-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, HylLI7+EevkXjjQibRGgKo8Cw64AB8g6qqjLCEq+K5rLuxYZOmg3i02XeokXRoFa tco5Lz2zpsfTrGfPzajveQ== 0000900421-98-000016.txt : 19980330 0000900421-98-000016.hdr.sgml : 19980330 ACCESSION NUMBER: 0000900421-98-000016 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980327 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: MAXXAM GROUP INC /DE/ CENTRAL INDEX KEY: 0000764542 STANDARD INDUSTRIAL CLASSIFICATION: SAWMILLS, PLANNING MILLS, GENERAL [2421] IRS NUMBER: 131310680 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 001-08857 FILM NUMBER: 98574916 BUSINESS ADDRESS: STREET 1: 5847 SAN FELIPE STE 2600 CITY: HOUSTON STATE: TX ZIP: 77057 BUSINESS PHONE: 7139757600 MAIL ADDRESS: STREET 1: 5847 SAN FELIPE STE 2600 STREET 2: STE 2600 CITY: HOUSTON STATE: TX ZIP: 77057 10-K405 1 MGI 1997 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K --------------- ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 Commission File Number 1-8857 MAXXAM GROUP INC. (Exact name of Registrant as Specified in its Charter) DELAWARE 13-1310680 (State or other (I.R.S. Employer jurisdiction Identification Number) of incorporation or organization) 5847 SAN FELIPE, SUITE 2600 77057 HOUSTON, TEXAS (Zip Code) (Address of Principal Executive Offices) Registrant's telephone number, including area code: (713) 975-7600 --------------- Securities registered pursuant to Section 12(b) of the Act: None. Securities registered pursuant to Section 12(g) of the Act: None. --------------- Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / All of the Registrant's voting stock is held by an affiliate of the Registrant. Number of shares of Common Stock outstanding at March 15, 1998: 100 REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION (J)(1)(A) AND (B) OF FORM 10-K AND IS THEREFORE FILING THIS FORM WITH THE REDUCED DISCLOSURE FORMAT. DOCUMENTS INCORPORATED BY REFERENCE: Not applicable. TABLE OF CONTENTS PART I Item 1. Business 2 Item 2. Properties 13 Item 3. Legal Proceedings 13 Item 4. Submission of Matters to a Vote of Security Holders 15 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters 15 Item 6. Selected Financial Data 15 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 15 Item 8. Financial Statements and Supplementary Data Report of Independent Public Accountants 20 Consolidated Balance Sheet 21 Consolidated Statement of Operations 22 Consolidated Statement of Cash Flows 23 Notes to Consolidated Financial Statements 24 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 36 PART III Items 10-13. Not applicable. PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 36 PART I ITEM 1. BUSINESS GENERAL MAXXAM Group Inc. (the "Company" or "MGI") is a wholly owned subsidiary of MAXXAM Group Holdings Inc. ("MGHI"), which in turn is a wholly owned subsidiary of MAXXAM Inc. ("MAXXAM"). The Company engages in forest products operations through its wholly owned subsidiaries, The Pacific Lumber Company and its wholly owned subsidiaries (collectively referred to herein as "Pacific Lumber," unless the context indicates otherwise), and Britt Lumber Co., Inc. ("Britt"). Pacific Lumber's principal wholly owned subsidiaries are Scotia Pacific Holding Company ("Scotia Pacific") and Salmon Creek Corporation ("Salmon Creek"). As used herein, the terms "Company" or "MGI," "MGHI," "Pacific Lumber" or "MAXXAM" refer to the respective companies and their subsidiaries, unless otherwise noted or the context indicates otherwise. Pacific Lumber, which has been in continuous operation for over 125 years, engages in several principal aspects of the lumber industry--the growing and harvesting of redwood and Douglas-fir timber, the milling of logs into lumber products and the manufacturing of lumber into a variety of value-added finished products. Britt manufactures redwood fencing and decking products from small diameter logs, a substantial portion of which Britt acquires from Pacific Lumber (as Pacific Lumber cannot efficiently process them in its own mills). This Annual Report on Form 10-K contains statements which constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. These statements appear in a number of places (see Item 1. "Business--Regulatory and Environmental Factors and Headwaters Agreement," Item 3. "Legal Proceedings," and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations--Background," "--Financial Condition and Investing and Financing Activities" and "--Trends"). Such statements can be identified by the use of forward-looking terminology such as "believes," "expects," "may," "estimates,""will," "should," "plans" or "anticipates" or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy. Readers are cautioned that any such forward- looking statements are not guarantees of future performance and involve significant risks and uncertainties, and that actual results may vary materially from those in the forward-looking statements as a result of various factors. These factors include the effectiveness of management's strategies and decisions, general economic and business conditions, developments in technology, new or modified statutory or regulatory requirements and changing prices and market conditions. This report identifies other factors that could cause such differences. No assurance can be given that these are all of the factors that could cause actual results to vary materially from the forward-looking statements. PACIFIC LUMBER OPERATIONS Timberlands Pacific Lumber owns and manages approximately 202,000 acres of virtually contiguous commercial timberlands located in Humboldt County along the northern California coast, an area which has very favorable soil and climate conditions for growing timber. These timberlands contain approximately three-quarters redwood and one-quarter Douglas-fir timber, are located in close proximity to Pacific Lumber's four sawmills and contain an extensive network of roads. Approximately 179,000 acres of Pacific Lumber's timberlands are owned by Scotia Pacific (the "Scotia Pacific Timberlands"), a special purpose Delaware corporation and wholly owned subsidiary of Pacific Lumber. Pacific Lumber has the exclusive right to harvest (the "Pacific Lumber Harvest Rights") approximately 8,000 acres of the Scotia Pacific Timberlands consisting substantially of virgin old growth redwood and virgin old growth Douglas-fir timber located on numerous small parcels throughout the Scotia Pacific Timberlands. The timber on the Scotia Pacific Timberlands which is not subject to the Pacific Lumber Harvest Rights is referred to herein as the "Scotia Pacific Timber." Substantially all of Scotia Pacific's assets are pledged as security for Scotia Pacific's 7.95% Timber Collateralized Notes due 2015 (the "Timber Notes"). Pacific Lumber harvests and purchases from Scotia Pacific all of the logs harvested from the Scotia Pacific Timber. See "--Relationships With Scotia Pacific and Britt" for a description of this and other relationships among Pacific Lumber, Scotia Pacific and Britt. The forest products industry grades lumber in various classifications according to quality. The two broad categories within which all grades fall, based on the absence or presence of knots, are called "upper" and "common" grades, respectively. "Old growth" trees, often defined as trees which have been growing for approximately 200 years or longer, have a higher percentage of upper grade lumber than "young growth" trees (those which have been growing for less than 200 years). "Virgin" old growth trees are located in timber stands that have not previously been harvested. "Residual" old growth trees are located in timber stands which have been partially harvested in the past. Pacific Lumber engages in extensive efforts to supplement the natural regeneration of timber and increase the amount of timber on its timberlands. Pacific Lumber is required to comply with California forestry regulations regarding reforestation, which generally require that an area be reforested to specified standards within an established period of time. Pacific Lumber also actively engages in efforts to establish timberlands from open areas such as pasture land. Regeneration of redwood timber generally is accomplished through the natural growth of new redwood sprouts from the stump remaining after a redwood tree is harvested. Such new redwood sprouts grow quickly, thriving on existing mature root systems. In addition, Pacific Lumber supplements natural redwood regeneration by planting redwood seedlings. Douglas-fir timber grown on Pacific Lumber's timberlands is regenerated almost entirely by planting seedlings. During 1997, Pacific Lumber planted an estimated 659,000 redwood and Douglas-fir seedlings. Harvesting Practices The ability of Pacific Lumber to sell logs or lumber products will depend, in part, upon its ability to obtain regulatory approval of timber harvesting plans ("THPs"). THPs are required to be developed by registered professional foresters and must be filed with, and approved by, the California Department of Forestry ("CDF") prior to the harvesting of timber. Each THP is designed to comply with applicable laws and regulations. The CDF's evaluation of proposed THPs incorporates review and analysis of such THPs by several California and federal agencies and public comments received with respect to such THPs. An approved THP is applicable to specific acreage and specifies the harvesting method and other conditions relating to the harvesting of the timber covered by such THP. See "--Regulatory and Environmental Factors and Headwaters Agreement" for information regarding Pacific Lumber's obligation to develop a plan establishing a long-term sustained yield level for its timberlands. That section also contains information regarding threatened and endangered species listings, a critical habitat designation and similar matters concerning Pacific Lumber and its operations. The number of Pacific Lumber's approved THPs and the amount of timber covered by such THPs varies significantly from time to time, depending upon a variety of factors, including the timing of agency review. Pacific Lumber maintains a detailed geographical information system covering its timberlands (the "GIS"). The GIS covers numerous aspects of Pacific Lumber's properties, including timber type, tree class, wildlife data, roads, rivers and streams. By carefully monitoring and updating this data base and conducting field studies, Pacific Lumber's foresters are better able to develop detailed THPs addressing the various regulatory requirements. Pacific Lumber also utilizes a Global Positioning System ("GPS") which allows precise location of geographic features through satellite positioning. Pacific Lumber employs a variety of well-accepted methods of selecting trees for harvest. These methods, which are designed to achieve optimal regeneration, are referred to as "silvicultural systems" in the forestry profession. Silvicultural systems range from very light thinnings aimed at enhancing the growth rate of retained trees to clear cutting which results in the harvest of all trees in an area and replacement with a new forest stand. In between are a number of varying levels of partial harvests which can be employed. Production Facilities Pacific Lumber owns four highly mechanized sawmills and related facilities located in Scotia, Fortuna and Carlotta, California. The sawmills historically have been supplied almost entirely from timber harvested from Pacific Lumber's timberlands. Since 1986, Pacific Lumber has implemented numerous technological advances that have increased the operating efficiency of its production facilities and the recovery of finished products from its timber. Over the past three years, Pacific Lumber's annual lumber production has averaged approximately 297 million board feet, with approximately 309, 291 and 290 million board feet produced in 1997, 1996 and 1995, respectively. The Fortuna sawmill produces primarily common grade lumber. During 1997, the Fortuna mill produced approximately 101 million board feet of lumber. The Carlotta sawmill produces both common and upper grade redwood lumber. During 1997, the Carlotta mill produced approximately 76 million board feet of lumber. Sawmills "A" and "B" are both located in Scotia. Sawmill "A" processes Douglas-fir logs and Sawmill "B" primarily processes large diameter redwood logs. During 1997, Sawmills "A" and "B" produced 91 million and 41 million board feet of lumber, respectively. Pacific Lumber operates a finishing and remanufacturing plant in Scotia which processes rough lumber into a variety of finished products such as trim, fascia, siding and paneling. These finished products include the redwood lumber industry's largest variety of customized trim and fascia patterns. Remanufacturing enhances the value of some grades of lumber by assembling knot-free pieces of narrower and shorter lumber into wider or longer pieces in its state-of-the-art end and edge glue plants. The result is a standard sized upper grade product which can be sold at a premium over common grade products. Pacific Lumber has also installed a lumber remanufacturing facility at its mill in Fortuna which processes low grade redwood common lumber into value-added, higher grade redwood fence and related products. Pacific Lumber dries the majority of its upper grade lumber before it is sold. Upper grades of redwood lumber are generally air-dried for three to twelve months and then kiln-dried for seven to twenty-four days to produce a dimensionally stable and high quality product which generally commands higher prices than "green" lumber (which is lumber sold before it has been dried). Upper grade Douglas-fir lumber is generally kiln-dried immediately after it is cut. Pacific Lumber owns and operates 34 kilns, having an annual capacity of approximately 95 million board feet, to dry its upper grades of lumber efficiently in order to produce a quality, premium product. Pacific Lumber also maintains several large enclosed storage sheds which hold approximately 27 million board feet of lumber. In addition, Pacific Lumber owns and operates a modern 25-megawatt cogeneration power plant which is fueled almost entirely by the wood residue from Pacific Lumber's milling and finishing operations. This power plant generates substantially all of the energy requirements of Scotia, California, the town adjacent to Pacific Lumber's timberlands where several of its manufacturing facilities are located. Pacific Lumber sells surplus power to Pacific Gas and Electric Company. In 1997, the sale of surplus power accounted for approximately 2% of Pacific Lumber's total revenues. Products The following table sets forth the distribution of Pacific Lumber's lumber production (on a net board foot basis) and revenues by product line:
Year Ended December 31, 1997 Year Ended December 31, 1996 ----------------------------------------- ----------------------------------------- % of Total % of Total Lumber % of Total Lumber % of Total Production Lumber % of Total Production Lumber % of Total Product Volume Revenues Revenues Volume Revenues Revenues ------------- ------------- ------------- ------------- ------------- ------------- Upper grade redwood lumber 12% 34% 29% 13% 33% 28% Common grade redwood lumber 55% 42% 35% 53% 42% 35% ------------- ------------- ------------- ------------- ------------- ------------- Total redwood lumber 67% 76% 64% 66% 75% 63% ------------- ------------- ------------- ------------- ------------- ------------- Upper grade Douglas- fir lumber 4% 6% 5% 3% 6% 5% Common grade Douglas- fir lumber 25% 16% 13% 27% 16% 13% ------------- ------------- ------------- ------------- ------------- ------------- Total Douglas- fir lumber 29% 22% 18% 30% 22% 18% ------------- ------------- ------------- ------------- ------------- ------------- Other grades of lumber 4% 2% 2% 4% 3% 2% ------------- ------------- ------------- ------------- ------------- ------------- Total lumber 100% 100% 84% 100% 100% 83% ============= ============= ============= ============= ============= ============= Logs 7% 9% ============= ============= Hardwood chips 3% 2% Softwood chips 4% 4% ------------- ------------- Total wood chips 7% 6% ============= =============
Lumber. In 1997, Pacific Lumber sold approximately 312 million board feet of lumber, which accounted for approximately 84% of Pacific Lumber's total revenues. Lumber products vary greatly by the species and quality of the timber from which it is produced. Lumber is sold not only by grade (such as "upper" grade versus "common" grade), but also by board size and the drying process associated with the lumber. Redwood lumber is Pacific Lumber's largest product category. Redwood is commercially grown only along the northern coast of California and possesses certain unique characteristics that permit it to be sold at a premium to many other wood products. Such characteristics include its natural beauty, superior ability to retain paint and other finishes, dimensional stability and innate resistance to decay, insects and chemicals. Typical applications include exterior siding, trim and fascia for both residential and commercial construction, outdoor furniture, decks, planters, retaining walls and other specialty applications. Redwood also has a variety of industrial applications because of its chemical resistance and because it does not impart any taste or odor to liquids or solids. Upper grade redwood lumber, which is derived primarily from large diameter logs and is characterized by an absence of knots and other defects, is used primarily in distinctive interior and exterior applications. The overall supply of upper grade lumber has been diminishing due to increasing environmental and regulatory restrictions and other factors, and Pacific Lumber's supply of upper grade lumber has decreased in some premium product categories. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations-- Background." Common grade redwood lumber, Pacific Lumber's largest volume product, has many of the same aesthetic and structural qualities of redwood uppers, but has some knots, sapwood and a coarser grain. Such lumber is commonly used for construction purposes, including outdoor structures such as decks, hot tubs and fencing. Douglas-fir lumber is used primarily for new construction and some decorative purposes and is widely recognized for its strength, hard surface and attractive appearance. Douglas-fir is grown commercially along the west coast of North America and in Chile and New Zealand. Upper grade Douglas-fir lumber is derived primarily from old growth Douglas-fir timber and is used principally in finished carpentry applications. Common grade Douglas-fir lumber is used for a variety of general construction purposes and is largely interchangeable with common grades of other whitewood lumber. Logs. Pacific Lumber currently sells certain logs that, due to their size or quality, cannot be efficiently processed by its mills into lumber. The majority of these logs are purchased by Britt. The balance are purchased by surrounding mills which do not own sufficient timberlands to support their mill operations. See "--Relationships with Scotia Pacific and Britt" below. Except for the agreement with Britt described below, Pacific Lumber does not have any significant contractual relationships with third parties relating to the purchase of logs. Pacific Lumber has historically not purchased significant quantities of logs from third parties; however, Pacific Lumber may from time to time purchase logs from third parties for processing in its mills or for resale to third parties if, in the opinion of management, economic factors are advantageous to Pacific Lumber. Wood Chips. Pacific Lumber uses a whole-log chipper to produce wood chips from hardwood trees which would otherwise be left as waste. These chips are sold to third parties primarily for the production of facsimile and other specialty papers. Pacific Lumber also produces softwood chips from the wood residue from its milling operations. These chips are sold to third parties for the production of wood pulp and paper products. Backlog and Seasonality Pacific Lumber's backlog of sales orders at December 31, 1997 and 1996 was approximately $26.4 and approximately $21.3 million, respectively, the substantial portion of which was delivered in the first quarter of the next fiscal year. Pacific Lumber has historically experienced lower first quarter sales due largely to the general decline in construction-related activity during the winter months. As a result, Pacific Lumber's results in any one quarter are not necessarily indicative of results to be expected for the full year. Other The Company also derives revenues from a soil amendment operation and a concrete block manufacturing operation. Marketing The housing, construction and remodeling markets are the primary markets for Pacific Lumber's lumber products. Pacific Lumber's policy is to maintain a wide distribution of its products both geographically and in terms of the number of customers. Pacific Lumber sells its lumber products throughout the country to a variety of accounts, the large majority of which are wholesalers, followed by retailers, industrial users, exporters and manufacturers. Upper grades of redwood and Douglas-fir lumber are sold throughout the entire United States, as well as to export markets. Common grades of redwood lumber are sold principally west of the Mississippi River, with California accounting for approximately 66% of these sales in 1997. Common grades of Douglas-fir lumber are sold primarily in California. In 1997, Pacific Lumber had three customers which accounted for approximately 10%, 5% and 5%, respectively, of Pacific Lumber's total revenues. Exports of lumber accounted for approximately 6% of Pacific Lumber's total revenues in 1997. Pacific Lumber markets its products through its own sales staff which focuses primarily on domestic sales. Pacific Lumber actively follows trends in the housing, construction and remodeling markets in order to maintain an appropriate level of inventory and assortment of products. Due to its high quality products, large inventory, competitive prices and long history, Pacific Lumber believes it has a strong degree of customer loyalty. Competition Pacific Lumber's lumber is sold in highly competitive markets. Competition is generally based upon a combination of price, service, product availability and product quality. Pacific Lumber's products compete not only with other wood products but with metals, masonry, plastic and other construction materials made from non-renewable resources. The level of demand for Pacific Lumber's products is dependent on such broad factors as overall economic conditions, interest rates and demographic trends. In addition, competitive considerations, such as total industry production and competitors' pricing, as well as the price of other construction products, affect the sales prices for Pacific Lumber's lumber products. Pacific Lumber currently enjoys a competitive advantage in the upper grade redwood lumber market due to the quality of its timber holdings and relatively low cost production operations. Competition in the common grade redwood and Douglas-fir lumber market is more intense, and Pacific Lumber competes with numerous large and small lumber producers. Employees As of March 1, 1998, Pacific Lumber had approximately 1,550 employees, none of whom are covered by a collective bargaining agreement. Relationships with Scotia Pacific and Britt In March 1993, Pacific Lumber consummated its offering of $235 million of 10-1/2% Senior Notes due 2003 (the "Pacific Lumber Senior Notes") and Scotia Pacific consummated its offering of $385 million of Timber Notes. Upon the closing of such offerings, Pacific Lumber, Scotia Pacific and Britt entered into a variety of agreements. Pacific Lumber and Scotia Pacific entered into a Services Agreement (the "Services Agreement") and an Additional Services Agreement (the "Additional Services Agreement"). Pursuant to the Services Agreement, Pacific Lumber provides operational, management and related services with respect to the Scotia Pacific Timber not performed by Scotia Pacific's own employees. Such services include the furnishing of all equipment, personnel and expertise not within Scotia Pacific's possession and reasonably necessary for the operation and maintenance of the Scotia Pacific Timber. In particular, Pacific Lumber is required to regenerate Scotia Pacific Timber, prevent and control loss of Scotia Pacific Timber by fires, maintain a system of roads throughout the Scotia Pacific Timberlands, take measures to control the spread of disease and insect infestation affecting Scotia Pacific Timber and comply with environmental laws and regulations. Pacific Lumber is also required (to the extent necessary) to assist Scotia Pacific personnel in updating the GIS and to prepare and file, on Scotia Pacific's behalf, all pleadings and motions and otherwise diligently pursue appeals of any denial of any THP and related matters. As compensation for these and the other services to be provided by Pacific Lumber, Scotia Pacific pays a fee which is adjusted on January 1 of each year based on a specified government index relating to wood products. The fee was approximately $115,400 per month in 1997 and is expected to be approximately $117,300 per month in 1998. Pursuant to the Additional Services Agreement, Scotia Pacific provides Pacific Lumber with a variety of services, including (a) assisting Pacific Lumber to operate, maintain and harvest its own timber properties, (b) updating and providing access to the GIS with respect to information concerning Pacific Lumber's own timber properties, and (c) assisting Pacific Lumber with its statutory and regulatory compliance. Pacific Lumber pays Scotia Pacific a fee for such services equal to the actual cost of providing such services, as determined in accordance with generally accepted accounting principles. Pacific Lumber and Scotia Pacific also entered into a Master Purchase Agreement (the "Master Purchase Agreement"). The Master Purchase Agreement governs all purchases of logs by Pacific Lumber from Scotia Pacific. Each purchase of logs by Pacific Lumber from Scotia Pacific is made pursuant to a separate log purchase agreement (which incorporates the terms of the Master Purchase Agreement) for the Scotia Pacific Timber covered by an approved THP. Such log purchase agreement provides for the sale to Pacific Lumber of the logs harvested from the Scotia Pacific Timber covered by such THP and generally constitutes an exclusive agreement with respect to the timber covered thereby, subject to certain limited exceptions. The Master Purchase Agreement generally contemplates that all sales of logs by Scotia Pacific to Pacific Lumber will be at a price which equals or exceeds the applicable stumpage price for such species and category, as set forth in the most recent Harvest Value Schedule published by the California State Board of Equalization (the "SBE Price"). The Harvest Value Schedule is published by the California State Board of Equalization at six month intervals for the purpose of computing yield taxes imposed on the harvesting of timber. SBE Prices are based on average actual log prices between unrelated parties over a recent twenty-four month period. As Pacific Lumber purchases logs from Scotia Pacific pursuant to the Master Purchase Agreement, Pacific Lumber is responsible, at its own expense, for harvesting and removing the standing Scotia Pacific Timber covered by approved THPs, and the purchase price is therefore based upon "stumpage prices." Substantially all of Scotia Pacific's revenues are derived from the sale of logs to Pacific Lumber under the Master Purchase Agreement. Pacific Lumber, Scotia Pacific and Salmon Creek also entered into a Reciprocal Rights Agreement granting to each other certain reciprocal rights of egress and ingress through their respective properties in connection with the operation and maintenance of such properties and their respective businesses. In addition, Pacific Lumber entered into an Environmental Indemnification Agreement with Scotia Pacific pursuant to which Pacific Lumber agreed to indemnify Scotia Pacific from and against certain present and future liabilities arising with respect to hazardous materials, hazardous materials contamination or disposal sites, or under environmental laws with respect to the Scotia Pacific Timberlands. In particular, Pacific Lumber is liable with respect to any contamination which occurred on the Scotia Pacific Timberlands prior to the date of the agreement. Pacific Lumber entered into an agreement with Britt (the "Britt Agreement") which governs the sale of logs by Pacific Lumber and Britt to each other, the sale of hog fuel (wood residue) by Britt to Pacific Lumber for use in Pacific Lumber's cogeneration plant, the sale of lumber by Pacific Lumber and Britt to each other, and the provision by Pacific Lumber of certain administrative services to Britt (including accounting, purchasing, data processing, safety and human resources services). The logs which Pacific Lumber sells to Britt and which are used in Britt's manufacturing operations are sold at approximately 75% of applicable SBE prices (to reflect the lower quality of these logs). Logs which either Pacific Lumber or Britt purchases from third parties and which are then sold to each other are transferred at the actual cost of such logs. Hog fuel is sold at applicable market prices, and administrative services are provided by Pacific Lumber based on Pacific Lumber's actual costs and an allocable share of Pacific Lumber's overhead expenses consistent with past practice. BRITT LUMBER OPERATIONS Business Britt is located in Arcata, California, approximately 45 miles north of Pacific Lumber's headquarters. Britt's primary business is the processing of small diameter redwood logs into wood fencing products for sale to retail and wholesale customers. Britt was incorporated in 1965 and operated as an independent manufacturer of fence products until July 1990, when it was purchased by a subsidiary of the Company. Britt purchases small diameter (6 to 11 inch) redwood logs of varying lengths. Britt's purchases are primarily from Pacific Lumber, although it does purchase a variety of different diameter and different length logs from various other timberland owners. Britt processes logs at its mill into a variety of different fencing products, including "dog-eared" 1" x 6" fence stock in six foot lengths, 4" x 4" fence posts in 6 through 12 foot lengths, and other lumber products in 6 through 12 foot lengths. Britt's purchases of logs from third parties are generally consummated pursuant to short-term contracts of twelve months or less. See "--Pacific Lumber Operations-- Relationships with Scotia Pacific and Britt" for a description of Britt's log purchases from Pacific Lumber. Marketing In 1997, Britt sold approximately 90 million board feet of lumber products to approximately 84 different customers. Over one-half of its 1997 lumber sales were in California. The remainder of its 1997 sales were in ten other western states. In 1997, Britt had four customers which accounted for 29%, 18%, 10% and 8%, respectively, of Britt's total sales. Britt markets its products through its own salesmen to a variety of customers, including distribution centers, industrial remanufacturers, wholesalers and retailers. Britt's backlog of sales orders at December 31, 1997 and 1996 was approximately $5.4 million and $4.2 million, respectively, the substantial portion of which was delivered in the first quarter of the next fiscal year. Facilities and Employees Britt's manufacturing operations are conducted on 12 acres of land, 10 acres of which are leased on a long-term fixed-price basis from an unrelated third party. Production is conducted in a 46,000 square foot mill. An 18-acre log sorting and storage yard is located one quarter of a mile away. The mill was constructed in 1980, and capital expenditures to enhance its output and efficiency are made periodically. Britt's (single shift) mill capacity, assuming 40 production hours per week, is estimated at 37.4 million board feet of fencing products per year. As of March 1, 1998, Britt employed approximately 125 people, none of whom are covered by a collective bargaining agreement. Competition Management estimates that Britt accounted for approximately one- third of the total redwood fence market in 1997. Britt competes primarily with the northern California mills of Louisiana Pacific, Georgia Pacific, Eel River and Redwood Empire. REGULATORY AND ENVIRONMENTAL FACTORS AND HEADWATERS AGREEMENT This section contains statements which constitute "forward- looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. See Item 1. "Business--General" and "Status of Multi- Species HCP, SYP and Headwaters Agreement" in this section for cautionary information with respect to such forward-looking statements. General Pacific Lumber's business is subject to a variety of California and federal laws and regulations dealing with timber harvesting, threatened and endangered species and habitat for such species, and air and water quality. Compliance with such laws and regulations plays a significant role in Pacific Lumber's business. The California Forest Practice Act (the "Forest Practice Act") and related regulations adopted by the California Board of Forestry (the "BOF") set forth detailed requirements for the conduct of timber harvesting operations in California. These requirements include the obligation of timber companies to prepare, and obtain regulatory approval of, detailed THPs (timber harvesting plans) containing information with respect to areas proposed to be harvested (see "-- Harvesting Practices" above). As described further below, California law has also required large timber companies submitting THPs to demonstrate that their proposed timber operations will not decrease the sustainable productivity of their timberlands. A timber company may comply with this requirement by submitting for review and approval by the CDF a long-term sustained yield plan ("SYP") establishing a long-term sustained yield harvest level for their timberlands. The federal Endangered Species Act (the "ESA") and California Endangered Species Act (the "CESA") provide in general for the protection and conservation of specifically listed wildlife and plants which have been declared to be endangered or threatened. The operations of Pacific Lumber are also subject to the California Environmental Quality Act ("CEQA"), which provides for protection of the state's air and water quality and wildlife, and the California Water Quality Act and Federal Clean Water Act, which require that Pacific Lumber conduct its operations so as to reasonably protect the water quality of nearby rivers and streams. While compliance with such laws, regulations and judicial and administrative interpretations, together with the cost of litigation incurred in connection with certain timber harvesting operations, have increased the costs of Pacific Lumber, they have not had a significant adverse effect on its financial position, results of operations or liquidity. However, these laws and related administrative actions and legal challenges have severely restricted the ability of Pacific Lumber to harvest virgin old growth timber on its timberlands, and to a lesser extent, residual old growth timber. As a result, Pacific Lumber, Scotia Pacific and Salmon Creek in April 1996 filed two actions (the "Takings Litigation") alleging that certain portions of their timberlands had been "taken" by California and the United States and seeking just compensation. See Item 3. "Legal Proceedings--Takings Litigation." Headwaters Agreement On September 28, 1996, Pacific Lumber (on behalf of itself, its subsidiaries and affiliates) and MAXXAM (collectively, the "Pacific Lumber Parties") entered into an agreement with the United States and California ("Headwaters Agreement") which provides the framework for the acquisition by the United States and California of approximately 5,600 acres of Pacific Lumber's timberlands. These timberlands are commonly referred to as the Headwaters Forest and the Elk Head Springs Forest (collectively, the "Headwaters Timberlands"). A substantial portion of the Headwaters Timberlands consists of virgin old growth timberlands. Approximately 4,900 of these acres are owned by Salmon Creek, with the remaining acreage being owned by Scotia Pacific (Pacific Lumber having harvesting rights on approximately 300 of such acres). The Headwaters Timberlands would be transferred in exchange for (a) property and other consideration from the United States and California having an aggregate fair market value of $300 million, and (b) approximately 7,755 acres of adjacent timberlands (the "Elk River Timberlands") to be acquired from a third party. As part of the Headwaters Agreement, the Pacific Lumber Parties agreed to not enter the Headwaters Forest or the Elk Head Springs Forest to conduct any logging or salvage operations. Closing of the Headwaters Agreement is subject to various conditions, including (a) the United States and California furnishing the requisite consideration, (b) approval of an SYP for Pacific Lumber's timberlands, in form and substance satisfactory to Pacific Lumber, (c) approval of a habitat conservation plan covering multiple species ("Multi- Species HCP") and issuance of a related incidental take permit (the "Permit") covering Pacific Lumber's timberlands, each in form and substance satisfactory to Pacific Lumber, (d) the issuance by the Internal Revenue Service and the California Franchise Tax Board of tax closing agreements in form and substance sought by and satisfactory to the Pacific Lumber Parties, (e) acquisition of the Elk River Timberlands, (f) the absence of a judicial decision in any litigation brought by third parties that any party reasonably believes will significantly delay or impair the transactions described in the Headwaters Agreement, and (g) the dismissal of the Takings Litigation. In November 1997, President Clinton signed an appropriations bill which contains authorization for the expenditure of $250 million of federal funds toward consummation of the Headwaters Agreement (the "Interior Appropriations Bill"). The federal funding is to remain available until March 1, 1999 and is subject to, among other things, contribution by the State of California of its $130 million portion of funding for the Headwaters Agreement. Although California has not enacted legislation providing funds for its portion of the acquisition contemplated by the Headwaters Agreement, representatives of the State of California continue to indicate that they are considering various methods of furnishing the required consideration. In August 1997, Pacific Lumber submitted drafts of the Multi-Species HCP and the SYP to the appropriate government agencies for review. On February 27, 1998, Pacific Lumber, MAXXAM and various government agencies entered into a Pre-Permit Application Agreement in Principle (the "HCP/SYP Agreement") regarding certain understandings that they had reached regarding the Multi-Species HCP, the Permit and the SYP. The parties have been discussing the tax closing agreements but, to date, have not been able to reach agreement. The parties to the Headwaters Agreement are working diligently to satisfy the other closing conditions. Terms of the HCP/SYP Agreement The Company believes that execution of the HCP/SYP Agreement mentioned above is an important milestone toward completion of the Headwaters Agreement. The HCP/SYP Agreement provides that the Permit and Multi-Species HCP would have a term of 50 years. Subject to certain rights of Pacific Lumber to seek an amendment to the Permit and Multi-Species HCP, the HCP/SYP Agreement provides that for the term of the Permit, only management activities designed to enhance habitat could be conducted by Pacific Lumber in twelve forest groves not being sold to the United States and California. These groves aggregate approximately 8,000 acres and consist of substantial quantities of virgin and residual old growth redwood and Douglas-fir timber. These limitations are designed primarily to protect habitat for the marbled murrelet, a coastal seabird which has been listed as endangered under the CESA and threatened under the ESA. The HCP/SYP Agreement also requires Pacific Lumber to initiate a specified watershed assessment process, which Pacific Lumber has begun. This process is intended to result in appropriate protective zones for fish and other wildlife being established adjacent to the streams on Pacific Lumber's timberlands. Until the watershed assessment process is complete, Pacific Lumber must incorporate certain interim stream protective measures into its THPs, including amending its pending (but not yet approved) THPs. These interim stream protection measures are more stringent than the measures currently required by existing state regulations. Effect of the HCP/SYP Agreement In addition to being an important milestone toward completion of the Headwaters Agreement, the Company also believes that the HCP/SYP Agreement would be a positive development in respect of the environmental challenges that it has faced over the last several years. For instance, various groups and individuals have filed objections with the CDF and the BOF regarding these agencies' actions and rulings with respect to certain of Pacific Lumber's THPs. In addition, lawsuits are pending or threatened which seek to prevent Pacific Lumber from implementing certain of its approved THPs. While challenges with respect to Pacific Lumber's young growth timber have historically been limited, a lawsuit was recently filed under the ESA which relates to a significant number of THPs covering young growth timber of Pacific Lumber. See Item 3. "Legal Proceedings--Timber Harvesting Litigation." While the Company expects these environmentally focused objections and lawsuits to continue, it believes that the HCP/SYP Agreement will enhance its position in connection with these challenges. The Company also believes that the Multi-Species HCP would expedite the preparation and facilitate approval of its THPs. A related environmental challenge which Pacific Lumber has faced is the listing of threatened or endangered species which are found on Pacific Lumber's timberlands. Several species, including the northern spotted owl, the marbled murrelet and the coho salmon, have been listed as endangered or threatened under the ESA and/or the CESA. Other species such as the steelhead trout could be listed in the future. Pacific Lumber has developed federal and state northern spotted owl management plans which permit harvesting activities to be conducted so long as Pacific Lumber adheres to certain measures designed to protect the northern spotted owl. The potential impact of the listings of the marbled murrelet and the coho salmon is more uncertain. The marbled murrelet has been listed as endangered under the CESA and as threatened under the ESA. Approximately 33,000 acres of Pacific Lumber's timberlands have been designated as critical habitat for the marbled murrelet. Pacific Lumber incorporates mitigation measures into its THPs as necessary to protect and maintain habitat for the marbled murrelet on its timberlands and conducts certain pre-harvest marbled murrelet surveys. These surveys delay the review and approval process with respect to certain of the THPs filed by Pacific Lumber. They have also indicated that Pacific Lumber has certain timberlands which are occupied murrelet habitat. As discussed in "--Terms of the HCP/SYP Agreement" above, the HCP/SYP Agreement contains provisions regarding protection of the marbled murrelet. The coho salmon was listed in April 1997 as threatened under the ESA in northern California, including Pacific Lumber's timberlands. The State of California and other persons, including Pacific Lumber, are working with NMFS and other government agencies to determine what mitigation measures will be instituted to protect the coho salmon. As discussed above, the HCP/SYP Agreement contains provisions regarding establishment of protective measures for the coho salmon and other fish and wildlife species. Pacific Lumber is also attempting to include in the Multi-Species HCP a resolution of the potential effect of limits by the Environmental Protection Agency ("EPA") on sedimentation, temperature and other factors (i.e. non-point source total maximum daily loadings; "TMDL"). The EPA is in the process of establishing limits on TMDL under the Federal Clean Water Act for seventeen northern California rivers and certain of their tributaries, including rivers within Pacific Lumber's timberlands. The TMDL limits will be aimed at protecting water quality. As a result of the HCP/SYP Agreement, Pacific Lumber will revise and resubmit the Multi-Species HCP. If the Multi-Species HCP is approved, Pacific Lumber would be issued the Permit, which would allow limited incidental "take" of listed species so long as there was no "jeopardy" to the species. The Multi-Species HCP would also identify measures to be instituted in order to minimize and mitigate the anticipated level of take to the greatest extent possible. The Multi-Species HCP will be designed to protect habitat for and accommodate species currently listed under the ESA and CESA such as the marbled murrelet and coho salmon, as well as to consider candidate and future-listed species and their potential habitat needs. This forward-looking feature of the Multi-Species HCP is designed to both protect future-listed species and their habitat, and to provide more certainty and protection to Pacific Lumber against further restrictions on harvesting as a result of future listings or unforeseen circumstances. This additional protection and certainty against future listings and unforeseen circumstances is referred to as the "no surprises" policy of the United States Fish and Wildlife Service ("USFWS"), which must review and approve the Multi-Species HCP. The HCP/SYP Agreement also contains certain provisions relating to the SYP. Pacific Lumber will submit a revised SYP, which will assume that the transactions contemplated by the Headwaters Agreement (including acquisition of the Elk River Timberlands) will be consummated and that the Multi-Species HCP will be approved. Subject to further study, the Company expects Pacific Lumber to propose a long-term sustained yield harvest level ("LTSY") which is somewhat less than Pacific Lumber's recent harvest levels. In order to mitigate the anticipated impact of the SYP, Pacific Lumber has acquired approximately 11,000 acres of timberlands since January 1, 1996 and expects to continue to acquire such additional timberlands as will enable it to maintain recent harvest levels. However, there can be no assurance that Pacific Lumber would be able to continue such acquisitions, which would be limited by Pacific Lumber's financial resources and the availability of acceptable properties. If the SYP is approved, Pacific Lumber will have complied with certain BOF regulations requiring that timber companies project timber growth and harvest on their timberlands over a 100-year planning period and establish an LTSY harvest level. The SYP must demonstrate that the average annual harvest over any rolling ten-year period will not exceed the LTSY harvest level and that Pacific Lumber's projected timber inventory is capable of sustaining the LTSY harvest level in the last decade of the 100-year planning period. The HCP/SYP Agreement provides that upon submission of certain timber growth estimates by Pacific Lumber, CDF will find the SYP sufficient for public review. An approved SYP is expected to be valid for ten years, although it would be subject to review after five years. Thereafter, revised SYPs will be prepared every decade that address the LTSY harvest level based upon reassessment of changes in the resource base and other factors. Status of the Multi-Species HCP, the SYP and the Headwaters Agreement The final terms of the SYP, the Multi-Species HCP and the Permit are subject to additional negotiation and agreement among the parties. At such time as the parties reach agreement on the form of the Multi-Species HCP and the Permit, these documents, along with federal and state environmental impact statements, will be made available for public review and comment. After the government agencies complete the public review process and approve a final environmental impact statement, the agencies will decide whether to approve a Multi-Species HCP and a Permit. A similar process will occur with respect to the SYP. While the Company believes that the HCP/SYP Agreement represents an important milestone toward completion of the Headwaters Agreement and the parties are working diligently to complete the Multi-Species HCP and the SYP as well as the other closing conditions contained in the Headwaters Agreement, there can be no assurance that the Headwaters Agreement will be consummated or that an SYP, Multi-Species HCP or Permit acceptable to Pacific Lumber will be approved. In the event that a Multi-Species HCP is not approved, Pacific Lumber will not enjoy the benefits of expedited preparation and facilitated review of its THPs. Furthermore, if a Multi-Species HCP acceptable to Pacific Lumber is not approved, it is impossible for the Company to determine the potential adverse effect of the listings of the marbled murrelet and coho salmon or the TMDL limits on the Company's financial position, results of operations or liquidity until such time as the various regulatory and legal issues are resolved; however, if Pacific Lumber is unable to harvest, or is severely limited in harvesting, on significant amounts of its timberlands, such effect could be materially adverse to the Company. If the Headwaters Agreement is not consummated and Pacific Lumber is unable to harvest or is severely limited in harvesting on various of its timberlands, it intends to continue and/or expand its Takings Litigation seeking just compensation from the appropriate governmental agencies on the grounds that such restrictions constitute an uncompensated governmental taking of private property for public use. Potential Future Developments Laws, regulations and related judicial decisions and administrative interpretations dealing with Pacific Lumber's operations are subject to change and new laws and regulations are frequently introduced concerning the California timber industry. From time to time, bills are introduced in the California legislature and the U.S. Congress which relate to the business of Pacific Lumber, including the protection and acquisition of old growth and other timberlands, endangered species, environmental protection, air and water quality and the restriction, regulation and administration of timber harvesting practices. It is impossible to predict the content of any such bills, the likelihood of any of the bills passing or the impact of any of these bills on the future liquidity, financial position or operating results of the Company. Furthermore, any bills which are passed are subject to executive veto and court challenge. In addition to existing and possible new or modified statutory enactments, regulatory requirements and administrative and legal actions, the California timber industry remains subject to potential California or local ballot initiatives and evolving federal and California case law which could affect timber harvesting practices. It is impossible, however, to assess the effect of such matters on the Company's financial position, operating results or liquidity. ITEM 2. PROPERTIES A description of the Company's properties is included under Item 1 above. ITEM 3. LEGAL PROCEEDINGS This section contains statements which constitute "forward- looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. See Item 1. "Business--General" for cautionary information with respect to such forward-looking statements. TIMBER HARVESTING LITIGATION On January 26, 1998, an action entitled Coho Salmon, et al. v. Pacific Lumber, et al. (No. 98-0283) (the "Coho lawsuit") was filed against Pacific Lumber, Scotia Pacific and Salmon Creek in the United States District Court for the Northern District of California. This action alleges, among other things, violations of the ESA and claims that defendants' logging operations in five watersheds have contributed to the "take" of the coho salmon. This action relates to a significant number of the Company's approved or pending THPs. Plaintiffs seek, among other things, to enjoin timber harvesting on the THPs and acreage identified. The THPs which are the subject of the Coho lawsuit are at various stages of the THP cycle. Approximately one-third of the THPs have been submitted to the CDF, but have not yet been approved and will have to be amended pursuant to the HCP/SYP Agreement discussed above under Item 1. "-- Regulatory and Environmental Factors and Headwaters Agreement." Pacific Lumber estimates that as of February 15, 1998, approximately 28 million board feet of standing timber remained to be harvested under the approved THPs. While the Company believes that completion of the HCP/SYP Agreement is a positive development in respect of the Coho lawsuit, the Company is unable to predict the outcome of this case or its ultimate impact on the Company. On December 30, 1997, the CDF issued a statement of issues in connection with an administrative action entitled In the Matter of the Statement of Issues Against: The Pacific Lumber Company, Timber Operator License A-5326 (No. LT 97-8). This administrative action sought to deny Pacific Lumber's application for a timber operator's license ("TOL") based on various violations of the rules and regulations of the Forest Practice Act. On the same date, Pacific Lumber entered into a Stipulation with the CDF and received a conditional TOL for 1998. The 1998 TOL and Stipulation are conditioned on, among other things, Pacific Lumber (a) complying with existing requirements governing timber harvesting, as well as additional obligations concerning, primarily, wet weather operations and minimizing the flow of sediment into water courses on properties of Pacific Lumber, and (b) complying with additional self-monitoring and inspection obligations. Compliance with the obligations set forth in the Stipulation will restrict Pacific Lumber's ability to harvest timber and transport logs during periods of wet weather and could impair Pacific Lumber's ability to maintain adequate log inventories during these periods. Pacific Lumber has instituted additional policies and procedures to assure that it complies with the Stipulation. Should Pacific Lumber's TOL nevertheless be revoked, Pacific Lumber could engage independent contractors to complete these activities on its behalf (independent contractors currently account for approximately 60% of the harvesting activities on Pacific Lumber's timberlands). Pacific Lumber therefore does not believe that loss of its TOL would have a significant adverse effect on its operations or financial performance. TAKINGS LITIGATION On April 22, 1996, Salmon Creek filed a lawsuit entitled Salmon Creek Corporation v. California State Board of Forestry, et al. (No. 96CS01057) in the Superior Court of Sacramento County. This action seeks to overturn the BOF's decision denying approval of a THP relating to approximately 8 acres of virgin old growth timber in the Headwaters Forest. Salmon Creek seeks a court order requiring approval of the THP so that it may harvest timber in order to construct a road in accordance with the THP. Salmon Creek also seeks constitutional "just compensation" damages to the extent that its old growth timber within and surrounding the THP has been "taken" without compensation by reason of this regulatory denial and previous actions of governmental authorities. In addition, on May 7, 1996, Pacific Lumber, Scotia Pacific and Salmon Creek filed a lawsuit entitled The Pacific Lumber Company, et al. v. The United States of America (No. 96- 257L) in the United States Court of Federal Claims. The suit alleges that the federal government has "taken" without compensation over 3,800 acres of Pacific Lumber's old growth timberlands through its application of the ESA. Pacific Lumber and Salmon Creek seek constitutional "just compensation" damages for the taking of these timberlands by the federal government's actions. The court in each of these actions has granted the parties' agreed motions to stay the actions pursuant to the Headwaters Agreement. These actions would be dismissed if the Headwaters Agreement is consummated. See Item 1. "Business--Regulatory and Environmental Factors and Headwaters Agreement" for description of the Headwaters Agreement. ZERO COUPON NOTE LITIGATION In April 1989, an action was filed against the Company, MAXXAM, MAXXAM Properties Inc., a wholly owned subsidiary of the Company ("MPI"), and certain of MAXXAM's directors in the Court of Chancery of the State of Delaware, entitled Progressive United Corporation v. MAXXAM Inc., et al. (No. 10785). Plaintiff purports to bring this action as a stockholder of MAXXAM derivatively on behalf of MAXXAM and MPI. In May 1989, a second action containing substantially similar allegations was filed in the Court of Chancery of the State of Delaware, entitled Wolf v. Hurwitz, et al. and the two cases were consolidated (under case No. 10785; collectively, the "Zero Coupon Note actions"). The Zero Coupon Note actions relate to a Put and Call Agreement entered into between MPI and Mr. Charles Hurwitz (Chairman of the Board of the Company, MAXXAM and MPI), as well as a predecessor agreement (the "Prior Agreement"). Among other things, the Put and Call Agreement provided that Mr. Hurwitz had the option (the "Call") to purchase from MPI certain notes (or MAXXAM's common stock into which they were converted) for $10.3 million. In July 1989, Mr. Hurwitz exercised the Call and acquired 990,400 shares of MAXXAM's common stock. The Zero Coupon Note actions generally allege that in entering into the Prior Agreement Mr. Hurwitz usurped a corporate opportunity belonging to MAXXAM, that the Put and Call Agreement constituted a waste of corporate assets of MAXXAM and MPI, and that the defendant directors breached their fiduciary duties in connection with these matters. Plaintiffs seek to have the Put and Call Agreement declared null and void, among other remedies. On February 3, 1998, the Court dismissed this action. USAT MATTER In January 1995, an action entitled U.S., ex rel., Martel v. Hurwitz, et al. (No. C950322) (the "Martel action") was filed against MAXXAM, the Company and others and is pending in the U.S. District Court for the Southern District of Texas. This action is purportedly brought by plaintiff on behalf of the U.S. government; however, the U.S. government has declined to participate in the suit. The suit alleges that defendants made false statements and claims in violation of the Federal False Claims Act in connection with their operation of United Savings Association of Texas ("USAT"). Plaintiff alleges, among other things, that defendants used the federally insured assets of USAT to acquire junk bonds from Michael Milken and Drexel, Burnham, Lambert Inc. ("Drexel"). Plaintiffs allege that in exchange Mr. Milken and Drexel arranged financing for defendants' various business ventures, including the acquisition of Pacific Lumber by MAXXAM. Plaintiff alleges that as a result of USAT's insolvency defendants should be required to pay $1.6 billion (subject to trebling) to cover USAT's losses. Plaintiff seeks, among other things, that the Court impose a constructive trust upon the fruits of the alleged improper use of USAT funds. On February 6, 1998, defendants' motion to dismiss was taken under submission by the Court. OTHER LITIGATION The Company is involved in other claims, lawsuits and other proceedings. While uncertainties are inherent in the final outcome of such matters and it is presently impossible to determine the actual costs that ultimately may be incurred, management believes that the resolution of such uncertainties and the incurrence of such costs should not have a material adverse effect on the Company's financial position, results of operations or liquidity. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All of the Company's common stock is owned by MGHI. Accordingly, the Company's common stock is not traded on any stock exchange and has no established public trading market. The Company declared and paid cash dividends on its common stock of $3.0 million, $3.9 million and $4.8 million in 1997, 1996 and 1995, respectively. As of December 31, 1997, approximately $4.1 million of dividends could be paid by the Company. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations--Financial Condition and Investing and Financing Activities" and Note 4 to the Consolidated Financial Statements appearing in Item 8. The Company's 11-1/4% Senior Secured Notes due 2003 (the "MGI Senior Notes") and the Company's 12-1/4% Senior Secured Discount Notes due 2003 (the "MGI Discount Notes," which, together with the MGI Senior Notes, are referred to collectively as the "MGI Notes") are secured by a pledge of 27,938,250 shares of common stock of Kaiser Aluminum Corporation ("Kaiser") owned by MGHI. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations--Financial Condition and Investing and Financing Activities" and Note 4 to the Consolidated Financial Statements appearing in Item 8. ITEM 6. SELECTED FINANCIAL DATA Not applicable. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BACKGROUND This section contains statements which constitute "forward- looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. See Item 1. "Business--General" for cautionary information with respect to such forward-looking statements. The Company engages in forest products operations principally through its subsidiaries, Pacific Lumber and Britt. The Company's business is seasonal in that the forest products business generally experiences lower first quarter sales due largely to the general decline in construction-related activity during the winter months. The following should be read in conjunction with the Company's Consolidated Financial Statements and the Notes thereto appearing in Item 8. Old growth trees constitute Pacific Lumber's principal source of upper grade redwood lumber, Pacific Lumber's most valuable product. Due to restrictions on Pacific Lumber's ability to harvest old growth timber on its property, Pacific Lumber's supply of upper grade lumber has decreased in some premium product categories. Furthermore, logging costs have increased, primarily due to the harvest of smaller diameter logs and, to a lesser extent, compliance with environmental regulations relating to the harvesting of timber and litigation costs incurred in connection with certain timber harvesting plans ("THPs") filed by Pacific Lumber. Pacific Lumber has been able to lessen the impact of these factors by instituting a number of measures at its sawmills during the past several years designed to enhance the efficiency of its operations, such as expansion of its manufactured lumber facilities and other improvements in lumber recovery and installation of a lumber remanufacturing facility at its Fortuna lumber mill. However, unless Pacific Lumber is able to sustain the harvest level of old growth trees, Pacific Lumber expects that its production of premium upper grade lumber products will decline and that its manufactured lumber products will constitute a higher percentage of its shipments of upper grade lumber products. See also "--Trends" and Item 1. "Business-- Regulatory and Environmental Factors and Headwaters Agreement." RESULTS OF OPERATIONS The following table presents selected operational and financial information for the years ended December 31, 1997, 1996 and 1995.
Years Ended December 31, ----------------------------------------- 1997 1996 1995 ------------- ------------- ------------- (In millions of dollars, except shipments and prices) Shipments: Lumber: (1) Redwood upper grades 52.4 49.7 46.5 Redwood common grades 244.2 229.6 216.7 Douglas-fir upper grades 11.5 10.6 7.4 Douglas-fir common grades 75.3 74.9 64.6 Other 14.5 17.2 11.4 ------------- ------------- ------------- Total lumber 397.9 382.0 346.6 ============= ============= ============= Logs (2) 11.9 20.1 12.6 ============= ============= ============= Wood chips (3) 237.8 208.9 214.0 ============= ============= ============= Average sales price: Lumber: (4) Redwood upper grades $ 1,443 $ 1,380 $ 1,495 Redwood common grades 531 511 477 Douglas-fir upper grades 1,203 1,154 1,301 Douglas-fir common grades 455 439 392 Logs (4) 414 477 440 Wood chips (5) 73 76 102 Net sales: Lumber, net of discount $ 256.1 $ 234.1 $ 211.3 Logs 4.9 9.6 5.6 Wood chips 17.4 15.8 21.7 Cogeneration power 4.5 3.3 2.5 Other 4.3 1.8 1.5 ------------- ------------- ------------- Total net sales $ 287.2 $ 264.6 $ 242.6 ============= ============= ============= Operating income $ 83.8 $ 72.0 $ 73.2 ============= ============= ============= Operating cash flow (6) $ 111.0 $ 100.2 $ 99.6 ============= ============= ============= Income before income taxes $ 18.6 $ 4.9 $ 4.7 ============= ============= ============= Net income $ 12.6 $ 5.6 $ 3.5 ============= ============= ============= Capital Expenditures $ 22.9 $ 15.2 $ 10.5 ============= ============= ============= - --------------- (1) Lumber shipments are expressed in millions of board feet. (2) Log shipments are expressed in millions of feet, net Scribner scale. (3) Wood chip shipments are expressed in thousands of bone dry units of 2,400 pounds. (4) Dollars per thousand board feet. (5) Dollars per bone dry unit. (6) Operating income before depletion and depreciation, also referred to as "EBITDA."
Net sales Net sales for 1997 increased over 1996 due to higher average realized prices and an increase in shipments for most categories of redwood and Douglas-fir lumber. Net sales for 1996 increased compared to 1995 principally due to higher lumber shipments in all categories and higher average realized prices for common grade lumber. Partially offsetting these improvements were lower average realized prices for upper grade redwood lumber and wood chips. Shipments of fencing and other value-added common lumber products from the Company's new remanufacturing facility were a contributing factor in the improved redwood common lumber realizations. Operating income Operating income for 1997 increased over 1996, principally due to the increase in net sales discussed above. Operating income, after excluding from 1995 the benefit from a $1.5 million insurance settlement, increased in 1996 due to the increase in net sales discussed above. Increases in costs of goods sold reflect both the impact of additional manufacturing costs attributable to the increased shipments of manufactured lumber products, higher shipments of lower margin lumber and the increasing cost of regulatory compliance for the Company's timber harvesting operations. Income before income taxes Income before taxes for 1997 increased over 1996 principally due to higher operating income discussed above and due to an increase in net gains on marketable securities in 1997. Income before income taxes for 1996 was basically flat as compared to 1995. Credit in lieu of income taxes The credit in lieu of income taxes for 1996 includes a benefit of $2.3 million relating to the refund of taxes previously paid in connection with a settlement of certain federal income tax matters in 1996. FINANCIAL CONDITION AND INVESTING AND FINANCING ACTIVITIES This section contains statements which constitute "forward- looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. See Item 1. "Business--General" for cautionary information with respect to such forward-looking statements. The Company conducts its operations primarily through its subsidiaries, Pacific Lumber and Britt. Substantially all of the Company's consolidated assets are owned by Pacific Lumber and a significant portion of Pacific Lumber's consolidated assets are owned by Scotia Pacific. Moreover, Pacific Lumber is dependent upon Scotia Pacific for most of its log requirements. The holders of the Timber Notes ($320.0 million outstanding as of December 31, 1997) have priority over the claims of creditors of Pacific Lumber with respect to the assets and cash flows of Scotia Pacific, and the holders of the $235.0 million of 10-1/2% Pacific Lumber Senior Notes (the "Pacific Lumber Senior Notes") have priority over the claims of creditors of the Company with respect to the assets and cash flows of Pacific Lumber. In the event Scotia Pacific's cash flows are not sufficient to generate distributable funds to Pacific Lumber, Pacific Lumber would effectively be precluded from distributing funds to the Company, and the Company's ability to pay interest on the MGI Notes and its other indebtedness would also be materially impaired. The Company is dependent upon its existing cash resources and dividends from Pacific Lumber and Britt to meet its financial and debt service obligations as they become due. The Company expects that Pacific Lumber will provide a major portion of its future operating cash flow. The indentures governing the MGI Notes, the Pacific Lumber Senior Notes, the Timber Notes (the "Timber Note Indenture") and Pacific Lumber's revolving credit agreement (the "Pacific Lumber Credit Agreement") contain various covenants which, among other things, limit the ability to incur additional indebtedness and liens, to engage in transactions with affiliates, to pay dividends and to make investments. Under the terms of the Timber Note Indenture, Scotia Pacific will generally have available cash for distribution to Pacific Lumber when Scotia Pacific's cash flow from operations exceeds the amounts required by the Timber Note Indenture to be reserved for the payment of current debt service (including interest, principal and premiums) on the Timber Notes, capital expenditures and certain other operating expenses. Pacific Lumber can pay dividends in an amount that is generally equal to 50% of Pacific Lumber's consolidated net income plus depletion and cash dividends received from Scotia Pacific, exclusive of the net income and depletion of Scotia Pacific as long as any Timber Notes are outstanding. Dividends paid are as follows:
Dividends Paid for Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------- ------------- ------------- (In millions of dollars) Scotia Pacific $ 60.8 $ 76.9 $ 59.0 ============= ============= ============= Pacific Lumber $ 23.0 $ 20.5 $ 22.0 Britt 4.0 6.0 6.0 ------------- ------------- ------------- $ 27.0 $ 26.5 $ 28.0 ============= ============= ============= MGI $ 3.0 $ 3.9 $ 4.8 ============= ============= =============
On October 9, 1997, the Pacific Lumber Credit Agreement was amended to, among other things, extend the date on which it expires to May 31, 2000. The Pacific Lumber Credit Agreement provides for borrowings of up to $60.0 million, of which $20.0 million may be used for standby letters of credit and $30.0 million is restricted to acquisition of timberlands. Borrowings made pursuant to the portion of the credit facility restricted to timberland acquisitions are secured by the purchased timberlands. As of December 31, 1997, $9.4 million of borrowings were outstanding and letters of credit outstanding amounted to $15.1 million. As of December 31, 1997, $35.5 million of borrowings was available under the Pacific Lumber Credit Agreement, of which $4.9 million was available for letters of credit and $20.6 million was restricted to timberland acquisitions. As of December 31, 1997, the Company had working capital of $161.7 million and long-term debt of $734.5 million (net of current maturities and restricted cash deposited in a liquidity account for the benefit of the holders of the Timber Notes) as compared to $131.4 million and $729.8 million, respectively, at December 31, 1996. The change in long-term debt was primarily due to $9.4 million of borrowings under the Pacific Lumber Credit Agreement and $13.2 million in accretion of discount on the MGI Discount Notes offset by $16.2 million in principal payments on the Timber Notes. Recent capital expenditures were made to improve production efficiency, reduce operating costs and acquire additional timberlands. The Company's consolidated capital expenditures were $22.9 million, $15.2 million and $10.5 million for the years ended December 31, 1997, 1996 and 1995, respectively. Capital expenditures, excluding expenditures for timberlands, are estimated to be between $10.0 million and $20.0 million per year for the 1998 - 2000 period. Pacific Lumber expects to purchase additional timberlands from time to time as appropriate opportunities arise to maintain recent harvest levels. However, there can be no assurance that Pacific Lumber would be able to continue such operations which would be limited by its financial resources and the availability of acceptable properties. As of December 31, 1997, the Company had cash and marketable securities of approximately $141.2 million, $38.8 million of which represents cash and marketable securities held by subsidiaries. The Company anticipates that cash from operations, together with existing cash, marketable securities and available sources of financing, will be sufficient to fund its working capital and capital expenditure requirements for the next year. With respect to their long-term liquidity, the Company believes that its existing cash and cash equivalents, together with its ability to generate sufficient levels of cash from operations and its ability to obtain both short- and long-term financing, should provide sufficient funds to meet its working capital and capital expenditure requirements. However, due to its highly leveraged condition, the Company is more sensitive than less leveraged companies to factors affecting its operations, including governmental regulation and litigation affecting its timber harvesting practices (see "--Trends" below), increased competition from other lumber producers or alternative building products and general economic conditions. TRENDS This section contains statements which constitute "forward- looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. See Item 1. "Business--General" for cautionary information with respect to such forward-looking statements. The Company's forest products operations are primarily conducted by Pacific Lumber. Pacific Lumber's operations are subject to a variety of California and federal laws and regulations dealing with timber harvesting, threatened and endangered species and habitat for such species, and air and water quality. Moreover, these laws and regulations are modified from time to time and are subject to judicial and administrative interpretation. Compliance with such laws, regulations and judicial and administrative interpretations, together with the cost of litigation incurred in connection with certain timber harvesting operations of Pacific Lumber, have increased the cost of logging operations. Pacific Lumber is subject to certain pending matters which could have a material adverse effect on the Company's consolidated financial position, results of operations or liquidity. There can be no assurance that these pending matters or future governmental regulations, legislation or judicial or administrative decisions would not have a material and adverse effect on the Company. See Item 1. "Business--Regulatory and Environmental Factors and Headwaters Agreement," Item 3. "Legal Proceedings--Timber Harvesting Litigation" and Note 9 to the Consolidated Financial Statements for further information regarding regulatory and legal proceedings affecting the Company's operations. Judicial or regulatory actions adverse to Pacific Lumber, increased regulatory delays and inclement weather in northern California, independently or collectively, could impair Pacific Lumber's ability to maintain adequate log inventories and force Pacific Lumber to temporarily idle or curtail operations at certain lumber mills from time to time. There can be no assurance that the above described pending matters or future governmental regulations, legislation or judicial or administrative decisions would not have a material adverse effect on Pacific Lumber. YEAR 2000 Internal assessments undertaken for the Company have determined that the Company's software and related technologies will be affected to a small extent by the year 2000 date change. Spending is expected to be less than $100,000. System modification costs will be expensed as incurred. Costs associated with new systems will be capitalized and amortized over the estimated useful life of the product. RECENT ACCOUNTING PRONOUNCEMENTS During June 1997, two new accounting standards were issued that will affect future financial reporting. Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS No. 130"), requires the presentation of an additional income measure (termed "comprehensive income"), which adjusts traditional net income for certain items that previously were only reflected as direct charges to equity, (such as minimum pension liabilities). Statement of Financial Accounting Standards No. 131, "Disclosures About Segments of an Enterprise and Related Information" ("SFAS No. 131"), requires that segment reporting for public reporting purposes be conformed to the segment reporting used by management for internal purposes. SFAS No. 131 also adds a requirement for the presentation of certain segment data on a quarterly basis starting in 1999. SFAS No. 130 and SFAS No. 131 must both be adopted in the Company's first quarter ending March 31, 1998 and year-end 1998 reporting, respectively, if applicable. Early adoption is acceptable but not required. Management is evaluating the impact of these two standards on the Company's future financial reporting. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholder and Board of Directors of MAXXAM Group Inc.: We have audited the accompanying consolidated balance sheets of MAXXAM Group Inc. (a Delaware corporation and a wholly owned subsidiary of MAXXAM Group Holdings Inc.) and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations and cash flows for each of the three years in the period ended December 31, 1997. These financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of MAXXAM Group Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedule listed in Item 14(a)(2) of this Form 10-K is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN LLP San Francisco, California January 30, 1998 (Except for the matter discussed in the fourth paragraph of Note 9 as to which the date is February 27, 1998.) MAXXAM GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (IN THOUSANDS OF DOLLARS)
December 31, -------------------------- 1997 1996 ------------ ------------ ASSETS Current assets: Cash and cash equivalents $ 89,840 $ 72,418 Marketable securities 51,324 31,423 Receivables: Trade 19,269 18,850 Other 2,157 2,542 Inventories 58,078 69,307 Prepaid expenses and other current assets 13,080 5,474 ------------ ------------ Total current assets 233,748 200,014 Timber and timberlands, net of accumulated depletion of $236,824 and $221,063, respectively 321,206 324,986 Property, plant and equipment, net of accumulated depreciation of $85,468 and $76,753, respectively 102,761 102,029 Deferred financing costs, net 21,513 24,249 Deferred income taxes 49,623 55,047 Restricted cash 28,434 29,967 Other assets 4,209 6,455 ------------ ------------ $ 761,494 $ 742,747 ============ ============ LIABILITIES AND STOCKHOLDER'S DEFICIT Current liabilities: Accounts payable $ 3,535 $ 3,928 Accrued interest 24,338 24,899 Accrued compensation and related benefits 12,544 10,033 Deferred income taxes 9,671 10,173 Other accrued liabilities 2,564 3,335 Long-term debt, current maturities 19,429 16,258 ------------ ------------ Total current liabilities 72,081 68,626 Long-term debt, less current maturities 762,896 759,769 Other noncurrent liabilities 28,976 26,387 ------------ ------------ Total liabilities 863,953 854,782 ------------ ------------ Contingencies Stockholder's deficit: Common stock, $.08-1/3 par value; 1,000 shares authorized, 100 shares issued - - Additional capital 81,287 81,287 Accumulated deficit (183,746) (193,322) ------------ ------------ Total stockholder's deficit (102,459) (112,035) ------------ ------------ $ 761,494 $ 742,747 ============ ============ The accompanying notes are an integral part of these financial statements.
MAXXAM GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (IN THOUSANDS OF DOLLARS)
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Net sales: Lumber and logs $ 260,993 $ 243,726 $ 216,898 Other 26,182 20,858 25,694 ------------ ------------ ------------ 287,175 264,584 242,592 ------------ ------------ ------------ Operating expenses: Cost of goods sold 162,020 148,522 127,124 Selling, general and administrative expenses 14,205 15,853 15,884 Depletion and depreciation 27,108 28,176 26,405 ------------ ------------ ------------ 203,333 192,551 169,413 ------------ ------------ ------------ Operating income 83,842 72,033 73,179 Other income (expense): Investment, interest and other income 13,444 10,942 9,393 Interest expense (78,674) (78,045) (77,824) ------------ ------------ ------------ Income before income taxes 18,612 4,930 4,748 Credit (provision) in lieu of income taxes (6,036) 680 (1,211) ------------ ------------ ------------ Net income $ 12,576 $ 5,610 $ 3,537 ============ ============ ============ The accompanying notes are an integral part of these financial statements.
MAXXAM GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS OF DOLLARS)
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 12,576 $ 5,610 $ 3,537 Adjustments to reconcile net income to net cash provided by operating activities: Depletion and depreciation 27,108 28,176 26,405 Amortization of deferred financing costs and discounts on long-term debt 15,888 14,714 13,328 Net sales (purchases) of marketable securities (11,330) 10,298 (19,533) Net gains on marketable securities (8,571) (5,153) (4,175) Increase (decrease) in cash resulting from changes in: Receivables (28) 1,284 5,778 Inventories, net of depletion 9,657 6,011 (7,695) Prepaid, expenses and other current assets (5,360) 714 (3,384) Accounts payable (54) (238) 463 Accrued interest (561) (455) (411) Accrued and deferred income taxes 5,618 (925) 2,303 Other liabilities 3,280 (4,288) 7,734 Other 96 5 1,020 ------------ ------------ ------------ Net cash provided by operating activities 48,319 55,753 25,370 ------------ ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures (13,467) (15,200) (9,852) Payment of note receivable from affiliate - - 2,500 Net proceeds from sale of assets 336 122 18 ------------ ------------ ------------ Net cash used for investing activities (13,131) (15,078) (7,334) ------------ ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Redemptions, repurchases of and principal payments on long-term debt (16,299) (14,153) (14,300) Dividends paid (3,000) (3,900) (4,800) Restricted cash withdrawals, net 1,533 1,400 1,035 Incurrence of financing costs - - (150) ------------ ------------ ------------ Net cash used for financing activities (17,766) (16,653) (18,215) ------------ ------------ ------------ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 17,422 24,022 (179) CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 72,418 48,396 48,575 ------------ ------------ ------------ CASH AND CASH EQUIVALENTS AT END OF YEAR $ 89,840 $ 72,418 $ 48,396 ============ ============ ============ The accompanying notes are an integral part of these financial statements.
MAXXAM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements include the accounts of MAXXAM Group Inc. ("MGI") and its subsidiaries, collectively referred to herein as the "Company." MGI is a wholly owned subsidiary of MAXXAM Group Holdings Inc. ("MGHI") which is a wholly owned subsidiary of MAXXAM Inc. ("MAXXAM"). Intercompany balances and transactions have been eliminated. Certain reclassifications have been made to prior years' financial statements to be consistent with the current year's presentation. The Company is engaged in forest products operations conducted through its wholly owned subsidiaries, The Pacific Lumber Company ("Pacific Lumber") and Britt Lumber Co., Inc. ("Britt"). Pacific Lumber's principal wholly owned subsidiaries are Scotia Pacific Holding Company ("Scotia Pacific") and Salmon Creek Corporation ("Salmon Creek"). Pacific Lumber is engaged in several principal aspects of the lumber industry, including the growing and harvesting of redwood and Douglas-fir timber, the milling of logs into lumber and the manufacture of lumber into a variety of finished products. Britt manufactures redwood and cedar fencing and decking products from small diameter logs, a substantial portion of which are obtained from Pacific Lumber. Housing, construction and remodeling are the principal markets for the Company's lumber products. Export sales generally constitute approximately 5% of sales. A significant portion of forest product sales are made to third parties located west of the Mississippi River. USE OF ESTIMATES AND ASSUMPTIONS The preparation of financial statements in accordance with generally accepted accounting principles requires the use of estimates and assumptions that affect (i) the reported amounts of assets and liabilities, (ii) the disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published and (iii) the reported amount of revenues and expenses recognized during each period presented. The Company reviews all significant estimates affecting its consolidated financial statements on a recurring basis and records the effect of any necessary adjustments prior to their publication. Adjustments made with respect to the use of estimates often relate to improved information not previously available. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of the Company's consolidated financial statements; accordingly, it is possible that the subsequent resolution of any one of the contingent matters described in Note 8 could differ materially from current estimates. The results of an adverse resolution of such uncertainties could have a material effect on the Company's consolidated financial position, results of operations or liquidity. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Cash Equivalents Cash equivalents consist of highly liquid money market instruments with original maturities of three months or less. Marketable Securities Marketable securities are carried at fair value. The cost of the securities sold is determined using the first-in, first-out method. Included in investment, interest and other income for each of the three years ended December 31, 1997 were: 1997 - net unrealized holding gains of $2,851,000 and net realized gains of $5,720,000; 1996 - net unrealized holding losses of $902,000 and net realized gains of $5,287,000; and 1995 - net unrealized holding gains of $1,666,000 and net realized gains of $2,509,000. Inventories Inventories are stated at the lower of cost or market. Cost is primarily determined using the last-in, first-out ("LIFO") method. Timber and Timberlands Timber and timberlands are stated at cost, net of accumulated depletion. Depletion is computed utilizing the unit-of-production method based upon estimates of timber values and quantities. Property, Plant and Equipment Property, plant and equipment, including capitalized interest, is stated at cost, net of accumulated depreciation. Depreciation is computed utilizing the straight-line method at rates based upon the estimated useful lives of the various classes of assets. Deferred Financing Costs Costs incurred to obtain financing are deferred and amortized over the estimated term of the related borrowing. Restricted Cash and Concentrations of Credit Risk Restricted cash represents the amount deposited into an account (the "Liquidity Account") held by the Trustee under the Indenture governing the 7.95% Timber Collateralized Notes due 2015 (the "Timber Notes") of Scotia Pacific. See Note 4. The Liquidity Account is not available, except under certain limited circumstances, for Scotia Pacific's working capital purposes; however, it is available to pay the Rated Amortization (as defined in Note 4) and interest on the Timber Notes if and to the extent that cash flows are insufficient to make such payments. The required Liquidity Account balance will generally decline as principal payments are made on the Timber Notes. Investment, interest and other income for the years ended December 31, 1997, 1996 and 1995 includes interest of approximately $2,336,000, $2,457,000 and $2,560,000, respectively, attributable to an investment rate agreement (at 7.95% per annum) with the financial institution which holds the Liquidity Account. At December 31, 1997 and 1996, cash and cash equivalents include $17,784,000 and $17,600,000, respectively, (the "Payment Account") which is reserved for debt service payments on the Timber Notes (see Note 4). The Payment Account and the Liquidity Account are each held by a different financial institution. In the event of nonperformance by such financial institutions, the Company's exposure to credit loss is represented by the amounts deposited plus any unpaid accrued interest thereon. The Company mitigates its concentrations of credit risk with respect to these restricted cash deposits by maintaining them at high credit quality financial institutions and monitoring the credit ratings of these institutions. Fair Value of Financial Instruments The carrying amounts of cash equivalents and restricted cash approximate fair value. Marketable securities are carried at fair value which is determined based on quoted market prices. As of December 31, 1997 and 1996, the estimated fair value of long-term debt, including current maturities, was $816,014,000 and $747,991,000, respectively. The estimated fair value of long-term debt is determined based on the quoted market prices for the Timber Notes, Pacific Lumber's 10-1/2% Senior Notes due 2003 (the "Pacific Lumber Senior Notes"), the Company's 11-1/4% Senior Secured Notes due 2003 (the "MGI Senior Notes") and the Company's 12-1/4% Senior Secured Discount Notes due 2003 (the "MGI Discount Notes" and together with the MGI Senior Notes, the "MGI Notes"), and on the current rates offered for borrowings similar to the other debt. Some of the Company's publicly traded debt issues are thinly traded financial instruments; accordingly, their market prices at any balance sheet date may not be representative of the prices which would be derived from a more active market. 2. INVENTORIES Inventories consist of the following (in thousands):
December 31, --------------------------- 1997 1996 ------------- ------------- Lumber $ 43,731 $ 49,829 Logs 14,347 19,478 ------------- ------------- $ 58,078 $ 69,307 ============= =============
3. PROPERTY, PLANT AND EQUIPMENT The major classes of property, plant and equipment are as follows (dollar amounts in thousands):
Estimated December 31, -------------------------- Useful Lives 1997 1996 ------------- ------------ ------------ Logging roads, land and improvements 15 years $ 16,685 $ 11,541 Buildings 33 years 36,637 34,877 Machinery and equipment 3 - 15 years 134,823 132,364 Construction in progress 84 - ------------ ------------ 188,229 178,782 Less: accumulated depreciation (85,468) (76,753) ------------ ------------ $ 102,761 $ 102,029 ============ ============
Depreciation expense for the years ended December 31, 1997, 1996 and 1995 was $9,774,000, $ 9,382,000 and $9,663,000, respectively. 4. LONG-TERM DEBT Long-term debt consists of the following (in thousands):
December 31, -------------------------- 1997 1996 ------------ ------------ 7.95% Scotia Pacific Timber Collateralized Notes due through July 20, 2015 $ 319,965 $ 336,130 10-1/2% Pacific Lumber Senior Notes due March 1, 2003 235,000 235,000 Pacific Lumber Credit Agreement 9,445 - 11-1/4% MGI Senior Secured Notes due August 1, 2003 100,000 100,000 12-1/4% MGI Senior Secured Discount Notes due August 1, 2003, net of discount 117,325 104,173 Other 590 724 ------------ ------------ 782,325 776,027 Less: current maturities (19,429) (16,258) ------------ ------------ $ 762,896 $ 759,769 ============ ============
The indenture governing the Timber Notes (the "Timber Note Indenture") prohibits Scotia Pacific from incurring any additional indebtedness for borrowed money and generally limits the business activities of Scotia Pacific to the ownership and operation of its timber and timberlands. The Timber Notes are senior secured obligations of Scotia Pacific and are not obligations of, or guaranteed by, Pacific Lumber or any other person. The Timber Notes are secured by a lien on (i) Scotia Pacific's timber and timberlands (representing $154,288,000 of the Company's consolidated balance at December 31, 1997), (ii) Scotia Pacific's contract rights and certain other assets, (iii) the funds deposited in the Payment Account and the Liquidity Account, and (iv) substantially all of Scotia Pacific's other property and equipment. The Timber Notes are structured to link, to the extent of available cash, the deemed depletion of Scotia Pacific's timber (through the harvest and sale of logs) to the required amortization of the Timber Notes. The required amount of amortization due on any Timber Note payment date is determined by various mathematical formulas set forth in the Timber Note Indenture. The minimum amount of principal which Scotia Pacific must pay (on a cumulative basis) through any Timber Note payment date in order to avoid an Event of Default (as defined) is referred to as rated amortization ("Rated Amortization"). If all payments of principal are made in accordance with Rated Amortization, the payment date on which Scotia Pacific will pay the final installment of principal is July 20, 2015. The amount of principal which Scotia Pacific must pay through each Timber Note payment date in order to avoid prepayment or deficiency premiums is referred to as scheduled amortization ("Scheduled Amortization"). If all payments of principal are made in accordance with Scheduled Amortization, the payment date on which Scotia Pacific will pay the final installment of principal is July 20, 2009. Substantially all of the Company's consolidated assets are owned by Pacific Lumber and a significant portion of Pacific Lumber's assets are owned by Scotia Pacific. The Company expects that Pacific Lumber will provide a major portion of the Company's future operating cash flow. Pacific Lumber is dependent upon Scotia Pacific for a significant portion of its operating cash flow. The holders of the Timber Notes have priority over the claims of creditors of Pacific Lumber with respect to the assets and cash flows of Scotia Pacific, and the holders of the Pacific Lumber Senior Notes have priority over the claims and creditors of the Company with respect to the assets and cash flows of Pacific Lumber. Under the terms of the Timber Note Indenture, Scotia Pacific will generally have available cash for distribution to Pacific Lumber when Scotia Pacific's cash flow from operations exceeds the amounts required by the Timber Note Indenture to be reserved for the payment of current debt service (including interest, principal and premiums) on the Timber Notes, capital expenditures and certain other operating expenses. Principal and interest on the Timber Notes are payable semi- annually on January 20 and July 20. On January 20, 1998, Scotia Pacific paid $10,773,000 of principal on the Timber Notes. The Timber Notes are redeemable at the option of Scotia Pacific, in whole but not in part, at any time. The redemption price of the Timber Notes is equal to the sum of the principal amount, accrued interest and a prepayment premium calculated based upon the yield of like-term Treasury securities plus 50 basis points. Interest on the Pacific Lumber Senior Notes is payable semi- annually on March 1 and September 1. The Pacific Lumber Senior Notes are redeemable at the option of Pacific Lumber, in whole or in part, on or after March 1, 1998 at a price of 103% of the principal amount plus accrued interest. The redemption price is reduced annually until March 1, 2000, after which time the Pacific Lumber Senior Notes are redeemable at par. The Pacific Lumber Senior Notes are unsecured and are senior indebtedness of Pacific Lumber; however, they are effectively subordinated to the Timber Notes. The indenture governing the Pacific Lumber Senior Notes contains various covenants which, among other things, limit Pacific Lumber's ability to incur additional indebtedness and liens, to engage in transactions with affiliates, to make investments and to pay dividends. On October 9, 1997, Pacific Lumber amended its revolving credit agreement with a bank (the "Pacific Lumber Credit Agreement") to extend the date on which it expires to May 31, 2000. Borrowings under the Pacific Lumber Credit Agreement are secured by Pacific Lumber's trade receivables and inventories, with interest currently computed at the bank's reference rate plus 1-1/4% or the bank's offshore rate plus 2-1/4%. The Pacific Lumber Credit Agreement provides for borrowings of up to $60,000,000, of which $20,000,000 may be used for standby letters of credit and $30,000,000 is restricted to timberland acquisitions. Borrowings made pursuant to the portion of the credit facility restricted to timberland acquisitions would also be secured by the purchased timberlands. As of December 31, 1997, $35,484,000 of borrowings was available under the Pacific Lumber Credit Agreement, of which $4,929,000 was available for letters of credit and $20,554,000 was restricted to timberland acquisitions. As of December 31, 1997, $9,445,000 borrowings were outstanding and letters of credit outstanding amounted to $15,071,000. The Pacific Lumber Credit Agreement contains covenants substantially similar to those contained in the indenture governing the Pacific Lumber Senior Notes. As of December 31, 1997, under the most restrictive covenants contained in the indentures governing the Pacific Lumber Senior Notes, the Timber Notes and the Pacific Lumber Credit Agreement, Pacific Lumber could pay approximately $15,900,000 of dividends. On August 4, 1993, the Company issued $100,000,000 aggregate principal amount of the MGI Senior Notes and $126,720,000 aggregate principal amount (approximately $70,000,000 net of original issue discount) of the MGI Discount Notes. The MGI Notes are secured by the Company's pledge of 100% of the common stock of Pacific Lumber, Britt and MAXXAM Properties Inc. ("MPI"), a wholly owned subsidiary of the Company, and by MGHI's pledge of 27,938,250 shares of Kaiser Aluminum Corporation ("Kaiser") common stock. The indenture governing the MGI Notes, among other things, restricts the ability of the Company to incur additional indebtedness and liens, engage in transactions with affiliates, pay dividends and make investments. As of December 31, 1997, under the most restrictive of these covenants, approximately $4,100,000 of dividends could be paid by the Company. The MGI Notes are senior indebtedness of the Company; however, they are effectively subordinated to the liabilities of the Company's subsidiaries, which include the Timber Notes and the Pacific Lumber Senior Notes. The MGI Discount Notes are net of discount of $8,395,000 and $21,547,000 at December 31, 1997 and 1996, respectively. The MGI Senior Notes pay interest semi-annually on February 1 and August 1 of each year. The MGI Discount Notes will not pay any interest until February 1, 1999, at which time semi-annual interest payments will become due on each February 1 and August 1 thereafter. Maturities Scheduled maturities of long-term debt for the five years following December 31, 1997, using the Scheduled Amortization for the Timber Notes, are: $19,429,000 in 1998, $24,107,000 in 1999, $26,426,000 in 2000, $27,189,000 in 2001, $27,213,000 in 2002 and $666,356,000 thereafter. Maturities for 1998 through 2002 are principally attributable to the Timber Notes. Restricted Net Assets of Subsidiaries At December 31, 1997, certain debt instruments restricted the ability of Pacific Lumber to transfer assets, make loans and advances and pay dividends to the Company. As of December 31, 1997, all of the assets of Pacific Lumber and its subsidiaries are subject to such restrictions. 5. CREDIT (PROVISION) IN LIEU OF INCOME TAXES Income taxes are determined using an asset and liability approach which requires the recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Under this method, deferred income tax assets and liabilities are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates. The Company and its subsidiaries are members of MAXXAM's consolidated return group for federal income tax purposes. Pursuant to a tax allocation agreement between MAXXAM, Pacific Lumber, Scotia Pacific and Salmon Creek (the "PL Tax Allocation Agreement"), Pacific Lumber is liable to MAXXAM for the federal consolidated income tax liability of Pacific Lumber, Scotia Pacific and certain other subsidiaries of Pacific Lumber (but excluding Salmon Creek) (collectively, the "PL Subgroup") computed as if the PL Subgroup was a separate affiliated group of corporations which was never connected with MAXXAM. The PL Tax Allocation Agreement further provides that Salmon Creek is liable to MAXXAM for its federal income tax liability computed on a separate company basis as if it was never connected with MAXXAM. The remaining subsidiaries of MGI are each liable to MAXXAM for their respective income tax liabilities computed on a separate company basis as if they were never connected with MAXXAM, pursuant to their respective tax allocation agreements. MGI's tax allocation agreement with MAXXAM, (the "Tax Allocation Agreement"), provides that the Company's federal income tax liability is computed as if MGI files a consolidated tax return with all of its subsidiaries except Salmon Creek, and that such corporations were never connected with MAXXAM (the "MGI Consolidated Tax Liability"). The federal income tax liability of MGI is the difference between (i) the MGI Consolidated Tax Liability and (ii) the sum of the separate tax liabilities for the Company's subsidiaries (computed as discussed above), but excluding Salmon Creek. To the extent that the MGI Consolidated Tax Liability is less than the aggregate amounts in (ii), MAXXAM is obligated to pay the amount of such difference to MGI. The credit (provision) in lieu of income taxes on income before income taxes consists of the following (in thousands):
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Current: Federal (provision) in lieu of income taxes $ (423) $ (159) $ (167) State and local (provision) (139) (9) (35) ------------ ------------ ------------ (562) (168) (202) ------------ ------------ ------------ Deferred: Federal credit (provision) in lieu of income taxes (5,523) 363 (33) State and local credit (provision) 49 485 (976) ------------ ------------ ------------ (5,474) 848 (1,009) ------------ ------------ ------------ $ (6,036) $ 680 $ (1,211) ============ ============ ============
A reconciliation between the credit (provision) in lieu of income taxes and the amount computed by applying the federal statutory income tax rate to income before income taxes is as follows (in thousands):
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Income before income taxes $ 18,612 $ 4,930 $ 4,748 ============ ============ ============ Amount of federal income tax based upon the statutory rate $ (6,514) $ (1,726) $ (1,662) Revision of prior years' tax estimates and other changes in valuation allowances 982 3,372 907 Expenses for which no federal tax benefit is available (178) (493) - State and local taxes, net of federal tax effect (59) (573) (657) Other (267) 100 201 ------------ ------------ ------------ $ (6,036) $ 680 $ (1,211) ============ ============ ============
Revision of prior years' tax estimates and other changes in valuation allowances as shown in the table above include amounts for the reversal of reserves which the Company no longer believes are necessary, other changes in prior year tax estimates and changes in valuation allowances with respect to deferred income tax assets. Generally, the reversal of reserves relates to the expiration of the relevant statute of limitations with respect to certain income tax returns or the resolution of specific income tax matters with the relevant tax authorities. For the years ended December 31, 1996 and 1995, the reversal of reserves which the Company believes are no longer necessary resulted in a credit to the income tax provision of $3,203,000 and $127,000, respectively. There was no reversal of reserves for the year ended December 31, 1997. The components of the Company's net deferred income tax assets (liabilities) are as follows (in thousands):
December 31, -------------------------- 1997 1996 ------------ ------------ Deferred income tax assets: Loss and credit carryforwards $ 68,140 $ 79,411 Timber and timberlands 25,800 28,992 Other liabilities and other 32,316 22,934 Valuation allowances (49,828) (51,049) ------------ ------------ Total deferred income tax assets, net 76,428 80,288 ------------ ------------ Deferred income tax liabilities: Property, plant and equipment (17,455) (17,458) Inventories (12,750) (15,091) Other (6,271) (2,865) ------------ ------------ Total deferred income tax liabilities (36,476) (35,414) ------------ ------------ Net deferred income tax assets $ 39,952 $ 44,874 ============ ============
The valuation allowances listed above relate to loss and credit carryforwards. As of December 31, 1997, approximately $25,800,000 of the net deferred income tax assets listed above relate to the excess of the tax basis over financial statement basis with respect to timber and timberlands. The Company believes that it is more likely than not that this net deferred income tax asset will be realized, based primarily upon the estimated value of its timber and timberlands which is well in excess of its tax basis. Also included in net deferred income tax assets as of December 31, 1997 is $18,312,000 which relates to the benefit of loss and credit carryforwards, net of valuation allowances. The Company evaluated all appropriate factors to determine the proper valuation allowances for loss and credit carryforwards. These factors included any limitations concerning use of the carryforwards, the year the carryforwards expire and the levels of taxable income necessary for utilization. The Company has concluded that it will more likely than not generate sufficient taxable income to realize the benefit attributable to the loss and credit carryforwards for which valuation allowances were not provided. Included in the net deferred income tax assets listed above are $35,683,000 and $41,206,000 at December 31, 1997 and 1996, respectively, which are recorded pursuant to the tax allocation agreements with MAXXAM. The following table presents the estimated tax attributes for federal income tax purposes for the Company and its subsidiaries as of December 31, 1997, under the terms of the respective tax allocation agreements (in thousands). The utilization of certain of these attributes is subject to limitations.
Expiring Through ------------- Regular Tax Attribute Carryforwards: Net operating losses $ 186,814 2012 Net capital losses 4,201 1998 Minimum tax credit 802 Indefinite Alternative Minimum Tax Attribute Carryforwards: Net operating losses $ 159,334 2012 Net capital losses 4,201 1998
6. EMPLOYEE BENEFIT PLANS RETIREMENT PLAN Pacific Lumber has a defined benefit plan which covers all employees of Pacific Lumber. Under the plan, employees are eligible for benefits at age 65, or earlier, if certain provisions are met. The benefits are determined under a career average formula based on each year of service with Pacific Lumber and the employee's compensation for that year. Pacific Lumber's funding policy is to contribute annually an amount at least equal to the minimum cash contribution required by The Employee Retirement Income Security Act of 1974, as amended. A summary of the components of net periodic pension cost is as follows (in thousands):
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Service cost - benefits earned during the year $ 1,937 $ 1,903 $ 1,483 Interest cost on projected benefit obligation 1,892 1,682 1,693 Actual gain on plan assets (3,988) (2,762) (3,900) Net amortization and deferral 2,451 1,448 2,460 ------------ ------------ ------------ Net periodic pension cost $ 2,292 $ 2,271 $ 1,736 ============ ============ ============
The following table sets forth the funded status and amounts recognized in the Consolidated Balance Sheet (in thousands):
December 31, -------------------------- 1997 1996 ------------ ------------ Actuarial present value of accumulated plan benefits: Vested benefit obligation $ 22,181 $ 18,506 Non-vested benefit obligation 2,176 1,371 ------------ ------------ Total accumulated benefit obligation $ 24,357 $ 19,877 ============ ============ Projected benefit obligation $ 28,940 $ 23,582 Plan assets at fair value, primarily equity and debt securities (25,872) (21,800) ------------ ------------ Projected benefit obligation in excess of plan assets 3,068 1,782 Unrecognized net transition asset 12 18 Unrecognized net gain 4,226 2,855 Unrecognized prior service cost (950) (39) ------------ ------------ Accrued pension liability $ 6,356 $ 4,616 ============ ============
The assumptions used in accounting for the defined benefit plan were as follows:
1997 1996 1995 ------------- ------------- ------------- Rate of increase in compensation levels 5.0% 5.0% 5.0% Discount rate 7.25% 7.5% 7.25% Expected long-term rate of return on assets 8.0% 8.0% 8.0%
POSTRETIREMENT MEDICAL BENEFITS Pacific Lumber has an unfunded benefit plan for certain postretirement medical benefits which covers substantially all employees of Pacific Lumber. Participants of the plan are eligible for certain health care benefits upon termination of employment and retirement and commencement of pension benefits. Participants make contributions for a portion of the cost of their health care benefits. The expected costs of postretirement medical benefits are accrued over the period the employees provide services to the date of their full eligibility for such benefits. A summary of the components of net periodic postretirement medical benefit cost is as follows (in thousands):
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Service cost - medical benefits earned during the year $ 287 $ 332 $ 228 Interest cost on accumulated postretirement medical benefit obligation 362 415 317 Net amortization and deferral (42) - (53) ------------ ------------ ------------ Net periodic postretirement medical benefit cost $ 607 $ 747 $ 492 ------------ ------------ ------------
The postretirement medical benefit liability recognized in the Company's Consolidated Balance Sheet is as follows (in thousands):
December 31, -------------------------- 1997 1996 ------------ ------------ Retirees $ 710 $ 1,182 Actives eligible for benefits 893 905 Actives not eligible for benefits 3,434 3,818 ------------ ------------ Accumulated postretirement medical benefit obligation 5,037 5,905 1,003 (86) Unrecognized net gain (loss) ------------ ------------ Postretirement medical benefit liability $ 6,040 $ 5,819 ============ ============
The annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) is 10.0% for 1998 and is assumed to decrease gradually to 5.5% in 2009 and remain at that level thereafter. Each one percentage point increase in the assumed health care cost trend rate would increase the accumulated postretirement medical benefit obligation as of December 31, 1997 by approximately $655,000 and the aggregate of the service and interest cost components of net periodic postretirement medical benefit cost by approximately $112,000. The discount rates used in determining the accumulated postretirement medical benefit obligation were 7.25% and 7.5% at December 31, 1997 and 1996, respectively. EMPLOYEE SAVINGS PLAN Pacific Lumber's employees are eligible to participate in a defined contribution savings plan sponsored by MAXXAM. This plan is designed to enhance the existing retirement programs of participating employees. Employees may elect to defer up to 16% of their base compensation to the plan. For those participants who have elected to defer a portion of their compensation to the plan, Pacific Lumber's contributions consist of a matching contribution of up to 4% of the base compensation of participants. The cost to the Company of this plan was $1,516,000, $1,388,000 and $1,281,000 for the years ended December 31, 1997, 1996 and 1995, respectively. WORKERS' COMPENSATION BENEFITS Pacific Lumber is self-insured for workers' compensation benefits, whereas Britt is insured for workers' compensation benefits. Included in accrued compensation and related benefits and other noncurrent liabilities are accruals for workers' compensation claims amounting to $10,800,000 and $8,000,000 at December 31, 1997 and 1996, respectively. Workers' compensation expenses amounted to $4,660,000, $2,564,000 and $3,579,000 for the years ended December 31, 1997, 1996 and 1995, respectively. 7. RELATED PARTY TRANSACTIONS MAXXAM provides the Company and certain of the Company's subsidiaries with accounting and data processing services. In addition, MAXXAM provides the Company with office space and various office personnel, insurance, legal, operating, financial and certain other services. MAXXAM's expenses incurred on behalf of the Company are reimbursed by the Company through payments consisting of (i) an allocation of the lease expense for the office space utilized by or on behalf of the Company and (ii) a reimbursement of actual out-of-pocket expenses incurred by MAXXAM, including, but not limited to, labor costs of MAXXAM personnel rendering services to the Company. Charges by MAXXAM for such services were $2,160,000, $2,423,000 and $1,994,000 for the years ended December 31, 1997, 1996 and 1995, respectively. The Company believes that the services being rendered are on terms not less favorable to the Company than those which would be obtainable from unaffiliated third parties. 8. STOCKHOLDER'S DEFICIT Changes in stockholder's deficit were (in thousands):
Common Stock ($.08-1/3 Additional Accumulated Par) Capital Deficit Total ------------ ------------ ------------ ------------ Balance, January 1, 1995 $ - $ 81,287 $ (193,769) $ (112,482) Net income - - 3,537 3,537 Dividends - - (4,800) (4,800) ------------ ------------ ------------ ------------ Balance, December 31, 1995 - 81,287 (195,032) (113,745) Net income - - 5,610 5,610 Dividends - - (3,900) (3,900) ------------ ------------ ------------ ------------ Balance, December 31, 1996 - 81,287 (193,322) (112,035) Net income - - 12,576 12,576 Dividends - - (3,000) (3,000) ------------ ------------ ------------ ------------ Balance, December 31, 1997 $ - $ 81,287 $ (183,746) $ (102,459) ============ ============ ============ ============
9. CONTINGENCIES Pacific Lumber's business is subject to a variety of California and federal laws and regulations dealing with timber harvesting, threatened and endangered species and habitat for such species, and air and water quality. Compliance with such laws and regulations plays a significant role in Pacific Lumber's business. While compliance with such laws, regulations and judicial and administrative interpretations, together with the cost of litigation incurred in connection with certain timber harvesting operations, have increased the costs of Pacific Lumber, they have not had a significant adverse effect on its financial position, results of operations or liquidity. However, these laws and related administrative actions and legal challenges have severely restricted the ability of Pacific Lumber to harvest virgin old growth timber on its timberlands, and to a lesser extent, residual old growth timber. On September 28, 1996, Pacific Lumber (on behalf of itself, its subsidiaries and affiliates) and MAXXAM (collectively, the "Pacific Lumber Parties") entered into an agreement with the United States and California ("Headwaters Agreement") which provides the framework for the acquisition by the United States and California of approximately 5,600 acres of Pacific Lumber's timberlands. These timberlands are commonly referred to as the Headwaters Forest and the Elk Head Springs Forest (collectively, the "Headwaters Timberlands"). A substantial portion of the Headwaters Timberlands consists of virgin old growth timberlands. Approximately 4,900 of these acres are owned by Salmon Creek, with the remaining acreage being owned by Scotia Pacific (Pacific Lumber having harvesting rights on approximately 300 of such acres). The Headwaters Timberlands would be transferred in exchange for (a) property and other consideration from the United States and California having an aggregate fair market value of $300 million, and (b) approximately 7,755 acres of adjacent timberlands (the "Elk River Timberlands") to be acquired from a third party. As part of the Headwaters Agreement, the Pacific Lumber Parties agreed to not enter the Headwaters Forest or the Elk Head Springs Forest to conduct any logging or salvage operations. Closing of the Headwaters Agreement is subject to various conditions, including federal and California funding, approval of a sustained yield plan ("SYP"), approval of a habitat conservation plan covering multiple species ("Multi-Species HCP") and issuance of a related incidental take permit (the "Permit") and the issuance of certain tax agreements satisfactory to the Pacific Lumber Parties. In November 1997, President Clinton signed an appropriations bill which contains authorization for the expenditure of $250 million of federal funds toward consummation of the Headwaters Agreement. On February 27, 1998, Pacific Lumber, MAXXAM and various government agencies entered into a Pre-Permit Application Agreement in Principle (the "HCP/SYP Agreement") regarding certain understandings that they had reached regarding the Multi- Species HCP, the Permit and the SYP. The HCP/SYP Agreement provides that the Permit and Multi-Species HCP would have a term of 50 years, and would limit the activities to those which would enhance habitat. These groves could be conducted by Pacific Lumber in twelve forest groves to those which would enhance habitat. These groves aggregate approximately 8,000 acres and consist of substantial quantities of virgin and residual old growth redwood and Douglas-fir timber. In addition to being an important milestone toward completion of the Headwaters Agreement, the Company also believes that the HCP/SYP Agreement is a positive development in respect of the environmental challenges that it has faced over the last several years. Several species, including the northern spotted owl, the marbled murrelet and the coho salmon, have been listed as endangered or threatened under the federal Endangered Species Act ("ESA") and/or the California Endangered Species Act ("CESA"). Pacific Lumber has developed federal and state northern spotted owl management plans which permit harvesting activities to be conducted so long as Pacific Lumber adheres to certain measures designed to protect the northern spotted owl. The potential impact of the listings of the marbled murrelet and the coho salmon is more uncertain. If the Multi-Species HCP is approved, Pacific Lumber would be issued the Permit, which would allow limited incidental "take" of listed species so long as there was no "jeopardy" to the species and the Multi-Species HCP would identify the measures to be instituted in order to minimize and mitigate the anticipated level of take to the greatest extent possible. The Multi-Species HCP would be designed to protect currently listed species as well as to consider candidate and future-listed species. Pacific Lumber is also attempting to include in the Multi-Species HCP a resolution of the potential effect of limits by the Environmental Protection Agency ("EPA") on sedimentation, temperature and other factors for seventeen northern California rivers and certain of their tributaries, including rivers within Pacific Lumber's timberlands. These limitations will be aimed at protecting water quality. Lawsuits are pending or threatened which seek to prevent Pacific Lumber from implementing certain of its approved timber harvesting plans ("THPs"). While challenges with respect to Pacific Lumber's young growth timber have historically been limited, a lawsuit was recently filed under the ESA which relates to a significant number of THPs covering young growth timber of Pacific Lumber. While the Company expects these environmentally focused objections and lawsuits to continue, it believes that the HCP/SYP Agreement will enhance its position in connection with these challenges. The Company also believes that the Multi-Species HCP would expedite the preparation and facilitate approval of its THPs. The HCP/SYP Agreement also contains certain provisions relating to the SYP. Subject to further study, the Company expects Pacific Lumber to propose a long-term sustained yield harvest level ("LTSY") which is somewhat less than Pacific Lumber's recent harvest levels. If the SYP is approved, Pacific Lumber will have complied with certain BOF regulations requiring that timber companies project timber growth and harvest on their timberlands over a 100-year planning period and establish an LTSY harvest level. The SYP must demonstrate that the average annual harvest over any rolling ten-year period will not exceed the LTSY harvest level and that Pacific Lumber's projected timber inventory is capable of sustaining the LTSY harvest level in the last decade of the 100-year planning period. An approved SYP is expected to be valid for ten years, although it would be subject to review after five years. Thereafter, revised SYPs will be prepared every decade that address the LTSY harvest level based upon reassessment of changes in the resource base and other factors. The final terms of the SYP, the Multi-Species HCP and the Permit are subject to additional negotiation and agreement among the parties as well as public review and comment. While the parties are working diligently to complete the Multi-Species HCP and the SYP as well as the other closing conditions contained in the Headwaters Agreement, there can be no assurance that the Headwaters Agreement will be consummated or that an SYP, Multi-Species HCP or Permit acceptable to Pacific Lumber will be approved. In the event that a Multi-Species HCP is not approved, Pacific Lumber will not enjoy the benefits of expedited preparation and facilitated review of its THPs. Furthermore, if a Multi-Species HCP acceptable to Pacific Lumber is not approved, it is impossible for the Company to determine the potential adverse effect of the listings of the marbled murrelet and coho salmon or the EPA's limitations on the Company's financial position, results of operations or liquidity until such time as the various regulatory and legal issues are resolved; however, if Pacific Lumber is unable to harvest, or is severely limited in harvesting, on significant amounts of its timberlands, such effect could be materially adverse to the Company. 10. SUPPLEMENTAL CASH FLOW AND OTHER INFORMATION
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------- ------------ ------------ (In thousands) Supplemental information on non-cash investing and financing activities: Net margin payments for marketable securities $ - $ - $ 6,648 Timber and timberlands acquired subject to long-term debt 9,445 - 615 Supplemental disclosure of cash flow information: Interest paid, net of capitalized interest $ 63,644 $ 63,785 $ 64,907 Income taxes paid (refunded) 166 (2,900) (5,190) Tax allocation payments to MAXXAM 418 188 -
Items Related to 1992 Earthquake In 1995 Pacific Lumber recorded reductions in cost of sales of $1,527,000 resulting from business interruption insurance reimbursements for higher operating costs and the related loss of revenues resulting from the April 1992 earthquake. 11. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summary quarterly financial information for the years ended December 31, 1997 and 1996 is as follows (in thousands):
Three Months Ended ------------------------------------------------------ March 31 June 30 September 30 December 31 ------------ ------------ ------------ ------------ 1997: Net sales $ 66,815 $ 76,848 $ 72,811 $ 70,701 Operating income 18,687 24,125 22,813 18,217 Net income 15 5,351 4,064 3,146 1996: Net sales $ 59,804 $ 71,303 $ 68,473 $ 65,004 Operating income 16,417 19,010 17,184 19,422 Net income (loss) 124 3,909 (35) 1,612
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Not applicable. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A) INDEX TO FINANCIAL STATEMENTS PAGE 1. FINANCIAL STATEMENTS (INCLUDED UNDER ITEM 8): Report of Independent Public Accountants 20 Consolidated balance sheet at December 31, 1997 and 1996 21 Consolidated statement of operations for the years ended December 31, 1997, 1996 and 1995 22 Consolidated statement of cash flows for the years ended December 31, 1997, 1996 and 1995 23 Notes to consolidated financial statements 24 2. FINANCIAL STATEMENT SCHEDULES: Schedule I - Condensed financial information of Registrant at December 31, 1997 and 1996 and for the years ended December 31, 1997, 1996 and 1995 37 The consolidated financial statements and notes thereto of Kaiser Aluminum Corporation and The Pacific Lumber Company are incorporated herein by reference and included as Exhibits 99.1 and 99.2 hereto, respectively. All other schedules are inapplicable or the required information is included in the consolidated financial statements or the notes thereto. (B) REPORTS ON FORM 8-K There were no reports on Form 8-K during the fourth quarter of 1997. (C) EXHIBITS Reference is made to the Index of Exhibits immediately preceding the exhibits hereto (beginning on page 42), which index is incorporated herein by reference. SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT MAXXAM GROUP INC. BALANCE SHEET (UNCONSOLIDATED) (IN THOUSANDS OF DOLLARS)
December 31, -------------------------- 1997 1996 ------------ ------------ ASSETS Current assets: Cash and cash equivalents $ 51,058 $ 45,611 Marketable securities 51,324 31,423 Other current assets 1,398 102 ------------ ------------ Total current assets 103,780 77,136 Deferred income taxes 23,986 21,947 Deferred financing costs and other assets 3,615 4,260 ------------ ------------ $ 131,381 $ 103,343 ============ ============ LIABILITIES AND STOCKHOLDER'S DEFICIT Current liabilities: Accounts payable and other accrued liabilities $ 1,240 $ 866 Accrued interest 4,688 4,688 ------------ ------------ Total current liabilities 5,928 5,554 Long-term debt 217,325 204,173 Advances from and investments in subsidiaries 9,802 5,351 Other liabilities 785 300 ------------ ------------ Total liabilities 233,840 215,378 ------------ ------------ Stockholder's deficit: Common stock, $.08-1/3 par value; 1,000 shares authorized; 100 shares issued - - Additional capital 81,287 81,287 Accumulated deficit (183,746) (193,322) ------------ ------------ Total stockholder's deficit (102,459) (112,035) ------------ ------------ $ 131,381 $ 103,343 ============ ============ The accompanying notes are an integral part of these financial statements.
MAXXAM GROUP INC. STATEMENT OF OPERATIONS (UNCONSOLIDATED) (IN THOUSANDS OF DOLLARS)
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Investment, interest and other income $ 6,813 $ 1,961 $ 1,341 Interest expense (25,047) (23,573) (22,341) General and administrative expenses (866) (826) (370) Equity in earnings of subsidiaries 24,112 16,514 16,170 ------------ ------------ ------------ Income before income taxes 5,012 (5,924) (5,200) Credit in lieu of income taxes 7,564 11,534 8,737 ------------ ------------ ------------ Net income $ 12,576 $ 5,610 $ 3,537 ============ ============ ============ The accompanying notes are an integral part of these financial statements.
MAXXAM GROUP INC. STATEMENT OF CASH FLOWS (UNCONSOLIDATED) (IN THOUSANDS OF DOLLARS)
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 12,576 $ 5,610 $ 3,537 Adjustments to reconcile net income to net cash provided by (used for) operating activities: Amortization of deferred financing costs and discounts on long-term debt 13,797 12,320 11,059 Equity in earnings of subsidiaries (24,112) (16,514) (16,170) Net sales (purchases) of marketable securities (11,370) 10,246 (20,011) Net gains on marketable securities (8,531) (5,101) (3,697) Increase (decrease) in cash resulting from changes in: Receivables 352 (3,505) 171 Accrued and deferred income taxes (2,752) (1,519) (5,237) Accounts payable and other accrued liabilities (72) 4,104 298 Accrued interest - - 32 Other - - (16) ------------ ------------ ------------ Net cash provided by (used for) operating activities (20,112) 5,641 (30,034) ------------ ------------- ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Net advances from subsidiaries 28,559 22,008 33,112 ------------ ------------ ------------ Net cash provided by investing activities 28,559 22,008 33,112 ------------ ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Dividends paid (3,000) (3,900) (4,800) Redemptions of long-term debt - - (630) ------------ ------------ ------------ Net cash used for financing activities (3,000) (3,900) (5,430) ------------ ------------ ------------ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 5,447 23,749 (2,352) CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 45,611 21,862 24,214 ------------ ------------ ------------ CASH AND CASH EQUIVALENTS AT END OF YEAR $ 51,058 $ 45,611 $ 21,862 ============ ============ ============ The accompanying notes are an integral part of these financial statements.
MAXXAM GROUP INC. NOTES TO FINANCIAL STATEMENTS A. DEFERRED INCOME TAXES The deferred income tax assets and liabilities reported in the accompanying unconsolidated balance sheet are determined by computing such amounts on a consolidated basis, as if MGI files a consolidated tax return with all of its subsidiaries except Salmon Creek, and that such corporations were never connected with MAXXAM, and then reducing such consolidated amounts by the amounts recorded by the Company's subsidiaries, but excluding Salmon Creek, pursuant to their respective tax allocation agreements with MAXXAM. The Company's net deferred income tax assets relate primarily to loss and credit carryforwards and to the excess of the tax basis over financial statement basis with respect to timber and timberlands. The Company has concluded that it is more likely than not that these net deferred income tax assets will be realized based in part upon the estimated values of the underlying assets which are in excess of their tax basis. B. LONG-TERM DEBT The MGI Notes are secured by the Company's pledge of 100% of the common stock of Pacific Lumber, Britt and MPI and by MGHI's pledge of 27,938,250 shares of Kaiser's common stock. Long-term debt consists of the following (in thousands):
December 31, --------------------------- 1997 1996 ------------- ------------- 11-1/4% MGI Senior Secured Notes due August 1, 2003 $ 100,000 $ 100,000 12-1/4% MGI Senior Secured Discount Notes due August 1, 2003, net of discount 117,325 104,173 ------------- ------------- $ 217,325 $ 204,173 ============= =============
C. SUPPLEMENTAL CASH FLOW INFORMATION
Years Ended December 31, ----------------------------------------- 1997 1996 1995 ------------- ------------- ------------- (In thousands) Supplemental information on non-cash investing and financing activities: Net margin payments for marketable securities $ - $ - $ 6,648 Supplemental disclosure of cash flow information: Interest paid $ 11,250 $ 11,253 $ 11,250 Tax allocation refunds from MAXXAM 4,812 7,127 3,500 Income taxes refunded - 3,121 -
SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MAXXAM GROUP INC. Date: March 26, 1998 By: /S/ PAUL N. SCHWARTZ Paul N. Schwartz Vice President, Chief Financial Officer and Director Date: March 26, 1998 By: /S/ GARY L. CLARK Gary L. Clark Vice President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date: March 26, 1998 By: /S/ CHARLES E. HURWITZ Charles E. Hurwitz Chairman of the Board, President, Chief Executive Officer and Director Date: March 26, 1998 By: /S/ PAUL N. SCHWARTZ Paul N. Schwartz Vice President, Chief Financial Officer and Director (Principal Financial Officer) Date: March 26, 1998 By: /S/ JOHN A. CAMPBELL John A. Campbell Vice President and Director Date: March 26, 1998 By: /S/ JOHN T. LA DUC John T. La Duc Vice President and Director Date: March 26, 1998 By: /S/ WILLIAM S. RIEGEL William S. Riegel Vice President and Director Date: March 26, 1998 By: /S/ GARY L. CLARK Gary L. Clark Vice President (Principal Accounting Officer) INDEX OF EXHIBITS
EXHIBIT NUMBER DESCRIPTION 3.1 Certificate of Incorporation of MAXXAM Group Inc. (the "Company" or "MGI") (incorporated herein by reference to Exhibit 3.1E to the Company's definitive proxy statement dated October 24, 1984) 3.2 Certificate of Amendment of Certificate of Incorporation of the Company dated as of September 28, 1988 (incorporated herein by reference to Exhibit 3(b) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988) 3.3 Certificate of Amendment of Certificate of Incorporation of the Company dated as of June 1, 1989 (incorporated herein by reference to Exhibit 3(c) to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989) 3.4 By-laws of the Company (incorporated herein by reference to Exhibit 3.2 to the Company's Current Report on Form 8-K dated July 10, 1986) 4.1 Indenture between the Company and Shawmut Bank, N.A., Trustee, regarding the Company's 12-3/4% Senior Secured Discount Notes due 2003 and 11-1/4% Senior Secured Notes due 2003 (incorporated herein by reference to Exhibit 4.1 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993) 4.2 Indenture between The Pacific Lumber Company ("Pacific Lumber") and State Street Bank and Trust Company ("State Street"), regarding Pacific Lumber's 10-1/2% Senior Notes due 2003 (incorporated herein by reference to Exhibit 4.1 to the Annual Report on Form 10-K of Pacific Lumber for the fiscal year ended December 31, 1993, File No. 1-9204) 4.3 Indenture between Scotia Pacific Holding Company ("Scotia Pacific") and State Street, as Trustee, regarding Scotia Pacific's 7.95% Timber Collateralized Notes due 2015 (incorporated herein by reference to Exhibit 4.1 to Scotia Pacific's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, File No. 55538; the "Scotia Pacific 1993 Form 10-K") 4.4 Deed of Trust, Security Agreement, Financing Statement, Fixture Filing and Assignment among Scotia Pacific, State Street, as Trustee, and State Street, as Collateral Agent (incorporated herein by reference to Exhibit 4.2 to the Scotia Pacific 1993 Form 10-K) 4.5 Amended and Restated Credit Agreement dated as of November 10, 1995 between Pacific Lumber and Bank of America National Trust and Savings Association (the "Pacific Lumber Credit Agreement;" incorporated herein by reference to Exhibit 4.1 to the Quarterly Report on Form 10-Q of Pacific Lumber for the quarter ended September 30, 1995; File No. 1-9204) 4.6 First Amendment, dated February 10, 1997, to the Pacific Lumber Credit Agreement (incorporated herein by reference to Exhibit 4.4 to the Annual Report on Form 10-K of The Pacific Lumber Company for the fiscal year ended December 31, 1996; File No. 1-9204) 4.7 Form of Deed of Trust, Assignment of Rents, Grant of Easement and Fixture Filing (incorporated herein by reference to Exhibit 4.2 to the Quarterly Report on Form 10-Q of Pacific Lumber for the quarter ended September 30, 1995; File No. 1-9204) 4.8 Second Amendment, dated October 9, 1997, to the Pacific Lumber Credit Agreement (incorporated herein by reference to Exhibit 4.1 to the Quarterly Report on Form 10-Q of the Pacific Lumber Company for the quarter ended September 30, 1997; File No. 1-9204) Note: Pursuant to Regulation Section 229.601, Item 601 (b)(4)(iii) of Regulation S-K, upon request of the Securities and Exchange Commission, the Company hereby agrees to furnish a copy of any unfiled instrument which defines the rights of holders of long-term debt of the Company and its consolidated subsidiaries (and for any of its unconsolidated subsidiaries for which financial statements are required to be filed) wherein the total amount of securities authorized thereunder does not exceed 10 percent of the total consolidated assets of the Company 10.1 Tax Allocation Agreement between the Company and MAXXAM Inc. dated August 4, 1993 (incorporated herein by reference to Exhibit 10.6 to the Amendment No. 3 to the Registration Statement on Form S-2 of the Company, Registration No. 33-64042; the "MGI Registration Statement") 10.2 Tax Allocation Agreement dated as of May 21, 1988 among MAXXAM Inc., the Company, Pacific Lumber and the corporations signatory thereto (incorporated herein by reference to Exhibit 10.8 to Pacific Lumber's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-9204) 10.3 Tax Allocation Agreement among Pacific Lumber, Scotia Pacific, Salmon Creek Corporation and MAXXAM Inc. dated March 23, 1993 (incorporated herein by reference to Exhibit 10.1 to Amendment No. 3 to the Form S-1 Registration Statement of Scotia Pacific, Registration No. 33-55538) 10.4 Tax Allocation Agreement between MAXXAM Inc. and Britt Lumber Co., Inc., dated as of July 3, 1990 (incorporated herein by reference to Exhibit 10.4 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1993) 10.5 Agreement dated December 20, 1985 between Pacific Lumber and General Electric Company (incorporated herein by reference to Exhibit 10(m) to Pacific Lumber's Registration Statement on Form S-1, Registration No. 33-5549; the "1985 GE Agreement") 10.6 Amendment No. 1 to Agreement between Pacific Lumber and General Electric Company dated July 29, 1986 relating to the 1985 GE Agreement (incorporated herein by reference to Exhibit 10.4 to Pacific Lumber's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-9204) 10.7 Power Purchase Agreement dated January 17, 1986 between Pacific Lumber and Pacific Gas and Electric Company (incorporated herein by reference to Exhibit 10(n) to Pacific Lumber's Registration Statement on Form S-1, Registration No. 33-5549) 10.8 Master Purchase Agreement between Pacific Lumber and Scotia Pacific (incorporated herein by reference to Exhibit 10.1 to the Scotia Pacific 1993 Form 10-K) 10.9 Services Agreement between Pacific Lumber and Scotia Pacific (incorporated herein by reference to Exhibit 10.2 to the Scotia Pacific 1993 Form 10-K) 10.10 Additional Services Agreement between Pacific Lumber and Scotia Pacific (incorporated herein by reference to Exhibit 10.3 to the Scotia Pacific 1993 Form 10-K) 10.11 Reciprocal Rights Agreement among Pacific Lumber, Scotia Pacific and Salmon Creek Corporation (incorporated herein by reference to Exhibit 10.4 to the Scotia Pacific 1993 Form 10-K) 10.12 Environmental Indemnification Agreement between Pacific Lumber and Scotia Pacific (incorporated herein by reference to Exhibit 10.5 to the Scotia Pacific 1993 Form 10-K) 10.13 Purchase and Services Agreement between Pacific Lumber and Britt Lumber Co., Inc. (incorporated herein by reference to Exhibit 10.17 to Amendment No. 2 to the Form S-2 Registration Statement of Pacific Lumber; Registration Statement No. 33-56332) 10.14 Put and Call Agreement dated November 16, 1987 between Charles E. Hurwitz and MPI (incorporated herein by reference to Exhibit C to Schedule 13D dated November 24, 1987, filed by the Company with respect to MAXXAM Inc.'s common stock; the "Put and Call Agreement") 10.15 Amendment to Put and Call Agreement, dated May 18, 1988 (incorporated herein by reference to Exhibit D to the Final Amendment to Schedule 13D dated May 20, 1988, filed by the Company relating to MAXXAM Inc.'s common stock) 10.16 Amendment to Put and Call Agreement, dated as of February 17, 1989 (incorporated herein by reference to Exhibit 10.35 to MAXXAM Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1988, File No. 1-3924) 10.22 Undertaking, dated August 4, 1993, executed by MAXXAM in favor of the Company (incorporated herein by reference to Exhibit 10.24 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1994) 10.23 Agreement (the "Headwaters Agreement") dated September 28, 1996 among MAXXAM Inc., The Pacific Lumber Company (on behalf of itself, its subsidiaries and its affiliates), the United States of America and the State of California (incorporated herein by reference to Exhibit 10.1 to MAXXAM Inc.'s Form 8-K dated September 28, 1996; File No. 1-3924) 10.24 Pre-Permit Application Agreement in Principle dated February 27, 1998 relating to the Headwaters Agreement (incorporated herein by reference to Exhibit 10.16 to the Annual Report on Form 10-K of Pacific Lumber for the fiscal year ended December 31, 1997, File No. 1- 9204) *10.25 Pre-Permit Application Agreement in Principle dated February 27, 1998 relating to the Headwaters Agreement. *27 Financial Data Schedule *99.1 The consolidated financial statements and notes thereto of Kaiser Aluminum Corporation for the fiscal year ended December 31, 1997 *99.2 The consolidated financial statements and notes thereto of The Pacific Lumber Company for the fiscal year ended December 31, 1997 - --------------- * Included with this filing.
EX-27 2 FDS TO MGI 1997 10-K
5 This schedule contains summary financial information extracted from the Company's consolidated balance sheet and consolidated statement of operations and is qualified in its entirety by reference to such consolidated financial statements together with the related footnotes thereto. 1,000 U.S. DOLLARS 12-MOS DEC-31-1997 JAN-01-1997 DEC-31-1997 1 89,840 51,324 19,269 0 58,078 233,748 188,229 85,468 761,494 72,081 782,325 0 0 0 (102,459) 761,494 287,175 287,175 162,020 162,020 41,313 0 78,674 18,612 6,036 12,576 0 0 0 12,576 0 0
EX-99 3 EXHIBIT 99.1 TO MGI 1997 10-K KAISER ALUMINUM CORPORATION AND SUBSIDIARY COMPANEIS REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and the Board of Directors of Kaiser Aluminum Corporaiton: We have audited the accompanying consolidated balance sheets of Kaiser Aluminum Corporation (a Delaware corporation) and subsidiaries as of December 31, 1997 and 1996, and the related statements of consolidated income (loss) and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Kaiser Aluminum Corporation and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. HOUSTON, TEXAS February 16, 1998 KAISER ALUMINUM CORPORATION AND SUBSIDIARY COMPANIES C O N S O L I D A T E D B A L A N C E S H E E T S
December 31, ------------------------------ (In millions of dollars, except share amounts) 1997 1996 ------------------------------------------------------------------------------------------ ASSETS Current assets: Cash and cash equivalents $ 15.8 $ 81.3 Receivables: Trade, less allowance for doubtful receivables of $5.8 in 1997 and $4.7 in 1996 232.9 177.9 Other 107.3 74.5 Inventories 568.3 562.2 Prepaid expenses and other current assets 121.3 127.8 -------------- -------------- Total current assets 1,045.6 1,023.7 Investments in and advances to unconsolidated affiliates 148.6 168.4 Property, plant, and equipment - net 1,171.8 1,168.7 Deferred income taxes 330.6 264.5 Other assets 317.3 308.7 -------------- -------------- Total $ 3,013.9 $ 2,934.0 ============== ============== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 176.2 $ 189.7 Accrued interest 37.6 35.6 Accrued salaries, wages, and related expenses 97.9 95.4 Accrued postretirement medical benefit obligation - current portion 45.3 50.1 Other accrued liabilities 145.6 132.7 Payable to affiliates 82.7 97.0 Long-term debt - current portion 8.8 8.9 -------------- -------------- Total current liabilities 594.1 609.4 Long-term liabilities 491.9 458.1 Accrued postretirement medical benefit obligation 720.3 722.5 Long-term debt 962.9 953.0 Minority interests 127.7 121.7 Commitments and contingencies Stockholders' equity: Preferred stock, par value $.05, authorized 20,000,000 shares; PRIDES Convertible, par value $.05, issued and outstanding, 8,673,850 in 1996. - .4 Common stock, par value $.01, authorized 100,000,000 shares; issued and outstanding, 78,980,881 and 71,646,789 in 1997 and 1996 .8 .7 Additional capital 533.8 531.1 Accumulated deficit (417.6) (460.1) Additional minimum pension liability - (2.8) -------------- -------------- Total stockholders' equity 117.0 69.3 -------------- -------------- Total $ 3,013.9 $ 2,934.0 ============== ==============
The accompanying notes to consolidated financial statements are an integral part of these statements. KAISER ALUMINUM CORPORATION AND SUBSIDIARY COMPANIES S T A T E M E N T S O F C O N S O L I D A T E D I N C O M E ( L O S S )
Year Ended December 31, ---------------------------------------------- (In millions of dollars, except share amounts) 1997 1996 1995 ---------------------------------------------------------------------------------------------------------- Net sales $ 2,373.2 $ 2,190.5 $ 2,237.8 -------------- -------------- -------------- Costs and expenses: Cost of products sold 1,962.6 1,869.1 1,798.4 Depreciation 91.1 96.0 94.3 Selling, administrative, research and development, and general 131.8 127.6 134.5 Restructuring of operations 19.7 - - -------------- -------------- -------------- Total costs and expenses 2,205.2 2,092.7 2,027.2 -------------- -------------- -------------- Operating income 168.0 97.8 210.6 Other income (expense): Interest expense (110.7) (93.4) (93.9) Other - net 3.0 (2.7) (14.1) -------------- -------------- -------------- Income before income taxes and minority interests 60.3 1.7 102.6 (Provision) credit for income taxes (8.8) 9.3 (37.2) Minority interests (3.5) (2.8) (5.1) -------------- -------------- -------------- Net income 48.0 8.2 60.3 Dividends on preferred stock (5.5) (8.4) (17.6) -------------- -------------- -------------- Net income (loss) available to common shareholders $ 42.5 $ (0.2) $ 42.7 ============== ============== ============== Earnings per common share: Basic $ .57 $ .00 $ .69 ============== ============== ============== Diluted $ .57 $ .00 $ .69 ============== ============== ============== Weighted average common shares outstanding (000): Basic 74,221 71,644 62,000 ============== ============== ============== Diluted 74,382 71,644 62,264 ============== ============== ==============
The accompanying notes to consolidated financial statements are an integral part of these statements. KAISER ALUMINUM CORPORATION AND SUBSIDIARY COMPANIES S T A T E M E N T S O F C O N S O L I D A T E D C A S H F L O W S
Year Ended December 31, ---------------------------------------------- (In millions of dollars) 1997 1996 1995 ----------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 48.0 $ 8.2 $ 60.3 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 91.1 96.0 94.3 Restructuring of operations 19.7 - - Non-cash benefit for income taxes (12.5) - - Amortization of excess investment over 11.4 11.6 11.4 equity in unconsolidated affiliates Amortization of deferred financing costs 6.1 5.6 5.4 and net discount on long-term debt Undistributed equity in (income) losses of unconsolidated affiliates, net 7.8 3.0 (19.2) of distributions Minority interests 3.5 2.8 5.1 (Increase) decrease in receivables (85.9) 51.8 (109.7) Increase in inventories (9.3) (36.5) (57.7) Decrease (increase) in prepaid expenses 1.6 (39.5) 82.9 and other assets (Decrease) increase in accounts payable (13.5) 5.2 32.4 Increase (decrease) in accrued interest 2.0 3.6 (.6) (Decrease) increase in payable to (19.6) (62.9) 10.6 affiliates and accrued liabilities Decrease in accrued and deferred income (17.4) (36.5) (7.4) taxes Other 12.0 9.5 10.9 -------------- -------------- -------------- Net cash provided by operating 45.0 21.9 118.7 activities -------------- -------------- -------------- Cash flows from investing activities: Additions to property, plant, and equipment (128.5) (161.5) (88.4) Other 19.9 17.2 8.6 -------------- -------------- -------------- Net cash used for investing (108.6) (144.3) (79.8) activities -------------- -------------- -------------- Cash flows from financing activities: Borrowings (repayments) under revolving credit - (13.1) 6.4 facility, net Borrowings of long-term debt 19.0 225.9 - Repayments of long-term debt (8.8) (9.0) (11.8) Incurrence of financing costs (.9) (6.2) (.8) Dividends paid (4.2) (10.5) (20.8) Capital stock issued .4 - 1.2 Increase in restricted cash, net (5.3) - - Redemption of minority interests' preference stock (2.1) (5.3) (8.8) -------------- -------------- -------------- Net cash (used for) provided by (1.9) 181.8 (34.6) financing activities -------------- -------------- -------------- Net (decrease) increase in Cash and cash equivalents (65.5) 59.4 4.3 during the year Cash and cash equivalents at beginning of year 81.3 21.9 17.6 -------------- -------------- -------------- Cash and cash equivalents at end of year $ 15.8 $ 81.3 $ 21.9 ============== ============== ============== Supplemental disclosure of cash flow information: Interest paid, net of capitalized interest $ 102.7 $ 84.2 $ 88.8 Income taxes paid 24.4 22.7 35.7 Tax allocation payments to MAXXAM Inc. 11.8 1.1 -
The accompanying notes to consolidated financial statements are an integral part of these statements. KAISER ALUMINUM CORPORATION AND SUBSIDIARY COMPANIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In millions of dollars, except share amounts) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the statements of Kaiser Aluminum Corporation ("Kaiser" or the "Company") and its majority owned subsidiaries. The Company is a subsidiary of MAXXAM Inc. ("MAXXAM") and conducts its operations through its wholly owned subsidiary, Kaiser Aluminum & Chemical Corporation ("KACC"). KACC operates in all principal aspects of the aluminum industry-the mining of bauxite (the major aluminum bearing ore), the refining of bauxite into alumina (the intermediate material), the production of primary aluminum, and the manufacture of fabricated and semi-fabricated aluminum products. Kaiser's production levels of alumina and primary aluminum exceed its internal processing needs, which allows it to be a major seller of alumina and primary aluminum to domestic and international third parties (see Note 11). The preparation of financial statements in accordance with generally accepted accounting principles requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published, and the reported amounts of revenues and expenses during the reporting period. Uncertainties, with respect to such estimates and assumptions, are inherent in the preparation of the Company's consolidated financial statements; accordingly, it is possible that the actual results could differ from these estimates and assumptions, which could have a material effect on the reported amounts of the Company's consolidated financial position and results of operation. Investments in 50%-or-less-owned entities are accounted for primarily by the equity method. Intercompany balances and transactions are eliminated. Certain reclassifications of prior-year information were made to conform to the current presentation. CASH AND CASH EQUIVALENTS The Company considers only those short-term, highly liquid investments with original maturities of 90 days or less to be cash equivalents. INVENTORIES Substantially all product inventories are stated at last-in, first-out ("LIFO") cost, not in excess of market value. Replacement cost is not in excess of LIFO cost. Other inventories, principally operating supplies and repair and maintenance parts, are stated at the lower of average cost or market. Inventory costs consist of material, labor, and manufacturing overhead, including depreciation. Inventories consist of the following:
December 31, ------------------------------ 1997 1996 - ------------------------------------------------------------------------------------- Finished fabricated products $ 103.9 $ 113.5 Primary aluminum and work in process 226.6 200.3 Bauxite and alumina 108.4 110.2 Operating supplies and repair and maintenance parts 129.4 138.2 -------------- -------------- $ 568.3 $ 562.2 ============== ==============
DEPRECIATION Depreciation is computed principally by the straight-line method at rates based on the estimated useful lives of the various classes of assets. The principal estimated useful lives of land improvements, buildings, and machinery and equipment are 8 to 25 years, 15 to 45 years, and 10 to 22 years, respectively. STOCK-BASED COMPENSATION The Company applies the intrinsic value method to account for a stock-based compensation plan whereby compensation cost is recognized only to the extent that the quoted market price of the stock at the measurement date exceeds the amount an employee must pay to acquire the stock. No compensation cost has been recognized for this plan as the stock options granted in 1997 were at the market price. No stock options were granted in 1996 or 1995. (See Note 7). OTHER INCOME (EXPENSE) Other expense in 1997, 1996, and 1995 includes $8.8, $3.1, and $17.8 of pre-tax charges related principally to establishing additional: (i) litigation reserves for asbestos claims, net of estimated aggregate insurance recoveries, and (ii) environmental reserves for potential soil and ground water remediation matters, each pertaining to operations which were discontinued prior to the acquisition of the Company by MAXXAM in 1988. DEFERRED FINANCING COSTS Costs incurred to obtain debt financing are deferred and amortized over the estimated term of the related borrowing. Such amortization is included in interest expense. FOREIGN CURRENCY The Company uses the United States dollar as the functional currency for its foreign operations. DERIVATIVE FINANCIAL INSTRUMENTS Hedging transactions using derivative financial instruments are primarily designed to mitigate KACC's exposure to changes in prices for certain of the products which KACC sells and consumes and, to a lesser extent, to mitigate KACC's exposure to changes in foreign currency exchange rates. KACC does not utilize derivative financial instruments for trading or other speculative purposes. KACC's derivative activities are initiated within guidelines established by management and approved by KACC's and the Company's boards of directors. Hedging transactions are executed centrally on behalf of all of KACC's business segments to minimize transaction costs, monitor consolidated net exposures and allow for increased responsiveness to changes in market factors. Most of KACC's hedging activities involve the use of option contracts (which establish a maximum and/or minimum amount to be paid or received) and forward sales contracts (which effectively fix or lock-in the amount KACC will pay or receive). Option contracts typically require the payment of an up-front premium in return for the right to receive the amount (if any) by which the price at the settlement date exceeds the strike price. Any interim fluctuations in prices prior to the settlement date are deferred until the settlement date of the underlying hedged transaction, at which point they are reflected in net sales or cost of sales (as applicable) together with the related premium cost. Forward sales contracts do not require an up-front payment and are settled by the receipt or payment of the amount by which the price at the settlement date varies from the contract price. No accounting recognition is accorded to interim fluctuations in prices of forward sales contracts. KACC has established margin accounts and credit limits with certain counterparties related to open forward sales and option contracts. When unrealized gains or losses are in excess of such credit limits, KACC is entitled to receive advances from the counterparties on open positions or is required to make margin deposits to counterparties, as the case may be. At December 31, 1997, KACC had neither received nor made any margin deposits. At December 31, 1996, KACC had received $13.0 of margin advances from counterparties. Management considers credit risk related to possible failure of the counterparties to perform their obligations pursuant to the derivative contracts to be minimal. Deferred gains or losses as of December 31, 1997, are included in Prepaid expenses and other current assets and Other accrued liabilities (See Note 10). FAIR VALUE OF FINANCIAL INSTRUMENTS The Company estimates the fair value of its outstanding indebtedness to be $1,020.0 and $1,007.0 at December 31, 1997, and 1996, respectively, based on quoted market prices for KACC's 9-7/8% Senior Notes due 2002 (the "9-7/8% Notes"), 12-3/4% Senior Subordinated Notes due 2003 (the "12-3/4% Notes"), and 10-7/8% Senior Notes due 2006 (the "10-7/8% Notes"), and the discounted future cash flows for all other indebtedness, using the current rate for debt of similar maturities and terms. The Company believes that the carrying amount of other financial instruments is a reasonable estimate of their fair value, unless otherwise noted. EARNINGS (LOSS) PER SHARE In the fourth quarter of 1997 the Company adopted Statement of Financial Accounting standards No. 128, Earnings Per Share ("SFAS No. 128") which, among other things, requires the presentation of "Basic" and "Diluted" earnings per share in lieu of "Primary" and "Fully Diluted" earnings per share. Basic differs from Primary earnings per share in that it only includes the weighted average impact of outstanding shares of the Company's Common Stock (i.e., it excludes common stock equivalents and the dilutive effect of stock options, etc.). Diluted earnings per share is substantially similar to Fully diluted earnings per share as previously reported. In accordance with the provision of SFAS No. 128, all earnings per share data for prior periods has been restated to conform to the new computation and presentation guidelines of SFAS No. 128. However, such restatement did not have a significant impact on earnings per share amounts previously reported for any recent prior period. Basic - Earnings (loss) per share is computed by deducting preferred stock dividends from net income (loss) in order to determine net income (loss) available to common share holders. This amount is then divided by the weighted average number of common shares outstanding during the period, including the weighted average impact of the shares of common stock issued during the year from the date(s) of issuance. Diluted - Diluted earnings per share for the years ended December 31, 1997, and 1995 include the dilutive effect of outstanding stock options (161,000 and 264,000 shares, respectively). The impact of outstanding stock options was excluded from the computation for the year ended December 31, 1996, as its effect would have been antidilutive. The Company's 8.255% PRIDES, Convertible Preferred Stock ("PRIDES") have not been treated "as if" converted for purposes of the Diluted computation in any period presented as such treatment would have been antidilutive. The Company's Mandatory Conversion Premium Dividend Preferred Stock was not treated "as if" converted in the Diluted computation for the year ended December 31, 1995, because such treatment would have been antidilutive. 2. INVESTMENTS IN AND ADVANCES TO UNCONSOLIDATED AFFILIATES Summary combined financial information is provided below for unconsolidated aluminum investments, most of which supply and process raw materials. The investees are Queensland Alumina Limited ("QAL") (28.3% owned), Anglesey Aluminium Limited ("Anglesey") (49.0% owned), and Kaiser Jamaica Bauxite Company (49.0% owned). The equity in earnings (losses) before income taxes of such operations is treated as a reduction (increase) in cost of products sold. At December 31, 1997, and 1996, KACC's net receivables from these affiliates were not material. The summary combined financial information for the year ended December 31, 1997, also contains the balances and results of AKW L.P. (50% owned), an aluminum wheels joint venture formed with a third party during May 1997. (See Note 4) SUMMARY OF COMBINED FINANCIAL POSITION
December 31, ------------------------------ 1997 1996 - ------------------------------------------------------------------------------------- Current assets $ 393.0 $ 450.3 Long-term assets (primarily property, plant, and 395.0 364.7 equipment, net) -------------- -------------- Total assets $ 788.0 $ 815.0 ============== ============== Current liabilities $ 117.1 $ 116.9 Long-term liabilities (primarily long-term debt) 400.8 386.7 Stockholders' equity 270.1 311.4 -------------- -------------- Total liabilities and stockholders' equity $ 788.0 $ 815.0 ============== ==============
SUMMARY OF COMBINED OPERATIONS
Year Ended December 31, ---------------------------------------------- 1997 1996 1995 - ------------------------------------------------------------------------------------------------ Net sales $ 644.1 $ 660.5 $ 685.9 Costs and expenses (637.8) (631.5) (618.7) Provision for income taxes (8.2) (8.7) (18.7) -------------- -------------- -------------- Net income (loss) $ (1.9) $ 20.3 $ 48.5 ============== ============== ============== Company's equity in income (loss) $ 2.9 $ 8.8 $ 19.2 ============== ============== ============== Dividends received $ 10.7 $ 11.8 $ - ============== ============== ==============
The Company's equity in income (loss) differs from the summary net income (loss) due to various percentage ownerships in the entities and equity method accounting adjustments. At December 31, 1997, KACC's investment in its unconsolidated affiliates exceeded its equity in their net assets by approximately $28.8 which amount will be fully amortized over the next three years. The Company and its affiliates have interrelated operations. KACC provides some of its affiliates with services such as financing, management, and engineering. Significant activities with affiliates include the acquisition and processing of bauxite, alumina, and primary aluminum. Purchases from these affiliates were $245.2, $281.6, and $284.4 in the years ended December 31, 1997, 1996, and 1995, respectively. 3. PROPERTY, PLANT, AND EQUIPMENT The major classes of property, plant, and equipment are as follows:
December 31, ------------------------------ 1997 1996 - ------------------------------------------------------------------------------------- Land and improvements $ 163.9 $ 157.5 Buildings 228.3 216.0 Machinery and equipment 1,529.1 1,441.1 Construction in progress 51.2 84.7 -------------- -------------- 1,972.5 1,899.3 Accumulated depreciation (800.7) (730.6) -------------- -------------- Property, plant, and equipment, net $ 1,171.8 $ 1,168.7 ============== ==============
During June 1997, Kaiser Bellwood Corporation, a newly formed, wholly owned subsidiary of KACC, completed the acquisition of Reynolds Metals Company's Richmond, Virginia, extrusion plant and its existing inventories for a total purchase price of $41.6, consisting of cash payments of $38.4 and the assumption of approximately $3.2 of employee related and other liabilities. Upon completion of the transaction, Kaiser Bellwood Corporation became a subsidiary guarantor under the indentures in respect of the 9-7/8% Notes, 10-7/8% Notes, and the 12-3/4% Notes. (See Note 5). 4. RESTRUCTURING OF OPERATIONS The Company has previously disclosed that it set a goal of achieving significant cost reductions and other profit improvements, measured against 1996 results, with the full effect planned to be realized in 1998 and beyond. The initiative is based on the Company's conclusion that the level of performance of its existing facilities and businesses would not achieve the level of profits the Company considers satisfactory based upon historic long-term average prices for primary aluminum and alumina. During the second quarter of 1997, the Company recorded a $19.7 restructuring charge to reflect actions taken and plans initiated to achieve the reduced production costs, decreased corporate selling, general and administrative expenses, and enhanced product mix intended to achieve this goal. The significant components of the restructuring charge are enumerated below. ERIE PLANT DISPOSITION During the second quarter of 1997, the Company formed a joint venture with a third party related to the assets and liabilities associated with the wheel manufacturing operations at its Erie, Pennsylvania, fabrication plant. Management subsequently decided to close the remainder of the Erie plant in order to consolidate its aluminum forgings operations at two other facilities for increased efficiency. As a result of the joint venture formation and plant closure, the Company recognized a net pre-tax loss of approximately $1.4. OTHER ASSET DISPOSITIONS As a part of the Company's profit enhancement and cost reduction initiative, management made decisions regarding product rationalization and geographical optimization, which led management to decide to dispose of certain assets which had nominal operating contribution. These strategic decisions resulted in the Company recognizing a pre-tax charge of approximately $15.6 associated with such asset dispositions. EMPLOYEE AND OTHER COSTS As a part of the Company's profit enhancement and cost reduction initiative, management concluded that certain corporate and other staff functions could be consolidated or eliminated resulting in a second quarter pre-tax charge of approximately $2.7 for the benefit and other costs. 5. LONG-TERM DEBT Long-term debt and its maturity schedule are as follows:
December 31, 2003 ---------------------- and 1997 1996 1998 1999 2000 2001 2002 After Total Total - ---------------------------------------------------------------------------------------------------------------------------- Credit Agreement - - 9-7/8% Senior Notes due 2002, $ 224.2 $ - $ 224.2 $ 224.0 net 10-7/8% Senior Notes due 2006, 225.8 225.8 225.9 net 12-3/4% Senior Subordinated 400.0 400.0 400.0 Notes due 2003 Alpart CARIFA Loans - (fixed and variable rates) 60.0 60.0 60.0 due 2007, 2008 Other borrowings (fixed and $ 8.8 $ .4 $ .3 $ .3 .3 51.6 61.7 52.0 variable rates) ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total $ 8.8 $ .4 $ .3 $ .3 $ 224.5 $ 737.4 971.7 961.9 ========== ========== ========== ========== ========== ========== Less current portion 8.8 8.9 ---------- ---------- Long-term debt $ 962.9 $ 953.0 ========== ==========
CREDIT AGREEMENT In February 1994, the Company and KACC entered into a credit agreement (as amended, the "Credit Agreement") which provides a $325.0 five-year secured, revolving line of credit. KACC is able to borrow under the facility by means of revolving credit advances and letters of credit (up to $125.0) in an aggregate amount equal to the lesser of $325.0 or a borrowing base relating to eligible accounts receivable and eligible inventory. As of December 31, 1997, $273.4 (of which $73.4 could have been used for letters of credit) was available to KACC under the Credit Agreement. The Credit Agreement is unconditionally guaranteed by the Company and by certain significant subsidiaries of KACC. Interest on any outstanding balances will bear a premium (which varies based on the results of a financial test) over either a base rate or LIBOR, at the Company's option. In January 1998, the term of the Credit Agreement was extended from February 1999 to August 2001. LOAN COVENANTS AND RESTRICTIONS The Credit Agreement requires KACC to comply with certain financial covenants and places restrictions on the Company's and KACC's ability to, among other things, incur debt and liens, make investments, pay dividends, undertake transactions with affiliates, make capital expenditures, and enter into unrelated lines of business. The Credit Agreement is secured by, among other things, (i) mortgages on KACC's major domestic plants (excluding KACC's Gramercy alumina plant and Nevada Micromill(TM) facility); (ii) subject to certain exceptions, liens on the accounts receivable, inventory, equipment, domestic patents and trademarks, and substantially all other personal property of KACC and certain of its subsidiaries; (iii) a pledge of all the stock of KACC owned by Kaiser; and (iv) pledges of all of the stock of a number of KACC's wholly owned domestic subsidiaries, pledges of a portion of the stock of certain foreign subsidiaries, and pledges of a portion of the stock of certain partially owned foreign affiliates. The obligations of KACC with respect to its 9-7/8% Notes, its 10-7/8% Notes and its 12-3/4% Notes are guaranteed, jointly and severally, by certain subsidiaries of KACC. The indentures governing the 9-7/8% Notes, the 10-7/8% Notes and the 12-3/4% Notes (collectively, the "Indentures") restrict, among other things, KACC's ability to incur debt, undertake transactions with affiliates, and pay dividends. Further, the Indentures provide that KACC must offer to purchase the 9-7/8% Notes, the 10-7/8% Notes and the 12-3/4% Notes, respectively, upon the occurrence of a Change of Control (as defined therein), and the Credit Agreement provides that the occurrence of a Change in Control (as defined therein) shall constitute an Event of Default thereunder. Under the most restrictive of the covenants in the Credit Agreement, neither the Company nor KACC currently is permitted to pay dividends on its common stock. In December 1991, Alpart entered into a loan agreement with the Caribbean Basin Projects Financing Authority ("CARIFA"). Alpart's obligations under the loan agreement are secured by a $64.2 letter of credit guaranteed by the partners in Alpart (of which $22.5 is guaranteed by the Company's minority partner in Alpart). Alpart has also agreed to indemnify bondholders of CARIFA for certain tax payments that could result from events, as defined, that adversely affect the tax treatment of the interest income on the bonds. RESTRICTED NET ASSETS OF SUBSIDIARIES Certain debt instruments restrict the ability of KACC to transfer assets, make loans and advances, and pay dividends to the Company. The restricted net assets of KACC totaled $121.9 and $56.1 at December 31, 1997 and 1996, respectively. CAPITALIZED INTEREST Interest capitalized in 1997, 1996, and 1995 was $6.6, $4.9, and $2.8, respectively. 6. INCOME TAXES Income (loss) before income taxes and minority interests by geographic area is as follows:
Year Ended December 31, ---------------------------------------------- 1997 1996 1995 - ------------------------------------------------------------------------------------------- Domestic $ (112.6) $ (45.8) $ (55.9) Foreign 172.9 47.5 158.5 -------------- -------------- -------------- Total $ 60.3 $ 1.7 $ 102.6 ============== ============== ==============
Income taxes are classified as either domestic or foreign, based on whether payment is made or due to the United States or a foreign country. Certain income classified as foreign is also subject to domestic income taxes. The (provision) credit for income taxes on income (loss) before income taxes and minority interests consists of:
Federal Foreign State Total - ------------------------------------------------------------------------------------------------- 1997 Current $ (2.0) $ (28.7) $ (.2) $ (30.9) Deferred 30.5 (7.0) (1.4) 22.1 -------------- -------------- -------------- -------------- Total $ 28.5 $ (35.7) $ (1.6) $ (8.8) ============== ============== ============== ============== 1996 Current $ (1.6) $ (21.8) $ (.1) $ (23.5) Deferred 8.6 7.6 16.6 32.8 -------------- -------------- -------------- -------------- Total $ 7.0 $ (14.2) $ 16.5 $ 9.3 ============== ============== ============== ============== 1995 Current $ (4.3) $ (40.2) $ (.1) $ (44.6) Deferred 15.2 (4.9) (2.9) 7.4 -------------- -------------- -------------- -------------- Total $ 10.9 $ (45.1) $ (3.0) $ (37.2) ============== ============== ============== ==============
A reconciliation between the (provision) credit for income taxes and the amount computed by applying the federal statutory income tax rate to income before income taxes and minority interests is as follows:
Year Ended December 31, ---------------------------------------------- 1997 1996 1995 - ------------------------------------------------------------------------------------------------ Amount of federal income tax provision based on $ (21.1) $ (.6) $ (35.9) the statutory rate Revision of prior years' tax estimates and other 12.5 10.0 1.5 changes in valuation allowances Percentage depletion 4.2 3.9 4.2 Foreign taxes, net of federal tax benefit (3.1) (5.5) (5.4) Other (1.3) 1.5 (1.6) -------------- -------------- -------------- (Provision) credit for income taxes $ (8.8) $ 9.3 $ (37.2) ============== ============== ==============
Included in revision of prior years' tax estimates and other changes in valuation allowances for 1997 and 1996 shown above are $12.5 and $9.8 related to the resolution of certain income tax matters in the second quarter of 1997 and fourth quarter of 1996, respectively. The components of the Company's net deferred income tax assets are as follows:
December 31, ------------------------------ 1997 1996 - ----------------------------------------------------- ------------------------------ Deferred income tax assets: Postretirement benefits other than pensions $ 288.9 $ 290.5 Loss and credit carryforwards 99.3 135.1 Other liabilities 169.3 157.6 Other 102.0 86.7 Valuation allowances (113.3) (127.2) -------------- -------------- Total deferred income tax assets-net 546.2 542.7 -------------- -------------- Deferred income tax liabilities: Property, plant, and equipment (139.7) (160.9) Other (54.8) (72.6) -------------- -------------- Total deferred income tax liabilities (194.5) (233.5) -------------- -------------- Net deferred income tax assets $ 351.7 $ 309.2 ============== ==============
The principal component of the Company's net deferred income tax assets is the tax benefit, net of certain valuation allowances, associated with the accrued liability for postretirement benefits other than pensions. The future tax deductions with respect to the turnaround of this accrual will occur over a 30-to-40-year period. If such deductions create or increase a net operating loss in any year subsequent to 1997, the Company has the ability to carry forward such loss for 20 taxable years. For these reasons, the Company believes that a long-term view of profitability is appropriate and has concluded that this net deferred income tax asset will more likely than not be realized. A substantial portion of the valuation allowances provided by the Company relates to loss and credit carryforwards. To determine the proper amount of valuation allowances with respect to these carryforwards, the Company evaluated all appropriate factors, including any limitations concerning their use and the year the carryforwards expire, as well as the levels of taxable income necessary for utilization. With regard to future levels of income, the Company believes, based on the cyclical nature of its business, its history of operating earnings, and its expectations for future years, that it will more likely than not generate sufficient taxable income to realize the benefit attributable to the loss and credit carryforwards for which valuation allowances were not provided. As of December 31, 1997 and 1996, $53.7 and $69.7, respectively, of the net deferred income tax assets listed above are included on the Consolidated Balance Sheets in the caption entitled Prepaid expenses and other current assets. Certain other portions of the deferred income tax liabilities listed above are included on the Consolidated Balance Sheets in the captions entitled Other accrued liabilities and Long-term liabilities. The Company and its domestic subsidiaries file consolidated federal income tax returns. During the period from October 28, 1988 through June 30, 1993, the Company and its domestic subsidiaries were included in the consolidated federal income tax returns of MAXXAM. During 1997 MAXXAM reached a settlement with the Internal Revenue Service regarding all remaining years where the Company and its subsidiaries were included in the MAXXAM consolidated federal income tax returns. As a result of this settlement, KACC paid $11.8 to MAXXAM in respect of its liabilities pursuant to its tax allocation agreement with MAXXAM. Payments or refunds for periods prior to July 1, 1993, related to other jurisdictions could still be required pursuant to the Company's and KACC's respective tax allocation agreements with MAXXAM. In accordance with the Credit Agreement, any such payments to MAXXAM by KACC would require lender approval, except in certain specific circumstances. The tax allocation agreements of the Company and KACC with MAXXAM terminated pursuant to their terms, effective for taxable periods beginning after June 30, 1993. At December 31, 1997, the Company had certain tax attributes available to offset regular federal income tax requirements, subject to certain limitations, including net operating loss and general business credit carryforwards of $33.2 and $10.4, respectively, which expire periodically through 2011, foreign tax credit ("FTC") carryforwards of $50.0, which expire periodically through 2002, and alternative minimum tax ("AMT") credit carryforwards of $21.6, which have an indefinite life. The Company also has AMT net operating loss and FTC carryforwards of $17.6 and $74.7, respectively, available, subject to certain limitations, to offset future alternative minimum taxable income, which expire periodically through 2011 and 2002, respectively. 7. EMPLOYEE BENEFIT AND INCENTIVE PLANS RETIREMENT PLANS Retirement plans are non-contributory for salaried and hourly employees and generally provide for benefits based on a formula which considers length of service and earnings during years of service. The Company's funding policies meet or exceed all regulatory requirements. The funded status of the employee pension benefit plans and the corresponding amounts that are included in the Company's Consolidated Balance Sheets are as follows:
Plans with Accumulated Benefits Exceeding Assets(1) December 31, ----------------------------- 1997 1996 - ----------------------------------------------------------- ------------- - ------------- Accumulated benefit obligation: Vested employees $ 785.4 $ 737.7 Nonvested employees 41.2 38.5 ------------- ------------- Accumulated benefit obligation 826.6 776.2 Additional amounts related to projected salary increases 46.4 40.0 ------------- ------------- Projected benefit obligation 873.0 816.2 Plan assets (principally common stocks and fixed income obligations) at fair value (756.9) (662.0) ------------- ------------- Plan assets less than projected benefit obligation 116.1 154.2 Unrecognized net gains (losses) .3 (13.6) Unrecognized net obligations (.3) (.4) Unrecognized prior-service cost (22.2) (26.9) Adjustment required to recognize minimum liability 5.4 13.7 ------------- ------------- Accrued pension obligation included in the Consolidated Balance Sheets (principally in Long-term liabilities) $ 99.3 $ 127.0 ============= =============
(1) Includes accrued pension obligations of approximately $6.3 and $.3 in 1997 and 1996, respectively, related to plans with assets exceeding accumulated benefits. As required by Statement of Financial Accounting Standards No. 87, Employers' Accounting for Pensions, the Company recorded after-tax credits to equity of $2.8 and $11.0 at December 31, 1997 and 1996, respectively, to reduce the deficit of the minimum liability over the unrecognized net obligation and prior-service cost. These amounts were recorded net of the related income tax provision of $1.3 and $6.5 as of December 31, 1997 and 1996, respectively, which approximated the federal and state statutory rates. The components of net periodic pension cost are:
Year Ended December 31, ---------------------------------------------- 1997 1996 1995 - ----------------------------------------------------------------------------------------------------- Service cost - benefits earned during the period $ 13.4 $ 12.9 $ 10.0 Interest cost on projected benefit obligation 61.6 60.0 59.8 Return on assets: Actual gain (129.9) (89.8) (112.2) Deferred gain 68.1 34.8 64.6 Net amortization and deferral 6.0 5.5 4.2 -------------- -------------- -------------- Net periodic pension cost $ 19.2 $ 23.4 $ 26.4 ============== ============== ==============
Assumptions used to value obligations at year-end, and to determine the net periodic pension cost in the subsequent year are:
1997 1996 1995 - ------------------------------------------------------------------------------------------------ Discount rate 7.25% 7.75% 7.5% Expected long-term rate of return on assets 9.5% 9.5% 9.5% Rate of increase in compensation levels 5.0% 5.0% 5.0%
POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company and its subsidiaries provide postretirement health care and life insurance benefits to eligible retired employees and their dependents. Substantially all employees may become eligible for those benefits if they reach retirement age while still working for the Company or its subsidiaries. The Company has not funded the liability for these benefits, which are expected to be paid out of cash generated by operations. The Company reserves the right, subject to applicable collective bargaining agreements, to amend or terminate these benefits. The Company's accrued postretirement benefit obligation is composed of the following:
December 31, ------------------------------ 1997 1996 - ------------------------------------------------------------------------------------------ Accumulated postretirement benefit obligation: Retirees $ 446.7 $ 498.7 Active employees eligible for postretirement benefits 35.1 36.7 Active employees not eligible for postretirement 62.7 67.4 benefits -------------- -------------- Accumulated postretirement benefit obligation 544.5 602.8 Unrecognized net gains 135.0 71.3 Unrecognized gains related to prior-service costs 86.1 98.5 -------------- -------------- Accrued postretirement benefit obligation $ 765.6 $ 772.6 ============== ==============
The components of net periodic postretirement benefit cost are:
Year Ended December 31, ---------------------------------------------- 1997 1996 1995 - ----------------------------------------------------------------------------------------------------- Service cost $ 6.1 $ 3.8 $ 4.5 Interest cost 43.9 46.9 52.3 Amortization of prior service cost (12.4) (12.4) (8.9) -------------- -------------- -------------- Net periodic postretirement benefit cost $ 37.6 $ 38.3 $ 47.9 ============== ============== ==============
In 1997 annual assumed rates of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) for non-HMO are 7.5% and 5.5% for retirees under 65 and over 65, respectively, and 4.0% for HMO at all ages. Non-HMO rates are assumed to decrease gradually to 5.35% in 2007 and remain at that level thereafter. The health care cost trend rate has a significant effect on the amounts reported. A one percentage point increase in the assumed health care cost trend rate would increase the accumulated postretirement benefit obligation as of December 31, 1997, by approximately $53.0 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1997 by approximately $6.0. The weighted average discount rate used to determine the accumulated postretirement benefit obligation at December 31, 1997 and 1996, was 7.25% and 7.75%, respectively. POSTEMPLOYMENT BENEFITS The Company provides certain benefits to former or inactive employees after employment but before retirement. INCENTIVE PLANS The Company has an unfunded incentive compensation program, which provides incentive compensation based on performance against annual plans and over rolling three-year periods. In addition, the Company has a "nonqualified" stock option plan and KACC has a defined contribution plan for salaried employees. The Company's expense for all of these plans was $8.3, $(2.1) and $11.9 for the years ended December 31, 1997, 1996 and 1995, respectively. The Company has a total of 5,500,000 shares of Common Stock reserved for grant under its incentive compensation programs. At December 31, 1997, 3,536,653 shares of Common Stock remained available for grant after consideration of the 3,000,000 share increase in available shares, approved by shareholders in May 1997, and current year share grants and stock option activity. Stock options granted pursuant to the Company's nonqualified stock option program are granted at the prevailing market price, generally vest at a rate of 20 - 33% per year, and have a ten year term. Information concerning nonqualified stock option plan activity is shown below. The weighted average price per share for each year is shown parenthetically.
1997 1996 1995 - ----------------------------------------------------------------------------------------------------- Outstanding at beginning of year ($10.33, $10.32 and 890,395 926,085 1,119,680 $9.85) Granted ($10.06) 15,092 - - Exercised ($8.33, $8.99, and $7.32) (48,410) (8,275) (155,500) Expired or forfeited ($10.12, $10.45, and $8.88) (37,325) (27,415) (38,095) -------------- -------------- -------------- Outstanding at end of year ($10.45, $10.33, and 819,752 890,395 926,085 $10.32) ============== ============== ============== Exercisable at end of year ($10.53, $10.47, and 601,115 436,195 211,755 $10.73) ============== ============== ==============
In accordance with Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation ("SFAS No. 123"), the Company is required to calculate pro forma compensation cost for all stock options granted subsequent to December 31, 1994. No stock options were granted during 1995 and 1996. However, as shown in the table above, 15,092 options were granted in 1997 which would be subject to the pro forma calculation requirements. For SFAS No. 123 purposes, the fair value of the 1997 stock option grant was estimated using the Black-Scholes option pricing model. The estimated fair value of the 1997 stock options grants of $.1 would result in increased pro forma compensation expense and therefore reduced net income. 8. STOCKHOLDER'S EQUITY AND MINORITY INTERESTS Changes in stockholders' equity and minority interests were:
Minority Interests Stockholders' Equity --------------------- ------------------------------------------------------- Additional Redeemable Accu Minimum Preference Preferred Common Additional mulated Pension Stock Other Stock Stock Capital Deficit Liability - --------------------------------------------------- --------------------------------------------------------- BALANCE, DECEMBER 31, 1994 $ 29.1 $ 87.1 $ .6 $ .6 $ 527.8 $ (502.6) $ (9.1) Net income 60.3 Redeemable preference stock: Accretion 3.9 Stock redemption (8.7) Stock repurchase 5.4 Conversions (1,222 preference shares into cash) (.1) Common stock issued upon redemption and conversion of preferred stock (.2) .1 1.1 Dividends on preferred stock (17.6) Minority interests 6.0 Incentive plans accretion 1.4 Additional minimum (4.7) pension liability ---------- ------- ---------- ------- ---------- ---------- ---------- BALANCE, DECEMBER 31, 1995 29.7 93.0 .4 .7 530.3 (459.9) (13.8) Net income 8.2 Redeemable preference stock: Accretion 3.1 Stock redemption (5.3) Common stock issued upon redemption and conversion of preferred stock .1 Dividends on preferred stock (8.4) Minority interests 1.2 Incentive plan accretion .7 Reduction of minimum pension liability 11.0 ---------- ------- ---------- ------- ---------- ---------- ---------- BALANCE, DECEMBER 31, 1996 27.5 94.2 .4 .7 531.1 (460.1) (2.8) Net income 48.0 Redeemable preference stock: Accretion 2.3 Stock redemption (2.1) Common stock issued upon redemption and conversion of preferred stock (.4) .1 1.7 Stock options exercised .4 Dividends on preferred stock (5.5) Minority interests 5.8 Incentive plan accretion .6 Reduction of minimum pension liability 2.8 ---------- ------- ---------- ------- ---------- ---------- ---------- BALANCE, DECEMBER 31, 1997 $ 27.7 $ 100.0 $ - $ .8 $ 533.8 $ (417.6) $ - ========== ======= ========== ======= ========== ========== ==========
REDEEMABLE PREFERENCE STOCK In 1985, KACC issued its Cumulative (1985 Series A) Preference Stock and its Cumulative (1985 Series B) Preference Stock (together, the "Redeemable Preference Stock") each of which has a par value of $1 per share and a liquidation and redemption value of $50 per share plus accrued dividends, if any. No additional Redeemable Preference Stock is expected to be issued. Holders of the Redeemable Preference Stock are entitled to an annual cash dividend of $5 per share, or an amount based on a formula tied to KACC's pre-tax income from aluminum operations, when and as declared by the Board of Directors. The carrying values of the Redeemable Preference Stock are increased each year to recognize accretion between the fair value (at which the Redeemable Preference Stock was originally issued) and the redemption value. Changes in Redeemable Preference Stock are shown below.
1997 1996 1995 - ----------------------------------------------------------------------------------------------- Shares: Beginning of year 634,684 737,363 912,167 Redeemed (39,631) (102,679) (174,804) ------------- -------------- -------------- End of year 595,053 634,684 737,363 ============= ============== ==============
Redemption fund agreements require KACC to make annual payments by March 31 of the subsequent year based on a formula tied to consolidated net income until the redemption funds are sufficient to redeem all of the Redeemable Preference Stock. On an annual basis, the minimum payment is $4.3 and the maximum payment is $7.3. KACC also has certain additional repurchase requirements which are, among other things, based upon profitability tests. The Redeemable Preference Stock is entitled to the same voting rights as KACC common stock and to certain additional voting rights under certain circumstances, including the right to elect, along with other KACC preference stockholders, two directors whenever accrued dividends have not been paid on two annual dividend payment dates or when accrued dividends in an amount equivalent to six full quarterly dividends are in arrears. The Redeemable Preference Stock restricts the ability of KACC to redeem or pay dividends on common stock if KACC is in default on any dividends payable on Redeemable Preference Stock. PREFERENCE STOCK KACC has four series of $100 par value Cumulative Convertible Preference Stock ("$100 Preference Stock") with annual dividend requirements of between 4-1/8% and 4-3/4%. KACC has the option to redeem the $100 Preference Stock at par value plus accrued dividends. KACC does not intend to issue any additional shares of the $100 Preference Stock. The $100 Preference Stock can be exchanged for per share cash amounts between $69 - $80. KACC records the $100 Preference Stock at their exchange amounts for financial statement presentation and the Company includes such amounts in minority interests. At December 31, 1997, and 1996, outstanding shares of $100 Preference Stock were 20,543 and 21,630, respectively. PREFERRED STOCK PRIDES Convertible - during August 1997, the remaining 8,673,850 outstanding shares of PRIDES were converted into 7,227,848 shares of Common Stock pursuant to the terms of the PRIDES Certificate of Designations. Further, in accordance with the PRIDES Certificate of Designations, no dividends were paid or payable for the period June 30, 1997, to, but not including, the date of conversion. However, in accordance with generally accepted accounting principles, the $1.3 of accrued dividends attributable to the period June 30, 1997, to, but not including, the conversion date is treated as an increase in Additional capital at the date of conversion and must still be reflected as a reduction of Net income available to common shareholders. Series A Convertible - In September 1995, the Company redeemed all 1,938,295 shares of its Series A Mandatory Conversion Premium Dividend Preferred Stock, which resulted in the simultaneous redemption of all of its $.65 Depositary Shares in exchange for (i) 13,126,521 shares of the Company's Common Stock and (ii) $2.8 in cash in satisfaction of all accrued and unpaid dividends and fractional shares of Common Stock that would have otherwise been issuable. PLEDGED SHARES From time to time MAXXAM or certain of its subsidiaries which own the Company's Common Stock may use such stock as collateral under various financing arrangements. At December 31, 1997, 27,938,250 shares of the Company's Common Stock (the "Pledged Shares") beneficially owned by MAXXAM Group Holdings Inc. ("MGHI"), a wholly owned subsidiary of MAXXAM, were pledged as security for debt of MAXXAM Group Inc. ("MGI"), a wholly owned subsidiary of MGHI, consisting of $100.0 aggregate principal amount of 11-1/4% Senior Secured Notes due 2003 and $125.7 aggregate principal amount of 12-1/4% Senior Secured Discount Notes due 2003 (collectively the "MGI Secured Debt"). Additionally, up to 16,055,000 of the Pledged Shares are to be pledged by MGHI as security for $130.0 principal amount of 12% Senior Secured Notes due 2003 issued in December 1996 by MGHI, if any of the Pledged Shares are released as security for the MGI Secured Debt by reason of an early retirement of such indebtedness (other than by a refinancing). 9. COMMITMENTS AND CONTINGENCIES COMMITMENTS KACC has a variety of financial commitments, including purchase agreements, tolling arrangements, forward foreign exchange and forward sales contracts (see Note 10), letters of credit, and guarantees. Such purchase agreements and tolling arrangements include long-term agreements for the purchase and tolling of bauxite into alumina in Australia by QAL. These obligations expire in 2008. Under the agreements, KACC is unconditionally obligated to pay its proportional share of debt, operating costs, and certain other costs of QAL. The aggregate minimum amount of required future principal payments at December 31, 1997, is $97.6, of which approximately $12.0 is due in each of 2000 and 2001 with the balance being due thereafter. KACC's share of payments, including operating costs and certain other expenses under the agreements, has ranged between $100.0 - $120.0 over the past three years. KACC also has agreements to supply alumina to and to purchase aluminum from Anglesey. Minimum rental commitments under operating leases at December 31, 1997, are as follows: years ending December 31, 1998 - $26.5; 1999 - $32.0; 2000 - $28.8; 2001 - $28.1; 2002 - $26.4; thereafter - $134.3. The future minimum rentals receivable under noncancelable subleases was $62.5 at December 31, 1997. Rental expenses were $30.4, $29.6, and $29.0, for the years ended December 31, 1997, 1996, and 1995, respectively. ENVIRONMENTAL CONTINGENCIES The Company and KACC are subject to a number of environmental laws, to fines or penalties assessed for alleged breaches of the environmental laws, and to claims and litigation based upon such laws. KACC currently is subject to a number of lawsuits under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended by the Superfund Amendments Reauthorization Act of 1986 ("CERCLA"), and, along with certain other entities, has been named as a potentially responsible party for remedial costs at certain third-party sites listed on the National Priorities List under CERCLA. Based on the Company's evaluation of these and other environmental matters, the Company has established environmental accruals, primarily related to potential solid waste disposal and soil and groundwater remediation matters. The following table presents the changes in such accruals, which are primarily included in Long-term liabilities, for the years ended December 31, 1997, 1996, and 1995:
1997 1996 1995 - -------------------------------------------------------------------------------------------------- Balance at beginning of period $ 33.3 $ 38.9 $ 40.1 Additional amounts 2.0 3.2 3.3 Less expenditures (5.6) (8.8) (4.5) -------------- -------------- -------------- Balance at end of period $ 29.7 $ 33.3 $ 38.9 ============== ============== ==============
These environmental accruals represent the Company's estimate of costs reasonably expected to be incurred based on presently enacted laws and regulations, currently available facts, existingb technology, and the Company's assessment of the likely remediation action to be taken. The Company expects that these remediation actions will be taken over the next several years and estimates that annual expenditures to be charged to these environmental accruals will be approximately $3.0 to $8.0 for the years 1998 through 2002 and an aggregate of approximately $8.0 thereafter. As additional facts are developed and definitive remediation plans and necessary regulatory approvals for implementation of remediation are established or alternative technologies are developed, changes in these and other factors may result in actual costs exceeding the current environmental accruals. The Company believes that it is reasonably possible that costs associated with these environmental matters may exceed current accruals by amounts that could range, in the aggregate, up to an estimated $18.0. As the resolution of these matters is subject to further regulatory review and approval, no specific assurance can be given as to when the factors upon which a substantial portion of this estimate is based can be expected to be resolved. However, the Company is currently working to resolve certain of these matters. The Company believes that KACC has insurance coverage available to recover certain incurred and future environmental costs and is actively pursuing claims in this regard. However, no accruals have been made for any such insurance recoveries and no assurances can be given that the Company will be successful in its attempt to recover incurred or future costs. While uncertainties are inherent in the final outcome of these environmental matters, and it is presently impossible to determine the actual costs that ultimately may be incurred, management currently believes that the resolution of such uncertainties should not have a material adverse effect on the Company's consolidated financial position, results of operations, or liquidity. ASBESTOS CONTINGENCIES KACC is a defendant in a number of lawsuits, some of which involve claims of multiple persons, in which the plaintiffs allege that certain of their injuries were caused by, among other things, exposure to asbestos during, and as a result of, their employment or association with KACC or exposure to products containing asbestos produced or sold by KACC. The lawsuits generally relate to products KACC has not manufactured for at least 20 years. The following table presents the changes in number of such claims pending for the years ended December 31, 1997, 1996, and 1995.
1997 1996 1995 - ----------------------------------------------------------------------------------------------- Number of claims at beginning of period 71,100 59,700 25,200 Claims received 15,600 21,100 41,700 Claims settled or dismissed (9,300) (9,700) (7,200) -------------- -------------- -------------- Number of claims at end of period 77,400 71,100 59,700 ============== ============== ==============
Based on past experience and reasonably anticipated future activity, the Company has established an accrual for estimated asbestos-related costs for claims filed and estimated to be filed through 2008. There are inherent uncertainties involved in estimating asbestos-related costs, and the Company's actual costs could exceed these estimates. The Company's accrual was calculated based on the current and anticipated number of asbestos-related claims, the prior timing and amounts of asbestos-related payments, and the advice of Wharton Levin Ehrmantraut Klein & Nash, P.A. with respect to the current state of the law related to asbestos claims. Accordingly, an estimated asbestos-related cost accrual of $158.8, before consideration of insurance recoveries, is included primarily in Long-term liabilities at December 31, 1997. While the Company does not presently believe there is a reasonable basis for estimating such costs beyond 2008 and, accordingly, no accrual has been recorded for such costs which may be incurred beyond 2008, there is a reasonable possibility that such costs may continue beyond 2008, and such costs may be substantial. The Company estimates that annual future cash payments in connection with such litigation will be approximately $13.0 to $20.0 for each of the years 1998 through 2002, and an aggregate of approximately $80.0 thereafter. The Company believes that KACC has insurance coverage available to recover a substantial portion of its asbestos-related costs. Claims for recovery from some of KACC's insurance carriers are currently subject to pending litigation and other carriers have raised certain defenses, which have resulted in delays in recovering costs from the insurance carriers. The timing and amount of ultimate recoveries from these insurance carriers are dependent upon the resolution of these disputes. The Company believes, based on prior insurance-related recoveries in respect of asbestos-related claims, existing insurance policies, and the advice of Thelen, Marrin, Johnson & Bridges LLP with respect to applicable insurance coverage law relating to the terms and conditions of those policies, that substantial recoveries from the insurance carriers are probable. Accordingly, an estimated aggregate insurance recovery of $134.0, determined on the same basis as the asbestos-related cost accrual, is recorded primarily in Other assets at December 31, 1997. Subsequent to December 31, 1997, KACC reached agreements settling approximately 25,000 of the pending asbestos-related claims. Also, subsequent to year-end 1997, KACC reached agreements on asbestos related coverage matters with two insurance carriers under which the Company will collect a total of approximately $17.5 during the first quarter of 1998. The insurance recoveries will reduce the approximately $134.0 of asbestos related receivable accrued at December 31, 1997. As the amounts related to the claim settlements and insurance recoveries were consistent with the Company's year-end 1997 accrual assumptions, these events are not expected to have a material impact on the Company's financial position, results of operations or liquidity. Management continues to monitor claims activity, the status of lawsuits (including settlement initiatives), legislative progress, and costs incurred in order to ascertain whether an adjustment to the existing accruals should be made to the extent that historical experience may differ significantly from the Company's underlying assumptions. While uncertainties are inherent in the final outcome of these asbestos matters and it is presently impossible to determine the actual costs that ultimately may be incurred and insurance recoveries that will be received, management currently believes that, based on the factors discussed in the preceding paragraphs, the resolution of asbestos-related uncertainties and the incurrence of asbestos-related costs net of related insurance recoveries should not have a material adverse effect on the Company's consolidated financial position, results of operations, or liquidity. OTHER CONTINGENCIES The Company or KACC is involved in various other claims, lawsuits, and other proceedings relating to a wide variety of matters. While uncertainties are inherent in the final outcome of such matters, and it is presently impossible to determine the actual costs that ultimately may be incurred, management currently believes that the resolution of such uncertainties and the incurrence of such costs should not have a material adverse effect on the Company's consolidated financial position, results of operations, or liquidity. 10. DERIVATIVE FINANCIAL INSTRUMENTS AND RELATED HEDGING PROGRAMS At December 31, 1997, the net unrealized loss on KACC's position in aluminum forward sales and option contracts, (based on an average price of $1,643 per ton ($.75 per pound) of primary aluminum), natural gas and fuel oil forward purchase and option contracts, and forward foreign exchange contracts, was approximately $21.0. Any gains or losses on the derivative contracts utilized in KACC's hedging activities are offset by losses or gains, respectively, on the transactions being hedged. ALUMINA AND ALUMINUM The Company's earnings are sensitive to changes in the prices of alumina, primary aluminum and fabricated aluminum products, and also depend to a significant degree upon the volume and mix of all products sold. Primary aluminum prices have historically been subject to significant cyclical price fluctuations. Alumina prices as well as fabricated aluminum product prices (which vary considerably among products) are significantly influenced by changes in the price of primary aluminum but generally lag behind primary aluminum price changes by up to three months. Since 1993, the Average Midwest United States transaction price for primary aluminum has ranged from approximately $.50 to $1.00 per pound. From time to time in the ordinary course of business, KACC enters into hedging transactions to provide price risk management in respect of the net exposure of earnings resulting from (i) anticipated sales of alumina, primary aluminum and fabricated aluminum products, less (ii) expected purchases of certain items, such as aluminum scrap, rolling ingot, and bauxite, whose prices fluctuate with the price of primary aluminum. Forward sales contracts are used by KACC to effectively fix the price that KACC will receive for its shipments. KACC also uses option contracts (i) to establish a minimum price for its product shipments, (ii) to establish a "collar" or range of price for KACC's anticipated sales, and/or (iii) to permit KACC to realize possible upside price movements. As of December 31, 1997, KACC had sold forward, at fixed prices, approximately 109,850 and 24,000 tons of primary aluminum with respect to 1998 and 1999, respectively. KACC had also purchased put options to establish a minimum price for approximately 52,000 tons with respect to 1998 and as of December 31, 1997, had entered into option contracts that established a price range for an additional 243,600 and 124,500 tons with respect to 1998 and 1999, respectively. Additionally, at December 31, 1997, KACC also held fixed price purchase contracts for 134,850 tons of primary aluminum with respect to 1998. As of December 31, 1997, KACC had sold forward virtually all of the alumina available to it in excess of its projected internal smelting requirements for 1998 and 1999 at prices indexed to future prices of primary aluminum. ENERGY KACC is exposed to energy price risk from fluctuating prices for fuel oil and natural gas consumed in the production process. Accordingly, KACC from time to time in the ordinary course of business enters into hedging transactions with major suppliers of energy and energy related financial instruments. As of December 31, 1997, KACC had a combination of fixed price purchase and option contracts for the purchase of approximately 41,000 MMBtu of natural gas per day during 1998. At December 31, 1997, KACC also held a combination of fixed price purchase and option contracts for an average of 232,000 and 25,000 barrels of fuel oil per month for 1998 and 1999, respectively. FOREIGN CURRENCY KACC enters into forward exchange contracts to hedge material cash commitments to foreign subsidiaries or affiliates. At December 31, 1997, KACC had net forward foreign exchange contracts totaling approximately $136.6 for the purchase of 180.0 Australian dollars from January 1998 through February 1999, in respect of its commitments for 1998 and 1999 expenditures denominated in Australian dollars. 11. SEGMENT AND GEOGRAPHICAL AREA INFORMATION The Company's operations are located in many foreign countries, including Australia, Canada, Ghana, Jamaica, and the United Kingdom. Foreign operations in general may be more vulnerable than domestic operations due to a variety of political and other risks. Sales and transfers among geographic areas are made on a basis intended to reflect the market value of products. The aggregate foreign currency gain included in determining net income was immaterial for the years ended December 31, 1997, 1996, and 1995. No single customer accounted for sales in excess of 10% of total revenue in 1997, 1996 or 1995. Export sales were less than 10% of total revenue during the years ended December 31, 1997, 1996, and 1995. Geographical area information relative to operations is summarized as follows:
Year Ended Other December 31, Domestic Caribbean Africa Foreign Eliminations Total - ------------------------------------------------------------------------------------------------------------------- ------------- Net sales to unaffiliated customers 1997 $ 1,720.3 $ 204.6 $ 234.2 $ 214.1 $ 2,373.2 1996 1,610.0 201.8 198.3 180.4 2,190.5 1995 1,589.5 191.7 239.4 217.2 2,237.8 Sales and transfers among 1997 $ 121.7 $ 197.3 $ (319.0) geographic areas 1996 116.9 206.0 (322.9) 1995 79.6 191.5 (271.1) Equity in income (losses) of 1997 $ 4.8 $ (1.9) $ 2.9 unconsolidated affiliates 1996 .3 8.5 8.8 1995 (.2) 19.4 19.2 Operating income 1997 $ 18.9 $ 11.6 $ 72.2 $ 65.3 $ 168.0 1996 4.4 1.6 27.8 64.0 97.8 1995 32.0 9.8 83.5 85.3 210.6 Investment in and advances to 1997 $ 15.8 $ 23.9 $ 108.9 $ 148.6 unconsolidated affiliates 1996 .5 25.3 142.6 168.4 Identifiable assets 1997 $ 2,274.9 $ 391.2 $ 179.6 $ 168.2 $ 3,013.9 1996 2,136.7 391.2 194.7 211.4 2,934.0
Financial information by industry segment at December 31, 1997 and 1996, and for the years ended December 31, 1997, 1996, and 1995, is as follows:
Year Ended Bauxite & Aluminum December 31, Alumina Processing Corporate Total - ------------------------------------------------------------------------------------------------------------------ Net sales to unaffiliated customers 1997 $ 483.3 $ 1,889.9 $ 2,373.2 1996 508.0 1,682.5 2,190.5 1995 514.2 1,723.6 2,237.8 Intersegment sales 1997 $ 193.2 $ 193.2 1996 181.6 181.6 1995 159.7 159.7 Equity in income (losses) of 1997 $ (7.0) $ 9.9 $ - $ 2.9 unconsolidated affiliates 1996 1.7 6.7 .4 8.8 1995 3.6 15.8 (.2) 19.2 Operating income (loss) 1997 $ 20.0 $ 222.6 $ (74.6) $ 168.0 1996 1.1 156.5 (59.8) 97.8 1995 54.0 238.9 (82.3) 210.6 Depreciation 1997 $ 29.3 $ 58.7 $ 3.1 $ 91.1 1996 31.2 61.7 3.1 96.0 1995 31.1 60.4 2.8 94.3 Capital expenditures 1997 $ 27.8 $ 99.0 $ 1.7 $ 128.5 1996 29.9 126.9 4.7 161.5 1995 27.3 53.0 8.1 88.4 Investment in and advances to 1997 $ 88.6 59.5 .5 148.6 unconsolidated affiliates 1996 121.3 46.6 .5 168.4 Identifiable assets 1997 $ 735.9 $ 1,510.9 $ 767.1 $ 3,013.9 1996 784.6 1,408.5 740.9 2,934.0
EX-99 4 EXHIBIT 99.2 TO MGI 1997 10-K REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholder of The Pacific Lumber Company: We have audited the accompanying consolidated balance sheets of The Pacific Lumber Company (a Delaware corporation) and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The Pacific Lumber Company and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP San Francisco, California January 30, 1998 (Except for the matter discussed in the fourth paragraph of Note 9 as to which the date is February 27, 1998.) THE PACIFIC LUMBER COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (IN THOUSANDS OF DOLLARS)
December 31, -------------------------- 1997 1996 ------------ ------------ ASSETS Current assets: Cash and cash equivalents $ 31,768 $ 26,027 Receivables: Trade 19,216 18,080 Other 2,123 2,514 Inventories 56,079 65,690 Prepaid expenses and other current assets 12,898 5,329 ------------ ------------ Total current assets 122,084 117,640 Timber and timberlands, net of accumulated depletion of $236,824 and $221,063, respectively 321,206 324,986 Property, plant and equipment, net of accumulated depreciation of $82,070 and $73,772, respectively 96,292 95,515 Deferred financing costs, net 17,912 20,003 Deferred income taxes 27,018 34,639 Restricted cash 28,434 29,967 Other assets 4,186 6,424 ------------ ------------ $ 617,132 $ 629,174 ============ ============ LIABILITIES AND STOCKHOLDER'S DEFICIT Current liabilities: Accounts payable $ 3,538 $ 3,765 Accrued compensation and related benefits 12,365 9,673 Accrued interest 19,650 20,211 Deferred income taxes 9,671 10,173 Other accrued liabilities 1,042 2,325 Long-term debt, current maturities 19,429 16,258 ------------ ------------ Total current liabilities 65,695 62,405 Long-term debt, less current maturities 545,571 555,596 Other noncurrent liabilities 27,991 25,887 ------------ ------------ Total liabilities 639,257 643,888 ------------ ------------ Contingencies Stockholder's deficit: Common stock, $.01 par value, 100 shares authorized and issued - - Additional capital 157,520 157,520 Accumulated deficit (179,645) (172,234) ------------ ------------ Total stockholder's deficit (22,125) (14,714) ------------ ------------ $ 617,132 $ 629,174 ============ ============ The accompanying notes are an integral part of these financial statements.
THE PACIFIC LUMBER COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (IN THOUSANDS OF DOLLARS)
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Net sales: Lumber and logs $ 235,588 $ 225,017 $ 197,320 Other 25,789 19,832 24,619 ------------ ------------ ------------ 261,377 244,849 221,939 ------------ ------------ ------------ Operating expenses: Cost of goods sold 147,372 136,335 116,445 Selling, general and administrative expenses 12,915 14,570 14,992 Depletion and depreciation 26,525 27,644 25,927 ------------ ------------ ------------ 186,812 178,549 157,364 ------------ ------------ ------------ Operating income 74,565 66,300 64,575 Other income (expense): Investment, interest and other income 2,516 4,209 3,928 Interest expense (53,613) (54,456) (55,462) ------------ ------------ ------------ Income before income taxes 23,468 16,053 13,041 Provision in lieu of income taxes (7,879) (6,107) (6,480) ------------ ------------ ------------ Net income $ 15,589 $ 9,946 $ 6,561 ============ ============ ============ The accompanying notes are an integral part of these financial statements.
THE PACIFIC LUMBER COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS OF DOLLARS)
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 15,589 $ 9,946 $ 6,561 Adjustments to reconcile net income to net cash provided by operating activities: Depletion and depreciation 26,525 27,644 25,927 Amortization of deferred financing costs 2,091 2,394 2,269 Net loss on asset dispositions 67 6 419 Increase (decrease) in cash resulting from changes in: Receivables (740) 803 5,913 Inventories, net of depletion 8,039 7,304 (7,301) Prepaid expenses and other current assets (5,331) 682 (3,273) Accounts payable (548) (164) 589 Accrued interest (561) (455) (443) Accrued and deferred income taxes 7,425 7,135 7,572 Other liabilities 3,513 (8,046) 7,406 Other - (12) 423 ------------ ------------ ------------ Net cash provided by operating activities 56,069 47,237 46,062 ------------ ------------ ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Net proceeds from sale of assets 226 115 13 Capital expenditures (12,788) (14,552) (9,140) ------------ ------------ ------------ Net cash used for investing activities (12,562) (14,437) (9,127) ------------ ------------ ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Dividends paid (23,000) (20,500) (22,000) Redemptions, repurchase of and principal payments on long-term debt (16,299) (14,153) (13,670) Incurrence of financing costs - - (150) Decrease in restricted cash 1,533 1,400 1,035 ------------ ------------ ------------ Net cash used for financing activities (37,766) (33,253) (34,785) ------------ ------------ ------------ NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 5,741 (453) 2,150 CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 26,027 26,480 24,330 ------------ ------------ ------------ CASH AND CASH EQUIVALENTS AT END OF YEAR $ 31,768 $ 26,027 $ 26,480 ============ ============ ============ The accompanying notes are an integral part of these financial statements.
THE PACIFIC LUMBER COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements include the accounts of The Pacific Lumber Company and its wholly owned subsidiaries, collectively referred to herein as the "Company." The Company is an indirect wholly owned subsidiary of MAXXAM Group Inc. ("MGI"). MGI is a wholly owned subsidiary of MAXXAM Group Holdings Inc. ("MGHI") which is a wholly owned subsidiary of MAXXAM Inc. ("MAXXAM"). Pacific Lumber's principal wholly owned subsidiaries are Scotia Pacific Holding Company ("Scotia Pacific") and Salmon Creek Corporation ("Salmon Creek"). Intercompany balances and transactions have been eliminated. Certain reclassifications have been made to prior years' financial statements to be consistent with the current year's presentation. The Company grows and harvests redwood and Douglas-fir timber, mills logs into lumber and manufactures lumber into a variety of finished products. Housing, construction and remodeling are the principal markets for the Company's lumber products. Export sales approximate 6% of the Company's sales. A significant portion of the Company's sales are made to third parties located west of the Mississippi River. USE OF ESTIMATES AND ASSUMPTIONS The preparation of financial statements in accordance with generally accepted accounting principles requires the use of estimates and assumptions that affect (i) the reported amounts of assets and liabilities, (ii) the disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published and (iii) the reported amount of revenues and expenses recognized during each period presented. The Company reviews all significant estimates affecting its consolidated financial statements on a recurring basis and records the effect of any necessary adjustments prior to their publication. Adjustments made with respect to the use of estimates often relate to improved information not previously available. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of the Company's consolidated financial statements; accordingly, it is possible that the subsequent resolution of any one of the contingent matters described in Note 8 could differ materially from current estimates. The results of an adverse resolution of such uncertainties could have a material effect on the Company's consolidated financial position, results of operations or liquidity. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Cash Equivalents Cash equivalents consist of highly liquid money market instruments with original maturities of three months or less. Marketable Securities Marketable securities are carried at fair value. The cost of the securities sold is determined using the first-in, first-out method. Included in investment, interest and other income for the years ending 1997, 1996 and 1995 were net realized gains of $40,000, $52,000 and $478,000, respectively. Inventories Inventories are stated at the lower of cost or market value. Cost is determined using the last-in, first-out ("LIFO") method. Timber and Timberlands Timber and timberlands are stated at cost, net of accumulated depletion. Depletion is computed utilizing the unit-of-production method based upon estimates of timber values and quantities. Property, Plant and Equipment Property, plant and equipment, including capitalized interest, is stated at cost, net of accumulated depreciation. Depreciation is computed utilizing the straight-line method at rates based upon the estimated useful lives of the various classes of assets. Deferred Financing Costs Costs incurred to obtain financing are deferred and amortized over the estimated term of the related borrowing. Restricted Cash and Concentrations of Credit Risk Restricted cash represents the amount deposited into an account (the "Liquidity Account") held by the Trustee under the Indenture governing the 7.95% Timber Collateralized Notes due 2015 (the "Timber Notes") of Scotia Pacific. See Note 4. The Liquidity Account is not available, except under certain limited circumstances, for Scotia Pacific's working capital purposes; however, it is available to pay the Rated Amortization (as defined in Note 4) and interest on the Timber Notes if and to the extent that cash flows are insufficient to make such payments. The required Liquidity Account balance will generally decline as principal payments are made on the Timber Notes. Investment, interest and other income for the years ended December 31, 1997, 1996 and 1995 includes interest of approximately $2,336,000, $2,457,000 and $2,560,000, respectively, attributable to an investment rate agreement (at 7.95% per annum) with the financial institution which holds the Liquidity Account. At December 31, 1997 and 1996, cash and cash equivalents include $17,784,000 and $17,600,000, respectively, (the "Payment Account") which is reserved for debt service payments on the Timber Notes (see Note 4). The Payment Account and the Liquidity Account are each held by a different financial institution. In the event of nonperformance by such financial institutions, the Company's exposure to credit loss is represented by the amounts deposited plus any unpaid accrued interest thereon. The Company mitigates its concentrations of credit risk with respect to these restricted cash deposits by maintaining them at high credit quality financial institutions and monitoring the credit ratings of these institutions. Fair Value of Financial Instruments The carrying amounts of cash equivalents and restricted cash approximate fair value. Marketable securities are carried at fair value which is determined based on quoted market prices. As of December 31, 1997 and 1996, the estimated fair value of long-term debt, including current maturities, was $584,423,000 and $579,102,000, respectively. The estimated fair value of long-term debt is determined based on the quoted market prices for the Timber Notes and the Company's 10-1/2% Senior Notes due 2003 (the "Senior Notes"), and on the current rates offered for borrowings similar to the Company's other debt. Some of the Company's publicly traded debt issues are thinly traded financial instruments; accordingly, their market prices at any balance sheet date may not be representative of the prices which would be derived from a more active market. 2. INVENTORIES Inventories consist of the following (in thousands):
December 31, --------------------------- 1997 1996 ------------- ------------- Lumber $ 41,737 $ 46,882 Logs 14,342 18,808 ------------- ------------- $ 56,079 $ 65,690 ============= =============
3. PROPERTY, PLANT AND EQUIPMENT The major classes of property, plant and equipment are as follows (dollar amounts in thousands):
Estimated December 31, -------------------------- Useful Lives 1997 1996 ------------- ------------ ------------ Machinery and equipment 5 - 15 years $ 126,079 $ 123,909 Buildings 33 years 36,217 34,285 Logging roads 15 years 16,066 11,093 ------------ ------------ 178,362 169,287 Less: accumulated depreciation (82,070) (73,772) ------------ ------------ $ 96,292 $ 95,515 ============ ============
Depreciation expense for the years ended December 31, 1997, 1996 and 1995 was $9,191,000, $8,850,000 and $9,185,000, respectively. 4. LONG-TERM DEBT Long-term debt consists of the following (in thousands):
December 31, -------------------------- 1997 1996 ------------ ------------ 7.95% Scotia Pacific Timber Collateralized Notes due through July 20, 2015 $ 319,965 $ 336,130 10-1/2% Pacific Lumber Senior Notes due March 1, 2003 235,000 235,000 Revolving Credit Agreement 9,445 - Other 590 724 ------------ ------------ 565,000 571,854 Less: current maturities (19,429) (16,258) ------------ ------------ $ 545,571 $ 555,596 ============ ============
The indenture governing the Timber Notes (the "Timber Note Indenture") prohibits Scotia Pacific from incurring any additional indebtedness for borrowed money and generally limits the business activities of Scotia Pacific to the ownership and operation of its timber and timberlands. The Timber Notes are senior secured obligations of Scotia Pacific and are not obligations of, or guaranteed by, the Company or any other person. The Timber Notes are secured by a lien on (i) Scotia Pacific's timber and timberlands (representing $154,288,000 of the Company's consolidated balance at December 31, 1997), (ii) Scotia Pacific's contract rights and certain other assets, (iii) the funds deposited in the Payment Account and the Liquidity Account, and (iv) substantially all of Scotia Pacific's other property and equipment. The Timber Notes are structured to link, to the extent of available cash, the deemed depletion of Scotia Pacific's timber (through the harvest and sale of logs) to the required amortization of the Timber Notes. The required amount of amortization due on any Timber Note payment date is determined by various mathematical formulas set forth in the Timber Note Indenture. The minimum amount of principal which Scotia Pacific must pay (on a cumulative basis) through any Timber Note payment date in order to avoid an Event of Default (as defined) is referred to as rated amortization ("Rated Amortization"). If all payments of principal are made in accordance with Rated Amortization, the payment date on which Scotia Pacific will pay the final installment of principal is July 20, 2015. The amount of principal which Scotia Pacific must pay through each Timber Note payment date in order to avoid prepayment or deficiency premiums is referred to as scheduled amortization ("Scheduled Amortization"). If all payments of principal are made in accordance with Scheduled Amortization, the payment date on which Scotia Pacific will pay the final installment of principal is July 20, 2009. Principal and interest on the Timber Notes are payable semi- annually on January 20 and July 20. On January 20, 1998, Scotia Pacific paid $10,773,000 of principal on the Timber Notes. The Timber Notes are redeemable at the option of Scotia Pacific, in whole but not in part, at any time. The redemption price of the Timber Notes is equal to the sum of the principal amount, accrued interest and a prepayment premium calculated based upon the yield of like-term Treasury securities plus 50 basis points. Interest on the Senior Notes is payable semi-annually on March 1 and September 1. The Senior Notes are redeemable at the option of the Company, in whole or in part, on or after March 1, 1998, at a price of 103% of the principal amount plus accrued interest. The redemption price is reduced annually until March 1, 2000, after which time the Senior Notes are redeemable at par. The Senior Notes are unsecured and are senior indebtedness of the Company; however, they are effectively subordinated to the Timber Notes. The indenture governing the Senior Notes contains various covenants which, among other things, limit the Company's ability to incur additional indebtedness and liens, to engage in transactions with affiliates, to make investments and to pay dividends. On October 9, 1997, the Company amended its revolving credit agreement with a bank (the "Revolving Credit Agreement") to extend the date on which it expires to May 31, 2000. Borrowings under the Revolving Credit Agreement are secured by the Company's trade receivables and inventories, with interest currently computed at the bank's reference rate plus 1-1/4% or the bank's offshore rate plus 2-1/4%. The Revolving Credit Agreement provides for borrowings of up to $60,000,000, of which $20,000,000 may be used for standby letters of credit and $30,000,000 is restricted to timberland acquisitions. Borrowings made pursuant to the portion of the credit facility restricted to timberland acquisitions would also be secured by the purchased timberlands. As of December 31, 1997, $35,484,000 of borrowings was available under the Revolving Credit Agreement, of which $4,929,000 was available for letters of credit and $20,554,000 was restricted to timberland acquisitions. $9,445,000 of borrowings were outstanding as of December 31, 1997, and letters of credit outstanding amounted to $15,071,000. The Revolving Credit Agreement contains covenants substantially similar to those contained in the indenture governing the Senior Notes. As of December 31, 1997, under the most restrictive covenants contained in the indentures governing the Senior Notes, the Timber Notes and the Revolving Credit Agreement, the Company could pay approximately $15,900,000 of dividends. Scheduled maturities of long-term debt outstanding at December 31, 1997, using the Scheduled Amortization for the Timber Notes, are as follows: years ending December 31, 1998 - $19,429,000; 1999 - $24,107,000; 2000 - $26,426,000; 2001 - $27,189,000; 2002 - $27,213,000; thereafter - $440,636,000. 5. PROVISION IN LIEU OF INCOME TAXES Income taxes are determined using an asset and liability approach which requires the recognition of deferred income tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Under this method, deferred income tax assets and liabilities are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates. The Company and its subsidiaries are members of MAXXAM's consolidated return group for federal income tax purposes. The Company's tax allocation agreement with MAXXAM (the "Tax Allocation Agreement") provides that the Company, excluding its wholly owned subsidiaries ("Pacific Lumber"), is liable to MAXXAM for the federal consolidated income tax liability of Pacific Lumber, Scotia Pacific and certain other subsidiaries of Pacific Lumber (but excluding Salmon Creek) (collectively, the "PL Subgroup") computed as if the PL Subgroup was a separate affiliated group of corporations which was never connected with MAXXAM. The Tax Allocation Agreement further provides that Salmon Creek is liable to MAXXAM for its federal income tax liability computed as if Salmon Creek was a separate corporation which was never affiliated with MAXXAM. The provision in lieu of income taxes on income before income taxes and extraordinary item consists of the following (in thousands):
Years Ended December 31, ----------------------------------------- 1997 1996 1995 ------------- ------------- ------------- Current: Federal provision in lieu of income taxes $ 369 $ 189 $ 239 State and local 391 28 61 ------------- ------------- ------------- 760 217 300 ------------- ------------- ------------- Deferred: Federal provision in lieu of income taxes 6,851 5,613 4,755 State and local 268 277 1,425 ------------- ------------- ------------- 7,119 5,890 6,180 ------------- ------------- ------------- $ 7,879 $ 6,107 $ 6,480 ============= ============= =============
A reconciliation between the provision in lieu of income taxes and the amount computed by applying the federal statutory income tax rate to income before income taxes is as follows (in thousands):
Years Ended December 31, ----------------------------------------- 1997 1996 1995 ------------ ------------ ------------- Income before income taxes $ 23,468 $ 16,053 $ 13,041 ============ ============ ============= Amount of federal income tax based upon the statutory rate $ 8,213 $ 5,619 $ 4,564 Revision of prior years' tax estimates (1,134) (981) 651 State and local taxes, net of federal tax effect 428 1,080 966 Expenses for which no federal tax benefit is available 176 489 - Other 196 (100) 299 ------------ ------------ ------------- $ 7,879 $ 6,107 $ 6,480 ============ ============ =============
Revision of prior years' tax estimates as shown in the table above primarily include amounts for the reversal of reserves which the Company no longer believes are necessary. Generally, the reversal of reserves relates to the expiration of the relevant statute of limitations with respect to certain income tax returns or the resolution of specific income tax matters with the relevant tax authorities. For the years ended December 31, 1996 and 1995, the reversal of reserves which the Company believes are no longer necessary resulted in a credit to the income tax provision of $883,000 and $127,000, respectively. There was no reversal of reserves for the year ended December 31, 1997. The components of the Company's net deferred income tax assets (liabilities) are as follows (in thousands):
December 31, -------------------------- 1997 1996 ------------ ------------ Deferred income tax assets: Timber and timberlands $ 25,800 $ 28,992 Loss and credit carryforwards 14,619 22,089 Other liabilities and other 12,407 8,468 Valuation allowances (2,795) (1,884) ------------ ------------ Total deferred income tax assets, net 50,031 57,665 ------------ ------------ Deferred income tax liabilities: Inventories (15,803) (15,102) Property, plant and equipment (12,771) (15,917) Other (4,110) (2,180) ------------ ------------ Total deferred income tax liabilities (32,684) (33,199) ------------ ------------ Net deferred income tax assets $ 17,347 $ 24,466 ============ ============
A principal component of the net deferred income tax assets listed above relates to the excess of the tax basis over financial statement basis with respect to timber and timberlands. The Company believes that it is more likely than not that this net deferred income tax asset will be realized, based primarily upon the estimated value of its timber and timberlands which is well in excess of its tax basis. The valuation allowances listed above relate to loss and credit carryforwards. The Company evaluated all appropriate factors to determine the proper valuation allowances for loss and credit carryforwards. These factors included any limitations concerning use of the carryforwards, the year the carryforwards expire and the levels of taxable income necessary for utilization. The Company has concluded that it will more likely than not generate sufficient taxable income to realize the benefit attributable to the loss and credit carryforwards for which valuation allowances were not provided. Included in the net deferred income tax assets listed above are $15,735,000 and $22,586,000 at December 31, 1997 and 1996, respectively, which are recorded pursuant to the Tax Allocation Agreement with MAXXAM. The following table presents the Company's estimated tax attributes, for federal income tax purposes, under the terms of the Tax Allocation Agreement at December 31, 1997 (in thousands):
Expiring Through ------------- Regular Tax Attribute Carryforwards: Net operating losses $ 31,589 2012 Charitable contribution deduction 99 2002 Minimum tax credit 733 Indefinite Alternative Minimum Tax Attribute Carryforwards: Net operating losses $ 1,929 2012
6. EMPLOYEE BENEFIT PLANS RETIREMENT PLAN The Company has a defined benefit plan which covers all employees of the Company. Under the plan, employees are eligible for benefits at age 65 or earlier, if certain provisions are met. The benefits are determined under a career average formula based on each year of service with the Company and the employee's compensation for that year. The Company's funding policy is to contribute annually an amount at least equal to the minimum cash contribution required by The Employee Retirement Income Security Act of 1974, as amended. A summary of the components of net periodic pension cost is as follows (in thousands):
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Service cost - benefits earned during the year $ 1,937 $ 1,903 $ 1,483 Interest cost on projected benefit obligation 1,892 1,682 1,693 Actual gain on plan assets (3,988) (2,762) (3,900) Net amortization and deferral 2,451 1,448 2,460 ------------ ------------ ------------ Net periodic pension cost $ 2,292 $ 2,271 $ 1,736 ============ ============ ============
The following table sets forth the funded status and amounts recognized in the Consolidated Balance Sheet (in thousands):
December 31, -------------------------- 1997 1996 ------------ ------------ Actuarial present value of accumulated plan benefits: Vested benefit obligation $ 22,181 $ 18,506 Non-vested benefit obligation 2,176 1,371 ------------ ------------ Total accumulated benefit obligation $ 24,357 $ 19,877 ============ ============ Projected benefit obligation $ 28,940 $ 23,582 Plan assets at fair value, primarily equity and debt securities (25,872) (21,800) ----------- ------------ Projected benefit obligation in excess of plan assets 3,068 1,782 Unrecognized net transition asset 12 18 Unrecognized net gain 4,226 2,855 Unrecognized prior service cost (950) (39) ----------- ------------ Accrued pension liability $ 6,356 $ 4,616 =========== ============
The assumptions used in accounting for the defined benefit plan were as follows (in thousands):
1997 1996 1995 ------------- ------------- ------------- Rate of increase in compensation levels 5.0% 5.0% 5.0% Discount rate 7.25% 7.5% 7.25% Expected long-term rate of return on assets 8.0% 8.0% 8.0%
POSTRETIREMENT MEDICAL BENEFITS The Company has an unfunded benefit plan for certain postretirement medical benefits which covers substantially all employees of the Company. Participants of the plan are eligible for certain health care benefits upon termination of employment and retirement and commencement of pension benefits. Participants make contributions for a portion of the cost of their health care benefits. The expected costs of postretirement medical benefits are accrued over the period the employees provide services to the date of their full eligibility for such benefits. A summary of the components of net periodic postretirement medical benefit cost is as follows (in thousands):
Years Ended December 31, ---------------------------------------- 1997 1996 1995 ------------ ------------ ------------ Service cost - medical benefits earned during the year $ 287 $ 332 $ 228 Interest cost on accumulated postretirement medical benefit obligation 362 415 317 Net amortization and deferral (42) - (53) ------------ ------------ ------------ Net periodic postretirement medical benefit cost $ 607 $ 747 $ 492 ============ ============ ============
The postretirement medical benefit liability recognized in the Company's Consolidated Balance Sheet is as follows (in thousands):
December 31, -------------------------- 1997 1996 ------------ ------------ Retirees $ 710 $ 1,182 Actives eligible for benefits 893 905 Actives not eligible for benefits 3,434 3,818 ------------ ------------ Accumulated postretirement medical benefit obligation 5,037 5,905 Unrecognized net gain (loss) 1,003 (86) ------------ ------------ Postretirement medical benefit liability $ 6,040 $ 5,819 ============ ============
The annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) is 10.0% for 1998 and is assumed to decrease gradually to 5.5% in 2009 and remain at that level thereafter. Each one percentage point increase in the assumed health care cost trend rate would increase the accumulated postretirement medical benefit obligation as of December 31, 1997 by approximately $655,000 and the aggregate of the service and interest cost components of net periodic postretirement medical benefit cost by approximately $112,000. The discount rates used in determining the accumulated postretirement medical benefit obligation were 7.25% and 7.5% at December 31, 1997 and 1996, respectively. EMPLOYEE SAVINGS PLAN The Company's employees are eligible to participate in a defined contribution savings plan sponsored by MAXXAM. This plan is designed to enhance the existing retirement programs of participating employees. Employees may elect to defer up to 16% of their base compensation to the plan. For those participants who have elected to defer a portion of their compensation to the plan, the Company's contributions consist of matching contributions of up to 4% of the base compensation of participants. The cost to the Company of this plan was $1,516,000, $1,388,000 and $1,281,000 for the years ended December 31, 1997, 1996 and 1995, respectively. WORKERS' COMPENSATION BENEFITS The Company is self-insured for workers' compensation benefits. Included in accrued compensation and related benefits and other noncurrent liabilities are accruals for workers' compensation claims amounting to $10,800,000 and $8,000,000 at December 31, 1997 and 1996, respectively. Workers' compensation expenses amounted to $4,381,000, $2,409,000 and $3,302,000 for the years ended December 31, 1997, 1996 and 1995, respectively. 7. RELATED PARTY TRANSACTIONS MAXXAM provides the Company with personnel, insurance, legal, accounting, financial, and certain other services. MAXXAM is compensated by the Company through the payment of a fee representing the reimbursement of actual out-of-pocket expenses incurred by MAXXAM, including, but not limited to, labor costs of personnel of MAXXAM rendering services to the Company. Charges by MAXXAM for such services were $1,358,000, $1,664,000 and $1,694,000, for the years ended December 31, 1997, 1996, and 1995, respectively. The Company believes that the services being rendered are on terms not less favorable to the Company than those which would be obtainable from unaffiliated third parties. An agreement with Britt Lumber Co., Inc., an indirect wholly owned subsidiary of MGI ("Britt"), governs, among other things, the sale of logs and lumber by the Company and Britt to each other and the sale of hog fuel (wood residue) by Britt to the Company. The logs which the Company sells to Britt are sold at approximately 75% of the applicable price for such species and category as established by the California State Board of Equalization, which reflects the lower quality of these logs. Logs which either the Company or Britt purchases from third parties and which are then sold to each other are transferred at the actual cost of such logs. Hog fuel is sold to the Company by Britt at applicable market prices. Net sales for the years ended December 31, 1997, 1996 and 1995 include revenues of $13,907,000, $14,710,000 and $13,627,000, respectively, from Britt. The Company recognized operating income of $6,505,000, $6,784,000 and $5,527,000 on these revenues for the years ended December 31, 1997, 1996 and 1995, respectively. At December 31, 1997 and 1996, receivables include $1,049,000 and $1,281,000, respectively, related to these affiliate sales. All of the Company's issued and outstanding common stock is pledged as collateral for MGI's $100,000,000 11-1/4% Senior Secured Notes due 2003 and $125,720,000 12-1/4% Senior Secured Discount Notes due 2003 (collectively, the "MGI Notes"). MGI conducts its operations primarily through subsidiary companies. The Company represents the substantial portion of MGI's assets and operations. The indenture governing the MGI Notes requires the Company's board of directors to declare and pay dividends on the Company's common stock to the maximum extent permitted by any consensual restriction or encumbrance on the Company's ability to declare and pay dividends, unless the Board determines in good faith that such declaration and payment would be detrimental to the capital or other operating needs of the Company. 8. STOCKHOLDER'S DEFICIT Changes in stockholder's deficit were (in thousands):
Common Stock Additional Accumulated ($.01 Par) Capital Deficit Total ------------ ------------ ------------ ------------ Balance, January 1, 1995 $ - $ 157,520 $ (146,241) $ 11,279 Net income - - 6,561 6,561 Dividends - - (22,000) (22,000) ------------ ------------ ------------ ------------ Balance, December 31, 1995 - 157,520 (161,680) (4,160) Net income - - 9,946 9,946 Dividends - - (20,500) (20,500) ------------ ------------ ------------ ------------ Balance, December 31, 1996 - 157,520 (172,234) (14,714) Net income - - 15,589 15,589 Dividends - - (23,000) (23,000) ------------ ------------ ------------ ------------ Balance, December 31, 1997 $ - $ 157,520 $ (179,645) $ (22,125) ============ ============ ============ ============
9. CONTINGENCIES The Company's business is subject to a variety of California and federal laws and regulations dealing with timber harvesting, threatened and endangered species and habitat for such species, and air and water quality. Compliance with such laws and regulations plays a significant role in the Company's business. While compliance with such laws, regulations and judicial and administrative interpretations, together with the cost of litigation incurred in connection with certain timber harvesting operations, have increased the costs of the Company, they have not had a significant adverse effect on its financial position, results of operations or liquidity. However, these laws and related administrative actions and legal challenges have severely restricted the ability of the Company to harvest virgin old growth timber on its timberlands, and to a lesser extent, residual old growth timber. On September 28, 1996, the Company (on behalf of itself, its subsidiaries and affiliates) and MAXXAM (collectively, the "Pacific Lumber Parties") entered into an agreement with the United States and California ("Headwaters Agreement") which provides the framework for the acquisition by the United States and California of approximately 5,600 acres of the Company's timberlands. These timberlands are commonly referred to as the Headwaters Forest and the Elk Head Springs Forest (collectively, the "Headwaters Timberlands"). A substantial portion of the Headwaters Timberlands consists of virgin old growth timberlands. Approximately 4,900 of these acres are owned by Salmon Creek, with the remaining acreage being owned by Scotia Pacific (the Company having harvesting rights on approximately 300 of such acres). The Headwaters Timberlands would be transferred in exchange for (a) property and other consideration from the United States and California having an aggregate fair market value of $300 million, and (b) approximately 7,755 acres of adjacent timberlands (the "Elk River Timberlands") to be acquired from a third party. As part of the Headwaters Agreement, the Pacific Lumber Parties agreed to not enter the Headwaters Forest or the Elk Head Springs Forest to conduct any logging or salvage operations. Closing of the Headwaters Agreement is subject to various conditions, including federal and California funding, approval of a sustained yield plan ("SYP"), approval of a habitat conservation plan covering multiple species ("Multi-Species HCP") and issuance of a related incidental take permit (the "Permit") and the issuance of certain tax agreements satisfactory to the Pacific Lumber Parties. In November 1997, President Clinton signed an appropriations bill which contains authorization for the expenditure of $250 million of federal funds toward consummation of the Headwaters Agreement. On February 27, 1998, the Company, MAXXAM and various government agencies entered into a Pre-Permit Application Agreement in Principle (the "HCP/SYP Agreement") regarding certain understandings that they had reached regarding the Multi-Species HCP, the Permit and the SYP. The HCP/SYP Agreement provides that the Permit and Multi-Species HCP would have a term of 50 years, and would limit the activities which could be conducted by the Company in twelve forest groves to those which would enhance habitat. These groves aggregate approximately 8,000 acres and consist of substantial quantities of virgin and residual old growth redwood and Douglas-fir timber. In addition to being an important milestone toward completion of the Headwaters Agreement, the Company also believes that the HCP/SYP Agreement is a positive development in respect of the environmental challenges that it has faced over the last several years. Several species, including the northern spotted owl, the marbled murrelet and the coho salmon, have been listed as endangered or threatened under the federal Endangered Species Act ("ESA") and/or the California Endangered Species Act ("CESA"). The Company has developed federal and state northern spotted owl management plans which permit harvesting activities to be conducted so long as the Company adheres to certain measures designed to protect the northern spotted owl. The potential impact of the listings of the marbled murrelet and the coho salmon is more uncertain. If the Multi-Species HCP is approved, the Company would be issued the Permit, which would allow limited incidental "take" of listed species so long as there was no "jeopardy" to the species and the Multi-Species HCP would identify the measures to be instituted in order to minimize and mitigate the anticipated level of take to the greatest extent possible. The Multi-Species HCP would be designed to protect currently listed species as well as to consider candidate and future-listed species. The Company is also attempting to include in the Multi-Species HCP a resolution of the potential effect of limits by the Environmental Protection Agency ("EPA") on sedimentation, temperature and other factors for seventeen northern California rivers and certain of their tributaries, including rivers within the Company's timberlands. These limitations will be aimed at protecting water quality. Lawsuits are pending or threatened which seek to prevent the Company from implementing certain of its approved timber harvesting plans ("THPs"). While challenges with respect to the Company's young growth timber have historically been limited, a lawsuit was recently filed under the ESA which relates to a significant number of THPs covering young growth timber of the Company. While the Company expects these environmentally focused objections and lawsuits to continue, it believes that the HCP/SYP Agreement will enhance its position in connection with these challenges. The Company also believes that the Multi-Species HCP would expedite the preparation and facilitate approval of its THPs. The HCP/SYP Agreement also contains certain provisions relating to the SYP. Subject to further study, the Company expects the Company to propose a long-term sustained yield harvest level ("LTSY") which is somewhat less than the Company's recent harvest levels. If the SYP is approved, the Company will have complied with certain BOF regulations requiring that timber companies project timber growth and harvest on their timberlands over a 100-year planning period and establish an LTSY harvest level. The SYP must demonstrate that the average annual harvest over any rolling ten-year period will not exceed the LTSY harvest level and that the Company's projected timber inventory is capable of sustaining the LTSY harvest level in the last decade of the 100-year planning period. An approved SYP is expected to be valid for ten years, although it would be subject to review after five years. Thereafter, revised SYPs will be prepared every decade that address the LTSY harvest level based upon reassessment of changes in the resource base and other factors. The final terms of the SYP, the Multi-Species HCP and the Permit are subject to additional negotiation and agreement among the parties as well as public review and comment. While the parties are working diligently to complete the Multi-Species HCP and the SYP as well as the other closing conditions contained in the Headwaters Agreement, there can be no assurance that the Headwaters Agreement will be consummated or that an SYP, Multi-Species HCP or Permit acceptable to the Company will be approved. In the event that a Multi-Species HCP is not approved, the Company will not enjoy the benefits of expedited preparation and facilitated review of its THPs. Furthermore, if a Multi-Species HCP acceptable to the Company is not approved, it is impossible for the Company to determine the potential adverse effect of the listings of the marbled murrelet and coho salmon or the EPA s limitations on the Company's financial position, results of operations or liquidity until such time as the various regulatory and legal issues are resolved; however, if the Company is unable to harvest, or is severely limited in harvesting, on significant amounts of its timberlands, such effect could be materially adverse to the Company. 10. SUPPLEMENTAL CASH FLOW AND OTHER INFORMATION Items Related to 1992 Earthquake In 1995, the Company recorded reductions in cost of sales of $1,527,000 resulting from business interruption insurance reimbursements for higher operating costs and the related loss of revenues resulting from the April 1992 earthquake.
Years Ended December 31, ----------------------------------------- 1997 1996 1995 ------------- ------------- ------------- (In thousands) Supplemental information on non-cash investing and financing activities: Timber and timberlands acquired subject to long-term debt $ 9,445 $ - $ 615 Supplemental disclosure of cash flow information: Interest paid, net of capitalized interest $ 52,380 $ 52,517 $ 53,636 Income taxes paid (refunded) 166 221 (5,190) Tax allocation payments to MAXXAM 454 330 -
11. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Summary quarterly financial information for the years ended December 31, 1997 and 1996 is as follows (in thousands):
Three Months Ended ------------------------------------------------------- March 31 June 30 September 30 December 31 ------------- ------------- ------------- ------------- 1997: Net sales $ 60,849 $ 67,810 $ 66,592 $ 66,126 Operating income 16,512 20,810 20,584 16,659 Net income 2,193 4,905 4,678 3,813 1996: Net sales $ 54,903 $ 65,299 $ 62,965 $ 61,682 Operating income 14,310 17,485 15,415 19,090 Net income 884 3,144 1,473 4,445
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