R U S S E L M E T A L S 2 0 0 5 A N N U A L R E P O R T 2 0 0 5 A n n u a l R e p o r t 1900 Minnesota Court, Suite 210 Mississauga, Ontario, Canada L5N 3C9 Tel: (905) 819-7777 Fax: (905) 819-7409 E-mail: info@russelmetals.com Internet: www.russelmetals.com > five-year financial highlights For the years ended December 31 2005 2004 2003 2002 2001 OPERATING RESULTS ($000) Revenues Net earnings EBIT (Notes) EBITDA (Notes) Basic earnings per common share ($) $ $ 2,615,246 124,716 202,681 221,839 2.47 $ 2,412,502 177,846 305,761 324,359 3.64 $ $ 1,503,814 18,499 55,050 71,380 0.41 $ $ 1,403,275 29,236 67,923 83,115 0.71 $ $ 1,402,509 8,608 38,759 53,422 0.17 $ 356,079 474,034 1,333 $ 356,755 553,915 1,658 $ 247,513 303,048 2,005 $ 197,653 329,415 2,770 $ 192,244 265,417 2,053 BALANCE SHEET INFORMATION ($000) Metals Accounts receivable Inventories Prepaid expenses and other assets Accounts payable and accrued liabilities $ Net working capital – Metals Fixed assets Goodwill Net assets employed in metals operations Other operating assets Net income tax assets and liabilities Deferred financing charges Pension and benefit liabilities Other corporate assets and liabilities Total net assets employed $ (291,259) 540,187 162,263 9,205 711,655 21,955 (9,575) 7,240 (9,308) (24,194) 697,773 (318,450) 593,878 161,597 9,205 764,680 22,387 (59,270) 8,357 (10,146) (26,196) 699,812 $ CAPITALIZATION ($000) Bank indebtedness, net of cash Long-term debt Preferred shares Total interest bearing debt, net of cash Market capitalization (Notes) Total firm value $ (44,957) 204,033 – 159,076 1,106,834 $ 1,265,910 $ 32,608 210,630 – 243,238 773,259 $ 1,016,497 OTHER INFORMATION (Notes) $ Common shareholders’ equity ($000) Book value per share ($) $ Free cash flow ($000) (Notes) $ Capital expenditures ($000) $ Depreciation and amortization ($000) $ Earnings multiple (Notes) Firm value as a multiple of EBIT Firm value as a multiple of EBITDA Interest bearing debt/EBITDA Debt as percentage of capitalization (Notes) Market capitalization as a % of book value Return on capital employed (Notes) 538,697 10.63 130,628 26,463 19,158 8.8 6.2 5.7 0.7 23% 205% 29% $ $ $ $ $ 456,574 9.15 189,408 25,394 18,598 4.3 3.3 3.1 0.7 35% 169% 44% (207,886) 344,680 165,112 4,216 514,008 23,257 (1,468) 3,547 (11,542) (5,473) 522,329 59,085 179,402 30,000 268,487 378,175 646,662 253,842 5.90 7,606 34,879 16,330 21.4 11.7 9.1 3.8 51% 149% 11% $ $ $ $ $ $ $ $ (178,623) 351,215 88,898 2,709 442,822 24,750 768 4,962 (9,590) (2,597) 461,115 (3,927) 212,602 30,000 238,675 194,091 432,766 222,440 5.84 45,210 12,768 15,192 7.2 6.4 5.2 2.9 52% 87% 15% $ $ $ $ $ $ $ $ (157,300) 302,414 85,825 15,123 403,362 26,434 13,326 6,177 (9,242) 3,615 443,672 (17,151) 214,105 30,000 226,954 136,733 363,687 216,718 5.71 30,336 8,152 14,663 21.2 9.4 6.8 4.2 51% 63% 9% $ $ $ $ $ $ $ $ COMMON SHARE INFORMATION Ending outstanding common shares Average outstanding common shares Dividend yield (Notes) Dividend per share (Notes) Share price – High Share price – Low Share price – Ending $ $ $ $ 50,656,009 50,461,330 49,887,659 48,671,915 43,023,342 40,021,479 38,057,001 38,024,034 37,981,501 37,981,501 4.6% 1.00 22.75 13.40 21.85 $ $ $ $ 4.5% 0.70 15.75 11.61 15.50 $ $ $ $ 3.6% 0.32 8.90 4.65 8.79 $ $ $ $ 4.7% 0.24 5.49 3.46 5.10 $ $ $ $ 5.6% 0.20 3.90 2.70 3.60 NOTES: (1) In this Annual Report the Company uses certain financial measures that do not comply with Canadian generally accepted accounting principles (GAAP) or have standardized meanings and thus may not be comparable to similar measures presented by other issuers, for example EBIT and EBITDA and other information in the above table. Management believes that EBIT and EBITDA may be useful in assessing our operating performance and as an indicator of our ability to service or incur indebtedness, make capital expenditures and finance working capital requirements. EBIT and EBITDA should not be considered in isolation or as an alternative to cash from operating activities or other combined income or cash flow data prepared in accordance with Canadian GAAP. EBIT, EBITDA and a number of the ratios provided under Other Information are used by debt and equity analysts to compare our performance against other public companies. This terminology is defined on the inside back cover, under Definitions. See financial statements for GAAP earnings. (2) Statements contained in this document that relate to Russel Metals’ beliefs or expectations as to certain future events are not statements of historical fact and are forward-looking statements. Russel Metals cautions readers that there are important factors, risks and uncertainties, including but not limited to economic, competitive and governmental factors affecting Russel Metals’ operations, markets, products, services and prices that could cause the Company’s actual results, performance or achievements to be materially different from those forecasted or anticipated by Russel Metals in such forward- looking statements. All dollar references in this report are in Canadian dollars unless otherwise stated. DEFINITIONS EBIT -- Earnings from continuing operations before deduction of interest and income taxes. EBITDA – Earnings from continuing operations before deduction of interest, income taxes, depreciation and amortization. Earnings multiple -- Period ending common share price divided by basic earnings per common share. Free cash flow -- Cash from operating activities before working capital less capital expenditures plus sale of assets. Market capitalization -- Outstanding common shares times market price of a common share at December 31. Return on capital employed -- EBIT over net assets employed. Dividend per share – Dividend per share is the December 15th quarterly dividend annualized. Dividend yield – Dividend yield is the dividend per share divided by the year end common share price. Book value per share – Equity value divided by ending shares outstanding in period. RUSS 1064 2005AR_Innards 3/23/06 1:11 PM Page 1 > report to shareholders For the year ended December 31, 2005 sustainability. in last year’s Annual Report continued to be factors throughout 2005 and into The global trends influencing the industry discussed 2006. These include the continued worldwide consolidation of steel producers, rising energy and input costs for steel producers, the preoccupation with the evaluation of the impact China and India will have in the steel market, continued steel price volatility, and the strengthening of the Canadian dollar. Brian R. Hedges Executive Vice President and Chief Financial Officer Edward M. Siegel, Jr. President and Chief Executive Officer Maureen A. Kelly Vice President, Information Systems Marion E. Britton Vice President and Chief Accounting Officer David J. Halcrow Vice President, Purchasing and Inventory Management R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 1 RUSS 1064 2005AR_Innards 3/23/06 1:11 PM Page 2 > report to shareholders cont’d Despite these macroeconomic factors, and coming off a record 2004, in 2005 we have been able to produce our second best year in history, with an excellent return on capital invested, positive cash flow, and strengthening of the balance sheet. These were all achieved in a market where steel prices declined for most of the year. In addition, both the common share dividend and common share price increased during 2005, further rewarding our shareholders. In the last three years both the dividend and the share price have more than quadrupled. As indicated in last year’s outlook, 2004 was going to be a hard act to follow, but 2005 was twice as profitable as any year prior to 2004. The 2005 earnings per share was $2.47 as earnings and margins improved in the second half of the year. In the first half, steel prices declined from the record highs of 2004, especially in hot rolled coil and hollow structural shapes. Due to the decline in steel prices, we experienced inventory holding losses which caused the operating margins and earnings to decline early in 2005. In the third quarter, steel prices stabilized and inventory holding losses declined. This resulted in improved margins and earnings in both the third and fourth quarters of 2005. Interestingly, if one adjusts for the inventory holding gains estimated for 2004 and the losses estimated for 2005, the earnings for both years are very similar. Operations Metals service centers produced a segment operating profit of $115 million, which was two and a half times higher than any previous year except 2004. The metals service centers return on ending net assets employed was an industry-leading 29%. Our metals service centers operations are concentrated in Canada and we remain concerned about the effect that the strengthening Canadian dollar will have on our customers who export to the United States. Many operations in Canada compete with similar manufacturers or with plants owned by their parent companies within the United States, causing margin pressure on their Canadian content, although higher prices for many finished products have helped to mitigate this situation. Our energy tubular products segment had improved earnings during 2005 due to the continued strength of oil and gas drilling activities. This segment generated record operating earnings of $54 million and a 27% return on ending net assets employed. Specifically, our Comco Pipe and Supply Company operation produced record earnings boosted by the amount of activity in the oil sands area of Northern Alberta. Our steel distributors segment experienced the same margin pressures as the metals service centers and also improved in the second half of the year. Our steel distributors operating profits for 2005 were $47 million, again second only to the 2004 net earnings of $78 million. The 40% return on ending net assets employed in steel distributors was, for the second straight year, the highest of our three business segments. Liquidity The Company generated $136 million in positive cash flow from operating activities in 2005. This allowed us to increase the common share dividend. We paid our shareholders $45 million in dividends during 2005. We reduced net interest bearing debt by $169 million from its peak of $328 million in March 2005, further improving one of the strongest balance sheets in the metals sector. The 2005 cash flow includes tax payments related to 2004, which reduced the reported cash flow for 2005 by approximately $61 million. Without these payments, the 2005 cash generated from operating activities would have been $197 million. 2 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:11 PM Page 3 Our earnings for each of the last two years have increased substantially from prior years primarily due to successful acquisitions and higher steel prices. The financial community continues to discuss the importance of aligning the cash flow and the earnings for companies that experience significant increases in profitability. Our earnings for each of the last two years have increased substantially from prior years, primarily due to successful acquisitions and higher steel prices. The positive cash flow generated in 2005 is in sync with the increased profitability and validates the fundamental strength of our business model. The strong earnings have financed a $310 million increase in inventory and accounts receivable balances over the last two years in addition to a significant reduction of interest bearing debt. The balance sheet has never been healthier and total interest bearing debt net of cash has improved to 23% of capitalization. The inventory levels were reduced during 2005, and current assets represent over 80% of the total assets. Management Priorities In last year’s Annual Report, we stated that the 2004 results exceeded the targets for all management priorities. I am pleased to say that the same is true for 2005. Revenue levels increased in 2005 versus 2004, but the emphasis on working capital levels, stated as a priority for 2005, yielded inventory reductions. Acquisition opportunities presented themselves but the valuations paid exceeded our comfort zone in what remains a highly cyclical industry. We continue to evaluate all opportunities with patience and discipline. We will not execute acquisitions solely for top-line revenue growth, as they must show immediate earnings accretion. Acquisitions that meet our stringent criteria remain a priority for 2006. The 2005 per formance was very strong. The return on ending capital employed was 29%, our industry-leading ninth consecutive year in double digits. Our focus on health and safety practices has resulted in significant premium reductions due to the improved health and safety record. The management priorities for 2006 are to continue to produce excellent results, to position us for the inevitable steel price volatility, and to ensure that all of our operations remain highly focused. Corporate Governance Our website was enhanced during 2005 and includes the Company’s Values Statement, the Code of Business Conduct and the Charter of the Board of Directors and its committees. Our corporate governance practices are aligned with the best practices in Canada and we continue to enhance them as needed. We believe the most important consideration in strong governance is the tone from the top of the organization as set by the Board of Directors and management at all levels. Our Board of Directors has set very high levels of expectations, stressing honesty, transparency and straightforward communications in our reporting to all of our stakeholders. In addition, they closely scrutinize all acquisitions and large capital projects. As a result, our financial reporting is as transparent as possible given the myriad of accounting rules that exist today. Due to increased workload after accepting the position of Chairman at a large financial institution, Mr. Pierre Brunet has regrettably stepped down from our Board. The Board of Directors greatly appreciates his service. At the Board meeting on February 23, 2006, Mr. Alain Benedetti was appointed to our Board. He brings extensive financial experience, having been the Vice Chairman and Canadian Area Managing Partner for Ernst & Young LLP. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 3 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 4 > report to shareholders cont’d Our common share dividend has doubled since December 2004 to an annual dividend of $1.40 per share. We are required to be compliant with the Sarbanes-Oxley legislation in the United States, in addition to Canadian regulatory requirements, by year end 2006. The team assembled last year is well into its mandate to ensure our compliance with the regulatory requirements of both jurisdictions. Shareholder Returns 2005 was an interesting year for dividend stocks. On a macro level, the Canadian government proposed lower taxes on dividends, and the continuation of low interest rates made dividend stocks more attractive to investors. On a micro level, the addition of Russel Metals to the S&P/TSX Composite Index and increased market capitalization expanded the number of investment funds that could invest in the Company. The dividend increases in the first and third quarters attracted new individual investors and income-oriented mutual funds, in addition to our traditional value investors, which resulted in a significant increase to our shareholder base. The annual dividend increased 43% to $1.00 per share in 2005 and was increased a further 40% in the first quarter of 2006. At year end, our dividend yield was one of the top five in the S&P/TSX Composite Index. Our share price reached the highest level ever during 2005. It increased by 41% in 2005 and has appreciated by 653% in the last five years and 328% in the last three years, excluding dividends. The shares continue to trade at a lower multiple and higher dividend yield to other companies in the S&P/TSX Composite Index. Based on the year end share price, the Company trades at an 8.8 times price earnings multiple, significantly lower than the index as a whole. Outlook Before I discuss 2006, I would like to take this opportunity to thank our employees for a great 2005. Once again, the Russel Metals employees showed their skill at reacting quickly and maximizing returns as well as, if not better than, any in the sector. In addition, I would like to thank Ken Gilbert, Vice President Quebec Region, who retired in 2005 after a successful 42-year career with Russel Metals that culminated with his leadership role in the successful integration of Acier Leroux within Russel Metals. The steel sector has been as stable in the second half of 2005 as we have experienced in several years and it is projected to remain that way into early 2006. All three legs of our platform: the metals service centers, the energy tubular products and the steel distributors sectors are per forming at excellent levels. Assuming there is no major surprise in the price of steel, the price of oil and gas and the Canadian dollar does not appreciate materially, we are optimistic that 2006 should be another excellent year for Russel Metals. E.M. Siegel, Jr. President and Chief Executive Officer February 23, 2006 4 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 5 Russel Metals is one of the largest metals distribution companies in North America. We conduct business primarily in three metals distribution segments: metals service centers, energy tubular products and steel distributors. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 5 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 6 > management’s discussion and analysis For the year ended December 31, 2005 The following management’s discussion and analysis of financial condition and results of operations of Russel Metals Inc. and its subsidiaries provides information to assist the reader and should be read in conjunction with the audited Consolidated Financial Statements for the year ended December 31, 2005, including the notes thereto. Statements contained in this document that relate to our beliefs or expectations as to certain future events are not statements of historical fact and are forward-looking statements. We caution readers that there are important factors, risks and uncertainties, including but not limited to economic, competitive and governmental factors affecting our operations, markets, products, services and prices that could cause our actual results, performance or achievements to be materially different from those forecasted or anticipated by us in such forward-looking statements. All dollar references in this report are in Canadian dollars unless otherwise stated. This management’s discussion and analysis of financial condition and results of operations includes a number of measures that are not prescribed by generally accepted accounting principles (GAAP) and as such may not be comparable to similar measures presented by other companies. We believe these measures are commonly employed to measure performance in our industry and are used by analysts, investors, lenders and other interested parties to evaluate financial performance and our ability to incur and service debt to support our business activities. The measures we use are specifically defined where they are first used in this report. While we believe that non-GAAP measures are helpful supplemental information, they should not be considered in isolation as an alternative to net income, cash flows generated by operating, investing or financing activities, or other financial statement data presented in accordance with GAAP. Additional information related to Russel Metals Inc., including our Annual Information Form, may be obtained from SEDAR at www.sedar.com or on our website at www.russelmetals.com. Overview We are one of the largest metals distribution companies in North America. We conduct business primarily in three metals distribution segments: metals service centers; energy tubular products; and steel distributors. The continued strong performance in all three of our operating segments is reflected in our results. Revenues for 2005 increased over 2004 levels, as the average selling price of steel remained elevated despite declining from the peak of 2004. The unprecedented rate of increase in the price of steel in 2004 and our successful acquisition of Acier Leroux in 2003 were the most significant factors affecting our results for 2004. Both the moderate decline in metal prices and the continued high average level of pricing contributed to another strong year in 2005. The basic earnings per share of $2.47 for the year ended December 31, 2005 are lower than those reported for the year ended December 31, 2004 of $3.64, mainly due to the swing to inventory holding losses in 2005 from inventory holding gains in 2004. Total Revenues $ millions Earnings per Share $ per share Return on Capital Employed % 2,615 2,413 1,403 1,403 1,504 3.64 2.47 0.71 0.41 0.17 44 29 15 11 9 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 6 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 7 Summarized Financial Information The table discloses selected information related to revenues, earnings and common share information over the last eight quarters. The quarterly numbers for 2004 and the first quarter of 2005 have been restated to reclassify the operations of Armabec Inc. to discontinued, related to the sale in the second quarter of 2005. 2005 (in thousands of dollars, except per share data and volumes) Mar. 31 June 30 Sept. 30 Dec. 31 Three Months Ended Year Ended Dec. 31 Revenues Earnings from operations Net earnings – continuing operations Net earnings Basic earnings per common share – continuing operations Basic earnings per common share Diluted earnings per common share – continuing operations Diluted earnings per common share Market price of common shares High Low $ 693,889 $ 644,845 $ 629,604 $ 646,908 $ 2,615,246 58,807 39,205 42,687 60,842 201,541 33,490 33,444 23,540 23,524 25,932 25,932 41,816 41,816 124,778 124,716 $ $ $ $ $ $ 0.67 0.67 0.66 0.66 18.78 14.60 $ $ $ $ $ $ 0.47 0.47 0.46 0.46 16.84 13.40 $ $ $ $ $ $ 0.51 0.51 0.50 0.50 18.84 13.85 $ $ $ $ $ $ 0.83 0.83 0.81 0.81 22.75 17.25 $ $ $ $ $ $ 2.47 2.47 2.42 2.42 22.75 13.40 Number of common shares traded 12,304,628 17,461,794 13,890,518 13,100,827 56,757,767 2004 (in thousands of dollars, except per share data and volumes) Mar. 31 June 30 Sept. 30 Dec. 31 Three Months Ended Year Ended Dec. 31 Revenues Earnings from operations Net earnings – continuing operations Net earnings Basic earnings per common share – continuing operations Basic earnings per common share Diluted earnings per common share – continuing operations Diluted earnings per common share Market price of common shares High Low $ 512,402 $ 588,014 $ 688,812 $ 623,274 $ 2,412,502 59,971 90,806 99,130 73,204 323,111 25,651 25,304 51,304 50,407 57,740 58,605 45,774 43,530 180,469 177,846 $ $ $ $ $ $ 0.54 0.53 0.53 0.52 9.65 8.01 $ $ $ $ $ $ 1.05 1.03 1.01 1.00 11.25 8.55 $ $ $ $ $ $ 1.16 1.18 1.14 1.16 13.00 10.25 $ $ $ $ $ $ 0.92 0.87 0.91 0.86 15.75 11.61 $ $ $ $ $ $ 3.70 3.64 3.61 3.56 15.75 8.01 Number of common shares traded 8,078,316 21,082,325 17,151,707 15,858,809 62,171,157 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 7 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 8 > management’s discussion and analysis cont’d Results of Operations The following table provides operating profits from continuing operations before interest, taxes and restructuring costs. The corporate expenses included are not allocated to specific operating segments. The gross margins (revenue minus cost of sales) as a percentage of revenues for the operating segments are also shown below. The table shows the segments as they are reported to management and they are consistent with the segmented reporting in the consolidated financial statements. (in thousands of dollars, except percentages) 2005 2004 2003 of 2004 of 2003 2005 2004 Change as a % Change as a % Segment Revenues Metals service centers Energy tubular products Steel distributors Other Segment Operating Profits Metals service centers Energy tubular products Steel distributors Other Corporate expenses $ 1,539,673 $ 1,532,048 $ 595,215 468,720 11,638 395,296 471,205 13,953 909,502 297,532 283,579 13,201 $ 2,615,246 $ 2,412,502 $ 1,503,814 $ 115,218 $ 209,413 $ 53,977 46,575 2,385 47,200 78,189 4,565 (16,614) (16,256) 37,567 13,764 13,380 4,002 (8,018) Operating profits from continuing operations $ 201,541 $ 323,111 $ 60,695 Segment Gross Margin as a % of Revenues Metals service centers Energy tubular products Steel distributors Total operations Segment Operating Profits as a % of Revenues Metals service centers Energy tubular products Steel distributors Total operations 23.1% 14.6% 14.3% 19.8% 7.5% 9.1% 9.9% 7.7% 30.9% 19.6% 23.5% 27.8% 13.7% 11.9% 16.6% 13.4% 26.2% 11.6% 10.8% 20.8% 4.1% 4.6% 4.7% 4.0% 0% 51% (1%) (17%) 8% (45%) 14% (40%) (48%) (2%) (38%) 68% 33% 66% 6% 60% 457% 243% 484% 14% (103%) 432% Return on Averaged Capital Employed Metals Service Centers % Energy Tubular Products % 50.5 26.3 15.4 12.5 10.1 40.8 29.2 17.5 14.7 14.2 Steel Distributors % 69.8 27.6 31.5 13.6 13.3 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 8 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 9 Metals Service Centers Our metals service centers carry a broad line of products in a wide range of sizes, shapes and specifications, including carbon hot rolled and cold finished steel, pipe and tubular products, stainless steel and aluminum. a) Description of operations We provide processing and distribution services to a broad base of more than 19,000 end users through a network of 52 Canadian locations and four U.S. locations. Our metals service centers carry a broad line of products in a wide range of sizes, shapes and specifications, including carbon hot rolled and cold finished steel, pipe and tubular products, stainless steel and aluminum. We purchase these products primarily from steel producers in North America and process and package them in accordance with end user specifications. We service all major geographic regions of Canada and the Midwest region in the United States. Within Canada, the service centers operate under the names Russel Metals, Métaux Russel, A.J. Forsyth, Acier Leroux, Acier Loubier, Acier Richler, B&T Steel, Leroux Steel, Mégantic Métal, McCabe Steel, Russel Leroux and York-Ennis. Our U.S. service center operations are conducted under the names Russel Metals Williams Bahcall and Baldwin International. The Williams Bahcall operations focus primarily on the distribution of general line carbon products through three facilities all located in Wisconsin. Baldwin International distributes specialty alloy products from its facility in Ohio. Our metals service centers results for 2003, 2004 and the first quarter of 2005 have been restated to report Armabec Inc. as a discontinued operation. Armabec was sold during the second quarter of 2005. Similarly, our metals service centers results for 2003 and 2004 were restated at the end of 2004 to report Poutrelles Delta Inc. as discontinued operations. Poutrelles Delta was sold in the first quarter of 2005. Both operations were acquired as part of the Acier Leroux acquisition in 2003. As such, results for Armabec and Poutrelles Delta are not included in the metals service centers segment. Factors affecting results b) The following is a general discussion of the significant factors affecting metals service centers results. More specific information on how these factors impacted 2005, 2004 and 2003 is found in the sections that follow. Steel pricing fluctuates significantly throughout the business cycle. Steel pricing was the most significant factor affecting both the 2005 and 2004 results. Steel prices are influenced by overall demand, trade sanctions, scrap steel pricing and product availability. Supply side management, practiced by steel producers in North America, and international supply and demand which impacts steel imports affect product availability. Trade sanctions are initiated either by steel mills or government agencies in North America and, less directly, worldwide. Over the last several years steel prices have been extremely volatile. Demand is significantly affected by economic cycles with revenues and operating profit fluctuating with the level of general business activity in the markets serviced. We are most impacted by the manufacturing (excluding automotive), resource and construction segments of the Canadian economy. Demand has been relatively stable over the last several years. Canadian service centers, which represent the majority of the metals service centers operations, are particularly affected by regional general economic conditions. We have operations in all regions of Canada and believe that we have a national market share of more than 25%. This large market share and our diverse customer base, of approximately 19,000 customers, suggest that our results should mirror the performance of the regional economies of Canada, excluding the automotive industry. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 9 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 10 > management’s discussion and analysis cont’d c) Metals service centers segment results -- 2005 compared to 2004 Revenue for 2005 approximates that of 2004. The average selling price of steel for the year ended December 31, 2005 is approximately the same as the year ended December 31, 2004. The average selling price increased during the first nine months of 2004 to a price peak in September 2004. The price declined since that date to July 2005 and has been relatively stable since then. The average selling price for the quarter ended December 31, 2005 declined approximately 12% from the quarter ended December 31, 2004. This decline is modest compared to the increase of 62% for the quarter ended December 31, 2004 compared to the quarter ended December 31, 2003. Overall tons shipped for the year ended December 31, 2005 approximated those in 2004. Tons shipped declined in Eastern Canada and improved in the Prairie region and at Williams Bahcall. Tons shipped in the Prairie region were approximately 8% higher for the year ended December 31, 2005 compared to 2004, due to strong oil and gas activity in that area. Demand was strong at the Williams Bahcall operations with approximately a 5% increase in tons due to customer demand in that region. We believe that the decline in tons shipped in the Eastern Canadian regions primarily relates to a slowdown in manufacturing activity and reductions in inventories at our customers’ locations. In January 2004, steel mills initiated raw material surcharges due to sharp price increases in scrap metal and other input costs that caused the price of steel to increase substantially. These surcharges, which were being applied to most of the service center carbon steel products, approximated $190 per ton in September 2004. During 2005, many mills have included the surcharge within their base metal price and eliminated the surcharge as a separate cost. The average price of metal has declined since September 2004; however, the average price of metal remains high compared to the price prior to the implementation of surcharges. Based on our product mix, the average cost of metal received, including surcharges, in the month of December 2005 is approximately 44% above the price for the month of December 2003 prior to the implementation of surcharges. Based on our product mix, the average cost of metal received, including surcharges, increased approximately 56% from January 2004 to December 2004. The increase was more significant in the first half of 2004 with approximately two thirds of the increase occurring in that period. Based on our database, the average cost of metal received during the month of December 2005 was approximately 14% lower than the average cost of metal received for the month of December 2004. Gross margin as a percentage of revenues declined from 30.9% for the year ended December 31, 2004 to 23.1% for the year ended December 31, 2005. Metals Service Centers Revenues $ millions Operating Profit $ millions Operating Profit as a % of Revenues 1,532 1,540 910 706 751 209 115 32 38 19 13.7 7.5 4.2 4.1 2.7 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 1 0 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 11 We estimated that our operating profit for the year ended December 31, 2004 included a before tax inventory holding gain of approximately $63 million due to rising steel prices. For the year ended December 31, 2005, we estimate that our operating profit includes a before tax inventory holding loss of approximately $38 million due to falling steel prices. The majority of our inventories are accounted for using average cost. The inventory holding gains or losses were estimated based on the best information available. We are unable to quantify with precision inventory holding gains or losses due to the complexity of our 56 service center locations, which buy and sell over 14,000 different SKU’s. The average revenue per invoice for 2005 was approximately $1,888 compared to the average for the 2004 year of approximately $1,866 and for 2003 of approximately $989. The change in the Canadian dollar versus the U.S. dollar has not been a significant factor in the metals service centers results as the value of sales in U.S. dollars is not significant and inventory is purchased for the Canadian operations from Canadian or U.S. suppliers based on the landed cost at the specific location in Canada. Operating expenses in the service center segment have decreased by $23.8 million, or 9%, for 2005 compared to 2004, primarily as a result of variable compensation programs that reflect the decreased earnings, year over year and lower compensation paid in locations that were restructured in 2004 or early 2005. Service center operating profits for the year ended December 31, 2005 decreased $94.2 million, or 45%, compared to the same period in 2004. The decline relates to an unfavorable change in inventory holding gains and losses of approximately $101 million for the 2005 year compared to the 2004 year, offset by lower expenses. d) Metals service centers segment results -- 2004 compared to 2003 Revenue for 2004 increased $623 million due to the acquisition of Acier Leroux and the increased price of steel compared to the year ended December 31, 2003. The operations of Acier Leroux were fully merged with our service centers and thus the impact of the acquisition on revenue was only estimated. We estimated, before giving effect to the impact of increased steel prices, that approximately a quarter of the revenue increase for the year ended December 31, 2004 related to the acquisition of Acier Leroux. Gross margin percentages and segment operating profits as a percentage of revenue for the Acier Leroux operations were similar to those of our other service center operations, which had increased by the same amount. Increased selling prices accounted for the balance of the increased revenue in 2004. The selling price increase occurred across all regions and product lines. The Williams Bahcall operations had a very profitable turnaround year due to steel pricing. The raw material surcharges initiated by steel mills in January 2004 caused the price of steel to increase substantially. We had estimated that our operating profit for 2004 included a before tax inventory holding gain of approximately $63 million. This holding gain occurred during the first nine months of 2004 and was estimated based on the best information available. We estimated that the average selling price per ton, for our product mix in the service centers segment, had increased approximately 43% for 2004 compared to 2003. The increases in each quarter during 2004 compared to the prior quarter were first quarter 17%, second quarter 19%, third quarter 12% and fourth quarter 4%. The average selling price increase is consistent with the increase in the cost of metal. Based on a comparison of inventory at December 31, 2004 to inventory at December 31, 2003, the average cost per ton of inventory on hand had increased approximately 69%. For 2003 and 2004, demand, based on tons sold, excluding the Acier Leroux acquisition, was surprisingly stable given the increase in selling price and the stronger Canadian dollar. The change in the Canadian dollar versus the U.S. dollar was not a significant factor in the metals service centers results as the value of sales in U.S. dollars was not significant and inventory was purchased for the Canadian operations from Canadian or U.S. suppliers based on the landed cost at the location in Canada. We remain concerned about the impact that the appreciation of the Canadian dollar may have on our Canadian manufacturing customers. Operating expenses in the metals service centers segment had increased significantly primarily as a result of the Acier Leroux acquisition. In addition, we have a pay for performance program, which covers a large portion of our employees. Provisions for incentive payouts, based on the higher level of profits, had increased operating expenses. Operating expenses as a percentage of revenues improved as the higher revenues more than offset the higher expenses. Metals service centers operating profits for 2004 increased $172 million, or 457%, compared to 2003. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 1 1 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 12 > management’s discussion and analysis cont’d Energy Tubular Products These operations distribute oil country tubular goods (OCTG), line pipe, tubes, valves and fittings, primarily to the energy industry in Western Canada and the Western United States, from 5 Canadian and 2 U.S. locations. a) Description of operations These operations distribute oil country tubular goods (OCTG), line pipe, tubes, valves and fittings, primarily to the energy industry in Western Canada and the Western United States, from 5 Canadian and 2 U.S. locations. We purchase these products either from the pipe processing arms of North American steel mills, independent manufacturers of pipe and pipe accessories or international steel mills. The energy tubular products segment operates under the names Comco Pipe & Supply Company, Fedmet Tubulars, Triumph Tubular & Supply, Pioneer Pipe and Spartan Steel. Factors affecting results b) The following is a general discussion of the factors affecting our energy tubular products segment operations. More specific information on how these factors impacted 2005, 2004 and 2003 is found in the sections that follow. Oil and gas pricing, which impacts oil rig count and subsequent drilling activities particularly in Western Canada, significantly affects demand. Oil and gas pricing has been high throughout 2004 and 2005. Oil and gas drilling in Western Canada peaks during the period from October to March; thus revenues and operating profits have been historically higher during this period. The Canadian operations are affected by the U.S. dollar exchange rate since some products are sourced outside Canada and are priced in U.S. dollars. While metal pricing has impacted our earnings more significantly, the appreciation of the Canadian dollar has also contributed by reducing our average cost of metal. Pricing is influenced by overall demand, trade sanctions and product availability. Trade sanctions are initiated either by steel mills or government agencies in North America. Trade sanctions have not been a factor for pipe products during the reported periods. Energy Tubular Products Revenues $ millions 595 395 361 290 298 Operating Profit $ millions 54 47 18 14 14 Operating Profit as a % of Revenues 11.9 9.1 5.1 4.7 4.6 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 1 2 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 13 Energy tubular products segment results -- 2005 compared to 2004 c) Revenues increased 51% to $595.2 million in the year ended December 31, 2005 compared to the year ended December 31, 2004. Oil and gas related activity in Alberta is the driving factor for this large increase in volume. Project revenue, mainly from increased demand in the oil sands of Northern Alberta, accounted for approximately 23% of the revenue increase. Continued high oil and gas pricing and more rig activity during 2005 compared to 2004 accounted for the rest of the increase in revenue. The gross margin for this segment as a percentage of revenues at 14.6% for the year ended December 31, 2005 is a decline from the segment gross margin percentage of 19.6% for the year ended December 31, 2004. The lower margin mainly relates to the increased cost of goods sold resulting from higher metal pricing. Operating profits increased by $6.8 million, or 14%, for the year ended December 31, 2005, compared to the year ended December 31, 2004. This increase in operating profits is driven by higher volumes and higher metal prices. Energy tubular products segment results -- 2004 compared to 2003 d) Revenues increased 33% in 2004 compared to 2003. Stable oil and gas pricing and more rig activity during 2004 compared to 2003 had resulted in some volume increases for the OCTG operations in Western Canada and the Western United States. Increased prices resulted in higher revenues and the realization of some inventory holding gains. Revenues and operating profits had increased with the higher metal pricing. The segments gross margins as a percentage of revenues were 19.6% for 2004 compared to 11.6% for 2003 due mainly to stronger demand and pricing. Operating profits increased by $33 million, or 243%, in 2004, compared to 2003. The increase was due to higher volumes in the OCTG operations and strong margins. Steel Distributors Our steel distributors act as master distributors selling steel in large volumes to other steel service centers and equipment manufacturers mainly on an “as is” basis and providing processing of coil products for their customer base. a) Description of operations Our steel distributors act as master distributors selling steel in large volumes to other steel service centers and equipment manufacturers mainly on an “as is” basis and providing processing of coil products for their customer base. Our steel distributors source their steel both domestically and offshore. The international sourcing provides our other business segments with valuable insight regarding international pricing trends and their potential impact on steel markets in North America. The main steel products sourced by this segment are structural beam, plate, coils, pipe and tubing. The operations in this sector are Wirth Steel and Sunbelt Group. Arrow Steel, a division of Sunbelt Group, processes coils. Factors affecting results b) The following is a general discussion of the factors affecting our steel distributors. More specific information on how these factors impacted 2005, 2004 and 2003 is found in the sections that follow. Steel pricing is influenced by overall demand, trade sanctions and by product availability both domestically and worldwide. Trade sanctions are initiated either by steel mills or government agencies in North America. Mill capacity by product line in North America and international supply and demand impact steel imports and significantly affect product availability. The large demand for steel and scrap steel in China during 2004 was a significant factor in the price of steel and the availability of imports to North America. During this period, our steel distributors found availability of supply within North America, which they continue to utilize along with imports. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 1 3 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 14 > management’s discussion and analysis cont’d Movement in the U.S. dollar has had some effect on the Canadian steel distributor operations since purchases of inventory are mainly in U.S. dollars. Steel is predominantly transacted in U.S. dollars and the Canadian mills adjust the price accordingly. The effect of the strengthening Canadian dollar was fully offset by rising metal prices. c) Steel distributors segment results – 2005 compared to 2004 Steel distributors revenues decreased 1% in the year ended December 31, 2005 compared to the year ended December 31, 2004. While revenue was flat, the 2005 revenues were generated by lower average selling prices offset by higher volumes. Gross margin as a percentage of revenues declined from 23.5% for the year ended December 31, 2004 to 14.3% for the year ended December 31, 2005. This decline primarily was related to the price of steel being at the highest levels in 2004 and stronger demand for certain products in 2004. The 2005 margins are closer to historical levels excluding 2004. The 2005 results also are impacted by holding losses versus holding gains in 2004. Operating expenses are 37% lower for 2005 compared to 2004, which is mainly due to lower variable compensation. The operating profit for 2005 is $46.6 million, which is $31.6 million lower than 2004, mainly driven by steel pricing. d) Steel distributors segment results – 2004 compared to 2003 Steel distributors revenues increased 66% in 2004 compared to 2003 mainly due to higher selling prices and demand for imported product. The demand for imports was due to lack of availability of certain products in North America. In the first quarter of 2004, volumes were negatively impacted by a lack of supply into North America due to high demand in the Far East and the lower U.S. dollar compared to other currencies. During the remainder of 2004, the steel distributors operations realized selling prices above average due to continuous price increases for their products during the year. This resulted in inventory holding gains on both inventory on hand and inventory ordered prior to the January 2004 raw material surcharge added by the North American mills. The gross margin achieved in the year continued to be higher than we had previously experienced in the steel distributors segment due to the rapid increase in the price of steel in North America and tight supply of certain products; however, it had declined during the last two quarters of 2004. Operating expenses had increased due to expenses related to highly variable compensation plans driven by operating profits. Other – 2005 Compared to 2004 Other revenue and income represents the results of our coal handling terminal in Thunder Bay, Ontario. Revenue in 2005 was lower than the same period in 2004 and 2003 due to decreased coal and potash volumes. The lower volumes resulted in an operating profit of $2.4 million for 2005 compared to a profit of $4.6 million for 2004. Steel Distributors Revenues $ millions 471 469 348 321 284 Operating Profit $ millions Operating Profit as a % of Revenues 78 47 28 14 13 16.6 9.9 8.1 4.4 4.7 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 1 4 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 15 Corporate -- 2005 Compared to 2004 and 2003 The corporate expenses for 2005 are comparable to 2004; however, the 2005 expenses include lower costs for corporate incentive plans based on lower earnings levels offset by increased costs for work in 2005 to address the Sarbanes-Oxley and OSC internal control certification requirements and expensing of stock-based compensation. The majority of the corporate expense increase for 2005 and 2004 compared to 2003 reflects accruals for corporate incentive plans based on earnings levels. Consolidated Results -- 2005 Compared to 2004 and 2003 The results for 2005 represent a decline from the 2004 year; however, they are significantly above 2003 and prior years. Operating profits from continuing operations before other costs were $201.5 million in 2005, compared to $323.1 million in 2004 and $60.7 million in 2003. Lower gross margins in the metals service centers and steel distributors segments accounted for most of the difference between 2004 and 2005. This related to declining metal prices resulting in inventory holding losses in 2005 compared to inventory holding gains in 2004. Strong volumes and corresponding operating profits in the energy tubular products sector offset a portion of the decline. Both 2005 and 2004 have higher volume and higher operating profits than 2003 due to the acquisition of Acier Leroux in July 2003 and the impact of the high price of metal. Interest expense The following table shows the components of interest expense. (in thousands of dollars) Interest on long-term debt 6.375% Senior Notes 10% Senior Notes 8% Convertible Debentures Other interest (net) Total interest 2005 2004 2003 $ 15,184 $ 13,464 $ – – 15,184 2,345 2,936 557 16,957 3,067 – 16,420 2,400 18,820 3,903 $ 17,529 $ 20,024 $ 22,723 Consolidated interest expense for 2005 decreased by $2.5 million compared to 2004 and $5.2 million compared to 2003. This was due to lower interest rates on long-term debt and lower exchange rates on the unhedged portion of the U.S. denominated long-term debt in 2005 compared to 2004 and 2003. In addition, strong cash flow from operations reduced short-term debt and corresponding short-term interest. Debt restructuring cost During the first quarter of 2004, we restructured our long-term debt at interest rates that significantly reduced the interest costs. We issued US$175 million of 6.375% Senior Notes due March 1, 2014. As of June 1, 2004 all other long-term debt was redeemed. We also entered into fixed interest cross currency swaps to hedge US$100 million of the 6.375% Senior Notes to eliminate the foreign exchange exposure. The currency swaps result in an additional interest cost of $0.3 million per quarter, which is included in the interest expense. On February 23, 2004, we redeemed US$95.5 million of our 10% Senior Notes at US$1,072.50 per US$1,000 unit. The US$72.50 per unit premium as well as the deferred costs related to the debt redeemed resulted in a charge of $11.3 million in the first quarter of 2004. The remaining US$20.1 million of 10% Senior Notes was redeemed on June 1, 2004 at US$1,050 per US$1,000 unit. The US$50.00 per unit premium and the remaining deferred costs resulted in a charge of $1.9 million in the second quarter of 2004. The remaining deferred costs of $0.5 million related to the previous bank facility were charged to debt redemption costs in the fourth quarter of 2004. Restructuring The restructuring charges for 2003 and 2004 related to the rationalization of overlapping Acier Leroux and Russel Metals operations. During the second quarter of 2005, we completed the sale of the Lachine property for a before tax gain of $2.9 million. In the third quarter of 2005, a decision was made to close an Ontario facility made redundant by the Acier Leroux acquisition. In the third quarter of 2005, we accrued the severance for the employees and wrote down the facility and equipment to their net realizable values resulting in restructuring costs of $1.8 million. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 1 5 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 16 > management’s discussion and analysis cont’d During 2004, we recorded a charge of $3.6 million mainly related to restructuring at the Russel Metals Ontario locations and the carrying costs of the vacant Lachine, Quebec facility. In 2003, we recorded a restructuring charge of $3.6 million mainly related to employee severances, pensions and benefits for the closure of our Lachine location at the end of 2003. Employee-related charges for Ontario and Atlantic region restructuring were also recorded during the six months from July to December 2003. In September 2002, we acquired the Williams Steel operation in Milwaukee, Wisconsin. Prior to 2004, economic conditions in the Wisconsin region resulted in significant deterioration in the Williams Bahcall customer base. As this operation was unprofitable and did not project a significant improvement over the forecast period, we determined that goodwill of $2.4 million related to this acquisition was impaired. The goodwill related to Williams Bahcall was reduced to zero in the fourth quarter of 2003. Income taxes The provision for income taxes for 2005 was $60.4 million, which is lower than 2004 due to higher earnings in 2004. In addition, during 2005, the Company recorded income tax recoveries of $6.7 million related to tax reassessment, issues under appeal with the tax authorities and adjustments related to prior years’ taxes. This recovery of taxes reduced the income tax rate for 2005 to 32.6%. Excluding the tax recoveries, our income tax rate for the year ended December 31, 2005 would have been 36.2%. For the year ended December 31, 2004, the income tax rate of 36.8% was higher than the average combined statutory rate due to non- deductible items. Our normalized effective income tax rate based on current operations is estimated to be 35.5%. Earnings Earnings from continuing operations for 2005 were $124.8 million compared to $180.5 million for 2004 and $19.1 million for 2003. Basic earnings per common share from continuing operations for 2005 were $2.47 compared to $3.70 for 2004 and $0.42 for 2003. The lower earnings per share for 2005 are primarily as a result of declining metal prices compared to rising metal prices in 2004. In December 2004, the minority shareholders of our Poutrelles Delta business indicated that they would exercise their right to purchase the business. The transaction closed on February 23, 2005. We reclassified Poutrelles Delta to discontinued operations in the income statement for 2004 and the balance sheet as at December 31, 2004. During the fourth quarter of 2004, we recorded a write-down to fair value of $0.6 million in anticipation of the sale. The loss of $38,000 in 2005 represents losses reported by this unit prior to sale. In May 2005, we completed the sale of Armabec Inc. to a third party for book value. The transaction costs of approximately $30,000 were expensed to discontinued operations. Net proceeds from this transaction were $2.4 million. Although Armabec was not a material operation, its sale required us to restate the income statement to reclassify it to discontinued operations. Total Revenues $ millions Total Operating Profit $ millions Interest Expense $ millions 2,615 2,413 1,403 1,403 1,504 323 23 23 20 20 18 202 70 61 51 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 1 6 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 17 Net loss from discontinued operations was $2.6 million for 2004. During 2004, we recorded a provision of $3.2 million, net of income taxes, related to lease obligations under a long-term lease from an operation discontinued in 1995 and environmental cleanup costs. The property had been vacant for the last year and we have been unsuccessful in finding a new tenant; thus, the provision previously provided under discontinued operations was not sufficient to cover the remaining lease obligations. We continue to honor our obligations for environmental cleanup at properties utilized by operations disposed of in the early 1990s. The U.S. operations of Acier Leroux earned $0.3 million during 2004. We sold the operation in Plattsburgh, New York in the third quarter of 2004. Shares outstanding and dividends The weighted average number of common shares outstanding for 2005 was 50,461,330 compared to 48,671,915 for 2004 and 40,021,479 for 2003. The increase relates to the public offering of 5,750,000 common shares in February 2004 and employee stock options exercised. The number of common shares outstanding at December 31, 2005 was 50,656,009. The significant increase in our stock price during the last three years resulted in employees exercising stock options to acquire 768,350 common shares during 2005, 1,114,317 common shares during 2004 and 1,419,567 common shares during 2003. We have returned a portion of our earnings to our common shareholders by paying common share dividends of $45.4 million in 2005, $25.0 million in 2004 and $11.6 million in 2003. In July 2005, the Board of Directors approved a 25% increase in the quarterly dividend to $0.25 per common share, which was the amount paid during the last half of 2005. The cash dividend declared on common shares was $0.90 per share for 2005, $0.505 per share for 2004 and $0.29 per share for 2003. Our U.S. Senior Notes consider any dividend payment in excess of $0.08 per common share per quarter to be a restricted payment. We currently have $144 million available for restricted payments in our “basket”. The basket is replenished from earnings on a quarterly basis. We have adequate room at our current dividend level for a number of years assuming we remain profitable. As at February 23, 2006, we had 50,656,009 common shares outstanding. EBITDA The following table shows the reconciliation of GAAP earnings from continuing operations to EBITDA: (in thousands of dollars) Earnings from continuing operations Income taxes Interest expense Earnings before interest and income taxes (EBIT) Depreciation and amortization 2005 2004 $ 124,778 $ 180,469 $ 60,374 17,529 202,681 19,158 105,268 20,024 305,761 18,598 2003 19,077 13,250 22,723 55,050 16,330 Earnings before interest, income taxes, depreciation and amortization (EBITDA) $ 221,839 $ 324,359 $ 71,380 Dividends Paid per Common Share $ per share Common Share Price $ per share Common Share Appreciation % 0.90 0.505 0.29 0.15 0.17 21.85 15.50 8.79 5.10 3.60 76 72 42 41 24 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 1 7 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 18 > management’s discussion and analysis cont’d We believe that EBITDA may be useful in assessing our operating performance and as an indicator of our ability to service or incur indebtedness, make capital expenditures and finance working capital requirements. The items excluded in determining EBITDA are significant in assessing our operating results and liquidity. Therefore, EBITDA should not be considered in isolation or as an alternative to cash from operating activities or other combined income or cash flow data prepared in accordance with GAAP. EBITDA to Interest Expense Ratio (in thousands of dollars, except ratios) EBITDA Interest expense EBITDA to interest expense 2005 2004 $ 221,839 $ 324,359 $ 17,529 12.7x 20,024 16.2x 2003 71,380 22,723 3.1x The EBITDA to interest expense ratio is provided to assist readers in determining our ability to generate cash from operations to cover our financial charges, income taxes and items not considered to be in the ordinary course of business. Debt analysts and debt rating agencies routinely use this measure to evaluate companies. Accounting Policies and Estimates a) Change in accounting policies There were no new accounting policies adopted during 2005. Note 2 to the consolidated financial statements includes our current accounting policies. b) Other The preparation of our financial statements requires management to make estimates and judgements that affect the reported amounts. On an ongoing basis, we evaluate our estimates, including those related to bad debts, inventory obsolescence, useful lives of fixed assets, asset retirement obligations, income taxes, restructuring costs, pensions and other post-retirement benefits, fair values, guarantees, environmental obligations, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgements about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. Our most significant assets are accounts receivable and inventory. Accounts Receivable We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Assessments are based on aging of receivables, legal issues (bankruptcy status), past collection experience, current financials or credit agency reports and the experience of our credit personnel. Accounts, which we determine as uncollectible, are reserved in the period in which the determination is made. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Inventories We review our inventory for obsolescence, slow moving product and to ensure that the cost of inventory is not in excess of its estimated market value. Inventory reserves or write-downs are recorded when cost exceeds the market value and when product is determined to be slow moving or obsolete. Significant reductions in market value could result in additional write-downs. Other areas involving significant estimates and judgements include: Income Taxes We believe that we have adequately provided for income taxes based on all of the information that is currently available. The calculation of income taxes in many cases, however, requires significant judgement in interpreting tax rules and regulations, which are constantly changing. Our tax filings are also subject to audits, which could materially change the amount of current and future income tax assets and liabilities. Any change would be recorded as a charge or a credit to income tax expense. Employee Benefit Plans We perform a valuation at least every three years to determine the actuarial present value of the accrued pension and other retirement benefits. The valuation uses management’s assumptions for the discount rate, expected long-term rate of return on plan assets, rate of compensation increase, health care cost trend and expected average remaining years of service of employees. 1 8 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 19 While we believe that these assumptions are reasonable, differences in actual results or changes in assumptions could materially affect employee benefit obligations and future net benefit plans costs. We account for differences between actual and assumed results by recognizing differences in benefit obligations and plan performance over the working lives of the employees who benefit from the plans. Capital Expenditures Capital expenditures were $26.5 million for 2005 compared to $25.4 million in 2004. In 2005, we divested fixed assets which had a total net book value of $5.5 million; thus after depreciation expense the fixed asset balance is comparable to 2004. Our normal capital expenditures are mainly related to maintenance capital, the purchase of additional processing equipment across a broad base of our operations and upgrades to our existing facilities and computer systems. Our expectation is for capital expenditures to be at levels higher than depreciation expense over a period of years due to the construction of larger facilities in growing markets and expanding product lines. Depreciation expense was $17.7 million in 2005 and $17.3 million in 2004. Liquidity We stress working capital management to ensure working capital is minimized and leverage reduced over the economic cycle. The metals distribution business experiences significant swings in cash flow in order to fund working capital. Inventory and accounts receivable represent a large percentage of our total assets employed and vary throughout each cycle. At December 31, 2005 and 2004, inventory and accounts receivable represented approximately 80% of our total assets excluding cash. Inventory and accounts receivable balances are higher during 2005 and 2004 due to metal pricing and we have had no significant increase in fixed assets, as volumes have remained stable. Accounts receivable and inventory as a percentage of total assets (in thousands of dollars, except percentages) Accounts receivable and inventory Total assets less cash % of total assets less cash 2005 2004 2003 $ 833,628 $ 914,611 $ 551,952 1,048,128 1,145,847 771,611 80% 80% 72% Our existing bank credit facilities are used to fund the growth in working capital caused by demand or steel price increases, which require higher inventory and accounts receivable levels to support the higher activity levels. Based on our experience, an increase of $100 million in revenues would require approximately $30 million of net working capital to support the higher activity levels. When demand weakens, or the price of steel declines, cash is generated from the reduction of inventory and lower levels of accounts receivable. This cash is used to reduce the borrowings under our bank credit facilities. EBITDA $ millions 324 222 EBITDA to Interest Expense Ratio Times 16.2 12.7 83 71 53 4.1 3.1 2.3 Inventories $ millions 329 303 265 554 474 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 1 9 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 20 > management’s discussion and analysis cont’d The balances disclosed in our consolidated cash flow statements are adjusted to remove the non-cash component related to foreign exchange rate fluctuations impacting inventory, accounts receivable, accounts payable and income tax balances of our U.S. operations. Inventory turns Metals service centers Energy tubular products Steel distributors Total Dec. 31 2005 Sept. 30 2005 June 30 2005 4.8 3.8 4.4 4.4 5.4 3.5 5.1 4.7 5.2 2.9 3.6 4.2 Quarters Ended Mar. 31 2005 Dec. 31 2004 4.4 4.4 3.9 4.3 3.7 2.9 3.3 3.4 Inventory turns are calculated using the cost of sales for the quarter annualized divided by the ending inventory position. Inventory declined during 2005 providing cash of $76.5 million. Metals service centers had improved turns of 4.8 related to lower inventory levels. Our goal is to ensure that we keep our inventory levels as low as possible while still satisfying the needs of our customers in order to minimize inventory valuation risk. We expect our metals service centers operations to turn over their inventory at higher rates than the industry average. Based on information published by the Metals Service Center Institute in its monthly Metals Activity Report, the average inventory turns for U.S. based steel companies for the three months ended December 31, 2005 was 4.1 turns and for Canadian based companies was 4.0 turns. Our metals service centers inventory based on tons was approximately 17% lower at December 31, 2005 than it was a year earlier. The improvement in inventory turns for the energy tubular products segment in the fourth quarter of 2005 compared to the fourth quarter of 2004 relates to higher cost of sales in 2005. Inventory levels are higher in 2005 to service higher revenues. Steel distributors had improved turns mainly related to lower inventory levels at December 31, 2005 compared to December 31, 2004. The other major components of working capital are accounts receivable and accounts payable. Accounts receivable as at December 31, 2005 are approximately the same as at December 31, 2004. Accounts payable decreased $32.2 million, which related to lower variable compensation levels accrued at December 31, 2005 compared to 2004 and lower purchases of inventory in 2005. During the year ended December 31, 2005, we made income tax payments of $110.4 million. This represented final instalments of $60.7 million for the 2004 year and instalments of $49.7 million for the 2005 year. During 2004, we made tax payments of $47.3 million. During 2005, we utilized cash of $26.5 million on capital expenditures and $45.4 million on common share dividends. During 2004, we utilized cash of $25.4 million on capital expenditures and $25.0 million on common share dividends. Net Assets Employed $ millions Free Cash Flow $ millions 700 698 522 444 461 189 131 45 30 8 Book Value per Common Share $ per share 10.63 9.15 5.71 5.84 5.90 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 2 0 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 21 Free Cash Flow (in thousands of dollars) 2005 2004 2003 Cash from operating activities before working capital $ 149,578 $ 210,278 $ 40,681 Purchase of fixed assets Proceeds on sale of fixed assets Proceeds on assets held for sale and sale of businesses (26,463) (25,394) 1,644 5,869 849 3,675 (34,879) 1,804 – $ 130,628 $ 189,408 $ 7,606 Free cash flow may be useful in assessing our ability to pay dividends and reduce outstanding debt. Our investors and analysts regularly refer to this number. Debt and Credit Facilities In 2004, we consolidated our long-term debt and we currently have outstanding US$175 million of 6.375% Senior Notes due in 2014. We also entered into fixed interest cross currency swaps on US$100 million of this debt to eliminate the foreign exchange exposure on the portion of the debt not hedged by our investment in our U.S. subsidiaries. Our long-term debt at December 31, 2005 is $204.0 million compared to $210.6 million at December 31, 2004 and $179.4 million at December 31, 2003. We manage our cash position based on bank borrowings net of cash. Our bank credit facilities table provides the split between loans and outstanding cheques or cash on deposit. The net borrowings peaked during the first quarter of 2005 at $116.3 million and have been reduced to $nil at the end of 2005 due to a reduction in inventory and strong earnings during 2005. Bank credit facilities As at December 31, 2005 (in millions of dollars) Bank loans Outstanding cheques (on deposit) Net borrowings (cash) Letters of credit Facilities availability Russel Metals Facility U.S. Subsidiary Facility $ $ $ – $ – $ (13.3) (13.3) 46.1 32.8 200.0 $ $ (31.7) (31.7) 35.7 4.0 52.5 $ $ Total – (45.0) (45.0) 81.8 36.8 252.5 Debt to Capitalization % 51 52 51 35 23 Interest Bearing Debt, Net of Cash $ millions 268 243 239 227 159 Total Market Capitalization $ millions 1,107 773 378 194 137 01 02 03 04 05 01 02 03 04 05 01 02 03 04 05 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 2 1 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 22 > management’s discussion and analysis cont’d We have a facility, with a syndicate of Canadian and U.S. banks, for a revolving loan of $200 million, which currently expires on October 29, 2008. We may extend this facility annually with the consent of the syndicate. We are entitled to borrow, on a revolving basis, up to an amount equal to the sum of specified percentages of our eligible accounts receivable and inventories, to a maximum of $200 million. At December 31, 2005, we were entitled to borrow $200 million, including letters of credit under this facility. At December 31, 2005, we had no borrowings and had letters of credit of $46.1 million under this facility. At December 31, 2004, we had borrowings of $13.0 million and had letters of credit of $35.1 million under this facility. In addition, certain U.S. subsidiaries have their own one-year bank credit facility. The maximum borrowing under this facility is US$45.0 million. At December 31, 2005, these subsidiaries had no borrowings and had letters of credit of US$30.6 million. At December 31, 2004, these subsidiaries had no borrowings and had letters of credit of US$14.6 million. Cash generated from operating activities before working capital changes was $210.3 million for the 2004 year, and was $149.6 million for 2005. This is significantly stronger than the prior three years when it averaged $45 million. The maximum borrowing available under our bank facilities is approximately $253 million. Including cash, we have approximately $216 million of unutilized borrowing capacity at December 31, 2005. We expect that the cash generated from operating activities combined with our unutilized bank facilities will be sufficient to fund our interest obligations and fixed asset purchases in 2006. The rapid growth in revenue required additional working capital funding of $202.6 million during 2004 and $121.6 million during the first quarter of 2005. Increased profitability enabled us to finance the majority of this working capital growth. The remainder was financed through our bank facilities. Reduction in inventory levels and continued profitability allowed us to repay all bank borrowings by the end of 2005. We have made several acquisitions and we believe we can continue to grow by acquisition. We believe we have the ability to fund future acquisitions through the utilization or expansion of our existing bank facilities and the issuance of new equity, if required. At December 31, 2005 we had a very low financial leverage with a debt to equity ratio of 0.3. Contractual Obligations As at December 31, 2005, we were contractually obligated to make payments under our long-term debt agreements and operating lease obligations that come due during the following periods. (in thousands of dollars) Long-Term Debt Maturities Cross Currency Swaps Long-Term Debt Interest Lease Obligations 2006 2007 2008 2009 2010 2011 and beyond Total $ $ – – – – – – – – – – 204,033 15,210 $ 15,200 $ 10,151 $ 15,200 15,200 15,200 15,200 48,167 8,483 6,202 5,607 4,629 7,519 Total 25,351 23,683 21,402 20,807 19,829 274,929 $ 204,033 $ 15,210 $ 124,167 $ 42,591 $ 386,001 The fixed interest cross currency swaps obligate us to purchase US$100 million at $1.3180 for each US$1.00. Based on the December 31, 2005 exchange rate, we would incur an obligation of $15.2 million in addition to our long-term debt obligation of $204.0 million. The long-term debt interest in the table includes the impact of our swaps. Off-Balance Sheet Arrangements Our off-balance sheet arrangements consist of letters of credit disclosed in the bank credit facilities table, operating lease obligations disclosed in the contractual obligation table and short-term foreign exchange contracts. The short-term foreign exchange contracts are used to hedge specific inventory purchases, denominated in U.S. dollars and euros, of approximately US$58.7 million and ¤2.9 million maturing in the first half of 2006. We have multiple defined benefit pension plans in Canada, as disclosed in Note 14 to the 2005 Consolidated Financial Statements. We expect to contribute approximately $3.5 million to these plans during 2006. Vision and Strategy The metals distribution business is a segment of a mature, cyclical industry. The use of service centers and steel distributors by both manufacturers and end users of steel continues to grow. This is evidenced by the growth in the percentage of total steel shipments from steel producers to service centers. As the distribution segment’s share of steel industry shipments continues to grow, service centers such as ours can grow their business over the course of a cycle. 2 2 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 23 We strive to deal with the cyclical nature of the business by operating with the lowest possible net assets throughout the course of a cycle. In addition, our aim is to be more profitable through the various successive peaks and troughs within the steel cycle. In order to achieve this, management emphasizes profitability rather than revenue growth. This intensive asset management reduces borrowings and therefore interest expense in declining periods in the economic cycle. This in turn creates higher, more stable returns on net assets over the course of the cycle. Our conservative management approach creates relatively stronger trough earnings but could cause potential peak earnings to be somewhat muted. Management strongly believes that it is more prudent to be profitable throughout a cycle, without the spikes in earnings caused by less emphasis on asset management, and have average earnings over the full range of the cycle in the top deciles of the industry. Growth from selective acquisitions is also a core management philosophy. We focus on investment opportunities in businesses that have strong market niches or provide mass to our existing operations. In both the energy tubular products and steel distributors segments, all of the business units have significant operations in the market niche that they service. Consistent with our acquisition philosophy, any new acquisitions in these areas could likely be either major stand-alone operations or those that complement our existing operations. In the future, we believe that the length of the steel-based economic cycle will continue to shorten and a management structure and philosophy that allows the fastest reaction to the changes that affect the industry will be the most successful. We will continue to invest in business systems to enable faster reaction times to changing business conditions. In addition, management believes the high level of service and flexibility provided by service centers will enable this distribution channel to capture an increasing percentage of total steel revenues to end users, allowing for increased growth within the sector. Risk The timing and extent of future price changes from the steel producers and their impact on us can not be predicted with any certainty due to the inherent cyclical nature of the steel industry. Controls and Procedures As of December 31, 2005, an evaluation was carried out, under the supervision of and with the participation of management, including the President and Chief Executive Officer and the Executive Vice President and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15 under the U.S. Securities and Exchange Act of 1934 and under Multilateral Instrument 52-109. Based on that evaluation, the President and Chief Executive Officer and the Executive Vice President and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective. No changes were made in our internal control over financial reporting during the year ended December 31, 2005, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Outlook Before we discuss 2006, we would like to take this opportunity to thank our employees for a great 2005. Once again, the Russel Metals employees showed their skill at reacting quickly and maximizing returns as well as, if not better than, any in the sector. In addition, we would like to thank Ken Gilbert, Vice President Quebec Region, who retired in 2005 after a successful 42-year career with Russel Metals that culminated with his leadership role in the successful integration of Acier Leroux within Russel Metals. The steel sector has been as stable in the second half of 2005 as we have experienced in several years and it is projected to remain that way into early 2006. All three legs of our platform: the metals service centers, the energy tubular products and the steel distributors segments are per forming at excellent levels. Assuming there is no major surprise in the price of steel, the price of oil and gas and the Canadian dollar does not appreciate materially, we are optimistic that 2006 should be another excellent year for Russel Metals. February 23, 2006 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 2 3 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 24 > management’s report to the shareholders The accompanying consolidated financial statements, management’s discussion and analysis and all information in the Annual Report have been prepared by management and approved by the Audit Committee and the Board of Directors of the Company. These consolidated financial statements were prepared in accordance with Canadian generally accepted accounting principles and, where appropriate, reflect management’s best estimates and judgements. Management is responsible for the accuracy, integrity and objectivity of the consolidated financial statements and management’s discussion and analysis within reasonable limits of materiality and for the consistency of financial data included in the text of the Annual Report with that contained in the consolidated financial statements. To assist management in the discharge of these responsibilities, the Company maintains a system of internal controls designed to provide reasonable assurance that its assets are safeguarded, that only valid and authorized transactions are executed, and that accurate, timely and comprehensive financial information is prepared. In addition, the Company maintains a system of disclosure controls in order to provide reasonable assurance that the financial information is relevant, reliable and accurate. The Company’s Audit Committee is appointed annually by the Board of Directors. The Audit Committee, which is composed entirely of outside directors, meets with management to satisfy itself that management is properly discharging its financial reporting responsibilities and to review the consolidated financial statements, the management’s discussion and analysis and the report to shareholders. The Audit Committee reports its findings to the Board of Directors for consideration in approving the consolidated financial statements, the management’s discussion and analysis and the report to shareholders for presentation to the shareholders. The consolidated financial statements have been audited on behalf of the shareholders by the external auditors, Deloitte & Touche LLP, in accordance with Canadian generally accepted auditing standards. Deloitte & Touche LLP has full and free access to the Audit Committee. February 23, 2006 E.M. Siegel, Jr. President and Chief Executive Officer Brian R. Hedges Executive Vice President and Chief Financial Officer 2 4 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 25 > auditors’ report To the Shareholders of Russel Metals Inc. We have audited the consolidated balance sheets of Russel Metals Inc. as at December 31, 2005 and 2004 and the consolidated statements of earnings and retained earnings and of cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance 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. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Company as at December 31, 2005 and 2004 and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2005 in accordance with Canadian generally accepted accounting principles. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly we express no such opinion. Deloitte & Touche LLP Chartered Accountants Toronto, Ontario January 30, 2006 COMMENTS BY AUDITORS ON CANADA–U.S. REPORTING DIFFERENCES The standards of the Public Company Accounting Oversight Board (United States) require the addition of an explanatory paragraph (following the opinion paragraph) when there are changes in accounting principles that have a material effect on the comparability of the Company’s consolidated financial statements, such as the changes described in Note 2 to the consolidated financial statements. Our report to the Shareholders, dated January 30, 2006, is expressed in accordance with Canadian reporting standards which do not require a reference to such changes in accounting principles in the auditors’ report when the change is properly accounted for and adequately disclosed in the financial statements. Deloitte & Touche LLP Chartered Accountants Toronto, Ontario January 30, 2006 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 2 5 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 26 > consolidated balance sheets At December 31 ($000) ASSETS Current Cash Accounts receivable Inventories Prepaid expenses and other assets Income taxes receivable Discontinued operations (Note 5) Property, Plant and Equipment (Note 6) Assets Held for Sale (Note 4) Deferred Financing Charges Goodwill (Note 4) Future Income Tax Assets (Note 10) Other Assets LIABILITIES AND SHAREHOLDERS’ EQUITY Current Bank indebtedness Accounts payable and accrued liabilities Income taxes payable Discontinued operations (Note 5) Contingencies, Guarantees and Commitments (Note 15) Other Accrued Liabilities (Note 12) Long-Term Debt (Note 8) Pensions and Benefits (Note 14b) Future Income Tax Liabilities (Note 10) Shareholders’ Equity (Note 11) On behalf of the Board, C.R. Fiora Director R. Hartog Director 2 6 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 2005 2004 $ 47,055 $ 634 359,594 474,034 7,010 304 – 360,696 553,915 7,069 5,996 9,483 887,997 937,793 181,841 180,655 5,085 7,240 9,205 994 2,821 6,291 8,357 9,205 1,614 2,566 $ 1,095,183 $ 1,146,481 $ 2,098 $ 33,242 312,937 5,588 2,386 323,009 15,210 204,033 8,949 5,285 556,486 538,697 348,166 60,049 9,403 450,860 11,440 210,630 10,146 6,831 689,907 456,574 $ 1,095,183 $ 1,146,481 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 27 > consolidated statements of earnings and retained earnings For the years ended December 31 ($000, except per share data) Revenues Cost of sales and operating expenses 2005 2004 2003 $ 2,615,246 $ 2,412,502 $ 1,503,814 2,413,705 2,089,391 1,443,119 Earnings before the following Restructuring (Note 4) Debt restructuring costs (Note 8) Foreign exchange gain (Note 12) Goodwill impairment (Note 4) Interest expense, net (Note 9) Earnings before income taxes Provision for income taxes (Note 10) Earnings from continuing operations Loss from discontinued operations (Note 5) Net earnings for the year Retained earnings Dividends on preferred shares Earnings available to common shareholders Dividends on common shares Retained earnings, beginning of the year Retained earnings, end of the year (Note 11) Basic earnings per common share – continuing operations (Note 11) Basic earnings per common share Diluted earnings per common share – continuing operations Diluted earnings per common share 201,541 (1,140) – – – 323,111 3,632 13,718 – – 17,529 20,024 185,152 (60,374) 124,778 (62) 124,716 285,737 (105,268) 180,469 (2,623) 177,846 60,695 3,583 – (348) 2,410 22,723 32,327 (13,250) 19,077 (578) 18,499 – (611) (2,250) 124,716 (45,434) 262,733 342,015 2.47 2.47 2.42 2.42 $ $ $ $ $ 177,235 (25,004) 110,502 262,733 3.70 3.64 3.61 3.56 $ $ $ $ $ 16,249 (11,605) 105,858 110,502 0.42 0.41 0.40 0.39 $ $ $ $ $ R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 2 7 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 28 > consolidated cash flow statements For the years ended December 31 ($000) Operating activities Earnings from continuing operations Depreciation and amortization Future income taxes (Gain) loss on sale of fixed assets and assets held for sale Stock-based compensation Restructuring costs Debt redemption costs Goodwill impairment 2005 2004 2003 $ 124,778 $ 180,469 $ 19,158 6,305 (1,972) 1,309 – – – 18,598 5,021 264 804 2,051 3,071 – Cash from operating activities before working capital 149,578 210,278 Changes in non-cash working capital items Accounts receivable Inventories Accounts payable and accrued liabilities Current income taxes Other Change in non-cash working capital Cash from operating activities Financing activities (Decrease) increase in bank borrowing Issue of common shares Dividends on common shares Dividends on preferred shares Deferred financing costs Issuance of long-term debt Repurchase of long-term debt Redemption of preferred shares Repayment of debt assumed (2,368) 76,475 (32,189) (55,644) 51 (13,675) 135,903 (31,144) 4,385 (45,434) – (338) – – – – Cash used in financing activities (72,531) (122,814) (260,898) 128,473 54,711 (2,075) (202,603) 7,675 (44,851) 54,439 (25,004) (611) (9,117) 235,200 (184,715) (30,000) – (4,659) Investing activities Purchase of fixed assets Proceeds on sale of fixed assets Proceeds from assets held for sale and sale of businesses Purchase of businesses (Note 4) Other Cash used in investing activities Discontinued operations Operating activities Investing activities Cash from (used in) discontinued operations Increase (decrease) in cash Cash position, beginning of the year Cash position, end of the year 2 8 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT (20,565) (108,062) (26,463) (25,394) 1,644 5,869 – (4,443) (23,393) (62) 6,504 6,442 46,421 634 849 3,675 – 305 (1,174) 349 (825) (18,374) 19,008 $ 47,055 $ 634 $ 19,077 16,330 (426) (89) 217 3,162 – 2,410 40,681 18,193 91,439 (12,669) 11,681 2,571 111,215 151,896 56,952 5,663 (11,605) (2,250) (77) – – – (99,262) (50,579) (34,879) 1,804 – (70,359) (4,628) (406) 1,091 685 (6,060) 25,068 19,008 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 29 > notes to the consolidated financial statements 1. Summary of Significant Accounting Policies Basis of presentation a) The consolidated financial statements include the accounts of Russel Metals Inc. and its subsidiary companies herein referred to as the Company. The reporting currency is Canadian dollars unless otherwise noted. All inter-company balances, transactions and profits have been eliminated. These consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles. Material differences from accounting principles generally accepted in the U.S. are disclosed in Note 16. The revenue and results of operations of Poutrelles Delta and Armabec Inc., which have been sold, have been reclassified to reflect the classification of these operations as discontinued (Note 5). Inventories b) Inventories are recorded at the lower of cost and net realizable value. Cost is determined on either an average cost basis or an actual cost basis depending on the business unit. Property, plant, equipment and depreciation c) Property, plant, equipment and leasehold improvements are recorded at cost. Depreciation is provided on a straight-line basis at rates that charge the original cost of such assets to operations over their estimated useful lives. The rates used are 20 to 40 years for buildings, 10 years for machinery and equipment, 2 to 5 years for computer equipment, and over the lease term for leasehold improvements. Depreciation expense was $17,703,000 in 2005 (2004: $17,326,000; 2003: $15,140,000). Deferred financing charges and amortization d) Costs incurred that relate to financing are deferred and amortized on a straight-line basis over the period of the related financing. Deferred financing charges are recorded at cost less accumulated amortization. Amortization of deferred financing charges was $1,455,000 in 2005 (2004: $1,271,000; 2003: $1,190,000). Goodwill e) Goodwill represents the excess purchase price paid on acquisitions over the value assigned to identifiable net assets acquired. The Company reviews goodwill for impairment annually and whenever facts and circumstances indicate that carrying amounts may not be recoverable. As part of the evaluation, the estimated future undiscounted cash flows associated with the underlying business operation are compared to the carrying amount of goodwill to determine if a write-down is required. If such an assessment indicates that the undiscounted future cash flows will not be recovered, the carrying amount is reduced to the estimated fair value (Note 4). Pensions f) The cost of pension benefits earned by employees covered under defined benefit plans is determined using the projected benefit method prorated on service and is charged to expense as services are rendered. Actuarial gains and losses and past service costs are amortized on a straight-line basis over the estimated average remaining service lives of the employee groups. The amortization of actuarial gains and losses utilizes the corridor approach. The cost of post-retirement benefits other than pensions is recognized on an accrual basis over the working lives of employees. Income taxes g) The Company uses the liability method of income tax allocation. Under this method, future tax assets and liabilities are determined based on differences between the financial accounting and tax bases of assets and liabilities and are measured using the substantively enacted tax rates and laws that will be in effect when the differences are expected to reverse. Future income tax assets are recognized to the extent that their realization is more likely than not. Foreign currency translation h) The accounts of self-sustaining foreign subsidiaries are translated into Canadian dollars at the noon spot rates in effect at the balance sheet date. For 2005, the U.S. dollar published exchange rate was 1.1659 (2004: 1.2036). Revenues and expenses are translated at the average rate of exchange for the year. For 2005, the U.S. dollar published average exchange rate was 1.2114 (2004: 1.3013; 2003: 1.4010). The resulting gains or losses are included in the cumulative translation adjustment line of shareholders’ equity. Exchange gains or losses on long-term debt denominated in foreign currencies not designated as a hedge are expensed as incurred (see Note 12). Exchange gains or losses on the translation of long-term debt denominated in a foreign currency designated as a hedge of the Company’s net investment in foreign subsidiaries are included in the cumulative translation adjustment line of shareholders’ equity. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 2 9 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 30 > notes to the consolidated financial statements Earnings per share i) Basic earnings per common share are calculated using the weighted daily average number of common shares outstanding. The weighted average number of common shares for 2005 was 50,461,330 (2004: 48,671,915; 2003: 40,021,479). Revenue recognition j) Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, selling price is fixed and collection is reasonably assured. Revenue on certain sales within the energy tubular products segment, where the Company acts as an agent, is presented on a net basis. Freight and shipping billed to customers are included in revenue. Stock-based compensation k) The Company uses the fair value-based approach to account for stock-based compensation granted to employees subsequent to January 1, 2003. Compensation expense and an increase in contributed surplus is recognized for stock options over their vesting period based on their estimated fair values on the date of grant, as determined by the Black-Scholes option-pricing model. Compensation expense is also recognized for deferred share units when issued with the liability marked to market until exercised. Derivative financial instruments l) The Company uses foreign exchange contracts to manage foreign exchange risk on certain committed cash outflows, primarily inventory purchases. When the derivative instruments have been designated and are highly effective at offsetting risks, hedge accounting is applied. Hedge accounting requires that gains and losses on the hedging item are recognized through income in the same period or manner as the hedged item. Realized and unrealized foreign exchange gains and losses not designated as a hedge are included in income. Derivatives are not entered into for speculative purposes and the use of derivative contracts is governed by documented risk management policies. The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives to specific firm commitments or forecasted transactions. The Company assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in the cash flows of hedged items. Cash m) Cash includes short-term investments with a maturity of less than 30 days. Use of estimates n) The preparation of consolidated financial statements in conformity with Canadian generally accepted accounting principles requires management to make estimates and assumptions that affect the reported assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. In particular, inventories, accounts receivable, asset retirement obligations, fair values, other contingencies, and assigned values on net assets acquired represent management’s best estimates. Actual results could differ from these estimates. 2. Change in Accounting Policies a) Effective January 1, 2004, the Company adopted the new accounting guideline, AcG-13, Hedging Relationships, which establishes certain conditions when hedge accounting may be applied. The guideline sets out the requirements for the identification, designation, documentation and effectiveness of hedging relationships for the purpose of applying hedge accounting. The adoption of this standard did not have a material effect on the Company’s results of operations, financial position or cash flows. The Company has applied this standard to the fixed for fixed cross currency swaps entered into on February 20, 2004, in order to hedge the last US$100 million of its US$175 million U.S. Senior Notes (Note 8). In addition, this standard has been applied to the Company’s other hedging relationships, namely foreign exchange contracts used to manage certain committed cash flows and the hedge of the net investment in U.S. subsidiaries. b) Effective January 1, 2004, the Company adopted the new CICA Handbook section 3110, Asset Retirement Obligations. This standard establishes standards for the recognition, measurement and disclosure of liabilities for asset retirement obligations and the associated asset retirement costs. The Company has certain significant asset retirement obligations relating to its land lease for its Thunder Bay Terminal operations. The landlord has the option to retain the facilities or to require the Company to remove them. In addition, the Company has certain end-of-lease obligations in six of its service center operations (Note 6). The adoption of this standard did not have a material effect on the Company’s results of operations, financial position or cash flows. 3 0 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 31 c) Effective January 1, 2004, the Company prospectively adopted the new CICA Handbook section 1100, Generally Accepted Accounting Principles (GAAP). This standard establishes what constitutes Canadian generally accepted accounting standards and provides guidance on the GAAP hierarchy. The adoption of this standard did not have a material effect on the Company’s results of operations, financial position or cash flows. d) Effective October 1, 2004, the Company prospectively adopted the new accounting guideline AcG-15, Variable Interest Entities. The adoption of this standard did not have a material effect on the Company’s results of operations, financial position or cash flows. e) Effective May 1, 2003, the Company adopted the new accounting standard for the Disposal of Long-Lived Assets and Discontinued Operations. This standard, along with emerging issues abstracts EIC-134, Accounting for Severance and Termination Benefits and EIC-135, Accounting for Costs Associated with Exit and Disposal Activities (Including Costs Incurred in a Restructuring) have been applied to the restructuring as a result of the Acier Leroux inc. acquisition (Note 4). 3. Future Accounting Changes On September 8, 2005, the CICA issued EIC-156, Accounting by a Vendor for Consideration Given to a Customer (Including a Reseller of the Vendor’s Products). The Company is currently evaluating the effect of this standard on its consolidated financial statements and is expected to adopt the standards effective January 1, 2006. During 2005, the CICA issued three new accounting standards: CICA Handbook section 1530, Comprehensive Income; CICA Handbook section 3855, Financial Instruments – Recognition and Measurement; and CICA Handbook section 3865, Hedges. These standards, which must be adopted together, are effective for fiscal years beginning on or after October 1, 2006. The Company is currently evaluating the impact on its consolidated financial statements of adopting these standards effective January 1, 2007. Comprehensive Income a) This standard provides guidance on the presentation of comprehensive income which is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources. Comprehensive income is comprised of net income and other comprehensive income. Other comprehensive income includes certain gains and losses that are recognized outside of net income. Financial Instruments – Recognition and Measurement b) This standard provides guidance for recognizing and measuring financial assets and financial liabilities which are to be valued at fair value with certain limited exceptions. The standard also provides guidance on the classification of gains and losses into net income or other comprehensive income. Hedges c) This standard replaces existing hedge accounting guidance in CICA Handbook section 1650, Foreign Currency Translation, and accounting guideline AcG-13, Hedging Relationships, and provides requirements for the designation, documentation and disclosure of qualifying hedge relationships. 4. Business Acquisitions and Restructuring Acquisitions a) On July 3, 2003, the Company purchased 99.52% of the issued and outstanding Class A shares, 97.53% of the issued and outstanding Class B shares, 86.61% of the outstanding 8% convertible unsecured subordinated debentures and 87.2% of the outstanding 7.25% convertible unsecured subordinated debentures of Acier Leroux inc. Acier Leroux is a metals service center operation with Canadian locations in Ontario, Quebec and the Atlantic provinces. The Company issued 3,546,874 shares and paid $48,947,000 in cash in consideration for the shares and $16,684,000 in cash in consideration for the tendered debentures. In addition, the Company entered into an arrangement with the former Chairman and Chief Executive Officer of Acier Leroux requiring payments over a three-year period in the amount of $1,350,000, which was accrued as a transaction cost. On August 19, 2003, the Company, under the provisions of the Companies Act (Quebec), acquired the remaining shares of Acier Leroux for $1,190,000 in cash. On August 27, 2003, Acier Leroux redeemed the debentures not acquired in the offer. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 3 1 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 32 > notes to the consolidated financial statements cont’d The final net assets acquired, at assigned values, are as follows: ($000) Accounts receivable Inventories Fixed assets Other assets Goodwill Total assets – continuing operations Accounts payable and accrued liabilities Accrued pension and benefit liability Future income taxes Net identifiable assets – continuing operations Discontinued operations Total net assets acquired, before debt assumed Financed by: Debt assumed, net of cash of $2.7 million Cash consideration Russel Metals common shares – issued Transaction costs, net of taxes $ $ $ 74,572 82,880 60,180 2,122 7,815 227,569 (47,127) (1,380) 11,057 190,119 7,481 197,600 123,956 50,137 19,969 3,538 $ 197,600 Effective September 1, 2000, the Company purchased Triumph Tubular & Supply Ltd., a Calgary, Alberta, distributor of oil country tubular goods. Under the purchase agreement, additional amounts under an earnout based on results could be paid over five years and would be incremental to goodwill. The final payment in this earnout arrangement of $1,390,000 was paid in 2004. These acquisitions were accounted for using the purchase method and their results of operations have been consolidated since their respective acquisition dates. The 2004 goodwill relating to Triumph Tubular & Supply Ltd. has been allocated to the energy tubular products segment. The remaining goodwill for 2004 and 2003 was allocated to the metals service centers segment. The tax-deductible portion of goodwill is $nil. The continuity of the carrying value of the goodwill is as follows: ($000) Balance, December 31, 2003 Change in allocation of the purchase price of Acier Leroux Triumph Tubular earnout Balance, December 31, 2004 and 2005 $ $ 4,216 3,599 1,390 9,205 Restructuring b) Restructuring of the Company’s service center segment’s operations as a result of acquisitions is charged to income as incurred. Under certain conditions, restructuring relating to the acquired operation is included in the net assets acquired. In 2003, a restructuring charge of $3.6 million was recorded relating to the severance, employee benefits and termination costs due to the closure of the Russel Metals’ operations as a result of the acquisition of Acier Leroux. These costs primarily relate to the closure of the Russel Metals’ Lachine, Quebec location. Operations ceased at Lachine on December 31, 2003, and the vacant property along with the vacant Dartmouth property acquired in the Leroux acquisition were classified in Assets Held for Sale in the first quarter of 2004. During 2004, the Company sold its Dartmouth property for the book value of $2.2 million. In 2004, the Company incurred a restructuring charge of $3.7 million related to the restructuring of the Russel Metals’ locations as a result of the Acier Leroux acquisition. These costs primarily relate to the restructuring of the Ontario region and the ongoing costs associated with the Lachine property. 3 2 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 33 In 2004, restructuring of $0.5 million (2003: $3.1 million) was charged to provisions provided for the restructuring of the Bahcall locations as a result of the Williams Steel purchase in 2002. The unutilized balance of $0.3 million relating to A.J. Forsyth was released to income in 2004. Also, the additional restructuring relating to Bahcall of $0.2 million was charged to income in 2004. The restructuring of these operations as a result of acquisitions was completed in 2004. On May 2, 2005, the Company sold its Lachine property, previously classified as an Asset Held for Sale, for net proceeds of $5.8 million. The resulting before tax gain of $2.9 million has been recorded in restructuring. On September 2, 2005, the Company announced the closure of one of its Ontario branches. The Company determined based on a valuation that the carrying amount of the property and equipment was greater than the fair value and recorded an impairment loss in the third quarter of $1.3 million. On December 31, 2005, the Company vacated the property and accordingly classified its carrying value of $5.1 million as an Asset Held for Sale. In addition, the Company provided for contractual termination costs of $0.5 million relating to the employees at this location. At December 31, 2005, $0.2 million of these costs remained to be paid. In 2005, the Company recorded restructuring income of $361,000 relating to costs accrued as part of the fair value of Acier Leroux net assets acquired that were not required. These costs primarily related to the resolution of matters relating to Poutrelles Delta (Note 5). Restructuring was charged to income as follows: ($000) 2005 2004 2003 Impairment loss on Ontario branch $ 1,315 $ Ontario branch severance and other employee termination costs Gain on Asset Held for Sale Acier Leroux restructuring Acier Leroux unutilized acquisition Williams Steel acquisition A.J. Forsyth acquisition Restructuring The continuity of the Acier Leroux restructuring provision is as follows: 525 (2,932) 313 (361) – – $ – – – 3,695 – 231 (294) – – – 3,583 – – – $ (1,140) $ 3,632 $ 3,583 ($000) Balance, December 31, 2003 Restructuring expensed in 2004 Cash payments Non-cash changes to the provision Balance, December 31, 2004 Restructuring expensed in 2005 Cash payments Special Termination Benefits Contractual Termination Costs Other $ 228 $ 2,402 $ 532 $ – (198) (30) – – – – 783 (1,516) (1,169) 500 (359) (73) 2,912 (861) (2,583) – 672 (672) $ 68 $ – $ Total 3,162 3,695 (2,575) (3,782) 500 313 (745) 68 Balance, December 31, 2005 $ Non-cash changes to the provision relate to the write-down of fixed assets and changes in accrued employee benefit obligations. Goodwill impairment c) The Company completed its annual goodwill impairment tests, using projected discounted cash flows during the fourth quarter of 2005 and 2004, resulting in no impairment charge. In the fourth quarter of 2003, this evaluation concluded that the fair value associated with the service center segment’s Williams Bahcall operation due to continuing operating losses could not support the carrying value of the goodwill, and, accordingly, the Company recorded a goodwill impairment charge of $2.4 million. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 3 3 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 34 > notes to the consolidated financial statements cont’d 5. Discontinued Operations and Divestitures During 2005, the Company disposed of two operations acquired with the Acier Leroux acquisition. On May 10, 2005, the Company sold its investment in Armabec Inc., a metals service center, for book value less selling costs of approximately $30,000. In the second quarter of 2005, as a result of this divestiture, the Company classified Armabec Inc. as discontinued, and the revenue and results of operations for the period from January 1, 2005 to the date of sale and the comparative years ended December 31, 2004 and 2003 were reclassified to discontinued operations accordingly. The revenue generated by this operation for the period prior to sale was $1.0 million (2004: $6.1 million; 2003: $3.2 million) and the pre-tax profit for the period prior to sale was $5,000 (2004: $0.4 million; 2003: $0.3 million). On December 23, 2004, the Company received an offer pursuant to the Shareholders Agreement whereby the minority shareholders would purchase the Company’s holdings of Poutrelles Delta Inc. For the year ended December 31, 2004, the Company classified Poutrelles Delta as discontinued and recorded a loss to fair value of $0.6 million. On February 23, 2005, the Company sold its investment in Poutrelles Delta Inc., for $4.1 million in cash. The write-down to fair value at December 31, 2004 resulted in no additional gain or loss upon sale. The revenue and results of operations for Poutrelles Delta for the current and prior periods was reclassified as discontinued. The revenue generated by this operation for 2005 was $3.0 million (2004: $25.9 million; 2003: $10.1 million) and pre-tax loss was $71,000 (2004: $0.6 million; 2003: $nil). During 2004, the Company disposed of two asset groups acquired with the Acier Leroux acquisition. On May 14, 2004, the Company sold the inventory and certain fixed assets of the Dollard Steel operation for book value of $1.5 million. On July 30, 2004, the Company sold the inventory and fixed assets of its Plattsburgh, New York, operation for the book value of US$360,000. As part of the acquisition of Acier Leroux, the Company had adopted a formal plan to dispose of their U.S. operations and classified them as discontinued. All of the Leroux U.S. operations have been divested. The Company has certain residual obligations relating to these operations which are recorded as a discontinued operations liability of $2.4 million. The revenue generated by these operations prior to sale was $3.4 million (2003: $3.3 million) and the pre-tax loss was $0.3 million (2003: $0.8 million loss). During the year ended December 31, 2004, the Company incurred an additional charge of $3.2 million, net of tax, relating to long- term lease obligations and other environmental cleanup costs for operations classified as discontinued in 1995. Basic and fully diluted loss per share from discontinued operations was $0.00 (2004: $0.06; 2003: $0.01). 6. Property, Plant and Equipment ($000) Land and buildings Machinery and equipment Leasehold improvements Cost 2005 Net Cost 2004 Net $ 132,768 $ 96,482 $ 134,861 $ 101,497 193,512 25,657 75,333 10,026 184,833 24,547 69,668 9,490 $ 351,937 $ 181,841 $ 344,241 $ 180,655 During the year ended December 31, 2005, the Company increased its probability-weighted undiscounted expected cash flow relating to its asset retirement obligations by $1.3 million and the probability-weighted discounted expected cash flow by $0.3 million primarily as a result of an increase in the probabilities. The probability range is 50%–99% and the discount rate used was 9%. The asset retirement obligation, including applicable accretion at December 31, 2005, was $0.4 million (2004: $0.1 million). 3 4 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 35 7. Revolving Credit Facilities On October 29, 2004, the Company entered into a credit facility with a syndicate of banks, which provides a line of credit to a maximum of $200 million, including letters of credit. This three-year facility provides for annual extensions. On October 29, 2005, the Company extended the facility for an additional one-year period to October 29, 2008. Borrowings under this facility are restricted by certain financial covenants which the Company was in compliance with at December 31, 2005. The obligations of the Company under this agreement are secured by a pledge of trade accounts receivable and inventories of a significant portion of the Company’s operations. At December 31, 2005, the Company had borrowings of $nil (2004: $13.0 million) and letters of credit of $46.1 million (2004: $35.1 million) under this facility. Deferred charges relating to the previous bank facility of $0.5 million were charged to income in 2004. In addition, certain U.S. subsidiaries of the Company have their own credit facility. The maximum borrowing under this facility is US$45.0 million. At December 31, 2005, these subsidiaries had US$nil borrowings (2004: US$nil) and letters of credit of US$30.6 million (2004: US$14.6 million) under this facility. On February 25, 2005, the Company entered into an agreement with its banking syndicate to provide, in addition to existing facilities, a $50 million bridge facility for a term of one year. The provisions of the existing credit facilities, including financial covenants therein, applied to the new bridge facility. This bridge facility was repaid and cancelled in its entirety on August 29, 2005. 8. Long-Term Debt The long-term debt is comprised of the following: ($000) 6.375% US$175 million Senior Notes due March 1, 2014 2005 2004 $ 204,033 $ 210,630 On February 20, 2004, the Company completed the issue of US$175 million of Senior Notes due March 1, 2014, bearing interest at 6.375%. The proceeds of this issue were used to redeem US$95.5 million of the 10% Senior Notes due June 1, 2009, including a call premium for 1.0725; the $30 million 8% Subordinated Debentures due June 15, 2006, and the $30 million Class II preferred shares during the first quarter of 2004. The remaining US$20.1 million of 10% Senior Notes were redeemed on June 1, 2004, including a call premium, for 1.05. The call premiums and deferred charges of $2.5 million relating to the redeemed debt were charged to income in 2004. The US$175 million Senior Notes are redeemable, in whole or in part, at the option of the Company on or after March 1, 2009 at 103.188% of the principal amount declining rateably to 100% of the principal amount on or after March 1, 2012. In addition, the Senior Notes are also redeemable, in whole, at the option of the Company at any time at 100% of the principal amount in the event of certain changes affecting Canadian withholding taxes. The Senior Notes contain certain restrictions on the payment of common share dividends in excess of $0.08 per share per quarter. The Company was in compliance with all debt covenants at December 31, 2005. On February 20, 2004, the Company entered into fixed for fixed cross currency swaps with major banks to manage the foreign currency exposure on the last US$100 million of the 6.375% Senior Notes. On the swaps, the Company receives U.S. denominated interest at 6.375% on a notional US$100 million and pays Canadian dollar interest at 7.12% on a notional $131.8 million. As part of the swaps, the Company exchanged US$100 million for $131.8 million on February 20, 2004 and will receive US$100 million for $131.8 million on March 1, 2014. Both the swap counterparties and the Company have the right to early terminate the swaps in the first quarter of 2009. On a monthly basis, the Senior Notes are recorded at month-end exchange rates and the difference between the swap rate of $1.3180 and the month-end rate on the US$100 million relating to the swap is recorded separately in Other Assets or Other Accrued Liabilities. 9. Interest Expense ($000) Interest on long-term debt Other interest expense, net 2005 15,184 2,345 17,529 $ $ 2004 16,957 $ 3,067 2003 18,820 3,903 20,024 $ 22,723 $ $ Interest income on short-term investments is recorded as a reduction of short-term interest expense. Total interest paid by the Company in 2005 was $17,732,000 (2004: $20,071,000; 2003: $21,746,000). R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 3 5 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 36 > notes to the consolidated financial statements cont’d 10. Income Taxes a) The non-current future income tax balances consist of: ($000) Future income tax assets 2005 2004 Tax benefits of loss carryforwards $ 771 $ Plant and equipment Pensions and benefits Other timing Gross future income tax assets Valuation allowance Total future income tax assets Future income tax liabilities Plant and equipment Pensions and benefits Other timing Unrealized foreign exchange charged to equity Total future income tax liabilities (533) 999 1,624 2,861 (1,867) 994 (6,175) 2,123 1,105 (2,338) (5,285) Net future income taxes $ (4,291) $ b) The Company’s effective income tax rate is derived as follows: Average combined statutory rate Rate difference of U.S. companies Recognition of previously unrecorded tax benefits Statutory tax rate changes Large Corporation Tax Other Average effective tax rate c) The details of the income tax provision are as follows: ($000) Current provision Future provision Statutory rate adjustments 2005 35.5% 0.7% (1.3)% – – (2.3)% 32.6% 2004 36.0% 0.9% – – – (0.1)% 36.8% 2005 2004 54,069 $ 100,225 $ 6,305 – 5,043 – 2003 13,664 (1,314) 900 60,374 $ 105,268 $ 13,250 $ $ d) Income taxes paid in 2005 were $110,388,000 (2004: $47,311,000; 2003: $7,777,000). The Company has Canadian net operating losses carried forward for tax purposes for which a valuation allowance has been e) recorded that expire as follows: ($000) Year of Expiry Amount $ 2006 2007 2008 2009 2010 2011 2012 543 745 507 4 263 145 4 3 6 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 860 (649) 981 2,644 3,836 (2,222) 1,614 (5,137) 2,399 (2,250) (1,843) (6,831) (5,217) 2003 37.0% – – 2.8% 0.6% 0.6% 41.0% RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 37 11. Shareholders’ Equity a) The components of shareholders’ equity are as follows: ($000) Common shares Retained earnings Contributed surplus (relating to stock-based compensation) Cumulative translation adjustment 2005 2004 $ 208,139 $ 203,090 342,015 1,091 (12,548) 262,733 446 (9,695) $ 538,697 $ 456,574 b) At December 31, 2005, the authorized share capital of the Company consists of: (i) an unlimited number of common shares without nominal or par value; (ii) an unlimited number of Class I preferred shares without nominal or par value, issuable in series; and (iii) an unlimited number of Class II preferred shares without nominal or par value, issuable in series. The Directors have the authority to issue the Class I and Class II preferred shares in series and fix the designation, rights, privileges and conditions to be attached to each series, except that the Class I shares shall be entitled to preference over the Class II shares with respect to the payment of dividends and the distribution of assets in the event of liquidation, dissolution or winding-up of the Company. The Company’s 1,200,000 cumulative, redeemable Class II preferred shares were redeemed on March 22, 2004 (Note 8). c) The number of common shares issued and outstanding at December 31 was as follows: Balance, December 31, 2003 Common shares issued Stock options exercised Balance, December 31, 2004 Stock options exercised Balance, December 31, 2005 Number of Shares Amount ($000) 43,023,342 $ 147,981 5,750,000 1,114,317 49,887,659 768,350 49,240 5,869 203,090 5,049 50,656,009 $ 208,139 d) The Company has a shareholder-approved share option plan, the purpose of which is to provide the directors and employees of the Company and its subsidiaries with the opportunity to participate in the growth and development of the Company. The number of common shares that may be issued under the share option plan is 5% of the current issued and outstanding common shares. The options are exercisable on a cumulative basis to the extent of 20% per year of total options granted, except that under certain specified conditions the options become exercisable immediately. The consideration paid by employees for purchase of common shares is added to share capital. The following is a continuity of options outstanding: Number of Options Weighted Average Exercise Price Balance, beginning of the year 1,793,816 2,031,133 $ 6.52 $ 2005 2004 2005 Granted Exercised Expired and forfeited Balance, end of the year Exercisable 856,000 888,500 (768,350) (1,114,317) (12,000) (11,500) 1,869,466 1,793,816 275,666 327,216 $ $ 15.85 5.71 6.75 11.12 11.87 $ $ 2004 4.40 9.15 4.76 4.03 6.52 5.45 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 3 7 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 38 > notes to the consolidated financial statements cont’d The outstanding options have an exercise price range as follows: (number of options) $15.85 $9.15 $5.50 – $9.14 $4.50 – $5.49 $3.00 – $4.49 Options outstanding 2005 852,800 553,600 – 335,066 128,000 2004 – 776,050 27,000 567,766 423,000 1,869,466 1,793,816 The options expire in the years 2007 to 2015 and have a weighted average remaining contractual life of 8.2 years (2004: 7.8 years). The Black-Scholes option-pricing model assumptions used to compute compensation expense under the fair value-based method are as follows: Dividend yield Expected volatility Expected life Risk free rate of return 2005 5.0% 25.3% 7 yrs 5.0% 2004 5.0% 28.5% 7 yrs 5.0% Weighted average fair value of options granted $ 2.93 $ 1.89 $ 2003 5.0% 34.6% 7 yrs 5.0% 1.30 e) The Company has established a Deferred Share Unit (DSU) plan for its directors. A DSU entitles the holder to receive, upon redemption, a cash payment equivalent to the market value of a common share at the redemption date. DSUs are credited to the director accounts on a quarterly basis and vest immediately. At December 31, 2005, there were 18,024 DSUs outstanding (2004: 7,775). f) Total compensation cost for stock-based compensation is as follows: ($000) Stock options DSUs g) Diluted share amounts were computed as follows: (number of shares) Weighted average shares outstanding Dilution impact of stock options Diluted weighted average shares outstanding 12. Financial Instruments 2005 1,309 $ 274 2004 804 120 $ 1,583 $ 924 $ $ $ 2003 217 – 217 2005 2004 2003 50,461,330 48,671,915 40,021,479 1,070,367 1,114,227 1,981,324 51,531,697 49,786,142 42,002,803 Fair value a) The fair value of long-term debt as at December 31, 2005 and 2004 is estimated based on the last quoted trade price, where it exists, or on the current rates available to the Company for similar debt of the same remaining maturities. ($000) Long-term debt Carrying amount Fair value 3 8 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 2005 2004 $ 204,033 $ 210,630 197,912 212,736 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 39 On February 20, 2004, the Company entered into fixed for fixed cross currency swaps with major banks (Note 8). At December 31, 2005, the fair value of the liability relating to these swaps was $29.8 million (2004: $19.4 million). The change in the spot foreign exchange rate on the swaps of $15.2 million (2004: $11.4 million) is recorded as an Other Accrued Liability. At December 31, 2005 and 2004, the Company had forward exchange contracts outstanding whose fair value approximates their contract value. As at December 31, 2005 and 2004, the estimated fair value of other financial assets, liabilities and off-balance sheet instruments approximates their carrying values. Credit risk b) The Company, in the normal course of business, is exposed to credit risk relating to accounts receivable from its customers. This risk is mitigated by the fact that its customer base is geographically diverse and in different industries. The Company is also exposed to credit risk from the potential default by any of its counterparties on its foreign exchange forward contracts and the fixed for fixed cross currency swaps. The Company mitigates this risk by entering into forward contracts and swaps with members of the credit facility syndicate. Interest rate risk c) The Company is not exposed to significant interest rate risk. The Company’s long-term debt is at fixed rates. The Company’s bank debt that is used to finance working capital, which is short-term in nature, is at floating interest rates. Foreign exchange risk d) The Company uses foreign exchange contracts with maturities of less than a year to manage foreign exchange risk on certain future committed cash outflows. As at December 31, 2005, the Company had outstanding forward foreign exchange contracts in the amounts of US$58.7 million and ¤2.9 million, maturing in the first half of 2006 (2004: US$27.6 million and ¤nil). The foreign exchange gain on U.S. denominated financial assets and liabilities included in 2005 operating earnings from continuing operations was $1.6 million (2004: $2.3 million; 2003: $881,000). The Company has designated US$75 million of the Senior Notes as a hedge of its net investment in foreign subsidiaries. The exchange gains and losses on U.S. borrowings not designated as a hedge of its net investment or hedged by the fixed for fixed cross currency swaps are charged to income as incurred. The hedge designation resulted in no net foreign exchange gain or loss recognized in income in 2005 (2004: $nil; 2003: $348,000). 13. Segmented Information The Company conducts business primarily in three metals business segments. (i) (ii) (iii) Metals service centers The Company’s network of metals service centers provides processing and distribution services on a broad line of metal products in a wide range of sizes, shapes and specifications, including carbon hot rolled and cold finished steel, pipe and tubular products, stainless steel and aluminum. The Company services all major geographic regions of Canada and certain regions in the Midwestern United States. Energy tubular products The Company’s energy tubular products operations distribute oil country tubular products, line pipe, tubes, valves and fittings, primarily to the energy sector in Western Canada and the Western United States. Steel distributors The Company’s steel distributors act as master distributors selling steel to customers in large volumes, mainly on an “as is” basis. The steel distributors source their steel domestically and offshore. The Company has segmented its operations on the basis of type of customer, management reporting and geographic segments in which it operates. The inter-segment sales from steel distributors to metals service centers were $57.4 million (2004: $54.4 million; 2003: $33.8 million). These sales, which are at market rates, are eliminated in the table following. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 3 9 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 40 > notes to the consolidated financial statements cont’d a) Results by business segment: ($000) Segment Revenues Metals service centers Energy tubular products Steel distributors Other Segment Operating Profits Metals service centers Energy tubular products Steel distributors Other income Corporate expenses Capital Expenditures Metals service centers Energy tubular products Steel distributors Other Depreciation Expense Metals service centers Energy tubular products Steel distributors Other Identifiable Assets Metals service centers Energy tubular products Steel distributors Identifiable assets by segment Assets not included in segments Cash Income tax assets Deferred financing charges Other assets Corporate and other operating assets 2005 2004 2003 $ 1,539,673 $ 1,532,048 $ 909,502 595,215 468,720 395,296 471,205 297,532 283,579 2,603,608 2,398,549 1,490,613 11,638 13,953 13,201 $ 2,615,246 $ 2,412,502 $ 1,503,814 $ 115,218 $ 209,413 $ 53,977 46,575 215,770 2,385 (16,614) 47,200 78,189 334,802 4,565 (16,256) 37,567 13,764 13,380 64,711 4,002 (8,018) $ $ $ $ $ $ 201,541 $ 323,111 $ 60,695 23,612 $ 24,390 $ 1,436 188 1,227 758 71 175 33,466 1,032 77 304 26,463 $ 25,394 $ 34,879 15,049 $ 14,817 $ 981 428 1,245 1,108 463 938 12,575 1,126 529 910 17,703 $ 17,326 $ 15,140 583,827 $ 662,422 $ 501,433 280,968 138,119 228,325 192,383 1,002,914 1,083,130 47,055 1,298 7,240 2,821 33,855 634 7,610 8,357 2,566 44,184 144,809 71,436 717,678 19,008 16,370 3,547 2,840 31,176 Total assets $ 1,095,183 $ 1,146,481 $ 790,619 4 0 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 41 b) Results by geographic segment: ($000) Segment Revenues Canada United States Segment Operating Profits Canada United States Identifiable Assets Canada United States 2005 2004 2003 $ 1,984,968 $ 1,770,290 $ 1,124,630 618,640 628,259 365,983 $ 2,603,608 $ 2,398,549 $ 1,490,613 $ $ $ 161,313 54,457 215,770 $ $ 232,512 102,290 334,802 $ $ 55,448 9,263 64,711 839,401 $ 903,019 $ 580,955 163,513 180,111 136,723 $ 1,002,914 $ 1,083,130 $ 717,678 14. Pensions and Benefits The Company maintains defined benefit pension plans, post-retirement benefit plans and defined contribution pension plans a) in Canada and 401(k) defined contribution pension plans in the United States. Actuarial valuations are performed on defined benefit plans every three years or earlier if required. Three of the Company’s plans were valued at December 31, 2005, eight of the Company’s plans were valued at December 31, 2004, one plan was valued November 1, 2004, and four plans were valued at January 1, 2004. All of the Company’s pension plans have a measurement date of December 31, 2005. The components of the Company’s pension and benefit expense include the following: ($000) Defined benefit pension plans Benefits earned during the year Interest cost on benefit obligation Expected return on plan assets Curtailment loss Settlement loss Other Post-retirement benefits Defined contribution plans Paid during the year Related to discontinued operations Pension and benefit expense 2005 2004 2003 $ 1,761 $ 1,505 $ 4,476 (4,191) – – 325 2,371 376 792 3,539 (244) 4,166 (3,952) 81 225 334 2,359 12 808 3,179 (230) $ 3,295 $ 2,949 $ 1,538 3,825 (3,353) 225 648 170 3,053 112 794 3,959 (462) 3,497 The actuarial determinations were based on the following assumptions in each year: Assumed discount rate – year end Expected long-term rate of return on plan assets Rate of increase in future compensation Rate of increase in future government benefits 2005 2004 2003 5.0% 7.0% 4.0% 3.5% 6.0% 7.0% 4.0% 3.5% 6.5% 7.0% 4.0% 3.5% R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 4 1 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 42 > notes to the consolidated financial statements cont’d The health care cost trend rates used were 5% for dental and 10% (2004: 8%; 2003: 9%) graded out for medical, which is reduced 1% per year until 5% and 5% thereafter. A 1% change in trend rates would result in an increase in the accrued benefit obligation for post-retirement benefits of $742,000 or a decrease of $633,000 and an increase in net periodic cost of $45,000 or a decrease of $38,000. The following information pertains to the Company’s defined benefit pension and other benefit plans, excluding those which b) are in the process of being wound up. ($000) Reconciliation of accrued benefit obligation Pension Plans Other Benefit Plans 2005 2004 2005 2004 Balance, beginning of the year $ 74,256 $ 64,159 $ 6,390 $ 5,643 Current service cost Participant contribution Interest cost Benefits paid Plan amendments Corporate restructuring giving rise to curtailment Actuarial loss Balance, end of the year Reconciliation of fair value of plan assets Balance, beginning of the year Actual return of plan assets Employer contributions Employee contributions Benefits paid Balance, end of the year Unamortized amounts Funded status – (deficit) Unrecognized prior service cost Unamortized net actuarial loss Accrued benefit liability 1,761 317 4,476 (5,434) 590 – 11,881 1,505 327 4,166 (3,347) 312 81 7,053 – – 371 (396) – – 507 87,847 $ 74,256 $ 6,872 $ 59,832 $ 56,335 $ 7,982 3,549 317 (5,434) 3,156 3,361 327 (3,347) $ – – 396 – (396) 66,246 $ 59,832 $ – $ 8 – 355 (377) – (348) 1,109 6,390 – – 377 – (377) – (21,601) $ (14,424) $ (6,872) $ (6,390) 851 17,531 315 9,713 – 1,142 – 640 (3,219) $ (4,396) $ (5,730) $ (5,750) $ $ $ $ $ As at December 31, 2005, all the plans in the above table had an unfunded obligation. On December 31, 2004, one of the Company’s pension plans, included in the previous table, had a projected benefit obligation of $9.3 million, a fair value of plan assets of $9.5 million and a surplus of $0.2 million. At December 31, 2004, the remaining plans had an unfunded obligation. The closure of Lachine (see Note 4) resulted in a par tial settlement and cur tailment of one of the Company’s plans. In 2003, the Company acquired two pension plans as part of the Acier Leroux acquisition. These plans had assets of $4.2 million and an accrued benefit obligation of $5.6 million as of the acquisition date. The deficit in the plan of $1.4 million was included in the net assets acquired in the Leroux acquisition. The other benefit plans represent obligations to retired employees of sold or closed businesses. No active employees are entitled to post-retirement benefits. ($000) Defined contribution plans Fair value of plan assets Canadian plans 401(k) U.S. plans 4 2 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 2005 2004 $ $ 6,523 $ 22,916 5,598 19,149 29,439 $ 24,747 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 43 The Company has a number of plans in the process of being wound up that relate to previously discontinued operations with no further benefit obligation. The resolution of the surplus may result in sharing arrangements with employees of those operations. The fair value of the plan assets and surplus at December 31, 2005 is $2.8 million (2004: $2.7 million). As at December 31, 2005, approximately 43% of all pension plan assets were invested in equities, 30% in fixed income c) securities, and 27% in cash and cash equivalents. The expected return on plan assets is based on the fair value of plan assets. Management endeavours to have an asset mix of approximately 55% in equities, 40% in fixed income securities and 5% in cash and cash equivalents. The investment policy allows up to 30% in cash and cash equivalents. The volatility of the markets has caused management to invest a correspondingly greater percentage of the pension plan assets in cash and cash equivalents. The plan assets are not invested in either derivatives or real estate assets. The expected annual benefits to be paid from the plans are as follows: ($000) 2006 2007 2008 2009 2010 Pension Plans Other Benefit Plans $ 4,079 $ 3,605 3,762 3,939 4,158 $ 352 376 399 422 442 Total 4,431 3,981 4,161 4,361 4,600 2011 – 2015 25,064 2,438 27,502 As a result of a recent court decision, the Company may be subject to a surplus sharing arrangement on one of its pension plans as a result of a partial plan windup. The timing and the amount of surplus subject to sharing is currently being reviewed by the Company. The elements of defined benefit costs recognized in the year are as follows: ($000) Current service costs Interest on accrued benefit obligation Actual return on assets Actuarial loss on accrued benefit obligation Curtailment Settlement Prior service costs Elements of future benefit costs Adjustments to recognize the long-term nature of employee benefit costs: Difference between expected and actual return on assets Difference between actuarial losses recognized and actuarial losses incurred Difference between prior service costs recognized and prior service costs incurred 2005 $ 1,761 $ 4,847 (7,982) 12,389 – – 590 11,605 3,791 (12,113) (536) 2004 1,513 4,521 (3,156) 5,277 (267) 225 312 8,425 (796) (5,206) (52) Defined benefit cost recognized $ 2,747 $ 2,371 15. Contingencies, Guarantees and Commitments The Company and certain of its subsidiaries have been named defendants in a number of legal actions. Although the outcome a) of these claims cannot be determined, management intends to defend all claims and has recorded provisions based on its best estimate of the potential losses. In the opinion of management the resolution of these matters is not expected to have a materially adverse effect on the Company’s financial position, cash flows or operations. The Company and its subsidiary companies have operating lease commitments, with varying terms, requiring approximate b) annual payments as follows: 2006: $10.2 million; 2007: $8.5 million; 2008: $6.2 million; 2009: $5.6 million; 2010: $4.6 million; 2011 and beyond: $7.5 million. Rental expense on operating leases was as follows: 2005: $11.1 million, 2004: $13.6 million and 2003: $10.1 million. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 4 3 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 44 > notes to the consolidated financial statements cont’d The Company is incurring site cleanup and restoration costs related to properties not utilized in current operations. Remedial c) actions are currently underway at three sites. The estimated costs of these cleanups have been provided for based on management’s best estimates. Additional costs may be incurred at these or other sites as site cleanup and restoration progress, but the amounts cannot be quantified at this time. d) The Company has also entered into other agreements that provide indemnifications to counterparties in certain transactions including underwriting agreements. These indemnifications generally require the Company to indemnify the counterparties for costs incurred as a result of losses from litigation that may be suffered by counterparties arising from those transactions. The Company does not expect to make a payment on these indemnifications and, accordingly, no liability has been accrued. 16. United States Generally Accepted Accounting Principles The following table represents the differences between Canadian and U.S. generally accepted accounting principles (GAAP): ($000) Net earnings for the year under Canadian GAAP Amortization of transitional obligation – pensions Net earnings – U.S. GAAP Change in other comprehensive income items: Currency translation adjustment, net of tax Fair value of derivatives, net of tax Unrealized gain in available for sale securities Minimum pension liability, net of tax Comprehensive earnings – U.S. GAAP Opening retained earnings and comprehensive earnings – U.S. GAAP Dividends on common shares Dividends on preferred shares Comprehensive earnings – U.S. GAAP Closing retained earnings and comprehensive earnings – U.S. GAAP Common shares Contributed surplus Shareholders’ equity – U.S. GAAP Basic earnings per common share – U.S. GAAP – continuing operations Fully diluted earnings per common share – U.S. GAAP – continuing operations Basic earnings per common share – U.S. GAAP Fully diluted earnings per common share – U.S. GAAP 2005 2004 2003 $ 124,716 $ 177,846 $ 18,499 (561) (561) 124,155 177,285 (2,853) (4,136) – (3,758) 113,408 249,650 (45,434) – 113,408 317,624 208,139 1,091 526,854 2.46 2.41 2.46 2.41 $ $ $ $ $ $ $ (4,862) (5,196) (262) (599) 166,366 108,899 (25,004) (611) 166,366 249,650 203,090 446 453,186 3.68 3.60 3.63 3.55 $ $ $ $ $ $ $ (561) 17,938 909 – 262 1,395 20,504 102,250 (11,605) (2,250) 20,504 108,899 147,981 192 257,072 0.41 0.39 0.39 0.37 $ $ $ $ $ $ $ In 1999, for Canadian GAAP purposes, the Company retroactively adopted CICA Handbook section 3461, Employee Future a) Benefits, and recorded a cumulative charge to retained earnings in connection with the re-measurement of its pension obligations. Under U.S. GAAP, an actuarial loss was recognized upon the re-measurement of the pension obligations, which is being amortized to net income using the corridor approach, over the expected average service lives of the employee group. In addition, the U.S. standard requires the recognition of an additional minimum pension liability. Five of the Company’s plans and one executive arrangement have a minimum liability, which has been charged to other comprehensive income under U.S. GAAP. Other cumulative comprehensive income also includes changes in the cumulative translation account, which represents a b) reduction in the Company’s shareholders’ equity and represents unrealized translation adjustments, that arise on the translation to Canadian dollars of U.S. denominated assets and liabilities. The Company has designated certain U.S. denominated debt as a hedge of its net investment in these U.S. subsidiaries (Note 12). The change in the cumulative exchange account relating to debt designated as a hedge of the Company’s net investment in its foreign subsidiaries is a gain of $2.8 million in 2005 (2004 gain: $14.1 million; 2003 gain: $25.1 million). Under Canadian GAAP, these amounts are included in the cumulative translation adjustment component of shareholders’ equity. 4 4 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 45 Under Canadian GAAP, certain financial instruments qualify as a hedge for accounting purposes and therefore any gains and losses on these contracts are recognized in income when the hedged item affects earnings. Under U.S. GAAP, all derivative instruments must be recognized on the balance sheet at fair value. The Company has designated its fixed for fixed cross currency swaps and other forward contracts as hedges. The effective portion of the changes in fair value of these instruments is accumulated in other comprehensive income and is released from other comprehensive income when the hedged item affects earnings. As at December 31, 2005, the fair value of the fixed for fixed swaps not included in Other Accrued Liabilities was $14.6 million (2004: $8.0 million) net of tax of $4.5 million (2004: $2.8 million). As at December 31, 2005, the fair value of the forward contracts, net of tax, was $0.1 million (2004: $nil). c) As at December 31, 2003, the Company had certain available-for-sale securities that are recorded at the lower of cost or market for Canadian accounting standards and marked to market through other comprehensive income in the amount of $262,000, net of tax of $141,000 as required by U.S. standards. These securities were sold in 2004. In March 2005, the FASB issued FIN 47, Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB d) Statement No. 143 (FIN 47), which requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 was adopted by the Company during the year. The adoption of this standard did not have a material effect on the Company’s results of operations, financial position or cash flows. During 2004, the Company adopted FASB FIN 46, Consolidation of Variable Interest Entities. The adoption of this standard did e) not have a material effect on the Company’s results of operations, financial position or cash flows. During 2003, the Company adopted SFAS 143, Accounting for Asset Retirement Obligations; SFAS 144, Accounting for the f) Impairment or Disposal of Long-Lived Assets; SFAS 148, Accounting for Stock-based Compensation, Transition and Disclosure; and EITF 02-16, Accounting by a Customer for Certain Consideration Received from a Vendor. The implementation of these standards did not differ materially from the corresponding Canadian standards except that the Company adopted the Canadian Asset Retirement Obligation standard January 1, 2004. In December 2004, FASB issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based g) Payments, or SFAS 123R. SFAS 123R applies to all awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date. SFAS 123R will be effective in the Company’s fiscal year ending December 31, 2006. In March 2005, the SEC Staff issued Staff Accounting Bulletin No. 107 (SAB 107) to give guidance on the implementation of SFAS 123R. The Company utilizes the fair value-based approach to account for stock-based compensation and is currently evaluating the impact of these standards on the Company’s consolidated financial statements. R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 4 5 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 46 > metals service centers directory Thetford Mines Mégantic Métal 1400, boulevard Frontenac Est, G6G 5R9 Tel: (418) 338-3188 NEW BRUNSWICK Edmundston 25, rue Richards, E3V 4H4 Tel: (506) 739-9561 Sackville 141 Crescent Street, E4L 3V2 Tel: (506) 364-1234 Saint John 37 McIlveen Drive, McAllister Industrial Park, E2L 4B3 Tel: (506) 635-0005 NOVA SCOTIA Halifax – Regional Office 28 Lakeside Park Drive, B3T 1A3 Tel: (902) 876-7861 NEWFOUNDLAND Mount Pearl 11 Panther Place, Donovans Industrial Estates, A1N 5B7 Tel: (709) 364-3300 UNITED STATES Russel Metals Williams Bahcall Appleton, Wisconsin 975 North Meade Street, 54912 – 1054 Tel: (920) 734-9271 Green Bay, Wisconsin 895 Hinkle Street, 54303 Tel: (920) 497-1020 Milwaukee, Wisconsin 999 West Armour Avenue, 53221 Tel: (414) 481-7100 Baldwin International Solon, Ohio 30403 Bruce Industrial Parkway, 44139 Tel: (440) 248-9500 Operating under the name Russel Metals, unless otherwise noted. CANADA BRITISH COLUMBIA Operating under the name A.J. Forsyth throughout BC Delta (Vancouver) – Regional Office 830 Carlisle Road, V3M 5P4 Tel: (604) 525-0544 Campbell River 2710 Vigar Road, V9W 6A3 Tel: (250) 287-8841 Fort Nelson 4850 44th Avenue, V0C 1R0 Tel: (250) 774-7553 Fort St. John Mile 49 1/2 Alaska Highway, V1J 4M6 Tel: (250) 785-5641 Kelowna 668 Willow Park Road, V1X 5C4 Tel: (250) 765-3123 Kitimat 815 Enterprise Avenue, V8C 2P1 Tel: (250) 632-4702 Nanaimo 1950 East Wellington Road, V9S 5V2 Tel: (250) 753-1555 Prince George 1154 Pacific Street, V2N 5S3 Tel: (250) 563-1274 990 Industrial Way, V2N 5S1 Tel: (250) 563-1274 ALBERTA Calgary 5724 40th Street SE, T2C 2A1 Tel: (403) 279-6600 Edmonton 7016 99th Street NW, T6E 3R3 Tel: (780) 439-2051 5730 72A Avenue NW, T6B 3L1 (Specializing in plate processing) Tel: (780) 439-2051 2471 76th Avenue NW, T6P 1P6 (Specializing in non-ferrous sales) Tel: (780) 440-0779 Grande Prairie 11035 89th Avenue, T8V 5B9 Tel: (780) 539-3193 Red Deer 6724 Golden West Avenue, T4P 1A8 Tel: (403) 346-2096 SASKATCHEWAN Regina 445 1st Avenue E, S4N 4Z3 Tel: (306) 721-6411 475 1st Avenue E, S4N 4Z3 Tel: (306) 721-9355 Saskatoon 922 51st Street E, S7K 5C7 Tel: (306) 931-3338 MANITOBA Winnipeg 1359 St. James Street, R3H 0K9 Tel: (204) 772-0321 1510 Clarence Avenue, R3T 1T6 Tel: (204) 475-8584 ONTARIO Mississauga (Toronto) – Regional Office 1900 Minnesota Court, Suite 210, L5N 3C9 (Ontario general line sales) Tel: (800) 268-0750 Aberfoyle (Guelph) 24 Nicholas Beaver Road, N1H 6H9 Tel: (519) 653-1588 Burlington Milspec Industries 5036 South Service Road, L7L 5Y7 (Specializing in strapping) Tel: (905) 333-0646 Cambridge 15 Cherry Blossom Road, N3H 4R7 Tel: (519) 650-1666 Hamilton 175 Shaw Street, L8N 3S2 (Specializing in non-ferrous sales) Tel: (905) 522-5930 (Specializing in chain) Tel: (905) 522-1130 Kingston 191 Dalton Avenue, K7K 6C2 Tel: (613) 546-1281 London 685 Hale Street, N5W 1J1 Tel: (519) 451-1140 Ottawa 2420 Stevenage Drive, K1G 3W3 Tel: (613) 738-2961 Port Robinson York – Ennis 200 South Street North, L0S 1K0 Tel: (905) 384-9794 Stoney Creek (Hamilton) Russel Metals – B&T Steel 1052 South Service Road, L8E 6G3 (Specializing in flat rolled) Tel: (905) 643-3008 McCabe Steel 687 Arvin Avenue, L8E 5R2 Tel: (905) 643-8284 Thunder Bay 620 Norah Crescent, P7C 5V8 Tel: (807) 622-8898 Windsor 3702 Walker Road, N8W 3S8 Tel: (519) 250-3788 QUEBEC Boucherville – Regional Office Acier Leroux 1331, rue Graham-Bell, J4B 6A1 Tel: (450) 641-4360 Acier Richler 1330, rue Graham-Bell, J4B 6H5 (Specializing in non-ferrous sales) Tel: (450) 449-5112 Amos Acier Leroux 1675, route de l’Aéroport, J9T 3A8 Tel: (819) 732-8381 Baie-Comeau Acier Leroux 55, avenue William-Dobell, G4Z 1T8 Tel: (418) 296-8626 Chicoutimi Acier Leroux 2149, rue de la Fonderie, G7H 8C1 Tel: (418) 545-8881 Jonquière Métaux Russel 2420, rue Bauman, G7S 4S4 Tel: (418) 548-3103 Longueuil Armabec 2300, rue Garneau, J4G 1E8 (Specializing in rebar) Tel: (450) 442-9527 Quebec Acier Loubier 5225, rue John Molson, G1X 3X4 Tel: (418) 656-9911 Rimouski Acier Leroux 221, rue des Négociants, G5M 1B7 Tel: (418) 724-4937 Saint-Augustin-de-Desmaures Acier Leroux 167, rue de Rotterdam, G3A 2K2 Tel: (418) 878-5737 Sept-Îles Acier Leroux 533, boulevard Laure Est, G4R 4K2 Tel: (418) 962-6374 Terrebonne Acier Leroux 1025, boulevard des Entreprises, J6Y 1V2 (Specializing in structurals) Tel: (450) 622-2060 4 6 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 47 > energy tubular products directory Fedmet Tubulars Calgary, Alberta 700 9th Avenue SW, Suite 2200, T2P 3V4 Tel: (403) 237-0955 Triumph Tubular & Supply Calgary, Alberta 441 5th Avenue SW, Suite 875, T2P 2V1 Tel: (403) 262-3777 CANADA Comco Pipe and Supply Company Edmonton, Alberta 5910 17th Street NW, T6P 1S5 Tel: (780) 440-2000 Calgary, Alberta 9307 48th Street SE, T2C 2R1 Tel: (403) 203-0831 Stonewall, Manitoba 116 4th Street E, R0C 2Z0 Tel: (204) 467-8797 Guelph, Ontario Kerr Industrial Park, N1H 6H9 Tel: (519) 763-1114 Sarnia, Ontario 1018 Gladwish Drive N, N7T 7H3 Tel: (519) 332-6666 UNITED STATES Pioneer Pipe Denver, Colorado 1660 Lincoln Street, Suite 2300, 80264 Tel: (303) 289-3201 Lindon, Utah (Provo) 1610 West 200 South, 84042 Tel: (801) 224-8739 Houston, Texas 2203 Timberloch Place, Suite 125-1, The Woodlands, 77380 Tel: (281) 292-2875 Spartan Steel Products Evergreen, Colorado 2942 Evergreen Parkway, Suite 207, 80439 Tel: (303) 670-9048 > steel distributors directory CANADA Wirth Steel Montreal, Quebec 1 Westmount Square, Suite 200, H3Z 2P9 Tel: (514) 939-5555 Burnaby, British Columbia 4603 Kingsway, Suite 308, V5H 4M4 Tel: (604) 436-1741 UNITED STATES Sunbelt Group Houston, Texas 1990 Post Oak Boulevard, Suite 950, 77056-3817 Tel: (713) 840-0550 Overland Park, Kansas 7300 W. 110th Street, Suite 660, 66210 Tel: (913) 491-6660 Arrow Steel Processors Houston, Texas 8710 Clinton Drive, 77029 Tel: (713) 673-0666 > other Thunder Bay Terminals Ltd. Thunder Bay, Ontario Station F, McKellar Island, P7C 5J7, Canada Tel: (807) 625-7800 > head office 1900 Minnesota Court, Suite 210, Mississauga, Ontario, Canada, L5N 3C9 Tel: (905) 819-7777 Fax: (905) 819-7409 E-mail: info@russelmetals.com Internet: www.russelmetals.com R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT 4 7 RUSS 1064 2005AR_Innards 3/23/06 1:12 PM Page 48 > russel metals inc. directory Head Office 1900 Minnesota Court, Suite 210, Mississauga, Ontario, Canada, L5N 3C9 Tel: (905) 819-7777 Fax: (905) 819-7409 E-mail: info@russelmetals.com Internet: www.russelmetals.com Board of Directors Alain Benedetti Corporate Director James F. Dinning Chairman of the Board, Western Financial Group Anthony F. Griffiths Corporate Director, Chairman of the Board, Russel Metals Inc. Robbert Hartog President, Robhar Investments Ltd. John W. Robinson Corporate Director, steel industry executive Edward M. Siegel, Jr. President and Chief Executive Officer, Russel Metals Inc. Carl R. Fiora Corporate Director, steel industry executive Lise Lachapelle Corporate Director Corporate Governance Detailed disclosure concerning the Company’s governance practices may be found in the Management Proxy Circular. Officers Anthony F. Griffiths Chairman of the Board Toronto Marion E. Britton Vice President, Chief Accounting Officer and Assistant Secretary Mississauga Edward M. Siegel, Jr. President and Chief Executive Officer Mississauga Lesley M.S. Coleman Controller Mississauga Elaine G. Toomey Assistant Secretary Mississauga Shareholder Information Stock Symbol: The Toronto Stock Exchange – RUS Brian R. Hedges Executive Vice President and Chief Financial Officer Mississauga William M. O’Reilly Secretary Davies Ward Phillips & Vineberg, LLP Toronto Transfer Agent and Registrar CIBC Mellon Trust Company P.O. Box 7010, Adelaide Street Postal Stn., Toronto, Ontario, Canada, M5G 2W9 Answer line: Toronto (416) 643-5500 Toll free: 1-800-387-0825 E-mail: inquiries@cibcmellon.ca Internet: www.cibcmellon.ca 4 8 R U S S E L M E TA L S 2 0 0 5 A N N U A L R E P O RT > five-year financial highlights For the years ended December 31 2005 2004 2003 2002 2001 OPERATING RESULTS ($000) Revenues Net earnings EBIT (Notes) EBITDA (Notes) Basic earnings per common share ($) $ $ 2,615,246 124,716 202,681 221,839 2.47 $ 2,412,502 177,846 305,761 324,359 3.64 $ $ 1,503,814 18,499 55,050 71,380 0.41 $ $ 1,403,275 29,236 67,923 83,115 0.71 $ $ 1,402,509 8,608 38,759 53,422 0.17 $ 356,079 474,034 1,333 $ 356,755 553,915 1,658 $ 247,513 303,048 2,005 $ 197,653 329,415 2,770 $ 192,244 265,417 2,053 BALANCE SHEET INFORMATION ($000) Metals Accounts receivable Inventories Prepaid expenses and other assets Accounts payable and accrued liabilities $ Net working capital – Metals Fixed assets Goodwill Net assets employed in metals operations Other operating assets Net income tax assets and liabilities Deferred financing charges Pension and benefit liabilities Other corporate assets and liabilities Total net assets employed $ (291,259) 540,187 162,263 9,205 711,655 21,955 (9,575) 7,240 (9,308) (24,194) 697,773 (318,450) 593,878 161,597 9,205 764,680 22,387 (59,270) 8,357 (10,146) (26,196) 699,812 $ CAPITALIZATION ($000) Bank indebtedness, net of cash Long-term debt Preferred shares Total interest bearing debt, net of cash Market capitalization (Notes) Total firm value $ (44,957) 204,033 – 159,076 1,106,834 $ 1,265,910 $ 32,608 210,630 – 243,238 773,259 $ 1,016,497 OTHER INFORMATION (Notes) $ Common shareholders’ equity ($000) Book value per share ($) $ Free cash flow ($000) (Notes) $ Capital expenditures ($000) $ Depreciation and amortization ($000) $ Earnings multiple (Notes) Firm value as a multiple of EBIT Firm value as a multiple of EBITDA Interest bearing debt/EBITDA Debt as percentage of capitalization (Notes) Market capitalization as a % of book value Return on capital employed (Notes) 538,697 10.63 130,628 26,463 19,158 8.8 6.2 5.7 0.7 23% 205% 29% $ $ $ $ $ 456,574 9.15 189,408 25,394 18,598 4.3 3.3 3.1 0.7 35% 169% 44% (207,886) 344,680 165,112 4,216 514,008 23,257 (1,468) 3,547 (11,542) (5,473) 522,329 59,085 179,402 30,000 268,487 378,175 646,662 253,842 5.90 7,606 34,879 16,330 21.4 11.7 9.1 3.8 51% 149% 11% $ $ $ $ $ $ $ $ (178,623) 351,215 88,898 2,709 442,822 24,750 768 4,962 (9,590) (2,597) 461,115 (3,927) 212,602 30,000 238,675 194,091 432,766 222,440 5.84 45,210 12,768 15,192 7.2 6.4 5.2 2.9 52% 87% 15% $ $ $ $ $ $ $ $ (157,300) 302,414 85,825 15,123 403,362 26,434 13,326 6,177 (9,242) 3,615 443,672 (17,151) 214,105 30,000 226,954 136,733 363,687 216,718 5.71 30,336 8,152 14,663 21.2 9.4 6.8 4.2 51% 63% 9% $ $ $ $ $ $ $ $ COMMON SHARE INFORMATION Ending outstanding common shares Average outstanding common shares Dividend yield (Notes) Dividend per share (Notes) Share price – High Share price – Low Share price – Ending $ $ $ $ 50,656,009 50,461,330 49,887,659 48,671,915 43,023,342 40,021,479 38,057,001 38,024,034 37,981,501 37,981,501 4.6% 1.00 22.75 13.40 21.85 $ $ $ $ 4.5% 0.70 15.75 11.61 15.50 $ $ $ $ 3.6% 0.32 8.90 4.65 8.79 $ $ $ $ 4.7% 0.24 5.49 3.46 5.10 $ $ $ $ 5.6% 0.20 3.90 2.70 3.60 NOTES: (1) In this Annual Report the Company uses certain financial measures that do not comply with Canadian generally accepted accounting principles (GAAP) or have standardized meanings and thus may not be comparable to similar measures presented by other issuers, for example EBIT and EBITDA and other information in the above table. Management believes that EBIT and EBITDA may be useful in assessing our operating performance and as an indicator of our ability to service or incur indebtedness, make capital expenditures and finance working capital requirements. EBIT and EBITDA should not be considered in isolation or as an alternative to cash from operating activities or other combined income or cash flow data prepared in accordance with Canadian GAAP. EBIT, EBITDA and a number of the ratios provided under Other Information are used by debt and equity analysts to compare our performance against other public companies. This terminology is defined on the inside back cover, under Definitions. See financial statements for GAAP earnings. (2) Statements contained in this document that relate to Russel Metals’ beliefs or expectations as to certain future events are not statements of historical fact and are forward-looking statements. Russel Metals cautions readers that there are important factors, risks and uncertainties, including but not limited to economic, competitive and governmental factors affecting Russel Metals’ operations, markets, products, services and prices that could cause the Company’s actual results, performance or achievements to be materially different from those forecasted or anticipated by Russel Metals in such forward- looking statements. All dollar references in this report are in Canadian dollars unless otherwise stated. DEFINITIONS EBIT -- Earnings from continuing operations before deduction of interest and income taxes. EBITDA – Earnings from continuing operations before deduction of interest, income taxes, depreciation and amortization. Earnings multiple -- Period ending common share price divided by basic earnings per common share. Free cash flow -- Cash from operating activities before working capital less capital expenditures plus sale of assets. Market capitalization -- Outstanding common shares times market price of a common share at December 31. Return on capital employed -- EBIT over net assets employed. Dividend per share – Dividend per share is the December 15th quarterly dividend annualized. Dividend yield – Dividend yield is the dividend per share divided by the year end common share price. Book value per share – Equity value divided by ending shares outstanding in period. R U S S E L M E T A L S 2 0 0 5 A N N U A L R E P O R T 2 0 0 5 A n n u a l R e p o r t 1900 Minnesota Court, Suite 210 Mississauga, Ontario, Canada L5N 3C9 Tel: (905) 819-7777 Fax: (905) 819-7409 E-mail: info@russelmetals.com Internet: www.russelmetals.com