10-Q 1 fy05mar10q.txt 10Q 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 26, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 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, 2005: Class A Common Shares 5,450,127 Class B Common Shares 1,204,733 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 26, 2005 and March 27, 2004 (unaudited) 3 Consolidated Statements of Cash Flows - thirteen and thirty-nine weeks ended March 26, 2005 and March 27, 2004 (unaudited) 4 Consolidated Balance Sheets - March 26, 2005 (unaudited) and June 26, 2004 5 Consolidated Statements of Stockholders' Equity - thirty-nine weeks ended March 26, 2005 and March 27, 2004 (unaudited) 6 Notes to Consolidated Financial Statements 7-9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9-17 Item 3. Quantitative and Qualitative Disclosures About Market Risk 17 Item 4. Controls and Procedures 17 Part II. Other Information: Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 17 Item 6. Exhibits and Reports on Form 8-K 17-18 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 3/26/05 3/27/04 3/26/05 3/27/04 Net sales 50,028 44,945 146,078 131,040 Cost of goods sold (37,503) (33,017) (106,371)(100,985) Selling and general expense (12,663) (11,684) (36,579) (34,518) Other income (expense) 189 (64) 570 (416) Earnings (loss) before income taxes 51 180 3,698 (4,879) Provision (benefit) for federal, foreign and state income taxes (98) (264) 573 (2,395) Net earnings (loss) 149 444 3,125 (2,484) Basic and diluted earnings (loss) per share .02 .07 .47 (.37) Average outstanding shares used in per share calculations (in thousands) Basic 6,650 6,642 6,645 6,653 Diluted 6,671 6,658 6,662 6,653 Dividends per share .10 .10 .30 .30 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 3/26/05 3/27/04 3/26/05 3/27/04 Cash flows from operating activities: Net earnings (loss) 149 444 3,125 (2,484) Non-cash items included: Depreciation and amortization 2,653 2,658 7,865 8,249 Deferred taxes (1,279) (462) (1,108) (1,494) Retirement benefits (476) (116) (1,427) (350) Working capital changes: Receivables 2,623 2,866 4,270 4,101 Inventories (2,421) 2,144 (6,766) 9,723 Other assets and liabilities 382 (167) (790) 1,920 Prepaid pension cost and other 155 49 283 224 Net operating cash flows 1,786 7,416 5,452 19,889 Cash flows from investing activities: Additions to plant and equipment (1,014) (1,363) (4,412) (4,658) Proceeds from sale of real estate 1,522 Change in short-term investments 919 (8,792) 351 (14,019) Net investing cash flows (95) (10,155) (2,539) (18,677) Cash flows from financing activities: Short-term borrowings 97 443 737 900 Long-term borrowings (repayments) (540) 614 (1,116) (2,180) Common stock issued 82 455 226 Treasury shares purchased (235) (394) (633) Dividends (665) (663) (1,995) (1,993) Net financing cash flows (1,026) 159 (2,313) (3,680) Exchange rate change effect on cash 8 123 112 221 Net increase (decrease) in cash 673 (2,457) 712 (2,247) Cash, beginning of period 2,522 3,516 2,483 3,306 Cash, end of period 3,195 1,059 3,195 1,059 See Notes to Consolidated Financial Statements Page 4 of 18 THE L. S. STARRETT COMPANY Consolidated Balance Sheets (in thousands of dollars) March 26 June 26 2005 2004 ASSETS (unaudited) Current assets: Cash 3,195 2,483 Investments 32,111 32,023 Accounts receivable (less allowance for doubtful accounts of $1,494 and $1,358) 31,066 33,434 Inventories: Raw materials and supplies 14,334 8,510 Goods in process and finished parts 18,267 16,780 Finished goods 20,080 17,987 52,681 43,277 Prepaid expenses, taxes and other current assets 10,631 11,534 Total current assets 129,684 122,751 Property, plant and equipment, at cost (less accumulated depreciation of $108,500 and $100,767) 60,717 62,859 Prepaid pension cost 33,536 32,370 Other assets 374 944 224,311 218,924 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Notes payable and current maturities 2,505 2,302 Accounts payable and accrued expenses 16,143 16,005 Accrued salaries, wages and postretirement benefits 3,986 4,375 Total current liabilities 22,634 22,682 Deferred income taxes 13,090 14,214 Long-term debt 2,661 2,536 Accumulated postretirement medical benefit obligation 17,053 17,209 Stockholders' equity: Class A Common $1 par (20,000,000 shrs. auth.; 5,444,053 outstanding on 3/26/05, 5,396,679 outstanding on 6/26/04 5,444 5,397 Class B Common $1 par (10,000,000 shrs. auth.; 1,206,801 outstanding on 3/26/05, 1,250,106 outstanding on 6/26/04 1,207 1,250 Additional paid-in capital 50,219 49,934 Retained earnings reinvested and employed in the business 130,253 129,282 Accumulated other comprehensive loss (18,250) (23,580) Total stockholders' equity 168,873 162,283 224,311 218,924 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 26, 2005 and March 27, 2004 (in thousands of dollars) (unaudited) Common Addi- Accumulated Stock Out- tional Other standing Paid-in Retained Comprehensive ($1 Par) Capital Earnings Loss Total Balance June 28, 2003 6,659 49,826 134,547 (26,081) 164,951 Comprehensive income(loss): Net loss (2,484) (2,484) Unrealized net gain on investments 29 29 Translation gain, net 3,659 3,659 Total comprehensive income 1,204 Dividends ($.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 Balance June 26, 2004 6,647 49,934 129,282 (23,580) 162,283 Comprehensive income(loss): Net earnings 3,125 3,125 Unrealized net gain on investments 29 29 Translation gain, net 5,301 5,301 Total comprehensive income 8,455 Dividends ($.30 per share) (1,995) (1,995) Treasury shares: Purchased (25) (210) (159) (394) Issued 13 196 209 Options exercised 16 299 315 Balance March 26, 2005 6,651 50,219 130,253 (18,250) 168,873 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 26, 2005 and June 26, 2004; the results of operations and cash flows for the thirteen and thirty-nine weeks ended March 26, 2005 and March 27, 2004; and changes in stockholders' equity for the thirty-nine weeks ended March 26, 2005 and March 27, 2004. 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 period data to conform with current year presentation. The Company incurred approximately $1.3 million and $1.2 million in outbound shipping costs in the March quarters of fiscal 2005 and 2004, respectively, and $3.8 million and $3.5 million in the nine month periods then ended. Approximately 25% of these shipping costs were billed to, and reimbursed by, customers. Beginning with the March 2005 quarter, the Company is recording all outbound freight as cost of sales rather than the previous practice of netting such costs against sales. Prior period amounts have not been reclassified as they are immaterial to the consolidated statements of operations. In the nine month period ended March 27, 2004, 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 (13,781 shares) is antidilutive in periods with a loss. Included in investments at March 26, 2005 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 Thirty-nine Weeks Ended March Ended March 2005 2004 2005 2004 Interest income 262 220 754 565 Interest expense and com- mitment fees (270) (271) (651) (834) Realized and unrealized exchange gains (losses) 224 7 (39) (3) Gain on sale of real estate 662 Other (27) (20) (156) (144) 189 (64) 570 (416) Page 7 of 18 Net periodic costs (benefits) for the Company's defined benefit pension plans consist of the following (in thousands): Thirteen Weeks Thirty-nine Weeks Ended March Ended March 2005 2004 2005 2004 Service cost 804 813 2,412 2,439 Interest cost 1,648 1,530 4,944 4,591 Expected return on plan assets (2,578) (2,352) (7,734) (7,057) Amort. of transition obligation (245) (244) (735) (731) Amort. of prior service cost 107 106 321 317 Amort. of unrecognized loss 73 219 (264) (74) (792) (222) Net periodic costs (benefits) for the Company's postretirement medical plan consist of the following (in thousands): Thirteen Weeks Thirty-nine Weeks Ended March Ended March 2005 2004 2005 2004 Service cost 129 164 387 493 Interest cost 238 259 714 778 Amort. of prior service cost (118) (88) (354) (265) Amort. of unrecognized loss 16 31 48 93 265 366 795 1,099 Approximately two thirds of all inventories are valued on the LIFO method. At March 26, 2005 and June 26, 2004, total inventories are approximately $20 million less than if determined on a FIFO basis. During the March 2004 quarter, the Company reduced the levels of certain LIFO inventories that were carried in the aggregate at lower costs prevailing in prior years. The effect of this LIFO inventory reduction was to increase net earnings in the March 2004 quarter by approximately $.6 million, or $.05 per share. Long-term debt is comprised of the following (in thousands): March June 2005 2004 Revolving credit agreement - - Capitalized lease obligations payable in Brazilian currency due 2005-2007, 15%-24% 3,598 3,971 Less current portion 938 1,435 2,661 2,536 Current notes payable carry interest at approximately 5%. Page 8 of 18 RECENT ACCOUNTING PRONOUNCEMENTS FSP FASB 109-1: In December 2004, the FASB issued FASB Staff Position No. 109-1, Application of FASB Statement No. 109 (SFAS 109), Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (FSP 109-1). FSP 109-1 clarifies that the manufacturer's deduction provided for under the American Jobs Creation Act of 2004 (AJCA) should be accounted for as a special deduction in accordance with SFAS 109 and not as a tax rate reduction. The adoption of FSP 109-1 will have no impact on the Company's results of operations or financial position for fiscal year 2005 because the manufacturer's deduction is not available to the Company until fiscal year 2006. The company is evaluating the effect that the manufacturer's deduction will have in subsequent years. FSP FASB 109-2: In December 2004, the FASB issued FASB Staff Position No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (FSP 109-2). The AJCA introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. FSP 109-2 provides accounting and disclosure guidance for the repatriation provision. Until the Treasury Department or Congress provides additional clarifying language on key elements of the repatriation provision, the amount of foreign earnings to be repatriated by the Company, if any, cannot be determined. FSP 109-2 grants an enterprise additional time beyond the year ended December 31, 2004, in which the AJCA was enacted, to evaluate the effects of the AJCA on its plan for reinvestment or repatriation of unremitted earnings. FSP 109-2 calls for enhanced disclosures of, among other items, the status of a Company's evaluations, the effects of completed evaluations, and the potential range of income tax effects of repatriations. The Company has just begun this evaluation process. At the present time, deferred taxes have not been recorded on approximately $40 million of undistributed earnings of foreign subsidiaries or the related unrealized translation adjustments because such amounts are considered permanently invested, and it is possible that remittance taxes, if any, would be reduced by U.S. foreign tax credits. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS QUARTERS ENDED MARCH 26, 2005 AND MARCH 27, 2004 Sales Sales for the fiscal 2005 March quarter are up $3.8 million or 8% compared to the fiscal 2004 March quarter. This is before the reclassification of outbound freight costs as discussed in the Notes to Consolidated Financial Statements. Foreign sales are up 31% (18% in local currency), but domestic sales are flat. The overall increase in sales reflects the good economic conditions in the Company's Brazilian market, and modest improvement in the U.S. industrial manufacturing sector offset to some degree by the loss of approximately $2 million in business with W.W. Grainger (one of the Company's three largest distributors in fiscal 2004). It is very difficult to calculate the effect of the loss of this business early in fiscal 2005 since many of the Grainger end users have the ability to continue to buy our products through other distributors. Page 9 of 18 Earnings before taxes Pretax earnings for the quarter were $.1 million compared to $.2 million a year earlier. Domestic operations had a pretax loss of $.9 million in the March 2005 quarter compared to income of $.2 million in the March 2004 quarter, while foreign operations had pretax income of $1.0 million in the March 2005 quarter compared to a $.1 million loss in the March 2004 quarter. The major items having a favorable effect on the quarter to quarter comparison are improved foreign sales ($1.1 million) and gross margins ($1.0 million). These are being more than offset by higher foreign selling expenses ($1.0 million, half of which is from exchange rate changes), the favorable impact in the March 2004 quarter of domestic LIFO inventory layer liquidations ($.6 million), and the double personnel and occupancy costs($.5 million, which are being incurred as part of domestic operations) associated with transferring manufacturing operations from Puerto Rico to the Company's new Dominican Republic facility, which is beginning to manufacture measuring tapes and levels. Domestic margins were flat in the quarter to quarter comparison excluding the effects of LIFO inventory liquidations and the transfer of manufacturing to the Dominican Republic described above. Income Taxes There was an income tax benefit of $.1 million and $.3 million on pretax income of $.1 million and $.2 million in the March 2005 and 2004 quarters, respectively. An effective tax rate comparison is not meaningful under these circumstances because large fluctuations in these rates come about when pretax results are so close to breakeven in most jurisdictions 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%. In addition, an intercompany dividend from our Brazilian subsidiary had a significant favorable effect on last year's March tax provision. This is having an unfavorable effect on the quarter to quarter tax provision comparison of approximately $.3 million. The Company continues to believe it will be able to utilize its tax operating loss carryforwards, but the situation is continually monitored and could change in the future. Net earnings per share As a result of the above factors, the Company had basic and diluted earnings of $.02 per share in the March 2005 quarter compared to $.07 per share in the March 2004 quarter. $.05 of the decrease in the quarter to quarter comparison was due to LIFO inventory liquidation profits in the March 2004 quarter, which are not expected to recur in the near future. NINE MONTH PERIODS ENDED MARCH 26, 2005 AND MARCH 27, 2004 As discussed below under "Coordinate Measuring Machine (CMM) division," the Company took a pretax charge of $3.2 million in the December 2003 quarter in order to write down its CMM inventory to net realizable value. After giving effect to income taxes, this charge amounted to $2.1 million, or a $.32 per share reduction in the results for the nine months ended March 2004. Management routinely reviews the results of operations both with and without large, identifiable charges and credits to better understand the performance of the Company's core business. Sales Sales for the first nine months of fiscal 2005 are up $13.7 million or 10% compared to the first nine months of fiscal 2004. This is before the Page 10 of 18 reclassification of freight out discussed in the Notes to Consolidated Financial Statements. Domestic sales are up 5% and foreign sales are up 24% (18% in local currency). The increase in sales reflects the improvement, mainly in the first two quarters of the fiscal year, in the U.S. industrial manufacturing sector, which started to affect us in the December 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 light of the weakening U.S. dollar noted above and the fact that the September quarter of fiscal 2004 was the Company's lowest sales quarter in over 10 years because of the weak U.S. industrial manufacturing sector. In addition, see the remarks related to the loss of W.W. Grainger business under the quarter to quarter sales comparison above. The nine month to nine month decrease in sales to Grainger was approximately $5.7 million. 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 investigation of the Company's CMM division. 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 costs related to this investigation, including legal fees, were all recorded in fiscal 2003 and 2004, including a $3.2 million pretax write-down of the CMM division's inventory to net realizable value in the December quarter of fiscal 2004. See the additional comments below under "Reorganization/ Restructuring Plans" regarding the CMM division. Earnings (loss) before taxes Pretax earnings for the first nine months of fiscal 2005 were $3.7 million compared to a $4.9 million loss for the first nine months of fiscal 2004. $3.2 million of last year's loss was attributable to the CMM inventory write-down discussed above. The remaining improvement of $5.4 million was, as a function of current year sales, 4 percentage points. Domestic operations had a pretax loss of .9% of sales in the March 2005 nine month period compared to a 2.5% loss on sales in the comparable March 2004 period (before the CMM inventory write-down), while foreign operations had pretax income of about 8% of sales in the March 2005 nine month period and 1% in the comparable March 2004 period. The major items causing the $5.4 million improvement in earnings before the CMM inventory write-down were increased sales ($3.8 million), a gain on the sale of the Company's Skipton, England real estate ($.7 million), and improved gross margins (27.4% this year compared to 25.4% last year, or $2.9 million). These improvements were offset by a $2.0 million increase in selling and general expense although, as a percentage of sales, selling and general expense actually improved from 26.3% to 25.3%. Included in this selling and general expense increase are external costs incurred as a result of compliance with Section 404 of the Sarbanes-Oxley Act (internal controls) estimated to be at least $.5 million, as well as $.6 million as a result of exchange rate changes. The gross margin improvement is due to lower headcount and higher production levels, offset by the benefit ($.9 million) in fiscal 2004 of liquidating LIFO inventories and the costs in 2005 mentioned above associated with establishing a Dominican Republic manufacturing facility for the Company's measuring tapes and levels. Income taxes The effective income tax rate was 15% in the March 2005 nine month period and 49% in the March 2004 nine month period. The fluctuation in these rates is due to the fact that pretax results are so close to breakeven in most Page 11 of 18 jurisdictions 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%. Intercompany dividends from our wholly-owned Brazilian subsidiary in both fiscal 2005 and 2004 has, and is expected to continue to, reduce our tax expense for both fiscal years by approximately $.4, and the nine month tax provisions have been adjusted accordingly. In addition, the $.7 million gain on the sale of Skipton, England 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 an additional 5 percentage points in the fiscal 2005 nine month period. 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 earnings per share for the first nine months of fiscal 2005 of $.47 per share compared to a net loss of $.37 per share in the first nine months of fiscal 2004, an improvement of $.84 per share. $.32 of the fiscal 2004 nine month loss was a result of the CMM inventory write-down in the December 2003 quarter. RECENT ACCOUNTING PRONOUNCEMENTS See "RECENT ACCOUNTING PRONOUNCEMENTS" in "Notes to Consolidated Financial Statements" above. LIQUIDITY AND CAPITAL RESOURCES Cash flows (in thousands) 13 Weeks Ended 39 Weeks Ended 3/26/05 3/27/04 3/26/05 3/27/04 Operating cash flow 1,786 7,416 5,452 19,889 Investing cash flow (95) (10,155) (2,539) (18,677) Financing cash flow (1,026) 159 (2,313) (3,680) Despite operating results being close to breakeven, cash provided by operations has been positive. Non-cash depreciation charges of approximately $3 million per quarter contribute to this, but fiscal 2004 benefited significantly by reductions in inventories both in the quarter and nine month periods. This inventory trend has reversed slightly in fiscal 2005. "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 $.5 million of non-cash income per quarter ($.1 million per quarter in the prior year). On an accrual basis, retirement benefit expense is approximately $.1 million per quarter in the current year and $.4 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 decrease in cash used for investing activities, both in the quarter and nine month comparison, is a result of the decrease in cash being generated by operations. Page 12 of 18 Cash flows related to financing activities are primarily the payment of dividends and repayment of debt. Activity in these areas has not fluctuated significantly in the periods presented. 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, steps may have to be taken in order to maintain liquidity, including plant consolidations and workforce and dividend reductions. The Company maintains a $15 million line of credit, but is not currently borrowing under it. The Company had a working capital ratio of 5.7 to one as of March 26, 2005 and 5.4 to one as of June 26, 2004. REORGANIZATION/RESTRUCTURING INITIATIVES 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 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. Actions being considered for the CMM division (see "Coordinate Measuring Machine (CMM) division" above) range from staying in the business, to outsourcing, to exiting altogether. During the past two years, the Company consolidated its Skipton, England optical comparator manufacturing into its manufacturing facility in Jedburgh, Scotland; closed, and is currently trying to sell, its Alum Bank, Pennsylvania level plant and relocated that manufacturing operation to the Dominican Republic; closed its Cleveland warehouse, and is in the process of closing and selling its Chicago warehouse as well as consolidating a small Gardner, Massachusetts production facility into the Company's Athol, Massachusetts facility; and is in the process of transferring its Puerto Rico and South Carolina tape measure production to the Dominican Republic. The Company's goal is to achieve labor savings and maintain margins while satisfying the requirements of its customers with lower prices. 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 implementation of these or other steps will result in savings to the Company. It is also possible that the Company may need to incur additional charges in connection with these initiatives. 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 Page 13 of 18 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 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. Tax reserves are also established to cover risks associated with activities or transactions that may be at risk for additional taxes. Should any significant changes in the tax law or our estimate of the necessary valuation allowances or reserves 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. Page 14 of 18 CHIEF FINANCIAL OFFICER As previously disclosed in the Current Report on Form 8-K filed on February 25, 2005, Roger U. Wellington, Jr., a director and the Chief Financial Officer (CFO) of the Company, has announced his intention to retire from the Company in June 2005. His replacement has been identified subject to Board approval at its June 1, 2005 meeting. 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 evaluate possible consolidations and reorganizations 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, if identified and implemented, will result in cost savings to the Company. The implementation of any 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. If the Company is unable to maintain 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 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. As a result, the future performance of the Brazilian operations is inherently unpredictable. Risks Related to Manufacturing Sector: The Company's primary customers are in the industrial manufacturing business and, in particular, in the metal working industry. 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 wage foreign countries where the Page 15 of 18 Company does not have a substantial market presence. Economic weakness in the industrial manufacturing sector as well as the shift of manufacturing to low wage counties where the Company does not have a substantial market presence 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 could adversely impact the Company's performance as well. 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 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 has significantly reduced its relationship with W.W.Grainger, one of the three customers, during early fiscal 2005. The effect this has had on total Company sales and profits is very difficult to determine since much of the Grainger business could potentially be picked up by other Company distributors, although no such assurances can be made that this will in fact happen. In recent years, Grainger has accounted for approximately $2 million in sales per quarter. 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 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 as $.5 million and, in certain circumstances, 5% of the loss. Risks 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 Page 16 of 18 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 December 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 less than $5 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 $33.3 million and debt of $5.4 million at December 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 $2.3 million by $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 26, 2005, 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 2. UNREGISTERED SALE OF EQUITY SECURITIES AND USE OF PROCEEDS A summary of the Company's repurchases of shares of its common stock for the three months ended March 26, 2005 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 12/26/04- 1/29/05 none none 1/30/05- 2/26/05 none none 2/27/05- 3/26/05 none none Page 17 0f 18 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 February 25, 2005 announcing it was conducting a search for a new Chief Financial Officer to replace Roger Wellington, Jr., who had announced his intention to retire in June 2005. 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 5, 2005 S/R.U.WELLINGTON, JR. R. U. Wellington, Jr. (Vice President, Treasurer and Chief Financial Officer) Date: May 5, 2005 S/S.G.THOMSON S. G. Thomson (Chief Accounting Officer) Page 18 of 18