10-Q 1 realco020846_10q.txt REALCO, INC. FORM 10-Q U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2001 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934 For the transition period from ___________________ to _____________________ Commission file number: 0-27552 REALCO, INC. -------------------------------------------------------------------------------- (Exact name of Registrant as specified in its charter) New Mexico 85-0316176 -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1650 University Blvd., N.E., Suite 5-100, Albuquerque, New Mexico 87102 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip code) (505) 242-4561 -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) Not applicable -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by the 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 for the past 90 days. Yes _X_ No ___ As of February 12, 2002 the Company had approximately 4,841,000 shares outstanding of its no par value common stock, the Company's only class of common stock. PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS 2 REALCO, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands)

See accompanying notes. 3 REALCO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Three months ended December 31, (Dollars in thousands, except per share amounts)

See accompanying notes. 4 REALCO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Three months ended December 31, (Dollars in thousands)

See accompanying notes. 5 REALCO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001 NOTE A - BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements of Realco, Inc. and its wholly owned subsidiaries have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions of Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three months ended December 31, 2001 are not necessarily indicative of the results that may be expected for the fiscal year ending September 30, 2002. For further information refer to the financial statements and footnotes included in the company's annual report on Form 10-K for the year ended September 30, 2001. On June 2, 2001, the Company sold its residential brokerage operations. Such brokerage operations operated under a franchise from Prudential Real Estate Affiliates, Inc. in Albuquerque, New Mexico and Phoenix, Arizona. The financial data related to these operations is accounted for as a discontinued operation for all periods presented. 1. Principles of Consolidation: The consolidated financial statements include the accounts of Realco, Inc. and its wholly-owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. 2. Earnings (Loss) Per Common Share: Earnings (loss) per common share is calculated based on the weighted average number of shares outstanding during the year. Stock options and warrants are antidilutive for all periods presented. 6 REALCO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2001 The following shows the amounts used in computing earnings (loss) per common share for the three months ended December 31: 2001 2000 ------------ ------------ Earnings (loss) from continuing operations $ 172,000 $ (379,000) Preferred stock - negative return 154,000 2,180,000 ------------ ------------ Earnings (loss) from continuing operations applicable to common shares used for basic earnings per share 326,000 1,801,000 Effect of dilutive convertible preferred stock - negative return (154,000) (2,180,000) ------------ ------------ Earnings (loss) from continuing operations applicable to common shares used for diluted earnings per share $ 172,000 $ (379,000) ============ ============ Weighted average number of common shares outstanding used for basic earnings per share 3,892,985 2,964,308 Effect of dilutive convertible preferred stock 946,957 424,394 ------------ ------------ Weighted average number of common shares outstanding used for diluted earnings per share 4,839,942 3,388,702 ============ ============ 3. Debt: At December 31, 2001, the Company was in violation of the minimum net worth covenant relating to its subordinated sinking fund notes with a principal balance of $2,550,000. Therefore, the trustee or noteholders have the right to deliver a Notice of Default to the Company. If Notice of Default is delivered and the violation is not cured within 30 days, the notes may be declared due and payable immediately. At December 31, 2001, the Company would be required to raise capital of more than $310,000 to cure this default. The Company has continued to make the scheduled debt service payments on the subordinated sinking fund notes. Management believes if these obligations were declared immediately due and payable the Company's cash position and working capital would be adversely affected but the Company would be able to satisfy the obligations and maintain adequate working capital for the Company's operations for a reasonable period of time. 7 REALCO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2001 4. Other Comprehensive Earnings (Loss): Total comprehensive earnings (loss) for the quarters ended December 31, 2001 and 2000 was $134,000 and $(1,322,000), respectively. 5. Stockholders' Equity: During the quarter ended December 31, 2000, all the then outstanding preferred stock of the Company was converted into 464,804 shares of common stock. The excess carrying value of the preferred stock, including cumulative undeclared dividends, over the fair value of the common stock given was approximately $2,180,000, which is reflected as a negative return on preferred stock for determining earnings applicable to common shares in the statement of operations for the quarter ended December 31, 2000. On December 20, 2001, the Company issued 1,452,000 shares of its Common Stock upon the conversion of 484,000 shares of its Series "D" Preferred Stock. The Series "D" Preferred Stock was issued on March 1, 2001, pursuant to the terms of a merger in which the Company acquired Equity Securities Investments, Inc. ("ESI"). The Series "D" Preferred Stock was not initially convertible into Common Stock. However, the terms of the Series "D" Preferred Stock provided that each share would automatically be converted into three shares of Common Stock if the shareholders of the Company approved such conversion, and that the conversion, if approved, would occur automatically on the twenty-first (21st) day following the date on which the shareholders approved the conversion. The Company agreed in the merger agreement to ask its shareholders to approve the conversion and, at the Annual Meeting of Shareholders of the Company held on November 29, 2001, the shareholders voted upon and approved the conversion of the Series "D" Preferred Stock into Common Stock. In connection with this conversion, Preferred Stock dividends in arrears of $211,000 at the date of conversion were waived by the shareholders. The elimination of these dividends, net of dividends incurred during the quarter ended December 31, 2001 is reflected as a negative return on preferred stock for determining earnings applicable to common shares in the statement of operations. 6. Segment Information: The Company operates in the following segments: commercial real estate broker, residential construction and land development, commercial construction, and financial services. Information concerning the Company's business segments for the quarter ended December 31 is as follows: 8 REALCO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2001 2001 2000 ------------ ------------ Revenues Commercial real estate broker $ 178,000 $ 723,000 Residential construction and land development 6,535,000 3,609,000 Commercial construction 851,000 1,370,000 Financial services 1,929,000 36,000 Interest and other Sales to unaffiliated customers 101,000 68,000 Intersegment sales 65,000 191,000 Eliminations (65,000) (191,000) ------------ ------------ Total $ 9,594,000 $ 5,806,000 ============ ============ Earnings (loss) from continuing operations before taxes Commercial real estate broker $ (159,000) $ 17,000 Residential construction and land development 685,000 71,000 Commercial construction 31,000 6,000 Financial services (360,000) (68,000) Unallocated general corporate expenses -- (106,000) ------------ ------------ Earnings (loss) from continuing operations before taxes $ 197,000 $ (80,000) ============ ============ 7. Income Taxes: For the quarters ended December 31, 2001 and 2000, the Company's effective income tax rate differed from the federal statutory rate due to changes in the valuation allowance for deferred tax assets. 8. New Accounting Pronouncements: In July 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards (SFAS) No. 141, "Business Combinations" and No. 142, "Goodwill and Other Intangible Assets". These standards prohibit the application of the pooling of interests method of accounting for business combinations effective June 30, 2001 and require companies to stop amortizing existing goodwill and intangible assets with indefinite lives. Under the new rules, companies would only adjust the carrying amount of goodwill or indefinite life intangible assets upon an impairment of the goodwill or indefinite life intangible assets. The Company adopted these standards effective October 1, 2001 and as such, has not recorded any amortization of goodwill during the quarter ended December 31, 2001. 9 REALCO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2001 Initial adoption of these standards will require that the first step of a goodwill impairment test be completed by March 31, 2002 and that if the carrying amount of the net assets of a reporting unit (including goodwill) exceeds the fair value of that reporting unit, the second step of the transitional goodwill impairment test must be completed as soon as possible, but no later than September 30, 2002. The effect, if any, these impairment tests will have on the Company's financial position or results of operations is not yet known. The following reconciles reported net earnings (loss) and related per share amounts to amounts that would have been presented exclusive of amortization expense recognized for goodwill that is no longer being amortized: Three months ended December 31, 2000 ------------------ Net loss $ (873,000) Goodwill amortization 44,000 ------------------ Adjusted net loss $ (829,000) ================== Net earnings per share - basic Reported net earnings $ .44 Goodwill amortization .02 ------------------ Adjusted net earnings $ .46 ================== Net loss per share - diluted Reported net loss $ (.26) Goodwill amortization .02 ------------------ Adjusted net loss $ (.24) ================== SFAS No. 144, "Accounting for Impairment or Disposal of Long-Lived Assets", (SFAS 144) is effective for the Company for the fiscal year beginning October 1, 2002, and addresses accounting and reporting for the impairment or disposal of long-lived assets. SFAS 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and APB Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business." SFAS 144 retains the fundamental provisions of SFAS No. 121 and expands the reporting of discontinued operations to include all components of an entity with operations that can be distinguished from the rest of the entity and that will be eliminated from the ongoing operations of the entity in a disposal transaction. The Company estimates that the new standard will not have a material effect on its financial statements but is still in the evaluation process. 10 REALCO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2001 9. Contingencies: In connection with the Company's disposition of its residential brokerage operations, a leased office facility is no longer being used for operating purposes. This facility is sublet under an agreement expiring in May 2002, which provides for rental payments based upon a percentage of tenant revenues. In connection with the disposition, the Company recorded an estimated loss relating to its remaining costs in the facility, including leasehold improvements and remaining rental payments, reduced by sublease income. Sublease income has been estimated based on the existing sublease and on management's estimate of probable future sublease income which is predicated on current economic conditions. Adverse changes in economic conditions could negatively affect management's estimate of probable future sublease income which could result in the Company recognizing additional losses on this facility. In December 2001, the Company was named as a defendant in a lawsuit in the District Court for Hennepin County, Minnesota. The plaintiffs are certain institutional and individual customers of Miller & Schroeder Financial, Inc. (MSF), a broker-dealer. The lawsuit was commenced against MSF, Miller & Schroeder, Inc. (MSI), the parent corporation of MSF, and certain officers, directors, and shareholders of MSI who are alleged to be controlling persons of MSI and MSF. The Company is a shareholder of MSI. James A. Arias, the Company's Chief Executive Officer, is also named as a defendant. Mr. Arias served as a director of MSI during the period covered by the plaintiffs' complaint. The plaintiffs, on their own behalf and on behalf of a class of investors they seek to represent, are seeking rescission or compensatory damages with respect to debentures issued by United Homes, Inc. and purchased by the plaintiffs from or through MSF. The plaintiffs assert numerous claims against MSF and the other defendants, including claims based on negligence, negligent misrepresentation, common law fraud, and violations of the Minnesota Securities Act, the Minnesota Consumer Fraud Act, the U.S. Securities Act of 1933, and the Minnesota Uniform Fraudulent Transfer Act. In January 2002, the Company and Mr. Arias filed a motion to dismiss the lawsuit with respect to them. The hearing on the motion is scheduled for March 2002. If they are not dismissed from the lawsuit, the Company and Mr. Arias intend to defend the lawsuit vigorously. At present, the Company is unable to predict the outcome of this litigation or any exposure to loss. 11 REALCO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED December 31, 2001 10. Discontinued Operations: On June 2, 2001, the Company sold its residential real estate brokerage operations. Certain information with respect to the discontinued operations of the Company's residential real estate brokerage is as follows: Three months ended December 31, 2000 ------------------ Revenues $ 6,043,000 ================== Loss from discontinued operations $ (494,000) ================== Loss per common share from dis- continued operations - basic $ (.17) ================== Loss per common share from dis- continued operations - diluted $ (.15) ================== 12 ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW OF CONTINUING OPERATIONS --------------------------------- Based upon the various lines of business in which the Company is engaged, it has defined the following operating segments for purposes of financial accounting and reporting: Commercial Real Estate Brokerage Segment, Residential Construction and Land Development Segment, Commercial Construction Segment, and Financial Services Segment. The Company's continuing operations are primarily within the metropolitan areas of Albuquerque, New Mexico and Minneapolis, Minnesota. For the Quarter Ended December 31, 2001 The Company experienced pre-tax earnings of $197,000 from continuing operations for the quarter ended December 31, 2001 compared to a pre-tax loss of $80,000 for the same period in fiscal 2001. The primary component of current quarter pre-tax earnings is $716,000 in pre-tax earnings from the construction and land development segments. Total revenues increased $3,788,000 or 65% for the quarter ended December 31, 2001 compared to revenues for the same period in fiscal 2001. Construction sales increased $2,407,000 or 48%, which was offset partially by a decrease in brokerage commissions and fees of $545,000 or 75%. Financial services revenues increased to $1,893,000, the primary component for the increase was brokerage commissions and fees derived from the March 1, 2001 acquisition of Equity Securities Investments, Inc. (ESI), the Company's securities brokerage subsidiary. Gross profits on commissions, construction and lot sales increased $716,000 or 85% compared to the same period in fiscal 2001. An increase in selling, general and administrative expenses and depreciation expense of $644,000 or 75% also affected comparability between the periods. This increase is primarily attributable to selling, general and administrative expenses of $430,000 of ESI and increase of $170,000 of corporate expense primarily attributable to executive compensation of additional corporate officers and increased insurance costs. INCOME TAXES The Company's effective income tax rate for the periods ended December 31, 2001 and 2000 differs from the federal statutory rate due to changes in the valuation allowance for deferred tax assets. RESULTS OF OPERATIONS BY SEGMENT -------------------------------- Commercial Real Estate Brokerage Segment: The commercial real estate brokerage segment consists of First Commercial Real Estate Services, Inc. (First Commercial). 13 For the Quarter Ended December 31, 2001 A pre-tax loss of $159,000 was recognized in the quarter ended December 31, 2001 as compared to pre-tax earnings of $17,000 in the same period in fiscal 2001. The current period loss is the result of a $545,000 or 75% decline in brokerage commissions to $178,000 and the corresponding $166,000 or 65% decline in company dollar to $89,000. These declines are typical of a small commercial real estate brokerage, as timing of significant closings can affect comparability between periods. Selling, general and administrative expenses declined $19,000 or 8% in the quarter ended December 31, 2001 as compared to the same period in fiscal 2001. Residential Construction and Land Development Segment: The residential construction operations are conducted in the Albuquerque, Rio Rancho and Los Lunas, New Mexico metropolitan areas. Such operations are conducted by Charter Building & Development Corp. (Charter) and Success Venture, a joint venture. This segment also includes development activities consisting of the acquisition of raw land for development into residential homesites, which are sold to Charter or to other builders. Such land development projects may be performed under joint venture agreements or entirely by the Company. Profits on lots sold to Charter, either directly, by a subsidiary or by a joint venture, are eliminated in consolidation of this segment until the lot is removed from Charter's inventory. Such profits totaled $75,000 for the quarter ended December 31, 2001. For the Quarter Ended December 31, 2001 This segment experienced an increase in pre-tax earnings of $614,000 to $685,000 for the quarter ended December 31, 2001. Overall profitability increased 865%, as a result of substantially larger sales and gross profits, reduced operating expenses, equity earnings of investees and increased construction management fees. Residential construction sales increased $2,481,000 or 75% to $5,797,000 in the quarter ended December 31, 2001. This increase in revenues is the backlog effect of contracts booked during fiscal 2001 and delivered in fiscal 2002, as the construction period for homes is approximately 120 days. Gross profits on residential construction sales increased $441,000 or 125% to $795,000 for the quarter ended December 31, 2001. Such increase outpaced the increase in sales due to profit margins increasing from 10.7% in the quarter ended December 31, 2000 to 13.7% in the quarter ended December 31, 2001. This increase is the result of an increase in delivery of homes, improved gross margins, and fewer sales of older speculative homes and model homes at lesser discounts. The Company's ownership and management of a joint venture in a large subdivision also contributes to the increase in residential construction sales. As operations are conducted in a joint venture, equity earnings are recognized from the operations, as opposed to recognizing gross results of operations. Sales from this venture totaled $1,101,000 for the quarter ended December 31, 2001 and resulted in equity earnings of $47,000 as compared to sales for the same period in fiscal 2001 which totaled $1,020,000 and equity earnings of $19,000. The gain as compared to the prior period is attributable primarily to the fact that gross margins improved from 7% in the same period in fiscal 2001 to 10.85% in the quarter ended December 31, 2001. 14 Lot sales increased $444,000 or 151% to $738,000 in the quarter ended December 31, 2001. This increase is directly related to the aforementioned increase in construction sales. Gross profits on lot sales increased $114,000 or 211% to $168,000. Such increase is attributable to the increase in sales, which resulted in delivery of homes, which included intercompany sales of lots, gains on which are recognized upon the completion of sales to third parties. Other significant items affecting operating results include selling, general and administrative expenses, which increased $20,000 or 7% to $305,000 in the quarter ended December 31, 2001 and interest expense, which decreased $58,000 or 44% to $73,000 in the quarter ended December 31, 2001 due to principal reductions and lower bank borrowings. Commercial Construction Segment: Commercial construction operations are conducted by Realco Construction, Inc. (Realco Construction), an Albuquerque based general contractor. Additionally, the Company has commenced operations in California under a joint venture arrangement. For the Quarter Ended December 31, 2001 Operating results for the quarter ended December 31, 2001 resulted in pre-tax earnings of $31,000 as compared to $6,000 in the same period in fiscal 2001. This improvement in operating results was largely attributable to stable overhead costs and improved gross margins which is the result of improved cost controls. Sales decreased 38% to $851,000; however, gross profits increased 21% to $222,000 in the quarter ended December 31, 2001. The decline in revenues is the result of timing of significant projects between the periods, while the increase in gross profits is primarily attributable to a change in estimated completion costs on several projects which recently concluded. Financial Services Segment: The financial services segment consists primarily of the operations of the parent company, ESI, and PHS, Inc. (PHS). ESI, a Minneapolis, Minnesota based broker and dealer in securities, was acquired effective March 1, 2001 through the issuance of 484,000 shares of Series D preferred stock. On December 20, 2001, the holders of the 484,000 shares of series D preferred stock exchanged their shares under the terms of the conversion provision of the stock, into 1,452,000 common stock of the Company. See Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS section for a more detailed description of the transaction. This acquisition is a key component of the Company's plan to expand its financial services operations. The Company is currently identifying and evaluating other growth opportunities to complement this segment. In addition to financial services performed directly by the Company, operations also include the Company's share of earnings from its 49.99% equity interest in PHS Mortgage Company, a full service residential mortgage banker. 15 For the Quarter Ended December 31, 2001 The Financial Services segment realized a pre-tax loss of $360,000 for the quarter ended December 31, 2001 as compared to a pre-tax loss of $68,000 in the same period in fiscal 2001. The primary cause for the increased loss is increased executive payroll, increased general liability and health insurance costs, reduced residential mortgage fees and reduction of gains on securities held for sale. Other significant items affecting operating results are discussed below. ESI's operations, which were acquired effective March 1, 2001, resulted in a pre-tax loss of $50,000 in the quarter ended December 31, 2001 which results were not included in the Company's financial statements for the same period in fiscal 2001. Commissions earned were $1,179,000 and gross profits on commissions totaled $289,000 in addition to interest income of $111,000 and operating expenses totaled $450,000 resulting in an operating loss for the quarter ended December 31, 2001 of $50,000. Management is in the process of expanding these operations and is currently incurring costs to accommodate growth initiatives, such as facilities relocation costs and broker recruiting costs. This operation is expected to be profitable in the near term. Net equity earnings recognized from PHS Mortgage Company were $25,000, as compared to $64,000 in the same period in fiscal 2001. In the past, this equity method investee received the majority of its business from the Company's residential real estate brokerage operations which were sold in June 2001. Management is attempting to maintain the referral relationship with the sales agents, however the buyers of these operations also promote mortgage services. Additionally, management is planning to promote the operations of PHS to other residential real estate brokerage firms. There can be no assurance that these efforts will be successful. In the event new sources of business cannot be secured, this equity investee will no longer contribute earnings to the Company. LIQUIDITY AND CAPITAL RESOURCES ------------------------------- At December 31, 2001, the Company was in violation of the minimum net worth covenant relating to its subordinated sinking fund notes with a principal balance of $2,550,000. Therefore, the Trustee or Noteholders have the right to deliver a Notice of Default to the Company. If Notice of Default is delivered and the violation is not cured within thirty days, the notes may be declared due and payable immediately. To cure this default, the Company would be required to raise capital of more than $310,000. If these obligations were declared immediately due and payable the Company's cash position and working capital would be adversely affected. If demand payment is required, management believes it will be able to satisfy the obligation and maintain adequate working capital for the Company's operations over the ensuing twelve months as follows: 1. Utilization of existing cash reserves. 2. Drawing additional funds available under existing construction loans. 3. Utilization of expected positive cash flow provided by operations. 4. Reducing operating expenses and other expenditures. 5. Securing funds from other lenders as may become available. 16 The Company's working capital consists primarily of cash, accounts receivable, and borrowings under construction advances and notes payable collateralized by inventory. The Company intends to apply its capital resources to expand its business by establishing or acquiring complementary operations and to reducing its outstanding debt. It is expected that future cash needs will be financed by a combination of cash flows from operations, future advances under construction loans, and if needed, other financing arrangements, which may be made available to the Company. The Company does not have any material commitments for capital expenditures for fiscal 2002. The Company's projection of future cash requirements is affected by numerous factors, including but not limited to, changes in customer receipts, consumer industry trends, sales volume, operating cost fluctuations, acquisitions of existing businesses and unplanned capital spending. COMPETITION AND MARKET FACTORS ------------------------------ The business in which the Company is engaged is highly competitive. Many of the Company's competitors have nationwide operations. As such, a number of the Company's competitors have greater financial resources. It is for that reason that the Company continues to pursue strategic alliances with other companies. The real estate and financial services industries, and therefore, the Company's operations, can be cyclical and are affected by consumer confidence levels, prevailing economic conditions and interest rates. Other factors effecting business include increases in construction costs, increases in costs associated with home ownership such as interest rates, property taxes, and changes in consumer preferences and demographic trends. FORWARD LOOKING STATEMENTS -------------------------- Investors are cautioned that certain statements contained in this document are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 (the Act). Statements which are predictive in nature, which depend upon or refer to future events or conditions constitute forward-looking statements. In addition, any statements concerning future financial performance, ongoing business strategies or prospects, and possible future Company actions, which may be provided by management are also forward-looking statements as defined by the Act. Forward-looking statements are based on current expectations and projections about future events and are subject to risks, uncertainties, assumptions, and economic and market conditions in the real estate and financial services industry, among other things. Actual events and results may differ materially from those expressed or forecasted in the forward-looking statements made by the Company or Company management due to a number of factors. Important factors that could cause such differences include but are not limited to, changes in general economic conditions either nationally or in regions in where the Company operates or may commence operations, employment growth or unemployment rates, availability and costs of land and homebuilding materials, labor costs, 17 interest rates, prevailing rates for sales associate commissions, industry competition and regulatory developments. ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have not been any material changes in the sources and effects of the Company's market risk since September 30, 2001. 18 PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS In December 2001, the Company was named as a defendant in a lawsuit in the District Court for Hennepin County, Minnesota. The plaintiffs are certain institutional and individual customers of Miller & Schroeder Financial, Inc., a broker-dealer ("MSF"). The lawsuit was commenced against MSF, Miller & Schroeder, Inc., the parent corporation of MSF ("MSI"), and certain officers, directors and shareholders of MSI who are alleged to be controlling persons of MSI and MSF. The Company is a shareholder of MSI. James A. Arias, the Company's Chief Executive Officer, is also named as a defendant. Mr. Arias served as a director of MSI during the period covered by the plaintiff's complaint. The plaintiffs, on their own behalf and on behalf of a class of investors they seek to represent, are seeking rescission or compensatory damages with respect to debentures issued by United Homes, Inc. and purchased by the plaintiffs from or through MSF. The plaintiffs assert numerous claims against MSF and the other defendants including claims based on negligence, negligent misrepresentation, common law fraud, and violations of the Minnesota Securities Act, the Minnesota Consumer Fraud Act, the U.S. Securities Act of 1933, and the Minnesota Uniform Fraudulent Transfer Act. In January 2002, the Company and Mr. Arias filed a motion to dismiss the lawsuit with respect to them. The hearing on the motion is scheduled for March 2002. If they are not dismissed from the lawsuit, the Company and Mr. Arias intend to defend the lawsuit vigorously. The Company is engaged in various other legal proceedings incidental to its normal business activities. Management of the Company does not believe that the outcome of each such proceeding or all of them combined will have a material adverse effect on the Company's operations or financial position. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS On December 20, 2001, the Company issued 1,452,000 shares of its Common Stock upon the conversion of 484,000 shares of its Series "D" Preferred Stock. The Series "D" Preferred Stock was issued on March 1, 2001, pursuant to the terms of a merger in which the Company acquired Equity Securities Investments, Inc. ("ESI"). The Series "D" Preferred Stock was not initially convertible into Common Stock. However, the terms of the Series "D" Preferred Stock provided that each share would automatically be converted into three shares of Common Stock if the shareholders of the Company approved such conversion, and that the conversion, if approved, would occur automatically on the twenty-first (21st) day following the date on which the shareholders approved the conversion. The Company agreed in the merger agreement to ask its shareholders to approve the conversion and, at the Annual Meeting of Shareholders of the Company held on November 29, 2001, the shareholders voted upon and approved the conversion of the Series "D" Preferred Stock into Common Stock. The shares of Series "D" Preferred Stock, and the shares of Common Stock issued upon conversion of the Series "D" Preferred Stock, were issued to Laurence S. Zipkin and Edward S. Adams, the shareholders of ESI prior to the merger. The shares of Series "D" Preferred Stock were issued in a transaction that was exempt from the registration requirements of the Securities Act of 1933, as amended (the "Securities Act") pursuant to Section 4(2) of the Securities Act. The shares of Common Stock issued upon conversion of the Series "D" Preferred Stock were issued in a transaction that was exempt from 19 the registration requirements of the Securities Act pursuant to Section 3(a)(9) of the Securities Act. No underwriting discounts or commissions were paid in connection with such transactions. ITEM 3. DEFAULTS IN SENIOR SECURITIES At December 31, 2001, the Company was in violation of the minimum net worth covenant relating to its subordinated sinking fund notes with a principal balance of $2,550,000. Therefore, the Trustee or Note holders have the right to deliver a Notice of Default to the Company. If Notice of Default is delivered and the violation is not cured within thirty days, the notes may be declared due and payable immediately. At December 31, 2001, the Company would be required to raise capital of more than $310,000 to cure this default. If these obligations were declared immediately due and payable the Company's cash position and working capital would be adversely affected. If demand payment is required, management believes it will be able to satisfy the obligation and maintain adequate working capital for the Company's operations over the ensuing twelve months as follows: 1. Utilization of existing cash reserves. 2. Drawing additional funds available under existing construction loans. 3. Utilization of expected positive cash flow provided by operations. 4. Reducing operating expenses and other expenditures. 5. Securing funds from other lenders as may become available. ITEM 4. SUBMISSIONS OF MATTERS TO A VOTE OF SECURITIES HOLDERS At the Annual Meeting of Shareholders of the Company held on November 29, 2001, the shareholders voted upon and approved the following items: 1. The shareholders approved the conversion of each of the outstanding shares of the Company's Series "D" Preferred Stock into three shares of Common Stock. The holders of the 484,000 shares of Series "D" Preferred Stock did not vote on this item. FOR AGAINST ABSTAIN BROKER NON-VOTES --------- ------- ------- ---------------- 2,134,563 63,312 5,600 807,683 2. The shareholders elected the following persons as directors of the Company, to serve until the next annual meeting of shareholders: VOTES FOR VOTES WITHHELD --------- -------------- Edward S. Adams 3,485,358 9,800 James A. Arias 3,485,358 9,800 Brad J. Buscher 3,485,358 9,800 Martin S. Orland 3,485,358 9,800 Gregory E. Spitzer 3,485,358 9,800 Alan R. Woinski 3,485,358 9,800 Laurence S. Zipkin 3,485,358 9,800 20 3. The shareholders approved an amendment to the Company's 1997 Employee Incentive Stock Plan increasing the number of shares of the Company's Common Stock reserved for issuance under the Plan from 262,500 shares to 800,000 shares. FOR AGAINST ABSTAIN BROKER NON-VOTES --------- ------- ------- ---------------- 2,610,225 63,800 13,450 807,683 4. The shareholders ratified the appointment of Grant Thornton LLP as the Company's independent auditors to examine the financial statements of the Company for the fiscal year ended September 30, 2001. FOR AGAINST ABSTAIN BROKER NON-VOTES --------- ------- ------- ---------------- 3,489,108 1,100 4,950 -0- ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) There are no exhibits filed with this Report. (b) Reports on Form 8-K: None. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. REALCO, INC. Date: February 14, 2002 /s/ JAMES A. ARIAS --------------------------------------- James A. Arias, President and Chief Executive Officer Date: February 14, 2002 /s/ EDWARD S. ADAMS --------------------------------------- Edward S. Adams, Vice President and Principal Financial Officer 21

REALCO INC /NM/ 10-Q