10-Q 1 fy04mar10q.txt 10QMAR04 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 27, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 1-367 THE L. S. STARRETT COMPANY (Exact name of registrant as specified in its charter) MASSACHUSETTS 04-1866480 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 121 CRESCENT STREET, ATHOL, MASSACHUSETTS 01331-1915 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code 978-249-3551 Former name, address and fiscal year, if changed since last report. Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES X NO Common Shares outstanding as of April 30, 2004 : Class A Common Shares 5,380,818 Class B Common Shares 1,253,752 Page 1 of 18 THE L. S. STARRETT COMPANY CONTENTS Page No. Part I. Financial Information: Item 1. Financial Statements Consolidated Statements of Operations - thirteen and thirty-nine weeks ended March 27, 2004 and March 29, 2003 (unaudited) 3 Consolidated Statements of Cash Flows - thirteen and thirty-nine weeks ended March 27, 2004 and March 29, 2003 (unaudited) 4 Consolidated Balance Sheets - March 27, 2004 (unaudited) and June 28, 2003 5 Consolidated Statements of Stockholders' Equity - thirty-nine weeks ended March 27, 2004 and March 29, 2003 (unaudited) 6 Notes to Consolidated Financial Statements 7-9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9-16 Item 3. Quantitative and Qualitative Disclosures About Market Risk 17 Item 4. Controls and Procedures 17 Part II. Other information: Item 2. Changes in Securities and Use of Proceeds 17 Item 6. Exhibits and reports on Form 8-K 18 SIGNATURES 18 Page 2 of 18 Part I. Financial Information Item 1. Financial Statements THE L. S. STARRETT COMPANY Consolidated Statements of Operations (in thousands of dollars except per share data)(unaudited) 13 Weeks Ended 39 Weeks Ended 3/27/04 3/29/03 3/27/04 3/29/03 Net sales 44,945 41,525 131,040 131,688 Cost of goods sold (33,017) (32,363) (100,985)(103,448) Selling and general expense (11,684) (11,507) (34,518) (35,165) Other expense (64) 90 (416) (1,165) Earnings (loss) before income taxes and cumulative effect of change in accounting principle 180 (2,255) (4,879) (8,090) Benefit from federal, foreign and state income taxes (264) (988) (2,395) (3,647) Earnings (loss) before cumulative effect of change in accounting principle 444 (1,267) (2,484) (4,443) Cumulative effect of change in accounting principle for goodwill (6,086) Net earnings (loss) 444 (1,267) (2,484) (10,529) Basic and diluted earnings (loss) per share before cumulative effect of change in accounting principle .07 (.19) (.37) (.67) Cumulative effect of change in accounting principle for goodwill (.93) Basic and diluted earnings (loss) per share .07 (.19) (.37) (1.60) Average outstanding shares used in per share calculations (in thousands) Basic 6,642 6,632 6,653 6,591 Diluted 6,658 N/A N/A N/A Dividends per share .10 .20 .30 .60 See Notes to Consolidated Financial Statements Page 3 of 18 THE L. S. STARRETT COMPANY Consolidated Statements of Cash Flows (in thousands of dollars)(unaudited) 13 Weeks Ended 39 Weeks Ended 3/27/04 3/29/03 3/27/04 3/29/03 Cash flows from operating activities: Net earnings (loss) 444 (1,267) (2,484) (10,529) Non-cash items included: Cumulative effect of change in accounting principle 6,086 Depreciation and amortization 2,658 2,802 8,249 8,334 Deferred taxes (462) 37 (1,494) (254) Unrealized exchange losses (gains) (1) (89) (33) 1,371 Retirement benefits (116) (31) (350) (535) Working capital changes: Receivables 2,866 1,932 4,101 3,217 Inventories 2,144 4,509 9,723 16,617 Other assets and liabilities (167) (2,777) 1,920 (2,117) Prepaid pension cost and other 49 88 224 (19) Net operating cash flows 7,415 5,204 19,856 22,171 Cash flows from investing activities: Additions to plant and equipment (1,363) (1,681) (4,658) (4,670) Change in short-term investments (8,792) 422 (14,019) (13,210) Net investing cash flows (10,155) (1,259) (18,677) (17,880) Cash flows from financing activities: Short-term borrowings (repayments) 443 (9) 900 (860) Long-term borrowings (repayments) 615 (1,014) (2,147) 1,735 Common stock issued 1,041 226 2,350 Treasury shares purchased (235) (98) (633) (455) Dividends (663) (1,328) (1,993) (3,952) Net financing cash flows 160 (1,408) (3,647) (1,182) Exchange rate change effect on cash 123 19 221 (60) Net increase (decrease) in cash (2,457) 2,556 (2,247) 3,049 Cash, beginning of period 3,516 2,165 3,306 1,672 Cash, end of period 1,059 4,721 1,059 4,721 See Notes to Consolidated Financial Statements Page 4 of 18 THE L. S. STARRETT COMPANY Consolidated Balance Sheets (in thousands of dollars) Mar. 27 June 28 2004 2003 ASSETS (unaudited) Current assets: Cash 1,059 3,306 Investments 36,865 21,995 Accounts receivable (less allowance for doubtful accounts of $1,573 and $1,392) 29,399 32,175 Inventories: Raw materials and supplies 9,508 9,859 Goods in process and finished parts 16,578 20,344 Finished goods 19,407 23,832 45,493 54,035 Prepaid expenses, taxes and other current assets 8,404 9,703 Total current assets 121,220 121,214 Property, plant and equipment, at cost (less accumulated depreciation of $99,203 and $89,223) 64,759 67,093 Prepaid pension cost 31,123 30,565 Other assets 791 868 217,893 219,740 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Notes payable and current maturities 1,928 3,585 Accounts payable and accrued expenses 14,972 12,859 Accrued salaries, wages and postretirement benefits 4,562 4,940 Total current liabilities 21,462 21,384 Deferred income taxes 13,253 14,696 Long-term debt 3,117 2,652 Accumulated postretirement medical benefit obligation 16,306 16,057 Stockholders' equity: Class A Common $1 par (20,000,000 shrs. auth.; 5,374,296 outstanding on 3/27/04, excluding 1,321,553 in treasury; 5,344,033 outstanding on 6/28/03, excluding 1,294,542 in treasury) 5,374 5,344 Class B Common $1 par (10,000,000 shrs. auth.; 1,259,774 outstanding on 3/27/04, excluding 332,019 in treasury; 1,315,489 outstanding on 6/28/03, excluding 332,019 in treasury) 1,260 1,315 Additional paid-in capital 49,700 49,826 Retained earnings reinvested and employed in the business 129,814 134,547 Accumulated other comprehensive loss (22,393) (26,081) Total stockholders' equity 163,755 164,951 217,893 219,740 See Notes to Consolidated Financial Statements Page 5 of 18 THE L. S. STARRETT COMPANY Consolidated Statements of Stockholders' Equity For the Thirty-nine Weeks Ended March 27, 2004 and March 29, 2003 (in thousands of dollars) (unaudited) Common Addi- Accumulated Stock Out- tional Other standing Paid-in Retained Comprehensive ($1 Par) Capital Earnings Loss Total Balance June 29, 2002 6,544 47,858 150,029 (24,090) 180,341 Comprehensive income(loss): Net loss (10,529) (10,529) Unrealized net loss on investments (12) (12) Translation loss, net (2,647) (2,647) Total comprehensive loss (13,188) Dividends ($.60 per share) (3,952) (3,952) Treasury shares: Purchased (24) (204) (227) (455) Issued 135 2,081 2,216 Options exercised 10 124 134 Balance March 29, 2003 6,665 49,859 135,321 (26,749) 165,096 Balance June 28, 2003 6,659 49,826 134,547 (26,081) 164,951 Comprehensive income(loss): Net loss (2,484) (2,484) Unrealized net gain on investments 29 29 Translation gain, net 3,659 3,659 Total comprehensive income 1,204 Dividends ($.30 per share) (1,993) (1,993) Treasury shares: Purchased (40) (337) (256) (633) Issued 13 194 207 Options exercised 2 17 19 Balance March 27, 2004 6,634 49,700 129,814 (22,393) 163,755 See Notes to Consolidated Financial Statements Page 6 of 18 THE L. S. STARRETT COMPANY Notes to Consolidated Financial Statements In the opinion of management, the accompanying financial statements contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company as of March 27, 2004 and June 28, 2003; the results of operations and cash flows for the thirteen and thirty-nine weeks ended March 27, 2004 and March 29, 2003; and changes in stockholders' equity for the thirty-nine weeks ended March 27, 2004 and March 29, 2003. The Company follows the same accounting policies in the preparation of interim statements as described in the Company's annual report filed on Form 10-K for the year ended June 28, 2003, other than the change for stock based compensation as discussed below, and these financial statements should be read in conjunction with said annual report. Certain reclassifications have been made to prior period data to conform with current year presentation. Except in the fiscal 2004 March quarter, which had net earnings, shares used to compute basic and diluted loss per share are the same since the inclusion of common stock equivalents (8,553 shares in the quarter ended March 29, 2003, 13,781 shares in the nine months ended March 27, 2004, and 7,394 shares in the nine months ended March 29, 2003) would be antidilutive. As discussed under Management's Discussion and Analysis of Financial Condition and Results of Operations, the Company took reserves and charged pretax operations with $3.1 million ($.30 per share after tax) in the first quarter of fiscal 2003 in connection with a government investigation of its Coordinate Measuring Machine (CMM) division, and additional charges were incurred thereafter. As of March 27, 2004, approximately $.2 million remains reserved for future legal and professional costs related to this matter. No assurances can be made that this amount reflects the actual future costs that will be incurred by the Company or that the Company will not need to take additional reserves in connection with this matter. Effective with the beginning of the first quarter of fiscal 2004, the Company has adopted the fair value method of accounting for stock-based compensation on a prospective basis as described in SFAS 123 and 148. The Company incurred $27,000 in stock-based compensation costs in the December 2003 quarter. Historically, stock-based compensation has not been material. The Company adopted SFAS 142, Goodwill and Other Intangible Assets, as of June 30, 2002, the first day of fiscal 2003, and performed a transitional fair value based impairment test as of that date. As a result, a one-time, non-cash, impairment charge of $6,086,000 ($.93 per share before and after taxes since there were no income taxes associated with the charge), relating primarily to the acquisition of the Company's Evans Rule division in 1986, was recorded as of the first day of the first quarter of fiscal 2003 and related amortization of $67,000 per quarter was discontinued. The charge is reflected as the cumulative effect of a change in accounting principle in the accompanying Statements of Operations. Included in investments at March 27, 2004 is $2.3 million of AAA-rated Puerto Rico debt obligations that have maturities greater than one year but carry the benefit of possibly reducing repatriation taxes. These investments represent "core cash" and are part of the Company's overall cash management and liquidity program and, under SFAS 115, are considered "available for sale." The investments themselves are highly liquid, carry no early redemption penalties, and are not designated for acquiring non-current assets. Page 7 of 18 Other income (expense) is comprised of the following (in thousands): Thirteen Weeks Thirty-nine Weeks Ended March Ended March 2004 2003 2004 2003 Interest income 220 212 565 602 Interest expense and com- mitment fees (271) (230) (834) (448) Realized and unrealized exchange gains (losses) 7 187 (3) (1,155) Other (20) (79) (144) (164) (64) 90 (416) (1,165) Net periodic benefit costs (benefits) for the Company's defined benefit pension plans consists of the following (in thousands): Thirteen Weeks Thirty-nine Weeks Ended March Ended March 2004 2003 2004 2003 Service cost 813 820 2,439 2,459 Interest cost 1,530 1,623 4,591 4,868 Expected return on plan assets (2,352) (2,568) (7,057) (7,703) Amort. of transition obligation (244) (239) (731) (717) Amort. of prior service cost 106 102 317 306 Amort. of unrecognized (gain)loss 73 (15) 219 (44) (74) (277) (222) (831) Net periodic benefit costs (benefits) for the Company's postretirement medical plan consists of the following (in thousands): Thirteen Weeks Thirty-nine Weeks Ended March Ended March 2004 2003 2004 2003 Service cost 164 158 493 475 Interest cost 259 264 778 793 Amort. of prior service cost (88) (88) (265) (265) Amort. of unrecognized (gain)loss 31 14 93 42 366 348 1,099 1,045 Approximately 70% of all inventories are valued on the LIFO method. At March 27, 2004 and June 28, 2003, total inventories are approximately $22 million less than if determined on a FIFO basis. During fiscal 2004, the Company has reduced the levels of certain LIFO inventories that were carried in the aggregate at lower costs prevailing in prior years. The effect of the LIFO inventory reductions was to increase the March 2004 quarter and year- to-date net earnings by approximately $.6 million and $.9 million, respectively ($.05 and $.08 per share). Page 8 of 18 Long-term debt is comprised of the following (in thousands): March June 2004 2003 . Note payable at 3.1% due 12/03 2,318 Capitalized lease obligations payable in Brazilian currency due 2003 - 2007, 15%-21% 3,666 3,433 3,666 5,751 Less current portion 549 3,099 3,117 2,652 The Company is considering various reorganization and restructuring plans and options as discussed under "Management's Discussion and Analysis of Financial Condition and Results of Operations" below. These considerations could result in asset impairments and additional costs that will be recognized if and when reorganization or restructuring plans are implemented or obligations are incurred. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS QUARTERS ENDED MARCH 27, 2004 AND MARCH 29, 2003 Sales Total Company sales for the March 2004 quarter were approximately 8% higher than the corresponding quarter of a year ago, approximately half the increase being the result of exchange rate changes. Domestic sales were up 7% and foreign sales were up 12%, although in local currency foreign sales were actually down 4% because of the weak U.S. dollar. Domestic sales are improving, although the U.S. industrial manufacturing sector, particularly in metal working, will continue to be affected by the migration of manufacturing, both customers and competitors, to lower cost countries. Earnings (Loss) Before Income Taxes The Company had pretax earnings for the quarter of $.2 million, compared to a $2.3 million loss a year earlier. The current and prior year quarters included charges of $.1 million and $.6 million, respectively, for professional fees associated with the government investigation of the Company's Coordinate Measuring Machine (CMM) division (see below). Domestic operations had pretax earnings of 1% of sales compared to a loss of 6% of sales last year (before considering the $.1 million and $.6 million for professional fees mentioned above). Foreign operations essentially broke even on a pretax basis for the March quarters in both years. Excluding the $.1 million and $.6 million charges for professional fees, the major item contributing to the $1.9 million improvement in earnings was improved gross margins (26.5% in the March 2004 quarter compared to 22% in the March 2003 quarter, or $2.0 million). The gross margin improvement is primarily domestic and resulted from higher production levels and the benefit ($.6 million) of liquidating LIFO inventories; all partially offset by higher retirement and group medical costs ($.5 million) and costs associated with the consolidation of the Company's Skipton, England plant into its Scotland facilities ($.3 million). Although selling and general expense decreased as a percent of sales from 28% last year to 26% this year, the dollars reported remained about the same because foreign currencies strengthened against the U.S. dollar, accounting for approximately half the increase in sales. Page 9 of 18 Income Tax Benefit The effective income tax rate was over 100% in the March 2004 quarter and accounted for $.05 per share of the Company's net earnings for the quarter. The rate was 44% in the prior year's corresponding quarter. The fluctuation in these rates comes about because pretax results are so close to breakeven that permanent book/tax differences and varying tax rates among jurisdictions get exaggerated when converted to percentages. As a result, it is very difficult to predict what the effective rate is going to be for the full year. Puerto Rico tax incentives and somewhat lower foreign income tax rates all contribute to an overall effective tax rate that is normally slightly lower than the combined U.S. state and federal rate of approximately 38%. However, in the periods presented, the least profitable operations have been in the jurisdictions with the highest tax rates. In addition, the decision in the quarter to have our wholly-owned Brazilian subsidiary pay a dividend increased our expected tax benefit for the full fiscal year by $.5 million, three quarters of which has been recorded in the current quarter. The effect of this was to increase earnings per share by approximately $.02 in the quarter. Despite recent losses, the Company currently expects that it will be able to utilize its tax operating loss carryforwards and is therefore recognizing their benefit against current losses. This is continually monitored and could change in the future. Net earnings (loss) per share As a result of the above factors, the Company had basic and diluted earnings of $.07 per share in the March 2004 quarter compared to a loss of $.19 per share in the March quarter a year ago (earnings of $.08 per share and a loss of $.13 per share a year ago excluding the charges for professional fees mentioned above). NINE MONTH PERIODS ENDED MARCH 27, 2004 AND MARCH 29, 2003 OVERVIEW As more fully discussed below, results for the first nine months of fiscal 2004 show the Company incurred a net loss of $2.5 million, or $.37 per share, compared to a net loss of $10.5 million, or $1.60 per share, in the comparable prior year nine month period. A significant portion of current and prior year losses was caused by unusual charges: in the current year the $3.2 million, or $.32 per share after tax, write-down to net realizable value of CMM inventories and $.3 million, or $.03 per share after tax, in charges for professional fees in connection with the government's investigation of the Company's CMM division; and in the prior year the write-off of $6.1 million, or $.93 per share before and after tax, of goodwill in connection with the adoption of SFAS 142 and $3.7 million, or $.36 per share after tax, in charges in connection with the CMM division investigation and replacement program. Excluding these unusual charges, the Company incurred a net loss for the first nine months of fiscal 2004 of $.3 million, or $.04 per share compared to a net loss of $2.1 million or $.31 per share in the corresponding prior year nine month period. Sales Sales for the first nine months of fiscal 2004 were about the same as the corresponding period a year ago. Domestic sales were down 4.5% and foreign sales were up 10%. In local currency foreign sales were actually down 4% in fiscal 2004 since the dollar has continued to weaken against the British pound and Brazilian real. The decrease in domestic sales results primarily from low first quarter 2004 sales. Loss before income taxes and cumulative effect of change in accounting The pretax losses for the first nine months of fiscal 2004 and 2003 were $4.9 million and $8.1 million, respectively. Both nine month periods contain Page 10 of 18 unusual charges: in the current fiscal year, $3.2 million to write down the CMM inventory to net realizable value and $.3 million for additional professional fees in connection with the government investigation; and, in the prior fiscal year, $3.7 million in connection with the government investigation ($2.1 million of this was charged to selling and general expense and $1.6 million to cost of sales). Excluding these unusual charges, pretax losses for the nine month periods were $1.4 million in fiscal 2004 and $4.4 million in fiscal 2003, a $3.0 million improvement. The major items causing the $3.0 million improvement were lower ($1.2 million) exchange losses, primarily in Brazil, and better gross margins (25% compared to 23% or $3.4 million excluding unusual charges). Despite slightly lower sales and excluding the effect on cost of sales in both years of the unusual charges related to the CMM division, the gross margin improved over 2 percentage points due primarily to lower headcount, higher production levels, and LIFO inventory liquidation profits ($.9 million), all partially offset by costs ($.6 million) associated with the consolidation of the Company's Skipton, England plant into its Scotland facilities. The exchange rate and margin improvements were partially offset by higher interest expense ($.4 million) in Brazil due to borrowing in local currency and an overall $1.2 million increase in selling and general expense. Contributing to this $1.2 million increase in selling and general expense were higher retirement benefit costs and the effect of a weaker U.S. dollar this year compared to last year. Income tax benefit The effective income tax rate was 49% in the first nine months of fiscal 2004 and 45% in the corresponding prior year nine month period. Puerto Rico tax incentives, and somewhat lower foreign income tax rates all contribute to an overall effective tax rate that is normally slightly lower than the combined U.S. state and federal rate of approximately 38%. However, in the periods presented, the least profitable operations have been in the jurisdictions with the highest tax rates. In addition, the decision in the fiscal 2004 March quarter to have our wholly-owned Brazilian subsidiary pay a dividend increased our expected tax benefit for the full fiscal year by $.5 million, three quarters of which has been recorded as of the end of the first nine months of fiscal 2004. Despite recent losses, the Company currently expects that it will be able to utilize its tax operating loss carryforwards and is therefore recognizing their benefit against current losses. This is continually monitored and could change in the future. Net loss per share As a result of the above factors and before the change in accounting principle (adoption of SFAS 142 in fiscal 2003), the Company incurred a basic and diluted net loss per share for the first nine months of fiscal 2004 of $.37 per share compared to $1.60 per share in the corresponding period a year ago. Excluding the unusual charges related to the CMM division ($.35 per share in the current year and $.36 in the prior year) and excluding the $.93 per share related to the adoption of SFAS 142 (write-off of goodwill) discussed in the notes to the financial statements, the Company incurred a net loss of $.02 per share in the first nine months of fiscal 2004 compared to a net loss of $.31 per share in the corresponding period a year ago. Coordinate Measuring Machine (CMM) division As discussed in more detail in the Company's Annual Report on Form 10-K for fiscal 2003, the Company's CMM division is the subject of a federal government investigation being coordinated through the Department of Justice. The Company became aware of the investigation on September 5, 2002, when federal agents conducted a search of the CMM division. The Page 11 of 18 investigation apparently was prompted by a qui tam action filed under seal in federal court in Massachusetts. The division, which is located in the Company's Mt. Airy, North Carolina facility, accounted for less than 2% of the Company's net sales during fiscal 2003. The CMM division manufactures and sells coordinate measuring machines. The government is investigating allegations apparently made by a former independent contractor that the CMM division defrauded its customers and the government in connection with the sale of coordinate measuring machines and software. In response to a September 2002 newspaper article, the Company denied allegations that the Company defrauded its customers or the government. The Company has not been served with any qui tam complaint, and is cooperating with the government. As a result of the investigation and the CMM replacement program initiated prior thereto in March 2002, the Company took reserves and charged pretax operations with $3.1 million ($.30 per share after tax) in the September 2002 quarter, $.6 million in the March 2003 quarter, $.2 million in the September 2003 quarter, and $.1 million in the March 2004 quarter. As of March 27, 2004, approximately $.2 million remains reserved for professional fees. In addition, the Company charged cost of sales and wrote down the carrying cost of its CMM inventory by $3.2 million to net realizable value in the December 2003 quarter. No assurances can be made that these reserves and write-downs reflect the actual additional costs that will be incurred by the Company. See the additional comments below under "Reorganization and Restructuring Plans" regarding the CMM division. LIQUIDITY AND CAPITAL RESOURCES Cash Flows 13 Weeks Ended 39 Weeks Ended 3/27/04 3/29/03 3/27/04 3/29/03 Operating cash flow 7,415 5,204 19,856 22,171 Investing cash flow (10,155) (1,259) (18,677) (17,880) Financing cash flow 160 (1,408) (3,647) (1,182) Despite recurring operating results being close to breakeven before the unusual charges discussed above, cash provided by operations has been significant in all periods presented. Non-cash depreciation charges of approximately $3 million per quarter contribute to this, but the most significant factor contributing to positive operating cash flow has been the reduction in inventories, which has been slowing and is unlikely to continue much longer. "Retirement benefits" under non-cash expenses in the detailed cash flow statement shows the effect on operating cash flow of the Company's pension and retiree medical plans. Primarily because the Company's domestic defined benefit plan is overfunded, retirement benefits in total are currently generating approximately $.1 million of non-cash income per quarter ($.3 million per quarter in the prior year). On an accrual basis, retirement benefit expense is approximately $.4 million per quarter in the current year and $.2 million in the prior year. The Company's investing activities consist of expenditures for plant and equipment and the investment of cash not immediately needed for operations. The increase in cash used for investing activities in the current quarter is partially a result of the increase in cash available for investment from operations, but mainly reflects the timing of activity from quarter to quarter. Cash flows related to financing activities are primarily the payment of dividends and repayment of debt. The Company entered into a lease financing arrangement in Brazil in the 2003 fiscal year worth approximately $3 million that reduced the 2003 year to date cash required for financing activities. In addition, the Company reduced the quarterly dividend from $.20 to $.10 beginning in the fourth quarter of fiscal 2003. Page 12 of 18 Liquidity and credit arrangements The Company believes it maintains sufficient liquidity and has the resources to fund its operations in the near term. If the Company is unable to return to consistent profitability, additional steps will have to be taken in order to maintain liquidity, including plant consolidations and further workforce and dividend reductions (see "Reorganization and Restructuring Plans" section below). The Company and its lender have amended the Company's credit agreement, including reducing the line to $15 million. Although the credit line is not currently collateralized, it is possible, based on the Company's financial performance, that in the future the Company will have to provide collateral in order to maintain the credit agreement. The Company is not currently borrowing under its line of credit. The Company has a working capital ratio of 5.6 to one as of March 27, 2004 and 5.7 to one as of June 28, 2003. Reorganization and Restructuring Plans As discussed in greater detail in the Company's Form 10-Q for the quarter ended December 27, 2003, manufacturing globalization has adversely affected the Company's customer base and competitive position, particularly in North America, as more and more products are produced in low wage countries. As a result, the Company has been rethinking almost all aspects of its business and is formulating plans to lower wage costs, consolidate operations, move the strategic focus from manufacturing location to product group and distribution channel as well as achieving the goals of enhanced marketing focus and global procurement. Although there have been and may in the future be non-recurring costs associated with these plans (see CMM division comments above), Management believes it is premature to take additional charges at this time. Regardless of the outcome of the ongoing government investigation, the outlook for the CMM division is problematic. Specific actions being considered for the CMM division range from staying in the business, to outsourcing, to exiting altogether. In the December 2003 quarter, the Company wrote down its CMM inventories by $3.2 million to an estimated net realizable value of $1.0 million (see above). The Company is consolidating its optical comparator manufacturing in Skipton, England into its manufacturing facility in Jedburgh, Scotland. It is anticipated that the cost of this move, including severance costs, should ultimately be offset by a gain on the sale of the Skipton real estate, although no assurances can be made that such costs will be offset by any gain. The Company has closed, and is trying to sell, its Alum Bank, Pennsylvania level manufacturing plant and is relocating the manufacturing to the Dominican Republic. Relocation of other manufacturing capacity is also being considered. In addition, the Company has recently consolidated its consumer hardware products activities under one business unit head and created a new consumer hardware sales and marketing organization. The Company believes these changes may result in labor savings and allow the Company to maintain its margins and satisfy the requirements of its largest customers with lower prices. Severance and relocation costs associated with these activities, including potential plant and equipment write-downs, could be in the $1-2 million range, although no assurances can be made that the costs will not be greater. The Company has closed one warehouse and is evaluating consolidating or eliminating others. Depending on how this capacity is replaced, this could reduce inventory requirements and may save $1 million annually in operating costs with the potential of a net gain due to the market value of the related real estate. No material costs or asset write-downs are currently expected as a result of these actions pertaining to distribution facilities. There can be no assurances that the Company will implement all these actions and that, if such actions are implemented, they will result in savings to the Company. It is also possible that the Company may need to incur additional charges in connection with these plans. Page 13 of 18 OFF-BALANCE SHEET ARRANGEMENTS The Company does not have any material off-balance sheet arrangements as defined under Securities Exchange Commission rules. CRITICAL ACCOUNTING POLICIES The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. The footnotes to the Company's Annual Report on Form 10-K for fiscal 2003 describe the significant accounting policies and methods used in the preparation of the consolidated financial statements. Judgments, assumptions, and estimates are used for, but not limited to, the allowance for doubtful accounts receivable and returned goods; inventory allowances; income tax reserves; employee turnover, discount, and return rates used to calculate pension obligations; normal expense accruals for such things as workers compensation and employee medical expenses; and, of particular importance, the previously discussed charges connected with the government investigation of the Company's CMM division. Actual results could differ from these estimates. The allowance for doubtful accounts and sales returns is based on the Company's assessment of the collectibility of specific customer accounts, the aging of our accounts receivable and trends in product returns. While the Company believes that the allowance for doubtful accounts and sales returns is adequate, if there is a deterioration of a major customer's credit worthiness, actual defaults are higher than previous experience, or actual future returns do not reflect historical trends, estimates of recoverability of amounts due, and sales, could be adversely affected. Inventory purchases and commitments are based upon future demand forecasts. If there is a sudden and significant decrease in demand for the Company's products or there is a higher risk of inventory obsolescence because of rapidly changing technology and requirements, the Company may be required to increase its inventory reserves and, as a result, gross profit margins could be adversely affected. Accounting for income taxes requires estimates of future tax liabilities. Due to timing differences in the recognition of items included in income for accounting and tax purposes, deferred tax assets or liabilities are recorded to reflect the impact on future tax payments of these differences. With respect to recorded tax assets, the Company assesses the likelihood that the asset will be realized. If realization is in doubt because of uncertainty regarding future profitability or enacted tax rates, the Company provides a valuation allowance related to the asset. Should any significant changes in the tax law or estimate of the necessary valuation allowance occur, the Company would record the impact of the change, which could have a material effect on financial position or results of operations. Pension and postretirement medical costs and obligations are dependent on assumptions used by the Company's actuaries in calculating such amounts. These assumptions include discount rates, healthcare cost trends, inflation, salary growth, long-term return on plan assets, retirement rates, mortality rates, and other factors. These assumptions are made based on a combination of external market factors, actual historical experience, long-term trend analysis, and an analysis of the assumptions being used by other companies with similar plans. Actual results that differ from our assumptions are accumulated and amortized over future periods. Significant differences in actual experience or significant changes in assumptions would affect the Company's pension and other postretirement benefit costs and obligations. Page 14 of 18 SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This Quarterly Report on Form 10-Q, the 2003 Annual Report to stockholders, including the President's letter, and the Annual Report on Form 10-K for fiscal 2003 include forward-looking statements about the Company's business, competition, sales, expenditures, environmental regulatory compliance, foreign operations, progress and effect of the government investigation, write-downs and reserves relating to the consolidation of manufacturing and distribution facilities, plans for reorganization, interest rate sensitivity, debt service, liquidity and capital resources, and other operating and capital requirements. In addition, forward-looking statements may be included in future Company documents and in oral statements by Company representatives to security analysts and investors. The Company is subject to risks that could cause actual events to vary materially from such forward-looking statements, including the following risk factors: Risks Related to Reorganization: The Company continues to develop plans to consolidate and reorganize some of its manufacturing and distribution operations. There can be no assurance that the Company will be successful in these efforts or that any consolidation or reorganization will result in cost savings to the Company. The implementation of these reorganization measures may disrupt the Company's manufacturing and distribution activities, could adversely affect operations, and could result in asset impairment charges and other costs that will be recognized if and when reorganization or restructuring plans are implemented or obligations are incurred. Risks Related to Government Investigation: Based on information currently known to management, the Company has recorded an estimate of the costs related to the government investigation of its CMM division. However, no assurances can be made that charges recorded for this matter reflect the actual costs that will ultimately be incurred by the Company or that the Company will not need to take additional charges. Risks Related to Technology: Although the Company's strategy includes investment in research and development of new and innovative products to meet technology advances, there can be no assurance that the Company will be successful in competing against new technologies developed by competitors. Risks Related to the Euro: The United Kingdom has not adopted the euro and the Company's Scottish subsidiary transacts a significant amount of business with euro countries. There can be no assurance that this situation will not result in unforeseen economic conditions that affect the Company's business. Risks Related to Foreign Operations: Approximately a third of the Company's sales and a quarter of net assets relate to foreign operations. Foreign operations are subject to special risks that can materially affect the sales, profits, cash flows, and financial position of the Company, including taxes and other restrictions on distributions and payments, currency exchange rate fluctuations, political and economic instability, inflation, minimum capital requirements, and exchange controls. In particular, the Company's Brazilian operations, which constitute over half of the Company's revenues from foreign operations, can be very volatile, changing from year to year due to the political situation and economy. As a result, the future performance of the Brazilian operations is inherently unpredictable. Risks Related to the Weakness of the Industrial Manufacturing Sector: The market for most of the Company's products is subject to economic conditions affecting the industrial manufacturing sector, including the level of capital spending by industrial companies and the general movement of manufacturing to low cost foreign countries where the Company does not have a substantial Page 15 of 18 market presence. Accordingly, economic weakness in the industrial manufacturing sector has and may continue to result in decreased demand for certain of the Company's products and will adversely affect performance. Economic weakness in the consumer market will also adversely impact the Company's performance. In the event that demand for any of the Company's products declines significantly, the Company could be required to recognize certain costs as well as asset impairment charges on long-lived assets related to those products. Risks Related to Shift in Manufacturing: The Company's primary customers are in the manufacturing business and, in particular, in the metal working industry. Manufacturing is shifting to low wage countries where the Company does not have a substantial market presence. As a result, unless the Company can penetrate these markets, the Company's sales and performance may be adversely affected. Risks Related to Competition: The Company's business is subject to direct and indirect competition from both domestic and foreign firms. In particular, low-wage foreign sources have created severe competitive pricing pressures. Under certain circumstances, including significant changes in U.S. and foreign currency relationships, such pricing pressures tend to reduce unit sales and/or adversely affect the Company's margins. Risks Related to Customer Concentration: Sales to the Company's three biggest customers account for approximately 25% of revenues. The loss or reduction in orders by any of these customers, including reductions due to market, economic or competitive conditions, could adversely affect business and results of operations. In addition, these customers have, and may continue to, place pressure on the Company to reduce its prices. This pricing pressure may affect the Company's margins and revenues and could adversely affect business and results of operations. Risks Related to Insurance Coverage. The Company carries liability, property damage, workers' compensation, medical, and other insurance coverages that management considers adequate for the protection of its assets and operations. There can be no assurance, however, that the coverage limits of such policies will be adequate to cover all claims and losses. Such uncovered claims and losses could have a material adverse effect on the Company. The Company self- insures for health benefits and retains risk in the form of deductibles and sublimits. Depending on the risk, deductibles can be as high as 5% of the loss or $500,000. Risk Related to Raw Material and Energy Costs. Steel is the principal raw material used in the manufacture of the Company's products. The price of steel has historically fluctuated on a cyclical basis and has often depended on a variety of factors over which the Company has no control. The cost of producing the Company's products is also sensitive to the price of energy. The selling prices of the Company's products have not always increased in response to raw material, energy or other cost increases, and the Company is unable to determine to what extent, if any, it will be able to pass future cost increases through to its customers. The Company's inability to pass increased costs through to its customers could materially and adversely affect its financial condition or results of operations. Risks Related to Stock Market Performance. Although the Company's domestic defined benefit pension plan is significantly overfunded, a significant (over 30%) drop in the stock market, even if short in duration, could cause the plan to become temporarily underfunded and require the temporary reclassification of prepaid pension cost on the balance sheet from an asset to a contra equity account, thus reducing stockholders equity and book value per share. Page 16 of 18 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Market risk is the potential change in a financial instrument's value caused by fluctuations in interest and currency exchange rates, and equity and commodity prices. The Company's operating activities expose it to risks that are continually monitored, evaluated, and managed. Proper management of these risks helps reduce the likelihood of earnings volatility. At March 2004 and June 2003, the Company was not a party to any derivative arrangement and the Company does not engage in trading, market-making or other speculative activities in the derivatives markets. The Company does not enter into long-term supply contracts with either fixed prices or quantities. The Company does not engage in regular hedging activities to minimize the impact of foreign currency fluctuations. Net foreign monetary assets total approximately $7 million as of March 27, 2004. A 10% change in interest rates would not have a significant impact on the aggregate net fair value of the Company's interest rate sensitive financial instruments (primarily variable rate investments of $29 million and debt of $4 million at March 27, 2004) or the cash flows or future earnings associated with those financial instruments. A 10% change in interest rates would impact the fair value of the Company's fixed rate investments of $2.3 million by approximately $30,000. Item 4. CONTROLS AND PROCEDURES The Company's management, under the supervision and with the participation of the Company's President and Chief Executive Officer and Chief Financial Officer, have evaluated the Company's disclosure controls and procedures as of March 27, 2004, and they have concluded that these controls and procedures are effective. There have been no significant changes in internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. In August 2003, as reported in the Company's Annual Report on Form 10-K for fiscal 2003, the Company's management and its outside auditors reported to the Audit Committee one reportable condition related to computer file access and the Company has corrected the condition. PART II. OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds A summary of the Company's repurchases of shares of its common stock for the three months ended March 27, 2004 is as follows: ISSUER PURCHASES OF EQUITY SECURITIES Shares Purchased Shares yet to be Shares Average Under Announced Purchased Under Period Purchased Price Programs Announced Programs 12/28/03- 1/27/04 none 1/28/04- 2/27/04 15,000 15.61 none none 2/28/04- 3/27/04 none All of the above shares were repurchased by the Company on February 23, 2004 directly from the Company's 401(k) plan in connection with diversifications made by participants in the plan. Page 17 of 18 Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits 10g Amendment dated as of March 1, 2004 to the Company's $25,000,000 Revolving Credit Agreement, filed herewith. 31a Certification of Chief Executive Officer Pursuant to Rule 13a-14(a), filed herewith. 31b Certification of Chief Financial Officer Pursuant to Rule 13a-14(a), filed herewith. 32 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Rule 13a-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code), filed herewith. (b) Reports on Form 8-K The following reports on Form 8-K were filed with or furnished to the SEC in the quarter covered by this report: 1. The Company furnished a report on Form 8-K on February 6, 2004 announcing it had issued a Quarterly Shareholder Earnings Letter containing a summary of its fiscal 2004 second quarter consolidated financial results. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. THE L. S. STARRETT COMPANY (Registrant) Date: May 7, 2004 S/R.U.WELLINGTON, JR. R. U. Wellington, Jr. (Vice President, Treasurer and Chief Financial Officer) Date: May 7, 2004 S/S.G.THOMSON S. G. Thomson (Chief Accounting Officer) Page 18 of 18