Distribution Solutions Group, Inc. - Quarter Report: 2006 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

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FORM 10-Q

(Mark one)

For the quarterly period ended June 30, 2006

OR

For the transition period from ___________________ to ___________________

Commission File Number: 0-10546

LAWSON PRODUCTS, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone no., including area code: (847) 827-9666

Not applicable

Former name, former address and former 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.

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. (Check one):

Large accelerated filer o          Accelerated Filer x          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 x 

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Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

As of July 31, 2006, 8,997,515 shares of common stock were outstanding. 

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

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NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS

A) Basis of Presentation and Summary of Critical Accounting Policies

As contemplated by the Securities and Exchange Commission, the accompanying consolidated financial statements and footnotes have been condensed and therefore, do not contain all disclosures required by generally accepted accounting principles. Reference should be made to Lawson Products, Inc.’s (the “Company”) Annual Report on Form 10-K for the year ended December 31, 2005. The Condensed Consolidated Balance Sheet as of June 30, 2006, the Condensed Consolidated Statements of Income for the three and six month periods ended June 30, 2006 and 2005 and the Condensed Consolidated Statements of Cash Flows for the six month periods ended June 30, 2006 and 2005 are unaudited. In the opinion of the Company, all adjustments (consisting only of normal recurring accruals) have been made, which are necessary to present fairly the results of operations for the interim periods. Operating results for the three and six month periods ended June 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.

Certain amounts have been reclassified in the 2005 financial statements to conform to the 2006 presentation.

Stock-Based Compensation - Beginning January 1, 2006 the Company accounted for stock-based compensation in accordance with SFAS No. 123(R), Share-Based Payment. Under the fair value recognition provisions of this statement, the Company measured share-based compensation cost based on the value of the award, at the grant date which is recognized as expense over the vesting period.

Stock-based compensation expense recognized in the Consolidated Statement of Income for the first six months of fiscal 2006 is based on awards ultimately expected to vest, reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience. In the Company’s pro forma information required under SFAS 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred. Judgment is required in estimating the amount of share-based awards that are expected to be forfeited. If actual forfeitures differ significantly from these estimates, stock-based compensation expense and the results of operations could be materially impacted.

Compensation expense for all stock-based compensation awards, including stock performance rights (“SPRs”) granted on or prior to January 1, 2006 will be recognized using the straight-line amortization method. Under the terms of the plan, employees and non-employee directors, who are retirement eligible, defined as age 65 or older, are permitted to retain their awards after retirement and exercise them during the remaining contractual life. Grants of share-based awards, with the retirement eligible provision, prior to the adoption of SFAS 123(R) will continue to be recognized as expense over the stated vesting period. Grants of share-based payments to employees and non-employee directors, after the adoption of SFAS 123(R) on January 1, 2006 will be recognized as expense over the requisite service period as determined by each individual grantee’s age at the time of grant. During the first six months of 2006, the effect of this change in accounting policy on expense for SPRs granted in 2006 was $0.3 million.

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Prior to adoption of SFAS 123(R), the Company accounted for stock options and SPRs under the ABP 25 method. As all options were awarded at an exercise price equal to the fair market value of company stock as of the grant date, there was no stock-based expense recorded. SPRs were valued at the intrinsic value of each SPR as of the reporting date, and the expense associated with these awards was included in the Company’s reported net income and net income per share.

B) Comprehensive Income

Comprehensive income (in thousands) was $3,541 and $4,877 for the second quarters of 2006 and 2005, respectively. Comprehensive income (loss) includes foreign currency translation adjustments, net of related income tax of $336 and $(731) for the three-month periods ended June 30, 2006 and 2005, respectively.

For the six-month periods ended June 30, 2006 and 2005, comprehensive income (in thousands) was $8,245 and $9,722, respectively. Comprehensive income (loss) includes foreign currency translation adjustments, net of related income tax of $52 and $(842) for the six months ended June 30, 2006 and 2005, respectively.

Accumulated comprehensive income consists only of foreign currency translation adjustments, net of related income tax.

C) Earnings Per Share

The calculation of dilutive weighted average shares outstanding for the three and six months ended June 30, 2006 and 2005 are as follows (in thousands):

D) Revolving Line of Credit

The revolving line of credit has a maximum borrowing capacity of $75 million and a maturity date of March 27, 2009. The revolving line of credit carries a floating interest rate of prime minus 150 basis points or LIBOR plus 75 basis points, at the Company’s option. Interest is payable quarterly on prime rate borrowings and at contract expirations for LIBOR borrowings. The line of credit contains certain financial

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covenants regarding interest coverage, minimum stockholders’ equity and working capital, all of which the Company was in compliance with at June 30, 2006. The Company had no borrowings under the line at June 30, 2006 and December 31, 2005.

E) Reserve for Severance

The table below shows an analysis of the Company’s reserves for severance and related payments, included in selling, general and administrative expenses, for the first six months of 2006 and 2005:

F) Intangible Assets

Intangible assets subject to amortization, included within other assets, were as follows (in thousands):

Trademarks and tradenames are being amortized over 15 years. The non-compete covenant is being amortized over 5 years. Amortization expense for intangible assets is expected to be $250,000 for 2006 and for each of the next four years.

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G) Stock-Based Compensation

The Company has adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the recognition of compensation expense related to the fair value of our stock-based compensation awards at the beginning of 2006. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in fiscal 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).

For the three and six months ended June 30, 2005, the Company complied with FASB Statement No.148, “Accounting for Stock Based Compensation – Transition and Disclosure,” which required interim disclosure to show the effect on net income and net income per share as required by FASB Statement No. 123, “Accounting for Stock-Based Compensation.” For the reporting periods ending March 31, 2005 and June 30, 2005, no fair value expense was reported for stock-based compensation, as the options were fully vested prior to the beginning of each reporting period. As a result, there was no pro forma expense reported under the fair value method.

As a result of adopting Statement 123(R) on January 1, 2006, the Company’s income before income taxes including cumulative effect of accounting change and net income for the three months ended June 30, 2006 are $0.3 million and $0.2 million lower, respectively, than if it had continued to account for share-based compensation under Opinion 25. Basic and diluted earnings per share for the three months ended June 30, 2006 are $0.02 lower than if the Company had continued to account for share-based compensation under Opinion 25. The Company’s income before income taxes including cumulative effect of accounting change and net income for the six months ended June 30, 2006, are $1.5 million and $0.9 million lower, respectively, than if it had continued to account for share-based compensation under Opinion 25. Basic and diluted earnings per share for the six months ended June 30, 2006 are $0.10 lower than if the Company had continued to account for share-based compensation under Opinion 25.

The Incentive Stock Plan (“Plan”), provides for the issuance of incentive compensation to non-employee directors, officers and key employees in the form of stock options, stock performance rights, stock purchase agreements and stock awards. As of December 31, 2005, 493,859 shares of common stock were available for issuance under the Plan.

In the second quarter of 2006, a total of 4,774 common stock awards were issued to non-employee directors.

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Stock Options

The following is a summary of the activity in the Company’s stock options during the three and six months ended June 30, 2006:

The aggregate intrinsic value for options outstanding and exercisable as of June 30, 2006 is $0.3 million. The aggregate intrinsic value for options exercised during the first six months of 2006 was $0.3 million.

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As of June 30, 2006, the Company had the following outstanding options:

As of December 31, 2005, all outstanding stock options were fully vested, and no remaining unrecognized compensations expense is to be recorded in 2006.

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Stock Performance Rights

The Company grants SPRs pursuant to the Plan to selected executives and outside directors. These SPRs have exercise prices ranging from $38.67 to $41.55 per right granted in 2005 and $44.02 per right granted in 2006. These SPRs vest at 20% to 33% per year and entitle the recipient to receive a cash payment equal to the excess of the market value of the Company’s common stock over the SPR exercise price when the SPRs are surrendered.

Employees and non-employee directors who are retirement eligible, defined as age 65 or older, are permitted to retain their awards after retirement and exercise them during the remaining contractual life.

Grants of SPRs, with the retirement eligible provision, prior to the adoption of SFAS 123(R) will continue to be recognized as expense over the vesting period.

Grants of SPRs, with the retirement eligible provision, after the adoption of SFAS 123(R) on January 1, 2006 will be recognized as expense on the grant date. During the first six months of 2006 expense for these SPRs was $0.3 million.

As required by SFAS 123(R), the SPRs outstanding as of January 1, 2006 have been remeasured at fair value using the Black-Scholes valuation model. Compensation expense (included in selling, general and administrative expenses) for the SPRs in the three months ended June 30, 2006 was $0.3 million and for the first six months of 2006 was $1.5 million which included $0.6 million for the cumulative effect resulting from the adoption of SFAS 123(R).

The following is a summary of the activity in the Company’s SPRs during the three and six months ended June 30, 2006:

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The aggregate intrinsic value of SPRs outstanding as of June 30, 2006 is $1.8 million. Unrecognized compensation cost related to non-vested SPRs was $1.7 million at June 30, 2006, which will be recognized over a weighted average period of 1.4 years.

Valuation Information

The Company estimated the fair value of SPRs using the Black-Scholes valuation model. This model requires the input of subjective assumptions that will usually have a significant impact on the fair value estimate. The weighted-average estimated value of SPRs outstanding as of June 30, 2006 was $14.88 per SPR using the Black-Scholes valuation model with the following assumptions:

In addition to the grants outstanding, there was an SPR grant delivered during the second quarter of 2006 with a Black-Scholes fair value of $12.80 as of June 30, 2006.

The Company based the calculation of expected volatility on the trailing 5 year historic volatility of the Company’s stock price, adjusted to reflect the expected term of each SPR grant. The Company based the risk-free interest rate on the U.S. Treasury yield curve in effect at June 30, 2006, adjusted to reflect the expected term of each SPR grant.

H) Loss on Sale of Equipment

In the second quarter of 2006, the Company incurred a loss of $0.8 million ($0.5 million, net of tax) on the sale of equipment related to the Company’s decision to outsource the manufacturing of a product line in the Company’s OEM business. Net book value for the disposed equipment totaled $1.0 million.

I) Legal Proceedings

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

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under the program. In addition, the Company has terminated one sales employee and fifteen independent agents 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. See “Item 1A. Risk Factors” for additional information.

J) Segment Reporting

The Company has two reportable segments: Maintenance, Repair and Replacement distribution in North America (MRO), and Original Equipment Manufacturer distribution and manufacturing in North America (OEM).

The Company’s MRO distribution segment distributes a wide range of MRO parts to repair and maintenance organizations primarily through the Company’s force of independent field sales agents, as well as inside sales personnel. The MRO segment includes Rutland Tool and Supply Co. (“Rutland”) acquired by the Company in December 2005.

The Company’s OEM segment manufactures and distributes component parts to OEM manufacturers through a network of independent manufacturers’ representatives as well as internal sales personnel.

The Company’s reportable segments are distinguished by the nature of products, types of customers, and manner of servicing customers.

The Company evaluates performance and allocates resources to reportable segments primarily based on operating income.

Financial information for the Company’s reportable segments consisted of the following:

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The reconciliation of segment profit to consolidated income from continuing operations before income taxes and cumulative effect of accounting change consisted of the following:

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The reconciliation of segment profit to consolidated income from continuing operations before income taxes and cumulative effect of accounting change consisted of the following:

Asset information for continuing operations related to the Company’s reportable segments consisted of the following:

At June 30, 2006 and December 31, 2005, the carrying value of goodwill within each reportable segment was as follows (in thousands):

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Report of Independent Registered Public Accounting Firm

Board of Directors and Shareholders

Lawson Products, Inc.

We have reviewed the condensed consolidated balance sheet of Lawson Products, Inc. and subsidiaries as of June 30, 2006 and the related condensed consolidated statements of income for the three-month and six-month periods ended June 30, 2006 and 2005, and the condensed consolidated statements of cash flows for the six-month periods ended June 30, 2006 and 2005. These financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated interim financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Lawson Products, Inc. and subsidiaries as of December 31, 2005, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for the year then ended, not presented herein, and in our report dated March 10, 2006, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2005, is fairly stated in all material respects, in relation to the consolidated balance sheet from which it has been derived.

Chicago, Illinois

July 31, 2006

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Safe Harbor” Statement under the Securities Litigation Reform Act of 1995: This Quarterly Report on Form 10-Q 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 impact of governmental investigations, such as the investigation by the U.S. Attorney's office for the Northern District of Illinois; excess and obsolete inventory; disruptions of the company's information systems; risks of rescheduled or cancelled orders; increases in commodity prices; the influence of controlling stockholders; competition and competitive pricing pressures; the effect of general economic conditions and market conditions in the markets and industries the company serves; the risks of war, terrorism, and similar hostilities; and, all of the factors discussed in the Company's "Risk Factors" set forth in its Annual Report on Form 10-K for the year ended December 31, 2005.

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.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Quarter ended June 30, 2006 compared to Quarter ended June 30, 2005

The following table presents a summary of the Company’s financial performance for the second quarter of 2006 and 2005:

NET SALES AND GROSS PROFIT

Consolidated net sales for the three-month period ended June 30, 2006 increased 17.0% to $131.0 million, from $112.0 million in the same period of 2005.

The following table presents the Company’s net sales results for its MRO and OEM businesses for the second quarter of 2006 and 2005:

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