Description
Filed with the SEC from July 19 to July 25:
STR Holdings (STRI)
Discovery Equity Partners said in a filing that it believes the trading prices of [STR] do not adequately reflect the potential value of STR's underlying business. Discovery also said it may hold additional discussions with management.
BUSINESS OVERVIEW
Overview
STR Holdings, Inc. and its subsidiaries ("we", "us", "our" or the "Company") commenced operations in 1944 as a plastics and industrial materials research and development company. Based upon our expertise in polymer science, we evolved into one of the leading providers of encapsulants to the solar industry. Encapsulant is a critical component used to protect and hold solar modules together.
We were the first to develop ethylene-vinyl-acetate ("EVA") based encapsulants for use in commercial solar module manufacturing. Our initial development research was conducted while under contract to the predecessor of the U.S. Department of Energy in the 1970s. Since that time we have greatly expanded our solar encapsulant business, further investing in research and development and global production capacity. Currently, we manufacture encapsulants for some of the largest solar module manufacturers in the world.
The Company also launched a quality assurance business ("QA") during the 1970s, which provided product development, inspection, testing and audit services that enabled retailers and manufacturers to determine whether products met applicable safety, regulatory, quality, performance and social standards. In September 2011, we sold our QA business to Underwriters Laboratories, Inc. ("UL") for $275.0 million in cash, plus assumed cash. We divested QA to allow us to focus exclusively on our solar encapsulant business and to seek further product offerings related to the solar industry, as well as other growth markets related to our polymer manufacturing capabilities, and to retire our long-term debt. The historical results of operations of our former QA business have been recast and presented as discontinued operations in this Annual Report on Form 10-K. Further information about our divesture of QA is included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Note 3, Discontinued Operations, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.
Solar Energy Market Overview
Solar energy has emerged as one of the most rapidly growing sources of renewable energy. A number of different technologies have been developed to harness solar energy. The most prevalent technology is the use of interconnected photovoltaic ("PV") cells to generate electricity directly from sunlight. Solar energy has many advantages over other existing renewable sources and traditional non-renewable sources relative to environmental impact, delivery risk, distributed nature of generation and matching of peak generation with demand.
PV systems have been used to produce electricity for several decades. However, technological advances and production efficiencies combined with the rising costs of conventional/carbon-based electricity and the availability of government subsidies and incentives, have led to solar becoming one of the fastest growing renewable energy technologies.
Bloomberg New Energy Finance, a business analysis firm, predicts in its 2012 PV Market Outlook dated February 6, 2012 that total global demand for PV module installations will be between 24 gigawatts ("GW") and 31 GW in 2012 and between 37 GW and 42 GW in 2013. They also estimate that global demand for modules was between 27 GW and 29 GW in 2011.
Among the key demand drivers for PV are government incentive programs which make solar energy more price competitive with other energy sources. In recent years, the largest growth in the demand for PV has been in the European Union, driven by its goal of generating 20% of its electricity from renewable sources by 2020. However, its share of total global demand is expected to decline to about a third by 2013 as many European Union countries, such as Germany and Italy, continue to evaluate changes to their subsidy programs in relation to financing constraints, overall fiscal policy, and saturation due to cumulative installed capacity. Uncertainty may lead to a reduction in overall solar demand, which when combined with module overproduction may lead to excess inventory. Although these conditions have tempered growth in 2011, they have driven a reduction in selling prices throughout the supply chain and are expected to allow future growth in new end markets as grid-parity is achieved and a price elastic model emerges. In particular, Bloomberg New Energy Finance estimates there will be growth in installation of PV modules in the United States, China, India, South America, Africa and the Middle East.
Despite our expectations for favorable conditions for the adoption of solar electricity generation, solar energy continues to represent only a very small fraction of the world's electricity supply.
Solar Energy Systems
Solar electricity is primarily generated by PV systems that are comprised of solar modules, mounting structures and electrical components. PV systems are either grid-connected or off-grid. Grid-connected systems are tied to the transmission and distribution grid and feed solar electricity into the end-user's electrical system and/or the grid. Such systems are commonly mounted on the rooftops of buildings, integrated into building facades or installed on the ground using support structures and range in size from kilowatts to multiple megawatts. Off-grid PV systems are typically much smaller and are frequently used in remote areas where they may be the only source of electricity for the end-user.
Solar Modules
PV cells are semiconductor devices that convert sunlight directly to electricity by a process known as the photovoltaic effect. A solar module is an assembly of PV cells that are electrically interconnected, laminated and framed in a durable and weatherproof package.
There are two primary commercialized categories of solar cells: crystalline silicon and thin-film. PV devices can be manufactured using different semiconductor materials, including mono- and poly-crystalline silicon for silicon cells, and amorphous silicon, gallium arsenide, copper indium gallium selenide and cadmium telluride for thin-film cells. Crystalline silicon cells typically operate at higher conversion efficiency. Historically, crystalline silicon cells have been higher in cost due to a more complex production process and the need for more expensive raw materials. In recent years, the price of polysilicon has declined, eroding the cost advantage of thin-film cells.
Encapsulants
Regardless of the technology used to create solar energy from a PV system, the core component of the solar cell is the semiconductor circuit. To protect and preserve that circuit, solar module manufacturers typically use an encapsulant. Encapsulants are critical to the proper functioning of solar modules, as they protect cells from the elements, bond the multiple layers of a module together and provide electrical isolation. Encapsulants must incorporate high optical transparency, stability at high temperatures and high levels of ultraviolet radiation, good adhesion to different module materials, adequate mechanical compliance to accommodate stresses induced by differences in thermal expansion and contraction between glass and cells, and good dielectric properties (electrical isolation). Even slight deterioration of any of these properties over time could significantly impair the electrical output of the solar module, which is of critical importance in the solar industry where solar module manufacturers typically provide 20 to 25-year warranties for their products.
Over the years, various encapsulant materials have been used in solar modules, including EVA, polyvinyl butyral ("PVB") and poly dimethyl siloxane or silicone. We currently use EVA to make all of our encapsulant products. EVA is modified with additives to increase stability and make the encapsulant suitable for long-term outdoor applications, such as solar modules.
We typically sell our encapsulants in square meters. However, because the solar industry's standard measurement for production volume and capacity is in watts, megawatts ("MW") or GW, we convert our capacity and production volume from square meters to approximate MW depending on the applicable conversion efficiencies that are specific to our customers. The conversion rate ranges from 10,100 to 15,500 square meters of encapsulant per MW. This rate is based on our calculations using publicly available information, our industry experience and assumptions that our management believe to be appropriate and reasonable. Certain production capacity and market metrics included in this Annual Report on Form 10-K are based on these calculations. Our calculations may not be accurate, and we may change the methodology of our calculations in the future as new information becomes available. In that case, period to period comparisons of such metrics may not be meaningful.
Financial Information About Our Segment and Geographic Areas
Financial information about our segment and geographic areas are included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and Note 16, Reportable Segment and Geographical Information, of the Notes to Consolidated Financial Statements, included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.
Our Business
We are one of the leading global providers of encapsulants to the solar module industry. Encapsulant is a critical component used in solar modules. We were the first to develop the original EVA encapsulants used in commercial solar module manufacturing in the 1970s in conjunction with the Jet Propulsion Laboratory of the California Institute of Technology under a NASA contract for the U.S. Energy Research and Development Administration, which later became known as the U.S. Department of Energy. We have no ongoing relationships with any of these agencies. We have sold our encapsulants commercially since the late 1970s. We have continually improved our encapsulants and have developed many significant innovations since we first commercialized our encapsulants, including encapsulants that maintain their dimensional stability and ultra-fast curing formulations. Our encapsulants are used in both of the prevailing solar panel technologies, crystalline silicon and thin-film, and are valued by certain of our customers because they maintain their size and shape throughout the solar module manufacturing process, have fast curing times and demonstrated long-term stability. These attributes are critical to some solar module manufacturers, which typically provide 20 to 25-year warranties of the performance of their solar modules and continually seek to maximize manufacturing yield and optimize efficiency. Despite the critical nature of encapsulant to solar cell applications, the encapsulant represents a small percentage of the total manufacturing cost of a solar module.
Our PhotoCap® products consist primarily of EVA, which is modified with additives and put through our proprietary manufacturing process to increase product stability and make the encapsulant suitable for use in extreme, long-term outdoor applications. The inclusion of specific additives results in a limited shelf life before our encapsulants must be integrated into a solar module, making long-term stocking impractical. Our encapsulant is generally made-to-order to customer specifications for use in their solar module manufacturing process.
Our Strategy
Our mission is to be the leading global supplier of encapsulation products through continued innovation and operational excellence. Our strategies to meet this objective are:
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Further Reduce Costs. We continuously seek to improve our competitive position by reducing our manufacturing costs. Due to the excess capacity that currently exists in the solar panel industry and continued price pressure experienced by the entire supply chain, cost reduction has become our most important short-term goal. In 2011, we created the position of Chief Operating Officer to, among other things, focus on cost discipline through process improvement and supply chain optimization. We have recently executed on a number of cost reduction initatives involving raw materials, labor and overhead.
Raw Materials: During 2010 and into much of 2011, we experienced significant raw material cost inflation, primarily related to EVA resin, which accounts for approximately 50% to 55% of our cost of sales. In 2011, we expanded our supply chain expertise with the hiring of a Director of Global Supply Chain who is focusing on ensuring that our supply chain is effective and efficient and to reduce our raw material costs, including EVA resin. We continued to identify new vendors to increase our depth in sourcing alternatives. In the latter part of 2011, we were able to purchase resin at an approximate 25% lower average cost than the price paid in mid-year 2011 due to our increased efforts and favorable dynamics in the resin market. We will not see this benefit in our results of operations until we utilize the higher cost resin we are carrying in inventory.
We are in the process of introducing a paperless encapsulant that will offer a less expensive option to our customers and retain the long-term quality benefits that we believe our encapsulants provide. Since this product does not require paper backing, we believe that it can be commercialized at a lower price, yet generate similar gross margin as our existing products.
Labor: In 2011, we reduced our headcount by approximately 84 employees at our various facilities, including those employees at our Florida facility, which was closed in the fourth quarter. Estimated savings associated with these cost reduction efforts is approximately $3.7 million on a pre-tax annual basis. We incurred approximately $0.2 million of severance cost associated with these actions.
In the first quarter of 2012, we further reduced headcount by 17 employees at our Connecticut plant and corporate headquarters. We also entered into a Labor Force Adjustment Plan with our union and the local government at our Spain facility that will temporarily furlough approximately 60 employees for the period of February 1 to July 31, 2012. Estimated savings associated with these cost reduction efforts is approximately $2.1 million on a pre-tax annual basis. We will incur approximately $0.1 million of severance cost to implement these actions.
We will continue to adjust our labor resources to match forecasted demand for our encapsulants and to keep our cost structure competitive.
Overhead: In 2011, we closed our St. Augustine, Florida manufacturing facility. We ceased production at this plant in October 2011 and exited the 20,000 square foot leased facility as of year-end. The closure resulted in approximately $0.8 million in pre-tax charges, $0.5 million of which were non-cash. In addition to the labor cost reduction in Florida discussed above, we expect annual pre-tax cash savings of $0.8 million as a result of this consolidation. The consolidation will also have a positive impact on gross margin driven by improved absorption from higher capacity utilization.
We have made modifications to our production process to achieve a 20% increase in throughput with minimal additional capital investment. Although we did not receive any benefits in 2011, we expect this improvement to generate additional fixed cost absorption once that level of capacity is utilized.
We will seek to make additional improvements to our cost structure by trying to obtain continued raw material price reductions, improving raw material utilization and scrap rates, increasing fixed cost absorption associated with the leverage of future sales volume growth and optimizing our global manufacturing and distribution footprint to reduce delivery and other logistical costs.
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Leverage Global Infrastructure. Our manufacturing facilities are designed to provide the ability to expand our capacity to meet customer demand. To meet anticipated growth in demand in the solar module market and increase our market share, we plan to increase capacity by adding new production lines at our existing facilities and opening new facilities. Our Malaysia facility currently has 3.6 GW of production capacity. We recently increased the floor space of our Malaysia facility to provide space for total capacity of up to approximately 5.0 GW. We believe that our Malaysia plant has enhanced our competitive position in various Asian markets by allowing us to take advantage of reduced lead times, lower logistics costs and improved customer service.
During the first quarter of 2011, we purchased a 275,000 square foot manufacturing facility in East Windsor, Connecticut. This facility will provide us with the space needed to meet future capacity demands and enable us to consolidate our U.S.-based operations, including the construction of a state-of-the-art, 20,000 square foot R&D facility. We currently have 2.9 GW of production capacity in North America. In addition, we have 2.9 GW of production capacity at our Spain facility.
We expect to increase our global production capacity to approximately 10.2 GW by the end of 2012.
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Continue Product Innovation. Throughout our history, we have been innovators in the field of encapsulant technology. We intend to leverage our technical experience and the expertise derived from our greater than 30 years of innovation to continue to develop high value-added products that can be commercialized quickly and with scale to meet evolving customer needs and to maintain and enhance our competitive position. In 2010, we hired a Chief Technology Officer to oversee our research and development and technical service functions with the intent of accelerating our development of next generation encapsulant technology and creating a pipeline of new innovative products.
We have increased our investment in research and development, including the addition of technical personnel and research scientists. Our East Windsor, Connecticut facility will house a 20,000 square foot, state-of-the-art research and development center. We expect the new laboratory to be operational in the second quarter of 2012.
We have expanded our overall product portfolio to meet various customer requirements. Our recently launched mega fast encapsulant enables significant capital avoidance and efficiency gains for automated module manufacturers, such as a 4-minute lamination cycle, which is significantly faster than the typical 12 to 18 minutes. We are in the process of introducing a paperless encapsulant that will offer a less expensive option to our customers while retaining the long-term quality benefits that we believe our encapsulants provide. Since this product does not require paper backing, we believe that it can be commercialized at a lower price, yet generate similar gross margin as our existing products. We have also developed a premium high-light transmission formulation that enables light to better penetrate certain cells, which may enhance module output by approximately 1%.
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Asia Growth Strategy. Our strategy for growing our Asia business is called One + China Growth Strategy. Our plant in Malaysia represented the first stage in the execution of this strategy through the utilization of Malaysia as an enhanced conduit to Asia. During 2009, global solar demand shifted as module manufacturers located in Asia, particularly in China, obtained market share from European competitors. Also, many Asian governments announced solar incentive programs to increase the demand for solar energy in their respective countries, such as the Golden Sun and Building Integrated Photovoltaic programs in China. Based on these two emerging patterns, we have been actively seeking to increase our market share in the Asia-Pacific region.
We are focused on increasing our presence in the Asian market through our Malaysia facility. The strategic location of this plant serves as an advantageous gateway to all of Asia including China, South Korea, Japan, India and Taiwan. Also, some of the Asia module manufacturers have either announced or executed expansion plans to construct plants in North America. We believe we will also obtain market share with these customers as they penetrate North America due to our strong U.S. manufacturing base.
Our net sales into the Asia Pacific region increased by approximately 4.4% in 2011 compared to 2010. We have recently formed a wholly foreign owned enterprise ("WFOE") and purchased land near Shanghai. We are in the process of creating local Chinese management, sales and technical service teams. We have recently relocated our Director of Global Sales to China. We expect to commence the construction of our China facility when industry conditions improve.
Our Products
We have 12 commercial encapsulant formulations. Drawing upon our considerable experience, we develop our formulations internally and work in conjunction with our customers to meet their varying requirements. Our encapsulant formulations offer a range of properties and processing attributes, including various curing times and temperatures that align with the requirements of our customers' individual lamination processes and module constructions. Our formulations can be used in both crystalline silicon and thin-film modules.
Our Markets and Customers
Our customers are solar module manufacturers located in North America, Europe and Asia. Our largest crystalline silicon and thin-film customers include many of the world's largest solar module manufacturers. First Solar, Inc. ("First Solar") and Suntech Power Holdings Co. Ltd. ("Suntech"), each of which accounted for at least 10% of our net sales, together accounted for 33% and 28% of our net sales for the years ended December 31, 2011 and 2010, respectively. Sales to First Solar accounted for 27% of our net sales in the year 2009. Our top five customers accounted for approximately 53%, 43% and 55% of our net sales in 2011, 2010 and 2009, respectively.
We typically sell our encapsulants on a purchase order basis or through contracts that specify prices and delivery parameters, but can be canceled or postponed prior to production. In recent years, we followed a strategy of entering into formal contractual relationships. These contracts provide for better operational and capital efficiency as well as improved manufacturing visibility, allowing us to better serve the needs of our growing customers. In addition, we provide technical support and assist our customers when they are qualifying solar modules that utilize our products, which can take from two months to more than two years. Historically, our sales strategy has focused on developing long-term relationships with solar module manufacturers and working collaboratively during their product development efforts. During 2011, we began using independent sales agents as a part of our Asian growth strategy, primarily in Japan. We intend to expand our marketing and sales efforts by increasing the resources of our global sales organization.
CEO BACKGROUND
Dennis L. Jilot, 64, has been our Executive Chairman of the Board of Directors since January 1, 2012. Mr. Jilot served as our President and Chief Executive Officer from 1997 through 2011 and has been Chairman of our Board of Directors since 2002. Mr. Jilot has been a director since 1997. Prior to joining us, Mr. Jilot was Executive Vice President of Corning Clinical Laboratories, President and Chief Executive Officer of Corning Nichols Institute and President and Chief Operating Officer of MetPath Incorporated. Mr. Jilot holds a B.S. from the University of Wisconsin at Stevens Point and completed the Executive M.B.A. program at the University of Virginia Darden School of Business.
Mr. Jilot was selected to serve on our Board in light of his substantial experience as a director and our Executive Chairman, his long history of senior executive leadership positions at other large companies, his in-depth understanding of our business and the markets in which we compete and the continuity his service provides to our Board as a whole.
Scott S. Brown, 55, has served on our Board since our initial public offering in November 2009. Mr. Brown is the Chief Executive Officer and Managing Partner of New Energy Capital Partners, manager of NEC Cleantech Infrastructure Fund LP, which invests in, owns and operates renewable energy and distributed generation projects. He has held that position or similar positions in predecessor companies since 2004. Between 2001 and December 2003, Mr. Brown was Chief Executive Officer of Sinclair Brown Associates, a management and investment consulting firm. Previously, Mr. Brown was on the founding management team of Solar Cells, Inc. (the predecessor company of First Solar) and President and Chief Executive Officer of Glasstech Solar, Inc., a manufacturer of semiconductor equipment for the photovoltaic industry. Between 1998 and 2005, Mr. Brown was a member of the National Advisory Board of the National Renewable Energy Laboratory. He holds a B.A. from Dartmouth College and a J.D. from Harvard Law School.
Mr. Brown was selected to serve on our Board in light of his extensive experience in the fields of renewable energy, corporate governance and project development, his experience as a well-known industry speaker for clean energy and his in-depth understanding of the solar business and the markets in which we compete.
Robert M. Chiste, 64, has served on our Board since August 2010. Mr. Chiste is an Executive in Residence with the Silicon Valley venture capital firm El Dorado Ventures, where he leads the firm's cleantech activities. He is also Principal of Sorfina Capital focusing on early stage cleantech and bio-technology companies. He served as Chairman, President and CEO of Comverge, Inc. (NASDAQ: COMV) from 2001 until his retirement in 2009. As a private investor, he co-founded technology systems management solutions provider TriActive, Inc., on-demand fuel industry software provider FuelQuest, Inc., and internet industrial products auction company iMark, Inc. Mr. Chiste was Vice Chairman, President and CEO of publicly-traded Allwaste, Inc., and was founder, President and CEO of American National Power, Inc., a subsidiary of Transco Energy Company. Mr. Chiste currently serves on the board of directors of three private companies, REGEN Energy, AisRe and Enbala Power Systems. Mr. Chiste received a B.A. from the College of New Jersey and J.D. and M.B.A. degrees from Rutgers University.
Mr. Chiste was selected to serve on our Board in light of his sound knowledge of renewable energy, and extensive experience serving as CEO of public companies.
John A. Janitz, 69, has served on our Board since June 2007. Mr. Janitz is Chairman and Co-Founding Partner at Evergreen Capital Partners LLC, an investment firm that provides advisory services to and co-invests with private equity firms under exclusive contractual arrangements, and is affiliated with The Gores Group where Mr. Janitz is responsible for sourcing investment opportunities, and providing strategic, operational and financial guidance to the firm with respect to portfolio company investments in the industrial sector. Evergreen had provided these services to DLJ Merchant Banking Partners from March 2007 to April 2010 and TowerBrook Capital Partners L.P. from May 2010 to September 2011. From October 2003 to March 2007, he served as Co-Managing Principal for Questor Management Company, a turnaround capital investment firm based in Michigan. Mr. Janitz engaged in various advisory and consulting arrangements with several private equity firms from October 2001 until February 2003. Prior to joining Questor, from 1999 to 2001 Mr. Janitz was President and Chief Operating Officer of Textron, a NYSE-listed multi-industry company. Before Textron, Mr. Janitz was an Executive Vice President with TRW, a multinational company providing advanced technology products and services. In addition, he served as President of Wickes Manufacturing Company ("Wickes"), and held a number of key executive positions with Wickes' predecessor company, Gulf & Western Industries, Inc. Mr. Janitz serves as a director of two private companies, Hilex Poly Co. LLP and LLL Holdings. Mr. Janitz holds a B.S. from Villanova University, an M.B.A. from Eastern Michigan University and completed the Harvard Advanced Management Program.
Mr. Janitz was selected to serve on our Board in light of his extensive experience serving as a director for both public and private companies, prior senior executive experience at large multinational organizations and his significant operational and strategic business expertise.
Andrew M. Leitch, 68, has served on our Board since our initial public offering in November 2009. Mr. Leitch was a senior partner with Deloitte & Touche LLP for over 27 years, last serving as the Vice Chairman of the Management Committee, Hong Kong from September 1997 through his retirement in March 2000. Mr. Leitch has served as a director, chairman of the board and member of the audit committee and compensation committees of Blackbaud Inc., and as a director and chairman of the audit committee of Cardium Therapeutics Inc. since February 2004 and August 2007, respectively. Mr. Leitch served as director and chairman of the audit committee of Aldila, Inc. from May 2004 through February 2010 and a director of L&L Energy Inc. from February 2011 through August 2011. Mr. Leitch also serves as a director of various private companies. He is a Certified Public Accountant in the state of New York, and a Chartered Accountant in Ontario, Canada.
Mr. Leitch was selected to serve on our Board in light of his extensive experience as a director of various public and private companies, serving as the chairman of certain boards and audit committees and as a member of certain compensation committees and governance committees, and his extensive understanding of U.S. and international financial accounting principles, systems of internal control and corporate governance principles.
Dominick J. Schiano, 57, has served on our Board since June 2007. He is President and Co-Founding Partner of Evergreen Capital Partners LLC. Evergreen provides advisory services and co-invests with private equity sponsors under exclusive contractual relationships and is affiliated with The Gores Group where Mr. Schiano is responsible for sourcing investment opportunities, and providing strategic, operational and financial guidance to the firm with respect to portfolio company investments in the industrial sector.
Evergreen has previously been engaged by TowerBrook Capital Partners where Mr. Schiano was a member of the Management Advisory Board and by DLJ Merchant Banking Partners, the Private equity arm of Credit Suisse where he held the position of Vice Chairman—Global Industrial Partners.
Prior to forming Evergreen, Mr. Schiano served as a Managing Director and member of the Investment Committee of Questor Partners Funds. Previously, Mr. Schiano served in various executive roles at Textron Inc., including Executive Vice President and CFO of Textron Automotive, Executive Vice President and CFO of Textron Fastening Systems, Inc., and finally as Executive Vice President and General Manager of Textron Fastening Systems Inc. (Threaded Products Group). Prior to Textron, Mr. Schiano held senior positions at TRW Inc., where he was responsible for mergers and acquisitions, joint ventures, licensing, and strategic alliances. Prior to that, Mr. Schiano held progressively responsible finance, M&A and operating roles at Wickes Companies Inc., its predecessor, Gulf & Western Industries Inc. and Emerson Electric Company Inc.
Mr. Schiano also serves as a director and member of the audit committees of Material Sciences Corporation (NASDAQ:MASC), and two private companies, Sage Automotive Interiors, Inc. and Hilex Poly Holdings Inc. He is a member of the advisory board of Great Range Capital. Mr. Schiano attended Long Island University.
Mr. Schiano was selected to serve on our Board for his business acumen gained from significant management experience as a senior executive in a variety of industries with responsibilities in the areas of general management, finance, mergers and acquisitions, operations and business strategy as well as his experience as a director and audit committee member on a number of publric and private company boards.
Susan C. Schnabel, 50, has served on our Board since June 2007. Ms. Schnabel is the Head of DLJ Merchant Banking Partners—Americas where she has served as a Managing Director since 1998. Ms. Schnabel joined Donaldson, Lufkin and Jenrette's Investment Banking Division in 1990. In 1997, she left Donaldson, Lufkin and Jenrette's Investment Banking Division to serve as Chief Financial Officer of PetSmart, Inc., a specialty retailer of pet products and supplies, and joined DLJ Merchant Banking Partners as a Managing Director in 1998. Ms. Schnabel served as a director of Pinnacle Gas Resources, Inc. from June 2005 to January 2011 and Rockwood Holdings, Inc. from August 2004 to January 2009. Ms. Schnabel received a B.S. from Cornell University and an M.B.A. from Harvard Business School.
Ms. Schnabel was selected to serve on our Board in light of her leadership, business experience, and experience serving as a director on 2 public and 12 private company boards in the past five years. She has extensive knowledge of various industries and significant expertise in corporate governance principles.
Robert S. Yorgensen, 48, has been our President and Chief Executive Officer and a director of our Board since January 2012. Prior to becoming our CEO, Mr. Yorgensen was the President of our Solar division since 2007 and has been employed with STR for 26 years. Mr. Yorgensen has held a variety of positions with us, including Extruded Products Manager and Senior Technical Specialist of Materials RD&E and Specialty Manufacturing, Technical Specialist of Materials RD&E and Specialty Manufacturing and Project Leader of Development Engineering and Specialty Manufacturing. He holds a Bachelor of Technology, Mechanical Engineering from the University of Connecticut and an A.S. from Hartford State Technical College.
Mr. Yorgensen was selected to serve on our Board in light of his substantial experience as President of STR Solar and his 26 year tenure with STR where he has made significant contributions to our research and development, process engineering, business development efforts and led our rapid growth in the solar market.
MANAGEMENT DISCUSSION FROM LATEST 10K
Overview
We were founded in 1944 as a plastic and industrial materials research and development company and evolved into two core businesses: solar encapsulant manufacturing and quality assurance services. We launched our former Quality Assurance business ("QA") in 1973 and we commenced sales of our solar encapsulant products in the late 1970s.
We are one of the leading global providers of encapsulants to the solar module industry. Encapsulant is a critical component used in solar modules. Our PhotoCap® products consist primarily of ethylene-vinyl-acetate, or EVA, which is modified with additives and put through our proprietary manufacturing process to increase product stability and make the encapsulant suitable for use in extreme, long-term outdoor applications. We supply encapsulants to many of the largest solar module manufacturers worldwide. We believe this is due to our product performance, global manufacturing base, customer service and technical support. Our encapsulants are used in both crystalline silicon and thin-film solar modules. Our net sales have increased from $9.9 million in 2003 to $232.4 million in 2011, representing a compound annual growth rate ("CAGR") of 48.4%.
Prior to its divesture in September 2011, QA provided product development, inspection, testing and audit services that enabled retailers and manufactures to determine whether products met applicable safety, regulatory, quality, performance and social standards.
Strategic Divesture of QA
On September 1, 2011, we completed the sale of QA to Underwriters Laboratories, Inc. ("UL"). This strategic divesture was executed to allow us to focus exclusively on the solar encapsulant opportunity and to seek further product offerings related to the solar industry, as well as other growth markets related to our polymer manufacturing capabilities, and to retire our long-term debt. The following transactions occurred as a result of the divesture:
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We received $275.0 million, plus assumed cash in proceeds. The sale generated an after-tax gain of approximately $14.0 million that included a tax liability of $105.9 million. This gain is recorded in discontinued operations in the Consolidated Statements of Comprehensive Income and the proceeds received are recorded in discontinued operations in the Consolidated Statements of Cash Flows in 2011.
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In order to sell the assets of the QA business free and clear of liens provided pursuant to our first lien credit agreement and second lien credit agreement (together, the "2007 Credit Agreements"), we terminated the 2007 Credit Agreements on September 1, 2011 by using approximately $237.7 million of the sale proceeds to repay all amounts outstanding thereunder to Credit Suisse AG as administrative and collateral agent. The cash payment was recorded in discontinued operations in 2011 in the Consolidated Statements of Cash Flows. The interest expense associated with the 2007 Credit Agreements is recorded in discontinued operations in the Consolidated Statements of Comprehensive Income and Consolidated Statements of Cash Flows for all periods presented.
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Upon termination of the 2007 Credit Agreements, we wrote off the unamortized deferred financing costs of $3.6 million. The write-off was recorded to continuing operations in 2011 in the Consolidated Statements of Comprehensive Income.
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In conjunction with the sale, we entered into an agreement to lease our real property located at 10 Water Street, Enfield, Connecticut to a subsidiary of UL. Prior to the closing of the sale, the property served as the QA headquarters and a testing facility. The term of the lease is for one year. Since this property generates rental income of $0.3 million per year, we evaluated whether the carrying value of the property was recoverable. Based on this evaluation, an impairment loss of $1.9 million was recognized in continuing operations in 2011 in the Consolidated Statements of Comprehensive Income.
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On October 7, 2011, we entered into a multicurrency credit agreement (the "Credit Agreement") among us, certain of our domestic subsidiaries, as guarantors (the "Guarantors"), the lenders from time to time party thereto and Bank of America, N.A., as administrative agent, swing line lender and letter of credit issuer. The Credit Agreement provides for a revolving senior credit facility of up to $150.0 million that matures on October 7, 2015. The Credit Agreement includes a $50.0 million sublimit for multicurrency borrowings, a $25.0 million sublimit for the issuance of letters of credit and a $5.0 million sublimit for swing line loans. The Credit Agreement also contains an expansion option permitting us to request an increase of the revolving senior credit facility from time to time up to an aggregate additional $50.0 million from any of the lenders or other eligible lenders as may be invited to join the Credit Agreement, that elect to make such increase available, upon the satisfaction of certain conditions.
QA's historical operating results are recorded in discontinued operations in the Consolidated Statements of Comprehensive Income and Consolidated Statements of Cash Flows for all periods presented. In accordance with ASC 360-Property, Plant and Equipment, the assets and liabilities of the QA business have been classified as assets held for sale as of September 1, 2011. For comparative purposes, the Company has reclassified the assets and liabilities of the QA business as assets held for sale in all prior periods presented.
The discussion contained herein relates to continuing operations unless otherwise noted.
Corporate Structure
On June 15, 2007, DLJ Merchant Banking Partners IV, L.P. and affiliated investment funds ("DLJMB"), and its co-investors, together with members of our Board of Directors, our executive officers, certain prior investors and other members of management, acquired 100% of the voting equity interests in our wholly-owned subsidiary, Specialized Technology Resources, Inc., for $365.6 million, including transaction costs. In connection with the acquisition:
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DLJMB and its co-investors contributed $145.7 million in cash for approximately 81.6% of the voting equity interests in STR Holdings LLC;
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Dennis L. Jilot, our Executive Chairman, Robert S. Yorgensen, our President and Chief Executive Officer, and Barry A. Morris, our Executive Vice President and Chief Financial Officer, exchanged a portion of their existing equity investments in Specialized Technology Resources, Inc., valued at approximately $11.5 million, for approximately 6.4% of the voting equity interests in STR Holdings LLC;
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other stockholders of Specialized Technology Resources, Inc., including some current and former employees and former directors, exchanged a portion of their existing equity investments in Specialized Technology Resources, Inc., valued at approximately $21.5 million, for approximately 12.0% of the voting equity interests in STR Holdings LLC;
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Specialized Technology Resources, Inc., as borrower, and STR Holdings LLC, as a guarantor, entered into a first lien credit facility providing for a fully drawn $185.0 million term loan facility and an undrawn $20.0 million revolving credit facility and a second lien credit facility providing for a fully drawn $75.0 million term loan facility, in each case, with Credit Suisse, as administrative agent and collateral agent; and
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with the cash contributed from DLJMB and certain of its co-investors and the borrowings under our first lien and second lien credit facilities, STR Holdings LLC (i) purchased the remaining shares of stock in Specialized Technology Resources, Inc., for $324.7 million, (ii) repaid $61.7 million of debt held by Specialized Technology Resources, Inc., (iii) settled Specialized Technology Resources, Inc. stock options for $1.5 million, (iv) paid financing costs of $7.9 million and transaction costs of $4.4 million; and (v) retained the remaining $5.5 million in proceeds for working capital purposes.
We refer to the foregoing transactions collectively as the "DLJ Transactions."
Prior to November 5, 2009, we conducted our business through STR Holdings LLC and its subsidiaries. STR Holdings (New) LLC ("NewCo"), a Delaware limited liability company, was formed on September 30, 2009 as an indirect subsidiary of STR Holdings LLC and held no material assets and did not engage in any operations.
Pursuant to the corporate reorganization on November 5, 2009, STR Holdings LLC liquidated. A subsidiary of NewCo merged with and into Specialized Technologies Resources, Inc. ("STRI") and, as a result, STRI became a wholly-owned subsidiary of NewCo. The unitholders of STR Holdings LLC became unitholders of NewCo. On November 6, 2009, NewCo converted from a limited liability company into a Delaware 'C' corporation, named STR Holdings, Inc., and the outstanding units of NewCo converted into a single class of common stock of STR Holdings, Inc. pursuant to the terms of the LLC agreement.
On November 12, 2009, we closed our IPO of 12,300,000 shares of common stock at an offering price of $10 per share, of which 3,300,000 shares were sold by us and 9,000,000 shares were sold by selling stockholders, resulting in net proceeds to us of approximately $25.0 million after deducting underwriting discounts, commissions and other offering costs of approximately $7.8 million. Effective with the conversion of NewCo into STR Holdings, Inc., our outstanding units were converted into shares of common stock and restricted common stock. In connection with our IPO, we repaid $15.0 million of borrowings under our first lien credit facility, and also paid $2.6 million to terminate an advisory services and monitoring agreement we entered into in connection with the DLJ Transactions.
Under the STR Holdings LLC Agreement, STR Holdings LLC's Class A, B, C, D, E and F units were subject to a priority distribution of shares of common stock in the event of an IPO. In connection with the IPO, the priority distribution of shares was based on our equity value as represented by the IPO price. For the units issued in connection with the DLJ Transactions, the shares of common stock were distributed as follows: (i) first, the Class A unitholders received an aggregate amount of common stock equal in value to their aggregate capital contributions; and (ii) second, a pro rata distribution was made with respect to the Class A, B, C, D and F units until the Class A unitholders received an aggregate amount of common stock equal in value to 2.5 times their aggregate capital contributions; and (iii) finally, a pro rata distribution was made of the remaining value to each Class A, B, C, D, E and F unitholder based upon the number of units held by each unitholder. Class C and D incentive units that were issued in 2008 did not convert nor did any of the Class E incentive units that were issued as a result of not meeting the required aggregate value distribution thresholds.
Components of Net Sales and Expenses and Anticipated Trends
Net Sales
Our net sales are derived from the sale of encapsulants to both crystalline silicon and thin-film solar module manufacturers. We expect that our results of operations, for the foreseeable future, will depend primarily on the sale of encapsulants to a relatively small number of customers. We believe the concentration will increase as we expect a consolidation of module manufacturers driven by overcapacity that currently exists. First Solar and Suntech, each of which accounted for at least 10% of our net sales, together accounted for 33% and 28% of our net sales for the years ended December 31, 2011 and 2010, respectively. Sales to First Solar accounted for 27% of our net sales in the year ended December 31, 2009. The top five customers accounted for approximately 53%, 43% and 55% of our net sales in the years ended December 31, 2011, 2010 and 2009, respectively.
Net sales to our customers have been typically made through non-exclusive, short-term purchase order arrangements that specify prices and delivery parameters but do not obligate the customer to purchase any minimum amounts. As our customers look to secure materials or access to our production capacity to support their module production, we have frequently entered into, renewed or are in negotiations to enter into, contracts that may include periods of exclusivity and/or minimum requirements.
Our net sales are significantly driven by end-user demand for solar modules. As more solar modules are sold, there is greater demand from module manufacturers for encapsulants. The solar power industry is impacted by a variety of factors, including government subsidies and incentives, availability of financing, worldwide economic conditions, environmental concerns, energy costs, the availability of polysilicon and other factors. A key demand driver for solar module growth in the future will be the ability of solar module manufacturers to reduce their cost structure. During 2011, overall solar industry demand decreased while capacity expansion in the solar module supply chain increased. Increased competition, particularly from China, and continued vertical integration of many manufacturers in the solar supply chain contributed to the increase in capacity. These events caused many module manufacturers to significantly reduce the average selling price of their modules as the extra capacity drove a severe inventory build. From an industry standpoint, the reduction in module selling prices has improved rates of return on solar investments for the end-user and is a long-term industry trend that we believe will help to bring solar energy closer to grid-parity and will drive increased demand for our encapsulants. However, we believe that the demand for our encapsulants will be reduced until inventory in the channel is cleared and normal order patterns reemerge.
Demand for our encapsulants also depends, in large part, on government incentives aimed to promote greater use of solar energy. The type of government incentives vary from country to country and can change rapidly. For example, in Germany, which is currently the largest solar PV end-user market, the government enacted legislation that reduced feed-in-tariffs beginning June 30, 2010. In early 2011, the German government enacted further legislation to accelerate the annual year-end feed-in-tariff reduction to July 1, 2011 for roof-top systems and September 1, 2011 for ground-mount projects. If solar module demand in Germany continues to grow at a rate that the German government believes is excessive, the amount of PV installations that may qualify for feed-in-tariff incentives could be capped, which would negatively impact our net sales as overall solar module growth in the world's largest PV market would be limited. Also, many European governments are currently experiencing fiscal issues. As such, a risk exists that some of these governments will have to reduce and/or eliminate current subsidies provided for PV installations in conjunction with overall tighter fiscal policies.
Even though we may see flat or reduced solar module demand in the European Union in the next few years compared to the growth experienced in 2010, we expect an increase in demand for solar energy in the United States as a result of continued cost reductions in the solar industry. Also, many states, including California, have enacted renewable portfolio standards ("RPS") that require utilities to increase their production of energy from renewable sources including solar PV. China, India, Taiwan, Japan and other countries have also announced plans to increase their use of renewable energy, including solar. We are actively trying to penetrate a number of Tier 1 Chinese module manufacturers to increase our market share, and we expect that a larger proportion of our future net sales will come from the Asia-Pacific region.
Pricing of our encapsulants is impacted by the competition faced by our customers, and the quality and performance of our encapsulant formulations, including their impact on improving our customers' manufacturing yields, their history in the field, our ability to meet our customers' delivery requirements, overall supply and demand levels in the industry and our customer service and technical support. We have typically priced our encapsulants at a premium to our competition based on product attributes that among other benefits provide a high value proposition to our customers in a period of tight capacity. During 2011, the excess capacity that existed at most module manufacturers has reduced the value proposition of the throughput and other production efficiencies that our encapsulants provide and has caused encapsulant cost to become a more important factor in the procurement process for many customers. As such, we experienced an average selling price decline of approximately 5% from the prior year that was mainly driven by price concessions exchanged for entering into formal contracts with some of our largest customers and competition in an industry focused on cost reductions. We expect further price pressure to reduce our 2012 net sales by approximately $55.0 million.
Cost of Sales
We manufacture all of the products that we sell. Cost of sales consists of our costs associated with raw materials and other components, direct labor, manufacturing overhead, salaries, other personnel-related expenses, write-offs of excess or obsolete inventory, quality control, freight, insurance, disposition of defective product, depreciation of fixed assets and amortization of intangibles as a result of the DLJ Transactions. Approximately 70% of our cost of sales is variable in nature; 10% is step-variable and relates to direct labor cost and is fixed in the short-term and the remaining 20% is fixed. Resin constitutes the majority of our raw materials and components costs at approximately 50% to 55% of our cost of sales, and paper liner is the second largest cost. The price and availability of resin and paper liner are subject to market conditions affecting supply and demand, have been volatile and we believe cannot be hedged in the commodity markets.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
OVERVIEW
STR Holdings, Inc. and its subsidiaries (“we”, “us” or “our”), are one of the leading global providers of encapsulants to the solar module industry. The encapsulant is a critical component used in solar modules. We were the first to develop the original ethylene—vinyl—acetate (“EVA”) encapsulants used in commercial solar module manufacturing in the 1970s in conjunction with the Jet Propulsion Laboratory of the California Institute of Technology under a NASA contract for the U.S. Energy Research and Development Administration, which later became known as the U.S. Department of Energy. We supply encapsulants globally to many of the world’s large solar module manufacturers. We believe this is due to our product performance, global manufacturing base, customer service and technical support. Our encapsulants are used in both crystalline silicon and thin—film solar modules.
STRATEGIC FOCUS
Our objective is to enhance our position as a leading global provider of encapsulants to solar module manufacturers. Some of our strategies to meet that objective are to (i) continue our history of product innovation, (ii) further reduce our manufacturing costs, (iii) strengthen our balance sheet, (iv) leverage our global infrastructure and (v) continue to execute our Asia Growth Strategy. We have recently executed on these strategic objectives as follows:
Innovation
• We have continued to increase our investments in research and development, including the addition of technical personnel and research scientists. Our East Windsor, Connecticut facility houses a new, 20,000 square foot, state—of—the—art research and development laboratory that became operational early in the second quarter of 2012. Our goal is to continue to develop high value—add products that can be commercialized quickly and with scale.
• We have developed a premium high—light transmission formulation that enables light to better penetrate certain cells, which may enhance module output by approximately 1%. We also continue to invest in the development of products engineered for the specific requirements of Chinese module manufacturers.
Cost Reduction
• We have recently expanded our manufacturing and supply chain expertise with the hiring of Chief Operating Officer, STR Solar and Director of Global Supply Chain. Both individuals focus their efforts on cost reduction, supply chain optimization and process improvement.
• During the first quarter of 2012, we reduced headcount by 18 employees at our Connecticut facilities. In conjunction with the headcount reduction, we recognized severance of less than $0.1 million. Estimated savings associated with this cost reduction action is approximately $1.1 million on a pre —tax annual basis. We also entered into a Labor Force Adjustment Plan with the union and the local government at our Spain facility that will temporarily furlough approximately 63 employees for the period of February 1, 2012 to July 31, 2012. Estimated savings associated with this cost reduction action is approximately $0.7 million for 2012.
• We are in the process of introducing a paperless encapsulant that will offer a less expensive option to our customers while retaining the long—term quality benefits that we believe our encapsulants provide. Since this product does not require paper backing, we believe that it can be commercialized at a lower price, yet generate similar gross margin as our existing products.
• We ceased production at our St. Augustine, Florida plant in October 2011 and exited the 20,000 square foot leased facility as of December 31, 2011. The closure resulted in approximately $0.8 million in pre—tax charges, $0.5 million of which were non—cash. We expect annual pre—tax savings of $1.1 million as a result of this consolidation. We also expect the consolidation will have a positive impact on gross margin with improved absorption from higher capacity utilization.
Strengthen our Balance Sheet
• On August 16, 2011, we entered into an equity purchase agreement to sell our Quality Assurance (“QA”) business to Underwriters Laboratories (“UL”) for $275.0 million plus assumed cash. The QA business provided consumer product testing, inspection, auditing and consulting services that enabled retailers and manufacturers to determine whether products and facilities met applicable safety, regulatory, quality, performance, social and ethical standards. On September 1, 2011, we completed the sale of the QA business for total net cash proceeds of $283.4 million, which included $8.4 million of estimated cash assumed in certain QA locations. We decided to sell the QA business in order to focus exclusively on the solar encapsulant opportunity and to seek further product offerings related to the solar industry, as well as other growth markets related to our polymer manufacturing capabilities, and to retire our long—term debt.
• On October 7, 2011, we entered into a multicurrency credit agreement (the “Credit Agreement”) among us, certain of our domestic subsidiaries, as guarantors (the “Guarantors”), the lenders from time to time party thereto and Bank of America, N.A., as administrative agent, swing line lender and letter of credit issuer. The Credit Agreement provides for a revolving senior credit facility of up to $150.0 million that matures on October 7, 2015. The Credit Agreement includes a $50.0 million sublimit for multicurrency borrowings, a $25.0 million sublimit for the issuance of letters of credit and a $5.0 million sublimit for swing line loans. The Credit Agreement also contains an expansion option permitting us to request an increase of the revolving senior credit facility from time to time up to an aggregate additional $50.0 million from any of the lenders or other eligible lenders as may be invited to join the Credit Agreement, that elect to make such increase available, upon the satisfaction of certain conditions. Based on our forecasted 2012 EBITDA and the required minimum Consolidated Leverage Ratio, we expect to be able to draw down on at least $40.0 million of the $150.0 million Credit Agreement during 2012. If our actual EBITDA, as defined in the Credit Agreement, is less than forecasted, we may not be able to borrow as much, or any amounts, under the Credit Agreement.
Global Infrastructure and Asia Growth Strategy
• In the first quarter of 2012, we relocated our Global Director of Sales and Marketing to China and have expanded our local sales and technical service teams in the Asia Pacific region. We have also recently formed a wholly foreign owned enterprise, received a business license and purchased land near Shanghai.
• During 2011, we increased the floor space of our Malaysia facility to provide for total capacity of up to approximately 5.0 GW and increased our production capacity to 3.6 GW. We believe that our Malaysian plant has enhanced our competitive position in various Asian markets by allowing us to take advantage of reduced lead times, lower logistics costs and improved customer service.
CRITICAL ACCOUNTING POLICIES
Our discussion and analysis of our financial condition and results of operations are based upon our interim condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, net sales and expenses, and related disclosures of contingent assets and liabilities. We continually evaluate our estimates, including those related to bad debts, valuation of inventory, long—lived intangible and tangible assets, goodwill, product performance matters, income taxes, stock—based compensation and deferred tax assets and liabilities. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. The accounting policies we believe to be most critical to understand our financial results and condition and that require complex and subjective management judgments are discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” in our Annual Report on Form 10–K filed with the Securities and Exchange Commission on March 14, 2012.
In accordance with ASC 250—20—Presentation of Financial Statements—Discontinued Operations and ASC 740—20—Income Taxes—Intraperiod Tax Allocation, the accompanying Condensed Consolidated Statements of Comprehensive Income and Condensed Consolidated Statements of Cash Flows present the results of the QA business as discontinued operations. Prior to the sale, the QA business was one of our segments. We have no continuing involvement in the operations of the QA business and have no direct cash flows from the QA business subsequent to the sale. Accordingly, we have presented QA as discontinued operations in all periods presented in the condensed consolidated financial statements.
There have been no changes in our critical accounting policies during the quarter ended March 31, 2012.
IMPAIRMENT ANALYSIS
In accordance with ASC 350—Intangibles—Goodwill and Other and ASC 360—Property, Plant and Equipment, we assess the impairment of our long—lived assets including our definite—lived intangible assets, property, plant and equipment and goodwill whenever changes in events or circumstances indicate that the carrying value of such assets may not be recoverable. During each reporting period, we assess if the following factors are present which would cause an impairment review: overall negative solar industry conditions; a significant or prolonged decrease in sales that are generated under its trademarks; loss of a significant customer or a reduction in demand for customers’ products; a significant adverse change in the extent to or manner in which we use our trademarks or proprietary technology; such assets becoming obsolete due to new technology or manufacturing processes entering the markets or an adverse change in legal factors; and the market capitalization of our common stock. During the first three months of 2012, the market capitalization of our common stock declined by approximately 50%. As a result of this decline that does not appear to be temporary, we determined that a triggering event occurred requiring vs to test our long—lived assets and our reporting unit for impairment as of March 31, 2012.
We tested our long—lived assets for impairment as of March 31, 2012. We have concluded that no impairment exists as the sum of the undiscounted expected future cash flows exceeded our long—lived assets’ carrying values as of March 31, 2012. We also determined that no change to the estimated useful lives was required. However, if we continue to experience a significant reduction in sales volume or profitability in the future, or any adverse circumstances as discussed above, certain of our long—lived assets may be subject to accelerated depreciation/amortization and/or future impairment.
We valued our reporting unit with the assistance of a valuation specialist and determined that our reporting unit’s net book value exceeded its fair value. We then performed step two of the goodwill impairment assessment which involved calculating the implied fair value of goodwill by allocating the fair value of the reporting unit to all of our assets and liabilities other than goodwill and comparing the residual amount to the carrying amount of goodwill. We determined that our implied fair value of goodwill was lower than our carrying value and recorded a goodwill impairment of $82.5 million. We estimated the fair value of our reporting unit under the income approach using a discounted cash flow method which incorporated our cash flow projections. We also considered our market capitalization, control premiums and other valuation assumptions in reconciling the calculated fair value to the market capitalization at the assessment date. Based on the other than temporary decline in our stock price and our net book value exceeding the market capitalization of our common stock during the first quarter of 2012, the market approach was given a higher weighting in determining fair value. We believe the cash flow projections and valuation assumptions were reasonable and consistent with market participants. Inherent in our development of cash flow projections are assumptions and estimates, including those related to future earnings, growth prospects and the weighted average cost of capital. Many of the factors used in assessing the fair value are outside the our control, and these assumptions and estimates can change in future periods as a result of both our specific factors and overall economic conditions.
Cost Reduction Actions
During the first quarter of 2012, we reduced headcount by 18 employees at our Connecticut facilities. In conjunction with the headcount reduction, we recognized severance of less than $0.1 million. Estimated savings associated with this cost reduction is approximately $1.1 million on a pre-tax annual basis. We also entered into a Labor Force Adjustment Plan with the union and the local government at our Spain facility that will temporarily furlough approximately 63 employees for the period of February 1, 2012 to July 31, 2012. Estimated 2012 savings associated with this cost reduction action is approximately $0.7 million on a pre —tax basis.
We will continue to adjust our labor resources and production requirements to match forecasted demand for our encapsulants, including the closure or consolidation of existing facilities, if required, to keep our cost structure competitive.
Non — GAAP Earnings Per Share from Continuing Operations
To supplement our condensed consolidated financial statements, we use a non—GAAP financial measure called non—GAAP EPS. Non—GAAP EPS is defined for the periods presented in the following table. For the periods prior to 2011, the diluted weighted—average common shares outstanding were determined on a GAAP basis and the resulting share count was used for computing both GAAP and non—GAAP diluted EPS. Since we recorded a loss from continuing operations in 2011 on a GAAP basis, the weighted—average common share count for GAAP reporting does not include the number of potentially dilutive common shares since these potential shares do not share in any loss generated and are anti—dilutive. However, we have included these shares in our 2011 non—GAAP EPS calculation to be consistent with prior periods and such shares are dilutive. Refer to the weighted—average shares reconciliation below. All amounts are stated in thousands except per share amounts and unless otherwise noted.
We believe that non—GAAP EPS provides meaningful supplemental information regarding our performance by excluding certain expenses that may not be indicative of the core business operating results and may help in comparing current period results with those of prior periods as well as with our peers. Non—GAAP EPS is one of the main metrics used by management and our Board of Directors to plan and measure our operating performance. In addition, non—GAAP EPS is a metric used to determine annual bonus compensation for our Executive Chairman, President and Chief Executive Officer and Executive Vice President and Chief Financial Officer.
Although we use non—GAAP EPS as a measure to assess the operating performance of our business, non—GAAP EPS has significant limitations as an analytical tool because it excludes certain material costs. Because non—GAAP EPS does not account for these expenses, its utility as a measure of our operating performance has material limitations. The omission of the substantial amortization expense associated with our intangible assets, deferred financing costs, goodwill and asset impairments and stock—based compensation expense further limits the usefulness of this measure. Non—GAAP EPS also adjusts for the related tax effects of the adjustments and the payment of taxes is a necessary element of our operations. Because of these limitations, we do not view non—GAAP EPS in isolation and use other measures, such as Adjusted EBITDA, net earnings from continuing operations, net sales, gross margin and operating income, to measure operating performance.
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Fund Letters
