Distribution Solutions Group, Inc. - Annual Report: 2006 (Form 10-K)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

Commission file number: 0-10546

 

LAWSON PRODUCTS, INC.

(Exact Name of Registrant as Specified in Charter)

 

 

1666 East Touhy Avenue, Des Plaines, Illinois 60018

(Address of principal executive offices)

 

Registrant’s telephone number, including area code:

(847) 827-9666

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

(Title of class)

 

Indicate by check mark if the Company is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the Company is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes o     No þ

 

Indicate by check mark whether the Registrant (l) 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 þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

 

Indicate by check mark whether the registrant is a large accelerated filer. An accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o     Accelerated Filer þ     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of the Registrant’s voting stock held by non-affiliates (based upon the per share closing price of $39.42) on June 30, 2006 was approximately $173,801,000.

 

As of February 28, 2007, 8,521,001 shares of Common Stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The following documents are incorporated into this Form 10-K by reference:

 

Part III incorporates information by reference to the registrant’s definitive proxy statement, to be filed with the Securities and Exchange Commission within 120 days after the close of the fiscal year.

 

 

TABLE OF CONTENTS

 

 

“Safe Harbor” Statement under the Securities Litigation Reform Act of 1995:  This Annual Report on Form 10-K contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. The terms “may,” “should,” “could,” “anticipate,” “believe,” “continues,” “estimate,” “expect,” “intend,” “objective,” “plan,” “potential,” “project” and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. These statements are based on management’s current expectations, intentions or beliefs and are subject to a number of factors, assumptions and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. Factors that could cause or contribute to such differences or that might otherwise impact the business include the risk factors set forth in Item 1A of this Form 10-K.

 

The Company undertakes no obligation to update any such factor or to publicly announce the results of any revisions to any forward-looking statements contained herein whether as a result of new information, future events or otherwise.

 

Lawson Products, Inc. (“Lawson” or the “Company”) was incorporated in Illinois in 1952 and reincorporated in Delaware in 1982. The Company has two reportable segments: (i) maintenance, repair and operations distribution in North America (the “MRO business”); and (ii) original equipment manufacturer distribution and manufacturing in North America (the “OEM business”). Please see Note P in the Notes to the Consolidated Financial Statements, included elsewhere in this Annual Report on Form 10-K, for additional information regarding segment results and sales by geographic region (and such information is incorporated herein by reference).

 

Overview

 

Lawson is a North American distributor and marketer of systems, services and products to the industrial, commercial and institutional maintenance, repair and operations (“MRO”) marketplace. The Company also manufactures, sells and distributes specialized component parts to the original equipment marketplace (“OEM”), including automotive, appliance, aerospace, construction and transportation industries.

 

Lawson markets its products from its MRO segment primarily through a network of approximately 1,700 independent sales agents. The Company’s OEM segment sells primarily through inside sales representatives. The majority of the Company’s sales agents and inside sales representatives utilize catalogs, websites and call centers to facilitate customer ordering activity.

 

The Company achieved record sales levels in 2006; however, operating profits declined, primarily due to higher general and administrative expenses associated with the Company’s ongoing investments in marketing, technology, and supply chain initiatives. The Company believes that the investments in these initiatives are important factors in driving long-term growth and profitability. General and administrative expenses also increased due to legal costs incurred in conjunction with the ongoing government investigation which is discussed further in Item 3 Legal Proceedings.

 

Products

 

The Company offers expendable maintenance, repair and operations products in both of its segments. The Company’s products can be divided into three broad categories: Fasteners, Fittings and Related Parts, such as screws, nuts, rivets and other fasteners; Industrial Supplies, such as hoses and hose fittings, lubricants, cleansers, adhesives and other chemicals, as well as files, drills, welding products and other shop supplies; and Automotive and Equipment Maintenance Parts, such as primary wiring, connectors and other electrical supplies, exhaust and other automotive parts.

 

The Company estimates that these categories of products accounted for the following percentages of its total consolidated net sales for 2006, 2005 and 2004, respectively:

 

 

Substantially all of the Company’s MRO products are manufactured by others and must meet the Company’s specifications. A majority of MRO products distributed by the Company are purchased by the Company in bulk and repackaged in smaller quantities. The Company regularly uses a large number of suppliers and has no long-term or fixed price contracts with any of them. Most of the Company’s MRO products are purchased from several sources, and the Company believes that the loss of any single supplier

would not significantly affect its operations. No single supplier accounted for more than 3% of the Company’s purchases in 2006.

 

In the OEM business, the Company sources most products based on customer specifications through a variety of domestic and international suppliers. A small portion of OEM products are manufactured by the Company, primarily precision engineered machine parts. In addition to customer-oriented products, the OEM business provides supply chain management services such as in-plant inventory management and automatic re-stock programs for many customers.

 

Markets

 

The Company’s principal markets are as follows:

 

In-Plant and Building Maintenance.  This market includes facilities engaged in a broad range of manufacturing and processing activities, as well as institutions such as hospitals, universities, school districts and government units. The Company estimates that approximately 46% of 2006 and 43% of 2005 net sales were made to customers in this market.

 

Heavy Duty Equipment Maintenance.  Customers in this market include operators of trucks, buses, agricultural implements, construction and road building equipment, mining, logging and drilling equipment and other off-the-road equipment. The Company estimates that approximately 23% of 2006 and 24% of 2005 net sales were made to customers in this market.

 

Original Equipment Manufacturers.  This market includes supplying production lines engaged in a broad range of manufacturing and processing activities with component parts. The Company estimates that approximately 17% of 2006 and 2005 net sales were made to customers in this market.

 

Vehicle Maintenance and Transportation.  Customers in this market include automobile service center chains, independent garages, automobile dealers, car rental agencies and other fleet operators. The Company estimates that approximately 14% of 2006 and 16% of 2005 net sales were made to customers in this market.

 

At December 31, 2006, the Company had approximately 377,000 customers. Sales were made primarily through a network of approximately 1,700 independent sales agents and inside sales representatives. Independent sales agents and inside sales representatives are compensated on a commission basis and are responsible for repayment of commissions on any uncollectible accounts. Sales force management includes 39 regional managers who coordinate regional marketing efforts. The Company had approximately 1,540 employees at December 31, 2006.

 

The Company’s products are sold in all 50 states, the District of Columbia, Mexico, Puerto Rico and Canada. The Company believes that an important factor in its success is its ability to service customers promptly. Rapid shipment is facilitated by computer controlled order entry and inventory control systems in each general distribution center. Sales representatives in the field are equipped with technology to automatically transmit customer orders. Shipments to customers typically are delivered by common carrier.

 

Inventories

 

The Company is required to carry significant amounts of inventories in order to meet its high standards of rapid processing of customer orders. The Company has historically funded its working capital requirements for inventories internally. Such internally generated funds, along with a $75 million unsecured revolving line of credit, are expected to finance the Company’s working capital requirements.

 

Distribution and Manufacturing Facilities

 

The Company’s MRO products are primarily stocked in and distributed from eleven general distribution centers located in: Addison, Illinois; Reno, Nevada; Farmers Branch, Texas; Suwanee, Georgia; Fairfield, New Jersey; Whittier, California; Houston, Texas; Mississauga, Ontario, Canada; Guadalajara, Mexico; Vernon Hills, Illinois and Charlotte, North Carolina.

 

In 2006 the Company began a 140,000 square foot expansion of its Reno, Nevada distribution facility to increase capacity.

 

Also in December 2006, the Company began the process of closing its Mexico operation. See Note Q for additional information.

 

OEM products are stocked and distributed primarily from five facilities located in Des Plaines, Illinois; Memphis, Tennessee; Lenexa, Kansas; Dunlap, Tennessee and Cincinnati, Ohio. Certain OEM products are manufactured at the Company’s plant in Decatur, Alabama.

 

In the opinion of the Company, all existing facilities are in good condition and are well maintained. All facilities are being used substantially to capacity on a single shift basis, except the manufacturing facility in Decatur, Alabama and the inbound facility in Des Plaines, Illinois, each of which operate two shifts. Further expansion of warehousing capacity may require new or expanded warehouses, some of which may be located in new geographical areas.

 

International Operations

 

Approximately 7% of the Company’s net sales came from international sales, primarily in Canada and Mexico.

 

Canadian operations are conducted at the Company’s general distribution center in Mississauga, Ontario, a suburb of Toronto. These operations constituted approximately 6% of the Company’s net sales during 2006.

 

Operations in Mexico are conducted under the name of Lawson Products de Mexico, S de R.L. de C.V. from a facility in Guadalajara, Mexico. These operations constituted approximately 1% of the Company’s net sales during 2006. In December 2006, the Company began the process of closing its Mexico operation. See Note Q for additional information.

 

The Company is from time to time exposed to market risk relating to the impact of foreign currency exchange rates. The Company considers the market risk relating to the impact of foreign currency exchange rates to be immaterial.

 

Competition

 

The Company encounters intense competition from several national distributors and manufacturers and a large number of regional and local distributors. Due to the nature of its business and the absence of reliable trade statistics, the Company cannot estimate its position in relation to its competitors. However, the Company recognizes that some competitors may have greater financial and personnel resources, handle more extensive lines of merchandise, operate larger facilities and price some merchandise more competitively than the Company. Although the Company believes that the prices of its products are competitive, it endeavors to meet competition primarily through its service capabilities, the quality of its product line, its response time and its delivery systems.

Executive Officers of the Registrant

 

The executive officers, all of whose terms of office expire in 2007, are as follows:

 

 

Available Information

 

The Company’s internet address is: www.lawsonproducts.com. Information on our website is not incorporated by reference into this report. The Company makes available free of charge through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act and Section 16 reports as soon as reasonably practicable after such documents are electronically filed with the Securities and Exchange Commission.

 

In addition to the other information in this Annual Report on Form 10-K for the fiscal year ended December 31, 2006, the following factors should be considered in evaluating Lawson’s business. The Company’s operating results depend upon many factors and are subject to various risks and uncertainties. The material risks and uncertainties known to the Company which may cause the operating results to vary from anticipated results or which may negatively affect the Company’s operating results and profitability are as follows:

 

If the Company is unable to successfully conclude the pending governmental investigation of the Company, the Company’s business, financial condition, results of operations and stock price could be adversely affected.

 

In December 2005, the FBI executed a search warrant for records at the Company’s offices and informed the Company that it was conducting an investigation as to whether any of the Company’s representatives improperly provided gifts or awards to purchasing agents (including government purchasing agents) through the Company’s customer loyalty programs. The U.S. Attorney’s office for the Northern District of Illinois subsequently issued a subpoena for documents in connection with this investigation. The Company’s internal investigation regarding these matters has consisted of a review of the Company’s records and interviews with Company employees and independent agents and is not complete. In conjunction with the Company’s internal investigation, several customer loyalty programs have been terminated because the Company believes that these programs provided or had the potential of providing promotional considerations, such as gifts and awards, to purchasing agents that the Company has deemed inappropriate. The Company has modified another customer loyalty program to limit the amount and nature of customer gifts distributed under the program. In addition, twenty-three independent agents have been terminated or have resigned and the Company has terminated four employees in connection with its investigation. The Company is cooperating with the ongoing investigation of the U.S. Attorney, however, the Company cannot predict when the investigation will be

completed or what the outcome or the effect of the investigation will be. The outcome of the investigation could result in criminal sanctions or civil remedies against the Company, including material fines, injunctions or the loss of the Company’s ability to conduct business with governmental entities.

 

A significant portion of Lawson’s inventory may become obsolete.

 

Lawson’s business strategy requires the Company to carry a significant amount of inventory in order to meet rapid processing of customer orders. If the Company’s inventory forecasting and production planning processes result in the Company carrying inventory levels in excess of the levels demanded by the Company’s customers, the Company’s operating results could be adversely affected due to costs of carrying the inventory and additional inventory write-downs for excess and obsolete inventory.

 

Work stoppages and other disruptions at transportation centers or shipping ports may adversely affect Lawson’s ability to obtain inventory and make deliveries to Lawson’s customers.

 

The Company’s ability to provide rapid processing of customer orders is an integral component of the Company’s overall business strategy. Disruptions at transportation centers or shipping ports, due to events such as severe weather or labor interruptions or other events, affect both the Company’s ability to maintain core products in inventory and deliver products to the Company’s customers on a timely basis, which may in turn adversely affect the Company’s results of operations. In addition, severe weather conditions could adversely affect demand for the Company’s products in particularly hard hit regions.

 

Changes in the Company’s customers and product mix could cause the Company’s gross margin percentage to fluctuate or decline in the future.

 

From time to time, the Company has experienced changes in product mix and inventory costs. When the Company’s product mix changes, there can be no assurance that the Company will be able to maintain its historical gross profit margins. Changes in the Company’s customers, product mix, or the volume of Lawson’s orders could cause its gross profit margin percentage to fluctuate or decline.

 

Increases in energy costs and the cost of raw materials used in Lawson’s products could impact Lawson’s cost of goods and distribution and occupancy expenses, which may result in lower operating margins.

 

Costs of raw materials used in Lawson’s products (e.g. steel) and energy costs have been rising during the last several years, which has resulted in increased production costs for Lawson’s vendors. Those vendors typically look to pass their increased costs along to Lawson through price increases. If Lawson is unable to fully pass these increased prices and costs through to Lawson’s customers or to modify Lawson’s activities to mitigate the impact would have an adverse effect on the Company’s operating profit margins.

 

Disruptions of Lawson’s information systems could adversely affect the Company.

 

The Company depends upon its information systems to help process orders, to manage inventory and accounts receivable collections, to purchase, sell and ship products, to maintain cost-effective operations, and to service customers. Disruptions in the operation of information systems can occur due to a variety of factors including power outages, computer bugs and human error. Any disruption in the operation of the Company’s information systems whether over a short or an extended period of time or affecting one or multiple distribution centers could have a material adverse effect on Lawson’s business, financial condition and results of operations.

 

A limited number of the Company’s stockholders can exert significant influence over the Company.

 

As of February 28, 2007, members of the Port family collectively beneficially owned 55.3% of the outstanding shares of common stock. This share ownership would permit these stockholders, if they chose to act together, to exert significant influence over the outcome of stockholder votes, including votes concerning the election of directors, by-law amendments, possible mergers, corporate control contests and other significant corporate transactions.

 

The Company operates in highly competitive markets.

 

The Company’s marketplace, although consolidating, still includes large, fragmented industries that are highly competitive. The Company believes that customers and competitors may continue to consolidate over the next few years, which may make the industry even more competitive. The Company’s current or future competitors include companies with similar or greater market presence, name recognition, and financial, marketing, and other resources, and the Company believes they will continue to challenge the marketplace with their product selection, financial resources, and services.

 

The Rutland acquisition and future acquisitions are subject to integration and other risks.

 

The Company anticipates that it may, from time to time, selectively acquire additional businesses or assets. Acquisitions are accompanied by risks, such as potential exposure to unknown liabilities of acquired companies and the possible loss of key employees and customers of the acquired business. In addition, the Company may not obtain the expected benefits or cost savings from the Rutland acquisition or any other acquisition. Further, acquisitions are subject to risks associated with financing the acquisition and integrating the operations and personnel of the acquired businesses or assets. If any of these risks materialize, they may result in disruptions to Lawson’s business and the diversion of management time and attention, which could increase the costs of operating the Company’s existing or acquired businesses or negate the expected benefits of the acquisitions.

 

A slowdown in the economy could negatively impact Lawson’s sales and earnings.

 

General economic conditions affect Lawson’s customers and its sales opportunities. In general, the Company’s sales represent spending on consumption needs by the Company’s customers. This spending is affected by many factors, including, among others: general business conditions, interest rates, inflation, taxation, fuel prices and electrical power rates, unemployment trends, terrorist attacks and acts of war, and other matters that influence consumer confidence and spending. Additionally, in the event of an economic downturn, Lawson could experience customer bankruptcies, reduced volume of business from its existing customers and lost volume due to customer plant shutdowns or consolidations.

 

An economic or other situation that affects government and tax-supported entities could negatively impact Lawson’s sales and earnings.

 

The Company sells to numerous government and tax supported entities. Any situation that impacts these funded entities or the Company’s ability to sell to these entities could have a material adverse effect on the Company.

 

None.

 

The Company owns two facilities located in Des Plaines, Illinois. These buildings contain the Company’s main administrative functions and an inbound warehouse facility that principally supports the MRO businesses. The Company also leases a facility in Des Plaines, Illinois. This building contains administrative and warehouse activities. The Company also leases administrative and distribution facilities in Whittier, California, Suwanee, Georgia, and Houston, Texas. Additional administrative, warehouse and distribution facilities owned by the Company are located in Addison, Illinois , Fairfield, New Jersey , Reno, Nevada , Suwanee, Georgia , Farmers Branch, Texas and Mississauga, Ontario, Canada . The Company also leases administrative office space in Independence, Ohio.

 

Chemical products are distributed from an owned facility in Vernon Hills, Illinois and welding products are distributed from an owned facility located in Charlotte, North Carolina. Administrative and distribution facilities in Guadalajara, Mexico are leased by the Company. Production components are distributed from

leased facilities in Des Plaines, Illinois, Memphis, Tennessee, Lenexa, Kansas, Dunlap, Tennessee and Cincinnati, Ohio. The Company owns a facility in Decatur, Alabama from which it manufacturers and distributes precision engineered machine products. From time to time, the Company leases additional warehouse space near its present facilities. Management believes that the current facilities are adequate to meet its needs. See Item 1, “Business — Distribution and Manufacturing Facilities” for further information regarding the Company’s properties.

 

There is no material pending litigation to which the Company, or any of its subsidiaries, is a party or to which any of their property is subject. The Company is subject to audits by the Internal Revenue Service (“IRS”) periodically.

 

In December 2005, the FBI executed a search warrant for records at the Company’s offices and informed the Company that it was conducting an investigation as to whether any of the Company’s representatives improperly provided gifts or awards to purchasing agents (including government purchasing agents) through the Company’s customer loyalty programs. The U.S. Attorney’s office for the Northern District of Illinois subsequently issued a subpoena for documents in connection with this investigation. The Company’s internal investigation regarding these matters has consisted of a review of the Company’s records and interviews with Company employees and independent agents and is not complete. In conjunction with the Company’s internal investigation, several customer loyalty programs have been terminated because the Company believes that these programs provided or had the potential of providing promotional considerations, such as gifts and awards, to purchasing agents that the Company has deemed inappropriate. The Company has modified another customer loyalty program to limit the amount and nature of customer gifts distributed under the program. In addition, twenty-three independent agents have been terminated or have resigned and the Company has terminated four employees in connection with its investigation. The Company is cooperating with the ongoing investigation of the U.S. Attorney, however, the Company cannot predict when the investigation will be completed or what the outcome or the effect of the investigation will be. The outcome of the investigation could result in criminal sanctions or civil remedies against the Company, including material fines, injunctions or the loss of the Company’s ability to conduct business with governmental entities.

 

No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this Report.

 

The Company’s Common Stock is traded on the NASDAQ Global Select Market under the symbol of “LAWS.” The approximate number of stockholders of record as of February 28, 2007 was 659. The following table sets forth the high and low closing sale prices as reported on the NASDAQ Global Select Market during the last two years for the periods presented. The table also indicates the cash dividends for each outstanding share of common stock paid by the Company during such periods. The closing sales price of our common stock on February 28, 2007 on the NASDAQ Global Select Market was $39.19 per share.

 

Company Stock Repurchases

 

The following table provides information about purchases that the Company made during the quarter ended December 31, 2006 of equity securities that are registered by the Company pursuant to Section 12 of the Exchange Act.

 

 

 

Stock Price Performance Chart

 

Set forth below is a line graph comparing the yearly percentage change in the cumulative total stockholder return on the Company’s Common Stock against the cumulative total return of the S&P Small Capitalization Index and a peer group (the “Peer Group”) of the Company for the five prior years. The Peer Group consists of Barnes Group Inc. and Strategic Distribution, Inc.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Lawson Products, The S &P Smallcap 600 Index And A Peer Group.

 

 

 

 

Copyright^© 2007, Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved.

www.researchdatagroup.com/S&P.htm

 

 

The following selected financial data should be read in conjunction with the Consolidated Financial Statements of the Company and Notes thereto included elsewhere in this Annual Report. The income statement data and balance sheet data are for, and as of the end of each of, the years in the five-year period ended December 31, 2006, and are derived from the audited Financial Statements of the Company.

 

 

 

SUMMARY OF FINANCIAL PERFORMANCE

 

 

 

 

Overview

 

The Company recorded net sales of $518.2 million in 2006, a 15.1% increase over the prior year. Operating income decreased 37.1% to $22.3 million in 2006 from $35.4 million in 2005. For 2006, diluted income per share from continuing operations before cumulative effect of accounting change decreased by 38.1% to $1.46 from $2.36 per share in 2005.

 

Continuing operations excludes the results of the Company’s United Kingdom business, which was closed in the fourth quarter of 2005, and excludes the gain realized from the sale of a real estate investment held in a real estate partnership as well as results from the partnership’s operations. Those results are reported as discontinued operations for all the periods presented. Please see Note C — Business Combination and Discontinued Operations to the Company’s Consolidated Financial Statements included in this Form 10-K. Financial results for 2006 and 2005 include results for Rutland Tool & Supply Co. (“Rutland”), acquired by the Company on December 1, 2005.

 

Management’s discussion and analysis of operating results below focuses on the MRO and OEM business segments. For additional information on the Company’s segment reporting, refer to Note P — Segment Reporting in the Notes to Consolidated Financial Statements included in this form 10-K.

 

YEAR ENDED DECEMBER 31, 2006 COMPARED TO YEAR ENDED DECEMBER 31, 2005

 

Net Sales and Gross Profit

 

Net sales increased by $68.0 million to $518.2 million in 2006 compared to $450.2 million in 2005, a 15.1% increase.

 

The following table presents the Company’s net sales results for its MRO and OEM segments for the past two years:

 

 

MRO net sales increased $59.3 million in 2006, to $427.9 million from $368.6 million in the prior year period, including $54.8 million of sales in 2006 and $4.1 million of sales in 2005 from its subsidiary Rutland Tool and Supply Co., which was acquired by the Company in December 2005. The $8.6 million or 2.4% sales increase for other MRO businesses was primarily driven by price increases implemented in response to commodity material cost increases experienced throughout 2006.

 

OEM sales grew by $8.7 million or 10.7% in 2006 compared to 2005, driven by domestic growth. The OEM business increased sales unit volume, primarily through increased sales to existing customers in 2006.

 

Gross profit increased by $25.5 million or 9.1%, to $305.3 million in 2006 compared to $279.8 million in 2005. As a percent of sales, gross profit decreased 320 basis points to 58.9% in 2006 from 62.1% in 2005.

 

MRO gross profit margins declined by 410 basis points to 66.3% in 2006 from 70.4% in 2005. The primary driver of the MRO gross profit margin decline was due to the change in sales mix related to the Rutland business acquired in December 2005. The gross profit margins for MRO businesses other than Rutland remained comparable year over year.

 

In the OEM segment, gross profit margins declined 80 basis points to 24.0% in 2006 from 24.8% in 2005 as the OEM businesses utilized pricing measures to increase account penetration and drive sales volume, resulting in lower overall gross profit margin in 2006 compared to 2005.

 

Operating Expenses and Operating Income

 

Operating expenses increased by 15.8% or $38.6 million to $283.0 million in 2006 compared to $244.4 million in 2005. Of the $38.6 million increase for 2006, approximately $16.6 million is attributable to the Rutland acquisition which closed in December 2005. The remaining $22.0 million increase in operating expenses is primarily due to $12.9 million higher employee compensation costs, $2.6 million higher technology infrastructure costs, $3.2 million in legal expenses, $1.4 million increase in variable selling expenses and a $0.8 million loss on sale of equipment. The $12.9 million increase in employee compensation includes $2.7 million associated with the Company’s annual and long-term performance based incentive plans, $2.4 million related to stock performance rights (“SPRs”), $1.3 million for severance cost related to the termination of employees in connection with the Company’s process improvement initiatives (see Note D), as well as $6.5 million for general wage increases, higher health care costs and various personnel additions, primarily in marketing and technology. The Company incurred legal expenses of $3.2 million in 2006 in connection with an ongoing investigation by the U.S. Attorney’s office for the Northern District of Illinois related to whether Company sales representatives provided improper gifts or awards to purchasing agents (including government purchasing agents) through the Company’s customer loyalty programs. The Company did not incur such legal costs in the prior year period. This investigation is ongoing and the Company expects to incur legal costs throughout the remainder of 2007 related to this matter. See Note N for additional information.

 

As a percentage of sales, operating expenses increased to 54.6% in 2006 from 54.3% in 2005, primarily as the result of the items mentioned above.

 

Operating income decreased by 37.1% in 2006 to $22.3 million, primarily due to general and administrative cost increases in the areas discussed above.

 

Other Income and Expense, Net

 

Other income and expense, net increased to $2.2 million in 2006 from $1.2 million in 2005 primarily due to higher realized foreign currency gains of $0.9 million in 2006. In 2006, the Company reduced its excess cash balances held in Canadian currency, resulting in foreign currency gains.

 

Provision for Income Taxes

 

The effective tax rates for continuing operations for 2006 and 2005 were 46.8% and 41.3%, respectively. The Company believes its normalized tax rate is in the range of 39% to 41%. The higher effective tax rate in 2006 reflects an adjustment of $1.9 million or ($0.22 per diluted share), related to the elimination of tax deductions associated with the Company’s customer loyalty and promotions programs in its MRO business for tax years 2005, 2004 and 2003. Many of the customer loyalty and promotion programs in place for these years were terminated or replaced early in 2006. See Note M for additional information.

 

Income from Continuing Operations before Cumulative Effect of Accounting Change

 

Income from continuing operations before cumulative effect of accounting change for 2006 decreased 39.5%, to $13.0 million, compared to $21.5 million in the comparable period of 2005. The $8.5 million decrease results both from lower pre-tax operating income and a higher effective tax rate, both of which are discussed above. Diluted per share comparisons were positively impacted due to the Company’s repurchase of shares under the modified “Dutch Auction” tender offer completed on October 11, 2006.

 

Income from Discontinued Operations

 

Income from discontinued operations of $5.3 million for 2005 reflects the impact of: (i) gain of $12.2 million related to the sale of a real estate investment held in a real estate partnership and related operating income of $0.6 million, (ii) losses of $6.7 million associated with the closure of the Company’s UK business and related operating losses of $0.8 million.

 

Cumulative Effect of Accounting Change

 

The $0.4 million cumulative accounting change represents the effect of adopting Financial Accounting Standards Board (FASB) Statement No. 123(R), “Share-Based Payment,” which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation.” See Note K for more information.

 

Net Income

 

Net income decreased by $14.1 million or 52.8% to $12.6 million ($1.42 per diluted share) in 2006 from $26.7 million ($2.94 per diluted share) in 2005. $5.3 million of the decrease relates to lower income from discontinued operations. The factors that resulted in the remaining $8.8 million net income decline were higher operating expenses and income taxes, as discussed above. Diluted per share net income comparisons were positively impacted by $0.04 per share due to the Company’s repurchase of shares under the modified “Dutch Auction” tender offer completed on October 11, 2006.

 

YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004

 

Net Sales and Gross Profit

 

Net sales increased by $40.6 million to $450.2 million in 2005 compared to $409.6 million in 2004, a 9.9% increase.

 

The following table presents the Company’s net sales results for its MRO and OEM segments for 2005 and 2004:

 

 

MRO sales grew by $30.7 million or 9.1% in 2005. Increases in average unit selling prices were the primary driver of MRO sales growth in 2005. Changes in product sales mix and the effects of selling price increases contributed to the increase in average unit selling prices in 2005. MRO results include the acquisition of Rutland as of December 1, 2005, which accounted for $4.1 million of MRO sales growth in 2005 over 2004.

 

OEM sales grew by $9.9 million or 13.8% in 2005 compared to 2004, driven by domestic growth. The OEM business added new customers and improved account penetration in 2005.

 

Gross profit increased by $19.5 million or 7.5%, to $279.8 million in 2005 compared to $260.3 million in 2004. As a percent of sales, gross profit decreased 150 basis points to 62.1% in 2005 from 63.6% in 2004, primarily due to lower gross profit margins in the MRO segment in 2005.

 

MRO gross profit margins declined by 140 basis points to 70.4% in 2005 from 71.8% in 2004, caused by higher product costs incurred, particularly in the first half of 2005. As a result of pricing actions and cost management programs, MRO gross profit margins improved during the second half of 2005.

 

In the OEM segment, gross profit margins were 24.8% in both 2005 and 2004. Sales mix between the MRO and OEM segments had minimal impact on consolidated gross profit margins comparisons for 2005 and 2004.

 

Operating Expenses and Operating Income

 

Operating expenses increased by 7.1% or $16.3 million to $244.4 million in 2005 compared to $228.1 million in 2004. The Company recorded a $0.4 million reduction to compensation expense in 2005 to account for the reduced value of Stock Performance Rights (“SPRs”). The effect of SPRs in 2004 resulted in a $2.6 million of compensation expense. Excluding the accounting effect for the impact of SPRs, operating expenses increased by $19.3 million or 8.6% in 2005 compared to 2004, including $6.5 million of higher sales commissions related to higher sales in 2005. Excluding those sales volume commission related costs, operating expenses increased $12.9 million, driven by higher compensation costs of $5.8 million, meetings, travel and supply costs of $4.3 million, and professional fees of $2.3 million.

 

The $5.8 million increase in compensation costs was driven primarily by personnel additions in the marketing and information technology departments. Management believes that investments in its marketing and technology capabilities are important components of the Company’s strategic plans.

 

The increases in meetings, travel and supply costs and professional fees noted above were also related primarily to the Company’s marketing and technology initiatives.

 

As a percentage of sales, operating expenses decreased from 55.7% in 2004 to 54.3% in 2005, primarily as the result of higher sales and the Company’s ability to leverage its operating cost infrastructure over a larger revenue base, as well as the reduction in compensation expense due to the SPRs.

 

Operating income increased by 9.9% in 2005 to $35.4 million. This increase is the result of the sales increases and improved operating expense leverage discussed above, offset somewhat by lower gross profit margins in the MRO segment.

 

Other Income and Expense, Net

 

Other income increased to $1.2 million in 2005 from $0.9 million in 2004 due to higher realized foreign currency gains of $0.1 million and higher interest and dividend income of $0.2 million.

 

Provision for Income Taxes

 

The effective tax rates for continuing operations for 2005 and 2004 were 41.3% and 35.1%, respectively. The Company believes its normalized tax rate is in the range of 39% to 41%. The 2005 rate is slightly higher than the normalized rate as a result of adjustments to various tax liability accounts.

 

In 2004, the effective tax rate was lower than the Company’s normalized rate range primarily as a result of the impact of $1.9 million of tax-free proceeds from executive life insurance.

 

Income from Continuing Operations before Cumulative Effect of Accounting Change

 

Income from continuing operations before cumulative effect of accounting change of $21.5 million in 2005 was consistent with the 2004 amount, as higher taxes in 2005 offset a 9.9% increase in operating income for 2005. Diluted earnings per share from continuing operations increased 4.0% to $2.36 in 2005 compared to $2.27 in 2004, due to the impact of the Company’s share repurchase program.

 

Income from Discontinued Operations

 

Income from discontinued operations of $5.3 million for 2005 reflects the impact of: (i) gain of $12.2 million related to the sale of a real estate investment held in a real estate partnership and related operating income of $0.6 million, (ii) losses of $6.7 million associated with the closure of the Company’s UK business and related operating losses of $0.8 million.

 

For 2004, discontinued income from operations of $0.7 million from the investment in the real estate partnership was essentially offset by losses from the UK division.

 

Net Income

 

Net income increased by $5.3 million or 24.8% to $26.7 million in 2005 from $21.4 million in 2004, including the impact of $5.3 million of higher income from discontinued operations. The factors that affected net income comparisons have been discussed above. Diluted net income per share of $2.94 for 2005 increased by $.10 per share as a result of fewer shares outstanding in conjunction with the Company’s share repurchase program.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Cash provided by operations and a $75 million unsecured revolving line of credit have been sufficient to fund operating requirements, cash dividends and capital improvements. Cash provided by operations and the line of credit are also expected to finance the Company’s future operations.

 

Cash provided by operations for 2006, 2005 and 2004 were $19.9 million, $17.8 million and $26.4 million, respectively. The increase in 2006 cash provided by operations compared with 2005 was primarily due to working capital improvements in account receivable, prepaid expenses and accounts payable and accrued expenses offset by increases in inventories, cash value of life insurance and lower net income. The decline in 2005 cash provided by operations from 2004 was due primarily to increases in net operating assets, primarily accounts receivable, prepaid expenses and cash value of life insurance more than offsetting the $5.3 million increase in net income.

 

Working capital at December 31, 2006 and 2005 was approximately $101.8 million and $117.7 million, respectively. At December 31, 2006 the current ratio was 2.6 to 1 as compared to 3.2 to 1 at December 31, 2005.

 

Over the past three years, the Company has made the following purchases of its common stock:

 

 

On October 12, 2006 the Company purchased 486,493 shares in its “Dutch Auction” tender offer at $43.00 per share. These tendered shares represented 5.4% of the shares outstanding as of October 11, 2006. The tendered shares were paid for with $13.0 million of funding from the Company’s revolving credit line and $7.9 million cash from operations. The tendered shares were retired by the Company.

 

In October 2004, the Company’s Board of Director’s authorized the purchase of up to 500,000 shares of the Company’s common stock in addition to that previously authorized. There is no expiration relative to this authorization. At December 31, 2006, 202,780 shares were available for purchase pursuant to the 2004 authorization.

 

The Company’s investing activities used net cash of $4.7 million for 2006 which consisted of $2.1 million primarily related to purchases of equipment, $2.0 million for software development and $0.6 million for the Reno, Nevada facility expansion. The Company anticipates the Reno facility expansion will be completed in 2007 and will require approximately $8.4 million of additional capital expenditures in 2007.

 

In 2005, the sale of real estate held in a real estate partnership generated $15.7 million of cash proceeds. The Company used cash of $14.6 million in 2005 to acquire Rutland and 2005 purchases of property, plant and equipment were $9.3 million. Capital expenditures in 2005 consisted of $2.3 million for land, $4.5 million for software development and the remainder principally for equipment.

 

For 2004, capital expenditures of $4.3 million were related to improvement of existing facilities and the purchase of related equipment as well as the development of software.

 

Net cash used in financing activities increased by approximately $4.9 to $27.2 million in 2006 from $22.3 million in 2005, primarily due to an increase in common stock purchases over 2005, partially offset by a decrease in payments on mortgage payable.

 

In 2005 the net cash used in financing activities increased by approximately $5.4 million to $22.3 million from $16.9 million in 2004, primarily due to an increase in common stock purchases in 2005 compared to 2004.

 

Future contractual obligations consisted of the following at December 31, 2006:

 

 

 

 

BUSINESS ACQUISITIONS

 

Purchase of Rutland Tool & Supply Co.

 

On December 1, 2005, the Company purchased the business and substantially all of the assets, except for accounts receivable, and assumed certain liabilities of Rutland Tool & Supply Co. (“Rutland”) for the purchase price of $14.6 million, net of cash acquired. This cash transaction was accounted for as a purchase; accordingly, the accounts and transactions of Rutland have been included in the consolidated financial statements since the date of acquisition. The assets acquired and liabilities assumed were recorded at fair values as determined by the Company’s management as follows: inventory $13.4 million; prepaid assets $0.1 million; property, plant and equipment $0.9 million; intangibles $1.0 million; and accrued liabilities of $0.9 million.

 

BUSINESS DISPOSALS

 

Discontinued Operations of UK Business

 

In the fourth quarter of 2005, the Company closed its UK business which was engaged primarily in the business of OEM sales. In 2005, the UK business had after-tax losses of approximately $7.5 million, largely related to inventory write-offs, goodwill and intangible write offs, and termination costs associated with the closing.

 

Sale of Real Estate

 

In the fourth quarter of 2005, the Company sold its investment in real estate held in a real estate partnership in which the Company was a 98.5% limited partner. The sale resulted in a gain of $12.2 million. In conjunction with this transaction, an officer and member of the Board of Directors of the Company, who is also the partnership’s general partner, received a $2.0 million fee from the real estate partnership, which is reflected in the net gain on sale of real estate.

 

CRITICAL ACCOUNTING POLICIES

 

The Company has disclosed its major accounting policies in Note B to the Consolidated Financial Statements. The following provides supplemental information to these accounting policies as well as information on the accounts requiring more significant estimates.

 

Allowance for Doubtful Accounts — Methodology:  The Company evaluates the collectibility of accounts receivable based on a combination of factors. In circumstances where the Company is aware of a specific customer’s inability to meet its financial obligations (e.g., bankruptcy filings, substantial down-grading of credit ratings), a specific reserve for bad debts is recorded against amounts due to reduce the receivable to the amount the Company reasonably believes will be collected. For all other customers, the Company recognizes reserves for bad debts based on the Company’s historical experience of bad debt write-offs as a percent of accounts receivable outstanding. If circumstances change (i.e., higher than expected defaults or an unexpected material adverse change in a major customer’s ability to meet its financial obligations), the estimates of the recoverability of amounts due the Company could be revised by a material amount.

 

Inventories — Slow Moving and Obsolescence:  The Company carries significant amounts of inventories, which is a part of the Company’s strategy as a competitive advantage in its ability to fulfill the vast majority of our customers’ orders the same day received. However, this strategy also increases the chances that portions of the inventory have decreased in value below their carrying cost. To reduce inventory to a lower of cost or market value, the Company records a reserve for slow-moving and obsolete inventory. The Company defines obsolete as those inventory parts on hand which the Company plans to discontinue offering to its customers. Slow-moving inventory is monitored by examining reports of parts which have not been sold for extended periods. The Company records the reserve needed based on its historical experience of how much the selling prices must be reduced to move these obsolete and slow-moving products. If experience or market conditions change, estimates of the reserves needed could be revised by a material amount.

 

Income Taxes:  Deferred tax assets and liabilities are determined based on the difference between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The Company records a provision for income taxes based on domestic and international statutory income tax rates and tax planning opportunities in the jurisdictions in which we operate. Significant judgment is required in determining income tax provisions as well as deferred tax asset and liability balances, including the estimation of valuation allowances and the evaluation of tax positions.

 

The Company, through its foreign subsidiaries, distributes products in Canada and Mexico. The functional currency of these subsidiaries is their respective local currencies which are translated into U.S. dollars. As a result, the Company is from time to time exposed to market risk relating to the impact of foreign currency exchange rates. The Company considers the market risk relating to the impact of foreign currency exchange rates to be immaterial. A hypothetical 10% adverse movement in exchange rates would have decreased income by $203,000 in 2006.

 

The Company had no loans outstanding as of December 31, 2006 under its revolving line of credit or otherwise.

 

The following information is presented in this item:

 

Management’s Report on Internal Control Over Financial Reporting

 

Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting

 

Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements

 

Consolidated Balance Sheets as of December 31, 2006 and 2005

 

Consolidated Statements of Income for the Years ended December 31, 2006, 2005 and 2004

 

Consolidated Statements of Changes in Stockholders’ Equity for the Years ended December 31, 2006, 2005 and 2004

 

Consolidated Statements of Cash Flows for the Years ended December 31, 2006, 2005 and 2004

 

Notes to Consolidated Financial Statements

 

Schedule II

Management’s Report on Internal Control Over Financial Reporting

 

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). The Company’s management conducted an evaluation, with the participation of the Company’s chief executive officer and chief financial officer, of the effectiveness of its internal control over financial reporting based on the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”).

 

Based on this evaluation, described above under COSO criteria, the Company’s management concluded that our internal control over financial reporting was effective as of December 31, 2006.

 

Ernst & Young LLP, the Company’s independent registered public accounting firm, has issued an attestation report on the Company’s management assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, which is included herein.

Report of Independent Registered Public Accounting Firm
on Internal Control Over Financial Reporting

 

To the Stockholders and Board of Directors

Lawson Products, Inc.

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Lawson Products, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Lawson Products, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that Lawson Products, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects based on the COSO criteria. Also, in our opinion, Lawson Products, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.

 

We have also audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Lawson Products, Inc. and subsidiaries as of December 31, 2006 and 2005 and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006 and our report dated March 9, 2007 expressed an unqualified opinion thereon.

 

 

Chicago, Illinois

March 9, 2007

Report of Independent Registered Public Accounting Firm
on Consolidated Financial Statements

 

To the Stockholders and Board of Directors

Lawson Products, Inc.

 

We have audited the accompanying consolidated balance sheets of Lawson Products, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lawson Products, Inc. and subsidiaries at December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects the information set forth therein.

 

As discussed in Note B to the consolidated financial statements effective January 1, 2006, the Company changed its method of accounting for stock-based compensation.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Lawson Products, Inc. and subsidiaries’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 9, 2007, expressed an unqualified opinion thereon.

 

 

Chicago, Illinois

March 9, 2007

Lawson Products, Inc.

 

Consolidated Balance Sheets

 

 

See notes to consolidated financial statements

Lawson Products, Inc.

 

Consolidated Statements of Income

 

 

See notes to consolidated financial statements

Lawson Products, Inc.

 

Consolidated Statements of

Changes in Stockholders’ Equity

 

 

See notes to consolidated financial statements

Lawson Products, Inc.

 

Consolidated Statements of Cash Flows