Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
FORWARD LOOKING STATEMENTS
Certain statements herein about our expectations of future events or results constitute forward-looking statements for purposes of the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. You can identify forward-looking statements by terminology such as “may,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue,” or the negative of these terms or other comparable terminology. Such forward-looking statements are based on currently available competitive, financial and economic data and management’s views and assumptions regarding future events. Such forward-looking statements are inherently uncertain, and investors must recognize that actual results may differ from those expressed or implied in the forward-looking statements. In addition, certain factors could affect the outcome of the matters described herein. This Quarterly Report on Form 10-Q may contain forward-looking statements that involve risks and uncertainties including, but not limited to, changes in customer demand and response to products and services offered by AZZ, including demand by the power generation markets, electrical transmission and distribution markets, the industrial markets, and the hot dip galvanizing markets; prices and raw material cost, including zinc and natural gas which are used in the hot dip galvanizing process; changes in the economic conditions of the various markets that AZZ serves, foreign and domestic, customer requested delays of shipments, acquisition opportunities, currency exchange rates, adequacy of financing, and availability of experienced management employees to implement AZZ’s growth strategy; a downturn in market conditions in any industry relating to the products we inventory or sell or the services that we provide; the continuing economic volatility in the U.S. and other markets in which we operate; acts of war or terrorism inside the United States or abroad; and other changes in economic and financial conditions. AZZ has provided additional information regarding risks associated with the business in AZZ’s Annual Report on Form 10-K for the fiscal year ended
February 29, 2012
and other filings with the SEC, available for viewing on AZZ’s website at www.azz.com and on the SEC’s website at www.sec.gov.
You are urged to consider these factors carefully in evaluating the forward-looking statements herein and are cautioned not to place undue reliance on such forward-looking statements, which are qualified in their entirety by this cautionary statement. These statements are based on information as of the date hereof and AZZ assumes no obligation to update any forward-looking statements, whether as a result of new information, future events, or otherwise.
The following discussion should be read in conjunction with management’s discussion and analysis contained in our Annual Report on Form 10-K for the year ended
February 29, 2012
and with the condensed consolidated financial statements and notes thereto included in this Quarterly Report on Form 10-Q.
RESULTS OF OPERATIONS
We have two operating segments as defined in our Annual Report on Form 10-K for the year ended
February 29, 2012
. Management believes that the most meaningful analysis of our results of operations is to analyze our performance by segment. We use revenue and operating income by segment to evaluate our segments. Segment operating income consists of net sales less cost of sales, specifically identifiable selling, general and administrative expenses, and other (income) expense items that are specifically identifiable to a segment. The other (income) expense items included in segment operating income are generally insignificant. For a reconciliation of segment operating income to pretax income, see Note 4 to our quarterly consolidated financial statements included in this Quarterly Report on Form 10-Q.
Orders and Backlog
Our entire backlog relates to our Electrical and Industrial Products Segment. Our backlog was $215.8 million as of
November 30, 2012
, an increase of $77.2 million, or 56%, as compared to $138.6 million at
February 29, 2012
. Our backlog was $132.1 million as of November 30, 2011. We acquired approximately $78.5 million of this backlog through our acquisition of NLI on June 1, 2012. Our book-to-ship ratio was 1.02 to 1 for the third quarter ended
November 30, 2012
, as compared to 1.08 to 1 for the same period in the prior year. Incoming orders increased 22% for the quarter compared to the same period in fiscal 2012. The acquisition of NLI contributed 18% of the 22% increase in incoming orders for the third quarter of fiscal 2013. Our book to ship ratio benefited primarily due to improved order intake for the transmission and distribution markets as well as the industrial market during the third quarter of fiscal 2013.
Backlog Table
(in thousands)(unaudited)
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Period Ended
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Period Ended
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Backlog
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2/29/2012
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$
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138,621
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2/28/2011
|
|
$
|
108,379
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Bookings
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124,666
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|
|
|
|
120,697
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Shipments
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|
|
|
127,143
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|
|
|
|
114,333
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Backlog
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5/31/2012
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$
|
136,144
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5/31/2011
|
|
$
|
114,743
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Book to Ship Ratio
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|
|
|
0.98
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|
|
|
|
1.06
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Bookings
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|
|
151,804
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|
|
|
|
123,097
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Acquired Backlog
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78,491
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—
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Shipments
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153,385
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|
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|
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114,661
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Backlog
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8/31/2012
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$
|
213,054
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8/31/2011
|
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$
|
123,179
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Book to Ship Ratio
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0.99
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|
|
1.07
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Bookings
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152,421
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125,381
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Shipments
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149,675
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116,493
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Backlog
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11/30/2012
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$
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215,800
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11/30/2011
|
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$
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132,067
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Book to Ship Ratio
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1.02
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|
|
|
1.08
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Segment Revenues
The following table reflects the breakdown of revenue by segment:
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Three Months Ended
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Nine Months Ended
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11/30/2012
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11/30/2011
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11/30/2012
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11/30/2011
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(In thousands)(unaudited)
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Revenue:
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Electrical and Industrial Products
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$
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60,421
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$
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43,849
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|
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$
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171,633
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|
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$
|
136,518
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Galvanizing Services
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89,254
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72,644
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258,570
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|
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208,969
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Total Revenue
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$
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149,675
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|
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$
|
116,493
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$
|
430,203
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$
|
345,487
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For the three and nine-month periods ended
November 30, 2012
, consolidated revenues were $149.7 million and $430.2 million, respectively, a 29% and 25% increase, respectively, as compared to the same periods in fiscal 2012. The Electrical and Industrial Products Segment contributed 40% and 38%, respectively, and the Galvanizing Services Segment accounted for 60% and 62%, respectively, of the Company’s combined revenues for the three month periods ended
November 30, 2012
and 2011. For both the nine month periods ended
November 30, 2012
and 2011, the Electrical and Industrial Products Segment contributed 40% of the Company’s revenues, and the Galvanizing Services Segment accounted for 60%, of the combined revenues.
Revenues for the Electrical and Industrial Products Segment increased $16.6 million, or 38%, for the three-month period ended
November 30, 2012
, and increased $35.1 million, or 26%, for the nine-month period ended
November 30, 2012
, as compared to the same periods in fiscal 2012. For the three and nine month periods ended November 30, 2012, revenues increased due primarily to the acquisition of NLI, as compared to prior periods. Revenues from NLI were $16.4 million and $27.8 million for the three and nine month periods, respectively, ended November 30, 2102. Without the acquisition of NLI, revenues were flat for the three month period and increased 5% for the nine month period ended November 30, 2012, as compared to the same periods in the prior year. Increased revenues for the nine month period ended November 30, 2012, were a result of increased order intake during the last two quarters of fiscal 2012, which drove revenues higher during the first half of fiscal 2013.
Revenues in the Galvanizing Services Segment increased $16.6 million, or 23%, for the three-month period ended
November 30, 2012
, as compared to the same period in fiscal 2012 and increased $49.6 million, or 24%, for the nine-month period ended
November 30, 2012
, as compared to the same period in fiscal 2012. The increased revenues in our Galvanizing Services Segment resulted from a continued improved demand from the renewable energy, industrial and OEM markets. In addition to the improvements in these markets, our acquisition of Galvan Metal Inc. in the fourth quarter of fiscal 2012, combined with Galvcast Manufacturing Inc., which was acquired on October 1, 2012, contributed 12% and 7% or $8.6 million and $14.9 million, respectively, for the three and nine month periods ended November 30, 2012 of the increase in
revenue. Historically, revenues for this segment have closely followed the condition of the industrial sector of the general economy.
Segment Operating Income
The following table reflects the breakdown of total operating income by segment:
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Three Months Ended
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Nine Months Ended
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11/30/2012
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11/30/2011
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11/30/2012
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11/30/2011
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(In thousands)(Unaudited)
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Segment Operating Income:
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Electrical and Industrial Products
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$
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8,952
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$
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5,719
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|
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$
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25,087
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|
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$
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18,214
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Galvanizing Services
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24,449
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|
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18,555
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|
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70,631
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|
|
54,431
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Total Segment Operating Income
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$
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33,401
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|
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$
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24,274
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|
|
$
|
95,718
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|
|
$
|
72,645
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|
Our total segment operating income increased 38% for the quarter ended
November 30, 2012
to $33.4 million as compared to $24.3 million for the same period in fiscal 2012. For the nine-month period ended
November 30, 2012
, our total segment operating income increased 32% to $95.7 million, as compared to $72.6 million for the same period ended
November 30, 2011
.
Segment operating income in the Electrical and Industrial Products Segment increased 57% and 38%, respectively, for the three and nine-month periods ended
November 30, 2012
, to $9.0 million and $25.1 million, respectively, as compared to $5.7 million and $18.2 million, respectively, for the same periods in fiscal 2012. Operating margins were 15% for both the three month and nine month periods ended
November 30, 2012
, as compared to 13% for both the comparable periods in fiscal 2012. Operating profits and margins increased for the compared periods due to leverage obtained from increased revenues combined with improved pricing as we continue to adhere to our strategy of not accepting orders with margins that fall below our targeted range. NLI had operating profits of $3.0 million and $3.5 million, respectively, for the three and nine month periods ended November 30, 2012. Without the amortization of intangibles resulting from the acquisition of NLI, the operating margins would have been 18% and 17% for the three and nine month periods ended November 30, 2012. The acquisition of NLI resulted in the amortization of intangibles of NLI was $1.7 million and $3.4 million for the three and nine month periods, respectively, ended November 30, 2012.
In the Galvanizing Services Segment, operating income increased 32% and 30% for the three and nine-month periods ended
November 30, 2012
, to $24.4 million and $70.6 million, respectively, as compared to $18.6 million and $54.4 million, respectively, for the same periods in fiscal 2012. Operating margins were 27% for both the three and nine-month periods ended
November 30, 2012
, as compared to 26% for both the comparable periods in fiscal 2012. For the three and nine month periods ended
November 30, 2012
, a loss was recorded in the amount of $1.0 million and $2.7 million, respectively, at our Joliet, Illinois location. This resulted from the loss of production due to a fire that resulted in a total loss of the facility. This loss is expected to be offset with insurance proceeds for business interruption in a future quarter, once the claim is settled. Without this loss, operating margins would have been 29% and 28% for the three and nine month periods ended November 30, 2012. The Canadian acquisitions of Galvan Metal and Galvcast combined contributed $2.8 million and $4.8 million, respectively in operating profits for the three and nine month periods ended November 30, 2012.
General Corporate Expenses
General Corporate expenses, (see Note 4 to consolidated financial statements) not specifically identifiable to a segment, for the three-month period ended
November 30, 2012
, were $5.7 million compared to $4.7 million for the same period in fiscal 2012. For the nine-month period ended
November 30, 2012
, general corporate expenses were $17.8 million as compared to $15.8 million for the comparable period in the prior year. As a percentage of sales, general corporate expenses were 4% for both the three and nine-month periods ended
November 30, 2012
, as compared to 4% and 5%, respectively, for the same periods in fiscal 2012. Due to increased revenues for the compared periods, general corporate expenses as a percentage of sales were lower than those reported for the nine month period in fiscal 2012. For the first nine months of fiscal 2013, the Company has expensed acquisition costs of $1.1 million related to the acquisition of NLI and Galvcast, (see Note 6 to the condensed consolidated financial statements).
Interest
Net interest expense for the three and nine-month periods ended
November 30, 2012
was $3.2 million and $9.8 million, respectively, as compared to $3.5 and $10.5 million, respectively, for the same periods in fiscal 2012. As of
November 30, 2012
, we had outstanding debt of $210.7 million, compared to $225 million at the same date last year. Our long-term debt to equity ratio was .60 to 1 at
November 30, 2012
, as compared to .76 to 1 at
November 30, 2011
.
Net (Gain) On Insurance Settlement
For the nine-month period ended
November 30, 2012
, the Company received a portion of the insurance recovery in the amount of $10 million for the fire that occurred on April 29, 2012, at our galvanizing facility in Joliet, Illinois. Based on a preliminary estimate of the damage sustained at the Joliet facility, a pretax asset impairment charge of approximately $4 million was recorded during the first quarter of fiscal 2013. The net gain on the insurance settlement of property, plant and equipment of $6 million has been recorded as an item under Net (Gain) Loss On Insurance Settlement or On Sale of Property, Plant and Equipment. During the same period last year the amount reflected was insignificant. We anticipate receiving additional insurance proceeds from these claims in an amount ranging from $10 million to $15 million when all claims are settled.
Other (Income) Expense
For the three and nine-month periods ended
November 30, 2012
and 2011 the amounts in other (income) expense not specifically identifiable with a segment (see Note 4 to consolidated financial statements) were insignificant.
Income Taxes
The provision for income taxes reflects an effective tax rate of 36.4% for the three-month period ended
November 30, 2012
, as compared to 38.0% for same period in fiscal 2012. For the nine month period ended
November 30, 2012
the tax rate was 36.1% as compared to 37.8% for the same period in the prior year. The decrease in the effective tax rate for the compared periods relates to the elimination of a valuation allowance that was recorded in the previous year for the Canadian net operating loss carry forward. The valuation allowance was not required in the current fiscal year due to the net income results from Galvan Metal Inc. Galvan Metal Inc. was acquired in January of 2012.
LIQUIDITY AND CAPITAL RESOURCES
We have historically met our cash needs through a combination of cash flows from operating activities, unsecured notes and bank borrowings. Our cash requirements are generally for operating activities, capital improvements, debt repayment, possible future cash dividend payments and possible acquisitions. We believe that working capital, funds available under our Credit Agreement (as defined below), and funds generated from operations should be sufficient to finance anticipated operational activities, capital improvements, payment of debt, potential redemption of our shares, and possible future cash dividend payments and possible future acquisitions.
Our operating activities generated cash flows of approximately $66.6 million for the nine month period ended
November 30, 2012
compared to $46.8 million for the same period in the prior fiscal year. Cash flows from operations for the nine month period ended
November 30, 2012
included net income in the amount of $47.2 million, depreciation and amortization in the amount of $21.1 million, and other adjustments to reconcile net income to net cash in the amount of $0.2 million. Included in other adjustments were increases from share-based compensation expense in the amount of $2.8 million, provisions for bad debts in the amount of $.5 million, deferred income taxes in the amount of $2.5 million, gain or loss on the sale of assets or insurance settlement in the amount of $(5.8) million, and other non-cash adjustments in the amount of $0.2 million. Reductions in other adjustments related to increased accounts receivable, inventories and prepaid expenses in the amount of $8.3 million, $6.7 million and $1.1 million, respectively. Positive cash flows were recognized due to increased accounts payable and other accrued liabilities in the amount of $2.5 million and $9.5 million, respectively, and decreased revenue in excess of billings and other assets in the amount of $2.0 million and $0.1 million, respectively. Accounts receivable average days outstanding were 49 days for the nine month period ended
November 30, 2012
, as compared to 48 days for the same period in the prior fiscal year.
During the nine month period ended
November 30, 2012
, capital improvements were made in the amount of $19.6 million.
During the nine month period ended
November 30, 2012
, dividends were paid in the amount of $9.9 million.
Our working capital declined to $142.6 million at
November 30, 2012
, as compared to $238.1 million at November 30, 2011, due primarily to the acquisition of NLI and GalvCast.
On May 25, 2006, we entered into the Second Amended and Restated Credit Agreement (as subsequently amended, the “Credit Agreement”) with Bank of America, N.A. (“Bank of America”). The Credit Agreement provides for a $125 million unsecured
revolving line of credit maturing on October 1, 2017. The Credit Agreement is used to provide for working capital needs, capital improvements, future acquisitions and letter of credit needs.
The Credit Agreement provides various financial covenants requiring us, among other things, to a) maintain on a consolidated basis net worth equal to at least the sum of $182.3 million, plus 50% of future net income, b) maintain on a consolidated basis a Leverage Ratio (as defined in the Credit Agreement) not to exceed 3.25:1.0, c) maintain on a consolidated basis a Fixed Charge Coverage Ratio (as defined in the Credit Agreement) of at least 1.75:1.0 and d) not to make Capital Expenditures (as defined in the Credit Agreement) on a consolidated basis in an amount in excess of $40 million (excluding certain Capital Expenditures relating to the rebuilding of our Joliet facility), e) purchase price of acquisitions in a twelve month period must not exceed the last twelve months EBITDA (as defined in the Credit Agreement).
The Credit Agreement also provides for an applicable margin ranging from 1.00% to 1.75% over the Eurodollar Rate and Commitment Fees ranging from .20% to .30% depending on our Leverage Ratio.
At
November 30, 2012
, we had no outstanding debt borrowed under the revolving credit agreement; we had letters of credit outstanding at that date in the amount of $16.9 million, which left approximately $108.1 million of additional credit available under the revolving credit facility.
On March 31, 2008, the Company entered into a Note Purchase Agreement (the “Note Purchase Agreement”) pursuant to which the Company issued $100 million aggregate principal amount of its 6.24% unsecured Senior Notes (the “2008 Notes”) due March 31, 2018 through a private placement (the “2008 Note Offering”). Pursuant to the Note Purchase Agreement, the Company’s payment obligations with respect to the 2008 Notes may be accelerated upon any Event of Default, as defined in the Note Purchase Agreement. In connection with the 2008 Note Offering, the Company obtained the consent of Bank of America to the 2008 Note Offering and the agreement of Bank of America that the 2008 Note Offering will not constitute a default under the Credit Agreement.
The Company entered into an additional Note Purchase Agreement on January 21, 2011 (the “2011 Agreement”), pursuant to which the Company issued $125 million aggregate principal amount of its 5.42% unsecured Senior Notes (the “2011 Notes”), due in January of 2021, through a private placement (the “2011 Note Offering”). Pursuant to the 2011 Agreement, the Company’s payment obligations with respect to the 2011 Notes may be accelerated under certain circumstances. The Company anticipates using the proceeds from the 2011 Note Offering for possible future acquisitions, working capital needs, capital improvements and future cash dividend payments. In connection with the 2011 Note Offering, the Company obtained the consent of Bank of America to the 2011 Note Offering and the agreement of Bank of America that the 2011 Note Offering will not constitute a default under the Credit Agreement.
The 2008 Notes and the 2011 Notes each provide for various financial covenants requiring us, among other things, to a) maintain on a consolidated basis net worth equal to at least the sum of $116.9 million plus 50% of future net income; b) maintain a ratio of indebtedness to EBITDA (as defined in Note Purchase Agreement) not to exceed
3.25:1.00; c) maintain on a consolidated basis a Fixed Charge Coverage Ratio (as defined in the Note Purchase Agreement) of at least 2.0:1.0; d) not at any time permit the aggregate amount of all Priority Indebtedness (as defined in the Note Purchase Agreement) to exceed 10% of Consolidated Net Worth (as defined in the Note Purchase Agreement).
As of
November 30, 2012
, we were in compliance with all of our debt covenants.
Our current ratio (current assets/current liabilities) was 2.3 to 1 at
November 30, 2012
, as compared to 4.2 to 1 at November 30, 2011. Our ratio of long-term debt to shareholders’ equity was .60 to 1 at
November 30, 2012
.
Historically, we have not experienced a significant impact on our operations from increases in general inflation other than for specific commodities. We have exposure to commodity price increases in both segments of our business, primarily copper, aluminum and steel in the Electrical and Industrial Products Segment, and zinc and natural gas in the Galvanizing Services Segment. When market conditions allow, we attempt to minimize these increases through escalation clauses in customer contracts for copper, aluminum and steel and through protective caps and fixed contract purchases on zinc. In addition to these measures, we attempt to recover other cost increases through improvements to our manufacturing process and through increases in prices where competitively feasible. Many economists predict increased inflation in coming years due to U.S. and international monetary policies, and there is no assurance that inflation will not impact our business in the future.
Subsequent Events
On January 2, 2013, we acquired G3 Galvanizing, a galvanizing operation in Halifax, Nova Scotia. This acquisition is part of the stated AZZ strategy to continue the geographic expansion of its served markets that should provide a basis for continued growth of the Galvanizing Services Segment of AZZ.
OFF BALANCE SHEET TRANSACTIONS AND RELATED MATTERS
Other than operating leases discussed below, there are no off-balance sheet transactions, arrangements, obligations (including contingent obligations), or other relationships with unconsolidated entities or other persons that have, or may have, a material effect on financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources of the Company.
CONTRACTUAL COMMITMENTS
Leases
We lease various facilities under non-cancelable operating leases with an initial term in excess of one year. The future minimum payments required under these operating leases as of
November 30, 2012
are summarized in the table below under “Other.”
Commodity pricing
The Company manages its exposures to commodity prices through the use of the following:
In the Electrical and Industrial Products Segment, we have exposure to commodity pricing for copper, aluminum and steel. Because the Electrical and Industrial Products Segment does not commit contractually to minimum volumes,
increases in price for these items are normally managed through escalation clauses in customer contracts, although during difficult market conditions these escalation clauses may not be obtainable. In addition, we look to get firm pricing contracts from our vendors on material at the time we receive orders from our customers to minimize risk.
In the Galvanizing Services Segment, we utilize contracts with our zinc suppliers that include protective caps and fixed cost contracts to guard against rising zinc prices. We also secure firm pricing for natural gas supplies with individual utilities when possible. Management believes these agreements ensure adequate supplies and partially offset exposure to commodity price swings.
We have no contracted commitments for any other commodity items including steel, aluminum, natural gas, copper, zinc or any other commodity, except for those entered into under the normal course of business.
Other
At
November 30, 2012
, we had outstanding letters of credit in the amount of $16.9 million. These letters of credit are issued, in lieu of performance and bid bonds, to some of our customers to cover any potential warranty costs that the customer might incur. In addition, as of
November 30, 2012
, a warranty reserve in the amount of $1.3 million has been established to offset any future warranty claims.
The following summarizes our operating leases, and long-term debt and interest expense for the next five years and beyond.
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Operating
Leases
|
|
Long-Term
Debt
|
|
Interest
|
|
Total
|
|
|
(In thousands)
|
2013
|
|
$
|
1,162
|
|
|
$
|
—
|
|
|
$
|
3,387
|
|
|
$
|
4,549
|
|
2014
|
|
4,269
|
|
|
14,286
|
|
|
11,678
|
|
|
30,233
|
|
2015
|
|
4,027
|
|
|
14,286
|
|
|
10,786
|
|
|
29,099
|
|
2016
|
|
3,734
|
|
|
14,286
|
|
|
9,895
|
|
|
27,915
|
|
2017
|
|
3,539
|
|
|
14,286
|
|
|
9,004
|
|
|
26,829
|
|
Thereafter
|
|
8,903
|
|
|
153,570
|
|
|
28,883
|
|
|
191,356
|
|
Total
|
|
$
|
25,634
|
|
|
$
|
210,714
|
|
|
$
|
73,633
|
|
|
$
|
309,981
|
|
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of the consolidated financial statements requires us to make estimates that affect the reported value of assets, liabilities, revenues and expenses. Our estimates are based on historical experience and various other factors that we believe are reasonable under the circumstances and form the basis for our conclusions. We continually evaluate the information used to make these estimates as business and economic conditions change. Accounting policies and estimates considered most critical are allowances for doubtful accounts, accruals for contingent liabilities, revenue recognition, impairment of long-lived assets, identifiable intangible assets and goodwill, and accounting for income taxes and stock options and stock appreciation rights. Actual results may differ from these estimates under different assumptions or conditions. The development and selection of the critical accounting policies and the related disclosures below have been reviewed with the Audit Committee of the Board of Directors. More information regarding significant accounting policies can be found in Note 1 to the Annual Consolidated Financial Statements filed with our Annual Report on Form 10-K for the fiscal year ended February 29, 2012.
Allowance for Doubtful Accounts
- The carrying value of our accounts receivable is continually evaluated based on the likelihood of collection. An allowance is maintained for estimated losses resulting from our customers’ inability to make required payments. The allowance is determined by historical experience of uncollected accounts, the level of past due accounts, overall level of outstanding accounts receivable, information about specific customers with respect to their inability to make payments and future expectations of conditions that might impact the collectability of accounts receivable. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances could be required.
Accruals for Contingent Liabilities
- The amounts we record for estimated claims, such as self insurance programs, warranty, environmental and other contingent liabilities, requires us to make judgments regarding the amount of expenses that will ultimately be incurred. We use past history and experience and other specific circumstances surrounding these claims in evaluating the amount of liability that should be recorded. Actual results may be different than what we estimate.
Revenue Recognition
- Revenue is recognized for the Electrical and Industrial Products Segment upon transfer of title and risk to customers, or based upon the percentage of completion method of accounting for electrical products built to customer specifications under long term contracts. We typically recognize revenue for the Galvanizing Service Segment at completion of the service unless we specifically agree with the customer to hold its material for a predetermined period of time after the completion of the galvanizing process and, in that circumstance, we invoice and recognize revenue upon shipment. Customer advanced payments presented in the balance sheets arise from advanced payments received from our customers prior to shipment of the product and are not related to revenue recognized under the percentage of completion method. The extent of progress for revenue recognized using the percentage of completion method is measured by the ratio of contract costs incurred to date to total estimated contract costs at completion. Contract costs include direct labor and material and certain indirect costs. Selling, general and administrative costs are charged to expense as incurred. Provisions for estimated losses, if any, on uncompleted contracts are made in the period in which such losses are able to be determined. The assumptions made in determining the estimated cost could differ from actual performance resulting in a different outcome for profits or losses than anticipated.
Impairment of Long-Lived Assets, Identifiable Intangible Assets and Goodwill
- We record impairment losses on long-lived assets, including identifiable intangible assets, when events and circumstances indicate that the assets might be impaired and the undiscounted projected cash flows associated with those assets are less than the carrying amounts of those assets. In those situations, impairment losses on long-lived assets are measured based on the excess of the carrying amount over the asset’s fair value, generally determined based upon discounted estimates of future cash flows. A significant change in events, circumstances or projected cash flows could result in an impairment of long-lived assets, including identifiable intangible assets. An annual impairment test of goodwill is performed in the fourth quarter of each fiscal year. The test is calculated using the anticipated future cash flows after tax from our operating segments. Based on the present value of the future cash flows, we will determine whether impairment may exist. A significant change in projected cash flows or cost of capital for future years could result in an impairment of goodwill in future years. Variables impacting future cash flows include, but are not limited to, the level of customer demand for and response to products and services we offer to the power generation market, the electrical transmission and distribution markets, the general industrial market and the hot dip galvanizing market, changes in economic conditions of these various markets, raw material and natural gas costs and availability of experienced labor and management to implement our growth strategies. Our testing concludes goodwill is not reasonably likely to be impaired.
Accounting for Income Taxes
- We account for income taxes under the asset and liability method. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in our financial statements or tax returns. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater
than a 50% likelihood of being realized upon ultimate settlement. Developing our provision for income taxes requires significant judgment and expertise in federal and state income tax laws, regulations and strategies, including the determination of deferred tax assets and liabilities and, if necessary, any valuation allowances that may be required for deferred tax assets. Our judgments and tax strategies are subject to audit by various taxing authorities.
Stock Options, Stock Appreciation Rights and Restricted Stock Units
- Our employees and directors are periodically granted restricted stock units, stock options or stock appreciation rights by the Compensation Committee of the Board of Directors. The compensation cost of all employee stock-based compensation awards is measured based on the grant-date fair value of those awards and that cost is recorded as compensation expense over the period during which the employee is required to perform service in exchange for the award (generally over the vesting period of the award).
The valuation of stock based compensation awards, with the exception of restricted stock units, is complex in that there are a number of variables included in the calculation of the value of the award:
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Volatility of our stock price
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Expected term of the option
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Expected dividend yield
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Risk-free interest rate over the expected term
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Expected forfeitures
We have elected to use a Black-Scholes pricing model in the valuation of our stock options and stock appreciation rights. Restricted stock units are valued at the stock price on the date of grant.
These variables are developed using a combination of our internal data with respect to stock price volatility and exercise behavior of option holders and information from outside sources. The development of each of these variables requires a significant amount of judgment. Changes in the values of the above variables would result in different option valuations and, therefore, different amounts of compensation cost.