ITEM 1 BUSINESS
GENERAL
The Company, through its Steinway and Selmer subsidiaries, is one of the world's leading manufacturers of musical instruments. Steinway produces the highest quality piano in the world and has one of the most widely recognized and prestigious brand names. For more than a century, the Steinway concert grand has been the piano of choice for the world's greatest and most popular pianists. More than 90% of the piano soloists performing during the 1998 concert season chose Steinway grand pianos. Selmer is the leading domestic manufacturer of band and orchestral instruments and related accessories, including a complete line of brasswind, woodwind, percussion and stringed instruments. SELMER PARIS saxophones, BACH trumpets and trombones and LUDWIG snare drums are considered by many to be the finest such instruments in the world. The Company's net sales of $293 million for the year ended December 31, 1998 were comprised of Steinway piano sales of $161 million and Selmer band and orchestral instrument sales of $132 million.
Steinway concentrates on the high-end grand piano segment of the industry. Steinway also offers vertical pianos as well as a full mid-priced line of pianos under the Boston brand name. Steinway hand crafts its pianos in New York and Germany and sells them worldwide through approximately 200 independent piano dealers and five Steinway-operated retail showrooms located in New York, New Jersey, London, Hamburg and Berlin. In 1998, approximately 61% of Steinway's sales were in the United States, 30% in Europe and the remaining 9% primarily in Asia.
Selmer has the leading domestic market share in virtually all of its product lines, with such widely recognized brand names as SELMER PARIS, BACH, EMERSON, GLAESEL, WILLIAM LEWIS, LUDWIG and MUSSER. Selmer's products are made by a highly skilled workforce at manufacturing facilities in Indiana, North Carolina, Ohio and Illinois, and sold through approximately 1,600 independent dealers. Beginner instruments accounted for 74% of Selmer's unit sales and 50% of instrument revenues in 1998 with advanced and professional instruments representing the balance. In 1998, approximately 84% of Selmer's sales were in the United States.
The Company acquired the Kluge company, Europe's largest manufacturer of piano keys, on December 28, 1998, for approximately $1.8 million. Steinway has been a major customer of Kluge for many years. The vertical integration of Kluge is expected to improve manufacturing efficiency and is consistent with the Company's strategy of acquiring complementary businesses.
Certain statements contained throughout this annual report are "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements represent the Company's present expectations or beliefs concerning future events. The Company cautions that such statements are necessarily based on certain assumptions which are subject to risks and uncertainties, including, but not limited to, changes in general economic conditions, increased competition, exchange rate fluctuations, and the availability of production capacity which could cause actual results to differ materially from those indicated herein. Further information on these factors is included in the Company's Final Prospectus filed in August 1996, particularly the section therein entitled "Risk Factors".
PRODUCTS
The Company offers pianos, band and orchestral instruments and services through the following subsidiaries and operating divisions:
STEINWAY AND SONS offers two premium-priced product lines: grand pianos and vertical pianos. Steinway pianos differ from all others in design specifications, materials used and the assembly process. All of Steinway's patented designs and innovations provide the unique sound and quality of the Steinway piano.
Grand pianos historically have accounted for the bulk of Steinway's production. Steinway offers eight models of the grand piano ranging from the 5'1" baby grand to the largest 9' concert grand. The smaller grands are sold to both individual and institutional customers, while the concert grands are sold primarily to institutions. Steinway grand pianos are premium pianos in terms of quality and price, with retail prices generally ranging from $31,200 to $79,900 in the United States. In 1998, Steinway sold 3,326 grand pianos, of which 2,419 units were shipped from its New York facility to dealers in North and Latin America. The remaining 907 units were shipped from its German facility to Europe, Africa and Asia.
Vertical pianos offer dealers a complete line of quality pianos to satisfy the needs of institutions and other customers who are constrained by space limitations but unwilling to compromise on quality. Steinway also provides services, such as restoration, repair, replacement part sales, tuning and regulation of pianos, at locations in New York, London, Hamburg and Berlin. Restoration services range from minor damage repairs to complete restorations of old pianos. Steinway expanded its restoration capacity in 1998 to accommodate an increased focus on the procurement and resale of used Steinway pianos.
BOSTON PIANO COMPANY offers a complete line of grand and vertical pianos priced in the upper end of the mid-priced piano market. These pianos, which are designed by Steinway and produced by a Japanese manufacturer, provide Steinway dealers with an opportunity to realize better margins in this price range while capturing sales that would have otherwise gone to a competitor. The Boston line is comprised of nine upright and grand piano models, with retail prices ranging from $5,495 to $33,310. The Boston piano provides an entry-level product for future Steinway grand piano customers, since 75% of Steinway customers have previously owned a piano. The product line also increases Steinway's business with its dealers, making Steinway the dealer's primary supplier in many instances.
SELMER DIVISION manufactures brasswind and woodwind instruments, including clarinets, flutes, piccolos, trumpets, cornets, trombones, saxophones, oboes and bassoons, at its facilities in Elkhart, Indiana. The division also manufactures mouthpieces and distributes accessories such as oils, lubricants, polishes, stands, batons, sax straps, mutes and reeds. The division's products are manufactured under the SELMER, BACH, BUNDY and SIGNET brand names and are sold to student, amateur and professional musicians. Suggested retail prices generally range from $600 to $800 for student instruments and from $1,500 to $6,000 for step-up and professional instruments. Products sold to professional musicians are often customized to meet specific design options or sound characteristics. The Company believes that specialization of products helps Selmer maintain a competitive edge in quality and product design.
Selmer is the exclusive U.S. distributor for SELMER PARIS products. The SELMER PARIS saxophone is generally considered to be one of the best in the world. SELMER PARIS, in turn, has exclusive distribution rights to Selmer's woodwind and brasswind products in France. SELMER PARIS products represented approximately 7% of Selmer's sales in 1998.
LUDWIG/MUSSER DIVISION manufactures acoustical and tuned percussion instruments, including outfit drums, marching drums, concert drums, marimbas, xylophones, vibraphones, orchestra bells, chimes, mallets and accessories. This division manufactures its products in Monroe, North Carolina and LaGrange, Illinois under the LUDWIG and MUSSER brand names. LUDWIG is considered a leading brand name in drums and MUSSER has the dominant market share of tuned percussion products.
GLAESEL/WILLIAM LEWIS DIVISION manufactures and distributes stringed instruments, including violins, violas, cellos and basses, and accessories such as bridges, covers, mutes, pads, chin rests, rosins, strings, bows, cases and instrument care products. Components are primarily imported from several European and Asian suppliers and are assembled at the factory in Cleveland, Ohio.
VINCENT BACH INTERNATIONAL, LTD. ("VBI"), located in London, England, is a wholly-owned subsidiary of Selmer. VBI distributes Selmer's products, in addition to other products that do not compete directly with Selmer's products, in the United Kingdom. Selmer also exports products to Europe and other parts of the world under its trademark name of VINCENT BACH INTERNATIONAL.
EMERSON MUSICAL INSTRUMENTS, INC. ("EMERSON"), located in Elkhart, Indiana, manufactures a complete line of flutes and piccolos. Emerson's instruments are sold to student, amateur and professional musicians. Product offerings include student model flutes and piccolos, alto, bass and other background flutes, and professional model flutes made of sterling silver or gold.
CUSTOMERS
Steinway's core customer base consists of professional artists and amateur pianists, as well as institutions such as concert halls, conservatories, colleges, universities and music schools. Customers purchase Steinway pianos either through one of the Company's five retail stores or through independently owned dealerships. Approximately 85% of Steinway piano sales in the United States are to individuals. In other countries, sales to individuals are a smaller percentage. Steinway pianos primarily are purchased by affluent individuals with incomes in excess of $100,000 per year. The typical customer is over 45 years old and has a serious interest in music. Steinway's largest dealer accounted for approximately 5% of sales in 1998, while the top 15 accounts represented 29% of sales.
Musical instrument dealers sell the majority of Selmer instruments to students enrolled in music education programs. Traditionally, students join school bands or orchestras at age 10 or 11 and learn on beginner level instruments, progressing to an advanced or professional level instrument after several years. Selmer products are also sold to professional players and institutions or groups, such as school systems or orchestras. Selmer's largest dealer accounted for approximately 6% of sales in 1998, while the top 15 accounts represented approximately 31% of sales.
SALES AND MARKETING
Steinway distributes its products primarily on a wholesale basis through approximately 200 select dealers around the globe. These dealers accounted for approximately 86% of Steinway units sold in 1998. The remaining 14% were sold directly by Steinway at one of its five company-operated retail locations in New York, New Jersey, London, Hamburg and Berlin. Steinway's West 57th Street store in New York City, known as Steinway Hall, is one of the largest and most famous piano stores in the world.
In 1997, Steinway established a Japanese subsidiary, Steinway & Sons Japan Ltd., to increase its market share in Japan, particularly at the consumer level. Steinway pianos, previously sold in Japan exclusively through a single retailer, are now offered by 20 dealers.
Steinway employs seven district sales managers, four domestically and three internationally, whose responsibilities include developing close working partnerships with Steinway dealers. Through these highly experienced professionals, Steinway provides sales training and technical support, as well as sales and marketing programs for consumers and institutions. Steinway sales managers are also responsible for promoting the Piano Bank and Steinway Artist programs described below.
THE CONCERT AND ARTIST PIANO BANK. Virtually all major venues throughout the world own a Steinway piano. However, to ensure all pianists, and especially Steinway Artists, have a broad selection of instruments to meet their individual touch and tonal preferences, Steinway maintains the famed Concert and Artist Piano Bank (the "Piano Bank"). The Piano Bank includes approximately 350 instruments worldwide. Of these instruments, approximately 275 are located in the United States. In New York City, the Steinway concert department has approximately 110 concert grands available for various occasions. The balance of the domestic-based pianos are leased to dealers around the country who actively support the Steinway Artists program. In addition to promoting Steinway's products in the music industry, the Piano Bank provides Steinway with feedback on the quality and performance of the instruments from its most critical customer, the professional pianist. Since the average age of the instruments in the Piano Bank is less than 4 years, Steinway receives continuous feedback on recently produced instruments. Generally, the Piano Bank instruments are sold after five years and are replaced with new pianos.
STEINWAY ARTISTS. For years Steinway has successfully used renowned artists in its marketing programs. This form of marketing has helped solidify brand-name recognition as well as clearly demonstrate that Steinway pianos surpass all other brands in quality. The "Steinway Artists" program, the endorsement of world class pianists who voluntarily select the Steinway piano, is unique in that Steinway does not pay artists to endorse its instruments. To become a Steinway Artist, a pianist must not only meet certain performance and professional criteria, he or she must also own a Steinway piano. The Steinway Artist roster currently includes over 1,000 of the world's finest pianists who perform only on Steinway pianos. In return for their endorsements, Steinway Artists are provided with access to the Piano Bank described above.
DISTRIBUTION, SALES AND MARKETING OF THE BOSTON PIANO LINE. The Boston piano line is targeted at the high end of the mid-priced segment of the market. The line provides both a broader product offering for dealers and an entry-level product for future Steinway grand piano customers. With certain limited exceptions, Steinway allows only Steinway dealers to carry the Boston piano line and thus ensures that the pianos will be marketed as a complementary product line. Increased traffic generated by the Boston piano creates current and future customers for Steinway. The introduction of a lower-priced alternative has not negatively impacted the sales of other Steinway pianos. The Boston piano line benefits from the "spillover" effect created by the marketing efforts supporting Steinway's main product lines.
BAND AND ORCHESTRAL INSTRUMENTS. Band, orchestral and percussion instruments and related accessories are distributed worldwide through approximately 1,600 musical instrument dealers. These products are marketed in the U.S. and Canada by district sales managers and independent sales representatives who are responsible for sales within assigned geographic territories. Each district sales manager is also responsible for developing relationships with elementary, junior high, high school and college band and orchestral educators and professional players. These individuals are the primary influence in the choice of an instrument brand. Band directors will generally refer students to designated dealers for the purchase of instruments. Management believes that its well established, long standing relationships with these influential music educators are an important component of its distribution strategy.
Internationally, products are sold through distributors located in each major country. Distributors establish their own dealer networks and service them with their own sales representatives. Selmer employs an international representative to help distributors market the Company's products.
Dealers and distributors are supported through incentive programs, advertising and promotional activities. Trade shows, print media, direct mail, telemarketing, the internet and personal sales calls are the primary methods of reaching customers. The Company actively advertises in consumer, educator and trade magazines and publications. In addition, Selmer representatives attend several trade shows each year providing opportunities to interface directly with customers.
The Company's educational director travels extensively, lecturing and motivating students, educators and parents on the value of music in a child's development. The Company also provides educational materials, catalogs and product specifications to students, educators, dealers and distributors.
MUSICAL INSTRUMENT INDUSTRY
PIANOS. The overall piano industry can be best analyzed when subdivided into three categories: high end grand pianos, mid/low end grand pianos, and vertical pianos. Domestic piano sales had been declining over the past two decades primarily due to a decrease in vertical pianos. During this period, verticals were impacted by the increase in competition stemming from electronic alternatives and lower-cost, smaller, mass produced grand pianos. Since Steinway realizes the vast majority of its profit from high end grand piano sales which are generally more affected by economic cycles, the vertical piano decline did not have a material adverse effect on Steinway's operating results. Over the past two years, the industry has experienced growth in all categories of pianos. Management believes this trend is attributable to the strong U.S. economy, favorable demographics and a general resurgence in music interests.
Market size and volume trends are difficult to quantify for international markets as there is no single source for worldwide sales data. Korea, China and Japan are the three largest piano markets in the world. Steinway's strongest international markets outside the Americas are Germany, Japan, the United Kingdom, France and Switzerland.
While adverse economic conditions in the Asian markets have slowed expansion opportunities in Japan, the Company believes that its long-term prospects remain good. Japan is currently the second largest grand piano market in the world. Steinway currently has less than 2% market share in Japan, compared to an average market share of nearly 9% in other major markets. The Company's distribution strategy is aimed at improving its market share.
BAND AND ORCHESTRAL INSTRUMENTS. The Company believes that the band and orchestral instrument industry has historically been impacted more by demographic trends and school budgeting than by
macroeconomic cycles. The domestic band and orchestral instrument industry experienced moderate sales declines starting in the mid to late 1970s, which strongly correlated to a decline in eleven year old children during the same time period. Since 1984, the industry has experienced steady growth, consistent with the increases in both student enrollment (grades K through 12) and school expenditures. While the overall trend continued in 1998, the weak Asian economy did impact the domestic market for band and orchestral instruments. As manufacturers experienced declines in shipments into foreign markets, their products became available for distribution in the U.S., resulting in a highly competitive domestic market where certain product lines experienced higher than normal growth due to favorable pricing.
The Company believes the outlook for continued steady growth remains strong. Positive demographic trends and recent studies emphasizing the importance of music education in a child's development are expected to contribute to the industry's continued growth. The Company believes that parents are encouraging their children to pursue musical instruments as a response to recent studies that show participation in music programs increase a student's ability to excel in other aspects of their education (e.g., college entrance test scores). In addition, many school band directors are promoting band programs as social organizations rather than the first step of intensive music study.
COMPETITION
The Company is one of the largest domestic producers of band and orchestral instruments. New entrants have difficulty competing with the Company due to the long learning curve inherent in the production of musical instruments, cost of tooling, significant capital requirements, lack of name-brand recognition and an effective distribution system.
The Company enjoys leading market shares in most of its product lines and holds a unique position at the top end of the market for grand pianos. Few manufacturers compete directly with Steinway, both in terms of quality and price.
Management believes that used instruments provide significant competition within certain sections of the musical instrument industry. Because of the potential savings associated with buying a used Steinway piano, as well as the durability of the instrument, a relatively large market exists for used Steinways. It is difficult to estimate the significance of used piano sales, since most are conducted in the private aftermarket. The Company, however, believes that used Steinway pianos provide the most significant competition in its market segment. To capitalize on this, Steinway enlarged its restoration facilities in 1998 to increase its emphasis on both restoration services and the procurement, refurbishment and sale of used Steinway pianos. The effect of used instruments in the band and orchestral market is less significant since instruments are less durable.
PATENTS AND TRADEMARKS
The Company has several trademarks and patents effective and pending in the United States and in several foreign countries for varying lengths of time, including the trademarks STEINWAY, STEINWAY & SONS, the Lyre symbol, STEINWAY THE INSTRUMENT OF THE IMMORTALS, BOSTON, DESIGNED BY STEINWAY & SONS, SELMER, BACH, BUNDY, SIGNET, WILLIAM LEWIS, LUDWIG, MUSSER and EMERSON. Steinway has pioneered the development of the modern piano with over 125 patents granted since its founding. Management considers its various trademarks and patents to be important and valuable assets.
MANUFACTURING PROCESS
The manufacturing process for musical instruments involves essentially two main production phases: the production of component parts and instrument assembly. Employees perform various forming, drilling, and cutting operations during the parts production phase. Investment in new equipment in this area over the last three years has allowed the Company to increase its production capacity and improve quality. Skilled craftsmen assemble component parts for the final assembly of the instruments. Each instrument is tested or tuned and regulated to the Company's specifications.
The manufacturing process for pianos takes up to nine months to achieve the high quality standards expected for Steinway pianos. Raw materials are purchased primarily in the United States and Europe.
The Company maintains a fairly constant production schedule for band and orchestral instruments in order to minimize labor disruptions and to keep work-in-process inventories relatively stable. Raw materials used in the production of brasswind and woodwind instruments are purchased primarily in the United States. Component parts are imported from Europe and Asia for stringed and percussion instruments.
LABOR
As of December 31, 1998, the Company employed 2,118 people, consisting of 1,589 hourly and 529 salaried employees. Of the 2,118 employees, 1,643 were employed in the United States and the remaining 475 were employed in Europe.
At the New York manufacturing and retail facilities, all employees except executives, supervisory employees and clerical, administrative and retail sales department employees are represented by the United Furniture Workers/IUE, AFL/CIO. In October 1997, the Company entered into a new collective bargaining agreement with these workers which will expire in September 2000. In Hamburg, Germany, manufacturing employees are represented by the workers' council, Gewerkschaft Holz und Kunststoff, which negotiates on their behalf. In Germany, Steinway participates in a consortium with other local manufacturers in similar industries to negotiate labor rates. Wage increases tend to track those of the major unions in Germany. The contract covering hourly German employees is negotiated annually. The United Auto Workers and the United Brotherhood of Carpenters represent 671 members of Selmer's workforce. In March 1997, the Company entered into new collective bargaining agreements with the United Auto Workers membership which will expire in February 2000. The agreement covering the rest of its union membership expires in November 1999. The Company believes that its relationship with its employees is generally good.
ITEM 2
ITEM 2 PROPERTIES
The Company owns most of its manufacturing and warehousing facilities. All of the Steinway retail stores are leased. Substantially all of the domestic real estate has been pledged to secure the Company's debt. The following table lists the Company's owned and leased facilities.
The Company spent approximately $6.3 million for capital expenditures in 1998. The majority of the expenditures were used for new machinery and building improvements, including refurbishing the piano restoration center. The Company expects to increase its level of capital expenditures in the future as it continues to modernize its equipment and renovate its facilities in order to improve its production efficiency.
On January 28, 1999, the Company signed a letter of intent to purchase the building which includes its Steinway Hall Showroom on West 57th Street in New York City. The transaction will involve the purchase of the building coupled with a 99-year land lease. A definitive purchase agreement is expected to be signed by the end of the first quarter of 1999.
ITEM 3
ITEM 3 LEGAL PROCEEDINGS
The Company is involved in three legal proceedings regarding Environmental Matters, which are described below. Further, in the ordinary course of business, the Company is party to various legal actions
that management believes are routine in nature and incidental to the operation of its business. While the outcome of such actions cannot be predicted with certainty, management believes that, based on its experience in dealing with these matters, the ultimate resolution of these matters will not have a material adverse impact on the business, financial condition and results of operations or prospects of the Company.
ENVIRONMENTAL MATTERS - The Company is subject to compliance with various federal, state, local and foreign environmental laws, including those relating to discharges to air, water and land, the handling and disposal of solid and hazardous waste and the cleanup of properties affected by hazardous substances. Certain environmental laws, such as the Comprehensive Environmental Response, Compensation, and Liability Act, as amended ("CERCLA"), impose strict, retroactive, joint and several liability upon persons responsible for releases of hazardous substances, which responsibility is broadly construed.
On August 9, 1993, Philips Electronics North America Corporation ("Philips") agreed to continue to indemnify the Company for any and all losses, damages, liabilities and claims relating to environmental matters resulting from certain activities of Philips occurring prior to December 29, 1988 (the "Environmental Indemnity Agreement"). To date, Philips has fully performed its obligations under the Environmental Indemnity Agreement. The Environmental Indemnity Agreement terminates on December 29, 2008. Four matters covered by the Environmental Indemnity Agreement are currently pending. For two of these sites, Philips has entered into Consent Orders with the Environmental Protection Agency ("EPA") or the North Carolina Department of Environment, Health and Natural Resources, as appropriate, whereby Philips has agreed to pay required response costs. For the third site, the EPA has notified Selmer it intends to carry out the final remediation remedy itself. The EPA estimates that this remedy has a present net cost of approximately $12 million. Over 40 persons or entities have been named by the EPA as potentially responsible parties at this site. This matter has been tendered to Philips pursuant to the Environmental Indemnity Agreement. On October 22, 1998, the Company was joined as defendant in an action involving a site formerly occupied by a business acquired by the Company in Illinois. The defense of this action has been accepted by Philips pursuant to the terms of the Environmental Indemnity Agreement. The potential liability of the Company at any of these sites is affected by several factors including, but not limited to, the method of remediation, the Company's portion of the materials in the site relative to the other named parties, the number of parties participating and the financial capabilities of the other potentially responsible parties once the relative share has been determined. No assurance can be given, however, that additional environmental issues will not require additional, currently unanticipated investigation, assessment or remediation expenditures or that Philips will make payments that it is obligated to make under the Environmental Indemnity Agreement.
The Company operates manufacturing facilities at locations where hazardous substances (including chlorinated solvents) were used. The Company believes that an entity that formerly operated one such facility may have released hazardous substances at such location, which is leased by the Company. The Company has not contributed to such release. Further, the Company has a contractual indemnity from certain stockholders of such entity. Such facility is not the subject of a legal proceeding involving the Company and to the Company's knowledge, is not subject to investigation. However, no assurance can be given that legal proceedings will not arise in the future and that such indemnitors would make the payments described in the indemnity.
The matters described above and the Company's other liabilities and compliance costs arising under environmental laws are not expected to have a material impact on the Company's capital expenditures, earnings or competitive position. However, some risk of environmental liability is inherent in the nature of the Company's current and former businesses and the Company might in the future incur material costs to meet current or more stringent compliance, cleanup or other obligations pursuant to environmental laws.
ITEM 4
ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of the Company's security holders during the fourth quarter of the fiscal year ended December 31, 1998.
PART II
ITEM 5
ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The ordinary common stock of the Company is traded on the New York Stock Exchange ("NYSE") under the symbol "LVB". The following table sets forth, for the period indicated, the high and low sales price per share of the ordinary common stock as reported on the NYSE.
The Company's common stock is comprised of two classes: Class A and Ordinary. With the exception of disparate voting power, both classes are substantially identical. Each share of Class A common stock entitles the holder to 98 votes. Holders of Ordinary common stock are entitled to one vote per share. Class A common stock shall automatically convert to Ordinary common stock if, at any time, the Class A common stock is not owned by an original Class A holder. As of March 8, 1999, there were 376 holders of record of the Company's Ordinary common stock and two holders of record of the Class A common stock.
The Company has no plans to pay cash dividends on the common stock. The Company presently intends to retain earnings to reduce outstanding indebtedness and to fund the growth of the Company's business. The payment of any future dividends will be determined by the Board of Directors in light of conditions then existing, including the Company's results of operations, financial condition, cash requirements, restrictions in financing agreements, business conditions and other factors.
The Company is restricted by the terms of its outstanding debt and financing agreements from paying cash dividends on its common stock, and may in the future enter into loan or other agreements that restrict the payment of cash dividends on the common stock.
ITEM 6
ITEM 6 SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected consolidated financial data of the Company as of and for the five years ended December 31, 1998, derived from the audited financial statements of the Company. The table should be read in conjunction with the audited consolidated financial statements of the Company, including the notes thereto, and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this report.
NOTES TO SELECTED CONSOLIDATED FINANCIAL DATA:
(1) The Company acquired Steinway in May 1995. (2) Adjusted gross profit and EBITDA under the captions "Other Financial Data" and "Margins" for the years ending 1994 and 1995 reflect positive adjustments of $264 and $9,638, respectively, relating to purchase accounting adjustments to inventory for the acquisitions of Selmer in 1993 and Steinway in 1995. (3) EBITDA represents earnings before depreciation and amortization, net interest expense, other expenses (including certain management fees and bank fees) and income tax expense (benefit), adjusted to exclude non-recurring charges. While EBITDA should not be construed as a substitute for operating income or a better indicator of liquidity than cash flow from operating activities, which are determined in accordance with generally accepted accounting principles, it is included herein to provide additional information with respect to the ability of the Company to meet its future debt service, capital expenditure and working capital requirements which the Company believes certain investors find to be useful. EBITDA is not necessarily a measure of the Company's ability to fund its cash needs.
ITEM 7
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The following discussion provides an assessment of the results of operations and liquidity and capital resources for the Company and should be read in conjunction with the consolidated financial statements of the Company and the notes thereto included elsewhere in this report.
OVERVIEW
The Company, through its Steinway and Selmer subsidiaries, is one of the world's leading manufacturers of musical instruments. The Company's net sales and income from operations improved 5.5% and 10.4%, respectively, for 1998 compared to 1997. The Company believes that these operating performance improvements have resulted from the Company's strategy to capitalize on its strong brand names, leading market positions, and emphasis on quality products. The Company's net sales of $293 million for the year ended December 31, 1998 were comprised of Steinway piano sales of $161 million and Selmer band and orchestral instrument sales of $132 million.
Steinway's piano sales are influenced by general economic conditions in the United States and Europe, demographic trends and general interest in music and the arts. Steinway's operating results are primarily affected by grand piano sales. Given the total number of grand pianos sold by Steinway in any year (3,326 sold in 1998), a decrease of a relatively few number of units being sold by Steinway can have a material impact on the Company's business and operating results. Domestic grand piano unit shipments have increased 27% from 1995 to 1998, largely attributable to the strong U.S. economy as well as increased selling and marketing efforts. Grand piano unit shipments to international markets have remained relatively flat over the same period reflecting the weakness of the European and Asian economies. In 1998, approximately 61% of Steinway's sales were in the United States, 30% in Europe and the remaining 9% primarily in Asia.
Selmer student instrument sales are strongly influenced by trends in school enrollment and general attitudes toward music and the arts. The school instrument business is generally resistant to macroeconomic cycles and strongly correlated to the number of school children in the United States, which is expected to grow steadily through 2005. Beginner instruments accounted for 74% of Selmer's unit shipments and 50% of instrument revenues in 1998 with advanced and professional instruments representing the balance.
Selmer student instrument sales were affected by the weak foreign markets in 1998. The strong U.S. economy attracted both domestic and foreign manufacturers who were experiencing declines in international shipments during the year. This created an oversupply of instruments which, coupled with pricing pressures, resulted in a highly competitive domestic market. The decrease in foreign shipments, as well as the increased domestic competition, resulted in an overall 3% decline in Selmer's unit shipments in 1998. Despite this decline, Selmer's unit shipments and sales have grown an average of 1% and 6% per year, since 1995. The unit and sales growth is the result of management's efforts to capitalize on the favorable demographic trends and the generally positive attitudes towards music education by parents.
Although the Company cannot accurately predict the precise effect of inflation on its operations, it does not believe that inflation has had a material effect on sales or results of operations in recent years. Sales to customers outside the United States represent approximately 28% of consolidated sales, with
Steinway's international sales accounting for over 75% of these international sales. A significant portion of Steinway's international sales originate from its German manufacturing facility, resulting in sales, cost of sales and related operating expenses denominated in Deutsche marks. While currency translation has affected international sales, cost of sales and related operating expenses, it has not had a material impact on operating income. The Company utilizes financial instruments such as forward exchange contracts and currency options to reduce the impact of exchange rate fluctuations on firm and anticipated cash flow exposures and certain assets and liabilities denominated in currencies other than the functional currency. The Company does not purchase currency related financial instruments for purposes other than exchange rate risk management. The Company believes the introduction of the Euro over the next three years will have a positive long-term impact on its business, as consistent prices throughout Europe will create a more favorable selling environment for its products.
The Company's effective tax rates vary depending on the relative proportion of foreign to U.S. income (foreign income generally, and German income in particular, bear higher rates of tax) and absorption of foreign tax credits in the U.S.. In 1998, German income decreased relative to total income and the rate of credit absorption increased. This shift in income combined with certain tax saving strategies reduced the Company's effective tax rate from 48% in 1997 to 46% in 1998.
The Company has historically grown through strategic acquisitions of complementary businesses. Recent acquisitions have included Emerson Musical Instruments in January 1997 and the Kluge group of companies in December 1998. The following discussion includes each of these businesses since its date of acquisition.
RESULTS OF OPERATIONS
FISCAL YEAR 1998 COMPARED TO FISCAL YEAR 1997
NET SALES - Net sales increased $15.4 million (5.5%) to $293.3 million in 1998. Piano sales increased $15.8 million (10.9%). Total piano shipments increased nearly 12%, comprised of a 17% increase in Boston units and a 7% increase in Steinway units. Band and orchestral instrument sales remained essentially flat in 1998. A decline in foreign shipments and a highly competitive domestic market caused a 3% decrease in band and orchestral instrument shipments for the year.
GROSS PROFIT - Gross profit increased $5.2 million (5.6%) to $98.5 million. Gross margins remained flat at 33.6% in both years. Piano margins improved to 35.4% in 1998 from 33.4% in 1997. This improvement is primarily due to greater efficiencies associated with higher levels of piano production combined with a yen driven reduction in costs of the Boston piano line of approximately $1.7 million. Band instrument margins were negatively impacted by manufacturing inefficiencies experienced with the introduction of a new student saxophone, resulting in a decline in margins from 33.7% in 1997 to 31.3% in 1998.
OPERATING EXPENSES - Operating expenses increased only $1.2 million (2.1%) to $55.5 million in 1998. Overall, operating expenses decreased as a percentage of sales from 19.6% in 1997 to 18.9% in 1998.
INCOME FROM OPERATIONS - Income from operations increased by $4.0 million (10.4%) to $43.0 million in 1998. These improved earnings resulted from increased sales combined with firm control over operating expenses.
NET INTEREST EXPENSE - Net interest expense decreased $0.9 million (6.8%) to $11.9 million in 1998. This decrease represents the savings realized from lower average outstanding balances on the Company's debt.
FISCAL YEAR 1997 COMPARED TO FISCAL YEAR 1996
NET SALES - Net sales increased $19.9 million (7.7%) to $277.8 million in 1997. Piano sales increased $8.9 million (6.6%) despite the negative impact of $7.9 million from foreign currency translation. Total piano shipments increased nearly 19%, comprised of a 33% increase in Boston units and a 6% increase in Steinway units. Band and orchestral instrument sales increased $11.0 million (9.0%) in 1997. The acquisition of Emerson contributed $2.9 million of the band sales increase. Total instrument shipments increased 5% for the year.
GROSS PROFIT - Gross profit increased $9.0 million (10.7%) to $93.3 million. Gross margins increased to 33.6% in 1997 compared to 32.7% in 1996. This improvement is primarily due to greater efficiencies associated with higher levels of piano production combined with a yen driven reduction in costs of the Boston piano line of approximately $2.1 million.
OPERATING EXPENSES - Operating expenses increased $3.1 million (6.1%) to $54.3 million in 1997. Additional operating costs associated with new subsidiaries totaled $1.6 million in 1997. After adjusting for these additional expenses, operating costs increased only 3.1% over 1996. Overall, operating expenses decreased as a percentage of sales from 19.9% in 1996 to 19.6% in 1997.
INCOME FROM OPERATIONS - Income from operations increased by $5.9 million (17.9%) to $38.9 million in 1997. These improved earnings resulted from increased sales combined with improved gross profit margins and firm control over operating expenses.
NET INTEREST EXPENSE - Net interest expense decreased $4.3 million (25.3%) to $12.8 million in 1997. This decrease represents the savings realized from the retirement of the Company's Senior Secured Notes in September 1996.
LIQUIDITY AND CAPITAL RESOURCES
The Company has relied primarily upon cash provided by operations, supplemented as necessary by seasonal borrowings under its working capital line, to finance its operations, repay long-term indebtedness and fund capital expenditures.
Cash provided by operations was $5.9 million in 1996, $13.8 million in 1997 and $14.2 million in 1998. Cash provided by the Company's initial public offering in 1996 was used to repay $54.6 million of Senior Secured Notes and related prepayment penalties of $4.5 million. Cash used for the acquisitions of Emerson and Kluge was $1.6 million in 1997 and $1.3 million in 1998, respectively.
Capital expenditures in 1996, 1997 and 1998 were $5.2 million, $5.6 million and $6.3 million, respectively. These capital expenditures were primarily used for purchasing new machinery and building improvements. The Company expects to increase its level of capital expenditures in the future as it continues to modernize its equipment and renovate its facilities in order to improve its production efficiency.
Consistent with industry practice, Selmer sells band instruments almost entirely on credit utilizing the two financing programs described below. These programs create large working capital requirements during the year when band instrument receivable balances reach highs of approximately $60-65 million in August and September, and lows of approximately $30-35 million in January and February. The financing options, intended to assist dealers with the seasonality inherent in the industry and to facilitate the rent-to-own programs offered to students by many retailers, also allow Selmer to match its production and delivery schedules. Selmer offers the following two forms of financing to qualified band instrument dealers:
a) RECEIVABLE DATING: Purchases made from January through September have payment due in October. Purchases made from October to December have payment due in January. Dealers are offered discounts for early payment.
b) NOTE RECEIVABLE FINANCING: Qualified dealers may convert open accounts to a note payable to Selmer. The note program is offered in January and October, and coincides with the receivable dating program. The note receivable is secured by dealer inventories and receivables. The majority of notes receivable are purchased by a third-party financing company, on a full recourse basis. The Company's current arrangement, which allows the financing company to purchase, at its option, up to an aggregate amount outstanding at any time of $15.0 million of notes receivable, expires in 2000. Net notes receivable sales generated approximately $15.1 million and $14.9 million in cash in 1997 and 1998, respectively.
Unlike many of its competitors in the piano industry, Steinway does not provide extended financing arrangements to its dealers. To facilitate long-term financing required by some dealers, Steinway has arranged for financing through a third-party provider which generally involves no guarantee by Steinway.
The Company's domestic, seasonal borrowing requirements are accommodated through a committed, revolving credit facility with a domestic bank (the "Credit Facility"). The Credit Facility provides the Company with a potential borrowing capacity of up to $60.0 million, based on eligible accounts receivable and inventory. Borrowings are secured by a first lien on the Company's domestic inventory, receivables, and fixed assets. As of December 31, 1998, no amounts were outstanding, and availability was approximately $56.4 million. The Credit Facility currently bears interest at the Eurodollar rate plus 2.5% and expires March 31, 2000. Open account loans with foreign banks also provide for borrowings by Steinway's foreign subsidiaries of up to 25 million Deutsche marks.
At December 31, 1998, the Company's total outstanding indebtedness amounted to $117.0 million, consisting of $110.0 million of 11% Senior Subordinated Notes and $7.0 million of notes payable to foreign banks. Cash interest paid was $13.5 million and $13.0 million in 1997 and 1998, respectively. All of the Company's debt agreements contain covenants that place certain restrictions on the Company, including its ability to incur additional indebtedness, to make investments in other entities, and to pay cash dividends.
The Company's share repurchase program authorizes management to make discretionary repurchases of its ordinary common stock up to a limit of $25 million. Repurchased shares are being held as treasury shares to be used for corporate purposes. The Company repurchased 85,900 shares at a cost of $1.9 million in 1997 and 151,500 shares at a cost of $3.7 million in 1998.
Management believes that cash on hand, together with cash flow anticipated from operations and available borrowings under the Credit Facility, will be adequate to meet debt service requirements, fund continuing capital requirements and satisfy working capital and general corporate needs through the next twelve months.
YEAR 2000 COMPLIANCE - The Year 2000 issue is the result of computer programs being written using two digits rather than four digits to define the applicable year. Computer programs and hardware that are date sensitive may recognize a date using "00" as the year 1900 rather than the year 2000. The Company's products, which are finely crafted instruments, do not contain software programs and therefore their functionality will not be affected by this issue. However, it could cause some disruptions of internal operations, including, among other things, a temporary inability to process transactions or engage in normal business activities.
The Company has focused its Year 2000 review in the following areas: (1) information technology ("IT") systems such as hardware and software; (2) non-IT systems such as manufacturing, distribution and facility equipment containing embedded microprocessors; and (3) the readiness of third-parties such as suppliers and customers. An inventory of all IT and non-IT systems has been taken and efforts are underway to insure that the appropriate testing and remediation or replacement occurs.
Virtually all of the Company's critical manufacturing and accounting information systems have been tested for Year 2000 compliance. Many of the critical information systems were replaced over the past two years with Year 2000 compliant programs in the normal course of business. The Company intends to replace or upgrade non-compliant IT hardware and software systems by the end of the third quarter of 1999.
Preliminary testing of non-IT systems and equipment indicates that many of these systems rely on time intervals rather than dates in their operation. The Company is contacting the manufacturers of the non-IT equipment used in production to obtain assurances as to whether the manufacturers' systems are Year 2000 compliant. Testing and remediation of these systems will continue throughout 1999.
The Company has communicated with major suppliers and customers to determine the extent to which the Company may be vulnerable if a supplier fails to correct their own Year 2000 issue. Most suppliers and customers who have replied to our inquiries indicated that they expect to be Year 2000 compliant on a timely basis. There can be no assurance, however, that third parties will address the Year 2000 issue in a timely manner.
Based on its review to date, the Company believes the Year 2000 problem will not pose significant internal operational disruptions. Events beyond the Company's reasonable control could adversely affect the Company's ability to produce and deliver its products in a timely manner. These events could include failure of infrastructure systems, including power, heat and water; disruptions in distribution channels; or the inability of suppliers and customers to engage in normal business activities. In the third quarter of 1999, the Company will develop a contingency plan based on the magnitude and probability that operational disruptions may still occur on January 1, 2000. The Company currently believes that the risk of disruption will be minimal since its operations are geographically dispersed and rely on a large supplier and customer base.
The Company does not expect the costs associated with its Year 2000 compliance to be material. Internal employees, whose salaries and wages are included in normal operating expenses, have modified many of the Company's information technology systems. Less than $1 million has been spent to date and future costs are not anticipated to be material to its financial position or results of operations.
NEW ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board released Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes new standards of accounting and reporting for derivative instruments and hedging activities. This statement requires that all derivatives be recognized at fair value in the balance sheet, and that the corresponding gains or losses be reported either in the statement of operations or as a component of comprehensive income, depending on the type of hedging relationship that exists. The statement will be effective for the Company in fiscal 2000. Management is currently evaluating the effect of adopting SFAS No. 133 on the consolidated financial statements.
In March 1998, the American Institute of Certified Public Accountants issued Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". SOP 98-1 requires external and internal indirect costs of developing or obtaining internal-use software to be capitalized as a long-lived asset and also requires training costs included in the purchase price of computer software and costs associated with research and development to be expensed as incurred. SOP 98-1 will be effective for the Company in fiscal 1999. Management is currently evaluating the effects of this statement on the consolidated financial statements.
ITEM 7A
ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is subject to market risk associated with changes in foreign currency exchange rates and interest rates. The Company mitigates its foreign currency exchange rate risk by holding forward foreign currency contracts. These contracts are used as a hedge against intercompany transactions and are not used for trading or speculative purposes. The fair value of the forward foreign currency exchange contracts is sensitive to changes in foreign currency exchange rates. As of December 31, 1998, a 10% adverse change in foreign currency exchange rates from market rates would decrease the fair value of the contracts by approximately $0.6 million. Gains and losses on the foreign currency exchange contracts are defined as the difference between the contract rate at its inception date and the current exchange rate. However, any such gains and losses would generally be offset by corresponding losses and gains, respectively, on the related hedged asset or liability.
The Company's interest rate exposure is limited primarily to interest rate changes on its variable rate Credit Facility. The Credit Facility bears interest at rates which fluctuate with changes in the Eurodollar rate. As of December 31, 1998, a hypothetical 10% immediate increase in interest rates would not have a material effect on the Company's interest expense. To date, the Company has not entered into interest rate swap agreements to fix the interest rate on its short-term borrowings.
Substantially all of the Company's long-term debt, approximately $117.0 million at December 31, 1998, is at fixed interest rates. Accordingly, there would be no immediate impact on the Company's interest expense associated with its long-term debt due to fluctuations in market interest rates. However, based on a hypothetical 10% immediate decrease in market interest rates, the fair value of the Company's long-term debt, which would be sensitive to such interest rate changes, would be increased by approximately $0.8 million as of December 31, 1998. Such fair value changes may affect the Company's determination as to whether to retain, replace or retire its long-term debt.
ITEM 8
ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEPENDENT AUDITORS' REPORT
CONSOLIDATED FINANCIAL STATEMENTS:
Consolidated Balance Sheets as of December 31, 1997 and 1998 Consolidated Statements of Operations for the Years Ended December 31, 1996, 1997 and 1998
Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1996, 1997 and 1998
Consolidated Statements of Cash Flows for the Years Ended December 31, 1996, 1997 and 1998
Notes to Consolidated Financial Statements
Schedule II - Valuation and Qualifying Accounts
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Steinway Musical Instruments, Inc.
We have audited the accompanying consolidated balance sheets of Steinway Musical Instruments, Inc. and subsidiaries as of December 31, 1997 and 1998, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedule listed in the Index at Item 14(a)(1). These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Steinway Musical Instruments, Inc. and subsidiaries as of December 31, 1997 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ DELOITTE & TOUCHE LLP Boston, Massachusetts February 23, 1999
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1997 AND 1998 (DOLLARS IN THOUSANDS EXCEPT SHARE DATA)
See notes to consolidated financial statements.
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 (DOLLARS IN THOUSANDS EXCEPT SHARE AND PER SHARE AMOUNTS)
See notes to consolidated financial statements.
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 (DOLLARS IN THOUSANDS)
See notes to consolidated financial statements.
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 (DOLLARS IN THOUSANDS)
See notes to consolidated financial statements.
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1996, 1997 AND 1998 (DOLLARS IN THOUSANDS EXCEPT SHARE DATA)
(1) NATURE OF BUSINESS
Steinway Musical Instruments, Inc. and subsidiaries (the "Company") is one of the world's leading manufacturers of musical instruments. The Company, through its wholly-owned subsidiaries, The Steinway Piano Company, Inc. (Steinway) and The Selmer Company, Inc. (Selmer), manufactures and distributes products within the musical instrument industry. Steinway produces the highest quality piano in the world and has one of the most highly recognized and prestigious brand names. Selmer is the leading domestic manufacturer of band and orchestral instruments and related accessories, including a complete line of brasswind, woodwind, percussion and stringed instruments. Selmer Paris saxophones, Bach trumpets and trombones and Ludwig snare drums are considered by many to be the finest such instruments in the world. The Company purchased the assets of Emerson Musical Instruments, Inc. in January 1997 for approximately $2.0 million, and the Kluge group of companies on December 28, 1998 for approximately $1.8 million. Each acquisition has been accounted for as a purchase for financial reporting purposes and the purchase prices have been allocated to the acquired assets and liabilities based on their relative fair values. The consolidated financial statements of the Company include the results of operations for each acquired business since its date of acquisition.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION - The consolidated financial statements of the Company include the accounts of all of its direct and indirect wholly-owned subsidiaries, including Selmer and Steinway. Significant intercompany balances have been eliminated in consolidation.
USE OF ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
REVENUE RECOGNITION - Revenue is generally recognized upon shipment. The Company provides for the estimated costs of warranties at the time of sale.
INVENTORIES - Inventories are stated at the lower of cost, determined on a first-in, first-out basis, or market.
DEPRECIATION AND AMORTIZATION - Property, plant and equipment are recorded at cost or at fair value in the case of assets acquired through business acquisitions. Depreciation is provided using the straight-line method over the estimated useful lives of the respective assets. Leasehold improvements are amortized using the straight-line method over the estimated useful lives of the improvements or the remaining term of the respective lease, whichever is shorter. Estimated useful lives are as follows:
Cost in excess of fair value acquired is amortized over 40 years. Trademarks acquired are recorded at appraised value and are amortized over 10 years. Deferred financing costs are amortized on a straight-line basis over the repayment periods of the underlying debt.
The Company periodically evaluates the recoverability of its long-lived assets by comparison of the expected future undiscounted cash flows expected to be generated by those assets to their carrying value. To date, no impairment losses have been noted or recorded as a result of this evaluation process.
INCOME TAXES - Income taxes are provided using an asset and liability approach to financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed annually for differences between the financial statement and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities.
FOREIGN CURRENCY TRANSLATION - Assets and liabilities of non-U.S. operations are translated into U.S. dollars at year-end rates, and revenues and expenses at average rates of exchange prevailing during the year. The resulting translation adjustments are reported as a separate component of comprehensive income. Foreign currency transaction gains and losses are recognized in the statements of operations currently.
FOREIGN EXCHANGE CONTRACTS - The Company enters into foreign exchange contracts as a hedge against foreign currency transactions. Gains and losses arising from fluctuations in exchange rates are recognized at the end of each reporting period. Such gains and losses directly offset the foreign exchange gains or losses associated with the hedged receivable or payable. Gains and losses on foreign exchange contracts which exceed the related balance sheet or firm purchase commitment exposure are included in foreign currency gain or loss in the statement of operations.
STOCK-BASED COMPENSATION - The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees".
INCOME PER COMMON SHARE - Basic income per common share is computed using the weighted average number of common shares outstanding during each year. Diluted income per common share reflects the effect of the Company's outstanding options (using the treasury stock method), except where such items would be antidilutive.
A reconciliation of the weighted average shares used for the basic and diluted computations is as follows for the years ended December 31:
ENVIRONMENTAL MATTERS - Potential environmental liabilities are accounted for in accordance with Statement of Financial Accounting Standards ("SFAS") No. 5, "Accounting for Contingencies", which requires a liability to be recorded when it is probable that a loss has been incurred and its amount can reasonably be estimated. See Note 7.
SEGMENT REPORTING - The Company has determined that it has two distinct reportable segments: the piano segment and the band and orchestral instrument segment. The Company considers these two segments reportable as they are managed separately and the operating results of each segment are regularly reviewed and evaluated separately by the Company's senior management.
COMPREHENSIVE INCOME - Effective January 1, 1998, the Company adopted the provisions of SFAS No. 130, "Reporting Comprehensive Income" and as a result, has reported comprehensive income and its components in the statements of stockholders' equity for all periods presented. Currently, in addition to net income, the only item included in comprehensive income is foreign currency translation adjustments. No provision for U.S. income and foreign withholding taxes has been made because it is expected that the earnings which gave rise to such translation adjustments will be reinvested indefinitely.
RETIREMENT PLANS - Effective December 31, 1998, the Company adopted SFAS No. 132, "Employer's Disclosures about Pensions and Other Postretirement Benefits". SFAS No. 132 supersedes the disclosure requirements in SFAS No. 87, "Employers' Accounting for Pensions", and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The overall objective of SFAS No. 132 is to improve and standardize disclosures about pensions and other postretirement benefits and to make the required information more understandable. The adoption of SFAS No. 132 did not affect the results of operations or financial position, but did affect the disclosures for pensions and other postretirement benefits. See Note 8.
NEW ACCOUNTING PRONOUNCEMENTS - In June 1998, the Financial Accounting Standards Board released SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No. 133 establishes new standards of accounting and reporting for derivative instruments and hedging activities. This statement requires that all derivatives be recognized at fair value in the balance sheet, and that the corresponding gains or losses be reported either in the statement of operations or as a component of comprehensive income, depending on the type of hedging relationship that exists. The statement will be effective for the Company in fiscal 2000. Management is currently evaluating the effect of adopting SFAS No. 133 on the consolidated financial statements.
In March 1998, the American Institute of Certified Public Accountants issued Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use". SOP 98-1 requires external and internal indirect costs of developing or obtaining internal-use software to be capitalized as a long-lived asset and also requires training costs included in the purchase price of computer software and costs associated with research and development to be expensed as incurred. SOP 98-1 will be effective for the Company in fiscal 1999. Management is currently evaluating the effects of this statement on the consolidated financial statements.
(3) CONSOLIDATED FINANCIAL STATEMENT DETAILS
INVENTORIES
PROPERTY, PLANT AND EQUIPMENT, NET
OTHER ASSETS, NET
OTHER CURRENT LIABILITIES
(4) INCOME TAXES
The components of the provision for income tax are as follows:
The components of income before income taxes are as follows:
The Company's provision for income tax differed from that using the statutory U.S. federal rate as follows:
At December 31, 1998, accumulated retained earnings of non-U.S. subsidiaries totaled $1,671. No provision for U.S. income and foreign withholding taxes has been made because it is expected that such earnings will be reinvested indefinitely.
The components of net deferred taxes are as follows:
Valuation allowances provided relate to excess foreign tax credits generated over expected credit absorption. Of these valuation allowances, $6,373 and $6,226 relate to the acquisition of Steinway as of December 31, 1997 and 1998, respectively. Should the related tax benefits be recognized in the future, the effect of removing the valuation allowances associated with the acquisition of Steinway would generally be a decrease in goodwill. During 1997, the valuation allowance decreased by $3,022 primarily due to the write-off of expired foreign tax credits. During 1998, the valuation allowance increased by $2,596 due to the generation of additional excess foreign tax credits. Foreign tax credit carryforwards expire in varying amounts through 2002.
(5) NOTES PAYABLE AND LONG TERM DEBT
Notes payable and long-term debt consists of the following:
Scheduled maturities of long-term debt as of December 31, 1998 are as follows:
The 11% Senior Subordinated Notes may be redeemed at the Company's option, in whole or in part, at the following redemption prices (expressed as percentages of the principal amount) plus accrued and unpaid interest and liquidated damages, as defined, thereon to the applicable redemption date, if redeemed during the twelve-month period beginning on June 1 of the years indicated below:
The open account loans provide for borrowings by foreign subsidiaries of up to DM 25,000 ($15,000 at the December 31, 1998 exchange rate) payable on demand. A portion of the open account loan can be converted into a maximum of (pound)1,083 ($1,798 at the December 31, 1998 exchange rate) for use by the Company's UK subsidiary and (Y)340,000 ($2,997 at the December 31, 1998 exchange rate) for use by the Company's Japanese subsidiary. Demand borrowings bear interest at rates of 5.875 to 6.0% for the Deutsche mark loans, 6.75% for British pounds sterling loans, and 1.31% for Japanese yen loans. Term borrowings bear interest at Libor plus .75%.
The Company's domestic, seasonal borrowing requirements are accommodated through a senior revolving credit facility with a domestic bank (the "Credit Facility"). The Credit Facility provides the Company with a potential borrowing capacity of up to $60.0 million, based on eligible accounts receivable and inventory balances. The Credit Facility, as amended on January 1, 1997, bears interest at the Eurodollar rate plus 2.5%. Borrowings are collateralized by the Company's domestic accounts receivable, inventory and fixed assets. As of December 31, 1998, no amounts were outstanding, and availability was approximately $56.4 million.
All of the Company's debt agreements contain certain financial covenants which, among other things, require the maintenance of certain financial ratios and net worth, place certain limitations on additional borrowings and capital expenditures, and prohibit the payment of cash dividends. The Company is in compliance with all such covenants.
(6) STOCKHOLDERS' EQUITY
In August 1996, the Company completed an initial public offering of 3,570,000 shares of its ordinary common stock. In conjunction with the offering, all of the Company's outstanding preferred stock was converted to ordinary common stock and the expiration date for exercising outstanding warrants was accelerated, so that no preferred stock or warrants remained outstanding on December 31, 1996.
The Company's common stock is comprised of two classes: Class A and Ordinary. With the exception of disparate voting power, both classes are substantially identical. Each share of Class A common stock entitles the holder to 98 votes. Holders of Ordinary common stock are entitled to one vote per share. Class A common stock shall automatically convert to Ordinary common stock if, at any time, the Class A common stock is not owned by an original Class A holder.
EMPLOYEE STOCK PURCHASE PLAN - The Company has an employee stock purchase plan (the "Purchase Plan") under which substantially all employees may purchase common stock through payroll deductions at a purchase price equal to 85% of the lower of the fair market values as of the beginning or end of each twelve month offering period. Stock purchases under the Purchase Plan are limited to 5% of an employee's annual base earnings. During 1997 and 1998, 29,557 and 30,431 shares, respectively, were issued under the Purchase Plan. Of the 500,000 shares originally reserved for issuance under the Purchase Plan, 440,012 shares remain reserved for future issuance as of December 31, 1998.
STOCK PLAN - The 1996 stock plan (the "Stock Plan") provides for the granting of 778,250 stock options (including incentive stock options and non-qualified stock options), stock appreciation rights, and other stock awards to certain key employees, consultants and advisors of the Company and its subsidiaries. Common stock reserved for issuance under the Stock Plan was 752,450 shares as of December 31, 1998.
Option activity for the years ended December 31 is as follows:
The following table sets forth information regarding outstanding and exercisable options at December 31, 1998:
STOCK-BASED COMPENSATION EXPENSE - As described in Note 2, the Company uses the intrinsic value method to measure compensation expense associated with grants of stock options to employees. Had the Company used the fair value method to measure compensation, as required by SFAS No. 123 "Accounting for Stock-Based Compensation", reported net income and net income per share would have been as follows for the years ended December 31:
The fair value of options on their grant date, including the valuation of the option feature implicit in the Purchase Plan, was measured using the Black-Scholes option pricing model. Key assumptions used to apply this pricing model are as follows:
The weighted average fair value of options on their grant date, including the valuation of the option feature implicit in the Purchase Plan is as follows:
It should be noted that the Black-Scholes option pricing model was designed to value readily tradable options with relatively short lives and no vesting restrictions. In addition, option valuation models require the input of highly subjective assumptions including the expected price volatility. Because the options granted are not tradable and have contractual lives of up to ten years, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of the options issued under the Company's Stock Plan and Purchase Plan.
(7) COMMITMENTS AND CONTINGENT LIABILITIES
LEASE COMMITMENTS - The Company leases various facilities and equipment under noncancelable operating lease arrangements. These leases expire at various times through 2016 with various renewal options. Rent expense was $3,176, $3,145 and $3,638 for the years ended December 31, 1996, 1997 and 1998, respectively. Future minimum lease payments under noncancelable operating leases for the years ending December 31 are as follows:
NOTES RECEIVABLE SOLD WITH RECOURSE - The Company sells notes receivable on a recourse basis to a financing company under a three-year facility. Pursuant to the terms of the facility, the financing company may, at its option, purchase up to an aggregate principal amount outstanding at any time of $15 million of the Company's notes receivable. The Company received proceeds of approximately $15.1 and $14.9 million from the sales of such notes during the years ended December 31, 1997 and 1998, respectively. Other current liabilities include a recourse obligation of $1.3 and $1.4 million as of December 31, 1997 and 1998, respectively for the notes sold with recourse.
ENVIRONMENTAL MATTERS - Certain environmental matters are pending against the Company, which might result in monetary damages, the amount of which, if any, cannot be determined at the present time. Philips Electronics, a previous owner of the Company, has agreed to hold the Company harmless from any financial liability arising from these environmental matters which were pending as of December 29, 1988. Management believes that these matters will not have a material adverse impact on the Company's results of operations or financial condition.
LITIGATION - In the ordinary course of its business, the Company is party to various legal actions that management believes are routine in nature and incidental to the operation of its business. While the outcome of such actions cannot be predicted with certainty, management believes that, based on the experience of the Company in dealing with these matters, the ultimate resolution of these matters will not have a material adverse impact on the financial condition or results of operations of the Company.
(8) RETIREMENT PLANS
The Company has defined benefit pension plans covering the majority of its employees, including certain employees in foreign countries. Plan assets are invested primarily in common stocks and fixed income securities. The Company makes contributions generally equal to the minimum amounts required by federal laws and regulations. Foreign plans are funded in accordance with the requirements of regulatory bodies governing each plan.
The following table sets forth the funded status and amounts recognized as of December 31, 1997 and 1998 for the Company's domestic and foreign defined benefit pension plans:
The components of net pension expense for the year ended December 31 are as follows:
The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets were $32,616, $31,120 and $19,065, respectively, as of December 31, 1997 and $19,556, $18,440 and $4,392, respectively, as of December 31, 1998.
The Company provides postretirement health care and life insurance benefits to eligible hourly retirees and their dependents. The health care plan is contributory, with retiree contributions adjusted every three years as part of a union contract agreement. The plans are unfunded and the Company pays part of the health care premium and the full amount of the life insurance cost.
The following table sets forth the funded status of the Company's postretirement benefit plans and accrued postretirement benefit cost reflected in the Company's balance sheet at year end:
The assumed weighted average discount rate as of December 31, 1997 and 1998 was 7.0% and 6.75%, respectively. The annual assumed rate of increase in the per capita cost of covered health care benefits is 9.5% for retirees under age 65 in 1999 and is assumed to decrease gradually to 4.5% in 2008, and remain at that level thereafter.
Net postretirement benefit costs are as follows:
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plan. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
The Company also sponsors 401(k) retirement savings plans for eligible employees. Discretionary employer contributions, as determined annually by the Board of Directors, are made to one of these plans. The 1997 and 1998 contribution approximated $368 and $433, respectively.
(9) FOREIGN EXCHANGE CONTRACTS
At December 31, 1997, the Company's German divisions, whose functional currency is the Deutsche mark, had forward contracts and purchased options to sell (Y)430,900 and (pound)1,060 and to buy $3,195 in order to manage any currency exchange fluctuations on its intercompany transactions. These instruments matured at various dates through December 31, 1998.
At December 31, 1998, these instruments, maturing at various dates through October 1999, consisted of forward contracts and purchased options to sell (Y)460,000 and (pound)700 and to buy $1,300. The Company's only use of purchased options is to manage currency exchange fluctuations.
(10) RELATED PARTY TRANSACTIONS
The principals of Kirkland Messina LLC, a merchant banking firm, control 84% of the voting power of the Company's common stock. Kirkland Messina LLC received $1.0 million in 1996 for arranging, negotiating and obtaining waivers and other required consents in connection with the Company's initial public offering. In addition, Kirkland Messina LLC and its principals received annual payments of $400 in 1996, 1997 and 1998 for ongoing management and other services to the Company.
(11) FAIR VALUES OF FINANCIAL INSTRUMENTS
The following disclosures of the estimated fair values of financial instruments are made in accordance with the requirements of SFAS No. 107, "Disclosures about Fair Values of Financial Instruments". The estimated fair values have been developed using appropriate methodologies; however, considerable judgment is required to develop these estimates. Accordingly, the estimates presented herein are not necessarily indicative of amounts that could be realized in a current market exchange. Use of different assumptions or methodologies could have a significant effect on these estimates. The net carrying value and estimated fair value of the Company's financial instruments is as follows at December 31:
The carrying amount of cash, accounts, notes and leases receivable, and accounts payable approximate fair value because of the short maturity of these instruments.
The estimated fair value of existing notes payable and long-term debt is based on rates currently available to the Company for debt with similar terms and remaining maturities.
The estimated fair value of foreign currency contracts (used for hedging purposes) has been determined as the difference between the current spot rate and the contract rate multiplied by the notional amount of the contract or upon the estimated fair value of purchased option contracts. The net carrying value of these contracts approximates zero as any gains or losses on the contracts is generally offset by losses or gains on the related hedged asset or liability.
(12) SEGMENT INFORMATION
As discussed in Note 2, the Company has identified two distinct and reportable segments: the piano segment and the band and orchestral instrument segment. The Company considers these two segments reportable as they are managed separately and the operating results of each segment are regularly reviewed and evaluated separately by the Company's senior management.
The accounting policies of each segment are the same as those described in Note 2. Intercompany transactions are generally recorded at cost plus a predetermined markup.
The following tables present information about the Company's operating segments:
(13) SUMMARIZED FINANCIAL INFORMATION
The Company is a holding company whose only material asset consists of its investment in its wholly-owned subsidiary, The Selmer Company, Inc. Summarized financial information for The Selmer Company, Inc. and subsidiaries is as follows:
(14) SUMMARY OF MERGER AND GUARANTEES
On May 25, 1995, Selmer acquired Steinway pursuant to an Agreement and Plan of Merger dated as of April 11, 1995. The total purchase price of approximately $104 million, including fees and expenses, was funded by Selmer's issuance of $105 million of 11% Senior Subordinated Notes (the "Notes") due 2005 and available cash balances of the Company.
Selmer's payment obligations under the Notes are fully and unconditionally guaranteed on a joint and several basis by the Company as Parent (the "Guarantor Parent"), and by Steinway and certain wholly-owned subsidiaries of Steinway, each a direct or indirect wholly-owned subsidiary of the Company and each a "Guarantor" (the "Guarantor Subsidiaries"). These subsidiaries, together with the operating divisions of Selmer, represent all of the operations of the Company conducted in the United States. The remaining subsidiaries, which do not guarantee the Notes, represent foreign operations (the "Non Guarantor Subsidiaries").
The following condensed consolidating supplementary data illustrates the composition of the combined Guarantors. Separate complete financial statements of the respective Guarantors would not provide additional material information which would be useful in assessing the financial composition of the Guarantors. No single Guarantor has any significant legal restrictions on the ability of investors or creditors to obtain access to its assets in event of default on the Guarantee other than its subordination to senior indebtedness.
Investments in subsidiaries are accounted for by the parent on the cost method for purposes of the supplemental consolidating presentation. Earnings of subsidiaries are therefore not reflected in the parent's investment accounts and earnings. The principal elimination entries eliminate investments in subsidiaries and intercompany balances and transactions.
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEETS DECEMBER 31, 1997 (DOLLARS IN THOUSANDS)
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING BALANCE SHEETS DECEMBER 31, 1998 (DOLLARS IN THOUSANDS)
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1996 (DOLLARS IN THOUSANDS)
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1997 (DOLLARS IN THOUSANDS)
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1998 (DOLLARS IN THOUSANDS)
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS YEAR ENDED DECEMBER 31, 1996 (DOLLARS IN THOUSANDS)
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS YEAR ENDED DECEMBER 31, 1997 (DOLLARS IN THOUSANDS)
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS YEAR ENDED DECEMBER 31, 1998 (DOLLARS IN THOUSANDS)
(15) QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of unaudited results of operations (in thousands except share and per share data) for the years ended December 31, 1997 and 1998.
(16) SUBSEQUENT EVENT
On January 28, 1999, the Company signed a letter of intent to purchase the building which includes its Steinway Hall Showroom on West 57th Street in New York City. The transaction will involve the purchase of the building coupled with a 99-year land lease. A definitive purchase agreement is expected to be signed by the end of the first quarter of 1999.
STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS (DOLLARS IN THOUSANDS)
Note: (1) Includes foreign currency translation adjustments (2) Represents accounts written off, net of recoveries; and reclassifications to and from other accounts
ITEM 9
ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10
ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information called for by this item is hereby incorporated by reference to the Registrant's definitive Proxy Statement for the fiscal year ended December 31, 1998, which Proxy Statement will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year covered by this report.
ITEM 11
ITEM 11 EXECUTIVE COMPENSATION
The information called for by this item is hereby incorporated by reference to the Registrant's definitive Proxy Statement for the fiscal year ended December 31, 1998, which Proxy Statement will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year covered by this report.
ITEM 12
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information called for by this item is hereby incorporated by reference to the Registrant's definitive Proxy Statement for the fiscal year ended December 31, 1998, which Proxy Statement will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year covered by this report.
ITEM 13
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by this item is hereby incorporated by reference to the Registrant's definitive Proxy Statement for the fiscal year ended December 31, 1998, which Proxy Statement will be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year covered by this report.
PART IV
ITEM 14
ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as a part of this report:
(3) EXHIBITS: The Exhibits listed below are filed as part of, or incorporated by reference into this Report.
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(1) Previously filed with the Commission on February 8, 1994 as an exhibit to the Registrant's Registration Statement on Form S-1.
(2) Previously filed with the Commission on April 28, 1994 as an exhibit to the Registrant's Amendment No. 1 to Registration Statement on Form S-1.
(3) Previously filed with the Commission on March 30, 1995, as an exhibit to the Registrant's Annual Report on Form 10-K.
(4) Previously filed with the Commission on June 7, 1995 as an exhibit to the Registrant's Current Report on Form 8-K.
(5) Previously filed with the Commission on June 7, 1995 as an exhibit to the Registrant's Registration Statement on Form S-4.
(6) Previously filed with the Commission on May 14, 1996 as an exhibit to the Registrant's Registration Statement on Form S-1.
(7) Previously filed with the Commission on July 25, 1996 as an exhibit to the Registrant's Amendment No. 2 to Registration Statement on Form S-1.
(8) Previously filed with the Commission on March 27, 1997 as an exhibit to the Registrant's Annual Report on Form 10-K.
(9) Previously filed with the Commission on March 27, 1998 as an exhibit to the Registrant's Annual Report on Form 10-K.
(b) Reports on Form 8-K
The following report on Form 8-K was filed during the quarter ended December 31, 1998:
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
STEINWAY MUSICAL INSTRUMENTS, INC.
MARCH 30, 1999 By /S/ DANA D. MESSINA - -------------- ------------------------ (Date) Dana D. Messina
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
THE SELMER COMPANY, INC.
MARCH 30, 1999 By /S/ DANA D. MESSINA - -------------- --------------------- (Date) Dana D. Messina
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated: