UNIVERSAL STAINLESS & ALLOY PRODUCTS INC - Quarter Report: 2011 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

For the Quarterly Period Ended June 30, 2011

OR

For the Transition Period from              to             

Commission File Number 000-25032

UNIVERSAL STAINLESS & ALLOY PRODUCTS, INC.

(Exact name of Registrant as specified in its charter)

600 Mayer Street

Bridgeville, PA 15017

(Address of principal executive offices, including zip code)

(412) 257-7600

(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 definition 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

As of July 31, 2011, there were 6,830,803 shares of the Registrant’s Common Stock outstanding.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations and other sections of this Quarterly Report on Form 10-Q contain forward-looking statements that reflect the current views of Universal Stainless & Alloy Products, Inc. (the “Company”) with respect to future events and financial performance. Statements looking forward in time, including statements regarding future growth, cost savings, expanded production capacity, broader product lines, greater capacity to meet customer quality reliability, price and delivery needs, enhanced competitive posture, effect of new accounting pronouncements and no material financial impact from litigation or contingencies are included in this Quarterly Report on Form 10-Q pursuant to the “safe harbor” provision of the Private Securities Litigation Reform Act of 1995.

The Company’s actual results may be affected by a wide range of factors including future compliance with Section 404 of the Sarbanes-Oxley Act of 2002; the concentrated nature of the Company’s customer base to date and the Company’s dependence on its significant customers; the receipt, pricing and timing of future customer orders; changes in product mix; the limited number of raw material and energy suppliers and significant fluctuations that may occur in raw material and energy prices; risks related to property, plant and equipment, including the Company’s reliance on the continuing operation of critical manufacturing equipment; risks associated with labor matters; the Company’s ongoing requirement for continued compliance with laws and regulations, including applicable safety and environmental regulations; the ultimate outcome of the Company’s current and future litigation matters; risks related to acquisitions that the Company may make; and the impact of various economic, credit and market risk uncertainties. Many of these factors are not within the Company’s control and involve known and unknown risks and uncertainties that may cause the Company’s actual results in future periods to be materially different from any future performance suggested herein. Any unfavorable change in the foregoing or other factors could have a material adverse effect on the Company’s business, financial condition and results of operations. Further, the Company operates in an industry sector where securities values may be volatile and may be influenced by economic and other factors beyond the Company’s control.

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Part I. FINANCIAL INFORMATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in Thousands, Except Per Share Information)

(Unaudited)

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

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in Thousands)

(Unaudited)

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

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CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)

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

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW

(Dollars in Thousands)

(Unaudited)

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

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NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of operations and statements of comprehensive income for the three- and six-month periods ended June 30, 2011 and 2010, balance sheets as of June 30, 2011 and December 31, 2010, and statements of cash flows for the six-month periods ended June 30, 2011 and 2010, have been prepared by Universal Stainless & Alloy Products, Inc. (the “Company”) in accordance with generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles has been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information not misleading. Accordingly, these statements should be read in conjunction with the audited financial statements, and notes thereto, as of and for the year ended December 31, 2010 included in the Company’s Annual Report on Form 10-K. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, all of which were of a normal, recurring nature, necessary to present fairly, in all material respects, the consolidated financial position at June 30, 2011 and December 31, 2010 and the consolidated results of operations and of cash flows for the periods ended June 30, 2011 and 2010, and are not necessarily indicative of the results to be expected for the full year.

Recently Adopted Accounting Pronouncement

In June 2011, the Financial Accounting Standards Board issued Accounting Standards Update 2011-05, “Comprehensive Income (Topic 220): Presentation of Comprehensive Income,” which amends current comprehensive income guidance. This accounting update eliminates the option to present the components of other comprehensive income as part of the statement of shareholders’ equity. Instead, the Company must report comprehensive income in either a single continuous statement of comprehensive income which contains two sections, net income and other comprehensive income, or in two separate but consecutive statements. The Company adopted this guidance during the three-month period ended June 30, 2011. The adoption of this guidance had no impact on the Company’s condensed consolidated financial statements, as it only required a change in the format of presentation.

Certain prior year amounts have been reclassified to conform to the 2011 presentation.

Note 2 – Common Stock

The reconciliation of the weighted average number of shares of Common Stock outstanding utilized for the earnings per common share computations are as follows:

Options not included in the computation of diluted net income per common share to purchase 19,150 and 153,350 shares of Common Stock at an average price of $41.27 and $34.36, respectively, per common share were outstanding at June 30, 2011 and 2010, respectively. These outstanding options were not included in the computation of diluted earnings per common share because their respective exercise prices were greater than the average market price of the Common Stock. These options were excluded from the computation of diluted earnings per common share under the treasury stock method.

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NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 3 – Inventory

The major classes of inventory are as follows:

Note 4 – Property, Plant and Equipment

Property, plant and equipment consists of the following:

Note 5 – Debt

The Company has an unsecured credit agreement with PNC Bank which provides for a $12.0 million term loan (“Term Loan”) scheduled to mature on February 28, 2014 and a $15.0 million revolving credit facility with a term expiring on June 30, 2012. There was no balance outstanding under the revolving credit facility at June 30, 2011 or December 31, 2010. Quarterly Term Loan principal payments of $600,000 began in May 2010. Interest on both facilities is based on short-term market rates, which may be adjusted if the Company does not maintain certain financial ratios. PNC Bank charges a commitment fee payable on the unused portion of the revolving credit facility of 0.25%, provided certain financial ratios are maintained. The Company is required to be in compliance with three financial covenants: a minimum leverage ratio, a minimum debt service ratio and minimum tangible net worth. The Company was in compliance with all such covenants at June 30, 2011 and December 31, 2010. At June 30, 2011 and December 31, 2010, $9.0 million and $10.2 million, respectively, was outstanding on the Term Loan, of which $6.6 million and $7.8 million, respectively, was included as a component of long-term debt on the Condensed Consolidated Balance Sheets.

The Company maintains a $400,000 20-year loan agreement with the Commonwealth of Pennsylvania’s Department of Commerce (the “PADC”), which bears interest at 6% per annum and matures in March 2016. In addition, the Company had a $200,000 15-year loan with the PADC, which bore interest at 5% per annum and matured and was repaid in April 2011. In February 2002, Dunkirk Specialty Steel issued two ten-year, 5% interest-bearing notes payable to the New York Job Development Authority for the combined amount of $3.0 million. Aggregate government debt outstanding at June 30, 2011 and December 31, 2010 was $407,000 and $623,000, respectively, of which $113,000 and $190,000, respectively, was included as a component of long-term debt on the Condensed Consolidated Balance Sheets.

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NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 6 – Derivatives and Hedging Activities

To manage interest rate risk, the Company entered into an interest rate swap that effectively converts the floating-rate Term Loan into a fixed-rate debt instrument. The interest rate swap agreement was executed to minimize the impact of interest rate changes on the Company’s floating-rate debt and is designated and accounted for as a cash flow hedge. The effective portion of the change in the fair value of the interest rate swap is recorded net of tax in accumulated other comprehensive loss (within stockholders’ equity). The Company utilizes the interest rate swap to maintain a fixed-rate of 4.515% on the Term Loan until its maturity on February 28, 2014. The notional amount of the interest rate swap decreases ratably over its term, as does the Term Loan, and was $9.0 million at June 30, 2011. During the three- and six-month periods ended June 30, 2011, the Company recognized $52,000 and $105,000, respectively, of interest expense on the Condensed Consolidated Statements of Operations from the monthly settlement of the interest rate swap.

In July 2009, the Company entered into nickel futures contracts to minimize the price change impact of anticipated purchases of nickel over the life of a customer short-term supply agreement. These contracts were designated as and accounted for as cash flow hedges. The effective portion of the change in the fair value of the nickel hedge agreements was recorded in accumulated other comprehensive loss until they expired on March 31, 2010.

The location and amounts recorded in the Condensed Consolidated Balance Sheets for the derivative instrument are as follows:

Note 7 – Fair Value Measurements

The fair value hierarchy has three levels based on the inputs used to determine fair value, which are as follows:

Level 1 — Unadjusted quoted prices available in active markets for the identical assets or liabilities at the measurement date.

Level 2 — Unadjusted quoted prices in active markets for similar assets or liabilities, or unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.

Level 3 — Unobservable inputs that cannot be corroborated by observable market data and reflect the use of significant management judgment. These values are generally determined using pricing models for which the assumptions utilize management’s estimates of market participant assumptions.

The fair value hierarchy requires the use of observable market data when available. In instances where the inputs used to measure fair value fall into different levels of the fair value hierarchy, the fair value measurement has been determined based on the lowest level input significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular item to the fair value measurement in its entirety requires judgment, including the consideration of inputs specific to the asset or liability. The interest rate swap is recorded at fair value based on Level 2 quoted LIBOR swap rates adjusted for credit and non-performance risk.

Financial instruments include cash, accounts receivable, other current assets, accounts payable, short-term debt, other current liabilities and long-term debt. The carrying amounts of these financial instruments approximated fair value at June 30, 2011 and December 31, 2010 due to their short-term maturities. The fair value of the Term Loan approximates the carrying amount as the interest rate is based upon one-month floating LIBOR rates.

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NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 8 – Commitments and Contingencies

From time to time, various lawsuits and claims have been or may be asserted against the Company relating to the conduct of its business, including routine litigation involving commercial and employment matters. The ultimate cost and outcome of any litigation or claim cannot be predicted with certainty. Management believes, based on information presently available, that the likelihood that the ultimate outcome of any such pending matter will have a material adverse effect on its financial condition, or liquidity or a material impact to the results of operations is remote, however the resolution of one or more of these matters may have a material adverse effect on the results of operations for the period in which the resolution occurs.

At June 30, 2011, the Company maintains reserves that it believes are adequate for outstanding product claims and legal actions.

Note 9 – Income Taxes

The tax rate used for interim periods is the estimated annual effective tax rate, based on the current estimate of full year results, except that taxes related to specific events, if any, are recorded in the interim period in which they occur.

The effective income tax rate in the three- and six-month periods ended June 30, 2011 was 35% as compared to a rate of 34% for the three- and six-month periods ended June 30, 2010.

Note 10 – Business Segments

The Company is comprised of two business segments: Universal Stainless & Alloy Products, which consists of the Bridgeville and Titusville facilities, and Dunkirk Specialty Steel, the Company’s wholly-owned subsidiary located in Dunkirk, New York. The Universal Stainless & Alloy Products manufacturing process involves melting, remelting, heat treating and hot and cold rolling of semi-finished and finished specialty steels. Dunkirk Specialty Steel’s manufacturing process involves hot rolling, heat treating and finishing of specialty steel bar, rod and wire products. The segment data is as follows:

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NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 11 – Pending Acquisition

On June 14, 2011, the Company announced that it had entered into an Asset Purchase Agreement (the “Agreement”) to purchase substantially all the assets of Patriot Special Metals, Inc and RSM Real Estate Holding, Inc., a specialty steel manufacturing facility currently under construction in North Jackson, Ohio (the “North Jackson Site”). Once operational, the North Jackson Site will have forging, vacuum induction melting, remelting, thermal treatment and finishing capabilities. The aggregate purchase price for the North Jackson Site will be $104.5 million, subject to adjustment up to $115.0 million. As part of the purchase price, the Company will deliver at closing convertible promissory notes in the aggregate principal amount of $20.0 million (collectively, the “Notes”). The Notes will be convertible into a number of shares of the Company’s Common Stock determined based upon a conversion price equal to 125% of the average of the market value of the Company’s Common Stock on the five trading days immediately prior to the closing date. The Company intends to finance the balance of the acquisition with cash on-hand and a new debt financing arrangement in the form of a term loan and a revolving credit facility. $2.5 million of the purchase price will be held in escrow. The Company also will assume approximately $6.7 million of obligations in accounts payable and open purchase orders related to certain approved capital expenditure projects at the North Jackson Site. The Company may be obligated to make a $2.0 million payment to be held in trust upon the Company’s acceptance of the qualification of the radial forge operation at the North Jackson Site, with such amount being creditable against the cash payable to the sellers at closing. This amount held in trust would be returned to the Company if the Agreement is terminated under certain circumstances but otherwise would be paid to the sellers.

The Company may terminate the Agreement and the subsequent agreed upon consent to extend the outward closing date under the Agreement if the following condition is not satisfied, among other things, the radial forge installed at the North Jackson Site meets certain operating specifications. Consummation of the transactions contemplated by the Agreement is subject to customary conditions, including, among others, (i) the absence of any injunction or other order restraining or prohibiting the transactions contemplated by the Agreement; (ii) the receipt by the Company of financing in order to consummate the transactions contemplated by the Agreement; and (iii) the accuracy of representations and warranties. In July 2011, the Company received notice of early termination of the Hart-Scott-Rodino Act waiting period.

For the three- and six-month periods ended June 30, 2011, the Company incurred $496,000 and $915,000, respectively, of acquisition related costs which are included as a component of selling and administrative expenses on the Condensed Consolidated Statements of Operations. The Company believes that the acquisition of the North Jackson Site will broaden the Company’s production capabilities and expand its product range and market penetration. The Company anticipates that the North Jackson Site acquisition will close and forging operations will begin during the three-month period ending September 30, 2011. The Company expects that the facility will be fully operational during the first quarter of 2012.

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Results of Operations

An analysis of the Company’s operations for the three- and six-month periods ended June 30, 2011 and 2010 is as follows:

Market Segment Information

Three- and six-month periods ended June 30, 2011 as compared to the similar periods in 2010

Net sales for the three- and six-month periods ended June 30, 2011 increased $12.0 million and $37.2 million, respectively, as compared to similar periods in 2010. The increase reflects a 7% and 26% increase for the three- and six-month periods ended June 30, 2011, respectively, in consolidated shipments, combined with pricing increases and a change in product mix. Shipments of aerospace products, general industrial products, conversion services and petrochemical products increased 38%, 28%, 20% and 18%, respectively, and were partially offset by decreases in service center plate and power generation products of 34% and 8%, respectively, for the three-month period ended June 30, 2011. For the six-month period ended June 30, 2011, increased shipments of aerospace products, conversion services, petrochemical, general industrial and power generation products of 70%, 51%, 32%, 23% and 19%, respectively, were partially offset by a decrease in service center plate products of 25%.

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Cost of products sold, as a percentage of net sales, was 81% for the three-month periods ended June 30, 2011 and 2010 and 81% and 83% for the six-month periods ended June 30, 2011 and 2010, respectively. This decrease is primarily due to lower operation costs per sales dollar due to increased production volumes incurred during the six-month period ended June 30, 2011, partially offset by higher raw material costs in relation to sales prices.

Selling and administrative expenses increased by $406,000 and $1.6 million for the three- and six-month periods ended June 30, 2011, respectively, as compared to the similar periods in 2010. Selling and administrative expenses as a percent of net sales was 6% for the three-month periods ended June 30, 2011 and 2010 and decreased from 7% for the six-month period ended June 30, 2010 to 6% for the similar period in the current year. The increase of $406,000 for the three-month period ended June 30, 2011 largely relates to $496,000 of expenses related to the previously announced agreement to acquire substantially all the assets of the North Jackson Site, which is described and defined further below, partially reduced by a $124,000 decrease in compensation expenses primarily incentive compensation. The six-month increase of $1.6 million for the period ended June 30, 2011 primarily relates to $915,000 of expenses related to the acquisition of substantially all the assets of the North Jackson Site and a $408,000 increase in compensation expenses. The Company expects to incur approximately $1.0 million to $1.5 million of additional acquisition related costs associated with the North Jackson Site acquisition during the three-month period ended September 30, 2011.

The effective income tax rate in the three- and six-month periods ended June 30, 2011 was 35% as compared to a tax rate of 34% for the three- and six-month periods ended June 30, 2010.

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Business Segment Results

An analysis of net sales and operating income for the reportable segments for the three- and six-month periods ended June 30, 2011 and 2010 is as follows:

Universal Stainless & Alloy Products Segment

Net sales for the three- and six-month periods ended June 30, 2011 for the Universal Stainless & Alloy Products segment, which consists of the Bridgeville and Titusville facilities, increased by $10.7 million, or 22%, in comparison to the three-month period ended June 30, 2010 and by $34.7 million, or 43%, in comparison to the similar 2010 six-month period. The increases reflect a 13% and 34% increase in shipments for the three- and six-month periods ended June 30, 2011, respectively, as well as pricing increases and a change in product mix. Increases in shipments of aerospace products, conversion services, general industrial and petrochemical products of 45%, 41%, 41% and 24%, respectively, were partially offset by decreases in service center plate and power generation products of 34% and 10%, respectively, for the three-month period ended June 30, 2011. Increases in shipments of aerospace products, conversion services, petrochemical, general industrial and power generation products of 79%, 76%, 45%, 32% and 21%, respectively, were partially offset by a decrease in service center plate products of 25% for the six-month period ended June 30, 2011.

Although net sales increased during the three-month period ended June 30, 2011, operating income declined by $340,000. This reduction in operating income is primarily a result of higher raw material costs in relation to net sales and product mix, partially offset by a decrease in operation costs per sales dollar. Material cost of sales, as a percentage of net sales, increased from 48% for the three-month period ended June 30, 2010 to 53% for the three-month period ended June 30, 2011. Additionally, the Company’s results for the three-month period ended June 30, 2010 were favorably impacted by a higher concentration of service center plate. Partially offsetting this reduction in operating income was a reduction in operation costs per sales dollar due to increased production volumes incurred during the current periods. Operation costs per sales dollar decreased from 34% for the three-month period ended June 30, 2010 to 33% for the three-month period ended June 30, 2011. Operating income for the six-month period ended June 30, 2011 increased by $2.6 million, as compared to the similar period in 2010. The increase is primarily due to a decrease in operation costs per sales dollar from 37% for the six-month period ended June 30, 2010 to 33% for the six-month period ended June 30, 2011, partially offset by higher raw material costs in relation to net sales. The material cost of sales, as a percentage of net sales, increased from 47% for the six-month period ended June 30, 2010 to 53% for the six-month period ended June 30, 2011.

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Dunkirk Specialty Steel Segment

Net sales for the three- and six-month periods ended June 30, 2011 for the Dunkirk Specialty Steel segment increased by $12.3 million, or 93%, in comparison to the three-month period ended June 30, 2010 and by $24.2 million, or 104%, in comparison to the similar 2010 six-month period. The increases reflect a 67% and 80% increase in shipments for the three- and six-month periods ended June 30, 2011, respectively, as well as pricing increases and a change in product mix. Increases in shipments of petrochemical, aerospace, general industrial and power generation products of 182%, 79%, 27% and 23%, respectively, for the three-month period ended June 30, 2011 and 148%, 105%, 33% and 20%, respectively, for the six-month period ended June 30, 2011 were partially offset by decreases in conversion services of 26% and 8% for the three- and six-month periods ended June 30, 2011, respectively.

Operating income for the three- and six-month periods ended June 30, 2011 increased by $1.7 million and $3.7, respectively, as compared to the similar periods in 2010. The increase is primarily due to a decrease in operation costs per sales dollar from 28% for the three-month period ended June 30, 2010 to 22% for the three-month period ended June 30, 2011 and from 30% for the six-month period ended June 30, 2010 to 22% for the six-month period ended June 30, 2011, partially offset by higher raw material costs in relation to net sales. Operation costs per sales dollar decreased primarily as a result of increased production volumes incurred during the current periods. Material cost of sales, as a percentage of net sales, increased from 54% for the three-month period ended June 30, 2010 to 61% for the three-month period ended June 30, 2011 and from 55% for the six-month period ended June 30, 2010 to 61% for the six-month period ended June 30, 2011.

Liquidity and Capital Resources

The Company has financed its operating activities through cash on hand at the beginning of the period and cash provided by operations. Working capital increased $9.4 million to $119.5 million at June 30, 2011 compared to $110.1 million at December 31, 2010. Net accounts receivable increased $3.7 million as a result of increased sales for the three-month period ended June 30, 2011 in comparison to the three-month period ended December 31, 2010. The $13.4 million increase in net inventory at June 30, 2011 compared to December 31, 2010 is due primarily to a 22% increase in the volume of work-in-process inventory in response to the rise in the Company’s backlog and higher material purchase prices. The backlog increased from $69.3 million at December 31, 2010 to $90.1 million at June 30, 2011, an increase of 30%. Accounts payable increased $3.0 million, or 15%, primarily related to the increase in production levels.

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Cash received from sales of $66.3 million and $119.6 million for the three- and six-month periods ended June 30, 2011, respectively, and of $44.0 million and $72.6 million for the three- and six-month periods ended June 30, 2010, respectively, represent the primary source of cash from operations. The primary uses of cash are as follows: