SKF's Veenendaal component manufacturing operations and SKF's 23 percent interest in NN Europe, we entered into a $90 million syndicated credit facility with AmSouth as the administrative agent and Suntrust Bank as the Euro loan agent for the lenders under which we borrowed $60.4 million and 26.3 million Euros ($29.6 million) (the "$90 million credit facility") This financing arrangement replaced our prior credit facility with AmSouth and NN Europe's credit facility with Hypo Vereinsbank Luxembourg, S.A. The credit facility, as originally entered into, consisted of a $30.0 million revolver expiring on March 15, 2005, subsequently extended to March 31, 2006, bearing interest at a floating rate equal to LIBOR (2.02% at September 30, 2004) plus an applicable margin of 1.25 to 2.0, a $30.4 million term loan expiring on May 1, 2008, bearing interest at a floating rate equal to LIBOR (2.02% at September 30, 2004) plus an applicable margin of 1.25 to 2.0 and a 26.3 million Euro ($29.6 million) term loan expiring on May 1, 2008 which bears interest at a floating rate equal to Euro LIBOR (2.15% at September 30, 2004) plus an applicable margin of 1.25 to 2.0. All amounts owed under the $30.4 million term loan were paid during the second quarter of 2004 with the proceeds from our $40 million notes and we no longer have borrowing capacity under that portion of the $90 million credit facility. The terms of the $30.0 million revolver and the 26.3 million Euro term loan remain unchanged. The loan agreement contains customary financial and non-financial covenants. Such covenants specify that we must maintain certain liquidity measures. The loan agreement also contains customary restrictions on, among other things, additional indebtedness, liens on our assets, sales or transfers of assets, investments, restricted payments (including payment of dividends and stock repurchases), issuance of equity securities, and mergers, acquisitions and other fundamental changes in our business. The credit facility is not collateralized except for the pledge of stock of certain foreign subsidiaries. No event of default had occurred as of September 30, 2004. On March 23, 2004 we entered into a $2.7 million short-term promissory note ("the $2.7 million note") with AmSouth Bank as the lender. This note bore interest at the prime rate. This agreement was entered into to fund short term operating capital requirements. All amounts owed under this note were paid during the second quarter of 2004 with the proceeds from our $40 million notes. See Note 8 of the Notes to Consolidated Financial Statements. -17- In connection with the acquisition of KLF's operations in Slovakia, on September 23, 2003 we entered into a $2.0 million short-term promissory note ("the $2.0 million note") with AmSouth as the lender. This note bore interest at the prime rate. All amounts owed under this note were paid during the second quarter 2004 with the proceeds from our $40 million notes. See Note 8 of the Notes to Consolidated Financial Statements. On April 26, 2004 we issued $40.0 million aggregate principal amount of senior notes in a private placement (the "$40 million notes"). These notes bear interest at a fixed rate of 4.89% and mature on April 26, 2014. Interest is paid semi-annually. As of September 30, 2004, $40.0 million remained outstanding. Annual principal payments of approximately $5.7 million begin on April 26, 2008 and extend through the date of maturity. Proceeds from this credit facility were used to repay our existing US dollar denominated term loan, $24 million, and repay a portion of our borrowings under our US dollar denominated revolving credit facility, $13 million, which are both components of our $90 million credit facility, and to repay borrowings remaining under our $2.0 million note and our $2.7 million note of $2 million and $1 million, respectively. The agreement contains customary financial and non-financial covenants. Such covenants specify that we must maintain certain liquidity measures. The agreement also contains customary restrictions on, among other things, additional indebtedness, liens on our assets, sales or transfers of assets, investments, restricted payments (including payment of dividends and stock repurchases), issuance of equity securities, and mergers, acquisitions and other fundamental changes in our business. No event of default had occurred as of September 30, 2004. The notes are not collateralized except for the pledge of stock of certain foreign subsidiaries. We incurred $0.7 million of related costs as a result of issuing these notes which have been recorded as a component of other non-current assets and are being amortized over the term of the notes. In connection with the issuance of the $40 million notes, capitalized costs in the amount of approximately $0.3 million associated with structuring of the $90 million credit facility were written off during the three months ended June 30, 2004 and are included as a component of other (income) expense. See Note 8 of the Notes to Consolidated Financial Statements. Our arrangements with our domestic customers typically provide that payments are due within 30 days following the date of shipment of goods by us, while arrangements with certain export customers (other than export customers that have entered into an inventory management program with the Company) generally provide that payments are due within either 90 or 120 days following the date of shipment. Our net sales have historically been of a seasonal nature due to our relative percentage of European business coupled with slower European production during the month of August. We bill and receive payment from some of our customers in Euros as well as other currencies. To date, we have not been materially adversely affected by currency fluctuations. Nonetheless, as a result of these sales, our foreign exchange transaction and translation risk has increased. Various strategies to manage this risk are available to management including producing and selling in local currencies and hedging programs. As of September 30, 2004, no currency hedges were in place. In addition, a strengthening of the U.S. dollar and/or Euro against foreign currencies could impair our ability to compete with international competitors for foreign as well as domestic sales. Working capital, which consists principally of accounts receivable and inventories, was $34.2 million at September 30, 2004 as compared to $25.7 million at December 31, 2003. The ratio of current assets to current liabilities increased from 1.41:1 at December 31, 2003 to 1.55:1 at September 30, 2004. Cash flow from operations increased to $22.0 million during the first nine months of 2004 from $8.2 million during the first nine months of 2003. Contributing to the improvement in cash flow from operations for the nine months ended September 30, 2004 was a reduction in inventory levels of approximately $3.6 million. During 2004, we plan to spend approximately $9.0 million on capital expenditures related primarily to equipment and process upgrades and replacements and approximately $2.5 million principally related to geographic expansion of our manufacturing base. Of these amounts approximately $8.0 million has been spent through September 30, 2004. We intend to finance these activities with cash generated from operations and funds available under the credit facilities described above. We believe that funds generated from operations and borrowings from the credit facilities will be sufficient to finance our working capital needs and projected capital expenditure requirements through September 2005. On October 27, 2004 we completed the sale of our idle warehouse in Kilkenny, Ireland for approximately -18- 1.6 million euro ($2.0 million), net of selling costs incurred. As a result of this transaction, we anticipate recording a loss on sale of fixed assets of approximately 0.1 million euro ($0.1 million) during the fourth quarter which will be recorded as a component of Other (income) expense, net. As of December 31, 2003 and September 30, 2004 this asset has been classified as a component of Property, plant and equipment, net. Proceeds received from the sale of this asset will be used to repay a portion of our $90 million credit facility. During the fourth quarter of 2004 we anticipate selling our idled land and building assets located in Walterboro, South Carolina in an auction sale. The approximate $1.1 million carrying value of these assets is classified as a component of Property, plant and equipment, net and is based principally upon fair market value appraisals. While the net selling price of these assets is not known, amounts we ultimately recover may differ from the assets carrying value resulting in the recording of a gain or loss. No such amounts have been recorded as of September 30, 2004. Any proceeds received from the sale of these assets will be used to repay a portion of our $90 million credit facility. New Accounting Pronouncements On March 31, 2004, the FASB issued an Exposure Draft, "Share-Based Payment", that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, "Accounting for Stock Issued to Employees", and generally would require instead that such transactions be accounted for using a fair-value method. On October 13, 2004, the FASB announced the final Statement for public companies would be effective for any interim or annual period beginning after June 15, 2005. We are currently evaluating the impacts of this Exposure Draft on the Company's consolidated financial statements. On May 19, 2004, the Financial Accounting Standards Board ("FASB") issued FASB Staff Position (FSP) No. 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003", which supersedes FSP No. 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003," (the Act). FSP No. 106-2 permits a sponsor of a postretirement health care plan that provides a prescription drug benefit to make a one-time election to defer accounting for the effects of the Act until authoritative guidance on accounting for subsidies provided by the Act is issued. The Act introduces a prescription drug benefit under Medicare as well as a federal subsidy to sponsors of retiree health care benefit plans. The Company does not anticipate that the Act will have an effect on the Company's Financial Statements. In December 2003, the FASB issued Financial Interpretation No. 46(R), "Consolidation of Variable Interest Entities," ("FIN 46(R)"). This interpretation addresses consolidation by business enterprises of variable interest entities with certain defined characteristics and replaces Financial Interpretation No. 46. The interpretation was effective January 1, 2004 for variable interest entities existing prior to February 2003. FIN 46(R) did not have a significant impact on the Company's consolidated financial statements. In December 2003, the FASB issued SFAS No. 132 (revised 2003), "Employers' Disclosures about Pensions and Other Postretirement Benefits". SFAS No. 132R revises employers' disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, "Employers' Accounting for Pensions", No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pensions Plans and for Termination Benefits, and No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". SFAS No. 132R requires additional disclosures to those in the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. With certain exceptions, principally related to disclosure requirements of foreign plans, SFAS No. 132R is effective for financial statements with fiscal years ending after December 15, 2003. As of September 30, 2004, we have complied with the disclosure requirements of SFAS No. 132R. -19- The Euro We currently have operations in Italy, Germany, Ireland, and The Netherlands, all of which are Euro participating countries, and sell product to customers in many of the participating countries. The Euro has been adopted as the functional currency at these locations. Seasonality and Fluctuation in Quarterly Results Our net sales historically have been of a seasonal nature due to a significant portion of our sales to European customers that cease or significantly slow production during the month of August. Inflation and Changes in Prices While the Company's operations have not been materially affected by general inflation during recent years, prices for 52100 Steel and other steel related raw materials have increased significantly during the past twelve months. In the Company's U.S. operations our typical pricing arrangements with steel suppliers are subject to adjustment once every six months. The Company's NN Europe Segment has entered into long-term agreements with its primary steel supplier, which provide for standard terms and conditions, annual unit price adjustments, and quarterly pricing adjustments in the form of scrap surcharges. In both our U.S. and European operations, the steel price increases we have experienced are related to increasing global demand for scrap and other steel related raw materials, principally from China. While we reserve the right to increase product prices periodically in the event of increases in its raw material costs, our current contracts in effect with SKF and INA/FAG call for adjustments in selling prices for raw material inflation to occur in January of the following year. As such, the majority of the inflation we are currently experiencing in raw material pricing will not be passed through until January 2005. For other customers, we are currently in the process of adjusting pricing levels to reflect the increases in steel pricing. Critical Accounting Policies Our significant accounting policies, including the assumptions and judgments underlying them, are disclosed in the Company's Annual Report on Form 10-K, for the fiscal year ended December 31, 2003 including those policies as discussed in Note 1. These policies, which have not significantly changed since December 31, 2003 have been consistently applied in all material respects and address such matters as revenue recognition, inventory valuation, asset impairment recognition, business combination accounting and pension and postretirement benefits. Due to the estimation processes involved, management considers the following summarized accounting policies and their application to be critical to understanding the Company's business operations, financial condition and results of operations. There can be no assurance that actual results will not significantly differ from the estimates used in these critical accounting policies. Accounts Receivable. Substantially all of the Company's accounts receivable are due primarily from the served markets: bearing manufacturers, automotive industry, electronics, industrial, agricultural and aerospace. In establishing allowances for doubtful accounts, the Company performs credit evaluations of its customers, considering numerous inputs when available including the customers' financial position, past payment history, relevant industry trends, cash flows, management capability, historical loss experience and economic conditions and prospects. Accounts receivable are written off when considered to be uncollectible. While management believes that adequate allowances for doubtful accounts have been provided in the Consolidated Financial Statements, it is possible that the Company could experience additional unexpected credit losses. Inventories. Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out method. The Company's inventories are not generally subject to obsolescence due to spoilage or expiring product life cycles. The Company operates generally as a make-to-order business; however, the Company also stocks products for certain customers in order to meet delivery schedules. While management believes that adequate write-downs for inventory obsolescence have been made in the Consolidated Financial Statements, the Company could experience additional inventory write-downs in the future. -20- Acquisitions and Acquired Intangibles. For new acquisitions, the Company uses estimates, assumptions and appraisals to allocate the purchase price to the assets acquired and to determine the amount of goodwill. These estimates are based on market analyses and comparisons to similar assets. Annual tests are required to be performed to assess whether recorded goodwill is impaired. The annual tests require management to make estimates and assumptions with regard to the future operations of its reporting units, the expected cash flows that they will generate, and their market value. These estimates and assumptions therefore impact the recorded value of assets acquired in a business combination, including goodwill, and whether or not there is any subsequent impairment of the recorded goodwill and the amount of such impairment. Impairment of Long-Lived Assets. The Company's long-lived assets include property, plant and equipment. The recoverability of the long-lived assets is dependent on the performance of the companies which the Company has acquired, as well as volatility inherent in the external markets for these acquisitions. In assessing potential impairment for these assets the Company will consider these factors as well as forecasted financial performance. For assets held for sale as of December 31, 2003, appraisals are relied upon to assess the fair market value of those assets. The assets held for sale of $1.8 million as of December 31, 2003 have been reclassified as held for use effective March 31, 2004. The amounts reclassified are carried at fair value which is lower than the carrying amount before the assets were classified as held for sale adjusted for depreciation expense. The reclassification of these assets did not have a material impact to our income from operations, net income or cash flow from operations for the three and nine months ended September 30, 2004. Future adverse changes in market conditions or adverse operating results of the underlying assets could result in the Company having to record additional impairment charges not previously recognized. Pension and Post-Retirement Obligations. The Company uses several assumptions in determining its periodic pension and post-retirement expense and obligations which are included in the Consolidated Financial Statements. These assumptions include determining an appropriate discount rate, rate of compensation increase, as well as the remaining service period of active employees. The Company uses an independent actuary to calculate the periodic pension and post-retirement expense and obligations based upon these assumptions and actual employee census data. Cautionary Statements for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act of 1995 The Company wishes to caution readers that this report contains, and future filings by the Company, press releases and oral statements made by the Company's authorized representatives may contain, forward-looking statements that involve certain risks and uncertainties. Statements regarding capital expenditures, future borrowings, and financial commitments are forward-looking statements. Readers can identify forward-looking statements by the use of such verbs as expects, anticipates, believes or similar verbs or conjugations of such verbs. The Company's actual results could differ materially from those expressed in such forward-looking statements due to important factors bearing on the Company's business, many of which already have been discussed in this filing and in the Company's prior filings. The differences could be caused by a number of factors or combination of factors including, but not limited to, the risk factors described below. You should carefully consider the following risks and uncertainties, and all other information contained in or incorporated by reference in this quarterly report on Form 10-Q, before making an investment in our common stock. Any of the following risks could have a material adverse effect on our business, financial condition or operating results. In such case, the trading price of our common stock could decline and you may lose all or part of your investment. The demand for our products is cyclical, which could adversely impact our revenues. The end markets for fully assembled bearings are cyclical and tend to decline in response to overall declines in industrial production. As a result, the market for bearing components is also cyclical and impacted by overall levels of industrial production. Our sales in the past have been negatively affected, and in the future will be negatively affected, by adverse conditions in the industrial production sector of the economy or by adverse global or national economic conditions generally. -21- We depend on a very limited number of foreign sources for our primary raw material and are subject to risks of shortages and price fluctuation. The steel that we use to manufacture precision balls and rollers is of an extremely high quality and is available from a limited number of producers on a global basis. Due to quality constraints in the U.S. steel industry, we obtain substantially all of the steel used in our U.S. ball and roller production from overseas suppliers. In addition, we obtain substantially all of the steel used in our European ball production from a single European source. If we had to obtain steel from sources other than our current suppliers, particularly in the case of our European operations, we could face higher prices and transportation costs, increased duties or taxes, and shortages of steel. Problems in obtaining steel, and particularly 52100 chrome steel, in the quantities that we require and on commercially reasonable terms, could increase our costs, negatively impact our ability to operate our business efficiently and have a material adverse effect on the operating and financial results of our Company. We depend heavily on a relatively limited number of customers, and the loss of any major customer would have a material adverse effect on our business. Sales to various U.S. and foreign divisions of SKF, which is one of the largest bearing manufacturers in the world, accounted for approximately 42% of consolidated net sales in 2003, and sales to INA/FAG accounted for approximately 16% of consolidated net sales in 2003. During 2003, our ten largest customers accounted for approximately 77% of our consolidated net sales. None of our other customers individually accounted for more than 5% of our consolidated net sales for 2003. The loss of all or a substantial portion of sales to these customers would cause us to lose a substantial portion of our revenue and would lower our profit margin and cash flows from operations. -22- We operate in and sell products to customers outside the U.S. and are subject to several related risks. Because we obtain a majority of our raw materials from overseas suppliers, actively participate in overseas manufacturing operations and sell to a large number of international customers, we face risks associated with the following: o adverse foreign currency fluctuations; o changes in trade, monetary and fiscal policies, laws and regulations, and other activities of governments, agencies and similar organizations; o the imposition of trade restrictions or prohibitions; o high tax rates that discourage the repatriation of funds to the U.S.; o the imposition of import or other duties or taxes; and o unstable governments or legal systems in countries in which our suppliers, manufacturing operations, and customers are located. We do not have a hedging program in place associated with consolidating the operating results of our foreign businesses into U.S. Dollars. An increase in the value of the U.S. Dollar and/or the Euro relative to other currencies may adversely affect our ability to compete with our foreign-based competitors for international, as well as domestic, sales. Also, a decline in the value of the Euro relative to the U.S. Dollar could negatively impact our consolidated financial results, which are denominated in U.S. Dollars. In addition, due to the typical slower summer manufacturing season in Europe, we expect that revenues in the third fiscal quarter will reflect lower sales, as our sales to European customers have increased as a percentage of net sales. The costs and difficulties of integrating acquired business could impede our future growth. We cannot assure you that any future acquisition will enhance our financial performance. Our ability to effectively integrate any future acquisitions will depend on, among other things, the adequacy of our implementation plans, the ability of our management to oversee and operate effectively the combined operations and our ability to achieve desired operating efficiencies and sales goals. The integration of any acquired businesses might cause us to incur unforeseen costs, which would lower our profit margin and future earnings and would prevent us from realizing the expected benefits of these acquisitions. We may not be able to continue to make the acquisitions necessary for us to realize our growth strategy. Acquiring businesses that complement or expand our operations has been and continues to be an important element of our business strategy. This strategy calls for growth through acquisitions constituting approximately two-thirds of our future growth, with the remainder resulting from internal growth and market penetration. We bought our plastic bearing component business in 1999, formed NN Europe with our two largest bearing customers, SKF and INA/FAG, in 2000 and acquired our bearing seal operations in 2001. During 2002, we purchased INA/FAG's minority interest in NN Europe and on May 2, 2003 we acquired SKF's minority interest in NN Europe, to become the sole owner at NN Europe. On May 2, 2003 we acquired SKF's tapered roller and metal cage manufacturing operations in Veenendaal, The Netherlands. On October 9, 2003 we acquired the precision ball producing assets of KLF-Gulickaren in Kysucke Nove Mesto, Slovakia. We cannot assure you that we will be successful in identifying attractive acquisition candidates or completing acquisitions on favorable terms in the future. In addition, we may borrow funds to acquire other businesses, increasing our interest expense and debt levels. Our inability to acquire businesses, or to operate them profitably once acquired, could have a material adverse effect on our business, financial position, results of operations and cash flows. -23- Our growth strategy depends on outsourcing, and if the industry trend toward outsourcing does not continue, our business could be adversely affected. Our growth strategy depends in significant part on major bearing manufacturers continuing to outsource components, and expanding the number of components being outsourced. This requires manufacturers to depart significantly from their traditional methods of operations. If major bearing manufacturers do not continue to expand outsourcing efforts or determine to reduce their use of outsourcing, our ability to grow our business could be materially adversely affected. Our market is highly competitive and many of our competitors have significant advantages that could adversely affect our business. The global market for bearing components is highly competitive, with a majority of production represented by the captive production operations of certain large bearing manufacturers and the balance represented by independent manufacturers. Captive manufacturers make components for internal use and for sale to third parties. All of the captive manufacturers, and many independent manufacturers, are significantly larger and have greater resources than do we. Our competitors are continuously exploring and implementing improvements in technology and manufacturing processes in order to improve product quality, and our ability to remain competitive will depend, among other things, on whether we are able to keep pace with such quality improvements in a cost effective manner. The production capacity we have added over the last several years has at times resulted in our having more capacity than we need, causing our operating costs to be higher than expected. We have expanded our ball and roller production facilities and capacity over the last several years. During 1997, we built an additional manufacturing plant in Kilkenny, Ireland, and we continued this expansion in 2000 through the formation of NN Europe with SKF and INA/FAG. Our ball and roller facilities have not always operated at full capacity and from time to time our results of operations have been adversely affected by the under-utilization of our production facilities, and we face risks of further under-utilization or inefficient utilization of our production facilities in future years. The price of our common stock may be volatile. The market price of our common stock could be subject to significant fluctuations and may decline. Among the factors that could affect our stock price are: o our operating and financial performance and prospects; o quarterly variations in the rate of growth of our financial indicators, such as earnings per share, net income and revenues; o changes in revenue or earnings estimates or publication of research reports by analysts; o loss of any member of our senior management team; o speculation in the press or investment community; o strategic actions by us or our competitors, such as acquisitions or restructurings; o sales of our common stock by stockholders; o general market conditions; and o domestic and international economic, legal and regulatory factors unrelated to our performance. -24- The stock markets in general have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our common stock. Provisions in our charter documents and Delaware law may inhibit a takeover, which could adversely affect the value of our common stock. Our certificate of incorporation and bylaws, as well as Delaware corporate law, contain provisions that could delay or prevent a change of control or changes in our management that a stockholder might consider favorable and may prevent you from receiving a takeover premium for your shares. These provisions include, for example, a classified board of directors and the authorization of our board of directors to issue up to 5,000,000 preferred shares without a stockholder vote. In addition, our restated certificate of incorporation provides that stockholders may not call a special meeting. We are a Delaware corporation subject to the provisions of Section 203 of the Delaware General Corporation Law, an anti-takeover law. Generally, this statute prohibits a publicly-held Delaware corporation from engaging in a business combination with an interested stockholder for a period of three years after the date of the transaction in which such person became an interested stockholder, unless the business combination is approved in a prescribed manner. A business combination includes a merger, asset sale or other transaction resulting in a financial benefit to the stockholder. We anticipate that the provisions of Section 203 may encourage parties interested in acquiring us to negotiate in advance with our board of directors, because the stockholder approval requirement would be avoided if a majority of the directors then in office approve either the business combination or the transaction that results in the stockholder becoming an interested stockholder. These provisions apply even if the offer may be considered beneficial by some of our stockholders. If a change of control or change in management is delayed or prevented, the market price of our common stock could decline. Item 3. Quantitative and Qualitative Disclosures About Market Risk We are exposed to changes in financial market conditions in the normal course of our business due to our use of certain financial instruments as well as transacting in various foreign currencies. To mitigate our exposure to these market risks, we have established policies, procedures and internal processes governing our management of financial market risks. We are exposed to changes in interest rates primarily as a result of our borrowing activities. At September 30, 2004, we had $14.4 million outstanding under the domestic credit facilities, $40.0 million aggregate principal amount of senior notes outstanding and NN Europe had 18.4 million Euro ($22.8 million) outstanding under the Euro term loan. See Note 8 of the Notes to Consolidated Financial Statements. At September 30, 2004, a one-percent increase in the interest rate charged on our outstanding borrowings under our credit facilities, that are subject to variable interest rates, would result in interest expense increasing annually by approximately $0.4 million. In connection with a variable EURIBOR rate debt financing in July 2000 our majority owned subsidiary, NN Europe entered into an interest rate swap with a notional amount of Euro 12.5 million for the purpose of fixing the interest rate on a portion of their debt financing. The interest rate swap provides for us to receive variable Euribor interest payments and pay 5.51% fixed interest. The interest rate swap agreement expires in July 2006 and the notional amount amortizes in relation to principal payments on the underlying debt over the life of the swap. This original debt was repaid in May 2003, however, the swap remains pursuant to its original terms. On May 1, 2003, we entered into the $90 million credit facility. This new financing arrangement replaces our prior credit facility with AmSouth and NN Europe's credit facility with Hypo Vereinsbank Luxembourg, S.A. On April 26, 2004, we issued $40.0 million of aggregate principal amounts of senior notes in a private placement, replacing a portion of our $90 million credit facility, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources". The nature and amount of our borrowings may vary as a result of future business requirements, market conditions and other factors. -25- Translation of our operating cash flows denominated in foreign currencies is impacted by changes in foreign exchange rates. Our NN Europe Segment, bills and receives payments from some of its foreign customers in their own currency. To date, we have not been materially adversely affected by currency fluctuations of foreign exchange restrictions. However, to help reduce exposure to foreign currency fluctuation, management has incurred debt in Euros and has periodically used foreign currency hedges. These currency hedging programs allow management to hedge currency exposures when these exposures meet certain discretionary levels. We did not hold a position in any foreign currency hedging instruments as of September 30, 2004. Item 4. Controls and Procedures As of September 30, 2004, we carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Rule 13a-14 and 15d-14 of the Securities Exchange Act of 1934 (the "Exchange Act"). Based upon that evaluation, the Company's management, including the Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's Exchange Act filings. There have been no changes in this fiscal quarter in the Company's internal control over financial reporting or in other factors that have materially affected, or are reasonably likely to materially affect, the registrant's internal control over financial reporting. -26- Part II. Other Information Item 1. Legal Proceedings All legal proceedings and actions involving the Company are of an ordinary and routine nature and are incidental to the operations of the Company. Management believes that such proceedings should not, individually or in the aggregate, have a material adverse effect on the Company's business or financial condition or on the results of operations. Item 2. Change in Securities and Use of Proceeds None Item 3. Defaults Upon Senior Securities None Item 4. Other Information None Item 5. Exhibits and Reports on Form 8-K. a. Exhibits Required by Item 601 of Regulation S-K 31.1 Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act. 31.2 Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act. 32.1 Certification of Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act. 32.2 Certification of Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act. -27- Reports on Form 8-K The Company furnished a Form 8-K, in response to Item 5, on July 9, 2004 announcing its expected date of release of second quarter 2004 financial results and conference call, and that increased Sarbanes-Oxley compliance costs and additional inventory reduction would impact results for the second quarter and full year. The Company furnished a Form 8-K, in response to Items 5 and 7, on July 29, 2004 announcing its financial results for the second quarter ended June 30, 2004. -28- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NN, Inc. ---------------------------------------- (Registrant) Date: November 9, 2004 /s/ Roderick R. Baty ---------------- ---------------------------------------- Roderick R. Baty, Chairman, President and Chief Executive Officer (Duly Authorized Officer) Date: November 9, 2004 /s/ David L. Dyckman ---------------- ---------------------------------------- David L. Dyckman Vice President-Corporate Development Chief Financial Officer (Principal Financial Officer) (Duly Authorized Officer) Date: November 9, 2004 /s/ William C. Kelly, Jr. ---------------- ----------------------------------------- William C. Kelly, Jr., Treasurer, Secretary and Chief Administrative Officer (Duly Authorized Officer)