Lawson Products Inc.
Annual Report 2004

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Lawson Products Inc.

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Contents 1 2 4 5 6 7 8 9 10 17 18 19 22 23 23 24 Five Year Selected Financial Data Letter to Shareholders Stock and Financial Data Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Changes in Stockholders’ Equity Consolidated Statements of Cash Flow Notes to Consolidated Financial Statements Management’s Report on Internal Control Over Financial Reporting Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting Management’s Discussion and Analysis Board of Directors and Corporate Management Profile of Lawson Products, Inc. Corporate Information Lawson Family of Businesses Five Year Selected Financial Data Lawson Products, Inc. and Subsidiaries ® Percent (Dollars in thousands, except per share data) 2004 Change 2003 2002 2001 2000 Net Sales1 $419,652 +7.9 $389,091 $387,456 $379,407 $348,967 Income Before Income Taxes2 33,438 +34.3 24,892 23,189 17,142 47,566 Net Income3 21,425 +32.3 16,196 12,447 8,787 28,136 Per Share of Common Stock: Basic Net Income $2.28 +33.3 $1.71 $1.30 $0.91 $2.85 Diluted Net Income 2.27 +33.5 1.70 1.30 0.91 2.85 Total Assets 260,550 +5.5 246,943 225,831 234,206 222,721 Noncurrent Liabilities 37,271 +1.5 36,714 31,765 40,520 28,946 Stockholders’ Equity 180,332 +4.0 173,351 162,343 159,898 159,912 Return on Average Equity (percent) 12.0 +25.0 9.6 7.7 5.4 18.6 Return on Assets (percent) 8.2 +25.4 6.6 5.5 3.8 12.6 Stockholders’ Equity Per Share4 19.16 +4.9 18.26 16.96 16.51 16.22 Cash Dividends Paid 0.72 +12.5 0.64 0.64 0.64 0.60 Basic Weighted Average Shares Outstanding 9,410 –0.9 9,492 9,570 9,685 9,860 Diluted Weighted Average Shares Outstanding 9,430 –0.9 9,511 9,596 9,708 9,874 1 Net sales for 2004, 2003, 2002 and 2001 were also positively impacted by the acquisition of the North American Industrial Products and Kent Automotive Divisions of Premier Farnell PLC in March 2001. 2 During 2003 the Company recorded a $2,789 pretax loss related to the sale of Lawson Products Limited, the Company’s former UK subsidiary. In 2001, income before taxes included charges of $11,881 related to the write-off of capitalized software and implementation costs related to an enterprise information system project which the Company decided to discontinue as well as a promotional program related to the acquisition of Premier operations. During 2000, the Company recorded a gain of $3,502 as a result of the sale of the Company’s interest in a real estate investment. 3 In 2003, income tax expense included a $2,157 reduction to reflect the partial utilization of a capital loss generated by the sale of the Company’s former UK subsidiary. In 2003 and 2002, the Company recorded $1,477 and $421 respectively, after tax, of charges for compensation arrangements related to management personnel reductions. The Company adopted SFAS No. 142 as of January 1, 2002. Therefore, the Company discontinued amortization of goodwill for 2002 and thereafter. Net income for 2001 was reduced by $731 related to goodwill amortization. In 2001, the Company recorded charges for the write-off of capitalized software and implementation costs related to an enterprise information system project which the Company decided to discontinue as well as a promotional program related to the acquisition of Premier operations. Together, these charges reduced net income by $7,159. During 2000, the Company recorded a gain of $2,136 as a result of the sale of the Company’s interest in a real estate investment. 4 These per share amounts were computed using basic weighted average shares outstanding for all periods presented. 1 Dear Fellow Shareholders, The year 2004 marked improved performance of the Lawson Family of Businesses. Our Company’s performance may be accurately described as being focused, innovative, value-driven and exceeding the expectations of customers. During 2004, the people of the Family of Businesses added a great deal of value to our Company. Sales growth coupled with operational improvements increased net income per diluted share 34% to $2.27. Lawson enjoyed record sales of approximately $420 million. Sales increased sequentially during the year achieving an increase of about 11% in the fourth quarter compared to that of the prior year. The Company supported its growth with a modest increase in operating costs of just over 3%, creating substantial leverage for 2004. Stockholders equity increased to $180.3 million and the book value per share of our common stock increased to $19.16. Return on shareholder equity increased to 12%, an increase of 25% over that of the prior year. Lawson retired nearly 250,000 shares of common stock, paid dividends at record levels, and invested in facilities and equipment. At year end, our Company had $29 million of cash and cash equivalents, no short term (other than a $1.6 million non-recourse mortgage on an investment property) or long-term debt, and a current ratio of 3.7 to 1. Dividends paid to shareholders during 2004 increased 12.5% to $.72 per share. The people of the Family of Businesses did a “better and better job” of increasing the strength of our Company and its value for our shareholders. The foundation of the Lawson Family of Businesses is its customers. Everything we do as a Company, every decision we make, must be undertaken from the viewpoint of our customers. Every endeavor must be driven by the needs and desires of our customers and set us apart from our competition. During 2004, we spent a great deal of time with the customers of each of our specialized businesses: customers of varied sizes, from varied industries, and located across the breadth of North America. We verified that our customers continue to want top quality products and top quality services. We learned that they prefer multiple “touch points” to our companies. Our customers prefer fewer suppliers and a reduced number of invoices. And, above all, our customers require the expert advice of our sales representatives to counsel them as to the newest products, the latest applications, the most efficient inventory systems and the most cost effective solutions to meet the needs of their businesses. We confirmed that many of the “experiments” we have been conducting have led us in proper directions. We are enjoying increased usage of inside sales, of combined invoicing systems, of e-ordering, electronic catalogs, electronic inventory services, on-site services and of special product acquisition systems. Our sales representatives have increased the availability of these services to our customers and our customers are enjoying the benefits. By providing additional tools and mechanisms centered around the talents, capabilities, and knowledge of our sales representatives, the level of customer service increases significantly. Combining what we’ve learned through experimentation and from our customers, the Family of Businesses has become more “customer driven” than ever before. This is inuring to the benefit of our customers, our sales representatives, our Company, and to its shareholders. Enhancements to our operating systems, including purchasing and inventory processes, invoicing and collection procedures, customer service mechanisms, and the ability to measure results achieved by our people are crucial to 2 Lawson Products, Inc. and Subsidiaries ® our growing businesses. For those reasons, our investment in information systems, both in people as well as equipment has increased. The results are anticipated to include improvements in customer service, increased product development, more rapid dissemination of information to our sales forces, and increased sales and profitability. Your Company has increased its efficiency and profitability while controlling costs. This is reflected in a more than 35% increase in operating income for 2004 against an 8% increase in sales. The continuing enhancement of our operations and distribution networks are intended to permit improved levels of operating leverage to continue, and perhaps increase, with the growth of our businesses. Our customers expect top performance from our businesses and we expect top performance from our people. A variety of education and compensation programs for our people provide the methods by which customer and sales force growth, process improvements and management expectations are established, measured and rewarded. We are benefiting from reduced turnover of people both in the field and internally, improved productivity, better penetration of customers and entry into new markets. During 2004, our Company also expanded its corporate marketing group. Our marketing people have led us to substantial increases in our government business, increased capability in e-ordering, and the expansion of on-site services. We have learned how to meet the needs of large, complex accounts in the manufacturing, processing, defense and construction industries. Our activity with such accounts has increased markedly. We are competing for that business at high and intense levels. And, we are winning. The on-site attention of our sales representatives lead Lawson’s multiple selling, inventory maintenance, and servicing capabilities. There is no need for our customers to spend valuable time buried in catalogs, telephone books, or even less productive, to send key personnel to a store. The Lawson customer enjoys reduced “downtime” and increased “uptime”. Our customers’ requirements for the maintenance of their facilities and equipment and for component parts for production are already in place; where they need it; when they need it. With the Family of Businesses, “It’s Already There.” That’s the Lawson Family of Businesses: Our customers’ Single Source of Supply, Keeping Businesses Running, at the Lowest Overall Cost. Our Company accomplished a great deal in 2004. We have a superior foundation of highly skilled people, systems and facilities. We have a hunger to make all of it better and to achieve more. We are building upon a history of integrity, quality and confidence in ourselves and in the valuable work we do while serving customers in a continually changing environment. Sincerely, Robert J. Washlow Chairman of the Board and CEO Lawson Products, Inc. April, 2005 3 Stock and Financial Data MARKET PRICES FOR COMMON STOCK The Company’s Common Stock is traded in the over-the-counter market under the NASDAQ symbol of “LAWS.” The approximate number of stockholders of record at December 31, 2004 was 746. The following table sets forth the High and Low closing sale prices as reported on the NASDAQ National Market System during the last two years. 2004 2003 High Low High Low First Quarter $34.49 $28.61 $30.81 $23.04 Second Quarter 38.15 32.67 28.48 24.40 Third Quarter 41.63 35.85 29.87 25.76 Fourth Quarter 51.25 41.46 34.74 27.47 CASH DIVIDENDS DECLARED PER SHARE 2004 2003 First Quarter $.18 $.16 Second Quarter .18 .16 Third Quarter .18 .16 Fourth Quarter .18 .18 $.72 $.66 CLASSES OF SIMILAR PRODUCTS The Company’s products may be grouped into the following classes of similar products, each of which accounted for the indicated percentages of consolidated revenues: Percent of Consolidated Revenues 2004 2003 2002 Fasteners, fittings and related parts 44% 43% 43% Industrial supplies 47 48 48 Automotive and equipment maintenance parts 9 9 9 100% 100% 100% 4 Lawson Products, Inc. and Subsidiaries ® Report of Independent Registered Public Accounting Firm To the Stockholders and Board of Directors Lawson Products, Inc. We have audited the accompanying consolidated balance sheets of Lawson Products, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the 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. consolidated financial position of Lawson Products, Inc. and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. As discussed in Note B to the financial statements, in 2003 the Company changed its method of accounting for its investment in a real estate partnership. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Lawson Products, Inc. and subsidiaries internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control – Integrated Framework issued by the Commitee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2005 expressed an unqualified opinion thereon. In our opinion, the financial statements referred to above present fairly, in all material respects, the Chicago, Illinois March 10, 2005 5 Consolidated Balance Sheets December 31, (Dollars in thousands) 2004 2003 ASSETS CURRENT ASSETS: Cash and cash equivalents $ 28,872 $ 23,555 Accounts receivable, less allowance for doubtful accounts (2004 – $1,986; 2003 – $2,121) 52,129 47,972 Inventories 65,687 59,817 Miscellaneous receivables 2,081 4,773 Prepaid expenses 7,479 6,666 Deferred income taxes 1,729 1,975 Total Current Assets 157,977 144,758 Property, plant and equipment, at cost, less allowances for depreciation and amortization (2004 – $58,837; 2003 – $58,692) 42,452 44,905 Other assets: Cash value of life insurance 15,089 13,201 Deferred income taxes 14,779 13,201 Goodwill, less accumulated amortization 28,649 28,649 Other intangible assets, less accumulated amortization (2004 – $1,335; 2003 – $1,219) 1,365 1,481 Other 239 748 60,121 57,280 $260,550 $246,943 LIABILITIES AND STOCKHOLDERS’ EQUITY CURRENT LIABILITIES: Accounts payable $ 8,746 $ 8,240 Accrued expenses and other 32,628 27,176 Current portion of long term debt 1,573 1,462 Total Current Liabilities 42,947 36,878 Noncurrent liabilities and deferred credits: Accrued liability under security bonus plans 21,528 20,823 Long term debt — 1,573 Deferred compensation and other liabilities 15,743 14,318 37,271 36,714 Stockholders’ equity: Preferred Stock, $1 par value: Authorized – 500,000 shares; Issued and outstanding – None — — Common Stock, $1 par value: Authorized – 35,000,000 shares; Issued – 2004 – 9,280,935 shares; 2003 – 9,493,511 shares 9,281 9,494 Capital in excess of par value 3,467 2,667 Retained earnings 167,187 161,831 179,935 173,992 Accumulated other comprehensive income (loss) 397 (641) Stockholders’ equity 180,332 173,351 $260,550 $246,943 See notes to consolidated financial statements 6 Lawson Products, Inc. and Subsidiaries ® Consolidated Statements of Income Year ended December 31, (Dollars in thousands, except per share data) 2004 2003 2002 Net sales $419,652 $389,091 $387,456 Cost of goods sold 155,971 141,124 137,129 Gross profit 263,681 247,967 250,327 Selling, general and administrative expenses 231,762 221,189 226,571 Other charges — 2,459 360 Provision for doubtful accounts 1,108 1,578 1,585 Operating Income 30,811 22,741 21,811 Interest and dividend income 122 194 53 Interest expense (184) (131) (154) Other income – net 2,689 2,088 1,479 2,627 2,151 1,378 Income Before Income Taxes 33,438 24,892 23,189 Income Tax Expense 12,013 8,696 10,742 Net Income $ 21,425 $ 16,196 $ 12,447 Net Income Per Share of Common Stock: Basic $2.28 $1.71 $1.30 Diluted $2.27 $1.70 $1.30 See notes to consolidated financial statements 7 Consolidated Statements of Changes in Stockholders’ Equity Accumulated Common Capital Other Stock, in excess of Retained Comprehensive Comprehensive (Dollars in thousands) $1 par value par value Earnings Income (Loss) Income Balance at January 1, 2002 $9,629 $ 913 $151,554 $(2,198) $ — Net income 12,447 12,447 Other comprehensive income, net of tax: Adjustment for foreign currency translation 165 165 Comprehensive income for the year $12,612 Cash dividends declared (6,115) Stock issued under employee stock plans 61 1,510 Purchase and retirement of common stock (196) (36) (5,391) Balance at December 31, 2002 9,494 2,387 152,495 (2,033) Net income 16,196 $16,196 Other comprehensive income, net of tax: Adjustment for foreign currency translation 1,392 1,392 Comprehensive income for the year $17,588 Cash dividends declared (6,265) Stock issued under employee stock plans 20 285 Purchase and retirement of common stock (20) (5) (595) Balance at December 31, 2003 9,494 2,667 161,831 (641) Net income 21,425 $21,425 Other comprehensive income, net of tax: Adjustment for foreign currency translation 1,038 1,038 Comprehensive income for the year $22,463 Cash dividends declared (6,751) Stock issued under employee stock plans 36 884 Purchase and retirement of common stock (249) (84) (9,318) Balance at December 31, 2004 $9,281 $3,467 $167,187 $ 397 See notes to consolidated financial statements 8 Lawson Products, Inc. and Subsidiaries ® Consolidated Statements of Cash Flow Year ended December 31, (Dollars in thousands) 2004 2003 2002 Operating activities Net income $ 21,425 $ 16,196 $ 12,447 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 5,299 5,359 5,506 Amortization 1,393 1,744 1,321 Provision for allowance for doubtful accounts 1,108 1,578 1,585 Deferred income taxes (1,775) (476) (2,177) Deferred compensation and security bonus plans 5,060 5,466 2,704 Payments under deferred compensation and security bonus plans (2,832) (2,099) (1,635) Income from investments in real estate — (360) (600) Changes in operating assets and liabilities: Accounts receivable (5,265) (5,888) 1,165 Inventories (5,870) 4,902 1,692 Prepaid expenses and other assets (89) (2,678) 5,557 Accounts payable and accrued expenses 5,998 3,176 1,958 Other 1,383 991 129 Net Cash Provided by Operating Activities 25,835 27,911 29,652 Investing activities Additions to property, plant and equipment (3,784) (5,734) (6,655) Other 250 286 756 Net Cash Used in Investing Activities (3,534) (5,448) (5,899) Financing Activities Proceeds from revolving line of credit — 4,000 36,500 Payments on revolving line of credit — (4,000) (50,500) Payments on mortgage payable (1,462) (805) — Purchases of common stock (9,651) (620) (5,623) Proceeds from exercise of stock options 920 305 1,571 Dividends paid (6,791) (6,075) (6,138) Net Cash Used in Financing Activities (16,984) (7,195) (24,190) Increase (Decrease) in Cash and Cash Equivalents 5,317 15,268 (437) Cash and Cash Equivalents at Beginning of Year 23,555 8,287 8,724 Cash and Cash Equivalents at End of Year $ 28,872 $ 23,555 $ 8,287 See notes to consolidated financial statements 9 Notes to Consolidated Financial Statements (Dollars in thousands) NOTE A – DESCRIPTION OF BUSINESS Lawson Products is an international seller and distributor of systems, services and products to the industrial, commercial and institutional maintenance, repair and replacement (“MRO”) marketplace. The Company also manufactures, sells and distributes production and specialized component parts to the original equipment marketplace (“OEM”). NOTE B – SUMMARY OF MAJOR ACCOUNTING POLICIES Principles of Consolidation: The accompanying consolidated financial statements include the accounts and transactions of the Company and its wholly owned and majority owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Revenue Recognition: Sales and associated cost of goods sold are recognized when products are shipped and title passes to customers. Shipping and Handling Fees and Costs: Costs related to shipping and handling fees are included on the Income Statement in the caption selling, general and administrative expenses. Amounts billed to customers for shipping fees are included in net sales and totaled $11,565, $11,159 and $11,898 in 2004, 2003 and 2002, respectively. Use of Estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates. Investment in Real Estate Partnership: The Company’s investment in real estate, representing a limited partnership interest, was carried on the basis of the equity method until June 30, 2003. The Company adopted FIN 46 as of July 1, 2003, which has resulted in the consolidation of the Company’s investment in a limited partnership, which owns an office building in Chicago, Illinois. An officer and member of the Board of Directors of the Company is the 1.5% general partner. (See Note I) The operations of the partnership consist of rental of the building under a long-term lease and the servicing of the non-recourse mortgage. The activities are insignificant for separate disclosure. Marketable Securities: Marketable equity and debt securities are classified as available-for-sale and are carried at fair value, with the unrealized gains and losses, net of tax, recorded in stockholders’ equity. Realized gains and losses, declines in value judged to be other- than-temporary, and interest and dividends are included in investment income. The cost of securities sold is based on the specific identification method. Inventories: Inventories which consist of principally finished goods are stated at the lower of cost (first-in, first-out method) or market. (See Note E) Property, Plant and Equipment: Provisions for depreciation and amortization are computed by the straight-line method for buildings using useful lives of 20 to 30 years and by the double declining balance method for machinery and equipment, furniture and fixtures, vehicles and capitalized software using useful lives of 3 to 10 years. Investment Tax Credits: Investment tax credits on asset leased to others are deferred and amortized over the useful life of the related asset. Cash Equivalents: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Stock Options: Stock options are accounted for under Accounting Principles Board Opinion No. 25 (APB 25), “Accounting For Stock Issued to Employees.” Under APB 25, the Company uses the intrinsic value method where no compensation expense is recognized because the exercise price of the stock options granted equals the market price of the underlying stock at the date of grant. The following table shows the effect on net income and earnings per share if the Company had applied the fair value recognition provision of Financial Accounting Standards Board (FASB) Statement No. 123, “Accounting for Stock-Based Compensation.” 2004 2003 2002 Net income – as reported $21,425 $16,196 $12,447 Deduct: Total stock based employee compensation expense determined under fair value method, net of tax (6) (27) (38) Net income – pro forma 21,419 16,169 12,409 Basic earnings per share – as reported 2.28 1.71 1.30 Diluted earnings per share – as reported 2.27 1.70 1.30 Basic earnings per share – pro forma 2.28 1.70 1.30 Diluted earnings per share – pro forma 2.27 1.70 1.29 10 Lawson Products, Inc. and Subsidiaries ® For purposes of pro forma disclosures, the estimated fair value of options granted is amortized as an expense over the option’s vesting period. The pro forma effect on net income is not representative of the pro forma effect on net income in future years because grants made in 1996 and later years have an increasing vesting period. Goodwill and Other Intangibles: Goodwill represents the cost of business acquisitions in excess of the fair value of identifiable net tangible assets acquired. (See Note G) Foreign Currency Translation: The financial statements of foreign entities have been translated in accordance with Statement of Financial Accounting Standards No. 52 and, accordingly, unrealized foreign currency translation adjustments are reflected as a component of stockholders’ equity. Realized foreign currency transaction gains and losses were not significant for the years ended December 31, 2004, 2003 and 2002. Income Per Share: Basic EPS is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted EPS reflects the potential dilution from the exercise or conversion of securities into common stock, such as stock options. Reclassifications: Certain amounts have been reclassified in the 2003 and 2002 financial statements to conform with the 2004 presentation. NOTE C – BUSINESS COMBINATION/DISPOSITION Sale of Lawson Products Limited, UK Subsidiary: In the fourth quarter of 2003, the Company sold its UK subsidiary, Lawson Products Limited, engaged primarily in the business of MRO sales, to a third party for approximately $647. The purchase price is in the form of a note payable to the Company over two years. Prior to the sale, the Company transferred certain assets and liabilities related to the OEM portion of this business to a newly formed subsidiary, Assembly Component Systems Limited. The sale of Lawson Products Limited resulted in a pre-tax loss of approximately $2,789, largely related to inventory write-offs and termination costs associated with the sale. This loss is classified in selling, general and administrative expenses in the statement of income. This business was part of the Company’s International OEM distribution segment. The sale also generated approximately $22,441 in capital losses for tax purposes. The Company was able to carryback $6,163 of the capital loss to offset capital gains in prior years tax returns. The effect of the carryback resulted in $2,157 of tax benefit realized in 2003 for financial statement purposes. A valuation allowance has been provided for the remainder of the capital loss due to the uncertainty of utilization. NOTE D – OTHER CHARGES In 2003, the Company recorded charges totaling $2,459 for severance payable to several members of management. Benefits of $1,175 and $422 were paid in 2004 and 2003 respectively. The remaining benefits will be paid through 2006. During 2002, the Company recorded a charge of $568 for severance payable to several members of management and a $208 adjustment to the reserve resulting from a severance settlement. Benefits of $92 and $155 were paid in 2004 and 2003 respectively. The remaining benefits will be paid in future years. The table below shows an analysis of the Company’s reserves for other charges: Severance and Related Description of Item Expenses Balance January 1, 2002 $1,458 Charged to earnings 2002 568 Cash paid in 2002 (942) Adjustment to reserves (208) Balance December 31, 2002 876 Charged to earnings 2003 2,459 Cash paid in 2003 (859) Balance December 31, 2003 2,476 Cash paid in 2004 (1,434) Balance December 31, 2004 $1,042 NOTE E – INVENTORIES The following is a summary of inventories and reserve for excess and obsolete inventory: 2004 2003 Inventories $ 68,759 $ 64,958 Reserve for excess and (5,141) obsolete inventory (3,072) $65,687 $59,817 11 NOTE F – PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of: 2004 2003 Land $ 8,472 $ 8,389 Buildings and improvements 51,839 51,556 Machinery and equipment 30,084 30,143 Furniture and fixtures 5,611 5,749 Vehicles 359 432 Capitalized software 4,372 6,771 Construction in progress 552 557 101,289 103,597 Accumulated depreciation and amortization (58,837) (58,692) $42,452 $44,905 NOTE G– GOODWILL AND OTHER INTANGIBLES The Company adopted FASB statement No. 142 “Goodwill and Other Intangibles” as of January 1, 2002. The Company performed its annual impairment test in the fourth quarter of 2004 and determined the Company’s goodwill was not impaired. Intangible assets subject to amortization were as follows: Gross Accumulated Net Carrying December 31, 2004 Balance Amortization Amount Trademarks and tradenames $1,747 $935 $812 Customer lists 953 400 553 $2,700 $1,335 $1,365 Gross Accumulated Net Carrying December 31, 2003 Balance Amortization Amount Trademarks and tradenames $1,747 $851 $896 Customer lists 953 368 585 $2,700 $1,219 $1,481 Trademarks and tradenames are being amortized over a weighted average 15.14 years. Customer lists are being amortized over 13.96 years. Amortization expense, all of which was included in the MRO distribution segment, for the intangible assets was $116, $518 and $377 in 2004, 2003 and 2002, respectively. Amortization expense for each of the next five years is estimated to be $83 per year. NOTE H – ACCRUED EXPENSES AND OTHER Accrued expenses and other liabilities consist of the following: 2004 2003 Salaries, commissions and other compensation $11,369 $ 6,802 Accrued other charges 1,042 2,476 Accrued and withheld taxes, other than income taxes 2,644 2,591 Accrued profit sharing contributions 3,626 3,448 Accrued stock performance rights 2,081 654 Accrued self-insured health benefits 1,560 1,800 Cash dividends payable 1,670 1,709 Other 8,636 7,696 $32,628 $27,176 NOTE I – LONG TERM DEBT On July 1, 2003 the Company adopted FIN 46 which has resulted in the Company’s consolidation of an investment in a limited partnership which owns an office building in Chicago, Illinois. In conjunction with the consolidation of its investment, the Company has recorded long-term debt, which represents a non-recourse mortgage payable relative to the building. The interest rate of the non-recourse mortgage payable is 7.315%, with a maturity date of December 31, 2005. The building and land have a net carrying value of $4,184, which are included in property, plant and equipment. The remaining assets, none of which are significant, are recorded in other assets. The Company’s mortgage obligations in effect at December 31, 2004 and 2003, with respect to this office building, amounted to approximately $1,573 and $3,035, respectively. Mortgage payments are payable as follows: 2005 - $1,573. Interest expense related to the mortgage totaled $171 and $124 in 2004 and 2003, respectively. On February 21, 2001, the Company entered into a $50 million unsecured multi-currency line of credit. The Company had no loans outstanding under the line at December 31, 2004 and 2003. Amounts outstanding under the line carry interest at 1.5% below the prime rate or .75% over LIBOR. The line matures on February 21, 2006. The line requires the Company to meet certain covenants, all of which were met at December 31, 2004. The Company paid interest of $0, $7 and $220, respectively, in 2004, 2003 and 2002. 12 Lawson Products, Inc. and Subsidiaries ® NOTE J – STOCK PLANS The Incentive Stock Plan (Plan), provides for the issuance of shares of Common Stock to non-employee directors, officers and key employees pursuant to stock options, stock performance rights (SPRs), stock purchase agreements and stock awards. As of December 31, 2004, 519,327 shares of Common Stock were available for issuance under the Plan. In 2003 and 2002, the Company granted SPRs pursuant to the Plan. These SPRs have exercise prices ranging from $24.64 to $33.15 per share. These SPRs vest at 20% per year and entitle the recipient to receive a cash payment equal to the excess of the market value of the Company’s common stock and the SPR price when the SPRs are surrendered. Compensation expense for the SPRs in 2004, 2003 and 2002 was $2,620, $410 and $244, respectively. Additional information with respect to SPRs is summarized as follows: Average SPR Exercise Price # of SPRs 230,350 Outstanding January 1, 2002(1) $26.90 Granted(2) 30.74 18,000 Outstanding December 31, 2002 27.18 248,350 Granted(3) 27.85 31,500 Exercised 26.77 (1,900) Outstanding December 31, 2003 27.26 277,950 Exercised 26.76 (66,450) Canceled 27.45 (22,500) Outstanding December 31, 2004 $27.41 189,000 (1) Includes 84,560 SPRs vested at December 31, 2004 (2) Includes 5,200 SPRs vested at December 31, 2004 (3) Includes 1,000 SPRs vested at December 31, 2004 The Plan permits the grant of incentive stock options, subject to certain limitations, with substantially the same terms as non-qualified stock options. Non-employee directors are not eligible to receive incentive stock options. Stock options are not exercisable within six months from date of grant and may not be granted at prices less than the fair market value of the shares at the dates of grant. Benefits may be granted under the Plan through December 16, 2006. Additional information with respect to the Plan is summarized as follows: Average Price Option Shares Outstanding January 1, 2002 $22.87 172,990 Granted — — Exercised 22.73 (50,954) Canceled or expired — — Outstanding December 31, 2002 22.93 122,036 Granted — — Exercised 22.50 (19,686) Canceled or expired — — Outstanding December 31, 2003 23.01 102,350 Granted — — (31,350) Exercised 23.62 Canceled or expired 22.70 (21,450) Outstanding December 31, 2004 $22.75 49,550 Exercisable options at Weighted Average Price Option Shares December 31, 2004 $22.75 49,550 December 31, 2003 $22.99 99,600 December 31, 2002 $22.90 114,286 As of December 31, 2004, the Company had the following outstanding options: Exercise Price $22.44-$22.50 $23.56 $26.75 Options Outstanding 40,550 8,000 1,000 Weighted Average Exercise Price $22.49 $23.56 $26.75 Weighted Average Remaining Life 1.9 5.4 3.3 Options Exercisable 40,550 8,000 1,000 Weighted Average Exercise Price $22.49 $23.56 $26.75 Disclosure of pro forma information regarding net income and net income per share is required by FASB Statement No. 123, “Accounting for Stock-Based Compensation,” and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. The fair value of these options was estimated at the date of grant using the Black-Scholes options pricing model. No options were granted in 2004, 2003 or 2002. See Note B - Stock Options for impact of options granted prior to 2002 on pro forma earnings per share. NOTE K – PROFIT SHARING AND SECURITY BONUS PLANS The Company and certain subsidiaries have a profit sharing plan for office and warehouse personnel. The amounts of the companies’ annual contributions are determined by the board of directors subject to limitations based upon operating results. 13 The plan also has a 401(k) defined contribution saving feature. This feature, available to all participants, was provided to give employees a pretax investment vehicle to save for retirement. The Company does not match the contributions made by plan participants. The Company and its subsidiaries also have in effect security bonus plans for the benefit of independent sales representatives and certain regional managers, under the terms of which participants are credited with a percentage of their yearly earnings. Of the aggregate amounts credited to participants’ accounts, 25% vests after five years and an additional 5% vests each year thereafter. For financial reporting purposes, amounts are charged to operations over the vesting period. Provisions for profit sharing and security bonus plans aggregated $5,979, $5,301 and $5,689 for the years ended December 31, 2004, 2003 and 2002, respectively. NOTE L – INCOME TAXES Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. In addition, deferred income taxes include net operating loss carryforwards of foreign subsidiaries which do not expire. The Company also has a capital loss related to the 2003 sale of the Company’s UK MRO business. A valuation allowance was recorded for a portion of the $22,441 capital loss due to the uncertainty of the Company’s ability to realize the capital loss against future capital gains prior to expiration in 2008. Significant components of the Company’s deferred tax assets and liabilities as of December 31 are as follows: Deferred Tax Assets: 2004 2003 Compensation and benefits $16,185 $15,237 Inventory 3,447 3,011 Net operating loss carryforwards of subsidiaries 2,619 2,619 Capital loss 5,580 5,697 Accounts receivable 762 669 Other — 345 Total Deferred Tax Assets 28,593 27,578 Valuation allowance for deferred tax assets (8,199) (8,316) Net Deferred Tax Assets 20,394 19,262 Deferred Tax Liabilities: Property, plant & equipment 1,192 2,381 Other 2,694 1,705 Total Deferred Tax Liabilities 3,886 4,086 Total Net Deferred Tax Assets $16,508 $15,176 Net Deferred Tax Assets: 2004 2003 Total Current Deferred Income Taxes $ 1,729 $ 1,975 Total Noncurrent Deferred Income Taxes 14,779 13,201 Total Net Deferred Tax Assets $16,508 $15,176 Net deferred tax assets include the tax impact of items in comprehensive income of $(214) and $345 at December 31, 2004 and 2003, respectively. Income (loss) before income taxes for the years ended December 31, consisted of the following: 2004 2003 2002 United States $32,182 $27,728 $27,906 Foreign 1,256 (2,836) (4,717) $33,438 $24,892 $23,189 The provisions for income taxes for the years ended December 31, consisted of the following: 2004 2003 2002 Current: Federal $11,652 $7,422 $ 10,972 State 2,136 1,750 1,947 13,788 9,172 12,919 Deferred benefit (1,775) (476) (2,177) $12,013 $8,696 $ 10,742 The reconciliation between the effective income tax rate and the statutory federal rate is as follows: 2004 2003 2002 Statutory federal rate 35.0% 35.0% 35.0% Increase (decrease) resulting from: State income taxes, net of federal income tax benefit 4.2 4.6 5.5 Foreign losses 1.2 6.7 9.3 Capital loss carryback — (8.7) — Executive life insurance (2.0) (2.9) 2.1 Other items, net (2.5) 0.2 (5.6) 46.3% Provision for income taxes 35.9% 34.9% Income taxes paid for the years ended December 31, 2004, 2003, and 2002 amounted to $12,097, $10,523 and $13,392, respectively. 14 Lawson Products, Inc. and Subsidiaries ® NOTE M – COMMITMENTS The Company’s minimum rental commitments, principally for equipment, under noncancelable leases in effect at December 31, 2004, amounted to approximately $14,349. Such rentals are payable as follows: 2010 2005 2006 2007 2008 2009 and thereafter $3,502 $2,936 $2,488 $1,685 $1,482 $2,256 Total rental expense for the years ended December 31, 2004, 2003 and 2002 amounted to $3,009, $3,977 and $3,669 respectively. NOTE N – INCOME PER SHARE The computation of basic and diluted earnings per share consisted of the following: Year ended December 31 2004 2003 2002 Numerator: Net income $21,425 $16,196 $12,447 Denominator: Denominator for basic income per share – weighted average shares 9,410 9,492 9,570 Effect of dilutive securities: Stock option plans 20 19 26 Denominator for diluted income per share – adjusted weighted average shares 9,430 9,511 9,596 Basic income per share $2.28 $1.71 $1.30 Diluted income per share $2.27 $1.70 $1.30 NOTE O – SEGMENT REPORTING The Company has four reportable segments: Maintenance, Repair and Replacement distribution in the U.S. (MRO-US), International Maintenance, Repair and Replacement distribution in Canada (MRO-CAN), Original Equipment Manufacturer distribution and manufacturing in the U.S. (OEM-US) and International Original Equipment Manufacturer distribution in Mexico and the United Kingdom (OEM-INTL). The operations of the Company’s MRO distribution segments distribute a wide range of MRO parts to repair and maintenance organizations by the Company’s force of independent sales agents. The operations of the Company’s OEM segments manufacture and distribute component parts to OEM manufacturers through a network of independent manufacturers representatives as well as internal sales employees. The Company’s reportable segments are distinguished by the nature of products distributed and sold, types of customers, manner of servicing them, and geographical location. The Company evaluates performance and allocates resources to reportable segments primarily based on operating income. The accounting policies of the reportable segments are the same as those described in the summary of significant policies except that the Company records its federal and state deferred tax assets and liabilities at corporate. Intersegment sales are not significant. Financial information for the Company’s reportable segments consisted of the following: Year ended December 31 2004 2003 2002 Net sales MRO-US $316,099 $302,047 $306,863 MRO-CAN 21,806 18,976 16,505 OEM-US 64,632 54,147 55,547 OEM-INTL 17,115 13,921 8,541 Consolidated total $419,652 $389,091 $387,456 Operating Income (loss) MRO-US $27,112 $24,993 $23,828 MRO-CAN 2,313 1,494 1,051 OEM-US 2,326 537 2,490 (5,558) OEM-INTL (940) (4,283) Consolidated total $30,811 $22,741 $21,811 Capital expenditures MRO-US $2,798 $2,792 $4,634 MRO-CAN 323 1,234 944 OEM-US 561 1,565 869 OEM-INTL 102 143 208 Consolidated total $3,784 $5,734 $6,655 Depreciation and amortization MRO-US $5,345 $5,592 $5,650 MRO-CAN 253 175 121 OEM-US 856 804 799 OEM-INTL 238 532 257 Consolidated total $6,692 $7,103 $6,827 Total assets MRO-US $174,777 $168,783 $154,832 MRO-CAN 18,519 17,137 13,989 OEM-US 40,275 36,076 33,181 OEM-INTL 10,471 9,771 8,379 Segment total 244,042 231,767 210,381 Corporate 16,508 15,176 15,450 Consolidated total $260,550 $246,943 $225,831 Goodwill MRO-US $22,104 $22,104 $22,104 MRO-CAN 4,294 4,294 4,294 OEM-US 2,251 2,251 2,251 OEM-INTL — — — Consolidated total $28,649 $28,649 $28,649 15 The reconciliation of segment profit to consolidated income before income taxes consisted of the following: Year ended December 31 2004 2003 2002 Total operating income for reportable segments $30,811 $22,741 $21,811 Interest and dividend income 122 194 53 Interest expense (184) (131) (154) Other - net 2,689 2,088 1,479 Income before income taxes $33,438 $24,892 $23,189 Financial information related to the Company’s operations by geographic area consisted of the following: Year ended December 31 2004 2003 2002 Net sales United States $380,731 $356,194 $362,410 Canada 21,806 18,976 16,505 Other foreign countries 17,115 13,921 8,541 Consolidated total $419,652 $389,091 $387,456 Year ended December 31 2004 2004 2003 Long-lived assets United States $62,677 $65,064 $62,157 Canada 8,269 8,199 7,139 Other foreign countries 155 291 376 Consolidated total $71,101 $73,554 $69,672 Net sales are attributed to countries based on the location of customers. Long-lived assets consist of total property, plant and equipment and goodwill. NOTE P – SUMMARY OF UNAUDITED QUARTERLY RESULTS OF OPERATIONS Unaudited quarterly results of operations for the years ended December 31, 2004 and 2003 are summarized as follows: Quarter ended 2004 Mar. 31 Jun. 30 Sept. 30 Dec. 31 (Dollars in thousands, except per share data) Net sales $100,658 $104,443 $107,380 $107,171 Cost of goods sold 35,261 38,796 40,667 41,247 Income before income taxes1 10,527 8,726 9,048 5,137 Provision for income taxes2 4,001 3,409 3,462 1,141 Net income 6,526 5,317 5,586 3,996 Net income per share of common stock: Basic and diluted 0.69 0.56 0.59 0.43 Diluted weighted average shares outstanding 9,515 9,475 9,422 9,343 Quarter ended 2003 Mar. 31 Jun. 30 Sept. 30 Dec. 31 (Dollars in thousands, except per share data) Net sales $96,075 $97,109 $99,301 $96,606 Cost of goods sold 34,548 35,034 35,349 36,193 Income before income taxes3 6,621 6,705 7,488 4,078 Provision for income taxes4 2,863 2,564 3,124 145 Net income5 3,758 4,141 4,364 3,933 Net income per share of common stock: Basic and Diluted 0.40 0.44 0.46 0.41 Diluted weighted average shares outstanding 9,511 9,506 9,511 9,519 1 The fourth quarter includes incentive compensation expense of $1,736 related to stock performance rights and a $881 increase to employee compensation accruals. 2 The fourth quarter includes a $560 reduction of the tax provision to reflect tax exempt income related to executive life insurance and charitable contributions of inventory. 3 The fourth quarter includes a $2,789 pretax loss related to the sale of Lawson Products Limited, the Company’s former UK subsidiary. 4 The fourth quarter includes a $2,157 reduction of the tax provision to reflect the partial utilization of a capital loss generated by the sale of the Company’s former UK subsidiary. 5 The second, third and fourth quarters, respectively, include $751, $240 and $486 of charges for compensation arrangements related to management personnel reductions. 16 Lawson Products, Inc. and Subsidiaries ® Management’s Report on Internal Control Over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a -15(f) under the Exchange Act. As required by Rule 13a -15(c) under the Exchange Act, the Company’s management carried out an evaluation, with the participation of the Company’s chief executive officer and chief financial officer, of the effectiveness of our internal control over financial reporting as of December 31, 2004. The framework on which the evaluation was based is contained in the report entitled “Internal Control – Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on our evaluation under COSO criteria, our management concluded that our internal control over financial reporting was effective as of December 31, 2004. Ernst & Young LLP, the Company’s independent registered public accounting firm, have issued an attestation report on the Company’s management assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, which is included herein. 17 Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting To the Stockholders and Board of Directors Lawson Products, Inc. We have audited management’s assessment, included in the accompanying consolidated financial statements, that Lawson Products, Inc.’s maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Lawson Products, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance 18 with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion management’s assessment that Lawson Products, Inc. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects based on the COSO criteria. Also, in our opinion, Lawson Products, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria. We have also audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Lawson Products, Inc. and subsidiaries as of December 31, 2004 and 2003 and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004 of Lawson Products, Inc. and subsidiaries and our report dated March 10, 2005 expressed an unqualified opinion thereon. Chicago, Illinois March 10, 2005 Lawson Products, Inc. and Subsidiaries ® Management’s Discussion and Analysis of Results of Operations and Financial Condition SUMMARY OF FINANCIAL PERFORMANCE (Dollars in thousands, except share data) 2004 % of Sales 2003 % of Sales 2002 % of Sales Net sales $419,652 100.0% $389,091 100.0% $387,456 100.0% Cost of goods sold 155,971 37.2 141,124 36.3 137,129 Gross profit 263,681 62.8 247,967 63.7 250,327 Operating expenses 232,870 55.5 225,226 57.9 228,516 Operating income 30,811 7.3 22,741 5.8 21,811 Other 2,627 0.6 2,151 0.6 1,378 Income before taxes 33,438 8.0 24,892 6.4 23,189 Income tax expense 12,013 2.9 8,696 2.2% 10,742 35.4 64.6 59.0 5.6 0.4 6.0 2.8 Net income $21,425 5.1% $16,196 4.2% $12,447 3.2% Diluted earnings per share $2.27 $1.70 $1.30 Total assests 260,550 246,943 225,831 Return on assets 8.2% 6.6% 5.5% Stockholders’ equity 180,332 173,351 162,343 Return on average equity 12.0% 9.6% 7.7% Lawson achieved solid financial results in 2004, including record sales of approximately $420 million. The Company effectively managed costs, resulting in strong operating income leverage and earnings growth. For 2004, net income per share increased by 33.5% to $2.27 per share from $1.70 per share in 2003. Management’s discussion and analysis of operating results below focuses on the MRO and OEM businesses. These businesses represent the domestic and international segments of the respective businesses. For additional information on the Company’s segment reporting refer to Footnote O-Segment Reporting in the Notes to Consolidated Financial Statements included elsewhere in this annual report. YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003 REVENUES AND GROSS PROFIT Net sales increased by $30.6 million to $419.7 million in 2004 compared to $389.1 million in 2003, a 7.9% increase. The following table presents the Company’s net sales results for its MRO and OEM businesses for the past two years: 2004 2003 MRO $337.9 $321.0 OEM 81.8 68.1 $419.7 $389.1 MRO sales grew by $16.9 million or 5.3% in 2004. Increases in average unit selling prices were the primary driver of MRO sales growth in 2004. Changes in product sales mix and the effects of selling price increases contributed to the increase in average unit selling prices in 2004. MRO sales increase was also due to enhanced account penetration, growth in government programs, and an improved business climate. OEM sales grew by $13.7 million or 20.1% in 2004 compared to 2003, driven by domestic and international growth. The OEM business added new customers and increased sales to existing customers in 2004. Gross profit increased by $15.7 million or 6.3%, to $263.7 million in 2004 compared to $248.0 million in 2003. As a percent of sales, gross profit decreased to 62.8% in 2004 from 63.7% in 2003. The decline in overall gross profit margins is primarily related to the rapid sales growth in the OEM segment. As discussed above, OEM segment sales increased at a 20.1% rate in 2004 compared to 5.3% in the MRO segment, having the effect of reducing consolidated gross profit margins compared to 2003. MRO segment gross profit margins increased from 71.3% in 2003 to 71.8 % in 2004. As a result of price increases implemented in 2004, average selling prices increased and drove gross profit margins higher. OPERATING EXPENSES AND OPERATING INCOME Operating expenses increased by 3.4% or $7.6 million to $232.9 million in 2004 compared to $225.2 million in 2003. The increase in operating expenses is primarily the result of higher compensation costs, including a $2.6 million charge for Stock Performance Rights, reflecting the accounting for the impact of the 51.8% increase in Lawson’s stock price from $33.07 at December 31, 2003 to $50.19 at December 31, 2004. Other 19 compensation costs increased, including sales commissions, as a result of higher MRO sales in 2004, and the payment of higher sales commissions. As a percentage of sales, operating expenses decreased from 57.9% in 2003 to 55.5% in 2004, primarily as the result of productivity improvements and the Company’s ability to leverage its operating cost infrastructure over a larger revenue base. Operating income increased by 35.5% in 2004 to $30.8 million. This increase is the result of net sales increases and improved operating expense leverage, offset somewhat by lower consolidated gross profit margins. OTHER INCOME AND EXPENSE Other income consists primarily of rental income from the Company’s investment in a real estate partnership, as well as other miscellaneous income and expenses. For 2004, other income increased by $0.5 million as a result of life insurance death benefits paid to the Company. PROVISION FOR INCOME TAXES The effective tax rates for 2004 and 2003 were 35.9% and 34.9%, respectively. In 2004, the effective tax rate included the impact of $1.9 million of tax free proceeds from executive life insurance. In 2003, the effective tax rate included the effect of a $2.2 million tax provision reduction to reflect the partial utilization of a capital loss carryback generated by the 2003 sale of the Company’s MRO business in the United Kingdom. NET INCOME Net income increased by $5.2 million or 32.3% to $21.4 million in 2004 from $16.2 million in 2003. The factors that affected net income comparisons have been discussed above. Per share net income comparisons were positively impacted by the Company’s share repurchase program. YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEAR ENDED DECEMBER 31, 2002 REVENUES AND GROSS PROFIT Gross profit decreased by $2.3 million, or 0.9%, to $248.0 million during 2003 from $250.3 million in 2002. This decrease resulted partially from product mix, as the Company sold a lower percentage of MRO products as a percentage of total sales in 2003 as compared to 2002. In 2003, MRO gross profit was 71.3% of sales, compared to 72.4% in 2003. OEM gross profit margins increased in 2003 to 28.8% of sales, compared to 25.3% in 2002. OPERATING EXPENSES AND OPERATING INCOME Operating expenses decreased by $3.3 million, or 1.4%, to $225.2 million (57.9% of sales) in 2003 from $228.5 million (59.0% of sales) in 2002. The decline in operating expenses was attributable to the Company’s continuing efforts to contain and reduce costs. Lower sales agent compensation and benefit costs more than offset increases in other expenses, principally wages and a loss of approximately $2.8 million in connection with the sale of the MRO operations of the Company’s former UK subsidiary. The decrease in sales agent compensation and benefits resulted principally from the expiration of a special promotional program ending in the second quarter of 2002. Operating income increased by $0.9 million, or 4.3%, to $22.7 million in 2003 from $21.8 million in 2002. The increase resulted primarily from lower operating expenses noted above, partially offset by lower gross profit and higher other charges. OTHER INCOME AND EXPENSE Other income consists primarily of rental income. For 2003, other income increased by $0.8 million primarily due to the consolidation of the Company’s investment in a real estate partnership beginning in July of 2003. PROVISION FOR INCOME TAXES The effective income tax rates were approximately 34.9% and 46.3%, respectively, for 2003 and 2002. The decrease in the effective tax rate was primarily attributable to a $2.2 million reduction of the income tax provision to reflect the partial utilization of a capital loss carryback generated by the 2003 sale of Lawson Products Limited, the Company’s former subsidiary in the United Kingdom. The following table presents the Company’s net sales results for its MRO and OEM businesses for 2003 and 2002: NET INCOME 2003 2002 MRO $321.0 $323.4 OEM 68.1 64.1 $389.1 $387.5 Net sales increased by $1.6 million, or 0.4 % in 2003 compared to 2002. The table above illustrates that OEM sales increased $4.0 million (6.2%) in 2003 while MRO sales declined $2.4 million (0.7 %). In the OEM segment, the Company increased key account penetration and expanded its international business. Overall, international sales growth in the OEM segment offset a slight decline in U.S. OEM sales in 2003. The MRO segment continued to face difficult market conditions in 2003, particularly in the United States. MRO sales gains in Canada for 2003 were offset by sales declines in domestic MRO business in 2003. Net income increased by $3.7 million, or 30.1%, to $16.2 million during 2003 from $12.5 million in 2002, while income per share increased 31.0% to $1.70 in 2003 from $1.30 in 2002. The principal factors affecting net income and earnings per share were lower income taxes and higher operating income, as discussed above. Per share net income for 2003 and 2002 was positively impacted by the Company’s share repurchase program. LIQUIDITY AND CAPITAL RESOURCES Cash flows from operations and an unused $50 million unsecured line of credit (entered into in February 2001) have been sufficient to fund operating requirements, cash dividends and capital improvements. Cash flows from operations and the line of credit are also expected to finance the Company’s future growth. Cash flows provided by operations for 2004, 2003 and 2002 were $25.8 million, $27.9 million and $29.7 million, respectively. The decline in 2004 was principally attributable to increasing operating assets, primarily accounts receivable and inventory, 20 Lawson Products, Inc. and Subsidiaries ® more than offsetting the $5.2 million increase in net income. The decline in 2003 from 2002 was due primarily to increasing operating assets, primarily accounts receivable and cash value of life insurance more than offsetting the $3.7 million increase in net income. Working capital at December 31, 2004 and 2003 was approximately $115.0 million and $107.9 million, respectively. At December 31, 2004 the current ratio was 3.7 to 1 as compared to 3.9 to 1 at December 31, 2003. Over the past three years, the Company has made the following purchases of its common stock: YEAR YEAR SHARES COST AUTHORIZED PURCHSED PURCHASED (in millions) BY BOARD 2004 249,236 $9.6 2000 2003 20,186 0.6 2000 2002 196,250 5.6 1999/2000 In October 2004, the Company’s Board of Director’s authorized the purchase of up to 500,000 shares of the Company’s common stock in addition to that previously authorized. There is no expiration relative to this authorization. At December 31, 2004, 500,000 shares were available for purchase pursuant to the 2004 authorization and 37,163 shares were available for purchase pursuant to the 2000 Board authorization. Funds to purchase these shares were provided by investments and cash flows from operations. Additions to property, plant and equipment were $3.8 million, $5.7 million and $6.7 million, respectively, for 2004, 2003 and 2002. Capital expenditures were principally related to improvement of existing facilities and the purchase of related equipment as well as the development of software. For 2004, the Company incurred lower facility expansion expenditures as compared to prior years. Future contractual obligations consisted of the following at December 31, 2004: 2010 and (In thousands) 2005 2006 2007 2008 2009 thereafter Total Rents $3,502 $2,936 $2,488 $1,685 $1,482 $ 2,256 $14,349 Mortgage payable 1,573 – – – – – 1,573 Deferred compensation 733 614 349 326 155 13,007 15,184 Security bonus plan1 – – – – – 21,528 21,528 Total contractual cash obligations $5,808 $3,550 $2,837 $2,011 $1,637 $36,791 $52,634 1Payments to beneficiaries of the security bonus plan are made on a lump sum basis at time of retirement. No such obligations exist at December 31, 2004. BUSINESS DISPOSALS Sale of MRO Operations in United Kingdom: During the fourth quarter of 2003, the Company completed the sale of its United Kingdom MRO subsidiary. As stated above, in connection with the sale of this operation, the Company incurred a loss of $2.8 million, including inventory write-offs of $1.8 million. The Company’s OEM customers in the United Kingdom will be serviced through a newly formed entity, Assembly Component Systems Limited. CRITICAL ACCOUNTING POLICIES The Company has disclosed its accounting policies in Note B to the consolidated financial statements. The following provides supplemental information to these accounting policies as well as information on the accounts requiring more significant estimates. Allowance for Doubtful Accounts - Methodology: The Company evaluates the collectibility of accounts receivable based on a combination of factors. In circumstances where the Company is aware of a specific customer’s inability to meet its financial obligations (e.g., bankruptcy filings, substantial down-grading of credit ratings), a specific reserve for bad debts is recorded against amounts due to reduce the receivable to the amount the Company reasonably believes will be collected. For all other customers, the Company recognizes reserves for bad debts based on the Company’s historical experience of bad debt write-offs as a percent of accounts receivable outstanding. If circumstances change (i.e., higher than expected defaults or an unexpected material adverse change in a major customer’s ability to meet its financial obligations), the estimates of the recoverability of amounts due the Company could be revised by a material amount. Inventories - Slow Moving and Obsolescence: The Company carries significant amounts of inventories, which is a part of the Company’s strategy as a competitive advantage in its ability to fulfill the vast majority of our customers’ orders the same day received. However, this strategy also increases the chances that portions of the inventory have decreased in value below their carrying cost. To reduce inventory to a lower of cost or market value, the Company records a reserve for slow-moving and obsolete inventory. The Company defines obsolete as those inventory parts on hand which the Company plans to discontinue to offer to its customers. Slow-moving inventory is monitored by examining reports of parts which have not been sold for extended periods. The Company records the reserve needed based on its historical experience of how much the selling prices must be reduced to move these obsolete and slow-moving products. If experience or market conditions change, estimates of the reserves needed could be revised by a material amount. Impact of Inflation and Changing Prices: The Company has historically been able to pass on to its customers most increases in product costs. Accordingly, gross margins have not been materially impacted. The impact from inflation has historically been more significant on the Company’s fixed and semi-variable operating expenses, primarily wages and benefits, although to a lesser degree in recent years due to moderate inflation levels. Although the Company expects that future costs of replacing warehouse and distribution facilities will rise due to inflation, such higher costs are not anticipated to have a material effect on future earnings. Quantitative and Qualitative Disclosures About Market Risk: The Company, through its foreign subsidiaries, distributes products in Canada, the United Kingdom and Mexico. As a result, the Company is from time to time exposed to market risk relating to the impact of foreign currency exchange rates. A hypothetical 10% adverse movement in exchange rates would increase income by $38,000 in 2004 to offset the loss by the foreign subsidiaries. The Company had no loans outstanding as of December 31, 2004 under its revolving line of credit. 21 BOARD OF DIRECTORS Sidney L. Port Founder and Vice Chairman of the Board of Directors Robert J. Washlow Chairman of the Board Chief Executive Officer James T. Brophy (Private Investor) Chairman, Audit Committee Ronald B. Port, M.D. (Retired Physician) Chairman, Variance Committee Mitchell H. Saranow (Chairman, Saranow Group LLC, a private investment firm) Chairman, Nominating and Governance Committee Wilma J. Smelcer (Trustee of Goldman Shehs Mutual Fund Complex and Former Chairman, Bank of America, Illinois) Lee S. Hillman (President, Liberation Investment Group, Investment Advisory Firm) Robert G. Rettig (Consultant) Chairman, Compensation Committee Jerome Shaffer Vice President and Special Advisor to the Chief Executive Officer CORPORATE MANAGEMENT Robert J. Washlow Chairman of the Board and Chief Executive Officer Roger F. Cannon Executive Vice President, Chief Officer, Field Sales Strategy and Development Kenneth E. Malik Group President, OEM & International Michael W. Ruprich Group President, MRO and New Channels Jeffrey B. Belford President and Chief Operating Officer Neil E. Jenkins Executive Vice President, Secretary and General Counsel Thomas Neri Executive Vice President, Chief Financial Officer, and Treasurer James J. Smith Vice President, Human Resources 22 Lawson Products, Inc. and Subsidiaries ® Profile Lawson Products, Inc. is an international seller and distributor of systems, services and products to the industrial, commercial, institutional and governmental maintenance, repair and replacement marketplace. The Company also manufactures, sells and distributes specialized component parts to the original equipment marketplace including automotive, appliance, aerospace, construction and transportation industries. The Company offers to customers over 900,000 products including fasteners, parts, chemical specialties, hardware, welding supplies, pneumatics, hydraulic and other flexible hose fittings, tools, safety items and electrical and shop supplies. Customers are currently served from seventeen strategically located facilities by approximately 1,800 sales representatives in the United States, Puerto Rico, Canada, Mexico and the United Kingdom. Lawson Products was founded in 1952 by Sidney L. Port, Vice Chairman of the Board of Directors. Corporate Information ANNUAL MEETING The annual meeting of stockholders will be held at 10:00 a.m. Tuesday, May 10, 2005 at Corporate Headquarters. FORM 10-K A copy of the Company’s 2004 Annual Report on Form 10-K to the Securities and Exchange Commission is available without charge to stockholders upon written request to the Secretary of the Company. CORPORATE HEADQUARTERS Lawson Products, Inc. 1666 East Touhy Avenue Des Plaines, Illinois 60018 847-827-9666 www.lawsonproducts.com PROFESSIONAL SERVICES Auditors Ernst & Young LLP Legal Counsel McDermott, Will & Emery Vedder, Price, Kaufman & Kammholz SHARE OWNER SERVICES EquiServe Trust Company, N.A. P.O. Box 43023 • Providence, RI 02940-3023 Telephone: (877)498-8861 (Operators are available Monday-Friday, 8:30 a.m. to 7:00 p.m. Eastern time. An interactive automated system is available around the clock every day.) Internet: http://www.equiserve.com Access your account via the internet: http://gateway.equiserve.com NASDAQ NATIONAL MARKET The common stock of Lawson Products is part of the NASDAQ National Market System. Stock quotations are included in the National Market system table in The Wall Street Journal and in leading daily newspapers across the country. These provide the same high, low and closing transaction prices as are shown for securities traded on the New York and other stock exchanges. 23 Lawson Family of Businesses LAWSON PRODUCTS, INC. and named subsidiaries in Canada, Mexico and the United Kingdom provide abrasives, electrical items, fasteners, fittings, hardware, hoses, hydraulics, pneumatics, supplies and tools, together with engineering consultations and inventory control solutions for the maintenance and repair requirements of customers. James W. Degnan President CRONATRON WELDING SYSTEMS, INC. Provides maintenance and repair operations with metallurgical solutions, welding equipment and supplies, wearplate, rods, polymers and powders along with inventory control systems. Susan J. Collins President DRUMMOND AMERICAN CORPORATION and its J.I. Holcomb Division provides specialty chemical solutions and inventory control systems to maintenance and repair operations, food service and housekeeping industries. Roland E. Lazzaro Jr. President KENT AUTOMOTIVE offers a broad range of specialty, high performance, problem-solving products and systems for the automotive collision and mechanical repair aftermarket. Thomas E. Pavlick Vice President and General Manager 24 ASSEMBLY COMPONENT SYSTEMS, INC. Provides original equipment manufacturers with just-in-time inventories of custom-ordered component parts and in-plant inventory systems or vendor-managed inventory systems through electronic commerce mechanisms. Richard Schwind President and Chief Operating Officer AUTOMATIC SCREW MACHINE PRODUCTS COMPANY, INC. Manufacturer of specialized machined parts for the OEM and MRO marketplaces. Michael Selby President C.B. LYNN COMPANY A custom solutions provider for obtaining special items supplemental to those products, parts and supplies regularly inventoried by the Family of Businesses. Scott O. McCullough Vice President and General Manager SPECTRUM INDUSTRIAL SOLUTIONS Customized Inventory Management Systems and Solutions provider servicing in-plant MRO customers utilizing a wide array of channel options to support uptime goals, achieve supply chain initiatives, system efficiencies, and to provide total cost effectiveness. Warren Ludvigsen Vice President Lawson Products, Inc. The Single Source of Supply Keeping Businesses Running at the Lowest Overall Cost 25 Lawson Products, Inc. Corporate Headquarters 1666 East Touhy Avenue Des Plaines, Illinois 60018 www.lawsonproducts.com

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