**UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549****FORM 10-K****ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES****EXCHANGEACT OF 1934** **For the fiscal year ended December 31, 2005****Commission file number 1-13293****The Hillman Companies, Inc.**(Exact name of registrant as specified in its charter)   **Delaware** **23-2874736**   (State or other jurisdiction of (I.R.S. Employerincorporation or organization) Identification No.)   **10590 Hamilton Avenue**  **Cincinnati, Ohio** **45231**   (Address of principal executive offices) (Zip Code)Registrant’s telephone number, including area code: **(513) 851-4900****Securities registered pursuant to Section 12(b) of the Act:**   Title of Class Name of Each Exchange on Which Registered   11.6% Junior Subordinated Debentures NonePreferred Securities Guaranty None**Securities registered pursuant to Section 12(g) of the Act:**NoneIndicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. YES o           NO þIndicate by check mark if the registrant is not required to file reports pursuant to Section 13 or15(d) of the Act of 1934. YES o           NO þIndicate by check mark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.YES o           NO þIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act. (Check one)Large accelerated filer o Accelerated filer o Non-accelerated filer þIndicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of theExchange Act.           YES o           NO þIndicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of the registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. þOn March 30, 2006, there were 6,212.9 Class A Common Shares issued and outstanding, 1,000.0 Class BCommon Shares issued and outstanding, 2,787.1 Class C Common Shares issued and outstanding,82,104.8 Class A Preferred Shares issued and outstanding by the Registrant and 57,282.4 Class APreferred Shares issued and outstanding by the Hillman Investment Company and 4,217,724 TrustPreferred Securities issued and outstanding by the Hillman Group Capital Trust. The TrustPreferred Securities trade on the American StockExchange under symbol HLM.Pr. The aggregate market value of the Trust Preferred Securities held bynon-affiliates at June 30, 2005 was $121,892,224.  
 

 
**PART I****Item 1 – Business****.****General**The Hillman Companies, Inc. (“Hillman” or the “Company”) is one of the largest providers ofhardware-related products and related merchandising services to retail markets in North America.The Company’s principal business is operated through its wholly-owned subsidiary, The HillmanGroup, Inc. (the “Hillman Group”) which had sales of approximately $382.5 million in 2005. TheHillman Group sells its products to hardware stores, home centers, mass merchants, pet supplystores, and other retail outlets principally in the United States, Canada, Mexico and SouthAmerica. Product lines include thousands of small parts such as fasteners and related hardwareitems; keys, key duplication systems and accessories; and identification items, such as, tags andletters, numbers, and signs. The Company supports its product sales with value added servicesincluding design and installation of merchandising systems and maintenance of appropriate in-storeinventory levels.The Company headquarters is located at 10590 Hamilton Avenue, Cincinnati, Ohio. The Companymaintains a website at http://www.hillmangroup.com. Information contained or linked on our websiteis not incorporated by reference into this annual report, and you should not consider any suchinformation to be a part of this annual report.**Background**On March 18, 2002, SunSource Inc., a Delaware corporation (“SunSource”), as a result of theacquisition of a majority of SunSource common stock by Allied Capital Corporation in September2001, changed its name to The Hillman Companies, Inc., which reflects its predominant business asone of the largest providers of hardware-related products and related merchandising services to theretail markets in North America. In connection with the SunSource name change, SunSource CapitalTrust, which has 4.2 million Trust Preferred Securities outstanding and trading on the AmericanStock Exchange under the symbol “HLM.Pr”, changed its name to the Hillman Group Capital Trust.On March 31, 2004, Hillman was acquired by an affiliate of Code Hennessy & Simmons LLC (“CHS”).Pursuant to the terms and conditions of the related Agreement and Plan of Merger (“MergerAgreement”), dated as of February 14, 2004, the Company was merged with an affiliate of CHS withthe Company surviving the merger (“Merger Transaction”). The total consideration paid in theMerger Transaction was $511.6 million including the repayment of outstanding debt and the value ofthe Company’s outstanding Trust Preferred Securities.As a result of the change of control, an affiliate of CHS owns 49.1% of the Company’s common stockand 54.5% of the Company’s voting common stock, Ontario Teacher’s Pension Plan (“OTPP”) owns 27.9%of the Company’s common stock and 31.0% of the Company’s voting common stock and HarbourVestPartners VI owns 8.7% of the Company’s common stock and 9.7% of the Company’s voting common stock.OTPP’s voting rights with respect to the election of directors to the Board of Directors is limitedto the lesser of 30.0% or the actual percentage of voting common stock held. Certain members ofmanagement own 14.1% of the Company’s common stock and 4.5% of the Company’s voting common stock.For a discussion of the Company’s capital stock, see Note 12, Common and Preferred Stock, of Notesto Consolidated Financial Statements.On January 5, 2006, the Company’s Hillman Group, Inc. subsidiary purchased certain assets of TheSteelWorks Corporation (“Steelworks”), a Denver, Colorado based manufacturer and distributor ofmetal shapes, threaded rod and metal sheet to the retail hardware and home improvement industry.Annual revenues of the SteelWorks customer base acquired are approximately $31 million. Theaggregate purchase price was $34.2 million paid in cash at closing.
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For additional information on certain of the transactions, see “Item 7 — Management’s Discussionand Analysis of Financial Conditions and Results of Operations.”**Industry Overview**Hillman operates in multiple channels of the retail marketplace such as hardware stores, nationaland regional home centers and mass merchants. Hillman focuses on delivering merchandising systems,point-of-sale displays, product support and sales installation services through its nationwidefield sales and service force to the retail sector.These retail channels have experienced significant change as a result of the growth of the largenational big box (“Big Box”) chains (defined as mass merchants, home centers and large-formatgrocery/drug centers), which have taken market share from the regional home centers and independenthardware dealers and cooperatives. Hillman has developed sales, marketing, merchandising andservice specifically to meet the needs of the Big Box chains. Hillman believes that its marketknowledge, merchandising skills, breadth of inventory, and value-added services, including supportand fulfillment capabilities, will enable the Company to maintain its good relationships with theBig Box chains.**The Hillman Group**The Company is organized as a single business segment, the Hillman Group. With annualized sales ofapproximately $382.5 million, the Hillman Group believes it is a leading provider of fasteners andrelated small hardware items; keys, key duplication systems and related accessories, andidentification items, such as tags and letters, numbers and signs to retail outlets in NorthAmerica. Retail outlets served by Hillman include hardware stores, home centers, mass merchants,pet supply stores, grocery stores and drug stores. Through its field sales and serviceorganization, Hillman complements its extensive product selection with value-added services for theretailer.Sales and service representatives regularly visit retail outlets to review stock levels, reorderitems in need of replacement, and interact with the store management to offer new product andmerchandising ideas. Thousands of items can be actively managed with the retailer experiencing asubstantial reduction in paperwork and labor costs. Service representatives also assist inorganizing the products in a consumer-friendly manner. Hillman complements its broad range ofproducts with value-added merchandising services such as displays, product identification stickers,retail price stickers, store rack and drawer systems, assistance in rack positioning and storelayout, and inventory restocking services. Hillman regularly introduces new products and packagedesigns with color-coding for ease of shopping by consumers and modifies rack designs to improvethe attractiveness of individual store displays. Hillman functions as a merchandising manager forretailers, supporting these services with high order fill rates and rapid delivery from its 12distribution centers across the United States and Canada. Currently, orders are shipped within 48hours with a 97% order fill rate.The Company ships its products from 12 strategically located distribution centers in the UnitedStates and Canada (See Item 2 – Properties). In 2002, Hillman invested $9.8 million in a state ofthe art distribution facility in Cincinnati, Ohio. In addition to improving order turnaround timeand reducing labor costs, the new facility provides additional capacity to accommodate future salesgrowth. In 2004, the Company moved into a new facility in Lewisville, Texas, and the implementationof warehouse management technology was completed in December. In June 2005, warehouse managementsoftware was implemented in the Shafter, California facility. Hillman utilizes a third partylogistics provider to warehouse and ship customer orders in Mexico.Hillman also manufactures and markets a value-added mix of high-tech and conventional products intwo core product categories: key duplication systems and identification systems. Thepatent-protected Axxess Precision Key Duplication SystemTM has proven to be a profitable revenuesource within Big Box retailers. The technology developed for this system revolutionized the keyduplicating process utilizing computer aided alignment, indexing and duplication of keys. Thissystem has been placed in over 14,000 retail locations to date and is supported by Hillman salesand service representatives.
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In addition, Hillman offers a commercialized, consumer-operated vending system, Quick-TagTM, whichprovides custom engraved specialty items, such as pet identification tags, luggage tags and otherengraved identification tags. To date, more than 3,450 Quick-TagTM machines have been placed inretail locations which are being supported by Hillman’s sales and service representatives.     ***Products and Suppliers***Currently, Hillman purchases its products from approximately 650 vendors, the largest of whichaccounted for approximately 9% of Hillman’s annual purchases and the top five of which accountedfor 32.7% of its purchases. About 42% of its purchases are from overseas suppliers, with thebalance from domestic manufacturers and master distributors. Hillman’s vendor quality controlprocedures include on-site evaluations and frequent product testing. Vendors are also evaluatedbased on delivery performance and the accuracy of their shipments.     ***Fasteners***Hillman’s fastener product line encompasses standard and specialty nuts, bolts, washers, screws,anchors and picture hanging items. The line also includes brass, nylon, stainless steel, chromeand galvanized and other miscellaneous fasteners. The depth of the line, over 40,000 products, isbelieved to be the largest among suppliers servicing the hardware retail segment. Fastenersgenerated 58.7% of total revenue in 2005.     ***Keys and Key Accessories***Hillman provides a line of metal key products for major retailers and the automotive sector.Hillman manufactures two metal key duplication systems that are niche-marketed to retail outlets,primarily mass merchants and home centers, and a code cutting system for use in automotivedealerships and in vehicle fleet environments.The Axxess Precision Key Duplication SystemTM produces duplicate keys with the precision of alocksmith while minimizing the technical skill required by operators. The system was developed inresponse to retailers’ needs for reducing the miscut rate on keys. Axxess keys provide retailerswith nearly ten times more gross profit per square foot than the average of all products sold ingrocery and mass merchant channels.Hillman also markets a conventional key cutting system. The styles of keys marketed includestandard brass keys, WackeysTM, NFL, MLB, NCAA logo keys, Color PlusTM keys, rubber head keys, andhigh security vehicle anti-theft key blanks. The conventional system is marketed to retailers whodo not experience high employee turnover and therefore do not have the same labor constraints asmass merchants, home centers or grocery and drug retailers.The key cutting system developed for the automotive industry, PC+ Code Cutter, produces automobilekeys using alphanumeric codes based on a vehicle’s identification number. Utilizing a proprietarycomputer program, the PC+ Code Cutter identifies and then cuts keys based on the automobile’soriginal key pattern. The PC+ Code Cutter is distributed through Barnes Distribution, adistribution company serving vehicular and industrial markets. Since its introduction in February1996, more than 7,900 PC+ Code Cutter and 4,100 of the new Flash Code Cutter systems have beensold.Hillman also markets key accessories in conjunction with its key duplication systems. Popularaccessories include the Key LightTM, Valet KeyChainTM, FanatixTM key identifiers, key coils and keyclips. The Key MatesTM line of key accessories includes a broad range of products such as keychains, tags, lights, floats, holders, whistles, and a host of other miscellaneous complementaryitems. Revenues for keys, key accessories, and the PC+ Code Cutter represented 24.3% of totalrevenues in 2005.     ***Engraving***Quick-TagTM is a patented, state-of-the-art consumer-operated vending system that custom engravesspecialty products such as pet identification tags, military-style I.D. tags, holiday ornaments andluggage tags. Hillman initially targeted the pet identification
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market with its Quick-TagTM system, and has facilitated the process of obtaining a pet tag byproviding pet owners with a quick and convenient means to custom engrave tags while shopping atlarge format retail stores such as Wal-Mart and PetSmart. Hillman has developed other high impactapplications for its Quick-TagTM interactive engraving technology, including luggage tags, keychains and military-style identification tags. The Company has placed over 3,450 Quick-Tagmachines in retail outlets throughout the United States and Canada. Using an interactive touchscreen, customers input information such as a pet name and telephone number, and the system’sproprietary technology engraves the tag in less than two minutes. The Quick-Tag system does notrequire incremental labor and generates high levels of customer satisfaction and attractive marginsfor the retailer. The Quick-Tag custom engraving systems generate retail profit per square footover seven times the typical retail average. Revenues for engraving products represented 8.4% oftotal revenues in 2005.Hillman purchases a wide variety of materials and components to manufacture the Axxess KeyDuplication and Quick-Tag engraving machines, many of which are manufactured to its specifications.Management does not believe that it is overly dependent on any one supplier. The machinecomponents do not generally require proprietary technology and Hillman has identified or usedalternate suppliers for its primary sourcing needs.     ***Letters, Numbers and Signs (“LNS”)***The LNS program offers an extensive collection of items for both domestic and commercial use suchas packaged self-adhesive letters and numbers, mailbox numbers and accessories, house numbers andletters, contractor safety program signs, and driveway markers and reflectors. Typical retailersdedicate eight linear feet of retail space for this product and view it as a significantcontributor to their retail offerings. Hillman also offers a variety of merchandisers and programconfigurations for this line. LNS sales accounted for 8.6% of 2005 revenues.     ***Markets and Customers***Hillman sells its products to national accounts such as Wal-Mart, Home Depot, Lowe’s, Sears,Tractor Supply, PetSmart, and PETCO. Hillman’s status as a national supplier of unique,proprietary products to Big Box retailers allows it to develop a strong market position and highbarriers to entry within its product categories. Management believes that the dynamics, which makeits services attractive to hardware retailers, are present with these larger customers as well.Hillman services approximately 15,000 franchise and independent (“F&I”) retail outlets. Theseindividual dealers are typically members of the larger cooperatives, such as True Value, Ace andDo-it-Best. The Company sells directly to the cooperative’s retail locations and also suppliesmany fastener items to the cooperative’s central warehouses. These central warehouses distributeto their members that do not have a requirement for Hillman’s in-store service. These arrangementsreduce credit risk and logistic expense for Hillman and reduce central warehouse inventory anddelivery costs for the cooperatives.A typical hardware store maintains in inventory thousands of different items, many of whichgenerate small dollar sales but large profits. It is difficult for a retailer to economicallymonitor all stock levels and to reorder the products from multiple vendors. The problem iscompounded by the necessity of receiving small shipments of inventory at different times and havingto stock the goods. However, failure to have these small items available will have an adverseeffect on store traffic, thereby denying the retailer the opportunity to sell items that generatehigher dollar sales.Hillman sells its products to approximately 21,500 customers, the top five of which accounted for44.3% of its annualized sales. Lowe’s is the single largest customer, representing 18.4% of totalsales, Home Depot is the second largest at 10.9% and Wal-Mart is the third largest at 9.5%. Noother customer accounted for more than 5% of the Company’s total sales in 2005.Hillman’s telemarketing activity sells to thousands of smaller hardware outlets and non-hardwareaccounts. New business is also being pursued internationally in such places as Canada, Mexico,South and Central America, and the Caribbean.
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     ***Sales and Marketing***Management believes that Hillman provides excellent product support, customer service and profitopportunities for its retail distribution partners. It also believes that a significant source ofits competitive advantage rests in its ability to provide a greater level of customer service thanits competitors. Hillman products are covered directly by the combined field service organization,which provides service support through field visits. These field visits provide Hillman withcritical information relating to consumer buying patterns and retailing trends, and complementstheir new product development efforts. Field service representatives also help retail customers toimprove the efficiency and profitability of Hillman’s on-site merchandising systems by consultingwith customers in the areas of EDI, product planning, inventory control, systems interface andstore operations.The national accounts field service organization consists of over 440 service people and 28 fieldmanagers focusing on Big Box retailers, pet super stores, large national discount chains andgrocery stores. This organization reorders products, details store shelves and sets up in-storepromotions.Management believes the Company consistently is able to be responsive to the needs of the F&Iretailers because it employs the largest direct sales organization in the retail home industry.This organization consists of 224 people, managed by 16 field managers. Each sales representativeis responsible for approximately 50 full service accounts that they call on approximately every twoweeks. Coupled with the efforts of the Marketing Department, the sales force not only sellsproducts, but can sell merchandising and technological support capabilities as well. The MarketingDepartment provides support through the development of new products, sales collateral material,promotional items, merchandising aids and marketing services such as advertising and trade showmanagement. Its electronic data interchange (“EDI”) system is used by a number of its largecustomers for handling of orders and invoices.     ***Competition***The primary competitors in the national accounts marketplace for fasteners are Crown-Bolt, ITWInc., R&B, Inc. and the Newell Group. Competition is based primarily on in-store service andprice. Other competitors are local and regional distributors.The principal competitors for Hillman’s F&I business are Midwest Fasteners, Serv-A-Lite and Hyko inthe hardware store marketplace. The first two carry mainly fastener products, while the latter isthe major competitor in LNS products and keys. Hillman competes primarily on field service,merchandising, as well as product availability, price and breadth of product line.Management estimates that Hillman sells to approximately 65% of the full service hardware stores inthe F&I marketplace. The hardware outlets that purchase products but not services from Hillmanalso purchase products from local and regional distributors and cooperatives. Competition in theF&I marketplace is primarily on the basis of price and availability.Hillman competes with Hyko for LNS sales in hardware stores, home centers and mass merchants.Competitors in the pet tag market are specialty retailers, direct mail order and retailers within-store mail order capability. The Quick-Tag system has patent protected proprietary technologythat is a major barrier to entry and preserves this market segment.**Insurance Arrangements**Under the Company’s current insurance programs, commercial umbrella coverage is obtained forcatastrophic exposure and aggregate losses in excess of expected claims. Since October 1991, theCompany has retained the exposure on certain expected losses related to worker’s compensation,general liability and automobile. The Company also retains the exposure on expected losses relatedto health benefits of certain employees. The Company believes that its present insurance isadequate for its businesses. See Note 17, Commitments and Contingencies, of Notes to ConsolidatedFinancial Statements of the Company as of and for the three years ended December 31, 2005.
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**Employees**As of December 31, 2005, the Company had 1,853 full time and part time employees. In the opinionof management, employee relations are good.**Backlog**The Company’s sales backlog from ongoing operations was $5.8 million as of December 31, 2005, and$5.7 million as of December 31, 2004.**Where You Can Find More Information**The Company files quarterly reports on Form 10-Q, annual reports on Form 10-K and special reportson Form 8-K, and other information with the Securities and Exchange Commission (the “Commission”).You may read and copy any reports, statements, or other information filed by the Company at theCommission’s public reference rooms at 100 F Street, N.E., Washington, D.C. 20549.Please call the Commission at 1-800-SEC-0330 for more information on the public reference rooms.The Commission also maintains an Internet site at http://www.sec.gov that contains reports,proxy and information statements, and other information regarding issuers, like Hillman, that fileelectronically with the Commission. Copies may also be obtained, after paying a duplicating fee,by electronic request to publicinfo@sec.gov or by written request to Public ReferenceSection, Washington, D.C. 20549-0102.You can inspect reports, proxy statements, and other information about the Company at the officesof The American Stock Exchange, 86 Trinity Place, New York, NY 10006.**Item 1A — Risk Factors.**An investment in the Company’s securities involves certain risks as discussed below. However, therisks set forth below are not the only risks the Company faces, and it faces other risks which havenot yet been identified or which are not yet otherwise predictable. If any of the following risksoccur or are otherwise realized, the Company’s business, financial condition and results ofoperations could be materially adversely affected. You should consider carefully the risksdescribed below and all other information in this annual report, including the Company’s financialstatements and the related notes and schedules thereto, prior to making an investment decision withregard to the Company’s securities.**The Company operates in a highly competitive industry, which may have a material adverse effect onits business, financial condition and results of operations.**The retail industry is highly competitive, with the principal methods of competition being price,quality of service, quality of products, product availability, credit terms and the provision ofvalue-added services, such as merchandising design, in-store service and inventory management. TheCompany encounters competition from a large number of regional and national distributors, some ofwhich have greater financial resources than the Company and may offer a greater variety ofproducts. If these competitors are successful, the Company’s business, financialcondition and results of operations may be materially adversely affected.**The Company’s business, financial condition and results of operations may be materially adverselyaffected by seasonality and general economic conditions affecting its sales.**Hillman has, in the past, experienced seasonal fluctuations in sales and operating results fromquarter to quarter. Typically, the first calendar quarter is the weakest due to the effect ofweather on home projects and the construction industry.
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**Largecustomer concentration and the inability topenetrate new channels of distribution could adversely affect the business.**The Company’s three largest customers constituted approximately 38.8% of sales for 2005. The lossof one of these customers or a material adverse change in the relationship with these customerscould have a negative impact on business. The Company’s inability to penetrate new channels ofdistribution may also have a negative impact on its future sales and business.**Successfulsales and marketing efforts depend on the Company’s ability torecruit and retain qualified employees.**The success of the Company’s efforts to grow itsbusiness depends on the contributions and abilities of key executives, its sales force and otherpersonnel, including the ability of its sales force to achieve adequate customer coverage.The Company must therefore continue to recruit, retain and motivate management, sales and other personnel to maintain its current business and support its projected growth. A shortage of these key employees might jeopardize the Company’s ability to implement its growth strategy.**The Company is exposed to adverse changes in currency exchange rates.**The Company imports a significant portion of its product from the Far East including China, Taiwanand India. As a result, the Company is exposed to movements in the exchange rates of thesecountries versus the United States Dollar.**The Company’s results of operations could be negatively impacted by inflation in the cost of rawmaterials, freight and energy.**The Company’s products are manufactured of metals, including but not limited to steel, aluminum,zinc, and copper. Additionally, the Company uses other commodity based materials in the manufactureof LNS that are resin based and subject to fluctuations in the price of oil. As described in moredetail in Item 7 hereto, the Company has been negatively impacted by commodity and freightinflation in recent years, and it expects energy and certain commodity prices, particularlynon-ferrous metals, may increase. If the Company is unable to mitigate these inflation increasesthrough various customer pricing actions and cost reduction initiatives, its profitability may beadversely affected.**The Company’s business is subject to risks associated with sourcing product from overseas.**The Company imports large quantities of its fastener products. Substantially all of its importoperations are subject to customs requirements and to tariffs and quotas set by governments throughmutual agreements or bilateral actions. In addition, the countriesfrom which the Company’s productsand materials are manufactured or imported may from time to time impose additional quotas,duties, tariffs or other restrictions on its imports or adversely modify existing restrictions.Imports are also subject to unpredictable foreign currency variation which may increase theCompany’s cost of goods sold. Adverse changes in these import costs and restrictions, or theCompany’s suppliers’ failure to comply with customs regulations or similar laws, could harm theCompany’s business.The Company’s ability to import products in a timely and cost-effective manner may also be affectedby conditions at ports or issues that otherwise affect transportation and warehousing providers,such as port and shipping capacity, labor disputes, severe weather or increased homeland securityrequirements in the U.S. and other countries. These issues could delay importation of products orrequire the Company to locate alternative ports or warehousing providers to avoid disruption tocustomers. These alternatives may not be available on short notice or could result in highertransit costs, which could have an adverse impact on the Company’s business and financialcondition.**If the Company were required to write down all or part of its goodwill or indefinite-livedtradenames, its net income could be materially adversely affected.**As a result of the Merger Transaction the Company has $241.5 million of goodwill and $44.7 millionof indefinite-lived tradenames recorded on its Consolidated Balance Sheet at December 31, 2005. TheCompany is required to periodically determine if its goodwill or indefinite-lived tradenames havebecome impaired, in which case it would write down the impaired portion of the intangible asset. Ifthe Company were required to write down all or part of its goodwill or indefinite-lived tradenames,its net income could be materially adversely affected.
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**The Company’s success is highly dependent on information and technology systems.**The Company believes that its proprietary computer software programs are an integral part of itsbusiness and growth strategies. Hillman depends on its information systems to process orders, tomanage inventory and accounts receivable collections, to purchase, sell and ship productsefficiently and on a timely basis, to maintain cost-effective operations and to provide superiorservice to its customers. There can be no assurance that the precautions which the Company hastaken against certain events that could disrupt the operations of its information systems willprevent the occurrence of such a disruption. Any such disruption could have a material adverseeffect on the Company’s business and results of operations.**The inability to make timely and cost effective acquisitions may adversely affect the Company’sbusiness.**One element of Hillman’s future growth strategy is to pursue selected acquisitions that eitherexpand or complement its businesses in new or existing markets. However, there can be no assurancethat the Company will be able to identify or acquire acceptable acquisition candidates on termsfavorable to the Company and in a timely manner, if at all, to the extent necessary to fulfillHillman’s growth strategy.The process of integrating acquired businesses into the Company’s operations may result inunforeseen difficulties and may require a disproportionate amount of resources and management’sattention, and there can be no assurance that Hillman will be able to successfully integrateacquired businesses into its operations, including the Steelworks acquisition in January 2006.**The Company is subject to fluctuations in interest rates.**A significant portion of the Company’s outstanding debt has variable rate interest. Increases inborrowing rates will increase the Company’s cost of borrowing,which may affect the Company’s results of operations andfinancial condition.**Item 1B— Unresolved Staff Comments.**None.
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**Item 2 – Properties.**The Company’s principal office, manufacturing and distribution properties are as follows:         **Approximate**  **Location** **Square Footage** **Description**Cincinnati, Ohio  240,000  Office, DistributionForest Park, Ohio  335,000  DistributionTempe, Arizona  185,000  Office, Mfg., DistributionShafter, California  84,000  DistributionLewisville, Texas  72,000  DistributionWilsonville, Oregon  29,000  DistributionCharlotte, North Carolina  40,000  DistributionGreen Island, New York  56,000  DistributionLaCrosse, Wisconsin  48,000  DistributionRiviera Beach, Florida  37,000  DistributionGoodlettsville, Tennessee  72,000  Mfg., DistributionMississauga, Ontario  11,000  DistributionWith the exception of Goodlettsville, Tennessee, all of the Company’s facilities are leased. Inthe opinion of management, the Company’s existing facilities are in good condition.**Item 3 – Legal Proceedings.**Legal proceedings are pending which are either in the ordinary course of business orincidental to the Company’s business. Those legal proceedings incidental to the business of theCompany are generally not covered by insurance or other indemnity. In the opinion of management,the ultimate resolution of the pending litigation matters will not have a material adverse effecton the consolidated financial position, operations or cash flows of the Company.**Item 4 – Submission of Matters to a Vote of Security Holders.**The Company did not submit any matters to a vote of Trust Preferred holders during the quarterended December 31, 2005.
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**Part II****Item 5– Market for Registrant’s Common Equity, Related****Stockholder Matters and Issuer Purchases of Equity Securities****.****Stock Exchange Listing**The Company’s common stock does not trade and is not listed on or quoted in an exchange or othermarket. However, the Trust Preferred Securities trade under the ticker symbol HLM.Pr on theAmerican Stock Exchange. The following table sets forth the high and low closing sale prices on theAmerican Stock Exchange composite tape for the Trust Preferred Securities.         **2005** **High** **Low**First Quarter $29.44  $27.55 Second Quarter  29.25   28.15 Third Quarter  29.29   28.75 Fourth Quarter  29.28   28.61          **2004** **High** **Low**First Quarter $27.50  $26.15 Second Quarter  27.55   26.50 Third Quarter  27.70   26.80 Fourth Quarter  29.45   27.40 The Trust Preferred Securities have a liquidation value of $25.00 per security. As of March 17,2006, there were 687 holders of Trust Preferred Securities and fifteen (15) common stockholders.The total number of Trust Preferred Securities outstanding as of March 30, 2006, was 4,217,724.The total number of shares of Common Stock outstanding as of March 30, 2006, was 10,000.**Distributions**The Company pays interest to the Hillman Group Capital Trust (“the Trust”) on the JuniorSubordinated Debentures underlying the Trust Preferred Securities at the rate of 11.6% per annum ontheir face amount of $105.4 million, or $12.2 million per annum in the aggregate. The Trustdistributes an equivalent amount to the holders of the Trust Preferred Securities. For the yearsended December 31, 2005 and 2004, the Company paid $12.2 million per year in interest on the JuniorSubordinated Debentures, which was equivalent to the amounts distributed on the Trust for the sameperiods.The interest payments on the Junior Subordinated Debentures underlying the Trust PreferredSecurities are deductible for federal income tax purposes by the Company under current law and willremain an obligation of the Company until the Trust Preferred Securities are redeemed or upon theirmaturity in 2027.For more information on the Trust and Junior Subordinated Debentures, see “Item 7-Management’sDiscussion and Analysis of Financial Condition and Results of Operations.”**Issuer Purchases of Equity Securities**The Company made no repurchases of its equity securities during 2005.
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**Item 6 – Selected Financial Data****.**As a result of the Merger Transaction, the Company’s operations for the periods presentedsubsequent to the September 30, 2001 acquisition by Allied Capital but prior to March 31, 2004 arereferenced herein as the predecessor operations (the “Predecessor” or “Predecessor Operations”).The Company’s operations for the periods presented since the Merger Transaction are referencedherein as the successor operations (the “Successor” or “Successor Operations”) and include theeffects of the Company’s debt refinancing. Periods prior to the acquisition by Allied Capital arereferred to below as the pre-predecessor operations (the “Pre-predecessor” or “Pre-predecessorOperations”).The following table sets forth selected consolidated financial data of the Pre-predecessor for thenine months ended September 30, 2001; and consolidated financial data of the Predecessor as of andfor the three months ended March 31, 2004, the years ended December 31, 2003 and 2002 and the threemonths ended December 31, 2001; and consolidated financial data of the Successor as of and for thenine months ended December 31, 2004 and the year ended December 31, 2005. See the accompanyingNotes to Consolidated Financial Statements and “Item 7 — Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” for information regarding the acquisition of theCompany by CHS and the Company’s debt refinancing as well as other acquisitions that affectcomparability.(dollars in thousands)                                                           **Pre-**  **Successor**  **Predecessor**  **Predecessor**      Nine  Three                   Months  Months         Three  Nine Months  Year Ended Ended  Ended Year Ended Year Ended Months Ended  Ended 9/30/01  12/31/05 12/31/04  03/31/04 12/31/03 12/31/02 12/31/01  (3)**Income Statement Data:**                                                             Net sales $382,512  $273,374   $78,190  $317,671  $286,599  $61,538   $340,426 Gross profit  206,290   150,402    42,807   174,316   160,503   35,249    142,986 Non-recurring expense (2)  —   —    30,707   —   —   —    — Net (loss) income  (3,654)  779    (20,366)  (5,709)  5,243   (2,128)   (1,097)                               **Balance Sheet Data at December 31:**                              Total assets $631,336  $628,899    N/A  $354,253  $375,653  $352,960    N/A Long-term debt and                              capitalized lease obligations (1)  263,508   264,101    N/A   150,338   147,175   130,836    N/A  (1) Includes current portion of long-term debt and capitalized lease obligations. (2) Non-recurring expenses incurred in connection with CHS merger including $24,353 forstock options granted at an exercise price below fair market value, $4,035 in investmentbanking and legal fees, $1,922 in management bonuses and $397 in payroll taxes. See theNotes to the Consolidated Financial Statements for further details. (3) Financial data for the nine months ended September 30, 2001 include the operatingresults of the SunSource Technology Services business, the assets of which were soldpursuant to an Asset Purchase Agreement on September 28, 2001.
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**Item 7 – Management’s Discussion and Analysis of Financial****Condition and Results of Operations****.**The following discussion provides information which management believes is relevant to anassessment and understanding of the Company’s operations and financial condition. This discussionshould be read in conjunction with the consolidated financial statements and related notes andschedules thereto appearing elsewhere herein.***General***The Hillman Companies, Inc. (“Hillman” or the “Company”) is one of the largest providers ofhardware-related products and related merchandising services to the retail markets in NorthAmerica.The Company’s principal business is operated through its wholly-owned subsidiary, The HillmanGroup, which had sales of approximately $382.5 million in 2005. The Hillman Group sells itsproduct lines and provides its services to hardware stores, home centers, mass merchants, petsupply stores, and other retail outlets principally in the United States, Canada, Mexico and SouthAmerica. Product lines include thousands of small parts such as fasteners and related hardwareitems; keys, key duplication systems and accessories; and identification items, such as, tags andletters, numbers, and signs. Services offered include design and installation of merchandisingsystems and maintenance of appropriate in-store inventory levels.***Merger Transaction***On March 31, 2004, The Hillman Companies, Inc. was acquired by an affiliate of Code Hennessy &Simmons LLC (“CHS”). Pursuant to the terms and conditions of an Agreement and Plan of Merger(“Merger Agreement”) dated as of February 14, 2004, the Company was merged with an affiliate of CHSwith the Company surviving the merger (“Merger Transaction”). The total consideration paid in theMerger Transaction was $511.6 million including repayment of outstanding debt and including thevalue of the Company’s outstanding Trust Preferred Securities ($102.4 million at merger).Prior to the merger, Allied Capital Corporation (“Allied Capital”) owned 96.8 % of the Company’scommon stock. As a result of the change of control, an affiliate of CHS owns 49.1% of theCompany’s common stock and 54.5% of the Company’s voting common stock, Ontario Teacher’s PensionPlan (“OTPP”) owns 27.9% of the Company’s common stock and 31.0% of the Company’s voting commonstock and HarbourVest Partners VI owns 8.7% of the Company’s common stock and 9.7% of the Company’svoting common stock. OTPP’s voting rights with respect to the election of directors to the Boardof Directors is limited to the lesser of 30.0% or the actual percentage of voting stock held.Certain members of management own 14.1% of the Company’s common stock and 4.5% of the Company’svoting common stock.The Company’s operations for the periods presented prior to the March 31, 2004 Merger Transactionare referenced herein as the predecessor financial statements (the “Predecessor” or “PredecessorFinancial Statements”). The Company’s Consolidated BalanceSheet as of December 31, 2005 and 2004and its related Consolidated Statements of Operations for the year ended December 31, 2005 and thenine months ended December 31, 2004, and its Consolidated Statements of Cash Flows and Changes inStockholders’ Equity for the year ended December 31, 2005 and the nine months ended December 31,2004 are referenced herein as the successor financial statements (the “Successor” or “SuccessorFinancial Statements”).***Financing Arrangements***On March 31, 2004, the Company, through its Hillman Group subsidiary, refinanced its revolvingcredit and senior term loans with a Senior Credit Agreement (the “Senior Credit Agreement”)consisting of a $40.0 million revolving credit (the “Revolver”) and a $217.5 million term loan (the“Term Loan”). The Senior Credit Agreement has a seven-year term and provides borrowings at interestrates based on the London Interbank Offered Rates (the
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“LIBOR”) plus a margin of between 2.25% and 3.00% (the “LIBOR Margin”), or prime (the “Base Rate”)plus a margin of between 1.25% and 2.0% (the “Base Rate Margin”). The applicable LIBOR Margin andBase Rate Margin is based on the Company’s leverage as of the last day of the preceding fiscalquarter. In accordance with the Senior Credit Agreement, letter of credit commitment fees arebased on the average daily face amount of each outstanding letter of credit multiplied by a letterof credit margin of between 2.25% and 3.00% per annum (the “Letter of Credit Margin”). The Letterof Credit Margin is also based on the Company’s leverage at the date of the preceding fiscalquarter. The Company also pays a commitment fee of 0.50% per annum on the average daily unusedRevolver balance.In addition, on March 31, 2004, the Company, through The Hillman Group, issued $47.5 million ofunsecured subordinated notes to Allied Capital maturing on September 30, 2011 (“Subordinated DebtIssuance”). Interest on the Subordinated Debt Issuance is at a fixed rate of 13.5% per annum, withcash interest payments required on a quarterly basis at a fixed rate of 11.25% commencing April 15,2004. The outstanding principal balance of the Subordinated Debt Issuance shall be increased on aquarterly basis at the remaining 2.25% fixed rate (the “PIK Amount”). All of the PIK Amounts aredue on the maturity date of the Subordinated Debt Issuance.The Company pays interest to the Trust on the Junior Subordinated Debentures underlying the TrustPreferred Securities at the rate of 11.6% per annum on their face amount of $105.4 million, or$12.2 million per annum in the aggregate. The Trust distributes an equivalent amount to theholders of the Trust Preferred Securities.On April 28, 2004, the Company entered into an Interest Rate Swap Agreement (“Swap”) with atwo-year term for a notional amount of $50.0 million. The Swap effectively fixes the interest rateon $50.0 million of the Term Loan at a rate of 1.17% plus the applicable interest rate margin forthe first three months of the Swap with incremental increases ranging from 28 to 47 basis points ineach successive quarter.***Acquisitions and Divestitures***On October 3, 2002, the Company, through The Hillman Group, purchased the net assets of theDIY division (“DIY”) of the Fastenal Company of Winona, MN (“Fastenal”). DIY, with annual sales ofapproximately $22 million, distributes fasteners, anchors, picture hanging wire, hooks, tacks, andbrads to national hardware cooperatives and home centers. The Company paid $15.3 million in cashto Fastenal for the net assets of DIY. The transaction was financed from the Company’s existingcredit lines.On May 1, 2002, the Company’s Hillman Group purchased certain assets of the Lowe’s specialtyfastener business from R&B, Inc. for cash consideration of $6.2 million. The purchase of thespecialty fastener business has expanded the breadth of the Company’s product offering to Lowe’s.In connection with this transaction, the Company settled litigation filed by R&B, Inc. in February1996 related to the Company’s sale of the Dorman Products division. The litigation settlement inthe amount of $1.25 million was fully reserved on the Company’s balance sheet, and accordingly,there was no charge to income in 2002.On March 2, 2000, the Company contributed the interests in its Kar Products, Inc. and A & H Bolt &Nut Company Limited operations (collectively, the “Kar business”), to a newly-formed partnershipaffiliated with Glencoe Capital, L.L.C. (“Glencoe”). Glencoe contributed cash equity to the newpartnership, GC-Sun Holdings L.P. (“G-C”). The Company received $105 million in cash proceeds fromthe transaction through repayment of assumed debt by G-C and retained minority ownership in G-C.Affiliates of Glencoe held the controlling interest in G-C. The Company recorded a pre-tax gain onthe transaction of approximately $49.1 million in the first quarter of 2000. On January 4, 2002,G-C provided the Company notice that it intended to exercise its call right to purchase theCompany’s partnership interest as a result of the merger transaction with Allied Capital. On April13, 2002, the Company entered into a Unit Repurchase Agreement with G-C, pursuant to which G-Cexercised its call right. In exchange for its interest in G-C, the Company received a $10 millionsubordinated note from G-C.
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In February 2003, G-C sold the assets of its largest operating division, Kar Products. The proceedsof the sale were primarily used to pay down G-C’s senior creditors. Following the sale of KarProducts, the Company estimated the enterprise value of G-C based on the cash flows and book valueof the remaining operating division under a held for sale methodology. The excess of the estimatedenterprise value less debt obligations senior to the G-C note were determined to be insufficient tosupport the value of the G-C note and accrued interest thereon. Accordingly, the Company recordedan $11.3 million charge to income during the year ended December 31, 2003 to write-down the facevalue of the note and accrued interest thereon to zero.The G-C note was distributed to the Company’s common stockholders on March 31, 2004.***Subsequent Event***OnJanuary 5, 2006, the Company’s Hillman Group, Inc. subsidiary purchased certain assets ofThe SteelWorks Corporation (“SteelWorks”), a Denver, Colorado based manufacturer and distributor ofmetal shapes, threaded rod and metal sheet to the Retail Hardware and Home Improvement Industry.Annual revenues of the SteelWorks customer base acquired are approximately $31 million. Theaggregate purchase price was $34.2 million paid in cash at closing.
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***Results of Operations*****Sales and Profitability for each of the Three Years Ended December 31**                           **(dollars in thousands)**   **2005**  **2004 (a)**  **2003**       **% of**      **% of**      **% of**   **Amount**  **Total**  **Amount**  **Total**  **Amount**  **Total** Net sales $382,512   100.0% $351,564   100.0% $317,671   100.0%Cost of sales (exclusive ofdepreciation and amortizationshown below)  176,222   46.1%  158,355   45.0%  143,355   45.1%                   Gross profit  206,290   53.9%  193,209   55.0%  174,316   54.9%                                            Operating expenses:                        Selling  72,282   18.9%  67,796   19.3%  57,939   18.2%Warehouse & delivery  47,705   12.5%  44,245   12.6%  40,590   12.8%General & Administrative  19,078   5.0%  18,221   5.2%  22,229   7.0%Stock compensation expense  1,601   0.4%  272   0.1%  —   0.0%                   Total SG&A  140,666   36.8%  130,534   37.1%  120,758   38.0%Non-recurring expense (b)  —   0.0%  30,707   8.7%  —   0.0%Depreciation  15,605   4.1%  15,187   4.3%  14,399   4.5%Amortization  7,228   1.9%  5,748   1.6%  1,437   0.5%Management fees  1,045   0.3%  1,329   0.4%  1,800   0.6%                   Total operating expenses  164,544   43.0%  183,505   52.2%  138,394   43.6%                                            Other income (expense)  (87)  0.0%  277   0.1%  681   0.2%                         Income from operations  41,659   10.9%  9,981   2.8%  36,603   11.5%                         Interest expense  20,974   5.5%  17,539   5.0%  15,405   4.8%Interest expense on mandatorilyredeemable preferred stock &management purchased preferredoptions  7,972   2.1%  5,458   1.6%  —   0.0%Interest expense on juniorsubordinated notes  12,609   3.3%  12,609   3.6%  —   0.0%Investment income on trustcommon securities  (378)  -0.1%  (378)  -0.1%  —   0.0%Distributions on guaranteedpreferred beneficial interests  —   0.0%  —   0.0%  12,231   3.9%Write-down of note receivable  —   0.0%  —   0.0%  11,258   3.5%                                            Income (loss) before taxes  482   0.1%  (25,247)  -7.2%  (2,291)  -0.7%                    (a) For the purpose of comparing the Company’s results of operations for each of the threeyears ended December 31, 2005, the results of the Predecessor Operations for the three monthsended March 31, 2004 have been combined with the results of the Successor Operations for thenine months ended December 31, 2004. (b) Represents one-time charges for stock options, management bonuses, investment banking, andlegal fees incurred in connection with the March 31, 2004 Merger Transaction.
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**Years Ended December 31, 2005 and 2004**Net sales of $382.5 million in 2005 increased $30.9 million or 8.8 % from 2004. Most of theincrease was due to sales to national accounts, including Lowe’s,Home Depot and Wal*Mart, which wereup $12.4 million or 8.2% in 2005. Lowe’s, on the strength of new store openings and new productintroductions, accounted for $8.1 million of the National Account sales increase. The Home Depotsales increase in 2005 of $5.3 million can also be attributed primarily to new store openings.Wal*Mart’s 2005 sales in the United States actually declined by 5% or $1.3 million as a result of aconcerted effort by Wal*Mart corporate to reduce inventory levels in their fiscal fourth quarter.Sales to Franchise and Independent (“F&I”) hardware stores improved by $9.6 million or 7.8%compared to 2004. The F&I accounts are typically individual hardware dealers who are members of alarger cooperative such as Ace, True Value and Do-it Best. After several years of slow growth, theF&I business had a second year of solid growth. New account activity, including 115 new stores andover 160 competitor conversions were the primary drivers of the 2005 sales growth. Also, Hillmanintroduced several new products to the F&I accounts in 2005 such as chrome plated fasteners and anew picture hanging line.Regional accounts including 84 Lumber, Sutherlands and Westlake Hardware, increased sales by $3.6million or 18.6%. Engraving sales also posted strong sales growth of 9.7% or $2.9 million in 2005.The growth can be attributed to new store openings at PetSmart and PETCO combined with improvementin Wal*mart same store sales. International sales including Canada, Mexico, the Caribbean and LatinAmerica increased $2.5 million or 34.0% in 2005. Other accounts including the coop wholesalers,direct marketing and commercial accounts, declined by $0.1 million in 2005.The Company’s sales backlog, based upon cancelable purchase orders, was $5.8 million as of December31, 2005 compared to $5.7 million as of December 31, 2004.Gross profit declined from 54.9% in2004 to 53.9% in 2005 and was negatively affected in 2005by cost increases in several commodities essential to both our key and LNS product lines. Thematerial cost of a key blank is largely dictated by the price of copper which experienced significantincreases in 2005. Also, styrene, which is used in the manufacture ofLNS, is a resin based productaffected by surging oil prices in 2005.Selling, general and administrative (“S,G&A”) expense of $140.6 million in 2005 increased $10.1million or 7.8% over 2004. The increase in selling expenses of $4.5 million can be attributedprimarily to the cost of displays for new national account locations and retrofits of existingstores which increased $2.1 million in 2005 compared with the prior year. The additional increasein selling cost is the result of costs to provide service and merchandising to the expanded storebase. Warehouse and delivery costs, which are almost wholly variable with sales volume increases,were up $3.5 million in 2005. Productivity gains from the 2005 implementation of new technology inthe Dallas and Bakersfield distributions centers kept the overall cost to pick and ship ordersrelatively flat compared to 2004 despite the 8.9% increase in sales volume. Freight costs of $21.6million, on the other hand, increased $2.6 million or 14% over the prior year. Freight costs werenegatively impacted by fuel surcharges imposed by most of the Company’s transit suppliers. Generaland administrative expenses were up $0.9 million in 2005 primarily as a result of additionalaccounting fees associated with the restatement of the 2004 10-K.Depreciation expense increased $0.4 million from $15.2 million in 2004 to $15.6 million in 2005.The increased depreciation was a result of additional capital spending in 2005 for the automationand expansion of distribution facilities, an ERP implementation in the Company’s Mexico facilityand expanded placement of Quick-Tag machines.Following the March 31, 2004 Merger Transaction, the value of intangible assets was determined byan independent appraisal. In 2005, amortization expense increased $1.5 million as a result of afull year amortization of the newly valued intangible assets.The Company has recorded a management and transaction fee charge of $1.0 million for 2005 and $1.3million for 2004. As of the closing of the Merger Transaction in March 2004, the Company isobligated to pay management fees to a subsidiary of CHS for management
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services rendered in the amount of fifty-eight thousand dollars per month, plus out of pocketexpenses, and to pay transaction fees to a subsidiary of OTPP in the amount of twenty-six thousanddollars per month, plus out of pocket expenses, for each month. The Company was obligated to paymanagement fees to a subsidiary of Allied Capital for management services rendered in the amount of$1.8 million, plus out of pocket expenses, for calendar years subsequent to 2001. The payment ofmanagement fees was due annually after delivery of the Company’s annual audited financialstatements to the Board of Directors of the Company. The obligation to pay management fees toAllied Capital was terminated upon the payment of outstanding fees in the amount of $2.3 million onMarch 31, 2004 in connection with the closing of the Merger Transaction.Interest expense, net, increased $3.5 million to $21.0 million in 2005 from $17.5 million in 2004.The increase in interest expense, net, was primarily the result of increased Company debt relatedto the Merger Transaction, the amortization of additional deferred financing costs and increasedborrowing costs on the variable rate Term Loan.Interest expense on the mandatorily redeemable preferred stock and management purchased preferredoptions related to the Merger Transaction increased from $5.5 million in 2004 to $8.0 million in2005. The increase can be attributed to an additional quarter of interest in 2005 and additionalvesting on the management purchased preferred options.The Company pays interest to the Trust on the junior subordinated debentures underlying the trustpreferred securities at the rate of 11.6% per annum on their face amount of $105.4 million, or$12.6 million per annum in the aggregate. The Company receives investment income on the trustcommon securities in the amount of $0.4 million per annum. The Trust distributes the equivalentnet amount to the holders of the trust preferred securities. For the years ended December 31, 2005and 2004, the Company paid interest net of investment income of $12.2 million on the juniorsubordinated debentures, which is equivalent to the amounts distributed by the Trust on the trustpreferred securities.The Company also pays interest to the Trust on the junior subordinated debentures underlying thetrust common securities at the rate of 11.6% per annum on their face amount of $3.3 million, or$0.4 million per annum in the aggregate. The Trust distributes an equivalent amount to the Companyas a distribution on the underlying trust common securities. For the years ended December 31, 2005 and 2004,the Company paid $0.4 million interest on the Junior Subordinated Debentures, which is equivalentto the amounts received by the Company as investment income.The effective tax rates in 2005 and 2004were 858.1% and 22.4%, respectively. The change in effective rateis attributable to lower levels of book income and the existence of large permanent differences. See Note 5, Income Taxes, of Notes to Consolidated Financial Statements of the Company for thethree years ended December 31, 2005, for income taxes and disclosures related to 2005 and 2004income tax events.**Years Ended December 31, 2004 and 2003**Net sales increased $33.9 million or 10.7% in 2004 to $351.6 million from $317.7 million in 2003.Sales to national accounts represented $19.4 million of the $33.9 million total sales increase.The new store growth of our national accounts customers was primarily responsible for the increasedfastener, keys, and LNS sales to Lowe’s, increased keys and LNS sales to Home Depot, and increasedkeys sales to Wal-Mart. Sales to Franchise and Independent (“F&I”) accounts increased $9.4 millionfrom 2003 primarily due to improved economic activity at the retail level and increased sales ofgalvanized fasteners used in the newly formulated treated lumber. The F&I accounts are typicallyindividual hardware dealers who are members of larger cooperatives, such as True Value, Ace, andDo-It-Best. In addition, the regional and engraving accounts increased $3.3 million over thecomparable period in 2003. The regional accounts represent mid-sized hardware and lumber chains.Sales by our Canadian division increased $1.3 million, export sales increased $0.7 million, andother sales were $0.2 million less than the prior year.The Company’s sales backlog, based upon cancelable purchase orders, was $5.7 million as of December31, 2004 and $4.8 million as of December 31, 2003.
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The Hillman Group’s gross margin of 55.0% in 2004 increased slightly from 54.9% in 2003. Priceincreases together with production efficiencies following the December 2003 consolidation of theRockford packaging and distribution facility into the Company’s Cincinnati facility offset therising cost of the Company’s products.The Company’s consolidated selling, general and administrative (“S,G&A”) expenses increased $9.7million or 8.1% from $120.8 million in 2003 to $130.5 million in 2004. Selling expenses increased$9.8 million or 17.1% primarily as a result of increased servicing and display costs at newnational account stores. Warehouse and delivery expenses increased $3.6 million or 8.9% as aresult of increased freight and labor costs of $2.8 million to process and ship the additionalsales volume. General and administrative expenses decreased by $4.0 million or 18.0% as a resultof a substantial decrease in medical claims experienced in 2004 compared to 2003 which included$1.5 million in claims by an employee for medical services. In addition, 2004 expense declinedfurther from 2003 as a result of the elimination of several positions from our corporate office andTempe facility together with the December 2003 shutdown of the Rockford facility. Stockcompensation expenses from stock options related to the Merger Transaction were $0.3 million in2004. There was no stock compensation expense in 2003.Depreciation expense increased $0.8 million to $15.2 million in 2004 from $14.4 million in 2003primarily as a result of an increase in the depreciable fixed asset base in connection with theplacement of key duplication machines used in new national accounts.Amortization expense increased $4.3 million to $5.7 million in 2004 from $1.4 million in 2003. Theincrease in amortization was the result of an increase in the valuation of certain intangibleassets in connection with the Merger Transaction.The Company has recorded a management and transaction fee charge of $1.3 million for 2004 and $1.8million for 2003. As of the closing of the Merger Transaction in March 2004, the Company isobligated to pay management fees to a subsidiary of CHS for management services rendered in theamount of fifty-eight thousand dollars per month, plus out of pocket expenses, and to paytransaction fees to a subsidiary of OTPP in the amount of twenty-six thousand dollars per month,plus out of pocket expenses. The Company was obligated to pay management fees to a subsidiary ofAllied Capital for management services rendered in the amount of $1.8 million, plus out of pocketexpenses, for calendar years subsequent to 2001. The payment of management fees was due annuallyafter delivery of the Company’s annual audited financial statements to the Board of Directors ofthe Company.Income from operations for the year endedDecember 31, 2004 was $10.0 million and includes $30.7million in non-recurring costs recorded in connection with the Merger Transaction. This compares to $36.6 million for the year ended December 31, 2003.The Company’s consolidated operating profit margin from operations (income from operations as apercentage of net sales) was 11.5% in 2003 and 2.8% in 2004. However, 2004 includes thenon-recurring costs of $30.7 million recorded in connection with the Merger Transaction. The operating profitmargin was impacted by a reduction of S,G&A expenses and management fees as a percentage of sales,but these benefits were offset by the increase in amortization costs as a percentage of sales whichresulted from the Merger Transaction.Interest expense, net, increased $2.1 million to $17.5 million in 2004 from $15.4 million in 2003.The increase in interest expense, net, was primarily the result of increased Company debt relatedto the Merger Transaction and the amortization of additional deferred financing costs.Interest expense was $5.5 million in 2004 on the mandatorily redeemable preferred stock andmanagement purchased preferred options related to the Merger Transaction. No such interest expensewas recorded in 2003.The Company pays interest to the Trust on the junior subordinated debentures underlying thetrust preferred securities at the rate of 11.6% per annum on their face amount of $105.4
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million, or $12.6 million per annum in the aggregate. The Company receives investment incomeon the trust common securities in the amount of $0.4 million per annum. The Trust distributes theequivalent net amount to the holders of the trust preferred securities. For the years endedDecember 31, 2004 and 2003, the Company paid interest net of investment income of $12.2 million onthe junior subordinated debentures, which is equivalent to the amounts distributed by the Trust onthe trust preferred securities.The Company also pays interest to the Trust on the junior subordinated debentures underlying thetrust common securities at the rate of 11.6% per annum on their face amount of $3.3 million, or$0.4 million per annum in the aggregate. The Trust distributes an equivalent amount to the Companyas a distribution on the underlying trust common securities. For the year ended December 31, 2004,the Company paid $0.4 million interest on the Junior Subordinated Debentures, which is equivalentto the amounts received by the Company as investment income.The effective tax rates in 2004 and 2003were 22.4% and (149.2)%, respectively. The 2004rate was impacted by the existence of large permanent items. The 2003 rate included a $3.9 million increase in the deferred taxvaluation allowance.See Note 5, Income Taxes, of Notes to Consolidated Financial Statements of the Company for thethree years ended December 31, 2005, for income taxes and disclosures related to 2004 and 2003income tax events.***Liquidity and Capital Resources***Net cash provided by operating activities for the year ended December 31, 2005 was $13.9million, primarily due to the net loss adjusted for non-cash charges of $32.5 million fordepreciation, amortization, dispositions of equipment, deferred taxes, PIK interest, and intereston mandatorily redeemable preferred stock which were partially offset by cash related adjustmentsof $18.6 million for routine operating activities represented by changes in inventories, accountsreceivable, accounts payable, accrued liabilities and other assets.The 2005 increase in accounts receivable of $4.1 million is primarily the result of sales growth.The inventory increase of $11.3 million in 2005 can be attributed to thegrowth in sales as well as inventory builds at the end of the year for anticipated roll outs of newcustomer programs scheduled for the first quarter of 2006. Accounts payable was $3.5 million lower at the endof 2005 as the Company elected to take advantageof cash discounts from vendors.Net cash used for investing activities was $15.4 million for the year ended December 31, 2005.Capital expenditures for the year totaled $15.2 million, consisting of $7.2 million for keyduplicating machines, $2.3 million for engraving machines, $1.5 million for Cincinnati officeexpansion and $4.2 million for equipment purchases.Net cash used for financing activities for the year ended December 31, 2005 was $1.7 million,primarily related to principal payments on the senior term loan.Management believes projected cash flows from operations and revolver availability will besufficient to fund working capital and capital expenditure needs for the next 12 months.The Company’s working capital (current assets minus current liabilities) position of $104.4 millionas of December 31, 2005, represents an increase of $16.7 million from the December 31, 2004 levelof $87.7 million as follows:(dollars in thousands)       Amount Decrease in cash and cash equivalents $(3,122)Increase in accounts receivable, net  4,113 Increase in inventories, net  11,343 Increase in other current assets  28 Decrease in deferred taxes  (1,053)Decrease in accounts payable  3,547 Decrease in accrued salaries and wages  921 Increase in accrued interest  (841)Decrease in other accrued liabilities  1,943 Other items, net  (142)    Net increase in working capital for the yearended December 31, 2005 $16,737     
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The Company’s contractual obligations in thousands of dollars as of December 31, 2005 aresummarized below:                           Payments Due       Less Than  1 to 3  3 to 5  More Than Contractual Obligations Total  One Year  Years  Years  Five Years Junior Subordinated Debentures (1) $117,295  $—  $—  $—  $117,295 Long Term Senior Term Loans  214,237   2,175   4,350   4,350   203,362 Bank Revolving Credit Facility  —   —   —   —   — Long Term Unsecured Subordinated Notes  49,172   —   —   —   49,172 Interest Payments (2)  100,387   21,955   40,897   32,846   4,689 Operating Leases  51,503   8,991   10,608   7,857   24,047 Mandatorily Redeemable Preferred Stock  69,695   —   —   —   69,695 Management Purchased Preferred Options  4,087   —   —   —   4,087 Deferred Compensation Obligations  4,809   167   334   334   3,974 Capital Lease Obligations  109   51   58   —   — Other Long Term Obligations  4,844   1,232   800   521   2,291                                      Total Contractual Cash Obligations $616,138  $34,571  $57,047  $45,908  $478,612                  (1) The junior subordinated debentures liquidation value is approximately $108,707. (2) Interest payments for the long term senior term loans and the long term unsecured subordinated notes. Interest payments onthe variable rate long term senior term loans were calculated at the LIBOR rate plus margin of 7.6875% in effect as of December 31, 2005.All of the obligations noted above are reflected on the Company’s Consolidated Balance Sheet as ofDecember 31, 2005, except for the Interest Payments and Operating Leases. See Notes to Consolidated Financial Statementsas of and for the three years ended December 31, 2005 for additional information.The Company has a purchase agreement with its supplier of key blanks which requires minimumpurchases of 100 million key blanks per year. To the extent minimum purchases of key blanks arebelow 100 million the Company must pay the suppliers $.0035 per key multiplied by the shortfall. Since theinception of the contract in 1998, the Company purchases of key blanks from the supplier haveexceeded 100 million. The purchase agreement expires on December 31, 2006.The Company does not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) ofRegulation S-K under the Securities Exchange Act of 1934, as amended.As of December 31, 2005, the Company had $34.8 million available under its secured creditfacilities. The Company had approximately $214.3 million of outstanding debt under its securedcredit facilities at December 31, 2005, consisting of $214.2 million in a term loan and $0.1million in capitalized lease obligations. The term loan consisted of a $213.1 million Term B Loancurrently at a six (6) month LIBOR rate plus margin of 7.6875%, a $0.6 million Term B Loancurrently at a three (3) month LIBOR rate plus margin of 7.812% and a $0.5 million Term B loan atthe prime rate plus margin of 9.5%. The capitalized lease obligations were at various interestrates.Interest on the Subordinated Debt Issuance of $47.5 million which matures September 30, 2011 is ata fixed rate of 13.5% per annum, with cash interest payments being required on a quarterly basis ata fixed rate of 11.25% commencing April 15, 2004. The outstanding principal balance of theSubordinated Debt Issuance shall be increased on a quarterly basis by the remaining 2.25% PIKAmount. All of the PIK Amounts are due on the maturity date of the Subordinated Debt Issuance. Asof December 31, 2005, the outstanding Subordinated Debt Issuance including the PIK Amounts was$49.2 million.In accordance with the Company’s Senior Credit Agreement, Hillman must maintain its fixed chargecoverage at all times in excess of 1.05x from January 1, 2005 through December 31, 2005 and 1.15xthereafter to continue monthly distributions on its Trust Preferred Securities ($1.0 million permonth). Hillman’s fixed charge coverage was 1.38x for the twelve-month period ended December 31,2005 as calculated in accordance with the Senior Credit Agreement.The Company had deferred tax assets aggregating $39.2 million, net of valuation allowance of $15.6million, and deferred tax liabilities of $69.6 million as of December 31, 2005, as determined inaccordance with SFAS 109. Management believes that the Company’s net deferred tax assets will berealized through the reversal of existing temporary differences between the financial statement andtax basis, as well as through future taxable income.
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***Inflation***The Company is sensitive to inflation present in the economies of the United States and ourforeign suppliers located primarily in Taiwan and China. Inflation in recent years has producedonly a modest impact on the Company’s operations, however, the recent growth in China’s economicactivity produced a spike in the cost of certain imported fastener products in the latter part of2003 and 2004 increasing the cost of certain fasteners as much as 45%. Additionally, recentincreases in the cost of diesel fuel have contributed to transportation rate increases. Continuedinflation and resulting cost increases over a period of years would result in significant increasesin inventory costs and operating expenses. Such higher cost of sales and operating expenses cangenerally be offset by increases in selling prices, although the ability of the Company’s operatingdivisions to raise prices is dependent on competitive market conditions. The Company was able to recover most of the 2003 and 2004fastener cost increases by raising prices to its customers.***Related Party Transactions***On September 26, 2001, the Company was acquired by Allied Capital pursuant to the terms andconditions of an Agreement and Plan of Merger dated as of June 18, 2001. In connection with thisAgreement and Plan of Merger, the Company was obligated to pay management fees to a subsidiary ofAllied Capital for management services rendered in the amount of $1.8 million per year, plus out ofpocket expenses, for calendar years subsequent to 2001. The Company has recorded a management feecharge of $0.5 million, and $1.8 million on the Predecessor’s Statement of Operations for the threemonths ended March 31, 2004 and the year ended December 31, 2003. Payment of management fees wasdue annually after delivery of the Company’s annual audited financial statements to the Board ofDirectors of the Company. The obligation to pay management fees to Allied Capital was terminatedupon the payment of outstanding fees in the amount of $2.3 million on March 31, 2004 in connectionwith the close of the Merger Transaction.On March 31, 2004, the Company was acquired by an affiliate of CHS. In connection with the CHSacquisition, the Company is obligated to pay management fees to a subsidiary of CHS in the amountof $58 thousand per month and to pay transaction fees to a subsidiary of OTPP in the amount of $26thousand per month, plus out of pocket expenses, for each month commencing with the closing date ofthe Merger Transaction. The Company has recorded management and transaction charges and expensesfrom CHS and OTPP of $1.0 million and $0.8 million for the year ended December 31, 2005 and thenine month period ended December 31, 2004.The Predecessor Company incurred interest expense to Allied Capital on the unsecured subordinatednote at a fixed rate of 18.0% per annum. Cash interest payments were required on a quarterly basisat a fixed rate of 13.5% with the remaining 4.5% fixed rate (the “PIK Amount”) being added to theprincipal balance. The subordinated debt and accrued interest thereon of $45.6 million were paidin full at March 31, 2004 in connection with the Merger Transaction. See discussion above and inNote 8, Long-Term Debt, of Notes to Consolidated Financial Statements.***Critical Accounting Policies and Estimates***The preparation of financial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions about future events that affectthe amounts reported in the financial statements and accompanying notes. Future events and theireffects cannot be determined with absolute certainty. Therefore, the determination of estimatesrequires the exercise of judgment. Actual results may differ from those estimates, and suchdifferences may be material to the Company’s consolidated financial statements and results ofoperations.The most significant accounting estimates inherent in the preparation of the Company’s consolidatedfinancial statements include estimates associated with its evaluation of the recoverability ofgoodwill as well as those used in the determination of liabilities related to insurance programs,litigation, and taxation. The Company’s purchase price allocation methodology requires estimatesof the fair value of assets acquired and liabilities assumed. In addition, significant estimatesform the basis for the Company’s reserves with respect to
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sales and returns allowances,collectibility of accounts receivable, inventory valuations, deferred tax assets, and certainbenefits provided to current employees. Variousassumptions and other factors underlie the determination of these significant estimates. Theprocess of determining significant estimates is fact specific and takes into account factors suchas historical experience, current and expected economic conditions and product mix. The Companyre-evaluates these significant factors and makes adjustments where facts and circumstances dictate.Specific factors are as follows: recoverability of goodwill and intangible assets are subject toannual impairment testing; purchase price allocation adjustments are based on changes insettlements of liabilities and assets realized; litigation is based on projections provided bylegal counsel; deferred taxes are based on the Company’s projections of future taxable income;sales and returns and allowances are based on historical activity and customer contracts; accountsreceivable reserves are based on doubtful accounts and aging of outstanding balances; inventoryreserves are based on expected obsolescence and excess inventory levels; and employee benefits arebased on benefit plan requirements and severance agreements. Historically, actual results have notsignificantly deviated from those determined using the estimates described above. The dollaramounts below are presented in thousands.**Revenue Recognition****:**Revenue is recognized when products are shipped or delivered to customers depending upon when titleand risks of ownership have passed.The Company offers a variety of sales incentives to its customers primarily in the form ofdiscounts, rebates and slotting fees. Discounts are recognized in the financial statements at thedate of the related sale. Rebates are estimated based on the anticipated rebate to be paid and aportion of the estimated cost of the rebate is allocated to each underlying sales transaction.Slotting fees are used on an infrequent basis and are not considered to be significant. Discounts,rebates and slotting fees are included in the determination of net sales.The Company also establishes reserves for customer returns and allowances. The reserve isestablished based on historical rates of returns and allowances. The reserve is adjusted quarterlybased on actual experience. Returns and allowances are included in the determination of net sales.**Accounts Receivable and Allowance for Doubtful Accounts**:The Company establishes the allowance for doubtful accounts using the specific identificationmethod and also provides a reserve in the aggregate. The estimates for calculating the aggregatereserve are based on historical information. The allowance for doubtful accounts was $434 and $526as of December 31, 2005 and 2004, respectively.**Inventory Realization**:Inventories consisting predominantly of finished goods are valued at the lower of cost or market,cost being determined principally on the weighted average cost method. Excess and obsoleteinventories are carried at net realizable value. The historical usage rate is the primary factorused by the Company in assessing the net realizable value of excess and obsolete inventory. Areduction in the carrying value of an inventory item from cost to market is recorded for inventorywith no usage in the preceding twenty-four month period or with on hand quantities in excess oftwenty-four months average usage. The inventory reserve amounts were $3,948 and $3,558 at December31, 2005 and 2004, respectively.**Property and Equipment**:Property and equipment, including assets acquired under capital leases, are carried at cost andinclude expenditures for new facilities and major renewals. Maintenance and repairs are charged toexpense as incurred. When assets are sold or otherwise disposed of, the cost and relatedaccumulated depreciation are removed from their respective accounts, and the resulting gain or lossis reflected in income from operations.
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**Depreciation**:For financial accounting purposes, depreciation, including that related to plant and equipmentacquired under capital leases, is computed on the straight-line method over the estimated usefullives of the assets, generally three to ten years, or over the terms of the related leases.**Goodwill and Other Intangible Assets**:The Company accounts for goodwill and other intangible assets in accordance with SFAS No. 142,“Goodwill and Other Intangible Assets,” which requires that goodwill and intangibles withindefinite lives no longer be amortized, but instead be tested for impairment at least annually. Ifimpairment is indicated a write-down to fair value is recorded. Other intangible assets arisingprincipally from the Merger Transaction are amortized on a straight-line basis over periods rangingfrom four to twenty-three years. Trademarks are not amortized due to their indefinite useful lives.**Long-Lived Assets**:Under the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-LivedAssets,” the Company has evaluated its long-lived assets for financial impairment and will continueto evaluate them based on the estimated undiscounted future cash flows as events or changes incircumstances indicate that the carrying amount of such assets may not be fully recoverable.**Investments:**All of the Company’s investments are in marketable equity securities classified asavailable-for-sale securities which are carried at fair value with the unrealized gains and losses,net of tax, reported in other comprehensive income.**Income Taxes**:Deferred income taxes are computed using the asset and liability method. Under this method,deferred income tax assets and liabilities are determined based on differences between financialreporting and tax basis of assets and liabilities (temporary differences) and are measured usingthe enacted tax rates and laws that will be in effect when the differences are expected to reverse.Valuation allowances are provided for tax benefits where it is more likely than not that certaintax benefits will not be realized. Adjustments to valuation allowances are recorded from changesin utilization of the tax related item.**Self-insurance Reserves**:The Company self insures its product liability, worker’s compensation and general liability lossesup to $250 thousand per occurrence. Catastrophic coverage is maintained for occurrences in excessof $250 thousand up to $35 million.The Company self insures its group health claims up to an annual stop loss limit of $150 thousandper participant. Aggregate coverage is maintained for annual group health insurance claims inexcess of 125% of expected claims.Provisions for losses expected under these programs are recorded based on an analysis of historicalinsurance claim data and certain actuarial assumptions.**Retirement Benefits**:Certain employees of the Company are covered under a profit-sharing and retirement savings plan(“defined contribution plan”). See Note 14, Retirement Benefits, of Notes to ConsolidatedFinancial Statements for additional information.
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**Shipping and Handling****:**The costs incurred to ship product to customers, including freight and handling expenses, areincluded in selling, general and administrative expenses on the Company’s Statements of Operations.The Predecessor Company’s shipping and handling costs were $3,629 and $15,916 for the three monthsended March 31, 2004 and the year ended December 31, 2003, respectively. The Successor Company’sshipping and handling costs were $18,615 and $12,790 for the year ended December 31, 2005 and thenine months ended December 31, 2004, respectively.**Research and Development**:The Company incurs research and development costs consisting primarily of internal wages andbenefits in connection with improvements to the key duplicating and engraving machines. ThePredecessor Company’s research and development costs were $277 and $1,381, for the three monthsended March 31, 2004 and the year ended December 31, 2003, respectively. The Successor Company’sresearch and development costs were $1,058 and $796 for the year ended December 31, 2005 and thenine months ended December 31, 2004, respectively.**Stock Based Compensation**:For options granted under the 2004 stock option plan, the Company applies the recognition andmeasurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees” (“APB 25”), and related interpretations in accounting for its stock based employeecompensation plans. The Company is also subject to disclosure requirements of SFAS No. 123,“Accounting for Stock Based Compensation” (“SFAS 123”). Had compensation cost for the plans beendetermined based on the fair value at the grant dates consistent with the fair value method of SFAS123, the effect on the Company’s net loss for the year ended December 31, 2005 would have beenapproximately $6. There would have been no compensation charge for the periods ended December 31,2004, March 31, 2004 or December 31, 2003.Using fair value method of SFAS 123, the fair value of the options granted in fiscal 2005 was $33.The fair value of the option grants is estimated on the date of grant using the Black-Scholesoption pricing model with the following assumptions: dividend yield equaling 0%, risk-free interestrate of 3.8%, expected volatility assumed to be 34%, and expected life of 6 years. See Note 13,Stock Based Compensation, of the Notes to the Consolidated Financial Statements.**Fair Value of Financial Instruments****:**Cash, accounts receivable, short-term borrowings, accounts payable, accrued liabilities and bankrevolving credit are reflected in the consolidated financial statements at fair value due toshort-term maturity or revolving nature of these instruments.**Translation of Foreign Currencies****:**The translation of the Company’s Canadian and Mexican foreign currency based financial statementsinto U.S. dollars is performed for balance sheet accounts using exchange rates in effect at thebalance sheet date and for revenue and expense accounts using an average exchange rate during theperiod. The exchange rates represent the noon buying rates reported by the Federal Reserve Bank ofNew York.
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**Comprehensive Income (Loss)****:**The components of comprehensive income (loss) were as follows:                   Successor  Successor  Predecessor  Predecessor   Year  Nine months  Three months  Year   ended  ended  ended  ended   December 31,  December 31,  March 31,  December 31,   2005  2004  2004  2003 Net (loss) income $(3,654) $779  $(20,366) $(5,709)Unrealized gains on investments, net  41  $34  $16  $19 Change in derivative security value, net  (24)  (18)  —   — Foreign currency translation adjustment, net  109   (110)  10   (135)                              Comprehensive (loss) income $(3,528) $685  $(20,340) $(5,825)             **Use of Estimates in the Preparation of Financial Statements:**The preparation of financial statements in conformity with accounting principles generally acceptedin the United States requires management to make estimates and assumptions that affect the reportedamount of assets and liabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expenses during the reportingperiod. Actual results could differ from those estimates. Please reference Note 2, Summary ofSignificant Accounting Policies, of Notes to Consolidated Financial Statements for additionalinformation.**Recent Accounting Pronouncements**:In May 2005, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 154,“Accounting Changes and Error Corrections.” SFAS No. 154 requires retrospective application toprior periods’ financial statements of changes in accounting principle, unless it is impracticableto determine either the period-specific effects or the cumulative effect of the change. SFAS No.154 requires that retrospective application of a change in accounting principle be limited to thedirect effects of the change, and that indirect effects of a change in accounting principle, suchas a change in non-discretionary profit-sharing payments resulting from an accounting change, berecognized in the period of the accounting change. SFAS No. 154 also requires that a change indepreciation, amortization, or depletion method for long-lived, non-financial assets be accountedfor as a change in accounting estimate effected by a change in accounting principle. SFAS 154 iseffective for accounting changes and corrections of errors made in fiscal years beginning afterDecember 15, 2005. Early adoption is permitted for accounting changes and error corrections made infiscal years beginning after the date the statement was issued. The Company is required to adoptthe provisions of SFAS 154 beginning January 1, 2006.In December 2004, the FASB issued SFAS No. 153, “Exchanges of Non-monetary Assets- an amendment ofAPB Opinion No. 29.” The statement amends Opinion 29 to eliminate the exception for non-monetaryexchanges of similar productive assets and replaces it with a general exception for exchanges ofnon-monetary assets that do not have commercial substance. A non-monetary exchange has commercialsubstance if the future cash flows of the entity are expected to change significantly as a resultof the exchange. The statement is effective for fiscal periods beginning after June 15, 2005 andadoption isnot expected to have a material impact on the Company’s results of operations or financialposition.In November 2004, the Financial Accounting Standards Board issued Statement of Financial AccountingStandards No. 151, “Inventory Costs” (“SFAS 151”). SFAS 151 amends the guidance in ARB No. 43,Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facilityexpense, freight, handling costs and spoilage. This statement requires that these items beexpensed as incurred and not included in overhead.
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In addition, SFAS 151 requires that allocationof fixed production overhead to conversion costs should be based on normal capacity of theproduction facilities. SFAS 151 is effective for inventory costs incurred during fiscal yearsbeginning after June 15, 2005 and adoption is not expected to have a material impact on theCompany’s results of operations or financial position.In December 2004, the Financial Accounting Standards Board issued Statement No. 123(R),“Share-Based Payment” (“SFAS 123(R)”). This statement revises Statement of Financial AccountingStandards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), and supersedes APBOpinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) will require compensationcosts related to share-based payment transactions to be recognized in the financial statements(with limited exceptions). The amount of compensation cost will be measured based on thegrant-date fair value of the equity or liability instruments issued. Compensation cost will berecognized over the period that an employee provides service in exchange for the award. On March29, 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB No. 107”), which providessupplemental guidance in adopting SFAS 123(R). Pursuant to the SEC guidance in SAB No. 107, theCompany will adopt the provisions of this statement in the first quarter of fiscal 2006.The Company will adopt SFAS 123(R) using the modified prospective application without restating prior periods, whichrequires the recognition of compensation expense for all stock options and other equity based awards that vest or become exercisable on and afterJanuary 1, 2006. The adoption of SFAS 123(R) is not expected to havea material effect on the Company’s result of operations or financial position.***Forward Looking Statements***Certain disclosures related to acquisitions and divestitures, refinancing, capitalexpenditures, resolution of pending litigation and realization of deferred tax assets contained inthis annual report involve substantial risks and uncertainties and may constitute forward-lookingstatements within the meaning of the Private Securities Litigation Reform Act of 1995. In somecases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,”“could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” “project” orthe negative of such terms or other similar expressions.These forward-looking statements are not historical facts, but rather are based on management’scurrent expectations, assumptions and projections about future events. Although managementbelieves that the expectations, assumptions and projections on which these forward-lookingstatements are based are reasonable, they nonetheless could prove to be inaccurate, and as aresult, the forward-looking statements based on those expectations, assumptions and projectionsalso could be inaccurate. Forward-looking statements are not guarantees of futureperformance. Instead, forward-looking statements are subject to known and unknown risks,uncertainties and assumptions that may cause the Company’s strategy, planning, actual results,levels of activity, performance, or achievements to be materially different from any strategy,planning, future results, levels of activity, performance, or achievements expressed or implied bysuch forward-looking statements. Actual results could differ materially from those currentlyanticipated as a result of a number of factors, including the risks and uncertainties discussedunder captions “Risk Factors” set forth in Item 1 of this annual report. Given theseuncertainties, current or prospective investors are cautioned not to place undue reliance on anysuch forward-looking statements.All forward-looking statements attributable to the Company or persons acting on its behalf areexpressly qualified in their entirety by the cautionary statements included in this annual report;they should not be regarded as a representation by the Company or any other individual. Weundertake no obligation to publicly update or revise any forward-looking statements, whether as aresult of new information, future events or otherwise. In light of these risks, uncertainties andassumptions, the forward-looking events discussed in this annual report might not occur or bematerially different from those discussed.
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**Item 7A – Quantitative and Qualitative Disclosures About Market Risk.**The Company is exposed to the impact of interest rate changes as borrowings under the SeniorCredit Agreement bear interest at variable interest rates. It is the Company’s policy to enterinto interest rate transactions only to the extent considered necessary to meet objectives. OnApril 28, 2004, the Company entered into an Interest Rate Swap Agreement (“Swap”) with a two-yearterm for a notional amount of $50 million. The Swap fixes the interest rate on $50 million of theTerm Loan at a rate of 1.17% plus the applicable interest rate margin for the first three months ofthe Swap with incremental increases ranging from 28 to 47 basis points in each successive quarter.Based on Hillman’s exposure to variable rate borrowings at December 31, 2005, a one percent (1%)change in the weighted average interest rate for a period of one year would change the annualinterest expense by approximately $1.6 million.The Company is exposed to foreign exchange rate changes of the Canadian and Mexican currencies asit impacts the $2.7 million net asset value of its Canadian and Mexican subsidiaries as of December31, 2005. Management considers the Company’s exposure to foreign currency translation gains orlosses to be minimal.
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**Item 8 – Financial Statements and Supplementary Data****.****INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND**