Filed with the SEC from Jan 26to Feb 01:
Lawson Products (LAWS)
Roberta Port Washlow decreased her holdings to 803,177 shares (9.4%), by selling or giving away 74,693 from Nov. 28 through Jan. 25, at prices ranging from $15 to $17.06. In her filing, Washlow said she intends to dispose of her entire stake via sales or gifts, depending "on general economic, market and business conditions...."
Lawson Products, Inc. (â€śLawsonâ€ť, the â€śCompanyâ€ť, â€śweâ€ť, â€śourâ€ť, or â€śusâ€ť) was incorporated in Illinois in 1952, and reincorporated in Delaware in 1982. Lawson is a North American distributor of products and services to the industrial, commercial, institutional, and governmental maintenance, repair and operations (â€śMROâ€ť) marketplace. The Company also manufactures and distributes production and specialized component parts to the original equipment marketplace (â€śOEMâ€ť) including the aerospace, off-road equipment, military and oil and gas exploration industries. In 2010, the Company discontinued operations of two of its subsidiaries, Assembly Component Systems, Inc. (â€śACSâ€ť) and Rutland Tool & Supply Company (â€śRutlandâ€ť). Accordingly, references within this Annual Report consist of continuing operations unless otherwise noted.
Industry and Competition
The MRO industrial distribution industry consists of companies that buy and stock products in bulk and supply these products to customers on an as needed basis. The customer benefits from lower costs and convenience of ordering smaller quantities maintained by MRO suppliers. We estimate the MRO industrial distribution industry in North America to exceed $100 billion in revenues.
We encounter intense competition from several national distributors and manufacturers and a large number of regional and local distributors. Some competitors have greater financial and personnel resources, handle more extensive lines of merchandise, operate larger facilities and price some merchandise more competitively than we do.
Sales through our MRO segment represented 96% of our total net sales for the year ended December 31, 2010. We compete for business in our industry by delivering on the value proposition we call â€śSmarter Maintenanceâ€ť under which we offer a personal approach to vendor managed inventory, provide technical expertise and supply quality products to our customers.
The majority of our sales are generated through a network of approximately 1,100 independent sales agents. Independent sales agents are compensated on a variable commission only basis and are responsible for repayment of commissions to the Company on any uncollectible accounts. In addition to offering high quality products to our customers, as part of our â€śSmarter Maintenanceâ€ť proposition, these sales agents also offer technical expertise and on-site problem resolution. Sales agents receive education in the best uses of our products, enabling them to provide customized solutions that address our customersâ€™ needs. This includes on-site visits to help manage customer inventories, introducing cost saving ideas and improving our customersâ€™ profitability. Regular inventory analysis and replenishment is conducted to prevent unnecessary purchases and unplanned downtime. Additionally, we provide customized storage systems for improved organization and a more efficient workflow. Product demonstrations that can improve our customersâ€™ productivity are regularly provided by our agents to our customers.
Customers place orders primarily through our agents; however, they can also order directly through the on-line catalog on our web site or through our customer service team via fax or phone. We sell products in all 50 states, the District of Columbia, Canada and Puerto Rico, and export products that support U.S. military efforts in Europe. An important factor in attracting and retaining customers is our ability to process orders promptly. We normally ship to our customers within one to two days of order placement. Products are stocked in and processed from strategically placed distribution centers in Addison, Illinois; Vernon Hills, Illinois; Reno, Nevada; Fairfield, New Jersey; Suwanee, Georgia; and Mississauga, Ontario.
Our engineering department, as part of our â€śSmarter Maintenanceâ€ť proposition, provides technical support for our extensive product line and on-site problem solutions. Our engineering department also develops and presents product safety and technical training seminars tailored to meet our customersâ€™ needs. Material Safety Data Sheets are maintained electronically and are available to our customers seven days a week, 24 hours a day. Our labs also provide the environment to perform quality checks on our products and to simulate customer situations that allow our engineers to provide remote technical problem solving. Product certifications and material test reports are available by contacting the engineering department at engineering@lawsonproduct s.com.
One of our subsidiaries, Automatic Screw Machine Products Company (â€śASMPâ€ť), manufactures and distributes components, fasteners, and fittings for use by OEM customers. Based in Decatur, Alabama, ASMP distributes components that are specific to the customersâ€™ production needs. ASMP seeks to obtain long-term commitments to enable proper support of the customersâ€™ supply chain. ASMP products are developed for high-strength, critical applications and ASMP also sources externally produced items if applications call for such goods. ASMP accounted for approximately 4% of the Companyâ€™s net sales for 2010.
Our MRO product offerings are listed in our on-line catalog on our web site and in approximately 30,000 catalogs that were distributed to our customers in 2010. All of our MRO products are manufactured by others, purchased in bulk and repackaged in smaller quantities for sale to our customers. We order product from our suppliers and usually transport the product to our national packaging center for repackaging, labeling or cross docking before shipping to our distribution centers. Customer orders are then fulfilled from our distribution centers.
During 2010, we sold products to over 100,000 customers. No customer accounted for more than two percent of net sales. In 2010, 91% of our net sales were generated in the United States and 9% from Canada. Our customers include a wide range of purchasers of industrial supply products from small repair shops to large national and governmental accounts. Our customers operate in a variety of industries including automotive repair, transportation, governmental including the military, manufacturing, food processing, distribution, construction, oil and gas, mining, wholesale, service and others.
We are committed to developing and executing an effective long-term strategy to enhance customer satisfaction, improve profitability and grow aggressively. As part of developing our strategy we undertook an extensive customer research project to help better understand our customersâ€™ value drivers. As a result of this project we are working to strengthen our relationships with our customers by responding to their needs and offering additional methods of doing business including an effective website. We plan to focus our resources and construct a foundation for growth around: (1) building the team, (2) strengthening the core MRO business, (3) focusing the portfolio of businesses and (4) growing aggressively.
Build the Team
Over the last few years, we have established a new organizational culture that emphasizes continuous improvement, producing positive results and, most of all, one that is focused on our customers. In order to develop this new environment, we needed to attract and retain team members with the right blend of company, industry and leadership experience to drive our business forward.
We have successfully recruited a number of key executives to develop and execute our strategy. New additions to the senior leadership team over the last three years include our Chief Operating Officer, Chief Financial Officer, Chief Information Officer and Senior Vice President, Human Resources. In addition to the senior leadership team, over 50% of our current vice presidents and directors have joined the Company within the last three years. Going forward, we are committed to continuing to develop our already strong team and culture.
Strengthen the Core MRO Business
We have identified three major initiatives that we believe will significantly strengthen our core business and enhance our ability to serve our MRO customers, drive more efficient operations and improve our business. The initiatives are to restructure our sales organization and go-to-market strategy, optimize our distribution network and replace our legacy information systems with a best-in-class Enterprise Resource Planning (â€śERPâ€ť) system.
Our sales are primarily driven by a force of approximately 1,100 independent sales agents who have an average tenure with us of 12 years. These independent agents have the primary responsibility for delivering on the technical expertise that our customers value. They are supported by an engineering team that provides a higher level of either remote or on-site technical expertise. We continue to improve our sales education programs which are offered to sales agents to integrate our agentsâ€™ product knowledge into the selling process to ensure that we continually provide a high level of technical knowledge to our customers.
Our sales agents are paid a commission on sales that is based on profitability to align the objectives of the sales force with our success. This system of compensation also ensures that our selling costs are more directly aligned with sales. However, we believe that there are certain measures we can take to improve the current sales agent model while retaining its advantages. Specifically, our transformation initiative will clarify the roles and responsibilities of our sales management team, develop and standardize certain sales tools offered to our agents, identify and prioritize high-potential customers, develop new sales channels, improve our product offering, create new sales roles, and modify our pricing policies and commission structures to maximize sales and profitability. We plan to continue to review and evaluate our sales model to maximize sales and enhance customer satisfaction.
Our sales agents are supported by district sales managers who are responsible for geographically defined territories. Historically, these district sales managers performed a dual role. They spent a portion of their time managing the district by coaching and supporting the agents within their territory and also spent time acting as sales agents selling products. During 2010, we completed the transition of independent district sales managers into full-time employees who are now concentrating their efforts on driving sales within their territory and working with the agents to develop new and existing customers. By segregating the managerial and selling functions, we believe that the district sales managers and independent sales agents will be able to better focus on their roles and increase sales productivity.
With this transition complete, we believe we can strengthen the quality of customer relationships and improve the consistency of sales execution throughout our organization. We are developing talent management programs to attract, motivate and retain new sales agents. We are reviewing our current territory design and account allocation policies to optimize territory management while maintaining or increasing our customer coverage.
Historically, we have been very effective at selling to and servicing small and medium sized accounts. As we look at our growth opportunities, we believe there are significant opportunities with larger, multi-location national accounts. We are taking deliberate steps to gain a share of larger national accounts. We have assembled a team of employee sales professionals to aggressively identify and prioritize high-potential customer and market segments in order to expand our revenue base. During 2010, strategic accounts sales volume grew by 13% over 2009 and represents approximately 9% of net sales.
We also have historically serviced the military branches of the government. We have taken action with a goal to accelerate our growth in this area by adding new resources and a new product offering for the military segment. During 2010, sales from our government segment (including military) grew by 33% and generated approximately 7% of our net sales.
Finally, we are taking steps to improve our pricing structure by migrating from a cost based method to a market based structure that better reflects the value of our products and services. This includes strategically pricing products and product groups based on segmentation of both product and customer groups to allow for more consistency amongst our sales team and agents.
Our MRO distribution process entails transporting product from our suppliers to our national packaging center for possible repackaging, labeling or cross-docking before shipping to our distribution centers where orders are picked, packed and shipped to our customers. Many factors affect the efficiency of this process including the physical characteristics of the distribution centers, routing logistics, the number of times the product needs to be handled, transportation costs and the flexibility to meet unique requirements requested by our customers. The goal of our network optimization initiative is to define the optimal location, size, inventory, material handling needs, and number of distribution centers to improve customer service and speed of delivery, lower operating expenses and improve working capital investment. We analyzed our distribution network as it was in 2008 and developed a detailed roadmap intended to transition from that state to a future optimal state. The optimal future state may include relocation or consolidation of our existing network locations to better serve our customers.
In 2009, we closed our Charlotte, North Carolina and Dallas, Texas MRO distribution centers. We have also identified and begun to make certain space optimization changes at our distribution centers and to implement certain process improvement projects and freight strategies which should further improve our ability to serve our customers, manage our inventory levels and lower operating costs.
Implementation of ERP System
During 2009, we conducted a thorough review of all of our MRO functional departments to assess the effectiveness of our current business processes and supporting information systems. After extensive study and analysis, we determined that the many benefits achievable by investing in a state-of-the-art ERP system, that would integrate our data and processes into one single system based upon industry best business practices, far exceeded the costs and efforts involved to implement this change.
We engaged a consulting firm to work with us to evaluate which ERP system would provide us with the maximum long-term benefit. This analysis included multiple factors including how the system would improve the ease of conducting business from a customerâ€™s perspective, how modules aligned with our current organizational structure, transactional transparency and visibility, flexibility to adapt to future business opportunities, user friendliness and stability of the underlying data structure. In February 2010 we selected SAP as our ERP solution.
We have committed a full-time cross-fuctional team of employees to work with our ERP partner and our systems integrator. This team is responsible for ensuring that the system configuration is consistent with our business requirements and best business practices, coordinating data migration, addressing change management issues, testing controls, resolving implementation issues and developing a user training program. We anticipate the one-time cost of implementation, both capital and expense, will range from $20 million to $25 million, consisting primarily of software and hardware costs, implementation costs, internal labor costs and data migration.
The project consists of five phases: Project Preparation, Blueprint, Realization (e.g. configuration), Final Preparation and Go Live & Support. During 2010, we completed the Project Preparation and Blueprint phases and we have also completed the Realization phase for the first wave of implementation. We anticipate completing the ERP project by the end of 2011. Since the commencement of the project, we have expended $10.3 million of our one-time implementation costs of which $6.5 million represents capital.
We expect that the new ERP system will provide us reliable, transparent, real-time data access providing us with the opportunity to make better and faster business decisions. We anticipate that the improved data access will lead to more accurate forecasting, shortening order fullfillment time and optimizing our inventory levels. The new ERP system is expected to fully integrate our revenue cycle, from initial order through cash receipt and order tracking, from product sourcing through payment. We expect the integration among various functional areas will lead to improved communication, productivity and efficiency. These improvements should enhance our ability to respond to our customersâ€™ needs and lead to increased customer satisfaction. Other advantages we expect to realize by centralizating our current systems into an ERP system are to eliminate the problem of synchronizing changes between multiple systems, improve coordination of business processes that cross functional boundaries and provide a top-down view of the enterprise.
Focus the Portfolio of Businesses
We have been actively evaluating various strategic options regarding our non-core operations. Over the past few years, these operations were hit particularly hard by the economic downturn, needed capital investment, had limited opportunity to leverage growth, provided minimal synergistic value and operated at lower margins than the core MRO business. As a result, during 2010, the Company sold substantially all of the assets of two of its business units, ACS and Rutland, in two separate transactions for an aggregate sales price of $30.0 million and the assumption of certain liabilities. We plan to use these proceeds to invest in internal growth and strategic acquisitions in our core MRO business. We plan to continue to evaluate alternatives regarding our remaining OEM operation.
By developing a strong team and strengthening the core MRO business, we believe we are positioning ourselves to grow aggressively in the future. Through these initiatives, we have established the foundation necessary to aggressively grow sales. We believe we have an opportunity to capture market share by focusing on certain sales channels and customer segments. In 2011, we plan to develop a channel strategy and design a new website for launch in late 2011 or 2012, we estimate this new website will improve our sales agent productivity and facilitate meeting our customersâ€™ unplanned purchase demand. The new website will allow us to expand our sales to new customers, increase sales team productivity by shifting certain types of sales through the website, improve retention of existing customers and capture a larger portion of our existing customersâ€™ â€śunplannedâ€ť spend.
We are also working aggressively to improve our sales agent productivity. In 2010, the average annual sales generated per agent was approximately $240,000. Our goal is to continue to increase sales per agent by identifying new sales channels, increasing sales to larger strategic accounts, developing sales tools to improve the productivity of the day-to-day activities of the sales team, identifying new product categories and focusing on customer retention.
Finally, given our current capital structure, $40.6 million in cash, access to funding under our credit facility and no outstanding debt, we are well positioned for growth.
As of December 31, 2010, our workforce included approximately 930 employees, comprised of approximately 290 in sales and marketing, 500 in operations and distribution and 140 management and administrative staff. Approximately 17% of our workforce is covered by four collective bargaining agreements. We believe that our relations with our employees and their collective bargaining organizations are good.
We file or furnish annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and file or furnish amendments to those reports pursuant to Section 13(a) or 15(d) of the Exchange Act and Section 16 reports with the Securities and Exchange Commission (â€śSECâ€ť). The public can obtain copies of these materials by visiting the SECâ€™s Public Reference Room at 100 F Street, NE, Washington DC 20549 or by accessing the SECâ€™s website at http://www.sec.gov. The public may obtain information on the operation of the SECâ€™s Public Reference Room by calling (800) SEC-0330. In addition, as soon as reasonably practicable after such materials are filed with or furnished to the Commission, we make copies available to the public free of charge through our website at www.lawsonproducts.com. Information on our website is not incorporated by reference into this report.
Ronald B. Port, M.D. has served as Chairman of the Board of Directors since April 2007. Mr. Port is a Retired Physician. Mr. Port has been a director of the Company since 1984 and is the son of the founder. Mr. Portâ€™s long term successful stewardship of the Company and the unique perspective and knowledge gained from his relationship with the Companyâ€™s founder, qualify him to serve as a Director.
Robert G. Rettig is a Consultant and a Retired Executive Vice President of Illinois Tool Works, Inc., a global industrial company. The experience and particular knowledge acquired from managing a multinational industrial company, qualify Mr. Rettig to serve as a Director.
Wilma J. Smelcer served as a member of the Board of Governors of the Chicago Stock Exchange from 2001 until April 2004. From 2001 through 2006, Ms. Smelcer was a trustee of Goldman Sachs Mutual Fund Complex (a registered investment company). Ms. Smelcer served as Chairman of Bank of America, Illinois from 1998 to 2001. These professional experiences along with Ms. Smelcerâ€™s extensive financial knowledge, qualify her to serve as a Director.
MANAGEMENT DISCUSSION FROM LATEST 10K
In 2010, the economy improved modestly from the global recession that affected previous periods, particularly in the latter half of the year. Sales from continuing operations increased by 5.0% during 2010 compared to 2009 versus a decline of 19.9% in 2009 from 2008. During this period, many of our customers reduced their inventories, suspended purchases of industrial supplies and downgraded the quality of product purchased due to the overall deterioration of the economy. Additionally, the contraction in the credit market made it difficult for many of our customers to finance purchases or expand their businesses.
We continue to review our strategic alternatives with a focus on our ability to meet customer demands in the current competitive environment. As a result, we developed a comprehensive plan focused on driving sales and improving our operating margins. During 2009 and 2010, we began transforming our current platform and infrastructure by executing on the following three initiatives to improve our core MRO business: (1) restructuring our sales organization, (2) optimizing our distribution network and (3) replacing our legacy information systems with a best-in-class ERP system. We dedicated a number of internal resources and made investments in these initiatives as we believe they will position us to better serve our existing customers and grow the organization in the future. We believe this is the right long-term strategy and, in 2010, we began to realize early benefits from these initiatives, including sales agent productivity improvements and reduced distribution expenses.
We are taking action to improve our current sales agent model while attempting to retain its advantages. During 2010, we completed the conversion of district sales managers into full-time employees who are now able to concentrate their efforts on managing their respective territories and increasing sales productivity. We also continued to streamline our cost structure including efficiencies in our distribution center network while maintaining high service levels to our customers. During 2009, we closed two distribution centers to better align our supply chain with our customer base and eliminate redundancies within our distribution network allowing us to realize cost savings throughout 2010. Along with these savings, the Company also implemented comprehensive cost control measures throughout the organization. Additionally, we have performed a comprehensive review of our existing information systems and have selected a new ERP solution that is planned for implementation in a phased approach throughout 2011. These initiatives, which are described in Item 1 â€” Business , will require additional effort and investment over the next few years, but should lead to a much more efficient, responsive and profitable organization in the future. These efforts, contributed to our improved operating income of $16.9 million in 2010 from $1.4 million in 2009.
In 2010, we sold substantially all of the assets of ACS and Rutland in two separate transactions for an aggregate sales price of $30.0 million plus the assumption of certain liabilities. These proceeds should allow us to re-invest in our core MRO business to drive internal growth and strategic acquisitions. We continue to evaluate alternatives regarding our remaining OEM operation, Automatic Screw Machine Products.
In addition to the cash received from the sale of the ACS and Rutland assets, we generated $21.3 million of cash from operations prior to making our last payment obligation under the DPA settlement agreement of $10.0 million. We ended the year with $40.6 million of cash and no outstanding borrowings. We shared these strong cash flows with our stockholders by increasing our quarterly dividend in 2010 to $0.12 per share.
Selling, General and Administrative Expenses
SG&A expenses were $180.0 million or 56.8% of net sales and $177.4 million or 58.8% of net sales in 2010 and 2009, respectively. Commission expenses decreased to $67.9 million in 2010 from $70.4 million in 2009 and decreased as a percent of MRO sales to 22.3% in 2010 from 24.3% in 2009. The decrease, as a percent of sales, reflects the changes of the district sales managers transitioning to full-time employees during 2010 and an increase in sales to customers with a lower commission percentage.
Excluding commission expenses, the remaining Selling, general and administrative expenses increased $4.9 million or 4.8%. The increase was primarily driven by the transition of independent district sales managers to full-time employees, ERP implementation expenses of $3.8 million since the commencement of the project, and higher incentive compensation expense as a result of improved performance and an increase in our stock price. These increases were partially offset by lower legal fees, a full year of savings from the closure of the Dallas, Texas and Charlotte, North Carolina distribution centers in 2009 and a continued effort to streamline our overall cost structure.
Severance expenses were $3.6 million in 2010 compared to $6.2 million in 2009. A restructuring of some of our managerial responsibilities focused on improved operating efficiencies in 2010 resulted in the elimination of certain positions within both the sales and corporate teams. In 2009 we reduced the size of our workforce across the organization in response to the economic recession.
Loss (Gain) on Sale of Assets
In 2010, we sold our previously discontinued Dallas, Texas distribution center for $2.0 million, resulting in a gain of $1.7 million.
Other Operating (Income) Expenses
In 2010, we recorded a $4.1 million benefit related to proceeds received from a settlement agreement and legal remedies related to the actions of several former sales agents and the Share Corporation (â€śShareâ€ť) alleging, among other things, breach of contract and interference with our customer relationships. In exchange for the proceeds, we agreed to settle all related claims with Share and the former sales agents.
In 2009, we recorded an impairment charge of $0.3 million to reduce the carrying value of certain property, plant and equipment in our OEM segment to fair value. We also incurred $0.2 million of costs related to the DPA.
Interest expense decreased $0.6 million to $0.4 million in 2010 from $1.0 million in 2009 as strong cash flows from operations allowed us to reduce the average balance outstanding on our revolving line of credit during the year.
Other income was $0.2 million in 2010 compared to $1.0 million in 2009. Other income in 2009 included a non-recurring $0.6 million gain on the sale of an investment.
Income Tax Expense
The effective tax rates for continuing operations for 2010 and 2009 were 42.6% and (36.1)%, respectively. The 2010 effective tax rate reflects the effect of capital losses not expected to be utilized due to tax effects of the sales of ACS and Rutland and other deferred expenses. The 2009 effective tax rate reflects the effect of the agreement reached with the Internal Revenue Service Appeals Office for the years 2000 through 2003, as well as a decrease in the valuation allowance recorded for the capital loss carryforward.
Selling, General and Administrative Expenses
SG&A expenses were $177.4 million or 58.8% of net sales and $211.1 million or 56.1% of net sales in 2009 and 2008, respectively. The $33.7 million reduction in 2009 includes a $21.0 million reduction in sales agent compensation and $12.7 million due to cost containment initiatives. Agent commissions as a percent of MRO sales decreased slightly to 24.3% for 2009 compared to 25.3% for 2008 due to a mix in the customer base. Other cost containment initiatives included a reduction in workforce, a temporary suspension in annual compensation increases and curtailment or delayed spending on certain services and supplies. We also recognized savings through the closure of two of our distribution centers. SG&A as a percent of net sales increased 2.7 percentage points in 2009 as fixed costs were not reduced in proportion to the accelerated decrease in net sales.
Severance Expense s
During 2009, we implemented certain cost reduction measures in response to the deteriorating economic conditions. These measures included a reduction in force across the organization including the closure of our Charlotte, North Carolina and Dallas, Texas distribution centers. The upfront cost we incurred in 2009 to implement these measures was $6.2 million, primarily related to the work force reduction.
In 2008, we recorded $5.2 million of severance and other charges related to severance costs associated with the departure of certain executives and employees and operational efficiency improvement initiatives.
Other Operating (Income) Expenses
Other operating expenses for 2009 include settlement expenses of $0.2 million related to legal and other fees from the DPA and an impairment charge of $0.3 million to reduce the carrying value of certain property, plant and equipment in our OEM segment to fair value.
Other operating expenses for 2008 included unclaimed property liabilities of $4.0 million and settlement costs of $31.7 million. Settlement costs consisted of $30.0 million related to the DPA with the U.S. Attorneyâ€™s Office and $1.7 million of expense in connection with the investigation.
Interest expense increased $0.2 million to $1.0 million in 2009 from $0.8 million in 2008. This increase in interest expense was due to an increase in average borrowings in 2009.
Other income was $1.0 million in 2009 compared to $0.6 million in 2008. Other income in 2009 included a non-recurring $0.6 million gain on the sale of an investment.
Income Tax Expense
We recorded a $0.5 million income tax benefit based on pre-tax income of $1.4 million in 2009 compared to a $8.3 million income tax expense based on a pre-tax loss of $15.4 million in 2008. The 2009 income tax benefit reflects the effect of the agreement reached with the Internal Revenue Service Appeals Office for the years 2000 through 2003, as well as a decrease in the valuation allowance recorded for the capital loss carryforward, due to our ability to realize a portion of the capital loss against future capital gains prior to expiration in 2012. The 2008 income tax expense reflects the effect of $29.2 million related to the penalty under the DPA which was non-deductible and a $6.1 million non-deductible expense related to a decline in the cash value of life insurance.
LIQUIDITY AND CAPITAL RESOURCES
Cash provided by operating activities for 2010, 2009 and 2008 was $11.3 million, $10.6 million and $7.5 million, respectively. Cash from operations was net of $10.0 million settlement payments in 2010, 2009 and 2008, respectively. In 2010, cash was primarily generated from operating income and proceeds received from the sale of ACS and Rutland. In 2009 and 2008, cash was primarily generated through the streamlining of working capital by reducing excess inventories and increased collection of accounts receivable. Working capital increased to $79.4 million on December 31, 2010 from $75.1 million on December 31, 2009.
Cash used to purchase property, plant and equipment was $10.0 million in 2010 compared to $2.7 million in 2009 and $2.9 million in 2008. Purchases during 2010 included $6.5 million for the new ERP system. We received $2.0 million of proceeds from the sale of our Dallas, Texas property in 2010 and $2.2 million of proceeds from the sale of our Charlotte, North Carolina property in 2009. Our financing activities included dividends paid to stockholders of our common stock of $2.2 million, $2.7 million and $6.8 million in 2010, 2009 and 2008, respectively and net payments on our line of credit of $7.7 million and $3.3 million in 2009 and 2008, respectively.
We have a credit agreement with The PrivateBank and Trust Company (â€śCredit Agreementâ€ť). The Credit Agreement provides us with a total borrowing capacity of $55.0 million in the form of a revolving line of credit and letters of credit and expires on August 21, 2012. Additionally, we have a one-time option, subject to the agentâ€™s consent, to increase the maximum borrowing capacity by an additional $20.0 million, thus increasing the maximum borrowing capacity to $75.0 million. The applicable interest rate margins for borrowings are based on the Companyâ€™s debt to EBITDA ratio and range from LIBOR plus 2.25 to 3.00 or Prime minus .25 to zero percent. The Credit Agreement is secured by cash, accounts receivable and inventory. At December 31, 2010, we had no borrowings outstanding on our revolving line of credit and $1.3 million of outstanding letters of credit, leaving borrowing availability at $53.7 million.
CRITICAL ACCOUNTING POLICIES
We have disclosed our significant accounting policies in Note 2 to the Consolidated Financial Statements. The following provides supplemental information to these accounting policies as well as information on the accounts requiring more significant estimates.
Allowance for Doubtful Accounts â€” We evaluate the collectability of accounts receivable based on a combination of factors. In circumstances where we are aware of a specific customerâ€™s inability to meet its financial obligations (e.g., bankruptcy filings, substantial down-grading of credit ratings), a specific reserve for bad debts is recorded against amounts due to reduce the receivable to the amount we believe will be collected. For all other customers, we recognize reserves for bad debts based on our historical experience of bad debt write-offs as a percent of accounts receivable outstanding. If circumstances change (e.g., higher than expected defaults or an unexpected material adverse change in a major customerâ€™s ability to meet its financial obligations), the estimates of the recoverability of amounts due to us could be revised by a material amount. At December 31, 2010, our allowance reserve was 3.1% of our gross accounts receivables outstanding. A hypothetical change of one percent to our reserve allowance would have affected our annual doubtful accounts expense by approximately $0.3 million.
Inventory Reserves â€”Inventories consist principally of finished goods and are stated at the lower of cost (first-in-first-out method) or market. Most of our products are not exposed to the risk of obsolescence due to technology changes. However, some of our products do have a limited shelf life, and from time to time we add and remove items from our catalogs, brochures or website for marketing and other purposes. In addition, we carry varying levels of customer specific inventory.
To reduce our inventory to a lower of cost or market value, we record a reserve for slow-moving and obsolete inventory based on historical experience and monitoring current inventory activity. We use estimates to determine the necessity of recording these reserves based on periodic detailed analysis reviews using both qualitative and quantitative factors. As part of this analysis, we consider several factors including the inventoriesâ€™ length of time on hand, historical sales, product shelf life, product life cycle, product classification, and product obsolescence. In general, depending on product classification, we reserve inventory with low turnover at higher rates than inventory with high turnover. Our policy is to not re-value inventory to the original cost basis subsequent to establishing a new cost basis.
At December 31, 2010, our inventory reserve was $4.7 million, equal to approximately 9% of our total inventory. A hypothetical change of one percent to our reserve allowance would have affected our cost of goods sold by $0.5 million.
Income Taxes â€” Deferred tax assets or liabilities reflect temporary differences between amounts of assets and liabilities for financial and tax reporting. Such amounts are adjusted, as appropriate, to reflect changes in enacted tax rates expected to be in effect when the temporary differences reverse. A valuation allowance is established to offset any deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The determination of the amount of a valuation allowance to be provided on recorded deferred tax assets involves estimates regarding (1) the timing and amount of the reversal of taxable temporary differences, (2) expected future taxable income, (3) the impact of tax planning strategies and (4) the ability to carry back deferred tax assets to offset prior taxable income. In assessing the need for a valuation allowance, we consider all available positive and negative evidence, including past operating results, projections of future taxable income and the feasibility of ongoing tax planning strategies. The projections of future taxable income include a number of estimates and assumptions regarding our volume, pricing and costs. Additionally, valuation allowances related to deferred tax assets can be impacted by changes to tax laws. Significant judgment is required in determining income tax provisions as well as deferred tax asset and liability balances, including the estimation of valuation allowances and the evaluation of tax positions.
The Company recognizes the benefit of tax positions when a benefit is more likely than not (i.e., greater than 50% likely) to be sustained on its technical merits. Recognized tax benefits are measured at the largest amount that is more likely than not to be sustained, based on cumulative probability, in final settlement of the position. The Company recognizes interest and penalties related to unrecognized tax benefits as a component of income tax expense.
Goodwill Impairment â€” Goodwill, all of which is included in our MRO segment, is tested annually during the fourth quarter, or when events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit below its carrying value. Impairment of goodwill is evaluated using a two step process. First the fair value of the reporting unit is compared with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered impaired, and thus, the second step of the impairment test is unnecessary. If the carrying amount of the reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any.
We estimate the fair value of the MRO segment using a market approach, which relies on the market value of companies that are engaged in the same line of business. We also prepare a discounted cash flow (â€śDCFâ€ť) analysis based on our operating plan to determine a range of fair values. The DCF model relies on a number of assumptions that have a significant affect on the resulting fair value calculation and may change in future periods. Estimated future cash flows are affected both by future economic conditions outside the control of management and operating results directly related to managementâ€™s execution of our business strategy. Our DCF model is also affected by our estimate of a discount rate that is consistent with the weighted average cost of capital that we anticipate a potential market participant would use.
We then assess the reasonableness of our estimate of the fair value of the MRO segment. This is done by applying the same valuation methodology and estimates described above to the entire Company and reconciling the resulting estimated fair value of the consolidated Company to its market capitalization based on the trading range of the Companyâ€™s stock near the measurement date.
Currently, the calculated fair value of the MRO segment exceeds its carrying value by over $57 million using our most conservative estimate and, therefore, is not considered impaired. Changes in the assumptions used in our DCF calculation could have a material affect on the fair value estimate and could change our assessment of impairment. A hypothetical 10% decrease in the estimated future annual cash flows generated by the MRO segment would decrease its estimated fair value by approximately $16 million. A hypothetical 100 basis point increase in the discount rate would decrease its estimated fair value by approximately $14 million.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Gross profit decreased $7.4 million in the third quarter of 2011, to $42.5 million from $49.9 million in the prior year period. MRO gross profit as a percent of net MRO sales decreased to 58.4% in the third quarter of 2011, compared to 63.3% achieved in the third quarter of 2010. The decline was driven by three factors: (i) Increased vendor costs were not passed along to our customers as we held pricing constant to facilitate our ERP conversion; (ii) Outbound freight costs increased as we shipped more single line orders to support our customers during the conversion; and (iii) our strategic decision to pursue larger customers with lower margins, which should increase retention and allow for margin dollar expansion over time.
OEM gross profit increased $0.2 million and increased as a percent of OEM sales to 20.7% in the third quarter of 2011 from 16.3% in the third quarter of 2010, driven primarily by a shift in sales toward higher margin customers.
Selling, General and Administrative Expenses (â€śSG&Aâ€ť)
SG&A expenses increased 4.0% to $45.3 million in the third quarter of 2011 from $43.6 million in 2010. SG&A expenses consist of selling expenses (i.e. commissions paid to our independent agents and employee sales expenses and related expenses to support our sales efforts), costs within our distribution network, and general and administrative costs to manage the business.
Selling expenses decreased to $19.3 million in the third quarter of 2011 from $20.3 million in the third quarter of 2010, but increased as a percent of net sales to 25.7% in 2011 from 24.9% in 2010, primarily reflecting higher health insurance claims.
General and administrative (â€śG&Aâ€ť) expenses increased $2.7 million, primarily driven by expenses related to our ERP implementation of $2.3 million, investments in our comprehensive website re-development, higher health insurance claims and temporary labor costs, partially offset by decreased incentive and stock based compensation expenses.
Severance expense in the third quarter of 2011 was $0.3 million compared to $1.3 million in the third quarter of 2010. Severance expense in both 2011 and 2010 related to the elimination of certain positions associated with the realignment of various operating responsibilities.
During the third quarter of 2010, we recorded a $3.5 million benefit related to proceeds received from legal remedies related to the actions of several former sales agents and Share Corporation alleging, among other things, breach of contract and interference with customer relationships.
Income Tax (Benefit) Expense
An income tax benefit of $0.9 million was recorded based on a pre-tax loss of $3.1 million for the three months ended September 30, 2011, resulting in an effective tax benefit rate of 30.3%. For the three months ended September 30, 2010, income tax expense was $2.6 million based on pre-tax income of $8.4 million, resulting in an effective tax rate of 31.3%.
Income (Loss) from Continuing Operations
We reported a loss from continuing operations of $2.2 million or $0.25 per diluted share in the third quarter of 2011. Income from continuing operations for the third quarter of 2010 which included a favorable legal settlement of $3.5 million was $5.8 million or $0.68 per diluted share. Excluding the legal settlement and related tax impact, income from continuing operations was $0.39 per diluted share in for the third quarter of 2010.
Net sales for the first nine months of 2011 increased 2.3% to $242.1 million, from $236.8 million in the first nine months of 2010. Excluding the Canadian exchange rate impact, net sales increased 1.6% over the prior year period.
MRO net sales increased 2.1% in the first nine months of 2011, to $231.4 million from $226.7 million in the prior year period. MRO average daily sales increased to $1.211 million in the first nine months of 2011 compared to $1.187 million in the first nine months of 2010. National and government accounts represented approximately 17.1% of net sales for the first nine months of 2011 versus approximately 15.7% in the prior year period.
OEM net sales increased 6.4% in the first nine months of 2011, to $10.7 million from $10.1 million in the prior year period, driven by strength in our aerospace customer base and new customer growth.
Gross profit decreased $4.3 million in the first nine months of 2011, to $140.8 million from $145.1 million in the prior year period. MRO gross profit as a percent of net MRO sales decreased to 59.9% in the first nine months of 2011, compared to 63.3% achieved in the prior year period, primarily due to the shift toward acquiring new larger customers at lower margins, increased outbound freight costs and increased vendor costs while holding customer pricing constant to facilitate our ERP conversion.
OEM gross profit increased $0.6 million and increased as a percent of OEM sales to 19.7% in the first nine months of 2011 from 15.3% in the first nine months of 2010. The improvement as a percent of sales was primarily driven by higher margin new business growth.
Selling, General and Administrative Expenses (â€śSG&Aâ€ť)
SG&A expenses increased $4.9 million or 3.7% to $137.0 million in the first nine months of 2011 from $132.1 million in 2010. As a percent of net sales, SG&A increased by 0.9 percentage points to 56.7% in the first nine months of 2011 compared to 55.8% in the prior year period.
Selling expenses increased slightly to $60.9 million in the first nine months of 2011 from $60.8 million in the first nine months of 2010 and decreased as a percent of net sales to 25.2% in 2011 from 25.7% in 2010. The decrease, as a percent of sales, reflects costs incurred in 2010 related to the transition of the district sales managers to full-time employees and the planned shift toward higher volume lower margin national customers that pay a lower commission.
G&A expenses increased $4.8 million or 6.7%, primarily driven by additional ERP implementation expenses in 2011 over 2010 of $4.4 million, partially offset by lower incentive compensation. Excluding ERP, G&A expenses increased $0.4 million or 0.6%.
Severance expense was $1.5 million in the first nine months of 2011 compared to $3.0 million in the first nine months of 2010. Severance expense in both 2011 and 2010 related to the elimination of certain positions associated with the realignment of various operating responsibilities.
In the first nine months of 2010, we recorded a $4.1 million benefit related to proceeds received from legal remedies related to the actions of several former sales agents and Share Corporation alleging, among other things, breach of contract and interference with customer relationships.
Gain on Sale of Assets
During the first nine months of 2010 we recorded a gain on sale of assets of $1.7 million related to the sale of our Dallas, Texas distribution center.
Other Expense, net
Other expense, net of $0.5 million in the first nine months of 2011 relates primarily to interest assessed on unclaimed property settlements. Other expense, net of $0.4 million in the first nine months of 2010 relates primarily to interest charged on our credit facility.
Income Tax Expense
Income tax expense of $0.8 million was recorded based on pre-tax income of $1.7 million for the nine months ended September 30, 2011, resulting in an effective tax rate of 43.5%. For the nine months ended September 30, 2010, income tax expense was $5.9 million based on pre-tax income of $15.4 million resulting in an effective tax rate of 38.3%. The 2011 tax rate increased from 2010 primarily due to the effect of permanent tax differences on lower projected pre-tax income in 2011.
Income from Continuing Operations
We reported income from continuing operations of $1.0 million or $0.11 per diluted share in the first nine months of 2011. Income from continuing operations for the prior year period, which included the gain from the sale of the Dallas distribution center and a favorable legal settlement, was $9.5 million or $1.11 per diluted share. Excluding these items and related tax impact, income from continuing operations was $0.70 per diluted share in 2010.
Liquidity and Capital Resources
Cash and cash equivalents were $19.3 million on September 30, 2011 compared to $40.6 million on December 31, 2010. Net cash used in operating activities was $8.4 million for the first nine months of 2011 compared to $0.5 million for the first nine months of 2010 which included a $10.0 million settlement payment. The increase in cash used in operations was driven by lower income and increases in working capital during the first nine months of the year. Accounts receivable increased due to seasonal fluctuations and temporarily easing our collection efforts during the ERP conversion. Additionally, inventory declined due to lower product purchases during the quarter along with a sell through of pre-ERP inventory.
Capital expenditures were $8.9 million for the first nine months of 2011 compared to $5.2 million for the first nine months of 2010. Capital expenditures related to the ERP implementation were $6.5 million for the first nine months of 2011 compared to $4.2 million in 2010. To date, the Company has invested, including both capital and expense, $23.4 million related to the ERP implementation. We anticipate that total capital expenditures for 2011 will be approximately $12.0 million.
Cash flows from investing activities in the first nine months of 2010 benefited from the receipt of $16.0 million from the sale of ACS and the receipt of $2.0 million from the sale of our Dallas, Texas distribution center. Net cash used in financing activities included dividend payments of $3.1 million and $1.5 million for the first nine months of 2011 and 2010, respectively.
During the third quarter of 2011, we entered into an Amendment to the Credit Agreement (â€śAmended Credit Agreementâ€ť). The Amended Credit Agreement extends the term of the $55.0 million credit facility, which includes an additional $20.0 million accordion feature, to October 1, 2016. The Amended Credit Agreement decreases the interest rate spreads and the unused line fee, increases the annual allowable dividends from $7.0 million to $10.0 million, increases the allowance for acquisitions and reduces the minimum working capital to total debt ratio from 2.00 to 1.75