Starrett L S Co (SCX) SEC Annual Report (10-K) for 2012

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(check one)

OR

Commission File No. 1-367

THE L.S. STARRETT COMPANY

(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code 978-249-3551

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

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   Yes   ¨     No   x

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

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 the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes   x No   ¨

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 this Form 10-K or amendment to this Form 10-K.    x

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. (Check one)

Large Accelerated Filer   ¨     Accelerated Filer   x

Non-Accelerated Filer   ¨     Smaller Reporting Company ¨

(Do not check if a smaller reporting company)

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes   ¨     No   x

The Registrant had 5,977,176 and 782,620 shares, respectively, of its $1.00 par value Class A and B common stock outstanding on December 31, 2011. On December 31, 2011, the last business day of the Registrant's second fiscal quarter, the aggregate market value of the common stock held by nonaffiliates was approximately $76,312,794.

There were 6,025,871 and 764,814 shares, respectively, of the Registrant's $1.00 par value Class A and Class B common stock outstanding as of August 31, 2012.

The exhibit index is located on pages 52-54.

DOCUMENTS INCORPORATED BY REFERENCE

The Registrant intends to file a definitive Proxy Statement for the Company's 2012 Annual Meeting of Stockholders within 120 days of the end of the fiscal year ended June 30, 2012. Portions of such Proxy Statement are incorporated by reference in Part III.

THE L.S. STARRETT COMPANY

FORM 10-K

FOR THE YEAR ENDED JUNE 30, 2012

TABLE OF CONTENTS

All references in this Annual Report to "Starrett", the "Company", "we", "our" and "us" mean The L.S. Starrett Company and its subsidiaries.

PART I

Item 1 - Business

General

Founded in 1880 by Laroy S. Starrett and incorporated in 1929, the Company is engaged in the business of manufacturing over 5,000 different products for industrial, professional and consumer markets. As a global manufacturer with major subsidiaries in Brazil (1956), Scotland (1958) and China (1997), the Company offers its broad array of products to the market through multiple channels of distribution throughout the world. The Company's products include precision tools, non-contact industrial measurement systems, electronic gages, gage blocks, optical vision and laser measuring equipment, custom engineered granite solutions, tape measures, levels, chalk products, squares, band saw blades, hole saws, hacksaw blades, jig saw blades, reciprocating saw blades, M1® lubricant and precision ground flat stock.  The Company's financial reporting is based upon one business segment.

Starrett® is brand recognized around the world for precision, quality and innovation.

Products

The Company's tools and instruments are sold throughout North America and in over 100 other countries. By far the largest consumer of these products is the metalworking industry including aerospace, medical, and automotive but other important consumers are marine and farm equipment shops, do-it-yourselfers and tradesmen such as builders, carpenters, plumbers and electricians.

For 132 years the Company has been a recognized leader in providing measurement solutions consisting of hand measuring tools and precision instruments such as micrometers, vernier calipers, height gages, depth gages, electronic gages, dial indicators, steel rules, combination squares, custom and non-contact gaging  and many other items. Skilled personnel, superior products, manufacturing expertise, innovation  and unmatched service has earned the Company its reputation as the "Best in Class" provider of measuring application solutions for industry. During 2012 the Company has expanded its reach with new product introductions. These include a range of force measurement, surface roughness testers and roundness test equipment and IP67 water resistant electronic indicators. The Company also entered the in process gaging field with the acquisition of Bytewise measurement systems which makes state of the art laser measurement equipment and software for shop floor applications.

The Company's saw product lines enjoy strong global brand recognition and market share. These products encompass a breadth of uses. The Company introduced several new products in the recent past including its ADVANZ carbide tipped products and its VERSATIX products with a patent pending tooth geometry designed for the cutting of structurals and small solids. These new product lines were enhanced through the global introduction of new support programs and marketing collateral. These actions are aimed at positioning Starrett for global growth in wide band products for production applications as well as product range expansions for shop applications. A full line of complementary saw products, including hack, jig, reciprocating saw blades and hole saws provide cutting solutions for the building trades and are offered primarily through construction, electrical, plumbing and retail distributors.  

Personnel

At June 30, 2012, the Company had 1,928 employees, approximately 53% of whom were domestic. This represents a net decrease from June 30, 2011 of 23 employees. The headcount change included an increase of 37 domestically and a decrease of 60 internationally.

None of the Company's operations are subject to collective bargaining agreements. In general, the Company considers relations with its employees to be excellent. Domestic employees hold a large share of Company stock resulting from various stock purchase plans. The Company believes that this dual role of owner-employee has strengthened employee morale over the years.

Competition

The Company is competing on the basis of its reputation as the best in class for quality, precision and innovation combined with its commitment to customer service and strong customer relationships. To that end, Starrett is increasingly focusing on providing customer centric solutions. Although the Company is generally operating in highly competitive markets, the Company's competitive position cannot be determined accurately in the aggregate or by specific market since none of its competitors offer all of the same product lines offered by the Company or serve all of the markets served by the Company.

The Company is one of the largest producers of mechanics' hand measuring tools and precision instruments. In the United States, there are three major foreign competitors and numerous small companies in the field. As a result, the industry is highly competitive. During fiscal 2012, there were no material changes in the Company's competitive position. The Company's products for the building trades, such as tape measures and levels, are under constant margin pressure due to a channel shift to large national home and hardware retailers. The Company is responding to such challenges by expanding its manufacturing operations in China.  Certain large customers offer private labels ("own brand") that compete with Starrett branded products. These products are often sourced directly from low cost countries.

Saw products encounter competition from several domestic and international sources. The Company's competitive position varies by market segment and country. Continued research and development, new patented products and processes, strategic acquisitions and investments and strong customer support have enabled the Company to compete successfully in both general and performance oriented applications.

Foreign Operations

The operations of the Company's foreign subsidiaries are consolidated in its financial statements. The subsidiaries located in Brazil, Scotland and China are actively engaged in the manufacturing and distribution of precision measuring tools, saw blades, optical and vision measuring equipment and hand tools. Subsidiaries in Canada, Australia, New Zealand, Mexico, Germany and Singapore are engaged in distribution of the Company's products. The Company expects its foreign subsidiaries to continue to play a significant role in its overall operations. A summary of the Company's foreign operations is contained in Note 15 to the Company's fiscal 2012 financial statements under the caption "OPERATING DATA" found in Item 8 of this Form 10-K.

Orders and Backlog

The Company generally fills orders from finished goods inventories on hand. Sales order backlog of the Company at any point in time is not significant. Total inventories amounted to $69.9 million at June 30, 2012 and $58.8 million at June 30, 2011. 

Intellectual Property

When appropriate, the Company applies for patent protection on new inventions and currently owns a number of patents. Its patents are considered important in the operation of the business, but no single patent is of material importance when viewed from the standpoint of its overall business. The Company relies on its continuing product research and development efforts, with less dependence on its current patent position. It has for many years maintained engineers and supporting personnel engaged in research, product development and related activities. The expenditures for these activities during fiscal years 2012, 2011 and 2010 were approximately $2.2 million, $1.9 million and $1.3 million, respectively.

The Company uses trademarks with respect to its products and considers its trademark portfolio as one of its most valuable assets. All of the Company's important trademarks are registered and rigorously enforced.

Environmental

Compliance with federal, state, local, and foreign provisions that have been enacted or adopted regulating the discharge of materials into the environment or otherwise relating to protection of the environment is not expected to have a material effect on the capital expenditures, earnings and competitive position of the Company. Specifically, the Company has taken steps to reduce, control and treat water discharges and air emissions. The Company takes seriously its responsibility to the environment, has embraced renewable energy alternatives and is ready to bring a new hydro – generation facility on line at its Athol, MA plant to reduce its carbon foot print and energy costs, an investment in excess of $1.0 million.

Strategic Activities

Globalization has had a profound impact on product offerings and buying behaviors of industry and consumers in North America and around the world, forcing the Company to adapt to this new, highly competitive business environment. The Company continuously evaluates most aspects of its business, aiming for new world-class ideas to set itself apart from its competition.

Our strategic concentration is on global brand building and providing unique customer value propositions through technically supported application solutions for our customers. Our job is to recommend and produce the best suited standard product or to design and build custom solutions. The combination of the right tool for the job with value added service gives us a competitive advantage. The Company continues its focus on lean manufacturing, plant consolidations, global sourcing, new software and hardware technologies, and improved logistics to optimize its value chain.

The execution of these strategic initiatives has expanded the Company's manufacturing and distribution in developing economies, resulting in international sales revenues totaling 55% of consolidated sales for fiscal 2012.

SEC Filings and Certifications

The Company makes its public filings with the Securities and Exchange Commission ("SEC"), including its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all exhibits and amendments to these reports, available free of charge at its website, www.starrett.com, as soon as reasonably practicable after the Company files such material with the SEC. Information contained on the Company's website is not part of this Annual Report on Form 10-K.

Item 1A – Risk Factors

SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

This Annual Report on Form 10-K and the Company's 2012 Annual Report to Stockholders, including the President's letter, contain forward-looking statements about the Company's business, competition, sales, gross margins, capital expenditures, foreign operations, plans for reorganization, interest rate sensitivity, debt service, liquidity and capital resources, and other operating and capital requirements. In addition, forward-looking statements may be included in future Company documents and in oral statements by Company representatives to security analysts and investors. The Company is subject to risks that could cause actual events to vary materially from such forward-looking statements, including the following risk factors:

Risks Related to Financial Reporting:   If the Company or its independent registered public accounting firm are unable to affirm the effectiveness of internal control over financial reporting in future years, the market value of the Company's common stock could be adversely affected.  The Company's independent registered public accounting firm did audit and report on internal controls over financial reporting as of June 30, 2012 and June 30, 2011.  For the year ended June 30, 2011, a material weakness in internal controls in income tax analysis and reporting was identified.  Management has implemented the remediation steps outlined in the Annual Report on Form 10-K for fiscal 2012, and resolved this financial reporting issue.

Risks Related to the Economy: The Company's results of operations are materially affected by the conditions in the global economy.  As a result of the global economic recession, U.S. and foreign economies have experienced significant declines in employment, household wealth, consumer spending, and lending.  Businesses, including the Company and its customers, faced weakened demand for their products and services, difficulty obtaining access to financing, increased funding costs, and barriers to expanding operations.  While the Company's results of operations in fiscal 2010 were negatively impacted by the global economic recession, business activity improved for the Company in fiscal 2011 and continued to grow in fiscal 2012.  The Company can provide no assurance that the past two fiscal year improvements will continue or that its future results of operations will improve.

Risks Related to Reorganization: The Company continues to evaluate consolidation and reorganization of some of its manufacturing and distribution operations. There can be no assurance that the Company will be successful in these efforts or that any consolidation or reorganization will result in revenue increases or cost savings to the Company. The implementation of these reorganization measures may disrupt the Company's manufacturing and distribution activities, could adversely affect operations, and could result in asset impairment charges and other costs that will be recognized if and when reorganization or restructuring plans are implemented or obligations are incurred.

Risks Related to Technology: Although the Company's strategy includes investment in research and development of new and innovative products to meet technology advances, there can be no assurance that the Company will be successful in competing against new technologies developed by competitors.

Risks Related to Foreign Operations: Approximately 55% of the Company's sales and 66% of net assets related to foreign operations for fiscal 2012. Foreign operations are subject to special risks that can materially affect the sales, profits, cash flows and financial position of the Company, including taxes and other restrictions on distributions and payments, currency exchange rate fluctuations, political and economic instability, inflation, minimum capital requirements and exchange controls.  The Company's Brazilian operations can be very volatile, changing from year to year due to the political situation, currency risk and the economy. As a result, the future performance of the Brazilian operations may be difficult to forecast.

Risks Related to Industrial Manufacturing Sector: The market for most of the Company's products is subject to economic conditions affecting the industrial manufacturing sector, including the level of capital spending by industrial companies and the general movement of manufacturing to low cost foreign countries where the Company does not have a substantial market presence. Accordingly, economic weakness in the industrial manufacturing sector may, and in some cases has, resulted in decreased demand for certain of the Company's products, which adversely affects sales and performance. Economic weakness in the consumer market will also adversely impact the Company's performance. In the event that demand for any of the Company's products declines significantly, the Company could be required to recognize certain costs as well as asset impairment charges on long-lived assets related to those products.

Risks Related to Competition: The Company's business is subject to direct and indirect competition from both domestic and foreign firms. In particular, low cost foreign sources have created severe competitive pricing pressures. Under certain circumstances, including significant changes in U.S. and foreign currency relationships, such pricing pressures tend to reduce unit sales and/or adversely affect the Company's margins.

Risks Related to Insurance Coverage: The Company carries liability, property damage, workers' compensation, medical and other insurance policies that management considers adequate for the protection of its assets and operations. There can be no assurance, however, that the coverage limits of such policies will be adequate to cover all claims and losses. Such uncovered claims and losses could have a material adverse effect on the Company. Depending on the risk, deductibles can be as high as 5% of the loss or $500,000.

Risks Related to Raw Material and Energy Costs: Steel is the principal raw material used in the manufacture of the Company's products. The price of steel has historically fluctuated on a cyclical basis and has often depended on a variety of factors over which the Company has no control. The cost of producing the Company's products is also sensitive to the price of energy. The selling prices of the Company's products have not always increased in response to raw material, energy or other cost increases, and the Company is unable to determine to what extent, if any, it will be able to pass future cost increases through to its customers. The Company's inability to pass increased costs through to its customers could materially and adversely affect its financial condition or results of operations.

Risks Related to Overall Stock Market Performance: Currently, the Company's U.S. defined benefit pension plan is underfunded. The Company will be required to provide an additional $1.5 million to the domestic pension fund in fiscal 2013. The Company could be required to fund the domestic plan in the future.  The Company's UK plan, which is also underfunded, required Company contributions during fiscal 2010, 2011 and 2012.

Risks Related to Acquisitions: Acquisitions involve special risks, including the potential assumption of unanticipated liabilities and contingencies, difficulty in assimilating the operations and personnel of the acquired businesses, disruption of the Company's existing business, dissipation of the Company's limited management resources, and impairment of relationships with employees and customers of the acquired business as a result of changes in ownership and management. While the Company believes that strategic acquisitions can improve its competitiveness and profitability, the failure to successfully integrate and realize the expected benefits of such acquisitions could have an adverse effect on the Company's business, financial condition and operating results. 

Risks Related to Investor Expectations: The Company's share price remained relatively stable in fiscal 2012   The price rose steadily through the first three quarters of fiscal 2012 before declining in the fourth quarter.  The Company's earnings may not continue to grow at rates similar to the growth rates achieved in recent years and may fall short of either a prior quarter or investors' expectations. If the Company fails to meet the expectations of securities analysts or investors, the Company's share price may decline.

Risks Related to Information Systems: The efficient operation of the Company's business is dependent on its information systems, including its ability to operate them effectively and to successfully implement new technologies, systems, controls and adequate disaster recovery systems.  In addition, the Company must protect the confidentiality of data of its business, employees, customers and other third parties. The failure of the Company's information systems to perform as designed or its failure to implement and operate them effectively could disrupt the Company's business or subject it to liability and thereby harm its profitability. For those reasons, the Company implemented a new Enterprise Resource Planning (ERP) system in fiscal 2010 at its principal North American locations.

Risks Related to Litigation and Changes in Laws, Regulations and Accounting Rules: Various aspects of the Company's operations are subject to federal, state, local or foreign laws, rules and regulations, any of which may change from time to time. Generally accepted accounting principles may change from time to time, as well. In addition, the Company is regularly involved in various litigation matters that arise in the ordinary course of business. Litigation, regulatory developments and changes in accounting rules and principles could adversely affect the Company's business operations and financial performance.

Item 1B – Unresolved Staff Comments

None.

Item 2 - Properties

The Company's principal plant and its corporate headquarters are located in Athol, MA on approximately 15 acres of Company-owned land. The plant consists of 25 buildings, mostly of brick construction of varying dates, with approximately 535,000 square feet.

The Company's Webber Gage Division in Cleveland, OH, owns and occupies two buildings totaling approximately 50,000 square feet.

The Company-owned facility in Mt. Airy, NC consists of one building totaling approximately 320,000 square feet. It is occupied by the Company's Saw Division, Ground Flat Stock Division and a distribution center. A separate 36,000 square foot building which formerly housed the distribution center was vacated in November 2008 and is currently listed for sale.

A manufacturing and warehousing facility in North Charleston encompassing 173,000 square feet was closed in fiscal 2005 and the building was sold in fiscal 2011.

The Company's subsidiary in Itu, Brazil owns and occupies several buildings totaling 209,000 square feet.

The Company's subsidiary in Jedburgh, Scotland owns and occupies a 175,000 square foot building.

A wholly owned manufacturing subsidiary in The People's Republic of China leases a 133,000 square foot building in Suzhou.  In fiscal 2012, the Company closed a 5,000 square foot Shanghai distribution center and sales office, consolidated the distribution into the Suzhou facility and leased a new sales office in Shanghai.

The Tru-Stone Division owns and occupies a106,000 square foot facility in Waite Park, MN.

The Kinemetric Engineering Division occupies a 18,000 square foot leased facility in Laguna Hills, CA.

The Bytewise Division occupies a 10,000 square foot leased facility in Columbus, GA.

In addition, the Company operates warehouses and/or sales-support offices in the U.S., Canada, Australia, New Zealand, Mexico, Germany, Singapore and Japan.  

In the Company's opinion, all of its property, plants and equipment are in good operating condition, well maintained and adequate for its needs.

Item 3 - Legal Proceedings

The Company is, in the ordinary course of business, from time to time involved in litigation that is not considered material to its financial condition or operations.

Item 4 – Mine Safety Disclosures

Not applicable.

PART II

Item 5 - Market for the Company's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The Company's Class A common stock is traded on the New York Stock Exchange. Quarterly dividend and high/low closing market price information is presented in the table below. The Company's Class B common stock is generally nontransferable, except to lineal descendants, and thus has no established trading market, but it can be converted into Class A common stock at any time. The Class B common stock was issued on October 5, 1988, and the Company has paid the same dividends thereon as have been paid on the Class A common stock since that date. On June 30, 2012, there were approximately 1,410 registered holders of Class A common stock and approximately 1,167 registered holders of Class B common stock.

The Company's dividend policy is subject to periodic review by the Board of Directors. Based upon economic conditions, the Board of Directors decided to maintain the quarterly dividend at $0.10 for all quarters of fiscal 2012.

ISSUER PURCHASES OF EQUITY SECURITIES

Summary of Stock Repurchases:

A summary of the Company's repurchases of shares of its common stock for the fourth quarter fiscal 2012 is as follows:

PERFORMANCE GRAPH

The following graph sets forth information comparing the cumulative total return to holders of the Company's Class A common stock over the last five fiscal years with (1) the cumulative total return of the Russell 2000 Index ("Russell 2000") and (2) a peer group index (the "Peer Group") reflecting the cumulative total returns of certain small cap manufacturing companies as described below. The peer group is comprised of the following companies: Acme United, Q.E.P. Co. Inc., Badger Meter, Federal Screw Works, National Presto Industries, Regal-Beloit Corp., Tecumseh Products Co., Tennant Company, The Eastern Company and WD-40.

Item 6 - Selected Financial Data

The following selected condensed financial data has been derived from and should be read in conjunction with "Management Discussion and Analysis of Financial Condition and Results of Operations" and our Consolidated Financial Statements and notes thereto, included elsewhere in this annual report on Form 10-K.

Items 7 and 7A- Management's Discussion and Analysis of Financial Condition and Results of Operations and Quantitative and Qualitative Disclosure about Market Risk

RESULTS OF OPERATIONS

Fiscal 2012 Compared to Fiscal 2011

Overview

Solid revenue growth continued in fiscal 2012 as sales increased over a strong fiscal 2011.  The Company was not immune to the financial volatility over the past twelve months. Lower long-term interest rates driven by Federal Reserve policy led to  the discount rate falling to historic lows.  As a result the Company recognized a significantly higher pension liability, and a $17.2 million non-cash pension expense, of which $15.2 million was recorded in the fourth quarter  of fiscal 2012.  The eight fold increase over normal pension expense negatively impacted gross margin and selling, general and administrative expenses and was the prime driver in a net loss in the fourth quarter and near breakeven results for the year.  The Company closed its Dominican Republic facility in December 2011 and added advanced metrology technology through its acquisition of Bytewise in November 2011,

Net sales for fiscal 2012 increased $15.3 million or 6.3% compared to fiscal 2011 due to a recovering manufacturing sector and increased market penetration.  Gross margins declined $3.7 million from $81.8 million or 33 % of sales in fiscal 2011 to $78.1million or 30% of sales in fiscal 2012.  Selling, general and administrative expenses increased $9.2 million or 13% from $70.8 million in fiscal 2011 to $78.0 million in fiscal 2012.  Operating income declined $14.3 million from a profit of $12.4 million in fiscal 2011 to a loss of $1.9 million in fiscal 2012.  All of these changes, as more fully described below, were significantly affected by the pension expense noted above.

Net Sales

Net sales in North America increased $9.4 million or 8% from $119.7 million in fiscal 2011 to $129.1 million in fiscal 2012.  All divisions, excluding Tru Stone,  posted gains led by precision tools.  The Bytewise acquisition represented $6.1 million of the gain.  International sales increased $5.9 million or 5% from $125.1 million in fiscal 2011 to $131.0 million in fiscal 2012.  Foreign currency exchange rate fluctuations represented a marginal unfavorable impact of $0.9 million..  All international subsidiaries achieved sales increases and account for over 50% of the Company's global revenues.  The Company is cautiously optimistic about fiscal 2013 based upon orders in the fourth quarter of fiscal 2012; however, recent unfavorable economic news could have a negative impact on the year.

Gross Margin

Gross margin in North America decreased $5.4 million or 15% from $35.2 million in fiscal 2011 to $29.8 million in fiscal 2012 and declined as a percentage of sales from 29% in fiscal 2011 to 23% in fiscal 2012.  Higher sales and improved efficiencies contributed $1.2 million and $6.8 million, respectively.  However, these gains were offset by an increase in non-cash pension expense of $13.4 million.  Higher production levels for precision tools and saws were the primary factor influencing the improvement in efficiencies coupled with the contribution of the newly acquired higher margin Bytewise business.   International gross margins increased $1.7 million or 4% from $46.6 million in fiscal 2011 to $48.3 million in fiscal 2012 and remained level as a percentage of sales at 37% in both fiscal 2011 and 2012.  Foreign exchange rate fluctuations represented an unfavorable charge of $0.3.million.  Improvements in China were offset by declines in Europe.

Selling, General and Administrative Expenses

North American selling, general and administrative expenses increased $4.7 million or 13%.   Employee benefits increased $4.7 million principally due to a $3.0 million increase in non-cash pension expense, all of which was related to a decrease in the discount rate used to measure the pension benefit obligation.  Salaries and insurance expenses increased $0.4 and $0.2 million, respectively.  International selling, general and administrative expenses increased $4.5 million or 13% due to a $0.8 million bad debt; a $0.6 million increase in research and development expenses; and increased selling expenses, particularly in South America, related to increased competition including: $0.6 for advertising and marketing, $0.4 million in commissions and $0.3 travel and entertainment.  International salaries and benefits also increased $0.7 million.

Operating Loss

Higher sales and improved gross margins were more than offset by a $16.4 million increase in North American non-cash pension expense resulting in a $1.9 million operating loss.  The discount rate used for valuing  the pension liability declined from 5.44% as of June 30, 2011 to 3.92% as of June 30, 2012 and increased the pension liability by $21.0 million, which was the prime driver behind the increase in pension expense.

Other Income, Net

Other income, net increased $1.1 million from $0.8 in fiscal 2011 to $1.9 million in fiscal 2012 primarily due to foreign currency exchange rate changes.

Income Taxes

The effective tax rate was a benefit of 700%  for fiscal 2012.  The rate reflects federal, state and foreign adjustments for permanent book tax differences.   The principal reason for the rate significantly greater than the US normalized combined federal and state tax rate of approximately 40% includes the very low book income which causes even small dollar adjustments to have a very large impact on the tax rate.   One significant item which reduced tax expense is income earned in foreign countries taxed at rates lower than the US tax rate.

There were no significant changes in valuation allowances relating to carryforwards for foreign NOL's, foreign tax credits and certain state NOL's.  The Company continues to believe that it is more likely than not that it will be able to utilize its domestic federal net operating loss carryforward of approximately $16.8 million.

Significant Fourth Quarter Activity

As discussed in Note 16, the Company recorded a $9.1 million loss before income taxes in the fourth quarter of fiscal 2012 compared to a $4.5 million profit in fiscal 2011 as $15.7 million of the annual $17.2 million pension expense was recorded in the fourth quarter of fiscal 2012.  The "mark to market" method of pension accounting which the Company adopted in fiscal 2011 specifies the pension liability must be valued on the last day of the fiscal year and the resulting pension expense adjustment must be recorded in the fourth quarter.

Consolidated sales decreased $1.2 million or 2% from $71.2 million in fiscal 2011 to $70.0 million in fiscal 2012 with North America representing a $1.2 million increase and International a $2.4 million decrease.   The impact of the $15.9 million non-cash pension expense in fiscal 2012 significantly distorts fourth quarter gross margin and selling, general and administrative comparisons to fiscal 2011.

Fiscal 2011 Compared to Fiscal 2010

As further explained in Note 2 to the consolidated financial statements in fiscal 2011, the Company changed its fiscal year end from the last Saturday in June to June 30.  This change facilitated an improved closing process and conformed North American to International subsidiaries' year end.  In fiscal 2010, the Company changed the fiscal year end of its international subsidiaries to that of the Company.  Those subsidiaries previously reported on a one-month lag.  Management has concluded that the effects of the change from a fiscal to a calendar year end and the inclusion of the additional month for its international subsidiaries in fiscal 2010 are immaterial to the consolidated financial statements.

Overview

The Company began to experience an economic upturn in the second quarter of fiscal 2010.  To service higher demand the Company began to increase manufacturing output, inventory raw material purchases, and selling, general, and administrative expenses globally in the third quarter of fiscal 2010.  Sales increased $21.5 million or 24% in the second half of fiscal 2011 compared to the first half of fiscal 2010. Sales in the first half of 2011 were $23.7 million or 26% higher than in the first half of 2010.  The Company experienced higher backorder levels in the first half of fiscal 2011 as a result of the inability to quickly adjust inventory and manufacturing staffing levels to match demand, however, this backorder position decreased in the second half of fiscal 2011.

Net sales for fiscal 2011 increased $41.1 million or 20% compared to fiscal 2010 due to global economic recovery and increased market penetration.  Gross margins improved $25.4 million from $56.4 million or 28% of sales in fiscal 2010 to $81.8 million or 33% of sales in fiscal 2011.  Selling, general and administrative expenses increased $6.7 million or 10% from $64.1 million in fiscal 2010 to $70.8 million in fiscal 2011.  Operating income increased $21.8 million from a loss of $9.4 million in fiscal 2010 to a profit of $12.4 million in fiscal 2011.

Net Sales

Net sales in North America increased $22.6 million or 23% from $97.1 million in fiscal 2010 to $119.7 million in fiscal 2011.  All divisions posted gains except Evans Rule, which lost the Sears contract in the fourth quarter of fiscal 2010.  Tru-Stone and Kinemetric benefited from renewed capital equipment markets registering sales increases in fiscal 2011 of 64% and 71%, respectively, as our customers reinvested in their businesses.  International sales, excluding U.S. exports, increased $18.5 million or 17% from $106.6 million in fiscal 2010 to $125.1 million in fiscal 2011.  Foreign currency exchange rate fluctuations represented $8.1 million of the sales gain principally due to a weaker U.S. dollar.  All International subsidiaries achieved double digit sales increases and account for over 50% of the Company's global revenues.  

Gross Margin

Gross margin in North America increased $10.8 million or 44% from $24.5 million in fiscal 2010 to $35.3 million in fiscal 2011 and improved as a percentage of sales from 25.3% in fiscal 2010 to 29.5% in fiscal 2011.  Higher sales, improved manufacturing efficiencies, and a reduction in pension cost were the key drivers in the improved margin performance.  In addition, the gross margin improvement overcame an unfavorable LIFO swing of $9.5 million based upon a reduction in cost of sales of $8.5 million in fiscal 2010 to an increase in cost of sales of $1.0 million in fiscal 2011.  The change in LIFO was the result of lower inventories during the recession in fiscal 2010 compared to an increase in inventories in conjunction with the economic recovery in fiscal 2011.  International gross margins increased $14.6 million or 46% from $31.9 million in fiscal 2010 to $46.5 million in fiscal 2011 and improved as a percentage of sales from 30% in fiscal 2010 to 37% in fiscal 2011.  Higher sales, improved manufacturing efficiencies, lower pension expense and favorable foreign exchange rates all contributed to the improved international gross margins.

Selling, General and Administrative Expenses

North American selling, general and administrative expenses increased $3.6 million or 11% but declined as a percentage of sales from 33% in fiscal 2010 to 30% in fiscal 2011.   Salaries and benefits in North America increased $2.2 million in fiscal 2011 compared to fiscal 2010, principally due to the restoration of previous salary reductions, a 3% salary increase and higher medical costs.  Higher sales also resulted in a $0.9 million increase in travel and commission expenses.  International selling, general and administrative expenses increased $3.1 million or 10% and declined from 30% to 28% of sales.  Salaries and benefits increased $2.5 million due to restoration of previous salary reductions, while increased sales resulted in a $1.3 million increase in travel and commission expenses.  These expense increases were partially offset by a $2.2 million reduction in pension expense.

Operating Profit

Operating income in fiscal 2011 of $12.4 million represented a $21.8 million improvement from an operating loss of $9.4 million in fiscal 2010.  Higher sales and improved margins accounted for $11.4 and $14.0 million, respectively, of the $25.4 million gross margin improvement and offset the selling, general and administrative increase of $6.7 million. The net impact of combined losses related to restructuring costs and goodwill impairment of $1.7 million in fiscal 2010 compared to a $1.3 million gain on the sale of a building in fiscal 2011 represents the incremental operating profit improvement of $3.0 million.

Other Income, Net

Higher interest income was the primary factor for the $0.7 million improvement in other income, net.

Income Taxes

The effective tax rate for fiscal 2011 was 48%.  The principal reason for the 8% increase over a normalized combined federal and state statutory tax rate of 40% is book losses not benefited principally in the Dominican Republic and China as well as an increase in the valuation allowance for losses in Argentina.

There were no significant changes in the valuation allowance relating to foreign tax credits. There was an increase in the valuation allowance for state NOL's and a reduction relating to realization of NOL benefits for certain foreign subsidiaries.  The Company continues to believe that it is more likely than not that it will be able to utilize its domestic federal net operating loss carryforward of approximately $21.9 million.

Significant Fourth Quarter Activity

The Company recorded a $4.5 million profit before taxes in the fourth quarter of fiscal 2011 compared to a comparable $1.5 million loss in fiscal 2010.

Consolidated sales increased $7.4 million or 12 % from $63.9 million in fiscal 2010 to $71.3 million in fiscal 2011 with North America representing $7.3 million of the increase.  International sales increase was modest due to three months of sales in fiscal 2011 compared to four months in fiscal 2010.  The four months in fiscal 2010 for International was a result of dropping the one month lag.  Higher sales and improved margins generated a $5.3 million increase in gross margins which more than offset a $0.6 million increase in selling, general and administrative expenses resulting in a $4.7 million net contribution to profits.  The remaining $1.5 comparative profit improvement was principally due to losses of $1.7 million related to restructuring and impairment charges in fiscal 2010 compared to no similar costs in fiscal 2011.

FINANCIAL INSTRUMENT MARKET RISK

Market risk is the potential change in a financial instrument's value caused by fluctuations in interest and currency exchange rates, and equity and commodity prices. The Company's operating activities expose it to risks that are continually monitored, evaluated and managed. Proper management of these risks helps reduce the likelihood of earnings volatility.

The Company does not engage in tracking, market-making or other speculative activities in derivatives markets. The Company does not enter into long-term supply contracts with either fixed prices or quantities. The Company engages in an immaterial amount of hedging activity to minimize the impact of foreign currency fluctuations and had $2.0 million in forward currency contracts outstanding at June 30, 2012.  Net foreign monetary assets are approximately $35 million as of June 30, 2012.

A 10% change in interest rates would not have a significant impact on the aggregate net fair value of the Company's interest rate sensitive financial instruments or the cash flows or future earnings associated with those financial instruments.    A 10% increase in interest rates would not have a material impact on our borrowing costs.  See Note 12 to the Consolidated Financial Statements for details concerning the Company's long-term debt outstanding of $29.4 million.

LIQUIDITY AND CAPITAL RESOURCES

The Company has a working capital ratio of 5.0 as of June 30, 2012 as compared to  3.9 as of June 30, 2011.  Cash, short-term investments, accounts receivable and inventories represent 90% and 92% of current assets in fiscal 2012 and fiscal 2011, respectively.  The Company had accounts receivable turnover of 6.0 in fiscal 2012 compared to 6.2 in fiscal 2011 and an inventory turnover ratio of 2.8 in fiscal 2012 compared to 3.2 in fiscal 2011.

Net cash provided by operations of $3.5 million in fiscal 2012 is principally due to operating performance improvement (excluding a non-cash pension expense increase of $16.4 million) partially offset by higher inventory levels.

The Company has invested $25.9 million in fiscal 2012.  The Bytewise acquisition represented $15.1 million and investments in plant and equipment accounted for an additional $10.8 million.

 The Company increased debt $22.2 million in fiscal 2012 compared to fiscal 2011 principally to finance the Bytewise acquisition and higher working capital requirements.

Effects of translation rate changes on cash primarily result from the movement of the U.S. dollar against the British Pound, the Euro and the Brazilian Real. The Company uses a limited number of forward contracts to hedge some of this activity and a natural hedge strategy of paying for foreign purchases in local currency when economically advantageous.

Liquidity and Credit Arrangements

The Company believes it maintains sufficient liquidity and has the resources to fund its operations in the near term.  In addition to its cash and short-term investments, the Company has maintained a $23.0 million line of credit, of which, $0.2 million is reserved for letters of credit and $15.5 million was outstanding as of June 30, 2012.  

On June 30, 2009, The L.S. Starrett Company (the "Company") and certain subsidiaries of the Company subsidiaries (the "Subsidiaries") entered into a Loan and Security Agreement (the "Credit Facility") with TD Bank, N.A.. The amended Credit Facility is scheduled to mature on April 30, 2015 and bears interest at LIBOR plus 1.50%.

The obligations under the Credit Facility are unsecured.  However, in the event of certain triggering events, the obligations under the Credit Facility will become secured by the assets of the Company and the subsidiaries party to the Credit Facility.  Triggering events are two consecutive quarters of failure to achieve the financial covenants outlined in Note 12.

Availability under the Credit Facility is subject to a borrowing base comprised of accounts receivable and inventory. The Company believes that the borrowing base will consistently produce availability under the Credit Facility in excess of $23.0 million. As of August 31, 2012, the Company had borrowings of $15.5 million under the Credit Facility.

OFF-BALANCE SHEET ARRANGEMENTS

The Company does not have any material off-balance sheet arrangements as defined under the Securities and Exchange Commission rules.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. The second footnote to the Company's Consolidated Financial Statements describes the significant accounting policies and methods used in the preparation of the consolidated financial statements.

Judgments, assumptions, and estimates are used for, but not limited to, the allowance for doubtful accounts receivable and returned goods; inventory allowances; income tax reserves; employee turnover, discount and return rates used to calculate pension obligations.

Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the Company's Consolidated Financial Statements. The following sections describe the Company's critical accounting policies.

Revenue Recognition and Accounts Receivable : Sales of merchandise and freight billed to customers are recognized when products are delivered, title and risk of loss has passed to the customer, no significant post delivery obligations remain and collection of the resulting receivable is reasonably assured. Sales are net of provisions for cash discounts, returns, customer discounts (such as volume or trade discounts), cooperative advertising and other sales related discounts.  Cooperative advertising payments made to customers are included as advertising expense in selling, general and administrative in the Consolidated Statements of Operations.  While the Company does allow its customers the right to return in certain circumstances, revenue is not deferred, but rather a reserve for sales returns is provided based on experience, which historically has not been significant.

The allowance for doubtful accounts of $1 million and $0.4 million at the end of fiscal 2012 and 2011, respectively, is based on our assessment of the collectability of specific customer accounts and the aging of our accounts receivable. The $0.6 million increase in doubtful accounts is principally the result of a $0.8 million reserve for a foreign customer previously reported in the fiscal 2012 first quarter. While the Company believes that the allowance for doubtful accounts is adequate, if there is a deterioration of a major customer's credit worthiness, actual defaults are higher than our previous experience, or actual future returns do not reflect historical trends, the estimates of the recoverability of the amounts due the Company and sales could be adversely affected.

Inventory Valuation :  Inventory purchases and commitments are based upon future demand forecasts. If there is a sudden and significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and requirements, the Company may be required to increase the inventory reserve and, as a result, gross profit margin could be adversely affected.

Long-lived Assets and Goodwill :  The Company values property, plant and equipment (PP&E) at historical cost less accumulated depreciation. Impairment losses are recorded when indicators of impairment, such as plant closures, are present and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount. The Company continually reviews for such impairment and believes that PP&E is being carried at its appropriate value.

The Company assesses the fair value of its goodwill generally based upon a discounted cash flow methodology. The discounted cash flows are estimated utilizing various assumptions regarding future revenue and expenses, working capital, terminal value, and market discount rates. If the carrying amount of the goodwill is greater than the fair value, an impairment charge is recognized to the extent the recorded goodwill exceeds the implied fair value of goodwill.  The Company will perform its annual assessment of goodwill resulting from the Bytewise acquisition as of October 1.  As permitted by ASU 2011-08, the Company is evaluating whether it will utilize a qualitative approach in performing this assessment.

Our long-lived assets consist primarily of property, plant and equipment. The Company groups long-lived assets for impairment analysis by division and/or product line.  Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of such an asset may not be recoverable. Such events or circumstances include, but are not limited to, a significant decrease in the fair value of the underlying business or change in utilization of property and equipment.

Recoverability of the net book value of property, plant and equipment is measured by comparison of the carrying amount to estimated future undiscounted net cash flows the assets are expected to generate. Those cash flows include an estimated terminal value based on a hypothetical sale at the end of the assets' depreciation period. Estimating these cash flows and terminal values requires management to make judgments about the growth in demand for our products, sustainability of gross margins, and our ability to achieve economies of scale. If assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the long-lived asset exceeds its fair value.

Depreciation is included in cost of goods sold and selling, general and administrative expenses in the Consolidated Statement of Operations based upon where the assets are contributing to the measurement of cost or expense by functional area. Depreciation of equipment used in the manufacturing process is a component of inventory and included in costs of goods sold.  Depreciation of equipment used for office and administrative functions is an expense in selling, general and administrative expenses.

Income Taxes :  Accounting for income taxes requires estimates of future benefits and tax liabilities. Due to temporary differences in the timing of recognition of items included in income for accounting and tax purposes, deferred tax assets or liabilities are recorded to reflect the impact arising from these differences on future tax payments. With respect to recorded tax assets, the Company assesses the likelihood that the asset will be realized. If realization is in doubt because of uncertainty regarding future profitability or enacted tax rates, the Company provides a valuation allowance related to the asset. Should any significant changes in the tax law or the estimate of the necessary valuation allowance occur, the Company would record the impact of the change, which could have a material effect on our financial position or results of operations.

Defined Benefit Pension Plans: The Company has two defined benefit pension plans, one for U.S. employees and another for U.K. employees.

In 2011, we elected to retrospectively change our method of recognizing certain actuarial gains and losses. Previously, the market related value of plan assets for the U.S. plan was equal to fair value, and the market-related value of plan assets for the U.K. plan, was based on a calculated five-year moving average of market value. Actuarial gains and losses were recognized in other comprehensive income as of the measurement date.  Net actuarial gains or losses in excess of ten percent (10%) of the greater of the market-related value of plan assets or of the plans' projected benefit obligation ( the corridor ) were amortized in net periodic benefit cost over the average remaining service period (fourteen-years). The primary factors contributing to actuarial gains and losses are changes in the discount rate used to value pension obligations as of the measurement date each year and the differences between expected and actual returns on plan assets.

Under our current accounting method, both plans use fair value as the market-related value of plan assets and continue to recognize actuarial gains or losses within the corridor in other comprehensive income but instead of amortizing net actuarial gains or losses in excess of the corridor in future periods, excess gains and losses will be recognized in net periodic (benefit) cost as of the plan measurement date, which is the same as the fiscal year end of the Company ( MTM adjustment ). This accounting method is a permitted option which results in immediate recognition of excess net actuarial gains and losses in net periodic benefit cost instead of in other comprehensive income.  Immediate recognition in net periodic benefit cost could potentially increase the volatility of net periodic benefit cost. The MTM adjustments to net periodic benefit cost for 2012, 2011 and 2010 were $15.3, $0.0, and $9.4 million, respectively.

Calculation of pension and postretirement medical costs and obligations are dependent on actuarial assumptions.  These assumptions include discount rates, healthcare cost trends, inflation, salary growth, long-term return on plan assets, employee turnover rates, retirement rates, mortality and other factors. These assumptions are made based on a combination of external market factors, actual historical experience, long-term trend analysis, and an analysis of the assumptions being used by other companies with similar plans. Significant differences in actual experience or significant changes in assumptions would affect pension and other postretirement benefit costs and obligations. See also Employee Benefit Plans (Note 11 to the Consolidated Financial Statements).

Cost of Goods Sold :  The Company includes material direct and indirect labor and manufacturing overhead in cost of goods sold.  Included in these costs are inbound freight, personnel (manufacturing plants only), receiving costs, internal transferring, employee benefits (including pension expense) and inspection costs.

Selling General and Administrative Expenses :  The Company includes distribution expenses in selling, general and administrative expenses.  Distribution expenses include shipping labor and warehousing costs associated with the storage of finished goods at each manufacturing facility.  The Company also includes costs for our dedicated distribution centers as selling expenses.  Employee benefits, including pension expense, are also included in selling, general and administrative expenses.

CONTRACTUAL OBLIGATIONS

The following table summarizes future estimated payment obligations by period.

ANNUAL NYSE CEO CERTIFICATION AND SARBANES-OXLEY SECTION 302 CERTIFICATIONS

In fiscal 2012, the Company submitted an unqualified "Annual CEO Certification" to the New York Stock Exchange as required by Section 303A.12(a) of the New York Stock Exchange Listed Company Manual. Further, the Company is filing with the Securities and Exchange Commission the certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 as exhibits to the Company's Annual Report on Form 10-K.

Item 8 - Financial Statements and Supplementary Data

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders

The L.S. Starrett Company

We have audited the accompanying consolidated balance sheets of The L.S. Starrett Company and subsidiaries ("the Company") as of June 30, 2012 and 2011, and the related consolidated statements of operations, stockholders' equity and comprehensive income (loss), and cash flows for each of the three years in the period ended June 30, 2012.  Our audits of the basic consolidated financial statements included the financial statement schedule listed in the index appearing under Item 15(a)(2).  These financial statements and financial statement schedule are the responsibility of the Company's management.  Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The L.S. Starrett Company and subsidiaries as of June 30, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2012 in conformity with accounting principles generally accepted in the United States of America.  Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

THE L.S. STARRETT COMPANY

Consolidated Balance Sheets

(in thousands except share data)

 See notes to consolidated audited financial statements

THE L.S. STARRETT COMPANY

Consolidated Statements of Operations

For the three years ended June 30, 2012

 (in thousands except per share data)

See notes to consolidated audited financial statements

THE L.S. STARRETT COMPANY

Consolidated Statements of Stockholders' Equity and Comprehensive Income (Loss)

For the three years ended June 30, 2012

(in thousands except per share data)

See notes to consolidated audited financial statements 

For the three years ended June 30, 2012

 (in thousands)

See notes to consolidated audited financial statements

THE L.S. STARRETT COMPANY

Notes to Consolidated Financial Statements

June 30, 2012 and 2011

1. DESCRIPTION OF BUSINESS

The L. S. Starrett Company (the "Company") is incorporated in the Commonwealth of Massachusetts and is in the business of manufacturing industrial, professional and consumer measuring and cutting tools and related products. The largest consumer of these products is the metalworking industry, but others include automotive, aviation, marine, farm, do-it-yourselfers and tradesmen such as builders, carpenters, plumbers and electricians.

2. SIGNIFICANT ACCOUNTING POLICIES

Principles of consolidation : The consolidated financial statements include the accounts of The L. S. Starrett Company and its subsidiaries, all of which are wholly-owned. All significant intercompany items have been eliminated in consolidation. The Company's fiscal year ends on June 30 effective for fiscal year 2011. Previously the fiscal year ended on the last Saturday in June.  Fiscal year 2010 represents a 52 week year.  This change in reporting period was not considered material to the Company's results of operations, therefore the results of operations for fiscal 2010 have not been restated.

Financial instruments and derivatives : The Company's financial instruments include cash, investments and long term debt. Investments are stated at cost which approximates fair market value. The carrying value of long-term debt, which is at current market interest rates, also approximates its fair value.    The Company's U.K. subsidiary entered into various forward exchange contracts. The amount of contracts outstanding as of June 30, 2012 and June 30, 2011 amounted to $2.0 million and $10.7 million, respectively.

Accounts receivable : Accounts receivable consist of trade receivables from customers. The expense for bad debts amounted to $0.8, $0.3, and $0.1 million in fiscal 2012, 2011 and 2010, respectively. In establishing the allowance for doubtful accounts, management considers historical losses, the aging of receivables and existing economic conditions.

Inventories : Inventories are stated at the lower of cost or market. Substantially all United States inventories are valued using the last-in-first-out ("LIFO") method of accounting.  All non-U.S. subsidiaries use the first-in-first-out ("FIFO") method or the average cost method, as LIFO is not an accepted method of inventory valuation outside the U.S.

Long-lived assets : The cost of buildings and equipment is depreciated using straight-line and accelerated methods over their estimated useful lives as follows: buildings and building improvements 10 to 50 years, machinery and equipment 3 to 12 years. Leases are capitalized under the criteria set forth in Accounting Standards Codification (ASC) 840, "Leases" which establishes the four criteria of a capital lease.  At least one of the four following criteria must be met for a lease to be considered a capital lease:  a transfer of ownership of the property to the lessee by the end of the lease term; a bargain purchase option; a lease term that is greater than or equal to 75 percent of the economic life of the leased property; present value of the future minimum lease payments equals or exceeds 90 percent of the fair market value of the leased property.  If none of the aforementioned criteria are met, the lease will be an operating lease. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less cost to sell. A gain or loss is recorded on individual fixed assets when retired or disposed of. Included in buildings and building improvements and machinery and equipment at June 30, 2012 and June 30, 2011 were $3.3 million and $5.0 million, respectively, of construction in progress.  Also included in machinery and equipment at June 30, 2012 and June 30, 2011 were $0.5 million and $0.5 million net of depreciation, respectively, of capitalized interest cost. Repairs and maintenance of equipment are expensed as incurred.

Intangible assets and goodwil l: Intangibles are recorded at cost and are amortized on a straight-line basis over a 5-14 year period. Patents are amortized over 15 years. Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired businesses. Goodwill is not subject to amortization but is tested for impairment annually and at any time when events suggest impairment may have occurred. The Company will annually test the goodwill associated with the November 2011 acquisition of Bytewise as of October 1.. The Company assesses the fair value of its goodwill using impairment tests, generally based upon a discounted cash flow methodology. The discounted cash flows are estimated utilizing various assumptions regarding future revenue and expenses, working capital, terminal value and market discount rates. In the event that the carrying value of goodwill exceeds the fair value of the goodwill, an impairment loss would be recorded for the amount of that excess.  

Revenue recognition : Sales of merchandise and freight billed to customers are recognized when title and risk of loss has passed to the customer, no significant post delivery obligations remain and collection of the resulting receivable is reasonably assured. Sales are presented net of provisions for cash discounts, returns, customer discounts (such as volume or trade discounts), cooperative advertising and other sales related discounts.   Cooperative advertising payments made to customers are included as advertising expense in selling, general and administrative in the Consolidated Statements of Operations.  While the Company does allow its customers the right to return in certain circumstances, revenue is not deferred, but rather a reserve for sales returns is provided based on experience, which historically has not been significant.

Advertising costs : The Company's policy is to generally expense advertising costs as incurred, except catalogs costs, which are deferred until mailed.  Advertising costs were expensed as follows: $5.6 million in fiscal 2012, $5.1 million in fiscal 2011 and $5.0 million in fiscal 2010 and are included in selling, general and administrative expenses.

Freight costs : The cost of outbound freight and the cost for inbound freight included in material purchase costs are both included in cost of sales.

Warranty expense : The Company's warranty obligation is generally one year from shipment to the end user and is affected by product failure rates, material usage, and service delivery costs incurred in correcting a product failure. Historically, the Company has not incurred significant warranty expense and consequently its warranty reserves are not material.

Pension and Other Postretirement Benefits:

The Company has two defined benefit pension plans, one for U.S. employees and another for U.K. employees.  The Company also has defined contribution plans.  In addition, certain U.S. employees participate in an Employee Stock Ownership Plan (ESOP).

The Company sponsors both funded and unfunded U.S. and non-U.S. defined benefit pension plans covering the majority of our U.S. and U.K. employees. The Company also sponsors postretirement benefit plans that provide health care benefits and life insurance coverage to eligible U.S. retirees. In 2011, the Company elected to retrospectively change its method of recognizing certain actuarial gains and losses. Previously, the market related value of plan assets for the U.S. plan was equal to fair value, and the market-related value of plan assets for the U.K. plan was based on a calculated five-year moving average of market value. Actuarial gains and losses were recognized in other comprehensive income as of the measurement date.  Net actuarial gains or losses in excess of ten percent (10%) of the greater of the market-related value of plan assets or of the plans' projected benefit obligation ( the corridor ) were amortized in net periodic benefit cost over the average remaining service period (currently fourteen-years). The primary factors contributing to actuarial gains and losses were changes in the discount rate used to value pension obligations as of the measurement date each year and the differences between expected and actual returns on plan assets.

Under the Company's current accounting method, both plans use fair value as the market-related value of plan assets and continue to recognize actuarial gains or losses within the corridor in other comprehensive income (loss) but instead of amortizing net actuarial gains or losses in excess of the corridor in future periods, such excess gains and losses, if any, are recognized in net periodic benefit cost as of the plan measurement date, which is the same as the fiscal year end of the Company ( MTM adjustment ). This method is a permitted option which results in immediate recognition of excess net actuarial gains and losses in net periodic benefit cost instead of in other comprehensive income (loss).  Such immediate recognition in net periodic benefit cost could potentially increase the volatility of net periodic benefit cost. The MTM adjustments to net periodic benefit cost for fiscal 2012, 2011 and 2010 were $ 15.3 million, $0.0 million, and $9.4 million, respectively.

Income taxes : Deferred tax expense results from differences in the timing of certain transactions for financial reporting and tax purposes. Deferred taxes have not been recorded on approximately $71.7 million of undistributed earnings of foreign subsidiaries as of June 30, 2012 or the related unrealized translation adjustments because such amounts are considered permanently invested. In addition, it is possible that remittance taxes, if any, would be reduced by U.S. foreign tax credits. Valuation allowances are recognized if, based on the available evidence, it is more likely than not that some portion of the deferred tax assets will not be realized.

Research and development : Research and development costs are expensed as incurred and were as follows: $2.2 million in fiscal 2012, $1.9 million in fiscal 2011 and $1.3 million in fiscal 2010 and are included in selling general and administrative expenses.

Earnings per share (EPS) : Basic EPS is computed by dividing earnings available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution by securities that could share in the earnings. The Company had 36,555, 19,236, and 12,687 of potentially dilutive common shares in fiscal 2012, 2011 and 2010, respectively, resulting from shares issuable under its stock option plan. For fiscal year 2012 and 2011, these shares had no impact on the calculated per share amounts. These additional shares are not used for the diluted EPS calculation in loss years.

Translation of foreign currencies : The financial statements of our foreign subsidiaries, where the local currency is the functional currency, are translated at exchange rates in effect on reporting dates, and income and expense items are translated at average rates or rates in effect on transaction dates as appropriate. The resulting foreign currency translation adjustments are charged or credited directly to the "Accumulated Other Comprehensive Loss" account included as part of stockholders' equity.  Net foreign currency gains (losses) are disclosed in Note 9.

Use of accounting estimates : The preparation of the financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of sales and expenses during the reporting period. Judgments, assumptions and estimates are used for, but not limited to: the allowances for doubtful accounts receivable and returned goods; inventory allowances; income tax valuation allowances, uncertain tax positions and pension obligations. Amounts ultimately realized could differ from those estimates.

Reclassifications: Certain reclassifications have been made to the prior periods as a result of the current year presentation with no effect on net earnings.

Recent A ccounting Pronouncements:

In May 2011, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2011-04 to amend fair value measurements and related disclosures; the guidance becomes effective on a prospective basis for interim and annual periods beginning after December 15, 2012. This new guidance results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between International Financial Reporting Standards ("IFRS") and U.S. GAAP. The new guidance also changes some fair value measurement principles and enhances disclosure requirements related to activities in Level 3 of the fair value hierarchy. The adoption of this updated authoritative guidance is not expected to have any impact on the Company's consolidated financial statements.

In June 2011, the FASB issued ASU 2011-05 to amend the presentation of comprehensive income in financial statements. This guidance allows companies the option to present other comprehensive income in either a single continuous statement or in two separate but consecutive statements. Under both alternatives, companies will be required to present each component of net income and comprehensive income. The adoption of this updated authoritative guidance will impact the presentation of the Company's consolidated financial statements, but it will not change the items that must be reported in other comprehensive income. The guidance must be applied retrospectively and is effective for the first quarter of fiscal 2013. The Company is in the process of evaluating the presentation options required by this ASU.

In September 2011, the FASB issued ASU 2011-08 to amend the impairment assessment criteria for goodwill. The guidance permits an entity to first assess qualitative factors to determine whether it is "more likely than not" that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is then necessary to perform the two-step goodwill impairment test. The more likely than not threshold is defined as having a likelihood of more than 50%. The guidance is effective for the first quarter of fiscal 2013.  The Company is in the process of evaluating whether it will utilize a qualitative approach in its upcoming annual goodwill impairment assessment.

Bytewise designs, develops and manufactures non-contact, industrial measurement systems and software that capture the external geometric profile of a product and analyze that data to meet measurement and/or quality control requirements.

The acquisition was accounted for under the acquisition method of accounting.  The total purchase price was allocated to Bytewise's net tangible assets and identifiable intangible assets based on their estimated fair value as of November 22, 2011.  The allocation of the purchase price is based upon management's valuation and was finalized in the fourth quarter of fiscal 2012.

The table below presents the allocation of the purchase price to the acquired net assets of Bytewise (in thousands):

Acquisition costs were expensed as incurred and totaled approximately $0.13 million for fiscal year 2012, which are included in selling, general and administrative expenses.

The estimates for definite-lived amortizable intangible assets acquired include approximately $4.95 million for customer relationships, $1.48 million for trademarks and trade names, $2.0 million for completed technology, $0.6 million for non-compete agreements and $0.26 million for order backlog.  Amortizable intangible assets are amortized on a straight-line basis over their respective useful lives. The weighted-average amortization period is 9.3 years.

The following table reflects the Bytewise acquisition as if the transaction had occurred as of the beginning of the Company's fiscal year 2011.  The unaudited pro forma information does not necessarily reflect the actual results that would have occurred had the Company and Bytewise been combined during the periods presented (in thousands except per share amounts):

In fiscal 2010, the Company entered into an agreement with a private software development company to invest $1.5 million over the subsequent twelve to eighteen months in exchange for a 36% equity interest in the software development company.  The Company invested $0.3 million and $1.2 million in fiscal 2012 and 2011, respectively, and  recorded other income of $0.2 million in fiscal 2012 and other loss of $0.6 million in fiscal 2011 under the equity method of accounting.  The net carrying value of the investment included in other long term assets in the Consolidated Balance Sheet as of June 30, 2012 and June 30, 2011 is $1.2 million and $0.9 million, respectively.  In August 2011, the Company guaranteed a loan of $0.5 million between the private software development company and a lender.

4. CASH AND SHORT-TERM INVESTMENTS

Cash and investments held in foreign subsidiaries amounted to $20.6 million and $18.9 million at June 30, 2012 and June 30, 2011, respectively. Of this amount, $9.0 million in U.S. dollar equivalents were held in British Pound Sterling and $7.4 million in U.S. dollar equivalents were held in Brazilian Reals.

As of June 30, 2012 and June 30, 2011, the Company's U.K. subsidiary held a $6.3 million twelve month fixed rate deposit and a $6.4 million six month fixed rate deposit, respectively, with a financial institution.

5.  INVENTORIES

Inventories consist of the following (in thousands):

LIFO inventories were $19.7 million and $15.4 million at June 30, 2012 and June 30, 2011, respectively, such amounts being approximately $27.5 million and $26.2 million, respectively, less than if determined on a FIFO basis.  The use of LIFO, as compared to FIFO, on an annual basis resulted in a $1.3 million increase in cost of sales in fiscal 2012 compared to a $1.0 million increase in cost of sales in fiscal 2011 and a $8.5 million reduction in cost of sales in fiscal 2010.

6. GOODWILL AND INTANGIBLES

The following tables present information about the Company's intangible assets on the dates indicated (in thousands):

Amortizable intangible assets consist of the following (in thousands):

Amortizable intangible assets are being amortized on a straight-line basis over the period of expected economic benefit.  Amortization expense of $869 thousand was recorded on the Bytewise acquisition assets as of June 30, 2012.

The estimated useful lives of the intangible assets subject to amortization are 14 years for trademarks and trade names, 8 years for non-compete agreements, 10 years for completed technology, 8 years for customer relationships and 0.5 years for backlog.

The estimated aggregate amortization expense, for each of the next five years, and thereafter, is as follows (in thousands):

The Company performed its annual goodwill impairment test for Kinemetric as of June 26, 2010.    The results indicated that goodwill in the Kinemetric reporting unit was fully impaired, resulting in a $1.1 million impairment recorded in the fourth quarter of fiscal 2010.  The impairment charge was primarily the result of continued sales declines and the decline in the forecasted cash flows expected by the Company.

7. PROPERTY, PLANT AND EQUIPMENT:

Property, plant and equipment consists of the following as of June 30, 2012 and 2011 (in thousands):

Included in machinery and equipment are assets under capital leases of $0.7 million as of June 30, 2012 and $0.9 million as of June 30, 2011 relating to domestic and Brazilian operations. The accumulated amortization relating to these leases was $0.4 million and $1.0 million for fiscal 2012 and 2011, respectively.

Operating lease expense was $1.8 million, $1.5 million and $1.9 million in fiscal 2012, 2011 and 2010, respectively. Future commitments under operating leases are as follows (in thousands):

8. REORGANIZATION COSTS

In May 2010, Sears informed the Company it would no longer purchase "Craftsman" brand measuring tapes from the Company's Evans Rule subsidiary.  Evans Rule was the leading supplier of measuring tapes to Sears for over 30 years.  As a result of Sears' decision, the Company incurred an inventory write-off of approximately $2.0 million, which was included in the Cost of Goods Sold on the Consolidated Statement of Operations for 2010.  Also in 2010, the Company determined that $0.6 million of long-lived equipment of this subsidiary was impaired by comparing undiscounted cash flows to carrying value. This adjustment was reported as Reorganization costs in the Consolidated Statement of Operations.  

The Company closed its Dominican Republic facility effective December 31, 2011.  The decision to close the facility was the result of the Sears decision to no longer purchase "Craftsman" brand measuring tapes from the Company.  The Company incurred approximately $0.3 million in costs in fiscal 2012 related to facility closure, severance and asset write-offs.  The costs included in the fiscal 2012 Consolidated Statements of Operations in costs of sales, selling, general and administrative expenses and other income and expense are ($0.1) million $0.2 million, and $0.1 million, respectively.

9. OTHER INCOME AND EXPENSE

Other income and expense consists of the following (in thousands):

10. INCOME TAXES

Components of earnings (loss) before income taxes are as follows (in thousands):

The provision (benefit) for income taxes consists of the following (in thousands):

Reconciliations of expected tax expense (benefit) at the U.S. statutory rate to actual tax expense (benefit) are as follows (in thousands):

 No valuation allowance has been recorded for the domestic federal NOL.  The Company believes that forecasted future taxable income and certain tax planning opportunities eliminate the need for any valuation allowance.

Conversely, a valuation allowance was provided on certain state NOLs in 2006 as a result of much shorter carryforward periods and the uncertainty of generating adequate taxable income at the entity and state level.  This valuation allowance has remained through fiscal 2012.  Similarly, a valuation allowance has been provided on certain foreign NOLs due to the uncertainty of generating future taxable income in those jurisdictions. Lastly, a valuation allowance has been provided for foreign tax credit carryforwards due to the uncertainty of generating sufficient foreign source income in the future. The need for any valuation allowance on the domestic federal NOL and the continued need for allowance on state and foreign NOLs and tax credits is reevaluated as facts and assumptions change over time.

Deferred income taxes at June 30, 2012 and June 30, 2011 are attributable to the following (in thousands):

As of June 30, 2012 and June 30, 2011, the net long-term deferred tax asset and deferred tax liabilities on the balance sheet are as follows (in thousands):

Foreign operations deferred assets (current) relate primarily to book reserves.  Foreign operations net deferred assets (long-term) relate primarily to pension benefits.  Amounts related to foreign operations included in the long-term portion of deferred liabilities relate primarily to depreciation.

The Company is subject to U.S. federal income tax and various state, local and international income taxes in numerous jurisdictions. The Company's domestic and international tax liabilities are subject to the allocation of revenues and expenses in different jurisdictions and the timing of recognizing revenues and expenses. Additionally, the amount of income taxes paid is subject to the Company's interpretation of applicable tax laws in the jurisdictions in which it files.

Reconciliations of the beginning and ending amount of unrecognized tax benefits are as follows (in thousands):

The long-term tax obligations on the balance sheet as of June 30, 2012 and June 30, 2011 relate primarily to transfer pricing adjustments.  The Company has also recorded a non-current tax receivable for $3.8 million and $3.6 million at June 30, 2012 and 2011, respectively, representing the corollary effect of transfer pricing competent authority adjustments.

During the next 12 months, the Company expects there is the possibility that there will be a decrease in the total amount of unrecognized tax benefits as a result of the passing of the related statute of limitations.  The Company recognizes interest and penalties related to income tax matters in income tax expense.

The Company's US tax returns are no longer subject to U.S. federal examination by the Internal Revenue Service for years prior to 2005. As of June 30, 2012, the Company did have a state income tax audit in process.  There were no other local or federal income tax audits as of June 30, 2012.  In international jurisdictions the years that may be examined vary by country.  

The federal NOL carryforward of $16.8 million expires beginning in 2026. The state tax loss carryforward tax effected benefit of $0.9 million expire at various times over the next 5 years. The foreign tax credit carryforward of $1.0 million expires in the years 2014 through 2015.

No deferred taxes have been provided on the undistributed non-U.S. subsidiary earnings that are considered to be permanently invested. At June 30, 2012, the estimated amount of total unremitted earnings is $71.7 million. The Company has not determined the total amount of the unrecognized deferred taxes related to these earnings as the Company has permanently invested those earnings overseas.

11. EMPLOYEE BENEFIT AND RETIREMENT PLANS

The Company has two defined benefit pension plans, one for U.S. employees and another for U.K. employees.   The UK plan was closed to new entrants in fiscal 2009.  The Company also has defined contribution plans.  The Company has a postretirement medical and life insurance benefit plan for U.S. employees.  In addition, certain U.S. employees participate in an Employee Stock Ownership Plan (ESOP).

The Company's contribution toward medical benefits for qualified retirees between ages 55 and 64 is based on a sliding scale ranging from 15% to 75% of the current annual premium rates.  For retirees 65 and older, the Company's contribution is fixed at $28.50 or $23 per month depending upon the plan the retiree has chosen.

The Company makes periodic contributions to the ESOP in the form of Company stock or in cash to be invested in Company stock. Employees are not required or permitted to make contributions to the ESOP. Ninety percent of the actuarially determined annuity value of their ESOP shares is used to offset benefits otherwise due under the domestic defined benefit pension plan.

Under both U.S and U.K. defined benefit plans, benefits are based on years of service and final average earnings. Plan assets, including those of the ESOP, consist primarily of investment grade debt obligations, marketable equity securities and shares of the Company's common stock. The asset allocation of the Company's domestic pension plan is diversified, consisting primarily of investments in equity and debt securities. The Company seeks a long-term investment return that is reasonable given prevailing capital market expectations. Target allocations are 40% to 70% in equities (including 10% to 20% in Company stock), and 30% to 60% in cash and debt securities.

The Company uses an expected long-term rate of return assumption of 6.0% for the U.S. domestic pension plan, and 6.4% for the U.K. plan. In determining these assumptions, the Company considers the historical returns and expectations for future returns for each asset class as well as the target asset allocation of the pension portfolio as a whole. In fiscal 2012, the Company used a discount rate assumption of 3.9% for the U.S. plan and 4.4% for the U.K. plan. In determining these assumptions, the Company considers published third party data appropriate for the plans.

Other than the discount rate, pension valuation assumptions are generally long-term and not subject to short-term market fluctuations, although they may be adjusted as warranted by structural shifts in economic or demographic outlooks.  Long-term assumptions are reviewed annually to ensure they do not produce results inconsistent with current market conditions. The discount rate is adjusted annually based on corporate investment grade (rated AA or better) bond yields as of the measurement date.

Based upon the actuarial valuations performed on the Company's defined benefit plans as of June 30, 2012, the U.S. plan will require a $1.5 million contribution in fiscal 2013 and the U.K. plan will require a $1.5 million contribution in fiscal 2013.

The Company's overall investment strategy had been to achieve a long-term rate of return of 8.0%, with a wide diversification of asset types.  Based upon the Company's current accounting policy, management began to adjust its portfolio and return in fiscal 2012 to realize a 60% fixed – 40% equity asset allocation and a 6% long-term rate return in fiscal 2013.  This policy change is intended to minimize the market volatility in the future.

The table below sets forth the actual asset allocation for the assets within the Company's plans.

The Company determines its investments strategies based upon the composition of the beneficiaries in its defined benefit plans and the relative time horizons that those beneficiaries are projected to receive payouts from the plans. The Company engages an independent investment firm to manage the pension assets.

Cash equivalents are held in money market funds.

The Company's fixed income portfolio includes mutual funds that hold a combination of short-term, investment-grade fixed income securities and a diversified selection of investment-grade, fixed income securities, including corporate securities and U. S. government securities.

The Company invests in equity securities, which are diversified across a spectrum of value and growth in large, medium and small capitalization as appropriate to achieve the objective of a balanced portfolio and optimize the expected returns and volatility in the various asset classes.

In accordance with ASC 820, the Company has categorized its financial assets (including its pension plan assets), based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy as set forth below. If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.

Financial assets are categorized based on the inputs to the valuation techniques as follows:

The tables below show the portfolio by valuation category as of June 30, 2012 and June 30, 2011 (in thousands).