10-K 1 combined.txt FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark One) X ANNUAL REPORT PURSUANT TO SECTION 13 or 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED) For the fiscal year ended September 29, 2001 OR _____ TRANSITION REPORT PURSUANT TO SECTION 13 or 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED) For the transition period from __________________ to ________________. Commission File No. 0-22416 KENTUCKY ELECTRIC STEEL, INC. (Exact name of Registrant as specified in its charter) Delaware 61-1244541 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) P. O. Box 3500, Ashland, Kentucky 41105-3500 (Address of principal executive office, Zip code) (606) 929-1222 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share (Title of Class) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes ( ) No (X) (Cover Page 1 of 2 Pages) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Registration S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statement incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. (X) Aggregate market value of the voting stock held by non-affiliates of the Registrant based on the closing price on January 7, 2002: $2,089,962. Indicate the number of shares outstanding of each of the Registrant's classes of common stock as of January 7, 2002: 4,100,285 shares of Common Stock, par value $.01 per share. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's Proxy Statement for the Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14(a) are incorporated herein by reference in response to items 10 through 13 in Part III of this report. (Cover Page 2 of 2 Pages) KENTUCKY ELECTRIC STEEL, INC. AND SUBSIDIARY FORM 10-K TABLE OF CONTENTS Page PART I .......................................................... 4 Item 1. Business .......................................... 4 Item 2. Properties ........................................ 9 Item 3. Legal Proceedings ................................. 10 Item 4. Submission of Matters to a Vote of Security Holders 10 PART II ......................................................... 11 Item 5. Market for Registrant's Common Equity and Related Shareholder Matters ............................... 11 Item 6. Selected Financial Data ........................... 11 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ............... 12 Item 7A. Qualitative and Quantitative Disclosure about Market Risk ....................................... 20 Item 8. Financial Statements and Supplementary Data ....... 20 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure ............... 20 PART III ........................................................ 21 Item 10. Directors and Executive Officers of the Registrant 21 Item 11. Executive Compensation ............................ 21 Item 12. Security Ownership of Certain Beneficial Owners and Management ............................. 21 Item 13. Certain Relationships and Related Transactions .... 21 PART IV ......................................................... 22 Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K ............................... 22 SIGNATURES ...................................................... 25 INDEX TO FINANCIAL STATEMENTS AND SCHEDULES .................... 26 KENTUCKY ELECTRIC STEEL, INC. AND SUBSIDIARY PART I Item 1. Business General Kentucky Electric Steel, Inc., a Delaware corporation incorporated in August, 1993 (the "Company"), owns and operates a steel mini-mill near Ashland, Kentucky. As a mini-mill producer of bar flats, the Company recycles steel from scrap, a process designed to result in lower production costs than those of integrated steel mills, which produce steel by processing iron ore and other raw materials in blast furnaces. Bar flats are produced to a variety of specifications and fall primarily into two general quality levels - merchant bar quality steel bar flats ("MBQ Bar Flats") for generic types of applications, and special bar quality steel bar flats ("SBQ Bar Flats"), where more precise customer specifications require the use of various alloys, customized equipment and special production procedures to insure that the finished product meets critical end-use performance characteristics. The Company is a leading manufacturer of SBQ Bar Flats for the cold drawn bar converter and truck trailer support beam markets. The Company manufactures over 2,600 different Bar Flat items which are sold to a variety of relatively small volume niche markets, including the leaf-spring suspension market for light and heavy-duty trucks, mini-vans and utility vehicles, cold drawn bar converters, certain specialty applications for steel service centers, truck trailer manufacturers and other miscellaneous markets. The Company's mill was specifically designed to manufacture wider and thicker bar flats up to three inches in thickness and twelve inches in width that are required by these markets. In addition, the Company employs a variety of specially designed equipment which is necessary to manufacture SBQ Bar Flats to the specifications demanded by its customers. Although the Company specializes in SBQ Bar Flats, particularly in the thicker and wider sections, it also, to a much lesser extent, competes in the MBQ Bar Flat market. The Company's business strategy is to increase its share of the SBQ Bar Flat market and to expand into related niche market applications where it can supply products for special customer needs. The Company plans to expand its business primarily by increasing the number of products it sells to existing customers and the development of new customers. Current Industry Conditions During the past three years, market conditions within the domestic steel industry have experienced significant downward economic pressure largely due to market price and shipment volume declines. These market conditions are a result of a number of factors including a decline in the general economy of the United States, a decline in the industries of the Company's customers, the increased cost of production due to high electricity and natural gas costs and an increase in competition from foreign steel companies. These forces have driven market prices to levels below the cost of production for certain domestic producers, and as a result, many steel manufacturers have curtailed production or ceased operations, and a number of steel industry producers have sought protection under the United States Bankruptcy Code. As a result of these conditions, the Company has experienced sharp declines in shipment volumes and operating margins during fiscal 2001, which impacted the Company's cash flows and produced a pre-tax loss of approximately $9.6 million in fiscal 2001. Since March 31, 2001, the Company has failed to meet the fixed charge coverage ratio covenant of its loan agreements which required the Company to maintain a fixed charge coverage ratio of 2:1 for each rolling four quarter period. In addition to the default of the fixed charge coverage ratio covenant, the Company failed to make a scheduled principal payment on its unsecured senior notes of $3,333,333 due on November 1, 2001. In response to these conditions, the Company has undertaken and will continue to undertake certain cost control initiatives and was successful in restructuring its long-term debt obligations and bank credit facility in order to manage the Company's liquidity through this difficult market environment. Management anticipates that the market conditions discussed above will continue to impact the Company's operations through fiscal 2002 and negatively impact the Company's financial performance. Management believes that the Company has the ability to sustain its operations and meet its commitments at least for the near-term through effective management of its operations and the restructured debt and bank credit facility. However, should these negative market conditions worsen or persist on a long-term basis, the Company's ability to continue to manage its liquidity for the long-term may be jeopardized. Manufacturing Operations The Company recycles steel by melting steel scrap in two 50-ton electric arc furnaces. The molten steel is then taken to the ladle metallurgy facility where a variety of alloys are added to make different grades of steel in accordance with customer specifications. The refined molten steel is then poured into a continuous caster to produce continuous strands of steel with cross-sectional dimensions ranging from approximately 16 to 72 square inches. The Company can utilize up to four continuous strands in producing certain sizes. The strands are cut to produce billets of specified length which are reheated to approximately 2,300 degrees Fahrenheit at the Company's rolling mill and fed through a series of roll stands to reduce their size and form them into steel bar sections. These sections emerge from the rolling mill, are uniformly cooled on a cooling bed, and are cut to lengths specified by the customer. The cut bar flats are stacked into bundles ready for shipment. The production capacity of the Company for finished products is 330,000 tons per year. The Company sold 181,500 tons of finished goods in 2001 which constitutes 55% of its melting and casting capacity. In addition, the Company sold 1,700 billet tons (semi- finished product) in 2001. The Company transports its products by common carrier, generally shipping by truck and by rail. The Company has railroad sidings at its facilities. Capital Improvements and Expansion Annual capital expenditures over the last five fiscal years have averaged $2.2 million, which includes $.8 million expended in fiscal year 2001. The Board of Directors has currently authorized the use of $.5 million for capital expenditures in fiscal 2002, which includes completion of various projects begun in fiscal 2001, as well as equipment upgrades and replacements. Additional capital expenditures, which may be required, must be approved by the Board of Directors. Primary Markets and Products The Company is primarily a special bar quality ("SBQ") producer of alloy and carbon steel bar flats. Its primary markets are manufacturers of leaf-spring suspensions, cold drawn bar converters, flat bed truck trailer manufacturers and steel service centers. Leaf-Spring Suspension Market. High tensile SBQ spring steel is produced to customer and industry specifications for use in leaf- spring assemblies. These assemblies are utilized in light, medium and heavy duty trucks, trailers, mini-vans and four-wheel drive vehicles with off-road capability. The trend toward tapered leaf-spring products and air-ride suspension continues. These products use somewhat less steel but they are manufactured from larger cross section bar flats that match the Company's manufacturing strengths. Cold Drawn Bar Converters Market. The Company sells its expanded range of SBQ hot rolled bar products to cold drawn bar manufacturers. The Company's product range, 1/4" through 3" in thickness and 2" through 12" in width, enables the Company to supply practically all the sizes needed by the converters. The converters remove the scale from the hot rolled bar and draw it through a die. The drawing reduces the cross section, improves surface and internal properties, and produces a more exacting tolerance bar. The end product is sold through distributors and directly to original equipment manufacturers. Steel Service Centers Market. Approximately 30% of all steel shipments to the end-user are distributed through steel service centers, making this the largest single market for steel manufacturers. The Company sells both MBQ and SBQ Bar Flats into this market. Truck Trailers Market. The Company is a significant supplier of SBQ Bar Flats for flat bed trailer support beam flange material. This material is engineered and produced to exacting specifications consistent with trailer manufacturers' requirements. Miscellaneous Markets. The Company supplies other markets including metal building, grader blades, agricultural equipment, construction/ fabricating, railroad and industrial chain manufacturers. The products furnished to these markets are primarily SBQ Bar Flats along with a mixture of MBQ Bar Flats. Customers The Company sells to over 350 customers. Several wholly-owned subsidiaries of Republic Technologies International aggregated approximately 10.1% of sales for fiscal 2001. No other customer accounted for more than 10% of sales in fiscal 2001. The loss of a principal customer could have a material adverse effect on the Company's operations. The Company's foreign sales as a percentage of total sales were 8.3% in fiscal 2001. These sales consisted primarily of shipments to Canada and Mexico. Marketing Senior management of the Company is directly involved in sales to new and existing customers. Sales are nationwide and in certain foreign markets. Sales efforts are primarily performed by in-house sales personnel and augmented with manufacturers' representative companies. The efforts of these sales representatives are directed by the Company's Vice President, Sales and Marketing. Competition and Other Market Factors The domestic and foreign steel industries are characterized by intense competition. The Company competes with domestic and foreign producers, many of whom have financial resources substantially greater than those available to the Company. The Company has identified its principal competition from the following sources: (i) in its leaf- spring suspension market, the Company faces competition from four North American mills; (ii) in its cold drawn bar converters market, the Company competes with five North American mills; (iii) in the steel service center market, the Company encounters competition from numerous North American mills; and (iv) in its truck trailer market, the Company competes with three North American mills. The Company believes that the principal competitive factors affecting its business are quality, service, price and geographic location. Backlog and Seasonality As of September 29, 2001, the Company had firm orders for approximately 37,500 tons representing approximately $16.0 million in sales, as compared with approximately 51,600 tons representing approximately $22.4 million in sales, at September 30, 2000. The Company operates on a continuous basis with two scheduled shutdowns for heavy maintenance work in July and December. The Company's operations are not subject to seasonal fluctuations in operations or sales. Raw Materials The principal raw material used in the Company's steel mill is ferrous scrap. Ferrous scrap is derived from, among other sources, discarded automobiles, appliances, structural steel, railroad cars and machinery. The purchase price of scrap is subject to market conditions largely beyond the control of the Company. The Company is located in an area where scrap is generally available and typically maintains less than one month of scrap supply. Historically, price fluctuations of scrap have had no material long-term impact on the Company. However, while the Company has generally been successful in passing on scrap cost increases through price increases, the effect of steel imports, market price competition and under-utilized industry capacity has in the past, and could in the future, limit the Company's ability to increase prices. Two scrap dealers supplied approximately 60% of the Company's scrap in fiscal 2001. In an attempt to ensure an adequate source of raw materials, however, the Company has identified, inspected and purchased scrap from 25 dealers. The Company's manufacturing process consumes large amounts of electricity, which the Company purchases from Kentucky Power Company, d/b/a American Electric Power ("AEP"). An abundant regional supply of coal, used in producing electricity, helps keep the Company's energy costs relatively low. Effective November 13, 1997, the Company and AEP entered into a contract for Operating Reserve Interruptible Electric Service ("1997 Contract") which will have a minimum term of five years, or until an open competitive market exists, unless the Company gives AEP at least one year's notice of termination. The 1997 Contract limits AEP's right to interrupt service to only those instances that an AEP unit goes offline or that AEP is responsible to share reserves with other electrical generators pursuant to the East Central Area Reliability Coordination Agreement (ECAR), and any such interruption can be no more than 30 minutes in duration. Interruptions in the Company's electric service under the 1997 Contract with AEP have been minimal in fiscal 2001 and did not significantly impact the Company's operations. Employees As of September 29, 2001, the Company employed 346 people, approximately 80% of whom are members of the United Steelworkers of America. The Company's current five-year collective bargaining agreement expires in September 2004. The Company believes that its wage rates and benefits are competitive with other mini-mills. Environmental and Regulatory Matters The Company is subject to federal, state, and local environmental laws and regulations concerning, among other matters, wastewater discharge, air emissions and furnace dust disposal. As with similar mills in the industry, the Company's furnaces are classified as generating hazardous waste (K061) because the furnaces produce certain types of dust containing lead, chromium and cadmium ("Furnace Dust"). Between 1981 and 1983, the prior operator (the "Prior Operator") disposed of Furnace Dust in the Cooksey Brother's landfill, in Cannonsburg, Kentucky ("Cooksey Landfill"). Before 1981 the Prior Operator disposed of Furnace Dust in other locations, including a strip mine. The Company did not assume any liability from the Prior Operator for disposal at the Cooksey Landfill or such other sites. The Cooksey Landfill is operating pursuant to a permit and bond issued and approved by the Kentucky Division of Waste Management, and the Company has no reason to believe that the Cooksey Landfill or other sites are likely targets for listing as a Kentucky "uncontrolled site" or Federal Superfund Site. On May 5, 1999, the Company was notified by the Kentucky Division of Waste Management ("DWM") that as a result of a RCRA Facility Assessment ("RFA") conducted in 1986 and 1987 while the Company's mill was operated by the Prior Operator, that DWM requests that the Company undertake a RCRA Facility Investigation ("RFI") and, if necessary, thereafter, a RCRA Corrective Measures Study ("CMS") and, if necessary, thereafter, a RCRA Corrective Measures Implementation ("CMI"). On June 8, 1999, the Company was notified by DWM that the Company's mill had been listed with 32 other sites in Kentucky as a high priority for clean-up on the RCRA Corrective Action Baseline List of Facilities. The Company has not made a determination as to whether the Prior Operator released any hazardous waste at its site, has submitted a confirmatory sampling plan and is continuing negotiations with DWM. The Company, however, could incur investigation and/or clean-up expenses in the future with respect to the operation of the Company's facility by the Prior Operator with respect to the Cooksey Landfill or such other sites if (1) the sites are listed as a Kentucky "Uncontrolled Site" or Federal Superfund Site, (2) DWM required the Company to undertake an RFI, CMS and CMI, and (3) the Company is not successful in obtaining full indemnification from the Prior Operator. The Company's operations are subject to the Federal Clean Air Act which provides for regulation, through state implementation of federal requirements, of the emission of certain air pollutants. On June 2, 1999, the Kentucky Division for Air Quality issued to the Company its Title V Operating Permit ("Air Permit") with an expiration date of June 2, 2004. As with similar mills in the industry, the Federal Clean Air Act required that the Permit include emission limitations and standards as well as monitoring, recordkeeping, reporting, inspection and entry requirements to assure compliance with those limits. Pursuant to the United States Environmental Protection Agency (USEPA) Mini-mill Audit Initiative, the Company continues to evaluate past compliance with applicable regulations. The Company has also agreed with the Kentucky Division for Air Quality to conduct a stack test of emissions from its EAF/LMF baghouse to further evaluate compliance with its Air Permit. Additionally, the Company does not know whether it will be able to consistently comply with the Air Permit without additional capital and/or operating expense. The Company's operations are also subject to the Federal Clean Water Act which provides for regulation through state implementation of federal requirements of the discharge of certain water pollutants. On March 19, 1999, the Kentucky Division of Water ("DOW") issued the Company its Kentucky Pollutant Discharge Elimination System Permit ("Water Permit") with an expiration date of May 31, 2002. In its application for the Water Permit, the Company requested that DOW re- evaluate the temperature limits established in its prior permit. DOW agreed to determine allowable surface water temperatures on a site- specific basis and included in the Water Permit a requirement that the Company conduct a year-long thermal plume study to assess the impact of the effluent temperature on the aquatic biota in the receiving stream. The study has been completed and DOW will determine whether to allow surface water temperatures on a site-specific basis utilizing available data and the results of the thermal plume study. The Company, therefore, does not know whether it will be able to comply with temperature limits without additional capital and/or operating expense when the limits are determined by DOW. Further, there can be no assurance that evolving federal and state environmental requirements or discovery of unknown conditions will not (1) require the Company to make material expenditures in the future or (2) affect the Company's ability to obtain permits for its existing operations or any future expansion. The Company will continue to plan and budget, as appropriate, for any additional capital and operating expenses that may be required to upgrade or install new or additional pollution control equipment in order to comply with all permits. Except as otherwise indicated, the Company believes it is in substantial compliance with applicable environmental laws and regulations. Notwithstanding such compliance, if damage to persons or property or contamination of the environment has been or is caused by the conduct of the Company's business or by hazardous substances or wastes used, generated or disposed of by the Company (or possibly by prior operators of the Company's mini-mill or by third parties), the Company may be held liable for such damages and be required to pay the cost of investigation and remediation of such contamination. The amount of such liability to the Company could be material. Changes in federal or state laws, regulations or requirements or discovery of unknown conditions could require additional expenditures by the Company. Item 2. Properties The Company's operations are located on approximately 126 acres of land near Ashland, Kentucky, next to an interstate highway and a rail line. The Company believes that its facilities are well maintained, in good condition and adequate and suitable for its operating needs. The Company has completed certain capital expenditures with respect to its properties. See Item 1 - Business - "Manufacturing Operations" and "Capital Improvements and Expansion." Item 3. Legal Proceedings The Company is subject to various claims and lawsuits arising in the ordinary course of business with respect to commercial, product liability and other matters, which seek remedies or damages. Based upon its evaluation of available information, management does not believe that any such matters are likely, individually or in the aggregate, to have a material adverse effect upon the Company's business, financial position, results of operations or cash flows. See also Item 1 "Business - Environmental and Regulatory Matters." Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of shareholders during the fourth quarter of the fiscal year ended September 29, 2001. Executive Officers of the Registrant Pursuant to General Instruction G(3) of Form 10-K, the following list is included as an unnumbered Item in Part I of this report in lieu of being included in the Proxy Statement for the Annual Meeting of Stockholders scheduled to be held February 26, 2002. The names, ages and positions of all of the executive officers of the Registrant as of September 29, 2001 are listed below with their business experience with the Registrant for the past five years. Officers are elected annually by the Board of Directors at the first meeting of directors following the annual meeting of stockholders. There are no family relationships among these officers, nor any agreement or understanding between any officer and any other person pursuant to which the officer was selected. Charles C. Hanebuth, 57, has been President and Chief Executive Officer of the Company since its formation in August 1993. From November 1990 to October 1993, Mr. Hanebuth was President and Chief Operating Officer of Kentucky Electric Steel Corporation, a wholly- owned subsidiary of NS Group, Inc. Mr. Hanebuth has 22 years management experience in the steel industry. Mr. Hanebuth is a advisory director of Fifth Third Bank Ohio Valley. William J. Jessie, 51, a certified public accountant, has been Vice President, Secretary, Treasurer and Chief Financial Officer of the Company since its formation in August 1993. Prior to August 1993, he was Controller of Kentucky Electric Steel Corporation since 1986. Mr. Jessie has 21 years of public accounting experience with national and local accounting firms. Joseph E. Harrison, 57, has been Vice President of Sales and Marketing of the Company since its formation in August 1993. From February 1991 to August 1993 he was General Sales Manager of Kentucky Electric Steel Corporation. Mr. Harrison has over 31 years of sales experience in the steel industry. William H. Gerak, 56, has been Vice President of Administration of the Company since January 1994. From February 1988 to December 1993 he was the Director of Human Resources and Labor Relations for Heekin Can, Inc., a wholly-owned subsidiary of Ball Corporation, a producer of steel food and aerosol containers, head-quartered in Cincinnati, Ohio. Mr. Gerak has over 27 years of human resource and administrative experience. PART II Item 5. Market for Registrant's Common Equity and Related Shareholder Matters Effective with the opening of the stock market on August 20, 2001, the Company's common stock trades on the NASDAQ Small Cap Market under the symbol "KESI." Prior to August 20, 2001, the Company's common stock traded on the NASDAQ National Market under the symbol "KESI." The following table sets forth, for the fiscal periods indicated, the high and low closing prices of the stock on the NASDAQ National or NASDAQ Small Cap Market: Fiscal 2000 Fiscal 2001 High Low High Low First Quarter $ 4.000 $ 2.375 $ 2.500 $ 1.500 Second Quarter 2.625 1.750 1.875 1.250 Third Quarter 2.781 1.875 1.900 1.280 Fourth Quarter 2.500 1.625 1.370 .600 On January 7, 2002, there were approximately 800 beneficial owners of the Company's common stock. The Company currently intends to retain all earnings to support the development of its business. Certain of the Company's debt instruments currently prohibit the payment of dividends and the repurchase of Company stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 6 of the Notes to Consolidated Financial Statements of the Company. Item 6. Selected Financial Data The selected financial data shown below for the five years in the period ended September 29, 2001 are derived from the audited financial statements of the Company. The information set forth below should be used in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Financial Statements and related notes thereto included elsewhere herein. Year Ended Sept. 27, Sept. 26, Sept. 25 Sept. 30, Sept. 29, 1997 1998 1999 2000 2001 (In thousands, except share and per share data) Income Statement Data: Net sales ............ $ 97,966 $113,676 $110,265 $120,585 $ 77,859 Cost of goods sold ... 93,306 101,940 100,016 110,883 77,863 ------- ------- ------- ------- ------- Gross profit (loss). 4,660 11,736 10,249 9,702 (4) Selling and admini- strative expenses .. 6,800 7,011 7,627 7,573 8,298 ------- ------- ------- ------- ------- Operating income (loss) (2,140) 4,725 2,622 2,129 (8,302) Interest expense ..... (2,125) (2,395) (2,274) (2,528) (2,051) Interest income and other .............. 34 80 1,234 911 909 Loss on abandonment of assets .......... - - - - (457) Gain on involuntary con- version of equipment - - - - 256 ------- ------- ------- ------- ------- Income (loss) before income taxes ...... (4,231) 2,410 1,582 512 (9,645) Income taxes ......... (1,599) 916 604 195 5,624 ------- ------- ------- ------- ------- Net income (loss) $ (2,632) $ 1,494 $ 978 $ 317 $(15,269) Net income (loss) per common share - basic and diluted... $ (.57) $ .32 $ .24 .08 $ (3.74) Weighted average shares outstanding-basic 4,633,315 4,624,671 4,085,480 4,074,463 4,081,966 Weighted average shares outstanding-diluted 4,633,315 4,630,920 4,089,219 4,074,463 4,081,966 Balance Sheet Data: Working capital ..... $ 11,335 $14,153 $15,718 $23,924 $15,935 Total assets ........ 78,770 80,251 82,941 76,954 60,014 Long-term debt (1) .. 20,000 20,000 20,000 16,667 16,667 Shareholders' equity 34,211 35,192 35,252 35,612 20,383
(1) Net of current portion. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following analysis of results of operations and financial condition of the Company should be read in conjunction with "Selected Financial Data" and Financial Statements and Supplementary Data included elsewhere herein. General The Company manufactures special bar quality alloy and carbon steel bar flats to precise customer specification for sale in a variety of niche markets. Market conditions caused the Company to experience sharp declines in shipment volumes and operating margins during fiscal 2001, which impacted the Company's cash flows and produced a pre-tax loss of approximately $9.6 million. See "Current Industry Conditions." The Company's fiscal year ends on the last Saturday of September. The fiscal year normally consists of fifty-two weeks; however, the fiscal year ended September 30, 2000 has fifty-three weeks. The fiscal year ended September 29, 2001 has fifty-two weeks. Results of Operations The following table sets forth the percentages of the Company's net sales represented by certain income and expense items for the periods indicated. Year Ended September September September 25, 1999 30, 2000 29, 2001 Net sales .................... 100.0% 100.0% 100.0% Cost of goods sold ........... 90.7 92.0 100.0 ----- ----- ----- Gross profit (loss) .......... 9.3 8.0 - Selling and administrative expenses ................... 6.9 6.3 10.7 ----- ----- ----- Operating income (loss) ...... 2.4 1.7 (10.7) Interest expense ............. (2.1) (2.1) (2.6) Interest income and other .... 1.1 .8 1.2 Loss on abandonment of assets - - (.6) Gain on involuntary conversion of equipment ............... - - .3 ----- ----- ----- Income (loss) before income taxes ............... 1.4 .4 (12.4) Income taxes ................ .5 .1 7.2 ----- ----- ----- Net income (loss) ............ .9% .3% (19.6%) Year Ended September 29, 2001 Compared with Year Ended September 30, 2000 Net Sales. Net sales for fiscal 2001 decreased by $42.7 million (35.4%) to $77.9 million from $120.6 million in fiscal 2000. The decrease in net sales is attributable to a significant decrease in shipments combined with a decrease in average selling price. Finished goods tons shipped decreased 31.5% from 264,800 tons in fiscal 2000 to 181,500 tons in fiscal 2001. The decrease in finished goods tons shipped reflects market conditions throughout the steel industry. The average selling price per finished goods shipped was down 3.9% in fiscal 2001 as compared to fiscal 2000. The decrease in average selling price for fiscal 2001 is attributed to market price reductions and a change in product mix. In addition, fiscal 2001 shipments included 1,700 tons of billets (semi-finished product) as compared to 11,800 tons of billets in fiscal 2000. Cost of Goods Sold. Cost of goods sold for fiscal 2001 decreased by $33.0 million, or 29.8% to $77.9 million from $110.9 million in fiscal 2000. As a percentage of net sales, cost of goods sold increased from 92.0% in fiscal 2000 to 100% in fiscal 2001. The decrease in cost of goods sold reflects the decrease in shipments (as discussed above) offset by an increase in the per ton cost of tons shipped. The increase in the per ton manufacturing costs of tons shipped for fiscal 2001 resulted from lower production levels and higher energy costs partially offset by lower scrap costs. The increase in cost of goods sold, as a percentage of net sales for fiscal 2001, as compared to fiscal 2000, reflects lower selling prices (as discussed above) and the increase in per ton manufacturing costs. Gross Profit (Loss). As a result of the above, gross profit for fiscal 2001 decreased by $9.7 million from $9.7 million in fiscal 2001 to ($4,000) in fiscal 2001. As a percentage of net sales, gross profit decreased from 8.0% in fiscal 2000 to 0% in fiscal 2001. Selling and Administrative Expenses. Selling and administrative expenses include salaries and benefits, corporate overhead, insurance, sales commissions and other expenses incurred in the executive, sales and marketing, shipping, human resources, and other administrative departments. Selling and administrative expenses for fiscal 2001 increased by $.7 million (9.6%) to $8.3 million from $7.6 million in fiscal 2001. As a percentage of net sales, such expenses increased from 6.3% for fiscal 2000 to 10.7% for fiscal 2001. The increase in the percentage of selling and administrative expenses to net sales for fiscal 2001, as compared to fiscal 2000, is due to the significant decrease in net sales and the increase in actual expenses. The increase in selling and administrative expenses for fiscal 2001 as compared to fiscal 2000 is primarily due to an increase in bad debt expense. The increase in bad debt expense is due to the bankruptcy of a large customer which is currently in reorganization. Operating Income (Loss). For the reasons described above, operating income decreased by $10.4 million from $2.1 million in fiscal 2000 to an operating loss of $(8.3) million in fiscal 2001. As a percentage of net sales, operating income decreased from 1.7% in fiscal 2000 to (10.7%) in fiscal 2001. Interest Expense. Interest expense decreased by $.4 million to $2.1 million in fiscal 2001 from $2.5 million in fiscal 2000. The decrease in interest expense in fiscal 2001 is due to the decrease in long-term debt and the decrease in the average amount outstanding on the Company's line of credit. To a lesser extent, the decrease in interest expense reflects lower line of credit interest rates and the fact that there was one less week in fiscal 2001. Interest Income and Other. Interest and other income for fiscal 2001 and 2000 was $.9 million. Fiscal 2001 and 2000 includes $.4 million and $.8 million, respectively, for a claim settlement pertaining primarily to the Company's purchase of electrodes during the years 1992 and 1997. Interest income increased $.2 million in fiscal 2001 due to the investment of proceeds from the sale and leaseback transaction completed in September 2000. Loss on Abandonment of Assets. During fiscal 2001, the Company disposed of certain assets that were no longer in service. The net book value of the equipment abandoned was $.5 million which is reflected as a loss in the financial statements for fiscal 2001. Gain on Involuntary Conversion of Equipment. As a result of a fire which destroyed an auxiliary building and certain equipment, the Company received insurance proceeds of $448,000 for the replacement cost of the building and equipment and other additional expenses associated with the fire. The net book value of the assets destroyed was approximately $57,000 and the Company has incurred approximately $135,000 in additional expenses associated with the fire and expended $313,000 on the new building and equipment. The excess of the replacement cost over the net book value of the building and equipment destroyed resulted in a gain of approximately $256,000. Provision (Credit) for Income Taxes. The Company has recorded a tax provision of approximately $5.6 million in fiscal 2001 which, based on a pre-tax loss of approximately $9.6 million, results in a negative effective tax rate of approximately 59%. Due to the loss incurred in fiscal 2001, continuing losses, related debt re- structurings (see "Current Industry Conditions"), the potential limitation of utilizing net operating losses under Section 382 of the Internal Revenue Code (as discussed below) and management's current belief that the available objective evidence creates sufficient uncertainty regarding the realizability of previously recognized deferred tax assets, the Company recorded a valuation allowance of approximately $8.9 million during the fourth quarter of fiscal 2001 which fully offsets previously recognized deferred tax assets. The Financial Accounting Standards Board Statement No. 109 (SFAS 109) "Accounting for Income Taxes", requires that the Company record a valuation allowance when it is "more likely than not that some portion or all of the deferred tax asset will not be realized." The Company will continue to provide a 100% valuation allowance for the deferred tax asset in the future until the Company returns to an appropriate level of cumulative financial accounting income. The ultimate realization of a future tax benefit related to net operating loss carryforwards depends on the Company's ability to generate sufficient taxable income in the future. If the Company is able to generate sufficient taxable income in the future, the Company will reduce the valuation allowance through a reduction of income tax expense (and a corresponding increase in shareholders' equity). The realization of a benefit from net operating loss carryforwards which can, and previously did, generate deferred tax assets, may also be limited by Section 382 of the Internal Revenue Code. Section 382 of the Internal Revenue Code contains rules designed to discourage persons from buying and selling the net operating losses of companies. These rules generally operate by focusing on ownership changes among stockholders owning directly or indirectly 5% or more of the common stock of a company or any change in ownership arising from a new issuance of stock by a company. In general, Section 382 rules limit the ability of a company to utilize net operating losses after a change of ownership of more than 50% of its common stock over a three-year period. Purchases of the Company's common stock in amounts greater than specified levels could inadvertently create a limitation on the Company's ability to utilize its net operating losses for tax purposes in the future. Net Income (Loss). As a result of the above, net income decreased by $15.6 million from $.3 million in fiscal 2000 to a net loss of $(15.3) million in fiscal 2001. As a percentage of net sales, net income (loss) decreased from .3% in fiscal 2000 to (19.6%) in fiscal 2001. Year Ended September 30, 2000 Compared with Year Ended September 25, 1999 Net Sales. Net sales for fiscal 2000 increased by $10.3 million (9.4%) to $120.6 million from $110.3 million in fiscal 1999. The increase in net sales is attributable to an increase in shipments offset by a decrease in average selling price. Finished goods shipments increased by 8.9% from 243,100 tons in fiscal 1999 to 264,800 in fiscal 2000. The average selling price per finished goods shipped was down 2.0% in fiscal 2000 as compared to fiscal 1999. The decrease in finished goods average selling price for fiscal 2000 is primarily attributable to a change in product mix as the Company increased its participation in lower priced products. In addition, fiscal 2000 shipments included 11,800 tons of billets (semi-finished product) as compared to 800 tons of billets in fiscal 1999. Cost of Goods Sold. Cost of goods sold for fiscal 2000 increased by $10.9 million, or 10.9% to $110.9 million from $100.0 million in fiscal 1999. As a percentage of net sales, cost of goods sold increased from 90.7% in fiscal 1999 to 92.0% in fiscal 2000. The increase in cost of goods sold reflects the increase in shipments (as discussed above) offset by a decrease in the per ton cost of tons shipped. The decrease in the per ton manufacturing costs of tons shipped for fiscal 2000 resulted from lower conversion costs due to increased productivity offset by higher scrap costs. The increase in cost of goods sold as a percentage of net sales for fiscal 2000, as compared to fiscal 1999, reflects lower selling prices (as discussed above) partially offset by lower per ton manufacturing costs. Gross Profit. As a result of the above, gross profit for fiscal 2000 decreased by $.5 million from $10.2 million in fiscal 1999 to $9.7 million in fiscal 2000. As a percentage of net sales, gross profit decreased from 9.3% in fiscal 1999 to 8.0% in fiscal 2000. Selling and Administrative Expenses. Selling and administrative expenses include salaries and benefits, corporate overhead, insurance, sales commissions and other expenses incurred in the executive, sales and marketing, shipping, human resources, and other administrative departments. Selling and administrative expenses for fiscal 2000 and 1999 were $7.6 million with decreases in legal and professional fees being offset by increases in the provision for bad debt expense, sales commissions, and miscellaneous other items. As a percentage of net sales, such expenses decreased from 6.9% for fiscal 1999 to 6.3% for fiscal 2000. The decrease in selling and administrative expenses as a percentage of net sales for fiscal 2000, as compared to fiscal 1999, is due to higher net sales in 2000. Operating Income. For the reasons described above, operating income decreased by $.5 million (18.8%) from $2.6 million in fiscal 1999 to $2.1 million in fiscal 2000. As a percentage of net sales, operating income decreased from 2.4% in fiscal 1999 to 1.7% in fiscal 2000. Interest Expense. Interest expense increased by $.2 million to $2.5 million in fiscal 2000 from $2.3 million in fiscal 1999. The increase in interest expense is due to an increase in both the average interest rate and the average amount outstanding on the line of credit. Provision (Credit) for Income Taxes. The Company has recorded a tax provision of approximately $.2 million in fiscal 2000 as compared to a tax provision of approximately $.6 million in fiscal 1999 at an effective tax rate of 38% for both years. As of September 30, 2000 the Company had net deferred tax assets of $5.7 million, which were net of a $2.7 million valuation allowance. Included in the $8.4 million of gross deferred tax assets was $5.4 million representing the tax benefit of net operating tax loss carryforwards which expire beginning in 2011. The realization of the deferred tax assets is dependent in part upon generation of sufficient future taxable income. Management considered the levels of currently anticipated pre-tax income in assessing the required level of the deferred tax asset valuation allowance. Taking into consideration historical pre-tax income levels of operations for fiscal 1998, 1999, and 2000, and other factors, management believed it was more likely than not that the net deferred tax asset, after consideration of the valuation allowance which has been established, would be realized. The amount of the net deferred tax asset considered realizable, however, could be reduced in future years if estimates of future taxable income during the carryforward period are reduced. Interest Income and Other. Interest and other income decreased by $.3 million from $1.2 million in fiscal 1999 to $.9 million in fiscal 2000. Fiscal 2000 and fiscal 1999 include other income of $.8 million and $1.1 million, respectively, for a claim settlement pertaining primarily to the Company's purchase of electrodes during the years 1992 through 1997. Net Income. As a result of the above, net income decreased by $.7 million from $1.0 million in fiscal 1999 to $.3 million in fiscal 2000. As a percentage of net sales, net income decreased from .9% in fiscal 1999 to .3% in fiscal 2000. Liquidity and Capital Resources The Company considers its level of cash, availability under its line of credit, and its current ratio and working capital to be its most important measures of short-term liquidity. In terms of long- term liquidity indicators, the Company believes its historical levels of cash generated from operations and required debt repayments to be the most important measures. Cash flows from operating activities amounted to $.7 million and $6.2 million in fiscal 1999 and 2000, respectively. Net cash used by operating activities was $7,000 in fiscal 2001. Fiscal 1999 operating cash flows reflect net income of $1.0 million, depreciation and amortization of $3.6 million and the decrease in the net deferred tax asset of $.7 million. Operating cash flows were negatively impacted by increases in accounts receivable and inventories of $2.1 million and $2.4 million, respectively. Also, operating cash flows were positively impacted by an increase of $1.2 million in trade accounts payable. The increase in inventories and accounts payable is primarily due to an increase in scrap and billet inventory. The increase in accounts receivable reflects the higher sales level in the latter part of fiscal 1999. Fiscal 2000 operating cash flows reflect net income of $.3 million and depreciation and amortization of $3.8 million. Operating cash flows were positively impacted by decreases in accounts receivable and inventories of $3.3 million and $1.1 million, respectively. Operating cash flows were negatively impacted by a $1.9 million decrease in trade accounts payable. The decrease in accounts receivable reflects the lower sales level in the latter part of fiscal 2000. The decrease in inventories is primarily due to a decrease in billet inventories and a decrease in the carrying value of finished good inventory offset by slightly higher scrap inventories. The decrease in the carrying value of finished goods inventory reflects the lower conversion costs in fiscal 2000. The decrease in accounts payable is due to timing of payments on open accounts. Fiscal 2001 operating cash flows reflect the net loss of $15.3 million, the write-off of deferred tax assets of $5.7 million, depreciation and amortization of $2.8 million and the loss on abandonment of assets of $.5 million. Operating cash flows were positively impacted by decreases in inventories and accounts receivable of $4.7 million and $2.3 million, respectively. Also, operating cash flows were negatively impacted by the decrease in trade accounts payable of $.9 million. The decrease in inventories is due to a decrease in the tons of scrap, billets, and finished goods inventory which reflects lower operating levels. The decrease inventory tonnage was offset somewhat by an increase in the carrying value of billets and finished goods inventory. The increase in the carrying value of billets and finished goods inventory reflects higher per ton cost due to lower production levels in fiscal 2001. The decrease in accounts receivable is due to the decrease in sales in fiscal 2001. The decrease in accounts payable is due to lower operating levels. Cash flows used by investing activities consisted of capital expenditures of $2.8 million in fiscal 1999. Cash flows provided by investing activities amounted to $7.2 million in fiscal 2000 and consisted of proceeds from sale-leaseback transaction of $8.5 million offset by capital expenditures of $1.3 million. Cash flows used by investing activities amounted to $.5 million in fiscal 2001 and consisted of capital expenditures of $.8 million offset by proceeds from involuntary conversion of $.3 million. Cash flows provided from financing activities amounted to $2.2 million in fiscal 1999 and reflects $3.1 million in advances on the Company's line of credit facility offset by $1.0 million used to purchase treasury stock. Cash flows used in financing activities amounted to $4.9 million and $.7 million in fiscal 2000 and 2001, respectively. The $4.9 million in fiscal 2000 reflects the $4.9 million in net repayments on the Company's line of credit facility. The $.7 million in fiscal 2001 reflects the $3.3 million repayment of long-term debt offset by the $2.6 million in advances on the Company's line of credit facility. Working capital at September 29, 2001, was $15.9 million as compared to $23.9 million at September 30, 2000. The current ratio was 1.7 to 1.0 at September 29, 2001 as compared to 2.0 to 1.0 at September 30, 2000. The Company completed its 500,000 share buyback program during fiscal 1998 and the Board of Directors authorized the repurchase of an additional 500,000 shares of the Company's common stock. During the fiscal year ended September 29, 2001, the Company did not repurchase any shares of its common stock leaving 60,515 authorized repurchase shares remaining. The Company's primary ongoing cash requirements are for current capital expenditures and ongoing working capital. Since March 31, 2001, the Company has failed to meet the fixed charge coverage ratio covenant which required the Company to maintain a fixed charge coverage ratio of 2:1 for each rolling four quarter period. In addition to the default of the fixed charge coverage ratio covenant, the Company failed to make a scheduled principal payment on the unsecured senior notes of $3,333,333 due on November 1, 2001. These covenant violations were waived in connection with the debt restructuring as discussed below. On January 14, 2002, the Company was successful in restructuring its existing debt obligations. As a result of this restructured financing, the Company deferred its November 1, 2001 principal payment and a portion of the scheduled November 1, 2002 principal payment until November 1, 2005. Annual maturities of the senior notes under the restructured financing are $1,500,000 due on November 1, 2002, $3,333,333 due on September 30, 2003, $3,333,333 due on November 1, 2004 and $8,500,000 due on November 1, 2005. These notes bear interest at the fixed rate of 9.00% per annum, with interest paid monthly. The restructured financing also includes an $18 million secured bank credit facility which expires on November 1, 2005. Borrowings are limited to defined percentages of eligible inventory and accounts receivable. Interest on borrowings accrue at the rate of prime plus 2.5%. As of January 14, 2002, approximately $10.0 million was outstanding under the Company's line of credit, approximately $1.1 million was utilized to collateralize various letters of credit and $4.2 million was available for additional borrowings. In addition, the Company had approximately $.7 million in cash. Under the terms of the restructured financing, both the senior notes and the borrowings on the line of credit are secured by all current and future assets of the Company, including, but not limited to, accounts receivable, inventory, and all real property, plant and equipment. The senior notes and bank credit facility in the restructured financing contain restrictive covenants, which include, among other requirements , the maintenance of minimum shareholders' equity; minimum earnings before interest, taxes, depreciation, and amortization (EBITDA); minimum interest coverage ratio; minimum debt service coverage ratio; capital expenditure restrictions; and prohibition on the payment of dividends. Though the Company will continue its aggressive working capital management and cost reduction initiatives, continued losses similar to those incurred in fiscal 2001 will severely limit the Company's ability to provide future liquidity from operations and remain in compliance with the new covenants of the restructured financing. There can be no assurances that long-term cash requirements and compliance with existing debt covenants will be met if the Company continues to incur significant financial losses for an extended period of time. Recent Developments On March 15, 2001, the Company received a determination letter from the Nasdaq Stock Market, Inc. indicating that, absent a successful appeal by the Company, the Company's common stock would be removed from listing on the Nasdaq National Market. This determination was made based on the Company's common stock failing to maintain public float market value of $5,000,000 as required under Nasdaq's National Market rules. The Company requested a hearing on the written record before a Nasdaq Listing Qualifications Panel to appeal the staff's determination. The Company's appeal was rejected by the Nasdaq Listing Qualifications Panel. The Panel agreed to automatically transfer the Company's common stock to the Nasdaq Small Cap Market effective with the opening of the market on August 20, 2001. See "Current Industry Conditions" for other recent developments. Impact of Inflation and Changing Prices While the Company has not experienced any material long-term adverse effects on operations in recent years because of inflation, margins have been affected by inflationary conditions. The Company's primary cost components are steel scrap, labor, and energy, all of which are susceptible to domestic inflationary pressures. Scrap costs are frequently influenced by supply and demand factors as well as general economic conditions. Finished product prices are influenced by nationwide economic trends, steel imports, and manufacturing capacity within the steel industry. While the Company has generally been successful in passing on cost increases through price increases, the effect of steel imports, market price competition and under- utilized industry capacity has in the past, and could in the future, limit the Company's ability to increase prices. See "Business - Competition and Other Market Factors," "Raw Materials," "Manufacturing Operation" and "Employees." Forward Looking Statements The matters discussed or incorporated by reference in this Report on Form 10-K that are forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995) involve risks and uncertainties. These risks and uncertainties include, but are not limited to: the reliance on truck and utility vehicle industry; excess industry capacity; product demand and industry pricing; volatility of raw material costs, especially steel scrap; intense foreign and domestic competition; management's estimates of niche market data; the cyclical and capital intensive nature of the industry; and cost of compliance with environmental regulations. These risks and uncertainties could cause actual results of the Company to differ materially from those projected or implied by such forward-looking statements. Impact of Recent Accounting Pronouncements See Note 2 "Summary of Significant Accounting Policies" of the Notes to Consolidated Financial Statements of the Company. Item 7A. Qualitative and Quantitative Disclosure about Market Risk The Company is exposed to certain market risks that are inherent in financial instruments arising from transactions that are entered into in the normal course of business. The Company does not enter into derivative financial instrument transactions to manage or reduce market risk or for speculative purposes but is subject to interest rate risk on its fixed interest rate secured senior notes. The bank credit facility has a variable interest rate which reduces the potential exposure of interest rate risk from a cash flow perspective. The fair value of debt with a fixed interest rate generally will increase as interest rates fall given consistency in all other factors. Conversely, the fair value of fixed rate debt will decrease as interest rates rise. The Company is also subject to increases in the cost of energy, supplies and steel scrap due to inflation and market conditions. Item 8. Financial Statements and Supplementary Data The financial statements and schedules referenced in Item 14(a)(1) and (a)(2) hereof are included herein and are filed as part of this report. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Directors and Executive Officers of the Registrant The specified information required by this item is incorporated by reference to the information under the heading "Proposal I: Election of Directors" in the Proxy Statement as filed with the Commission or is included under the heading "Executive Officers of the Registrant" in Part I of this 10-K filing. The disclosure required by Item 405 of Regulation S-K is incorporated by reference to the information under the heading "Compliance with Section 16(a)" of the Proxy Statement. Item 11. Executive Compensation The specified information required by this item is incorporated by reference to the information under the heading "Executive Compensation" in the Proxy Statement as filed with the Commission. Item 12. Security Ownership of Certain Beneficial Owners and Management The specified information required by this item is incorporated by reference to the information in the table under the heading "Voting Securities and Principal Holders Thereof" in the Proxy Statement as filed with the Commission. Item 13. Certain Relationships and Related Transactions None. PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)1. See Index to Financial Statements and Schedule (a)2. See Index to Financial Statements and Schedule (a)3. Exhibits 3.1 Certificate of Incorporation of Kentucky Electric Steel, Inc., filed as Exhibit 3.1 to Registrant's Registration Statement on Form S-1 (No. 33-67140), and incorporated by reference herein. 3.2 By-Laws of Kentucky Electric Steel, Inc., filed as Exhibit 3.2 to Registrant's Registration Statement on Form S-1 (No. 33-67140), and incorporated by reference herein. 4.1 Senior Note Agreement between Registrant and a group of institutional investors. Filed as Exhibit 4.1 to Registrant's Form 10-K for the fiscal year ended September 30, 1995, File No. 0-22416, and incorporated by reference herein. 4.2 First Amendment Agreement to Senior Note Agreement between Registrant and a group of institutional investors. Filed as Exhibit 4.4 to Registrant's Form 10-Q, No. 0-22416, filed on February 11, 1997, and incorporated by reference herein. 4.3 Amended and Restated Loan Agreement between Registrant and National City Bank of Kentucky dated January 14, 2002, filed herewith. 4.4 Amendment No. 2 to Senior Note Agreement between Registrant and a group of institutional investors, filed herewith. 10.1 Transfer Agreement between NS Group, Inc., Kentucky Electric Steel Corporation, and Registrant, filed as Exhibit 10.2 to Registrant's Form 10-K for the fiscal year ended September 25, 1993, File No. 0-22416, and incorporated by reference herein. 10.2 Tax Agreement between NS Group, Inc., Kentucky Electric Steel Corporation and Registrant, filed as Exhibit 10.3 to Registrant's Form 10-K for the fiscal year ended September 25, 1993, File No. 0-22416, and incorporated by reference herein. 10.3 Form of Indemnification Agreement between Registrant and Its Executive Officers and Directors, filed as Exhibit 10.4 to Amendment No. 1 to Registrant's Registration Statement on Form S-1 (No. 33-67140), and incorporated by reference herein.* 10.4 Registration Rights Agreement between Registrant and NS Group, Inc., filed as Exhibit 10.7 to Registrant's Form 10-K for the fiscal year ended September 25, 1993, File No. 0-22416, and incorporated by reference herein. 10.5 Kentucky Electric Steel, Inc. 1993 Employee Stock Option/ Restricted Stock Plan, filed on Registrant's Form S-8 (No. 33-77598), filed on April 12, 1994, and incorporated by reference herein.* 10.6 Kentucky Electric Steel, Inc. 1993 Transition Stock Option Plan, filed on Registrant's Form S-8 (No. 33-77598), filed on April 12, 1994, and incorporated by reference herein. 10.7 The Kentucky Electric Steel, Inc. Salary Continuation Plan, effective June 7, 1994, as amended, for the benefit of the Company's eligible salaried employees, filed as Exhibit 10.8 to Registrant's Form 10-Q, File No. 0-22416, filed on August 6, 1999, and incorporated by reference herein.* 10.8 The Kentucky Electric Steel, Inc. Executive Severance Plan, effective June 7, 1994, as amended, for the benefit of the Company's eligible Executive Officers, filed as Exhibit 10.9 to Registrant's Form 10-Q, File No. 0-22416, filed on August 6, 1999, and incorporated by reference herein.* 10.9 Employment Agreements dated June 7, 1994, as amended, between Kentucky Electric Steel, Inc. and its four Executive Officers, filed as Exhibit 10.10 to Registrant's Form 10-Q, file No. 0-22416, filed on August 6, 1999 and incorporated by reference herein.* 10.10 Form of Salary Continuation Agreements entered into between Kentucky Electric Steel, Inc. and its four Executive Officers, filed as Exhibit 10.11 to Registrant's Form 10-K for fiscal year ended September 25, 1999, File No. 0-22416, and incorporated by reference herein.* 10.11 The Kentucky Electric Steel, Inc. Key Employee Stock/Loan Plan, effective February 2, 1995 for the benefit of the Company's Executive Officers, filed as Exhibit 10.14 to Registrant's Form 10-Q, No. 0-22416, filed on February 9, 1995, and incorporated by reference herein.* 10.12 Kentucky Electric Steel, Inc. 1994 Employee Stock Option/ Restricted Stock Plan, filed on Registrant's Form S-8 (No. 33-301218), filed on February 12, 1996, and incorporated by reference herein.* 10.13 Rights Agreement between Kentucky Electric Steel, Inc. and EquiServe Trust Company, N.A., dated as of September 1, 1999, filed as Exhibit 4.8 to Registrant's Form 8-K, File No. 0-22416, filed on September 14, 1999 and incorporated by reference herein. 10.14 The Kentucky Electric Steel, Inc. 1999 Share Plan for Non- Employee Directors, filed as Exhibit 10.18 to Registrant's Form 10-Q, No. 0-22416 filed on August 6, 1999 and incorporated by reference herein.* 10.15 Form of Promissory Note dated October 6, 1999, between Kentucky Electric Steel, Inc. and its four executive officers, filed as Exhibit 10.19 to Registrant's From 10-K for the fiscal year ended September 25, 1999, File No. 0- 22416, and incorporated by reference herein.* 10.16 Form of Loan Forgiveness Agreement dated October 6, 1999, between Kentucky Electric Steel, Inc. and its four executive officers, filed as Exhibit 10.20 to Registrant's Form 10-K for the fiscal year ended September 25, 1999, File No. 0-22416, and incorporated by reference herein.* 10.17 Trust Under Certain Kentucky Electric Steel Salary Continuation Agreements dated October 14, 1999, filed as Exhibit 10.21 to Registrant's Form 10-K for the fiscal year ended September 25, 1999, File No. 0-22416, and incorporated by reference herein.* 10.18 Master Equipment Lease for Manufacturing Equipment dated September 30, 2000 with Fifth Third Bank, Ohio Valley, filed as Exhibit 10.18 to Registrant's Form 10-K for fiscal year ended September 30, 2000, File No. 0-22416, and incorporated by reference herein. 10.19 Master Equipment Lease for Manufacturing Equipment dated September 30, 2000 with Fifth Third Bank, Ohio Valley, filed as Exhibit 10.19 to Registrant's Form 10-K for fiscal year ended September 30, 2000, File No. 0-22416, and incorporated by reference herein. 10.20 Kentucky Electric Steel, Inc. 2001 Share Plan for Non- Employee Directors, filed as Exhibit 10.22 to Registrant's Form 10-Q, File No. 0-22416, filed on March 31, 2001, and incorporated by reference herein. 10.21 Amended and Restated Addendum A to Master Equipment Lease for Manufacturing Equipment, dated January 14, 2002 with Fifth Third Bank, Ohio Valley, filed herewith. 23 Consent of Arthur Andersen LLP (b) Reports on Form 8-K There were no reports on Form 8-K filed during the quarter ended September 29, 2001. * Indicates management contracts or compensatory plans or arrangements in which one or more Directors or Executive Officers of the Company participate or is a party. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. KENTUCKY ELECTRIC STEEL, INC. AND SUBSIDIARY January 16, 2002 By: \s\Charles C. Hanebuth Charles C. Hanebuth President, Chief Executive Officer and Chairman Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signatures Title Date \s\Charles C. Hanebuth President, Chief Executive Officer January 16, 2002 Charles C. Hanebuth and Chairman \s\William J. Jessie Vice President, Secretary, January 16, 2002 William J. Jessie Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) \s\Clifford R. Borland Director January 16, 2002 Clifford R. Borland \s\Carl E. Edwards, Jr. Director January 16, 2002 Carl E. Edwards, Jr. \s\J. Marvin Quin, II Director January 16, 2002 J. Marvin Quin, II \s\David C. Struve Director January 16, 2002 David C. Struve
KENTUCKY ELECTRIC STEEL, INC. AND SUBSIDIARY INDEX TO FINANCIAL STATEMENTS AND SCHEDULE Financial Statements Page(s) Report of Independent Public Accountants .............. F-1 Consolidated Balance Sheets - September 30, 2000 and September 29, 2001 .................................... F-2 Consolidated Statements of Operations - Years ended September 25, 1999, September 30, 2000 and September 29, 2001 ................................ F-3 Consolidated Statements of Changes in Shareholders' Equity - Years ended September 25, 1999, September 30, 2000, and September 29, 2001 .......................... F-4 Consolidated Statements of Cash Flows - Years ended September 25, 1999, September 30, 2000 and September 29, 2001 ................................ F-5 Notes to Consolidated Financial Statements ............ F-6 Financial Statement Schedule Report of Independent Public Accountants .............. S-1 Schedule II Valuation and Qualifying Accounts ........ S-2 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Kentucky Electric Steel, Inc. and Subsidiary: We have audited the accompanying consolidated balance sheets of Kentucky Electric Steel, Inc. (a Delaware corporation) and Subsidiary as of September 30, 2000 and September 29, 2001, and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the period ended September 29, 2001. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Kentucky Electric Steel, Inc. and Subsidiary as of September 30, 2000 and September 29, 2001 and the results of their operations and their cash flows for each of the three years in the period ending September 29, 2001 in conformity with accounting principles generally accepted in the United States. Arthur Andersen LLP Cincinnati, Ohio, January 14, 2002 KENTUCKY ELECTRIC STEEL, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS (Dollars in Thousands) September September 30, 2000 29, 2001 ASSETS CURRENT ASSETS Cash and cash equivalents $ 8,688 $ 7,505 Accounts receivable, less allowance for doubtful accounts and claims of $685 in 2000 and $695 in 2001 10,923 8,600 Inventories 21,668 16,962 Operating supplies and other current assets 5,295 5,128 Refundable income taxes 175 - Deferred tax assets 1,028 - ------- ------- Total current assets 47,777 38,195 ------- ------- PROPERTY, PLANT AND EQUIPMENT Land and buildings 5,604 5,881 Machinery and equipment 34,833 35,252 Construction in progress 946 162 Less - accumulated depreciation (17,387) (19,936) ------- ------- Net property, plant and equipment 23,996 21,359 ------- ------- DEFERRED TAX ASSETS 4,636 - ------- ------- OTHER ASSETS 545 460 ------- ------- Total assets $ 76,954 $ 60,014 LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Advances on line of credit $ 9,572 $ 12,141 Accounts payable 7,193 6,303 Accrued liabilities 3,630 3,691 Current maturities of long-term debt 3,458 125 ------- ------- Total current liabilities 23,853 22,260 ------- ------- LONG-TERM DEBT 16,667 16,667 ------- ------- DEFERRED GAIN FROM SALE-LEASEBACK 822 704 ------- ------- Total liabilities 41,342 39,631 ------- ------- COMMITMENTS AND CONTINGENCIES SHAREHOLDERS' EQUITY Preferred stock, $.01 par value, 1,000,000 shares authorized, no shares issued - - Common stock, $.01 par value, 15,000,000 shares authorized, 5,022,544 and 5,051,566 shares issued, respectively 50 51 Additional paid-in capital 15,778 15,817 Less treasury stock - 951,281 shares at cost (4,309) (4,309) Retained earnings 24,093 8,824 ------- ------- Total shareholders' equity 35,612 20,383 ------- ------- Total liabilities and shareholders' equity $ 76,954 $ 60,014
See notes to consolidated financial statements KENTUCKY ELECTRIC STEEL, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in Thousands, Except Share and Per Share Data) Year Ended September September September 25, 1999 30, 2000 29, 2001 NET SALES $110,265 $120,585 $ 77,859 COST OF GOODS SOLD 100,016 110,883 77,863 ------- ------- ------- Gross profit (loss) 10,249 9,702 (4) SELLING AND ADMINISTRATIVE EXPENSES 7,627 7,573 8,298 ------- ------- ------- Operating income (loss) 2,622 2,129 (8,302) INTEREST EXPENSE (2,274) (2,528) (2,051) INTEREST INCOME AND OTHER 1,234 911 909 LOSS ON ABANDONMENT OF ASSETS - - (457) GAIN ON INVOLUNTARY CONVERSION OF EQUIPMENT - - 256 ------- ------- ------- Income (loss) before income taxes 1,582 512 (9,645) PROVISION FOR INCOME TAXES 604 195 5,624 ------- ------- ------- Net income (loss) $ 978 $ 317 $(15,269) NET INCOME (LOSS) PER COMMON SHARE - BASIC AND DILUTED $ .24 $ .08 $ (3.74) WEIGHTED AVERAGE SHARES OUTSTANDING - BASIC 4,085,480 4,074,463 4,081,966 WEIGHTED AVERAGE SHARES OUTSTANDING - DILUTED 4,089,219 4,074,463 4,081,966 See notes to consolidated financial statements KENTUCKY ELECTRIC STEEL, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY For the Three Years in the Period Ended September 29, 2001 (Dollars in Thousands) Addi- De- tional ferred Common Stock Paid-In Treasury Stock Compen- Retained Shares Amount Capital Shares Amount sation Earnings Total BALANCE, Sept. 26, 1998 4,985,937 $50 $15,671 (526,996) $(3,254) $(73) $22,798 $35,192 Amortization of deferred comp- ensation - - - - - 43 - 43 Issuance of Stock 17,937 - 57 - - - - 57 Purchases of treasury stock - - - (405,585) (1,018) - - (1,018) Net income - - - - - - 978 978 --------- -- ------ ------- ----- --- ------ ------ BALANCE, Sept. 25, 1999 5,003,874 50 15,728 (932,581) (4,272) (30) 23,776 35,252 Amortization of deferred comp- ensation - - - - - 30 - 30 Issuance of Stock 18,670 - 50 - - - - 50 Purchases of treasury stock - - - (18,700) (37) - - (37) Net income - - - - - - 317 317 --------- -- ------ ------- ----- --- ------ ------ BALANCE, Sept. 30, 2000 5,022,544 50 15,778 (951,281) (4,309) - 24,093 35,612 Issuance of Stock 29,022 1 39 - - - - 40 Net loss - - - - - - (15,269) (15,269) --------- -- ------ ------- ----- --- ------ ------ BALANCE, Sept. 29, 2001 5,051,566 $51 $15,817 (951,281) $(4,309) $ - $ 8,824 $20,383
See notes to consolidated financial statements KENTUCKY ELECTRIC STEEL, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in Thousands) Year Ended September September September 25, 1999 30, 2000 29, 2001 Cash Flows From Operating Activities: Net income (loss) $ 978 $ 317 $(15,269) Adjustments to reconcile net income (loss) to net cash flows from operating activities: Depreciation and amortization 3,636 3,827 2,790 Loss on abandonment of assets - - 457 Gain on involuntary conversion of equipment - - (256) Change in deferred taxes 737 617 4,636 Change in other 23 (430) 65 Changes in current assets and current liabilities: Accounts receivable (2,143) 3,257 2,323 Inventories (2,388) 1,083 4,706 Operating supplies and other current assets (88) (1) 167 Refundable income taxes (315) 140 175 Deferred tax assets (35) (345) 1,028 Accounts payable 1,153 (1,873) (890) Accrued liabilities 154 (358) 61 Environmental liabilities (982) - - ------ ------ ------ Net cash flows from operating activities 730 6,234 (7) ------ ------ ------ Cash Flows From Investing Activities: Capital expenditures (2,848) (1,341) (752) Proceeds from sale-leaseback - 8,536 - Proceeds from involuntary conversion - - 300 ------ ------ ------ Net cash flows from investing activities (2,848) 7,195 (452) ------ ------ ------ Cash Flows From Financing Activities: Repayment of long-term debt - - (3,333) Net advances (repayments)on line of credit 3,113 (4,938) 2,569 Issuance of common stock 57 50 40 Purchases of treasury stock (1,018) (37) - ------ ------ ------ Net cash flows from financing activities 2,152 (4,925) (724) ------ ------ ------ Net increase (decrease)in cash and cash equivalents 34 8,504 (1,183) Cash and Cash Equivalents - Beginning of Period 150 184 8,688 ------ ------ ------ Cash and Cash Equivalents - End of Period $ 184 $ 8,688 $ 7,505 Interest Paid $ 2,262 $ 2,472 $ 2,144 Income Taxes Paid (Received) $ 216 $ 80 $ (175) See notes to consolidated financial statements KENTUCKY ELECTRIC STEEL, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Nature of Operations Kentucky Electric Steel, Inc. (KESI or the Company), a Delaware corporation, owns and operates a steel mini-mill near Ashland, Kentucky. The Company manufactures special bar quality alloy and carbon steel bar flats to precise customer specifications for sale in a variety of niche markets. During the past three years, market conditions within the domestic steel industry have experienced significant downward economic pressure largely due to market price and shipment volume declines. These market conditions are a result of a number of factors including a decline in the general economy of the United States, a decline in the industries of the Company's customers, the increased cost of production due to high electricity and natural gas costs and an increase in competition from foreign steel companies. These forces have driven market prices to levels below the cost of production for certain domestic producers, and as a result, many steel manufacturers have curtailed production or ceased operations, and a number of steel industry producers have sought protection under the United States Bankruptcy Code. As a result of these conditions, the Company has experienced sharp declines in shipment volumes and operating margins during fiscal 2001, which impacted the Company's cash flows and produced a pre-tax loss of approximately $9.6 million in fiscal 2001. Since March 31, 2001, the Company has failed to meet the fixed charge coverage ratio covenant of its loan agreements which required the Company to maintain a fixed charge coverage ratio of 2:1 for each rolling four quarter period. In addition to the default of the fixed charge coverage ratio covenant, the Company failed to make a scheduled principal payment on the unsecured senior notes of $3,333,333 due on November 1, 2001. However, the Company is current on all interest payments. In response to these conditions, the Company has undertaken and will continue to undertake certain cost control initiatives and subsequent to September 29, 2001, the Company was successful in restructuring its long-term debt obligations and bank credit facility in order to manage the Company's liquidity through this difficult market environment. Management anticipates that the market conditions discussed above will continue to impact the Company's operations through fiscal 2002 and negatively impact the Company's financial performance. Management believes that the Company has the ability to sustain its operations and meet its commitments at least for the near-term through effective management of its operations and the restructured debt and bank credit facility. However, should these negative market conditions worsen or persist on a long-term basis, the Company's ability to continue to manage its liquidity for the long-term may be jeopardized. (2) Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of Kentucky Electric Steel, Inc. and its wholly-owned subsidiary, KESI Finance Company, which was formed in October 1996 to finance the ladle metallurgy facility. All significant intercompany accounts and transactions have been eliminated. On September 28, 2001, the Company dissolved KESI Finance Company as a separate legal entity. Accounting Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Reclassifications Certain reclassifications of previously reported amounts have been made to conform with current classifications. Cash and Cash Equivalents Cash includes currency on-hand and deposits with financial institutions. Cash equivalents consist of investments with original maturities of three months or less. Amounts are stated at cost, which approximates market value. Cash and cash equivalents as of September 30, 2000 includes the proceeds from the sale-leaseback transaction. Inventories Inventory costs include material, labor and manufacturing overhead. Inventories are valued at the lower of average cost or market. Property, Plant and Equipment and Depreciation Property, plant and equipment is recorded at cost, less accumulated depreciation. For financial reporting purposes, depreciation is provided on the straight-line method over the estimated useful lives of the assets, generally 3 to 12 years for machinery and equipment and 15 to 30 years for buildings and improvements. Depreciation for income tax purposes is computed using accelerated methods. Expenditures for maintenance and repairs are charged to expense as incurred. Expenditures for equipment renewals, which extend the useful life of any asset, are capitalized. The Company assesses its long-lived assets for impairment when events and circumstances indicate the assets may be impaired and the undiscounted cash flows estimated to be generated by those assets are less than their carrying amounts. Revenue Recognition The Company recognizes revenue from sales at the time of shipment. Income Taxes The Company accounts for income taxes pursuant to the asset and liability method. Deferred tax assets and liabilities are recognized based upon the estimated increase or decrease in taxes payable or refundable in future years expected to result from reversal of temporary differences and utilization of carryforwards which exist at the end of the current year. Temporary differences represent the differences between the financial statement carrying amount of assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates scheduled to apply to taxable income in the years in which the temporary differences are expected to be settled, and are adjusted in the period of enactment for the effect of a change in tax law or rates. Valuation allowances are provided against deferred tax assets for which it is "more likely than not" the assets will not be realized. The valuation allowance was increased to $11.5 million as a result of the uncertainty of the recoverability of such tax benefits. (See Note 9 to the Consolidated Financial Statements) Fiscal Year End The Company's fiscal year ends on the last Saturday of September. The fiscal year normally consists of fifty-two weeks, however, the fiscal year ending September 30, 2000 consisted of fifty- three weeks. The fiscal year ending September 29, 2001 consisted of fifty-two weeks. Segment Information Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the decision-making group in deciding how to allocate resources. The Company has one business unit. New Accounting Pronouncements SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities" In June 1998, the Financial Accounting Standards Board issued Statement No. 133 (SFAS No. 133) "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The Company adopted SFAS No. 133 effective as of the beginning of the first quarter of fiscal 2001. The Company does not currently have any derivative financial instruments; therefore, SFAS No. 133 does not currently apply. SFAS No. 141 "Business Combinations" In July 2001, the Financial Accounting Standards Board issued Statement No. 141 (SFAS 141) "Business Combinations". This standard eliminates the pooling of interest method of accounting for business combinations. This standard is effective for all business combinations initiated after June 30, 2001. As the Company has not completed any business combinations or mergers in the current year, this standard currently does not apply. SFAS No. 142 "Goodwill and Other Intangible Assets" In July 2001, the Financial Accounting Standards Board issued Statement No. 142 (SFAS 142) "Goodwill and Other Intangible Assets". SFAS 142 establishes accounting and reporting standards for acquired goodwill and other intangible assets. It requires that an entity cease amortization of goodwill and intangible assets and establishes an annual requirement to test these assets for impairment. This standard is required to be adopted for fiscal years beginning after December 15, 2001. As such, the Company is not required to adopt this standard until the fiscal year beginning September 29, 2002. Early application of this standard is permitted for entities with fiscal years beginning after March 15, 2001. The Company did not early adopt this standard. Management does not believe that the adoption of this standard will have a material impact on the financial position or results of operations of the Company. SFAS No. 143 "Accounting for Asset Retirement Obligations" In August 2001, the Financial Accounting Standards Board issued Statement No. 143 (SFAS 143) "Accounting for Assets Retirement Obligations". SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. This standard is required to be adopted for fiscal years beginning after June 15, 2002. As such, the Company is not required to adopt this standard until the fiscal year beginning September 29, 2002. Management does not believe that the adoption of this standard will have a material impact on the financial position or results of operations of the Company. SFAS No. 144 "Accounting for the Impairment or Disposal of Long- Lived Assets In October 2001, the Financial Accounting Standards Board issued Statement No. 144 (SFAS 144) "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS 144 addresses financial accounting impairment or disposal of long-lived assets and requires that one accounting model be used for long-lived assets to be disposed of by sale and broadens the presentation of discontinued operations to include more disposal transactions. This standard is required to be adopted for fiscal years beginning after December 15, 2001. As such, the Company is not required to adopt this standard until the fiscal year beginning September 28, 2002. Management does not believe that the adoption of this standard will have a material impact on the financial position or results of operations of the Company. (3) Inventories Inventories at September 30, 2000 and September 29, 2001 consist of the following ($000's): 2000 2001 Raw materials $ 3,181 $ 2,113 Semi-finished and finished goods 18,487 14,849 Total inventories $21,668 $16,962 (4) Accrued Liabilities Accrued liabilities at September 30, 2000 and September 29, 2001 consist of the following ($000's): 2000 2001 Accrued payroll and related liabilities $ 1,293 $ 1,095 Accrued insurance and workers' compensation 880 1,050 Accrued interest payable 770 677 Other 687 869 $ 3,630 $ 3,691 (5) Involuntary Conversion Due to Fire The Company experienced a fire which destroyed an auxiliary building and certain equipment during the first quarter of fiscal 2001. This fire did not interrupt the Company's operations. The resulting damage and replacement costs were covered by the Company's insurance carrier, subject to a $100,000 deductible. The Company completed construction of new facilities during the fourth quarter of fiscal 2001. The net book value of the assets destroyed was approximately $57,000 and the Company incurred approximately $135,000 in additional expenses associated with the fire and expended $313,000 on the new building and equipment. The excess of the replacement cost over the net book value of the building and equipment destroyed resulted in a gain of approximately $256,000. The insurance company advanced the Company $300,000 related to this claim. The financial statements as of September 29, 2001 include a receivable from the insurance company of approximately $148,000. (6) Advances on Line of Credit and Long-Term Debt Long-term debt of the Company at September 30, 2000 and September 29, 2001, as restructured, consists of the following ($000's): 2000 2001 Secured senior notes, due in annual installments from November 2000 through 2005, interest at 9.00% $ 20,000 $ 16,667 Other 125 125 20,125 16,792 Less - Current portion (3,458) (125) $ 16,667 $ 16,667 At September 29, 2001, before the debt restructuring, the Company had outstanding borrowings of $16.7 million on the unsecured senior notes. These notes bore interest at a fixed rate of 7.66% per annum, with interest paid semi-annually. Additionally, the Company had a $24.5 million unsecured bank credit facility which expired on January 31, 2002. Borrowings were limited to defined percentages of eligible inventory and accounts receivable. Interest on borrowings accrued at the rate of LIBOR plus 1.35% or the prime rate minus 1/2%. As of September 29, 2001, approximately $12.1 million was outstanding under the old bank credit facility, approximately $1.1 million was utilized to collateralize various letters of credit. The weighted average interest rate on short-term borrowings as of September 30, 2000 and September 29, 2001 were 8.2% and 5.5%, respectively. The maximum and average borrowings for the year ended September 29, 2001 were $13,210,000 and $10,587,000, respectively. The senior notes and the bank credit facility contained restrictive covenants, which include, among other restrictions, a maximum ratio of total funded debt to total capitalization, a minimum fixed charge coverage ratio, a minimum net worth requirement and restrictions on the payment of dividends. Since March 31, 2001, the Company failed to meet the fixed charge coverage ratio covenant which required the Company to maintain a fixed charge coverage ratio of 2:1 for each rolling four quarter period. In addition to the default of the fixed charge coverage ratio covenant, the Company failed to make the scheduled principal payment of $3,333,333 due on November 1, 2001. These covenant violations were waived in connection with the debt restructuring as discussed below. On January 14, 2002, the Company was successful in obtaining restructured financing of its existing debt obligations. As a result of this restructured financing, the Company deferred its November 1, 2001 principal payment and a portion of the scheduled November 1, 2002 principal payment until November 1, 2005. Annual maturities of the senior notes under the restructured financing are $1,500,000 due on November 1, 2002, $3,333,333 due on September 30, 2003, $3,333,333 due on November 1, 2004 and $8,500,000 due on November 1, 2005. These notes bear interest at the fixed rate of 9.00% per annum, with interest paid monthly. The restructured financing also includes an $18 million secured bank credit facility which expires on November 1, 2005. Borrowings are limited to defined percentages of eligible inventory and accounts receivable. Interest on borrowings accrue at the rate of prime plus 2.5%. As of January 14, 2002, approximately $12.1 million was outstanding under the Company's line of credit, approximately $1.1 million was utilized to collateralize various letters of credit. In addition, the Company had approximately $3.7 million in cash. Under the terms of the restructured financing, both the senior notes and the borrowings on the line of credit are secured by all current and future assets of the Company, including, but not limited to, accounts receivable, inventory, and all real property, plant and equipment. The senior notes and bank credit facility in the restructured financing contain restrictive covenants, which include, among other requirements, the maintenance of minimum shareholders' equity; minimum earnings before interest, taxes, depreciation, and amortization (EBITDA); minimum interest coverage ratio; minimum debt service coverage ratio; capital expenditure restrictions; and prohibition on the payment of dividends. The estimated fair value of the Company's secured senior notes is estimated using discounted cash flow analysis, based upon the estimated market rate as of September 29, 2001. The fair value of the secured senior notes was approximately $17.7 million as of September 29, 2001 and $19.8 million as of September 30, 2000. (7) Sale-Leaseback Transaction In September 2000, the Company entered into a sale-leaseback transaction for its ladle metallurgy facility and certain other of its machinery and equipment for approximately $8.5 million, resulting in a deferred gain of $.8 million, to be amortized over the seven year term of the lease. Lease expense for the ladle metallurgy facility and certain other machinery and equipment was $1,318,000. The Company has an early buyout option for a certain portion of the leased assets at the end of 5 years, and another early buyout option for all the leased assets at the end of 6-1/2 years at an amount approximating the estimated fair value of the assets. The Company also has a purchase option at the end of the lease term at an amount equal to the equipment's then fair market value. If the purchase option is not exercised, the lease automatically renews for a term and rate to be negotiated by the Company and the lessor. The lease has been accounted for as an operating lease. The future minimum lease payments are as follows ($000's): 2002 $1,448 2003 1,360 2004 1,297 2005 1,275 2006 1,210 thereafter 1,310 Total $7,900 (8) Significant Customers and Foreign Sales The Company grants trade credit to customers within the markets it serves. Sales to the leaf-springs suspension market represented 12.5%, 16.7%, and 13.8% of total sales for fiscal 1999, 2000 and 2001, respectively. One company, through several wholly-owned subsidiaries, which are customers of the Company, represented 13.5%, 11.2%, and 10.1% of net sales in fiscal 1999, 2000, and 2001, respectively. Another customer, through two wholly-owned subsidiaries, which are customers of the Company, accounted for 11.0%, 8.0%, and 6.8% of net sales in fiscal 1999, 2000, and 2001, respectively. No other customer accounted for more than 10% of net sales. The Company's foreign sales represented 8.6%, 12.7%, and 8.3% of total sales for 1999, 2000 and 2001, respectively. (9) Income Taxes The provision (credit) for income taxes consists of the following ($000's): 1999 2000 2001 Current: Federal $ (98) $ (76) $ 775 State - - 103 (98) (76) 878 Deferred: Federal 626 249 3,142 State 76 22 1,604 702 271 4,746 Total provision (credit) for income taxes $ 604 $ 195 $ 5,624 The provision (credit)for income taxes differs from the amount computed by applying the statutory federal income tax rate to income before income taxes for the following reasons ($000's): 1999 2000 2001 Income tax provision (credit) at statutory tax rate of 34% $ 538 $ 174 $(3,312) State income taxes, net of federal effect 50 15 (311) Change in valuation allowance - - 8,865 Other, net 16 6 382 $ 604 $ 195 $ 5,624 The components of the net deferred tax asset at September 30, 2000 and September 29, 2001 are as follows ($000's): Sept. 30, Sept. 29, 2000 2001 Deferred tax components: Property, plant and equipment $(1,671) $(2,228) Intangibles 1,684 1,472 AMT credit carryforwards 992 951 NOL carryforward 5,362 9,509 Other 1,978 1,842 8,345 11,546 Valuation allowance (2,681) (11,546) Net deferred tax assets $ 5,664 $ 0 For Federal income tax purposes the Company has alternative minimum tax credit carryforwards of approximately $1.0 million, which are not limited by expiration dates. The Company also has gross operating tax loss carryforwards of approximately $27.9 million, which expire beginning in 2011. The Company has recorded deferred tax assets related to these carryforwards. The realization of deferred tax assets is dependent in part upon generation of sufficient future taxable income. Management has considered the levels of currently anticipated pre-tax income in assessing the required level of the deferred tax asset valuation allowance. After taking into consideration historical pre-tax income levels, the results of operations from fiscal 1999, 2000 and 2001, the potential limitation of net operating losses under Section 382 of the Internal Revenue Code and other available objective evidence, the realization of the deferred tax asset is no longer more likely than not. Therefore, the valuation allowance was increased to fully reserve the net deferred tax asset. Also, realization of deferred tax assets may be limited by Section 382 of the Internal Revenue Code. Section 382 of the Internal Revenue Code contains rules designed to discourage persons from buying and selling the net operating losses of companies. These rules generally operate by focusing on ownership changes among stockholders owning directly or indirectly 5% or more of the common stock of a company or any change in ownership arising from a new issuance of stock by a company. In general, Section 382 rules limit the ability of a company to utilize net operating losses after a change of ownership of more than 50% of its common stock over a three-year period. Purchases of our common stock in amounts greater than specified levels could inadvertently create a limitation on our ability to utilize our net operating losses for tax purposes in the future. (10) Profit Sharing Plans The Company has established profit sharing plans for its bargaining unit (hourly) and salaried employees. Generally, the plans require mandatory contributions of five percent of pretax profits (with a guaranteed minimum based on hours worked) for the hourly employees, and an additional discretionary contribution set by the Board of Directors for salaried employees. Expense for contributions was approximately $219,000, $225,000 and $175,000 in fiscal 1999, 2000 and 2001, respectively. (11) Earnings Per Share Statement of Financial Accounting Standards No. 128 (SFAS No. 128) related to earnings per share requires dual presentation of basic and diluted earnings per share on the face of the income statement for all entities with complex capital structures. The following is the reconciliation of the numerators and denominators of the basic and diluted earnings per share computations. Net Income ($000's) For the Year Ended For the Year Ended September 25, 1999 September 30, 2000 Per Per Net Share Net Share Income Shares Amount Income Shares Amount Amounts for Basic Earnings Per Share $ 978 4,085,480 $ .24 $ 317 4,074,463 $.08 Effect of Dilutive Securities Options - 3,739 - - - - Amounts for Diluted Earnings Per Share $ 978 4,089,219 $ .24 $ 317 4,074,463 $.08 For the Year Ended September 29, 2001 Per Net Share (Loss) Shares Amount Amounts for Basic Earnings Per Share $(15,269) 4,081,966 $(3.74) Effect of Dilutive Securities Options - - - Amounts for Diluted Earnings Per Share $(15,269) 4,081,966 $(3.74) The following options were not included in the computation of diluted earnings per share because to do so would have been antidilutive for the applicable period: 1999 2000 2001 Transition stock options 56,061 50,951 26,633 Employee stock options 378,668 561,052 601,744 434,729 612,003 628,377 See Note 12 for further information regarding options outstanding. (12) Stock Option/Restricted Stock Plan The Company has Employee Stock Option/Restricted Stock Plans which provide shares of common stock for awards to eligible employees in the form of stock options and restricted stock. Awards under the Plans may be made to any officer or other key employees of the Company. The options become exercisable on a pro rata basis over a period of four years beginning one year after the grant date, except for options issued in conjunction with the initial public offering, which became exercisable over a three-year period, which began upon approval by the stockholders of the 1993 Employee Stock Option/Restricted Stock Plan in February 1994. All unexercised options expire ten years after the date of grant. Option prices range from $1.50 to $12.31 per share. The Plans also provide for the issuance of restricted stock. The restricted shares vest three years after the grant date. During 1994 in connection with the initial public offering, 18,000 restricted shares were granted and issued, and vested on a pro rata basis over a period of four years beginning one year after the grant date. A summary of transactions in the above plans for fiscal 1999, 2000, and 2001 are as follows: 1999 2000 2001 Weighted- Weighted- Weighted- Average Average Average Stock Exercise Stock Exercise Stock Exercise Options Price Options Price Options Price Options outstanding, beginning of year 386,668 $ 9.15 469,860 $ 7.97 561,052 $ 8.99 Options granted 91,192 3.03 91,192 2.53 85,192 1.50 Options forfeited (8,000) 8.66 - - (44,500) 4.72 Options outstanding, end of year 469,860 $ 7.97 561,052 $ 7.09 601,744 $ 6.47 Options exercisable, end of year 318,022 $ 9.72 380,916 $ 8.99 423,559 $ 8.28 Restricted shares granted - - - Options and restricted shares available for grant 191,041 99,849 59,157
The 1993 Transition Stock Option Plan (the "Transition Plan") was approved by the shareholders in 1994. The Transition Plan was designed to substitute KESI stock options for previously issued NS Group stock options. KESI incentive stock options for 186,539 shares of Common Stock were issued in 1994, with exercise prices varying from $8.76 per share to $20.86 per share. All options outstanding at September 29, 2001 have ten year terms and expire in 2003. A summary of transactions in the plan for fiscal 1999, 2000, and 2001 are as follows: 1999 2000 2001 Weighted- Weighted- Weighted- Average Average Average Stock Exercise Stock Exercise Stock Exercise Options Price Options Price Options Price Options outstanding, beginning of year 92,335 $ 10.84 56,061 $ 8.93 50,951 $ 8.86 Options granted - - - - - - Options forfeited (6,340) 11.01 (4,755) 8.86 (10,640) 8.86 Options expired (29,934) 14.40 (355) 19.57 (13,678) 9.05 Options outstanding, end of year 56,061 $ 8.93 50,951 $ 8.86 26,633 $ 8.76 Options exercisable, end of year 56,091 $ 8.93 50,951 $ 8.86 26,633 $ 8.76
The Company accounts for its stock-based compensation plans using the intrinsic value method in accordance with APB Opinion No. 25 and related interpretations. Under this method, no compensation cost has been recognized for the Company's Employee Stock Option Plan for fiscal years 1999, 2000, and 2001. Had compensation cost for the stock option plans been determined based on the fair value of the options at the grant dates, under those plans consistent with the fair value method, pro forma net income and basic and diluted earnings per share would have been net income of $.9 million and $.21 per share for fiscal 1999, net income of $.2 million or $.05 per share for fiscal 2000, and net loss of $15.3 million and ($3.74) per share for fiscal 2001. The weighted-average fair value of options granted in fiscal 1999, 2000 and 2001 was $1.64, $1.48 and $.83 per share, respectively. The fair value of each option is estimated on the date of grant using the Black-Scholes options pricing model with the following assumptions: weighted average risk free interest rate of 5.1% for fiscal 1999, 6.78% for fiscal 2000 and 5.17% for fiscal 2001, weighted average volatility of 39.4% for fiscal 1999, 40.4% for fiscal 2000 and 40.95% for fiscal 2001, expected life of eight years and zero dividends. The following table summarizes information about stock options outstanding at September 29, 2001 under the Employee Stock Option/Restricted Stock Plans and the Transition Plan: Options Outstanding Options Exercisable Weighted- Average Weighted- Weighted- Number Remaining Average Number Average Range of Outstanding Contractual Exercise Exercisable Exercise Exercise Prices at 9/29/01 Life Price at 9/29/01 Price Employee Stock Option/Restricted Stock Plans: $ 9.13 - 12.31 208,784 2.97 Years $11.11 208,784 $11.11 5.56 - 7.63 153,884 5.11 Years 6.57 153,884 5.11 1.50 - 3.03 239,076 8.36 Years 2.36 60,891 2.86 $ 1.50 - 12.31 601,744 5.66 Years $ 6.47 423,559 $ 8.28 Transition Plan: $ 8.76 - 8.76 26,633 1.39 Years $ 8.76 26,633 $ 8.76
The Company has a key employees' stock loan plan which provides for the granting of loans to eligible employees for the purchase of the Company's common stock in the open market. Under the terms of the plan, the loans are forgiven, and the related amounts expensed, on a pro-rata basis over a five-year period of service beginning at the date of grant. The stock loan was fully amortized as of September 30, 2000. In fiscal 2000, the Company recognized approximately $30,000 of compensation expense related to the plan. During 1997, the Board of Directors established the Kentucky Electric Steel, Inc. Share Plan for Non-Employee Directors (the "Plan"), which provides for the issuance of stock in lieu of cash for director services. Under the Plan, 25,000 shares were authorized for issuance. In May 1999, the Board of Directors approved the 1999 Share Plan for Non-Employee Directors, which authorized 25,000 of additional shares to be used for Directors' compensation. In February 2001, the stockholders of the Company approved the 2001 Share Plan for Non- Employee Directors, which authorized 100,000 of additional shares to be used for Directors' compensation. The Plan provides for issuance of common stock for at least 60% of the fees payable with respect to the applicable meeting for each Non-Employee Director. During fiscal 2000, 18,670 shares were issued at stock prices ranging from $1.97 to $3.72 per share. During fiscal 2001, 29,022 shares were issued at stock prices ranging from $1.25 to $2.25. (13) Shareholders' Equity Each share of common stock outstanding (and each share of common stock issued prior to the occurrence of certain events) carries with it one Preferred Stock Purchase Right (a Right) to purchase at a price of $40, one-hundredth of a share of Series A Junior Participating Preferred Stock. The Rights are exercisable only if a person or group acquires or announces a tender offer which would result in ownership of 20% or more of the common stock. The Company can redeem the Rights for $.01 per Right at any time prior to the time a person or group acquires 20% or more of the Company's shares. Following the acquisition of 20% or more of the Company's common stock by a person or group, the holders of the Rights will be entitled to purchase additional shares of Company common stock at one-half the then current market price, and, in the event of a subsequent merger or other acquisition of the Company, to buy shares of common stock of the acquiring entity at one-half of the market price of those shares. In neither event, however, would the acquiring person or group be entitled to purchase shares at the reduced price. In connection with the shareholder rights plan, which was adopted by the Board of Directors on February 27, 1996 and amended and restated as of September 1, 1999, 150,000 shares of the Company's 1,000,000 authorized shares of preferred stock have been designated as Series A Junior Participating Preferred Stock. No shares of the Series A Junior Participating Preferred Stock have been issued. (14) Commitments and Contingencies The Company has various commitments for the purchase of materials, supplies and energy arising in the ordinary course of business. The Company is subject to various claims, lawsuits and administrative proceedings arising in the ordinary course of business with respect to commercial, product liability, environmental and other matters, which seek remedies or damages. Costs to be incurred in connection with environmental matters are accrued when the prospect of incurring costs for testing or remedial action is deemed probable and such amounts can be estimated. The Company maintains reserves which it believes are adequate related to testing, consulting fees and minor remediation. However, new information or developments with respect to known matters or unknown conditions could result in the recording of accruals in the periods in which they become known. The Company believes that any liability that may ultimately be determined with respect to commercial, product liability, environmental or other matters will not have a material effect on its financial condition or results of operations. (15) Quarterly Financial Data (Unaudited) Quarterly results of operations (in thousands, except share and per share amounts) for fiscal 2000 and fiscal 2001 are as follows: First Second Third Fourth Quarter Quarter Quarter Quarter 2000 Net sales $ 30,715 $ 31,171 $ 32,629 $ 26,070 Gross profit $ 1,619 $ 3,058 $ 3,246 $ 1,779 Net income (loss) $ (620) $ 362 $ 920 $ (345) Net income (loss) per common share - basic and diluted $ (.15) $ .09 $ .23 $ (.08)(A) Weighted average shares outstanding - basic 4,073,979 4,077,771 4,075,760 4,070,405 Weighted average shares outstanding - diluted 4,073,979 4,077,771 4,075,760 4,070,405 2001 Net sales $ 17,279 $ 22,737 $ 19,442 $ 18,401 Gross profit (loss) $ 273 $ 490 $ 34 $ (801) Net income (loss) $ (1,224) $ (1,407) $ (1,346) $ (11,292) Net income (loss) per common share - basic and diluted $ (.30) $ (.35) $ (.33) $ (2.76)(A) Weighted average shares outstanding - basic 4,072,476 4,076,545 4,085,150 4,093,694 Weighted average shares outstanding - diluted 4,072,476 4,076,545 4,085,150 4,093,694 (A) The sum of the quarters may not equal the annual amounts due to rounding.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Kentucky Electric Steel, Inc. and Subsidiary: We have audited in accordance with auditing standards generally accepted in the United States, the consolidated financial statements included in Kentucky Electric Steel, Inc. and Subsidiary's annual report on Form 10-K, and have issued our report thereon dated January 14, 2002. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedule listed in item 14(a)2 is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and regulations and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Arthur Andersen LLP Cincinnati, Ohio, January 14, 2002 SCHEDULE II KENTUCKY ELECTRIC STEEL, INC. AND SUBSIDIARY VALUATION AND QUALIFYING ACCOUNTS (Dollars in Thousands) Reserves Deducted from Assets in Balance Sheets Allowance for Doubtful Accounts (1) BALANCE, September 26, 1998 ....................... 460 Additions: Charged to costs and expenses ................. (30) Deductions: Net charge-off of accounts deemed uncollectible - --- BALANCE, September 25, 1999 ....................... $ 430 Additions: Charged to costs and expenses ................. 324 Deductions: Net charge-off of accounts deemed uncollectible (69) --- BALANCE, September 30, 2000 ....................... $ 685 Additions: Charged to costs and expenses ................. 719 Deductions: Net charge-off of accounts deemed uncollectible (709) --- BALANCE, September 29, 2001 ....................... $ 695 (1) Deducted from accounts receivable.