Item 1. Business
Statements of our belief in this section are based on our own internal studies or research, estimates of members of our senior sales management team, our knowledge of the industry or other information we have internally compiled.
Introduction
We are the leading producer of flat rolled steel in the western United States based on tonnage billed. We produce the widest range of flat rolled steel products in the region, including hot rolled, cold rolled and galvanized coil and sheet. We also produce electric resistance welded (referred to herein as ERW) pipe. Unlike integrated steel mills and mini-mills, we do not manufacture steel. Rather, we process steel slab manufactured by third parties. Our principal market consists of the 11 states located west of the Rocky Mountains. We have two main competitors located in the western United States. Steel products are also supplied to the western United States via imports from foreign companies and from domestic suppliers located outside the western United States. We believe our slab-based business model, breadth of products, non-union work environment, southern California location and long-standing customer relationships provide us with significant advantages over our competition.
Industry Overview
The steel industry is cyclical in nature. It is influenced by a combination of factors including periods of economic growth or recession, strength or weakness of the U.S. dollar, worldwide production capacity, levels of steel imports and tariffs. Consolidation of the industry, though a series of mergers and acquisitions, has significantly reduced the number of steel producing companies throughout the world. This has brought some stability to market conditions. However, steel, regardless of product type, responds to forces of supply and demand. Prices fluctuate in reaction to general and industry-specific economic conditions.
There are generally two types of steel producers: “integrated mills” and “mini-mills.” Steel manufacturing by an integrated producer includes iron making from raw materials, such as iron ore and coal in a blast furnace, followed by steelmaking, slab making, reheating and further rolling into coil or other shapes. A mini-mill is a steel producer that uses an electric arc furnace rather than a blast furnace to melt steel from ferrous scrap metal.
Unlike integrated steel mills and mini-mills, we do not manufacture steel. Rather, we process steel slab manufactured by third parties. As a result, we do not have the fixed costs associated with the manufacturing of steel. Historically, raw material costs comprise approximately 70% to 75% of our cost of goods sold. In the past few years, raw materials costs have increased due to higher slab and zinc costs and in 2006, our raw materials costs were approximately 80% of our cost of goods sold. We believe we are one of the largest purchasers of steel slab in the world. Our purchasing power provides us with the ability to negotiate favorable terms and conditions for steel slab from low cost and high quality producers throughout the world. Generally, prices of our flat rolled steel products have experienced a correlation to the prices of steel slab. Although we remain subject to the cyclicality inherent in the steel industry, we believe this correlation, combined with our slab-based business model, has historically protected our operating margins when compared to other flat rolled steel producers.
Recent Industry Conditions
As noted in the “Industry Overview” above, the steel industry is cyclical in nature. Demand during the first half of 2005 was lower than typically seen during this period. By the third quarter of 2005 and continuing through the end of the year, demand returned to normal levels. In 2006, demand for our flat-rolled products was very strong during the first six months, but tapered off slightly during the second half of the year. This was the effect of a combination of factors, but mostly in response to high import levels of galvanized steel.
Demand for ERW pipe products, however, was strong in 2005 and grew again in 2006. This is anticipated to continue through 2008, with the construction of gas and oil pipelines throughout the western United States.
Prices for all products were generally stable throughout the year; however, prices for galvanized products rose substantially in response to rising zinc costs.
Products and Customers
Our principal product lines are hot rolled coil and sheet, cold rolled coil and sheet, galvanized coil and sheet and electric resistance welded (ERW) pipe. The following table sets forth our billed tons by product category as a percentage of total shipments for the periods indicated:
The western U.S. steel market is comprised of many consumers typically requiring small order sizes with a wide variety of metallurgical qualities and specifications. In contrast, the majority of other U.S. steel markets primarily depend on heavy-tonnage steel consumers like the automotive and durable goods manufacturing industries. We believe that the western United States’ smaller and more diverse customer base helps balance pricing power between the consumer and the supplier. Instead of competing solely on price, we believe we benefit from having customers that place greater value on our competitive strengths, including integrated service, timeliness of delivery and ability to meet unique customer needs. We further believe that we benefit from our strategic location in Fontana, California.
We have approximately 225 active customers, with no single customer accounting for more than 7% of our 2006 net sales. Our customers include service and processing centers, construction and building material companies, roofing and decking manufacturers, tubing manufacturers, oil and gas producers and distributors, aftermarket automotive manufacturers, as well as various customers in other industries.
We do not actively pursue sales in foreign markets and we make foreign sales only when they are economically advantageous to us. In 2006, we sold approximately 9,771 tons of steel products to foreign customers, primarily in Canada, which represented less than 1% of our total 2006 tons billed.
Hot rolled coil and sheet is our largest product category as measured by tons billed per year. Our customers use hot rolled steel for a variety of manufacturing applications, including the production of spiral weld pipe, automobile wheels and rims, strapping, tubing and a variety of construction related products. In 2006, we directed approximately 37.9% of our hot rolled production to outside sales and we further processed approximately 62.1% internally for our own higher-margin, value added product needs.
Cold rolled coil and sheet are used in exposed steel applications where high surface quality is important. Typically, cold rolled material is coated or painted. Applications for our cold rolled products include electronic cabinetry, tubing and a variety of construction related products. In 2006, we directed approximately 19.2% of our cold rolled reduction production to outside sales and we further processed approximately 80.8% internally for our own higher-margin, value added product needs.
Galvanized coil and sheet is produced by adding a coating of zinc to cold rolled steel, and in some instances, to hot rolled steel, for additional corrosion resistance. We believe we offer the broadest range of thicknesses, widths and coatings of galvanized products in the western U.S. market. Applications for our galvanized coil product include a variety of construction related products such as roofing, decking, studs, tubing, and heating, venting and air conditioning equipment (HVAC).
We supply ERW pipe with diameters ranging from 6.625” to 16.0”. The principal end-users of our ERW pipe production are oil and gas transmission lines. We also sell standard pipe to industrial accounts for load bearing and low-pressure applications.
Operations
We initially began operations in 1984 utilizing certain purchased assets from the former Kaiser Steel Corporation. Based on a business model that depended on the purchase of semi-finished steel slab from third party vendors, we were the first company in the United States to operate steel rolling mills without a dedicated source of slab feedstock. Significant business success and market acceptance of our slab based business model encouraged us to consider a modernization program designed to increase production and improve our product mix.
In 2001, we completed a $265 million modernization program that allowed us to improve our product quality, double production volumes, and increase our percentage of high value added products to our product mix. Since the completion of our modernization program, we have continued to make selective investments designed to keep our facilities competitive or reduce operating costs. Total capital spending in 2006 was $33.2 million on various upgrades to our production facilities as well as safety and environmental improvements.
Production efficiencies continue to be gained through improved operating and maintenance practices, targeted capital investments and enhanced production planning and quality control procedures. We believe the success of our modernization program contributes to our being a low cost producer of flat rolled steel products.
Hot Strip Rolling and Finishing Mills
We produce hot rolled coil from slab in our hot strip mill. A walking beam furnace reheats slab, directs it to a multi-stand rolling mill to reduce thickness and roll it into coil. Equipped with an automatic gauge control system and technologically advanced computer controls, the hot strip mill currently possesses a throughput capacity of approximately 2.2 million tons annually and can produce hot rolled coil in gauges from 0.053” to 0.625”.
The hot strip mill facility is primarily composed of the following:
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A walking beam furnace with a capacity of approximately 6,900 tons of slab per day; and
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An 86” mill which consists of five roughing stands, a scale breaker, six finishing stands and two down coilers.
In addition, the hot strip finishing lines are composed of the following:
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An 80” coil slitter line that can trim product up to 0.375” in thickness and can be easily adjusted to meet a variety of customer-specified widths; and
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3 skin pass lines used for surface and other coil improvements.
Continuous Pickle Line
We can further process hot rolled coil on the 62-inch continuous pickle line for direct sales to our customers or for our own cold rolling and galvanizing production. The continuous pickle line is a conventional horizontal design with a coil entry section, welder, hot water preheat tanks, acid tanks, water rinse, dryer, looper, side trimmer, coiler, oiling equipment and scale. The line can currently yield up to approximately 1.45 million tons per year.
Five Stand Cold Reduction Mill
Pickled and oiled material may be further processed through the five stand cold reduction mill, which reduces the pickled steel strip from a gauge range of 0.075” to 0.225” to a range of 0.0098” to 0.1384” in thickness, with a maximum width of 60”. In the cold reduction process, pickled and oiled coils pass through five stands, arranged in tandem, with a predetermined amount of reduction taken on each stand until the final thickness is achieved upon exiting the fifth stand. Reductions are taken in one pass. The capacity of the five stand cold reduction mill is 1.43 million tons per year. Most material is further processed through the cold sheet mill or galvanized mills.
Cold Sheet Mill
Cold rolled sheet is hot rolled steel that has been further processed through the continuous pickle line and five stand cold reduction mill and is then processed through an annealing furnace and temper mill, improving uniformity, ductility and formability. Cold rolling can also impart various surface finishes and textures. Cold rolled steel is used in applications that demand higher quality or finish.
The cold rolled facility, with a current annual finished capacity of approximately 360,000 tons, includes the following:
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An electrolytic cleaning line;
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Twenty hydrogen annealing bases; and
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A 60” temper mill.
After cold reduction at the five stand cold reduction mill, the coil may be cleaned in a 200-feet to 1,000-feet per minute electrolytic cleaning line and then annealed. Hydrogen annealing is a process that heats steel coils to annealing temperatures in a pure hydrogen atmosphere and then slowly allows the steel coils to cool. This process restores ductility to our steel products that is lost as a result of cold reduction rolling. The strip is then run through final production in a 60” temper mill, where the steel is tempered to specified finish, shape and gauge.
Galvanizing Mills
Galvanized coil and sheet represent our highest value added products, requiring the greatest degree of processing and quality controls. We produce galvanized sheet by taking cold rolled coils, and in some instances, hot rolled coils, heating it in an annealing furnace and run the sheet steel, while still hot, through a pot of molten zinc. As the steel strip leaves the pot, coating controls ensure product specifications match customer requirements. The steel’s corrosion resistance makes it ideal for applications like air conditioning units, air ducts, metal ties, studs, siding, decking and roofing.
We currently operate two continuous galvanizing lines and believe that our galvanizing facilities can produce the full range of coated steel. The first continuous galvanizing line is horizontally configured and produces gauges from 0.016” to 0.173”, with a capacity of 482,000 tons per year. The second continuous galvanizing line is vertically configured and produces gauges from 0.010” to 0.057”, with a capacity of 372,000 tons per year.
Electric Resistance Weld (ERW) Pipe Mill
We produce ERW pipe by roll forming hot rolled skelp into a pipe shape, welding the edges together with a high frequency welder, annealing the weld and cutting the finished product to length on a continuous line. The ERW pipe may then undergo additional testing and/or finishing operations like hydrotesting and end beveling.
The pipe mill produces pipe with outside diameters ranging from 6.625” to 16” and wall thickness ranging from 0.156” to 0.375”, with lengths available up to 63 feet without mid-weld. Process coating is available through local coating applicators, one of whom leases space on our property. The ERW pipe mill has a current capacity of approximately 260,000 tons per year.
Semi-Finished Steel Slab and Suppliers
Steel slab is a semi-finished steel raw material in rectangular form and is generally the first form taken by molten steel after it solidifies. The principal users of steel slab are steel producers or processors that roll slab into finished products like plate or coil.
Historically, raw material costs comprise approximately 70% to 75% of our cost of goods sold. In the past few years, raw materials costs have increased due to higher slab and zinc costs and in 2006, our raw materials costs were approximately 80% of our cost of goods sold. We are one of the largest importers and one of the largest purchasers of slab in the world. We purchase slab from a diverse group of foreign suppliers to obtain high quality steel at competitive cost through reliable sources. Our foreign vendors are located in Brazil, Mexico, Australia, Japan, Russia, Venezuela and China.
We typically make our slab purchases on a quarterly basis. As of December 31, 2006 we were committed, in the form of open purchase orders, to purchase approximately $167.4 million in steel slabs. We negotiate slab procurement for longer periods when our purchasing power combined with market conditions provide us with the opportunity to negotiate on terms which we believe are favorable to us.
Although we are not reliant on any one single vendor, in 2006, we purchased approximately 23% of our slab from Arcelor Mittal Steel Lazaro Cardenas, approximately 21% from Companhia Siderurgica de Tubarão of Brazil (“CST-Arcelor Mittal”) and approximately 21% from Bluescope Steel of Australia.
In 2005, we completed the sale of our 4% interest in the common stock of CST to Arcelor S.A. (“Arcelor”). All slab purchases with CST before the sale of our interest to Arcelor were negotiated on an “arm’s length” basis and in accordance with market conditions. Accordingly, we continue to purchase slab from CST when we believe terms are favorable.
We negotiate with a variety of shipping companies to deliver our slab directly to the Port of Los Angeles. The vessels are loaded following a specific stowage plan that we developed. The plan is designed to provide high productivity rates at both the loading and unloading sites. Our agents are on site for the loading of each shipment. After unloading, the slab is transported to our facility by rail using the services of Burlington Northern Santa Fe Railroad. Our current contract with Burlington Northern Santa Fe Railroad is effective through December 2013. This agreement provides us with transportation services at fixed rates and
ensures us a dedicated level of rail availability through the term of the agreement. Additionally, Burlington Northern Santa Fe Railroad utilizes rail cars designed specifically to transport steel slab. We believe this improves the efficiency and safety of steel slab transportation through our community.
We believe that our integrated slab procurement system allows us to manage our slab inventory levels, improve tonnage levels as well as the slab quality necessary to meet our customers’ order specifications. As of December 2006, we had what we believed to be firm backlog orders to sell approximately 122,000 tons. Based on our average sales price at that time, the backlog value was approximately $92,663,000. As of December 2005, we had what we believed to be firm backlog orders of approximately 269,000 tons. Based on our average sales price at that time, the backlog value was approximately $169,138,000.
Marketing and Customer Service
We believe that we provide a high level of customer service and product support in the western U.S. market. Our emphasis on customer service and product quality has enabled us to establish long-standing relationships with our customers. Our relationships with 90% of our top 30 customers extend beyond 10 years. We attribute this customer loyalty, in large part, to the successful execution of our marketing strategies to provide a broad range of products and our ability to provide consistent service, reliable product availability and ancillary value added services.
We are the only producer of flat rolled steel products located in the western United States who can supply hot rolled, cold rolled and galvanized coil and sheet. We also produce ERW pipe in diameters ranging from 6.625” to 16.0”. We believe that we are well equipped to provide “one-stop shopping” for our customers and we believe that this maximizes sales opportunities and increases the convenience and value of the service we provide to customers. We will continue to invest in the quality of our products across all product lines, allowing us to market ourselves as a full-service provider of flat rolled steel in the region.
Our location in southern California not only gives us a significant freight cost advantage over our competitors, but also allows us to provide a more service-oriented approach to our customers. Our operating structure allows us to respond quickly to changes in the timing of customer requirements, adjust schedules, source stock inventory and meet specialized shipping needs. Our ability to deliver made-to-order products in a timely manner allows our customers to maximize their inventory turns and meet production targets. By maintaining a regional focus, we believe that we can most effectively service our customers and achieve our goal of increasing market share in higher margin value added products.
As part of our strategy to provide superior customer service, upon request of our current and prospective customers, we offer ancillary services such as engineering and metallurgical services to assist such customers with specific product needs. Substantial portions of our customers are small to medium-sized businesses. As a result, many do not have the resources to employ a sophisticated metallurgical engineering staff. Our metallurgical engineers work with our customers on a daily basis, often on site, providing advisory services focused on reducing procurement costs and improving overall production efficiency. These services are provided at no charge and no revenues are generated for such services.
Competition
The steel industry is cyclical in nature and highly competitive. We compete with domestic and foreign steel producers on the basis of customer service, product quality and price. We believe that the competitive landscape within the steel industry will continue to evolve, especially as mergers and acquisitions continue worldwide. We believe that because of our slab-based business model, breadth of products, non-union work environment, southern California location and long-standing customer relationships, we are well positioned to meet competitive threats. However, some of our competitors are larger and may have substantially greater capital resources, more modern technology and lower production costs than us, as well as excess production capacity in some products and could exert downward pressure on prices for some of our products in the future.
We are also subject to general economic trends and conditions, such as the presence or absence of sustained economic growth and currency exchange rates. We are particularly sensitive to trends in the construction, oil and gas transmission industries because these industries are significant markets for our steel products. If there were a downturn in one or more of these industries, our sales volume, prices, profitability and liquidity could be adversely affected.
U. S. Competition
High transportation costs have historically deterred mid-western and eastern steel producers from accessing the western United States market, a condition that continued during 2006, along with demand for products in their markets. However, continued competition from these mills at any significant level could negatively impact sales tonnage and average sales prices.
In hot rolled products, our principal domestic competition comes from a number of producers located in the Midwestern United States, although this is cyclical in nature, based on economic conditions in the mid-western markets. Some hot rolled products are produced by Oregon Steel Mills, located in Portland, Oregon, although Oregon Steel Mills typically ships to customers located in the Northwest United States. USS-POSCO Industries (UPI), located in Pittsburg, California is our principal competitor in galvanized and cold rolled products. We also compete in the galvanized market with Steelscape, Inc., which operates facilities located in Kalama, Washington and Rancho Cucamonga, California. We face increasing competition from producers of materials such as aluminum, composites, plastics and concrete that compete with steel in many markets.
Foreign Competition
Historically, foreign steel producers have competed in the western United States in all of our product categories. Although imported steel has relatively long lead times to reach the western United States markets, economic and currency dislocations in foreign markets may encourage importers to target the United States with excess capacity at aggressive prices. Some foreign producers benefit from low labor costs, weak local currencies and government subsidies. The surge of imported steel at discounted prices into the western United States impacted market conditions for our steel products, particularly during the second half of the year, increasing inventory levels at some of our customers. We think that is also cyclical and we do not believe it to be long-term in nature.
Employee Relations
At December 31, 2006, we had 931 full-time employees. We believe we have the largest non-union workforce located at any one steel facility in the United States. We provide our employees with supplemental work training and education programs. Our officers also routinely discuss our business plan with them. We believe that we have a good relationship with our employees.
Environmental Matters
Compliance with environmental laws and regulations is a significant factor in our business. We are subject to various federal, state and local environmental laws and regulations concerning, among other things, air emissions, waste water discharges and hazardous materials handling and waste disposal. We own property and conduct or have conducted operations at properties that are contaminated with hazardous materials and will require investigation and remediation according to federal, state or local environmental laws and regulations. Expenditures on environmental matters, including expenditures on pollution control equipment and remediation activities, totaled approximately $1.4 million in 2004, $1.4 million in 2005 and $1.3 million in 2006. We plan to spend approximately $1.6 million in 2007.
In 1996, we entered into an Expedited Remedial Action Voluntary Enforceable Agreement with the California Environmental Protection Agency, Department of Toxic Substances Control (“DTSC”). This agreement superseded a Voluntary and Enforceable Agreement and Imminent and/or Substantial Endangerment Order issued by the Department in 1992 and amended in 1994. According to the agreement, we engaged an environmental consultant to conduct a remedial investigation and develop a remediation plan and remediation cost projections based upon that plan. Utilizing the remediation plan developed by the environmental consultant, we developed an estimate for future costs of the remediation plan. The total aggregate cost of remediation was estimated to be approximately $1.8 million, which was accrued in 2002 and is included in other accrued expenses in 2006, 2005 and 2004 in our consolidated financial statements. The DTSC has not yet completed its review and approval of our remediation plan; however, preliminary discussions with the DTSC have not indicated the need for any significant changes to the remediation plan or to the Company’s estimate of related costs. The estimate of costs could change as a result of changes to the remediation plan required by the DTSC or unforeseen circumstances at the site, including without limitations, unknown site conditions, changes to applicable regulations or increased enforcement requirements by the regulators existing at the site.
Forward-Looking Statements
Certain information included in this Form 10-K and other materials filed or to be filed by us with the Securities and Exchange Commission (as well as information included in oral or written statements made by us or on our behalf) may contain forward-looking statements about our current and expected performance trends, growth plans, business goals and other matters. These statements may be contained in our filings with the Securities and Exchange Commission, in our press releases, in other written communications, and in oral statements made by or with the approval of one of our authorized officers. Words or phrases such as “believe,” “plan,” “will likely result,” “expect,” “intend,” “will continue,” “is anticipated,” “estimate,” “project”, “may,” “could,” “would,” “should” and similar expressions are intended to identify forward-looking statements. These statements, and any other statements that are not historical facts, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, as codified in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended from time to time (the “Act”).
In connection with the “safe harbor” provisions of the Act, we are filing the following summary to identify important factors, risks and uncertainties that could cause our actual results to differ materially from those projected in forward-looking statements made by us, or on our behalf. These cautionary statements are to be used as a reference in connection with any forward-looking statements. The factors, risks and uncertainties identified in these cautionary statements are in addition to those contained in any other cautionary statements, written or oral, which may be made or otherwise addressed in connection with a forward-looking statement or contained in any of our subsequent filings with the Securities and Exchange Commission. Because of these factors, risks and uncertainties, we caution against placing undue reliance on forward-looking statements. Although we believe that the assumptions underlying forward-looking statements are reasonable, any of the assumptions could be incorrect, and there can be no assurance that forward-looking statements will prove to be accurate. Forward-looking statements speak only as of the date on which they are made. We do not undertake any obligation to modify or revise any forward-looking statement to take into account or otherwise reflect subsequent events, or circumstances arising after the date that the forward-looking statement was made.
The following risk factors may affect our operating results and the environment within which we conduct our business. If our projections and estimates regarding these factors differ materially from what actually occurs, our actual results could vary significantly from any results expressed or implied by forward-looking statements. In addition to the risks and uncertainties referenced in this Annual Report on Form 10-K, these risk factors include, but are not limited to:
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Fluctuations in raw materials and freight prices as a result of changes in global steel consumption;
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Our substantial indebtedness, interest expense and principal repayment obligations under our bank facility, when drawn upon, and 6.125% senior notes, which could limit our ability to use operating cash flow in our business other than for debt-servicing obligations, obtain additional financing and react to changing market and general economic conditions, and which increase our vulnerability to interest rate increases;
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The possibility of deadlocks among our board of directors that could result in delays in making important business decisions which could result in a competitive disadvantage due to the size of our board currently consisting of four members as elected by our two stockholders, each of whom holds 50% of our stock;
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Fluctuations in commodity prices for our electricity and natural gas requirements, as well as the viability of the electrical power distribution system within the State of California;
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Possible adverse effects resulting from new U.S. trade measures or increases in tariffs on imported steel slab;
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Competitive factors and pricing pressures;
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The Company’s ability to control costs and maintain quality;
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Future expenditures for capital projects;
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Fluctuations in the cost of management and hourly labor or other resources necessary to successfully operate the Company’s manufacturing plant;
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The Company’s ability to raise prices sufficiently to offset cost increases, including increased costs for minimum wages, employee benefits and insurance arrangements;
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Legal claims and litigation against the Company;
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Changes in, or any failure to comply with, governmental regulations;
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Industry-wide market factors and general economic and business conditions; changes in general economic, demographic, geopolitical or public safety conditions which affect consumer behavior and spending for the products which use our goods, including the ongoing ramifications of the September 11, 2001 terrorist attacks and the governmental response thereto, including the continuing armed conflict in Iraq or in other countries; and
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Changes in accounting standards or interpretations of existing standards adopted by the Financial Accounting Standards Board, the Securities and Exchange Commission, and the American Institute of Certified Public Accountants that could impact the Company’s reported financial results.
Item 2.
Item 2. Properties
We are located on approximately 443 acres in Fontana, California. Our facilities are situated on approximately 115 acres of this space. The property includes a 22 mile railroad system serviced by Burlington Northern Santa Fe and Union Pacific rail lines.
Item 3.
Item 3. Legal Proceedings
The Company is subject to lawsuits, administrative proceedings and claims that arise in the ordinary course of our business. We believe that the final disposition of such lawsuits, proceedings and claims will not have a material adverse effect on our financial position, results of operations or liquidity. It is possible, however, that our future results of operations for a particular quarter or fiscal year could be impacted by changes in circumstances relating to lawsuits, proceedings or claims.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
In June 2006, draft resolutions were circulated to the shareholders of the Company seeking approval of a conversion of the 3,000 issued and outstanding shares of Class C preferred stock of the Company into 3,000 shares of common stock of the Company in a straight one to one conversion. The shareholders were further asked to approve an amendment to the Certificate of Incorporation of the Company to increase the authorized number of common shares from 2,000 to 5,000 to allow for the conversion. The shareholders adopted resolutions approving both the conversion and the amendment to the Certificate of Incorporation pursuant to a unanimous written consent which became effective in July 2006. The amendment to the Certificate of Incorporation was filed with the Delaware Secretary of State on July 25, 2006.
As a result of the conversion, the $30 million carrying value of the Class C redeemable preferred stock was reclassified to shareholders’ equity as part of common stock.
PART II
Item 5.
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters
Not applicable.
Item 6.
Item 6. Selected Consolidated Financial Data
The selected consolidated financial information presented below as of and for the fiscal years ended December 31, 2006, 2005, 2004, 2003, and 2002, has been derived from the Company’s audited consolidated financial statements. The consolidated balance sheets as of December 31, 2006 and 2005 and the consolidated statements of operations for the years ended December 31, 2006, 2005, and 2004 are contained elsewhere in this Form 10-K. The following selected consolidated financial information is qualified by reference to, and should be read in conjunction with the historical consolidated financial statements, including notes accompanying them and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” found elsewhere in this Form 10-K.
(1) Common share cash dividends are distributed to the holders of the shares of common stock of the Company at the time the dividends are declared. See Item 12 - Security Ownership of Certain Beneficial Owners and Management.
(2) EBITDA is defined as net income, plus income taxes, net interest expense and depreciation and amortization. In the Company’s presentation of EBITDA, as adjusted, we also included non-cash unamortized deferred cost of $2,155,000 on 8.5% senior notes redeemed in 2004. EBITDA, as adjusted, is not intended to represent cash flows from operations, cash flows from investing or cash flows from financing activities as defined by accounting principles generally accepted in the United States of America and should not be considered as an alternative to cash flow or a measure of liquidity or as an alternative to net earnings (loss) as indicative of operating performance. EBITDA, as adjusted, is included because management believes that investors find it a useful tool for measuring our ability to service the Company’s debt.
EBITDA, as adjusted, is reconciled to cash flows provided by operating activities, the most comparable measure under generally accepted accounting principles as follows (in thousands):
(3) EBITDA, as adjusted, margin represents EBITDA, as adjusted, per (2) above divided by net sales.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction
From Fontana, California, the Company produces flat rolled steel products: hot rolled, cold rolled, and galvanized, as well as ERW pipe, with a current annual finished shipment capability of approximately 2.0 million tons. The Company services a broad range of customers with applications that include pipe and tubing, heating, ventilating and air conditioning, strapping, drums, steel wheels and a variety of construction related products.
The Company ships products by truck and rail to manufacturers, contractors and distributors primarily in the 11 states west of the Rocky Mountains. The Company generally sells products free on board (FOB) shipping point, and title is transferred when
products are loaded for shipment. The Company recognizes revenue from product sales when products are shipped or delivered to the customer, depending on the terms of the sale. For products shipped FOB shipping point, revenue is recognized at the time of shipment and title has transferred to the customer. For products shipped FOB destination, revenue is recognized at the time of delivery and title is transferred to the customer. The Company’s revenue is dependent on the volume, product mix and sales prices of its products. General economic conditions as well as the supply and demand of steel products within the Company’s market influence sales prices. Management generally set its sales prices quarterly, and maintains no long-term sales agreements.
Cost of goods sold consists primarily of raw materials, labor, natural gas, electricity, depreciation and zinc costs. Raw material costs have historically comprised approximately 70% to 75% of the Company’s cost of goods sold. In 2006, the Company’s raw material costs continued to remain above its historical average at approximately 80% of its costs of goods sold as a result of higher slab and zinc costs. The Company’s slab consumption unit cost in 2006 was 6% lower than 2005 and 18% higher than 2004.
The Company generally purchases steel slab in boatload quantities. Imported slab arrives on chartered vessels in the Port of Los Angeles and is transported by rail to its Fontana facility. The Company generally purchases steel slab on open negotiated payment terms. Steel slab consumption costs include the FOB value of steel slab, quality extras, ocean transportation, rail freight, duties, unloading, insurance and handling costs. Historically, the Company has negotiated slab FOB prices quarterly and other rates through contracts of varying lengths. The Company’s purchasing power and management’s extensive knowledge of the worldwide slab market continues to provide the Company with the opportunity to negotiate with slab suppliers on terms that management believes are favorable. Management will continue to actively manage slab procurement to minimize costs and may opportunistically purchase slab in the future.
The Company uses zinc in the production of its galvanized products. The Company currently purchases zinc from various suppliers. Zinc is purchased on a monthly basis with both fixed price and floating price contracts and is priced using a formula tied to the London Metals Exchange zinc index plus negotiated delivery premiums. As zinc prices have been at historically high levels, the Company did not lock in pricing for any of its zinc requirements for 2007.
The Company’s daily average electrical demand is approximately 40 megawatts to operate production equipment in manufacturing its product. The Company is currently a full-service bundled utility customer of Southern California Edison. During 2007, the Company’s electricity costs are not expected to change materially from 2006 levels. In 2006, the Company’s electricity costs accounted for approximately 2.8% of its cost of goods sold compared to approximately 2.5% in 2005.
The Company generally utilizes a daily average of approximately 12,000 million British thermal units, or MMBTUs, of natural gas to produce its products. To stabilize price volatility, management regularly uses a risk management approach to fix the price on portions of the Company’s natural gas requirements up to two years ahead through financial and/or physical hedging arrangements. These arrangements include fixed-price contracts for the New York Mercantile Exchange (“NYMEX”), and/or the Southern California border basis (basis represents the difference between the NYMEX price at Henry Hub, Louisiana and the price at the Southern California border).
The Company currently has in place fixed price purchase agreements for approximately 40% of its natural gas commodity requirements for 2007, and approximately 40% of basis. Management continues to monitor the near and long term price trends of natural gas and may enter into additional purchase agreements when deemed appropriate or when opportunities present themselves. In 2006, the Company’s natural gas costs accounted for approximately 3.1% of its cost of goods sold compared to approximately 2.9% in 2005.
Selling, general and administrative expense consist primarily of sales and labor, and various administrative expenses. In 2006, labor costs comprised approximately 55% of the Company’s total selling, general and administrative expenses compared to 57% in 2005.
Results of Operations
The steel industry is cyclical in nature. Demand during the first half of 2005 was lower than typically seen during this period. By the third quarter of 2005 and continuing through the end of the year, demand returned to normal levels. In 2006, demand for our flat-rolled products was very strong during the first six months, but tapered off slightly during the second half of the year. This was the effect of a combination of factors, but mostly in response to high import levels of galvanized steel.
Demand for ERW pipe products, however, was strong in 2005 and grew again in 2006. This is anticipated to continue through 2008, with the construction of gas and oil pipelines throughout the western United States.
Prices for all products were generally stable throughout the year; however, prices for galvanized products rose substantially in response to rising zinc costs. Volumes sold by product line are as follows:
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Net sales. Net sales were $1,358,762,000 for the year ended December 31, 2006, an increase of $124,376,000 or 10.1%, compared to net sales of $1,234,386,000 for the same period in 2005. The Company’s average sales price increased by more than $23 per ton increasing its net sales by approximately $33,548,000 while an increase in volume added approximately $80,741,000 to its net sales. The Company sold 1,930,178 net tons in 2006, an increase of 116,147 net tons, when compared to 1,814,031 net tons in 2005. This increase is attributable to an increase in demand for the Company’s products as a result of market conditions. The change in product mix when compared to prior year increased the Company’s net sales by approximately $11,371,000.
Gross profit. Gross profit increased $101,799,000 from $114,118,000 last year to $215,917,000 this year. Gross profit as a percentage of net sales also increased from 9.2% in 2005 to 15.9% in 2006. The main reason for the increase in the Company’s gross profit was the result of increase sales volume at a higher average sales price per ton and lower average slab costs in 2006 compared to 2005. The higher zinc consumption cost per ton partially off set the increase in gross profit attributable to in the increase in sales volume at a higher average sales price per ton as well as the lower average slab costs in 2006.
Selling, general and administrative (SG&A) expenses. Selling, general and administrative expenses increased $2,127,000 from $27,669,000 last year to $29,796,000 this year, primarily due to increase in salaries and wages, including profit sharing. However, the Company’s SG&A expenses as a percentage of net sales remained unchanged with 2.2% in both 2006 and 2005.
Gain (loss) on disposition of property, plant and equipment (PP&E). For the year ending December 31, 2006, the Company suffered a net loss of $1,293,000 on the disposition of PP&E compared to a net gain of $2,071,000 for the same period in 2005. This change was mainly attributable to the gain on the sale of surplus land of $3,600,000 sold in 2005. There was no such gain in 2006.
Net interest expense. Net interest expense decreased $6,143,000 from $11,299,000 last year to $5,156,000 this year. The decrease in net interest expense is attributable to in an increase in interest income of $4,151,000 from 2005 to 2006. The increase in interest income is due to the higher cash balance maintained during the year. Interest expense figures are net of interest income and capitalized interest of $5,362,000 and $1,271,000 in 2006 and 2005, respectively.
Other income (expense), net. Net other income (expense) decreased $3,459,000 from income of $3,308,000 last year to an expense of $151,000 this year. Other income (expense) is comprised of miscellaneous income items such as rental income, proceeds from legal settlements, refund from anti dumping subsidy, etc. As many of these items occur infrequently or result in a one-time recognition of income, this category is subject to significant fluctuation from year to year.
Income tax expense. Income tax expense increased $33,372,000 from $37,164,000 last year to $70,536,000 this year. This increase is attributable to the increase in pretax income from last year. The effective tax rate for 2006 was 39.3% compared to an effective tax rate of 46.1% in 2005. The decrease in the effective tax rate was attributable to foreign tax credits and an increase in state tax deductions.
Net income. Net income for 2006 was $108,985,000 compared to the net income of $43,365,000 in 2005.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
Net sales. Net sales were $1,234,386,000 for the year ended December 31, 2005, a decrease of $22,606,000 or 1.8%, compared to net sales of $1,256,992,000 for the same period in 2004. The Company’s average sales price increased by more than $82 per ton increasing its net sales by approximately $143,624,000 while the decrease in volume reduced its net sales by approximately $174,859,000. The Company sold 1,814,031 net tons in 2005, a decrease of 292,339 net tons, when compared to 2,106,370 net tons in 2004. This decrease is attributable to a decrease in demand for the Company’s products as a result of market conditions. The change in product mix when compared to prior year increased the Company’s net sales by approximately $6,346,000.
Gross profit. Gross profit decreased $122,558,000 from $236,676,000 for the year ended December 31, 2004 to $114,118,000 for the year ended December 31, 2005. Gross profit as a percentage of net sales also decreased from 18.8% in 2004 to 9.2% in 2005. The main reason for the decrease in the Company’s gross profit was the result of a higher average slab consumption cost per ton in 2005 compared to 2004. The higher average slab consumption cost per ton was partially off set by the increase in the average sales price per ton in 2005.
Selling, general and administrative (SG&A) expenses. Selling, general and administrative expenses decreased $1,510,000 from $29,179,000 for the year ended December 31, 2004 to $27,669,000 for the year ended December 31, 2005, primarily due to a decrease in salaries and wages, including profit sharing. However, the Company’s SG&A expenses as a percentage of net sales remained comparable, 2.2% in 2005 and 2.3% in 2004.
Gain (loss) on disposition of property, plant and equipment (PP&E). For the year ending December 31, 2005, the Company had a net gain of $2,071,000 on the disposition of PP&E compared to a net loss of $546,000 for the same period in 2004. This increase was mainly attributable to the sales of surplus land for a gain of $3,600,000.
Loss on redemption of 8.5% senior notes. In 2004, the Company incurred a loss of $9,025,000 from the early redemption of its 8.5% senior notes due in 2009. There was no such redemption in 2005.
Income (loss) from equity investment in affiliate. During 2004, the Company entered into an option and waiver agreement with Arcelor S.A. (“Arcelor”) regarding Arcelor’s acquisition of our 4% interest in the common stock (which equates to 1.5% of total shareholders’ equity) in Companhia Siderurgica de Tubarão (“CST”). The Company and Arcelor were both shareholders in CST and were parties to the CST Shareholders’ Agreement governing the transfer of CST’s shares. Pursuant to the option agreement, Arcelor granted the Company an option to sell, and the Company granted to Arcelor an option to purchase the Company’s interest in CST. These options could be exercised during the thirty day period following the termination of the CST Shareholders’ agreement on May 25, 2005. Under the option agreement, all earnings or losses as well as dividends and distributions accrued to the benefit of Arcelor during the period from execution of the option agreement to the date it was exercised. In June 2005, the Company exercised its option and sold its investment. There was no gain or loss on the sale in 2005 compared to a net loss of $3,047,000 in 2004.
Net interest expense. Net interest expense increased $639,000 from $10,660,000 for the year ended December 31, 2004 to $11,299,000 for the year ended December 31, 2005. The increase in interest expense represents interest on Federal and State taxes. Interest expense figures are net of interest income and capitalized interest of $1,271,000 and $239,000 in 2005 and 2004, respectively.
Other income, net. Net other income increased $2,784,000 from $524,000 for the year ended December 31, 2004 to $3,308,000 for the year ended December 31, 2005. Other income is comprised of miscellaneous income items such as rental income, proceeds from legal settlements, refund from anti dumping subsidy, refund of property taxes, etc. As many of these items occur infrequently or result in a one-time recognition of income, this category is subject to significant fluctuation from year to year.
Income tax expense. Income tax expense decreased $38,244,000 from $75,408,000 for the year ended December 31, 2004 to $37,164,000 for the year ended December 31, 2005. This decrease is attributable to a decrease in pretax income in 2005
compared to 2004. The effective tax rate for 2005 was 46.1% compared to an effective tax rate of 40.8% in 2004. The increase in the effective tax rate was attributable to foreign taxes withheld on the sale of the CST stock investment and an increase in states taxes in 2005.
Net income. Net income for 2005 was $43,365,000 compared to the net income of $109,335,000 in 2004.
Liquidity and Capital Resources
At December 31, 2006, the Company had $5,561,000 in cash and cash equivalents and approximately $108,877,000 available under its bank facility. During the year, cash flow from operations provided $14,487,000, which consisted of $108,985,000 in net income, $29,496,000 in depreciation and amortization expense and a net cash flow decrease of $121,125,000 due to changes in assets and liabilities. Operating cash flow increased primarily as a result of a $2,945,000 decrease in other receivables and prepaid expenses. Operating cash flow decreased as a result of a $6,303,000 increase in accounts receivable, $95,044,000 increase in inventories, $13,626,000 decrease in accounts payable and $9,655,000 decrease in income tax payable. Cash flow from investing activities consisted primarily of $33,163,000 in capital expenditures. Cash flow from financing activities consisted of $79,118,000 paid as dividends to our shareholders. In 2006, the Company also paid $9,187,500, representing payment of interest on its 6.125% senior notes due in 2014.
In September 2005, the Company entered into a new five year $110,000,000 credit facility with a bank group led by Mizuho Corporate Bank, as administrative agent and a lender, The Bank of Tokyo-Mitsubishi, Ltd., Citibank (West), FSB and Wells Fargo Bank. Subject to the satisfaction of customary conditions and a borrowing base, advances under this new credit facility may be made at any time prior to the credit facility termination date. There were no outstanding borrowings under this facility as of December 31, 2006. The credit facility is collateralized by accounts receivable and inventory. Advances under this facility may be used for letters of credit, working capital, capital expenditures, payment of dividends and other lawful corporate purposes, including the refinancing of existing debt.
On March 22, 2004, the Company issued an aggregate of $150,000,000 of ten-year, 6.125% senior unsecured notes due in March 2014. With the proceeds of this issuance and cash on hand, the Company retired its 8.50% senior notes due in 2009. Interest on its 6.125% senior notes is payable on March 15 and September 15 of each year. The notes are senior in right of payment to all of the Company’s subordinated indebtedness and equal in right of payment to all of its existing and future indebtedness that is not by its terms subordinated to the notes. The Company may redeem the notes at any time after March 15, 2009. In addition, the Company may redeem up to 35% of the notes before March 15, 2007 with the net cash proceeds from a public equity offering. The indenture governing the notes contains covenants that limit the Company’s ability to incur additional indebtedness, pay dividends, redeem or repurchase capital stock and make investments, create liens, sell assets, sell capital stock of certain subsidiaries, engage in transactions with affiliates and consolidate, merge or transfer all or substantially all of its assets and the assets of certain subsidiaries on a consolidated basis.
In July 2006, the Company converted its 3,000 shares of Class C preferred stock to 3,000 shares of common stock. The Company also increased its authorized shares of common stock from 2,000 to 5,000 shares. The conversion of preferred stock to common stock has no impact on the Company’s current or long-term liquidity.
The Company currently has approximately $8,831,000 in material commitments for capital expenditures expected to be completed during fiscal 2007. These represent signed purchase orders for various production facility upgrades. The Company’s total budget for capital improvements in 2007 is approximately $33,000,000.
The Company anticipates that its primary liquidity requirements will be for working capital, capital expenditures, debt service and the payment of dividends. The Company believes that cash generated from operations and available borrowings under its bank facility will be sufficient to meet its liquidity requirements for fiscal 2007.
Commitments and Contingencies
The following table represents a comprehensive list of the Company’s contractual obligations and commitments as of December 31, 2006 (in thousands):
(1) Amounts relate to contractual commitments to purchase $167,431,000 ($63,300,000 from related parties) of steel slabs and the remaining in assorted other contractual commitments.
(2) Amounts represent the annual accrued interest on the Company’s $150,000,000 ten year 6.125% senior unsecured notes, which are due and payable in March 2014.
(3) Amounts reflect the anticipated expenditures on environmental matters pursuant to a proposed remediation plan submitted to the California Department of Toxic Substances Control. See discussion in Item 1 - Environmental Matters.
When market conditions warrant, the Company will enter into contracts to purchase certain commodities used in the manufacturing of its products, such as electricity and natural gas. Some of these forward contracts do not require derivative accounting as the Company takes possession of the commodities in the normal course of business whereas other forward contracts are accounted for as derivatives in accordance with SFAS No. 133 by the Company. None of the Company’s current contracts are designated as hedges.
Critical Accounting Policies
In December 2001, the Securities and Exchange Commission (“SEC”) requested that all registrants list their most “critical accounting policies” in Management’s Discussion and Analysis of Financial Condition and Results of Operations. The SEC indicated that a “critical accounting policy” is one which is both important to the portrayal of the company’s financial condition and results of operations and requires management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. The Company believes that the following accounting policies fit this definition:
Allowance for Doubtful Accounts: The Company has attempted to reserve for expected credit losses based on past experience with similar accounts receivable and believes its reserves to be adequate. It is possible, however, that the accuracy of the Company’s estimation process could be materially impacted as the composition of this pool of accounts receivable changes over time. The Company continually reviews and refines the estimation process to make it as reactive to these changes as possible; however, it cannot guarantee that it will be able to accurately estimate credit losses on these accounts receivable.
Environmental Reserve: The Company has engaged an environmental consultant to conduct a remedial investigation and develop a remediation plan and remediation cost projections based upon that plan. Utilizing the remediation plan developed by the environmental consultant, the Company developed an estimate for future costs of the remediation plan. The total aggregate cost of remediation is estimated to be approximately $1,800,000, which was accrued in 2002 and is included in accrued expenses in the 2006 and 2005 consolidated financial statements. The California Department of Toxic Substances Control (“DTSC”) has not yet completed its review and approval of the Company’s plan; however, preliminary discussions with DTSC have not indicated the need for any significant changes to the remediation plan or to the Company’s estimate of related costs. The estimate of costs could change as a result of changes to the remediation plan required by the DTSC or unforeseen circumstances at the site.
Self-insurance Liability: The Company is self-insured for workers’ compensation. The accrued liability associated with these programs is based on management’s estimate of the ultimate costs to settle known claims as well as claims incurred but not yet reported (“IBNR claims”) as of the balance sheet date. The estimated liability is not discounted and is based on information provided by the Company’s insurance brokers and insurers, combined with management’s judgments regarding a number of assumptions and factors, including the frequency and severity of claims, the Company’s claims development history, case jurisdiction, related legislation, and the Company’s claim settlement practice. Significant judgment is required to estimate IBNR claims as parties have yet to assert such claims. If actual claim trends, including the severity or frequency of claims, differ from management’s estimates, the Company’s financial results could be impacted.
Revenue Recognition: The Company recognizes revenue when products are shipped or delivered to the customer, depending on the terms of the sale. For products shipped FOB shipping point, revenue is recognized at the time of shipment when title and risk of loss are transferred to the customer. For products shipped FOB destination, revenue is recognized at the time of delivery. In certain cases, at the customer’s request, the Company will enter into bill and hold transactions whereby title transfers to the customer, but the product does not ship until a specified later date. Revenue on such transactions is recognized when the product is ready for shipment, and only after all conditions set forth under Staff Accounting Bulletin (SAB) No. 104 have been met.
Recently Issued Accounting Standards
In February 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140,” (“SFAS 155”). SFAS 155 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” SFAS 155 resolves issued addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” Among other provisions, the new rule (a) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (b) clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133, (c) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (d) clarifies that concentrations of credit risk in the form of subordination are not embedded derivates, and (e) amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for fiscal years beginning after September 15, 2006 and is required to be adopted by the Company in the first quarter of fiscal year 2007, beginning January 1, 2007. The Company is currently evaluating the effect that the adoption of SFAS 155 will have on its consolidated results of operations and financial position or cash flows, but does not expect it to have a material impact.
In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets - an amendment of FASB Statement No. 140,” (“SFAS 156”). SFAS 156 amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS 156 is effective for fiscal years beginning after September 15, 2006 and is required to be adopted by the Company in the first quarter of fiscal year 2007, beginning January 1, 2007. The Company is currently evaluating the effect that the adoption of SFAS 156 will have on its consolidated results of operations and financial position or cash flows, but does not expect it to have a material impact.
In July 2006, the FASB issued Final Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of SFAS No. 109,” (“FIN 48”). FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. In addition, FIN 48 excludes income taxes from the scope of SFAS No. 5, Accounting for Contingencies. FIN 48 is effective for fiscal years beginning after December 15, 2006. Differences between the amounts recognized in the consolidated balance sheets prior to the adoption of FIN 48 and the amounts reported after adoption will be accounted for as a cumulative-effect adjustment
recorded to the beginning balance of retained earnings. The Company is currently evaluating the effect that the adoption of FIN 48 will have on its results of operations and financial position.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS are effective for fiscal years beginning after November 15, 2007 and is required to be adopted by the Company in the first quarter of fiscal year 2008, beginning January 1, 2008. The Company is currently evaluating the effect that the adoption of SFAS 157 will have on its consolidated results of operations and financial position or cash flows, but does not expect it to have a material impact.
In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. Traditionally, there have been two widely-recognized methods for quantifying the effects of financial statement misstatements: the “roll-over” method and the “iron curtain” method. The roll-over method focuses primarily on the impact of a misstatement on the income statement, including the reversing effect of prior year misstatements, but its use can lead to the accumulation of misstatements in the balance sheet. The iron-curtain method, on the other hand, focuses primarily on the effect of correcting the period-end balance sheet with less emphasis on the reversing effects of prior year errors on the income statement. In SAB No. 108, the SEC Staff established an approach that requires quantification of financial statement misstatements based on the effects of the misstatements on each financial statement and the related financial statement disclosures. This model is commonly referred to as a “dual approach” because it requires quantification of errors under both the iron curtain and the roll-over methods. The Company adopted SAB No. 108 in the fourth quarter of 2006. This adoption did not have a material impact on the Company’s consolidated its results of operations and financial position or cash flows.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The Company is exposed to market risks related to fluctuations in interest rates on its 6.125% senior notes and its $110,000,000 floating interest rate bank facility. The Company does not currently use interest rate swaps or other types of derivative financial instruments. The carrying value of the floating rate bank facility approximates fair value as the interest rate is variable and resets frequently. The bank facility bears interest at the Eurodollar rate or the prime rate, which was approximately 5.875% (three month rate) (including margin) and 8.25%, respectively, at December 31, 2006. The Company estimates that the average amount of debt outstanding under the facility for fiscal year 2007 will be approximately $2,000,000. Therefore, a one-percentage point increase in interest rates would result in an increase in interest expense of $20,000 for the year.
For fixed rate debt instruments such as the Company’s 6.125% senior notes, changes in interest rates generally affect the fair value of such debt instruments. For variable rate debt such as its bank facility, changes in interest rates generally do not affect the fair value of such debt, but do affect earnings and cash flow. The Company does not have an obligation to repay its 6.125% senior notes prior to maturity in 2014 and, as a result, interest rate risk and changes in fair value should not have a significant impact on the Company. The Company believes that the interest rate on its 6.125% senior notes approximates the current rates available for similar types of financing and as a result the carrying amount of the 6.125% senior notes approximates fair value. The fair value of the Company’s senior notes at December 31, 2006 was approximately $142,500,000. The Company does not believe that the future market rate risk related to its 6.125% senior notes and floating rate bank facility will have a material impact on its financial position, results of operations or liquidity.
The Company’s daily average electrical demand is approximately 40 megawatts to operate production equipment in manufacturing its products. The Company is currently a full-service bundled utility customer of Southern California Edison. During 2007, the Company’s electricity costs are not expected to change materially from 2006 levels. In 2006, its electricity costs accounted for approximately 2.8% of its cost of goods sold compared to approximately 2.5% in 2005.
The Company generally utilizes a daily average of approximately 12,000 million British thermal units, or MMBTUs, of natural gas to produce its products. To stabilize price volatility, the Company regularly uses a risk management approach to fix the price on portions of its natural gas requirements up to two years ahead through financial and/or physical hedging arrangements. These arrangements include fixed-price contracts for the New York Mercantile Exchange (NYMEX), and/or the Southern California border basis (basis represents the difference between the NYMEX price at Henry Hub, Louisiana and the price at the Southern California border).
The Company currently has in place fixed price purchase agreements for approximately 40% of its natural gas commodity requirements for 2007, and approximately 40% of basis. The Company continues to monitor the near and long term price trends of natural gas and may enter into additional purchase agreements when the Company deems it appropriate or when opportunities
present themselves. In 2006, its natural gas costs accounted for approximately 3.1% of its cost of goods sold compared to approximately 2.9% in 2005.
Item 8.
Item 8. Consolidated Financial Statements and Supplementary Data
The Consolidated Financial Statements required to be filed hereunder are set forth on pages through.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
On December 18, 2006, California Steel Industries, Inc. (the “Company”) filed a Form 8-K, dismissing PricewaterhouseCoopers LLP (“PwC”) as its independent registered public accounting firm. PwC will continue as an independent registered public accounting firm to the Company until PwC completes its procedures on (i) the financial statements of the Company as of and for the fiscal year ending December 31, 2006 and (ii) the Company’s Form 10-K in which such financial statements will be included. On January 3, 2007, the Company filed an amended Form 8-K/A appointing Ernest and Young (“EY”) as the Company’s independent registered public accounting firm for the year ending December 31, 2007.
There were no disagreements with PwC on any matters of accounting principles or practices, financial statement disclosure, or auditing scope or procedure that would have caused PwC to make reference thereto in connection with their reports on the Company’s financial statements for the years ended December 31, 2006, 2005 and 2004.
Item 9A.
Item 9A. Controls and Procedures
For the period ending December 31, 2006 (the “Evaluation Date”), the Company carried out an evaluation, under the supervision and with the participation of its management, including the President and Chief Executive Officer and the Chief Financial Officer (the principal finance and accounting officer), of the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon this evaluation, the President and Chief Executive Officer and the Chief Financial Officer concluded that, as of December 31, 2006, the Company’s disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in the reports filed or submitted by the Company under the Exchange Act is recorded, processed, and summarized and reported within the time periods specified in the SEC’s rules and forms.
Additionally, the President and Chief Executive Officer and the Chief Financial Officer determined, as of December 31, 2006, that there were no changes in the Company’s internal controls over financial reporting or in other factors that could significantly affect its internal controls over financial reporting.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The following table sets forth the Company’s Directors and executive officers as of December 31, 2006. Directors are elected to terms of one year. All Directors hold their positions until their term expires and until their respective successor is elected and qualified. Executive officers are elected by and serve at the discretion of the Board of Directors until their term expires and their successor is duly chosen and qualified.
Name
Age
Position
Vicente Wright
Chairman of the Board of Directors
Hidenori Tazawa
Director
Toshihiro Kabasawa
Director
James Pessoa
Director
Masakazu Kurushima
President and Chief Executive Officer
Ricardo Bernardes
Executive Vice President and Chief Financial Officer
Toshiyuki Tamai
Executive Vice President, Operations
James Wilson
Vice President, Commercial
Brett Guge
Vice President, Administration and Corporate Secretary
Vicente Wright has served as Chairman of the Board of Directors since July 1, 2004. Since October 2004, he has also held the position of Managing Director of Rio Doce Limited. Mr. Wright was named President and Chief Executive Officer of the Company in February 2003. Mr. Wright served as the Executive Vice President, Finance, of the Company from February 1998 to February 2003. Mr. Wright was the Steel Division General Manager from 1992 to 1998 and Iron Ore Sales General Manager from 1991 to 1992 of Companhia Vale do Rio Doce. From 1987 to 1988, he served as Iron Ore Sales General Manager for Rio Doce Asia Ltd., a subsidiary of Companhia Vale do Rio Doce. In 1986 and 1987, he was the assistant to the President of California Steel Industries in charge of slab procurement and all of its related logistics. From 1978 to 1986, Mr. Wright served as Purchasing Executive and Slab Marketing Manager at Companhia Siderurgica de Tubarão. Mr. Wright was a member of the Board of Directors of Companhia Siderurgica Nacional, the largest steel company in Brazil, from 1993 to 1997; Acominas, a Brazilian steel mill, from 1994 to 1998; Siderar, an Argentine steel mill, from 1994 to 1997; Chairman of Nova Era Silicon, a Brazilian ferro-silicon company mill, from 1994 to 1997; and SEAS from 1994 to 1998. He graduated from Marquette University, Milwaukee, Wisconsin with a Bachelor’s Degree in Business Administration.
Hidenori Tazawa has served as a Director since 2004. He has been employed by JFE Steel America since 2004 where he serves as President. From 1976 through 2003, Mr. Tazawa held various management positions at NKK and NKK America with a primary focus on sales. Mr. Tazawa graduated from Touhoku University in 1976 with a Bachelor’s Degree in Law.
Toshihiro Kabasawa has served as a Director since July 2000. He has been employed by Kawasaki Steel Corporation since 1977 where he has held positions as Human Development Manager, Organization & Systems Manager, Steel Business Planning Manager and Manager of Overseas Business in Corporate Planning Department. He graduated from Tokyo University with a Bachelor’s Degree in Law.
James Pessoa has served as a Director since 2005. He has been employed by Companhia Vale do Rio Doce since May 2004 where he served as a General Manager in the Development Department and was promoted to the Director of the Steel Development and Holdings Department in April 2005. Mr. Pessoa is also President, Chief Executive Officer and member of the Board of Directors of Ferro Gusa Carajás, a joint-venture between CVRD and NUCOR in Brazil. Mr. Pessoa is a substitute Board Member at Usiminas. Additionally, he is Vice-President of CSA (Companhia Siderúrgica do Atlântico), a new joint-venture between CVRD and Thyssen Krupp Stahl AG formed to build a large integrated steel plant in Brazil. During 26 years of work in the steel sector, Mr. Pessoa has held management and executive positions at several important Brazilian and foreign companies, specializing in planning, installation, commissioning and management of steel plants, having also worked for steel equipment suppliers like Morgan Construction Co, Worcester, Mass, USA. and SMS Schloemann Siemag AG, Düsseldorf, Germany. Born in Brazil, he graduated in 1980 from Catholic University in Rio de Janeiro, with BsC and MsC degrees in Mechanical Engineering.
Masakazu Kurushima joined the Company in July 2004 as President and Chief Executive Officer. Mr. Kurushima came to the Company from JFE Steel America, Inc. where he served as President. Prior to his appointment to JFE Steel America, Mr. Kurushima was Staff General Manager of the Export Department of JFE Steel Corporation, Tokyo. He joined Kawasaki Steel Corporation in 1972 after graduating from Waseda University, Japan, with a degree in Economics.
Ricardo Bernardes joined the Company in September 2003 as Executive Vice President and Chief Financial Officer. Mr. Bernardes held various financial and executive positions in Brazil with RBS Group from November 1995 to July 2003, including the positions of Executive Director of Business Development, CFO Media, Broadcasting Finance Director and Telecommunications Director. He is familiar with the steel industry from his work on various projects as a senior consultant for Booz Allen & Hamilton in Latin America and from his work experience with the Gerdau Group. Mr. Bernardes holds a Masters of Business Administration from the University of California, Los Angeles.
Toshiyuki Tamai has served as Executive Vice President, Operations since July 2001. He has been with CSI since 1995, previously holding positions as Manager, Hot Strip Rolling and Finishing Operations and General Manager, Hot Rolling and Tubular Products. He joined Kawasaki Steel Corporation in 1973 where he served as Manager at the No. 2 Hot Strip Mill at Chiba Works. Prior to joining CSI, he worked as Senior Staff Engineer at AK Steel, Middletown, Ohio. Mr. Tamai graduated from Kyoto University with a Bachelor’s Degree in Mechanical Engineering.
James Wilson has served as Vice President, Commercial since June 2004, prior to which he served as Vice President, Sales since November 2000. He has been employed by California Steel Industries since 1984 holding the positions of Manager, Galvanized Products and Manager, Cold Rolled Products. Prior to joining California Steel Industries, he worked in various segments of the metals industry, including J.T. Ryerson & Sons, a service center, and in manufacturing. He graduated from the University of California, Berkeley, with a Bachelor of Science degree in Industrial Engineering.
Brett Guge has served as Vice President, Administration and Corporate Secretary since May 1997. From 1994 to 1997, he served as the Manager of Administration of Gallatin Steel. From 1983 to 1994, he was employed by Alcoa where he held positions as the Superintendent of Industrial Relations and Employment, Supervisor of Employee Relations and Superintendent of Industrial Relations and Training. Mr. Guge graduated from the University of Tennessee with a Bachelor’s Degree in Communications, and from Xavier University with a Master’s Degree in Business Administration.
Board Committees
The Company’s Board of Directors has a Compensation Committee and an Operations and Finance Committee.
The Compensation Committee is comprised of four members: Mr. Toshihiro Kabasawa, Director, and Mr. Kazuo Fujisawa, both of JFE Steel Corporation, and Mr. James Pessoa, Director, and Mr. Hilton Fuks, both of Companhia Vale do Rio Doce. The Compensation Committee met twice during 2006. The Compensation Committee reviews compensation packages for the Company’s officers and prepares the executive compensation proposal to the Board.
The Operations and Finance Committee is comprised of four members including Director Mr. Hidenori Tazawa and Mr. Hiroyuki Tezuka, both of JFE Steel Corporation, and Chairman of the Board, Mr. Vicente Wright and Mr. Leonardo Moretzsohn Andrade, both of Companhia Vale do Rio Doce. This committee met twice during 2006. The Operations and Finance Committee mainly reviews our investment plans, business plan, annual operating plan and budget. The Operations and Finance Committee is also responsible for reviewing the Company’s operating results and performance.
There is no separate Audit Committee as audit related decisions are made by the entire Board of Directors. The Board of Directors does not contain an audit committee financial expert as such term is defined in Item 401(h)(2) of Regulation S-K as the Board has determined that such an expert is not necessary to properly carry out its oversight responsibilities.
Code of Ethics
In 2005, the Company adopted a written code of ethics for our principal executive officer, principal financial officer, principal accounting officer or controller, and persons performing similar functions. A copy of the Code of Ethics is attached to our Annual Statement on Form 10-K filed with the Securities and Exchange Commission on March 28, 2005.
Two technical changes were approved for the Code of Ethics in 2006. The first change was to further define what is meant by compliance with foreign law. A parenthetical was added to the second sentence of Section 1.4 of the Code of Ethics as follows: “The Code represents CSI’s standards, designed reasonably to deter wrongdoing and promote ethical conduct, and shall not preempt any obligations that are imposed on Responsible Persons under applicable federal, state or foreign (the country that an individual may be located, whether as a resident or while traveling on company business) laws, rules or regulations or under other policies and/or standards of CSI.” The second change provides that any violation of the Code of Ethics which involves the Chief Executive Officer shall be reported to the Chairman of the Board rather than the Chief Financial Officer. A copy of the revised Code of Ethics is attached to this Annual Statement on Form 10-K.
Item 11.
Item 11. Executive Compensation
Compensation Discussion and Analysis
This section discusses the compensation paid to the principal executive and principal financial officers of the Company, as well as the three other most highly compensated executive officers of the Company (collectively, the “Executive Officers”).
Compensation Process
Executive compensation is the responsibility of the Board of Directors. The Board considers recommendations from the Compensation Committee of the Board with respect to the periodic review of the compensation of the Executive Officers and the design and structure of incentive compensation to reward executive performance. The Compensation Committee further authorizes benchmarking surveys of executive compensation for similarly sized manufacturing companies, including private companies and those publicly traded. The surveys are conducted by recognized consulting firms, analyzing executive compensation within the steel industry and other manufacturing sectors.
Objectives of Executive Compensation
The objectives of the executive compensation system at the Company are to (i) maximize annual Company profitability, (ii) reward the achievement of Company and individual objective performance targets, (iii) develop management competency and skill in a variety of areas related to Company operations, and (iv) provide a compensation package that is competitive within the steel industry and other manufacturing sectors.
Elements of Executive Compensation
The executive compensation system is designed to achieve the objectives of the Company and reward Executive Officer performance in three ways:
•
Base Salary - The Company seeks to provide a base salary to each of the Executive Officers which is competitive and will retain executives and thus provide stability and continuity within senior management. Base salary is benchmarked from time to time within the steel industry and other manufacturing sectors and is subject to adjustment on an annual basis in the form of cost of living adjustment applicable to all Executive Officers and/or individual changes. All Executive Officers were given a 3.5% increase in base salary in 2006.
•
Employee Profit Sharing Plan - The Executive Officers are eligible to receive profit sharing bonuses twice a year along with all other employees of the Company pursuant to the Company profit sharing plan. The purpose of this plan is to provide an incentive for all employees, including the Executive Officers, to contribute to the success of the Company and to maximize corporate profitability. The Company profit sharing plan awards bonuses to all employees based on a pool amount equal to 8% of the Company’s income before taxes excluding gain or loss on disposition of fixed assets and some other adjustments. The basis for determining the profit sharing pool is subject to review and approval of the Company’s Board of Directors. The employee’s share in the pool amount is based on his or her length of service with the Company during the profit sharing period. Employees who voluntarily terminate their employment for reasons others than retirement before the end of the profit sharing period and employees whose employment is involuntarily terminated are not eligible to receive any profit sharing award.
•
Executive Incentive Plan - The Executive Incentive Plan for the Executive Officers is made up of two components:
(i) Executive Profit Sharing - There is a separate profit sharing plan for the Executive Officers which provides an additional reward and incentive to the Executive Officers for maximizing corporate profitability. The profit sharing component of the Executive Incentive Plan is based on a pool amount equal to 0.5% of the Company’s income before taxes excluding gain or loss on disposition of fixed assets and some other adjustments. The Executive Officers participate in the pool based on a fixed percentage for each executive position, subject to a maximum bonus cap. The percentage allocation of each executive and the basis for determining the executive profit sharing pool is subject to review and approval of the Company’s Board of Directors.
(ii) Target Achievement - The second component of the Executive Incentive Plan is an individual target achievement component which rewards each Executive Officer with points for performance in a number of target areas. Target areas include general Company performance targets for all Executive Officers such as cash flow, on-time performance and plant safety and more specific target areas for individual Executive Officers such as yield, margin, inventory, sourcing of manufacturing inputs and sales. Finally, each Executive Officer is further given targets for
improving management competencies in areas such as initiative, innovation, teamwork, resource utilization, governance and adherence to Company principals. Points are awarded in ranges and the point total for each Executive Officer corresponds with a range of incentive bonus values, with higher point values earning greater bonus awards.
Equity Compensation and Incentives
The Company does not have any public equity outstanding and does not award equity compensation or incentives to its Executive Officers.
Executive Officer Benefits and 401K Plan
In addition to the compensation described above, the Company offers certain standard benefits, including paid vacation, subsidized health and dental insurance, subsidized life insurance, and an automobile allowance.
The Company further maintains the California Steel Industries, Inc. 401(k) Savings Plan (“401(k) Plan”), a tax qualified cash or deferred tax arrangement under Section 401(k) of the Internal Revenue Code of 1986, as amended. The 401(k) Plan provides the participants with benefits upon retirement, death, disability or termination of employment with the Company. Employees are eligible to participate in the salary reduction portion of the plan on the first day of the calendar month following their date of hire.
Participants may authorize the Company to contribute to the 401(k) Plan on their behalf a percentage of their compensation, not to exceed legally permissible limits, including an overall dollar limit of $15,000 for 2006 and $5,000 as a catch-up contribution for those participants who are 50 years old or older at December 31, 2006. The 401(k) Plan provides for the Company’s discretionary matching and profit sharing contributions. The Company currently match 100% of the first 4% of the participant’s deferral under the 401(k) Plan each year and 50% of the next 2% of the participant’s deferral under the 401(k) Plan each year. Each plan year the Company may also elect to make an additional contribution to the 401(k) Plan. This discretionary employer contribution, if the Company makes it, is allocated to each participant’s account based on the participant’s compensation for the year relative to the compensation of all participants for that year. In order to share in the allocation of the discretionary employer contribution, if any, a participant must complete 1,000 hours of service in the plan year.
Furthermore, the principal executive and principal financial officers, who are dispatched personnel from the Company’s two stockholders located in Japan and Brazil, receive certain additional extended paid home leave and expense reimbursements (which are described in greater detail below). These benefits are intended to compensate the dispatched personnel for the hardships of working for extended periods outside of their home country.
Summary Compensation Table
The following summary compensation table sets forth information regarding compensation earned in the fiscal years ended December 31, 2006, 2005 and 2004 by the Company’s Principal Executive Officer, Principal Financial Officer and each of its other three most highly compensated executive officers.
Summary Compensation Table
(1) Mr. Masakazu Kurushima took over the position following the resignation of Mr. Vicente Wright on July 1, 2004 as Mr. Wright became Chairman of the Board of Directors.
(2) Incentive compensation is composed of participation by the Executive Officers in the Employee Profit Sharing Plan and the Executive Incentive Plan. The breakdown for each Executive between the two plans in fiscal year 2006 is as follows:
(3) See “Summary Compensation Table - All Other Compensation” below for details of all other compensation.
Summary Compensation Table -
All Other Compensation
(1) Represents matching contributions made to the executive’s account in the Company’s 401(k) plan.
(2) Represents $10,250 in car allowance and $129,551 in medical expenses and home leave reimbursements. Home leave reimbursement is paid to executives who are foreign nationals in connection with trips by them and their family members to their country of origin.
(3) Represents $10,250 in car allowance and $10,099 in medical expenses and home leave reimbursements. Home leave reimbursement is paid to executives who are foreign nationals in connection with trips by them and their family members to their country of origin.
(4) Represents $10,250 in car allowance and $5,942 in medical expenses and home leave reimbursements. Home leave reimbursement is paid to executives who are foreign nationals in connection with trips by them and their family members to their country of origin.
(5) Represents $4,268 in car allowance and $12,266 in medical expenses and home leave reimbursements. Home leave reimbursement is paid to executives who are foreign nationals in connection with trips by them and their family members to their country of origin.
(6) Represents $9,750 in car allowance and $35,526 in medical expenses and home leave reimbursements. Home leave reimbursement is paid to executives who are foreign nationals in connection with trips by them and their family members to their country of origin.
(7) Represents $10,250 in car allowance and $25,590 in medical expenses and home leave reimbursements. Home leave reimbursement is paid to executives who are foreign nationals in connection with trips by them and their family members to their country of origin.
(8) Represents $10,250 in car allowance and $45,354 in medical expenses and home leave reimbursements. Home leave reimbursement is paid to executives who are foreign nationals in connection with trips by them and their family members to their country of origin.
(9) Represents $10,603 in car allowance and $4,363 in medical expenses and home leave reimbursements. Home leave reimbursement is paid to executives who are foreign nationals in connection with trips by them and their family members to their country of origin.
(10) Represents $10,250 in car allowance and $41,797 in medical expenses and home leave reimbursements. Home leave reimbursement is paid to executives who are foreign nationals in connection with trips by them and their family members to their country of origin.
(11) Represents $9,924 in car allowance and $22,216 in medical expenses and home leave reimbursements. Home leave reimbursement is paid to executives who are foreign nationals in connection with trips by them and their family members to their country of origin.
(12) Represents car allowance and other fringe benefits.
Pension Benefits
The following table sets forth the pension benefits payable to the named executive officers for the year ended December 31, 2006. The benefits mentioned below are calculated under the plan as described below.
Supplemental Executive Retirement Plans and Separation Agreement
On January 16, 2003, the Company entered into a Supplemental Executive Retirement Plan with James L. Wilson, Vice President, Commercial, who has been employed with the Company since 1984, intended to induce Mr. Wilson to remain in the Company’s employ. Upon his retirement, the Company is obligated to pay Mr. Wilson a monthly benefit for 180 months calculated as follows: one-twelfth of the product of 2.5% multiplied by the number of years he is employed with the Company limited to 18 years, multiplied by his average annual compensation, using a 5% discounted rate. This benefit vests at the rate of 6% for 2003 and 7% per year thereafter, continuing yearly except for the year Mr. Wilson turns 65, when the vesting will be 24%. The payment of the vested portion of this benefit will start at the first day of the month following the month in which Mr. Wilson reaches age 65. Upon death of the Executive, the Company agrees to pay the benefits to the Executive’s designated beneficiary. At December 31, 2006, he was vested 27% under this agreement.
On September 19, 2000, the Company entered into a Supplemental Executive Retirement Plan with Brett J. Guge, Vice President, Administration and Corporate Secretary, who has been employed with the Company since 1997, intended to induce Mr. Guge to remain in the Company’s employ. Upon his retirement, the Company is obligated to pay Mr. Guge a monthly benefit for 180 months calculated as follows: one-twelfth of the product of 2.5% multiplied by the number of years he is employed with the Company limited to 18 years, multiplied by his average annual compensation, using a 5% discounted rate. This benefit vests at the rate of 4% per year, continuing yearly except for the year Mr. Guge turns 65, when the vesting will be 24%. The payment of the vested portion of this benefit will start at the first day of the month following the month in which Mr. Guge reaches age 65. Upon death of the Executive, the Company agrees to pay the benefits to the Executive’s designated beneficiary. At December 31, 2006, he was vested 28% under this agreement.
Non-Qualified Defined Benefit and Deferred Compensation Plans
The Company currently has no non-qualified defined benefit or deferred compensation plans.
Severance and Change in Control Payments
See description of Supplemental Executive Retirement Plans under the “Pension Benefits” item above.
Director Compensation
No compensation payments are made to Directors or Committee Members of the Company. However, JFE Steel Corporation and Companhia Vale do Rio Doce were paid by the Company for providing the services of the Directors and the Committee Members for fiscal year 2006. The payment for Directors, except the Chairman, was $3,000 per month and $1,000 per month for committee members. For services of the Chairman of the Board of Directors, Mr. Vicente Wright, the Company paid $379,168 in 2006 and an additional $292,343 in 2007 for 2006 services paid directly to Companhia Vale do Rio Doce.
Shareholders’ Agreement
The Company is owned 50% by JFE Steel Corporation (formerly Kawasaki Steel Corporation), a Japanese corporation, and 50% by Rio Doce Limited, a New York corporation and a subsidiary of Companhia Vale do Rio Doce (“CVRD”), a Brazilian corporation. In June 2004, JFE Steel USA, Inc., a Delaware corporation (formerly Kawasaki Steel Holdings (USA), Inc.), also a subsidiary of JFE Steel Corporation, transferred its shares to JFE Steel Corporation. The Company’s two stockholders entered into a Shareholders’ Agreement dated June 27, 1995, replacing a Shareholders’ Agreement dated June 1, 1987. According to the Shareholders’ Agreement, the stockholders agreed to subscribe for additional shares of the Company’s stock in proportion to their respective ownership if any new stock is issued, and increases in the Company’s capital stock from time to time shall be allocated between the Company’s common stock and preferred stock as agreed upon by the stockholders. Each of the stockholders has the right and obligation to subscribe and pay fully for the new shares in proportion to its respective ownership of the Company’s common stock. In addition, either stockholder may let its Affiliated Corporations, as defined the Shareholders’ Agreement, subscribe, in whole or in part, to the new shares to be issued to it under the terms described below.
The Shareholders’ Agreement provides that the Board of Directors shall be constituted of five directors, one of whom shall be chairman, as elected by and among the directors. Each stockholder shall have the right to appoint two Directors and the fifth Director shall be elected by unanimous affirmative vote of the shareholders (in July 1999, the stockholders approved a revision to the Bylaws of the Company changing the number of directors to 4, however, no corresponding change was made to the Shareholders’ Agreement). In addition, the stockholders shall jointly appoint a president, who shall appoint other officers designated by the Board of Directors. The Shareholders’ Agreement also provides for a Consultative Council consisting of two members, one appointed by each of the stockholders. It is unclear whether the Consultative Council provisions are valid under Delaware corporation law. The Consultative Council decides on all relevant matters submitted to it by both or either of the stockholders and specifically resolves any deadlock among the Directors. Because no stockholder holds a majority of the Company’s stock and the Directors and members of the Consultative Council are elected by the stockholders in proportion to each of the stockholders’ holdings, there is a possibility that a deadlock may occur on any issue voted on by the stockholders, Board of Directors and Consultative Council. If a deadlock were to occur and the Consultative Council could not resolve the issue, the last recourse is arbitration according to the Shareholders’ Agreement.
The Shareholders’ Agreement provides that, subject to any limitation on the payment of dividends contained in any agreement the Company is a party to, the stockholders shall cause the Company to distribute from its profits the maximum dividend that may be distributed under the applicable laws and regulations, provided that the profits shall first be applied to the payment of dividends on the preferred stock. The Company has historically paid dividends of 50% of its net income per year.
If either one of the stockholders wishes to transfer or assign their shares of the Company’s stock to a third party, other than to one of its affiliated corporations, the stockholder must first offer to sell those shares to the other stockholder upon the same terms and conditions that the third party has offered to purchase the shares. Any stockholder who sells, transfers, assigns, or creates a pledge or other encumbrance on its shares in favor a third party, other than its affiliated corporations, is obligated to obtain an undertaking letter from the third party according to which the third party undertakes unconditionally and irrevocably the obligations of the transferring stockholder under the Shareholders’ Agreement in proportion to the number of shares transferred. Either stockholder may sell, transfer or assign to its affiliated corporations all or any part of its shares or preemptive rights to subscribe for new shares of the Company’s stock by giving written notice to the other stockholder, provided that the affiliated corporation has agreed to become a party to the Shareholders’ Agreement. In this case, both the transferor and the affiliated corporation shall jointly assume all of the obligations of the transferor under the Shareholders’ Agreement.
Dispatched Personnel
Pursuant to agreements with the Company’s stockholders CVRD and JFE, certain of the Company’s executive officers and employees coming from the stockholders are treated as dispatched personnel, which means that these executive officers and employees retain active employment status in their home country with the stockholder who appointed them. These agreements
further require that the Company provide certain benefits to employees who have been sent by a stockholder to work at the Company, such as extended home leave, home leave reimbursements and some other benefits. The Company further has an agreement with its stockholder, JFE, to reimburse JFE for the salary of employees who are designated as dispatched personnel, whereas dispatched personnel from the Company’s stockholder, CVRD, are paid directly by the Company.
Executive officers who in 2006 were treated as dispatched personnel from JFE Steel Corporation and its subsidiaries included Masakazu Kurushima and Toshiyuki Tamai. Executive officers who in 2006 were treated as dispatched personnel from CVRD and its subsidiaries included only Ricardo Bernardes. Mr. Hamamoto from JFE left CSI on June 30, 2004 and Mr. Vicente Wright, who left the Company as a full time employee on December 31, 2004, is currently Chairman of the Board. Notwithstanding the retention of formal active status, all individuals designated as dispatched personnel, with the exception of Vicente Wright, are full time employees of the Company.
The compensation and benefits of executive dispatched personnel, including any home leave reimbursement, is set forth in the Summary Compensation Table in Item 11.
Compensation Committee Interlocks and Inside Participation
Mr. Toshihiro Kabasawa, Director, Mr. James Pessoa, Director, Mr. Kazuo Fujisawa, and Mr. Hilton Fuks served as members of our Compensation Committee. None of the members of the Compensation Committee was, during 2006, an officer, employee or formerly an officer or employee of the Company or its subsidiary.
Mr. Kabasawa served as General Manager of Overseas Business Planning of JFE Steel Corporation (formerly Kawasaki Steel Corporation) during 2006. JFE Steel Corporation is one of the Company’s stockholders. In 2006, Mr. Fujisawa served as Deputy General Manager of Overseas Business Planning of JFE Steel Corporation. In 2006, Mr. James Pessoa served as Director of the Steel Development and Holdings Department of Companhia Vale do Rio Doce. In 2006, Mr. Fuks served as International Human Resources Coordinator for Americas of Companhia Vale do Rio Doce.
Board Compensation Committee Report on Executive Compensation
The Compensation Committee has reviewed and discussed with management the disclosures contained in the Compensation Discussion and Analysis section of this Item 11. Based upon this review and our discussions, the Compensation Committee recommended to its Board of Directors that the Compensation Discussion and Analysis section be included in this Annual Report on Form 10-K.
Submitted by the Compensation Committee of the Board of
Directors:
Toshihiro Kabasawa
James Pessoa
Kazuo Fujisawa
Hilton Fuks
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth, as of December 31, 2006, information regarding the shares of the Company’s common stock and Class C preferred stock beneficially owned by each stockholder that beneficially owns in excess of 5% of the outstanding shares of the Company’s common stock and Class C preferred stock. No director or named executive officer beneficially owns any shares of the Company’s common stock or Class C preferred stock.
In June 2006, draft resolutions were circulated to the stockholders of the Company seeking approval of a conversion of the 3,000 issued and outstanding shares of Class C preferred stock of the Company into 3,000 shares of common stock of the Company in a straight one to one conversion. The stockholders were further asked to approve an amendment to the Certificate of Incorporation of the Company to increase the authorized number of common shares from 2,000 to 5,000 to allow for the conversion. The stockholders adopted resolutions approving both the conversion and the amendment to the Certificate of Incorporation pursuant to a unanimous written consent which became effective in July 2006. The amendment to the Certificate of Incorporation was filed with the Delaware Secretary of State on July 25, 2006.
(1) Rio Doce Limited is a subsidiary of Companhia Vale do Rio Doce, a Brazilian corporation.
(2) In 2004, JFE Steel U.S.A., Inc., transferred its common and Class C preferred stock in the Company to JFE Steel Corporation.
Item 13.
Item 13. Certain Relationships and Related Transactions
The Company’s stockholders, JFE Steel Corporation, and Rio Doce Limited, a subsidiary of Companhia Vale do Rio Doce, are parties to a Shareholders’ Agreement. According to the Shareholders’ Agreement, the stockholders control the election of the Board of Directors. The stockholders also indirectly control the appointment of officers through their right to jointly elect the president, who is entitled to appoint the Company’s other officers.
The Shareholders’ Agreement also provides for a Consultative Council, comprised of two members. Each stockholder is entitled to elect one member. The Consultative Council decides on all matters submitted to it by either or both of the stockholders and resolves deadlocks among the Board of Directors. The Company has transactions in the normal course of business with affiliated companies. For example, the Company purchases slab from Cosipa Overseas, an affiliate of Companhia Vale do Rio Doce as of November 6, 2006. During 2006, the Company purchased $14,311,000 of slab from Cosipa Overseas and $144,251,000 of slab from JFE Steel Corporation. The Company conducted arms-length negotiations with Cosipa Overseas and JFE Steel Corporation in 2006. The executive officer negotiating the market price for the steel slab was the Executive Vice President & CFO.
The Company held a 4% interest in the common stock of Companhia Siderurgica de Tubarão, which represents 1.5% of the total equity interest in the company. Companhia Siderurgica de Tubarão was an affiliate of both Companhia Vale do Rio Doce and JFE Steel Corporation, the Company’s stockholders’ parent companies. In October 2004, the Company agreed in principal to sell its 4% interest in the common stock of CST to Arcelor S.A. (“Arcelor”). The transaction was structured by entering into an option and waiver agreement whereby Arcelor granted the Company an option to sell and the Company granted Arcelor an option to purchase the Company’s interest in CST. These options were exercised during the thirty day period following the termination of the CST shareholders agreement on May 25, 2005. Under the option agreement, all earnings or losses as well as dividends and distributions accrued to the benefit of Arcelor during the period from the execution of the option agreement to the date of exercise.
The Company further maintains contractual relationships with its stockholders in the form of Dispatched Personnel Agreements, as described in Item 11. Executive Compensation - Dispatched Personnel. These agreements provide for certain benefits and salary reimbursements with respect to personnel who are sent by the stockholders to work at the Company. All compensation and benefits paid to such personnel, including salary which is reimbursed, is set forth in Item 11. Executive Compensation - Summary Compensation Schedule.
Item 14.
Item 14. Principal Accounting Fees and Services
Aggregate fees billed by principal accountant in the past two years.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) (1) and (2) Financial Statements:
The following consolidated financial statements and schedule of the Registrant are included in response to Item 8 of this Report:
1. Consolidated Financial Statements:
All other schedules have been omitted since they are either not required, not applicable or the information is otherwise included.
(a)(3) Exhibits:
The Exhibits required to be filed with this Annual Report on Form 10-K are listed in the Exhibit Index included herein immediately following the Signature Page.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
California Steel Industries, Inc.:
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of California Steel Industries, Inc. and its subsidiary (the “Company”) at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
Los Angeles, California
February 7, 2007
California Steel Industries, Inc. and Subsidiary
Consolidated Balance Sheets
December 31, 2006 and 2005
(Dollars in thousands, except for share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
California Steel Industries, Inc. and Subsidiary
Consolidated Statements of Operations
For the Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
California Steel Industries, Inc. and Subsidiary
Consolidated Statements of Stockholders’ Equity
For the Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
California Steel Industries, Inc. and Subsidiary
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
California Steel Industries, Inc. and Subsidiary
Consolidated Statements of Cash Flows, Continued
For the Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
1. Organization and Nature of Operations
California Steel Industries, Inc. and Subsidiary (the “Company”) was incorporated in the state of Delaware on November 3, 1983. Its stockholders consist of two companies, JFE Steel Corporation (formerly Kawasaki Steel Corporation), a Japanese corporation, and Rio Doce Limited, a New York corporation, which each own 50% of the stock of the Company. From its site in Fontana, California, the Company manufactures a wide range of flat rolled steel products, including hot rolled, cold rolled, and galvanized coil and sheet. The Company also produces electric resistant welded pipe.
2. Summary of Significant Accounting Policies
Principles of consolidation: The accompanying consolidated financial statements include the accounts of the Company and its wholly owed subsidiary and are prepared on the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America. All significant intercompany balances and transactions have been eliminated in consolidation.
Cash and cash equivalents: The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. These bank accounts are guaranteed by the Federal Deposit Insurance Corporation (“FDIC”) up to $100,000. As of December 31, 2006, the Company had cash balances with banks in excess of the federally insured limit.
Trade accounts receivable: Trade accounts receivable are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a monthly basis. Management determines the allowance for doubtful accounts by identifying troubled accounts, using historical experience applied to an aging of accounts, regularly evaluating individual customer receivables and considering a customer’s financial condition and credit history, and current economic conditions. Trade accounts receivable are written off when deemed uncollectible. Recoveries of trade accounts receivable previously written off are recorded when received.
Inventories: Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out (“FIFO”) method of inventory accounting. Management routinely evaluates the carrying value of inventories and provides reserves when appropriate to reduce inventories to the lower of cost or market to reflect estimated net realizable value.
Investment in affiliated company: Investment in affiliated company consisted of 4% of the common stock of Companhia Siderurgica de Tubarao (“CST”), a Brazilian semi-finished steel slab and hot rolled manufacturer. The investment was accounted for by the equity method, since combined investments in CST by the Company and certain other related companies allow for significant influence over the financing and operating activities of CST. The Company’s share of earnings or losses from this investment is reflected in other income (expense) in the accompanying consolidated statements of operations. Dividends were credited against the investment when received. The Company’s interest in CST was sold in June 2005 as described in Note 6.
Deferred financing costs: Debt issuance costs are amortized on a straight-line basis (which approximates the effective interest method) over the term of the related debt agreement. Amortization of issuance costs is included as a component of interest expense. These costs are included in the other assets in the 2006 and 2005 consolidated balance sheets.
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
2. Summary of Significant Accounting Policies (Continued)
Property, plant and equipment: Property, plant and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets. The estimated useful lives of the assets are as follows:
Plant and equipment
3 to 25 years
Plant refurbishment costs
10 years
Furniture and fixtures
5 years
Assets under construction are not depreciated until placed into service. Ordinary repairs and maintenance are charged to operating costs when incurred. When assets are sold or otherwise disposed of, the cost and related accumulated depreciation are eliminated from the respective accounts, and any related gain or loss is included in the statement of operations.
Impairment of long-lived assets: The Company accounts for long-lived assets in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” This Statement requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.
Income taxes: Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is provided against the deferred tax asset for amounts which are not considered “more likely than not” to be realized.
Environmental: Environmental expenditures that relate to current operations are expensed or capitalized as appropriate. Expenditures are capitalized if they meet one of the following criteria: (1) extend the useful life, increase the capacity, or improve the safety or efficiency of property, (2) mitigate or prevent environmental contamination that has yet to occur and that otherwise may result from future operations or activities, or (3) incurred in preparing property currently held for sale. The Company accrues for costs associated with environmental remediation obligations when such losses are probable and reasonably estimable. Accruals for estimated losses from environmental remediation obligations are recognized no later than completion of the remedial feasibility study. Such accruals are adjusted as further information develops or circumstances change (see Note 10). Costs of future expenditures for environmental remediation obligations are not discounted to their present value.
Derivative financial instruments: Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted by other related accounting literature, establishes accounting and reporting standards for derivative instruments (including certain derivative instruments embedded in other contracts). SFAS No. 133 requires companies to record derivatives on their balance sheets as either assets or liabilities measured at their fair value unless exempted from derivative treatment as a normal sale and purchase transaction. All changes in the fair value of derivatives are recognized currently in earnings unless specific hedge criteria are met, which requires that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting.
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
2. Summary of Significant Accounting Policies (Continued)
The Company enters into contracts to purchase certain commodities used in the manufacturing of its products, such as electricity and natural gas. Some of these forward contracts (liabilities) do not require derivative accounting as the Company takes possession of the commodities in the normal course of business whereas other forward contracts are accounted for as derivatives in accordance with SFAS No. 133 by the Company. These derivatives did not qualify for hedge accounting treatment; therefore, these financial instruments are reported at fair value, with changes in fair value reported in current earnings. Credit risk related to the derivative financial instruments is considered minimal and is managed by requiring high credit standards for its counterparties and periodic settlements.
Self-insurance liability: The Company is self-insured for workers’ compensation. The accrued liability associated with these programs is based on management’s estimate of the ultimate costs to settle known claims as well as claims incurred but not yet reported (“IBNR claims”) as of the balance sheet date. The estimated liability is not discounted and is based on information provided by the Company’s insurance brokers and insurers, combined with management’s judgments regarding a number of assumptions and factors, including the frequency and severity of claims, the Company’s claims development history, case jurisdiction, related legislation, and the Company’s claim settlement practice. Significant judgment is required to estimate IBNR claims as parties have yet to assert such claims. If actual claim trends, including the severity or frequency of claims, differ from management’s estimates, the Company’s financial results could be impacted.
Use of estimates: Management of the Company has made a number of estimates and assumptions relating to the reporting of assts and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ from those estimates.
Fair value of financial instruments: The carrying value of cash and cash equivalents, trade accounts receivable, other receivables, accounts payable, and other accrued expenses are measured at cost which approximates their fair value because of the short maturity of those instruments. The fair values of long-term indebtedness are estimated based on the quoted market prices for the same or similar issues, or the current rates offered to the Company for debt of similar maturities. The carrying amounts and fair values of financial instruments at December 31, 2006 and 2005 are listed as follows (dollars in thousands):
Revenue recognition: The Company recognizes revenue when products are shipped or delivered to the customer, depending on the terms of the sale. For products shipped FOB shipping point, revenue is recognized at the time of shipment and title has transferred to the customer. For products shipped FOB destination, revenue is recognized at the time of delivery and title has transferred to the customer.
Shipping costs: The Company charges shipping fees to certain customers based upon the actual amounts incurred. Amounts billed for shipping costs are included in net sales for 2006, 2005 and 2004. The Company includes the associated shipping costs in cost of sales, which were approximately $9,550,000, $9,494,000 and $7,061,000 during 2006, 2005 and 2004, respectively.
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
2. Summary of Significant Accounting Policies (Continued)
Recent accounting pronouncements: In February 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140,” (“SFAS 155”). SFAS 155 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” SFAS 155 resolves issued addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” Among other provisions, the new rule (a) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (b) clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement133, (c) establishes a requirement to evaluate interest in securitized financial assets to identify interests that are freestanding derivates or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (d) clarifies that concentrations of credit risk in the form of subordination are not embedded derivates, and (e) amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for fiscal years beginning after September 15, 2006 and is required to be adopted by the Company in the first quarter of fiscal year 2007, beginning January 1, 2007. The Company is currently evaluating the effect that the adoption of SFAS 155 will have on its consolidated results of operations and financial position or cash flows, but does not expect it to have a material impact.
In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets - an amendment of FASB Statement No. 140,” (“SFAS 156”). SFAS 156 amends SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities,” with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS 156 is effective for fiscal years beginning after September 15, 2006 and is required to be adopted by the Company in the first quarter of fiscal year 2007, beginning January 1, 2007. The Company is currently evaluating the effect that the adoption of SFAS 156 will have on its consolidated results of operations and financial position or cash flows, but does not expect it to have a material impact.
In July 2006, the FASB issued Final Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of SFAS No. 109,” (“FIN 48”). FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. In addition, FIN 48 excludes income taxes from the scope of SFAS No. 5, “Accounting for Contingencies.” FIN 48 is effective for fiscal years beginning after December 15, 2006. Differences between the amounts recognized in the consolidated balance sheets prior to the adoption of FIN 48 and the amounts reported after adoption will be accounted for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings. The Company is currently evaluating the effect that the adoption of FIN 48 will have on its results of operations and financial position.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by the Company in the first quarter of fiscal year 2008, beginning January 1, 2008. The Company is currently evaluating the effect that the adoption of SFAS 157 will have on its consolidated results of operations and financial position or cash flows, but does not expect it to have a material impact.
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
2. Summary of Significant Accounting Policies (Continued)
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements. Traditionally, there have been two widely-recognized methods for quantifying the effects of financial statement misstatements: the “roll-over” method and the “iron curtain” method. The roll-over method focuses primarily on the impact of a misstatement on the income statement, including the reversing effect of prior year misstatements, but its use can lead to the accumulation of misstatements in the balance sheet. The iron curtain method, on the other hand, focuses primarily on the effect of correcting the period-end balance sheet with less emphasis on the reversing effects of prior year errors on the income statement. In SAB No. 108, the SEC Staff established an approach that requires quantification of financial statement misstatements based on the effects of the misstatements on each financial statement and the related financial statement disclosures. This model is commonly referred to as a “dual approach” because it requires quantification of error under both the iron curtain and the roll-over methods. The Company adopted SAB No. 108 in the fourth quarter of 2006. This adoption did not have a material impact on the Company’s consolidated results of operation and financial position or cash flows.
3. Inventories
Inventories consist of the following at December 31 (dollars in thousands):
4. Property, Plant and Equipment
Property, plant and equipment consist of the following at December 31 (dollars in thousands):
Depreciation expense was approximately $29,143,000 and $26,971,000 for the years ended 2006 and 2005, respectively. Capitalized interest was approximately $46,000 and $106,000 for the years ended 2006 and 2005, respectively. There was no capitalized interest for the year ended 2004. During 2005, the Company sold a surplus parcel of land for a total of $7,100,000, which resulted in a net gain of $3,600,000. The gain is reflected in the consolidated statements of operations.
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
5. Leases
The Company is obligated under various equipment leases that expire at various dates during the next four years. At December 31, 2006, the future minimum lease payments under noncanceable operating leases with commitments of at least one year are as follows (dollars in thousands):
Rental expense under operating leases totaled approximately $1,363,000, $4,536,000 and $5,575,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
The Company had leased a galvanizing line (“#2 CGL”) which was treated as an operating lease. The original term of the lease was ten years with an early buy-out option after seven years. In 2005, the Company exercised its buy-out option per the terms of the agreement and purchased the equipment for cash. The lease had varied rental payments which were recognized on the straight-line method over the original term of the lease. The Company continued to expense rental payments on the straight-line method on the #2 CGL through September 30, 2005, the date of purchase. Subsequent to the purchase, the deferred rent liability was credited against the purchase price of the #2 CGL.
6. Investment in Affiliated Company
The investment in the net assets of Companhia Siderurgica de Tubarao (“CST”) accounted for under the equity method amounted to $30,283,000 at December 31, 2004. The investment was sold in June 2005 as described below.
The Company received $2,242,000 in dividends from CST during the year ended December 31, 2004. No dividends were received in 2005.
In October 2004, the Company agreed in principal to sell its 4% interest in the common stock of CST to Arcelor S.A. (“Arcelor”). The transaction was structured by entering into an option and waiver agreement whereby Arcelor granted the Company an option to sell and the Company granted Arcelor an option to purchase the Company’s interest in CST. These options were exercised during the thirty day period following the termination of the CST shareholders agreement on May 25, 2005. Under the option agreement, all earnings or losses as well as dividends and distributions accrued to the benefit of Arcelor during the period from the execution of the option agreement to the date of exercise.
As a result of these agreements, the Company evaluated the carrying value of its investment in CST and recognized an impairment loss of approximately $5,258,000 in 2004. The impairment loss was determined by comparing the carrying value of the investment to the ultimate cash flow to be generated to the Company as a result of the option agreement. The Company determined that this cash flow would essentially be the sales proceeds as agreed to in the option agreement. The impairment loss recognized in 2004 was offset by earnings of CST recognized by the Company prior to executing the option agreement in the amount of $2,211,000, resulting in a net loss of $3,047,000 in equity of affiliate in the 2004 consolidated statement of operations. As of December 31, 2004, the Company had received $1,181,000 as a cash advance, which was classified as a reduction of the investment in CST in the 2004 consolidated balance sheet. The remaining $30,283,000 was received in 2005 upon exercise of the option.
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
7. Notes Payable and Long-term Debt
On June 30, 2003, the credit facility was amended with the then existing syndication of four financial institutions for an aggregate principal amount of up to $110,000,000. The term of the credit facility was also extended for a period of three years expiring on June 30, 2006. This credit facility was terminated on September 29, 2005 and on the same day, the Company entered into a new five-year revolving credit facility (the “Facility”) with a syndicate of four financial institutions. The Facility provided for an aggregate principal amount of up to $110,000,000 subject in all respects to a borrowing base coverage requirement. Advances under this Facility may be used for letters of credit, working capital, capital expenditures, payment of dividends and other lawful corporate purposes, including the refinancing of existing debt.
Under the Facility, a commitment fee is applied on the average daily undrawn portion of the commitments at a rate equal to the applicable margin. The applicable margin in effect from time to time will range from 0.1% to 0.3%, based upon the leverage ratio.
At the Company’s election, the amounts advanced under the Facility bear interest at the base rate or the Eurodollar rate, plus the applicable margin. Interest is generally payable quarterly and any accrued interest and principal is due and payable in September 2010.
There were no outstanding borrowings as of December 31, 2006. As of December 31, 2006, the Company had three outstanding letters of credit in the amount of $1,122,800 which expire on various dates through August 2007. This outstanding balance reduces the borrowing base. The Company had $108,877,200 of borrowings available under the Facility as of December 31, 2006.
Fees incurred on the Facility are being amortized over the term of the life of the loan. The unamortized amount of financing costs was approximately $417,000 and $529,000 at December 31, 2006 and 2005, respectively, and are classified as other assets in the consolidated balance sheet.
The Facility is collateralized by the Company’s accounts receivable and inventories. The Facility requires compliance with certain covenants and restrictions with regard to the interest coverage ratio, tangible net worth and shareholder distributions. At December 31, 2006 and 2005, the Company was in compliance with all covenants and restrictions.
On March 22, 2004, the Company issued an aggregate of $150,000,000 of ten-year, 6.125% unsecured senior notes due in March 2014. The interest on these senior notes is payable on March 15 and September 15 of each year, commencing September 15, 2004.
The notes are senior in right of payment to all of the Company’s subordinated indebtedness and equal in right of payment to all of the Company’s existing and future indebtedness that is not by its terms subordinated to the notes. The Company may redeem the notes at any time after March 15, 2009. In addition, the Company may redeem up to 35% of the notes before March 15, 2007 with the net cash proceeds from a public equity offering.
With the proceeds of the 6.125% senior notes and cash on hand, the Company retired the 8.5% senior notes due in 2009. Of the total $150,000,000 payable, the Company redeemed $132,140,000 in March 2004, with the remaining $17,860,000 in April 2004. The Company also incurred a loss of $9,025,000 from early redemption of the 8.5% senior notes due in 2009, which included premium costs of $6,870,000 and expensing the unamortized issuance costs of $2,155,000. The unamortized portion of the financing costs related to the 6.125% senior notes due in 2014 was approximately $1,744,000 and $1,986,000 at December 31, 2006 and 2005, respectively, and is classified as other assets in the consolidated balance sheet.
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
7. Notes Payable and Long-term Debt (Continued)
On June 24, 2004, the Company completed an exchange offer exchanging its unregistered 6.125% senior notes for 6.125% senior notes registered by the Company pursuant to a registration statement filed under the Securities Act of 1933.
Long-term debt at December 31, 2006 and 2005 consisted of the following (dollars in thousands):
Interest expense was approximately $9,582,000, $9,834,000 and $10,450,000 for the years ended 2006, 2005 and 2004, respectively.
8. Redeemable Preferred Stock and Stockholders’ Equity
The Class A, B and C preferred stock is redeemable by the Company at its option, in whole or in part, at par value. The Class C preferred stock has been classified outside of equity as the preferred stockholders control a majority of the board of directors and therefore control the redemption rights.
Class C preferred stock has priority over the common stock in the distribution of dividends and is entitled to a dividend equivalent to 10% of the par value per annum on a cumulative basis and is thereafter entitled to participate in the distribution of dividends at the same rate and upon the same conditions as the common stock.
In June 2006, draft resolutions were circulated to the stockholders of the Company seeking approval of a conversion of the 3,000 issued and outstanding shares of Class C preferred stock of the Company into 3,000 shares of common stock of the Company in a straight one to one conversion. The stockholders were further asked to approve an amendment to the Certificate of Incorporation of the Company to increase the authorized number of common shares from 2,000 to 5,000 to allow for the conversion. The stockholders adopted resolutions approving both the conversion and the amendment to the Certificate of Incorporation pursuant to a unanimous written consent which became effective in July 2006. The amendment to the Certificate of Incorporation was filed with the Delaware Secretary of State on July 25, 2006.
As a result of the conversion, the $30,000,000 carrying value of the Class C redeemable preferred stock was reclassified to stockholders’ equity as part of common stock.
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
8. Redeemable Preferred Stock and Stockholders’ Equity (Continued)
Each holder of common stock is entitled to one vote for each share held on record on each matter submitted to a vote of the stockholders. Holders of the common stock have no cumulative voting, conversion, or redemption rights, but are entitled to preemptive rights to subscribe for additional shares of common stock in any additional issuance of common stock or any security convertible into common stock. Subject to any preferences that may be granted to the holders of preferred stock, each holder of common stock is entitled to receive ratably dividends as may be declared by the board of directors, and in the event of liquidation, dissolution, or winding up, is entitled to share ratably in all Company assets remaining after payment of liabilities.
During the years ended December 31, 2006, 2005 and 2004, $79,118,000, $56,480,000 and $17,061,000, respectively, in dividends were declared and paid.
9. Related Party Transactions
The Company has transactions in the normal course of business with affiliated companies. The Company is 50% owned by JFE Steel Corporation, a Japanese corporation, and 50% owned by Rio Doce Limited, a subsidiary of Companhia Vale do Rio Doce (“CVRD”), a Brazilian corporation.
The Company purchases steel slab from CST, a former investee, JFE Steel and Cosipa Overseas, an affiliate of CVRD as of November 2006. CST was considered an affiliated company until the investment was sold in June 2005 (Note 6). The following represents total purchases made from affiliated companies for the years ended December 31 (dollars in thousands):
At December 31, 2006 and 2005, the Company owed affiliated companies $31,687,000 and $12,987,000, respectively, for goods and services. No amounts were owed to affiliated companies at December 31, 2004.
During the years ended December 31, 2006, 2005 and 2004, the Company had revenues from an affiliated company of JFE Steel. Sales to the affiliated company are at current market rates and terms. At December 31, 2006, 2005 and 2004, net sales and accounts receivable to this related party were (dollars in thousands):
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
10. Commitments and Contingencies
At December 31, 2006, the Company is committed, in the form of open purchase orders, to purchase approximately $190,159,000 in steel slabs and other commitments, of which $63,300,000 is from related parties.
When market conditions warrant, the Company enters into contracts to purchase certain commodities used in the manufacturing of its products, such as electricity and natural gas. Some of these forward contracts do not require derivative accounting as the Company takes possession of the commodities in the normal course of business whereas other forward contracts are accounted for as derivatives in accordance with SFAS No. 133 by the Company.
The Company has been contacted by various governmental agencies regarding specified environmental matters at its operating facility in Fontana, California. During September 1990, the Company reached a preliminary agreement with the California Regional Department of Health Services, which allows the Company to draft its own remediation agreement and move forward with its own plan of action at its operating facility. In November 1992, the Company entered into a Voluntary and Enforceable Agreement (the “Agreement”) with the California Department of Toxic Substances Control (“DTSC”) which sets forth certain terms and conditions related to the remediation of hazardous substances at the Company’s operating facility. The Agreement also preserves the Company’s right as to future assignment and apportionment of costs to other parties.
The Company is addressing environmental concerns caused by the former occupant at the Company’s Fontana site. The Company engaged an environmental consultant to conduct a remedial investigation and develop a remediation plan and remediation cost projections based upon the plan. Utilizing the remediation plan developed by the environmental consultant, the Company developed an estimate of future costs of the remediation plan. The total aggregate cost of remediation is estimated to be approximately $1,800,000, which is included in the other accrued expenses in the 2006 and 2005 consolidated financial statements. The DTSC has not yet completed its review and approval of the Company’s remediation plan; however, preliminary discussions between the DTSC and the Company have not indicated the need for any significant changes to the remediation plan or the Company’s estimate of related costs. The estimate of costs could change as a result of changes to the remediation plan required by the DTSC or unforeseen circumstances, including without limitations, unknown site conditions, changes to applicable regulations or increased enforcement requirements by the regulators existing at the site.
The Company is involved in legal actions and claims arising in the ordinary course of business. It is the opinion of management, based on advice of legal counsel, that this litigation will be resolved without material effect on the Company’s financial position, results of operations, or liquidity.
The Company is self-insured for workers’ compensation. The accrued liability associated with these programs is based on management’s estimate of the ultimate costs to settle known claims as well as claims incurred but not yet reported (“IBNR claims”) as of the balance sheet date. The estimated liability is not discounted and is based on information provided by the Company’s insurance brokers and insurers, combined with management’s judgments regarding a number of assumptions and factors, including the frequency and severity of claims, the Company’s claims development history, case jurisdiction, related legislation, and the Company’s claim settlement practice. Significant judgment is required to estimate IBNR claims as parties have yet to assert such claims. If actual claim trends, including the severity or frequency of claims, differ from management’s estimates, the Company’s financial results could be impacted.
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
11. Income Taxes
Income tax expense for the years ended December 31, 2006, 2005 and 2004 consists of the following (dollars in thousands):
Actual tax expense from the “expected” tax expense (computed by applying the U.S. federal statutory tax rate of 35% to income before income tax expense) is as follows (dollars in thousands):
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2006 and 2005 are as follows (dollars in thousands):
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
11. Income Taxes (Continued)
The Company recorded a valuation allowance to reduce its deferred tax asset attributable to foreign tax credits for taxes withheld on the sale of investment in affiliated company as described in Note 6. Management considered future foreign source income in determining the need for the valuation allowance and has determined that it is more likely than not that the Company will not generate a significant amount of foreign source income to realize the foreign tax credits before expiration. Therefore, a valuation allowance for the full amount of the remaining foreign tax credit carryforward was recorded as of December 31, 2006. Based on the Company’s historical pretax earnings, management believes it is more likely than not that the Company will realize the benefit of the deferred tax assets existing at December 31, 2006.
12. Employee Benefit and Retirement Plans
401(k) plan: The Company maintains a 401(k) savings plan (the “401(k) Plan”), a tax qualified cash or deferred tax arrangement defined contribution plan under Section 401(k) of the Internal Revenue Code of 1986, as amended. The 401(k) Plan provides the participants with benefits upon retirement, death, disability or termination of employment with the Company. Employees are eligible to participate in the salary reduction portion of the 401(k) Plan on the first day of the calendar month following their date of hire. Participants may authorize the Company to contribute to the 401(k) Plan on their behalf a percentage of their compensation, not to exceed the legally permissible limits.
The 401(k) Plan provides for the Company’s discretionary matching and profit sharing contributions. The Company currently matches 100% of the first 4% of the participant’s deferral under the 401(k) Plan and 50% of the next 2% of the participant’s deferral under the 401(k) Plan each year. Participants are immediately 100% vested in both their contributions and Company contributions plus actual earnings and losses thereon. Company contributions are accrued as participant contributions are withheld and are paid in full to the trustee of the 401(k) Plan on a pay period basis. Each year the Company may elect to make additional contributions to the 401(k) Plan. This discretionary employer contribution, if the Company makes it, is allocated to each participants account based on the participant’s compensation for the year relative to the compensation of all the participants for that year. In order to share in the allocation of the discretionary employer contribution, if any, a participant must complete 1,000 hours of service in the plan year.
Plan expense for the three years ended December 31, 2006, 2005 and 2004 were approximately $2,584,000, $2,393,000 and $2,446,000, respectively.
Profit sharing plan: The Company sponsors a profit sharing plan under which contributions are established based on a pool amount, equal to 8% of the Company’s income before taxes, gain or loss on disposition of fixed assets, and equity in income (loss) of affiliate. The basis for determining the profit sharing pool is subject to review and approval of the Company’s board of directors. The employee’s share in the pool amount is based on his or her length of service with the Company during the profit sharing period. Employees who voluntarily terminate their employment for reasons other than retirement before the end of the profit sharing period and employees whose employment is involuntarily terminated are not eligible to receive any profit sharing award. Profit sharing expense for the years ended December 31, 2006, 2005 and 2004 was approximately $15,982,000, $6,775,000 and $17,772,000, respectively.
California Steel Industries, Inc. and Subsidiary
Notes to Consolidated Financial Statements
13. Selected Quarterly Financial Data (Unaudited)
Summarized quarterly financial data for 2006 and 2005 is as follows (dollars in thousands):
CALIFORNIA STEEL INDUSTRIES, INC.
AND SUBSIDIARY
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
S-1
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
March 28, 2007
CALIFORNIA STEEL INDUSTRIES, INC.
By:
/s/ MASAKAZU KURUSHIMA
Masakazu Kurushima,
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
(1) Incorporated by reference to the Registrant’s Registration Statement on Form S-4, File No. 333-79587, as filed with the Securities and Exchange Commission on May 28, 1999, as amended.
(2) Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, for the period ended June 30, 2000, as filed with the Securities and Exchange Commission on August 4, 2000.
(3) Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, for the period ended September 30, 2000, as filed with the Securities and Exchange Commission on October 27, 2000.
(4) Incorporated by reference to the Registrant’s Annual Report on Form 10-K, for the year ended December 31, 2000, as filed with the Securities and Exchange Commission on March 29, 2001.
(5) Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, for the period ended September 30, 2001, as filed with the Securities and Exchange Commission on November 9, 2001.
(6) Incorporated by reference to the Registrant’s Annual Report on Form 10-K, for the year ended December 31, 2001, as filed with the Securities and Exchange Commission on March 28, 2002.
(7) Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, for the period ended March 31, 2002, as filed with the Securities and Exchange Commission on April 29, 2002.
(8) Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, for the quarter ended March 31, 2004, as filed with the Securities and Exchange Commission on April 28, 2004.
(9) Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, for the period ended September 30, 2004, as filed with the Securities and Exchange Commission on October 15, 2004.
(10) Incorporated by reference to the Registrant’s Annual Report on Form 10-K, for the year ended December 31, 2003, as filed with the Securities and Exchange Commission on March 8, 2004.
(11) Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, for the period ended September 30, 2005, as filed with the Securities and Exchange Commission on October 28, 2005.
(12) Incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, for the period ended September 30, 2006, as filed with the Securities and Exchange Commission on October 27, 2006.