This discussion should be read in conjunction with the consolidated financial statements, notes and tables included elsewhere in this report. Management's discussion and analysis may contain forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. However, such performance involves risks and uncertainties, which may cause actual results to differ materially from those expressed in the forward-looking statements.
Hawk operates primarily in two reportable segments: Friction Products ("Friction") and Powder Metal ("PM"). The Company's friction products are made from proprietary formulations of composite materials that primarily consist of metal powders and synthetic and natural fibers. Friction products are the replacement elements used in brakes, clutches and transmissions to absorb vehicular energy and dissipate it through heat and normal mechanical wear. Friction products manufactured by the Company include friction linings for use in brakes, transmissions and clutches in aerospace, construction, agricultural, truck and specialty vehicle markets. The Company's powder metal components are made from formulations of composite powder metal alloys. The PM segment manufactures a variety of components for use in fluid power, truck, lawn and garden, construction, agriculture, home appliance, automotive and office equipment markets.
Results of Operations
In 1998, Hawk Corporation experienced a 213.8 percent increase in net income over the prior year. This increase is primarily attributable to strong growth in PM segment sales, which increased 70.4 percent from 1997 levels primarily due to the acquisition of Sinterloy in August 1997 and Clearfield in June 1998. Sales gains in most of the markets served by the Company's Friction segment were offset by a softening of sales to the agricultural markets.
The Company is anticipating slight growth for 1999 as growth in the industrial markets served by the Company is expected to slow from the pace achieved in 1998. Additionally, the Company expects sales to the agricultural market to continue to be soft throughout 1999. Sales will also be adversely affected by the loss of a customer in the PM segment, which is expected to move the majority of its production and sourcing offshore during 1999. The acquisition of Allegheny Powder Metallurgy, Inc. ("Allegheny") in February 1999 will contribute to net sales in 1999.
Year Ended December 31, 1998 Compared
to Year Ended December 31, 1997
Net Sales.
Consolidated sales for 1998 were $182.1 million, an increase of $23.0 million or 14.5 percent over 1997. The largest increase in sales came from the PM segment, with 1998 sales exceeding 1997 sales by $22.1 million, or 70.4 percent. The sales increase was primarily attributable to the acquisition of Sinterloy in August 1997 and Clearfield in June 1998 as well as sales gains in the Company's other PM businesses. Sales in 1998 from the Sinterloy and Clearfield acquisitions represent a $16.8 million increase over 1997 sales contributed by Sinterloy. This increase represents 76.0 percent of the total increase in the 1998 PM segment sales. The Company experienced strong demand in all of its major PM product lines during 1998, including the lawn and garden, fluid power, truck and office equipment markets. Sales in the Friction segment were $109.6 million in 1998, an increase of 1.8 percent over 1997. Sales increases in the aerospace, construction and specialty markets served by the Friction segment were offset by declines in the agricultural market.
Gross Profit.
Gross profit increased $13.0 million to $58.4 million during 1998, a 28.6 percent increase over gross profit of $45.4 million in 1997. The gross profit margin increased to 32.1 percent in 1998 from 28.5 percent in the comparable period in 1997. The increase in margins occurred in both the Friction and PM segments. In the Friction segment, the Company benefited from favorable product mix and efficiencies realized from the capital expenditure and the friction facility consolidation programs undertaken by the Company. In the PM segment, the Company benefited from both favorable product mix and volume increases experienced by the PM manufacturing facilities.
Selling, Technical and Administrative Expenses.
Selling, technical and administrative ("ST&A") expenses increased $2.1 million, or 10.6 percent, from $19.9 million during 1997 to $22.0 million in 1998. As a percentage of net sales, ST&A declined to 12.1 percent of sales in 1998 from 12.5 percent of sales in 1997. The decline in ST&A expenses resulted from sales volume increases in 1998 without a corresponding increase in costs incurred by the Company. The Company spent $3.2 million or 1.8 percent of its net sales on product research and development costs compared to $3.1 million in 1997.
Income from Operations.
Income from operations increased $10.7 million, or 48.4 percent, from $22.1 million in 1997 to $32.8 million in 1998. Income from operations as a percentage of net sales increased to 18.0 percent in 1998 from 13.9 percent in 1997, reflecting the full benefits achieved from the consolidation of facilities, the acquisitions of Sinterloy and Clearfield, increased sales and favorable product mix.
Interest Expense.
Interest expense decreased $3.4 million, or 22.2 percent, to $11.9 million in 1998 from $15.3 million in 1997. The decrease is attributable to lower debt levels from the repayment of debt with proceeds from the Company's initial public offering. The Company also benefited from lower interest rates on its debt during the year.
Income Taxes.
The provision for income taxes increased $6.0 million to $9.7 million in 1998 from $3.7 million in 1997 because of the increase in pre-tax income. The decrease in the Company's effective tax rate in 1998 is due primarily to a change in Italian tax law, which required taxes previously paid on income to be paid on wages. Accordingly, the expense for this portion of the tax is reported in the Company's cost of sales. An analysis of changes in income taxes and the effective tax rate of the Company are presented in the accompanying consolidated financial statements.
Extraordinary Charge.
In 1998, the Company recorded an extraordinary charge of $3.1 million (net of $2.3 million of taxes) in prepayment premiums with the repayment of $35.0 million of the Company's 101/4% Senior Notes due 2003 (the "Senior Notes") and the write-off of deferred financing costs associated with the redemption of all of the $30.0 million of the Company's 12% Senior Subordinated Notes (the "Senior Subordinated Notes").
Net Income.
As a result of the factors noted above, net income was $9.1 million in 1998, an increase of 213.8 percent, compared to net income of $2.9 million reported in 1997.
Year Ended December 31, 1997 Compared
to Year Ended December 31, 1996
Net Sales.
Worldwide sales in 1997 exceeded $150 million for the first time in the Company's history, 28.3 percent above 1996. Net sales increased by $35.1 million to $159.1 million in 1997 from $124.0 million in 1996. The sales increase was attributable to the acquisitions of Hutchinson and Sinterloy and strong customer demand in all of the Company's product lines. Sales attributable to Hutchinson, which was acquired in January 1997, and Sinterloy, which was acquired in August 1997, were $11.3 million and $5.1 million, respectively, for 1997, or 46.7 percent of the net sales increase.
Sales in the Friction segment increased by $13.7 million, or 14.6 percent, to $107.7 million in 1997 from $94.0 million in 1996. This increase was attributable to strength in the aerospace, construction, agriculture and truck markets served by the Company. Sales in the Company's PM segment increased by $10.7 million, or 51.7 percent, to $31.4 million in 1997 from $20.7 million in 1996. The Sinterloy acquisition accounted for 47.7 percent of the total increase in powder metal sales in 1997.
Gross Profit.
Gross profit increased $13.3 million to $45.4 million during 1997, a 41.4 percent increase over gross profit of $32.1 million during 1996. The gross profit margin increased to 28.5 percent during 1997 from 25.9 percent during 1996. The increase was attributable to cost savings resulting from the consolidation of one of the Company's manufacturing facilities during 1996 into existing Company facilities, acquisitions of higher margin businesses in 1997, increased sales and favorable product mix.
Selling, Technical and Administrative Expenses.
ST&A expenses increased $4.4 million, or 28.4 percent, from $15.5 million during 1996 to $19.9 million during 1997. As a percentage of net sales, ST&A remained constant at 12.5 percent during 1997 and 1996. To enhance existing product lines, the Company spent $3.1 million in 1997 on product research and development, 19.2 percent above 1996 levels of $2.6 million.
Income from Operations.
Income from operations increased $12.3 million, or 125.5 percent, from $9.8 million in 1996 to $22.1 million in 1997. Income from operations as a percentage of net sales increased to 13.9 percent in 1997 from 7.9 percent in 1996, reflecting the benefits achieved from the consolidation of facilities, reduced plant consolidation expenses, acquisition of businesses in 1997, increased sales and favorable product mixes.
Interest Expense.
Interest expense increased $4.0 million, or 35.4 percent, to $15.3 million in 1997 from $11.3 million in 1996. The increase is attributable to higher debt levels, a result of the issuance of the Senior Notes in the fourth quarter of 1996.
Expenses from Canceled Public Offering.
During the fourth quarter 1997, the Company recognized a one-time charge of $0.9 million for professional services incurred in connection with the cancellation of an initial public offering of its common stock.
Income Taxes.
The provision for income taxes increased $2.9 million to $3.7 million in 1997 (56.1 percent of pre-tax income) from $0.8 million in 1996, reflecting the increase in pre-tax income. An analysis of changes in income taxes and the effective tax rate of the Company are presented in the accompanying consolidated financial statements.
Net Income (Loss).
As a result of the factors noted above, net income was $2.9 million in 1997 compared to a loss of $3.1 million in 1996.
Liquidity and Capital Resources
The primary financing requirements of the Company are (1) for capital expenditures for maintenance, replacement and acquisitions of equipment, expansion of capacity, productivity improvements and product development, (2) for making additional strategic acquisitions of complementary businesses, (3) for funding the Company's day-to-day working capital requirements and (4) to pay interest on, and to repay principal of, indebtedness. These requirements have been, and will continue to be, financed through a combination of cash flow from operations, borrowings under the Company's credit facility and the remaining proceeds from the May 1998 initial public offering of common stock.
In May 1998, the Company received net proceeds of $54.5 million from an initial public offering of 3,500,000 shares of its common stock. Additionally, in May 1998, the Company entered into a new credit facility and received net proceeds of $35.0 million. The proceeds from the stock offering and credit facility were used primarily to: (1) repay a portion of the Senior Notes and redeem all of the Senior Subordinated Notes, which aggregated $65.0 million, plus accrued interest and prepayment premium and (2) redeem preferred stock of $1.7 million.
In December 1998, the Board of Directors authorized a program to repurchase up to $5.0 million of the Company's common stock. The amount and timing of the share purchases will depend on market conditions, share price and other factors. In 1998, 281,800 shares were acquired under the program. Net cash provided by operating activities was $24.1 million in 1998 compared to $14.0 million in 1997. The increase in net income of $6.2 million and non-cash charges of $1.0 million, in addition to an improved working capital position at December 31, 1998, accounted for the increased operating cash flow. Net working capital was $39.9 million at year-end 1998 compared to $28.8 million at year-end 1997.
Net cash used in investing activities was $22.6 million and $35.2 million in 1998 and 1997, respectively. The cash used in investing activities in 1998 consisted primarily of $9.1 million for business acquisitions and $14.1 million for the purchase of property, plant and equipment. In 1997, cash used in investing activities consisted of $27.1 million attributable to the acquisitions of Hutchinson and Sinterloy and $8.3 million for the purchase of property, plant and equipment. In order to achieve long-term growth prospects and enhance product quality, capital spending in 1999 is anticipated to be approximately $11.0 million.
Net cash provided by financing activities was $8.5 million in 1998, primarily from the common stock offering and term loan proceeds. Proceeds of $87.7 million were used primarily to repay debt of $71.8 million and repurchase $2.0 million of its common stock. In 1997, net cash used in financing activities was $0.1 million primarily for payment of capital lease obligations and preferred stock dividends.
The Company believes that cash flow from operating activities, borrowings under its credit facility and access to capital markets will be sufficient to satisfy its working capital, capital expenditure and debt requirements and to finance continued growth through acquisitions for the next twelve months.
Market Risk Disclosures.
The following discussion about the Company's market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The Company is exposed to market risk related to changes in interest rates and foreign currency exchange rates. The Company does not use derivative financial instruments for speculative or trading purposes.
Interest Rate Sensitivity.
Approximately 31.7 percent of the Company's long-term debt obligations bear interest at a variable rate. In order to mitigate the risk associated with interest rate fluctuations, in June 1998, the Company entered into an interest rate swap with a notional amount of $35.0 million.
At December 31, 1998, the notional amount was $32.5 million. The notional amount is used to calculate the contractual cash flow to be exchanged and does not represent exposure to credit loss.
If this agreement were settled at December 31, 1998, the Company would pay approximately $0.6 million.
Foreign Currency Exchange Risk.
The Company currently does not hedge its foreign currency exposure and, therefore, has not entered into any forward foreign exchange contracts to hedge foreign currency transactions. The Company has operations outside the United States with foreign-currency denominated assets and liabilities, primarily denominated in Italian lira and Canadian dollars. Because the Company has foreign-currency denominated assets and liabilities, financial exposure may result, primarily from the timing of transactions and the movement of exchange rates. The unhedged foreign currency balance sheet exposures as of December 31, 1998 are not expected to result in a significant impact on earnings or cash flows.
Year 2000 Readiness
Since 1998, the Company has been addressing Year 2000 readiness for both information technology and non-information technology systems with a corporate-wide initiative led by the Company's Manager of Information Technology. The initiative includes the identification of affected software, the development of a plan for correcting that software in the most effective manner and the implementation and monitoring of the plan. The Company is primarily using its own employees to achieve readiness in most of its manufacturing and operating systems. The Company is also using outside expertise to insure that specific systems are made Year 2000 ready.
The Company's manufacturing facilities use minimal Year 2000 dependent non-information technology systems. The Company's investigation of these systems has not revealed any Year 2000 issues which cannot be addressed with supplier provided software upgrades. The Company is continuing to investigate any non-information technology systems for Year 2000 related problems.
Each of the Company's operating units, in coordination with the Manager of Information Technology, has identified and communicated with the Company's key suppliers, distributors and customers about their Year 2000 readiness plans and progress. To date, a majority of the Company's material suppliers, distributors and customers have provided the Company with positive statements of Year 2000 readiness.
The Company expects to have only limited expenditures related to Year 2000 issues, consisting principally of personnel costs incurred in the ordinary course of business. The Company expects that the costs of software and hardware replacements to make all of its technology systems Year 2000 compliant will be less than $0.3 million.
The Company is in the process of developing a strategy to address issues which may result from any Year 2000 failures. These plans will likely result in some expenditures, including, increased inventory to assure adequate levels of supply. The exact costs are not determinable at this time. A worst-case scenario could result in system failures, causing the disruption of operations, which would prohibit the Company from engaging in normal business activities and could result in a material adverse effect on the Company's business and results of operations.
In 1998, the Company began to implement a replacement of its manufacturing and accounting software and hardware systems, which are Year 2000 compliant, in its Friction segment. As of December 31, 1998, the implementation was completed at its domestic friction locations, and it is expected to be completed at its foreign friction location in mid to late 1999.
Implementation dates and costs of the Company's Year 2000 readiness program are subject to change based on new circumstances that may arise or new information becoming available that may change the Company's underlying assumptions or requirements. Because the Company's Year 2000 readiness program is not yet fully implemented, there can be no assurance that the Company will not incur material costs beyond those currently estimated by the Company.
Forward-Looking Statements
Statements that are not historical facts, including statements about the Company's confidence in its prospects and strategies and its expectations about growth of existing markets and its ability to expand into new markets, to identify and acquire complementary businesses and to attract new sources of financing, are forward-looking statements that involve risks and uncertainties. These risks and uncertainties include, but are not limited to:
These risks and others that are detailed in this Annual Report and in the Company's Form 10-K must be considered by any investor or potential investor in the Company.