UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-K

 

ý		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

COMMISSION FILE NUMBER 001-11911

 

STEINWAY MUSICAL INSTRUMENTS, INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number including area code:     (781) 894-9770

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:  None

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements during the past 90 days.    Yes ý    No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to this Form 10-K.  ý

 

The aggregate market value of the Common Stock held by non-affiliates of the registrant was $200,772,583 as of February 27, 2004 and $123,738,394 as of June 28, 2003.

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).   Yes ý     No o

 

Number of shares of Common Stock outstanding as of February 27, 2004:

 

Class A		477,952
Ordinary		7,333,742
Total		7,811,694

 

 

 

NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

Certain statements contained throughout this Annual Report on Form 10-K are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended.  These forward-looking statements represent our present expectations or beliefs concerning future events.  We caution you that such statements are necessarily based on certain assumptions which are subject to risks and uncertainties, which could cause actual results to differ materially from those indicated in this report.  These risk factors include, but are not limited to, the following: changes in general economic conditions; increased competition; work stoppages and slowdowns; exchange rate fluctuations; variations in the mix of products sold; market acceptance of new band instrument product and distribution strategies; ability of suppliers to meet demand; and fluctuations in effective tax rates resulting from shifts in sources of income.  We have included further information on these factors in our Final Prospectus filed in August 1996 and in Registration Statement No. 333-62790 filed in June 2001, particularly in the sections entitled “Risk Factors.”  We encourage you to read those descriptions carefully.  We caution investors not to place undue reliance on the forward-looking statements contained in this report.  These statements, like all statements contained in this report, speak only as of the date of this report (unless another date is indicated) and we undertake no obligation to update or revise the statements except as required by law.

 

NOTE REGARDING INCORPORATION BY REFERENCE

 

The Securities and Exchange Commission (“SEC”) allows us to disclose certain information to you by referring you to other documents we have filed with the SEC.  The information that we refer you to is “incorporated by reference” into this Annual Report on Form 10-K.  Please read that information.

 

PART I

 

ITEM 1                   BUSINESS

 

Introduction

 

Steinway Musical Instruments, Inc. (the “Company”), formerly Selmer Industries, Inc., was incorporated in 1993 under Delaware law.  During the last ten years, the Company has made various acquisitions of musical instrument manufacturers, including Steinway Musical Properties in 1995 and United Musical Instruments in 2000.

 

The Company, through its wholly-owned subsidiaries, The Steinway Piano Company, Inc. (“Steinway”) and Conn-Selmer, Inc. (“Conn-Selmer”) is engaged in the design, manufacture, marketing, and distribution of high quality musical instruments.  Throughout this form “we”, “us”, and “our” refer to Steinway Musical Instruments, Inc. and subsidiaries taken as a whole.

 

The legal merger of The Selmer Company, Inc. (“Selmer”) and United Musical Instruments, Inc. (“UMI”) into Conn-Selmer became effective on January 1, 2003. References to “Selmer” and “UMI” refer to events or circumstances prior to the merger.

 

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Our principal executive offices are located at 800 South Street, Suite 305, Waltham, Massachusetts, 02453.  Our primary telephone number is 781-894-9770, and our Internet website is located at www.steinwaymusical.com.  All of our filings with the SEC, including our annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, are available free of charge, immediately upon filing, through the Investor Relations page on our website.  Additionally, the SEC maintains an Internet site at www.sec.gov that contains reports, proxy and information statements and other information regarding issuers that file with the SEC.

 

We have adopted a Code of Ethics and Professional Conduct to provide guidance to our directors, officers and employees on matters of business ethics and conduct, including compliance standards, business conduct, conflicts of interest, and identification, reporting, and resolution of issues.  We have posted this Code, along with our Corporate Governance Guidelines and our Audit Committee Charter, on our website.  This information will be made available in print to any shareholder who requests it.

 

Please note that information contained on or connected to our website is not incorporated by reference into this annual report on Form 10-K and should not be considered part of this report or any other filing that we make with the SEC.

 

Financial Information by Segment and Geographic Location

 

Our revenues from external customers, operating profit, total assets, and financial information by geographic area for the last three years for our piano and band segments can be found in Note 17 to the consolidated financial statements included in this filing.

 

Business and Products

 

We are organized into two reportable segments – pianos and band and orchestral instruments.  Our piano division concentrates on the high-end grand piano market, handcrafting Steinway pianos in New York and Germany.  We also offer upright pianos as well as two mid-priced lines of pianos under the Boston and Essex brand names.  Moreover, we are the largest domestic producer of band and orchestral instruments and offer a complete line of brasswind, woodwind, percussion and stringed instruments and related accessories with well known brand names such as Bach, C.G. Conn, King, and Ludwig.

 

The Steinway & Sons grand piano is considered to be the highest quality piano in the world and has one of the most widely recognized and prestigious brand names.  We sell our pianos worldwide through approximately 170 independent piano dealers and ten company-operated retail showrooms including those located in New York, London, and Munich.  In 2003, approximately 57% of piano sales were in the United States, 28% in Europe and the remaining 15% primarily in Asia.

 

Our band and orchestral division holds the leading domestic market share in the majority of our product lines.  Instruments are made by a highly-skilled workforce at our manufacturing facilities in Indiana, Ohio, North Carolina, and Illinois, and sold through approximately 1,800 independent dealers and distributors.  We also sell certain student instruments that are made to our specifications by overseas manufacturers.  Beginner instruments accounted for 70% of band and orchestral unit sales and 43% of instrument revenues in 2003, with advanced and professional instruments representing the balance.  In 2003, approximately 84% of band sales were in the United States, 8% in Europe and the remaining 8% primarily in Asia.

 

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We offer pianos, band and orchestral instruments and services through the following subsidiaries and operating divisions:

 

Steinway & Sons offers two premium-priced product lines: grand pianos and upright pianos.  Steinway pianos differ from all others in design specifications, materials used and the assembly process.  Grand pianos historically have accounted for the bulk of Steinway’s production.  We offer eight sizes of the grand piano ranging from the 5’1” baby grand to the largest 9’ concert grand.  The smaller grands are sold to both individual and institutional customers, while the concert grands are sold primarily to institutions.  Steinway grand pianos are premium pianos in terms of quality and price, with retail prices generally ranging from $37,400 to $96,100 in the United States.  In 2003, we sold 2,928 grand pianos, of which 1,988 units were shipped from our New York facility to dealers in North and Latin America.  The remaining 940 units were shipped from our German facility to various countries in Europe and Asia.

 

Our upright pianos offer dealers a complete line of quality pianos to satisfy the needs of institutions and other customers who are constrained by space limitations.  We also provide services, such as restoration, repair, replacement part sales, tuning and regulation of pianos at locations in New York, London, Hamburg and Berlin.  Restoration services range from minor damage repairs to complete restorations of vintage pianos.

 

Boston Piano Company offers two complete lines of grand and upright pianos for the mid-priced piano market under the Boston and Essex brand names.  These pianos, which were designed by us and are produced by Asian manufacturers, provide our dealers with an opportunity to realize better margins in this price range while capturing sales that would have otherwise gone to a competitor.  These pianos provide future Steinway grand piano customers with the opportunity to join the Steinway family of owners sooner, since our research indicates that the vast majority of Steinway customers have previously owned another piano.  The product lines also increase our business with our dealers, making us the dealer’s primary supplier in many instances, since our three product lines together offer the full spectrum of piano prices and styles.  The Boston and Essex product lines together offer twelve upright and grand piano sizes, with retail prices ranging from $4,910 to $37,720 in the United States.

 

The Band Instrument Division manufactures brasswind and woodwind instruments, including piccolos, flutes, clarinets, oboes, bassoons, saxophones, trumpets, French horns, tubas, and trombones at facilities in Elkhart, Indiana, and Eastlake, Ohio.  We also manufacture mouthpieces, distribute accessories (oils, lubricants, polishes, stands, batons, straps, mutes and reeds), and distribute some imported student instruments which are made to our specifications.  We sell products under the Bach, Selmer, C.G. Conn, King, Armstrong, and Emerson brand names to student, amateur and professional musicians. Suggested retail prices generally range from $595 to $1,700 for student instruments and from $1,000 to $8,600 for step-up and professional instruments.  We often customize the products that we sell to professional musicians so that the product meets requested design specifications or has certain sound characteristics. We believe that specialization of products helps maintain a competitive edge in quality and product design.

 

We are the exclusive U.S. distributor for Selmer Paris products. The Selmer Paris saxophone is generally considered to be one of the best in the world.  Selmer Paris, in turn, has exclusive distribution rights to certain of our woodwind and brasswind products in France.

 

The Percussion Division manufactures and distributes acoustical and tuned percussion instruments, including outfit drums, marching drums, concert drums, marimbas, xylophones, vibraphones, orchestra bells, chimes, mallets and accessories.  We manufacture percussion products in Monroe, North Carolina and LaGrange, Illinois under the Ludwig and Musser brand names.  Ludwig is considered a leading brand name in acoustical drums and timpani and Musser has a strong market position in tuned percussion products.

 

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Suggested retail prices range from $550 to $4,600 for acoustical drum outfits and from $1,800 to $17,000 for tuned percussion instruments.

 

The Stringed Instrument Division manufactures and distributes violins, violas, cellos, basses, and accessories (bridges, covers, mutes, pads, chin rests, rosins, strings, bows, cases and instrument care products).  Products are sold under the Glaesel, Scherl & Roth, and William Lewis & Son brand names.  Suggested retail prices generally range from $200 to $2,200 for student instruments and from $1,100 to $11,000 for intermediate and advanced instruments. Components are primarily imported from Europe and Asia and assembled at our factory in Cleveland, Ohio.

 

Customers

 

Our core piano customer base consists of professional artists and amateur pianists, as well as institutions such as concert halls, conservatories, colleges, universities and music schools.  Most Steinway grand piano sales are to individuals.  These individuals are typically over 35 years old, have household income ranging from $150,000 to $300,000 per year and have a serious interest in music.  Sales to institutional customers have historically represented a larger portion of international revenue than domestic revenue.  Over the past several years, we have introduced several unique marketing programs designed to increase institutional sales in the United States.  As a result, domestic unit shipments to institutions increased nearly 2% in 2002 and another 1% in 2003 and they now represent 18% of domestic unit sales. Our largest piano dealer accounted for approximately 4% of piano sales in 2003, while the top 15 accounts represented 27% of piano sales.

 

The majority of our band instruments are purchased or rented from dealers by students enrolled in music education programs.  Traditionally, students join school bands or orchestras at age 10 or 11 and learn on beginner level instruments, progressing to advanced or professional level instruments in high school or college.  We estimate that approximately 85% of our domestic band sales are generated through educational programs.  The remaining domestic band sales are to professional or amateur musicians or performing groups, including orchestras and symphonies.  Our largest band dealer accounted for approximately 9% of band sales in 2003, while the top 15 accounts represented approximately 34% of sales.

 

Sales and Marketing

 

Pianos. We distribute pianos primarily on a wholesale basis through approximately 170 select dealers around the world.  We have subsidiaries and dealers in both Japan and China that provide direct access to the expansive Asian piano market. Sales to dealers accounted for approximately 84% of piano segment revenue in 2003. The remaining 16% was generated from sales made directly by us at one of our ten company-operated retail locations.

 

We employ district sales managers, whose responsibilities include developing close working relationships with domestic and international piano dealers. These highly experienced professionals provide sales training and technical support to dealers, as well as developing appropriate sales and marketing programs for the consumer and institutional markets.  These sales managers are also responsible for promoting the Piano Bank and the Steinway Artists programs described below.

 

The Concert and Artist Piano Bank.  To ensure that all pianists, especially Steinway Artists, have a broad selection of instruments to meet their individual touch and tonal preferences, we maintain the Concert and Artist Piano Bank (the “Piano Bank”).  The Piano Bank includes approximately 400 instruments worldwide.  Of these instruments, approximately 300 are located in the United States.  In New York City alone, the Steinway concert department has approximately 100 concert grands available for various

 

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occasions.  The balance of the domestic-based pianos is leased to dealers around the country who actively support the Steinway Artists program.  In addition to promoting our instruments in the music industry, the Piano Bank provides continuous feedback on the quality and performance of recently produced instruments from our most critical customer, the professional pianist.  The Piano Bank instruments are generally sold after five years and replaced with new pianos.

 

Steinway Artists.  For years, we have successfully used renowned artists in our marketing programs.  This technique has helped reinforce recognition of the Steinway brand name and its association with quality.  The “Steinway Artists” program is the endorsement of Steinway & Sons by world-class pianists who voluntarily select the Steinway piano. It is unique in that we do not pay artists to endorse our instruments.  To become a Steinway Artist, a pianist must not only meet certain performance and professional criteria, he or she must also own a Steinway piano.  The Steinway Artist roster currently includes approximately 1,300 of the world’s finest pianists who perform on Steinway pianos.  In return for their endorsements, Steinway Artists are provided with access to the Piano Bank described above.

 

Distribution, Sales and Marketing of the Boston and Essex Piano Lines.  The Boston and Essex piano lines are targeted at the mid-priced segment of the market.  The lines provide both a broader product offering for dealers and entry-level products for future Steinway grand piano customers. With certain limited exceptions, we allow only Steinway dealers to carry the Boston and Essex piano lines, thereby ensuring that these pianos will be marketed as complementary product lines.  Increased traffic generated by these pianos creates current and future customers for Steinway.  We do not believe that the availability of lower-priced Boston and Essex alternatives has negatively impacted the sales of Steinway & Sons pianos.  These lines benefit from the “spillover” effect created by the marketing efforts supporting the main Steinway product line.

 

Band and Orchestral Instruments.  Band, string and percussion instruments and related accessories are distributed worldwide through approximately 1,800 independent musical instrument dealers and distributors.  These products are marketed by district sales managers and telemarketing representatives who are responsible for sales within assigned geographic territories in the United States and Canada.

 

Each district sales manager is also responsible for developing relationships with band and orchestral directors.  These directors represent all levels of music educators, from those who teach elementary school children through those involved at the college and professional levels. These individuals are the primary influencers in the choice of an instrument brand.  Band directors will generally refer students to designated dealers for the purchase of instruments.  As part of our music director outreach and support strategy, we have developed Conn-Selmer University, which provides young teachers with the tools and instruction to excel in the music education environment.  We believe that our well-established, long-standing relationships with these influential music educators are an important component of our distribution strategy.

 

We also sell our products through dealers and distributors located in each major country outside of the United States.  International representatives help market our products to these dealers and distributors. Dealers and distributors in the United States and abroad are supported through incentive programs, advertising and promotional activities.

 

The primary methods of reaching customers are trade shows, educator conferences, print media, direct mail, telemarketing, the Internet and personal sales calls. We also actively advertise in consumer, educator and trade magazines and publications and provide educational materials, catalogs and product specifications to students, educators, dealers and distributors.  In addition, our representatives attend

 

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several trade shows and educator conferences each year, which provide opportunities to interact directly with customers.  Moreover, our educational director travels extensively, lecturing and motivating students, educators and parents on the value of music in a child’s development.

 

Musical Instrument Industry

 

Pianos. The overall piano industry is comprised of three main categories: high-end grand pianos, mid/low-end grand pianos, and upright pianos.  From the middle through the end of the 1990s, the industry experienced growth in all categories of pianos. The introduction of the Boston line in the early 1990s permitted us to compete in the mid-price category without sacrificing quality.   In recent years the industry has been impacted by the worldwide economic downturn.  Although piano sales were adversely affected, favorable demographics, institutional sales, and the public’s continued interest in music helped mitigate the impact of the economy.  Of late, economic indicators have improved, and we expect a favorable impact on our business as the economy rebounds.

 

Market size and volume trends are difficult to quantify for international markets, as there is no single source for worldwide sales data.  Our strongest international markets outside the Americas are Germany, Japan, the United Kingdom, France and Switzerland.

 

Outside of the United States, China and Japan are the two largest piano markets in the world, with Japan representing the second largest grand piano market.  With our three piano lines, our market share, based on grand piano units, is currently 4% in Japan, compared to an average market share of approximately 8% in other major markets.  While adverse economic conditions in some of the Asian markets have slowed our expansion, other markets, such as China, are growing at a rapid pace.  We continue to target this region in our distribution strategies and have appointed a president of Asian operations whose responsibilities include growth initiatives, strategic activities, and manufacturing relationships.  We have also established a distribution and selection facility in Shanghai.  We believe that our long-term prospects in Asia are favorable.

 

Band and Orchestral Instruments.  We believe that the band and orchestral instrument industry in the U.S. has historically been impacted more by demographic trends and school budgeting than by macroeconomic cycles.  While the domestic market continued to grow through the late 1990s, domestic supply has outpaced demand. In recent years there has been an increase in units imported into the domestic market from offshore low-cost producers, as well as a decline in exports by domestic manufacturers. These factors have created a highly price sensitive domestic market, where manufacturers implemented aggressive pricing programs in an attempt to maintain market share positions.

 

However, we believe the outlook for future growth remains positive.  Relatively stable demographic trends and studies emphasizing the importance of music education in a child’s development are expected to facilitate industry growth.  We believe that parents are encouraging their children to play musical instruments in response to the growing number of reports that show participation in music programs increases a student’s ability to excel in other aspects of his or her education.  In addition, many school band directors are promoting band programs as social organizations rather than the first step of intensive music study.   We believe that focusing on the educational component of the musical instrument industry will help us expand our market share in the relatively flat market expected in the near-term.

 

Competition

 

Few manufacturers compete directly with Steinway & Sons pianos, both in terms of quality and price.  We believe that used Steinway pianos provide the primary competition in our market segment.

 

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Because of the potential savings associated with buying a used Steinway piano, as well as the durability of the instrument, a large market exists for used Steinways.  It is difficult to estimate the significance of used piano sales, since most are conducted in the private aftermarket.  However, our increased emphasis on restoration services and the procurement, refurbishment and sales of used Steinway pianos has helped us mitigate the impact of these aftermarket sales.

 

We are the largest domestic producer of band and orchestral instruments.  New entrants into the domestic market experience difficulty competing with us due to the long learning curve inherent in the production of musical instruments, the high quality standards set by the market, cost of tooling, significant capital requirements, and need for both brand recognition and an effective distribution system.  However, offshore musical instrument manufacturers present an ever-increasing level of competition for us, primarily because their labor costs are so low.  They now offer a broad range of products at highly competitive prices.

 

It is difficult to quantify the impact of imported musical instruments since the majority of offshore manufacturers do not report data through typical industry channels, if at all.  However, it is clear from our research and the sales deterioration we’ve experienced that there is increased competition from offshore sources.  Furthermore, many non-traditional musical instrument retailers such as superstores and wholesale clubs have recently decided to sell these offshore products.  Currently we do not know what long-term impact, if any, these non-traditional retailers will have on the marketplace or whether they will continue to grow at the expense of the traditional music retailers.

 

Recognizing the competition from these imported products, in October 2003 we expanded our product line to include three distinct student product groupings, offering sourced instruments made to our specifications at prices comparable to that of offshore manufacturers. We now offer “good” entry-level imported instruments, “better” mid-priced instruments, which are either imported or manufactured by us, and “best” instruments, which are manufactured by us.

 

Patents and Trademarks

 

We pioneered the development of the modern piano with over 125 patents granted since our founding. Although we have several patents effective and pending, for varying lengths of time, in the United States and in several foreign countries, we do not believe our business is materially dependent upon any single patent.

 

We also have some of the most well-known brand names in the music industry.  Our piano trademarks include Steinway, Steinway & Sons, the Lyre design, Boston, Boston designed by Steinway & Sons, Heirloom Collection,and Essex. Our band and orchestral trademarks include Bach, Selmer, C.G. Conn, King, Armstrong, Ludwig, Musser, Glaesel, Scherl & Roth, William Lewis & Son, Emerson, and Artley.  We consider our trademarks to be important and valuable assets.  It is possible that the termination, expiration or infringement of one or more of our trademarks may have an adverse affect on our business, depending on the trademark and the jurisdiction.  Accordingly, we maintain trademark registrations in appropriate jurisdictions on an ongoing basis and vigorously pursue any infringement by competitors.

 

Raw Materials, Component Parts, and Sourced Products

 

Our raw materials consist primarily of metals and woods, the majority of which are sourced from the Americas, with the balance coming from Europe, Asia and Africa.  We have made strategic acquisitions of our sole domestic piano plate manufacturer and primary piano key maker to ensure

 

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availability of these component parts.  In addition, component parts are imported from Europe and Asia for stringed and percussion instruments.  We have had adequate supplies of raw materials and component parts in the past and do not expect any disruption to the supply of these items during 2004 or in the future.

 

Our Boston and Essex piano lines are each sourced from a single manufacturer, as are our Selmer Paris instruments and certain other component parts.  Although we may experience slight delays in availability of product due to the lead times required by these manufacturers, we do not anticipate any material disruptions to the supply of these products.  Additionally, many of the band and orchestral instruments included in our expanded product line are also sourced from single manufacturers.  Although we continuously scrutinize these suppliers and the quality of products that they manufacture to our specifications, we currently cannot accurately predict these manufacturers’ ability to react to changes in order quantities.   We expect availability of these sourced products to have some impact on results in the first half of 2004 until we are able to pinpoint anticipated demand and reconcile it with our suppliers’ required lead times.  However, we believe that we have a sufficient number of qualified suppliers to ensure availability of all offered products in the upcoming year.

 

Manufacturing Process

 

We manufacture a majority of the musical instruments that we sell. The manufacturing process involves essentially two main production phases: the production of component parts and instrument assembly.  Employees perform various forming, drilling, and cutting operations during the parts production phase.  Skilled workers assemble component parts, creating the instruments.  Each instrument is tested or tuned and regulated to our specifications.  The manufacturing process for our band instruments typically takes approximately two months, whereas the manufacturing process for pianos takes nine months to a year.

 

Historically, we have maintained a fairly constant production schedule for band and orchestral instruments in order to minimize labor disruptions and to keep work-in-process inventories relatively stable.  However, in the last two years we have implemented periodic shutdowns of selected manufacturing facilities in each segment of our business.  We utilize this process in order to control inventory levels while maintaining a skilled workforce.

 

Labor

 

As of December 31, 2003, we employed 2,283 people, consisting of 1,702 hourly production workers and 581 salaried employees.  Of the 2,283 employees, 1,783 were employed in the United States and the remaining 500 were employed primarily in Europe.

 

Other than management, employees in Germany are represented by the workers’ council.  Nevertheless, most employment contract conditions are settled in collective bargaining agreements made between various trade unions and the employer organizations to which we belong. Generally, agreements are negotiated on an annual basis.

 

Approximately 66% of our workforce in the United States is represented by labor unions.  Collective bargaining agreements covering these employees were negotiated at various dates throughout 2003.  During the negotiation process for these agreements, employees at our LaGrange, Illinois and Eastlake, Ohio plants, respectively, initiated work stoppages in an attempt to obtain improved contract offers.  However, we were eventually able to successfully negotiate all agreements.  In October 2003 we

 

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announced the pending closure of one of our Elkhart, Indiana woodwind manufacturing facilities.  In March 2004 the labor union at this facility voted unanimously to accept the shutdown agreement.

 

ITEM 2                   PROPERTIES

 

We own most of our manufacturing and warehousing facilities, as well as the building that includes Steinway Hall in New York City.  The remaining Steinway retail stores are leased.  Substantially all of the domestic real estate has been pledged to secure our debt.

 

The following table lists our significant owned and leased facilities:

 

Location		Owned/Leased		Approximate Floor Space (Square Feet)		Type of Facility and Activity Performed
New York, NY		Owned		450,000		Piano manufacturing; restoration center; administrative offices; training
		Owned		217,000		Piano retail store/showroom; office rental property
Westport, CT		Leased		11,000		Piano retail store/showroom
Coral Gables, FL		Leased		6,000		Piano retail store/showroom
Paramus, NJ		Leased		4,000		Piano retail store/showroom
Springfield, OH		Owned		110,000		Piano plate manufacturing
Hamburg, Germany		Owned		221,000		Piano manufacturing; executive offices; training
		Leased		7,000		Piano retail store/showroom
Munich, Germany		Leased		15,000		Piano retail store/showroom
Berlin, Germany		Leased		7,000		Piano retail store/showroom/service workshop
Wuppertal, Germany		Leased		27,000		Piano key manufacturing
Wilkow, Poland		Owned		10,000		Piano key manufacturing
Shanghai, China		Leased		12,000		Warehouse/showroom/workshop
London, England		Leased		10,000		Piano showroom
		Leased		6,000		Piano workshop/storage
Tokyo, Japan		Leased		9,000		Selection center; warehouse
		Leased		2,000		Administrative offices
Eastlake, OH		Owned		160,000		Brasswind manufacturing
Elkhart, IN		Owned		150,000		Brasswind manufacturing
		Owned		88,000		Woodwind manufacturing; warehouse; office
		Owned		77,000		Woodwind manufacturing (to be closed in 2004)
		Owned		81,000		Warehouse
		Owned		25,000		Administrative offices
Nogales, AZ		Owned		67,000		Former band instrument manufacturing, held for sale
		Owned		22,000		Former band instrument manufacturing, rental property
LaGrange, IL		Owned		46,000		Percussion instrument manufacturing
Monroe, NC		Leased		154,000		Drum and case manufacturing
Cleveland, OH		Leased		62,000		Stringed instrument manufacturing
London, England		Leased		8,000		Band instrument office; warehouse

 

We spent $5.5 million for capital improvements in 2003, consisting primarily of leasehold improvement projects related to our new piano retail stores, machinery and equipment purchases, and

 

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office equipment upgrades and replacements.  We expect capital spending in 2004 to be in the range of $5.5-6.5 million, relating to machinery and equipment purchases, system upgrades, and facility improvements.

 

ITEM 3                   LEGAL PROCEEDINGS

 

We are involved in certain legal proceedings regarding environmental matters, which are described below.  Further, in the ordinary course of business, we are party to various legal actions that management believes are routine in nature and incidental to the operation of the business.  While the outcome of such actions cannot be predicted with certainty, we believe that, based on our experience in dealing with these matters, their ultimate resolution will not have a material adverse impact on our business, financial condition or results of operations or prospects.

 

Environmental Matters – We are subject to compliance with various federal, state, local and foreign environmental laws, including those relating to discharges to air, water and land, the handling and disposal of solid and hazardous waste and the cleanup of properties affected by hazardous substances.  Certain environmental laws, such as the Comprehensive Environmental Response, Compensation, and Liability Act, as amended, impose strict, retroactive, joint and several liability upon persons responsible for releases of hazardous substances, which responsibility is broadly construed.

 

We operated manufacturing facilities at locations where hazardous substances (including chlorinated solvents) were used.  We believe that an entity that formerly operated one such facility may have released hazardous substances at such location, which we leased through July 2001.  We did not contribute to such release.  Further, we have a contractual indemnity from certain stockholders of such entity.  This facility is not the subject of a legal proceeding that involves us, nor, to our knowledge, is the facility subject to investigation.  However, no assurance can be given that legal proceedings will not arise in the future and that such indemnitors would make the payments described in the indemnity.

 

We operate other manufacturing facilities that were previously owned by Philips Electronics North America Corporation (“Philips”).  Philips agreed to indemnify us for any and all losses, damages, liabilities and claims relating to environmental matters resulting from certain activities of Philips occurring prior to December 29, 1988 (the “Environmental Indemnity Agreement”).  Philips has fully performed its obligations under the Environmental Indemnity Agreement, which terminates on December 29, 2008.  Four matters covered by the Environmental Indemnity Agreement are currently pending.  Philips has entered into Consent Orders with the Environmental Protection Agency (“EPA”) for one site and the North Carolina Department of Environment, Health and Natural Resources for a second site, whereby Philips has agreed to pay required response costs.  On October 22, 1998, we were joined as defendant in an action involving a site formerly occupied by a business we acquired in Illinois.  Philips has accepted the defense of this action pursuant to the terms of the Environmental Indemnity Agreement.  For the fourth site, the EPA has notified us it intends to carry out the final remediation itself.  The EPA estimates that this remedy has a present net cost of approximately $14.5 million.  The EPA has named over 40 persons or entities as potentially responsible parties at this site, which includes certain facilities that we acquired in 2000.  This matter has been tendered to Philips pursuant to the Environmental Indemnity Agreement for those facilities that were acquired from Philips.  Our potential liability at any of these sites is affected by several factors including, but not limited to, the method of remediation, our portion of the materials in the site relative to the other named parties, the number of parties participating, and the financial capabilities of the other potentially responsible parties once the relative share has been determined.  No assurance can be given, however, that additional environmental issues will not require

 

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additional, currently unanticipated investigation, assessment or remediation expenditures or that Philips will make payments that it is obligated to make under the Environmental Indemnity Agreement.

 

We are also continuing an existing environmental remediation program at a facility acquired in 2000.  We currently estimate that this project will take eighteen years to complete, at a total cost of approximately $1.2 million.  We have accrued approximately $0.8 million for the estimated remaining cost of this remediation program, which represents the present value of the total estimated cost using a discount rate of 5.0%.  A summary of expected payments associated with this project is as follows:

 

 

The matters described above and our other liabilities and compliance costs arising under environmental laws are not expected to have a material impact on our capital expenditures, earnings or competitive position.  However, some risk of environmental liability is inherent in the nature of our current and former businesses and we might, in the future, incur material costs to meet current or more stringent compliance, cleanup or other obligations pursuant to environmental laws.

 

ITEM 4                   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matter was submitted to a vote of our security holders during the fourth quarter of the fiscal year ended December 31, 2003.

 

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PART II

 

ITEM 5                                                        MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

Our ordinary common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “LVB”.  The following table sets forth, for the periods indicated, the high and low sales prices per share of our ordinary common stock as reported on the NYSE.

 

		High			Low
Fiscal Year Ended December 31, 2002
First Quarter		$	20.85		$	15.49
Second Quarter		23.83			18.88
Third Quarter		22.44			15.00
Fourth Quarter		19.19			15.25
Fiscal Year Ended December 31, 2003
First Quarter		$	16.60		$	14.25
Second Quarter		16.25			12.30
Third Quarter		18.20			15.27
Fourth Quarter		24.70			16.85

 

We have two classes of common stock: Class A and Ordinary.  With the exception of disparate voting power, both classes are substantially identical.  Each share of Class A common stock entitles the holder to 98 votes.  Holders of Ordinary common stock are entitled to one vote per share.  Class A common stock shall automatically convert to Ordinary common stock if, at any time, the Class A common stock is not owned by an original Class A holder.  As of February 2, 2004, there were 2,207 holders of record of our Ordinary common stock and two holders of record of the Class A common stock.

 

We are restricted by the terms of our outstanding debt and financing agreements from paying cash dividends on our common stock, and we may, in the future, enter into loan or other agreements that restrict the payment of cash dividends on the common stock.

 

We presently intend to retain earnings to reduce outstanding indebtedness and to fund the growth of our business.  The payment of any future dividends will be determined by the Board of Directors in light of conditions then existing, including our results of operations, financial condition, cash requirements, restrictions in financing agreements, tax treatment of dividends, business conditions and other factors.

 

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Equity Compensation Plans

 

The following table sets forth the equity compensation plan information for our Employee Stock Purchase Plan and our Amended and Restated 1996 Stock Plan, which were approved by security holders:

 

Plan Category		Number of securities to be issued upon exercise of outstanding options, warrants and rights (a)		Weighted-average exercise price of outstanding options, warrants and rights (b)		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (c)
Equity compensation plans approved by security holders		1,154,747		$19.63		494,843
Total		1,154,747		$19.63		494,843

 

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ITEM 6                   SELECTED CONSOLIDATED FINANCIAL DATA

 

The following table sets forth our selected consolidated financial data as of and for each of the five years ended December 31, 2003, derived from our audited financial statements.  The table should be read in conjunction with our consolidated financial statements, including the footnotes, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this report.

 

(In thousands except share and per share information)		Years Ended December 31,
		1999			2000 (1)			2001			2002			2003
Income statement data:
Net sales		$	304,636		$	331,698		$	352,612		$	332,297		$	337,220
Gross profit		100,748			101,688			103,521			97,151			92,553
Income from operations		41,140			38,419			34,495			31,399			22,824
Net income		17,345			14,887			8,738			14,909			9,698
Earnings per share:
Basic		$	1.88		$	1.67		$	0.98		$	1.68		$	1.09
Diluted		$	1.87		$	1.67		$	0.98		$	1.68		$	1.09
Weighted average shares:
Basic		9,213,145			8,921,091			8,928,000			8,877,256			8,924,578
Diluted		9,277,798			8,921,108			8,928,000			8,882,165			8,925,672
Balance sheet data (at year end):
Cash		$	4,664		$	4,989		$	5,545		$	19,099		$	42,283
Current assets		171,954			263,376			254,474			267,346			288,270
Total assets		309,641			419,739			409,537			423,731			445,665
Current liabilities		44,959			56,515			49,318			53,302			61,304
Total debt		140,080			223,410			211,203			200,636			196,602
Stockholders’ equity		98,202			111,190			115,773			131,208			152,635
Other financial data:
EBITDA (2)/net interest expense		4.1x			3.4x			3.0x			3.5x			3.9x
Capital expenditures (3)		5,399			7,890			7,141			5,604			5,462
Margins:
Gross profit		33.1		%	30.7		%	29.4		%	29.2		%	27.4		%
EBITDA (2)		18.0		%	16.3		%	14.2		%	14.0		%	13.7		%
Reconciliation from cash flows from operating activities to EBITDA (2):
Cash flows from operating activities		$	15,372		$	13,265		$	28,877		$	31,048		$	31,876
Changes in operating assets and liabilities		11,786			10,662			(2,265		)	(5,962		)	(9,333		)
Income taxes, net of deferred tax benefit		14,479			12,789			7,164			8,344			7,299
Net interest expense		13,276			16,110			16,731			13,279			11,945
Other		(91		)	(234		)	(425		)	(334		)	(329		)
Non-recurring, infrequent, or unusual charges		—			1,490			—			—			4,844
EBITDA (2)		$	54,822		$	54,082		$	50,082		$	46,375		$	46,302

 

Notes to Selected Consolidated Financial Data:

 

(1)          We acquired UMI in September 2000.

(2)          We use the non-GAAP measurement EBITDA, which we define as earnings before net interest expense, income taxes, depreciation and amortization, adjusted to exclude non-recurring, infrequent or unusual items.  We use EBITDA because it is useful to management and investors as a measure of core operating performance.  We also believe EBITDA is helpful in determining our ability to meet future debt service, capital expenditures and working capital requirements.  In addition, certain of our debt covenants are based primarily upon calculations using EBITDA and we use EBITDA as the primary measure for determining bonuses for our managers.  However, EBITDA should not be construed as a substitute for operating income or a better indicator of liquidity than cash flows from operating activities, which are determined in accordance with GAAP.

(3)          Capital expenditures for 1999 exclude $30.8 million for the purchase of Steinway Hall.

 

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ITEM 7                                                        MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Tabular Amounts in Thousands Except Share and Per Share Data)

 

Introduction

 

The following discussion provides an assessment of the results of our operations and liquidity and capital resources together with a brief description of certain accounting policies.  Accordingly, the following discussion should be read in conjunction with our Consolidated Financial Statements and the Notes to Consolidated Financial Statements included within this filing.

 

Overview

 

We, through our operating subsidiaries, are one of the world’s leading manufacturers of musical instruments.  Our strategy is to capitalize on our strong brand names, leading market positions, strong distribution networks, and quality products.

 

Piano Segment

 

Sales of our pianos are influenced by general economic conditions, demographic trends and general interest in music and the arts.  The operating results of our piano segment are primarily affected by Steinway & Sons grand piano sales.  Given the total number of these pianos that we sell in any year (2,928 sold in 2003), a slight change in units sold can have a material impact on our business and operating results.  Our results are also influenced by sales of Boston and Essex pianos, which together represented approximately 50% of total piano units sold and approximately 20% of total piano revenues in 2003.  Our Boston and Essex piano lines are manufactured in Asia, each by a single manufacturer.  The ability of these manufacturers to produce and ship products to us could materially impact our business and operating results.  In 2003, approximately 57% of piano sales were in the United States, 28% in Europe and the remaining 15% primarily in Asia. For the year ended December 31, 2003, our piano segment sales were $179.8 million, representing 53% of our total revenues.

 

Piano Outlook for 2004

 

We expect a successful year for our piano segment due to recent order patterns and indications of a stronger economy.  Gross margins are expected to remain stable as we return to normal production levels in our domestic manufacturing facility and reap the benefits of having two new retail stores open for the full year.  We expect these factors to offset the higher costs of Boston inventory purchases caused by unfavorable exchange rates.  We currently have sufficient, but not excessive, manufacturing capacity to meet anticipated or increased demand.

 

Band Segment

 

Our student band instrument sales are influenced by trends in school enrollment and general attitudes toward music and the arts. Management estimates that 85% of our domestic band sales are generated through educational programs.  Our school instrument business is correlated to the number of school children in the United States, which has peaked and is expected to remain relatively stable over the next few years.  However, the correlation has been adversely affected in recent years by two factors:  limited school budget resources and the resultant negative impact on school music program funding, and the abundance of competitively-priced imported student instruments.

 

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In order to compete with these mass-merchandised offshore instruments, we restructured our product line in 2003. Our product offerings now include quality, competitively-priced brand-name imported instruments that are built to our specifications.  We also began a facility rationalization project to eliminate excess manufacturing space and the corresponding overhead.  We believe these changes were necessary for us to remain competitive in the band instrument market.

 

Consistent with past patterns, beginner instruments accounted for 70% of band and orchestral unit shipments and 43% of instrument revenues in 2003, with advanced and professional instruments representing the balance. In 2003, approximately 84% of band sales were in the United States, 8% in Europe and the remaining 8% primarily in Asia.  For the year ended December 31, 2003, our band sales were $157.5 million, representing 47% of our total revenues.

 

Band Outlook for 2004

 

We expect a challenging first half of the year as we complete our facility rationalization project, pinpoint the demand for our recently introduced sourced products, and synchronize product availability with demand.  We expect the latter half of the year to show improvement over past performance, both in net sales and gross margin, since we will have worked through excess inventories, returned to more efficient production levels, and expect to have the appropriate balance of manufactured and imported products to meet demand for the back-to-school selling season.  We believe that providing quality-controlled, brand-name products at multiple pricepoints via distribution channels which support the music education market will prove to be a successful strategy for the long-term growth of this segment of our business.

 

Inflation and Foreign Currency Impact

 

Although we cannot accurately predict the precise effect of inflation on our operations, we do not believe that inflation has had a material effect on sales or results of operations in recent years.

 

Sales to customers outside the United States represent approximately 30% of consolidated sales, with international piano sales accounting for approximately 75% of these international sales.  A significant portion of international piano sales originate from our German manufacturing facility, resulting in sales, cost of sales and related operating expenses denominated in Euros. While currency translation has affected international sales, cost of sales and related operating expenses, it has not had a material impact on operating income.  We use financial instruments such as forward exchange contracts and currency options to reduce the impact of exchange rate fluctuations on firm and anticipated cash flow exposures and certain assets and liabilities denominated in currencies other than the functional currency of the affected division.  We do not purchase currency related financial instruments for purposes other than exchange rate risk management.

 

Taxes

 

Our effective tax rates vary depending on the relative proportion of foreign to U.S. income and the absorption of foreign tax credits in the U.S.  In 2001, the costs associated with our debt extinguishment, which were absorbed domestically, caused an increase in the proportion of our foreign source income, allowing us to utilize foreign tax credits carried forward from prior years.  In 2002, we were not able to utilize foreign tax credits carried forward from prior years. However, with the overall effective German rates on par with the U.S. rates, the shift towards income generated from the German divisions allowed us to better utilize our current foreign tax credits.  In 2003, we were once again able to

 

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utilize foreign tax credits carried forward from prior years due to the higher proportion of our foreign source income to overall income.

 

The strengthening of our domestic piano and band businesses is expected to result in less effective use of our foreign tax credits and credit carryforwards in the upcoming year.  In addition, the states in which we do business are either repealing legislation that had been beneficial to tax paying businesses, or have promulgated more restrictive tax legislation in an effort to boost tax revenues and eliminate state deficits.  These events will have a negative impact on our effective tax rate for 2004.  Accordingly, we expect our 2004 effective tax rate to approximate 40%.

 

Results of Operations

 

Fiscal Year 2003 Compared to Fiscal Year 2002

 

		Year Ended December 31,										Change
		2002					2003					$		%
Net sales
Band		$	167,708				$	157,460				(10,248	)	(6.1	)
Piano		164,589					179,760					15,171		9.2
Total sales		332,297					337,220					4,923		1.5
Cost of sales
Band		127,849					126,369					(1,480	)	(1.2	)
Piano		107,297					118,298					11,001		10.3
Total cost of sales		235,146					244,667					9,521		4.0
Gross profit
Band		39,859			23.8%		31,091			19.7%		(8,768	)	(22.0	)
Piano		57,292			34.8%		61,462			34.2%		4,170		7.3
Total gross profit		97,151					92,553					(4,598	)	(4.7	)
		29.2%					27.4%
Operating expenses		65,752					66,771					1,019		1.5
Facility rationalization charges		—					2,958					2,958
Total operating expenses		65,752					69,729					3,977		6.0
Income from operations		31,399					22,824					(8,575	)	(27.3	)
Other income, net		(3,939		)			(3,517		)			422		(10.7	)
Net interest expense		13,279					11,945					(1,334	)	(10.0	)
Income before income taxes		22,059					14,396					(7,663	)	(34.7	)
Income taxes		7,150					4,698					(2,452	)	(34.3	)
Net income		$	14,909				$	9,698				(5,211	)	(35.0	)

 

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Overview – 2003 was a year of transition in our band business. Our results were negatively impacted early on by strikes at two of our plants.  We began a facility rationalization project to reduce manufacturing space by 20% and improve future margins on manufactured products.  We reduced production in order to bring down excess manufactured inventory levels.  Lastly, in October, we expanded our product line and introduced many new, quality-controlled sourced products that have been made to our specifications.  We also revamped our distribution policy to include channels not previously utilized and now offer step-up and professional instruments through catalogs and via the Internet.  Additionally, we now offer school music dealers a full line of instruments, including lower-priced, brand-name instruments which are a favorable alternative to mass-produced, offshore products.   We expect this strategy to positively impact the latter half of 2004.

 

Our piano business started out slow but recovered in the last two quarters of 2003. While Steinway & Sons’ 150^th anniversary celebration caused sales and marketing expenses to increase, we believe that the additional publicity generated by this milestone event helped generate sales interest in the second half of the year.  However, due to the long production cycles for Steinway pianos and the lead-time required for ordering sourced pianos, we were unable to match the increase in demand by year-end.  Nevertheless, we believe that the increase in orders for both manufactured and sourced products is a positive indicator for 2004.

 

Change in Accounting Principle - Prior to October 1, 2003, we used the first-in, first-out (“FIFO”) method of costing inventory for approximately 75% of our inventories, with the cost of the remaining inventories determined using the last-in, first-out (“LIFO”) method.   Effective October 1, 2003, we decided to conform our method of costing inventory by adopting the FIFO method for all inventories.  We believe the FIFO method is preferable as the FIFO method better matches current costs with current revenues and provides a more meaningful presentation of our financial position by reflecting more recent costs in the balance sheet.   In addition, as we rationalize our facilities, combine manufacturing processes, and increase the use of outsourced product in our offerings, the use of a consistent method across all our inventories will enable us to better allocate resources and avoid significant costs that would likely be incurred to segregate and track inventory on separate methods that may flow through a single manufacturing facility.

 

In accordance with generally accepted accounting principles, the change in accounting principle has been applied by retroactively restating prior years consolidated financial statements.  The change in accounting resulted in a reduction of net income reported in 2001 of $2.6 million ($0.29 per share) and a reduction in retained earnings of $4.6 million as of December 31, 2001.  The change did not have a material effect on our 2002 or 2003 income statements.

 

Net Sales – The increase in net sales of $4.9 million resulted from a $15.2 million improvement in piano sales, which occurred despite relatively flat Steinway grand units shipments.  The piano sales increase reflects $10.2 million in benefit attributable to foreign exchange, as well as annual price increases and a shift in mix towards higher-priced retail units.  Band and orchestral instrument sales decreased $10.2 million on an overall unit decrease of 12%, reflecting the decreased demand for higher cost beginner instruments.  The delay in availability of product resulting from the union strikes at our LaGrange, Illinois and Eastlake, Ohio plants (settled in March and May, respectively) also contributed to the sales shortfall.  These factors were mitigated in part by a shift in sales mix towards higher-priced step-up and professional instruments and an 11% increase in percussion unit shipments.

 

Gross Profit – Gross profit decreased $4.6 million in 2003 as both the piano and band segments experienced deteriorating gross margins.  Piano margins decreased slightly to 34.2% despite the shift towards retail units, primarily due to the $1.4 million resulting from unfavorable foreign exchange rates

 

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on Boston inventory purchases.  Gross margins for the band and orchestral segment declined to 19.7%, corresponding to a gross profit decrease of $8.8 million.  This decrease includes $1.9 million paid to employees in accordance with the terms of expired labor contracts, and $1.3 million in underabsorbed overhead and lost profit resulting from the work stoppages at two of our plants.  In addition, we incurred $1.2 million in inventory impairment charges and $1.7 million in severance costs associated with the closure of our Nogales, Arizona woodwind manufacturing facility and the imminent (April 2004) closure of one of our Elkhart, Indiana woodwind manufacturing facilities.   Production levels, which were reduced at one of our brasswind plants in order to manage excess inventory levels, and increased pension expenses of $1.1 million, also adversely impacted band segment margins in 2003.

 

Operating Expenses – Operating expenses increased $4.0 million, primarily as a result of the $3.0 million of impairment charges taken on land, building, and equipment relating to our Nogales, Arizona and Elkhart, Indiana woodwind manufacturing facilities.  Foreign currency translation negatively impacted operating expenses by $2.1 million and additional sales and marketing expenses of over $1.0 million incurred in conjunction with Steinway & Sons’ 150^th anniversary celebration were also a factor.  Offsetting these costs was $2.6 million in savings realized by the band segment through administrative staff reductions and lower sales and marketing expenses.

 

Non-operating Expenses – Non-operating expenses decreased $0.9 million to $8.4 million in 2003 primarily due to lower net interest resulting from the use of cash from operations, as opposed to line of credit borrowings, in the current period.  In addition, our debt buyback of $4.7 million in December 2002 lowered interest expense by $0.4 million.

 

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Results of Operations

 

Fiscal Year 2002 Compared to Fiscal Year 2001

 

		Year Ended December 31,										Change
		2001					2002					$		%
Net sales
Band		$	183,646				$	167,708				(15,938	)	(8.7	)
Piano		168,966					164,589					(4,377	)	(2.6	)
Total sales		352,612					332,297					(20,315	)	(5.8	)
Cost of sales
Band		139,379					127,849					(11,530	)	(8.3	)
Piano		109,712					107,297					(2,415	)	(2.2	)
Total cost of sales		249,091					235,146					(13,945	)	(5.6	)
Gross profit
Band		44,267			24.1%		39,859			23.8%		(4,408	)	(10.0	)
Piano		59,254			35.1%		57,292			34.8%		(1,962	)	(3.3	)
Total gross profit		103,521					97,151					(6,370	)	(6.2	)
		29.4%					29.2%
Operating expenses		64,771					64,598					(173	)	(0.3	)
Amortization		4,255					1,154					(3,101	)	(72.9	)
Total operating expenses		69,026					65,752					(3,274	)	(4.7	)