SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
COMMISSION FILE NUMBER 1-15603
NATCO GROUP INC.
(Exact name of registrant as specified in its charter)
DELAWARE 22-2906892
(State or other jurisdiction of incorporation (I.R.S. Employer
or organization) Identification No.)
2950 NORTH LOOP WEST
7TH FLOOR
HOUSTON, TEXAS 77092
(Address of principal executive offices) (Zip Code)
713-683-9292
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12 b-2 of the Exchange Act). Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date:
As of April 30, 2004, $0.01 par value per share, 15,922,661 shares
NATCO GROUP INC.
FORM 10-Q
FOR THE QUARTER ENDED MARCH 31, 2004
TABLE OF CONTENTS
PAGE
NO.
----
PART I -- FINANCIAL INFORMATION
Item 1. Financial Statements................................... 3
Condensed Consolidated Balance Sheets -- March 31,
2004 (unaudited) and December 31, 2003................. 3
Unaudited Condensed Consolidated Statements of
Operations -- Three Months Ended March 31, 2004 and
2003................................................... 4
Unaudited Condensed Consolidated Statements of Cash
Flows -- Three Months Ended March 31, 2004 and 2003.... 5
Notes to Unaudited Condensed Consolidated Financial
Statements............................................. 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................... 17
Item 3. Quantitative and Qualitative Disclosures About Market
Risk................................................... 26
Item 4. Controls and
Procedures............................................. 26
PART II -- OTHER INFORMATION
Item 1. Legal Proceedings...................................... 27
Item 6. Exhibits and Reports on Form 8-K....................... 27
Signatures ....................................................... 28
2
PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NATCO GROUP INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
MARCH 31, DECEMBER 31,
2004 2003
---------- ------------
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents.................................. $ 3,018 $ 1,751
Trade accounts receivable, net............................. 71,229 70,902
Inventories................................................ 35,448 34,573
Prepaid expenses and other current assets.................. 8,592 7,770
---------- ---------
Total current assets................................. 118,287 114,996
Property, plant and equipment, net........................... 36,666 37,076
Goodwill, net................................................ 80,014 80,097
Deferred income tax assets, net.............................. 4,296 4,290
Other assets, net............................................ 1,176 1,269
---------- ---------
Total assets......................................... $ 240,439 $ 237,728
========== =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current installments of long-term debt..................... $ 7,926 $ 5,617
Accounts payable........................................... 34,877 38,976
Accrued expenses and other................................. 33,349 30,257
Customer advances.......................................... 5,980 5,527
---------- ---------
Total current liabilities............................ 82,132 80,377
Long-term debt, excluding current installments............... 39,739 38,003
Postretirement benefit and other long-term liabilities....... 12,518 12,771
---------- ---------
Total liabilities.................................... 134,389 131,151
---------- ---------
Series B redeemable convertible preferred stock (aggregate
redemption value of $15,000), $.01 par value. 15,000 shares
authorized, issued and outstanding (net of issuance costs). 14,101 14,101
Stockholders' equity:
Preferred stock $.01 par value. Authorized 5,000,000 shares
(of which 500,000 are designated as Series A and 15,000 are
designated as Series B); no shares issued and outstanding -- --
(except Series B shares above).............................
Series A preferred stock, $.01 par value. Authorized 500,000
shares; no shares issued and outstanding................. -- --
Common stock, $.01 par value. Authorized
50,000,000 shares; issued and outstanding 15,922,661 and
15,854,067 shares as of March 31, 2004 and December 31,
2003, respectively....................................... 159 159
Additional paid-in capital................................. 97,783 97,351
Accumulated earnings....................................... 7,696 8,115
Treasury stock, 795,692 shares at cost as of March 31, 2004
and December 31, 2003.................................... (7,182) (7,182)
Accumulated other comprehensive loss....................... (2,630) (2,127)
Notes receivable from officers............................. (3,877) (3,840)
----------- ---------
Total stockholders' equity........................... 91,949 92,476
---------- ---------
Commitments and contingencies
Total liabilities and stockholders' equity........... $ 240,439 $ 237,728
========== =========
See accompanying notes to unaudited condensed consolidated
financial statements.
3
NATCO GROUP INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED
MARCH 31,
-------------------
2004 2003
------- -------
Revenues........................................... $71,984 $68,013
Cost of goods sold................................. 55,169 52,202
------- -------
Gross profit............................. 16,815 15,811
Selling, general and administrative expense........ 13,295 12,644
Depreciation and amortization expense.............. 1,374 1,230
Closure and other.................................. -- 230
Interest expense................................... 935 1,062
Write-off of unamortized loan costs................ 667 --
Interest cost on postretirement benefit liability.. 225 209
Interest income.................................... (62) (49)
Other, net......................................... 454 346
------- -------
Income (loss) before income taxes and cumulative
effect of change in accounting principle..... (73) 139
Income tax provision (benefit)..................... (29) 50
------- -------
Net income (loss) before cumulative effect of
change in accounting principle............... (44) 89
Cumulative effect of change in accounting principle
(net of tax benefit of $18 in 2003).......... -- 34
------- -------
Net income (loss)........................ $ (44) $ 55
Preferred stock dividends......................... 375 25
------- -------
Net income (loss) available to common
stockholders........................ $ (419) $ 30
======= =======
Earnings (loss) per share -- basic:
Net income (loss) before cumulative effect of
change in accounting principle................... $ (0.03) $ --
Cumulative effect of change in
accounting principle ............................ -- --
------- -------
Net income (loss)........................ $ (0.03) $ --
======= =======
Earnings (loss) per share -- diluted:
Net income (loss) before cumulative effect of
change in accounting principle................... $ (0.03) $ --
Cumulative effect of change in
accounting principle............................. -- --
------- -------
Net income (loss)........................ $ (0.03) $ --
======= =======
Basic weighted average number of shares of
common stock outstanding......................... 15,908 15,804
Diluted weighted average number of shares
of common stock outstanding...................... 15,908 15,874
See accompanying notes to unaudited condensed consolidated
financial statements.
4
NATCO GROUP INC. AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31,
-------------------
2004 2003
---- ------
Cash flows from operating activities:
Net income (loss)............................................... $ (44) $ 55
Adjustments to reconcile net income (loss) to net
cash used in operating activities:
Cumulative effect of change in accounting
principle.................................................. -- 34
Deferred income tax expense.................................. 129 125
Depreciation and amortization expense........................ 1,374 1,230
Non-cash interest income..................................... (37) (40)
Non-cash interest expense.................................... 166 193
Write-off of unamortized loan costs.......................... 667 --
Revaluation of warrants and other............................ (26) --
Interest cost on postretirement benefit liability 225 209
(Gain)/loss on the sale of property, plant and
equipment.................................................. 5 (231)
Change in assets and liabilities:
Increase in trade accounts receivable...................... (21) (6,575)
Increase in inventories.................................... (875) (653)
Increase in prepaid expense and other current
assets................................................... (763) (1,985)
Increase in long-term assets............................... (67) (119)
Increase (decrease) in accounts payable.................... (3,849) 6,921
Increase (decrease) in accrued expenses and
other.................................................... 2,296 (2,307)
Increase (decrease) in customer advances................... 396 (818)
--------- -------
Net cash used in operating activities................... (424) (3,961)
--------- -------
Cash flows from investing activities:
Capital expenditures for property, plant and
equipment..................................................... (839) (3,072)
Proceeds from the sale of property, plant and
equipment..................................................... 60 618
--------- -------
Net cash used in investing activities................... (779) (2,454)
--------- -------
Cash flows from financing activities:
Net repayments under long-term revolving
credit facilities............................................. (10,134) (5,592)
Repayments of long-term debt.................................... (30,774) (1,775)
Borrowings of long-term debt.................................... 45,000 --
Proceeds from the issuance of preferred stock, net.............. -- 14,101
Issuance related to employee stock options...................... 359 --
Deferred financing fees......................................... (684) --
Change in bank overdrafts....................................... (304) (989)
Payments on postretirement benefit liability.................... (504) (374)
--------- -------
Net cash provided by financing activities .............. 2,959 5,371
--------- -------
Effect of exchange rate changes on cash and cash
equivalents..................................................... (489) 637
---------- -------
Change in cash and cash equivalents............................... 1,267 (407)
Cash and cash equivalents at beginning of period.................. 1,751 1,689
--------- -------
Cash and cash equivalents at end of period........................ $ 3,018 $ 1,282
========= =======
Cash payments for:
Interest........................................................ $ 419 $ 1,022
Income taxes.................................................... $ 95 $ 340
See accompanying notes to unaudited condensed consolidated
financial statements.
5
NATCO GROUP INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(1) BASIS OF PRESENTATION
The accompanying condensed consolidated interim financial statements
and related disclosures are unaudited and have been prepared by NATCO Group Inc.
pursuant to generally accepted accounting principles for interim financial
statements and the rules and regulations of the Securities and Exchange
Commission. As permitted by these regulations, certain information and footnote
disclosures that would typically be required in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted. However, the Company's management believes that these statements
reflect all the normal recurring adjustments necessary for a fair presentation,
in all material respects, of the results of operations for the periods
presented, so that these interim financial statements are not misleading. These
condensed consolidated financial statements should be read in conjunction with
the financial statements and notes thereto included in the Company's Annual
Report on Form 10-K filing for the year ended December 31, 2003.
To prepare financial statements in accordance with generally accepted
accounting principles, the Company's management is required to make estimates
and assumptions that affect the reported amounts of assets and liabilities,
disclosure of contingent assets and liabilities at the date of the financial
statements, and reported amounts of revenues and expenses incurred during the
reporting period. Actual results could differ from those estimates. Furthermore,
certain reclassifications have been made to 2003 amounts in order to present
these results on a comparable basis with amounts for 2004. These
reclassifications had no impact on net income.
References to "NATCO" and "the Company" are used throughout this
document and relate collectively to NATCO Group Inc. and its consolidated
subsidiaries.
(2) EMPLOYEE STOCK OPTIONS
The Company accounts for its employee stock option plans by applying
the provisions of Accounting Principles Board ("APB") Opinion No. 25,
"Accounting for Stock Issued to Employees," as permitted by Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation." SFAS No. 123 allows entities to recognize as expense over the
vesting period the fair value of all stock-based awards on the date of grant. If
entities continued to apply the provision of APB Opinion No. 25, pro forma net
income and earnings per share disclosures would be required for all employee
stock option grants made in 1995 and subsequent years, as if the fair
value-based method defined in SFAS No. 123 had been applied. SFAS No. 148,
"Accounting for Stock-Based Compensation -- Transition and Disclosure, an
amendment to FASB Statement No. 123," issued in December 2002, provided
alternative methods to transition to the fair value method of accounting for
stock-based compensation, on a volunteer basis, and required additional
disclosures at annual and interim reporting dates. The Company has elected to
continue to apply the provisions of APB Opinion No. 25 and to provide the pro
forma disclosures required by SFAS No. 123.
The Company determines pro forma net income and earnings per share by
applying the Black-Scholes Single Option -- Reduced Term valuation method. This
valuation model requires management to make highly subjective assumptions about
the volatility of NATCO's common stock, the expected term of outstanding stock
options, the Company's risk-free interest rate and expected dividend payments
during the contractual life of the options. The following table summarizes these
pro forma net earnings and earnings per share amounts for the three-month
periods ended March 31, 2004 and 2003.
6
THREE MONTHS ENDED
-------------------
MARCH 31,
---------
2004 2003
------ ------
(unaudited; in
thousands, except per
share amounts)
Net income (loss) available to common
stockholders -- as reported............ $ (419) $ 30
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all
awards, net of related tax effects (151) (151)
------ ------
Pro forma loss............................ $ (570) $ (121)
====== ======
Loss per share:
Basic -- as reported................... $(0.03) $ --
Basic -- pro forma .................... $(0.04) $(0.01)
Diluted -- as reported................. $(0.03) $ --
Diluted -- pro forma................... $(0.04) $(0.01)
(3) CAPITAL STOCK AND REDEEMABLE CONVERTIBLE PREFERRED STOCK
On March 25, 2003, the Company issued 15,000 shares of Series B
Convertible Preferred Stock ("Series B Preferred Shares") and warrants to
purchase 248,800 shares of NATCO's common stock, to Lime Rock Partners II, L.P.,
a private investment fund, for an aggregate price of $15.0 million.
Approximately $99,000 of the aggregate purchase price was allocated to the
warrants. Proceeds from the issuance of these securities, net of related
estimated issuance costs of approximately $800,000, were used to reduce the
Company's outstanding revolving debt balances and for other general corporate
purposes.
Each of the Series B Preferred Shares has a face value of $1,000 and
pays a cumulative dividend of 10% per annum of face value, which is payable
semi-annually on June 15 and December 15 of each year, except the initial
dividend payment which was payable on July 1, 2003. Each of the Series B
Preferred Shares is convertible, at the option of the holder, into (1) a number
of shares of common stock equal to the face value of such Series B Preferred
Share divided by the conversion price, which was $7.805 (or an aggregate of
1,921,845 shares) at March 31, 2004, and (2) a cash payment equal to the amount
of dividends on such shares that have accrued since the prior semi-annual
dividend payment date. As of March 31, 2004, the Company had accrued dividends
payable of $375,000 related to the Series B Preferred Shares.
In the event of a change in control, as defined in the certificate of
designations for the Series B Preferred Shares, each holder of the Series B
Preferred Shares has the right to convert the Series B Preferred Shares into
common stock or to cause the Company to redeem for cash some or all of the
Series B Preferred Shares at an aggregate redemption price equal to the greater
of (1) the sum of (a) $1,000 (adjusted for stock splits, stock dividends, etc.)
multiplied by the number of shares to be redeemed, plus (b) an amount (not less
than zero) equal to the product of $500 (adjusted for stock splits, stock
dividends, etc.) multiplied by the aggregate number of the Series B Preferred
Shares to be redeemed, less the sum of the aggregate amount of dividends paid in
cash since the issuance date, plus any gain on the related warrants, and (2) the
aggregate face value of the Series B Preferred Shares plus the aggregate amount
of dividends that have accrued on such shares since the last dividend payment
date. If the holder of the Series B Preferred Shares converts upon a change in
control occurring on or before March 25, 2006, the holder also would be entitled
to receive cash in an amount equal to the dividends that would have accrued
through March 25, 2006 less the sum of the aggregate amount of dividends paid in
cash through the date of conversion, and the aggregate amount of dividends
accrued in prior periods but not yet paid.
The Company has the right to redeem the Series B Preferred Shares for
cash on or after March 25, 2008, at a redemption price per share equal to the
face value of the Series B Preferred Shares plus the amount of dividends that
have been accrued but not paid since the most recent semi-annual dividend
payment date.
Due to the cash redemption features upon a change in control as
described above, the Series B Preferred Shares do not qualify for permanent
equity treatment in accordance with the Emerging Issues Task Force Topic D-98:
"Classification and Measurement of Redeemable Securities," which specifically
requires that permanent equity treatment be precluded for any security with
redemption features that are not solely within the control of the issuer.
Therefore, the Company has accounted for the Series B Preferred Shares as
temporary equity in the accompanying balance sheet, and has not assigned any
value to its right to redeem the Series B Preferred Shares on or after March 25,
2008.
7
If the Series B Preferred Shares are converted under contingent
redemption features, any redemption amount greater than carrying value would be
recorded as a reduction of income available to common stockholders when the
event becomes probable.
If the Company fails to pay dividends for two consecutive periods or
any redemption price due with respect to the Series B Preferred Shares for a
period of 60 days following the payment date, the Company would be in default
under the terms of such shares. During a default period, (1) the dividend rate
on the Series B Preferred Shares would increase to 10.25%, (2) the holders of
the Series B Preferred Shares would have the right to elect or appoint a second
director to the Board of Directors and (3) the Company would be restricted from
paying dividends on, or redeeming or acquiring its common or other outstanding
stock, with limited exceptions. If the Company fails to set aside or make
payments in cash of any redemption price due with respect to the Series B
Preferred Shares, and the holders elect, the Company's right to redeem the
shares may be terminated.
The warrants issued to Lime Rock Partners II, L.P. have an exercise
price of $10.00 per share of common stock and expire on March 25, 2006. The
Company can force the exercise of the warrants if NATCO's common stock trades
above $13.50 per share for 30 consecutive days. The warrants contain a provision
whereby the holder could require the Company to make a net-cash settlement for
the warrants in the case of a change in control. The warrants were deemed to be
derivative instruments and, therefore, the warrants were recorded at fair value
as of the issuance date. Fair value, as agreed with the counter-party to the
agreement, was calculated by applying a pricing model that included subjective
assumptions for stock volatility, expected term that the warrants would be
outstanding, a dividend rate of zero and an overall liquidity factor. The
Company recorded the resulting liability of $99,000 as of the issuance date. The
Company adjusted this liability to $122,000 as of March 31, 2004, as a result of
the change in the fair value of the warrants. Similarly, changes in fair value
in future periods will be recorded in net income during the period of the
change.
(4) EARNINGS (LOSS) PER SHARE
The Company computed basic earnings per share by dividing net income
(loss) available to common stockholders by the weighted average number of shares
outstanding for the period. Net loss available to common stockholders at March
31, 2004, represented the net loss before the cumulative effect of change in
accounting principle less preferred stock dividends accrued. The Company
determined diluted earnings (loss) per common and potential common share at
March 31, 2004, as net loss available to common stockholders divided by the
weighted average number of shares outstanding for the period, after applying the
if-converted method to determine any incremental shares associated with
convertible preferred stock, warrants and restricted stock outstanding. Since
the effect of such incremental shares was anti-dilutive at March 31, 2004, these
shares were not considered common and potential common shares for purposes of
calculating earnings (loss) per share at March 31, 2004, in accordance with SFAS
No. 128, "Earnings per Share." Outstanding employee stock options were
considered potential common shares for purposes of this calculation. However,
potential common shares related to employee stock options were anti-dilutive for
the three-month period ended March 31, 2004, as the Company recorded a net loss
available to common stockholders during this period. For the three months ended
March 31, 2003, potential common shares related to employee stock options
included in diluted weighted average shares were 70,525 shares. Anti-dilutive
stock options were excluded from the calculation of potential common shares. If
anti-dilutive shares were included in the calculation for the three-month
periods ended March 31, 2004 and 2003, the impact would have been a reduction of
321,385 shares and 465,598 shares, respectively. The following table presents
the computation of basic and diluted earnings (loss) per common and potential
common share for the three months ended March 31, 2004 and 2003, respectively:
8
THREE MONTHS ENDED MARCH 31, 2004 THREE MONTHS ENDED MARCH 31, 2003
------------------------------------------ -----------------------------------------
INCOME SHARES PER-SHARE INCOME SHARES PER-SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT (NUMERATOR) (DENOMINATOR) AMOUNT
--------- ----------- --------- --------- ----------- --------
(UNAUDITED, IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Net income (loss) before
cumulative effect of change
in accounting principle $ (44) $ 89
Less: Preferred stock
dividends accrued (375) (25)
------- -----
Basic EPS:
Income (loss) available to
common stockholders before
cumulative effect of change
in accounting principle $ (419) 15,908 $ (0.03) $ 64 15,804 $ --
======== ======
Effect of dilutive securities:
Stock options -- -- -- 70
------- ------ ----- ------
Diluted EPS:
Income (loss) available to
common stockholders before
cumulative effect of change
in accounting principle plus
assumed conversions $ (419) 15,908 $ (0.03) $ 64 15,874 $ --
======= ====== ======= ===== ====== ======
(5) INVENTORIES
Inventories consisted of the following amounts:
MARCH 31, DECEMBER 31,
2004 2003
-------- -----------
(UNAUDITED)
(IN THOUSANDS)
Finished goods...................... $ 11,499 $11,778
Work-in-process..................... 8,732 8,402
Raw materials and supplies.......... 17,082 16,168
-------- -------
Inventories at FIFO............... 37,313 36,348
Excess of FIFO over LIFO cost ...... (1,865) (1,775)
-------- -------
$ 35,448 $34,573
======== =======
For the three months ended March 31, 2004, cost of goods sold was
increased by $10,000 due to the liquidation of LIFO layers.
(6) COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS
Cost and estimated earnings on uncompleted contracts were as follows:
MARCH 31, DECEMBER 31,
2004 2003
-------- -----------
(UNAUDITED)
(IN THOUSANDS)
Cost incurred on uncompleted contracts............... $ 68,320 $86,076
Estimated earnings................................... 18,511 22,585
-------- -------
86,831 108,661
Less billings to date................................ 70,793 91,288
-------- -------
$ 16,038 $17,373
======== =======
Included in the accompanying balance sheet under the
captions:
Trade accounts receivable.......................... $ 20,665 $22,375
Advance payments................................... (4,627) (5,002)
-------- -------
$ 16,038 $17,373
======== ========
(7) CLOSURE AND OTHER
In September 2003, the Company recorded expenses of $722,000 associated
with a management-approved restructuring plan, which included the involuntary
termination of certain administrative and operating personnel in connection with
the closure of a manufacturing facility in Covington, Louisiana, at the
Company's corporate headquarters, at the Company's research and development
facility in Tulsa, Oklahoma, and related to the consolidation of operations in
the U.K. Of the total expense recognized
9
under this restructuring plan, $640,000 related to post-employment benefits,
which were accounted for in accordance with SFAS No. 112, "Employers' Accounting
for Post-employment Benefits, an amendment of FASB Statements No. 5 and 43," and
$82,000 related to consultant's fees, equipment moving costs and employee
relocations, which were accounted for in accordance with SFAS No. 146,
"Accounting for Costs Associated with Exit or Disposal Activities." During the
quarter ended March 31, 2004, the Company incurred an additional $77,000 of
expense related to this restructuring plan, offset by accrual reversals as a
result of changes in the assessment of liability under this plan, resulting in
no impact on net loss for the period. The Company had a liability of $31,000
related to this restructuring plan as of March 31, 2004.
In December 2003, the Company's management approved additional
restructuring costs including a plan to close an Engineered Systems location in
Singapore and recorded closure and other expense of $692,000, of which $515,000
related to severance, $35,000 related to the termination of a lease arrangement
and $142,000 related to employee relocation. As of March 31, 2004, the Company
had a liability of $163,000 related to this restructuring plan.
As of December 31, 2002, the Company had recorded a liability totaling
$304,000 related to certain restructuring costs incurred in connection with the
closure of a manufacturing facility in Edmonton, Alberta, Canada. Throughout
2003, this liability was reduced by $263,000, of which $137,000 related to
amounts paid and $126,000 related to a change in the assessment of liability
under the lease arrangement for the facility, with an increase in the accrual of
$47,000 related to exchange rate changes. As of March 31, 2004, the Company had
a liability of $112,000 related to this restructuring plan. In addition, the
Company recorded closure and other expense associated with this Canadian
restructuring plan of $230,000 during the three months ended March 31, 2003,
which were not included as part of the December 31, 2002 restructuring reserve.
These costs included equipment moving costs and employee relocations, including
severance costs of $129,000 that were not identified as restructuring costs as
of the plan measurement date.
(8) LONG-TERM DEBT
The Company had the following consolidated borrowings as of the dates
indicated:
MARCH 31, DECEMBER 31,
2004 2003
--------- -----------
(UNAUDITED)
(IN THOUSANDS, EXCEPT PERCENTAGES)
BANK DEBT
2004 term loan with variable interest rate (3.94% at March
31, 2004) and quarterly payments of principal ($1,607)
and interest, due March 31, 2007.......................... $45,000 $ --
2001 term loan with variable interest rate (3.91% at
December 31, 2003) and quarterly payments of principal
($1,750) and interest, due March 31, 2006................. -- 30,750
2001 revolving credit bank loans with variable interest
rate (4.88% at December 31, 2003) and quarterly
interest payments, due March 31, 2004..................... -- 10,881
Promissory note with variable interest rate (4.43% at
March 31, 2004 and 4.40% at December 31, 2003) and
quarterly payments of principal ($24) and interest, due
February 8, 2007.......................................... 1,265 1,289
Revolving credit bank loans (export sales facility) with
variable interest rate (4.00% at March 31, 2004 and
December 31, 2003) and monthly interest payments,
due July 23, 2004......................................... 1,400 700
------- -------
Total..................................................... $47,665 $43,620
Less current installments............................... (7,926) (5,617)
------- -------
Long-term debt....................................... $39,739 $38,003
======= =======
On March 15, 2004, the Company replaced its term loan and revolving
facilities agreement, referred to as the 2001 term loan and revolving credit
facilities, with a new term loan and revolving facilities agreement, referred to
as the 2004 term loan and revolving credit facilities, which provides for a term
loan of $45.0 million, a U.S. revolving facility with a borrowing capacity of
$20.0 million, a Canadian revolving facility with a borrowing capacity of $5.0
million and a U.K. revolving facility with a borrowing capacity of $10.0
million. All of the revolver borrowing capacities under the 2004 term loan and
revolving credit facilities agreement are subject to borrowing base limitations.
The Company recorded a charge of $667,000 in March 2004 to expense
unamortized loan costs related to the 2001 term loan and revolving credit
facilities, and incurred an additional $684,000 of deferred loan costs related
to the 2004 term loan and revolving credit facilities which will be amortized as
interest expense through the term of the facilities in March 2007.
10
The 2004 term loan and revolving credit facilities agreement provides
for interest at a rate based upon the ratio of Funded Debt to EBITDA, as defined
in the credit facility ("EBITDA"), and ranging from, at the Company's election,
(1) a high of the London Inter-bank Borrowing Rate ("LIBOR") plus 2.75% to a low
of LIBOR plus 2.00% or (2) a high of a base rate plus 1.75% to a low of a base
rate plus 1.00%. The Company will pay commitment fees related to this agreement
on the undrawn portion of the facility, depending upon the ratio of Funded Debt
to EBITDA, calculated at 0.50% at March 31, 2004.
Borrowings of $45.0 million were outstanding under the term loan
portion of the 2004 term loan and revolving credit facilities at March 31, 2004,
and bore interest at 3.94% per annum. No borrowings were outstanding under the
revolving credit portion of the 2004 term loan and revolving credit facilities
at March 31, 2004. However, the Company had letters of credit outstanding under
these revolving facilities of $19.1 million. Fees related to these letters of
credit were approximately 2.75% of the outstanding balance at March 31, 2004.
These letters of credit support contract performance and warranties and expire
at various dates through February 2008.
The 2004 term loan and revolving credit facilities agreement is
guaranteed by the Company and its operating subsidiaries and is secured by a
first lien or first priority security interest in or pledge of substantially all
of the assets of the borrowers, including accounts receivable, inventory,
equipment, intangibles, equity interests in U.S. subsidiaries and 66-1/3% of the
equity interest in active, non-U.S. subsidiaries. Assets of the Company and its
active U.S. subsidiaries secure the U.S., Canadian and U.K. revolving
facilities, assets of the Company's Canadian subsidiary also secure the Canadian
facility and assets of the Company's U.K. subsidiaries also secure the U.K.
facility. The U.S. facility is guaranteed by each U.S. subsidiary of the
Company, while the Canadian and U.K. facilities are guaranteed by NATCO Group
Inc., each of its U.S. subsidiaries and the Canadian subsidiary or the U.K.
subsidiaries, as applicable.
The 2004 term loan and revolving credit facilities agreement contains
restrictive covenants including, among others, those that limit the amount of
Funded Debt to EBITDA (as defined in the 2004 term loan and revolving credit
facilities agreement), impose a minimum fixed charge coverage ratio, a minimum
asset coverage ratio and a minimum net worth requirement. On March 31, 2004, the
Company was in compliance with all restrictive debt covenants under its loan
agreements.
Prior to March 15, 2004, the Company maintained the 2001 term loan and
revolving credit facilities, which consisted of a $50.0 million term loan, a
$30.0 million U.S. revolving facility, a $10.0 million Canadian revolving
facility and a $10.0 million U.K. revolving facility. The 2001 term loan was to
mature on March 31, 2006, and each of the 2001 revolving facilities was to
mature on March 31, 2004.
In July 2002, the Company's lenders approved the amendment of various
provisions of the 2001 term loan and revolving credit facilities agreement,
effective April 1, 2002. This amendment revised certain restrictive debt
covenants, modified certain defined terms, allowed for future capital investment
in the Company's Sacroc CO2 processing facility in West Texas, facilitated the
issuance of up to $7.5 million of subordinated indebtedness, increased the
aggregate amount of operating lease expense allowed during a fiscal year and
permitted an increase in borrowings under the export sales credit facility,
without further lender consent, up to a maximum of $20.0 million. These
modifications resulted in higher commitment fee percentages and interest rates
than in the original loan agreement, based on the Funded Debt to EBITDA ratio,
as defined in the underlying agreement, as amended.
In July 2003, the Company's lenders approved an amendment of the 2001
term loan and revolving credit facilities agreement, effective April 1, 2003.
The amendment modified several restrictive covenant terms, including the Fixed
Charge Coverage Ratio and Funded Debt to EBITDA Ratio, each as defined in the
agreement, as amended. Under the Company's 2001 term loan and revolving credit
facilities agreement, certain debt covenants became more restrictive during the
fourth quarter of 2003, and the Company was required to obtain a waiver of the
covenants related to net worth, Funded Debt to EBITDA ratio and Fixed Charge
Coverage Ratio through March 31, 2004, subject to the Company meeting a minimum
EBITDA threshold, in order to remain in compliance with the agreement, as
amended. The Company met this threshold requirement and was in compliance with
all covenant requirements, as amended.
Amounts borrowed under the 2001 revolving facilities portion of the
agreement bore interest at a rate based upon the ratio of Funded Debt to EBITDA
and ranging from, at the Company's election, (1) a high of LIBOR plus 3.00% to a
low of LIBOR plus 1.75% or (2) a high of a base rate plus 1.50% to a low of a
base rate plus 0.25%.
The Company paid commitment fees of 0.30% to 0.625% per year after 2002
on the undrawn portion of the 2001 revolving credit facilities agreement,
depending upon the ratio of Funded Debt to EBITDA. Prior to retirement of this
facility in March 2004, the Company's commitment fees were calculated at a rate
of 0.625% during the quarter.
On February 6, 2002, the Company borrowed $1.5 million under a
long-term promissory note to finance the purchase of a manufacturing facility in
Magnolia, Texas. This note accrues interest at the 90-day LIBOR plus 3.25% per
annum, and requires
11
quarterly payments of principal of approximately $24,000 and interest for five
years beginning May 2002, with a final balloon payment due February 2007. This
promissory note is collateralized by the manufacturing facility in Magnolia,
Texas.
The Company maintains a working capital facility for export sales that
provides for aggregate borrowings of $10.0 million, subject to borrowing base
limitations, under which borrowings of $1.4 million were outstanding at March
31, 2004, and which bore interest at 4.00% per annum. Letters of credit
outstanding under this facility as of March 31, 2004 totaled $58,000. Fees
related to these letters of credit were approximately 1% of the outstanding
balance at March 31, 2004. The export sales credit facility is secured by
specific project inventory and receivables, and is partially guaranteed by the
EXIM Bank. The facility loans mature on July 23, 2004, and require renewal
annually.
The Company also had unsecured letters of credit and bonds totaling
$584,000 and performance guarantees totaling $8.2 million at March 31, 2004.
(9) INCOME TAXES
NATCO's effective income tax rate for the three months ended March 31,
2004 was 39%, which exceeded the amount that would have resulted from applying
the U.S. federal statutory tax rate due to the impact of state income taxes,
foreign income tax rate differentials, losses in foreign subsidiaries, changes
in valuation allowances recorded and certain permanent book-to-tax differences.
(10) INDUSTRY SEGMENTS
The Company's operations are organized into three separate business
segments: North American Operations, which primarily provides traditional,
standard and small custom production equipment and components, replacement
parts, used equipment and components, equipment servicing and field operating
support (including operations of our domestic CO2 membrane facility); Engineered
Systems, which primarily provides customized and more complex technological
equipment, large scale integrated oil and gas production systems, and equipment
and services provided by certain international operations (including Axsia); and
Automation and Control Systems, which provides control panels and systems that
monitor and control oil and gas production, as well as installation and start-up
and other field services related to instrumentation and electrical systems.
The accounting policies of the reportable segments were consistent with
the policies used to prepare the Company's condensed consolidated financial
statements for the respective periods presented. The Company evaluates the
performance of its operating segments based on income before net interest
expense, income taxes, depreciation and amortization expense, closure and other,
write-off of unamortized loan costs, other, net and accounting changes.
In September 2003, the Company changed the presentation of its
reportable segments by reclassifying certain technology and product development
("TPD") costs and bonus expenses among the business segments from the "Corporate
and Other" segment. In addition, Other, net was excluded from the determination
of segment profit (loss). These changes were made as a result of a change in
management's internal reporting to better state total costs and profits of each
segment and have been retroactively reflected in all periods presented.
Consistent with the recent restructuring in late 2003 and to more
closely align the Company's segment presentation to the internal reporting
presentation used by the Company's management, the Company changed the
presentation of its reportable segments in December 2003, by reclassifying
certain manufacturing plants and related assets from the Engineered Systems
segment to the North American Operations segment. As a result of this
reclassification, total assets, capital expenditures and depreciation and
amortization expense for the North American Operations segment for the quarter
ended March 31, 2003 increased by $12.5 million, $47,000 and $239,000,
respectively, with corresponding decreases in the Engineered Systems segment, in
order to present these amounts on a comparable basis with the segment results
for the quarter ended March 31, 2004.
12
Summarized financial information for the Company's reportable segments is shown
in the following table.
NORTH AUTOMATION
AMERICAN ENGINEERED & CONTROL CORPORATE &
OPERATIONS SYSTEMS SYSTEMS OTHER TOTAL
---------- ---------- ----------- ----------- -----
(UNAUDITED, IN THOUSANDS)
THREE MONTHS ENDED
MARCH 31, 2004
Revenues from unaffiliated customers... $37,234 $23,936 $10,814 $ -- $ 71,984
Inter-segment revenues................. 274 172 804 (1,250) --
Segment profit (loss).................. 4,839 (174) 388 (1,533) 3,520
Total assets........................... 114,174 96,474 18,513 11,278 240,439
Capital expenditures................... 648 137 47 7 839
Depreciation and amortization.......... 948 224 101 101 1,374
THREE MONTHS ENDED
MARCH 31, 2003
Revenues from unaffiliated customers... $27,965 $26,016 $14,032 $ -- $ 68,013
Inter-segment revenues................. 650 30 1,209 (1,889) --
Segment profit (loss).................. 1,545 1,240 1,319 (937) 3,167
Total assets........................... 107,249 101,088 21,277 12,656 242,270
Capital expenditures................... 2,530 442 99 1 3,072
Depreciation and amortization.......... 814 234 93 89 1,230
The following table reconciles total segment profit to net income
(loss) before cumulative effect of change in accounting principle:
THREE MONTHS ENDED
MARCH 31,
----------------------
2004 2003
------ -----
(UNAUDITED, IN THOUSANDS)
Total segment profit $3,520 $3,167
Net interest expense 1,098 1,222
Depreciation and amortization 1,374 1,230
Closure and other -- 230
Write-off of unamortized loan costs 667
Other, net 454 346
------ ------
Net income (loss) before income taxes and
cumulative effect of change in
accounting principle (73) 139
Income tax provision (benefit) (29) 50
------ ------
Net income (loss) before cumulative
effect of change in accounting principle $ (44) $89
====== ======
The following table summarizes the impact on segment profit (loss) of
the September 2003 change in measurement method used for the three months ended
March 31, 2003:
THREE MONTHS ENDED MARCH 31, 2003
-------------------------------------------------------------------------------------
NORTH AMERICAN ENGINEERED AUTOMATION & CORPORATE
OPERATIONS SYSTEMS CONTROL SYSTEMS & OTHER TOTAL
-------------- ---------- --------------- ---------- -------
(UNAUDITED, IN THOUSANDS)
Original segment
profit (loss): $ 1,264 $ 972 $ 1,319 $ (964) $ 2,591
Other expense, net and closure 453 (88) -- 211 576
TPD and other (172) 356 -- (184) --
------- -------- ------- ------ -------
Segment profit (loss) $ 1,545 $ 1,240 $ 1,319 $ (937) $ 3,167
======= ======== ======= ====== =======
(11) PENSION AND OTHER POSTRETIREMENT BENEFITS
The Company maintains a postretirement benefit plan that provides
health care and life insurance benefits for retired employees of a predecessor
company. This plan is accounted for in accordance with SFAS No. 132, "Employer's
Accounting for Pensions and
13
Other Postretirement Benefits." The Company has recorded a liability for the
actuarially determined accumulated postretirement benefit obligation associated
with this plan.
On December 31, 2003, the President of the United States signed into
law the Medicare Prescription Drug Improvement and Modernization Act of 2003.
The Company has not finalized its review of the effects the Act will have on its
postretirement benefit arrangement and is waiting for guidance from the United
States Department of Health and Human Services on how the employer subsidy
provision will be administered and guidance from the Financial Accounting
Standards Board on how the impact of the Act should be recognized in the
Company's financial statements. However, based upon a preliminary assessment,
the Company's actuaries estimated that this law could reduce the Company's
overall accumulated postretirement benefit obligation by $1.9 million, and
thereby reduce the annual net periodic benefit cost associated with this plan.
Based on this preliminary assessment, for the three months ended March 31, 2004,
net periodic benefit cost was reduced by approximately $74,000, of which $29,000
related to a reduction of interest cost and $45,000 related to a reduction of
the amortization of the cumulative experience loss, to reflect the most recent
estimate of the Company's net periodic benefit cost under this postretirement
benefit plan. The Company intends to continue to review its assessment of the
impact of this law on its postretirement benefit plan during 2004, and expects
to adjust net periodic benefit cost accordingly.
The following table summarizes the components of net periodic benefit
cost under the Company's postretirement benefit plan as of March 31, 2004 and
2003, respectively:
THREE MONTHS ENDED MARCH 31,
----------------------------
2004 2003
---- ----
(UNAUDITED, IN THOUSANDS)
Unrecognized prior service cost $ (146) $ (146)
Interest cost 221 227
Unrecognized loss 150 128
------ ------
Net periodic benefit cost $ 225 $ 209
====== ======
During the three months ended March 31, 2004, there were no significant
modifications or changes to the level of contributions provided to the plan by
the Company or the plan participants.
Prior to plan termination, the Company maintained a plan that provided
pension benefits to certain union employees in Canada. In August 2001, the
participants of the plan voted to terminate contributions to the plan and
receive actuarially determined cash distributions. The plan was formally
terminated in December 2002, with distributions paid in early 2003. In February
2003, the Company purchased an annuity contract, and effective April 2003, all
liability for any future claims related to this plan were transferred to the
contract insurer. For the three months ended March 31, 2003, net periodic
benefit cost under this plan was $9,000, attributable primarily to interest
cost.
(12) GOODWILL AND INTANGIBLE ASSETS
In accordance with SFAS No. 142, "Goodwill and Other Intangible
Assets," the Company evaluates intangible assets with indefinite lives,
including goodwill, on an impairment basis, while intangible assets with a
defined term, such as patents, are amortized over the useful life of the asset.
Intangible assets subject to amortization as of March 31, 2004 and 2003
were:
AS OF MARCH 31, 2004 AS OF MARCH 31, 2003
------------------------ ------------------------
GROSS GROSS
CARRYING ACCUMULATED CARRYING ACCUMULATED
TYPE OF INTANGIBLE ASSET AMOUNT AMORTIZATION AMOUNT AMORTIZATION
----------------------- ------- ------------ -------- ------------
(UNAUDITED, IN THOUSANDS)
Deferred financing fees $ 684 $ 10 $ 3,324 $ 2,157
Patents 164 40 152 24
Other 534 286 299 208
------- ----- ------- -------
Total $ 1,382 $ 336 $ 3,775 $ 2,389
======= ===== ======= =======
Amortization and interest expense of $181,000 and $219,000 were
recognized related to these assets for the three months ended March 31, 2004 and
2003, respectively. In addition, the Company recorded expense of $667,000
related to the write-off of deferred
14
financing fees resulting from the retirement of the 2001 term loan and revolving
credit facilities. See Note 8, Long-term Debt. The estimated aggregate
amortization and interest expense for these assets for each of the following
five fiscal years, excluding the write-off of deferred financing fees mentioned
above, is: 2004 -- $400,000; 2005 -- $291,000; 2006 -- $286,000; 2007 --
$90,000; and 2008 -- $28,000. For segment reporting purposes, these intangible
assets and the related amortization expense were recorded under "Corporate and
Other."
Net goodwill of $80.0 million was the Company's only intangible asset
that did not require periodic amortization as of March 31, 2004. The change in
the value of goodwill during the three months ended March 31, 2004 related
entirely to currency exchange rate fluctuations.
In accordance with SFAS No. 142, the Company tested each business
segment for impairment of goodwill at December 31, 2003, and, based upon the
results of this testing, management determined that goodwill was not impaired.
The Company will test each business segment for goodwill impairment annually, as
required by the pronouncement, or more frequently if there are indications of
goodwill impairment. No additional testing was performed during the three months
ended March 31, 2004, as management noted no indications of goodwill impairment.
(13) CHANGE IN ACCOUNTING PRINCIPLE
Effective January 1, 2003, NATCO recorded the cumulative effect of
change in accounting principle related to the adoption of SFAS No. 143,
"Accounting for Asset Retirement Obligations." This standard required the
Company to record the fair value of an asset retirement obligation as a
liability in the period in which a legal obligation associated with the
retirement of tangible long-lived assets that result from acquisition,
construction, development and/or normal use of the assets, was incurred. In
addition, the standard requires the Company to record a corresponding asset that
will be depreciated over the life of the asset that gave rise to the liability.
Subsequent to the initial measurement of the asset retirement obligation, the
Company will be required to adjust the related liability at each reporting date
to reflect changes in estimated retirement cost and the passage of time. The
Company recorded a loss of $34,000, net of tax, as of January 1, 2003, as a
result of this change in accounting principle. The related asset retirement
obligation and asset cost of $96,000 was associated with an obligation to remove
certain leasehold improvements upon termination of lease arrangements, including
concrete pads and equipment. The asset cost will be depreciated over the
remaining useful life of the related assets. There was no significant change in
the asset or liability during the three months ended March 31, 2004.
(14) RELATED PARTY TRANSACTIONS
Under the terms of an employment agreement in effect prior to 1999, the
Company loaned its Chief Executive Officer $1.2 million in July 1999 to purchase
136,832 shares of common stock. During February 2000, after the Company
completed the initial public offering of its Class A common stock (now known as
common stock), also pursuant to the terms of that employment agreement, the
Company paid this executive officer a bonus equal to the principal and interest
accrued under this note arrangement and recorded compensation expense of $1.3
million. The officer used the proceeds of this settlement, net of tax, to repay
the Company approximately $665,000. In addition, on October 27, 2000, the
Company's board of directors agreed to provide a full recourse loan to this
executive officer to facilitate the exercise of certain outstanding stock
options. The amount of the loan was equal to the cost to exercise the options
plus any personal tax burdens that resulted from the exercise. The maturity of
these loans was July 31, 2003, and interest accrued at rates ranging from 6% to
7.8% per annum. As of June 30, 2002, these outstanding notes receivable totaled
$3.4 million, including principal and accrued interest. Effective July 1, 2002,
the notes were reviewed by the Company's board and amended to extend the
maturity dates to July 31, 2004, and to require interest to be calculated at an
annual rate based on LIBOR plus 300 basis points, adjusted quarterly, applied to
the notes balances as of June 30, 2002, including previously accrued interest.
As of March 31, 2004, the balance of the notes (principal and accrued interest)
due from this officer under these loan arrangements was $3.6 million. These
loans to this executive officer, which were made on a full recourse basis in
prior periods to facilitate direct ownership in the Company's common stock, are
currently subject to and in compliance with provisions of the Sarbanes-Oxley Act
of 2002.
As previously agreed in 2001, the Company loaned an employee who is an
executive officer and director $216,000 on April 15, 2002, under a full-recourse
note arrangement which accrued interest at 6% per annum and was to mature on
July 31, 2003. The funds were used to pay the exercise cost and personal tax
burdens associated with stock options exercised during 2001. Effective July 1,
2002, the note was amended to extend the maturity date to July 31, 2004, and to
require interest to be calculated at an annual rate based on LIBOR plus 300
basis points, adjusted quarterly, applied to the note balance as of June 30,
2002, including previously accrued interest. As of March 31, 2004, the balance
of the note (principal and interest) due from this officer under this loan
arrangement was approximately $235,000. This loan to this executive officer,
which was made on a full recourse basis in prior periods to facilitate direct
ownership in the Company's common stock, is currently subject to and in
compliance with provisions of the Sarbanes-Oxley Act of 2002.
15
(15) LITIGATION
Magnum Transcontinental Corp. Arbitration and Related Matter. These
matters stem from an agreement among NATCO Group, Magnum Transcontinental
Corporation, the U.S. procurement arm of Petroserv S.A., and Zephyr Offshore,
Inc., a Petroserv subsidiary, to manufacture and install a processing plant on a
Petroserv rig, and Petroserv's agency agreement with NATCO for certain projects
in Brazil. NATCO claims Magnum owes it $418,990 under the plant manufacturing
agreement for additional work performed in excess of the days agreed in the
contract. NATCO submitted the matter to binding American Arbitration Association
arbitration on October 29, 2003. An arbitrator has been selected, and
arbitration is scheduled in Houston, Texas during August 2004. In the
arbitration, Magnum has counter-claimed for $4,685,000, alleging breach of
contract. NATCO has not recorded an accrual related to this matter at March 31,
2004. NATCO disputes the amounts claimed by Magnum, and views a substantial
portion of the counterclaim to be barred by the consequential damages provisions
of the contract. NATCO intends to vigorously pursue its claims while defending
against the counterclaim. After NATCO filed its request for arbitration,
Petroserv submitted a mediation request under its representation agreement with
NATCO, claiming unpaid agency fees on several contracts, including the Magnum
contract. The mediation, held on January 23, 2004, was unsuccessful. NATCO
believes any fees owed to Petroserv under the agency agreement are offset by
NATCO's claims against Magnum. NATCO disputes that it owes any fees for the
Magnum work or any work obtained in Brazil after the representation agreement
terminated in early 2003. It is not presently known what, if any, further action
Petroserv will take in this regard.
The Company and its subsidiaries are defendants or otherwise involved
in a number of other legal proceedings in the ordinary course of business. While
the Company insures against the risk of these proceedings to the extent deemed
prudent by management, NATCO can offer no assurance that the type or value of
this insurance will meet the liabilities that may arise from any pending or
future legal proceedings related to business activities. While the Company
cannot predict the outcome of any legal proceedings with certainty, in the
opinion of management, ultimate liability with respect to these pending lawsuits
is not expected to have a material adverse effect on the Company's consolidated
financial position, results of operations or cash flows.
(16) RECENT ACCOUNTING PRONOUNCEMENTS
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." This
statement provides guidance on how to classify and measure certain financial
instruments that have characteristics of both liabilities and equity, and
generally requires treatment of these instruments as liabilities, including
certain obligations that the issuer can or must settle by issuing its own equity
securities. This pronouncement, which was effective for all financial
instruments entered into or modified after May 31, 2003, and otherwise became
effective on July 1, 2003, required cumulative effect of a change in accounting
principle treatment upon adoption. The Company adopted this pronouncement on
July 1, 2003, with no material impact on its financial condition or results of
operation.
In December 2003, the FASB issued an amendment of SFAS No. 132,
"Employers' Disclosures about Pensions and Other Postretirement Benefits." This
amendment, which was effective at December 31, 2003, requires additional annual
disclosures about pension or postretirement plan assets and liabilities, as well
as investment policies and strategies for plan assets, basis for expected rate
of return on assets and total accumulated benefit obligation. In addition, this
amendment requires interim disclosures of the components of net periodic benefit
cost in tabular format and contributions paid or expected to be paid during the
current fiscal year if significantly different than in prior year. Effective
December 31, 2004, the Company will be required to disclose benefits expected to
be paid in each of the next five years under each pension or postretirement
plan, and an aggregate amount expected to be paid for the succeeding five-year
period under these arrangements. The Company adopted this amendment to SFAS No.
132 on December 31, 2003, and the required interim disclosures have been
incorporated into this Quarterly Report on Form 10-Q. See Note 11, Pension and
Other Postretirement Benefits.
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
Management's Discussion and Analysis includes forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The
words "believe," "expect," "plan," "intend," "estimate," "project," "will,"
"could," "may" and similar expressions are intended to identify forward-looking
statements. Forward-looking statements in this document include, but are not
limited to, discussions regarding indicated trends in the level of oil and gas
exploration and production and the effect of such conditions on the Company's
results of operations (see " -- Industry and Business Environment"), future uses
of and requirements for financial resources (see " -- Liquidity and Capital
Resources"), and backlog levels in 2004 (see " -- Liquidity and Capital
Resources"). Our expectations about our business outlook, customer spending, oil
and gas prices, our business environment and that of the industry in general are
only our expectations regarding these matters. Actual results may differ
materially from those expressed in the forward-looking statements for reasons
including, but not limited to: market factors such as pricing and demand for
petroleum related products, the level of petroleum industry exploration and
production expenditures, the effects of competition, world economic conditions,
the level of drilling activity, the legislative environment in the United States
and other countries, policies of OPEC, conflict involving the United States or
in major petroleum producing or consuming regions, acts of terrorism, the
development of technology that could lower overall finding and development
costs, weather patterns and the overall condition of capital and equity markets
for countries in which we operate.
The following discussion should be read in conjunction with the
financial statements, related notes and other financial information appearing
elsewhere in this Quarterly Report on Form 10-Q. Readers also are urged to
review and consider carefully the various disclosures advising interested
parties of the factors that affect our business, including but not limited to,
the disclosures made under the caption "Risk Factors" and the other factors and
risks discussed in our Annual Report on Form 10-K for the year ended December
31, 2003, and in subsequent reports filed with the Securities and Exchange
Commission. We expressly disclaim any obligation or undertaking to release
publicly any updates or revisions to any forward-looking statement to reflect
any change in our expectations or any change in events, conditions or
circumstances on which any forward-looking statement is based.
OVERVIEW
References to "NATCO," "we" and "our" are used throughout this document
and relate collectively to NATCO Group Inc. and its consolidated subsidiaries.
We offer products and services as either integrated systems or
individual components primarily through three business lines:
- traditional production equipment and services, through which
we provide standardized components, replacement parts and used
components and equipment servicing;
- engineered systems, through which we provide customized, large
scale integrated oil, gas and water production and processing
systems; and
- automation and control systems, through which we provide
control panels and systems that monitor and control oil and
gas production, as well as repair, testing and inspection
services for existing systems.
We report three separate business segments: North American Operations,
Engineered Systems and Automation and Control Systems.
CRITICAL ACCOUNTING POLICIES
The preparation of our consolidated financial statements requires us to
make certain estimates and assumptions that affect the results reported in our
condensed consolidated financial statements and accompanying notes. These
estimates and assumptions are based on historical experience and on our future
expectations that we believe to be reasonable under the circumstances. Note 2 to
the consolidated financial statements filed in our Annual Report on Form 10-K
for the year ended December 31, 2003, contains a summary of our significant
accounting policies. We believe the following accounting policies are the most
critical in the preparation of our condensed consolidated financial statements:
17
Revenue Recognition: Percentage-of-Completion Method. We recognize
revenues from significant contracts (greater than $250,000 and longer than four
months in duration) and certain automation and control systems contracts and
orders on the percentage-of-completion method of accounting. Earned revenue is
based on the percentage that costs incurred to date relate to total estimated
costs of the project, after giving effect to the most recent estimates of total
cost. The timing of costs incurred, and therefore recognition of revenue, could
be affected by various internal or external factors including, but not limited
to: changes in project scope (change orders), changes in productivity,
scheduling, the cost and availability of labor, the cost and availability of raw
materials, the weather, client delays in providing approvals at benchmark stages
of the project and the timing of deliveries from third-party providers of key
components. The cumulative impact of revisions in total cost estimates during
the progress of work is reflected in the period in which these changes become
known. Earned revenues reflect the original contract price adjusted for agreed
claims and change order revenues, if applicable. Losses expected to be incurred
on the jobs in progress, after consideration of estimated probable minimum
recoveries from claims and change orders, are charged to income as soon as such
losses are known. Claims for additional contract revenue are recognized if it is
probable that the claim will result in additional revenue and the amount can be
reliably estimated. We generally recognize revenue and earnings to which the
percentage-of-completion method applies over a period of two to six quarters. In
the event a project is terminated by the customer before completion, our
customer is liable for costs incurred under the contract. We believe that our
operating results should be evaluated over a term of several years to evaluate
performance under long-term contracts, after all change orders, scope changes
and cost recoveries have been negotiated and realized. We record revenues and
profits on all other sales as shipments are made or services are performed.
Impairment Testing: Goodwill. As required by Statement of Financial
Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets,"
we evaluate goodwill annually for impairment by comparing the fair value of
operating assets to the carrying value of those assets, including any related
goodwill. As required by SFAS No. 142, we identify separate reportable units for
purposes of this evaluation. In determining carrying value, we segregate assets
and liabilities that, to the extent possible, are clearly identifiable by
specific reportable unit. Certain corporate and other assets and liabilities,
that are not clearly identifiable by specific reportable unit, are allocated in
accordance with the standard. Fair value is determined by discounting projected
future cash flows at our cost of capital rate, as calculated. The fair value is
then compared to the carrying value of the reportable unit to determine whether
or not impairment has occurred at the reportable unit level. In the event an
impairment is indicated, an additional test is performed whereby an implied fair
value of goodwill is determined through an allocation of the fair value to the
reporting unit's assets and liabilities, whether recognized or unrecognized, in
a manner similar to a purchase price allocation, in accordance with SFAS No.
141, "Business Combinations." Any residual fair value after this purchase price
allocation would be assumed to relate to goodwill. If the carrying value of the
goodwill exceeded the residual fair value, we would record an impairment charge
for that amount. Net goodwill was $80.0 million at March 31, 2004. The change in
the value of goodwill for the three months ended March 31, 2004 related entirely
to currency exchange rate fluctuations.
In accordance with SFAS No. 142, the Company tested each business
segment for impairment of goodwill at December 31, 2003, and, based upon the
results of this testing, management determined that goodwill was not impaired.
The Company will test each business segment for goodwill impairment annually, as
required by the pronouncement, or more frequently if there are indications of
goodwill impairment. No additional testing was performed during the quarter
ended March 31, 2004, as management noted no indications of goodwill impairment.
Deferred Income Tax Assets: Valuation Allowance. We account for income
taxes in accordance with SFAS No. 109, "Accounting for Income Taxes." SFAS No.
109 requires us to provide a valuation allowance for any net deferred income tax
assets that we believe will not be utilized through future operations. For the
most recent fiscal years, our Canadian subsidiary has recorded net losses, as
consolidated, partially due to certain restructuring efforts undertaken in late
2002 and early 2003, and the impact of foreign currency transactions. As a
result of these losses, we had a $382,000 valuation allowance as of March 31,
2004 to fully reserve for the net deferred tax asset at this subsidiary. In
addition, we had a $258,000 valuation allowance related to the realizability of
certain net operating losses related to Axsia, and another $196,000 related to
other foreign subsidiaries. Based upon the level of historical taxable income
and projected future taxable income over the periods to which our deferred tax
assets are deductible, we believe it is more likely than not that we will
realize the benefits of these deductible differences, net of the existing
valuation allowances at March 31, 2004. However, the amount of the deferred tax
asset considered realizable, and thus the amount of these valuation allowances,
could change if future taxable income differs from our projections.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations." This standard provides guidance on reporting and
accounting for obligations associated with the retirement of long-lived tangible
assets and the related retirement costs. This standard is effective for
financial statements issued for fiscal years beginning after June 15, 2002. On
January 1, 2003, we adopted this pronouncement and recorded a loss of $34,000,
net of tax effect, as the cumulative effect of change in accounting principle.
In addition, we recorded an asset retirement obligation liability and asset cost
of $96,000, associated with an obligation to
18
remove certain leasehold improvements upon termination of lease arrangements,
including concrete pads and equipment. We will depreciate the asset cost over
the remaining useful life of the related assets.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." This
statement provides guidance on how to classify and measure certain financial
instruments that have characteristics of both liabilities and equity, and
generally requires treatment of these instruments as liabilities, including
certain obligations that the issuer can or must settle by issuing its own equity
securities. This pronouncement, which was effective for all financial
instruments entered into or modified after May 31, 2003, and otherwise became
effective on July 1, 2003, required cumulative effect of a change in accounting
principle treatment upon adoption. We adopted this pronouncement on July 1,
2003, with no material impact on our financial condition or results of
operation.
In December 2003, the FASB issued an amendment of SFAS No. 132,
"Employers' Disclosures about Pensions and Other Postretirement Benefits." This
amendment, which was effective at December 31, 2003, requires additional annual
disclosures about pension or postretirement plan assets and liabilities, as well
as investment policies and strategies for plan assets, basis for expected rate
of return on assets and total accumulated benefit obligation. In addition, this
amendment requires interim disclosures of the components of net periodic benefit
cost in tabular format and contributions paid or expected to be paid during the
current fiscal year if significantly different than in the prior year. Effective
December 31, 2004, we will be required to disclose benefits expected to be paid
in each of the next five years under each pension or postretirement plan, and an
aggregate amount expected to be paid for the succeeding five-year period under
these arrangements. We adopted this amendment to SFAS No. 132 on December 31,
2003, and have incorporated the required interim disclosures into this Quarterly
Report on Form 10-Q.
INDUSTRY AND BUSINESS ENVIRONMENT
As a leading provider of wellhead process equipment, systems and
services used in the production of crude oil and natural gas, our revenues and
results of operations are closely tied to demand for oil and gas products and
spending by oil and gas companies for exploration and development of oil and gas
reserves. These companies have historically invested more in exploration and
development efforts during periods of favorable oil and gas commodity prices,
and have invested less during periods of unfavorable oil and gas prices. As
supply and demand change, commodity prices fluctuate producing cyclical trends
in the industry. During periods of lower demand, revenues for service providers
such as NATCO generally decline, as existing projects are completed and new
projects are postponed. During periods of recovery, revenues for service
providers can lag behind the industry due to the timing of new project awards.
Changes in commodity prices have impacted our business over the past
several years. The following table summarizes the price of domestic crude oil
per barrel and the wellhead price of natural gas per thousand cubic feet ("mcf")
for the three months ended March 31, 2004 and 2003, as well as averages for the
years ended December 31, 2003 and 2002, derived from published reports by the
U.S. Department of Energy, and the rotary rig count, as published by Baker
Hughes Incorporated.
19
THREE MONTHS ENDED YEAR ENDED
MARCH 31, DECEMBER 31,
--------------------- --------------------
2004 2003 2003 2002
---- ---- ------ ------
Average price of crude oil per barrel in the U.S. $30.77 (a) $30.04 $27.56 $22.51
Average wellhead price of natural gas per mcf in $ 5.22 $ 5.54 $ 4.97 $2.95
the U.S.
Average U.S. rig count 1,119 897 1,030 830
---------------------
(a) Calculated using published data from the U.S. Department of Energy for
the two months ended February 29, 2004; data for March 2004 was not yet
available.
At March 31, 2004, the spot price of West Texas Intermediate crude oil
was $35.75 per barrel, the price of Henry Hub natural gas was $5.64 per mcf per
the New York Mercantile Exchange and the U.S. rig count was 1,150, per Baker
Hughes Incorporated. At April 30, 2004, the spot price of West Texas
Intermediate crude oil was $37.31 per barrel, the price of Henry Hub natural gas
was $5.80 per mcf, and the U.S. rig count was 1,161. These spot prices reflect
the overall volatility of oil and gas commodity prices in the current and recent
periods.
Historically, we have viewed operating rig counts as a benchmark of
spending in the oil and gas industry for exploration and development efforts.
Our traditional equipment sales and services business generally correlates to
changes in rig activity, but tends to lag behind the North American rig count
trend. From a longer-term perspective, the U.S. Department of Energy estimates
that U.S. demand for and consumption of petroleum and natural gas products will
increase through 2025, with higher consumption rates expected worldwide, driven
by demand for refined products and the use of natural gas to power plants that
generate electricity. As demand grows and reserves in the U.S. decline,
producers and service providers in the oil and gas industry may continue to rely
more heavily on global sources of energy and expansion into new markets. The
industry continues to seek more innovative and technologically efficient means
to extract hydrocarbons from existing fields, as production profiles change. As
a result, additional and more complex equipment may be required to produce oil
and gas from these fields, especially since many new oil and gas fields produce
lower quality or contaminated hydrocarbon streams, requiring more complex
production equipment. In general, these trends should increase the demand for
our products and services.
Our Engineered Systems business is impacted largely by the awarding and
completion of larger, more complex oil and gas projects, primarily for
international offshore locations. These projects typically have a longer
bidding, evaluation, awarding and construction period than our traditional
equipment and services business and are more subject to our customers' long-term
view of the oil and gas supply and demand outlook for the related region, as
well as expected commodity prices and political or governmental situations. In
recent periods, we have experienced the absence of, delays in, or lack of large
international projects with favorable economic terms, which has impacted our
Engineered Systems business results as well as our current level of project
bookings for this segment. Although backlog level for Engineered Systems at
March 31, 2004 was below the level recorded at March 31, 2003, bookings
increased in the 2004 period relative to that in 2003.
During the fourth quarter of 2002 and throughout 2003, we streamlined
certain of our operations to decrease excess capacity and be more responsive to
current market trends, including the closure and consolidation of manufacturing
facilities in Edmonton, Alberta, Canada and Covington, Louisiana. Furthermore,
we reallocated various internal resources, consolidated certain Engineered
Systems operations in the U.K., and closed an Engineered Systems business
development office in Singapore.
In December 2003, we placed in service an expansion of our
gas-processing facilities at Sacroc, which increased our operating capacity at
this facility from 180 million cubic feet ("mmcf") per day to 367 mmcf per day.
We project that this expansion will contribute significantly to our earnings and
cash flows in 2004 compared to 2003, and, therefore, we expect a larger
percentage of our revenues and margins in 2004 to be attributable to our CO2
gas-processing business, a component of our North American Operations segment.
The following discussion of our historical results of operations and
financial condition should be read in conjunction with our condensed
consolidated financial statements and related notes.
20
RESULTS OF OPERATIONS
Three Months Ended March 31, 2004 Compared to Three Months Ended March 31, 2003
(unaudited)
Revenues. Revenues of $72.0 million for the three months ended March
31, 2004 increased $4.0 million, or 6%, from $68.0 million for the three months
ended March 31, 2003. This increase in revenues was primarily due to increased
sales of traditional equipment and services and a larger contribution from our
CO2 operations business, associated with our Sacroc facility expansion in
December 2003. The following table summarizes revenues by business segment for
the three-month periods ended March 31, 2004 and 2003, respectively.
THREE MONTHS ENDED
MARCH 31,
------------------
PERCENTAGE
2004 2003 CHANGE CHANGE
-------- -------- ------- ----------
(UNAUDITED)
(IN THOUSANDS, EXCEPT PERCENTAGE CHANGE)
North American Operations......... $ 37,508 $ 28,615 $ 8,893 31%
Engineered Systems................ 24,108 26,046 (1,938) (7%)
Automation and Control Systems.... 11,618 15,241 (3,623) (24%)
Corporate and Other............... (1,250) (1,889) 639 (34%)
--------- --------- -------
Total................... $ 71,984 $ 68,013 $ 3,971 6%
======== ======== =======
North American Operations revenues increased $8.9 million, or 31%, for
the three months ended March 31, 2004, compared to the three months ended March
31, 2003, due to increased exploration and development activity in the North
American oil and gas industry. The average number of operating rotary rigs in
the U.S. increased from 897 for the first quarter of 2003 to 1,119 for the first
quarter of 2004, with Canadian rig counts increasing from an average of 492 to
513. This increase in activity contributed to improved sales of our traditional
equipment and services and finished goods, as well as our parts and services. In
addition, our CO2 operations business provided an additional $2.0 million of
revenue during the first three months of 2004, due primarily to the expansion
placed in service in December 2003. Inter-segment revenues for this business
segment were $274,000 for the three months ended March 31, 2004, compared to
$650,000 for the three months ended March 31, 2003.
Revenues for the Engineered Systems segment decreased $1.9 million, or
7%, for the three months ended March 31, 2004, compared to the three months
ended March 31, 2003. This decrease was primarily due to a lower level of larger
international production system jobs underway in 2004 relative to the comparable
period in 2003, with fewer new projects in progress during the first three
months of 2004. These revenue declines were partially offset by an increase in
revenues provided by our operations in Southeast Asia. Engineered Systems
revenues of $24.1 million for the three months ended March 31, 2004 included
approximately $172,000 of inter-segment revenues, compared to $30,000 of
inter-segment revenues for the three months ended March 31, 2003.
Revenues for the Automation and Control Systems segment decreased $3.6
million, or 24%, for the three months ended March 31, 2004, compared to the
three months ended March 31, 2003. Activity levels for the first quarter of 2004
declined compared to 2003, due to the timing of project awards, decreased level
of activity in the Gulf of Mexico and the run-off of several large projects in
2003. We expect growth in international sales for this business segment.
Therefore, we increased bidding activity for international jobs during the
quarter ended March 31, 2004, especially in locations where we currently
operate. Inter-segment sales decreased from $1.2 million for the three months
ended March 31, 2003 to $804,000 for the three months ended March 31, 2004.
The change in revenues for Corporate and Other represents the
elimination of inter-segment revenues discussed above.
Gross Profit. Gross profit for the three months ended March 31, 2004
increased $1.0 million, or 6%, to $16.8 million, compared to $15.8 million for
the three months ended March 31, 2003. As a percentage of revenue, gross profit
remained at 23% for each of the quarters ended March 31, 2004 and 2003. The
following table summarizes gross profit by business segment for the periods
indicated:
21
THREE MONTHS ENDED
MARCH 31,
PERCENTAGE
2004 2003 CHANGE CHANGE
------- ------ ------ ---------
(UNAUDITED)
(IN THOUSANDS, EXCEPT PERCENTAGE CHANGE)
North American Operations......... $ 11,019 $7,354 $3,665 50%
Engineered Systems................ 4,248 5,871 (1,623) (28%)
Automation and Control Systems.... 1,548 2,586 (1,038) (40%)
-------- ------ -------
Total................... $ 16,815 $15,811 $1,004 6%
======== ======= ======
Gross profit for the North American Operations business segment
increased $3.7 million, or 50%, for the three months ended March 31, 2004,
compared to the three months ended March 31, 2003, primarily due to a 31%
increase in revenues between the respective periods, and a favorable product mix
that included a larger percentage of higher-margin revenues, primarily
associated with our CO2 operations, as the result of the start-up of our Sacroc
facility expansion in December 2003. As a percentage of revenue, gross margins
were 29% and 26% for the three-month periods ended March 31, 2004 and 2003,
respectively.
Gross profit for the Engineered Systems segment for the three months
ended March 31, 2004 decreased $1.6 million, or 28%, compared to the three
months ended March 31, 2003, due to a 7% decline in revenues between the
respective periods and as a result of unfavorable performance on certain jobs at
our U.K.-based operations. Gross margin as a percentage of revenues for
Engineered Systems was 18% and 23% for the three-month periods ended March 31,
2004 and 2003, respectively.
Gross profit for the Automation and Control Systems segment decreased
$1.0 million, or 40%, for the three months ended March 31, 2004 compared to the
three months ended March 31, 2003, due to a 24% decrease in revenues for the
segment during the period and a relative increase in production expenses due to
the reduced level of activity. Gross margin as a percentage of revenue for the
three months ended March 31, 2004 and 2003, was 13% and 17%, respectively.
Selling, General and Administrative Expense. Selling, general and
administrative expense of $13.3 million for the three months ended March 31,
2004, increased $651,000, or 5%, compared to the results for the three months
ended March 31, 2003. This increase in expense for the first quarter of 2004
relates primarily to higher employee medical costs, insurance costs,
professional fees and variable compensation based on operating results,
partially offset by cost savings due to restructuring activities in the U.S.,
Canada and U.K., begun in late 2002 and continuing throughout 2003. Overall
headcount declined from 1,721 employees at March 31, 2003 to 1,633 employees at
March 31, 2004.
Depreciation and Amortization Expense. Depreciation and amortization
expense of $1.4 million for the three months ended March 31, 2004, increased
$144,000, or 12%, compared to the results for the three months ended March 31,
2003, primarily due to capital expenditures of $11.5 million for the year ended
December 31, 2003, the majority of which related to the expansion of our Sacroc
gas-processing facility.
Closure and Other. We incurred closure and other expense of $230,000
for the three months ended March 31, 2003, related to equipment moving costs,
employee relocations and severance related to our restructuring efforts in
Canada in late 2002.
Write-off of Unamortized Loan Costs. We recorded a write-off of
unamortized loan costs of $667,000 in March 2004 related to the retirement of
our 2001 term loan and revolving credit facilities.
Interest Cost on Postretirement Benefit Liability. Interest cost on
postretirement liability of $225,000 for the three months ended March 31, 2004
increased $16,000, or 8%, compared to the three months ended March 31, 2003, due
to a change in the actuarial assumptions used to determine our obligation under
a postretirement benefit arrangement, partially offset by the projected impact
of changes to the Medicare laws enacted by the U.S. Congress in December 2003.
Other, net. Other, net was a loss of $454,000 and $346,000 for the
three months ended March 31, 2004 and 2003, respectively, and related primarily
to net realized and unrealized foreign exchange transaction losses.
Provision for Income Taxes. Income tax benefit for the three months
ended March 31, 2004 was $29,000 compared to tax expense of $32,000 for the
three months ended March 31, 2003. The change in tax expense was attributable to
the change in net income (loss) before preferred stock dividends from income of
$55,000 for the three months ended March 31, 2003 to a loss of $44,000 for the
three months ended March 31, 2004. The effective tax rate was 39% and 37% for
the three-month periods ended March 31, 2004 and 2003, respectively.
22
LIQUIDITY AND CAPITAL RESOURCES
As of March 31, 2004, we had cash and working capital of $3.0 million
and $36.2 million, respectively, as compared to cash and working capital of $1.8
million and $34.6 million, respectively, at December 31, 2003.
Net cash used in operating activities for the three months ended March
31, 2004 was $424,000, compared to $4.0 million for the three months ended March
31, 2003. Factors that contributed to the reduction in cash used for operating
activities during 2004 included an increase in trade accounts receivable during
the three months ended March 31, 2003 compared to the respective period in 2004,
partially offset by a decrease in trade accounts payable. These results reflect
increased collection efforts to reduce the number of days of receivables
outstanding in 2004, with cash collections applied toward debt reduction and
repayment of trade accounts payable.
Net cash used in investing activities for the three months ended March
31, 2004 was $779,000, which included $839,000 of capital expenditures,
partially offset by proceeds from the sale of certain operating equipment. For
the three months ended March 31, 2003, cash used in investing activities was
$2.5 million and related primarily to capital expenditures.
Net cash provided by financing activities for the three months ended
March 31, 2004 was $3.0 million. The primary source of funds for financing
activities was borrowings of $45.0 million under our 2004 term loan and
revolving credit facilities, used to retire borrowings under our 2001 term loan
and revolving credit facilities, including net repayments of $10.1 million under
revolving credit arrangements and $30.8 million under the term loan portion of
the agreement. In addition, we incurred $684,000 of deferred loan costs
associated with these new facilities, and paid benefits of $504,000 under our
postretirement benefit arrangement. Net cash provided by financing activities
for the three months ended March 31, 2003 was $5.4 million. The primary source
of funds for these financing activities was net proceeds of $14.1 million from
the issuance of our Series B Convertible Preferred Shares, offset by repayments
of long-term debt totaling $7.4 million and repayment of bank overdrafts
totaling $1.0 million.
We borrowed $1.5 million under a long-term promissory note arrangement
on February 6, 2002, to finance the purchase of a manufacturing facility in
Magnolia, Texas. This note accrues interest at the 90-day London Inter-bank
Offered Rate ("LIBOR") plus 3.25% per annum, and requires quarterly payments of
principal of approximately $24,000 and interest for five years beginning May
2002, with a final balloon payment due February 2007. This promissory note is
collateralized by our manufacturing facility in Magnolia, Texas.
On March 15, 2004, we replaced our term loan and revolving facilities
agreement, referred to as the 2001 term loan and revolving credit facilities,
with a new agreement, referred to as the 2004 term loan and revolving credit
facilities agreement, which provides for a term loan of $45.0 million, a U.S.
revolving facility with a borrowing capacity of $20.0 million, a Canadian
revolving facility with a borrowing capacity of $5.0 million and a U.K.
revolving facility with a borrowing capacity of $10.0 million. All of the
revolver borrowing capacities under the 2004 term loan and revolving credit
facilities agreement are subject to borrowing base limitations.
We recorded a charge of $667,000 in March 2004 to expense unamortized
loan costs related to our 2001 term loan and revolving credit facilities, and
incurred an additional $684,000 of deferred loan costs related to the 2004 term
loan and revolving credit facilities which will be amortized as interest expense
through maturity of the facilities in March 2007.
The 2004 term loan and revolving credit facilities agreement provides
for interest at a rate based upon the ratio of Funded Debt to EBITDA, as defined
in the credit facility ("EBITDA"), and ranging from, at our election, (1) a high
of LIBOR plus 2.75% to a low of LIBOR plus 2.00% or (2) a high of a base rate
plus 1.75% to a low of a base rate plus 1.00%. We will pay commitment fees
related to this agreement on the undrawn portion of the facility, depending upon
the ratio of Funded Debt to EBITDA, calculated at 0.50% as of March 31, 2004. We
had borrowings of $45.0 million outstanding under the term loan portion of the
2004 term loan and revolving credit facilities at March 31, 2004, which bore
interest at 3.94% per annum. No borrowings were outstanding under the revolving
credit portion of the 2004 term loan and revolving credit facilities at March
31, 2004. However, we had letters of credit outstanding under the 2004 revolving
credit facilities of $19.1 million at March 31, 2004. Fees related to these
letters of credit at March 31, 2004 were approximately 2.75% of the outstanding
balance. These letters of credit support contract performance and warranties and
expire at various dates through February 2008.
We and our operating subsidiaries guarantee our 2004 term loan and
revolving credit facilities agreement, which is secured by a first lien or first
priority security interest in or pledge of substantially all of the assets of
the borrowers and certain subsidiaries, including accounts receivable,
inventory, equipment, intangibles, equity interests in U.S. subsidiaries and
66-1/3% of the equity interest in active, non-U.S. subsidiaries. Our assets and
our active U.S. subsidiaries secure the U.S., Canadian and U.K. revolving
facilities, assets of
23
our Canadian subsidiary also secure the Canadian facility and assets of our
U.K. subsidiaries also secure the U.K. facility. The U.S. facility is guaranteed
by each of our U.S. subsidiaries, while the Canadian and U.K. facilities are
guaranteed by us, each of our U.S. subsidiaries and the Canadian subsidiary or
the U.K. subsidiaries, as applicable.
The 2004 term loan and revolving credit facilities agreement contains
restrictive covenants including, among others, those that limit the amount of
Funded Debt to EBITDA (as defined in the 2004 term loan and revolving credit
facilities agreement), impose a minimum fixed charge coverage ratio, a minimum
asset coverage ratio and a minimum net worth requirement. We were in compliance
with all restrictive debt covenants in our loan agreements as of March 31, 2004.
Prior to March 15, 2004, we maintained the 2001 term loan and revolving
credit facilities, which consisted of a $50.0 million term loan, a $30.0 million
U.S. revolving facility, a $10.0 million Canadian revolving facility and a $10.0
million U.K. revolving facility. The 2001 term loan was to mature on March 31,
2006, and each of the 2001 revolving facilities was to mature on March 31, 2004.
In July 2002, our lenders approved the amendment of various provisions
of the 2001 term loan and revolving credit facilities agreement, effective April
1, 2002. This amendment revised certain restrictive debt covenants, modified
certain defined terms, allowed for future capital investment in our Sacroc CO2
processing facility in West Texas, facilitated the issuance of up to $7.5
million of subordinated indebtedness, increased the aggregate amount of
operating lease expense allowed during a fiscal year and permitted an increase
in borrowings under the export sales credit facility, without further lender
consent, up to a maximum of $20.0 million. These modifications resulted in
higher commitment fee percentages and interest rates than in the original loan
agreement, based on the Funded Debt to EBITDA ratio, as defined in the
underlying agreement, as amended.
In July 2003, our lenders approved an amendment of the 2001 term loan
and revolving credit facilities agreement, effective April 1, 2003. The
amendment modified several restrictive covenant terms, including the Fixed
Charge Coverage Ratio and Funded Debt to EBITDA Ratio, each as defined in the
agreement, as amended. Under our 2001 term loan and revolving credit facilities
agreement, certain debt covenants became more restrictive during the fourth
quarter of 2003, and we were required to obtain a waiver of the covenants
related to net worth, Funded Debt to EBITDA ratio and Fixed Charge Coverage
Ratio through March 31, 2004, subject to our meeting a minimum EBITDA threshold,
in order to remain in compliance with the agreement, as amended. We met this
threshold requirement and were in compliance with all covenant requirements, as
amended, through the date the facility was retired.
Amounts borrowed under the 2001 revolving facilities portion of the
agreement bore interest at a rate based upon the ratio of Funded Debt to EBITDA
and ranging from, at our election, (1) a high of LIBOR plus 3.00% to a low of
LIBOR plus 1.75% or (2) a high of a base rate plus 1.50% to a low of a base rate
plus 0.25%.
We paid commitment fees of 0.30% to 0.625% per year after 2002 on the
undrawn portion of the 2001 revolving facilities agreement, depending upon the
ratio of Funded Debt to EBITDA. Prior to retirement in March 2004, our
commitment fees under the 2001 term loan and revolving credit facilities were
calculated at a rate of 0.625% during the quarter.
We maintain a working capital facility for export sales that provides
for aggregate borrowings of $10.0 million, subject to borrowing base
limitations, under which borrowings of $1.4 million were outstanding as of March
31, 2004, and which bore interest at 4.00% per annum. Letters of credit
outstanding under this facility at March 31, 2004 totaled $58,000. Fees related
to these letters of credit were approximately 1% of the outstanding balance at
March 31, 2004. The export sales credit facility is secured by specific project
inventory and receivables, and is partially guaranteed by the EXIM Bank. The
facility loans mature in on July 23, 2004, and require renewal annually.
We had unsecured letters of credit and bonds totaling $584,000 and
guarantees totaling $8.2 million at March 31, 2004.
Our sales backlog at March 31, 2004 was $96.0 million, compared to
$82.8 million at March 31, 2003. Backlog increased significantly for the North
American Operations business segment, reflecting an increase in oilfield
activity in 2004 compared to 2003, and also increased for the Automation and
Control Systems business segment, reflecting a major project booking in March
2004 to build control panels for a customer in Kazakhstan. These increases in
backlog were partially offset by a decline in backlog for the Engineered Systems
segment, largely attributable to a lack of large international production system
jobs.
On March 25, 2003, we issued 15,000 shares of Series B Convertible
Preferred Stock ("Series B Preferred Shares"), and warrants to purchase 248,800
shares of our common stock, to Lime Rock Partners II, L.P., a private investment
fund, for an aggregate price of $15.0 million. Approximately $99,000 of the
aggregate purchase price was allocated to the warrants. Proceeds from the
issuance of
24
these securities, net of related estimated issuance costs of approximately
$800,000, were used to reduce our outstanding revolving debt balances and for
other general corporate purposes.
Each of the Series B Preferred Shares has a face value of $1,000 and
pays a cumulative dividend of 10% per annum of face value, which is payable
semi-annually on June 15 and December 15 of each year, except the initial
dividend payment which was payable on July 1, 2003. Each of the Series B
Preferred Shares is convertible, at the option of the holder, into (1) a number
of shares of common stock equal to the face value of such Series B Preferred
Share divided by the conversion price, which was $7.805 (or an aggregate of
1,921,845 shares at March 31, 2004), and (2) a cash payment equal to the amount
of dividends on such share that have accrued since the prior semi-annual
dividend payment date. As of March 31, 2004, we had accrued dividends payable of
$375,000 related to the Series B Preferred Shares.
In the event of a change in control, as defined in the certificate of
designations for the Series B Preferred Shares, each holder of the Series B
Preferred Shares has the right to convert the Series B Preferred Shares into
common stock or to cause the Company to redeem for cash some or all of the
Series B Preferred Shares at an aggregate redemption price equal to the greater
of (1) the sum of (a) $1,000 (adjusted for stock splits, stock dividends, etc.)
multiplied by the number of shares to be redeemed, plus (b) an amount (not less
than zero) equal to the product of $500 (adjusted for stock splits, stock
dividends, etc.) multiplied by the aggregate number of Series B Preferred Shares
to be redeemed, less the sum of the aggregate amount of dividends paid in cash
since the issuance date, plus any gain on the related warrants, and (2) the
aggregate face value of the Series B Preferred Shares plus the aggregate amount
of dividends that have accrued on such shares since the last dividend payment
date. If the holder of the Series B Preferred Shares converts upon a change in
control occurring on or before March 25, 2006, the holder would also be entitled
to receive cash in an amount equal to the dividends that would have accrued
through March 25, 2006 less the sum of the aggregate amount of dividends paid in
cash through the date of conversion, and the aggregate amount of dividends
accrued in prior periods but not yet paid.
We have the right to redeem the Series B Preferred Shares for cash on
or after March 25, 2008, at a redemption price per share equal to the face value
of the Series B Preferred Shares plus the amount of dividends that have been
accrued but not paid since the most recent semi-annual dividend payment date.
Due to the cash redemption features upon a change in control as
described above, the Series B Preferred Shares do not qualify for permanent
equity treatment in accordance with the Emerging Issues Task Force Topic D-98:
"Classification and Measurement of Redeemable Securities," which specifically
requires that permanent equity treatment be precluded for any security with
redemption features that are not solely within the control of the issuer.
Therefore, we have accounted for the Series B Preferred Shares as temporary
equity in the accompanying balance sheet, and have not assigned any value to our
right to redeem the Series B Preferred Shares on or after March 25, 2008.
If the Series B Preferred Shares are redeemed under contingent
redemption features, any redemption amount greater than carrying value would be
recorded as a reduction of income available to common stockholders when the
event becomes probable.
If we fail to pay dividends for two consecutive periods or any
redemption price due with respect to the Series B Preferred Shares for a period
of 60 days following the payment date, we would be in default under the terms of
such shares. During a default period, (1) the dividend rate on the Series B
Preferred Shares would increase to 10.25%, (2) the holders of the Series B
Preferred Shares would have the right to elect or appoint a second director to
the Board of Directors and (3) we would be restricted from paying dividends on,
or redeeming or acquiring our common or other outstanding stock, with limited
exceptions. If we fail to set aside or make payments in cash of any redemption
price due with respect to the Series B Preferred Shares, and the holders elect,
our right to redeem the shares may be terminated.
The warrants issued to Lime Rock Partners II, L.P. have an exercise
price of $10.00 per share of common stock and expire on March 25, 2006. We can
force the exercise of the warrants if our common stock trades above $13.50 per
share for 30 consecutive days. The warrants contain a provision whereby the
holder could require us to make a net-cash settlement for the warrants in the
case of a change in control. The warrants were deemed to be derivative
instruments and, therefore, the warrants were recorded at fair value as of the
issuance date. Fair value, as agreed with the counter-party to the agreement,
was calculated by applying a pricing model that included subjective assumptions
for stock volatility, expected term that the warrants would be outstanding, a
dividend rate of zero and an overall liquidity factor. The resulting liability,
originally recorded at $99,000, was recorded at $122,000 as of March 31, 2004,
reflecting the change in the fair value of the warrants. Similarly, changes in
fair value in future periods will be recorded in net income during the period of
the change.
At March 31, 2004, available borrowing capacity under the 2004 term
loan and revolving credit facilities agreement and the export sales credit
agreement were $13.4 million and $2.5 million, respectively. Although no
assurances can be given, we believe that our operating cash flow, supported by
our borrowing capacity, will be adequate to fund operations for at least the
next twelve months.
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Should we decide to pursue acquisition opportunities, the determination
of our ability to finance these acquisitions will be a critical element of the
analysis of the opportunities.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our operations are conducted around the world in a number of different
countries. Accordingly, future earnings are exposed to changes in foreign
currency exchange rates. The majority of our foreign currency transactions
relate to operations in Canada and the U.K. In Canada, most contracts are
denominated in Canadian dollars, and most of the costs incurred are in Canadian
dollars, which mitigates risks associated with currency fluctuations. In the
U.K., many of our sales contracts and material purchases are denominated in a
currency other than British pounds sterling, primarily U.S. dollars and euros,
whereas our engineering and overhead costs are principally denominated in
British pounds sterling. Consequently, we have currency risk in our U.K.
operations. We were not party to any forward contracts or other currency-related
derivative hedge arrangements at March 31, 2004, and we do not currently intend
to enter into such contracts or arrangements as part of our currency risk
management strategy.
The warrants issued to the holders of our Series B Preferred Shares
provide for a net-cash settlement in the event of a change in control, as
defined in the warrants. Consequently, we use derivative accounting to record
the warrant transaction. The liability representing the fair value of this
derivative arrangement was recorded at $99,000 as of the date of issuance, March
25, 2003, and was adjusted to $122,000 as of March 31, 2004, to reflect the
projected change in fair value of the warrants during the period. A cumulative
loss of $23,000 has been recorded related to these warrants since issuance,
including a gain of $33,000 recorded for the three months ended March 31, 2004.
Fair value, as agreed with the counter-party to the agreement, was based on a
pricing model that included subjective assumptions concerning the volatility of
our common stock, the expected term that the warrants would be outstanding, an
expected dividend rate of zero and an overall liquidity factor. At each
reporting date, the liability will be adjusted to current fair value, with any
changes in fair value reported in earnings during the period of change. As such,
we may be exposed to certain income fluctuations based upon changes in the fair
market value of this liability due to changes in the price of our common stock,
as well as other factors.
Our financial instruments are subject to changes in interest rates,
including our revolving credit and term loan facilities and our working capital
facility for export sales. At March 31, 2004, we had borrowings of $45.0 million
outstanding under the term loan portion of the 2004 term loan and revolving
credit facilities, at an interest rate of 3.94%. No borrowings were outstanding
under the revolving credit portion of these facilities at March 31, 2004.
Borrowings of $1.4 million were outstanding under the working capital facility
for export sales at March 31, 2004, and bore interest at 4.00%. Borrowings under
the long-term arrangement secured by our Magnolia manufacturing facility totaled
$1.3 million and accrued interest at 4.43%.
Based on past market movements and possible near-term market movements,
we do not believe that potential near-term losses in future earnings, fair
values or cash flows from changes in interest rates are likely to be material.
Assuming our current level of borrowings, a 100 basis point increase in interest
rates under our variable interest rate facilities would increase our current
quarter net loss by $73,000 and decrease our cash flow from operations by
$119,000. In the event of an adverse change in interest rates, we could take
action to mitigate our exposure. However, due to the uncertainty of actions that
could be taken and the possible effects, this calculation assumes no such
actions. Furthermore, this calculation does not consider the effects of a
possible change in the level of overall economic activity that could exist in
such an environment.
ITEM 4. CONTROLS AND PROCEDURES
CONTROLS AND PROCEDURES
Members of our management team, including our Chief Executive Officer
and our Chief Financial Officer, have reviewed our disclosure controls and
procedures, as defined by the Securities and Exchange Commission in Rule
13a-15(e) of the Securities Exchange Act of 1934, as of March 31, 2004, in an
effort to evaluate the effectiveness of the design and operation of these
controls. Based upon this review, our management has determined that, as of the
end of the period covered by this Quarterly Report on Form 10-Q, our disclosure
controls and procedures operate such that important information is collected in
a timely manner, provided to management and made known to our Chief Executive
Officer and Chief Financial Officer to allow timely decisions regarding
disclosure in our public filings.
Furthermore, no significant changes have been made to our internal
controls and procedures during the three months ended March 31, 2004, or prior
to filing this Quarterly Report on Form 10-Q, and no corrective actions are
anticipated, as we noted no significant deficiencies or material weaknesses in
our internal control structure.
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PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The only material pending legal proceeding involving NATCO or one of
its subsidiaries is the Magnum Transcontinental Corp. Arbitration and Related
Matter, which has been previously reported in our Annual Report on Form 10-K for
the year ended December 31, 2003. There have been no material developments in
the Magnum arbitration or related matter from the disclosure made in the Form
10-K.
NATCO and its subsidiaries are defendants or otherwise involved in a
number of other legal proceedings in the ordinary course of their business.
While we insure against the risk of these proceedings to the extent deemed
prudent by our management, we can offer no assurance that the type or value of
this insurance will meet the liabilities that may arise from any pending or
future legal proceedings related to our business activities. While we cannot
predict the outcome of any legal proceedings with certainty, in the opinion of
management, our ultimate liability with respect to these pending lawsuits is not
expected to have a material adverse effect on our consolidated financial
position, results of operations or cash flows.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Reports on Form 8-K.
- Report on Form 8-K filed February 24, 2004 to report Fourth
Quarter 2003 Results.
- Report on Form 8-K filed March 16, 2004 to announce completion
of a bank refinancing and the award of a project using new
desulfurization technology.
- Report on Form 8-K filed May 5, 2004 to report First Quarter
2004 Results.
(b) Index of Exhibits
EXHIBIT NO. DESCRIPTION
---------- -----------
10.1 -- Loan Agreement ($20,000,000 U.S. Revolving Loan Facility,
$5,000,000 Canadian Revolving Loan Facility, $10,000,000 U.K.
Revolving Loan Facility and $45,000,000 Term Loan Facility) dated
as of March 15, 2004 among NATCO Group Inc., As U.S. Borrower,
NATCO Canada, Ltd. as Canadian Borrower, Axsia Group Limited, as
U.K. Borrower, Wells Fargo Bank, National Association, as U.S.
Agent and Co-Lead Arranger, HSBC Bank Canada, as Syndications
Agent and as Co-Lead Arranger, HSBC Bank Canada, as Syndications
Agent and as Co-Lead Arranger and the other Lenders now or
hereafter parties thereto (incorporated by reference to Exhibit
10.32 of the Company's Annual Report on Form 10-K for the period
ended December 31, 2003)
31.1* -- Certification of Chief Executive Officer of NATCO Group Inc.
pursuant to 15 U.S.C. Section 7241, as adopted pursuant to Section
302 of the Sarbanes- Oxley Act of 2002
31.2* -- Certification of Chief Financial Officer of NATCO Group Inc.
pursuant to 15 U.S.C. Section 7241, as adopted pursuant to Section
302 of the Sarbanes- Oxley Act of 2002
32.1* -- Certification of Chief Executive Officer and Chief Financial
Officer of NATCO Group Inc. pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
* Filed with this report.
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SIGNATURES
Pursuant to the requirements 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.
NATCO Group Inc.
By: /s/ Nathaniel A. Gregory
-----------------------------------------
Name: Nathaniel A. Gregory
Chairman of the Board and
Chief Executive Officer
Date: May 10, 2004
By: /s/ Richard W. FitzGerald
------------------------------------------
Name: Richard W. FitzGerald
Senior Vice President and Chief Financial
Officer
Date: May 10, 2004
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EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION
---------- -----------
10.1 -- Loan Agreement ($20,000,000 U.S. Revolving Loan Facility,
$5,000,000 Canadian Revolving Loan Facility, $10,000,000 U.K.
Revolving Loan Facility and $45,000,000 Term Loan Facility) dated
as of March 15, 2004 among NATCO Group Inc., As U.S. Borrower,
NATCO Canada, Ltd. as Canadian Borrower, Axsia Group Limited, as
U.K. Borrower, Wells Fargo Bank, National Association, as U.S.
Agent and Co-Lead Arranger, HSBC Bank Canada, as Syndications
Agent and as Co-Lead Arranger, HSBC Bank Canada, as Syndications
Agent and as Co-Lead Arranger and the other Lenders now or
hereafter parties thereto (incorporated by reference to Exhibit
10.32 of the Company's Annual Report on Form 10-K for the period
ended December 31, 2003)
31.1* -- Certification of Chief Executive Officer of NATCO Group Inc.
pursuant to 15 U.S.C. Section 7241, as adopted pursuant to Section
302 of the Sarbanes- Oxley Act of 2002
31.2* -- Certification of Chief Financial Officer of NATCO Group Inc.
pursuant to 15 U.S.C. Section 7241, as adopted pursuant to
Section 302 of the Sarbanes- Oxley Act of 2002
32.1* -- Certification of Chief Executive Officer and Chief Financial
Officer of NATCO Group Inc. pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
*Filed with this report.
29