10-Q 1 fs10q33105.txt FIVE STAR PRODUCTS 10-Q FOR THE QUARTER ENDED 3/31/05 United States Securities and Exchange Commission Washington, D.C. 20549 Form 10-Q [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended March 31, 2005 or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from _______________ to ______________ Commission File Number: 033-78252 -------------------------------------------------------- FIVE STAR PRODUCTS, INC. -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Delaware 13-3729186 ------------------------------------ ---------------------- (State or other jurisdiction of (I.R.S. Employer . incorporation or organization) Identification No.) 777 Westchester Avenue, Fourth Floor, White Plains, NY 10604 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip code) (914) 249-9700 -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) 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 for the past 90 days. Yes X No Indicate by check mark whether registrant is an accelerated filer. Yes No X Number of shares outstanding of each of issuer's classes of common stock as of May 2, 2005: Common Stock, par value $0.01 per share 14,309,577 shares FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES TABLE OF CONTENTS Page No. Part I. Financial Information Item 1. Financial Statement s (Unaudited) Consolidated Condensed Balance Sheets - March 31, 2005 and December 31, 2004 1 Consolidated Condensed Statements of Operations and Comprehensive Income - Three Months Ended March 31, 2005 and 2004 2 Consolidated Condensed Statements of Cash Flows - Three Months Ended March 31, 2005 and 2004 3 Notes to Consolidated Condensed Financial Statements 4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 Item 3. Quantitative and Qualitative Disclosures about Market Risks 14 Item 4. Controls and Procedures 14 Part II. Other Information Item 6. Exhibits and Reports on Form 8-K 15 Signatures 16 PART I. FINANCIAL INFORMATION FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED BALANCE SHEETS (in thousands)

See accompanying notes to the consolidated condensed financial statements. FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (Unaudited) (in thousands, except per share data)

See accompanying notes to the consolidated condensed financial statements. 2 FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands)

See accompanying notes to the consolidated condensed financial statements. 3 FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Unaudited) 1. Basis of Presentation and Summary of Significant Accounting Policies Description of Business Five Star Products, Inc. (the "Company" or "Five Star") owns 100% of Five Star Group, Inc., which is a wholesale distributor of home decorating, hardware and finishing products in the northeastern United States. At March 31, 2005 the Company is a majority owned subsidiary of National Patent Development Corporation ("NPDC"). The Company, which was then 37.5% owned by GP Strategies Corporation ("GPS"), purchased its business from GPS in 1998 in exchange for cash and a $5,000,000 unsecured 8% note payable ("the Note"). In 2002 and 2003, GPS converted $1,000,000 principal amount of the Note into 4,272,727 shares of the Company's common stock. In 2004, the Company repurchased approximately 2,628,000 shares of its common stock through a tender offer. The conversion of the Note and the tender offer increased GPS' ownership in the Company to approximately 64%. On July 30, 2004, GPS contributed its ownership interest in Five Star and the Note to NPDC. On November 24, 2004, GPS completed the spin-off to its shareholders of the common stock of NPDC. Basis of reporting The accompanying unaudited financial statements of the Company have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include certain information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, such statements include all adjustments (consisting only of normal recurring items), which are considered necessary for a fair presentation of the Company's financial position at March 31, 2005, and the results of its operations and cash flows for the quarter then ended. The results of operations for the quarter ended March 31, 2005 are not necessarily indicative of the operating results for the full year. It is suggested that these financial statements be read in conjunction with the financial statements and related disclosures for the year ended December 31, 2004 included in the Company's Form 10-K. Revenue recognition Revenue on product sales is recognized at the point in time when the product has been shipped, title and risk of loss has been transferred to the customer, and the following conditions are met: persuasive evidence of an arrangement exists, the price is fixed and determinable, and collectibility of the resulting receivable is reasonably assured. Allowances for estimated returns and allowances are recognized when sales are recorded. (Continued) 4 Inventory Inventory is valued at the lower of cost, using the first in, first-out (FIFO) method, or market. Inventory consists solely of finished products. Reclassifications Certain prior year amounts in the financial statements and notes thereto have been reclassified to conform to 2005 classifications. 2. Short-term borrowings In 2003, the Company's wholly-owned subsidiary, Five Star Group, Inc., obtained a Loan and Security Agreement (the "Loan Agreement") with Bank of America Business Capital (formerly Fleet Capital Corporation) (the "Lender"). The Loan Agreement has a five-year term, with a maturity date of June 30, 2008. The Loan Agreement, as amended in March 2005, provides for a $30,000,000 revolving credit facility, which allows Five Star Group, Inc. to borrow based upon a formula of up to 55% of eligible inventory and 80% of eligible accounts receivable, as defined therein. The interest rates under the Loan Agreement consist of LIBOR plus a credit spread of 2% (4.69% at March 31, 2005) for borrowings not to exceed $15,000,000 and the prime rate (5.75% at March 31, 2005) for borrowings in excess of the above-mentioned LIBOR-based borrowings. The credit spreads can be reduced in the event that Five Star Group, Inc. achieves and maintains certain performance benchmarks. At March 31, 2005 and December 31, 2004, approximately $27,955,000 and $18,234,000 was outstanding under the Loan Agreement and approximately $521,000 and $434,000 was available to be borrowed, respectively. Substantially all of the Company's assets are pledged as collateral for these borrowings. Under the Loan Agreement the Company is subject to covenants requiring minimum net worth, limitations on losses, if any, and minimum or maximum values for certain financial ratios. As of March 31, 2005 the Company was in compliance with all required covenants. In April 2005, Five Star Group, Inc. amended the Loan Agreement to allow it to increase the maximum amount that can be borrowed under the revolving credit facility to $30,800,000 through June 30, 2005; reverting back to a maximum of $28,000,000 on July 1, 2005. In connection with the Loan Agreement, Five Star Group, Inc. also entered into a derivative transaction with the Lender. The derivative transaction is an interest rate swap and has been designated as a cash flow hedge. Effective July 1, 2004 through June 30, 2008, Five Star Group, Inc. will pay a fixed interest rate of 3.38% to the Lender on notional principal of $12,000,000. In return, the Lender will pay to Five Star Group, Inc. a floating (Continued) 5 rate, namely, LIBOR, on the same notional principal amount. The credit spread under the new Loan Agreement is not included in, and will be paid in addition to this fixed interest rate of 3.38%. The fair value of the interest rate swap amounted to $341,000 and $105,000 at March 31, 2005 and December 31, 2004, respectively and is included in other assets in the accompanying balance sheets. On June 17, 2004, Five Star Group, Inc. also entered into a derivative interest rate collar transaction during the period from July 1, 2004 through June 30, 2008 on notional principal of $12,000,000. The transaction consists of an interest rate floor of 2.25%, whereas if LIBOR is below 2.25%, the Lender will pay to Five Star Group, Inc. the difference between LIBOR and 2.25%, on the same notional principal amount. The transaction also consists of an interest rate cap of 5.75%, whereas if LIBOR is above 5.75%, Five Star Group, Inc. will pay to the Lender the difference between LIBOR and 5.75%, on the same notional principal amount. 3. Derivatives and hedging activities The interest rate swap and interest rate collar entered into by the Company in connection with its loan agreement (see Note 2) are being accounted for under SFAS No. 133, as amended, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 requires all derivatives to be recognized in the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. If the derivative is a cash flow hedge, changes in the fair value of the derivative are recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value is immediately recognized in earnings. Changes in the fair value of the interest rate swap, which has been designated as a cash flow hedge, were recognized in other comprehensive income. Changes in the fair value of the interest rate collar are recognized in earnings. During the quarter ended March 31, 2005 the Company recognized a loss of $25,000, as part of other income, for the changes in the fair value of the interest rate collar. 4. Note payable to JL Distributors, Inc. The Company's wholly-owned subsidiary, Five Star Group, Inc., has an unsecured note payable (the "Note") to JL Distributors, Inc., a wholly-owned subsidiary of NPDC following the spin-off of NPDC from GPS on November 24, 2004. The Note, as amended, bears interest at 8%, which is payable quarterly, and matures on June 30, 2005. The Note is subordinated to the indebtedness under the Loan Agreement according to an Agreement of Subordination & Assignment (the "Subordination Agreement") between Five Star Group, Inc. and JL Distributors, Inc. dated June 20, 2003. The Subordination Agreement permits the annual repayment of principal under certain circumstances. The balance of the Note was $2,800,000 as of March 31, 2005. The Company is currently negotiating an extension of the maturity date of the Note, subject to approval by the Board of Directors of the Company and NPDC, respectively. (Continued) 6 5. Earnings per share Earnings per share (EPS) for the quarter ended March 31, 2005 and 2004 are as follows (in thousands, except per share amounts):

Basic earnings per share is based upon the weighted average number of common shares outstanding during the period. Diluted earnings per share is based upon the weighted average number of common shares outstanding during the period, assuming the issuance of common shares for all potential dilutive common shares outstanding. For the quarter ended March 31, 2004, 405,000 option shares were excluded, as their effect is anti-dilutive. (Continued) 7 8 6. Stock-based compensation Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation" encourages the use of the fair value based method of accounting for stock-based employee compensation. Alternatively, SFAS No. 123 allows entities to continue to apply the intrinsic value method prescribed by the Accounting Principles Board ("APB") Opinion 25, "Accounting for Stock Issued to Employees", and related interpretations and provide pro forma disclosures of net income (loss) and earnings (loss) per share, as if the fair value based method of accounting had been applied to employee awards. The Company has elected to continue to apply the provisions of APB Opinion 25 and provide the disclosures required by SFAS No. 123 and SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure", which was released in December, 2002, as an amendment of SFAS No. 123. The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all awards. Three months Ended March 31, 2005 2004 ---- ---- Reported net income $ 19 $ 259 Stock-based employee compensation determined under the intrinsic value method, net of tax - - Stock-based employee compensation determined under the fair value based method, net of tax (3) (3) --------- ------ Pro-forma net income $ 16 $ 256 ---- ------ Basic earnings per share: As reported $ .00 $ .02 ----- ----- Pro forma $ .00 $ .02 ----- ----- Diluted earnings per share: As reported $ .00 $ .02 ----- ----- Pro forma $ .00 $ .01 ----- ----- 8 FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Five Star is a publicly held company that is a leading distributor in the United States of home decorating, hardware, and finishing products. Five Star offers products from leading manufacturers in the home improvement industry and distributes those products to retail dealers, which include lumber yards, "do-it yourself" centers, hardware stores and paint stores. Five Star has grown to be one of the largest independent distributors in the Northeast United States by providing a complete line of competitively priced products, timely delivery and attractive pricing and financing terms to its customers. Results of Operations The Company had income before income taxes of $32,000 for the quarter ended March 31, 2005, as compared to income before income taxes of $446,000 for the quarter ended March 31, 2004. The decrease in income before income taxes for the quarter ended March 31, 2005 was primarily the result of increased delivery expense, interest expense and management fees charged by NPDC. Sales The Company had sales of $28,239,000 for the quarter ended March 31, 2005, as compared to sales of $26,991,000 for the quarter ended March 31, 2005. The increase in sales was a result of increased sales volume generated from the Company's annual trade shows; as well as rising prices due to increased raw material costs for certain of the Company's vendors. Gross margin Gross margin decreased to $4,404,000, or 15.6% of net sales, for the quarter ended March 31, 2005, as compared to $4,469,000, or 16.6% of net sales, for the quarter ended March 31, 2004. The decrease in gross margin dollars and gross margin percentage for the quarter ended March 31, 2005 is primarily a result of increased purchases during the period, an unfavorable shift in the product mix sold and increased warehouse expenses. Selling, general and administrative expense The Company had selling, general and administrative (SG&A) expense of $3,974,000 for the quarter ended March 31, 2005, as compared to $3,823,000 for the quarter ended March 31, 2004. The increase in SG&A expenses was primarily attributable to increases in salesmen commissions, in delivery expenses and in medical expenses; offset by a decrease in legal and professional fees. 9 Other income The Company had other losses of $19,000 for the quarter ended March 31, 2005, as compared to other income of $11,000 for the quarter ended March 31, 2004. The decrease in other income for the quarter ended March 31, 2005 is mainly a result of the Company recognizing a loss of $25,000 for the change in the fair value of the interest rate collar. Interest expense The Company had interest expense of $379,000 for the quarter ended March 31, 2005, as compared to interest expense of $211,000 for the quarter ended March 31, 2004. The increase in interest expense for the quarter ended March 31, 2005 is a result of an increase in average short-term borrowings and interest rates. Income taxes The effective income tax rate remained at approximately 42% for the quarter ended March 31, 2005 and 2004, which is the anticipated annualized effective rate. Liquidity and Capital Resources At March 31, 2005, the Company had cash of $3,000. Management believes that cash generated from operations and borrowing availability under existing credit agreements will be sufficient to fund the Company's working capital requirements for at least the next twelve months. For the three months ended March 31, 2005, the Company's working capital increased by $61,000 from $3,758,000 to $3,819,000, which was primarily due to increased accounts receivable, other current assets and decreased accounts payable and accrued expenses, offset by increased short-term borrowings. The decrease in cash of $1,000 for the three months ended March 31, 2005 resulted from cash used by operations of $9,672,000 and cash used by additions to property, plant and equipment of $50,000, offset by cash provided by short-term borrowings of $9,721,000. In 2003, the Company's wholly-owned subsidiary, Five Star Group, Inc., obtained a Loan and Security Agreement (the "Loan Agreement") with Bank of America Business Capital (formerly Fleet Capital Corporation) (the "Lender"). The Loan Agreement has a five-year term, with a maturity date of June 30, 2008. The Loan Agreement, as amended in March 2005, provides for a $30,000,000 revolving credit facility, which allows Five Star Group, Inc. to borrow based upon a formula of up to 55% of eligible inventory and 80% of eligible accounts receivable, as defined therein. The interest rates under the Loan Agreement consist of LIBOR plus a credit spread of 2% (4.69% at March 31, 2005) for borrowings not to exceed $15,000,000 and the prime rate (5.75% at March 31, 2005) for borrowings in excess of the above-mentioned LIBOR-based borrowings. The credit spreads can 10 be reduced in the event that Five Star Group, Inc. achieves and maintains certain performance benchmarks. At March 31, 2005 and December 31, 2004, approximately $27,955,000 and $18,234,000 was outstanding under the Loan Agreement and approximately $521,000 and $434,000 was available to be borrowed, respectively. Substantially all of the Company's assets are pledged as collateral for these borrowings. Under the Loan Agreement Five Star is subject to covenants requiring minimum net worth, limitations on losses, if any, and minimum or maximum values for certain financial ratios. As of March 31, 2005 the Company was in compliance with all required covenants. In April 2005, Five Star Group, Inc. amended the Loan Agreement to allow it to increase the maximum amount that can be borrowed under the revolving credit facility to $30,800,000 through June 30, 2005; reverting back to a maximum of $28,000,000 on July 1, 2005. In connection with the Loan Agreement, Five Star Group, Inc. also entered into a derivative transaction with the Lender. The derivative transaction is an interest rate swap and has been designated as a cash flow hedge. Effective July 1, 2004 through June 30, 2008, Five Star Group, Inc. will pay a fixed interest rate of 3.38% to the Lender on notional principal of $12,000,000. In return, the Lender will pay to Five Star Group, Inc. a floating rate, namely, LIBOR, on the same notional principal amount. The credit spread under the new Loan Agreement is not included in, and will be paid in addition to this fixed interest rate of 3.38%. The fair value of the interest rate swap amounted to $341,000 and $105,000 at March 31, 2005 and December 31, 2004, respectively and is included in other assets in the accompanying balance sheets. On June 17, 2004, Five Star Group, Inc. also entered into a derivative interest rate collar transaction during the period from July 1, 2004 through June 30, 2008 on notional principal of $12,000,000. The transaction consists of an interest rate floor of 2.25%, whereas if LIBOR is below 2.25%, the Lender will pay to Five Star Group, Inc. the difference between LIBOR and 2.25%, on the same notional principal amount. The transaction also consists of an interest rate cap of 5.75%, whereas if LIBOR is above 5.75%, Five Star Group, Inc. will pay to the Lender the difference between LIBOR and 5.75%, on the same notional principal amount. The interest rate swap and interest rate collar entered into by the Company in connection with its loan agreement (see Note 2) are being accounted for under SFAS No. 133, as amended, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 requires all derivatives to be recognized in the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. If the derivative is a cash flow hedge, changes in the fair value of the derivative are recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value is immediately recognized in earnings. Changes in the fair value of the interest rate swap, which has been designated as a cash flow hedge, were recognized in other comprehensive income. Changes in the fair value of the interest rate collar are recognized in earnings. During the quarter ended March 31, 2005 the Company recognized a loss of $25,000, as part of other income, for the changes in the fair value of the interest rate collar. 11 The Company's wholly-owned subsidiary, Five Star Group, Inc., has an unsecured note payable (the "Note") to JL Distributors, Inc., a wholly-owned subsidiary of NPDC following the spin-off of NPDC from GPS on November 24, 2004. The Note, as amended, bears interest at 8%, which is payable quarterly, and matures on June 30, 2005. The Note is subordinated to the indebtedness under the Loan Agreement according to an Agreement of Subordination & Assignment (the "Subordination Agreement") between Five Star Group, Inc. and JL Distributors, Inc. dated June 20, 2003. The Subordination Agreement permits the annual repayment of principal under certain circumstances. The balance of the Note was $2,800,000 as of March 31, 2005. The Company is currently negotiating an extension of the maturity date of the Note, subject to approval by the Board of Directors of the Company and NPDC, respectively. Application of Critical Accounting Policies The Company's consolidated condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Certain accounting policies have a significant impact on amounts reported in the financial statements. A summary of those significant accounting policies can be found in Note 2 to the Company's financial statements included in the Company's 2004 Annual Report on Form 10-K. The Company has not adopted any significant new accounting policies during the three months ended March 31, 2005. Among the significant judgments made by management in the preparation of the Company's financial statements are the determination of the allowance for doubtful accounts and adjustments of inventory valuations. These adjustments are made each quarter in the ordinary course of accounting. Forward-Looking Statements This report contains certain forward-looking statements reflecting management's current views with respect to future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements, all of which are difficult to predict and many of which are beyond the control of the Company, but not limited to the risk that the Company will not achieve the projected levels of profitability and revenues, and those risks and uncertainties detailed in the Company's periodic reports and registration statements filed with the Securities and Exchange Commission. 12 Item 3. Quantitative and Qualitative Disclosures about Market Risk We have no material changes to the disclosure on this matter made in our report on Form 10-K for the fiscal year ended December 31, 2004. Item 4. Controls and Procedures a. Evaluation of disclosure controls and procedures. The Company's Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of the Company's disclosure controls and procedures (as defined in Exchange Act Rules 240.13a-15(e) or 15d-15(e) as of the end of period covered by the report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company's current disclosure controls and procedures are effective as of the evaluation date, providing them with material timely information relating to the Company required to be disclosed in the reports the Company files or submits under the Exchange Act. b. Changes in internal controls. There have not been any significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. 13 PART II OTHER INFORMATION Item 6. Exhibits 10.1 Second Modification Agreement dated as of March 22, 2005 by and between Five Star Group, Inc. as borrower and Fleet Capital Corporation, as Lender. 31.1 Certification of Chief Executive Officer of the Company, dated May 16, 2005 pursuant to Securities Exchange Act Rule 13a-14(a)/15d-14(a), as adopted pursuant to Sections 302 and 404 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer of the Company, dated May 16, 2005 pursuant to Securities Exchange Act Rule 13a-14(a)/15d-14(a), as adopted pursuant to Sections 302 and 404 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of Chief Executive Officer and Chief Financial Officer of the Company dated May 16, 2005 pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 14 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed in its behalf by the undersigned thereunto duly authorized. FIVE STAR PRODUCTS, INC. DATE: May 16, 2005 Charles Dawson President DATE: May 16, 2005 Greg Golkov Chief Financial Officer 15

FIVE STAR PRODUCTS INC 10-Q