OLYMPIC STEEL INC - Quarter Report: 2013 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the quarterly period ended September 30, 2013

For the transition period from __________ to ____________

Commission File Number 0-23320

OLYMPIC STEEL, INC.

(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code (216) 292-3800

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 website, 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 Rule 12b-2 of the Exchange Act). Yes (  ) No (X)

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

Olympic Steel, Inc.

Index to Form 10-Q

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

Olympic Steel, Inc.

Consolidated Balance Sheets

(in thousands)

The accompanying notes are an integral part of these consolidated statements.

Olympic Steel, Inc.

Consolidated Statements of Comprehensive Income

(in thousands, except per share data) 

The accompanying notes are an integral part of these consolidated statements.

Olympic Steel, Inc.

Consolidated Statements of Cash Flows

For the Nine Months Ended September 30,

(in thousands)

The accompanying notes are an integral part of these consolidated statements.

Olympic Steel, Inc.

Supplemental Disclosures of Cash Flow Information

For the Nine Months Ended September 30,

(in thousands)

At September 30, 2013, the Company accrued $3.0 million to construction in progress related to its St. Paul, Minnesota expansion for the tubular and pipe products segment. The non-cash transaction was recorded to “Property and equipment, at cost” and “Other accrued liabilities” on the accompanying Balance Sheet as of September 30, 2013 and has been excluded from the Consolidated Statement of Cash Flows for the nine months ended September 30, 2013.

 The accompanying notes are an integral part of these consolidated statements.Olympic Steel, Inc.

Notes to Unaudited Consolidated Financial Statements

September 30, 2013

1.      Basis of Presentation:

The accompanying consolidated financial statements have been prepared from the financial records of Olympic Steel, Inc. and its wholly-owned subsidiaries (collectively, Olympic or the Company), without audit and reflect all normal and recurring adjustments which are, in the opinion of management, necessary to fairly state the results of the interim periods covered by this report. Year-to-date results are not necessarily indicative of 2013 annual results and these financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2012. All significant intercompany transactions and balances have been eliminated in consolidation.

The Company operates in two reportable segments; flat products and tubular and pipe products. Through its flat products segment, the Company sells and distributes large volumes of processed carbon, coated, aluminum and stainless flat-rolled sheet, coil and plate products. Through its tubular and pipe products segment, the Company distributes metal tubing, pipe, bar, valve and fittings and fabricates pressure parts supplied to various industrial markets.

Commencing with the first quarter of 2013, corporate expenses are reported as a separate line item in the segment reporting. Corporate expenses include the unallocated expenses related to managing the entire Company (i.e., both segments), including payroll expenses for certain personnel, expenses related to being a publicly traded entity such as board of directors expenses, audit expenses, and various other professional fees. Prior to 2013, these expenses were included in the flat products segment’s operating results. In March 2013, the Company revised the presentation of corporate expenses with a conforming change to the prior period presentation to reflect the new reporting structure.

In March 2013, the Company revised the presentation of the Industrial Revenue Bond (IRB) indebtedness to current portion of long-term debt on its Consolidated Balance Sheets with a conforming change to the prior period presentation because the IRB is remarketed on an annual basis. The effect of this revision had no impact on total liabilities, but it revised the total current liabilities as of December 31, 2012 from $138.1 million to $142.4 million.

2.      Accounts Receivable:

Accounts receivable are presented net of allowances for doubtful accounts and unissued credits of $2.8 million as of both September 30, 2013 and December 31, 2012. The allowance for doubtful accounts is maintained at a level considered appropriate based on historical experience and specific customer collection issues that have been identified. Estimations are based upon a calculated percentage of accounts receivable, which remains fairly level from year to year, and judgments about the probable effects of economic conditions on certain customers, which can fluctuate significantly from year to year. The Company cannot guarantee that the rate of future credit losses will be similar to past experience. The Company considers all available information when assessing the adequacy of its allowance for doubtful accounts and unissued credits each quarter.

3.      Inventories:

Inventories consisted of the following:

The Company values certain of its tubular and pipe products inventory at the last-in, first-out (LIFO) method. At September 30, 2013 and December 31, 2012, approximately $45.9 million, or 18.7% of consolidated inventory, and $46.7 million, or 16.1% of consolidated inventory, respectively, was reported under the LIFO method of accounting. The cost of the remainder of the tubular and pipe products inventory is determined using a weighted average rolling first-in, first-out (FIFO) method.

In the first quarter of 2013, the Company made an out-of-period adjustment to record previously unrecognized LIFO income of $1.9 million, which resulted in an increase to after-tax income of $1.2 million.  The Company determined that this adjustment was not material to its current or prior period consolidated financial statements.

If the FIFO method had been in use, inventories would have been $2.5 million lower than reported at September 30, 2013.

4.      Intangible Assets:

Intangible assets, net, consisted of the following:

The Company estimates that amortization expense for its intangible assets subject to amortization will be $0.9 million for the year ending December 31, 2013 and $0.9 million per year in each of the next five years.

5.      Debt:

The Company’s debt is comprised of the following components:

In March 2012, the Company amended its existing asset-based credit facility (ABL Credit Facility). The amendment provided, among other things: (i) a reduction in the applicable margin for loans under the Company’s Loan and Security Agreement; (ii) additional revolving commitments to the borrowers in an aggregate principal amount of $50 million, which additional revolving commitments do not impact the borrowers’ incremental facilities; and (iii) permits certain transactions among the borrowers and Metales de Olympic, S. de R.L. de C.V., an indirect subsidiary of the Company. The amended ABL Credit Facility consists of a revolving credit line of $315 million and a $64 million term loan, with monthly principal payments. At September 30, 2013, the term loan balance was $51.0 million. Revolver borrowings are limited to the lesser of a borrowing base, comprised of eligible receivables and inventories, or $315 million in the aggregate. The ABL Credit Facility matures on June 30, 2016.

The ABL Credit Facility requires the Company to comply with various covenants, the most significant of which include: (i) until maturity of the ABL Credit Facility, if any commitments or obligations are outstanding and the Company’s availability is less than the greater of $20 million, 12.5% of the aggregate amount of revolver commitments ($39.4 million at September 30, 2013), or 60% of the principal balance of the term loan then outstanding ($30.6 million at September 30, 2013), then the Company must maintain a ratio of EBITDA minus certain capital expenditures and cash taxes paid to fixed charges of at least 1.10 to 1.00 for the most recent twelve fiscal month period; (ii) limitations on dividend payments; (iii) restrictions on additional indebtedness; and (iv) limitations on investments and joint ventures. Effective with the March 2012 amendment, the Company has the option to borrow under its revolver based on the agent’s base rate plus a premium ranging from 0.00% to 0.50% or the London Interbank Offered Rate (LIBOR) plus a premium ranging from 1.50% to 2.00%. The interest rate under the term loan is based on the agent’s base rate plus a premium ranging from 0.25% to 0.75% or LIBOR plus a premium ranging from 1.75% to 2.25%. The premiums for the revolver and term loan are based on revolver utilization.

As of September 30, 2013, $3.7 million of bank financing fees were included in “Prepaid expenses and other” and “Other long-term assets” on the accompanying Consolidated Balance Sheets. The financing fees are being amortized over the remaining term of the ABL Credit Facility.

As of September 30, 2013, the Company was in compliance with its covenants and had approximately $90 million of availability under the ABL Credit Facility.   

As part of the 2011 Chicago Tube and Iron Company (CTI) acquisition, the Company assumed approximately $5.9 million of IRB indebtedness issued through the Stanly County, North Carolina Industrial Revenue and Pollution Control Authority. The bond matures in April 2018, with the option to provide principal payments annually on April 1st. The IRB bonds are remarketed annually and are included in “Current portion of long-term debt” on the accompanying Consolidated Balance Sheets. On April 1, 2013, the Company paid an optional principal payment of $0.8 million. Interest is payable monthly, with a variable rate that resets weekly. As a security for payment of the bonds, the Company obtained a direct pay letter of credit issued by JPMorgan Chase Bank, N.A. The letter of credit is reduced annually by the optional principal reduction amount. The interest rate at September 30, 2013 was 0.17% for the IRB.

CTI entered into an interest rate swap agreement to reduce the impact of changes in interest rates on the IRB. At September 30, 2013, the effect of the swap agreement on the bond was to fix the rate at 3.46%. The swap agreement matures in April 2018, and is reduced annually by the amount of the optional principal payments on the bond. The Company is exposed to credit loss in the event of nonperformance by the other parties to the interest rate swap agreement. However, the Company does not anticipate nonperformance by the counterparties.

On April 1, 2013, the Company purchased a facility in Streetsboro, Ohio for $1.4 million that was previously financed under a capital lease agreement. The capital lease obligation of $1.4 million was included in “Current portion of long-term debt” on the accompanying Consolidated Balance Sheets as of December 31, 2012. 

6.      Derivative Instruments:

Nickel swaps

During 2013 and 2012, the Company entered into nickel swaps indexed to the London Metal Exchange (LME) price of nickel with third-party brokers. The nickel swaps are treated as derivatives for accounting purposes. The Company entered into the swaps to mitigate certain customers’ risk of volatility in the price of nickel. The outstanding nickel swaps have one to 32 months remaining and are settled with the brokers at maturity. The economic benefit or loss arising from the changes in fair value of the swaps is contractually passed through to the customer. The primary risk associated with the nickel swaps is the ability of customers or third-party brokers to honor their agreements with the Company related to derivative instruments. If the customers or third-party brokers are unable to honor their agreements, the Company’s risk of loss is the fair value of the nickel swap.

While these derivatives are intended to help the Company manage risk, they have not been designated as hedging instruments. The periodic changes in fair value of the nickel and embedded customer derivative instruments are included in “Cost of materials sold” in the Consolidated Statements of Comprehensive Income. We recognize derivative positions with both the customer and the third party for the derivatives and we classify cash settlement amounts associated with them as part of “Cost of materials sold” in the Consolidated Statements of Comprehensive Income. The embedded customer derivatives are included in “Accounts receivable, net”, and the nickel swaps are included in “Other accrued liabilities” on the Consolidated Balance Sheets.

Interest rate swap

CTI entered into an interest rate swap to reduce the impact of changes in interest rates on its IRB. The swap agreement matures in April 2018, the same time as the IRB, and is reduced annually by the amount of the optional principal payments on the IRB. The Company is exposed to credit loss in the event of nonperformance by the other parties to the interest rate swap agreement. However, the Company does not anticipate nonperformance by the counterparties. The interest rate swap is not treated as a hedge for accounting purposes.

The periodic changes in fair value of the interest rate swap and cash settlement amounts associated with the interest rate swap are included in “Interest and other expense on debt” in the Consolidated Statements of Comprehensive Income.

Fixed rate interest rate hedge

In June 2012, the Company entered into a forward starting fixed rate interest rate hedge that commenced June 2013 in order to eliminate the variability of cash interest payments on $53.2 million of outstanding LIBOR-based borrowings under the ABL Credit Facility. The hedge is reduced monthly by the principal payments on the term loan. The balance of the hedge as of September 30, 2013 was $51.0 million. The hedge matures on June 1, 2016 and is reduced monthly by the principal payments on the term loan. The fixed rate interest rate hedge is accounted for as a cash flow hedging instrument for accounting purposes.

There was no net impact from the nickel swaps or embedded customer derivative agreements to the Company’s Consolidated Statements of Comprehensive Income for the three or nine months ended September 30, 2013 and 2012. The table below shows the total impact to the Company’s Consolidated Statements of Comprehensive Income through net income of the derivatives for the three and nine months ended September 30, 2013 and 2012.

7.      Fair Value of Financial Instruments:

The Company’s financial instruments include cash and cash equivalents, short-term trade receivables, derivative instruments, accounts payable and debt instruments. For short-term instruments, other than those required to be reported at fair value on a recurring basis and for which additional disclosures are included below, management concluded the historical carrying value is a reasonable estimate of fair value because of the short period of time between the origination of such instruments and their expected realization.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is an exit price concept that assumes an orderly transaction between willing market participants. Valuation techniques must maximize the use of observable inputs and minimize the use of unobservable inputs. To measure fair value, the Company applies a fair value hierarchy that is based on three levels of input, of which the first two are considered observable and the last unobservable, as follows:

Level 1 – Quoted prices in active markets for identical assets and liabilities.

Level 2 – Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

During the nine months ended September 30, 2013, there were no transfers of financial assets between Levels 1, 2 or 3 fair value measurements. There have been no changes in the methodologies used at September 30, 2013 since December 31, 2012. Following is a description of the valuation methodologies used for assets and liabilities measured at fair value as of September 30, 2013 and December 31, 2012:

Nickel swaps and embedded customer derivatives – Determined by using Level 2 inputs that include the price of nickel indexed to the LME. The fair value is determined based on quoted market prices and reflects the estimated amounts the Company would pay or receive to terminate the nickel swaps.

Interest rate swap – Based on the present value of the expected future cash flows, considering the risks involved, and using discount rates appropriate for the maturity date. Market observable Level 2 inputs are used to determine the present value of future cash flows.

The following table presents information about the Company’s assets and liabilities that were measured at fair value on a recurring basis and indicates the fair value hierarchy of the valuation techniques utilized by the Company:

8.      Equity Plans:

Stock Options

The following table summarizes stock option activity during the nine months ended September 30, 2013:

There were 11,667 and 2,170 stock options exercised during the nine months ended September 30, 2013 and 2012, respectively. The total intrinsic value of stock options exercised during the nine months ended September 30, 2013 and 2012 was $218 thousand and $43 thousand, respectively. All options outstanding are vested as of September 30, 2013.

Restricted Stock Units and Performance Share Units

Pursuant to the Olympic Steel 2007 Omnibus Incentive Plan (Plan), the Company may grant stock options, stock appreciation rights, restricted shares, restricted share units, performance shares, and other stock and cash-based awards to employees and Directors of, and consultants to, the Company and its affiliates. Under the Plan, 500,000 shares of common stock are available for equity grants.

On January 2, 2013 and January 3, 2012, the Compensation Committee of the Company’s Board of Directors approved the grant of 1,800 annual restricted stock units (RSUs) to each non-employee Director. Subject to the terms of the Plan and the RSU agreement, the RSUs vest after one year of service (from the date of grant). The RSUs are not converted into shares of common stock until the Director either resigns or is terminated from the Board of Directors.

The fair value of each RSU was estimated to be the closing price of the Company’s common stock on the date of the grant, which was $23.41 and $25.55 for the grants on January 2, 2013 and January 3, 2012, respectively.

In 2011, the Compensation Committee for the Company’s Board of Directors approved changes to the Senior Management Compensation Program to include an equity component in order to encourage more ownership of common stock by the senior management. Beginning in 2011, the Senior Management Compensation Program imposed stock ownership requirements upon the participants. Each participant is required to own at least 750 shares of common stock for each year that the participant participates in the Senior Management Compensation Program. Any participant that fails to meet to the stock ownership requirements will be ineligible to receive any equity awards under the Company’s equity compensation plans, including the Plan, until the participant satisfies the ownership requirements. To assist participants in meeting the stock ownership requirements, on an annual basis, if a participant purchases 500 shares of common stock on the open market, the Company will award that participant 250 shares of common stock. During the nine months ended September 30, 2013 and 2012, the Company matched 7,000 and 7,250 shares, respectively. Additionally, any participant who continues to comply with the stock ownership requirements as of the five-year, 10-year, 15-year, 20-year and 25-year anniversaries of the participant’s participation in the Senior Management Compensation Program will receive a restricted stock unit award with a dollar value of $25 thousand, $50 thousand, $75 thousand, $100 thousand and $100 thousand, respectively. Restricted stock unit awards will convert into the right to receive shares of common stock upon a participant’s retirement, or earlier upon the participant’s death or disability or upon a change in control of the Company.

Stock-based compensation expense recognized on RSUs for the three and nine months ended September 30, 2013 and 2012, respectively, is summarized in the following table:

All pre-tax charges related to RSUs were included in the caption “Administrative and general” on the accompanying Consolidated Statements of Comprehensive Income.

The following table summarizes the activity related to RSUs for the three and nine months ended September 30, 2013:

No RSUs were converted into shares during the nine months ended September 30, 2013. During the nine months ended September 30, 2012, 375 RSU’s were converted into shares.

9.      Income Taxes:

For the three months ended September 30, 2013, the Company recorded an income tax provision of $1.1 million, or 46.1% of income before income taxes, compared to $916 thousand, or 35.9% of income before income taxes, for the three months ended September 30, 2012. The higher effective tax rate for the three months ended September 30, 2013 is primarily a result of the impact of greater non-deductible expenses on the pre-tax income and the increase in the annual effective rate from the first six months of 2013.

For the nine months ended September 30, 2013, the Company recorded an income tax provision of $5.7 million, or 38.6% of income before income taxes, compared to $7.9 million, or 39.0% of income before income taxes, for the nine months ended September 30, 2012.

The Company’s tax provision for interim periods is determined using an estimate of the annual effective tax rate, adjusted for discrete items that are taken into account in the relevant period. Each quarter the estimate of the annual effective tax rate is updated, and if the estimated tax rate changes, a cumulative adjustment is made.

The quarterly tax provision and the quarterly estimate of the annual effective tax rate is subject to significant volatility due to several factors, including variability in accurately predicting the pre-tax and taxable income and loss and the mix of jurisdictions to which they relate, changes in law and relative changes of expenses or losses for which tax benefits are not recognized. Additionally, the effective tax rate can be more or less volatile based on the amount of pre-tax income. For example, the impact of discrete items and non-deductible expenses on the effective tax rate is greater when our pre-tax income is lower.

10.    Shares Outstanding and Earnings Per Share:

Earnings per share have been calculated based on the weighted average number of shares outstanding as set forth below:

11.    Segment Information:

The Company follows the accounting guidance that requires the utilization of a “management approach” to define and report the financial results of operating segments. The management approach defines operating segments along the lines used by the Company’s chief operating decision maker (CODM) to assess performance and make operating and resource allocation decisions. Our CODM evaluates performance and allocates resources based primarily on operating income (loss). Our operating segments are based on internal management reporting.

The Company operates in two reportable segments: flat products and tubular and pipe products. Through its flat products segment, the Company sells and distributes large volumes of processed carbon, coated, aluminum and stainless flat-rolled sheet, coil and plate products. Through its tubular and pipe products segment, the Company distributes metal tubing, pipe, bar, valve and fittings and fabricates pressure parts supplied to various industrial markets.

Commencing with the first quarter of 2013, corporate expenses are reported as a separate line item in the segment reporting. Corporate expenses include the unallocated expenses related to managing the entire Company (i.e., both segments), including payroll expenses for certain personnel, expenses related to being a publicly traded entity such as board of directors expenses, audit expenses, and various other professional fees. Prior to 2013, these expenses were included in the flat products segment’s operating results. The 2012 financial information below has been revised to reflect the new reporting structure.

The following table provides financial information by segment and reconciles the Company’s operating income by segment to the consolidated income before income taxes for the three and nine months ended September 30, 2013 and 2012.

There were no material intercompany revenue transactions between the flat products and tubular and pipe products segments.

The Company sells certain products internationally, primarily in North, Central and South America. International sales are immaterial to the consolidated financial results and to the individual segments’ results.

12.    Recently Issued Accounting Updates:

In July 2013, the Financial Accounting Standards Board issued ASU No. 2013-11, “Presentation of an Unrecognized Tax Benefit when a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists”. ASU No. 2013-11 requires an entity to present unrecognized tax benefits as a reduction to deferred tax assets when a net operating loss carryforward, similar tax loss or a tax credit carryforward exists, with limited exceptions. ASU No. 2013-11 is effective for fiscal years beginning on or after December 15, 2013, and for interim periods within those fiscal years. The provisions of this ASU are not expected to have a material impact on the Company’s financial statements.

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

The following discussion and analysis should be read in conjunction with our unaudited consolidated financial statements and accompanying notes contained herein and our consolidated financial statements, accompanying notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2012. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause a difference include, but are not limited to, those discussed under Item 1A (Risk Factors) in our Annual Report on Form 10-K for the year ended December 31, 2012. The following section is qualified in its entirety by the more detailed information, including our financial statements and the notes thereto, which appear elsewhere in this Quarterly Report on Form 10-Q.

Forward-Looking Information

This Quarterly Report on Form 10-Q and other documents we file with the SEC contain various forward-looking statements that are based on current expectations, estimates, forecasts and projections about our future performance, business, our beliefs and management’s assumptions. In addition, we, or others on our behalf, may make forward-looking statements in press releases or written statements, or in our communications and discussions with investors and analysts in the normal course of business through meetings, conferences, webcasts, phone calls and conference calls. Words such as “may,” “will,” “anticipate,” “should,” “intend,” “expect,” “believe,” “estimate,” “project,” “plan,” “potential,” and “continue,” as well as the negative of these terms or similar expressions, are intended to identify forward-looking statements, which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to certain risks and uncertainties that could cause our actual results to differ materially from those implied by such statements including, but not limited to:

Should one or more of these or other risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, intended, expected, believed, estimated, projected or planned. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to republish revised forward-looking statements to reflect the occurrence of unanticipated events or circumstances after the date hereof, except as otherwise required by law.

Overview

We are a leading metals service center that operates in two reportable segments; flat products and tubular and pipe products. We provide metals processing and distribution services for a wide range of customers. Our primary flat products focus is on the direct sale and distribution of large volumes of processed carbon, coated, aluminum and stainless flat-rolled sheet, coil and plate products. Commencing with the July 1, 2011 acquisition of Chicago Tube and Iron Company, or CTI, we distribute metal tubing, pipe, bar, valves and fittings and fabricate pressure parts supplied to various industrial markets. Products that require more value-added processing generally have a higher gross profit. In addition, tubular and pipe products segment gross margins are generally higher than our traditional flat products segment gross margins. Accordingly, our overall gross profit is affected by, among other things, product mix, the amount of processing performed, the demand for and availability of metals, and volatility in selling prices and material purchase costs. We also perform toll processing of customer-owned metals. We sell certain products internationally, primarily in North, Central and South America. International sales are immaterial to our consolidated financial results and to the individual segments’ results.

Our results of operations are affected by numerous external factors including, but not limited to: general and global business, economic, financial, banking and political conditions; competition; metals pricing, demand, global production levels and availability; energy prices; pricing and availability of raw materials used in the production of metals; global supply and inventory held in the supply chain; customers’ ability to manage their credit line availability; and layoffs or work stoppages by our own, our suppliers’ or our customers’ personnel. The metals industry also continues to be affected by the global consolidation of our suppliers, competitors and end-use customers.

Like other service centers, we maintain substantial inventories of metals to accommodate the short lead times and just-in-time delivery requirements of our customers. Accordingly, we purchase metals in an effort to maintain our inventory at levels that we believe to be appropriate to satisfy the anticipated needs of our customers based upon customer forecasts, historic buying practices, supply agreements with customers and market conditions. Our commitments to purchase metals are generally at prevailing market prices in effect at the time we place our orders. When metals prices increase, competitive conditions will influence how much of the price increase we can pass on to our customers. To the extent we are unable to pass on future price increases in our raw materials to our customers, the net sales and gross profits of our business could be adversely affected. When metals prices decline, customer demands for lower prices and our competitors’ responses to those demands could result in lower sale prices and, consequently, lower gross profits as we sell existing metals inventory.

At September 30, 2013, we employed approximately 1,781 people. Approximately 330 of the hourly plant personnel at our Duluth, Minnesota; Locust, North Carolina; Romeoville, Illinois; Minneapolis, Minnesota; Indianapolis, Indiana; Detroit, Michigan; Kansas City, Missouri; St. Paul, Minnesota; and Milan, Illinois facilities are represented by ten separate collective bargaining units. The table below shows the expiration dates of the collective bargaining agreements.

We have never experienced a work stoppage and we believe that our relationship with employees is good. However, any prolonged work stoppages by our personnel represented by collective bargaining units could have a material adverse impact on our business, financial condition, results of operations and cash flows.

Reportable Segments

We operate in two reportable segments; flat products and tubular and pipe products. We follow the accounting guidance that requires the utilization of a “management approach” to define and report the financial results of operating segments. The management approach defines operating segments along the lines used by the our chief operating decision maker, or CODM, to assess performance and make operating and resource allocation decisions. Our CODM evaluates performance and allocates resources based primarily on operating income (loss). Our operating segments are based on internal management reporting.

Commencing with the first quarter of 2013, corporate expenses are now reported as a separate line item in the segment reporting. Corporate expenses include the unallocated expenses related to managing the entire Company (i.e., both segments), including payroll expenses for certain personnel, expenses related to being a publicly traded entity such as board of directors expenses, audit expenses, and various other professional fees. Prior to 2013, these expenses were included in the flat products segment’s operating results. The 2012 financial information has been revised to reflect the new reporting structure.

Flat products

The primary focus of our flat products segment is on the direct sale and distribution of large volumes of processed carbon, coated, aluminum and stainless flat-rolled sheet, coil and plate products. We act as an intermediary between metals producers and manufacturers that require processed metals for their operations. We serve customers in most metals consuming industries, including manufacturers and fabricators of transportation and material handling equipment, construction and farm machinery, storage tanks, environmental and energy generation equipment, automobiles, food service and electrical equipment, military vehicles and equipment, as well as general and plate fabricators and metals service centers. We distribute these products primarily through a direct sales force.

The flat products segment has 24 strategically-located processing and distribution facilities in the United States and one in Monterrey, Mexico. This geographic footprint allows us to focus on regional customers and larger national and multi-national accounts, primarily located throughout the midwestern, eastern and southern United States. The flat products segment distributes these products primarily through a direct sales force.

Tubular and pipe products

The tubular and pipe products segment consists of the CTI business, acquired in 2011. Through our tubular and pipe products segment, we distribute metals tubing, pipe, bar, valve and fittings and fabricate pressure parts supplied to various industrial markets. Founded in 1914, CTI operates from nine locations in the midwestern and southeastern United States. The tubular and pipe products segment distributes its products primarily through a direct sales force.

Results of Operations

Consolidated Operations

The following table presents consolidated operating results for the three and nine months ended September 30, 2013 and 2012 (dollars are shown in thousands):

Net sales decreased 11.3% to $304.0 million in the third quarter of 2013 from $342.6 million in the third quarter of 2012. Flat products net sales were 81.7% of total net sales in the third quarter of 2013 compared to 81.5% of total net sales in the third quarter of 2012. Tubular and pipe products net sales were 18.3% of total net sales in the third quarter of 2013 compared to 18.5% of total net sales in the third quarter of 2012. The decrease in net sales was due to a 5.0% decline in consolidated sales volume as well as a 6.6% decline in consolidated average selling prices during the third quarter of 2013 compared to the third quarter of 2012.

Net sales decreased 10.9% to $972.9 million in the first nine months of 2013 from $1.1 billion in the first nine months of 2012. Flat products net sales were 81.4% of total net sales in the first nine months of 2013 compared to 82.7% of total net sales in the first nine months of 2012. Tubular and pipe products net sales were 18.6% of total net sales in the first nine months of 2013 compared to 17.3% of total net sales in the first nine months of 2012. The decrease in net sales was due to a 5.8% decline in consolidated sales volume as well as a 5.5% decline in consolidated average selling prices during the first nine months of 2013 compared to the first nine months of 2012.

Cost of materials sold decreased 12.8% to $241.0 million in the third quarter of 2013 from $276.5 million in the third quarter of 2012. The decrease in the cost of materials sold was due to the decline in consolidated sales volume and lower metals cost in the third quarter of 2013 compared to the third quarter of 2012. LIFO income was recorded in the third quarter of 2013, which resulted in a decrease to cost of materials sold of $0.2 million. 

Cost of materials sold decreased 12.5% to $769.0 million in the first nine months of 2013 from $879.1 million in the first nine months of 2012. The decrease in cost of materials sold was due to the consolidated decline in sales volume and lower metals cost in the first nine months of 2013 compared to the first nine months of 2012. In the first quarter of 2013, we made an out-of-period adjustment to record previously unrecognized LIFO income, which resulted in a decrease to cost of materials sold of $1.9 million. The total impact of LIFO income for the first nine months of 2013 was $2.5 million. 

As a percentage of net sales, gross profit (as defined in footnote (b) in the table above) increased to 20.7% in the third quarter of 2013 compared to 19.3% in the third quarter of 2012. As a percentage of net sales, gross profit increased to 21.0% in the first nine months of 2013 compared to 19.5% in the first nine months of 2012. The impact of LIFO income increased gross profit by 0.3% of sales in the first nine months of 2013. The increase in gross profit for the three and nine months ended September 30, 2013 was primarily due to the cost of materials sold decreasing more than selling prices, as well as the impact of LIFO income. We expect our gross profit as a percentage of sales in the fourth quarter of 2013 to be consistent with the third quarter of 2013, excluding LIFO income.

During the first quarter of 2013, we experienced a failure of a shear on one of our major pieces of processing equipment in the flat products segment, which was repaired and became fully operational in May 2013. The incremental expense of approximately $1.9 million incurred during the six months ended June 30, 2013 was fully covered by insurance. The insurance receivable of $1.9 million was received in September 2013. We do not expect any additional expenses related to the shear failure in the future.

Commencing with the first quarter of 2013, corporate expenses are reported as a separate line item in the segment reporting and are disclosed separately to reconcile segment operating income to consolidated operating income on the Consolidated Statements of Comprehensive Income. Corporate expenses include the unallocated expenses related to managing the entire Company (i.e., both segments), including payroll expenses for certain personnel, expenses related to being a publicly traded entity such as board of directors expenses, audit expenses, and various other professional fees. Prior to 2013, these expenses were included in the flat products segment’s operating results. Corporate expenses totaled $1.7 million for the three months ended September 30, 2013 compared to $1.5 million for the three months ended September 30, 2012. Corporate expenses totaled $5.7 million and $5.5 million for the nine months ended September 30, 2013 and September 30, 2012, respectively. The increase in Corporate expenses in 2013 is attributable to the relocation of certain of the Company’s executive offices from Bedford Heights, Ohio to Highland Hills, Ohio.

Interest and other expense on debt totaled $1.7 million, or 0.6% of net sales, for the three months ended September 30, 2013 compared to $2.1 million, or 0.6% of net sales, for the three months ended September 30, 2012. Interest and other expense on debt totaled $5.1 million, or 0.5% of net sales, for the nine months ended September 30, 2013 compared to $6.4 million, or 0.6% of net sales, for the nine months ended September 30, 2012. Our effective borrowing rate, exclusive of deferred financing fees and commitment fees, was 2.2% for the nine months ended September 30, 2013 compared to 2.8% for the nine months ended September 30, 2012. The decrease in interest and other expense on debt in 2013 was primarily due to lower average borrowings and the lower effective borrowing rate.

For the third quarter of 2013, income before income taxes totaled $2.5 million compared to $2.6 million in the third quarter of 2012. For the third quarter of 2013, income before income taxes included LIFO income of $0.2 million. For the nine months ended September 30, 2013, income before income taxes totaled $14.7 million compared to $20.3 million for the nine months ended September 30, 2012. The nine months ended September 30, 2013 included LIFO income of $2.5 million, inclusive of an out-of-period LIFO income adjustment of $1.9 million recorded in the first quarter of 2013.

An income tax provision of 46.1% was recorded for the third quarter of 2013, compared to 35.9% for the third quarter of 2012. The higher effective tax rate for the third quarter of 2013 was primarily a result of the impact of greater non-deductible expenses on the pre-tax income and the increase in the annual effective rate from the first six months of 2013. An income tax provision of 38.6% was recorded for the nine months ended September 30, 2013, compared to 39.0% for the nine months ended September 30, 2012. Our tax provision for interim periods is determined using an estimate of our annual effective tax rate, adjusted for discrete items that are taken into account in the relevant period. Each quarter we update our estimate of the annual effective tax rate, and if our estimated tax rate changes, we make a cumulative adjustment. We expect our effective tax rate to approximate 38% to 40% on an annual basis in 2013.

Net income for the third quarter of 2013 totaled $1.3 million or $0.12 per basic and diluted share, compared to $1.6 million or $0.15 per basic and diluted share for the third quarter of 2012. For the third quarter of 2013, the impact of LIFO income increased earnings per share by $0.01 per basic and diluted share. Net income for the nine months ended September 30, 2013 totaled $9.0 million or $0.82 per basic share and diluted share, compared to $12.4 million or $1.13 per basic and diluted share for the comparable period in 2012. For the nine months ended September 30, 2013, the impact of LIFO income increased earnings per share by $0.14 per basic and diluted shares, inclusive of the out-of-period LIFO income adjustment, which increased earnings per share by $0.11 per basic and diluted share.

Segment Operations

Flat products

The following table presents selected operating results for our flat products segment for the three and nine months ended September 30, 2013 and 2012 (dollars are shown in thousands, except per ton data):