UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

 

 

 

Commission File Number 0-22496

 

SCHNITZER STEEL INDUSTRIES, INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (503) 224-9900

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Class A Securities registered pursuant to Section 12(g) of the Act: None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act. Yes [ ] No [X]

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act. Yes [ ] No [X]

 

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in the definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (check one)

 

Large Accelerated Filer [X]       Accelerated Filer [ ]          Non-Accelerated Filer [ ]

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act). Yes [ ] No [X]

 

The aggregate market value of the registrant’s voting common stock outstanding held by non-affiliates on February 28, 2007 was $813,850,848.

 

The Registrant had 21,230,715 shares of Class A Common Stock, par value of $1.00 per share, and 7,328,387 shares of Class B Common Stock, par value of $1.00 per share, outstanding at October 19, 2007.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive Proxy Statement for the January 2008 Annual Meeting of Shareholders are incorporated herein by reference in Part III.

 

SCHNITZER STEEL INDUSTRIES, INC.
FORM 10-K

 

TABLE OF CONTENTS

 

 

FORWARD-LOOKING STATEMENTS

 

 

Statements and information included in this Annual Report on Form 10-K by Schnitzer Steel Industries, Inc. (the “Company”) that are not purely historical are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and are made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

 

Forward-looking statements in this Annual Report on Form 10-K include statements regarding the Company’s expectations, intentions, beliefs and strategies regarding the future, including statements regarding trends, cyclicality, and growth in the markets the Company sells into, strategic direction, changes to manufacturing processes, the cost of compliance with environmental and other laws, liquidity positions, ability to generate cash from continuing operations, expected growth, the potential impact of adopting new accounting pronouncements, expected results including pricing, sales volume, operating margins and operating income, obligations under the Company’s retirement plans, savings or additional costs from business realignment programs, and the adequacy of accruals.

 

When used in this report, the words “believes,” “expects,” “anticipates,” “intends,” “assumes,” “estimates,” “evaluates,” “may,” “could,” “opinions,” “forecasts,” “future,” “forward,” “potential,” “probable,” and similar expressions are intended to identify forward-looking statements.

 

The Company may make other forward-looking statements from time to time, including in press releases and public conference calls. All forward-looking statements made by the Company are based on information available to the Company at the time the statements are made, and the Company assumes no obligation to update any forward-looking statements, except as may be required by law. Actual results are subject to a number of risks and uncertainties that could cause actual results to differ materially from those included in, or implied by, such forward-looking statements. Some of these risks and uncertainties are discussed in Item 1A. Risk Factors of Part I of this Form 10-K. Other examples include volatile supply and demand conditions affecting prices and volumes in the markets for both the Company’s products and raw materials it purchases; world economic conditions; world political conditions; changes in federal and state income tax laws; impact of pending or new laws and regulations regarding imports and exports into the United States and other foreign countries; foreign currency fluctuations; competition; seasonality, including weather; energy supplies; freight rates; loss of key personnel; expectations regarding the Company’s compliance program; business integration issues relating to acquisitions of businesses and the separation of the joint ventures described herein; credit worthiness of suppliers and customers; new accounting pronouncements; availability of capital resources and business disruptions resulting from installation or replacement of major capital assets.

 

PART I

 

 

General

 

Founded in 1906, Schnitzer Steel Industries, Inc. (“the Company”), an Oregon corporation, is currently one of the nation’s largest recyclers of ferrous and nonferrous metals, a leading recycler of used and salvaged vehicles and a manufacturer of finished steel products.

 

The Company provides an end of life cycle solution for a variety of products through its vertically integrated businesses, including processing auto bodies and other metal products, resale of used auto parts and manufacturing scrap metal into finished steel products. The Company operates in three reportable segments: the Metals Recycling Business (“MRB”), the Auto Parts Business (“APB”) and the Steel Manufacturing Business (“SMB”). Corporate expense consists primarily of unallocated corporate expense for management and administrative services that benefit all three business segments. As a result of this unallocated expense, the operating income of each segment does not reflect the operating income the segment would have as a stand-alone business. For further information regarding the Company’s segments, including financial information about geographic areas, refer to Note 17 – Segment Information, in the notes to the consolidated financial statements, in Part II, Item 8 of this report.

 

Metals Recycling Business

 

Business

 

MRB buys, collects, processes, recycles, sells, trades and brokers recycled ferrous metals (containing iron) to foreign and domestic steel producers, including SMB, and nonferrous metals (not containing iron) to both domestic and export markets. MRB processes large pieces of scrap metal into smaller pieces by sorting, shearing, shredding, torching and baling, resulting in metal processed into pieces of a size, density and purity required by customers to meet their production needs. Smaller, more homogenous pieces of processed metal have more value because they melt more easily than larger pieces and, in the case of ferrous metals, more completely fill a steel mill’s furnace charge bucket, which results in lower energy usage and shorter cycle times, thus reducing costs.

 

One of the most efficient ways to process and sort recycled metals is to use shredding systems. Currently, each of the Company’s Everett, Massachusetts; Portland, Oregon; Oakland, California; and Tacoma, Washington facilities has a mega-shredder capable of processing over 2,500 tons of metal per day. The Company’s Johnston, Rhode Island facility operates a large shredder capable of processing up to 1,500 tons of metal per day, and the Kapolei, Hawaii and Anchorage, Alaska facilities operate smaller shredders. Coupled with additional capacity, the mega-shredders provide the ability to shred more efficiently and process a greater range of materials, including larger and thicker pieces of metal. Mega-shredders are designed to provide a denser product and, in conjunction with new separation equipment, a more refined and preferable form of ferrous metal which can be more efficiently used by steel mills. The larger shredders are also able to accept more types of material, resulting in more efficient processing. Shredders can reduce autobodies, home appliances and other metal into fist-size pieces of shredded recycled metal in seconds. The shredded material is then carried by conveyor under magnetized drums that attract the recycled ferrous metal and separate it from the nonferrous metal and other residue found in the shredded material, resulting in a relatively pure and clean shredded ferrous product. The remaining nonferrous metal and residue then pass through a series of mechanical and manual sorting systems that are designed to separate the nonferrous metal from the residue. The remaining nonferrous metal is either hand sorted and graded before being sold or is sold as a mixed product. MRB continues to invest in nonferrous metal recovery methods in order to maximize the recoverability of valuable nonferrous metals.

 

MRB has a global trade component of its business that purchases processed ferrous metal from metal processors operating in Russia and certain Baltic countries, and sells this metal to steel mills located primarily in Europe and the Mediterranean. Russia and the Baltic countries are attractive markets because of the ample supply of unprocessed metal available to metal processors due to the Cold War Era infrastructures, many of which are closed or obsolete. However, the Russian and Baltic transportation infrastructures make it more economically challenging to access the metal. MRB’s management believes that this business complements its processing

business and allows it to further meet its customers’ needs as well as expand its global market share of the recycled ferrous metal business.

 

Products

 

MRB sells both ferrous and nonferrous scrap metals. The ferrous products include shredded, sheared, torched and bundled scrap metal, and other purchased scrap metal. MRB also processes and sells nonferrous scrap metals, including aluminum, copper, stainless steel, nickel, brass, titanium and high temperature alloys.

 

Customers

 

MRB sells recycled metal to foreign and domestic customers and provides nearly 100% of the ferrous scrap metal required by SMB. MRB has developed long-standing relationships with foreign and domestic steel producers.

 

Presented below are MRB revenues by continent for the year ended August 31 (in millions):

 

 

In 2006, MRB accomplished its goal of expanding and diversifying its customer base by significantly increasing its sales to customers in Taiwan, Turkey, Malaysia, Spain, India, Egypt, Mexico and other countries located in Asia and Europe. In 2007, MRB further expanded its base of regular scrap consumers to include, among others, customers in Greece, Japan and Indonesia. MRB has representatives in South Korea, China, Taiwan, Southeast Asia and Japan to better serve the Asian markets to which it sells.

 

MRB’s five largest ferrous metal customers accounted for 25%, 23% and 66% of recycled ferrous metal revenues to unaffiliated customers in fiscal 2007, 2006 and 2005, respectively. There were no external customers that accounted for 10% or more of consolidated revenues in fiscal 2007 or fiscal 2006. In fiscal 2005 there was one external customer that accounted for $108 million, or 13%, of consolidated revenues. Customer purchase volumes of recycled ferrous metals vary from year to year due to demand, competition, relative currency values and other factors. Ferrous metal sales are generally denominated in United States (“U.S.”) dollars, and most shipments to foreign customers are supported by letters of credit. Ferrous metal is shipped to customers by ship, railroad, barge, container or truck.

 

The following table sets forth the amount of recycled ferrous metal sold by MRB to certain groups of customers during the last three fiscal years ended August 31:

 

 

 

 

MRB also sells recycled nonferrous metal to foreign and domestic customers. By continuing to improve the extraction processes used to recover nonferrous metal from the shredding process, MRB has been able to increase

the supply of nonferrous product available to sell to foreign and domestic customers. Many of MRB’s industrial suppliers utilize nonferrous metal in manufacturing automobiles and auto parts.

 

The following table sets forth the amount of recycled nonferrous metal sold by MRB to foreign and domestic customers during the last three fiscal years ended August 31:

 

 

 

Markets

 

Prices for both domestic and foreign recycled ferrous metals are generally based on prevailing market rates, which can differ by region and are subject to market cycles that are influenced by many factors, including worldwide demand from steel and other metal producers and the availability of materials that can be processed into saleable scrap. In recent years, worldwide demand for finished steel products has been growing at a faster rate than the available supply of recycled ferrous metal, which is one of the primary raw materials used in the manufacturing of steel. Demand for steel and for raw materials to produce steel products has increased recently, including as a result, the substantial increase in Chinese production and consumption of steel. MRB’s average net sales price per ton for recycled ferrous metal increased from $215 per ton in fiscal 2006 to $263 per ton in fiscal 2007, setting a historical record. Export recycled ferrous metal sales contracts generally provide for shipment within 30 to 90 days after the price is agreed to, which, in most cases, includes freight. MRB responds to changing price levels by adjusting scrap metal purchase prices at its recycling facilities in order to help maintain its operating margin dollars per ton. However, the margin between selling prices and the cost of purchased material are subject to a number of factors, including differences in the market conditions in the domestic regions where recycled metal is acquired and the areas in the world where the processed materials are sold, market volatility from the time the sales price is agreed to with the customer until the time the material is acquired, and changes in the assumed costs of transportation to or from the seller’s facility. MRB believes it generally benefits from rising recycled metal prices, which allow it to better maintain or expand both margins and unprocessed metal flow into its facilities. MRB also reduces its exposure to declining market prices by reducing the time that inventory is held, thus increasing inventory turnover.

 

Consolidation in the Scrap Metal Industry

 

The metals recycling industry has been consolidating over the last several years, primarily due to an increase in scrap metal prices, the growth in global demand for scrap metal, a high degree of fragmentation in the industry and the ability of large, well-capitalized processors to achieve competitive advantages by investing in capital improvements to improve efficiencies and lower processing costs.

 

Distribution

 

MRB delivers recycled ferrous and nonferrous metals to foreign steel customers by ship and container, and domestically by barge, rail and over the road transportation networks. Cost efficiencies are achieved by operating deep water terminal facilities at Everett, Massachusetts; Portland, Oregon; Oakland, California; Tacoma, Washington; Anchorage, Alaska; and Providence, Rhode Island. All of MRB’s terminal facilities except for the Providence, Rhode Island facility, which is operated under a long-term lease, are owned. The Kapolei, Hawaii and Anchorage, Alaska operations ship from public docks. Additionally, because most of the terminal facilities are operated by MRB, it is not normally subject to the same berthing delays often experienced by users of unaffiliated terminals. MRB believes that its loading costs are lower than they would be if it utilized third-party terminal facilities.

Sources of Unprocessed Metal

 

The most common forms of purchased raw metals are obsolete machinery and equipment, such as automobiles, railroad cars, railroad tracks, home appliances, waste metal from manufacturing operations and demolition metal from buildings and other obsolete structures. This metal is acquired from suppliers who unload at MRB’s facilities, from drop boxes at a diverse base of suppliers’ industrial sites and through negotiated purchases from other large suppliers, including railroads, industrial manufacturers, automobile salvage facilities, metal dealers and individuals. The majority of MRB’s scrap metal collection and processing facilities receive raw metal via major railroad routes, waterways or major highways. Metals recycling facilities situated near unprocessed metal sellers and major transportation routes have the competitive advantage of reduced freight costs because of the significant cost of freight relative to the cost of metal. The locations of MRB’s West Coast facilities allow it to competitively purchase raw metal from Hawaii, the San Francisco Bay area, northwards up the West Coast to Western Canada and Alaska and to the east, including Idaho, Montana, Utah and Nevada. The locations of the East Coast facilities provide access to sources of unprocessed metal in Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island and Vermont. In the Southeastern U.S., approximately half of MRB’s ferrous and nonferrous unprocessed metal volume is purchased from industrial companies, with the remaining volume being purchased from smaller dealers and peddlers. These industrial companies provide MRB with metals that are by-products of their manufacturing processes. The Southeastern U.S. has recently become a highly attractive location for domestic and international auto manufacturers, specifically Alabama and Georgia where MRB’s Southeastern facilities are located. With the rise of automobile manufacturing in the Southeast, automobile parts manufacturers have also established facilities in this area. These manufacturers have provided a consistent and growing supply of scrap metal.

 

Seasonality

 

MRB makes a number of large recycled ferrous metal shipments to foreign steel producers each year. Control over the timing of shipments is limited by customer requirements, shipping schedules, availability of suitable vessels and other factors. Variations in the number of shipments from quarter to quarter, often as a result of the timing of obtaining vessels, can result in significant fluctuations in quarterly revenues, earnings and inventory levels. Freezing conditions in the Baltic region generally limit the ability to ship product from this area during parts of the second and third fiscal quarters.

 

Backlog

 

On August 31, 2007, MRB had firm orders to sell $141 million of export ferrous metals compared to $145 million on August 31, 2006.

 

Competition

 

MRB competes in domestic and foreign markets for the purchase of scrap metal from suppliers. Competition for metal purchases comes primarily from large well-financed recyclers of scrap metal as well as smaller metal facilities and dealers. Many of these recyclers have varying types and sizes of processing equipment that include fixed and mobile shears and large and small ferrous metal shredders, all of which have varying effects on the purchase price of recycled metal. MRB also competes with brokers who buy scrap metal on behalf of domestic and foreign steel mills. Brokers have also begun to coordinate shipments of certain grades of processed scrap from smaller scrap dealers to foreign mills via shipping containers. The predominant competitive factors that impact recycled metal sales and the ability to obtain unprocessed metal are price (including shipping cost), availability and reliability of service and product quality.

 

MRB also competes in foreign and domestic markets for the sale of processed recycled metals to finished steel producers. Price (including shipping cost) and availability are the two most important competitive factors, but reliability of service and product quality are also relevant factors.

Auto Parts Business

 

Business and Products

 

APB purchases used and salvaged vehicles and sells used parts from these vehicles through its self-service and full-service auto parts stores, which are located across the U.S. and Western Canada. The remaining portions of the vehicles are sold to metal recyclers, including MRB where geographically feasible.

 

Auto parts stores operated by APB as of August 31, included the following:

 

 

 

Customers

 

Self-service stores generally serve customers who are looking to obtain serviceable used auto parts at a competitive price. These customers remove the used auto parts from vehicles in inventory without the assistance of store employees. Full-service stores generally serve business or wholesale customers, typically collision and repair shops, that are looking to obtain serviceable used parts at prices that are less than prices for new parts. Full-service stores retain professional staff to dismantle and inventory individual parts. Once parts are sold, they are pulled from inventory, cleaned, tested and delivered via APB delivery trucks and third parties to the customer. APB has one location that is comprised of both self-service and full-service stores. APB believes that it has enhanced the Company’s competitive advantage through its proprietary technology, which is used to centrally manage and operate the geographically diverse network; by applying a consistent approach to offering customers a large selection of vehicles from which to obtain parts; and by its efficient processing of autobodies. Additionally, APB has taken various steps, including remodeling certain facilities, to improve the customer’s shopping experience. There were no external customers that accounted for 10% or more of consolidated revenues in fiscal 2007, 2006 or 2005.

 

APB is dedicated to supplying low-cost used auto parts to its customers. In general, management believes that the prices of parts at its self-service stores are significantly lower than those offered at full-service auto dismantlers, retail car part stores and car dealerships. Each self-service store offers an extensive selection of vehicles from which consumers can remove parts. APB carries domestic and foreign cars, vans and light trucks and regularly rotates its inventory to provide its customers with greater access to a continually changing parts inventory.

 

APB total revenues for the year ended August 31 were (in thousands):

 

 

Fragmentation of the Auto Parts Industry

 

The auto parts industry is characterized by diverse and fragmented competition and is comprised of a large number of aftermarket and used auto part suppliers of all sizes. These companies range from large, multinational corporations, which serve both original equipment manufacturers and the aftermarket on a worldwide basis, to small, local producers that supply only a few parts for a particular car model. The auto parts industry is also characterized by a wide range of consumers as some consumers tend to demand original replacement parts, while others are price sensitive and exhibit minimal brand loyalty.

Distribution

 

APB sells used auto parts from each of its self-service and full-service retail stores. Upon arriving at a self-service store, a customer typically pays an admission charge and signs a liability waiver before entering the facility. When a customer finds a desired part on a vehicle, the customer removes it and pays a pre-established price for the part. The full-service business sells its parts primarily to collision and mechanical repair shops through its sales force, which includes inside and outside sales people. Once these parts are sold, they are pulled from inventory, cleaned, tested, and shipped to the customer through a network of company delivery trucks. In addition, the full-service business offers its customers visibility to all parts in inventory within a given region and fulfills orders with next day delivery by running nightly transfer trucks between locations.

 

Once the vehicle is removed from the customer area, certain remaining parts that can be sold wholesale (cores) are removed from the vehicle. In California, Florida and Texas, these cores (such as engines, transmissions and alternators) are consolidated at central facilities. From these facilities, the parts are sold through an auction system to a variety of wholesale buyers. Due to larger volumes generated by this consolidation process and higher prices for nonferrous metals, APB has been able to obtain increasingly higher prices for these cores.

 

After the core removal process is complete, the remaining autobody is crushed and sold as scrap metal in the wholesale market. The autobodies are sold on a price per ton basis, which is subject to fluctuations in the recycled ferrous metal markets. During fiscal 2007, 2006 and 2005, APB generated revenues of $22 million, $15 million and $13 million from sales to MRB respectively, thereby making MRB the single largest wholesale customer of APB. APB’s wholesale business consists of its core and scrap sales.

 

Marketing

 

APB continues to support the marketing initiatives unique to each of the self-service and full-service business lines. The full-service brand marketing plan recognizes the role that institutional entities, such as insurance companies and consolidators, as well as local repair facilities, play in the purchasing cycle and utilizes a marketing infrastructure that addresses all levels of customers. Through market education forums, market mailer programs, participation in industry forums and local marketing initiatives, the full-service platform highlights the advantages of using recycled auto parts to the consumer. The full-service brand also expanded its field representation to several key markets.

 

The self-service platform continues to focus on the local markets surrounding the stores and incorporates various components, including a points-based system for buying media, which is focused on making targeted impressions in the market; this includes the use of radio to support promotional events, regularly scheduled in-store promotions, and product promotion. Each store has a customized marketing calendar designed for its market and the community it serves.

 

APB typically seeks to locate its facilities with convenient access to major streets and in major population centers. By operating at locations that are convenient and visible to the target customer, the stores seek to become the customer’s first stop in acquiring used auto parts. Convenient locations also make it easier and less expensive for suppliers to deliver vehicles. APB has also developed a side-by-side full-service and self-service location to enhance the scope of parts available to its customers.

 

Sources of Vehicles

 

APB obtains vehicles from five primary sources: tow companies, private parties, auto auctions, city contracts and charities. APB employs car buyers who travel to vendors and bid on vehicles. APB also has a program to purchase vehicles from private parties called “Cash for Junk Cars,” which is advertised in telephone directories and newspapers. Private parties call a toll free number and receive a quote for their vehicle. The private party can either deliver the vehicle to one of APB’s retail locations or arrange for the vehicle to be picked up. APB is also attempting to secure more vehicle supplies at the source by contracting with additional suppliers. The full-service business also purchases damaged vehicles, reacquired vehicles and salvageable production parts from inactive test vehicles from Ford Motor Company and resells these parts through its sales network.

Seasonality

 

Historically, retail sales and admissions in the self-service stores have been somewhat seasonal and principally affected by weather and promotional events. Since APB’s self-service stores are subject to the natural elements, during periods of prolonged rain, cold or extreme heat, the retail business tends to slow down due to difficult customer working conditions. As a result, the first and third fiscal quarters tend to generate the most retail sales and the second and fourth fiscal quarters are the slowest in terms of retail sales in the self-service stores. By contrast, business at the full-service stores, which supply collision shops, tends to increase during and immediately following periods of inclement weather.

 

Competition

 

APB competes for customers with other self-service and full-service auto dismantlers as well as larger well-financed retail auto parts businesses. In addition, APB competes for vehicle inventory with other dismantlers, used car dealers, auto auctions and metal recyclers. Vehicle costs can fluctuate significantly depending on market conditions and prices for recycled metal.

 

Steel Manufacturing Business

 

Business

 

SMB purchases recycled metal from MRB at negotiated rates intended to approximate export market prices and uses its mini-mill to process the recycled metal and other raw materials into finished steel products.

 

Products

 

SMB produces rebar, coiled rebar, wire rod, merchant bar, and other specialty products. Rebar is produced in either straight length steel bars or coils and used to increase the tensile strength of poured concrete. Coiled rebar is preferred by some manufacturers because it reduces the waste generated by cutting individual lengths to meet customer specifications and, therefore, improves yield. Merchant bar consists of round, flat, angle and square steel bars used by manufacturers to produce a wide variety of products, including gratings, steel floor and roof joists, safety walkways, ornamental furniture, stair railings and farm equipment. Wire rod is steel wire, delivered in coiled form, used by manufacturers to produce a variety of products such as chain link fencing, nails, wire and stucco netting.

 

The table below sets forth, on a revenue and volume basis, the sale of these products during the last three fiscal years ended August 31:

 

 

 

 

Customers

 

During fiscal 2007, SMB sold its steel products to customers located primarily in the ten western states. Customers in California accounted for 42% of these sales. SMB’s customers are principally steel service centers, construction industry subcontractors, steel fabricators, wire drawers and major farm and wood product suppliers. SMB’s ten largest customers accounted for 34%, 38% and 44% of its revenues during fiscal 2007, 2006 and 2005, respectively.

There were no external customers that accounted for 10% or more of consolidated revenues in fiscal 2007, 2006 or 2005.

 

Consolidation in the Steel Industry

 

There has been significant consolidation in the global steel industry. Within the past few years, the U.S. steel industry has significantly consolidated, primarily led by Arcelor Mittal, United States Steel Corporation, Nucor Corporation and Steel Dynamics, Inc. Consolidation is also taking place in Central and Eastern Europe as well as in China. Cross border consolidation has also occurred with the aim of achieving greater efficiency and economies of scale, particularly in response to the effective consolidation undertaken by raw material suppliers and consumers of steel products.

 

Distribution

 

SMB sells directly from its mini-mill in McMinnville, Oregon, from its owned distribution center in El Monte, California (Los Angeles area) and from a third-party distribution center in Lathrop, California (Central California). The distribution centers facilitate sales by maintaining an inventory of products close to major customers for just-in-time delivery. SMB communicates regularly with major customers to determine their anticipated needs and plans its rolling mill production schedule accordingly. Shipments to customers are made by common carrier, primarily truck or rail.

 

Recycled Metal Supply

 

SMB believes it operates the only mini-mill in the Western U.S. that benefits from obtaining its entire recycled metal requirements from its own affiliated metal recycling operations, which is beneficial because there have been times where regional shortages of recycled metals have caused some mills to pay higher prices for recycled metal shipped from other regions or to temporarily curtail operations. MRB is able to deliver a mix of recycled metal grades to achieve optimum efficiency in SMB’s melting operations. Because the steel mill, and major MRB facilities are located on railway routes, SMB benefits from the reduced cost of shipping recycled metal by rail.

 

Energy Supply

 

Electricity represented 4% of SMB’s cost of goods sold in fiscal 2007 and 5% of cost of goods sold in fiscal 2006 and 2005. Natural gas represented 3% of cost of goods sold in fiscal 2007 and 2006 and 2% of cost of goods sold in fiscal 2005.

 

SMB purchases electric power under a long-term contract with McMinnville Water & Light (“MWL”), which in turn relies on the Bonneville Power Administration (the “BPA”). Historically, these contracts have had favorable prices. This contract expires in September 2011. On October 1, 2001, the BPA increased its electricity rates due to increased demand on the West Coast and lower supplies. This rate increase was in the form of a Cost Recovery Adjustment Clause (“CRAC”) added to the BPA’s contract with MWL. The CRAC is an additional monthly surcharge on selected power charges to recover costs associated with buying higher priced power during West Coast power shortages. Starting October 1, 2006, the BPA can adjust the CRAC on an annual basis instead of every six months. The CRAC for October 1, 2007 to September 30, 2008 is expected to be zero.

 

SMB also has a take-or-pay natural gas contract that expires on May 31, 2011 and obligates it to purchase a minimum of 3,435 million British Thermal Units (“MMBTU”) per day at tiered pricing, whether or not the amount is utilized. The blended rate for the period from November 1, 2006 through October 31, 2007 was $8.22 per MMBTU. Effective for the delivery period from November 1, 2007 through October 31, 2008, the blended rate will decrease from $8.22 per MMBTU per day to $7.70 per MMBTU per day.

 

Manufacturing

 

SMB has continued to reinvest in its mini-mill to improve efficiencies. SMB’s meltshop includes a 108-ton capacity electric-arc furnace, a ladle refining furnace and a five-strand continuous billet caster. The melt shop has enhanced steel chemistry refining capabilities, permitting the mill to produce special alloy grades of steel not currently

produced by other mills on the West Coast. The melt shop produced 762,000, 719,000 and 672,000 tons of billets during fiscal 2007, 2006 and 2005, respectively.

 

SMB operates two computerized rolling mills that allow for synchronized operations of the rolling mills and related equipment. The billets produced in the melt shop are reheated in two natural gas-fueled furnaces and are then hot- rolled through the two rolling mills to produce finished products. Rolling mill #1 is a 17-stand mill that was rebuilt in 1986. Rolling mill #2 is an 18-stand mill which was installed in 1996. In 1997, a rod block and related equipment for the manufacture of wire and coiled rebar was added to rolling mill #2. Since then, SMB has completed a number of improvement projects to both mills designed to increase the operating efficiency of each mill as well as to increase the types of products that can be competitively produced. Management continues to monitor the market for new products and, through discussions with customers, identify additional opportunities.

 

During fiscal 2007, SMB completed the process of enlarging the billet reheat furnace on rolling mill #2 as well as upgrading the billet yard craneway. These capital projects enable SMB to increase rebar production capabilities on rolling mill #2 as well as improve the process of inventory movement in the billet yard. This allowed SMB to increase its finished steel production from 698,000 tons in fiscal 2006 to 724,000 tons in fiscal 2007. As a result of these projects, SMB believes that its annual production capacity is now in excess of 750,000 tons.

 

Seasonality

 

SMB revenues can fluctuate significantly between quarters due to factors such as the seasonal slowdown in the construction industry, which occurs from the late fall through early spring. In the past, SMB has generally experienced its lowest sales during the second fiscal quarter. In fiscal 2007 and 2006, SMB did not experience a significant slowdown in the second quarter due to announced sales price increases, which resulted in an acceleration of sales orders that normally would have occurred in subsequent quarters. Although SMB did not experience a slowdown in the second quarter of fiscal 2007 or 2006, it expects this pattern to recur in the future.

 

Backlog

 

SMB generally ships products within days after the receipt of purchase orders. Backlog orders are seasonal and are typically greater in the third and fourth fiscal quarters. As of August 31, 2007 SMB had backlog orders of $17 million, compared to $16 million as of August 31, 2006.

 

Competition

 

The principal competitive factors in SMB’s market are price, product availability, quality and service. The mill’s primary domestic competitors are Nucor Corporation’s manufacturing facilities in Utah and Washington and TAMCO Steel’s facility in California.

 

In addition to domestic competition, SMB has historically competed intensely with foreign steel producers principally located in Asia, Canada, Mexico and Central and South America, primarily in shorter length rebar and certain wire rod grades. In the spring of 2002, the U.S. Government imposed anti-dumping and countervailing duties against wire rod products from eight foreign countries. These duties remain in effect today, are periodically reviewed and do not have a set expiration date. In July of 2007, the International Trade Commission extended existing rebar anti-dumping duties of up to 233% on imports from seven nations, through 2012.

 

Strategic Focus

 

Company Growth

 

In fiscal 2007, the Company completed the following acquisitions:

 

 

In fiscal 2006, the Company completed the following acquisitions:

 

 

The Company intends to continue to focus on growth through value-creating acquisitions and will pursue acquisition opportunities it believes will create shareholder value and earn after-tax income in excess of its cost of capital. With the Company’s continued strong balance sheet, cash flows from operations and available borrowing capacity, the Company believes it is in an attractive position to complete reasonably priced acquisitions fitting the Company’s long-term strategic plans.

 

Processing and Manufacturing Technology Improvements

 

The Company aims to be an efficient and competitive producer of both recycled metal and finished steel products in order to maximize the operating margin for both operations. To meet this objective, the Company has historically focused on, and will continue to emphasize, the cost effective purchasing of and efficient processing of scrap metals. During fiscal 2007, 2006 and 2005, the Company spent $81 million, $87 million and $48 million, respectively, on capital improvements. The increases in capital expenditures primarily reflect the Company’s significant investments in modern equipment to improve the efficiency and the capabilities of its businesses and to further maximize economies of scale. The capital expenditures in fiscal 2007 included partial payments for the installation of new mega-shredders at the Company’s Oakland, California; Everett, Massachusetts; and Portland, Oregon export facilities, major repairs to the dock at the Portland facility and other upgrades to equipment and infrastructure at the Company’s metals recycling facilities. The Company also expended capital for the implementation of a point-of-sale system at its self-service used auto parts stores, the conversion of five sites acquired in the GreenLeaf acquisition to the Company’s self-service store model and the reheat furnace and upgrade of the billet craneway and other projects at the SMB facility designed to improve efficiency and increase output. The Company believes these investments will provide future returns in excess of its cost of capital and will create value for its shareholders.

 

Capital projects in fiscal 2008 are expected to include significant enhancements to the Company’s information technology infrastructure, further investments in technology to improve the recovery of nonferrous materials from the shredding process, establishment of additional nonferrous collection facilities, improvements to the Company’s marine shipping infrastructure and further investments to improve efficiency, increase worker safety and enhance environmental systems.

Environmental Compliance

 

Compliance with environmental laws and regulations is a significant factor in the Company’s business operations. The Company’s businesses are subject to local, state and federal environmental, health, safety and transportation laws and regulations relating to, among others:

 

 

Environmental legislation and regulations have changed rapidly in recent years, and it is likely that the Company will be subject to even more stringent environmental standards in the future and will be required to make additional expenditures, which could be significant, relating to environmental matters on an ongoing basis.

 

It is not possible to predict the total cost to remediate environmental matters or the amount of capital expenditures or the increases in operating costs or other expenses that may be incurred by the Company or its subsidiaries in complying with environmental requirements applicable to the Company, its subsidiaries and their operations, or whether all such cost increases can be passed on to customers through product price increases. Moreover, environmental legislation has been enacted, and may in the future be enacted, to create liability for past actions that were lawful at the time taken but have been found to affect the environment and to increase public rights of action for environmental conditions and activities. As is the case with steel producers and recycled metal processors in general, if damage to persons or the environment has been caused, or could be caused in the future, by the Company’s activities or by hazardous substances now or hereafter located at the Company’s facilities, the Company may be fined and/or held liable for such damage and, in addition, may be required to remedy the condition. There can be no assurance that potential liabilities, expenditures, fines and penalties associated with environmental laws and regulations will not be imposed on the Company in the future or that such liabilities, expenditures, fines or penalties will not have a material adverse effect on the Company.

 

The Company has, in the past, been found not to be in compliance with certain environmental laws and regulations and has incurred liabilities, expenditures, fines and penalties associated with such violations. The Company’s objective is to maintain compliance with applicable environmental regulations.

 

The Company believes that it is materially in compliance with currently applicable environmental regulations. See Note 11 – Commitments and Contingencies, in the notes to the consolidated financial statements, in Part II, Item 8, of this report.

 

Employees

 

As of August 31, 2007, the Company had 3,499 full-time employees, consisting of 1,300 employees at MRB, 543 employees at SMB, 1,528 employees at APB and 128 corporate administrative employees. Of these employees, 993 were covered by collective bargaining agreements with the Company’s twenty unions. The SMB contract with the United Steelworkers of America (“USA”) covers 394 of these employees. This contract, which was successfully negotiated in fiscal 2005 and expires on April 1, 2008, now incorporates a production incentive bonus which ties a component of compensation to production improvements. The Company believes that in general its labor relations are good.

 

Available Information

 

The Company’s internet address is www.schnitzersteel.com. The Company makes all filings with the Securities and Exchange Commission (“SEC”) available on its website, free of charge, under the caption “Investor Relations – SEC Filings.” Included in these filings are annual reports on form 10-K, quarterly reports on Form 10-Q, current reports on

Form 8-K and any amendments to those reports, which are available as soon as reasonably practicable after electronically filing or furnishing such materials with the SEC pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934.

 

The public may read and copy any materials that are filed with the SEC at the SEC’s Public Reference Room located at 100 F Street NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains electronic versions of reports on its website, www.sec.gov.

 

 

Described below are risks that could have a material adverse effect on the Company’s results of operations and financial condition or could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Annual Report. See “Forward-Looking Statements” that precedes Part I of this Annual Report on Form 10-K. Additional risks and uncertainties that the Company is unaware of or that the Company currently deems immaterial may in the future have a material adverse effect on the Company’s results of operations and financial condition.

 

Risks Relating to the Company’s Businesses

 

Industries in which the Company operates, are cyclical and demand can be volatile, which could have a material adverse effect on the Company’s results of operations and financial condition.

 

MRB and SMB operate in industries that are cyclical in nature. The timing and magnitude of these industry cycles are difficult to predict. Purchase prices for autobodies and scrap metal and selling prices for scrap and recycled metal are volatile and beyond the Company’s control. While the Company attempts to respond to changing recycled metal selling prices through adjustments to its metal purchase prices, the Company’s ability to do so is limited by competitive and other market factors. Additionally, changing prices could potentially impact the volume of scrap metal available to the Company, the volume of processed metal sold by the Company and inventory levels. The cyclical nature of the Company’s businesses tends to reflect and be amplified by changes in general economic conditions, both domestically and internationally. For example, during recessions, the automobile and construction industries typically experience major cutbacks in production, resulting in decreased demand for steel, copper and aluminum. This can lead to significant decreases in demand and pricing for the Company’s recycled metal and finished steel products.

 

The Company’s businesses are affected by seasonal fluctuations.

 

APB experiences seasonal fluctuations in demand during periods of extreme temperatures and precipitation in the winter and summer months as customers of the self-service stores tend to delay their purchases and wait for milder conditions, in large part because the retail stores are open to the elements. As a result, retail sales are generally higher during the spring and fall of each calendar year. Wholesale sales also experience seasonal fluctuations, as sales to collision shops are generally lower in periods of good weather. Demand for SMB’s finished steel product generally decreases during the winter months due to weather-related slowdowns in the construction industry and increases during the peak summer months, when foreign customers tend to manufacture less in order to avoid higher energy costs.

 

The principal markets served by the Company are highly competitive.

 

The Company is subject to intense and increasing competition, including a significant increase in foreign competition with SMB in recent years. The Company also faces strong competition for raw materials. Many factors influence the Company’s competitive position, including product differentiation, geographic location, contract terms, business practices, customer service and cost reductions through improved efficiencies. Consolidation within the different industries in which the Company operates has increased the size of some of the Company’s competitors, some of which have used their financial resources to achieve competitive advantages by investing in capital improvements to improve efficiencies, achieve economies of scale and lower operating costs. If the Company is unable to remain competitive or if competition increases, this could have a material adverse effect on the Company’s results of operations and financial condition.

Fluctuations in the value of the U.S. dollar relative to other currencies could adversely affect the Company’s ability to price its products competitively.

 

A significant portion of the revenues and operating income earned by MRB is generated from sales to foreign customers, including customers located in Asian and Mediterranean countries. Some of the Company’s sales transactions are conducted in foreign currencies and may be impacted by foreign currency fluctuations. A strong U.S. dollar would make the Company’s products more expensive for non-U.S. customers, which could negatively impact export sales. A strong U.S. dollar also would make imported metal products less expensive, resulting in an increase in imports of scrap metal, scrap substitutes and steel products into the U.S. Past economic difficulties in Eastern Europe, Asia and Latin America have resulted in lower local demand for steel products and have encouraged greater steel exports to the U.S. at depressed prices. As a result, the Company’s products, which are made in the U.S., may become more expensive relative to imported raw metal and steel products, which could have a material adverse effect on the Company’s results of operations and financial condition.

 

The Company’s ability to deliver products to customers and the cost of shipping and handling may be affected by circumstances over which the Company has no control.

 

MRB and SMB often rely on third parties to handle and transport their raw materials to their production facilities and finished products to end users. Due to factors beyond the Company’s control, including changes in fuel prices, political events, governmental regulation of transportation, changes in market rates, carrier availability and disruptions in the transportation infrastructure, the Company may not be able to transport its products in a timely and cost-effective manner, which could have a material adverse effect on the Company’s results of operations and financial condition. For example, increases in freight costs could negatively impact the margins from export sales. In addition, the Company’s failure to deliver products in a timely manner could have a material adverse effect on the Company’s results of operations and financial condition and harm its reputation.

 

The Company’s businesses depend on adequate supplies of raw materials.

 

The Company’s businesses require certain materials that are sourced from third-party suppliers. Although the Company’s vertical integration allows it to be its own source for some raw materials, particularly with respect to SMB, the Company does rely on other suppliers, as well as industry supply conditions generally, which involves risks, including the possibility of increases in raw material costs and reduced control over delivery schedules. For example, purchase prices for autobodies and scrap metal are highly cyclical in nature and subject to U.S. and global economic conditions. As a result, the Company might not be able to obtain an adequate supply of quality raw materials in a timely or cost-effective manner.

 

Equipment upgrades and equipment failures may lead to production curtailments or shutdowns.

 

The Company’s recycling and manufacturing processes depend upon critical pieces of equipment, including shredders and furnaces, which may be out of service occasionally for scheduled upgrades or maintenance or as a result of unanticipated failures. The Company has made and is continuing to make significant investments in modern equipment, but the installation of new equipment may result in short-term disruptions to operations and may take several months to complete. In addition, the Company’s facilities are subject to equipment failures and the risk of catastrophic loss due to unanticipated events such as fires, accidents or violent weather conditions. As a result, the Company may experience interruptions in its processing and production capabilities, which could have a material adverse effect on the Company’s results of operations and financial condition.

 

The Company may not be able to negotiate future labor contracts on acceptable terms, which could result in strikes or other labor actions.

 

Approximately 28% of the Company’s full-time employees are represented by collective unions under bargaining agreements. As these agreements expire, the Company may not be able to negotiate extensions or replacements of such agreements on terms acceptable to the Company. Any failure to reach an agreement with one of the Company’s unions may result in strikes, lockouts or other labor actions. Any such labor actions, including work slowdowns or stoppages, could have a material adverse effect on the Company’s operations.

The availability and cost of electricity and natural gas are subject to volatile market conditions.

 

The Company’s facilities are large consumers of electricity and natural gas. The Company relies on third parties for its supply of energy resources consumed in the manufacture of its products. The prices for and availability of electricity, natural gas, oil and other energy resources are subject to volatile market conditions. These market conditions often are affected by weather conditions, as well as political and economic factors that are beyond the Company’s control. Disruptions in the supply of the Company’s energy resources could impair its ability to manufacture its products for its customers and could result in increases in the Company’s energy costs, which could have a material adverse effect on its results of operations and financial condition.

 

The Company may not be able to successfully integrate future acquisitions.

 

The Company has completed many recent acquisitions and expects to continue making acquisitions of and strategic alliances with complementary businesses, and investments in technologies to enable the Company to add products and services that enhance the Company’s customer base and related markets. Execution of this strategy involves a number of risks, including:

 

 

Failure to successfully integrate acquisitions could have a material adverse effect on the Company’s results of operations and financial condition.

 

If the Company loses its key management personnel, it may not be able to successfully manage its business or achieve its objectives.

 

The Company’s future success depends in large part on the leadership and performance of its executive management team and key employees at the operating level. If the Company were to lose the services of several of its executive officers or key employees at the operating level, it might not be able to replace them with similarly qualified personnel. As a result, the Company may not be able to successfully manage its business or achieve its business objectives, which could have a material adverse effect on its results of operations and financial condition.

 

Some of the Company’s operations present significant risk of injury or death.

 

The industrial activities conducted at the Company’s facilities present significant risk of serious injury or death to the Company’s employees, customers or other visitors to the Company’s operations, notwithstanding the Company’s safety precautions, including its material compliance with federal, state and local employee health and safety regulations. While the Company has in place policies and procedures to minimize such risks, it may nevertheless be unable to avoid material liabilities for an injury or death, which could have a material adverse effect on the Company’s results of operations and financial condition.

 

A significant increase in the use of recycled metal alternatives by current consumers of recycled metal could reduce demand for the Company’s product.

 

Continuous advances in materials sciences and resulting technologies, as well as the relative scarcity of ferrous scrap, particularly the “cleaner” grades, and its high price during periods of high demand, have given rise to new products, such as pig iron and direct reduced iron pellets, which compete with traditional recycled metals. Although these alternatives have not been a major factor in the industry to date, there can be no assurance that the use of alternatives to recycled metal may not proliferate in the future if the prices for recycled metals rise, if the supplies of available unprepared ferrous scrap tighten, or if the costs to import scrap metal changes. Any significant increase in the use of such substitutes could have a material adverse effect on the Company’s results of operations and financial condition.

The Company relies on information technology in critical areas of the Company’s operations, and a disruption relating to such technology could harm the Company.

 

The Company uses information technology systems in various aspects of the Company’s operations, including, but not limited to, the management of inventories, processing costs and customer sales. If the providers of these systems terminate their relationships with the Company, or if the Company decides to switch providers or to implement its own systems, it may suffer disruptions, which could have a material adverse effect on its results of operations and financial condition. In addition, the Company may underestimate the costs and expenses of switching providers or developing and implementing its own systems.

 

The Company could be subject to product liability claims.

 

If customers of repair shops that purchase the Company’s recycled auto parts are injured or suffer property damage as a result of purchasing the product, the Company could be subject to product liability claims. In addition, the Company has some exposure from radioactive scrap that could inadvertently end up in mixed scrap shipped to consumers worldwide. The Company has invested in radiation detection equipment. However the possibility still exists of potential failure in detection. The successful assertion of any such claim could have a material adverse effect on the Company’s results of operations and financial condition.

 

If Chinese steel production substantially exceeds local demand, it may result in the export of significant excess quantities of steel products.

 

Chinese economic expansion has affected the availability and increased the price volatility of recycled metal and steel products. Expansions and contractions in the Chinese economy can significantly affect the price of commodities used and sold by the Company, as well as the price of finished steel products. If expanding Chinese steel production significantly exceeds local consumption, exports of steel products from China could increase, resulting in lower volumes and selling prices for SMB’s steel products. Any resulting dislocations in foreign markets may encourage importers to target the U.S. with excess capacity at aggressive prices, and existing trade laws and regulations may be inadequate to prevent unfair trade practices, which could have a material adverse effect on the Company’s results of operations and financial condition.

 

The Company is subject to environmental regulations and environmental risks which could result in significant environmental compliance costs and environmental liability.

 

Compliance with environmental laws and regulations is a significant factor in the Company’s business. The Company is subject to local, state and federal environmental laws and regulations in the U.S. and other countries in relating to, among other matters:

 

 

The Company is also required to obtain environmental permits from governmental authorities for certain operations. Violation or failure to obtain permits or comply with these laws or regulations, could result in the Company being fined or otherwise sanctioned by regulators. The Company’s operations use and generate hazardous substances. In addition, previous operations by others at facilities that are currently or were formerly owned or operated by the Company or otherwise used by the Company may have caused contamination from hazardous substances. As a result, the Company is exposed to possible claims under environmental laws and regulations, especially for the remediation of waterways and soil or groundwater contamination. These laws can impose liability for the clean-up of hazardous substances, even if the owner or operator was neither aware of nor responsible for the release of the hazardous substances. Although the Company believes that it is in material compliance with all applicable environmental laws and regulations, future environmental compliance costs may increase because of new laws and regulations and changing interpretations by regulatory authorities, uncertainty regarding adequate

pollution control levels, the future costs of pollution control technology and issues related to global climate change. Environmental compliance costs and potential environmental liabilities could have a material adverse effect on the Company’s results of operations and financial condition.

 

Governmental agencies may refuse to grant or renew the Company’s licenses and permits.

 

The Company must receive licenses, permits and approvals from state and local governments to conduct certain of its operations or to develop or acquire new facilities. Governmental agencies often resist the establishment of certain types of facilities in their communities, including auto parts facilities. In addition, from time to time, both the U.S. and foreign governments impose regulations and restrictions on trade in the markets in which the Company operates. In some countries, governments can require the Company to apply for certificates or registration before allowing shipment of recycled metal to customers in those countries. There can be no assurance that future approvals, licenses and permits will be granted or that the Company will be able to maintain and renew the approvals, licenses and permits it currently holds, and failure to do so could have a material adverse effect on the Company’s results of operations and financial condition.

 

 

There are currently no unresolved issues with respect to any SEC staff written comments that were received 180 days or more before the end of fiscal 2007 that relate to the Company’s periodic or current reports under the Securities and Exchange Act of 1934.

 

 

Corporate Headquarters

 

The Company’s executive offices are located at 3200 NW Yeon Avenue in Portland, Oregon 97210, in approximately 31,000 sq. ft. of space, which was leased under a long-term lease from Schnitzer Investment Corp. (“SIC”), a related party, at August 31, 2007. Refer to Note 16 – Related Party Transactions, in the notes to the consolidated financial statements, in Part II, Item 8 of this report. SIC sold the building to an unrelated third party in the first quarter of fiscal 2008.

 

The Company also leases an additional 26,000 sq. ft. of office space that is located one mile from its principal executive offices under a long-term lease from a non-affiliated third-party.

 

Metals Recycling Business

 

At August 31, 2007, MRB’s operations were conducted on 38 properties. Of these, seven served as collection facilities, 27 as collection and processing facilities, three are currently inactive and in the process of relocation and

the remaining one is an export facility. Listed in the table below are the facility locations by type, including their total acreage:

 

 

The locations listed above are all owned by the Company, with the exception of one of the Bainbridge, Georgia facilities; one of the yards in Anchorage, Alaska; Madbury, New Hampshire; Providence, Rhode Island; and a portion of the Eugene, Oregon location, which are all leased from third parties. The lease on the Madbury, New Hampshire facility has expired, and the Company has exercised its option to purchase this property and is working with the owner to consummate the purchase.

 

The Portland, Oregon; Oakland, California; Tacoma, Washington; and Everett, Massachusetts collection and processing facilities are located at major deep-water ports, which facilitate the collection of unprocessed metal from suppliers and accommodate bulk shipments and efficient distribution of processed recycled metal to the U.S., Asia, the Mediterranean and other foreign markets. The Company also leases an export marine shipping facility in Providence, Rhode Island, near the Johnston, Rhode Island processing facility, and has access to public docks in Kapolei, Hawaii and Anchorage, Alaska.

Auto Parts Business

 

APB has auto parts operations in the following locations:

 

 

The Company owns the properties located in Arizona, Indiana, North Carolina and Nevada, and approximately 25 acres in California, 12 acres in Florida, 10 acres in Texas, 6 acres in Illinois and 3 acres in Utah. The remaining auto parts stores are located on sites leased by the Company.

 

Steel Manufacturing Business

 

SMB’s steel mill and administrative offices are located on an 83-acre site in McMinnville, Oregon owned by the Company. The Company also owns an 87,000 sq. ft. distribution center in El Monte, California and an additional 51 acres near the mill site in McMinnville, Oregon; however, this latter site is not currently utilized in SMB operations.

 

ITEM 3. LEGAL PROCEEDINGS

 

On October 16, 2006, the Company finalized settlements with the U.S. Department of Justice (“DOJ”) and the Securities and Exchange Commission (“SEC”) resolving an investigation related to a past practice of making improper payments to the purchasing managers of the Company’s customers in Asia in connection with export sales of recycled ferrous metal. Under the settlement, the Company agreed to a deferred prosecution agreement with the DOJ (the “Deferred Prosecution Agreement”) and agreed to an order, issued by the SEC, instituting cease-and-desist proceedings making findings and imposing a cease-and-desist order pursuant to Section 21C of the Exchange Act of 1934 (the “Order”). Under the Deferred Prosecution Agreement, the DOJ will not prosecute the Company if the Company meets the conditions of the agreement for a period of three years including, among other things, that the Company engage a compliance consultant to advise its compliance officer and Board of Directors on the Company’s compliance program. Under the Order, the Company agreed to cease and desist from the past practices that were the subject of the investigation and to disgorge $8 million of profits and prejudgment interest. The Order also contains provisions comparable to those in the Deferred Prosecution Agreement regarding the engagement of the compliance consultant. In addition, under the settlement, the Company’s Korean subsidiary, SSI International Far East, Ltd., pled guilty to Foreign Corrupt Practices Act anti-bribery and books and records provisions, conspiracy and wire fraud

charges and paid a fine of $7 million. These amounts were accrued during fiscal 2006 and paid in the first quarter of fiscal 2007. The investigation settlement in the first quarter of fiscal 2007 did not affect the Company’s previously reported financial results. Under the settlement, the Company has agreed to cooperate fully with any ongoing, related DOJ and SEC investigations.

 

The Company has incurred expenses, and may incur further expenses, in connection with the advancement of funds to, or indemnification of, individuals involved in such investigations. Under the terms of its corporate bylaws, the Company is obligated to indemnify all current and former officers or directors involved in civil, criminal or investigative matters in connection with their service. The Company is also obligated to advance fees and expenses to such person in advance of a final disposition of such matters, but only if the involved officer or director affirms a good faith belief of entitlement to indemnification and undertakes to repay such advance if it is ultimately determined by a court that such person is not entitled to be indemnified. The Company also has the option to indemnify employees and to advance fees and expenses, but only if the involved employees furnish the Company with the same written affirmation and undertaking. There is no limit on the indemnification payments the Company could be required to make under these provisions. The Company did not record a liability for these indemnification obligations based on the fact that they are employment-related costs. At this time, the Company does not believe that any indemnity payments the Company may be required to make will be material.

 

From time to time, the Company is involved in various litigation matters that arise in the normal course of business, involving normal and routine claims. Environmental compliance issues represent a significant portion of those claims. Management currently believes that the ultimate outcome of these proceedings, individually or in the aggregate, will not have a material adverse effect on the Company’s consolidated financial position, results of operations, cash flows or business. For additional information regarding litigation to which the Company is a party, which is incorporated into this item, see Note 11 – Commitment and Contingencies, in the notes to the consolidated financial statements in Part II, Item 8 of this report.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matter was submitted to a vote of security holders, during the fourth quarter of fiscal 2007 through the solicitation of proxies or otherwise.

 

PART II

 

 

 

The Company’s Class A Common Stock is a NASDAQ-listed security traded on The NASDAQ Stock Market, LLC under the symbol SCHN. There were 209 holders of record of Class A Common Stock on October 11, 2007. The stock has been trading since November 16, 1993. The following table sets forth the high and low prices reported at the close of trading on the NASDAQ Stock Market LLC and the dividends paid per share for the periods indicated.

 

 

 

The Company’s Class B Common Stock is not publicly traded. There were 13 holders of record of Class B Common Stock as of October 11, 2007.

 

Issuer Purchases of Equity Securities

 

Pursuant to a share repurchase program as amended in 2001 and in October 2006, the Company is authorized to repurchase up to 6.0 million shares of its Class A Common stock when management deems such repurchases to be appropriate. Prior to fiscal 2007, the Company had repurchased 1.3 million shares under the program. In fiscal 2007, the Company repurchased a total of 2.5 million shares under this program, leaving 2.2 million shares available for repurchase.

 

The share repurchase program does not require the Company to acquire any specific number of shares, may be suspended, extended or terminated by the Company at any time without prior notice and may be executed through open-market purchases, privately negotiated transactions or utilizing Rule 10b5-1 programs. Management evaluates long- and short-range forecasts as well as anticipated sources and uses of cash before determining the course of action that would best enhance shareholder value.

During the fourth quarter of fiscal 2007, the Company repurchased 1.0 million shares in open-market transactions at a cost of $54 million. The table below presents a summary of share repurchases made by the Company during the quarter ended August 31, 2007:

 

 

Performance Graph

 

The following graph compares cumulative total shareholder return on the Company’s Class A Common Stock for the five-year period from September 1, 2002 through August 31, 2007 with the cumulative total return for the same period of (i) the S&P 500 Index, (ii) the S&P Steel Index and (iii) the NASDAQ Composite Index. These comparisons assume an investment of $100 at the commencement of the period and that all dividends are reinvested. The stock performance outlined in the performance graph below is not necessarily indicative of the Company’s future performance, and the Company does not endorse any predictions as to future stock performance.

 

 

ITEM 6. SELECTED FINANCIAL AND OPERATING DATA

 

 

 

 

This section includes a discussion of the Company’s operations for the three fiscal years ended August 31, 2007. The following discussion and analysis provides information which management believes is relevant to an assessment and understanding of the Company’s results of operations and financial condition. This discussion may contain forward looking statements that anticipate results based on management’s plans that are subject to uncertainty. The discussion should be read in conjunction with the Consolidated Financial Statements and the related notes thereto, and the Selected Financial Data and Operating Statistics contained elsewhere in this Form 10-K.

 

Business

 

The Company operates in three reportable segments: MRB, APB and SMB. MRB purchases, collects, processes and recycles steel and other metal through its facilities and trades and brokers scrap metal. APB purchases used and salvaged vehicles and sells serviceable used auto parts through its self-service and full-service auto parts stores. APB is also a supplier of autobodies to MRB, which processes the autobodies into saleable recycled metal. SMB purchases recycled metal from MRB and uses its mini-mill near Portland, Oregon, to melt recycled metal to produce finished steel products. SMB also maintains mill depots in Central and Southern California. The Company provides an end of life cycle solution for a variety of products through its integrated businesses, including resale of used auto parts, processing autobodies and other metal products and manufacturing scrap metal into finished steel products.

 

The Company’s results of operations depend in large part on demand and prices for recycled metal in global markets and steel products in the Western U.S. The Company’s deep water port facilities on both the West and East coasts of the U.S. and in Hawaii allow the Company to take advantage of the increasing demand for recycled metal by steel manufacturers located in Europe, Asia, Mexico and the Mediterranean. The Company’s processing facilities in the Southeastern U.S. also provide access to the growing automobile and steel manufacturing industries in that region. Market prices for recycled ferrous and nonferrous metal fluctuate periodically, but have generally increased over the past three years. These higher prices have a significant impact on the results of operations for MRB and, to a lesser extent, for APB.

 

Key factors and trends affecting the industries in which the Company operates and its results of operations

 

The following key factors and trends affect the industries in which the Company operates: competition, consolidation in the scrap metal industry and the steel industry, fragmentation of the auto parts industry and volatility in price and sales volume decreases in the metals recycling industry. The following key factors and trends specifically affect the Company’s results of operations: the integration of acquired businesses, foreign business risks, replacement or installation of capital equipment, reliance on key pieces of equipment, geographic concentration, union relationships and pension and postretirement benefits. The foregoing key factors and trends are discussed elsewhere in this annual report.

 

Executive Overview

 

The Company completed another successful year in fiscal 2007, achieving record sales levels for the sixth consecutive year. The Company generated consolidated revenues of $2.6 billion for fiscal 2007, an increase of $718 million, or 39%, from $1.9 billion in fiscal 2006. Consolidated operating income for fiscal 2007 increased $39 million, or 22%, from $175 million in fiscal 2006 to $214 million in fiscal 2007. The increase in revenues was generated from all segments, while the increase in operating income was driven primarily from the improved financial results of MRB. Net income for fiscal 2007 was $131 million, a decrease of $12 million, or 8% compared to the prior year net income of $143 million. Diluted net income per share for the year was $4.32, a 7% decrease from fiscal 2006. Net income in fiscal 2006 included a $35 million gain (net of tax) from the separation and termination of the HNC joint ventures, which was partially offset by a $15 million charge related to the SEC and DOJ investigations into the Company’s past payment practices in Asia.

 

In fiscal 2007, MRB increased its revenues of by $682 million, or 49%, to $2.1 billion from $1.4 billion in fiscal 2006. The increase included a $550 million increase in ferrous revenues, or 49%, to $1.7 billion and a $129 million

increase in nonferrous revenues, or 48%, to $396 million. The increase in ferrous revenues was driven by a 21% increase in sales tons and a 22% increase in average net sales price. The increase in nonferrous revenues was driven by a 27% increase in sales tons and a 17% increase in average net sales price. Operating income for MRB was $166 million, or 8% of revenues in fiscal 2007, compared to $128 million, or 9% of revenues in fiscal 2006. The increase in operating income reflects the impact of the higher sales volume and prices. While the majority of the higher material costs were recovered through the higher net sales prices discussed above, the additional volume resulted in operating income being reduced as a percent of sales. Further offsetting the increases in average sales prices and volume was a $30 million increase in SG&A expenses compared to the prior year, primarily due to $21 million of higher compensation costs as a result of increased headcount, bonuses, and share-based compensation expense and a $5 million increase in allocated ERP and other information technology costs.

 

In fiscal 2007, APB increased its revenues by $48 million, or 22%, to $266 million from $218 million in fiscal 2006. The increase included a $10 million increase in core revenue, or 35%, over the prior year; a $13 million increase in scrap vehicle revenue, or 38%, from the self-service stores over the prior year; and a $22 million increase in full-service revenue over the prior year. The increase in core revenue was primarily due to a $22 increase in the average core sales per car and a 32,000 increase in cars crushed. The increase in scrap vehicle revenue was due to a $41 increase in the average scrap sales price per car and a 21,000 increase in tons shipped. The increase in full-service revenue was due to higher parts sales across several product types and as a result of a full year of revenues for GreenLeaf, which was acquired during the first quarter of fiscal 2006. Operating income for APB was $29 million, or 11% of revenue in fiscal 2007, compared to $28 million, or 13% of revenues in fiscal 2006. The slight increase in operating income for fiscal 2007 reflects the impact of higher sales volume and prices. While the majority of the higher car costs were recovered through the higher sales prices discussed above, the additional volume resulted in operating income being reduced as a percent of revenue. The increases in operating income were further offset by a $7 million increase in SG&A expenses compared to the prior year, primarily attributable to a $6 million increase in allocated ERP and other information technology costs and a $2 million increase in compensation expenses.

 

In fiscal 2007, SMB increased its revenues by $38 million, or 10%, to $425 million from $387 million in fiscal 2006. The increase over the prior year was the result of higher average net sales prices for finished steel products, due in part to strong demand, increased sales volumes and an improved product mix. Sales volumes increased 10,000 tons, or 1%, to 713,000 tons in fiscal 2007 compared to the prior year. The average net selling price increased $47 per ton, or 9%, to $575 per ton in fiscal 2007 compared to fiscal 2006 and resulted in increased revenues of $34 million. Operating income for SMB was $64 million, or 15% of revenues in fiscal 2007, compared to $75 million, or 19% of revenues in fiscal 2006. The decrease in operating income was primarily the result of higher raw material costs and higher conversion costs, which could not be passed through to SMB’s customers through higher prices.

 

Also during fiscal 2007, the Company repurchased 2.5 million shares, or approximately 8% of total shares outstanding for a total cost of $110 million under the authority granted by its Board of Directors.

 

Business Acquisitions

 

The Company intends to continue to focus on growth through value-creating acquisitions and will pursue acquisition opportunities it believes will create shareholder value and earn after-tax income in excess of its cost of capital. With the Company’s continued strong balance sheet, cash flows from operations and available borrowing capacity, the Company believes it is in an attractive position to continue to complete reasonably priced acquisitions fitting the Company’s long-term strategic plans.

 

In fiscal 2007, the Company completed the following acquisitions:

 

 

These acquisitions were not material to the Company’s financial position or results of operations, as the combined assets of these business acquisitions amounted to $10 million, or 1% of consolidated total assets, as of August 31, 2007 and their combined revenues amounted to $25 million, or 1% of consolidated revenues, for fiscal 2007.

The Company completed the following significant transactions in 2006:

 

 

See Note 7 - Business Combinations, in the notes to the consolidated financial statements in Part II, Item 8 of this report.

Results of Operations

 

 

 

Revenues

 

Consolidated revenues for fiscal 2007 increased $718 million, or 39%, to $2.6 billion from $1.9 billion in fiscal 2006. Revenues in fiscal 2007 increased for all Company business segments. The increase was primarily the result of higher

volumes in all business segments due to the Company’s focus on increasing throughput, the added volumes from a full year of operations for the acquisitions made in fiscal 2006 and increases in the market price of scrap and steel.

 

Consolidated revenues for fiscal 2006 increased $1.0 billion, or 117%, to $1.9 billion from $853 million in fiscal 2005. Revenues increased as a result of the acquisitions made in the MRB and APB reporting segments in fiscal 2006 and an increase in production from SMB.

 

Cost of Goods Sold

 

Consolidated cost of goods sold increased $651 million, or 43%, to $2.2 billion for fiscal 2007, compared to the prior year. Cost of goods sold in fiscal 2007 increased for all business segments, primarily resulting from increased material prices and increases due to a full year of operations for the acquisitions made in fiscal 2006. As a percentage of revenues, cost of goods sold increased from 82% in fiscal 2006 to 85% in fiscal 2007.

 

Consolidated cost of goods sold increased $893 million, or 141%, to $1.5 billion for fiscal 2006 compared to the prior year. As a percentage of revenues, cost of goods sold increased from 74% in fiscal 2005 to 82% in fiscal 2006 mainly as a result of acquisitions that occurred during fiscal 2006.

 

Selling, General and Administrative Expense

 

SG&A expense increased $29 million, or 19%, to $186 million for fiscal 2007 compared to the prior year. The $29 million increase over fiscal 2006 was due to higher SG&A expense incurred at each of the reporting segments, totaling $39 million combined, which was partially offset by a $10 million decrease at Corporate. These increases at the reporting segments were primarily attributable to an increase in compensation expense of $22 million due to increased headcount, bonuses and share-based compensation expense recognized for fiscal 2007, a $12 million increase related to higher allocated information technology costs as a result of the implementation and maintenance of an enterprise resource planning (“ERP”) software application, including related hardware upgrades and support, and other information technology costs. The net decrease at Corporate over the prior year was due primarily to the $15 million charge in fiscal 2006 associated with the establishment of a reserve related to the penalties that the Company estimated would be imposed by the DOJ and the SEC in connection with the investigation into the Company’s past payment practices in Asia as discussed in Note 11 – Commitments and Contingencies in the notes to the consolidated financial statements in Part II, Item 8 of this report. The net decrease at Corporate for fiscal 2007 included an $8 million increase in compensation costs resulting from increased headcount, bonus and share-based compensation expense.

 

SG&A expenses increased $99 million, or 170%, to $157 million for fiscal 2006 compared to the prior year. These increases were primarily attributable to a $55 million increase in SG&A expenses from the businesses acquired in fiscal 2006 and a $15 million increase in costs associated with the DOJ and the SEC investigation, as discussed in Note 11 – Commitments and Contingencies, in the notes to the consolidated financial statements in Part II, Item 8 of this report. In addition, there were increases of $7 million in contract labor, legal and accounting fees, an increase of $7 million in compensation costs and a $3 million increase in share-based compensation expense recognized in fiscal 2006.

 

Interest Expense

 

Interest expense was $8 million, $3 million and $1 million for fiscal 2007, 2006 and 2005, respectively. The increase from fiscal 2006 to 2007 reflects higher average interest rates and the Company carrying higher average debt balances during fiscal 2007 in order to complete and integrate acquisitions, as well as to support the increased level of working capital for the operations of these acquisitions, in addition to $110 million related to share repurchases. For more information about the Company’s outstanding debt balances, see Note 10 — Long-Term Debt, in the notes to the consolidated financial statements in Part II, Item 8 of this report. The increase from fiscal 2005 to fiscal 2006 was the result of higher average interest rates and the Company carrying higher average debt balances.

Other Income, Net of Interest Expense

 

Other income was $4 million, $60 million and $1 million for fiscal, 2007, 2006 and 2005, respectively. During fiscal 2006, the Company recorded a pre-tax gain of $57 million that arose from the HNC separation and termination agreement, based on the difference between the excess values of businesses acquired over the carrying value of the businesses sold. For a more detailed discussion of the HNC joint venture separation and termination agreement, see Note 7 – Business Combinations, in the notes to the consolidated financial statements in Part II, Item 8 of this report.

 

Income Tax Expense

 

The tax rates were 36.1%, 37.5% and 35.3% for fiscal 2007, 2006 and 2005, respectively. The tax rate in fiscal 2006 was higher than in fiscal 2007 primarily because of an accrual recorded in fiscal 2006 of $14 million for nondeductible penalties and profits disgorgement expensed in connection with the settlement of the SEC and DOJ investigation (see Item 3 Legal Proceedings). The nondeductible expense increased the fiscal 2006 tax rate by 2.1%. In addition, the fiscal 2006 tax rate was higher than normal because it included an estimated tax rate of 38.0% for the non-recurring $57 million gain arising from the HNC separation and termination (see Note 7 - Business Combinations, in the notes to the consolidated financial statements in Part II, Item 8 of this report), that was higher than the rate applicable to the Company’s recurring income. The 36.1% fiscal 2007 tax rate was comprised of the 35.0% federal statutory rate, a 1.5% effective state rate and 1.5% for nondeductible officers’ compensation, offset by a 1.9% benefit from a Section 199 manufacturing deduction and the Extraterritorial Income Exclusion benefit on export sales.

 

Financial results by segment

 

The Company operates its business across three reportable segments: MRB, APB and SMB. Additional financial information relating to these business segments is contained in Note 17 - Segment Information, in the notes to the consolidated financial statements in Part II, Item 8 of this report.

Metals Recycling Business

 

 

 

Fiscal 2007 compared with fiscal 2006

 

Revenues

 

MRB generated revenues of $2.1 billion for fiscal 2007 before intercompany eliminations, an increase of $682 million, or 49%, over fiscal 2006. The increase was primarily attributable to increased sales volumes as a result of the focus on increasing throughput at its processing facilities and prevailing market conditions whereby scrap metal demand was higher than supply, resulting in higher average net selling prices and higher sales volumes. Outbound freight costs, which, are included in the gross sales price, increased by 58% to $219 million for fiscal 2007 compared to fiscal 2006, primarily due to increased volumes and higher ocean freight rates.

 

Ferrous revenues increased $550 million, or 49%, to $1.7 billion during fiscal, 2007 compared to the prior year. The increase in ferrous revenues was driven by both higher average net sales prices and increased volumes. The average net sales price for ferrous processing increased $48 per ton, or 22% from fiscal 2006 to fiscal 2007. The average net sales price for ferrous trading increased $53 per ton, or 23%, in fiscal 2007, compared to fiscal 2006.

 

Ferrous processing sales volume increased by 1.0 million tons, or 30%, to 4.3 million tons in fiscal 2007 compared to fiscal 2006. The increase was primarily the result of the strategy to increase the volume of metal purchases and maximize throughput, which was accomplished through continued acquisitions of metal recyclers and increased purchases of ferrous materials. Ferrous trading sales volume remained fairly consistent at 1.2 million tons for both fiscal 2007 and 2006. Other domestic sales volume increased 38% to 722,000 tons in fiscal 2007, primarily as a result of the Regional acquisition made during fiscal 2006.

 

Nonferrous revenues increased $129 million, or 48%, to $396 million for fiscal 2007 compared to the same period last year. The increase in nonferrous revenues was driven by both higher average net sales prices and increased volume. The average net sales price increased $0.15, or 17%, to $1.02 per pound for fiscal 2007 over fiscal 2006. The increase in sales price per pound was the result of an improved product mix due to Regional and other acquisitions and increased Asian demand for nonferrous metals. Nonferrous pounds shipped increased 81 million pounds, or 27%, to nearly 383 million pounds for fiscal 2007, compared to the prior year. The increase in pounds shipped was primarily due to improvement in the recovery of nonferrous materials processed through the new mega-shredders, which have state of the art back-end sorting systems and the higher overall volume being processed.

 

Segment Operating Income

 

Operating income for MRB was $166 million, or 8% of revenues in fiscal 2007, compared to $128 million, or 9% of revenues, in fiscal 2006. The increase in operating income reflects the impact of the higher sales volume and the improved performance discussed above, partially offset by higher raw material costs, which increased on average 23%, over fiscal 2006. While the majority of the higher material cost was recovered through the higher net sales prices discussed above, operating income was reduced as a percent of revenues. Further offsetting the increases in average sales prices and volume was a $30 million increase in SG&A expenses compared to the prior year, primarily due to $21 million of higher compensation costs as a result of increased headcount, bonuses, and share-based compensation expense and a $5 million increase in allocated ERP and other information technology costs.

 

Fiscal 2006 compared with fiscal 2005

 

MRB generated revenues of $1.4 billion for fiscal 2006, before intercompany eliminations, an increase of $827 million, or 142% over fiscal 2005. Ferrous revenues increased $643 million, or 132% over fiscal 2005, primarily due to acquisition-related volume increases, which were partially offset by the decrease in the average net selling price for ferrous metal in fiscal 2006. Nonferrous revenues increased $196 million, or 277%, over fiscal 2005, primarily as a result of increased sales generated by the acquired entities and an increase of $0.31 per pound, or 55%, in the average nonferrous sales price. Operating income for MRB was $128 million, or 9% of revenues, in fiscal 2006, compared to $112 million, or 19% of revenues, in fiscal 2005. The $16 million increase in operating income was directly related to the increase in sales volume as a result of entities acquired in fiscal 2006.

Outlook

 

Demand for recycled ferrous metal is driven by world wide steel making capacity. In recent years, steel making capacity has increased significantly, primarily in the developing economies of the Middle-East and Asia. Due to this increased capacity, the demand for recycled metal has increased while at the same time the supply of metal available for recycling has not kept pace. As a result, prices for recycled metals have increased to levels higher than experienced in previous economic cycles. The Company believes these fundamentals will remain in the place for fiscal 2008, and while prices will continue to remain volatile, the general level of prices will be consistent with fiscal 2007.

 

To better take advantage of the positive markets in which it operates, MRB has made significant investments in the past two fiscal years to upgrade its equipment and infrastructure. MRB believes these investments will enable it to increase its capacity to process recycled metal, increase the extraction of higher value materials and improve overall operating efficiency. The additional capacity and improved efficiencies support MRB’s efforts to seek additional sources of supply and increase the throughput at its processing facilities. Due to the strong demand described above, the competition for recycled metal has been increasing, and MRB expects its efforts to maintain and increase the supply of recycled material it is able to purchase from suppliers could result in higher prices for those inputs. Nonetheless, MRB believes the size, breadth and efficiency of its operations provide it with a competitive advantage in procuring raw material and will allow it to continue to grow the volume of material available for sale into the world markets during fiscal 2008.

 

MRB also believes its access to deep water ports provide it with an efficient platform for exporting recycled metals to customers in Asia, the Middle East and around the world. MRB utilizes ocean going vessels to access these markets and the demand for vessels of the size and type required by MRB has been increasing. Historically, any change in the cost of shipping has been reflected in the price paid by customers for the metals being delivered. However, toward the end of fiscal 2007, the cost of shipping began to rise significantly, and while MRB believes the historical relationship between the prices for recycled metal and the cost of shipping the product to customers in Asia and elsewhere will remain consistent, rapid changes in shipping costs may result in margin pressures during fiscal 2008.

 

Auto Parts Business

 

 

Fiscal 2007 compared with fiscal 2006

 

Revenues

 

APB generated revenues of $266 million for fiscal 2007, before intercompany eliminations, an increase of $48 million, or 22%, over fiscal 2006. The increase over the prior year was primarily driven by increased sales of scrapped vehicles and cores, higher average sales prices and higher sales volume. Core revenue increased $10 million, or 35%, over the prior year, primarily due to a $22 increase in the average core sales per car and an increase of 32,000 cars crushed. Scrap vehicle revenue from the self-service business increased $13 million, or 38%, over the prior year, resulting from a $41 increase in the average scrap sales price per car and an increase in volume of 21,000 tons shipped. In addition, full-service revenue increased $22 million over the prior year due to higher parts sales across several product types and as a result of a full year of revenues for the GreenLeaf full-service business, which was acquired during the first quarter of fiscal 2006. During fiscal 2007, APB also benefited from the improved revenue contribution of the five stores converted from full-service to self-service compared to the same period last year.

Segment Operating Income

 

Operating income for APB was $29 million, or 11% of revenues, in fiscal 2007, compared to $28 million, or 13% of revenues, in fiscal 2006. The slight increase in operating income for fiscal 2007 reflects the impact of higher sales volume and improved performance at the full-service stores, offset by higher raw material costs, which increased $49 per car, or 35%, over fiscal 2006. Scrap tons sold increased 40,000 tons, or 14%, from 282,000 for fiscal 2006 to 322,000 for fiscal 2007. The increases in operating income were further offset by a $7 million increase in SG&A expenses compared to the prior year, primarily attributable to a $6 million increase in allocated ERP and other information technology costs and a $2 million increase in compensation expenses.

 

Fiscal 2006 compared with fiscal 2005

 

APB generated revenues of $218 million for fiscal 2006, before intercompany eliminations, an increase of $110 million, or 102%, over fiscal 2005. The increase in revenues was primarily attributable to $90 million of revenues generated from the GreenLeaf acquisition that occurred during fiscal 2006. Operating income for APB was $28 million, or 13% of revenues in fiscal 2006, compared to operating income of $28 million, or 26% of revenue, for fiscal 2005. The decrease in margins primarily attributable to APB’s entry into the full-service used parts market, which has higher costs associated with the purchase and removal of parts sold through the full-service distribution model, and increased demand and competition for unprocessed metals, which increased the costs for the purchase of cars in the self-service distribution model.

 

Outlook

 

APB operates two distribution channels in the used auto parts industry. The first, self-service auto parts, is primarily focused on older, end-of-life vehicles. Self-service revenues are driven by admissions and parts sales as well as wholesale revenues from the sale of cores and scrapped vehicles. APB remains committed to increasing its purchases of scrapped vehicles and believes that the increased volume should result in higher revenues from the sale of cores and scrap in fiscal 2008.

 

Demand in APB’s second distribution channel, full-service used auto parts, is driven primarily by the professional repair market. APB’s strategy has been to increase both the quantity and quality of its inventory by utilizing computer buying models that focus on acquiring used autos that contain high demand parts, which it believes will enable it to increase sales in its full-service distribution channel in fiscal 2008.

 

Steel Manufacturing Business

 

 

 

Fiscal 2007 compared with fiscal 2006

 

Revenues

 

SMB generated revenues of $425 million for fiscal 2007, before intercompany eliminations, an increase of $38 million, or 10%, over fiscal 2006. The increase over the prior year was the result of higher average net sales prices for finished steel products, due in part to strong demand, increased sales volume and an improved product

mix. Sales volume increased 10,000 tons, or 1%, to 713,000 tons in fiscal 2007 compared to the prior year. The average net selling price increased $47 per ton, or 9%, to $575 per ton in fiscal 2007 compared to fiscal 2006 and resulted in increased revenues of $34 million.

 

Segment Operating Income

 

Operating income for SMB was $64 million, or 15% of revenues, in fiscal 2007, compared to $75 million, or 19% of revenues, in fiscal 2006. The decrease in operating income reflects the impact of a 20% increase in the cost of scrap metal, which outpaced the 9% increase in average sales price per ton, an increase of $17 per ton in conversion costs, primarily related to higher costs for raw materials, other than scrap metals and $3 million in costs associated with the planned shut down of the larger rolling mill in the third quarter of fiscal 2007. SMB acquired all of its scrap metal requirements from MRB at negotiated rates intended to approximate market prices.

 

Fiscal 2006 compared with fiscal 2005

 

SMB generated revenues of $387 million in fiscal 2006, before intercompany eliminations, an increase of $71 million, or 23%, over fiscal 2005. The increase in revenue was primarily attributable to an increase in the number of tons sold of 108,000 tons, or 18%, and an increase of $16 per ton in the average net selling price in fiscal 2006 over fiscal 2005. The increase in sales volume was primarily due to increased demand from customers and capital improvements by SMB that enabled the steel mill to increase output to meet the demand. The average net selling price increased as a result of increased worldwide steel consumption and higher raw material costs that manufacturers passed through in the form of higher prices. Operating income for SMB in fiscal 2006 was $75 million, or 19% of revenues, compared to fiscal 2005 operating income of $43 million, or 14% of revenues. The higher operating margins were primarily attributable to the increase in production and a reduction in labor costs, raw material costs and melt shop conversion costs, reflecting the efficiencies gained through capital and equipment improvements.

 

Outlook

 

SMB sells its products primarily to construction markets located on the West Coast of the U.S. In the past few years, demand in these markets has been strong and West Coast steel manufacturers have generally been operating at full capacity. The strong demand has attracted competition from imported steel but prices have remained high by historical standards. As the market for steel products is worldwide, the level of imports is dependent upon differences in market prices in the U.S. and that attainable in other markets around the world.

 

West Coast demand for steel is based upon both residential and non-residential construction activity. During 2007, lower demand caused by a slowdown in the housing sector was offset by continued good demand in commercial construction. While the latter is closely related to economic conditions in the region, the high level of expected state and federal government spending in the West related to highway infrastructure may provide an offset to any weakening in commercial construction activity going forward.

 

To better take advantage of the positive market environment in which it operates, SMB has made a serious of capital investments that have increased capacity and improved efficiencies. As a result of these investments, capacity at the mill has been increased from around 600,000 tons annually prior to 2005 to greater than 750,000 tons currently. In 2008, SMB believes market demand will enable it to sell the incremental product it is able to produce.

 

The increased demand for steel worldwide has resulted in higher prices for the raw materials used in steel making, including scrap metal, alloys and fluxes. The ability of steel manufacturers to pass through increased costs is a function of demand in the markets in which they operate. During 2007, margins at SMB declined as the rise in raw material costs was greater than the increase in net selling prices. During 2008, raw material prices are expected to remain firm, and the ability of SMB to pass through these costs will be dependent upon the strength of market demand and the level of competition from foreign imports.

Liquidity and Capital Resources

 

The Company relies on cash provided by operating activities as a primary source of liquidity, supplemented by current cash resources and existing credit facilities.

 

Sources and Uses of Cash

 

The Company had cash balances of $13 million, $25 million and $21 million at August 31, 2007, 2006 and 2005, respectively. Cash balances are intended to be used for working capital and capital expenditures.

 

Net cash provided by operating activities in fiscal 2007 was $179 million, which included net income of $131 million, $41 million of depreciation and amortization expense, an increase in accounts payable of $17 million due to the timing of payments and a decrease in inventory of $15 million due to timing of shipments. These sources of cash were partially offset by a $43 million increase in accounts receivable due to the high volume of shipments made in the fourth quarter, and the $15 million payment for the SEC and DOJ settlement. Net cash provided by operating activities was $105 million and $146 million in fiscal 2006 and 2005, respectively. The decline in cash provided by operating activities in fiscal 2006 compared to fiscal 2005 was the result of a slight decrease in net income of $4 million, and a decrease in the impact of non-cash items, which was primarily related to a non-cash gain from the HNC separation and termination agreement in 2006, along with tax benefits from employee stock options.

 

Net cash used in investing activities in fiscal 2007 was $117 million compared to $198 million in fiscal 2006 and $72 million in fiscal 2005. Net cash used in investing activities in fiscal 2007 included $81 million in capital expenditures to upgrade the Company’s equipment and infrastructure and $45 million in acquisitions completed in fiscal 2007. The increase in outflows for investing activities in fiscal 2006 compared to fiscal 2005 was primarily related to capital expenditure costs to modernize and upgrade the Company’s infrastructure and equipment, along with significant acquisitions that occurred in fiscal 2006.

 

Net cash used in financing activities for fiscal 2007 was $74 million, compared to $97 million of cash provided by financing activities in fiscal 2006 and net cash used by financing activities of $65 million in fiscal 2005. The increase in cash used in financing activities from fiscal 2006 to 2007 was primarily due to $110 million in share repurchases, partially offset by $40 million provided by net borrowings. The increase in cash from financing activities in fiscal 2006 compared to fiscal 2005 was a result of the Company’s increased borrowings in fiscal 2006.

 

Credit Facilities

 

The Company has short-term borrowings consisting primarily of an unsecured credit line, which was increased on March 1, 2007, by $5 million to $20 million. This line of credit expires on March 1, 2008. Interest rates on outstanding indebtedness under the unsecured line of credit are set by the bank at the time of borrowing. The credit available under this agreement is uncommitted. The Company had $20 million of borrowings outstanding on this line as of August 31, 2007. The weighted average interest rate on this line was 5.98% at August 31, 2007. There were no amounts outstanding under the agreement as of August 31, 2006.

 

In November 2005, the Company entered into an amended and restated unsecured committed bank credit agreement with Bank of America, N.A., as administrative agent, and the other lenders party thereto, which was amended in July 2007. The revised agreement provides for a five-year, $450 million revolving credit facility loan maturing in July 2012. Interest rates on outstanding indebtedness under the amended agreement are based, at the Company’s option, on either the London Interbank Offered Rate (“LIBOR”) plus a spread of between 0.50% and 1.00%, with the amount of the spread based on a pricing grid tied to the Company’s leverage ratio, or the greater of the prime rate or the federal funds rate plus 0.50%. In addition, annual commitment fees are payable on the unused portion of the credit facility at rates between 0.10% and 0.25% based on a pricing grid tied to the Company’s leverage ratio.

 

As of August 31, 2007 and 2006, the Company had borrowings outstanding under the credit facility of $115 million and $95 million, respectively.

 

The two bank credit agreements contain various representations and warranties, events of default and financial and other covenants, including covenants regarding maintenance of a minimum fixed charge coverage ratio and a

maximum leverage ratio. As of August 31, 2007, the Company was in compliance with all such covenants, representations and warranties.

 

In addition, as of August 31, 2007 and 2006, the Company had $8 million of long-term bonded indebtedness that matures in January 2021.

 

Capital Expenditures

 

Capital expenditures totaled $81 million, $87 million and $48 million for fiscal 2007, 2006 and 2005, respectively. The increases in capital expenditures primarily reflect the Company’s significant investments in modern equipment to improve the efficiency and capabilities of its businesses and to further enhance the Company’s competitiveness. The capital expenditures in fiscal 2007 included partial payments for the installation of new mega-shredders at the Company’s Oakland, California; Everett, Massachusetts; and Portland, Oregon export facilities, major repairs to the dock at the Portland, Oregon facility and other upgrades to equipment and infrastructure at the MRB facilities. The Company also expended capital for the implementation of a point-of-sale system at its self-service used auto parts stores, the conversion of five sites acquired in the GreenLeaf acquisition to the Company’s self-service store model and the upgrade of the reheat furnace, billet craneway and other projects at the SMB facility designed to improve efficiency and increase output. The Company anticipates that capital expenditures in fiscal 2008 will approximate the expenditures made in fiscal 2007. Capital projects in fiscal 2008 are expected to include significant enhancements to the Company’s information technology infrastructure, further investments in technology to improve the recovery of nonferrous materials from the shredding process, the establishment of additional nonferrous collection facilities, improvements to the Company’s marine shipping infrastructure and further investments to improve efficiency, increase worker safety and enhance environmental systems. The Company expects to use cash from operations to fund capital expenditures and available lines of credit to fund acquisitions in fiscal 2008.

 

Share Repurchase Program

 

Pursuant to a share repurchase program as amended in 2001 and in October 2006, the Company is authorized to repurchase up to 6.0 million shares of its Class A Common stock when management deems such repurchases to be appropriate. Management evaluates long and short-range forecasts as well as anticipated sources and uses of cash before determining the course of action that would best enhance shareholder value. Prior to fiscal 2007, the Company had repurchased 1.3 million shares under the program. In fiscal 2007, the Company repurchased a total of 2.5 million shares under this program, leaving 2.2 million shares available for repurchase.

 

Pension Contributions

 

The Company maintains a defined benefit plan for certain of its non-union employees. In fiscal 2006, pension benefits were frozen for employees covered under this plan. Employees participating in the defined benefit plan and other employees of the Company will receive future retirement benefits under defined contribution retirement plans sponsored by the Company, which makes periodic contributions to fund the plans within the range allowed by applicable regulations. The Company makes contributions to a defined benefit pension plan, several defined contribution plans and several multi-employer pension plans. Contributions vary depending on the plan and are based upon plan provisions, actuarial valuations and negotiated labor agreements. In fiscal 2006, the Company froze further benefit accruals in its defined benefit plan and as a result made no further contributions in fiscal 2007 and anticipates making no contributions in fiscal 2008. However, changes in the discount rate or actual investment returns different from the expected long-term rate of return on plan assets could require the Company to make future contributions. The Company believes any additional funding requirements would not have a material impact on its financial condition. See Note 12 – Employee Benefits, in the notes to the consolidated financial statements in Part II, Item 8 of this report for further discussion of the Company’s retirement benefit plans. The Company expects to make contributions to its various defined contribution plans of approximately $9 million in fiscal 2008. Included in this amount is $4 million, of contributions the Company anticipates making to the multi-employer plans, including a contribution of more than $2 million for the multi-employer plan benefiting union employees of SMB.