10-Q 1 tenq3rd04.txt THIRD QUARTER 10-Q 2004 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 October 2, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM-- to-- . Commission File Number 0-599 THE EASTERN COMPANY ------------------- (Exact Name of Registrant as specified in its charter) Connecticut 06-0330020 ----------- ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 112 Bridge Street, Naugatuck, Connecticut 06770 ----------------------------------------- ----- (Address of principal executive offices) (Zip Code) (203) 729-2255 -------------- (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No-- . Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes-- No X . Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding as of October 2, 2004 ----- --------------------------------- Common Stock, No par value 3,632,221 -1- PART I FINANCIAL INFORMATION THE EASTERN COMPANY AND SUBSIDIARIES ITEM I CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
ASSETS October 2, 2004 January 3, 2004 --------------- --------------- CURRENT ASSETS Cash and cash equivalents $ 3,307,054 $ 4,896,816 Accounts receivable, less allowances: 2004 - $303,000; 2003 - $302,000 14,782,688 11,036,760 Inventories 19,618,508 16,926,548 Prepaid expenses and other 2,219,354 1,642,513 Deferred income taxes 321,700 462,700 ------------- ------------- Total Current Assets 40,249,304 34,965,337 -------------------- Property, plant and equipment 44,325,073 42,819,165 Accumulated depreciation (20,248,487) (17,888,740) ------------- ------------- 24,076,586 24,930,425 Goodwill and trademarks 10,553,626 10,687,373 Patents, technology and licenses, less accumulated amortization 1,915,823 1,877,408 Intangible pension asset 964,592 964,592 Prepaid pension cost 1,090,013 1,192,281 ------------- ------------- TOTAL ASSETS $ 78,849,944 $ 74,617,416 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable $ 7,060,236 $ 4,246,633 Accrued compensation 2,373,308 1,782,408 Other accrued expenses 2,515,868 2,034,918 Current portion of long-term debt 4,007,217 2,007,273 ------------- ------------- Total Current Liabilities 15,956,629 10,071,232 ------------------------- Deferred federal income taxes 1,243,264 1,243,264 Long-term debt, less current portion 11,858,295 15,814,669 Accrued postretirement benefits 2,261,058 2,384,770 Accrued rate swap obligation 228,612 580,055 Accrued pension obligation 4,015,858 4,015,858 Shareholders' Equity Preferred Stock, no par value Authorized shares - 2,000,000 (No shares issued) Common Stock, no par value: Authorized shares - 25,000,000 Issued and outstanding shares: 2004-3,632,221; 2003-3,616,039 excluding 1,680,342 in 2004 and 1,680,342 in 2003 shares held in treasury 897,237 664,949 Accumulated other comprehensive (loss): Foreign currency translation 22,541 (166,295) Additional minimum pension liability, net of taxes (4,049,886) (4,049,886) Derivative financial instruments, net of taxes (137,612) (348,055) ------------- ------------- (4,164,957) (4,564,236) Retained earnings 46,553,948 44,406,855 ------------- ------------- TOTAL SHAREHOLDERS' EQUITY 43,286,228 40,507,568 ------------- ------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 78,849,944 $ 74,617,416 ============= =============
See accompanying notes. -2- THE EASTERN COMPANY AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
Nine Months Ended Three Months Ended Oct. 2, 2004 Sept. 27, 2003 Oct. 2, 2004 Sept. 27, 2003 ------------ -------------- ------------- -------------- Net sales $75,357,662 $65,045,930 $25,494,490 $21,864,105 Cost of products sold 55,988,568 48,986,266 18,310,443 16,576,641 ----------- ----------- ----------- ----------- 19,369,094 16,059,664 7,184,047 5,287,464 Selling and administrative expenses 13,082,641 10,924,323 4,363,285 3,631,127 Interest expense 793,965 979,437 248,397 310,346 Other income (14,924) (198,701) (5,064) (172,883) ----------- ----------- ----------- ----------- INCOME BEFORE INCOME TAXES 5,507,412 4,354,605 2,577,429 1,518,874 Income taxes 2,163,878 1,521,781 1,070,994 576,115 ----------- ----------- ----------- ----------- NET INCOME $ 3,343,534 $ 2,832,824 $ 1,506,435 $ 942,759 =========== =========== =========== =========== Net income per share: Basic $ 0.92 $ 0.78 $ 0.41 $ 0.26 Diluted $ 0.90 $ 0.78 $ 0.40 $ 0.26 Cash dividends per share $ 0.33 $ 0.33 $ 0.11 $ 0.11
See accompanying notes. -3- THE EASTERN COMPANY AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Nine Months Ended October 2, 2004 Sept. 27, 2003 --------------- -------------- OPERATING ACTIVITIES: Net income $ 3,343,534 $ 2,832,824 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,598,731 2,727,814 (Gain)/loss on sales of equipment and other assets 46,006 - Postretirement benefits other than pensions (123,712) (142,303) Provision for doubtful accounts 3,764 156,291 Gain on sale of Common Stock held as investment - (166,788) Issuance of Common Stock for directors' fees 59,988 66,682 Changes in operating assets and liabilities: Accounts receivable (3,841,100) (1,070,982) Inventories (2,623,825) (421,909) Prepaid expenses and other (596,841) 180,967 Prepaid pension cost 290,821 93,901 Accounts payable 2,582,692 59,976 Other accrued expenses 1,188,544 (37,375) Other assets (50,754) (121,679) ------------ ------------ NET CASH PROVIDED BY OPERATING ACTIVITIES 2,877,848 4,157,419 INVESTING ACTIVITIES: Purchases of property, plant, and equipment (1,530,786) (1,732,042) Proceeds from sale of equipment 13,367 - Proceeds from sale of Common Stock held as investment - 915,133 Other - (4,461) ------------ ------------ NET CASH USED BY INVESTING ACTIVITIES (1,517,419) (821,370) FINANCING ACTIVITIES: Principal payments on long-term debt (1,956,237) (2,462,470) Proceeds from sale of Common Stock 172,300 - Purchases of Common Stock for treasury - (317,726) Dividends paid (1,196,441) (1,195,587) ------------ ------------ NET CASH USED BY FINANCING ACTIVITIES (2,980,378) (3,975,783) Effect of exchange rate changes on cash 30,187 3,935 ------------ ------------ NET CHANGE IN CASH AND CASH EQUIVALENTS (1,589,762) (635,799) Cash and cash equivalents at beginning of period 4,896,816 5,939,232 ------------ ------------ CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 3,307,054 $ 5,303,433 ============ ============
-4- THE EASTERN COMPANY AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
Nine Months Ended Three Months Ended October 2, 2004 September 27, 2003 October 2, 2004 September 27, 2003 --------------- ------------------ --------------- ------------------ Net income $ 3,343,534 $ 2,832,824 $ 1,506,435 $ 942,759 Other comprehensive income -- Foreign currency translation 188,836 724,608 324,300 16,006 Change in fair value of derivative financial instruments, net of income tax expense: 2004 - ($141,000) and ($41,000) respectively; 210,443 61,076 2003 - ($139,000) and ($61,000) respectively; 208,811 92,415 Unrealized holding loss on investment in common stock, net of income tax benefit 2003 - $23,200 and $48,900 respectively; - (35,893) - (74,964) ----------- ----------- ----------- --------- Comprehensive income $ 3,742,813 $ 3,730,350 $ 1,891,811 $ 976,216 =========== =========== =========== =========
See accompanying notes. -5- THE EASTERN COMPANY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) OCTOBER 2, 2004 Note A - Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements. Refer to the Company's consolidated financial statements and notes thereto included in its Form 10-K for the year ended January 3, 2004 for additional information. The accompanying condensed consolidated financial statements are unaudited. However, in the opinion of management, all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the results of operations for interim periods have been reflected therein. Operating results for interim periods are not necessarily indicative of the results that may be expected for the full year. Certain prior year amounts have been reclassified to conform to the current year presentation. These reclassifications had no effect on previously reported net income. The condensed balance sheet as of January 3, 2004 has been derived from the audited consolidated balance sheet at that date. Note B - Earnings Per Share The denominators used in the earnings per share computations follow:
Nine Months Ended Three Months Ended Oct. 2, 2004 Sept. 27, 2003 Oct. 2, 2004 Sept. 27, 2003 ------------ -------------- ------------ -------------- Basic: Denominator for basic earnings per share 3,625,627 3,622,791 3,631,028 3,612,748 ========= ========= ========= ========= Diluted: Weighted average shares outstanding 3,625,627 3,622,791 3,631,028 3,612,748 Dilutive stock options 102,710 26,821 101,941 75,260 --------- --------- --------- --------- Denominator for diluted earnings per share 3,728,337 3,649,612 3,732,969 3,688,008 ========= ========= ========= =========
Note C - Inventories The components of inventories follow:
Oct. 2, 2004 January 3, 2004 ------------ --------------- Raw materials and component parts $10,064,295 $ 8,687,003 Work in process 4,767,297 4,112,625 Finished goods 4,786,916 4,126,920 ----------- ----------- $19,618,508 $16,926,548 =========== ===========
-6- THE EASTERN COMPANY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) OCTOBER 2, 2004 Note D - Segment Information Segment financial information follows:
NINE MONTHS ENDED THREE MONTHS ENDED Oct. 2, 2004 Sept. 27, 2003 Oct. 2, 2004 Sept. 27, 2003 ------------ -------------- ------------ -------------- Revenues: Sales to unaffiliated customers: Industrial Hardware $34,140,587 $26,054,463 $11,984,777 $ 8,987,949 Security Products 32,127,719 28,848,739 11,028,825 9,987,630 Metal Products 9,089,356 10,142,728 2,480,888 2,888,526 ----------- ----------- ----------- ----------- $75,357,662 $65,045,930 $25,494,490 $21,864,105 =========== =========== =========== =========== Income Before Income Taxes: Industrial Hardware $ 4,679,001 $ 3,179,441 $ 2,027,603 $ 982,066 Security Products 3,739,370 3,508,853 1,636,688 1,348,586 Metal Products 294,016 118,759 123,614 (152,083) ----------- ----------- ----------- ----------- Operating Profit 8,712,387 6,807,053 3,787,905 2,178,569 General corporate expenses (2,411,010) (1,473,011) (962,079) (349,349) Interest expense (793,965) (979,437) (248,397) (310,346) ----------- ----------- ----------- ----------- $ 5,507,412 $ 4,354,605 $ 2,577,429 $ 1,518,874 =========== =========== =========== ===========
Note E - Stock-Based Compensation The Company measures compensation expense related to stock-based compensation using the intrinsic value method. Accordingly, no stock-based employee compensation cost is reflected in net income if the exercise price of the option equals or exceeds the fair value of the stock on the date of grant. Pro forma information regarding net income and earnings per share, as required by Statement No. 123 "Accounting for Stock-Based Compensation", has been determined as if the Company had accounted for its employee stock options under the fair value method. The fair value of the stock options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions: October 2, 2004 September 27, 2003 --------------- ------------------ Risk free interest rate N/A 4.60 Expected volatility N/A 3.04 Expected option life N/A 5 years Weighted-average dividend yield N/A 3.1% Assumptions are not applicable (N/A) because no options were granted in 2004. -7- THE EASTERN COMPANY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) OCTOBER 2, 2004 Note E - Stock-Based Compensation - continued
NINE MONTHS ENDED THREE MONTHS ENDED Oct. 2, 2004 Sept. 27, 2003 Oct. 2, 2004 Sept. 27, 2003 ------------ -------------- ------------ -------------- Net income, as reported $3,343,534 $2,832,824 $1,506,435 $942,759 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards granted, net of related tax effects (13,428) (65,008) (4,476) (39,076) ---------- ---------- ---------- -------- Pro forma net income $3,330,106 $2,767,816 $1.501,959 $903,683 ========== ========== ========== ======== Earnings per share: Basic-as reported $ 0.92 $ 0.78 $ 0.41 $ 0.26 Basic-pro forma $ 0.92 $ 0.76 $ 0.41 $ 0.25 Diluted-as reported $ 0.90 $ 0.78 $ 0.40 $ 0.26 Diluted-pro forma $ 0.89 $ 0.76 $ 0.40 $ 0.25
For the purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the stock options' vesting period ranging from 1 to 5 years. The pro forma effect on net income and related earnings per share may not be representative of future years' impact since the terms and conditions of new grants may vary from the current terms. Note F - Recent Accounting Pronouncements In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities," which was revised in December 2003 ("FIN No. 46-R"). This new rule requires that companies consolidate a variable interest entity if the company is subject to a majority of the risk of loss from the variable interest entity's activities and/or is entitled to receive a majority of the entity's residual returns. The provisions of FIN No. 46-R currently were required to be applied as of the end of the first reporting period after March 15, 2004 for the variable interest entities in which the company holds a variable interest that it acquired on or before January 31, 2003. The adoption of FIN No. 46-R did not have any impact on the financial position or results of operations of the Company. Note G - Legal Proceedings The Company was a party to a patent infringement suit, that resulted in a mediated settlement of $400,000, which was recorded as a charge to earnings in the second quarter 2004. In addition to the settlement, the Company incurred approximately $115,000 of legal expenses in 2003, and $69,000 and $398,000 of legal expenses in the third quarter and first nine months of 2004, respectively, relating to this suit. The legal expenses combined with the settlement resulted in charges to earnings net of taxes of $484,000 or $0.13 per diluted share in the nine month period. There are no other legal proceedings, other than ordinary routine litigation incidental to the Company's business, to which either the Company or any of its subsidiaries is a party or to which any of their property is the subject. -8- THE EASTERN COMPANY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) OCTOBER 2, 2004 Note H - Debt Effective January 4, 2004 the Company received approval from its financial institution to modify the basis of calculating its debt service covenant ratios from a rolling four-quarter test to a cumulative quarter test. The debt service covenant test will return to a rolling four-quarter test beginning in 2005. Note I - Retirement Benefit Plans The Company has non-contributory defined benefit pension plans covering certain U.S. employees. Plan benefits are generally based upon age at retirement, years of service and, for its salaried plan, the level of compensation. The Company also sponsors unfunded nonqualified supplemental retirement plans that provide certain current and former officers with benefits in excess of limits imposed by federal tax law. The Company also provides health care and life insurance for retired salaried employees in the United States who meet specific eligibility requirements. Significant disclosures relating to these benefit plans for the third quarter and first nine months of Fiscal 2004 and 2003 follow:
Pension Benefits Nine Months Ended Three Months Ended October 2, 2004 September 27, 2003 October 2, 2004 September 27, 2003 --------------- ------------------ --------------- ------------------ Service cost $ 898,705 $ 704,228 $ 308,545 $ 252,388 Interest cost 1,714,135 1,527,151 571,378 693,107 Expected return on plan assets (1,949,058) (1,600,771) (649,687) (725,315) Transition obligation (153,295) (140,905) (51,098) (60,563) Prior service cost 147,736 143,064 49,246 56,508 Losses recognized 264,335 256,142 88,111 120,410 ---------- ---------- ---------- ---------- Net periodic benefit cost $ 922,558 $ 888,909 $ 316,495 $ 336,535 ========== ========== ========== ==========
Postretirement Benefits Nine Months Ended Three Months Ended October 2, 2004 September 27, 2003 October 2, 2004 September 27, 2003 --------------- ------------------ --------------- ------------------ Service cost $ 88,388 $ 35,252 $ 30,357 ($ 127,316) Interest cost 105,976 151,467 17,480 (14,348) Expected return on plan assets (62,717) (76,411) (10,797) 7,238 Transition obligation 0 0 0 0 Prior service cost (30,415) (23,295) (9,491) 2,206 Losses recognized (40,390) (69,070) (5,514) 6,542 ----------- ----------- ----------- ---------- Net periodic benefit cost $ 60,842 $ 17,943 $ 22,035 ($ 125,678) =========== =========== =========== ==========
-9- THE EASTERN COMPANY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) OCTOBER 2, 2004 Note I - Retirement Benefit Plans - continued The Company's funding policy with respect to its qualified plans is to contribute at least the minimum amount required by applicable laws and regulations. The Company was required to contribute $1,007,929 into its salaried plan and $194,123 into one of its hourly plans. The Company has paid all of the required contributions into the salaried plan and into its hourly plans prior to filing its federal income tax return on September 15, 2004. The Company has a contributory savings plan under Section 401(k) of the Internal Revenue Code covering substantially all U.S. non-union employees. The plan allows participants to make voluntary contributions of up to 100% of their annual compensation on a pretax basis, subject to IRS limitations. The plan provides for contributions by the Company at its discretion. The Company made contributions of $36,718 and $112,411 in the third quarter and first nine months of 2004 respectively, and $34,480 and $105,885 in the third quarter and first nine months of 2003, respectively. Note J - Impact of Recently Issued Accounting Standards Accounting for Medicare Act On December 8, 2003, the "Medicare Prescription Drug Improvement and Modernization Act of 2003" ("the Act") was signed into law. The Act introduces a prescription drug benefit under Medicare as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least "actuarially equivalent" to Medicare Part D. In the second quarter of 2004, a Financial Accounting Standards Board (FASB) Staff Position (FSP FAS 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug Improvement and Modernization Act of 2003") was issued providing guidance on the accounting for the effects of the Act for employers that sponsor postretirement health care plans that provide prescription drug benefits. This FSP superceded FSP FAS 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug Improvement and Modernization Act of 2003." The FSP is effective for the first interim or annual period beginning after June 15, 2004. The guidance in this FSP applies only to the sponsor of a single-employer defined benefit postretirement health plan for which the employer has concluded that prescription drug benefits available under the plan are actuarially equivalent and thus qualify for the subsidy under the Act and the expected subsidy will offset or reduce the employer's share of the costs of postretirement prescription drug coverage by the plan. While the Company is currently in the process of assessing the actuarial equivalency of its prescription drug benefit under its retiree health care plan, based on guidance from our actuary, the Company expects any impact of the Act would be immaterial. The financial statements do not reflect any potential impact of the Act. -10- ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion is intended to highlight significant changes in the Company's financial position and results of operations for the thirty-nine weeks ended October 2, 2004. The interim financial statements and this Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto for the fiscal year ended January 3, 2004 and the related Management's Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 2004. Certain statements set forth in this discussion and analysis of financial condition and results of operations are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. They use such words as "may," "will," "expect," "believe," "plan" and other similar terminology. These statements reflect management's current expectations regarding future events and operating performance and speak only as of the date of this release. These forward-looking statements involve a number of risks and uncertainties and actual future results and trends may differ materially depending on a variety of factors including changing customer preferences, lack of success of new products, loss of customers, competition, increased raw material prices, problems associated with foreign sourcing of parts and products, changes within our industry segments and in the overall economy, litigation and legislation. In addition, terrorist threats and the possible responses by the U.S. government, the effects on consumer demand, the financial markets, the travel industry, the trucking industry, the mining industry and other conditions increase the uncertainty inherent in forward-looking statements. Forward-looking statements reflect the expectations of the Company at the time they are made, and investors should rely on them only as expressions of opinion about what may happen in the future and only at the time they are made. The Company undertakes no obligation to update any forward-looking statement. Although the Company believes it has an appropriate business strategy and the resources necessary for its operations, future revenue and margin trends cannot be reliably predicted and the Company may alter its business strategies to address changing conditions. In addition, the Company makes estimates and assumptions that may materially affect reported amounts and disclosures. These relate to valuation allowances for accounts receivable and for excess and obsolete inventories, accruals for pensions and other postretirement benefits (including forecasted future cost increases and returns on plan assets), provisions for depreciation (estimating useful lives), and, on occasion, accruals for contingent losses. Overview During the third quarter of 2004 the Company experienced a 16.6% increase in sales as compared to the third quarter of 2003. The Industrial Hardware and the Security Products segments experienced a 33.3% and 10.4%, respectively, increase in sales during the period while the sales of the Metal Products segment declined 14.1% from the comparable quarter of 2003. Sales for the first nine months of 2004 were up 15.9% compared to the same period a year ago. The Industrial Hardware and the Security Products segments experienced increases in sales of 31.0% and 11.4%, respectively, while the sales of the Metal Products segment declined 10.4% as compared to the first nine months of 2003. The Industrial Hardware sales increase came from our distributor network, original equipment manufacturers (OEM's), and as the result of a general improvement in the manufacturing sector of the economy. Sales increased to our service body OEM's, due to increased sales of our stainless steel paddles and our new PowerUp(TM) system; to subcontractors for military vehicles for retrofitting the Humvee, 1 ton and 3/4 ton trucks, with heavy duty rotary and paddle latches as the Army increases the armor on these vehicles; and to the class 8 truck market which is experiencing significant growth and which has increased the requirements for our hardware and sleeper boxes, particularly for Freightliner's Western Star tractor-trailer line of trucks. -11- The sales increase in the Security Products segment came as a result of increased sales of locks to computer manufacturers such as IBM, Dell and Sun Micro Systems as we gain more market share from our competitors; increased sales to the travel industry as the result of the introduction of our new SearchAlert(TM) lock which was recently introduced into the Transportation Security Administration's program for locking checked baggage at airports; industrial enclosures; meter cases used in the commercial laundry market; and increasing market share from competitors. Sales in the Metals Products segment were lower in both mine roof products and contract casting products for both the third quarter and first nine months of 2004 compared to the 2003 periods. Our proprietary mine roof anchors declined as the result of mining techniques where fewer of our proprietary mine roof anchors are required, and sales of contract casting products were down as the result of foreign competition. The Company signed a technical development contract in the second quarter of 2004 with China University of Mining and Technology. The contract calls for the testing and appraisal of our proprietary mine roof anchors for use in underground coal mining in China. The project is currently in the testing phase. The Company is experiencing or has been notified of cost increases affecting the majority of material it uses such as steel, zinc and brass, with cost increases ranging from 20% to 50%. The nine-month impact of the higher costs amounted to $651,000 net of tax benefit or $0.17 per diluted share. The Company has passed these increases in costs on to our customers where possible. Currently, there is no indication that the Company will not be able to obtain all the materials that it requires. Cash flow in the third quarter of 2004 declined compared to the third quarter of 2003. The Company's line of credit, along with controlling discretionary expenditures, should provide sufficient cash flow to meet all existing obligations. A more detailed analysis of the Company's results of operations and financial condition follows: Results of Operations The following table sets forth, for the periods indicated, selected Company statement of operations data expressed as a percentage of net sales.
Nine Months Ended Three Months Ended ----------------- ------------------ Oct. 2, 2004 Sept. 27, 2003 Oct. 2, 2004 Sept. 27, 2003 ------------ -------------- ------------ -------------- Net sales 100.0% 100.0% 100.0% 100.0% Cost of products sold 74.3% 75.3% 71.8% 75.8% ----- ----- ----- ----- Gross margin 25.7% 24.7% 28.2% 24.2% Selling and administrative expense 17.4% 16.8% 17.1% 16.6% Interest expense 1.0% 1.5% 1.0% 1.4% Other (income) expense 0.0% (0.3%) 0.0% (0.7%) ----- ----- ----- ----- Income before income taxes 7.3% 6.7% 10.1% 6.9% Income taxes 2.9% 2.3% 4.2% 2.6% ----- ----- ----- ----- Net Income 4.4% 4.4% 5.9% 4.3% ===== ===== ===== =====
Net income for the third quarter of 2004 was $1,506,435 or $.40 per diluted share on sales of $25.5 million compared to net income of $942,759 or $.26 per diluted share on sales of $21.9 million in the third quarter of 2003. Net income for the first nine months of 2004 was $3,343,534 or $.90 per diluted share on sales of $75.4 million compared to net income of $2,832,824 or $.78 per diluted share on sales of $65.0 million in the 2003 period. -12- Sales for the third quarter 2004 were up 16.6% compared to the same period a year ago. New product sales contributed 3.2%, sales volume of existing products increased 11.8% and prices increased 1.6% in the third quarter. Sales for the first nine months of 2004 were up 15.9% compared to the same period a year ago. Sales volume of existing products was up 11.7% and new product sales were up 3.6%, while prices increased 0.6%. The Industrial Hardware segment's third quarter sales were up 33.3% compared to the third quarter of 2003. New product sales increased 2.6%, sales volume of existing products increased 26.6% and prices were up 4.1%. New products include push button assembly and rotary lock with a hard case, both of which are used in the truck accessory market and a t-handle assembly, a paddle rotary and a key cylinder with rotation for the service body market. Sales of "sleeper boxes" for the class 8 truck market were up for the three and nine month periods by 54.9% and 57.6%, respectively. For the first nine months of 2004, sales were up 31.0% compared to the same period in 2003. New product sales increased 3.1%, sales volume of existing products increased 26.6% and prices increased 1.3%. The Company anticipates continued sales improvement in the Industrial Hardware segment throughout 2004. Our Eastern Industrial (Shanghai) Ltd., manufacturing facility located in Shanghai, China continues to be very active fulfilling quotation requests from the Company's sales networks. In addition, we have begun production of a variety of metal and plastic products for our U.S. and Canadian affiliates. This subsidiary will be instrumental in helping us to remain price competitive in North America and will open up the possibility to more effectively pursue global markets, including marketing the Company's products directly in China. The Security Products segment's sales were up 10.4% in the third quarter of 2004 as compared to the third quarter of 2003. New product sales increased 4.7% and sales volume of existing products increased 5.7%. Sales of new products included the SearchAlert(TM) luggage lock, a push button lock for the medical industry, and a spring latch assembly and a snap-in lock for the automotive accessory market. For the first nine months of 2004, sales were up 11.4% compared to the same period in 2003. New product sales increased 5.1% and sales volume of existing products increased 6.3%. The Company anticipates continued sales improvement in the Security Products segment throughout 2004. The Metal Products segment's sales were down 14.1% in the third quarter of 2004 as compared to the third quarter of 2003. Sales volume of existing products were down 13.6% and prices were down 0.5%. Sales of our contract casting products for use in the commercial and industrial construction industry decreased 15.0% and sales of our proprietary mine roof support anchors were down 13.6% for the third quarter of 2004 as compared to the third quarter of 2003. The decrease in sales of contract castings during the third quarter was due to foreign competition, while sales of mine roof support anchors continue to be negatively affected by the changes in mining techniques and surface mining requiring fewer roof support anchors. However, with the current record high energy prices we could expect to see some improvement in the Metal Products segment as demand for coal increases. For the first nine months of 2004, sales were down 10.4% compared to the same period in 2003. Sales volume of existing products decreased by 10.8% and prices increased by 0.4%. Sales of our contract casting products for use in the commercial and industrial construction industry decreased 3.8% and sales of our proprietary mine roof support anchors were down 13.5% for the first nine months of 2004 as compared to the first nine months of 2003. Sales are expected to remain below prior year levels throughout 2004. Gross margin as a percentage of sales for the three and nine month periods ended October 2, 2004 was 28.2% and 25.7%, respectively, compared to 24.2% and 24.7% in the comparable periods a year ago. The increase in gross margin in the third quarter is primarily the result of higher sales volume resulting in improved utilization of facilities, price increases and product mix. -13- Selling and administrative expenses were up 20.2% or $732,000 for the third quarter of 2004 and up 19.8% or $2.2 million for the first nine months of 2004 as compared to the same periods a year ago. The increase was due in large part to a patent infringement suit which in the three and nine month periods increased the Company's legal expenses by $69,000 and $398,000, respectively, plus a mediated settlement of $400,000 to settle this suit, as well as increased incentive compensation expenses. Interest expense decreased by $61,900 or 20.0% for the third quarter of 2004 and decreased by $185,500 or 18.9% for the first nine months of 2004 as compared to the same periods in 2003. This decrease in interest expense was due to the lower levels of debt in the current periods. Earnings before income taxes for the three months ended October 2, 2004 increased $1.1 million or 70.0% and for the nine months ended October 2, 2004 was up $1.2 million or 26.5% as compared to the same periods of 2003. The Industrial Hardware segment was up 106.5% or $1.0 million, the Security Products segment was up $288,100 or 21.4% and the Metal Products segment was up $275,700 or 181.3% as compared to the third quarter of 2003. For the first nine months of 2004, the Industrial Hardware segment was up 47.2% or $1.5 million, the Security Products segment was up $230,500 or 6.6% and the Metal Products segment was up $175,300 or 147.6% as compared to the same period of 2003. The increases in the Industrial Hardware segment reflect the general overall improvement in the economy in 2004, increased market share and the introduction of new products. The overall increase in the Security Products segment was mainly due to increases created by the general overall improvement in the economy in 2004, increased market share and the introduction of new products, offset by legal fees and the settlement of a patent infringement suit mentioned above. The Metal Products segment increase is the result of the continued decline in the use of our proprietary mine roof anchors in the North American mining industry as new mining technology continues to reduce the need for that product. The effective tax rate of 39.3% for the first nine months is higher than the 34.9% for the same period in 2003. The increase in the effective tax rate is the result of the Company deriving a higher percentage of its earnings from countries with higher effective tax rates. Liquidity and Sources of Capital The Company provided $2.9 million from operations for the first nine months of 2004 compared to $4.2 million provided from operations for the same period in 2003. These amounts reflect the net income earned by the Company during those periods adjusted for non-cash charges and changes in working capital which relate, primarily, to the timing of payments or receipts of current assets and current liabilities. Cash flow from operations coupled with cash on hand at the beginning of the year was sufficient to fund capital expenditures, debt service, contributions to the Company's pension plans, and dividend payments. Additions to property, plant and equipment were $1.5 million during the first nine months of 2004 versus $1.7 million for the comparable period in 2003. Total capital expenditures for 2004 are expected to be in the range of $2.0 million to $3.0 million. Total inventories as of October 2, 2004 were $19.6 million or $2.7 million higher than at the end of Fiscal 2003. The inventory turnover ratio of 3.8 turns at the end of the third quarter was comparable to both the 3.9 turns of the prior year third quarter and the 4.1 turns at the year end 2003. Accounts receivable increased by $3.7 million from year end 2003, primarily due to increased sales volume. The average days sales in accounts receivable for the third quarter of 2004 was 53 days compared to 50 days in the third quarter of 2003 and 48 days at the end of fiscal 2003. Cash flow from operating activities and funds available under the revolving credit portion of the Company's loan agreement are expected to be sufficient to cover future foreseeable working capital requirements. -14- The Company requested and received approval from its financial institution to modify the basis of calculating its debt service covenant ratios from a rolling four-quarter test to a cumulative quarter test effective for the periods beginning January 4, 2004. The debt service covenant test will return to a rolling four-quarter test for the fiscal years beginning in 2005. This modification to the debt service covenants will provide the Company more flexibility within its capital expenditure programs. ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK ------ ---------------------------------------------------------- There have been no material changes in market risk from what was reported in the 2003 Annual Report on Form 10-K. ITEM 4 CONTROLS AND PROCEDURES ------ ----------------------- Evaluation of Disclosure Controls and Procedures An evaluation was performed under the supervision and with the participation of the Company's management, including the Chief Executive Officer ("CEO") and Chief Financial Officer ("CFO"), of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Company's management, including the CEO and CFO, concluded that the Company's disclosure controls and procedures were effective as of the end of the period covered by this report based on such evaluation. The Company believes that a system of controls, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. The Company's disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and the CEO and CFO have concluded that these controls and procedures are effective at the "reasonable assurance" level. Changes in Internal Controls During the period covered by this report, there have been no significant changes in the Company's internal control over financial reporting or in other factors that have materially affected, or are reasonably likely to materially affect, the Company's internal controls. PART II OTHER INFORMATION ITEM 1 LEGAL PROCEEDINGS - ------ ------------------- During 2003 and 2004, the Company was a party to a patent infringement suit. Although management has determined this suit was without merit, the Company incurred approximately $115,000 of legal expenses in 2003, and $398,000 in the first nine months of 2004, $69,000 of which was in the third quarter of 2004. Subsequent to the close of the second quarter, the Company went to mediation and reached a settlement of $400,000, which was recorded as a charge to earnings in the second quarter 2004. The legal expenses combined with the settlement resulted in charges to earnings net of taxes of $42,000 or $0.01 per diluted share in the third quarter and $484,000 or $0.13 per diluted share in the nine month period. There are no other legal proceedings, other than ordinary routine litigation incidental to the Company's business, to which either the Company or any of its subsidiaries is a party or to which any of their property is the subject. ITEM 2 UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS ------ ----------------------------------------------------------- None -15- ITEM 3 DEFAULTS UPON SENIOR SECURITIES ------ ------------------------------- None ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ------ --------------------------------------------------- See the information set forth in Item 4 of the Form 10-Q of the Company for the quarterly period ended April 3, 2004. ITEM 5 OTHER INFORMATION ------ ----------------- None ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K ------- -------------------------------- (a) 31 Certifications required by Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32 Certifications pursuant to Rule 13a-14(b) and 18 USC 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99(1) The Registrant's Annual Report on Form 10-K for the fiscal year ended January 3, 2004 is incorporated herein by reference. (b) 99(2) Form 8-K filed on April 28, 2004 setting forth the press release reporting the Company's earnings for the quarter ended April 3, 2004 is incorporated herein by reference. 99(3) Form 8-K filed on July 28, 2004 setting forth the press release reporting the Company's earnings for the quarter ended July 3, 2004 is incorporated herein by reference. 99(4) Form 8-K filed on October 27, 2004 setting forth the press release reporting the Company's earnings for the quarter ended October 2, 2004 is incorporated herein by reference. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. THE EASTERN COMPANY ------------------- (Registrant) DATE: November 3, 2004 /s/Leonard F. Leganza ---------------- --------------------- Leonard F. Leganza President and Chief Executive Officer DATE: November 3, 2004 /s/John L. Sullivan, III ---------------- ------------------------ John L. Sullivan, III Vice President, Secretary and Treasurer -16-