MS Property owns a business block in Pasadena, California situated between the city hall and a large shopping mall. The mall has been redeveloped to include residential units and a multiscreen movie theater. The block’s improvements include a nine-story office building that was constructed in 1964 and has approximately 125,000 square feet of net rentable area, and a multistory garage with space for 425 vehicles. Of the 125,000 square feet of space in the office building, approximately 5,000 square feet are used by MS Property or leased to Blue Chip or Wesco. The remaining space is almost fully leased to outside parties, including Citibank (the ground floor tenant), law firms and others, under agreements expiring at dates extending to 2008. Adjacent to the building and garage is a vacant parcel; MS Property is seeking city approval of its plans to redevelop the parcel, together with a vacant parcel of land it owns in the next block.
MS Property also owns several buildings that are leased to various small businesses in a small shopping center in Southern California.
CORT’s showrooms generally have 4,000 to 5,000 square feet of floor space. CORT regularly reviews the presentation and appearance of its furniture showrooms and clearance centers and periodically improves or refurbishes them to enhance their attractiveness to customers.
Wesco continues to have an exceptionally strong, conservatively valued balance sheet at December 31, 2003, with relatively little debt and no hedging or off-balance sheet financing. Liquidity, which has traditionally been high, is even higher than usual due principally to sales and maturities during 2003 of most of Wesco’s mortgage-backed securities and other fixed-maturity investments and reinvestment of the proceeds in cash equivalents pending redeployment.
Ignoring realized investment gains, after-tax operating earnings declined in 2003 after remaining relatively flat in 2002 and 2001. Improved insurance underwriting results were more than offset by reduced investment income that resulted from the shift from longer-term to very-short-term fixed-maturity investments bearing lower interest rates. Also, the furniture rental and industrial segments suffered from the effects of the ongoing weak economy and other unfavorable factors.
Wesco does not manage with a view toward Wall Street expectations. Its management is not concerned with the volatility of short-term operating results, so long as long-term prospects are satisfactory.
Wesco’s consolidated borrowings totaled $12.7 million at December 31, 2003 versus $32.5 million at December 31, 2002. Of these amounts, $12.1 million and $22.0 million related to a $100 million revolving line of credit used in CORT’s furniture rental business. The remainder represented convertible notes of a subsidiary of CORT, which were in effect retired during 2003 (see Note 6 to Wesco’s consolidated financial statements).
In the following sections the data set forth in the foregoing summary on an after-tax basis are broken down and discussed. Attention is directed to Note 10 to the accompanying consolidated financial statements for additional information.
Premiums written for 2003, 2002 and 2001 included $67.1 million, $67.7 million and $32.8 million attributable to Wes-FIC, and $19.9 million, $20.7 million and $18.1 million attributable to KBS.
due to growth in volume of bank deposit guarantee bonds; this product currently accounts for approximately 45% of premiums written by KBS.
Since September 11, 2001, the insurance industry has been particularly concerned about its exposure to claims resulting from acts of terrorism. As explained in Item 1, Business, in spite of partial relief provided by the Terrorism Risk Insurance Act, enacted in November 2002, Wes-FIC is exposed to insurance losses from terrorist events. Although Wes-FIC’s (and thus Wesco’s) exposure to such losses from an insurance standpoint cannot be predicted, Wes-FIC’s management does not believe it likely that, on a worst-case basis, Wes-FIC’s shareholders’ equity would be severely impacted by future terrorism-related insurance losses under reinsurance or insurance contracts currently in effect.
Another industry concern in recent years has been its exposure to loss from environmental contamination, particularly asbestos-related claims. Wes-FIC’s management currently believes such exposure to be minimal.
Dividend and interest income has been earned by the insurance group principally (1) on earnings retained and reinvested by Wes-FIC, (2) on capital contributed by Wesco, and (3) on float (funds invested pending payment of claims). Dividend and interest income earned by the insurance segment declined for 2003 from the corresponding 2002 figure principally as proceeds from sales, maturities and early redemptions of higher-yielding, long-term investments were reinvested in lower-yielding, short-term investments. Dividend and interest income was essentially unchanged in 2002 from the amount earned in 2001.
Furniture sales revenues decreased 6.3% in 2003 from those reported in 2002 after having increased in 2002 by 10.3% over the 2001 level. CORT, in managing the level of excess, idle inventory, periodically discounts selling prices. It did so in 2002, resulting in higher-than-normal revenues.
Cost of rentals, sales and fees amounted to 29.4% of revenues for 2003 versus 29.9% for 2002 and 28.0% for 2001. The decrease in cost percentage for 2003 reflected improved rental and selling prices, as well as lower depreciation expense, in spite of a writedown of obsolete and excess inventories by $1.6 million in 2003. The increase in cost percentage in 2002 reflected mainly CORT’s efforts to trim excess, idle inventories through decreases in selling prices and would have been somewhat higher were it not for a decrease in depreciation expense. Purchases of new product have been generally declining in recent years; rental furniture is depreciated under the declining balance method, whereby recorded depreciation is higher in the first year and declines in each successive year. Excluding costs incurred by Relocation Central - $15.1 million in 2003, $10.3 million in 2002 and $5.0 million in 2001 - in generating apartment locator fees, segment costs in relation to furniture rentals and sales were 26.4% in 2003, 27.7% in 2002 and 26.8% in 2001.
The minority interest in net loss of Relocation Central of $1.3 million in 2003 relates to a period of several months during which minority shareholders held an approximately 20% equity interest in Relocation Central. (See Note 6 to the accompanying consolidated financial statements for further information.)
Following is a summary of the results of operations of the industrial segment, consisting of the businesses of Precision Steel and its subsidiaries. (Amounts are in thousands.)
At the start of 2004, a shortage of raw materials from domestic mills has produced near chaos in the steel service industry. Thus far in 2004, the impact on revenues and earnings has been favorable for Precision Steel, but it is not clear how the situation will work out.
Even without the $1.0 million provision for remediation in 2003 discussed above, operations of the industrial segment for 2003 would have resulted in a loss before income taxes of $.5 million, versus pre-tax income of $.7 million and $.9 million for 2002 and 2001. Income or loss before income taxes of the industrial segment is dependent not only on revenues, but also on operating costs and the cost of products sold. The latter, as a percentage of revenues, amounted to 83.9%, 81.7% and 80.9% for 2003, 2002 and 2001. The cost percentage typically fluctuates slightly from year to year as a result of changes in product mix and price competition at all levels. Precision Steel’s cost of products sold percentage is very sensitive to current changes in the cost of materials purchased, because it carries its inventories at the lower of last-in, first-out (“LIFO”) cost or market; under this method, the most recent costs are reflected in cost of goods sold. LIFO inventory accounting adjustments were insignificant in relation to industrial segment after-tax loss for 2003, but increased earnings by $.2 million and $.4 million for 2002 and 2001.
Goodwill represents the excess of the cost over the fair value of identified net assets of acquired businesses. In the case of the Wesco group, it relates to the acquisitions of CORT and KBS, as well as smaller entities acquired by CORT following its purchase by Wesco in February 2000. Prior to 2002, goodwill was amortized mainly on a straight-line basis over 40 years. Effective as of the beginning of 2002, Wesco discontinued amortization of goodwill and became subject to other changes in goodwill accounting, as required by the Financial Accounting Standards Board. (See Notes 1 and 2 to the accompanying consolidated financial statements for further information on goodwill accounting.)
Other nonsegment items include mainly (1) rental income from owned commercial real estate and (2) dividend and interest income from marketable securities and cash equivalents owned outside the insurance subsidiaries, reduced by real estate and general and administrative expenses - plus or minus income taxes related to such items. These taxes do not correlate well with total pre-tax income, primarily because dividend income is substantially tax-exempt.
Management’s principal goal is to maximize gain in Wesco’s intrinsic business value per share over the long term. Accounting consequences do not influence business decisions. There is no particular strategy as to the timing of sales of investments. Investments may be sold for a variety of reasons, including (1) the belief that prospects for future appreciation of a particular investment are less attractive than the prospects for reinvestment of the after-tax proceeds from its sale, or (2) the desire to generate funds for an acquisition or repayment of debt.
As explained in Item 1, Business, in spite of relief provided by enactment of the Terrorism Risk Insurance Act (“TRIA”) on November 26, 2002, Wes-FIC is exposed to losses from terrorist events covered by TRIA occurring after that date as well as terrorism losses not covered by TRIA. Although Wes-FIC’s and thus Wesco’s exposure to terrorism losses cannot be predicted, Wes-FIC’s management does not believe that, on a worst-case basis, Wes-FIC’s shareholder’s equity would likely be
Shareholders’ equity is impacted not only to the extent that unusual items affect earnings, but also to reflect changes in unrealized appreciation of investments, which are not reflected in earnings.
Wesco is not now suffering from inflation, but its business operations have potential exposure, particularly in the insurance and industrial segments. Large unanticipated changes in the rate of inflation could adversely impact the insurance business, because premium rates are established well in advance of expenditures. Precision Steel’s businesses are competitive and operate on tight gross profit margins, making their earnings susceptible to inflationary and deflationary cost changes; the impact, though not material in relation to Wesco’s consolidated net income, may be significant to that of the industrial segment, due particularly to the segment’s use of LIFO inventory accounting.
Wesco’s consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States (“GAAP”). The significant accounting policies and practices followed by Wesco are set forth in Note 1 to the accompanying consolidated financial statements. Following are the accounting policies and practices considered by Wesco’s management to be critical to its determination of consolidated financial position and results of operations.
In preparing the consolidated financial statements management is required to make estimates and assumptions based on evaluation of facts and circumstances using information currently available. Although the amounts of assets, liabilities, revenues and expenses included in the consolidated financial statements may differ significantly from those that might result from use of estimates and assumptions based on facts and circumstances not yet available, Wesco’s management does not believe such differences would have a material adverse effect on reported shareholders’ equity.
Goodwill of acquired businesses represents the difference between purchase cost and the fair value of net assets of acquisitions accounted for under the purchase method. Prior to 2002, goodwill from each acquisition was generally amortized as a charge to earnings over a period not exceeding 40 years, and was reviewed for impairment if conditions were identified that indicated possible impairment. Effective January 1, 2002, Wesco adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 eliminated the periodic amortization of goodwill in favor of an accounting model that is based solely upon impairment tests. Goodwill is reviewed for impairment using a variety of methods at least annually, and impairments, if any, are charged to operating earnings.
classifications is applicable, available-for-sale. In recent years Wesco’s management has classified all of its equity and fixed-maturity investments as available-for-sale; they are carried at fair value, with unrealized gains and losses, net of deemed applicable income taxes, reported as a separate component of shareholders’ equity.
Furniture rentals are recognized as revenue proportionately over the rental contact period; rentals received in advance are deferred in the liability section of the consolidated balance sheet. Related costs comprise the main element of cost of products and services sold on the consolidated income statement and include depreciation expense, repairs and maintenance and inventory losses. Rental furniture consists principally of residential and office furniture which is available for rental or, if no longer up to rental standards or excessive, for sale. It is carried on the consolidated balance sheet at cost, less accumulated depreciation calculated primarily on a declining-balance basis over 3 to 5 years using estimated salvage values of 25 to 40 percent of original cost.
Actual events and results may differ materially from those expressed or forecasted in forward-looking statements due to a number of factors. The principal important risk factors that could cause Wesco’s actual performance and future events and actions to differ materially from those expressed in or implied by such forward-looking statements include, but are not limited to, changes in market prices of Wesco’s significant equity investments, the occurrence of one or more catastrophic events such as acts of terrorism, hurricanes, or other events that cause losses insured by Wesco’s insurance subsidiaries, changes in insurance laws or regulations, changes in income tax laws or regulations, and changes in general economic and market factors that affect the prices of investment securities or the industries in which Wesco and its affiliates do business.
Listed below are financial statement schedules required by the SEC to be included in this report. The data appearing therein should be read in conjunction with the consolidated financial statements and notes thereto of Wesco and the independent auditors’ report referred to above. Schedules not included with these financial statement schedules have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto.