Distribution Solutions Group, Inc. - Quarter Report: 2012 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

(Mark One)

For quarterly period ended September 30, 2012

or

For the transition period from              to             

Commission file Number: 0-10546

LAWSON PRODUCTS, INC.

(Exact name of registrant as specified in its charter)

(773) 304-5050

(Registrant’s telephone number, including area code)

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

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

The number of shares outstanding of the registrant’s common stock, $1 par value, as of October 15, 2012 was 8,597,554.

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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:

all other factors discussed in the Company’s “Risk Factors” set forth in its Annual Report on Form 10-K for the year ended December 31, 2011 and in this Quarterly Report on Form 10-Q for the period ended September 30, 2012.

The Company undertakes no obligation to update any such factors 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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PART I - FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

Lawson Products, Inc.

Condensed Consolidated Balance Sheets

(Dollars in thousands, except per share data)

See notes to condensed consolidated financial statements.

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Lawson Products, Inc.

Condensed Consolidated Statements of Comprehensive Income (Loss)

(Dollars in thousands, except per share data)

(Unaudited)

See notes to condensed consolidated financial statements.

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Lawson Products, Inc.

Condensed Consolidated Statements of Cash Flows

(Dollars in thousands)

(Unaudited)

See notes to condensed consolidated financial statements.

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Note 1 — Basis of Presentation and Summary of Significant Accounting Policies

The accompanying unaudited condensed consolidated financial statements of Lawson Products, Inc. (the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not contain all disclosures required by generally accepted accounting principles. Reference should be made to the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. In the opinion of the Company, all normal recurring adjustments have been made, that are necessary to present fairly the results of operations for the interim periods. Operating results for the three and nine month periods ended September 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.

Certain reclassifications have been made to prior period amounts to conform to current period presentation. Such reclassifications have no effect on net income as previously reported. The effect of restricted share awards and future stock option exercises equivalent to 11 thousand and 34 thousand shares for the three and nine months ended September 30, 2012, respectively and 51 thousand shares for the three months ended September 30, 2011, would have been anti-dilutive and therefore, were excluded from the computation of diluted earnings per share.

The Company has adopted Accounting Standards Update (“ASU”) No. 2011-05 and 2011-12 regarding the presentation of comprehensive income in the financial statements. No other material changes occurred in our significant accounting policies during the nine months ended September 30, 2012 as compared to the significant accounting policies described in our Annual Report on Form 10-K for the year ended December 31, 2011. The Company has determined that except for the sale of our Des Plaines, Illinois facility (See Note 11- Subsequent Event), there were no other subsequent events to recognize or disclose in these financial statements.

Note 2 — Inventories, net

The Company increased its obsolete and excess inventory reserves by $5.4 million for the nine months ended September 30, 2012 primarily as a result of the discontinuation of certain products. Components of inventories were as follows:

Note 3 — Sale of assets and property held for sale

In the second quarter of 2012, in conjunction with the construction of a new distribution center in McCook, Illinois and the relocation of the Company’s headquarters to Chicago, Illinois, the Company sold three properties; its Addison, Illinois distribution center, its Vernon Hills, Illinois distribution center and a Des Plaines, Illinois administrative building. The Company received cash proceeds of $8.8 million for the sale of the three facilities, which were included in the MRO segment, resulting in a gain of $2.1 million. Operations currently conducted at the Addison, Illinois and Vernon Hills, Illinois distribution centers will be transferred to the new McCook, Illinois facility during the fourth quarter of 2012 and the first quarter of 2013. The Company has entered into various arrangements to lease these facilities back from the buyer for transition purposes until the second quarter of 2013.

In addition to these three property sales, the Company allowed the lease of another Des Plaines, Illinois facility to expire during the second quarter of 2012 and it was actively marketing its former Des Plaines, Illinois headquarters and packaging facility. The net book value of the former headquarters’ land and

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building of $1.9 million has been reclassified to Property held for sale in the Condensed Consolidated Balance Sheets and has not been depreciated after being classified as held for sale. This property was sold subsequent to September 30, 2012 (See Note 11 – Subsequent Event).

Note 4 — Goodwill Impairment

As a result of an acquisition in 2001, the Company had goodwill of $28.3 million, all of which related to its MRO segment. On an interim basis, the Company evaluates goodwill for potential impairment by determining if certain qualitative events have occurred or if circumstances have changed that would more likely than not reduce the fair value of the reporting unit below its carrying value. As a result of this evaluation, the Company identified indicators of impairment during the second quarter of 2012 related to operating losses and reduced market capitalization and, therefore, performed an interim impairment test of goodwill.

The Company estimated the fair value of the MRO reporting unit using a discounted cash flow analysis based on its current internal operating forecast to determine the reporting unit’s fair value. After completing the analysis, the Company concluded that the entire amount of the goodwill was impaired and a non-cash charge of $28.3 million was recorded in the second quarter of 2012.

Goodwill activity for the nine months ended September 30, 2012 was as follows:

Note 5 — Credit Facility

In the third quarter of 2012, the Company entered into a five-year, $40.0 million credit facility (“Credit Facility”). The Credit Facility consists of a $40.0 million revolving credit facility which includes a $10.0 million sub-facility for Letters of Credit. Until the later of June 30, 2014 or when the Company achieves certain financial covenants, credit available under the Credit Facility is based upon:

The applicable interest rate margins for borrowings under the Credit Facility are at the Prime rate or the LIBOR rate plus 2.75% for the first year and LIBOR plus 2.50% for the second year of the agreement. Following the second year, the interest rate will be based on the Company’s debt to EBITDA ratio and range from LIBOR plus 1.25 to 1.85 percent or Prime minus 1.00 to 0.40 percent.

The Credit Facility is secured by a first priority perfected security interest in substantially all existing assets of the Company. Dividends are restricted to $0 to $1,100,000 per quarter based on EBITDA achieved in the previous quarter compared to specified target amounts.

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In addition to other customary representations, warranties and covenants, the Credit Facility requires the Company to comply with certain financial covenants. A minimum Consolidated EBITDA level, as defined in the Credit Facility, must be achieved on a quarterly basis as detailed in the following table:

Upon meeting certain financial covenants, but not prior to June 30, 2014, the availability under the Credit Facility will be based upon the following covenants with a maximum borrowing level of $40.0 million:

For the period ended September 30, 2012, EBITDA, as defined in the Credit Facility, was $0.7 million which was in compliance with the minimum EBITDA covenant of $(1.0) million for the quarter.

At September 30, 2012, the Company had an outstanding balance of $19.6 million under the revolving line of credit of its Credit Facility and additional borrowing availability of $16.8 million. The weighted average interest rate was 2.0% through the first nine months of 2012 and the outstanding balance approximates fair value.

Note 6 — Severance Reserve

During the three and nine month periods ended September 30, 2012, the Company recorded $1.4 million and $8.2 million in severance charges, respectively, related to its MRO segment. These charges consisted of $1.3 million related to the retirement of the Company’s former President and Chief Executive Officer and $6.9 million related to the elimination of corporate and distribution positions primarily as a result of a strategic restructuring plan designed to reduce the Company’s cost structure.

The table below shows the changes in the Company’s reserve for severance and related payments as of September 30, 2012 and 2011:

Accrued severance charges are included in the line items of the Condensed Consolidated Balance Sheets at September 30, 2012 and December 31, 2011 as follows:

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All severance accrued at September 30, 2012 will be fully paid by September 30, 2014.

Note 7 — Income Tax

Due the substantial cumulative losses that the Company recorded over the past several quarters, the Company determined that it was more likely than not that the Company will not be able to utilize its deferred tax assets to offset future taxable income. Therefore, during the nine months ended September 30, 2012, the Company increased its deferred tax valuation allowance by $33.6 million. Substantially all future taxable income will be subject to this tax valuation allowance until the Company can establish that the recoverability of its deferred tax assets is more certain.

Income tax benefit as a percentage of pre-tax loss for the three months ended September 30, 2012 was 15.4% compared to an effective tax rate of 30.3% for the three months ended September 30, 2011. Income tax as a percentage of pre-tax loss for the nine months ended September 30, 2012 was negative 39.2% compared to a tax rate of 43.5% for the nine months ended September 30, 2011. Exclusive of the effect of the increase in the tax valuation allowances, the effective income tax rate would have been 33.6%.

The Company and its subsidiaries are subject to U.S. Federal income tax as well as income tax of multiple state and foreign jurisdictions. As of September 30, 2012, the Company is subject to U.S. Federal income tax examinations for the years 2009 and 2010, and income tax examinations from various other jurisdictions for the years 2006 through 2010.

Earnings from the Company’s foreign subsidiaries are considered to be indefinitely reinvested. A distribution of these non-U.S. earnings in the form of dividends or otherwise would subject the Company to both U.S. Federal and state income taxes, as adjusted for tax credits and foreign withholding taxes.

Note 8 — Contingent Liability

One of the Company’s subsidiaries, Drummond American LLC (“Drummond”), is under an employment tax examination for the years 2007 and 2008 of the long-standing treatment of its sales representatives as independent contractors. In January 2012 the Company received a Notice of Proposed Adjustment in the amount of $9.5 million, including penalties, from the IRS challenging Drummond’s position that the sales representatives were independent contractors. The Company disagreed with the IRS position and filed an administrative appeal with the IRS Appeals Office.

Although the Company intends to vigorously defend its position for the treatment of its sales representatives as independent contractors, the Company established a liability of $1.2 million during 2011 as its best estimate of the cost to resolve the matter with the IRS. The notice of Proposed Adjustment was determined by applying the full statutory rates and penalties, rather than applying the reduced tax rates provided by section 3509 of the Internal Revenue Code (“IRC”). The Company believes the use of reduced tax rates is mandatory for all IRS worker classification assessments, except when the employer intentionally disregarded its employment tax obligations. Because the Company believes it fully complied with its employment tax obligations, the Company based its estimated loss at the reduced tax rates. The Company applied these reduced tax rates against only one year because any settlement resolution would likely be limited to one year as this is consistent with the IRS’s settlement practices. The Company has assessed its potential exposure for other subsidiaries and time periods and has concluded that an additional liability is not probable. No adjustment has been proposed by the IRS for any other time periods or subsidiaries of the Company.

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The case has been assigned to the Chicago Appeals Office. The first meeting with the Appeals Office will likely happen in the fourth quarter of 2012. The Company is unable to establish an estimated time frame in which the case will be resolved through the appeals process. An unfavorable outcome of this matter could have a material adverse effect on the Company’s business, financial condition and results of operations.

Note 9 — Non-Cash Items

During the nine months ended September 30, 2012, the Company recorded an $8.0 million increase in Property, plant and equipment, along with a corresponding increase in liabilities, related to the build-to-suit lease of the McCook, Illinois distribution center. These non-cash increases have been excluded from the Condensed Consolidated Statements of Cash Flows.

Note 10 — Segment Reporting

The Company has two reportable operating segments: MRO and OEM. The Company’s MRO segment is a distributor of products and services to the industrial, commercial, institutional, and governmental maintenance, repair and operations marketplace. The Company’s OEM segment manufactures, sells and distributes production and specialized component parts to the original equipment marketplace. The Company’s two reportable segments are distinguished by the nature of products distributed and sold, types of customers and manner of servicing them. The Company evaluates performance and allocates resources to reportable segments primarily based on operating income.

The following table presents summary financial information for the Company’s reportable segments:

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The following table presents total assets for the Company’s reportable segments:

Note 11 — Subsequent Event

On October 5, 2012, the Company received cash proceeds of $3.4 million from the sale of its Des Plaines, Illinois packaging and administrative building, resulting in a gain of approximately $1.6 million. This facility was a component of the Company’s MRO segment.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

The MRO business is significantly influenced by the overall strength of the manufacturing sector of the U.S. economy. One measure used to gauge the strength of the industrial products market is the Purchasing Manufacturers Index (‘PMI’) published by the Institute for Supply Management. The PMI has declined to an average of 50.3 in the third quarter of 2012 compared to 52.1 in the third quarter of 2011 indicating a slowdown in the growth rate from a year ago. The MRO industry is highly fragmented. We compete for business with several national distributors as well as a large number of regional and local distributors.

During the third quarter, we made significant progress in our cost control and margin improvement efforts as previously announced in June 2012. As a result, operating results improved on a sequential basis over the second quarter of 2012 primarily as a result of the reduction of approximately 100 positions and improvement of gross margin through freight recoveries, and managing net customer pricing and other product related costs. For the third quarter of 2012, operating loss was $1.35 million, which included $1.41 million of severance expense, compared to a loss of $3.1 million a year ago. Excluding the severance expenses for the quarter, operating income would have been $0.1 million.

Quarter ended September 30, 2012 compared to quarter ended September 30, 2011

The following table presents a summary of our financial performance for the three months ended September 30, 2012 and 2011:

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Net Sales

Net sales for the third quarter of 2012 decreased 4.5% to $72.0 million, from $75.4 million in the third quarter of 2011. Excluding the Canadian exchange rate impact, net sales decreased 4.4% for the quarter.

MRO net sales decreased 5.1% in the third quarter of 2012, to $67.9 million from $71.5 million in the prior year period. MRO average daily sales decreased to $1.077 million in the third quarter of 2012 compared to $1.117 million in the third quarter of 2011. Of the $3.6 million decrease in sales, approximately $1.9 million was due to an increase in the number of vacant sales territories from a year ago, $1.1 million was due to one less selling day in the third quarter of 2012 compared to 2011 and $0.6 million from lower freight revenue. Government sales decreased $0.7 million from the prior year quarter primarily from lower sales to state and local agencies. National accounts increased 5.0% or $0.4 million versus a year ago primarily due to additional sales to existing customers. Our automotive segment grew $0.7 million driven by growth in our larger accounts.

OEM net sales increased 6.3% in the third quarter of 2012, to $4.1 million from $3.9 million in the prior year period, driven by stronger demand from existing customers.

Gross Profit

Gross profit increased 1.9% in the third quarter of 2012, to $43.4 million from $42.5 million in the prior year period.

MRO gross profit as a percent of net MRO sales increased to 62.6% in the third quarter of 2012, compared to 58.4% in the third quarter of 2011 primarily due to an improved focus on managing net customer pricing and other product related costs, as well as managing the liquidation of discontinued products better than anticipated. We expect that our gross margin percentage will be under pressure in the future as we continue to increase the percentage of national accounts in our customer mix and due to on-going competitive pressures. However, we do not anticipate that our decision to discontinue certain inventoried products, as announced in the second quarter, will have a material negative impact on our sales or gross margins as the majority of these products will either have suitable substitute items available or be offered on a drop-ship basis with similar pricing to our customers.

OEM gross profit increased $0.1 million and increased as a percent of OEM sales to 21.0% in the third quarter of 2012 from 20.7% in the third quarter of 2011. The improvement as a percent of sales was primarily driven by cost leverage gained from a higher sales volume from existing customers.

Selling, General and Administrative Expenses

Selling Expenses

Selling expenses consist of commissions paid to our independent sales representatives, employee sales expenses and related expenses to support our sales efforts. Selling expenses decreased $0.9 million to $20.3 million in the third quarter of 2012 from $21.2 million in the prior year quarter, primarily due to lower sales. Selling expenses as a percent of sales increased slightly to 28.3% in the third quarter of 2012 compared to 28.2% in the third quarter of 2011 due to the impact of fixed selling costs on the decreased sales levels.

General and Administrative Expenses

General and administrative expenses consist of expenses to operate our distribution network and overhead expenses to manage the business. General and administrative expenses decreased $1.1 million to $23.0 million in the third quarter of 2012 from $24.1 million in the prior year quarter. An increase in depreciation and facility costs of $1.3 million was more than offset by $1.8 million of lower ERP related expenses in 2012 compared to 2011 and a net decrease of $0.6 million in other general and administrative costs as we continue to focus on controlling costs.

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Severance Expenses

We recorded severance expense of $1.4 million in the third quarter of 2012, primarily related to the retirement of our former President and Chief Executive Officer, compared to $0.3 million of severance expense recorded in the prior year quarter.

Other Expense, net

Other expense, net of $0.2 million for the three months ended September 30, 2012 consists primarily of interest charged on the outstanding borrowings under our revolving line of credit.

Income Tax Expense

An income tax benefit of $0.2 million was recorded in the three months ended September 30, 2012 on a pre-tax loss of $1.6 million, resulting in an effective tax rate of 15.4%. For the three months ended September 30, 2011, income tax benefit was $0.9 million on pre-tax loss of $3.1 million, resulting in an effective tax rate of 30.3%.

Income (Loss) from Continuing Operations

We reported a loss from continuing operations of $1.3 million or a loss of $0.15 per diluted share in the third quarter of 2012 compared to a loss from continuing operations of $2.2 million or $0.25 per diluted share in the third quarter of 2011.

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Nine months ended September 30, 2012 compared to nine months ended September 30, 2011

The following table presents a summary of our financial performance for the nine months ended September 30, 2012 and 2011:

Net Sales

Net sales for the first nine months of 2012 decreased 8.2% to $222.3 million, from $242.1 million in the first nine months of 2011. Excluding the Canadian exchange rate impact, net sales decreased 7.9%.

MRO net sales decreased 9.6% in the first nine months of 2012, to $209.1 million from $231.4 million in the prior year period. MRO average daily sales decreased to $1.095 million in the first nine months of 2012 compared to $1.211 million in the first nine months of 2011. Of the $22.3 million decrease in sales, approximately $20.1 million was due to an increase in the number of vacant sales territories from a year ago and $2.2 million due to lower freight revenue. Government sales decreased $8.8 million in the first nine months of 2012 compared to the first nine months of 2011 primarily as a result of 2011 benefitting from troop deployments. We anticipate that growth in the government segment may be limited given our past support to troop deployments which is not expected to increase in the near future. National accounts increased $1.5 million primarily due to growth of existing relationships while our automotive business grew $1.1 million primarily due to growth in our larger accounts.

OEM net sales increased 23.4% in the first nine months of 2012, to $13.2 million from $10.7 million in the prior year period, driven by stronger demand from existing customers.

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Gross Profit

Gross profit decreased 13.7% in the first nine months of 2012, to $121.5 million from $140.8 million in the prior year period.

MRO gross profit as a percent of net MRO sales decreased to 56.7% in the first nine months of 2012, compared to 59.9% achieved in the first nine months of 2011. This decrease was primarily due to an increase of $5.4 million of inventory reserves, a decrease of $1.0 million in outbound freight recoveries and a shift toward higher volume national customers with lower margins. These national accounts represented approximately 12.2% of MRO sales in the first nine months of 2012 compared to approximately 10.5% in the prior year period. We expect that our gross margin percentage will be under pressure in the future as we continue to increase the mix of national accounts in our customer base and continued competitive pressures.

OEM gross profit increased $0.9 million and increased as a percent of OEM sales to 22.6% in the first nine months of 2012 from 19.7% in the first nine months of 2011. The improvement as a percent of sales was primarily driven by leverage gained from a higher sales volume from existing customers.

Selling, General and Administrative Expenses

Selling Expenses

Selling expenses decreased to $62.3 million in the first nine months of 2012 from $66.3 million in the prior year nine months primarily due to lower sales. Selling expenses increased as a percent of sales to 28.0% in 2012 from 27.4% in 2011 primarily due to the impact of fixed selling costs on the decreased sales levels.

General and Administrative Expenses

General and administrative expenses decreased to $70.5 million in the first nine months of 2012 from $70.7 million in the prior year nine months. We realized savings of $4.4 million from less ERP related expenses in 2012 compared to 2011. This savings was offset by an increase in depreciation and facility costs of $2.3 million, an increase of $1.1 million in bad debt expense and an increase of $0.8 million related to other outside services.

Severance Expenses

During the nine months ended September 30, 2012, we recorded an $8.2 million severance charge of which $1.3 million related to the retirement of our former President and Chief Executive Officer and $6.9 million related to the elimination of corporate and distribution positions, primarily as a result of a strategic restructuring plan designed to reduce our cost structure.

Goodwill Impairment

Our policy is to evaluate goodwill for potential impairment if certain qualitative events have occurred or if circumstances have changed that would more likely than not reduce the fair value of the reporting unit below its carrying value. During the second quarter of 2012, we identified indicators of potential goodwill impairment, specifically, the operating losses incurred in our MRO segment and a reduction in our market capitalization below book value. Therefore, we performed an impairment analysis of the goodwill related to our MRO segment. Based on this analysis, we determined that the full amount of the goodwill was impaired and recorded a non-cash charge of $28.3 million.

Gain on Sale of Assets

In the first nine months of 2012, in conjunction with the construction of a new distribution center in McCook, Illinois and the relocation of our headquarters to Chicago, Illinois we sold three properties: our Addison, Illinois distribution center; Vernon Hills, Illinois distribution center; and a Des Plaines, Illinois administrative building. We received cash proceeds of $8.8 million for the sale of the three facilities which resulted in a gain of $2.1 million.

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Other Expense, net

Other expense, net of $0.5 million recorded in the nine months ended September 30, 2012 primarily relates to interest charged on the outstanding borrowings of our revolving line of credit. The $0.5 million recorded in the first nine months of 2011 primarily relates to interest assessed on unclaimed property settlements.

Income Tax (Benefit) Expense

Income tax expense of $18.1 million was recorded for the nine months ended September 30, 2012 on a pre-tax loss of $46.1 million, resulting in an effective tax rate of negative 39.2%.

Due the substantial cumulative losses that we recorded over the past several quarters, we determined that it was more likely than not that we will not be able to utilize our deferred tax assets to offset future taxable income. Therefore, during the nine months ended September 30, 2012, we increased our deferred tax valuation allowance by $33.6 million. Exclusive of the effect of the increase in the tax valuation allowance, the effective income tax rate would have been 33.6%.

For the nine months ended September 30, 2011, income tax expense was $0.8 million on pre-tax income of $1.7 million, resulting in an effective tax rate of 43.5%.

Income (Loss) from Continuing Operations