10-Q 1 fy05sep10q.txt 10QMAIN 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 September 25, 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 filings 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 October 30, 2004: Class A Common Shares 5,410,412 Class B Common Shares 1,219,888 Page 1 of 16 THE L. S. STARRETT COMPANY CONTENTS Page No. Part I. Financial Information: Item 1. Financial Statements Consolidated Statements of Operations - thirteen weeks ended September 25, 2004 and September 27, 2003 (unaudited) 3 Consolidated Statements of Cash Flows - thirteen weeks ended September 25, 2004 and September 27, 2003 (unaudited) 4 Consolidated Balance Sheets - September 25, 2004 (unaudited) and June 26, 2004 5 Consolidated Statements of Stockholders' Equity - thirteen weeks ended September 25, 2004 and September 27, 2003 (unaudited) 6 Notes to Consolidated Financial Statements 7-8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 8-14 Item 3. Quantitative and Qualitative Disclosures About Market Risk 14 Item 4. Controls and Procedures 15 Part II. Other information: Item 1. Legal Proceedings 15 Item 2. Changes in Securities and Use of Proceeds 15 Item 4. Submission of Matters to a Vote of Security Holders 16 Item 6. Exhibits and Reports on Form 8-K 16 SIGNATURES 16 Page 2 of 16 Part I. Financial Information Item 1. Financial Statements THE L. S. STARRETT COMPANY Consolidated Statements of Operations (in thousands except per share data)(unaudited) 13 Weeks Ended 9/25/04 9/27/03 Net sales 46,795 40,675 Cost of goods sold (33,437) (30,940) Selling and general expense (11,849) (11,414) Other income (expense) 505 (271) Earnings (loss) before income taxes 2,014 (1,950) Income taxes (benefit) 350 (855) Net earnings (loss) 1,664 (1,095) Basic and diluted earnings (loss) per share .25 (.16) Average outstanding shares used in per share calculations (in thousands) Basic 6,648 6,661 Diluted 6,663 6,661 Dividends per share .10 .10 See notes to consolidated financial statements Page 3 of 16 THE L. S. STARRETT COMPANY Consolidated Statements of Cash Flows (in thousands)(unaudited) 13 Weeks Ended 9/25/04 9/27/03 Cash flows from operating activities: Net earnings (loss) 1,664 (1,095) Noncash expenses (income): Depreciation and amortization 2,561 2,755 Deferred taxes 52 (19) Retirement benefits (476) (117) Working capital changes: Receivables 933 249 Inventories (2,368) 714 Other assets and liabilities (289) 619 Prepaid pension cost and other 1,137 41 Net cash from operating activities 3,214 3,147 Cash flows from investing activities: Additions to plant and equipment (1,680) (1,278) Increase in investments (480) (2,280) Net cash used in investing activities (2,160) (3,558) Cash flows from financing activities: Short-term borrowing, net 433 523 Long-term debt repayments (85) (1,626) Common stock issued 126 118 Dividends (665) (668) Net cash used in financing activities (191) (1,653) Effect of exchange rate changes on cash (9) (48) Net decrease in cash 854 (2,112) Cash, beginning of period 2,483 3,306 Cash, end of period 3,337 1,194 See notes to consolidated financial statements Page 4 of 16 THE L. S. STARRETT COMPANY Consolidated Balance Sheets (in thousands except share data) Sept. 25 June 26 2004 2004 ASSETS (unaudited) Current assets: Cash 3,337 2,483 Investments 32,477 32,023 Accounts receivable (less allowance for doubtful accounts of $1,438 and $1,358) 32,793 33,434 Inventories: Raw materials and supplies 10,571 8,510 Goods in process and finished parts 17,643 16,780 Finished goods 17,989 17,987 46,203 43,277 Prepaid expenses, taxes and other current assets 10,071 11,534 Total current assets 124,881 122,751 Property, plant and equipment, at cost (less accumulated depreciation of $101,461 and $100,767) 61,571 62,859 Prepaid pension cost 32,760 32,370 Other assets 789 944 220,001 218,924 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Notes payable and current maturities 2,762 2,302 Accounts payable and accrued expenses 14,776 16,005 Accrued salaries and wages 4,083 4,375 Total current liabilities 21,621 22,682 Deferred income taxes 14,261 14,214 Long-term debt 2,615 2,536 Accumulated postretirement medical benefit obligation 17,125 17,209 Stockholders' equity: Class A Common $1 par (20,000,000 shares authorized; 5,433,356 outstanding at 9/25/04, excluding 1,302,086 held in treasury; 5,396,679 outstanding at 6/26/04, excluding 1,310,601 held in treasury) 5,433 5,397 Class B Common $1 par (10,000,000 shares authorized; 1,221,944 outstanding at 9/25/04, excluding 332,019 held in treasury; 1,250,106 outstanding at 6/26/04, excluding 332,019 held in treasury) 1,222 1,250 Additional paid-in capital 50,052 49,934 Retained earnings reinvested and employed in the business 130,281 129,282 Accumulated other comprehensive loss (22,609) (23,580) Total stockholders' equity 164,379 162,283 220,001 218,924 See notes to consolidated financial statements Page 5 of 16 THE L. S. STARRETT COMPANY Consolidated Statements of Stockholders' equity For the Thirteen Weeks Ended September 25, 2004 and September 27, 2003 (in thousands except per share data) (unaudited) Common Addi- Accumulated Stock Out- tional Other standing Paid-in Retained Comprehensive ($1 Par) Capital Earnings Loss Total Balance June 28, 2003 6,659 49,826 134,547 (26,081) 164,951 Comprehensive loss: Net loss (1,095) (1,095) Unrealized net loss on investments (10) (10) Translation loss, net (868) (868) Total comprehensive loss (1,973) Dividends ($.10 per share) (668) (668) Treasury shares issued 8 110 118 Balance September 27, 2003 6,667 49,936 132,784 (26,959) 162,428 Balance June 26, 2004 6,647 49,934 129,282 (23,580) 162,283 Comprehensive income: Net earnings 1,664 1,664 Unrealized net gain on investments 89 89 Translation gain, net 882 882 Total comprehensive income 2,635 Dividends ($.10 per share) (665) (665) Treasury shares issued 8 118 126 Balance September 25, 2004 6,655 50,052 130,281 (22,609) 164,379 See notes to consolidated financial statements Page 6 of 16 THE L. S. STARRETT COMPANY Condensed 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 September 25, 2004 and June 26, 2004; the results of operations and cash flows for the thirteen weeks ended September 25, 2004 and September 27, 2003; and changes in stockholders' equity for the thirteen weeks ended September 25, 2004 and September 27, 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 26, 2004, and these financial statements should be read in conjunction with said annual report. Certain reclassifications have been made to prior year data in order to conform with current year presentation. In the September 2003 quarter, shares used to compute diluted loss per share were the same as shares used to compute basic loss per share since inclusion of common stock equivalents (13,161 shares) is antidilutive in periods with a loss. Included in investments at September 25, 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. Other income (expense) is comprised of the following (in thousands): Thirteen Weeks Ended September 2004 2003 Interest income 235 155 Interest expense and commitment fees (195) (328) Realized and unrealized exchange losses (147) (39) Gain on sale of real estate 662 Other (50) (59) 505 (271) Net periodic benefit costs (benefits) for the Company's defined benefit pension plans consists of the following (in thousands): Thirteen Weeks Ended September 2004 2003 Service cost 804 811 Interest cost 1,648 1,526 Expected return on plan assets (2,578) (2,347) Amort. of transition obligation (245) (243) Amort. of prior service cost 107 105 Amort. of unrecognized loss 73 (264) (75) Page 7 of 16 Net periodic benefit costs (benefits) for the Company's postretirement medical plan consists of the following (in thousands): Thirteen Weeks Ended September 2004 2003 Service cost 129 164 Interest cost 238 259 Amort. of prior service cost (118) (88) Amort. of unrecognized loss 16 31 265 366 Approximately two thirds of all inventories are valued on the LIFO method. At September 25, 2004 and June 26, 2004, total inventories are approximately $20 million less than if determined on a FIFO basis. The Company has not realized any material LIFO layer liquidation profits in the periods presented. Long-term debt is comprised of the following (in thousands): September June 2004 2004 Revolving credit agreement - - Capitalized lease obligations payable in Brazilian currency due 2005-2008, 15%-21% 4,147 3,971 Less current portion 1,532 1,435 2,615 2,536 Current notes payable, primarily in Brazilian currency, carry interest at up to 15%. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Overview As more fully discussed below, the Company had net earnings of $1.7 million, or $.25 per share, in the first quarter of fiscal 2005 compared to a net loss of $1.1 million, or $.16 per share, in the first quarter of fiscal 2004. Included in the this year's quarter is a $.7 million gain, both before and after tax, or $.10 per share, on the sale of the Company's Skipton, England manufacturing facility, the operations of which were consolidated into the Company's Jedburgh, Scotland plant during fiscal 2004. Excluding this one-time gain, the Company had pro forma net earnings of $1.0 million, or $.15 per share, in the current quarter compared to a net loss of $1.1 million, or $.16 per share, in the September quarter of fiscal 2004, an improvement of $2.1 million, or $.31 per share. Sales Sales for the fiscal 2005 September quarter are up $6.1 million or 15% compared to the fiscal 2004 September quarter. Domestic sales are up 9% and foreign sales are up 27% (23% in local currency). The increase reflects the improvement in the U.S. industrial manufacturing sector, which started to affect us in the second quarter of fiscal 2004, as well as good economic conditions in Company's Brazilian market. The magnitude of the overall increase should be viewed in the context of last year's September quarter, which was the Company's lowest sales quarter in over 10 years because of the weak U.S. industrial manufacturing sector. Page 8 of 16 Earnings (loss) before taxes The current quarter's pretax earnings of $2.0 million are an improvement of $4.0 million over last year's pretax loss of $2.0 million. As discussed above, $.7 million of the current quarter's earnings is the result of a one- time gain on the sale of real estate. The sales increase itself caused approximately $1.5 million of the increase in pretax earnings. The major item causing the remaining $1.8 million increase in pretax earnings is improved gross margins (29% in the fiscal 2005 September quarter and 24% in the fiscal 2004 September quarter) at almost all locations coming about as a result of higher production levels. Selling and general expense is up 4% in dollars ($.4 million) as a result of the sales increase, but down from 28% of sales to 25% of sales for the same reason. Last year's September quarter included $.2 million in selling and general charges related to the Government's investigation of the CMM division, which was settled in August 2004 (see below). Final charges related to the investigation and settlement were all accrued into fiscal 2004 and there are no such charges recorded in the current September quarter. Additionally, improved asset returns and higher discount rates have reduced this year's retirement costs by approximately $.3 million per quarter. About three quarters of this reduction is recorded as a reduction of cost of sales and one quarter as a reduction of selling and general expense. Income tax benefit The effective income tax rate is 17% in the fiscal 2005 September quarter and 44% in the fiscal 2004 September quarter. 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, results are close enough to breakeven in both years that permanent book/tax differences and jurisdictional tax rate differentials have an exaggerated effect when converted to percentages. Of particular note in the current year is the fact that the $.7 million gain on the sale of real estate mentioned above carried practically no tax because cost is indexed for tax purposes in the U.K. This had the effect of lowering our effective tax rate by 10 percentage points in the current quarter. Despite recent losses, the Company continues to believe it will be able to utilize its tax operating loss carryforwards generated in prior periods. 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 net earnings per share of $0.25 in the fiscal 2005 September quarter ($.15 per share before the gain on sale of real estate) compared to a basic and diluted net loss of $.16 per share a year ago. Coordinate Measuring Machine (CMM) division As discussed in greater detail in the Company's annual report on Form 10-K for the fiscal year ended June 26, 2004, the Company reached a settlement in August 2004 with the U.S. Department of Justice resulting in the termination of the Government's two-year investigation of the Company's CMM division, which is located in Mount Airy, North Carolina and accounts for less than 2% of the Company's sales, and the dismissal with prejudice of the allegations in the qui tam complaint investigated by the Government. Under the terms of the settlement, the Company paid the Government $.5 million, and the Company and its officers, directors, employees and shareholders were released from any causes of action relating to the false claims allegations in the qui tam complaint that were the subject of the investigation. The Company cooperated with the Government throughout its investigation, and agreed to Page 9 of 16 settle the matter solely to avoid the delay, expense, inconvenience and uncertainty of protracted litigation. In this regard, the Company denies and contests the allegations in the qui tam complaint, denies any wrongdoing in connection with those allegations, and notes that the Government itself, notwithstanding two years of investigation, intervened in this action only for the purposes of settlement and dismissing the qui tam action as described above. The costs related to this investigation were all incurred in fiscal 2003 and 2004, including $.2 million in the September quarter of fiscal 2004. See the additional comments below under "Reorganization/ Restructuring Plans" regarding the CMM division. LIQUIDITY AND CAPITAL RESOURCES Cash flows (in thousands) 13 Weeks Ended 9/25/04 9/27/03 Cash provided by operations 3,214 3,147 Cash used in investing activities (2,160) (3,558) Cash used in financing activities (191) (1,653) Cash provided by operations was approximately the same in the quarters presented with the increase in earnings being offset by an increase in inventories. "Retirement benefits" under noncash 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 generated approximately $.5 million of noncash income in the current year's quarter and $.1 million in the prior year's quarter. Including this noncash income, retirement expense in total was approximately $.1 million in the fiscal 2005 September quarter and $.4 million in the fiscal 2004 September quarter. The Company's investing activities consist of expenditures for plant and equipment and the investment of cash not immediately needed for operations. An increase in capital expenditures of $.4 million in the fiscal 2005 September quarter was more than offset by $1.8 million less additions to short-term investments. Cash used in financing activities decreased $1.4 million from quarter to quarter because of lower debt repayments. 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 maintain consistent profitability, additional steps may have to be taken in order to maintain liquidity, including further plant consolidations and workforce and dividend reductions (see "Reorganization/Restructuring Plans" section below). The Company maintains a $15 million line of credit, but has not made any borrowings under it in the periods presented. The Company had a working capital ratio of 5.8 to one as of September 25, 2004 and 5.4 to one as of June 26, 2004. REORGANIZATION/RESTRUCTURING PLANS As discussed in greater detail in the Company's annual report on Form 10-K for the fiscal year ended June 26, 2004, manufacturing globalization has Page 10 of 16 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. The outlook for the CMM division is problematic. During fiscal 2003 and 2004, the Company took charges of about $8 million relating to the division in connection with the Government investigation, the replacement program for the Rapid Check CMM machines, and inventory write-downs. Actions being considered for the division range from staying in the business, to outsourcing, to exiting altogether. During fiscal 2004, the Company consolidated its Skipton, England optical comparator manufacturing into its manufacturing facility in Jedburgh, Scotland. The Company has closed, and is trying to sell, its Alum Bank, Pennsylvania level manufacturing plant and has relocated 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's goal is to achieve labor savings and maintain margins while satisfying the requirements of its customers with lower prices. The Company has closed one warehouse and is evaluating consolidating or eliminating others. No material unrecorded costs or asset write-downs are currently known as a result of these potential initiatives. 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. OFF-BALANCE SHEET ARRANGEMENTS The Company does not have any material off-balance sheet arrangements as defined under the Securities and 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 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; and normal expense accruals for such things as workers compensation and employee medical expenses. Actual results could differ from these estimates. The allowance for doubtful accounts and sales returns is based on our assessment of the collectibility of specific customer accounts, the aging of our accounts receivable and trends in product returns. While we believe that our 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 our previous experience, or actual future returns do not Page 11 of 16 reflect historical trends, our estimates of the recoverability of the amounts due us and our 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 our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and requirements, we may be required to increase our inventory reserve and, as a result, our gross profit margin could be adversely affected. Accounting for income taxes requires estimates of our 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 arising from these differences on future tax payments. With respect to recorded tax assets, we assess the likelihood that the asset will be realized. If realization is in doubt because of uncertainty regarding future profitability or enacted tax rates, we provide a valuation allowance related to the asset. Should any significant changes in the tax law or our estimate of the necessary valuation allowance occur, we would record the impact of the change, which could have a material effect on our financial position or results of operations. Pension and postretirement medical costs and obligations are dependent on assumptions used by our 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 our pension and other postretirement benefit costs and obligations. SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This Quarterly Report on Form 10-Q, the fiscal 2004 annual report to stockholders, including the President's letter, and the fiscal 2004 Annual Report on Form 10-K, contain forward-looking statements about the Company's business, competition, sales, expenditures, foreign operations, 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 Page 12 of 16 incurred. If the Company is unable to return to consistent profitability, additional steps will have to be taken, including further plant consolidations and workforce and dividend reductions. 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 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 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 market presence. Accordingly, economic weakness in the industrial manufacturing sector may, and in some cases has, resulted in decreased demand for certain of the Company's products, which adversely affects 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 accounted for approximately 25% of revenues in fiscal 2004. The Company is in the process of winding down its relationship with W.W.Grainger, one of the three customers, during fiscal 2005. The effect this will have on total Company sales and profits is unknown since much of the Grainger business is currently expected to be picked up by other Company distributors, although no such assurances can be made that this will in fact happen. The loss or reduction in orders by any of the remaining customers, including reductions due to market, economic or competitive conditions, or the failure of the Company to replace the Grainger sales could adversely Page 13 of 16 affect business and results of operations. Indeed, the Company's major 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 $.5 million and, in certain circumstances, 5% of the loss. 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. 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 September 2004 and 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 are approximately $4 million. 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 $29.2 million and debt of $4 million at September 25, 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 approximately $2.2 million by $35,000. Page 14 of 16 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 September 25, 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. PART II. OTHER INFORMATION Item 1 - Legal Proceedings As discussed in the Company's annual report on Form 10-K for the fiscal year ended June 26, 2004, on August 31, 2004 the Company reached a settlement with the U.S. Department of Justice resulting in the termination of the Government's two-year investigation of the Company's CMM division located in Mount Airy, North Carolina and the dismissal with prejudice of the allegations in the qui tam complaint investigated by the Government. The qui tam complaint, which prompted the Government's investigation, was filed under seal in March 2002 and was brought by a former independent contractor and former employee of the Company. The Company first became aware of the Government's investigation in September 2002, when the Government searched the Company's Mount Airy facility. Under the terms of the settlement, the Company paid the Government $.5 million, and the Government and the qui tam relators released the Company and its officers, directors, employees and shareholders from the causes of action in the complaint that were the subject of the Government's investigation. The Company cooperated with the Government throughout its investigation, and has agreed to settle this matter solely to avoid the delay, expense, inconvenience and uncertainty of protracted litigation. In this regard, the Company denies and contests the allegations in the qui tam complaint, denies any wrongdoing in connection with those allegations, and notes that the Government itself, notwithstanding two years of investigation, intervened in this action only for the purposes of settlement and dismissing the qui tam action as described above. In addition, the United States Attorney for the District of Massachusetts in early August 2004 informed the Company in writing that, based on the facts known to the Office of the United States Attorney, the United States Attorney's Office does not intend to seek criminal charges against the Company or its CMM division in connection with allegations arising out of, or relating to, the manufacture, sale or service of CMMs. 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 September 25, 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 6/27/04- 7/31/04 none none 8/1/04- 8/28/04 none none 8/29/04- 9/25/04 none none Page 15 of 16 Item 4. Submission of Matters to a Vote of Security Holders. (a) The annual meeting of shareholders was held on October 13, 2004. (c) 1. The following directors were elected at the annual meeting: Abstentions Votes Votes and Broker For Withheld Non-votes Class A shares voting as separate class: Richard B. Kennedy 4,454,221 489,664 N/A Class A and B shares voting together: Terry A. Piper 14,360,085 640,780 N/A Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits 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 filed a report on Form 8-K on September 1, 2004 announcing that it had reached a settlement with the U.S. Department of Justice resulting in the termination of the Government's investigation of the Company's Coordinate Measuring Machine division. 2. The Company filed a report on Form 8-K on September 10, 2004 announcing that it had mailed to its shareholders the Company's fiscal 2004 Annual Report to Shareholders, which included the President's Letter. 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 November 4, 2004 S/R.U.WELLINGTON, JR. R. U. Wellington, Jr. (Vice President, Treasurer and Chief Financial Officer) Date November 4, 2004 S/S.G.THOMSON S. G. Thomson (Chief Accounting Officer) Page 16 of 16