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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_________
FORM 10-Q
_________
[X] Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the quarterly period ended May 31, 2005 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 0-22496
SCHNITZER STEEL INDUSTRIES, INC.
--------------------------------
(Exact name of registrant as specified in its charter)
OREGON 93-0341923
- ------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3200 N.W. Yeon Ave.
P.O Box 10047
Portland, OR 97296-0047
- ---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
(503) 224-9900
----------------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [_]
The Registrant had 22,486,280 shares of Class A Common Stock, par value of $1.00
per share, and 7,985,366 shares of Class B Common Stock, par value of $1.00 per
share, outstanding at June 30, 2005.
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INDEX
PAGE NO.
PART I. FINANCIAL INFORMATION
Condensed Consolidated Balance Sheets at May 31, 2005
and August 31, 2004.......................................................3
Condensed Consolidated Statement of Operations for the
Three Months and Nine Months Ended May 31, 2005 and 2004..................4
Condensed Consolidated Statement of Shareholders' Equity for the
Year Ended August 31, 2004 and the Nine Months Ended May 31, 2005.........5
Condensed Consolidated Statement of Cash Flows for the
Nine Months Ended May 31, 2005 and 2004...................................6
Notes to Condensed Consolidated Financial Statements..........................7
Management's Discussion and Analysis of Financial Condition
and Results of Operations................................................18
Quantitative and Qualitative Disclosures about Market Risk...................37
Controls and Procedures......................................................37
PART II. OTHER INFORMATION
Legal Proceedings ...........................................................38
Exhibits.....................................................................38
SIGNATURE PAGE...............................................................39
2
SCHNITZER STEEL INDUSTRIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except per share amounts)
MAY 31, 2005 AUG. 31, 2004
------------ -------------
Assets
------
Current assets:
Cash and cash equivalents $ 5,328 $ 11,307
Accounts receivable, less allowance for doubtful
accounts of $812 and $772 49,964 43,444
Inventories (Note 2) 94,975 80,167
Deferred income taxes 5,404 5,383
Prepaid income taxes 5,046 --
Prepaid expenses and other 8,614 6,859
------------ ------------
Total current assets 169,331 147,160
Net property, plant and equipment 165,225 138,438
Other assets:
Investment in and advances to joint venture partnerships 188,262 182,845
Notes receivable, less current portion 1,216 1,337
Goodwill 151,181 131,178
Intangibles and other 6,091 5,015
------------ ------------
$ 681,306 $ 605,973
============ ============
Liabilities and Shareholders' Equity
------------------------------------
Current liabilities:
Current portion of long-term debt $ 110 $ 225
Accounts payable 36,112 31,881
Accrued payroll liabilities 20,703 20,183
Current portion of environmental liabilities 6,205 9,373
Accrued income taxes 246 4,954
Other accrued liabilities 7,232 7,450
------------ ------------
Total current liabilities 70,608 74,066
Deferred income taxes 24,884 24,884
Long-term debt, less current portion 15,442 67,801
Environmental liabilities, net of current portion 15,598 12,126
Other long-term liabilities 2,335 2,295
Minority interests 6,002 5,921
Commitments and contingencies -- --
Shareholders' equity:
Preferred stock--20,000 shares authorized, none issued -- --
Class A common stock--75,000 shares $1 par value
authorized, 22,482 and 22,022 shares issued and outstanding 22,482 22,022
Class B common stock--25,000 shares $1 par value
authorized, 7,986 and 8,306 shares issued and outstanding 7,986 8,306
Additional paid-in capital 126,585 110,177
Retained earnings 389,254 278,374
Accumulated other comprehensive income:
Foreign currency translation adjustment 130 1
------------ ------------
Total shareholders' equity 546,437 418,880
------------ ------------
$ 681,306 $ 605,973
============ ============
The accompanying notes to the unaudited consolidated
financial statements are an integral part of this statement.
3
SCHNITZER STEEL INDUSTRIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(Unaudited, in thousands, except per share amounts)
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
---------------------------- ----------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
Revenues $ 226,789 $ 193,750 $ 641,496 $ 483,729
Operating Expenses:
Cost of goods sold 167,721 140,179 462,787 384,046
Selling, general and administrative 15,135 14,269 39,321 32,679
Environmental matter -- -- 8,225 --
------------ ------------ ------------ ------------
Income from wholly-owned operations 43,933 39,302 131,163 67,004
Operating income from joint ventures 11,152 28,013 47,821 42,634
------------ ------------ ------------ ------------
Operating income 55,085 67,315 178,984 109,638
Other expense, net:
Interest expense (110) (562) (740) (1,488)
Other expense, net (195) (315) (555) (161)
------------ ------------ ------------ ------------
(305) (877) (1,295) (1,649)
------------ ------------ ------------ ------------
Income before income taxes and minority interests 54,780 66,438 177,689 107,989
Income tax provision (20,485) (23,187) (63,257) (32,951)
------------ ------------ ------------ ------------
Income before minority interests 34,295 43,251 114,432 75,038
Minority interests, net of tax (787) (737) (2,007) (1,797)
------------ ------------ ------------ ------------
Net income $ 33,508 $ 42,514 $ 112,425 $ 73,241
============ ============ ============ ============
Net income per share - basic: $ 1.10 $ 1.41 $ 3.70 $ 2.45
============ ============ ============ ============
Net income per share - diluted: $ 1.08 $ 1.37 $ 3.61 $ 2.36
============ ============ ============ ============
The accompanying notes to the unaudited consolidated
financial statements are an integral part of this statement.
4
SCHNITZER STEEL INDUSTRIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Unaudited, in thousands)
CLASS A CLASS B ACCUMULATED
COMMON STOCK COMMON STOCK ADDITIONAL OTHER
--------------------- --------------------- PAID-IN RETAINED COMPREHENSIVE
SHARES AMOUNT SHARES AMOUNT CAPITAL EARNINGS INCOME TOTAL
-------- --------- -------- --------- ---------- --------- ------------ ------------
Balance at August 31, 2003 12,445 $ 12,445 7,061 $ 7,061 $ 104,249 $ 179,242 $ -- $ 302,997
Net income 111,181 111,181
Foreign currency
translation adjustment 1 1
------------
111,182
Class B common stock
converted to Class A
common stock 1,743 1,743 (1,743) (1,743) --
Class A common stock issued 802 802 5,928 6,730
Stock dividend 7,032 7,032 2,988 2,988 (10,020) --
Cash dividends paid -
common ($0.068 per share) (2,029) (2,029)
-------- --------- -------- --------- ---------- --------- ------------ ------------
Balance at August 31, 2004 22,022 22,022 8,306 8,306 110,177 278,374 1 418,880
Net income 112,425 112,425
Foreign currency
translation adjustment 129 129
------------
112,554
Class B common stock
converted to Class A
common stock 320 320 (320) (320) --
Class A common stock issued 140 140 1,469 1,609
Tax benefits from employee
stock option plan 14,939 14,939
Cash dividends paid -
common ($0.051 per share) (1,545) (1,545)
-------- --------- -------- --------- ---------- --------- ------------ ------------
Balance at May 31, 2005 22,482 $ 22,482 7,986 $ 7,986 $ 126,585 $ 389,254 $ 130 $ 546,437
======== ========= ======== ========= ========== ========= ============ ============
The accompanying notes to the unaudited consolidated
financial statements are an integral part of this statement.
5
SCHNITZER STEEL INDUSTRIES, INC.
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited, in thousands)
FOR THE NINE MONTHS ENDED
----------------------------
MAY 31, 2005 MAY 31, 2004
------------ ------------
Operations:
Net income $ 112,425 $ 73,241
Noncash items included in income:
Depreciation and amortization 15,554 15,020
Minority interests 3,085 2,514
Equity in income of joint ventures (47,821) (42,634)
Deferred income tax (21) (10,677)
Tax benefit from employee stock option plan 14,939 --
(Gain) loss on disposal of assets 108 (212)
Cash provided (used) by changes in working capital:
Accounts receivable (6,520) (29,408)
Inventories (14,808) (26,828)
Prepaid expenses and other (6,801) 2,631
Accounts payable 4,231 9,865
Accrued liabilities (4,406) 23,243
Environmental liabilities (2,496) (1,428)
Other assets and liabilities (506) 195
------------ ------------
Net cash provided by operations 66,963 15,522
------------ ------------
Investing:
Capital expenditures (40,759) (17,046)
Investment in subsidiaries (22,331) (23,861)
Cash received from joint ventures 46,212 470
Cash paid to joint ventures (1,295) (2,595)
Proceeds from sale of assets 645 1,628
------------ ------------
Net cash used by investments (17,528) (41,404)
------------ ------------
Financing:
Issuance of Class A common stock 1,609 5,333
Distributions to minority interests (3,004) (1,824)
Dividends declared and paid (1,545) (1,514)
Increase (decrease) in long-term debt (52,474) 25,821
------------ ------------
Net cash provided (used) by financing (55,414) 27,816
------------ ------------
Net increase (decrease) in cash and cash equivalents (5,979) 1,934
Cash and cash equivalents at beginning of period 11,307 1,687
------------ ------------
Cash and cash equivalents at end of period $ 5,328 $ 3,621
============ ============
The accompanying notes to the unaudited consolidated
financial statements are an integral part of this statement.
6
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2005 AND 2004
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
BASIS OF PRESENTATION
- ---------------------
The accompanying unaudited condensed interim financial statements of Schnitzer
Steel Industries, Inc. (the Company) have been prepared pursuant to the rules
and regulations of the Securities and Exchange Commission (SEC). Certain
information and note disclosures normally included in annual financial
statements have been condensed or omitted pursuant to those rules and
regulations. In the opinion of management, all adjustments, consisting only of
normal, recurring adjustments considered necessary for a fair presentation, have
been included. Although management believes that the disclosures made are
adequate to ensure that the information presented is not misleading, management
suggests that these financial statements be read in conjunction with the
financial statements and notes thereto included in the Company's annual report
for the fiscal year ended August 31, 2004. The results for the three and nine
months ended May 31, 2005 and 2004 are not necessarily indicative of the results
of operations for the entire year.
RECLASSIFICATIONS
- -----------------
Certain prior year amounts have been reclassified to conform to the current year
presentation. These changes had no impact on previously reported results of
operations or shareholders' equity.
CASH AND CASH EQUIVALENTS
- -------------------------
Cash and cash equivalents include short-term securities that have an original
maturity date of 90 days or less.
EARNINGS AND DIVIDENDS PER SHARE
- --------------------------------
Basic earnings per share (EPS) are computed based upon the weighted average
number of common shares outstanding during the period. Diluted EPS reflects the
potential dilution that would occur if securities or other contracts to issue
common stock were exercised or converted into common stock.
The following represents reconciliation from basic EPS to diluted EPS (in
thousands, except per share amounts):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
(Unaudited)
Net income $ 33,508 $ 42,514 $ 112,425 $ 73,241
============ ============ ============ ============
Computation of shares:
Average common shares outstanding 30,463 30,088 30,412 29,897
Stock options 680 971 748 1,152
------------ ------------ ------------ ------------
Diluted average common shares
outstanding 31,143 31,059 31,160 31,049
============ ============ ============ ============
Basic net income per share $ 1.10 $ 1.41 $ 3.70 $ 2.45
============ ============ ============ ============
Diluted net income per share $ 1.08 $ 1.37 $ 3.61 $ 2.36
============ ============ ============ ============
Dividends per share $ 0.017 $ 0.017 $ 0.051 $ 0.050
============ ============ ============ ============
7
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2005 AND 2004
STOCK INCENTIVE PLAN
- --------------------
The Company's compensation expense for its stock incentive plans is determined
using the intrinsic value method. Accordingly, because the exercise price equals
the market price on the date of the grant, no compensation expense is generally
recognized by the Company for stock options issued to employees and directors.
If the fair value based method had been applied in measuring stock compensation
expense, the pro forma effect on net income per share would have been as follows
(in thousands, except earnings per share):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
(Unaudited)
Reported net income $ 33,508 $ 42,514 $ 112,425 $ 73,241
Add: Stock based compensation
expense included in reported net
income, net of tax 224 -- 673 --
Deduct: Total stock based employee
compensation benefit (expense) under
fair value based method for all
awards, net of tax 24 (139) (377) (405)
------------ ------------ ------------ ------------
Pro forma net income $ 33,756 $ 42,375 $ 112,721 $ 72,836
============ ============ ============ ============
Reported basic income per share $ 1.10 $ 1.41 $ 3.70 $ 2.45
Pro forma basic income per share $ 1.11 $ 1.41 $ 3.71 $ 2.44
Reported diluted income per share $ 1.08 $ 1.37 $ 3.61 $ 2.36
Pro forma diluted income per share $ 1.08 $ 1.36 $ 3.62 $ 2.35
All of the options issued and outstanding for the periods in fiscal 2005 and
fiscal 2004 are considered to be dilutive and are reflected in the table above.
The Company obtains an income tax benefit related to stock issued to employees
through stock options plans, which is recorded as additional paid-in capital
and, therefore, does not benefit the income tax provision. For income tax
purposes the Company can deduct the amount an employee would report as ordinary
income. The deduction is allowed in the year the employee exercises the stock
option. In the second fiscal quarter of 2005, the Company recorded a tax benefit
from employee stock option plans of $14.4 million as a result of amending or
planning to amend the previous year's tax returns to include the deduction.
On December 16, 2004, the FASB finalized SFAS No. 123R "Shared-Based Payment"
which will be effective for the first interim reporting period of the first
fiscal year beginning after June 15, 2005. The new standard will require the
Company to expense stock options beginning in the first quarter of fiscal 2006.
The Company has begun the process to analyze how the utilization of a binomial
lattice model could impact the valuation of the options. The effect of expensing
stock options on our financial results using the Black-Scholes model is
presented in the table above.
8
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2005 AND 2004
GOODWILL AND INTANGIBLE ASSETS
- ------------------------------
The changes in the carrying amount of goodwill for the nine months ended May 31,
2005, are as follows (in thousands):
METALS
RECYCLING AUTO PARTS
BUSINESS BUSINESS TOTAL
---------- ---------- ----------
Balance as of August 31, 2004 $ 34,771 $ 96,407 $ 131,178
Auto Parts Business Acquisition (see Note 3) -- 20,003 20,003
---------- ---------- ----------
Balance as of May 31, 2005 $ 34,771 $ 116,410 $ 151,181
========== ========== ==========
The Company performs impairment tests annually and whenever events and
circumstances indicate that the value of goodwill and other indefinite-lived
intangible assets might be impaired. Due to the operating results of each of the
businesses identified above and based upon the Company's impairment testing
completed in the second quarter of fiscal 2005, the Company determined that none
of the above balances were considered impaired.
NEW ACCOUNTING PRONOUNCEMENTS
- -----------------------------
In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS
151, "Inventory Costs". This statement clarifies the accounting for abnormal
amounts of idle facility expense and freight and handling costs when those costs
may be so abnormal as to require treatment as period charges. This statement is
effective for fiscal years beginning after June 15, 2005. The Company does not
anticipate this pronouncement to have a material impact on the consolidated
financial statements.
In December 2004, the FASB issued SFAS 153, "Exchanges of Nonmonetary Assets".
This statement explains that exchanges of nonmonetary assets should be measured
based on the fair value of the assets exchanged. This statement is effective for
fiscal years beginning after June 15, 2005. The Company does not anticipate this
pronouncement to have a material impact on the consolidated financial
statements.
In June 2005, the FASB issued SFAS 154, "Accounting Changes and Error
Corrections". This statement revises the reporting requirements related to
changes in accounting principles or adoption of new accounting pronouncements.
This statement is effective for fiscal years beginning after December 15, 2005.
The Company does not anticipate this pronouncement to have a material impact on
the consolidated financial statements.
NOTE 2 - INVENTORIES:
Inventories consisted of the following (in thousands):
MAY 31, AUGUST 31,
2005 2004
------------ ------------
Recycled metals $ 30,136 $ 34,551
Work in process 15,384 10,045
Finished goods 36,031 23,808
Supplies 13,424 11,763
------------ ------------
$ 94,975 $ 80,167
============ ============
9
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2005 AND 2004
NOTE 3 - ACQUISITIONS
On January 10, 2005, Pick-N-Pull Auto Dismantlers, a wholly-owned subsidiary of
the Company, acquired the assets and leased the sites for four self-service used
auto parts stores in St. Louis and Kansas City, Missouri; Columbus, Ohio; and
Virginia Beach, Virginia from Vehicle Recycling Solutions, LLC and certain of
its wholly-owned subsidiaries ("VRS"). The total acquisition cost of $22.2
million consisted of a cash purchase price of $18.8 million, $0.6 million of
acquisition expenses and additional environmental reserves recorded as a result
of due diligence of $2.8 million. The St. Louis, Kansas City and Columbus stores
increase the Company's existing mid-west store base. The Virginia Beach store
provides Pick-N-Pull with an eastern presence giving it the ability to expand
along the East Coast. The four new stores will be operated under the Pick-N-Pull
name and increase the total number of stores to 30 for the Company's Auto Parts
Business segment. The results of operations for these four stores after the
acquisition date are reflected in the consolidated results of the Company's Auto
Parts Business for the second fiscal 2005 quarter.
NOTE 4 - ENVIRONMENTAL LIABILITIES
The Company considers various factors when estimating its environmental
liabilities. Adjustments to the liabilities are made when additional information
becomes available that affects the estimated costs to remediate. The factors,
which the Company considers in its recognition and measurement of environmental
liabilities, include the following:
o Current regulations both at the time the reserve is established and
during the course of the clean-up which specify standards for
acceptable remediation;
o Information about the site, which becomes available as the site is
studied and remediated;
o The professional judgment of both senior-level internal staff and
external consultants who take into account similar, recent instances
of environmental remediation issues, among other considerations;
o Technologies available that can be used for remediation; and
o The number and financial condition of other potentially responsible
parties and the extent of their responsibility for the remediation.
PORTLAND HARBOR
In December 2000, the United States Environmental Protection Agency (EPA) named
the Portland Harbor, a 5.5 mile stretch of the Willamette River in Portland,
Oregon, as a Superfund site. The Company's metals recycling and deep water
terminal facility in Portland, Oregon is located adjacent to the Portland
Harbor. Crawford Street Corporation, a Company subsidiary, also owns property
adjacent to the Portland Harbor. The EPA has identified 69 potentially
responsible parties (PRPs), including the Company and Crawford Street
Corporation, which own or operate sites adjacent to the Portland Harbor
Superfund site. The precise nature and extent of any clean-up of the Portland
Harbor, the parties to be involved, and the process to be followed for such a
clean-up have not yet been determined. It is unclear whether or to what extent
the Company or Crawford Street Corporation will be liable for environmental
costs or damages associated with the Superfund site. It is also unclear whether
natural resource damage claims or third party contribution or damages claims
will be asserted against the Company. While the Company and Crawford Street
Corporation participated in certain preliminary Portland Harbor study efforts,
they are not parties to the consent order entered into by the EPA with other
PRPs (Lower Willamette Group) for a Remedial Investigation/Feasibility Study;
however, the Company could become liable for a share of the costs of this study
at a later stage of the proceedings.
Separately, the Oregon Department of Environmental Quality (DEQ) has requested
operating history and other information from numerous persons and entities which
own or conduct operations on properties adjacent to or upland from the Portland
Harbor, including the Company and Crawford Street Corporation. The DEQ
investigations at the Company and Crawford Street sites are focused on
controlling any current releases of contaminants into the Willamette River. The
Company has agreed to a voluntary Remedial Investigation/Source
10
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2005 AND 2004
Control effort with the DEQ regarding its Portland, Oregon deep water terminal
facility and the site owned by Crawford Street Corporation. DEQ identified these
sites as potential sources of contaminants that could be released into the
Willamette River. The Company believes that improvements in the operations at
these sites, often referred to as Best Management Practices (BMPs), will be
sufficient to effectively provide source control and avoid the release of
contaminants from these sites, and has proposed to DEQ the implementation of
BMPs as the resolution of this investigation.
While the cost of the investigations associated with these properties and the
cost of employment of source control BMPs are not expected to be material at May
31, 2005, $0.3 million has been accrued for studies related to the pending
Portland Harbor Superfund site. No estimate is currently possible and none has
been made as to the cost of remediation for the Portland Harbor or the Company's
adjacent properties.
MANUFACTURING MANAGEMENT, INC.
In 1994, Manufacturing Management, Inc. (MMI) recorded a reserve for the
estimated cost to cure certain environmental liabilities. This reserve was
carried over to the Company's financial statements when MMI was acquired in
1995. The reserve is evaluated quarterly according to Company policy. On May 31,
2005, the reserve aggregated $10.0 million.
General Metals of Tacoma (GMT), a subsidiary of MMI, owns and operates a metals
recycling facility located in the State of Washington on the Hylebos Waterway, a
part of Commencement Bay, which is the subject of an ongoing remediation project
by the United States Environmental Protection Agency (EPA) under the
Comprehensive Environmental Response, Compensation and Liability Act (CERCLA).
GMT and more than 60 other parties were named potentially responsible parties
(PRPs) for the investigation and clean-up of contaminated sediment along the
Hylebos Waterway. On March 25, 2002, EPA issued Unilateral Administrative Orders
(UAOs) to GMT and another party (Other Party) to proceed with Remedial Design
and Remedial Action (RD/RA) for the head of the Hylebos and to two other parties
to proceed with the RD/RA for the balance of the waterway. The issuance of the
UAOs did not require the Company to change its previously recorded estimate of
environmental liabilities for this site. The UAO for the head of the Hylebos
Waterway was converted to a voluntary consent decree in 2004, pursuant to which
GMT and the Other Party agreed to remediate the head of the Hylebos Waterway.
There are two phases to the remediation of the head of the Hylebos Waterway. The
first phase was the intertidal and bank remediation, which was conducted in 2003
and early 2004. The second phase is dredging in the head of Hylebos Waterway,
which began on July 15, 2004. During the first nine months of fiscal 2005, the
Company paid remediation costs of $13.8 million related to Hylebos dredging
which were charged to the environmental reserve. The Company's cost estimates
were based on the assumption that dredge removal of contaminated sediments would
be accomplished within one dredge season during July 2004 - February 2005.
However, due to a variety of factors, including equipment failures, dredge
contractor operational issues and other dredge related delays, the dredging was
not completed during the first dredge season. As a result, the Company recorded
environmental charges of $8.2 million in the first half of fiscal 2005 primarily
to account for additional estimated costs to complete this work during a second
dredging season. The Company and the Other Party have filed a complaint in the
United States Federal District Court for Western Washington against the dredge
contractor to recover a significant portion of the increased costs. However,
generally accepted accounting principles do not allow the Company to recognize
the benefits of any such recovery until receipt is highly probable.
GMT and the Other Party are pursuing settlement negotiations and legal actions
against other non-settling, non-performing PRPs to recover additional amounts
that may be applied against the head of the Hylebos remediation costs.
Uncertainties continue to exist regarding the total cost to remediate this site
as well as the Company's share of those costs; nevertheless, the Company's
estimate of its liabilities related to this site is based on information
currently available.
11
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2005 AND 2004
The Natural Resource Damage Trustees (Trustees) for Commencement Bay have
asserted claims against GMT and other PRPs within the Hylebos Waterway area for
alleged damage to natural resources. In March 2002, the Trustees delivered a
draft settlement proposal to GMT and others in which the Trustees suggested a
methodology for resolving the dispute, but did not indicate any proposed damages
or cost amounts. In June 2002, GMT responded to the Trustees' draft settlement
proposal with various corrections and other comments, as did twenty other
participants. It is unknown at this time whether, or to what extent, GMT will be
liable for natural resource damages. The Company's previously recorded
environmental liabilities include an estimate of the Company's potential
liability for these claims.
The Washington State Department of Ecology named GMT, along with a number of
other parties, as Potentially Liable Parties (PLPs) for a site referred to as
Tacoma Metals. GMT operated on this site under a lease prior to 1982. The
property owner and current operator have taken the lead role in performing a
Remedial Investigation and Feasibility Study (RI/FS) for the site. The RI/FS is
now completed and the parties are currently involved in a mediation settlement
process to address cost allocations. The Company's previously recorded
environmental liabilities include an estimate of the Company's potential
liability at this site.
MMI is also a named PRP at another third-party site at which it allegedly
disposed of automobile shredder residue (ASR). The site has not yet been subject
to significant remedial investigation. MMI has been named as a PRP at several
other sites for which it has agreed to de minimis settlements. In addition to
the matters discussed above, the Company's environmental reserve includes
amounts for potential future cleanup of other sites at which MMI has conducted
business or has allegedly disposed of other materials.
PROLER AND JOINT VENTURES
In 1996, prior to the Company's acquisition of Proler International Corp.
(Proler), Proler recorded a liability for the probable costs to remediate its
wholly-owned properties. This reserve was carried over to the Company's
financial statements upon acquiring Proler in 1996. The reserve is evaluated
quarterly according to Company policy. On May 31, 2005, the reserve aggregated
$3.4 million.
As part of the Proler acquisition, the Company became a 50% owner of Hugo
Neu-Proler Company (HNP). HNP has agreed, as part of its 1996 lease renewal with
the Port of Los Angeles (POLA), to conduct a multi-year, phased remedial
clean-up project involving certain environmental conditions on its metals
recycling facility at its Terminal Island site in Los Angeles, California, which
was completed in 2002. HNP is waiting for final certification from POLA and the
regulatory agencies overseeing the cleanup. Remediation included excavation and
off-site disposal of contaminated soils, paving and groundwater monitoring.
Other environmentally protective actions included installation of a stormwater
management system and construction of a noise barrier and perimeter wall around
a substantial portion of the facility.
Additionally, other Proler joint venture sites with potential environmental
clean-up issues have been identified. Estimated clean-up costs associated with
these sites have been accrued for by the joint ventures.
During the second quarter of fiscal 2005, in connection with the negotiation of
the separation and termination of the Company's metals recycling joint ventures
with Hugo Neu Corporation (see Note 9), the Company conducted an environmental
due diligence investigation of certain joint venture businesses it has now
agreed to directly acquire. As a result of this investigation, the Company
identified certain environmental risks and accrued $2.6 million for its share of
the estimated costs to remediate these risks.
AUTO PARTS BUSINESS
Since 2003, the Company has completed three acquisitions of businesses in the
Auto Parts Business segment. At the time of each acquisition, the Company
conducts an environmental due diligence investigation related to locations
involved in the acquisition. As a result of the environmental due diligence
investigations, the Company records a reserve for the estimated cost to cure
certain environmental liabilities. The reserve is evaluated quarterly
12
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2005 AND 2004
according to Company policy. On May 31, 2005, the reserve aggregated $5.5
million and includes $2.8 million added in the second quarter of fiscal 2005 in
connection with an acquisition. No environmental proceedings are pending at any
of these sites, other than discussed below.
On January 6, 2004, the Auto Parts Business was served with a Notice of
Violation (NOV) of the general permit requirements on its diesel powered car
crushers at the Rancho Cordova and Sacramento locations from the Sacramento
Metropolitan Air Quality Management District (SMAQMD). Since receiving the NOV,
the Sacramento and Rancho Cordova locations have converted their diesel powered
car crushers to electric powered. The Company has settled this matter which will
result in payment of a fine to SMAQMD during the Company's fourth fiscal
quarter. The settlement amount is less than the $0.6 million the Company had
previously reserved for this matter.
NOTE 5 - OTHER CONTINGENCIES
The Company and Hugo Neu Corporation ("HNC") are the 50% members of Hugo Neu
Schnitzer Global Trade, LLC ("HNSGT"), a joint venture engaged in global trading
of recycled metals. HNC manages the day-to-day activities of HNSGT. In January
2004, HNC advised the Company that it would charge HNSGT a 1% commission on
HNSGT's recycled metal sales, and began deducting those commissions. While some
reasonable reimbursement of HNC's costs may be appropriate, the Company has
responded that the 1% commission is excessive and that HNC had no authority to
unilaterally impose such commissions on HNSGT. As of May 31, 2005, the Company
estimated that its 50% share of the disputed commissions totaled $5.5 million.
In recording operating income from joint ventures, the Company has excluded from
joint venture expenses the excess of these disputed commissions over the
Company's estimate of reasonable reimbursements. As part of the negotiated
separation and termination of the Company's joint ventures with HNC (as
discussed in Note 9), the Company has agreed, subject to closing of the
transaction, to release its claim for reimbursement of the excess commissions.
The amount accrued for this claim will be treated as purchase price in the
purchase accounting for the transaction.
The Company was advised in 2004 that its practice of paying commissions to the
purchasing managers of customers in connection with export sales of recycled
ferrous metals to the Far East may raise questions of possible violations of
U.S. and foreign laws, and the practice was stopped. Thereafter, the Audit
Committee was advised and conducted a preliminary compliance review. On November
18, 2004, on the recommendation of the Audit Committee, the Board of Directors
authorized the Audit Committee to engage independent counsel and conduct a
thorough, independent investigation and directed that the existence and the
results of the investigation be voluntarily reported to the U.S. Department of
Justice (DOJ) and the Securities and Exchange Commission (SEC), and that the
Company cooperate fully with those agencies. The Board, through its Audit
Committee, is continuing its independent investigation, which is being conducted
by an outside law firm. The Company has notified the DOJ and the SEC of the
investigation; has instructed the outside law firm to provide those agencies
with the information obtained as a result of the investigation; and is
cooperating fully with those agencies. The investigation is not expected to
affect the Company's previously reported financial results, including those
reported in this 10-Q. The Company cannot predict the results of the
investigation or whether the Company or any of its employees will be subject to
any penalties or other remedial actions following completion of the
investigation.
NOTE 6 - RELATED PARTY TRANSACTIONS
PURCHASE OF PORTLAND METALS RECYCLING REAL PROPERTY
The Company's Portland metals recycling facility, including its deep water
terminal facilities are located on an approximately 60-acre industrial site (the
Portland Property) that has been leased from Schnitzer Investment Corp. (SIC)
pursuant to a Lease Agreement dated September 1, 1988, as amended (the Lease).
In the summer of 2004, SIC notified the Company of its intention to sell the
Portland Property. Due to the strategic significance of this key
13
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2005 AND 2004
asset and the impact on the metals recycling business, the Company decided to
enter into negotiations to purchase the Portland property. On May 11, 2005, the
Company purchased the Portland Property from SIC for $20 million pursuant to the
terms of a Purchase and Sale Agreement dated May 4, 2005 (the Agreement). The
Agreement, and the purchase of the Portland Property contemplated thereby, were
approved by the Company's Audit Committee in accordance with the Company's
policy on related party transactions.
As the Company has been responsible for the operation and maintenance of the
Portland Property under the terms of the Lease, the Portland Property was
purchased "as is, with all faults" and with very limited representations and
warranties from SIC. In addition, under the terms of the Lease, the Company was
obligated to indemnify SIC against any environmental liabilities associated with
the Portland Property, and this obligation of the Company survived the
termination of the Lease.
In connection with the purchase of the Portland Property, the Lease was
terminated. The rent under the Lease at the time of termination was $1.8 million
per year, subject to periodic adjustment for market rates and Consumer and
Producer Price indices. The Lease was scheduled to expire in 2063.
NOTE 7 - EMPLOYEE BENEFITS
The Company has a number of retirement benefit plans that cover both union and
non-union employees. The Company makes contributions following the provisions in
each plan.
Primary actuarial assumptions are determined as follows:
o The expected long-term rate of return on plan assets is based on our
estimate of long-term returns for equities and fixed income securities
weighted by the allocation of assets in the plans. The rate is
affected by changes in general market conditions, but because it
represents a long-term rate, it is not significantly affected by
short-term market swings. Changes in the allocation of plan assets
would also impact this rate.
o The assumed discount rate is used to discount future benefit
obligations back to today's dollars. The U.S. discount rate is as of
the measurement date, August 31, 2004. This rate is sensitive to
changes in interest rates. A decrease in the discount rate would
increase our obligation and expense.
o The expected rate of compensation increase is used to develop benefit
obligations using projected pay at retirement. This rate represents
average long-term salary increases and is influenced by our
compensation policies. An increase in this rate would increase our
obligation and expense.
DEFINED BENEFIT PENSION PLAN
- ----------------------------
For certain nonunion employees, the Company maintains a defined benefit pension
plan. The components of net periodic pension benefit cost are (in thousands):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
(Unaudited)
Service cost $ 296 $ 260 $ 824 $ 691
Interest cost 181 169 504 448
Expected return on plan assets (222) (192) (618) (511)
Amortization of past service cost 1 1 3 3
Recognized actuarial loss 52 48 143 127
------------ ------------ ------------ ------------
Net periodic pension benefit cost $ 308 $ 286 $ 856 $ 758
============ ============ ============ ============
14
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2005 AND 2004
For the year ended August 31, 2005, the Company expects to contribute $1.2
million to its defined benefit pension plan. As of May 31, 2005, the Company has
contributed $0.4 million to the defined benefit pension plan. The Company
typically makes annual contributions to the plan after it receives the annual
actuarial valuation report. These payments are typically made in the Company's
third and fourth fiscal quarters.
DEFINED CONTRIBUTION PLANS
- --------------------------
The Company has several defined contribution plans covering nonunion employees.
Company contributions to the defined contribution plans were as follows (in
thousands):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
(Unaudited)
Plan costs $ 294 $ 358 $ 803 $ 1,087
MULTIEMPLOYER PENSION PLANS
- ---------------------------
In accordance with collective bargaining agreements, the Company contributes to
multiemployer pension plans. Company contributions are as follows (in
thousands):
For the Three Months Ended For the Nine Months Ended
--------------------------- ---------------------------
May 31, 2005 May 31, 2004 May 31, 2005 May 31, 2004
------------ ------------ ------------ ------------
(Unaudited)
Plan contributions $ 713 $ 832 $ 2,049 $ 2,322
The Company is not the sponsor or administrator of these multiemployer plans.
Contributions were determined in accordance with provisions of negotiated labor
contracts. The Company is unable to determine its relative portion of or
estimate its future liability under the plans.
The Company learned during fiscal 2004 that one of the multiemployer plans for
the Steel Manufacturing Business would not meet ERISA minimum funding standards
for the plan year ending September 30, 2004. The trustees of that plan have
applied to the Internal Revenue Service (IRS) for certain relief from this
minimum funding standard. The IRS has tentatively responded, indicating a
willingness to consider granting the relief, provided the plan's contributing
employers, including the Company, agree to increased contributions. The
increased contributions are estimated to average 6% per year, compounded
annually, until the plan reaches the funded status required by the IRS. These
increases would be based on the Company's current contribution level to the plan
of approximately $2.2 million per year. The Plan Trustees have provided
information to the plan's contributing employers regarding the IRS proposed
contribution rate increases and are awaiting a commitment from the employers
before proceeding with the relief request.
Absent relief by the IRS, the plan's contributing employers will be required to
make additional contributions or pay excise tax that may equal or exceed the
full amount of that deficiency. The Company estimated its share of the required
additional contribution for the 2004 plan year to be approximately $1.1 million
and accrued for such amount in fiscal 2004.
NOTE 8 - SEGMENT INFORMATION:
The Company operates in three industry segments: metal processing and recycling
(Metals Recycling Business), mini-mill steel manufacturing (Steel Manufacturing
Business) and self-service used auto parts (Auto Parts Business). Additionally,
the Company is a non-controlling partner in joint ventures, which are in the
metals recycling business. The Joint Ventures in the metals recycling business
sell recycled metals that have been processed at their facilities (Processing)
and also buy and sell third parties' processed metals (Trading). The
15
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2005 AND 2004
Company considers these joint ventures to be separate segments because they are
managed separately. These joint ventures are accounted for using the equity
method. As such, the operating information related to the joint ventures is
shown separately from consolidated information, except for the Company's equity
in the net income of, investments in and advances to the joint ventures.
Additionally, assets and capital expenditures are not shown for the joint
ventures as management does not use that information to allocate resources or
assess performance. The Company does not allocate corporate interest income and
expense, income taxes or other income and expenses related to corporate activity
to its operating segments.
Revenues from external customers for the Company's consolidated operations are
as follows (in thousands):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
Metals Recycling Business $ 150,654 $ 137,997 $ 447,266 $ 326,926
Auto Parts Business 30,980 23,294 78,814 58,199
Steel Manufacturing Business 91,351 72,048 228,193 185,128
Intersegment revenues (46,196) (39,589) (112,777) (86,524)
------------ ------------ ------------ ------------
Consolidated revenues $ 226,789 $ 193,750 $ 641,496 $ 483,729
============ ============ ============ ============
Total revenues from external customers recognized by the joint ventures (in
thousands):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
Joint Ventures:
Processing $ 296,777 $ 347,753 $ 972,879 $ 738,413
Trading 256,450 193,946 693,660 424,406
------------ ------------ ------------ ------------
Total revenues $ 553,227 $ 541,699 $ 1,666,539 $ 1,162,819
============ ============ ============ ============
The Company's operating income is as follows (in thousands):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
Metals Recycling Business $ 27,441 $ 32,462 $ 101,210 $ 55,547
Auto Parts Business 8,548 8,554 23,139 19,537
Steel Manufacturing Business 13,408 6,956 31,526 9,506
Joint Ventures (1) 11,152 28,013 47,821 42,634
Corporate expense (5,894) (6,053) (14,493) (11,717)
Intercompany profit eliminations 430 (2,617) (1,994) (5,869)
Environmental matter -- -- (8,225) --
------------ ------------ ------------ ------------
Total operating income $ 55,085 $ 67,315 $ 178,984 $ 109,638
============ ============ ============ ============
(1) Operating income from the joint ventures includes environmental expenses of
$2.6 million for the nine months ended May 31, 2005.
16
SCHNITZER STEEL INDUSTRIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED MAY 31, 2005 AND 2004
The Company's share of depreciation and amortization expense included in the
determination of joint ventures' income from operations is as follows (in
thousands):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
Joint Ventures $ 1,824 $ 2,000 $ 5,524 $ 5,359
NOTE 9 - SUBSEQUENT EVENT:
On June 9, 2005, the Company and Hugo Neu Corporation (HNC) announced that they
and certain of their subsidiaries entered into a Master Agreement providing for
the separation and termination of their metals recycling joint venture
relationships and certain other transactions. Pursuant to the Master Agreement,
the Company and its subsidiary, Joint Venture Operations, Inc. (JVOI), and HNC
and its subsidiaries, Hugo Neu Co., LLC, HNE Recycling LLC and HNW Recycling
LLC, have agreed to take the following steps relating to the dissolution of
their joint venture relationships:
o JVOI will acquire the 50% interests in the joint ventures based in New
England that are owned by a Hugo Neu subsidiary with the result that
these joint ventures will become wholly-owned by JVOI;
o Subsidiaries of HNC will acquire the 50% interests in the joint
ventures based in New Jersey, New York and California that are owned
by a Schnitzer subsidiary with the result that these joint ventures
will become wholly-owned by subsidiaries of HNC;
o Hugo Neu Schnitzer Global Trade LLC (Global Trade), a joint venture
engaged primarily in scrap metal trading, will redeem JVOI's 50%
membership interest in it in exchange for the assets and liabilities
of Global Trade's trading business in Russia and certain Baltic
Countries and Global Trade will retain the trading business operating
outside of Russia and the Baltic Countries;
o JVOI will acquire HNC's metal recycling and greenwaste recycling
businesses in Hawaii;
o A subsidiary of HNC will pay JVOI approximately $52 million in cash;
o The Company and HNC and certain of their affiliates will enter into a
number of related agreements governing, among other things, employee
transitional issues, benefit plans, scrap sales and other transitional
services; and
o The Company and HNC and certain of their affiliates will execute and
deliver mutual global releases.
The Master Agreement has been approved by the Board of Directors of each of the
Company and HNC and the transactions contemplated by the Master Agreement are
subject to a number of conditions, including obtaining certain third party
consents, permit amendments or transfers, HNC obtaining required financing and
other customary closing conditions. With respect to the financing contingency,
HNC has confirmed to the Company that it has entered into a definitive credit
agreement sufficient to provide the required financing, subject to customary
closing conditions. The Company currently expects the closing of the transaction
will occur around the end of the Company's fiscal year.
17
SCHNITZER STEEL INDUSTRIES, INC.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
GENERAL
Schnitzer Steel Industries, Inc. (the Company) operates in three vertically
integrated business segments that include the wholly-owned and joint venture
metals recycling businesses, the Auto Parts Business and the Steel Manufacturing
Business. The wholly-owned Metals Recycling Business and certain joint venture
businesses collect, process and recycle metals by operating one of the largest
metals recycling businesses in the United States. The Auto Parts Business
operates as Pick-N-Pull in the United States and Canada, and the Company
believes it is one of the country's leading self-service used auto parts
networks with 30 retail store locations. Additionally, Pick-N-Pull is a supplier
of autobodies to the Metals Recycling Business which processes the autobodies
into sellable recycled metal. The Steel Manufacturing Business purchases
recycled metals from the Metals Recycling Business and uses its mini-mill to
process the recycled metals into finished steel products. As a result of the
Company's vertically integrated business, it is able to transform autobodies and
other unprocessed metals into finished steel products. The joint ventures in the
metals recycling business sell recycled metals that have been processed at their
facilities (Processing) and also buy and sell third parties' processed metals
(Trading).
On June 9, 2005, the Company announced the signing of an agreement to separate
and terminate its metals recycling joint ventures with Hugo Neu Corporation,
with closing of the transaction expected near the end of fiscal 2005. See Note 9
of Notes to Consolidated Financial Statements for details of the agreement. Upon
completion of this transaction, in addition to its existing operations in
Northern California, Washington and Oregon, the Company's Metals Recycling
Business will be the largest metals recycler in New England and in Hawaii, and
will operate a metals trading business in Russia and the Baltic Sea region.
RESULTS OF OPERATIONS
The Company's revenues and operating results by business segment are summarized
below (in thousands):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
(Unaudited)
REVENUES:
Metals Recycling Business:
Ferrous sales $ 129,495 $ 121,086 $ 389,974 $ 282,526
Nonferrous sales 19,440 15,174 52,037 39,661
Other sales 1,719 1,737 5,255 4,739
------------ ------------ ------------ ------------
Total sales 150,654 137,997 447,266 326,926
Auto Parts Business 30,980 23,294 78,814 58,199
Steel Manufacturing Business 91,351 72,048 228,193 185,128
Intercompany sales eliminations (46,196) (39,589) (112,777) (86,524)
------------ ------------ ------------ ------------
Total revenues $ 226,789 $ 193,750 $ 641,496 $ 483,729
============ ============ ============ ============
18
SCHNITZER STEEL INDUSTRIES, INC.
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
(Unaudited)
OPERATING INCOME:
Metals Recycling Business $ 27,441 $ 32,462 $ 101,210 $ 55,547
Auto Parts Business 8,548 8,554 23,139 19,537
Steel Manufacturing Business 13,408 6,956 31,526 9,506
Joint Ventures (1) 11,152 28,013 47,821 42,634
Corporate expense (5,894) (6,053) (14,493) (11,717)
Intercompany profit eliminations 430 (2,617) (1,994) (5,869)
Environmental matters (8,225)
------------ ------------ ------------ ------------
Total operating income $ 55,085 $ 67,315 $ 178,984 $ 109,638
============ ============ ============ ============
NET INCOME $ 33,508 $ 42,514 $ 112,425 $ 73,241
============ ============ ============ ============
(1) Operating income from the joint ventures includes environmental expenses of
$2.6 million for the nine months ended May 31, 2005.
The Joint Ventures' revenues and results of operations were as follows (in
thousands):
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
(Unaudited)
Joint Ventures
Processing $ 296,777 $ 347,753 $ 972,879 $ 738,413
Trading 256,450 193,946 693,660 424,406
------------ ------------ ------------ ------------
$ 553,227 $ 541,699 $ 1,666,539 $ 1,162,819
============ ============ ============ ============
Operating income from
Joint Ventures (1) $ 11,152 $ 28,013 $ 47,821 $ 42,634
============ ============ ============ ============
(1) Operating income from the joint ventures includes environmental expenses of
$2.6 million for the nine months ended May 31, 2005.
19
SCHNITZER STEEL INDUSTRIES, INC.
The following table summarizes certain selected operating data for the Company
and its joint venture businesses:
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
(Unaudited)
METALS RECYCLING BUSINESS:
Ferrous recycled metal average net
sales prices ($/ton) (1,2)
Domestic $ 222 $ 228 $ 221 $ 177
Export $ 236 $ 243 $ 243 $ 180
Average $ 230 $ 237 $ 236 $ 179
Ferrous recycled metal shipments
(tons in thousands) (2)
To Steel Manufacturing Business 190 158 459 448
To other unaffiliated domestic
customers 17 7 43 36
To export customers 289 280 941 871
------------ ------------ ------------ ------------
Total ferrous recycled metal 496 445 1,443 1,355
============ ============ ============ ============
Nonferrous metal shipments (pounds
in thousands) 33,600 28,100 93,900 81,300
============ ============ ============ ============
AUTO PARTS BUSINESS
Number of stores open at quarter end 30 26 30 26
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
--------------------------- ---------------------------
MAY 31, 2005 MAY 31, 2004 MAY 31, 2005 MAY 31, 2004
------------ ------------ ------------ ------------
(Unaudited)
STEEL MANUFACTURING BUSINESS:
Average sales price ($/ton) (1,2) $ 510 $ 448 $ 519 $ 368
Finished steel products sold
(tons in thousands) (2) 172 155 423 480
JOINT VENTURES:
Ferrous recycled metal shipments
(tons in thousands) (2)
Processing 814 1,086 2,794 2,588
Trading 840 621 2,307 1,921
------------ ------------ ------------ ------------
Total ferrous recycled metal 1,654 1,707 5,101 4,509
============ ============ ============ ============
(1) The Company reports revenues that include shipping costs billed to
customers. However, average net selling prices are shown net of shipping
costs.
(2) Tons for ferrous recycled metals are long tons (2,240 pounds) and for
finished steel products are short tons (2,000 pounds).
20
SCHNITZER STEEL INDUSTRIES, INC.
THIRD QUARTER FISCAL 2005 COMPARED TO THIRD QUARTER FISCAL 2004
RESULTS OF OPERATIONS
- ---------------------
The third quarter of fiscal 2005 was another strong quarter for the Company, but
this quarter's performance did not match the near record earnings level achieved
in the third quarter of fiscal 2004. Compared to last year's quarter, operating
results for the Steel Manufacturing Business improved dramatically due to higher
selling prices and sales volumes. However, operating income declined for the
Metals Recycling Business as margins per ton for ferrous metals were compressed
by moderately lower selling prices and higher unprocessed metal purchase prices.
Margins for the joint ventures were also compressed by higher unprocessed metal
purchase prices. Also, sales volumes for the processing joint ventures decreased
by 25%, which had a significant adverse affect on joint venture operating income
for the quarter.
The results of operations of the Company depend in large part upon demand and
prices for recycled metals in world markets and steel products in the Western
United States. Beginning in fiscal 2004, and continuing into the first half of
fiscal 2005, strong worldwide demand combined with a tight supply of recycled
metals created significant price volatility and drove the Metals Recycling
Business' average selling prices to unprecedented highs. Average selling prices
declined in the third quarter of 2005, and have continued to decline in the
fourth quarter. Market prices for recycled ferrous metals fluctuate periodically
and have a significant impact on the results of operations for the wholly-owned
operations and Joint Ventures in the metals recycling business and to a lesser
extent on the Auto Parts Business.
The Auto Parts Business purchases used and salvaged vehicles, sells parts from
those vehicles through its retail facilities and wholesale operations, and sells
the crushed autobodies to metal recyclers. The Auto Parts Business has acquired
four new stores since the end of the third fiscal quarter of last year, which
represents a 15% increase in the number of stores. These new stores have led to
increases in both retail and wholesale revenues. In addition, revenues for the
wholesale product lines are principally affected by commodity metal prices and
shipping schedules. The Auto Parts Business benefited from improved pricing for
crushed autobodies as compared to the third quarter of last year. The
self-service retail operations are somewhat seasonal and affected by weather
conditions and promotional events. Since the stores are open to the natural
elements, during periods of prolonged wet, cold or extreme heat, the retail
business tends to slow down due to the difficult customer working conditions. As
a result, the Company's first and third fiscal quarters tend to generate the
greatest retail sales and the second and fourth fiscal quarters are the slowest
in terms of retail sales.
During the first half of fiscal 2005, West Coast steel manufacturers (including
the Company) built inventory levels in anticipation of the spring construction
period. Also during the first half of fiscal 2005, many fabricators and steel
distributors used the traditionally slow sales period to reduce their inventory
levels and purchases of steel products. The third fiscal quarter of 2005
experienced higher sales volume as a result of customers replenishing their
reduced inventory levels to prepare for the West Coast construction season.
Average net selling prices for the Company's steel products have remained high,
increasing by 14% over the prior year quarter, although declining by 4% since
the first quarter of fiscal 2005. Fluctuations in the scrap metals market
pricing have caused buyers of steel to anticipate future price decreases and
some have adjusted their buying patterns. In addition, there has been a rise in
the amount of imported finished steel products, principally wire rod, being
delivered on the West Coast which have a lower selling price than the Company's
comparable products.
21
SCHNITZER STEEL INDUSTRIES, INC.
The Company's steel mill successfully completed the installation of a new
electric arc furnace in December 2004. It is anticipated that the new furnace
will improve productivity of the mill as well as reduce operating costs,
including the consumption of electricity. To date, the new furnace is performing
well and exceeding productivity expectations.
REVENUES. Consolidated revenues for the quarter ended May 31, 2005 increased
$33.0 million or 17% to $226.8 million from $193.8 million in the third quarter
of fiscal 2004. Revenues in the third quarter of fiscal 2005 increased for all
Company business segments. For the Metals Recycling Business, the revenue
increase resulted from increases in sales volumes due to continued strong demand
in worldwide metals markets. Significant improvements in world wide demand,
coupled with higher raw material cost, led to increases in selling prices for
finished steel products sold by the Steel Manufacturing Business. Auto Parts
Business revenues benefited from increased prices for sales of autobodies and
higher core sale revenues. In addition, the Auto Parts Business acquired four
retail locations in January 2005 that added revenue and operating income to the
segment over the prior year.
The Metals Recycling Business generated revenues of $150.7 million for the
quarter ended May 31, 2005, before intercompany eliminations, which was an
increase of $12.7 million or 9% over the same period of the prior year. Ferrous
revenues increased $8.4 million, or 7%, to $129.5 million as a result of higher
sales volume offset by a lower average selling price net of shipping cost
(average net selling price) and slightly lower freight costs. Total ferrous
sales volume increased 50,400 tons or 11% over the prior year quarter which was
primarily due to increased sales to the Company's Steel Manufacturing Business.
The increase in sales volume represents a $12.0 million increase in revenue.
This increase is offset by a 3% decrease in the average net sales price to $230
per ton which represents a $3.3 million decrease in revenue. The cost of freight
that is included in revenue remained consistent with the prior year quarter as a
5% decrease in freight rate per ton for export shipments was offset by increased
ferrous and non ferrous shipping volumes.
Sales to the Steel Manufacturing Business increased 31,200 tons, or 20%, to
190,000 tons as a result of increased demand for finished steel and the
installation of a new furnace at the Steel Manufacturing Business during
December 2004. With the new furnace installed and operating, the Steel
Manufacturing Business has increased its consumption of scrap metal.
Revenue from nonferrous metal sales increased $4.3 million over the prior year
third quarter which was a result of a $0.04 or 7% increase in average net sales
price to $0.57 per pound and a 5.5 million pound or 20% increase in the pounds
shipped. The increase in sales price per pound was a result of increased Asian
demand for nonferrous metals. The increase in pounds shipped over the prior year
third quarter was a result of more scrap metals being processed through the
Company's shredders as well as the implementation of a system to improve
recovery of nonferrous metals from the shredding process. Nonferrous metals are
a byproduct of the shredding process, and quantities available for shipment are
affected by the volume of materials processed in the Company's shredders.
The Auto Parts Business generated revenue of $31.0 million, before intercompany
eliminations, for the quarter ended May 31, 2005, which is an increase of $7.7
million or 33% over the same period of the prior year. This increase is a result
of higher wholesale revenues driven by higher average sales prices for scrapped
autobodies and higher core sale revenues in both the Company's recently acquired
and existing store locations. In addition, retail revenues increased as a result
of the acquisition of four retail store locations in January 2005 and, to a
lesser extent, same store sales improvement.
22
SCHNITZER STEEL INDUSTRIES, INC.
The Steel Manufacturing Business generated revenues of $91.4 million for the
quarter ended May 31, 2005, which is an increase of $19.3 million, or 27% over
the prior year quarter. The average net selling price increased $62 per ton, or
14% to $510 per ton, which increased revenue $10.7 million. The increase in
average net selling prices was due to a combination of factors including
increased steel consumption and higher raw material costs that manufacturers
passed through to the end users. Sales volumes increased 11% to 172,000 tons,
which increased revenues by $7.6 million. The increased sales volume is a result
of increased demand in the Company's normally busiest quarter. Sales volumes in
the third quarter are traditionally higher due to the spring construction season
on the West Coast.
COST OF GOODS SOLD. Consolidated cost of goods sold increased $27.5 million or
20% for the third quarter ended May 31, 2005, compared with the same period last
year. Cost of goods sold increased as a percentage of revenues from 72% to 74%.
Gross profit increased $5.5 million to $59.1 million during the latest quarter
compared to the prior year quarter driven by gross profit improvements at the
Company's Auto Parts and Steel Manufacturing Business segments.
Cost of goods sold for the Metals Recycling Business increased $17.8 million or
18% to $118.7 million. As a percentage of revenues, cost of goods sold increased
compared with the third quarter of fiscal 2004 from 73% to 79%. Gross profit
decreased by $5.2 million to $31.9 million. The decrease in gross profit was
primarily attributable to the combination of lower average net selling prices
per ferrous ton and higher ferrous purchase prices per ton, partially offset by
higher sales volumes and improved nonferrous margins. Compared to the third
quarter of last year, the average ferrous metals cost of sales per ton increased
8% due primarily to higher purchase costs for unprocessed ferrous metals.
The Auto Parts Business' cost of goods sold increased $6.3 million or 51% during
the third quarter of fiscal 2005 as compared to the cost of goods sold for the
fiscal 2004 third quarter. The higher cost of sales was primarily due to higher
car purchase costs that resulted from higher unprocessed metal prices, but also
due to the addition of four new stores since last year. As a percentage of
revenues, cost of goods sold increased compared with the prior year quarter from
53% to 60% due to increased car purchase costs and the addition of the four new
stores which earned a lower margin this quarter than the previously owned
stores. Gross profit increased $1.4 million or 13% over the prior year quarter
due to increased wholesale revenue earned from the higher market rates for
crushed autobodies and the acquisition of four new stores since the third
quarter of the prior year.
The Steel Manufacturing Business' cost of goods sold increased $13.1 million or
21% during the third quarter of fiscal 2005 as compared to the cost of goods
sold for the fiscal 2004 third quarter. As a percentage of revenues, cost of
goods sold decreased compared with the third quarter of fiscal 2004 from 89% to
84%. Average cost of goods sold per ton increased $31 per ton or 8% compared to
the prior year quarter, which was primarily caused by higher raw material costs
for recycled metal and alloys. This increase in cost of sales was more than
offset by the $62 per ton increase in average net selling price, and gross
profit improved by $6.2 million, to $14.3 million for the quarter.
JOINT VENTURES. The Joint Ventures in the metals recycling business
predominantly sell recycled ferrous and nonferrous metals. Revenues for this
segment in the third quarter of fiscal 2005 increased $11.5 million or 2%
compared with the prior year quarter primarily due to higher average net selling
prices per ton offset by a 3% decrease in the volume of ferrous recycled metal
sold from the prior year quarter. The overall 3% decrease in ferrous metal sales
volume of the Joint Ventures resulted from a 25% decrease in tons sold by the
processing Joint Ventures offset by a 35% increase in tons sold by the trading
Joint Venture. The decrease in volume for the processing Joint Ventures is
primarily due to the timing of export shipments and adverse weather conditions
in the Northeastern United States during the Company's second fiscal quarter
that led to a shortage of unprocessed metal available for processing and sale
during the Company's third quarter.
23
SCHNITZER STEEL INDUSTRIES, INC.
The Company's share of Joint Venture operating income for the third quarter of
fiscal 2005 decreased to $11.2 million from $28.0 million in the third quarter
of fiscal 2004. The decrease in operating income from these Joint Ventures
resulted from decreases in both sales volume and margin per ton for the
processing Joint Ventures and an operating loss despite increased sales volume
for the trading Joint Venture. Margins for the processing Joint Ventures were
affected by higher purchase costs for unprocessed ferrous metals. These
conditions were more pronounced in the Joint Venture locations the Company will
receive as part of the agreement to separate and terminate the joint ventures
with Hugo Neu Corporation identified in Note 9 of Notes to Consolidated
Financial Statements. The Company's share of the results of the trading Joint
Venture was an operating loss in the Company's third quarter of fiscal 2005 of
$0.8 million as compared with operating income of $2.9 million in the same
quarter of the prior fiscal year. This decrease was due to the decline in sales
prices from second quarter 2005 levels and the related impact of selling
inventories purchased before the selling prices began decreasing and a $0.7
million adjustment to mark quarter-end inventory down to the net realizable
value.
On June 9, 2005, the Company announced the signing of an agreement to separate
and terminate its metals recycling joint ventures with Hugo Neu Corporation,
with closing of the transaction expected near the end of fiscal 2005. See Note 9
of Notes to Consolidated Financial Statements for details of the agreement.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE. Compared with the third quarter of
fiscal 2004, selling, general and administrative expense for the same quarter
this fiscal year increased $0.9 million or 6%. The increase is a result of
increased legal and professional fees, including $1.6 million related to the
Audit Committee's investigation of payment practices in the Far East as
discussed in Note 5 to the consolidated financial statements, a $1.2 million
increase in expense for the Auto Parts Business primarily related to changes in
management infrastructure to allow growth of this business segment and expenses
related to the addition of four new stores, and the accelerated vesting of stock
options of $0.6 million, offset by a $2.9 million decrease in bonus expense. The
Company's bonus program considers both operating income and the utilization of
operating assets to determine bonus expense. As a result, the Company's
anticipated bonus expense is less than the prior year. As a percentage of
revenues, selling, general and administrative expense has decreased by 0.7%
percentage points, from 7.4% to 6.7% due to spreading these expenses over higher
revenues.
INTEREST EXPENSE. Interest expense for the third quarter of fiscal 2005
decreased 80% to $0.1 million compared with the third quarter of fiscal 2004.
The decrease was a result of lower average debt balances during the fiscal 2005
third quarter compared with the fiscal 2004 quarter.
INCOME TAX PROVISION. The tax rate of 37.4% for this quarter of fiscal 2005 was
higher than the 34.9% rate for the same quarter last year primarily because the
Extraterritorial Income Exclusion (ETI) tax benefit on export sales is projected
to decrease.
FIRST NINE MONTHS OF FISCAL 2005 COMPARED TO FIRST NINE MONTHS OF FISCAL 2004
RESULTS OF OPERATIONS
- ---------------------
REVENUES. Consolidated revenues for the nine months ended May 31, 2005 increased
$157.8 million or 33% to $641.5 million from $483.7 million for the same period
last year. The higher revenues were attributed to higher sales volume for the
Metals Recycling Business and higher average net selling prices for both the
Metals Recycling Business and the Steel Manufacturing Business as well as higher
wholesale and retail revenues for the Auto Parts Business. Revenues in the first
nine months of fiscal 2005 increased for the Metals Recycling Business primarily
as a result of increased sales volume and prices in the worldwide ferrous metals
market. Significant improvements in demand, coupled with higher raw material
cost led to increases in selling prices for finished steel products sold by the
Steel Manufacturing Business. Auto Parts Business revenues benefited from
increased prices for sales of autobodies and higher core sale revenues. In
addition, the Auto Parts Business
24
SCHNITZER STEEL INDUSTRIES, INC.
acquired four retail locations in the second quarter of fiscal 2005 that added
both revenue and operating income to the segment over the prior year.
The Metals Recycling Business generated revenues of $447.3 million for the nine
month period ended May 31, 2005, before intercompany eliminations, which was an
increase of $120.4 million or 37% over the same period of the prior year.
Ferrous revenues increased $107.4 million, or 38% to $390.0 million as a result
of higher average selling prices net of shipping cost (average net selling
prices), higher shipping costs and an increase in the volume sold. The average
net sales price for ferrous metals increased 32% to $236 per ton, which
represents $82.2 million of the revenue increase over the prior year nine month
period. The cost of freight that was included in revenues increased by $9.6
million over the prior year period due primarily to higher ocean chartering
costs. Average export shipping costs increased 15% over the same period in the
prior year. Total ferrous sales volumes increased by approximately 87,000 tons
or 6%, which represents $15.6 million of the revenue increase over the prior
year nine month period and was primarily due to normal variation in the timing
of when orders are received and ultimately sold.
Sales to the Steel Manufacturing Business increased by 11,000 tons or 2% to
459,000 tons due to increased production as a result of the new furnace
installed in December 2004. Nonferrous revenue increased $12.4 million or 31% to
$52.0 million due to higher average selling prices and higher volumes. The
average net nonferrous selling price in the nine months ended May 31, 2005 was
$0.55 per pound, an increase of $0.07 per pound or 14%. In addition, sales
volume increased 16% to 93.9 million pounds. The increases in average selling
price and volume are related to strong worldwide demand, especially from Asia,
and improved by-product recoveries of nonferrous metals from the ferrous metals
shredding process.
The Auto Parts Business generated revenue of $78.8 million, before intercompany
eliminations, for the nine months ended May 31, 2005, which is an increase of
$20.6 million or 35% over the same period of the prior year. This increase was a
result of higher wholesale revenues driven by higher average sales prices for
scrapped autobodies due to rising ferrous recycled metal prices and higher core
sale revenues in both the Company's recently acquired and existing store
locations. In addition, retail revenues increased as a result of the acquisition
of four retail store locations in January 2005.
The Steel Manufacturing Business generated revenues of $228.2 million for the
nine months ended May 31, 2005, which was an increase of $43.1 million, or 23%
over the same period of the last fiscal year. The average net selling price
increased $151 per ton, or 41% to $519 per ton, which represents a $63.8 million
increase in revenue. The increase in average net selling prices was due to a
combination of factors including increased worldwide steel consumption and
higher raw material costs that manufacturers passed through. However, sales
volumes decreased 12% to 423,000 tons, which reduced revenues by $21.0 million.
The lower sales volume during the first nine months of fiscal 2005 was primarily
due to abnormally high inventory levels held by fabricators and distributors of
steel during the first half of fiscal 2005. Many of the Company's customers used
the normal seasonal decline in consumption during the winter months to reduce
their inventory levels.
COST OF GOODS SOLD. Consolidated cost of goods sold increased $78.7 million or
21% for the nine months ended May 31, 2005, compared with the same period last
year. Cost of goods sold decreased as a percentage of revenues from 79% to 72%.
Gross profit increased $79.0 million to $178.7 million during the latest nine
month period compared to the same period in the prior year, driven by profit
margin improvements at the Company's Metals Recycling, Auto Parts and Steel
Manufacturing Business segments.
25
SCHNITZER STEEL INDUSTRIES, INC.
Cost of goods sold for the Metals Recycling Business increased $74.1 million or
29% to $333.1 million. As a percentage of revenues, cost of goods sold decreased
compared with the first nine months of fiscal 2004 from 79% to 75%. Gross profit
increased by $46.2 million to $114.1 million. The increase in gross profit was
primarily attributable to higher average net selling prices per ton, a decrease
in cost of goods sold related to inventory adjustments and higher sales volumes.
During the second quarter of fiscal 2005, several piles of ferrous metal
inventory were fully utilized revealing higher inventory volumes than the
Company had previously estimated, resulting in a decrease in cost of goods sold
of $5.4 million for the inventory adjustments. Compared with the first nine
months of last year, the average ferrous metals cost of sales per ton increased
25% due primarily to higher purchase costs for unprocessed ferrous metals.
Generally, a change in the cost of unprocessed metal has a strong correlation to
changes in the average selling price. Thus, as selling prices rose compared with
the first nine months of last year, so did the cost of unprocessed ferrous
metal.
The Auto Parts Business' cost of goods sold increased $13.7 million or 42% for
the nine months ended May 31, 2005 as compared to the cost of goods sold for the
same period of last fiscal year. The higher cost of sales was primarily due to
higher car purchase costs that resulted from higher scrap metal prices and the
addition of seven new stores since the beginning of last year. As a percentage
of revenues, cost of goods sold increased from 57% to 59% as compared to the
prior year period due to higher car purchase costs and the addition of the seven
new stores since the beginning of last year which earn a lower margin than the
previously owned stores. Gross profit increased $6.9 million or 27% related to
increased wholesale revenue earned from the higher market rates for scrap metals
and the addition of seven new stores since the beginning of last year.
The Steel Manufacturing Business' cost of goods sold increased $21.1 million or
12% to $193.8 million. As a percentage of revenues, cost of goods sold decreased
compared with the first nine months of fiscal 2004 from 93% to 85%. The average
cost of goods sold per ton increased $95 per ton or 28% compared to the prior
year nine month period, which was primarily caused by higher raw material costs
for recycled metal and alloys and the effects of the melt shop shut down in
December 2004. The increase in cost of sales was more than offset by the $151
per ton increase in average net selling price, and gross profit improved by
$22.0 million, to $34.4 million for the nine month period ended May 31, 2005.
The Steel Mill incurred approximately $5.0 million in costs during the second
quarter of fiscal 2005 related to the melt shop shut down and furnace
replacement project in December 2004.
JOINT VENTURES. The Joint Ventures in the metals recycling business
predominantly sell recycled ferrous and nonferrous metals. Revenues for this
segment in the first nine months of fiscal 2005 increased $503.7 million or 43%
compared with the same period last year primarily due to 30% and 39% increases
in average net selling prices per ton for the processing and trading businesses,
respectively, and a 13% increase in the volume of ferrous recycled metal sold,
over the prior year period. The increase in the average net selling price per
ton was due to the same supply and demand circumstances described earlier for
the Company's wholly-owned businesses.
The Company's share of Joint Venture operating income for the first nine months
of fiscal 2005 increased to $47.8 million from $42.6 million in the first nine
months of fiscal 2004. The increase in income from these Joint Ventures was
primarily caused by higher selling prices and volumes. The Company's share of
operating income from the trading joint venture decreased from $8.0 million in
the first nine months of fiscal 2004 to $6.2 million in the first nine months of
fiscal 2005, a 22% decrease. The Company's share of joint venture operating
income in the first nine months of fiscal 2005 included a charge of $2.6 million
for its share of environmental costs. During the second quarter of fiscal 2005,
in connection with the negotiation of the separation and termination of the
Company's metals recycling Joint Ventures with Hugo Neu Corporation, the Company
conducted an environmental due diligence investigation of certain joint venture
businesses it has now agreed to directly acquire, and identified certain
environmental risks for which estimated remediation costs were accrued.
26
SCHNITZER STEEL INDUSTRIES, INC.
On June 9, 2005, the Company announced the signing of an agreement to separate
and terminate its metals recycling joint ventures with Hugo Neu Corporation,
with closing of the transaction expected near the end of fiscal 2005. See Note 9
of Notes to Consolidated Financial Statements for details of the agreement.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE. Compared with the first nine months
of fiscal 2004, selling, general and administrative expense for the same period
this fiscal year increased $6.6 million or 20%. The increase is a result of
increased headcount of $2.6 million, increased legal and professional fees of
$3.5 million, the vesting of stock options for $1.0 million, and increased
administrative costs of $1.8 million related to new stores in the Auto Parts
Business segment, offset by a $3.2 million decrease in expense for the Company's
bonus program. Approximately $1.4 million of the increased headcount costs are
related to the development of the Auto Parts Business' management infrastructure
to allow growth of this business segment. The increase in legal and professional
fees is the result of approximately $2.5 million incurred related to the
investigation of payment practices in the Far East, as discussed in Note 5 to
the condensed consolidated financial statements, with an additional $1.0 million
spent on compliance with Sarbanes-Oxley and the use of outside experts to advise
or assist the Company in various projects. The Company's bonus program considers
both operating income and the utilization of operating assets to determine bonus
expense. As a result, the Company's anticipated bonus expense is less than the
prior year. As a percentage of revenues, selling, general and administrative
expense has decreased by 0.7% percentage points, from 6.8% to 6.1% due to
spreading these expenses over higher revenues.
ENVIRONMENTAL MATTERS. During the first nine months of fiscal 2005, the Company
recorded environmental charges of $8.2 million for additional estimated costs
related to the ongoing remediation of the head of the Hylebos Waterway adjacent
to the Company's Tacoma, Washington metals processing facility. An estimate of
this liability was initially recognized as part of the 1995 acquisition of the
Tacoma facility. The cost estimate was based on the assumption that dredge
removal of contaminated sediments would be accomplished within one dredge season
during July 2004 - February 2005. However, due to a variety of factors,
including equipment failures, dredge contractor operational issues and other
dredge related delays, the dredging was not completed during the first dredge
season. As a result, the Company increased its environmental accrual by $8.2
million related to this project primarily to account for additional estimated
costs to complete this work during a second dredging season. The Company has
filed a lawsuit against the dredge contractor to recover a significant portion
of the increased costs. However, generally accepted accounting principles do not
allow the Company to recognize the benefits of any such recovery until receipt
is highly probable.
INTEREST EXPENSE. Interest expense for the first nine months of fiscal 2005
decreased 50% to $0.7 million compared with the first nine months of fiscal
2004. The decrease was a result of lower average debt balances during the first
nine months of fiscal 2005 compared with the same period in fiscal 2004.
INCOME TAX PROVISION. The tax rate of 35.6% for the first nine months of fiscal
2005 was higher than the 30.5% rate for the same period last year for two main
reasons. First, the Extraterritorial Income Exclusion (ETI) tax benefit on
export sales is projected to decrease. Secondly, last year's tax rate benefited
from the final release of a valuation allowance that had once offset net
operating losses. The 35.6% rate approximates the 35% Federal statutory rate
because the projected ETI benefits are largely offset by the projected state
income taxes.
LIQUIDITY AND CAPITAL RESOURCES
Cash provided by operations for the nine months ended May 31, 2005 was $67.0
million compared with $15.5 million for the same period in the prior fiscal
year. The increase primarily resulted from the corresponding increase in net
income offset by a $19.8 million increase in inventory at the Steel
Manufacturing Business. The increase in inventory is a result of higher
inventory prices due to increases in raw material costs and maintaining a higher
quantity on hand to better meet customer demand, balance production on the
rolling mills and prepare for the expected fourth quarter shut down to replace
the transformer.
27
SCHNITZER STEEL INDUSTRIES, INC.
Capital expenditures for the nine months ended May 31, 2005 were $40.8 million
compared with $17.0 million during the first nine months of fiscal 2004. On May
11, 2005, the Company purchased its Portland metals recycling facility for $20.0
million; the facility was formerly leased by the Company for $1.8 million per
year (see additional discussion in Note 6 of Notes to Consolidated Financial
Statements). The increase in capital expenditures was also due to capital
improvement projects at the Company's Oakland, California recycling facility and
the furnace installation at the Company's steel mill. The Company expects to
spend up to $20 million on capital improvement projects during the remainder of
fiscal 2005.
Accrued environmental liabilities as of May 31, 2005 were $21.8 million. Over
the next 12 months, the Company expects to pay approximately $6.2 million
relating to previously accrued remediation projects including the remediation on
the Hylebos Waterway as discussed in Note 4 to the consolidated condensed
financial statements. Additionally, the Company anticipates future cash outlays
as it incurs the actual cost relating to the remediation of identified
environmental liabilities. The future cash outlays are anticipated to be within
the amounts established as environmental liabilities.
As of May 31, 2005, the Company had a committed unsecured bank credit facility
totaling $150 million that matures in May 2006. The credit facility contains a
provision whereby the Company may, upon obtaining consent of the bank group,
extend the term of the agreement by one year to May 2007. The Company has
provided notice of its intention to request such an extension and the bank group
has agreed to the request. The extension is subject to the Company providing
standard representations and warranties as of the May 2006 original maturity
date. The Company currently anticipates it will be able to provide the required
representations and warranties and the agreement will be extended. The Company
also has additional unsecured credit lines totaling $20 million, which are
uncommitted. The Company's debt agreements have certain restrictive covenants.
As of May 31, 2005, the Company had aggregate bank borrowings outstanding under
these facilities of $7.7 million and was in compliance with such covenants.
In July 2002, the Company's metals recycling joint ventures with Hugo Neu
Corporation entered into a revolving credit facility (JV Credit Facility) with a
group of banks for working capital and general corporate purposes. Prior to that
time, the joint ventures' working capital and other cash needs had been met by
advances provided equally by the Company and its partner, Hugo Neu Corporation.
During February 2004, the facility was increased to $110 million. The JV Credit
Facility expires on July 31, 2005 and is secured by the inventory and
receivables of the joint venture businesses. The joint venture has requested an
extension of the maturity date of the facility until December 31, 2005, but at
this time the extension has not been granted. The Company is not a guarantor of
the JV Credit Facility. The JV Credit Facility has a number of covenants and
restrictions, including restrictions on the level of distributions to the joint
venture partners. The joint ventures were in compliance with these covenants as
of May 31, 2005. As of May 31, 2005, $47.9 million was outstanding under the JV
Credit Facility, compared to no borrowings at August 31, 2004. The increase in
borrowings outstanding since August 31, 2004 was primarily the result of
increases in inventory and accounts receivable related to the timing of
purchases and sales of inventory.
Upon the closing of the agreement for the separation and termination of the
Company's joint ventures with Hugo Neu Corporation (HNC) as described in Note 9
of Notes to Consolidated Financial Statements, HNC will pay the Company
approximately $52 million in cash. In addition, the agreement provides that each
joint venture will make a final cash distribution equally to the two partners in
an amount equal to the net income of the joint venture for the period from
September 1, 2004 through the closing date, less any distributions of such
income made prior to the closing (of which the Company had received $23.3
million as of May 31, 2005). If necessary, cash to fund these distributions may
be borrowed under the JV Credit Facility. Following such distributions, the
Company and HNC shall each be obligated to repay the portion of the JV Credit
Facility borrowed on behalf of the joint venture businesses it acquired in the
transaction.
28
SCHNITZER STEEL INDUSTRIES, INC.
The Company makes contributions to a defined benefit pension plan, several
defined contribution plans and several multiemployer pension plans.
Contributions vary depending on the plan and are based upon plan provisions,
actuarial valuations and negotiated labor agreements. The Company anticipates
making contributions of approximately $6.0 million to the various pension plans
in fiscal 2005.
Pursuant to a stock repurchase program approved in 1996, the Company is
authorized to repurchase up to 3.0 million shares of its stock when the market
price of the Company's stock is not reflective of management's opinion of an
appropriate valuation of the stock. Management evaluates long and short range
forecasts as well as anticipated sources and uses of cash before determining the
course of action that would best enhance shareholder value. As a result, during
fiscal 2004 and 2005, the Company has made significant investments in capital
equipment and has completed several acquisitions to both grow the business and
enhance shareholder value. The Company is currently engaged in a growth strategy
to enhance shareholder value. During the first nine months of fiscal 2005, the
Company made no share repurchases. As of May 31, 2005, the Company had
repurchased a total of 1.3 million shares under this program.
The Company believes its current cash resources, internally generated funds,
existing credit facilities and access to the capital markets will provide
adequate financing for capital expenditures, working capital, joint ventures,
stock repurchases, debt service requirements, post retirement obligations and
future environmental obligations for the next twelve months. In the longer term,
the Company may seek to finance business expansion with additional borrowing
arrangements or additional equity financing.
OUTLOOK.
Recycled metal markets continue to experience significant price volatility;
however, consumption remains strong. Over the last 60 days, market selling
prices for ferrous metal declined, but recent export market activity has shown
evidence that prices may have firmed and even risen modestly on some individual
sales. The Company's wholly-owned Metals Recycling Business traditionally takes
ferrous export orders 60 to 90 days ahead of shipment, which may provide
management with the ability to adjust its buying prices to minimize the margin
impact of changes in selling prices. Ocean freight rates have declined sharply
in recent weeks, which partially mitigates the reduction in ferrous selling
prices. Based upon the wholly-owned Metals Recycling Businesses' current order
backlog, contracted average net selling prices that are anticipated to be
shipped in the fourth fiscal quarter of 2005 will be lower than the $230 per ton
average reported in the third quarter of fiscal 2005, but should remain above
the $199 per ton reported in last year's fourth fiscal quarter. Fourth quarter
2005 sales volumes are anticipated to be below the fiscal 2005 quarterly run
rate, but total fiscal 2005 sales volume should approximate last year's level.
The lower fourth quarter sales volumes are due in part to the timing of export
shipping dates and lower fourth quarter inventory levels. The cost of
unprocessed ferrous metal also remains very competitive and volatile.
Joint ventures in the metals recycling business are expected to experience
similar market trends as the Company's wholly-owned Metals Recycling Business;
however, their financial results will vary depending on a number of factors
including geographic locations, competition and available inventory.
29
SCHNITZER STEEL INDUSTRIES, INC.
The Auto Parts Business generally experiences modest seasonal declines in retail
demand in the summer months due to hot weather conditions reducing customer
admissions. Wholesale revenues are anticipated to have mixed results during the
fiscal 2005 fourth quarter; core sales volumes and pricing should remain strong,
but prices for crushed auto bodies are expected to be lower than the prices
realized during the third quarter of fiscal 2005 due to the recent decline in
ferrous metal selling prices. Over the last few quarters the business has
incurred increasing costs to procure automobile inventories due to rising
ferrous metal prices. In recent weeks, the business has reduced its prices paid
to procure inventory and is anticipated to continue to do so through the balance
of the fourth quarter. However, fourth quarter margins are anticipated to be
affected as the higher priced inventory is sold and replaced by lower cost
automobiles.
West Coast consumption of finished steel long products remains strong. The Steel
Manufacturing Business continues to experience good overall demand. In May 2005
the Company announced a $30 per ton price decrease for rebar and merchant bar
products, which was in reaction to declines by other domestic competitors. Also,
in early July, the Company announced a similar decrease for wire rod products.
The announced price decreases are anticipated to result in a modest decline in
fourth quarter average selling prices as compared to the third quarter of fiscal
2005 and the fourth quarter of fiscal 2004. The reduction in average selling
prices is anticipated to be partially mitigated by declines in ferrous metal
purchase prices. Fourth quarter 2005 sales volumes should approximate 155,000
tons, which should approximate the estimated volume of steel produced during the
period.
The Company's effective fourth quarter tax rate should approximate 36%.
FACTORS THAT COULD AFFECT FUTURE RESULTS. Management's Discussion and Analysis
of Financial Condition and Results of Operations, particularly "Outlook" above,
contains forward-looking statements, within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Act of 1934, that are
made pursuant to the safe harbor provisions of the Private Securities Litigation
Reform Act of 1995. One can generally identify these forward-looking statements
because they contain "expect", "believe" "anticipate", "estimate" and other
words which convey a similar meaning. One can also identify these statements as
they do not relate strictly to historical or current facts. Examples of factors
affecting Schnitzer Steel Industries, Inc.'s consolidated operations and its
joint ventures (the Company) that could cause actual results to differ
materially are the following:
Cyclicality and General Market Considerations: Purchase and selling prices for
recycled metals are highly cyclical in nature and subject to worldwide economic
conditions. In addition, the cost and availability of recycled metals are
subject to global supply and demand conditions which are volatile and beyond the
Company's control, resulting in periodic fluctuations in recycled metals prices
and working capital requirements. While the Company attempts to maintain and
grow margins by responding to changing recycled metals selling prices through
adjustments to its metals purchase prices, the Company's ability to do so is
limited by competitive and other market factors. Additionally, changing prices
could potentially impact the volume of recycled metal available to the Company,
the subsequent volume of processed metal sold by the Company, inventory levels
and the timing of collections and levels relating to the Company's accounts
receivable balances. Moreover, increases in recycled metals selling prices can
adversely affect the operating results of the Company's Steel Manufacturing
Business because increases in steel prices generally lag increases in ferrous
recycled metals prices.
The steel industry is also highly cyclical in nature and sensitive to general
economic conditions. Future economic downturns or a stagnant economy may
adversely affect the performance of the Company.
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SCHNITZER STEEL INDUSTRIES, INC.
The Company expects to continue to experience seasonal fluctuations in its
revenues and net income. Revenues can fluctuate significantly quarter to quarter
due to factors such as the seasonal slowdown in the construction industry, which
is an important buyer of the Company's finished steel products. In addition,
weather and economic conditions n the United States and abroad can also cause
fluctuations in revenue and net income.
Another factor which may affect revenues relates to the seasonal reduction in
demand from foreign customers who tend to reduce their finished steel production
and corresponding scrap metal requirements, during the summer months to offset
higher energy costs. Also, severe weather conditions may affect the Company's
global market conditions.
The Company makes a number of large ferrous recycled metals shipments to foreign
steel producers each year. Customer requirements, shipping schedules and other
factors limit the Company's control over the timing of these shipments.
Variations in the number of foreign shipments from quarter to quarter will
result in fluctuations in quarterly revenues and earnings. The Company's
expectations regarding ferrous metal sales prices and volumes, as well as
earnings, are based in part on a number of assumptions which are difficult to
predict (for example, uncertainties relating to customer orders, metal
availability, estimated freight rates, ship availability, weather, cost and
volume of unprocessed inventory and production output, etc.).
The Auto Parts Business experiences modest seasonal fluctuations in demand. The
retail stores are open to the elements. During periods of extreme temperatures
and precipitation, customers tend to delay their purchases and wait for milder
conditions. As a result, retail sales are generally higher during the spring and
fall of each calendar year and lower in the winter and summer months.
Additionally, the Auto Parts Business is subject to a number of other risks that
could prevent it from maintaining or exceeding its current levels of
profitability, such as volatile supply and demand conditions affecting prices
and volumes in the markets for its products, services and raw materials;
environmental issues; local and worldwide economic conditions; increasing
competition; changes in automotive technology; the ultimate success of the
Company's growth and acquisition plans; ability to build the infrastructure to
support the Company's growth plans; and business integration and management
transition issues.
Competition: The recycled metals industry is highly competitive, with the volume
of purchases and sales subject to a number of competitive factors, principally
price. The Company competes with both large and numerous smaller companies in
its markets for the purchase of recyclable metals. The Company also competes
with a number of domestic and foreign recycled metals processors and brokers for
processed and unprocessed metal as well as for sales to domestic and foreign
customers. For example, in 2001 and 2002, lower cost ferrous recycled metals
supplies from certain foreign countries adversely affected market selling prices
for ferrous recycled metals. Since then, many of these countries have imposed
export restrictions which have significantly reduced their export volumes and
lowered the worldwide supply of ferrous recycled metals. These restrictions are
believed to have had a positive effect on the Company's selling prices. Given
the intricacies in which the global markets operate, the Company cannot predict
when or if foreign countries will change their trading policies and what effect,
if any, such changes might have on the Company's operating results.
From time to time, both the United States and foreign governments impose
regulations and restrictions on trade in the markets in which the Company
operates. In the second quarter of fiscal 2005, the Company received a
certificate from China that allows the Company to continue shipping recycled
metals into China. The certificate is part of a process designed to ensure safe
industrial and agricultural production in China. Also, it is not unusual for
various constituencies to petition government entities to impose new
restrictions or change current laws. If imposed, these restrictions could affect
the Company's margins as well as its ability to ship goods to foreign customers.
Alternatively, restrictions could also affect the global availability of ferrous
recycled metals, thereby affecting the Company's volumes and margins. As a
result, it is difficult to predict what, if any, impact pending or future trade
restrictions will have on the operations of the Company.
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SCHNITZER STEEL INDUSTRIES, INC.
For the Metals Recycling Business, some of the more significant domestic
competitors include regional steel mills and their brokers who compete for
recycled metal for the purpose of providing the mills with feedstock to produce
finished steel. During periods when market supplies of metal are in short
supply, these buyers may, at times, react by raising buying prices to levels
that are not reasonable in relation to more normal market conditions. As a
result, the Company may have to raise its buying prices to maintain its
production levels which may result in compressed margins.
The Auto Parts Business competes with both full-service and self-service auto
dismantlers as well as larger well financed more traditional retail auto parts
chains for retail customers. Periodically, the Auto Parts Business increases
prices, which may affect customer flow and buying patterns. Additionally, in
markets where the Company has only a few stores, it does not have the same
pricing power it experiences in markets where it has more than one store in
which it operates. As this segment expands, the Company may experience new
competition from others attempting to replicate the Company's business model.
The ultimate impact of these dynamics cannot be predicted. Also, the business
competes for its automobile inventory with other dismantlers, used car dealers,
auto auctions and metal recyclers. Inventory costs can fluctuate significantly
depending on market conditions and prices for recycled metal.
The domestic steel industry also is highly competitive. Steel prices can be
highly volatile and price is a significant competitive factor. The Company
competes domestically with several steel producers in the Western United States
for sales of its products. In recent years, the Company has experienced
significant foreign competition, which is sometimes subsidized by large
government agencies. There can be no assurance that such competition will not
increase in the future. In the spring of 2002, the U.S. Government imposed
anti-dumping and countervailing duties against wire rod products from eight
foreign countries. These duties have assisted the Company in increasing sales of
wire rod products; any expiration or termination of the duties could have a
corresponding adverse effect. The Company has experienced increased competition
for certain products by foreign importers during fiscal 2005. The Company
believes that the rise in import levels is attributable to the increase in
selling prices in the West Coast market, which potentially allow the import
sales to be more profitable to the foreign companies.
The steel manufacturing industry has been consolidating over the last several
years and as a result several west coast manufacturing facilities have been
closed and remain idle. Any future start-up of operations of the currently idle
facilities could negatively impact the Company's recycled metal and finished
steel markets, prices, margins and potentially, cash flow.
Geographical Concentration: The Company competes in the scrap metal business
through its wholly-owned Metals Recycling Business as well as through its joint
venture businesses. Over the last few years, a significant portion of the
revenues and operating profits earned in these segments have been generated from
sales to Asian countries, principally China and South Korea. In addition, the
Company's sales in these countries are also concentrated with relatively few
customers that vary depending on buying cycles and general market conditions.
Due to the concentration of sales in these countries and to a relatively small
customer base, a significant change in buying patterns, change in political
events, change in regulatory requirements, tariffs and other export restrictions
within the United States or these foreign countries, severe weather conditions
or general changes in economic conditions could adversely affect the financial
results of the Company.
Ferrous Sales to Far East: As discussed in Part II, Item 1 "Legal Proceedings"
in this Form 10-Q, the Company recently terminated its practice of paying
commissions to the purchasing managers of customers in connection with export
sales of recycled ferrous metals to the Far East. Termination of this practice
could put the Company at a competitive disadvantage and could have a negative
impact on the Company's ferrous metal sales volumes and prices. In addition,
termination of this practice could have a greater impact under weaker ferrous
metal market conditions. The Company is therefore unable to determine whether
the termination of this practice will have an adverse effect on its customer
relationships or business.
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SCHNITZER STEEL INDUSTRIES, INC.
Union Contracts: The Company has a number of union contracts that expire in
fiscal year 2005. Labor contract negotiations opened during the second quarter
of fiscal 2005 with the union at the Steel Manufacturing Business. If the
Company is unable to reach agreement on the terms of a new contract with any of
these unions, the Company could be subject to work slowdowns or work stoppages.
Post Retirement Benefits: The Company has a number of post retirement benefit
plans that include defined benefit, Supplemental Executive Retirement Benefit
Plan (SERBP) and multiemployer plans. The Company's contributions to the defined
benefit and SERBP plans are based upon actuarial calculations which are based on
a number of estimates including the expected long-term rate of return on plan
assets, allocation of plan assets between equity or fixed income investments,
expected rate of compensation increases as well as other factors. Changes in
these actual rates from year to year cause increases or decreases in the
Company's annual contributions into the defined benefit plans and changes to the
expenses recognized in a current fiscal year. Management and the actuary
evaluate these rates annually and adjust if necessary.
The Company's union employees participate in a number of multiemployer pension
plans. The Company is not the sponsor or administrator of these multiemployer
plans. Contributions are determined in accordance with provisions of the
negotiated labor contracts. The Company is unable to determine its relative
portion or estimate its future liability under the multiemployer pension plans.
The Company learned during fiscal 2004 that one of the multiemployer plans of
the Steel Manufacturing Business would not meet ERISA minimum funding standards
for the plan year ending September 30, 2004. The trustees of that plan have
applied to the Internal Revenue Service (IRS) for certain relief from this
minimum funding standard. The IRS has tentatively responded, indicating a
willingness to consider granting the relief will be granted, provided the plan's
contributing employers, including the Company, agree to increased contributions.
The increased contributions are estimated to average 6% per year, compounded
annually, until the plan reaches the funded status required by the IRS. These
increases would be based on the Company's current contribution level to the plan
of approximately $2.2 million per year. The Plan Trustees have provided
information to the plan's contributing employers regarding the IRS proposed
contribution rate increases and are awaiting a commitment from the employers
before proceeding with the relief request.
Absent relief by the IRS, the plan's contributing employers will be required to
make additional contributions or pay excise tax that may equal or exceed the
full amount of that deficiency. The Company estimated its share of the required
additional contribution for the 2004 plan year to be approximately $1.1 million
and accrued for such amount in fiscal 2004. Future funding deficiency
assessments against the Company are possible until the multiemployer plan
obtains a waiver from the IRS or the plan reaches the minimum funded status
level required by the IRS.
Joint Ventures and Separation of HNC: The Company has significant investments in
joint venture companies, the most substantial of which are its five metals
recycling joint ventures with Hugo Neu Corporation (HNC). In each case, the
day-to-day activities of the joint venture business are managed by the Company's
joint venture partner, not the Company. As a result, the Company does not have
the same ability to control or predict the operations, cash flow, expenditures,
debt, and related financial results as it does with its consolidated businesses.
Therefore, it is difficult to predict the financial results of the joint
ventures.
In recent years, the Company's relationship with the chief executive officer of
HNC, its most significant joint venture partner, has deteriorated. There have
been disagreements regarding business decisions as well as personality clashes,
but the Company does not believe that these issues have materially affected the
operations or operating results of the joint ventures. The Company has disputed
HNC's recent unilateral assertion of a right to be paid certain commissions on
sales by the joint venture engaged in global trading of recycled metals, as
described in more detail in Note 5 of Notes to Consolidated Financial
Statements.
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SCHNITZER STEEL INDUSTRIES, INC.
On June 9, 2005, the Company announced the signing of an agreement to separate
and terminate its joint ventures with HNC, with closing of the transaction
expected near the end of fiscal 2005. See Note 9 of Notes to Condensed
Consolidated Financial Statements for details of the agreement. Closing of the
transaction is subject to a number of conditions, including obtaining certain
third party consents, permit amendments or transfers, and HNC obtaining required
financing. There can be no assurance that all conditions will be satisfied or
waived and the transaction closed.
The Company and HNC principally used historical earnings before interest and
taxes (EBIT) trends to arrive at an equitable separation of the various joint
venture assets. Since the second quarter of fiscal 2005, the businesses which
the Company is receiving have experienced challenging conditions that adversely
affected the financial results compared to historical EBIT trends and to the
businesses to be received by HNC. Management believes historical EBIT trends
used to separate the assets are good indicators of relative value, but
management is unable to predict the future performance of these businesses.
The Company depends on the efforts and abilities of its senior management and
other key employees. With the anticipated separation of the joint ventures with
HNC, the Company will be acquiring direct ownership of metals recycling
businesses in New England and Hawaii and a metals trading business in Russia and
the Baltic Sea region, the day-to-day operations of which are currently overseen
by HNC. The Company will depend on key employees of those businesses,
particularly those involved in the metals trading operations, becoming employed
by the Company and providing for the continuity of those businesses. Loss of key
personnel or other transition issues could adversely affect the Company.
The joint venture businesses are affected by many of the same risk factors
mentioned in this document. Additionally, two of these joint ventures continue
to use LIFO inventory accounting, which tends to defer income taxes.
Historically, the effects of LIFO adjustments, which are recorded during the
fourth quarter of each fiscal year, have been difficult to predict.
Replacement or Installation of Capital Equipment: The Company and its joint
venture partners install new equipment and construct facilities or overhaul
existing equipment and facilities (including export terminals) from time to
time. Some of these projects take several months to complete, require the use of
outside contractors and experts, require special permits and easements and have
higher degrees of risk. Examples of such major capital projects include the
installation of a mega-shredder at a metal recycling yard, the overhaul of an
export loading facility or the furnace replacement at the steel mill. Many times
in the process of preparing the site for installation, the Company is required
to temporarily halt or limit production for a period of time. If problems are
encountered during the installation and construction process, the Company may
lose the ability to process materials which may impact the amount of revenue it
is able to earn or may increase operating expenses. In either case, the
Company's ability to reasonably predict financial results may be hampered.
Reliance on Key Pieces of Equipment: The Company and its joint venture partners
rely on key pieces of equipment in the various manufacturing processes. Key
items include the shredders and ship loading facilities at the metals recycling
locations and the transformer, furnace, melt shop and rolling mills at the
Company's steel manufacturing business, including the electrical power and
natural gas supply into all of our locations. If one of these key pieces of
equipment were to have a mechanical failure and the Company were unable to
correct the failure, revenues and operating income may be adversely impacted.
Where practical, the Company has taken steps to reduce these risks such as
maintaining a supply of spare parts, performing a regular preventative
maintenance program and maintaining a well trained maintenance team that is
capable of making most of the Company's repairs.
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SCHNITZER STEEL INDUSTRIES, INC.
Energy Supply: The Company and its joint ventures utilize various energy sources
to operate their facilities. In particular, electricity and natural gas
currently represent approximately 8% of the cost of steel manufactured for the
Company's Steel Manufacturing Business. The Steel Manufacturing Business
purchases electric power under a long-term contract from McMinnville Water &
Light (McMinnville) which in turn relies on the Bonneville Power Administration
(BPA). Historically, these contracts have had favorable prices and are long-term
in nature. The Company's electrical power contract expires in September 2011. On
October 1, 2001, the BPA increased its electricity rates due to increased demand
on the West Coast and lower supplies. This increase was in the form of a Cost
Recovery Adjustment Clause (CRAC) added to BPA's contract with McMinnville. The
CRAC is an additional monthly surcharge on selected power charges to recover
costs associated with buying higher priced power during the West Coast power
shortage. Because BPA can adjust the CRAC every six months, it is not possible
to predict future rate changes.
The Steel Manufacturing Business also has a contract for natural gas at $4.50
per MMBTU. The current contract expires on May 31, 2009 and obligates the
business to purchase minimum amounts of gas at a fixed rate. Effective November
1, 2004, the natural gas rate was reduced to $4.39 per MMBTU. This is a take or
pay contract with a minimum average usage of 3,575 MMBTU per day. Gas not used
is sold on the open market and gains or losses are recorded in cost of sales.
If the Company is unable to negotiate favorable terms of electricity, natural
gas and other energy sources, this could adversely affect the performance of the
Company.
Environmental Matters: The Company records accruals for estimated environmental
remediation claims. A loss contingency is accrued when the Company's assessment
indicates that it is probable that a liability has been incurred and the amount
of the liability can be reasonably estimated. The Company's estimates are based
upon currently available facts and presently enacted laws and regulations. These
estimated liabilities are subject to revision in future periods based on actual
costs, new information or changes in laws and regulations.
Tax Laws: The Company's tax rate the last three years has benefited from state
income tax credits, from the federal Extraterritorial Income Exclusion (ETI) on
export sales, and from the final releases of a valuation allowance once
offsetting the net operating losses that had accompanied a 1996 business
acquisition. The Company's present and future tax rates will likely benefit only
from the first of these three factors because the recently-enacted American Jobs
Creation Act of 2004 (the Act) eliminated the ETI benefit and because there is
no further valuation allowance to release. Compensating for the Company's loss
of ETI benefit will be the new deduction under the Act for Qualified Production
Activities Income, but the effect of this new deduction on the Company's
effective tax rate will not be determinable until final regulations explaining
it are issued. Currently, a tax rate between 34% and 37% is projected for fiscal
2005.
Currency Fluctuations: Demand from the Company's foreign customers is partially
driven by foreign currency fluctuations relative to the U.S. dollar.
Strengthening of the U.S. dollar could adversely affect the competitiveness of
the Company's products in the markets in which the Company competes. The Company
has no control over such fluctuations and, as such, these dynamics could affect
the Company's revenues and earnings. The Company conducts most transactions in
U.S. dollars.
Shipping and Handling: Both the Metals Recycling Business and the Steel
Manufacturing Business often rely on third parties to handle and transport their
products to end users in a timely manner. The cost to transport the products can
be affected by circumstances over which the Company has no control such as fuel
prices, political events, governmental regulations on transportation and changes
in market rates due to carrier availability. In estimating future operating
results, the Company makes certain assumptions regarding shipping costs.
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SCHNITZER STEEL INDUSTRIES, INC.
The Steel Manufacturing Business relies on the availability of rail cars to
transport finished goods to customers and raw materials to the mill for use in
the production process. Market demand for rail cars along the west coast has
been very high which has reduced the number of rail cars available to the Steel
Manufacturing Business to transport finished goods. In addition, the Steel
Manufacturing Business utilizes rail cars to provide an inexpensive form of
transportation for delivering scrap metal to the mill for production. Although
the Company expects to be able to maintain an adequate supply of scrap metal, a
larger portion of those materials are anticipated to be delivered using trucks.
The Company anticipates this change in delivery may lead to increased raw
material costs.
Insurance: The cost of the Company's insurance is affected not only by its own
loss experience but also by cycles in the insurance market. The Company cannot
predict future events and circumstances which could cause rates to materially
change such as war, terrorist activities or natural disasters.
Asset Acquisition and Disposition: Throughout the Company's history, it has made
a number of acquisitions and divestures as management attempts to improve the
value of the Company for its shareholders. Over the last few years this activity
has principally been limited to acquisitions related to the Auto Parts Business.
It is anticipated that the Company will continue to pursue additional expansion
of the Auto Parts Business as well as other business segments. Each acquisition
or disposition comes with its own inherent risks that make it difficult to
predict the ultimate success of the transaction. An acquisition or disposition
may have a negative and/or unexpected impact on the Company's cash flow,
operating income, net income, earnings per share and financial position.
Intercompany Sales: The Auto Parts Business sells autobodies to the Metals
Recycling Business, and the Metals Recycling Business sells ferrous recycled
metal to the Steel Manufacturing Business, at prices that are intended to
approximate market. When the Company consolidates its results in accordance with
generally accepted accounting principles, the Company eliminates the
intercompany sales and purchases and also eliminates the estimated profit
remaining in inventory ("Profit Elimination") at the end of each reporting
period. In estimating future operating and financial performance, the Company
makes assumptions regarding the forecasted Profit Elimination computation and
its impact on the quarterly financial results of the Company. Small variations
in price, sales volume, production volume, and purchase prices and volumes from
both within the Company and from third parties can result in significant
differences between forecasted Profit Elimination and actual results.
It is not possible to predict or identify all factors that could cause actual
results to differ from the Company's forward-looking statements. Consequently,
the reader should not consider any such list to be a complete statement of all
potential risks or uncertainties. Further, the Company does not assume any
obligation to update any forward-looking statement.
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SCHNITZER STEEL INDUSTRIES, INC.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company periodically uses derivative financial instruments to limit exposure
to changes in interest rates. Because such derivative instruments are used
solely as hedges and not for speculative trading purposes, they do not represent
incremental risk to the Company. For further discussion of derivative financial
instruments, refer to "FAIR VALUE OF FINANCIAL INSTRUMENTS" in the consolidated
Financial Statements included in Item 8 of Form 10-K for the fiscal year ended
August 31, 2004.
ITEM 4. CONTROLS AND PROCEDURES
Schnitzer Steel Industries, Inc. management, under supervision of the Chief
Executive Officer and Chief Financial Officer, is responsible for establishing
and maintaining disclosure controls and procedures for Schnitzer Steel
Industries, Inc. and its subsidiaries. As of May 31, 2005, with the
participation of the Chief Executive Officer and the Chief Financial Officer,
management completed an evaluation of the Company's disclosure controls and
procedures. Based upon this evaluation, the Company's Chief Executive Officer
and Chief Financial Officer have concluded that the disclosure controls and
procedures as of May 31, 2005 are effective to ensure that all material
information relating to Schnitzer Steel Industries, Inc. and its subsidiaries is
made known to them by others within the organization as appropriate to allow
timely decisions regarding required disclosures.
There were no changes in the Company's internal control over financial reporting
during the third fiscal quarter that have materially affected, or are reasonably
likely to materially affect, the internal control over financial reporting.
The Company's Audit Committee may, as a result of its investigation into Far
East payment practices discussed in Part II, Item 1 immediately below, recommend
improvements to certain aspects of the Company's internal control over financial
reporting and/or disclosure controls and procedures related to Far East
transactions.
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SCHNITZER STEEL INDUSTRIES, INC.
PART II
ITEM 1. LEGAL PROCEEDINGS
The Company was advised in 2004 that its practice of paying commissions to the
purchasing managers of customers in connection with export sales of recycled
ferrous metals to the Far East may raise questions of possible violations of
U.S. and foreign laws, and the practice was stopped. Thereafter, the Audit
Committee was advised and conducted a preliminary compliance review. On November
18, 2004, on the recommendation of the Audit Committee, the Board of Directors
authorized the Audit Committee to engage independent counsel and conduct a
thorough, independent investigation and directed that the existence and the
results of the investigation be voluntarily reported to the U.S. Department of
Justice (DOJ) and the Securities and Exchange Commission (SEC), and that the
Company cooperate fully with those agencies. The Board, through its Audit
Committee, is continuing its independent investigation, which is being conducted
by an outside law firm. The Company has notified the DOJ and the SEC of the
investigation; has instructed the outside law firm to provide those agencies
with the information obtained as a result of the investigation; and is
cooperating fully with those agencies. The investigation is not expected to
affect the Company's previously reported financial results, including those
reported in this 10-Q. The Company cannot predict the results of the
investigation or whether the Company or any of its employees will be subject to
any penalties or other remedial actions following completion of the
investigation.
ITEM 6. EXHIBITS
3.2 Restated Bylaws of the Company.
31.1 Certification of Chief Executive Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350 as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C.
Section 1350 as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
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SCHNITZER STEEL INDUSTRIES, INC.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SCHNITZER STEEL INDUSTRIES, INC.
(Registrant)
Date: July 6, 2005 By: /s/ Kelly E. Lang
-------------- ------------------------------
Kelly E. Lang
Acting Chief Financial Officer
39