UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-K

 

 

COMMISSION FILE NUMBER 001-11911

 

STEINWAY MUSICAL INSTRUMENTS, INC.

(Exact name of registrant as specified in its charter)

 

DELAWARE		35-1910745
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)
800 South Street, Suite 305,
Waltham, Massachusetts		02453
(Address of Principal Executive Offices)		(Zip Code)
Registrant’s telephone number, including area code
(781) 894-9770
Securities registered pursuant to Section 12(b) of the Act:
Title of each class		Name of each exchange on which registered
Ordinary Common Shares, $.001 par value		New York Stock Exchange

 

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

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes  o  No  ý

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.   Yes  o  No  ý

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

 

Large accelerated filer o

Accelerated filer ý

Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes   o  No  ý

 

The aggregate market value of the Common Stock held by non-affiliates of the registrant was $236,697,002 as of June 30, 2005.

 

Number of shares of Common Stock outstanding as of March 24, 2006:		Class A		477,952
		Ordinary	ý	7,690,858
		Total	ý	8,168,810

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Part III - Items 10-14 - Definitive Proxy Statement of the Registrant to be filed pursuant to Regulation 14A, Parts I-IV - Final Prospectus of the Registrant dated August 1, 1996 filed pursuant to Rule 424(b).

 

 

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 readers that such statements are necessarily based on certain assumptions that 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 factors discussed in Item 1A of this report.  We encourage investors to read Item 1A carefully.  Undue reliance should not be placed 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 by referring the reader to other documents we have filed with the SEC.  The information to which we refer is “incorporated by reference” into this Annual Report on Form 10-K.  Please read that information.

 

PART I

 

Item 1.  Business

 

Company History

 

Steinway Musical Instruments, Inc., through its wholly owned subsidiaries, is a global leader in the design, manufacture, marketing and distribution of high quality musical instruments.  We are the largest domestic manufacturer of musical instruments.  Whenever we refer to the “Company” or to “us,” or use the terms “we” or “our” in this annual report, we are referring to Steinway Musical Instruments, Inc. and its subsidiaries.

 

Steinway Musical Instruments, Inc., formerly Selmer Industries, Inc., was incorporated in 1993, at which time it purchased The Selmer Company, Inc. (“Selmer”), the largest U.S. manufacturer of band & orchestral instruments.  In May of 1995, we purchased Steinway Musical Properties, Inc. (“Steinway”), a manufacturer and distributor of acoustic pianos.  In August of 1996, Steinway Musical Instruments, Inc. became publicly held.

 

In September of 2000, we acquired United Musical Instruments Holdings, Inc. (“UMI”), the second largest manufacturer of band & orchestral instruments in the United States and on January 1, 2003 Selmer and UMI merged into Conn-Selmer, Inc.
(“Conn-Selmer”).  In August of 2004, we acquired the assets of G. Leblanc Corporation, a manufacturer of high quality band instruments with production facilities in Wisconsin and France.

 

We are a Delaware corporation with our principal executive offices located at 800 South Street, Suite 305, Waltham, Massachusetts 02453, and our telephone number is (781) 894-9770.  Through our corporate website, www.steinwaymusical.com, we provide access free of charge to 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.  These reports are available immediately following filing with the SEC.  Information contained on or connected to our website is not incorporated by reference into this Annual

 

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Report on Form 10-K and should not be considered part of this report or any other filing that we make with the SEC.  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 electronically with the SEC.

 

Financial Information by Segment and Geographic Location

 

Information on business segments and geographic areas in which we operated for the years ended December 31, 2005, 2004 and 2003 is contained in Note 17 to the Consolidated Financial Statements included in this report.

 

Musical Instrument Industry

 

We operate two reportable segments within the musical instrument industry: pianos and band & orchestral instruments.

 

Pianos - The overall piano market is comprised of two main categories: grand pianos and upright pianos. Steinway & Sons pianos compete in the high-end segment of the market, whereas our Boston and Essex lines compete in the mid-priced segment of the piano market.

 

During the last few years, increases in piano imports, mainly from China and Indonesia, contributed to an increase in grand piano unit sales in the United States, the world’s largest grand piano market.  While these lower-priced imports have made it possible for more consumers to afford a piano, we believe industry revenues are on the decline as a result of lower average prices.  Since Steinway realizes the majority of its profit from high-end grand piano sales, our results are generally more affected by economic cycles, demographics, and the public’s continued interest in music than by industry trends.  The piano market in China is growing at a rapid pace and is now the second largest grand piano market outside the United States.  We continue to target this region in our distribution strategies. 

 

Band & Orchestral Instruments - Demand for band & orchestral instruments in the domestic market has traditionally been more significantly impacted by factors such as demographic trends and school budgeting rather than by macroeconomic cycles.  Recent studies have emphasized the importance of music education in a child’s development and many school band directors are promoting band programs as social organizations rather than the first step of intensive music study.  We expect this emphasis on music education and steady demographic trends to contribute to a relatively stable domestic market in the near-term.

 

In recent years, there has been an increase in units imported into the domestic market from offshore low-cost producers. This has created a highly price sensitive domestic market where manufacturers have implemented aggressive pricing programs in an attempt to maintain market share positions.  To remain competitive in this market, we now import some student woodwind and brass instruments, primarily entry-level, made to our specifications.  The impact of lower priced imported instruments has also led to consolidation within the industry, leaving Conn-Selmer, Yamaha and Jupiter as the top three remaining competitors.

 

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Business and Products

 

Piano Segment

 

Our piano division concentrates on the high-end grand piano market, handcrafting Steinway pianos in New York and Germany.  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 also offer upright pianos as well as two mid-priced lines of pianos under the Boston and Essex brand names.

 

Steinway & Sons - Steinway pianos differ from all others in design specifications, materials used and the assembly process.  We offer two premium-priced product lines under the Steinway & Sons brand: grand pianos and upright pianos.  Grand pianos historically have accounted for the majority of our production.  We offer seven 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 for ebony pianos generally ranging from $40,600 to $103,400 in the United States.  Limited edition pianos and pianos with exotic veneers sell for retail prices of up to $158,200.  In 2005, we sold 3,145 grand pianos, of which 2,114 units were shipped from our New York facility to dealers in the Americas.  The remaining 1,031 units were shipped from our German facility primarily to 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 repair, replacement part sales, tuning and regulation of pianos, and restoration. Restoration services range from repairs of minor damage to complete restorations of vintage pianos.

 

Boston Piano Company - We introduced the Boston line in the early 1990s to allow us to compete in the mid-price category.  Today we offer two complete lines of grand and upright pianos for the mid-priced piano market under the Boston and Essex brand names.  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 to the Steinway line.  These pianos, which were designed by us and are produced for us in Asia, 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.  Also, since our research indicates that the vast majority of Steinway customers have previously owned another piano, Boston and Essex pianos provide future Steinway piano customers with the opportunity to join the Steinway family of owners sooner.  The Boston and Essex product lines also increase our business with our dealers, making us their primary supplier in many instances.  Together, the Boston and Essex product lines offer 13 upright and grand piano sizes, with retail prices ranging from $3,995 to $39,990 in the United States.

 

Band Segment

 

We are the largest domestic producer of band & orchestral instruments and offer a complete line of brass, woodwind, percussion and string instruments with well-known brand names.  We have complemented our domestic manufacturing strategy with a sourcing strategy from Asia to remain competitive in the global marketplace.  Over the past few years, we have established relationships with several overseas manufacturers to produce imported entry-level student instruments to our design specifications.  As part of this global manufacturing strategy, we also began rationalizing our facilities to reduce manufacturing overhead.  We have closed two of our U.S. manufacturing plants, reducing our domestic manufacturing floor space by 20%.

 

In 2005, sales of sourced products accounted for 35% of our band division revenue.

 

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Approximately 25% of these sales were from our imported entry-level student woodwind and brass instruments.

 

Woodwind and Brass Instruments - We manufacture piccolos, flutes, clarinets, oboes, bassoons, saxophones, trumpets, French horns, tubas, and trombones in our manufacturing facilities in Indiana, Ohio, Wisconsin, and France.  We sell student level instruments in three distinct product groupings: “good” entry-level imported instruments, “better” mid-priced instruments, which are either imported or manufactured by us, and “best” instruments, which are primarily manufactured by us.  In addition, we also manufacture intermediate and professional level woodwind and brass instruments.  Sales of woodwind and brass instruments accounted for 70% of our band division revenue in 2005.

 

We sell our woodwind and brass products under the brand names Bach, Selmer, C.G. Conn, Leblanc, King, Armstrong, Holton, Martin, Yanagisawa,Vito, Emerson, Noblet, Artley and Benge.  Suggested retail prices generally range from $300 to $2,500 for student instruments and from $1,000 to $10,000 for intermediate 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.  Our specialized woodwind and brass instruments sell for up to $27,000.

 

We are the exclusive U.S. distributor for Yanagisawa saxophones and Selmer Paris musical instruments. The Selmer Paris saxophone is the best selling professional saxophone in the world.  Selmer Paris, in turn, has exclusive distribution rights to some of our brass instruments in France. 

 

Percussion Instruments - We manufacture, source, and distribute acoustical and tuned percussion instruments, including outfit drums, marching drums, concert drums, marimbas, xylophones, vibraphones, orchestra bells, and chimes.  We manufacture percussion products in North Carolina and 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.  Suggested retail prices range from $500 to $5,000 for acoustical drum outfits and from $2,000 to $15,000 for tuned percussion instruments, with specialized tuned instruments purchased by symphonies and orchestras selling for up to $20,000.  Sales of percussion instruments accounted for 14% of our band division revenue in 2005.

 

String Instruments - We assemble and distribute violins, violas, cellos, and basses.  Products are sold under the brand names Glaesel, Scherl & Roth, and William Lewis & Son.  Suggested retail prices generally range from $200 to $4,000 for student instruments and from $1,400 to $4,700 for intermediate and advanced instruments, with specialized instruments selling for up to $13,000. Components are primarily imported from Europe and Asia and assembled at our factory in Ohio.  Sales of string instruments accounted for 3% of our band division revenue in 2005.

 

Accessories - We manufacture mouthpieces and distribute accessories such as music stands, batons, mallets, straps, mutes, reeds, pads, chin rests, strings, bows, cases and instrument care products.  Sales of accessories accounted for 13% of our band division revenue in 2005.

 

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Customers

 

Piano Segment

 

Most Steinway grand piano sales are to individuals, both professional artists and amateur pianists.  Our typical customer is between 40 and 50 years old and has an intermediate to advanced level of musical skill.  He or she holds a graduate degree and reports an annual household income over $300,000.

 

We also sell pianos to institutions such as concert halls, conservatories, colleges, universities and music schools.  Nearly 20% of pianos sold in 2005 were to institutional customers.  We have a specific program focused on increasing piano sales to music schools, as this market segment is typically less sensitive to economic cycles.  Institutions can earn the “All-Steinway School” designation by owning primarily Steinway-designed pianos, enabling them to provide their students and faculties with the best instruments possible for the study of music, from the practice room to the recital hall.  To date, 57 schools and conservatories worldwide have earned the designation “All-Steinway School.” 

 

Market size and volume trends are difficult to quantify for international piano markets, as there is no single source for worldwide sales data.  Outside the United States, our strongest market shares are in Germany, Switzerland, the United Kingdom, and France.  We believe that we hold an average grand piano market share of approximately 16% in these countries.  We also continue to expand our presence in former Eastern Bloc countries where we significantly increased sales in 2005.

 

Outside of the United States, China is currently the second largest grand piano market in the world.  With our three piano lines, we believe our market share of grand piano units is currently 3% in China.  In 2004, we opened a distribution and selection facility in Shanghai.  Our unit sales in China increased over 50% in 2005 and we expect a large portion of our long-term growth to come from this market.

 

In 2005, approximately 57% of piano sales were in the United States, 28% in Europe and the remaining 15% primarily in Asia.  Our largest piano dealer accounted for approximately 5% of piano sales in 2005, while the top 15 accounts represented 29% of piano sales.

 

Band Segment

 

Band & orchestral instruments are sold to student, amateur and professional musicians, and institutions.  The majority of our instruments are purchased or rented from dealers by students enrolled in music education programs in the United States.  Traditionally, students join school bands or orchestras at age 10 or 11 and learn on beginner level instruments, progressing to intermediate 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 amateur or professional musicians or performing groups, including orchestras and symphonies. Student level instruments accounted for approximately 65% of band & orchestral unit sales and approximately 40% of instrument revenues in 2005, with intermediate and professional instruments representing the balance.

 

Historically, over 80% of our band sales have been in the United States.  We believe that the Asian and European markets present significant opportunities for growth due to the quality of our instruments and the strength of our brand names.  By focusing on these markets, we increased exports by approximately 20% during 2005.

 

In 2005, approximately 79% of band sales were in the United States, 8% in Europe and the remaining 13% primarily in Canada and Asia.  Our largest band dealer accounted for approximately 6% of band sales in 2005, while the top 15 accounts represented approximately 40% of band sales.

 

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Sales and Marketing

 

Piano Segment

 

We distribute our pianos worldwide through approximately 185 independent dealers who operate nearly 300 showrooms. We also sell our pianos through nine company operated retail showrooms: four in the United States and five in Europe.  We have subsidiaries and dealers in both Japan and China that provide direct access to the growing Asian piano market. Sales to dealers accounted for approximately 75% of piano segment revenue in 2005. The remaining 25% was generated from sales made directly by us at one of our nine company operated retail showrooms.

 

We employ district sales managers whose responsibilities include developing close working relationships with piano dealers. These highly experienced professionals provide dealers with sales training and technical support, and develop sales and marketing programs for the consumer and institutional markets.  These sales managers are also responsible for promoting the Steinway Artist Program described below.

 

Steinway Artist Program - Steinway Artists are world-class pianists who voluntarily endorse Steinway & Sons by selecting the Steinway piano.  Our Steinway Artist program 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.  We use these renowned artists in our marketing programs to help reinforce recognition of the Steinway brand name and its association with quality.  The Steinway Artist Program 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 Concert and Artist Piano Bank.

 

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 includes approximately 500 instruments worldwide.  Of these instruments, approximately 375 are located in the United States.  In New York City alone, the Piano Bank includes approximately 140 concert grands available for various occasions.  The remaining domestic-based pianos are leased to dealers around the country who actively support the Steinway Artists program.  The Piano Bank promotes our instruments in the music industry and provides management with continual 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.

 

Band Segment

 

Our band & orchestral, string and percussion instruments and related accessories are distributed worldwide through approximately 1,700 independent musical instrument dealers and distributors.

 

In North America, we market our products through district sales managers and telemarketing representatives who are responsible for sales within assigned geographic territories. Each district sales manager is also responsible for developing relationships with band & 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 as they will generally refer students to designated dealers for the purchase of instruments.

 

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As part of our band director outreach and support strategy, we have developed Conn-Selmer University (“CSU”).  Originally created to help graduating music education majors transition into teaching careers, we have expanded CSU to include three additional tracks: one for experienced music educators, another for music dealer representatives, and another for music business students.  We also have an educational director who travels extensively, lecturing and motivating students, educators and parents on the value of music in a child’s development.  We believe that our well-established, long-standing relationships with influential music educators are an important component of our distribution strategy and that our CSU efforts will further enhance these relationships.

 

To reach international markets, we primarily sell our instruments through distributors.  We reorganized our international sales staff to include regional sales directors who have more direct contact with our customers overseas.

 

We support our dealers and distributors through incentive programs, advertising and promotional activities.  We reach our customers through trade shows, educator conferences, print media, direct mail, telemarketing, the Internet and personal sales calls. We also actively advertise in educator and trade publications and provide educational materials, catalogs and product specifications to students, educators, dealers and distributors. 

 

Competition

 

Piano Segment

 

Steinway & Sons - The level of competition our pianos face depends on the market definition.  Steinway & Sons pianos hold a unique position at the top end of the grand piano market, both in terms of quality and price.  While there are many makers of pianos, only a few compete directly with our Steinway brand.  Other manufacturers of primarily higher priced pianos include Bösendorfer and Fazioli.

 

Because Steinway pianos are built to last for generations, used Steinways are the primary competition in our market segment.  It is difficult to estimate the significance of used piano sales, since most are conducted in the private aftermarket.  However, we have increased our emphasis on restoration services and the procurement, refurbishment and sale of used Steinway pianos to help us mitigate the impact of these aftermarket sales on our piano business.

 

Boston Piano Company – While our mid-priced pianos compete with brands such as Baldwin and Schimmel, our primary competition has been from Japanese and Korean manufacturers such as Kawai, Yamaha and Young Chang.  By working with manufacturers in the same geographic areas, we have been able to enjoy labor costs and manufacturing efficiencies similar to those of our primary competitors while offering consumers the added benefit of pianos designed by Steinway & Sons.

 

In recent years, piano manufacturing in China has been growing at a rapid pace.  While the vast majority of the production continues to be upright pianos, Chinese manufacturers have begun producing low-priced, smaller grand pianos.  In 2005, we established a relationship with Pearl River Piano Group, the largest piano manufacturer in China, to build pianos for our Essex line.  Through this new OEM relationship, we will be able to offer pianos priced in a considerably more competitive price range than previously available, bringing a good measure of Steinway design benefits to a wider reach of consumers.  We expect to introduce several new Essex models in 2006.

 

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Band Segment

 

We are the largest domestic producer of band & orchestral instruments.  We enjoy leading market shares with many of our professional level instruments.  Yamaha, a Japanese corporation, is our largest competitor.  New entrants into the domestic market generally experience difficulty competing due to the need for both brand recognition and an effective distribution system.

 

Competition for sales of student level instruments in the United States has intensified in recent years due to the growth of offshore manufacturers.  These producers benefit from low labor costs, enabling them to offer instruments 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 industry channels.

 

Patents and Trademarks

 

Steinway & Sons pioneered the development of the modern piano with over 125 patents granted since our founding.  While we have several patents effective and pending 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, Crown Jewel Collection and Essex. Our band & orchestral trademarks include Bach, Selmer, C.G. Conn, Leblanc, King, Armstrong, Ludwig, Musser, Holton, Vito, Glaesel, Scherl & Roth, Emerson, William Lewis & Son, Noblet, 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 these materials is sourced from the Americas, with the balance coming from Europe, Asia and Africa.  We acquired our sole domestic piano plate manufacturer and primary piano key maker to ensure availability of these component parts.  Component parts for string and percussion instruments are imported from Europe and Asia.  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 2006 or in the future.

 

Currently, 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 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.  Some of our entry-level band instruments are also sourced from single manufacturers.  We continually scrutinize these suppliers and the quality of products that they manufacture for us and we believe that we have a sufficient number of qualified suppliers to ensure availability of all offered products in the upcoming year.

 

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Labor

 

As of December 31, 2005, we employed 2,443 people, consisting of 1,849 hourly production workers and 594 salaried employees.  Of the 2,443 employees, 1,884 were employed in the United States and the remaining 559 were employed primarily in Europe.

 

Approximately 60% of our workforce in the United States is represented by labor unions.  The Company believes that relations with its employees and most of these unions are generally good.  The following table indicates the union representation and the current status of our collective bargaining agreements in the United States:

 

Location		Union affiliation		Type of manufacturing		Number of employees		Agreement expiration
Elkhart, IN		United Auto Workers		Band instruments		234		April 1, 2006
New York, NY		United Furniture Workers		Pianos		484		December 31, 2006
Elkhart, IN		United Auto Workers		Band instruments		13		March 31, 2007
Springfield, OH		Glass, Molders, Pottery, Plastics & Allied Workers		Piano plates		31		November 8, 2007
LaGrange, IL		Carpenters		Percussion instruments		34		November 16, 2007
Eastlake, OH		United Auto Workers		Band instruments		227		February 16, 2008
Elkhorn, WI		International Brotherhood of Boilermakers, Iron Shipbuilders, Blacksmiths, Forgers & Helpers		Band instruments		67		July 20, 2008

 

We are currently in labor negotiations with the union that represents 234 employees at our brass instrument manufacturing plant in Elkhart, Indiana.  We may not be able to come to a new agreement before the current agreement expires on April 1, 2006. 

 

In Germany, the workers’ council represents all employees other than management.  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.  The Company believes that relations with its employees and these unions are generally good.

 

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Item 1A.  Risk Factors

 

An investment in our company involves risk. In addition to the other information in this report, prospective investors should carefully consider the following risks before making an investment.  The risks described below are not the only risks we face.  There may be additional risks and uncertainties that we do not presently know of or that we currently consider immaterial. All of these risks could adversely affect our business, financial condition, or results of operations.

 

We operate in competitive markets

 

Our success depends upon our ability to maintain our share of the musical instrument market by providing the best instruments at prices equal to or below our competitors providing instruments of comparable quality.  Increased competition could lead to price reductions, fewer large sales to institutions, reduced operating margins and loss of market share.  Our piano division currently competes with companies such as Bechstein, Bösendorfer, Fazioli, Kawai and Yamaha, which also produce and market pianos at the higher end of the market.  Because of the potential savings associated with buying a used instrument, as well as the durability of the Steinway piano, a relatively large market exists for used Steinway pianos.  It is difficult to estimate the significance of used piano sales, because most are conducted in the private aftermarket.  However, we believe that used Steinway pianos provide the most significant competition in the high-end piano market.  Our band & orchestral division competes with a number of domestic and Asian manufacturers of musical instruments, including Jupiter and Yamaha.  Any of our competitors may concentrate their resources upon efforts to compete in our markets.  In addition, Asian musical instrument manufacturers have made significant strides in recent years to improve their product quality.  They now offer a broad range of quality products at highly competitive prices and represent a significant competitive challenge for us.  Our failure to compete effectively could have a negative impact on our results of operations.

 

Economic downturns and changes in consumer preferences could adversely affect our business

 

Our business is subject to a number of general economic factors, many of which are out of our control, that may, among other things, result in a decrease in sales and net income. Sales of musical instruments are dependent in part upon discretionary consumer spending, which may be affected by general economic conditions.  For example, Steinway, which represents more than half of our net sales, sells a relatively small number of Steinway & Sons grand pianos each year (3,145 in 2005).  Given the small number of pianos we sell, even a slight decrease in sales could adversely affect our profitability.  Band & orchestral sales are also dependent upon the continued interest of school-aged children in playing musical instruments.  Any decrease in consumer spending or reduction in school-aged children’s interest in music could result in decreased sales, which could adversely affect our business and operating results.  Furthermore, terrorist activities, war or other armed conflict involving the United States or its interests abroad may result in a downturn in the U.S and global economies, thus reducing spending on luxury goods and may exacerbate the risks to our business.

 

We could be subject to work stoppages or other business interruptions as a result of our unionized work force

 

A significant portion of our hourly employees are represented by various union locals and covered by collective bargaining agreements.  These agreements contain various expiration dates and must be renegotiated upon expiration.  A collective bargaining agreement covering the employees in one of our

 

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band manufacturing facilities in Elkhart, Indiana, expires in April 2006 and another agreement covering employees in our piano manufacturing facility in New York expires in December 2006.  We cannot assure investors that we will be able to reach agreements on terms that are acceptable to us, or at all.  If we are unable to negotiate any of our collective bargaining agreements on satisfactory terms prior to expiration, we could experience disruptions in our operations.  Our most recent work stoppage occurred at two of our band & orchestral manufacturing plants in January and March of 2003 and lasted for approximately 13 weeks and 9 weeks, respectively.  Any future prolonged work stoppage or delay in renegotiating collective bargaining agreements could have a material adverse effect on our operations. 

 

Any significant disruption in our supply from key suppliers could delay production and adversely affect our sales

 

Our Boston and Essex piano lines, our Selmer Paris instruments, and many of our student level band & orchestral instruments are sourced from single foreign manufacturers.  We are highly dependent on the availability of essential materials and purchased components from our suppliers, some of which may be available only from limited resources.  Moreover, we are dependent upon the availability of our suppliers to provide material that meets specifications, quality standards and delivery schedules.  Our suppliers’ failure to provide expected raw materials or component parts could adversely affect production schedules and profitability.

 

Although we have had adequate supplies of raw materials and component parts in the past, there is no assurance that we may not experience serious interruptions in the future.  Our continued supply of materials is subject to a number of risks including: 1) the destruction of our suppliers’ facilities or their distribution infrastructure; 2) work stoppages or strikes by our suppliers’ employees; 3) the failure of our suppliers to provide materials of the requisite quality; 4) the failure of essential equipment at our suppliers’ plants; 5) the failure or shortage of supply of raw materials to our suppliers; and 6) contractual amendments and disputes with our suppliers. 

 

We cannot assure investors that our suppliers will continue to provide products to us at attractive prices or at all, or that we will be able to obtain such products in the future from these or other providers on the scale and within the time periods we require.  Furthermore, we cannot assure investors that substitute raw materials or component parts will meet the strict specification and quality standards we impose.  If we are not able to obtain key materials, supplies, components or sourced instruments on a timely basis and at affordable costs, or we experience significant delays or interruptions of their supply, it could have a material adverse effect on our business, financial condition and results of operations.

 

We may be unable to successfully integrate acquisitions of related companies into our business

 

We have historically acquired other businesses whose operations or product lines complement our existing business, including Leblanc in August 2004.  We continually explore new opportunities to enter into business combinations with other companies in order to maintain and grow our revenues and market presence.  These potential transactions with other companies create risks such as difficulty in assimilating the personnel, customers, technology, products and operations with our personnel, customers, technology, products and operations; disruption of our ongoing business, including loss of management focus on existing businesses; and impairment of relationships with existing executives, employees, customers and business partners.  In addition, we may not be able to identify suitable candidates for these transactions or obtain financing or otherwise make these transactions on acceptable terms.  Furthermore, the benefits that we anticipate from these potential transactions may not develop as expected and we cannot be sure that we will recover our investment in any such strategic transaction.

 

12

 

Shifts in our product mix may result in declines in our gross margins and profit levels

 

Our gross margins vary among our product groups and have fluctuated from quarter to quarter as a result of shifts in product mix (that is, how much of each product type we sell in any particular quarter).  The introduction of new band products, decreases in average selling prices and shifts in the proportion of student level instruments to professional level instruments may cause variances in our gross margins.  We also experience variances in our gross margins as a result of shifts in the proportion of our piano retail sales to wholesale sales, as well as changes in amounts of piano sales to territories where we realize more favorable pricing.  For example, our product sales in the former Eastern Bloc countries generally produce higher margins because most sales are at retail prices.  We expect fluctuations in gross margins to continue in the future.

 

Failure of our new products to gain market acceptance may adversely affect our operating results

 

New products may not achieve significant market acceptance or generate sufficient sales to permit us to recover development, manufacturing and marketing costs associated with these products.  Achieving market acceptance for new products may also require substantial marketing efforts and expenditures to expand consumer demand.  These requirements could strain our management, financial and operational resources.  Furthermore, failure of our new products to achieve market acceptance could prevent us from maintaining our existing customer base, gaining new customers or expanding our markets and could have a material adverse effect on our business, financial condition and results of operations.  Additionally, price competition among our various brand names may adversely affect our sales, revenues and profitability.  For example, our mid-priced Essex line of pianos may be priced lower than our Boston line, therefore potentially diminishing sales of our Boston pianos.

 

Since we have a limited number of facilities, any loss of use of any of our facilities could adversely affect our operations

 

Our operations with respect to specific products are concentrated in a limited number of manufacturing facilities.  Because we are heavily dependent on each of these facilities, our operations would be adversely affected if we experience a disruption in business at any particular facility for a prolonged period of time because we would not have adequate substitute facilities available to us.

 

Our operations may subject us to liabilities for environmental matters, the costs of which could be material

 

Our manufacturing operations involve the use, handling, storage, treatment and disposal of materials and waste products that may be toxic or hazardous.  Consequently, we are subject to numerous federal, state and local environmental laws and regulations, specifically those relating to discharges to air, water and land, the handling and disposal of solid and hazardous waste and the cleanup of properties contaminated by hazardous substances.  Many environmental laws impose strict, retroactive, joint and several liability broadly upon owners and operators of properties, including with respect to environmental matters that occurred prior to the time the party became an owner or operator.  In addition, we may have liability with respect to third-party sites to which we sent wastes for disposal in the past.  Our potential liability at any of these sites is affected by many factors including, but not limited to, the method of remediation, our portion of the hazardous substances at the site relative to that of other responsible parties, the number of responsible parties, the financial capabilities of other parties, and contractual rights and obligations.

 

13

 

We have obligations and liability with respect to the remediation of current and former properties and third party waste disposal sites.  The liabilities and obligations in some cases are covered by indemnification agreements and we have accrued liabilities for sites where the liability is probable and can be estimated.  We cannot guarantee the indemnitors will continue to fund the cleanup liability or that the actual costs of cleanup will not exceed our present accruals.  Furthermore, we may be required to fund additional remedial programs in connection with other additional current, former or future facilities.

 

Future events, such as the discovery of additional contamination or other information concerning past releases of hazardous substances at our manufacturing sites (or at sites to which we sent wastes for disposal), changes in existing environmental laws or their interpretation, and more rigorous efforts by regulatory authorities, may require additional expenditures by us to modify operations, install pollution control equipment, clean contaminated sites or curtail our operations.  These expenditures could have a material negative impact on our operations.

 

We may not be able to protect our proprietary information

 

We rely in part on patent, trade secret, unfair competition, trade dress and trademark laws to protect our rights to aspects of our business and products, including product designs, proprietary manufacturing processes and technologies.  The laws of many foreign countries do not protect proprietary rights to the same extent as laws in the United States.  In addition, although we may have rights to a particular trademark in a given country, we may not have similar rights to that trademark in other countries.

 

Changes in our effective tax rates could affect future results

 

As an international company, we are subject to taxation in the United States and various other foreign jurisdictions in which we do business.  Some of these foreign jurisdictions have higher statutory rates than those in the United States, and certain of our international earnings are also taxable in the United States.  Accordingly, our effective tax rates will vary depending on the relative proportion of foreign to U.S. income and absorption of foreign tax credits, changes in the valuation of our deferred tax assets and liabilities, and changes in tax laws.  In addition, we are subject to examination of our income tax returns by the U.S. Internal Revenue Service and other tax authorities.  We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our income tax reserves and expense.  Should actual events or results differ from our current expectations, charges or credits to our income tax expense reserves and income tax expense may become necessary.  Any such adjustments could have a significant impact on our results of operations.

 

Our foreign operations are exposed to risks associated with foreign regulations, exchange rate fluctuations, trade restrictions and political, economic and social instability

 

We manufacture, market and distribute our products worldwide.  As a result, we are subject to the risks normally associated with foreign operations.  For example, foreign regulations may limit our ability to produce and sell some of our products or repatriate profits to the United States.  In addition, a foreign government may impose trade or foreign exchange restrictions or increased tariffs, which could adversely affect our operations.  Our operations may also be negatively impacted by political, economic and social instability in foreign countries in which we operate.  We are also exposed to risks associated with foreign currency fluctuations.  A strengthening of the U.S. dollar, the Japanese yen, the British pound, the Chinese yuan or the euro relative to each other or other foreign currencies could have a negative impact on us.  Although we sometimes engage in transactions to protect against risks associated with foreign currency fluctuations, we cannot be sure that these fluctuations will not have an adverse effect on us.  Sales outside the United States accounted for approximately 33% of our net sales in 2005.

 

14

 

The requirements of complying with the Sarbanes-Oxley Act may strain our resources and distract management

 

As a public company, we are subject to the reporting requirements of the Sarbanes-Oxley Act.  Sarbanes-Oxley requires that we maintain effective disclosure controls and procedures, corporate governance standards and internal controls over financial reporting.  Although we devote significant time and resources to ensure ongoing compliance with the reporting requirements of Sarbanes-Oxley, we can give no assurance that we will continue to meet these requirements in the future or that reportable conditions or material weakness in our internal controls and procedures may not arise despite our best efforts prevent them.  While we have taken and continue to take all steps necessary to comply with Sarbanes-Oxley, including internal controls, our failure to meet the requirements of Sarbanes-Oxley could negatively impact our business, financial condition and results of operations.  In addition, the effort to comply with these obligations may divert management’s attention from other business concerns.

 

Messrs. Kirkland and Messina exercise significant control over us, which could adversely affect investors

 

Mr. Kyle R. Kirkland, Chairman of the Board, and Mr. Dana D. Messina, Chief Executive Officer, hold in the aggregate 100% of our Class A common stock, representing approximately 86% of the voting power of our company’s capital stock.  So long as Messrs. Kirkland and Messina continue to hold a majority of the voting power, they will be able, acting together, to exercise a controlling influence over our company, including with respect to the composition of our board of directors and, through it, the direction and policies of the Company.  We cannot assure that Messrs. Kirkland and Messina will not pursue other business interests that will conflict with investors’ interests.

 

Item 1B.  Unresolved Staff Comments

 

None.

 

15

 

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
Long Island City, NY		Owned		450,000		Piano manufacturing; restoration center; administrative offices
New York, NY		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
		Leased		6,000		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		Piano warehouse/showroom/workshop
London, England		Leased		10,000		Piano showroom
		Leased		6,000		Piano workshop/storage
Tokyo, Japan		Leased		9,000		Piano selection center; warehouse
		Leased		2,000		Administrative offices
Eastlake, OH		Owned		160,000		Brass instrument manufacturing
Elkhart, IN		Owned		150,000		Brass instrument manufacturing
		Owned		88,000		Woodwind manufacturing; warehouse; office
		Owned		81,000		Warehouse
		Owned		25,000		Administrative offices
Elkhorn, WI		Owned		58,000		Brass instrument manufacturing
Kenosha, WI		Owned		95,000		Woodwind manufacturing; warehouse
Nogales, AZ		Owned		22,000		Former woodwind 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		String instrument manufacturing
London, England		Leased		8,000		Band instrument office; warehouse
LaCouture Boussey, France		Owned		32,000		Woodwind manufacturing

 

We spent $5.0 million for capital improvements in 2005 consisting primarily of machinery and equipment upgrades and replacements, facility upgrades, and telephone and computer system enhancements.  We expect capital spending in 2006 to be in the range of $5.0-7.0 million, relating to plant improvements, production equipment purchases, and facility improvements.

 

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Item 3.  Legal Proceedings

 

General

 

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 required to comply 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 contaminated by hazardous substances, including chlorinated solvents.  Our operations are subject to environmental laws and regulations that require us to obtain and maintain permits from regulatory authorities.  Non-compliance with environmental laws and regulations or the permits we have been issued could give rise to significant fines, penalties and other costs.  We currently do not expect to incur material expenditures relating to environmental compliance in 2006.

 

Certain environmental laws, such as the Comprehensive Environmental Response, Compensation, and Liability Act, as amended (“CERCLA”), impose strict, retroactive, joint and several liability upon persons responsible for releases of hazardous substances, which liability is broadly construed.  Under CERCLA and other laws, we may have liability for investigation and cleanup costs and other damages relating to our current or former properties, or third-party sites to which we sent wastes for disposal.  Our potential liability at any of these sites is affected by many factors including, but not limited to, the method of remediation, our portion of the hazardous substances at the site relative to that of other parties, the number of responsible parties, the financial capabilities of other parties, and contractual rights and obligations.

 

In this regard, we operate certain manufacturing facilities which were previously owned by Philips Electronics North America Corporation (“Philips”).  When we purchased these facilities, Philips agreed to indemnify us for certain environmental matters resulting from activities of Philips occurring prior to December 29, 1988 (the “Environmental Indemnity Agreement”).  To date, Philips has fully performed its obligations under the Environmental Indemnity Agreement, which terminates on December 29, 2008; however, we cannot assure investors that it will continue to do so in the future.  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 third 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.  At the fourth site, which is a third-party waste disposal site, the EPA has named over 40 persons or entities as potentially responsible parties (“PRP”), including four Conn-Selmer predecessor entities.  The four entities have been involved as members of PRP group in the ongoing negotiations with the site owners, the largest contributor, and the EPA in an attempt to reach a settlement and release PRP group members from further potential liability.  We expect a decision on the proposed settlement to be reached within the next twelve months.  For two of these predecessor entities, which were previously owned by Philips, this matter has been tendered to

 

17

 

Philips pursuant to the Environmental Indemnity Agreement.  With respect to the other two entities, based on current information concerning estimated cleanup costs at the site, and our share of liability, we do not believe our liability will be material.

 

In addition, we are continuing an existing environmental remediation plan at a facility we acquired in 2000.  We estimate our costs, which approximate $0.9 million, over a 15 year period.  We have accrued approximately $0.7 million for the estimated cost of this remediation program, which represents the present value total cost using a discount rate of 4.54%.  A summary of expected payments associated with this project is as follows:

 

 

In 2004, we acquired two manufacturing facilities from G. Leblanc Corporation, now Grenadilla, Inc. (“Grenadilla”), for which environmental remediation plans had already been established.  In connection with the acquisition, we assumed the existing accrued liability of approximately $0.8 million for the cost of these remediation activities.  Based on a review of past and ongoing investigatory and remedial work by our environmental consultants, discussions with state regulatory officials, and recent sampling, we estimate the remaining costs of such remedial plans to be $3.1 million as of December 31, 2005.  Pursuant to the purchase and sale agreement, we have sought indemnification from Grenadilla for anticipated costs above the original estimate in the amount of $2.5 million.  We have filed a claim against the escrow and recorded a corresponding receivable for this amount. However, we cannot be assured that we will be able to recover such costs from Grenadilla.

 

Based on our past experience and currently available information, 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 in an individual year.  However, some risk of environmental liability is inherent in the nature of our current and former businesses and we may, 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 matters were submitted to a vote of our security holders during the fourth quarter of the year ended December 31, 2005.

 

18

 

PART II

 

Item 5.  Markets for Registrant’s Common Equity and Related Stockholder Matters

 

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

 

Year Ended December 31, 2005		High			Low
First Quarter		$	31.15		$	26.63
Second Quarter		30.91			26.90
Third Quarter		30.35			25.50
Fourth Quarter		27.80			24.15

 

Year Ended December 31, 2004		High			Low
First Quarter		$	33.90		$	23.25
Second Quarter		36.50			32.10
Third Quarter		35.41			25.59
Fourth Quarter		29.36			26.76

 

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 March 24, 2006, there were 3,546 beneficial shareholders 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.

 

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.

 

19

 

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		836,249		$	20.39		428,233
Total		836,249		$	20.39		428,233

 

20

 

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 in the period ended December 31, 2005, as 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 data)

 

Years Ended December 31,		2005				2004 (1)				2003					2002					2001
Income statement data:
Net sales		$	387,143			$	375,034			$	337,220				$	332,297				$	352,612
Gross profit		111,534				109,133				92,553					97,151					103,521
Income from operations		34,837				34,241				22,824					31,399					34,495
Net income		13,792				15,867				9,698					14,909					8,738
Earnings per share:
Basic		$	1.71			$		1.97		$	1.09				$	1.68				$	0.98
Diluted		$	1.67			$		1.91		$	1.09				$	1.68				$	0.98
Weighted average shares:
Basic		8,069,721				8,046,256				8,924,578					8,877,256					8,928,000
Diluted		8,265,234				8,304,066				8,925,672					8,882,165					8,928,000
Balance sheet data (at December 31):
Cash		$	34,952			$	27,372			$		42,283			$		19,099			$		5,545
Current assets		295,731				308,761				288,270					267,346					254,474
Total assets		455,655				477,545				445,665					423,731					409,537
Current liabilities		71,881				72,893				61,304					53,302					49,318
Total debt		204,692				221,208				196,602					200,636					211,203
Stockholders’ equity		148,830				145,553				152,635					131,208					115,773
Other financial data:
Capital expenditures		$		5,004		$	5,186			$			5,462		$			5,604		$		7,141
Margins:
Gross profit		28.8			%	29.1			%	27.4				%	29.2				%	29.4			%
Operating		9.0			%	9.1			%	6.8				%	9.4				%	9.8			%

 

(1)   We acquired Leblanc in August 2004.

 

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Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Thousands)

 

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 report.

 

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 (3,145 sold in 2005), 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 over 50% of total piano units sold but less than 20% of total piano revenues in 2005.  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 impact our business and operating results.  In 2005, 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, 2005, our piano segment sales were $203.5 million, representing 53% of our total revenues.

 

Piano Outlook for 2006 – Overall, we expect a relatively stable year for our piano segment with respect to sales and gross profit.  We intend to focus on reducing existing inventory levels, developing our distribution structure in China and implementing various manufacturing improvement initiatives in the upcoming year.  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, general attitudes toward music and the arts, and our ability to provide competitively priced products to our dealer network.  Management estimates that 85% of our domestic band sales are generated through educational programs; the remainder is sales to amateur or professional musicians or performing groups, including symphonies and orchestras. 

 

Our sales growth has been adversely affected in recent years by the abundance of competitively priced imported student instruments available to our dealers and their ability to purchase these products directly from offshore sources.  In order to compete with these mass-merchandised offshore instruments, we restructured our product offerings to include quality, competitively priced brand-name imported instruments that are built to our specifications.  We now offer quality-controlled, brand-name products at multiple price points through distribution channels which support the music education market.  Our product offerings are tailored to the needs of traditional school music dealers who provide full-service rental programs to beginning band students, as well as music retailers and e-commerce dealers selling directly to end consumers from their stores or through the Internet.  We believe our product offerings have helped us remain competitive at various price points and will continue to do so in the future.

 

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In 2005, beginner instruments accounted for approximately 65% of band & orchestral unit shipments and approximately 40% of band instrument revenues, with advanced and professional instruments representing the balance. In 2005, approximately 79% of band sales were in the United States, 8% in Europe and the remaining 13% primarily in Canada and Asia.  For the year ended December 31, 2005, our band sales were $183.6 million, representing 47% of our total revenues.

 

Band Outlook for 2006 – We are entering 2006 with increased orders for both U.S. made and sourced products and expect to see improvement in both revenues and gross profit in the coming year.  Focused sales efforts have resulted in an expanding customer base in the U.S, particularly for percussion instruments, and in our export markets.  We are working more closely with our customers to understand their requirements so we may improve the coordination of product availability with their needs.  We expect continued improvement in the flow of sourced product from our suppliers as we monitor their capacity.  Our efforts to improve productivity at our various facilities should continue to yield more efficient production levels.  This, coupled with an increase in sales of sourced products, should lead to improved margins in 2006.

 

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 represented 33% of consolidated sales in 2005.  We record sales in euro, Japanese yen, British pounds, and Chinese yuan.  In 2005, we generated 69% of our international sales through our piano segment.  Foreign exchange rate changes impacted sales by less than $1.0 million in the current year.  Although currency fluctuation affects international sales, it also affects cost of sales and related operating expenses.  Consequently, it generally 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 – We are subject to U.S. income taxes as well as tax in several foreign jurisdictions in which we do business.  Some of these foreign jurisdictions have higher statutory rates than the United States.  In addition, certain of our operations are subject to both U.S. and foreign taxes.  However, in such cases we receive a credit against our U.S. taxes for foreign taxes paid equal to the percentage that such foreign income (as adjusted for reallocated interest) represents of the total income subject to U.S. tax.  Accordingly, our effective tax rates will vary depending on the relative proportion of foreign to U.S. income and the absorption of foreign tax credits in the United States.  In 2003, we were able to utilize foreign tax credits carried forward from prior years due to the higher proportion of our foreign source income to overall income.  In 2004, we were able to use the majority, but not all, of the foreign tax credits generated in that period.  However, because the American Jobs Creation Act of 2004 (the “Act”) extended the foreign tax credit carryover period, we were able to recognize a partial benefit for the excess foreign tax credits generated in 2004.  In 2005, we were unable to utilize approximately one third of the foreign tax credits generated in the current period.  This, coupled with the income generated in higher rate jurisdictions such as Germany, resulted in an increase in our overall tax rate in the current year. 

 

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.  We also anticipate higher

 

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pretax income in many of the states in which we do business.  These events may have an adverse impact on our effective tax rate for 2006.  Our overall tax rate will also be influenced by our ability to effectively use losses generated in certain tax jurisdictions. 

 

Results of Operations

 

Fiscal Year 2005 Compared to Fiscal Year 2004

 

												Change
For the years ended December 31,		2005					2004					$		%
Net sales
Band		$	183,626				$	171,346				12,280		7.2
Piano		203,517					203,688					(171	)	(0.1	)
Total sales		387,143					375,034					12,109		3.2
Cost of sales
Band		146,168					137,779					8,389		6.1
Piano		129,441					128,122					1,319		1.0
Total cost of sales		275,609					265,901					9,708		3.7
Gross profit
Band		37,458			20.4%		33,567			19.6%		3,891		11.6
Piano		74,076			36.4%		75,566			37.1%		(1,490	)	(2.0	)
Total gross profit		111,534					109,133					2,401		2.2
		28.8%					29.1%
Operating expenses		76,697					75,255					1,442		1.9
Facility rationalization		—					(363		)			363		(100.0	)
Total operating expenses		76,697					74,892					1,805		2.4
Income from operations		34,837					34,241					596		1.7
Other income, net		(800		)			(3,163		)			2,363		(74.7	)
Net interest expense		13,645					13,437					208		1.5
Income before income taxes		21,992					23,967					(1,975	)	(8.2	)
Income tax provision		8,200			37.3%		8,100			33.8%		100		1.2
Net income		$	13,792				$	15,867				(2,075	)	(13.1	)

 

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Overview – In 2005 we continued strengthening our band business.  Our purchase of substantially all of the assets of G. Leblanc Corporation in August 2004 resulted in sales growth for the segment.  We merged the administrative office operations of Leblanc into our existing operations in May 2005, thereby eliminating duplicative administrative costs.   Production at our woodwind facility, which was low in the early part of the year as we trained new workers, had significantly improved by the end of the period, and we continue to experience period over period improvement in our band segment margins. 

 

Our domestic piano division sales decreased due to unusually high turnover in sales personnel at the retail level, coupled with decreased demand for our Boston Piano lines. However, overall piano segment sales remained stable, primarily due to the revenue generated by our European divisions.  Piano margins declined slightly due to inefficiencies at both piano manufacturing facilities.

 

Net Sales – Net sales increased $12.1 million as a result of the increase in band division sales, which was caused primarily by incremental sales of Leblanc product through the first three quarters of 2005.  Overall band unit shipments increased 5.9%, due to the increase in brass and woodwind unit shipments of 9.5% (the largest component of the band business).  Total piano sales remained stable at $203.5 million.  Domestically, sales declined, in part due to attrition of retail sales staff in the early part of the year, as well as the 11% decrease in unit shipments of our Boston piano lines.  In the U.S., mid and lower-priced piano sales are being adversely impacted by the influx of low-priced Asian imports.  However, the shift in mix towards higher priced units sold by our German division resulted in consistent piano segment revenues.

 

Gross Profit – Gross profit improved $2.4 million driven by an increase in band sales and band margins.  Band margins were less affected by atypical charges in the current period. These costs totaled $1.6 million in 2005, and arose from the sell through of purchased Leblanc inventory, which was written up to fair value upon acquisition.  In the prior period, atypical charges totaled $2.6 million, comprised of $1.2 million from the sell through of purchased Leblanc inventory, and $1.4 million from severance costs associated with plant closures.  Band margins also benefited from a large, high margin sales transaction in the beginning of the fourth quarter.  Piano segment gross profit decreased $1.5 million despite the beneficial sales mix towards higher margin grands sold by our German division. The adverse impact of factory inefficiencies due in part to the disruptions caused by implementing production line improvements, as well as a larger book-to-physical inventory adjustment at our domestic piano manufacturing facility were the primary causes of the piano margin decrease.

 

Operating Expenses – Operating expenses increased $1.8 million, despite the decrease in external costs associated with Sarbanes-Oxley compliance efforts, which were approximately $1.2 million less in 2005.  The incremental operating expenses are primarily sales and marketing, $0.9 million of which resulted from commissions associated with the large sales transaction described above.  Piano sales commissions also increased as a result of the favorable performance by the German division.  In addition, this division had incremental public relations and advertising costs of $0.2 million as a result of its 125^th anniversary celebrations. Lastly, $0.9 million in additional operating expenses were associated with Leblanc, and were incurred in the early part of the year, prior to the consolidation of band administrative offices.

 

Non-operating Expenses – Non-operating expenses increased $2.6 million in 2005.  Approximately $0.5 million of this increase relates to losses on extinguishment of debt, which resulted from the buyback of $8.2 million of our 8.75% Senior Notes at 105%, and the write off of the corresponding deferred financing costs.  A shift of $0.3 million from foreign exchange gains to foreign exchange losses also contributed to the expense increase.  We incurred additional interest costs of approximately $0.2 million

 

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due to the increase in interest rates during the year.   The remainder of the expense increase primarily results from reclassification of certain items from non-operating expenses to operating expenses.

 

Results of Operations

 

Fiscal Year 2004 Compared to Fiscal Year 2003

 

												Change
For years ended December 31,		2004					2003					$		%
Net sales
Band		$	171,346				$	157,460				13,886		8.8
Piano		203,688					179,760					23,928		13.3
Total sales		375,034					337,220					37,814		11.2
Cost of sales
Band		137,779					126,369					11,410		9.0
Piano		128,122					118,298					9,824		8.3
Total cost of sales		265,901					244,667					21,234		8.7
Gross profit