10-K 1 fsp10k05.txt FIVE STAR PRODUCTS FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2005 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] Annual Report Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934 For the fiscal year ended December 31, 2005 or [ ] Transition Report Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934 For the transition period from to Commission File Number 333-78252 FIVE STAR PRODUCTS, INC. ------------------------------------------------------------------------------- (Exact name of Registrant as specified in its charter) Delaware 13-3729186 (State of Incorporation) (I.R.S. Employer Identification No.) 777 Westchester Avenue 10604 (Address of principal executive offices) (Zip Code) (914) 249-9700 Registrant's telephone number, including area code: Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, $.01 Par Value ---------------------------- (Title of Class) Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ___ No __X__ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ____ No __X__ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes _X__ No____ - Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ____ Accelerated filer__ Non-accelerated filer_X__ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12(b)-2 of the Exchange Act). Yes __ __ No __X__ --- - The aggregate market value of the outstanding shares of the Registrant's Common Stock, par value $.01 per share held by non-affiliates as of June 30, 2005 was approximately $2,122,226 based on the closing price of the Common Stock on the OTC Bulletin Board, which is operated by NASDAQ Stock Market. The number of shares outstanding of the registrant's Common Stock as of March 15, 2006: Class Outstanding Common Stock, par value $.01 per share 14,396,077 shares DOCUMENTS INCORPORATED BY REFERENCE None
TABLE OF CONTENTS PART I Page Item 1. Business....................................................................... 1 Item 1A. Risk Factors..................................................................6 Item 1B. Unresolved Staff Comments.....................................................7 Item 2. Properties.....................................................................7 Item 3. Legal Proceedings..............................................................8 Item 4. Submission of Matters to a Vote of Security Holders............................8 PART II Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters.................................................8 Item 6. Selected Financial Data.......................................................10 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.........................................11 Item 7A. Quantitative and Qualitative Disclosures About Market Risk...................17 Item 8. Financial Statements and Supplementary Data...................................20 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure....................................37 Item 9A. Controls and Procedures......................................................37 PART III Item 10. Directors and Executive Officers of the Registrant...........................38 Item 11. Executive Compensation.......................................................40 Item 12. Security Ownership of Certain Beneficial Owners and Management. and Related Stockholder Matters................................45 Item 13. Certain Relationships and Related Transactions...............................46 Item 14. Principal Accounting Fees and Services.......................................49 PART IV Item 15. Exhibits, Financial Statement Schedules......................................50 Signatures ....................................................................51
Cautionary Statement Regarding Forward-Looking Statements This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward looking statements. Forward-looking statements are not statements of historical facts, but rather reflect our current expectations concerning future events and results. We use words such as "expects", "intends", "believes", "may", "will" and "anticipates" to indicate forward-looking statements. Because these forward-looking statements involve risks and uncertainties, there are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements, including, but not limited to, those factors set forth under Item 1A - Risk Factors and those other risks and uncertainties detailed in the Company's periodic reports and registration statements filed with the Securities and Exchange Commission. We caution that these risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time to time. We cannot predict these new risk factors, nor can we assess the effect, if any, of the new risk factors on our business or the extent to which any factor or combination of factors may cause actual results to differ from those expressed or implied by these forward-looking statements. If any one or more of these expectations and assumptions proves incorrect, actual results will likely differ materially from those contemplated by the forward-looking statements. Even if all of the foregoing assumptions and expectations prove correct, actual results may still differ materially from those expressed in the forward-looking statements as a result of factors we may not anticipate or that may be beyond our control. While we cannot assess the future impact that any of these differences could have on our business, financial condition, results of operations and cash flows or the market price of shares of our common stock, the differences could be significant. We do not undertake to update any forward-looking statements made by us, whether as a result of new information, future events or otherwise. You are cautioned not to unduly rely on such forward-looking statements when evaluating the information presented in this report. PART I Item 1: Business General Development of Business Five Star Products Inc. (the "Company" or "Five Star") is engaged in the wholesale distribution of home decorating, hardware and finishing products. It serves over 3,500 independent retail dealers in twelve states, making Five Star one of the largest distributors of its kind in the Northeast. Five Star operates two state -of -the -art warehouse facilities, located in Newington, CT and East Hanover, NJ. All operations are coordinated from Five Star's New Jersey headquarters. At December 31, 2005 Five Star is a majority owned subsidiary of National Patent Development Corporation ("NPDC"). The Company, which was then 37.5% owned by GP Strategies Corporation ("GPS"), purchased its business from GPS in 1998 in exchange for cash and a $5,000,000 unsecured 8% note payable ("the Note"). In 2002 and 2003, GPS 1 converted $1,000,000 principal amount of the Note into 4,272,727 shares of the Company's common stock. In 2004, the Company, through a tender offer, repurchased approximately 2,628,000 shares of its common stock. The conversion of the Note and the tender offer increased GPS' ownership in the Company to approximately 64%. On July 30, 2004, GPS contributed its ownership interest in Five Star and the Note to National Patent Development Corporation ("NPDC"). On November 24, 2004, GPS completed the spin-off to its shareholders of the common stock of NPDC (the "Spin-Off"). . The Note, as amended, bore interest at 8%, payable quarterly, and matured on June 30, 2005. On June 30, 2005 the Company and NPDC agreed to extend the Note for a one-year term maturing on June 30, 2006. In consideration for NPDC extending the Note, the Company paid NPDC a fee of one percent of the Note's outstanding balance or $28,000. In addition, the interest rate on the Note has been increased to 9%. NPDC provided legal, tax, business development, insurance and employee benefit administration services to the Company pursuant to a management services agreement for a fee of up to $10,000 per month. The agreement is automatically renewable for successive one-year terms unless one of the parties notifies the other in writing at least six months prior to the end of any renewal thereof. The management fee increased to $25,000 per month effective October 1, 2004. In addition the Company agreed to reimburse NPDC for $16,666 per month for Mr. Feldman's (NPDC's Chief Executive Officer) for service to the Company effective October 1, 2004. The agreement was renewed for 2006. On January 1, 2006 the management fee was reduced from $25,000 to $14,167. As a result of the spin-off of NPDC, GPS transferred to NPDC the rights and obligations under this Agreement. In the first quarter of 2000, the Company expanded its sales territory with the addition of an established, dedicated sales force servicing the Mid-Atlantic States, and as far south as North Carolina. This addition to the sales force generates revenues of approximately $9 million annually. The Company services this new territory from its 236,000 square foot East Hanover, New Jersey facility, from which it also services the Northeast, enabling the Company to leverage its fixed costs over a broader revenue base. The Company offers products from leading manufacturers such as Valspar/Cabot Stain, William Zinsser & Company, DAP, General Electric Corporation, Newell/Irwin, USG, Stanley Tools, Minwax and 3M Company. The Company distributes its products to retail dealers, which include lumber yards, "do-it yourself" centers, hardware stores and paint stores principally in the northeast region. It carries an extensive inventory of the products it distributes and provides delivery, generally within 24 to 72 hours. The Company has grown to be one of the largest independent distributors in the Northeast by providing a complete line of competitively priced products, timely delivery and attractive pricing and financing terms to its customers. Much of the Company's success can be attributed to a continued commitment to provide customers with the highest quality service at reasonable prices. As one of the largest distributors of paint sundry items in the Northeast, the Company enjoys cost advantages and favorable supply arrangements over the smaller distributors in the industry. This enables the Company to compete as a "low cost" provider. The Company uses a fully computerized warehouse system to track all facets of its distribution operations. The Company has enhanced the sophistication of its warehouse and office facilities to take full advantage of economies of scale, speed the flow of orders and to compete as 2 a low cost distributor. Nearly all phases of the selling process from inventory management to receivable collection are automated and tracked; all operations are overseen by senior management at the New Jersey facility. The Company is able to capitalize on manufacturer discounts by strategically timing purchases involving large quantities. Management takes a proactive approach in coordinating all phases of the Company's operations. For example, sales managers require all sales representatives to call on customers once every week. Each salesperson transmits his or her orders through the Company's automated sales system, to the IBM AS/400 computer located at the New Jersey facility. The salesperson system combines the ability to scan product codes in the customers' stores and download the information to a hand held device computer for final transmission. Based on the floor plan of each warehouse and the location of products therein, the computer designs a pattern for the orders to be picked. The orders are then relayed to the appropriate location and typically picked in the evening. The warehouse facilities are well-maintained and skillfully organized. A bar-coded part number attached to the racking shelves identifies the location of each of the approximately 23,000 stock keeping units (SKUs). The products are loaded onto the Company's trucks in the evening in the order that they will be unloaded, and are delivered directly to the customers locations the following morning. Additional information about the Company may be found at www.fivestargroup.com Customers Five Star's largest customer accounted for approximately 4.0% of its sales in 2005 and its 10 largest customers accounted for approximately 13.7% of such sales. All such customers are unaffiliated and Five Star does not have a long-term contractual relationship with any of them. Management Information System All of Five Star's inventory control, purchasing, accounts payable and accounts receivable are fully automated on an IBM AS/400 computer system. In addition, Five Star's software alerts buyers to purchasing needs, and monitors payables and receivables. This system allows senior management to control closely all phases of Five Star's operations. Five Star also maintains a salesperson-order-entry system, which allows the salesperson to scan product information and then download the information to a hand held device. The hand held device contains all product and customer information and interacts with the AS/400. Purchasing Five Star relies heavily upon its purchasing capabilities to gain a competitive advantage relative to its competitors. Five Star's capacity to stock the necessary products in sufficient volume and its ability to deliver them promptly upon demand is one of the strongest components of service in the distribution business, and is a major factor in Five Star's success. Since retail outlets depend upon their distributor's ability to supply products quickly upon demand, inventory is the primary working capital 3 investment for most distribution companies, including Five Star. Through its strategic purchasing decisions, Five Star carries large quantities of inventory relative to its competitors and thus can boast fill ratios of approximately 95%. All purchasing decisions based on current inventory levels, sales projections, manufacturer discounts and recommendations from sales representatives, are made by the merchandising group, located in New Jersey, in order to effectively coordinate Five Star's activities. In addition to senior management's active involvement, regional sales managers play an extremely critical role in this day-to-day process. Five Star has developed strong, long-term relationships with the leading suppliers since its predecessor company, J. Leven, was founded in 1912. As a major distributor of paint sundry items, suppliers rely on Five Star to introduce new products to market. Furthermore, suppliers have grown to trust Five Star's ability to penetrate the market. As a result, Five Star is often called on first by manufacturers to introduce new products into the marketplace. For example, Minwax, Bestt Liebco and Cabot Stain have utilized Five Star to introduce and distribute some of their new product innovations. Marketing The do-it-yourself industry relies on distributors to link manufacturer's products to the various retail networks. The do-it-yourself market operates on this two-step distribution process, i.e., manufacturers deal through distributors who in turn service retailers. This occurs principally because most retailers are not equipped to carry sufficient inventory in order to be cost effective in their purchases from manufacturers. Thus, distributors add significant value by effectively coordinating and transporting products to retail outlets on a timely basis. Five Star distributes and markets products from hundreds of manufacturers to all of the various types of retailers from regional paint stores, to lumber yards, to independent paint and hardware stores. The marketing efforts are directed by regional sales managers. These individuals are responsible for designing, implementing and coordinating marketing policies. They work closely with senior management to coordinate company-wide marketing plans as well as to service Five Star's major multi-state customers. In addition, each regional sales manager is responsible for overseeing the efforts of his sales representatives. The sales representatives, by virtue of frequent contact with Five Star's customers, are the most integral part of Five Star's marketing strategy. It is their responsibility to generate revenue, ensure customer satisfaction and expand the customer base. Each representative covers an assigned geographic area. The representatives are compensated based solely on commission. Five Star has experienced low turnover in its sales force; most representatives have a minimum of five years' experience with Five Star. Many sales representatives had retail experience in the paint or hardware industry when they were hired by Five Star. Five Star's size, solid reputation for service, large inventory and attractive financing terms provide sales representatives with tremendous advantages relative to competing sales representatives from other distributors. In addition, the representatives' efforts are strengthened by company-sponsored 4 marketing events. For example, each year in the first quarter, Five Star invites all of its customers to special trade shows for Five Star's major suppliers, so that suppliers may display their products and innovations. Five Star also participates in advertising circular programs in the spring and the fall which contain discount specials and information concerning new product innovations. Five Star has a history of enhancing its growth through complementary acquisitions which have allowed it to preempt much of its competition as a high-quality, competitively priced distributor. Industry Dynamics The Do-It-Yourself Industry The paint sundry items distribution industry is closely related to the do-it-yourself retail market, which has tended to exhibit elements of counter-cyclicality. In times of recession, consumers tend to spend more on home improvements if they cannot afford to trade up to bigger homes. In times of economic strength, consumers tend to spend heavily in home improvements because they believe they can afford to complete their home improvement projects. According to the National Retail Hardware Association, total retail sales by home improvement retailers are estimated to be $270 billion in 2005 and are projected to grow at a 5.75% compound rate through 2009. Painting is the quintessential do-it-yourself project. Painting has to be done more frequently than most remodeling jobs, and it is a relatively inexpensive way to update the appearance of a home. For these reasons, the paint and paint sundry items industry tends to be counter-cyclical and a solid growth segment of the do-it-yourself market. Competition Competition within the industry is intense. There are large national distributors commonly associated with national franchises such as Ace and TruServ as well as smaller regional distributors, all of whom offer similar products and services. Five Star's customers face stiff competition from Home Depot and Lowe's, which purchase directly from manufacturers and dealer-owned distributors such as Ace and TruServ. Moreover, in some instances manufacturers will bypass the distributor and choose to sell and ship their products directly to the retail outlet. The principal means of competition for Five Star are its strategically placed distribution centers and its extensive inventory of quality, name-brand products. Five Star will continue to focus its efforts on supplying its products to its customers at a competitive price and on a timely, consistent basis. In the future, Five Star will attempt to acquire complementary distributors and to expand the distribution of its line of private-label products sold under the "Five Star" name. Through internal growth and acquisitions, Five Star has already captured a leading share in its principal market, the Northeast. This growth-oriented acquisition strategy of acquiring complementary distributors has allowed Five Star to compete against a substantial number of its competitors. While other paint sundry items distributors sell to the same retail networks as Five Star, they are at a distinct disadvantage due to Five Star's experience, sophistication and size. 5 Hardware stores that are affiliated with the large, dealer-owned distributors such as Ace also utilize Five Star's services because they are uncomfortable with relying solely on their dealer network. Most cooperative-type distributors lack the level of service and favorable credit terms that independent hardware stores enjoy with Five Star. Five Star effectively competes with the dealer-owned distributors because it provides more frequent sales calls, faster deliveries, better financing terms and a full line of vendors and products to choose from. Employees The Company employs approximately 245 people. Management-employee relations are considered good at both of Five Star's warehouse facilities. The Teamsters union represents approximately 94 union employees at the New Jersey warehouse facility. The Connecticut warehouse facility is completely non-unionized. Five Star has never experienced a labor strike at its facilities. Five Star's contract with Local No. 11, affiliated with the International Brotherhood of Teamsters expires on December 20, 2008. Item 1A Risk Factors Set forth below and elsewhere in this report and in other documents the Company files with the Securities and Exchange Commission are risks and uncertainties that could cause the Company's actual results to differ materially from the results contemplated by the forward-looking statements contained in this report and other public statements made by the Company. Expiration of Leases for Warehouse Facilities The Company's leases for its Connecticut and New Jersey facilities expire in the first quarter of 2007. At this time the Company is exploring its options, but has not yet renewed the current facility leases, nor entered into leases for new facilities. Our inability to enter into leases under favorable terms could have a material adverse impact on our business. The loss of our key personnel, including our executive management team, could harm our business. Our success is largely dependent upon the experience and continued services of our executive management team and our other key personnel. The loss of one or more of our key personnel and a failure to attract or promote suitable replacements for them may adversely affect our business. Competition Could Adversely Affect our Performance Competition within the do-it-yourself industry is intense. There are large national distributors commonly associated with national franchises such as Ace and TruServ as well as smaller regional distributors, all of whom offer products and services similar to those offered by Five Star. Moreover, in some instances, manufacturers will bypass distributors and choose to sell and ship their products directly to retail outlets. In addition, Five Star's customers face stiff competition from Home Depot, and Lowe's, which purchases directly from manufacturers, and national franchises such as Ace and TruServ. Five Star 6 competes principally through its strategically placed distribution centers and its extensive inventory of quality, name-brand products. Five Star will continue to focus its efforts on supplying its products to its customers at a competitive price and on a timely, consistent basis. Changing economic conditions in the United States could harm our business. Our revenues and profitability are related to general levels of economic activity and employment in the United States. As a result, any significant economic downturn or recession could harm our business or financial condition. Control by NPDC The Company is controlled by the Company's principal stockholder, NPDC, whose interest may not be aligned with those of the Company's other stockholders. As of March 15, 2006 NPDC owned approximately 64% of the Company's outstanding common stock. Accordingly, NPDC will be able to influence our management and affairs and all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying, discouraging or preventing a change in control and might affect the market price of the Company's common stock. See Notes 3 and 6 to Notes to Consolidated Financial Statements for a description of transactions between the Company and NPDC. Item 1B. Unresolved Staff Comments None Item 2. Properties Five Star leases 236,000 square feet in New Jersey, 111,000 square feet in Connecticut, 1,300 square feet of sales offices in New York and 800 square feet in Maryland. Five Star's operating lease for the New Jersey facility expires in March, 2007, and the annual rent is $1,187,000. Five Star's lease for the Connecticut facility expires in February, 2007, and its annual rent is $402,000. The New York sales office pays $19,000 per year in rent and the Maryland office pays $11,000. The Company's White Plains, New York office space is provided by GPS pursuant to the Agreement. The leases for the Company's Connecticut and New Jersey warehouse facilities expire in the first quarter of 2007. The Company is exploring alternatives. See "Risk Factors - Expiration of Leases for Warehouse Facilities". Except as described above, the current facilities leased by the Company are considered to be suitable and adequate for their intended uses and are considered to be well maintained and in good condition. 7 Item 3. Legal Proceedings The Company is from time to time subject to litigation or other legal proceedings arising in the ordinary course of business. The Company is not a party to any legal proceeding, the outcome of which is believed by management to have a reasonable likelihood of having any material adverse effect upon the financial condition and operating results of the Company. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. PART II Item 5: Market for the Registrant's Common Equity and Related Stockholder Matters The following table presents the high and low prices for the Common Stock for 2005 and 2004. The Company's Common Stock, $.01 par value, is quoted on the OTC Bulletin Board, which is operated by the NASDAQ Stock Market.
Quarter High Low 2005 First $0.33 $0.22 Second $0.45 $0.36 Third $0.45 $0.38 Fourth $0.42 $0.17 2004 First $0.30 $0.13 Second $0.32 $0.21 Third $0.30 $0.14 Fourth $0.45 $0.19
The number of shareholders of record of the Common Stock as of March 15, 2006 was 3,130 and the closing price of the Common Stock on the OTC Bulletin Board on that date was $0.19. The Company has not declared any cash dividends in 2005 and 2004. The current policy of the Company's Board of Directors is to retain earnings, if any, to finance the operation of the Company's business. The payment of cash dividends on the Common Stock in the future will depend on the Company's earnings, financial condition and capital needs and on other factors deemed pertinent by the Company's Board of Directors. 8 Equity Compensation Plan Information as of December 31, 2005.
------------------------------- ---------------------------- ------------------------- --------------------------------- Plan category Number of securities Weighted-average Number of securities to be issued upon exercise price of remaining available for Non-Qualified exercise of outstanding options future issuance under Stock Option Plan outstanding options equity compensation (a) (b) plans (excluding securities reflected in column(a)) (c) ------------------------------- ---------------------------- ------------------------- --------------------------------- ------------------------------- ---------------------------- ------------------------- --------------------------------- Equity compensation plans not approved by 1,100,000 $0.14 1,500,000 security holders ------------------------------- ---------------------------- ------------------------- --------------------------------- ------------------------------- ---------------------------- ------------------------- --------------------------------- Total 1,100,000 $0.14 1,500,000 ------------------------------- ---------------------------- ------------------------- ---------------------------------
For a description of the material terms of the Company's Non-Qualified Stock Option Plan, see Note 8 in the Notes to the Consolidated Financial Statements. 9 FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES SELECTED CONSOLIDATED FINANCIAL DATA (in thousands, except per share amounts) Item 6. Selected Financial Data Years Ended December 31, ------------------------------------------------------------------ ------------- ------------ ------------ ------------- ------------
2005 2004 2003 2002 2001 ---- ---- ---- ---- ---- Statement of Operations Data: Revenue $106,451 $101,982 $95,085 $94,074 $94,908 Cost of goods sold 88,804 82,592 77,366 77,461 78,854 Selling, general and administrative Expenses 16,447 16,329 15,743 14,313 13,576 Net income(loss) (287) 1,140 598 391 417 Income per share: Basic $(0.02) $0.08 $0.04 $0.03 $0.03 Diluted $(0.02) $0.07 $0.04 $0.03 $0.03
Years Ended December 31, -------------------------------------------------------------- ----------- ------------ ----------- ----------- -------------
2005 2004 2003 2002 2001 ---- ---- ---- ---- ---- Balance Sheet Data: Current assets $34,864 $39,296 $35,719 $34,214 $35,045 Current liabilities 31,365 35,538 29,651 27,585 28,762 Non-current liabilities 20 19 2,800 4,500 5,000 Working capital 3,499 3,758 6,068 6,629 6,283 Total assets 36,184 40,475 36,896 35,366 36,184 Total stockholders' equity 4,799 4,918 4,445 3,281 2,422
10 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Overview Five Star is a publicly held company that is a leading distributor in the United States of home decorating, hardware, and finishing products. Five Star offers products from leading manufacturers in the home improvement industry and distributes those products to retail dealers, which include lumber yards, "do-it yourself" centers, hardware stores and paint stores. Five Star has grown to be one of the largest independent distributors in the Northeast United States by providing a complete line of competitively priced products, timely delivery and attractive pricing and financing terms to its customers. The following key factors affect Five Star's financial and operation performance: o its ability to negotiate the lowest prices from its suppliers, o its ability to increase revenue by obtaining new customers, while maintaining a level fixed cost structure by utilizing its existing warehouses, o the housing market in general, o consumers' confidence in the economy, o consumers' willingness to invest in their homes, and o weather conditions that are conducive to home improvement projects. The following key performance measures are utilized by the Company's management to run Five Star's business: o new U.S. housing starts, o sales of existing homes, o sales of high margin products to its customers, o purchases from each vendor, and o performance benchmarks used by Home Depot and Lowe's, such as number of stores and square footage, as well as financial benchmarks. Five Star operates in the Home Improvement market, which has grown in recent years and for which the Home Improvement Research Institute predicts average annual industry growth of nearly 5.75% for the next several years. Nonetheless, Five Star faces intense competition from large national distributors, smaller regional distributors, and manufacturers that bypass the distributor and sell directly to the retail outlet. The principal means of competition for Five Star are its strategically placed distribution centers and its extensive inventory of quality, name-brand products. In addition, Five Star's customers face stiff competition from Home Depot and Lowe's, which purchase directly from manufacturers. As a result of such competition, while the Home Improvement market has expanded significantly in recent years, Five Star's revenue has not 11 increased at the same rate, and such revenue would have declined if Five Star had not entered into new geographic sales territories as described below. In spite of this, the independent retailers that are Five Star's customers remain a viable alternative to Home Depot and Lowe's, due to the shopping preferences of and the retailer's geographic convenience for some consumers. Five Star has continued to expand its sales territory with an addition of a sales force servicing the Mid-Atlantic States, as far south as North Carolina, which has generated additional annual revenues of approximately $10.4 million since 2000. Five Star services this territory from its existing New Jersey warehouse, enabling Five Star to leverage its fixed costs over a broader revenue base. To further expand, Five Star will attempt to grow its revenue base in the Mid-Atlantic States, to acquire complementary distributors and to expand the distribution of its use of private-label products sold under the "Five Star" name. Results of Operations Year Ended December 31, 2005 compared to Year Ended December 31, 2004 The Company recognized a loss before income taxes of $ 0.4 million for the year ended December 31, 2005 as compared to income before income taxes of $2 million for the year ended December 31, 2004. The decrease in profitability of $2.4 million is primarily due to decreased gross margin of $1.7 million, an increase of .8 million in interest expense and management fees offset by a reduction in selling, general and administrative expenses of $0.1 million. Sales. Sales increased by $4.4 million from $102 million in 2004 to $106 million in 2005. This increase was a result of rising prices due to increased raw material costs for certain of the Company's vendors, as well as increased sales volume generated from the Company's annual trade shows. In addition Five Star conducts small local trade shows for its customer base to create additional incremental revenue. Gross margin. Gross margin of $17.6 million or 16.6% of sales, in 2005 decreased by $1.7 million or 9.0% when compared to gross margin of $19.4 million, or 19.0% of sales in 2004. The decrease in gross margin percentages from 2004 to 2005 was the result of unfavorable shift in the product mix sold, increased price based competition , an increase in vendor pricing in particular for petroleum based products as well as a resistance to price increases from customers. Selling, general and administrative. Selling, general and administrative expenses increased by $0.1 million or less than 1% primarily due to increases in delivery expenses, salesmen commissions and management fees of $ 0.3 million offset by a reduction in general and administrative expenses of $ 0.2 million. Interest expense. The increase in interest expense in 2005 of $0.5 million is the result of an increase in average borrowings related to the Company's Loan Agreement, offset by a decrease in average borrowings related to the Note. 12 Income taxes. The company recognized an income tax benefit in 2005 of $ 0.1 million, and income tax expense of $0.8 million in 2004 at an effective tax rate of 25% in 2005 and 42% in 2004. Results of Operations Year Ended December 31, 2004 compared to Year Ended December 31, 2003 The Company recognized income before income taxes of $2 million for the year ended December 31, 2004 as compared to income before income taxes of $1 million for the year ended December 31, 2003. The increase in profitability of $1 million is primarily due to increased gross margin of $1.7 million, mainly offset by an increase in selling, general and administrative expenses of $ 0.5 million Sales. Sales increased by $6.9 million from $95.1 million in 2003 to $102 million in 2004. The increase was primarily a result of increased sales to the Company's existing customer base. Sales to existing customers have increased mainly due to Five Star offering more product lines for the retailers to stock, as well as Five Star conducting small local trade shows for its customers to create additional sales. Revenue was favorably affected by clement weather in the Northeast during 2004, causing an increase in home improvement projects. Gross margin. Gross margin of $19.4 million or 19% of sales, in 2004 increased by $1.7 million or 9.4%, when compared to gross margin of $17.7 million, or 18.6% of sales, in 2003. The increase in gross margin dollars was primarily the result of increased sales. The increase in gross margin percentages from 2003 to 2004 were primarily a result of improved purchasing efficiencies and product mix sold, partially offset by increased warehousing costs. The Company includes warehousing costs in Cost of Goods Sold. Selling, general and administrative. Selling, general and administrative expenses increased by $0.6 million or 3% primarily due to increased delivery expenses, salesmen commissions, medical expenses and legal and professional fees. Interest expense. The increase in interest expense in 2004 of $0.1 million is the result of an increase in average borrowings related to the Company's Loan Agreement, offset by a decrease in average borrowings related to the Note. Income taxes. The company recognized income tax expense of $0.8 million in 2004 and $0.4 in 2003, at an effective income tax rate of 42% for both years. Liquidity and Capital Resources At December 31, 2005, the Company had cash of $3,000 and working capital of $3,497,000, compared to cash of $4,000 and working capital of $3,758,000 as of December 31, 2004 respectively. The Company believes that cash generated from operations and borrowing availability under existing credit agreements will be sufficient to fund the Company's working capital requirements for at least the next twelve months. 13 The decrease in cash of $1,000 for the year ended December 31, 2005 resulted from cash used by operations of $1,355,000 primarily consisting of an increase in accounts receivable of $ 972,000, and a decrease in accounts payable and accrued expenses of $ 5,703,000 offset by a decrease in inventory of $ 6,000,000 and cash used for additions to property plant and equipment of $ 175,000, offset by cash provided by short term borrowings of $ 1,529,000. The increase in accounts receivable, which caused a decrease in operating cash flows, is a result of: slightly stronger sales during the fourth quarter of 2005 and the payments of accounts receivable. The decrease in accounts payable and accrued expenses, which caused a decrease in operating cash flows, is primarily a result of payments made to the Company's trade vendors. The decrease in inventory, which caused an increase in operating cash flows, is the result of the Company selling through its inventory, while minimizing the level of new purchases. The increase in short-term borrowings, which caused an increase in financing cash flows, is the result of the Company borrowing under its Loan and Security Agreement to finance the shortfall in operating cash flows. In 2003, the Company's wholly-owned subsidiary, Five Star Group, Inc., obtained a Loan and Security Agreement (the "Loan Agreement") with Bank of America Business Capital (formerly Fleet Capital Corporation) (the "Lender"). The Loan Agreement has a five-year term, with a maturity date of June 30, 2008. The Loan Agreement, as amended on August 1, 2005, provides for a $35,000,000 revolving credit facility, which allows Five Star Group, Inc. to borrow based upon a formula of up to 65% of eligible inventory and 85% of eligible accounts receivable, as defined therein. The interest rates under the Loan Agreement, as amended, consist of LIBOR plus a credit spread of 1.5% (6.64% at December 31, 2005) for borrowings not to exceed $15,000,000 and the prime rate (8.0% at December 31, 2005) for borrowings in excess of the above-mentioned LIBOR-based borrowings. The credit spreads can be reduced in the event that Five Star Group, Inc. achieves and maintains certain performance benchmarks. At December 31, 2005 and December 31, 2004, approximately $19,764,000 and $18,234,000 was outstanding under the Loan Agreement and approximately $1,451,000 and $434,000 was available to be borrowed, respectively. Substantially all of the Company's assets are pledged as collateral for these borrowings. Under the Loan Agreement the Company is subject to covenants requiring minimum net worth, limitations on losses, if any, and minimum or maximum values for certain financial ratios. For the year ended December 31, 2005 the Company was not in compliance with the covenant that required a certain minimum net income/fixed charge coverage ratios, however, for the period, the Company received a waiver of default from the Lender through December 31, 2005. In connection with the Loan Agreement, Five Star Group, Inc. also entered into a derivative transaction with the Lender on June 20, 2003. The derivative transaction is an interest rate swap and has been designated as a cash flow hedge. Effective July 1, 2004 through June 30, 2008, Five Star Group, Inc. will pay a fixed interest rate of 3.38% to the Lender on notional principal of $12,000,000. In return, the Lender will pay to Five Star Group, Inc. a floating rate, namely, LIBOR, on the same notional principal amount. The credit spread under the new Loan Agreement is not included in, and will be paid in addition to this fixed interest rate of 3.38%. 14 The fair value of the interest rate swap amounted to $ 395,000 at December 31, 2005 and $105,000 at December 31, 2004, and is included in other assets in the accompanying balance sheets. On June 17, 2004, Five Star Group, Inc. has also entered into a derivative interest rate collar transaction during the period from July 1, 2004 through June 30, 2008 on notional principal of $12,000,000. The transaction consists of an interest rate floor of 2.25%, whereas if LIBOR is below 2.25%, the Lender will pay to Five Star Group, Inc. the difference between LIBOR and 2.25%, on the same notional principal amount. The transaction also consists of an interest rate cap of 5.75%, whereas if LIBOR is above 5.75%, Five Star Group, Inc. will pay to the Lender the difference between LIBOR and 5.75%, on the same notional principal amount. The interest rate swap and interest rate collar entered into by the Company in connection with the Loan Agreement are being accounted for under SFAS No. 133, as amended, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 requires all derivatives to be recognized in the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. If the derivative is a cash flow hedge, changes in the fair value of the derivative are recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value is immediately recognized in earnings. Changes in the fair value of the interest rate swap, which has been designated as a cash flow hedge, were recognized in other comprehensive income. Changes in the fair value of the interest rate collar from June 17, 2004 through December 31, 2005 amount to approximately $20,000, which has been charged to earnings during the year ended December 31, 2005. The Company's wholly-owned subsidiary, Five Star Group, Inc., has an unsecured note payable (the "Note") to JL Distributors, Inc., a wholly-owned subsidiary of NPDC following the spin-off of NPDC from GPS on November 24, 2004. The Note, as amended, bore interest at 8%, payable quarterly, and matured on June 30, 2005. On June 30, 2005 the Company and NPDC agreed to extend the Note for a one-year term maturing on June 30, 2006. In consideration for NPDC extending the Note, the Company paid NPDC a fee of one percent of the Note's outstanding balance or $28,000. In addition, the interest rate on the Note has been increased to 9%. The Note is subordinated to the indebtedness under the Loan Agreement according to an Agreement of Subordination & Assignment (the "Subordination Agreement") between Five Star Group, Inc. and JL Distributors, Inc. dated June 20, 2003. The Subordination Agreement permits the annual repayment of principal under certain circumstances. The balance of the Note was $2,800,000 as of December 31, 2005. 15 Contractual Obligations and Commitments The following table summarizes the note payable, capital lease commitments, operating lease commitments, purchase commitments and a consulting agreement as of December 31, 2005 (in thousands):
Payments due in 2006 2007-2008 2009-2010 After 2010 Total ---- --------- --------- ---------- ----- Note Payable $ 2,800 $ - $ - $ - $ 2,800 Operating lease commitments 2,716 1,761 78 - 4,555 Consulting agreements 150 13 - - 163 ------- --- ----------- ------- ----- Total $ 5,666 $ 1,774 $78 $ - $7,518
Application of Critical Accounting Policies The Company's consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Certain accounting policies have a significant impact on amounts reported in the financial statements. A summary of those significant accounting policies can be found in Note 2 to the Company's financial statements included herein. Among the significant judgments made by management in the preparation of the Company's financial statements are the determination of the allowance for doubtful accounts and adjustments of inventory valuations. These adjustments are made each reporting period in the ordinary course of accounting. As the Company carries finished goods which turn over several times a year, the Company does not record a reserve for inventory obsolescence. The Company expenses defective finished goods in the period the defect is discovered. Revenue recognition Revenue on product sales is recognized at the point in time when the product has been shipped, title and risk of loss has been transferred to the customer, and the following conditions are met: persuasive evidence of an arrangement exists, the price is fixed and determinable, and collectibility of the resulting receivable is reasonably assured. Allowances for estimated returns and allowances are recognized when sales are recorded. Valuation of accounts receivable Provisions for allowance for doubtful accounts are made based on historical loss experience adjusted for specific credit risks. Measurement of such losses requires consideration of Five Star's historical loss experience, judgments about customer credit risk, and the need to adjust for current economic conditions. The allowance for doubtful accounts as a percentage of total gross trade receivables was 3.2 % and 2.1% as of December 31, 2005 and December 31, 2004. This increase is reflective of increased credit losses projected from several insolvent customers. 16 Recent Accounting Pronouncements During December 2004, the Financial Accounting Standards Board ("FASB") issued a new standard entitled Statement of Financial Accounting Standards ("SFAS") 123R, Share-Based Payment, which would revise SFAS No. 123, Accounting for Stock Based Compensation, and amend SFAS No. 95, Statement of Cash Flows. Among other items, the new standard would require the expensing, in the financial statements, of stock options issued by the Company. The new standard will be effective for the Company January 1, 2006. As permitted under SFAS No. 123 the Company currently accounts for share-based payments to employees using Accounting Principles Board ("APB") Opinion No. 25 intrinsic value method, and as such, recognizes no compensation cost for employee stock options. Accordingly the adoption of SFAS No. 123R fair value method could have a significant impact on the Company's results of operations, although it will have no impact on the Company's overall financial position. Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. As of December 31, 2005, the Company had approximately $7.8 million of variable rate borrowings. The Company estimates that for every 1% fluctuation in general interest rates, assuming debt levels at December 31, 2005, interest expense would vary by $78,000. The Company is a party to an interest rate swap agreement designated as a cash flow hedge whereby changes in the cash flows of the swap will offset changes in the interest rate payments on the Company's variable-rate revolving loan, thereby reducing the Company's exposure to fluctuations in LIBOR. Changes in the fair value of the interest rate swap are recognized in accumulated other comprehensive income, net of income taxes. Effective July 1, 2004 through June 30, 2008, Five Star Group, Inc. will pay a fixed interest rate of 3.38% to the Lender on notional principal of $12,000,000. In return, the Lender will pay to Five Star Group, Inc. a floating rate, namely, LIBOR, on the same notional principal amount. The credit spread under the new Loan Agreement is not included in, and will be paid in addition to this fixed interest rate of 3.38%. On June 17, 2004, Five Star Group has also entered into a derivative interest rate collar transaction during the period from July 1, 2004 through June 30, 2008 on notional principal of $12,000,000. The transaction consists of an interest rate floor of 2.25%, whereas if LIBOR is below 2.25%, the Lender will pay to Five Star Group, Inc. the difference between LIBOR and 2.25%, on the same notional principal amount. The transaction also consists of an interest rate cap of 5.75%, whereas if LIBOR is above 5.75%, Five Star Group, Inc. will pay to the Lender the difference between LIBOR and 5.75%, on the same notional principal amount. 17 8. Financial Statements and Supplementary Data INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Report of Independent Registered Public Accounting Firm 20 Financial Statements: Consolidated Balance Sheets - December 31, 2005 and 2004 21 Consolidated Statements of Operations and Comprehensive Income - Years ended December 31, 2005, 2004 and 2003 22 Consolidated Statements of Changes in Stockholders' Equity - Years ended December 31, 2005, 2004 and 2003 23 Consolidated Statements of Cash Flows - Years ended December 31, 2005, 2004 and 2003 24 Notes to Consolidated Financial Statements 25 18 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Stockholders of Five Star Products, Inc.: We have audited the accompanying consolidated balance sheets of Five Star Products Inc. and subsidiaries (the "Company") as of December 31, 2005 and 2004 and the related consolidated statements of operations and comprehensive income, changes in stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2005. 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 the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Five Star Products Inc. and subsidiaries as of December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for each of the years in the three year period ended December 31, 2005, in conformity with accounting principles generally accepted in the Unites States of America. EISNER LLP New York, New York March 10, 2006 19 FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share and per share data)
December 31, December 31, 2005 2004 ---- Assets Current assets Cash $ 3 $ 4 Accounts receivable, less allowance for doubtful accounts of $480 and $306, respectively 10,594 9,622 Inventory 23,317 29,334 Deferred income taxes 172 164 Prepaid expenses and other current assets 778 172 --------- --------- Total current assets 34,864 39,296 Machinery and equipment, net 712 855 Deferred income taxes 166 178 Other assets 442 146 ---------- ---------- Total Assets $36,184 $40,475 ======= ======= Liabilities and Stockholders' Equity Current liabilities Short-term borrowings $19,764 $18,234 Note payable to NPDC 2,800 2,800 Accounts payable and accrued expenses (including due to affiliates of $64 and $37, respectively) 8,801 14,504 ----- ------ Total current liabilities 31,365 35,538 Interest rate collar 20 19 --------- --------- Total Liabilities 31,385 35,557 ------ ------ Stockholders' equity Common stock, authorized 30,000,000 shares, par value $.01 per share; 17,293,09 shares issued and 14,396,077 outstanding in 2005 and 17,293,098 shares issued and 14,310,077 outstanding in 2004 173 173 Additional paid-in capital 8,552 8,552 Accumulated deficit (3,455) (3,168) Accumulated other comprehensive income 229 61 Treasury stock, at cost (700) (700) ----------- ----------- Total stockholders' equity 4,799 4,918 --------- --------- $ 36,184 $ 40,475 ======== ========
See accompanying notes to the consolidated financial statements. 20 FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (in thousands, except per share data) Year Ended December 31,
2005 2004 2003 ---- ---- ---- Sales $ 106,451 $ 101,982 $ 95,085 Cost of goods sold (net of promotional discounts) 88,804 82,592 77,366 ------ ------ ------- Gross margin 17,647 19,390 17,719 Selling, general and administrative expenses (16,447) (16,329) (15,743) -------- -------- -------- Operating income 1,200 3,061 1,976 Other income 41 16 45 Interest expense (including amounts to affiliates of $238, $224 and $312) (1,625) (1,096) (990) ------- ------- -------- (Loss) Income before income taxes (384) 1,981 1,031 Income tax benefit (expense) 97 (841) (433) ------ --------- -------- Net (loss) income $ (287) $ 1,140 $ 598 Other comprehensive income (loss), net of tax: Change in value of cash flow hedge 290 (17) 122 Tax (expense) benefit (122) 7 51 ----------- -------- --------- Comprehensive income $ (119) $ 1,130 $ 669 ======= ======= ======= Net income per share Basic $(0.02) $0.08 $ 0.04 ======= ===== ======== Diluted $(0.02) $0.07 $ 0.04 ======= ===== ========
See accompanying notes to the consolidated financial statements. 21 FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY Years Ended December 31, 2005, 2004 and 2003 (in thousands)
Accumulated Common Additional Treasury Other Total Stock Paid-in Accumulated Stock Comprehensive Stockholders' Par Value Capital Deficit At Cost Income Equity ------------------------------------------------- ----------- ------------- ------------ ------------ ------------- ---------------- ------------------------------------------------- ----------- ------------- ------------ ------------ ------------- ---------------- Balance at December 31, 2002 $153 $8,069 $(4,906) $(35) $0 $3,281 ------------------------------------------------- ----------- ------------- ------------ ------------ ------------- ---------------- ------------------------------------------------- ----------- ------------- ------------ ------------ ------------- ---------------- Net income 598 598 Purchase of 86,000 shares of treasury stock (8) (8) Issuance of compensatory stock options 3 3 Issuance of 2,000,000 shares of common stock in payment of indebtedness to GP Strategies 20 480 500 Increase in market value of interest rate swap, net of tax 71 71 ------------------------------------------------- ----------- ------------- ------------ ------------ ------------- ---------------- ------------------------------------------------- ----------- ------------- ------------ ------------ ------------- ---------------- Balance at December 31, 2003 $173 $8,552 $(4,308) $(43) $71 $4,445 Net income 1,140 1,140 Purchase of 2,628,000 shares of treasury stock (657) (657) Decrease in market value of interest rate swap, net of tax (10) (10) ------------------------------------------------- ----------- ------------- ------------ ------------ ------------- ---------------- ------------------------------------------------- ----------- ------------- ------------ ------------ ------------- ---------------- Balance at December 31, 2004 $173 $8,552 $(3,168) $(700) $61 $4,918 Net loss (287) (287) Increase in market value of interest rate swap, net of tax 168 168 ------------------------------------------------- ----------- ------------- ------------ ------------ ------------- ---------------- ------------------------------------------------- ----------- ------------- ------------ ------------ ------------- ---------------- Balance at December 31, 2005 $173 $8,552 $(3,455) $(700) $229 $4,799 ------------------------------------------------- ----------- ------------- ------------ ------------ ------------- ---------------- ------------------------------------------------- ----------- ------------- ------------ ------------ -------------------- ---------
See accompanying notes to the consolidated financial statements. 22 FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) Year Ended December 31, ------------------------------------------------ ---------------- -------------- ----------------
2005 2004 2003 ---- ---- ---- Cash flows from operating activities: Net (loss) income $ (287) $ 1,140 $ 598 Adjustments to reconcile net (loss) income to net cash used in operating activities: Depreciation and amortization 317 293 287 Deferred income taxes (109) (86) (55) Issuance of compensatory stock options - - 3 Loss on interest rate collar 1 19 - Changes in other operating items: Accounts receivable (972) (752) (817) Inventory 6,017 (2,907) (2,763) Prepaid expenses and other current assets (621) 136 64 Accounts payable and accrued expenses (5,703) 1,538 1,298 ------- ----- ------- Net cash used in operating activities (1,357) $ (619) (1,385) ------- ------- -------- Cash flows from investing activities: Additions to machinery and equipment (174) (275) (294) ----- ----- -------- Cash flows from financing activities: Net proceeds from short-term borrowings 1,530 1,549 2,877 Repayments of note payable to GP Strategies - - (1,200) Purchase of treasury stock - (657) (8) - ----- ---------- Net cash provided by financing activities 1,530 892 1,669 ----- --- ------ Net decrease in cash (1) (2) (10) Cash at beginning of period 4 6 16 - ------- -------- Cash at end of period $3 $ 4 $ 6 == ====== ======== Supplemental disclosures of cash flow information: Cash paid during the periods for: Interest $1,613 $ 979 $ 990 ====== ===== ====== Income tax $898 $ 522 $ 530 ==== ===== ====== Non-cash financing activity: Exchange of long-term debt to GP Strategies for common stock $- $ - $ 500 == ======= ======
See accompanying notes to the consolidated financial statements. 23 FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements 34 (Continued) 1. Business and relationship with National Patent Development Corporation Five Star Products, Inc. (the "Company" or "Five Star") owns 100% of Five Star Group, Inc. which is a wholesale distributor of home decorating, hardware and finishing products in the northeastern United States. At December 31, 2005 the Company is a majority owned subsidiary of National Patent Development Corporation ("NPDC"). The Company, which was then 37.5% owned by GP Strategies Corporation ("GPS"), purchased its business from GPS in 1998 in exchange for cash and a $5,000,000 unsecured 8% note payable ("the Note"). In 2002 and 2003, GPS converted $1,000,000 principal amount of the Note into 4,272,727 shares of the Company's common stock. In 2004, the Company, through a tender offer, repurchased approximately 2,628,000 shares of its common stock. The conversion of the Note and the tender offer increased GPS' ownership in the Company to approximately 64%. On July 30, 2004, GPS contributed its ownership interest in Five Star and the Note to NPDC. On November 24, 2004, GPS completed the spin-off to its shareholders of the common stock of NPDC. 2. Summary of significant accounting policies Principles of consolidation. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Revenue recognition. Revenue on product sales is recognized at the point in time when the product has been shipped, title and risk of loss has been transferred to the customer, and the following conditions are met: persuasive evidence of an arrangement exists, the price is fixed and determinable, and collectibility of the resulting receivable is reasonably assured. Allowances for estimated returns and allowances are recognized when sales are recorded. Inventory. Inventory is valued at the lower of cost, using the first-in, first-out (FIFO) method, or market. Inventory consists solely of finished products, and includes allocated warehousing costs. Machinery and equipment. Fixed assets are carried at cost less accumulated depreciation. Major additions and improvements are capitalized, while maintenance and repairs that do not extend the lives of the assets are expensed. Gain or loss, if any, on the disposition of fixed assets is recognized currently in operations. Depreciation is calculated primarily on a straight-line basis over estimated useful lives of the assets. Shipping and handling costs. Shipping and handling costs are included as a part of selling, general and administrative expenses. These costs amounted to $4,981,000, $4,756,000 and $4,416,000 for the years ended December 31, 2005, 2004 and 2003, respectively. Advertising costs. The Company expenses advertising costs as incurred. Advertising expense was $33,000, $91,000 and $57,000 for the years ended December 31, 2005, 2004 and 2003, respectively. 24 Income taxes. Income taxes are provided for based on the asset and liability method of accounting pursuant to Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes". Under SFAS No. 109, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Use of estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates. Concentration of credit risk. Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of accounts receivable. Sales are made principally to independently owned paint and hardware stores in the northeast United States. Fair value of financial instruments. The carrying value of cash and cash equivalents, accounts receivable and accounts payable approximate estimated fair values because of short maturities. The carrying value of short term borrowings approximates estimated fair value because borrowings accrue interest which fluctuates with changes in LIBOR. The estimated fair value for the Company's $2,800,000 fixed rate note payable to NPDC approximated carrying values at December 31, 2005 and 2004, respectively, using calculations based on market rates. Derivative instruments are carried at fair value representing the amount the Company would receive or pay to terminate the derivative. Derivatives and hedging activities. SFAS No. 133, as amended, "Accounting for Derivative Instruments and Hedging Activities" requires all derivatives to be recognized in the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through earnings. If the derivative is a cash flow hedge, changes in the fair value of the derivative are recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value is immediately recognized in earnings. Changes in the fair value of the interest rate swap, which has been designated as a cash flow hedge, were recognized in other comprehensive income. Changes in the fair value of the interest rate collar are recognized in earnings (See Note 3). Recent Accounting Pronouncements. During December 2004, the Financial Accounting Standards Board ("FASB") issued a new standard entitled Statement of Financial Accounting Standards ("SFAS") 123R, Share-Based Payment, which would revise SFAS No. 123, Accounting for Stock Based Compensation, and amend SFAS No. 95, Statement of Cash Flows. Among other items, the new standard would require the expensing, in the financial statements, of stock options issued by the Company. The new standard will be effective for the Company on January 1, 2006. As permitted under SFAS No. 123 the Company currently accounts for share-based 25 payments to employees using Accounting Principles Board ("APB") Opinion No. 25 intrinsic value method, and as such, recognizes no compensation cost for employee stock options. Accordingly the adoption of SFAS No. 123R fair value method could have a significant impact on the Company's results of operations, although it will have no impact on the Company's overall financial position. The impact of adoption of SFAS No. 123R cannot be predicted at this time, because it will depend on levels of share-based payments in the future. However had the Company adopted SFAS No. 123R in prior periods, the impact of that statement would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net (loss) income and related earnings per share data shown below under "Stock-based compensation" Stock-based compensation. The Company has elected to continue to account for its stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board. Opinion No. 25 ("APB No. 25"), "Accounting for Stock Issued to Employees". Under the provisions of APB No. 25, employee compensation is measured as the excess, if any, of the quoted market price of the Company's common stock at the date of the grant over the amount an employee must pay to acquire the stock. Had the Company determined compensation cost based on the fair value method at the grant date for its stock options under SFAS No. 123, the Company's net (loss) income and per share amounts would have been changed to the pro forma amounts indicated below (in thousands, except per share amounts): Year Ended December 31, ----------------------- 2005 2004 2003 ---- ---- ---- Net (loss) income - as reported $(287) $1,140 $598 Compensation expense net of tax (11) (12) (18) ---- ---- ----- Pro forma net income $(298) $1,128 $580 ====== ====== ==== Per share data Basic - as reported $(0.02) $0.08 $0.04 Basic - pro forma $(0.02) $0.08 $0.04 Diluted - as reported $(0.02) $0.07 $0.04 Diluted - pro forma $(0.02) $0.07 $0.04 The Company did not grant any options during 2005, 2004 and 2003. Earnings per share. Basic earnings per share (EPS) is based upon the weighted average number of common shares outstanding during the period. Diluted EPS is based upon the weighted average number of common shares outstanding during the period assuming the issuance of common shares for all dilutive potential common shares outstanding. For the years ended December 31, 2005 and 2003 options outstanding to purchase approximately 1,100,000 and 1,530,000 shares of common stock, respectively, were not included in the diluted per share computation because their effect would be anti-dilutive. 26 Earnings per share (EPS) for the years ended December 31, 2005, 2004 and 2003 are computed as follows (in thousands, except per share amounts): Year ended December 31, --------------------------------------------- --------------- -------------- --------------
2005 2004 2003 ---- ---- ---- Basic EPS Net (loss) income $ (287) $ 1,140 $ 598 ------- ------- ------ Weighted average shares outstanding 14,310 14,967 15,442 ------ ------ ------ Basic (loss) earnings per share $ (0.02) $0.08 $ 0.04 -------- ----- ------- Diluted EPS Net (loss) income $ (287) $ 1,140 $ 598 ------- ------- ------ Weighted average shares outstanding 14,310 14,967 15,442 Dilutive effect of stock options 395 --- Weighted average shares outstanding, diluted 14,310 15,362 15,442 ------ ------ Diluted (loss) earnings per share $ (0.02) $0.07 $ 0.04 -------- -------
3. Short-term borrowings In 2003, the Company's wholly-owned subsidiary, Five Star Group, Inc., entered into a Loan and Security Agreement (the "Loan Agreement") with Bank of America Business Capital (formerly Fleet Capital Corporation) (the "Lender"). The Loan Agreement has a five-year term, with a maturity date of June 30, 2008. The Loan Agreement, as amended on August 1, 2005, provides for a $35,000,000 revolving credit facility, which allows Five Star Group, Inc. to borrow based upon a formula of up to 65% of eligible inventory and 85% of eligible accounts receivable, as defined therein. The interest rates under the Loan Agreement, as amended, consist of LIBOR plus a credit spread of 1.5% (6.64% at December 31, 2005) for borrowings not to exceed $15,000,000 and the prime rate (8.0% at December 31, 2005) for borrowings in excess of the above-mentioned LIBOR-based borrowings. The credit spreads can be reduced in the event that Five Star Group, Inc. achieves and maintains certain performance benchmarks. At December 31, 2005 and 2004, $19,764,000 and $18,234,000 was outstanding under the Loan Agreement and approximately $1,451,000 and $434,000 was available to be borrowed, respectively. Substantially all of the Company's assets are pledged as collateral for these borrowings. Under the Loan Agreement the Company is subject to covenants requiring minimum net worth, limitations on losses, if any, and minimum or maximum values for certain financial ratios. For the year ended December 31, 2005 the Company was not in compliance with the covenant that required a certain minimum loss/fixed charge coverage ratios, however, for the 27 period ended December 31, 2005 the Company received a waiver of default from the Lender through December 31, 2005. In connection with the Loan Agreement, Five Star Group, Inc., on June 20, 2003 entered into an interest rate swap with the lender which has been designated as a cash flow hedge. Effective July 1, 2004 through June 30, 2008, Five Star Group, Inc. will pay a fixed interest rate of 3.38% to the Lender on notional principal of $12,000,000. In return, the Lender will pay to Five Star Group, Inc. a floating rate, namely, LIBOR, on the same notional principal amount. The credit spread under the Loan Agreement is not included in, and will be paid in addition to the 3.38%. The fair value of the interest rate swap amounted to $ 395,000 at December 31, 2005 and $105,000 at December 31, 2004, and is included in other assets in the accompanying balance sheets. Changes in the fair value of the interest rate swap were recognized in other comprehensive income. On June 17, 2004, Five Star Group, Inc. has also entered an into interest rate collar transaction during the period from July 1, 2004 through June 30, 2008 on notional principal of $12,000,000. The transaction consists of an interest rate floor of 2.25%, whereas if LIBOR is below 2.25%, the Lender will pay to Five Star Group, Inc. the difference between LIBOR and 2.25%, on the same notional principal amount. The transaction also consists of an interest rate cap of 5.75%, whereas if LIBOR is above 5.75%, Five Star Group, Inc. will pay to the Lender the difference between LIBOR and 5.75%, on the same notional principal amount. Changes in the fair value of the interest rate collar, which amounted to approximately $1,000 and $19,000 during 2005 and 2004, respectively, have been charged to earnings during such years. 4. 401(k) plan The Company maintains a 401(k) Savings Plan for employees who have completed one year of service. The Savings Plan permits pre-tax contributions to the Savings Plan of 2% to 50% of compensation by participants pursuant to Section 401(k) of the Internal Revenue Code. The Company matches 40% of the participants' first 6% of compensation contributed, not to exceed an amount equivalent to 2.4% of that participant's compensation. The Savings Plan is administered by a trustee appointed by the Board of Directors of the Company and all contributions are held by the trustee and invested at the participants' directions in various mutual funds. The Company's expense associated with the Savings Plan was approximately $119,000, $123,000 and $125,000 for the years ended December 31, 2005, 2004, and 2003, respectively. 28 5. Machinery and equipment Machinery and equipment consist of the following (in thousands):
December 31, Estimated 2005 2004 useful lives ---- ---- ------------ Machinery and equipment 440 $383 5-7 years Furniture and fixtures 1,214 1,196 5 years Leasehold improvements 971 872 3-9 years --- ------ 2,625 2,451 Accumulated depreciation and amortization (1,913) (1,596) ------- ------- $712 $ 855 ==== ======
Depreciation and amortization expense for the years ended December 31, 2005, 2004, and 2003 was $317,000, $293,000 and $287,000, respectively. 6. Related party transactions (a) Management agreement NPDC provided legal, tax, business development, insurance and employee benefit administration services to the Company pursuant to a management services agreement for a fee of up to $10,000 per month. The agreement is automatically renewable for successive one-year terms unless one of the parties notifies the other in writing at least six months prior to the end of any renewal thereof. The management fee increased to $25,000 per month effective October 1, 2004. In addition the Company agreed to reimburse NPDC for $16,666 per month for Mr. Feldman's (NPDC's Chief Executive Officer) for service to the Company effective October 1, 2004. The agreement was renewed for 2006. On January 1, 2006 the management fee was reduced from $25,000 to $14,167. As a result of the spin-off of NPDC, GPS transferred to NPDC the rights and obligations under this Agreement. Fees incurred under the Agreement totaled $500,000, $215,000 and $100,000, for the years ended December 31, 2005, 2004 and 2003, respectively, and are included in selling, general and administrative expenses in the consolidated statements of operations. At December 31, 2005 and 2004, the amount due to GPS under the Agreement was $43,000 and $37,000, respectively. In addition, GPS and NPDC incurred certain expenses on behalf of Five Star, primarily involving insurance, legal and other professional expenses. Five Star reimbursed GPS and NPDC for such expense, which amounted to approximately $242,000, $239,000 and $338,000 for the years ended December 31, 2005, 2004 and 2003, respectively. 29 (b) Related party debt The Company's wholly-owned subsidiary, Five Star Group, Inc., has an unsecured note payable (the "Note") to JL Distributors, Inc., a wholly-owned subsidiary of NPDC following the spin-off of NPDC from GPS on November 24, 2004. The Note, as amended, bears interest at 8%, which is payable quarterly, and was scheduled to mature on June 30, 2005. On June 30, 2005, the Company and NPDC agreed to extend the Note for a one-year term maturing on June 30, 2006. In consideration for NPDC extending the Note, the Company paid NPDC a fee of one percent of the Note's outstanding balance or $28,000. In addition, the interest rate on the Note has been increased to 9%. The Note is subordinated to the indebtedness under the Loan Agreement (see Note 3) according to an Agreement of Subordination & Assignment (the "Subordination Agreement") between Five Star Group, Inc. and JL Distributors, Inc. dated June 20, 2003. The Subordination Agreement permits the annual repayment of principal under certain circumstances. Pursuant to the provisions of the Subordination Agreement, the Company made repayments to GPS in the aggregate amount of $1,200,000 during 2003. In addition, in 2002 and 2003, GPS also exchanged $500,000 principal amount ($1,000,000 in total) of the Note for 2,272,727 and 2,000,000 shares of the Company's common stock, respectively. In connection with the 2003 exchange, in consideration for GPS agreeing to exchange at a price of $0.25 per share, which was at a significant premium to the market price of the Company's common stock on the day prior to the approval of the transaction, the Company agreed to terminate a voting agreement and thereby GPS obtained a controlling financial interest in the Company. The balance of the Note was $2,800,000 as of December 31, 2005 and 2004. (c) Other related party transactions On February 8, 2002, the Company entered into a Consulting and Severance Agreement (the "Agreement") with Richard Grad, the former President and Chief Executive Officer of the Company. Pursuant to the Agreement, Mr. Grad will receive $145,000 per year for consulting services to be rendered to the Company and a severance fee at the rate of $5,000 per year, for a five-year period ending February 8, 2007. In addition, in August, 2002, Mr. Grad was granted options to purchase 150,000 shares of the Company's Common Stock at the quoted market price on the date of grant, which options vest annually over the term of the Agreement in equal installments. Such options were valued at an aggregate amount of $13,000. The Agreement also provided for the repurchase by the Company of 192,308 shares of the Company's Common Stock held by Mr. Grad for an aggregate purchase price of $25,000. During this five-year period, Mr. Grad is also receiving certain benefits, including medical benefits, life insurance and use of an automobile. 30 7. Income taxes The components of income tax expense (benefit) are as follows (in thousands):
----------------------------------------------- -------------- -------------- --------------- Years ended December 31, 2005 2004 2003 ----------------------------------------------- -------------- -------------- --------------- ----------------------------------------------- -------------- -------------- --------------- Current Federal $0 $703 $372 State and local 12 224 116 ---- ----- ----- Total current expense 12 927 488 ---- ----- ----- Deferred Federal (84) (67) (43) State and local (25) (19) (12) ------- ------- ------ Total deferred benefit (109) (86) (55) -------- ------- ------ Total income tax (benefit) expense $(97) $841 $433 ----- ---- ----
As of December 31, 2005 and 2004, net deferred income taxes consist of the following (in thousands): December 31, --------------------------- ------------ -------------- Deferred tax assets (liabilities) 2005 2004 ---- ---- Allowance for doubtful accounts $ 154 $ 98 Accrued compensation 5 3 Inventory 13 63 ---- ---- Total current deferred tax assets 172 164 Net operating losses 76 Machinery and equipment 240 214 Interest rate collar 8 8 Deferred compensation 36 39 Interest rate swap (158) (44) ----- ---- Total long-term deferred tax assets 202 217 Valuation allowance (36) (39) ----- ----- Net long-term deferred tax assets 166 178 --- --- Net deferred tax assets $338 $342 ==== ==== 31 A reconciliation between the Company's tax provision and the U.S. statutory rate follows (in thousands): ---------------------------------- ------------------ --------- ---------------- Years ended December 31, 2005 2004 2003 ---------------------------------- ------------------ --------- ---------------- ---------------------------------- ------------------ --------- ---------------- Tax at U.S. statutory rate $(131) $673 $350 State and local taxes net of Federal benefit (8) 135 69 Items not deductible 29 25 23 Valuation allowance adjustment (3) - - Other 16 8 (9) ------- ------ ------ Income taxes $(97) $841 $433 ===== ==== ==== Under SFAS No. 109, a valuation allowance is provided when it is more likely than not that some portion of deferred tax assets will not be realized. The valuation allowance was decreased $3,000 during 2005 and was unchanged during 2004 and 2003. 8. Stock options On January 1, 1994, the Company's Board of Directors adopted the Five Star Products, Inc. 1994 Stock Option Plan (the "Stock Option Plan"), which became effective August 5, 1994. The Stock Option Plan, as amended provides for 4,000,000 shares of Common Stock to be reserved for issuance, subject to adjustment in the event of stock splits, stock dividends, recapitalizations, reclassifications or other capital adjustments. Unless designated as "incentive stock options" intended to qualify under Section 422 of the Internal Revenue Code, options granted under the Stock Option Plan are intended to be nonqualified options. Options may be granted to any director, officer or other key employee of the Company and its subsidiaries, and to consultants and other individuals providing services to the Company. The term of any option granted under the Stock Option Plan will not exceed ten years from the date of the grant of the option and, in the case of incentive stock options granted to a 10% or greater holder in the total voting stock of the Company, three years from the date of grant. The exercise price of any option will not be less than the fair market value of the Common Stock on the date of grant or, in the case of incentive stock options granted to a 10% or greater holder in the total voting stock, 110% of such fair market value. Options granted vest 20% on date of grant with the balance vesting in equal annual installments over four years. At December 31, 2005, the Company had 1,500,000 shares of common stock reserved for future grants under the Stock Option Plan. 32 Activity relating to stock options granted by the Company:
Number of Weighted-Average Shares Exercise Price Balance at December 31, 2002 2,930,000 0.16 Cancelled (1,400,000) 0.13 ----------- Balance at December 31, 2003 1,530,000 0.19 Cancelled (430,000) 0.33 ----------- Balance at December 31, 2004 and 2005 1,100,000 0.14 ========= Exercisable at December 31,2005 980,000 0.14 =======
The following table summarizes information about the Plan's options at December 31, 2005:
Exercise Number Weighted-Average Number Weighted-Average Price Outstanding Years Remaining Exercisable Years Remaining ---------------- ----------------------- ------------------------ ------------------- ------------------------- ---------------- ----------------------- ------------------------ ------------------- ------------------------- 0.14 900,000 1.0 810,000 1.0 0.15 50,000 1.3 50,000 1.3 0.16 150,000 1.6 120,000 1.6 ---------------- ----------------------- ------------------------ ------------------- ------------------------- ---------------- ----------------------- ------------------------ ------------------- ------------------------- Total 1,100,000 1.1 980,000 1.0 ========= =======
9. Commitments and contingencies The Company has several noncancellable leases which cover real property, machinery and equipment. Such leases expire at various dates and some of them have options to extend their terms. Minimum rental obligations under long-term operating leases are indicated in the table below (in thousands). Figures for real property include estimated amounts of supplemental lease obligations, such as pro-rated assessments for property taxes or common-area expenses. Machinery and Real Property equipment Total --------------------------------------------------------------- --------------------------------------------------------------- 2006 1,779 937 2,716 2007 436 930 1,366 2008 - 395 395 2009 - 78 78 --------------------------------------------------------------- --------------------------------------------------------------- Total $2,215 $2,340 $4,555 ====== ====== ====== During 2005, 2004, and 2003, the Company incurred $3,058,000, $2,886,000 and $2,914,000, respectively, of rental expenses. GPS has guaranteed the leases for the Company's New Jersey and Connecticut warehouses, totaling approximately $1,589,000 per year through the first quarter of 2007. 33 10. Valuation and Qualifying Accounts The following is a summary of the allowance for doubtful accounts related to accounts receivable for the years ended December 31 (in thousands): 2005 2004 2003 ---- ---- ---- Balance at beginning of year $ 306 $702 $640 Charged to expense 147 91 107 Uncollectible accounts written off, net of recoveries 27 (487) (45) -- ------ --- Balance at end of year $ 480 $306 $702 ===== ==== ==== 11. Accounts payable and accrued expenses Accounts payable and accrued expenses are comprised of the following at December 31, 2005 and 2004 (in thousands): December 31, 2005 2004 Accounts payable $6,290 $11,597 Accrued expenses 1,400 1,313 Due to NPDC/GPS 64 37 Other 1,047 1,557 ----- ----- $8,801 $14,504 34 FIVE STAR PRODUCTS, INC. AND SUBSIDIARIES 35 Selected Quarterly Financial Data (unaudited) The following is a summary of the quarterly results of operations for the years ended December 31, 2005 and 2004 (in thousands, except per share data): March 31 June 30 September 30 December 31
-------- ------- ------------ ----------- 2005: Sales $ 28,239 $ 29,579 $ 26,899 $ 21,734 Cost of goods sold 23,835 23,975 23,470 17,524 Gross margin 4,404 5,604 3,429 4,210 Net income (loss) 19 419 (691) (34) Earnings (loss) per share: Basic $0.00 $0.03 $(0.05) $0.00 Diluted $0.00 $0.03 $(0.05) $0.00 2004 Sales $ 26,991 $ 27,302 $ 26,678 $ 21,011 Cost of goods sold 22,522 22,362 21,934 15,774 Gross margin 4,469 4,940 4,744 5,237 Net income (loss) 259 244 126 511 Earnings (loss) per share: Basic $0.02 $0.01 $0.01 $0.04 Diluted $0.02 $0.01 $0.01 $0.03
35 ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None ITEM 9A. Controls and Procedures "Disclosure controls and procedures" are the controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports filed or submitted by it under the Securities Exchange Act of 1934, as amended (the "Exchange Act") is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. These controls and procedures are designed to ensure that information required to be disclosed by an issuer in its Exchange Act reports is accumulated and communicated to the issuer's management, including its principal executive and financial officers, as appropriate, to allow timely decisions regarding required disclosure. Under the supervision and with the participation of the Company's Chief Executive Officer and Chief Financial Officer, the Company carried out an evaluation of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to the Exchange Act Rule 13a-15(e) as of December 31, 2005. Based upon the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective as of the end of the period covered by this report. During the year ended December 31, 2005, there were no changes in the Company's internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the internal control over financial reporting. 36 PART III Item 10. Directors and Executive Officers of the Registrant Jerome I. Feldman has been Chairman of the Board of the Company since 1994. In 1959 he founded GP Strategies Corporation ("GPS"), a global provider of training and e-Learning solutions. He has been a director of GSE Systems, Inc., ("GSE"), a real-time simulations company since 1994 and Chairman of the Board of GSE since 1997, Chairman of the Board and Chief Executive Officer of NPDC since August 2004 and a director of Valera Pharmaceuticals, Inc. since January 2005. Mr. Feldman is also Chairman of the New England Colleges Fund and a Trustee of the Northern Westchester Hospital Foundation. Age 77 Charles Dawson has been President of the Company and of Five Star Group, Inc. ("Five Star") since 2002 and Vice President and a director of the Company since 1999. Since 1993 Mr. Dawson has held several managerial positions with Five Star. Age 50 Bruce Sherman has been Executive Vice President, Sales of the Company and of Five Star since 2002, Vice President and a director of the Company since 1999 and Vice President of Sales of Five Star since 1993. He is a member of the New York and New Jersey Paint and Decorating Association. Age 53 Steven Schilit has been Executive Vice President, Chief Operating Officer of the Company and of Five Star since 2002, Vice President and a director of the Company since 1999 and since 1981 has held several executive positions with Five Star. Age 59 John Moran has been a director of the Company since 2002. He is Chief Executive Officer of GSE and a director of GSE since November 2003 and had been Vice President of GPS since 2001, President and Chief Executive Officer of GP e-Learning Technologies, Inc. from 2000 to 2001 and from 1994 to 2000 he was Group President, Training and Technologies Group of General Physics Corporation. Age 55 Carll Tucker has been a director of the Company since 2002. In 1986 he founded Trader Publications and was its President until 1999, which published The Patent Trader newspaper and various local magazines, newsletters and programs for cultural institutions in Westchester, Putnam and Fairfield counties. Trader Publications was sold to Gannett Corporation in 1999. Mr. Tucker is the author of a weekly newspaper column in the Westchester Patent Trader, "Looseleaves", since 1983. Mr. Tucker is also a Trustee of Northern Westchester Hospital Center and was its Chairman of the Board from 1999-2001. Age 53 Compliance with Section 16(a) of the Exchange Act Section 16(a) of the Exchange Act requires the Company's officers and directors, and persons who own more than 10% of a registered class of the 37 Company's securities, to file reports of ownership and changes in ownership with the SEC and to furnish copies of such reports to the Company. Based solely on its review of copies of such reports for 2005, the Company believes that during 2005, all reports applicable to its officers, directors and greater than 10% beneficial owners were filed on a timely basis. Audit Committee The Company has established an Audit Committee of the Board of Directors consisting of Carll Tucker. The Board of Directors has determined that Mr. Tucker qualifies as an "audit committee financial expert" under applicable SEC regulations and satisfies the independence requirements of the SEC. Code of Ethics The Company has adopted a Code of Ethics for directors, officers, and employees of the Company and its subsidiaries, including but not limited to the principal executive officer, the principal financial officer, the principal accounting officer or controller, or persons performing similar functions for the Company and its subsidiaries. The Code of Ethics and Conduct of Business Policy is available on the Company's website at www.fivestargroup.com. A copy of this Code of Business Conduct and Ethics is also incorporated by reference into this report as Exhibit 14.1. If the Company makes any substantive amendment to the Code of Ethics or grants any waiver from a provision of the Code of Ethics for its executive officers or directors, the Company will disclose the nature of such amendment or waiver on its website at www.fivestargroup.com. The Company will also provide a copy of such Code of Ethics and Code of Business Policy to any person upon written request made to the Company's Secretary in writing to the following address: Five Star Products, Inc., Attn: Secretary, 777 Westchester Avenue, White Plains, NY 10604, with a copy to Five Star Products, Inc., General Counsel at the same address. 38 Item 11. Executive Compensation Executive Compensation The following table and notes present the aggregate compensation paid by the Company's subsidiary, Five Star, to its President and to the Company's other executive officers for services rendered to Five Star in 2005. SUMMARY COMPENSATION TABLE Annual Compensation Salary Bonus All Other Name and Principal Position Year ($) ($) ($) --------------------------- ---- --- --- --- Charles Dawson 2005 265,460 120,000(1) 1,804((2)) President 2004 251,933 55,000 1,170((2)) 2003 234,018 40,000 695((2)) Steven Schilit 2005 236,080 120,000(1) 9,890((3)) Executive Vice President and 2004 211,140 55,000 8,181((3)) Chief Operating Officer 2003 212,027 40,000 5,968((3)) Bruce Sherman 2005 259,584 120,000(1) 9,176((4)) Executive Vice President 2004 219,013 55,000 6,842((4)) Sales 2003 232,173 40,000 5,748((4)) (1) Bonus were accrued on December 31, 2004 and paid in 2005 pursuant to the term of the Employment Agreement. See "Executive Compensation - Employment Agreements"). (2) Consists of executive life insurance premiums. (3) Consists of $6,378, $5,200 and $4800 as matching contributions made by the Company to the 401(k) Savings Plan for 2005, 2004 and 2003, respectively, and $3,512, $2,981, and $1,168 for executive life insurance premiums for 2005, 2004 and 2003, respectively. (4) Consists of $6,737, $5,088 and $4,800 as matching contributions made by the Company to the 401(k) Savings Plan for 2005, 2004 and 2003 respectively, and $2,438, $1,754 and $948 for executive life insurance premiums for 2005, 2004 and 2003, respectively. Option Grants in 2005 No options were granted to the named executive officers in 2005. 39 Aggregate Option Exercises in 2005 And Fiscal Year-End Option Values The following table and note contain information concerning the exercise of stock options under the Plan during 2005 and unexercised options under the Plan held at the end of 2005 by the named executive officers. Unless otherwise indicated, options are to purchase shares of Common Stock.
Number of Value of Securities Unexercised Underlying In-the-Money Shares Acquired Unexercised Options at on Value Options at 12/31/2005 12/31/2005 ($) -- ----- ---------------------- -------------- Name Exercise ($) Realized ($) Exercisable Unexercisable Exercisable Unexercisable ---- ------------ ------------ ----------- ------------- ----------- ------------- Charles Dawson -0- -0- 150,000 - $6,000 - Steven Schilit -0- -0- 150,000 - $6,000 - Bruce Sherman -0- -0- 150,000 - $6,000 - ----------------- ----------------- ------------------ ------------------- --------------- ---------------- ----------------- ----------------- ------------------ ------------------- --------------- ---------------- -0- -0- 450,000 - $18,000 - ----------------- ----------------- ------------------ ------------------- --------------- ----------------
(1) Calculated based on $0.18, which the closing price of the Common Stock as was quoted on the OTC Bulletin Board on December 31, 2005, which is operated by the NASDAQ Stock Market. Directors Compensation During 2005, directors who were not employees of the Company or its subsidiaries received $1,500 for each meeting of the Board of Directors attended, and generally do not receive any additional compensation for service on the committees of the Board of Directors except for Carll Tucker who received $25,000 for serving on the Audit Committee. Employees of the Company or its subsidiaries do not receive additional compensation for serving as directors. Employment Agreements Charles Dawson. As of November 28, 2001, Charles Dawson and Five Star Group, Inc. entered into an employment agreement pursuant to which Mr. Dawson is employed as President of the Company for a period commencing January 1, 2002 until December 31, 2005, (the "Employment Term"), unless sooner terminated. The Employment Agreement expired on December 31, 2005. Commencing January 1, 2002, Mr. Dawson's base salary is $225,000, with annual increases of at least 3% effective on the second year of the Employment Term. Mr. Dawson will receive a target bonus of $100,000, calculated based upon the following two components: (1) earnings growth of the Company, and (2) an achievement of certain Company goals, weighted 75% and 25% respectively. Mr. Dawson's target bonus for the years 2004 and 2005, was $120,000, and $130,000, 40 respectively, which was be determined by components and weighting factors based upon the goals and objectives of the Company, mutually agreed upon. Pursuant to the employment agreement, on November 28, 2001 the Company granted Mr. Dawson under the Company's option plan, options to purchase 150,000 shares of the Company's Common Stock at an exercise price of $0.14 per share. Such options vest 20% immediately and 20% on each November 28, commencing November 28, 2001 and terminating on November 28, 2006. The Company is also required to provide Mr. Dawson with an automobile. The Company may terminate the employment agreement for cause which is defined as (i) breach by Mr. Dawson of any of the terms of the employment agreement, provided that the Company has given fifteen days notice prior to termination for any breach of any of the terms of the employment agreement which are capable of cure, (ii) gross neglect by Mr. Dawson of his duties continuing for 30 days after written warning issued to Mr. Dawson setting forth the conduct constituting such gross neglect, (iii) conviction of Mr. Dawson for any felony or any crime involving moral turpitude; (iv) the conviction of Mr. Dawson of any offense involving the property of the Company or any of its affiliates; (v) the commission by Mr. Dawson of any act of fraud or dishonesty; (vi) the engagement by Mr. Dawson in misconduct resulting in serious injury to the Company, or (vii) the physical or mental disability of Mr. Dawson, whether totally or partially, if he is unable to perform substantially his duties for a period of (i) two consecutive months or (ii) shorter periods aggregating three months during any twelve month period, such termination to be effective thirty days after written notice of such decision delivered to Mr. Dawson. If Mr. Dawson is terminated for cause, he shall not be entitled to any compensation, including without limitation, the bonus, if any, after the date of termination for the year in which the termination takes place. If Mr. Dawson's employment is terminated by his death or disability, the Company is required to pay Mr. Dawson his base salary then in effect for the month during which termination occurred, and four months thereafter. In the event that termination occurs more than six months after the start of the then-current contract year, Mr. Dawson shall receive a bonus for that year prorated through the date of termination. If the Company terminates the employment agreement for any reason, other than those set forth in the employment agreement, the Company is obligated to continue to pay Mr. Dawson's base salary as then in effect for the period commencing from the date of termination and ending on the termination date of the employment agreement and shall only be obligated to pay the Bonus, if any, through the date of termination on a pro rata basis. Bruce Sherman As of November 28, 2001, Bruce Sherman and Five Star Group, Inc. entered into an employment agreement pursuant to which Mr. Sherman is employed as Executive Vice President, Sales of the Company for a period commencing January 1, 2002 until December 31, 2005, (the "Employment Term"), unless sooner terminated. The employment Agreement expired on December 31, 2005. Commencing January 1, 2002, Mr. Sherman's base salary is $220,000, with annual increases of at least 3% effective on the second year of the Employment Term. Mr. Sherman will receive a target bonus of $100,000, calculated based upon the following two components: (1) earnings growth of the Company, and (2) an achievement of certain Company goals, weighted 75% and 25% respectively. Mr. Sherman's target bonus for the years 2004 and 2005, was $120,000, and $130,000, 41 respectively, which was determined by components and weighting factors based upon the goals and objectives of the Company, mutually agreed upon. Pursuant to the employment agreement, on November 28, 2001 the Company granted Mr. Sherman under the Company's option plan, options to purchase 150,000 shares of the Company's Common Stock at an exercise price of $0.14 per share. Such options vest 20% immediately and 20% on each November 28, commencing November 28, 2001 and terminating on November 28, 2006. The Company is also required to provide Mr. Sherman with an automobile. The Company may terminate the employment agreement for cause which is defined as (i) breach by Mr. Sherman of any of the terms of the employment agreement, provided that the Company has given fifteen days notice prior to termination for any breach of any of the terms of the employment agreement which are capable of cure, (ii) gross neglect by Mr. Sherman of his duties continuing for 30 days after written warning issued to Mr. Sherman setting forth the conduct constituting such gross neglect, (iii) conviction of Mr. Sherman for any felony or any crime involving moral turpitude; (iv) the conviction of Mr. Sherman of any offense involving the property of the Company or any of its affiliates; (v) the commission by Mr. Sherman of any act of fraud or dishonesty; (vi) the engagement by Mr. Sherman in misconduct resulting in serious injury to the Company, or (vii) the physical or mental disability of Mr. Sherman, whether totally or partially, if he is unable to perform substantially his duties for a period of (i) two consecutive months or (ii) shorter periods aggregating three months during any twelve month period, such termination to be effective thirty days after written notice of such decision delivered to Mr. Sherman. If Mr. Sherman is terminated for cause, he shall not be entitled to any compensation, including without limitation, the bonus, if any, after the date of termination for the year in which the termination takes place. If Mr. Sherman's employment is terminated by his death or disability, the Company is required to pay Mr. Sherman his base salary then in effect for the month during which termination occurred, and four months thereafter. In the event that termination occurs more than six months after the start of the then-current contract year, Mr. Sherman shall receive a bonus for that year prorated through the date of termination. If the Company terminates the employment agreement for any reason, other than those set forth in the employment agreement, the Company is obligated to continue to pay Mr. Sherman's base salary as then in effect for the period commencing from the date of termination and ending on the termination date of the employment agreement and shall only be obligated to pay the Bonus, if any, through the date of termination on a pro rata basis. Steven Schilit As of November 28, 2001, Steven Schilit and Five Star Group, Inc. entered into an employment agreement pursuant to which Mr. Schilit is employed as Executive Vice President and Chief Operating Officer of the Company for a period commencing January 1, 2002 until December 31, 2005, (the "Employment Term"), unless sooner terminated. The employment Agreement expired on December 31, 2005. Commencing January 1, 2002, Mr. Schilit's base salary is $200,000, with annual increases of at least 3% effective on the second year of the Employment Term. Mr. Schilit will receive a target bonus of $100,000, calculated based upon the following two components: (1) earnings growth of the Company, and (2) an achievement of certain Company goals, weighted 75% and 25% respectively. Mr. 42 Schilit's target bonus for the years 2004 and 2005, was be $120,000, and $130,000, respectively, which was determined by components and weighting factors based upon the goals and objectives of the Company, mutually agreed upon. Pursuant to the employment agreement, on November 28, 2001 the Company granted Mr. Schilit under the Company's option plan, options to purchase 150,000 shares of the Company's Common Stock at an exercise price of $0.14 per share. Such options vest 20% immediately and 20% on each November 28, commencing November 28, 2001 and terminating on November 28, 2005. The Company is required also to provide Mr. Schilit with an automobile. The Company may terminate the employment agreement for cause which is defined as (i) breach by Mr. Schilit of any of the terms of the employment agreement, provided that the Company has given fifteen days notice prior to termination for any breach of any of the terms of the employment agreement which are capable of cure, (ii) gross neglect by Mr. Schilit of his duties continuing for 30 days after written warning issued to Mr. Schilit setting forth the conduct constituting such gross neglect, (iii) conviction of Mr. Schilit for any felony or any crime involving moral turpitude; (iv) the conviction of Mr. Schilit of any offense involving the property of the Company or any of its affiliates; (v) the commission by Mr. Schilit of any act of fraud or dishonesty; (vi) the engagement by Mr. Schilit in misconduct resulting in serious injury to the Company, or (vii) the physical or mental disability of Mr. Schilit, whether totally or partially, if he is unable to perform substantially his duties for a period of (i) two consecutive months or (ii) shorter periods aggregating three months during any twelve month period, such termination to be effective thirty days after written notice of such decision delivered to Mr. Schilit. If Mr. Schilit is terminated for cause, he shall not be entitled to any compensation, including without limitation, the bonus, if any, after the date of termination for the year in which the termination takes place. If Mr. Schilit's employment is terminated by his death or disability, the Company is required to pay Mr. Schilit his base salary then in effect for the month during which termination occurred, and four months thereafter. In the event that termination occurs more than six months after the start of the then-current contract year, Mr. Schilit shall receive a bonus for that year prorated through the date of termination. If the Company terminates the employment agreement for any reason, other than those set forth in the employment agreement, the Company is obligated to continue to pay Mr. Schilit's base salary as then in effect for the period commencing from the date of termination and ending on the termination date of the employment agreement and shall only be obligated to pay the Bonus, if any, through the date of termination on a pro rata basis. 43 Item 12. Security Ownership of Certain Beneficial Owners and Management PRINCIPAL STOCKHOLDERS The following table sets forth certain information as of March 15, 2006, with respect to shares of Common Stock which are beneficially owned by (a) each person who owns more than 5% of the Company's Common Stock, (b) each director of the Company, (c) each of the persons named in the Summary Compensation Table and (d) all executive officers and directors of the Company as a group. Beneficial Ownership Number of Percentage Name and Address Common Shares of Class National Patent Development Corporation 9,133,417(1) 63.8% 777 Westchester Avenue White Plains, NY 10604 Jerome I. Feldman 150,000(2) * Charles Dawson 150,000(2) * Bruce Sherman 150,000((2)) * Steven Schilit 150,000((2)) * John Moran 150,000((2)) * Carll Tucker 50,000((2)) * All directors and executive officers as a group (6 persons) 800,000((2)) 5.3% -------------- * The number of shares owned is less than one percent of the outstanding shares of Common Stock. (1) See "Certain Relationships and Related Transactions." (2) Includes 150,000 shares of Common Stock issuable upon exercise of currently exercisable stock options held by each of Messrs. Feldman, Dawson, Sherman, Schilit, Moran, and 50,000 shares of Common Stock issuable upon exercise of currently exercisable stock options held by Mr. Tucker, and 800,000 shares for all executives and officers as a group. 44 EQUITY COMPENSATION PLAN INFORMATION The following is information as of December 31, 2005 about shares of Company Common Stock that may be issued upon exercise of options under the Company's Non-Qualified Stock Option Plan. For a description of the material terms of the Company's Non-Qualified Stock Option Plan, see Note 8 to the Notes to the Consolidated Financial Statements included in the Company's Annual Report for the year ended December 31, 2005.
------------------------------- ---------------------------- ------------------------- --------------------------------- Plan category Number of securities Weighted-average Number of securities Non-Qualified to be issued upon exercise price of remaining available for Stock Option Plan exercise of outstanding options, future issuance under outstanding options, warrants and rights equity compensation warrants and rights plans (excluding securities reflected in column(a) (a) (b) (c) ------------------------------- ---------------------------- ------------------------- --------------------------------- ------------------------------- ---------------------------- ------------------------- --------------------------------- Equity compensation (outstanding options) (weighted average number of options left plans not approved price) by security holders 1,100,000 $0.14 1,500,000 ------------------------------- ---------------------------- ------------------------- --------------------------------- ------------------------------- ---------------------------- ------------------------- --------------------------------- Total 1,100,000 $0.14 1,500,000 ------------------------------- ---------------------------- ------------------------- ---------------------------------
Item 13. Certain Relationships and Related Transactions On September 30, 1998, the Company purchased its business from GP Strategies Corporation ("GPS"), for approximately $16,500,000 in cash and a five year, 8%, $5,000,000 unsecured promissory note (the "Note"). The maturity of the Note was scheduled to mature on June 30, 2005 and was further extended until June 30, 2006. On August 2, 2002 the Company entered into a transaction to reduce its long-term debt to GPS. The principal amount of the Note was reduced by $500,000 to $4,500,000. In connection with this debt reduction, GPS received 2,272,727 shares of the Company's common stock. The transaction valued the Company's common stock at $0.22 per share, which was a premium to the open market value at that time. As a result of this transaction, GPS' ownership of the Company increased to approximately 48% from approximately 37% of the Company's outstanding shares of common stock. On October 8, 2003, GPS exchanged $500,000 principal amount of the Note for 2,000,000 shares of the Company's common stock, reducing the outstanding principal amount of the Note to $3,000,000 (as described below) and increasing GPS' ownership of the Company's common stock to approximately 54% of the then outstanding shares. In consideration for GPS agreeing to exchange the debt for common stock at a conversion price of $0.25 per share, which was more than twice the $0.11 closing market price of the Company's common stock on the day prior to approval of the transaction, the Company agreed to terminate the voting agreement between the Company and GPS. The voting agreement, which by its terms would in any case have terminated on June 30, 2004, provided that GPS (i) would vote its shares of the Company's common stock so that not more than 50% of the members of the Company's board of directors would be officers or directors of 45 the Company and (ii) would vote on matters other than the election of directors in the same proportion as the Company's other shareholders. The transaction was approved by a Special Committee of Company's board of directors; the Special Committee consisted of an independent non-management director who is unaffiliated with the Company. On June 20, 2003, GPS entered into an Agreement of Subordination and Assignments (the "Subordination Agreement") with the Company and its lenders that permits the annual repayment of principal on the Note. Pursuant to the provisions of the Subordination Agreement, in 2004 GPS received partial repayment from the Company in the amount of $1,200,000, which along with the exchange transaction described above reduced the outstanding principal amount of the Note from $4,500,000 to $2,800,000. On July 30, 2004, GPS contributed its ownership interest in the Company and the Note to NPDC. On November 24, 2004, GPS completed the spin-off of the common stock NPDC. The Note, as amended, bore interest at 8%, payable quarterly, and matured on June 30, 2005. On June 30, 2005 the Company and NPDC agreed to extend the Note for a one-year term maturing on June 30, 2006. In consideration for NPDC extending the Note, the Company paid NPDC a fee of one percent of the Note's outstanding balance or $28,000. In addition, the interest rate on the Note has been increased to 9%. The Note is subordinated to the indebtedness under the Loan Agreement according to an Agreement of Subordination & Assignment (the "Subordination Agreement") between Five Star Group, Inc. and JL Distributors, Inc. dated June 20, 2003. The Subordination Agreement permits the annual repayment of principal under certain circumstances. The balance of the Note was $2,800,000 as of December 31, 2005. On February 6, 2004, the Company announced an issuer tender offer through which it would repurchase up to 5,000,000 shares, or approximately 30% of its common stock currently outstanding, at $0.21 per share, originally set to expire on March 16, 2004. On March 17, 2004, the Company announced that it had increased the price it was offering to pay for the shares in the tender offer to $0.25 per share and extended the offer to March 31, 2004. Based on the final tabulation by the depositary for the tender offer, approximately 2,628,000 shares of common stock were tendered and acquired by the Company. The effect of the tender offer and the exchange transactions described above was to increase GPS' ownership in the Company to approximately 64%. If, following the tender offer, GPS were to increase its ownership to at least 80% of Five Star's common stock, Five Star would become, for federal tax purposes, part of the affiliated group of which GPS is the common parent. As a member of such affiliated group, Five Star would be included in GPS's consolidated federal income tax returns, Five Star's income or loss would be included as part of the income or loss of the affiliated group and any of Five Star's income so included might be offset by the consolidated net operating losses, if any, of the affiliated group. The agreement between GPS and Five Star also provided that, if Five Star became a member of the affiliated group, GPS and Five Star would enter into a tax sharing agreement pursuant to which Five Star would make tax sharing payments to GPS equal to 80% of the amount of taxes Five Star would pay if Five Star were to file separate consolidated tax returns but did not pay as a result of being included in GPS affiliated group. As a 46 result of the spin-off of NPDC, which held GPS's interest in Five Star, NPDC would enter into such tax sharing agreement in lieu of GPS. GPS has guaranteed the leases for Five Star's New Jersey and Connecticut warehouses and leases for certain equipment, totaling approximately $1,589,000 per year through the first quarter of 2007. GPS's guarantee of such leases was in effect when the Company's business was conducted by a wholly-owned subsidiary of GPS. In 1998, GPS sold substantially all of the operating assets of the Five Star business to the predecessor corporation of the Company. As part of this transaction, the landlord of the New Jersey and Connecticut facilities and the lessor of the equipment did not consent to the release of GPS's guarantee. GPS's guarantees have continued after the Spin-Off. Five Star's White Plains, New York office space is provided by GPS pursuant to the Management Services Agreement described below. John Moran, the Chief Executive Officer of GSE and a former executive of the GPS, is a director of the Company and Andrea D. Kantor, the Executive Vice President and General Counsel of GPS, is also the General Counsel of the Company. NPDC provided legal, tax, business development, insurance and employee benefit administration services to the Company pursuant to a management services agreement for a fee of up to $10,000 per month. The agreement is automatically renewable for successive one-year terms unless one of the parties notifies the other in writing at least six months prior to the end of any renewal thereof. The agreement was renewed for 2006. The management fee increased to $25,000 per month effective October 1, 2004. In addition the Company agreed to reimburse NPDC for $16,666 per month for Mr. Feldman's (NPDC's Chief Executive Officer) for service to the Company effective October 1, 2004. On January 1, 2006 the management fee was reduced from $25,000 to $14,167. As a result of the spin-off of NPDC, GPS transferred to NPDC the rights and obligations under this Agreement. Fees incurred under the Agreement totaled $500,000, $215,000 and $100,000, for the years ended December 31, 2005, 2004 and 2003, respectively. At December 31, 2004, the amount due to GPS under the Agreement which is included in accounts payable and accrued expenses was $37,000. At December 31, 2005, the amount due to NPDC under the Agreement was $43,000, which is included in accounts payable and accrued expenses. In addition, GPS and NPDC incurred certain expenses on behalf of Five Star, primarily involving insurance, legal and other professional expenses. Five Star reimbursed GPS and NPDC for such expense, which amounted to approximately $242,000, $239,000 and $338,000 for the years ended December 31, 2005, 2004 and 2003, respectively. 47 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Independent Auditors Fees The following table sets forth the fees billed to the Company for the fiscal years ended December 31, 2005 and 2004 for professional services rendered by the Company's independent auditors, Eisner LLP: December 31, December 31, 2005 2004 ---- ---- Audit Fees(a)......................$107,000. $100,000 Audit-Related Fees(b)................$.0.... $ 10,000 Tax Fees 0 0 All other Fees.........................0... 0 ---------- (a) Audit fees consisted principally of fees for the audit of the annual financial statements and reviews of the condensed consolidated financial statements included in the Company's quarterly reports on Form 10-Q and review of registration statements. (b) Audit-related fees consisted of the audit of the financial statements of the Company's employee benefit plan. Policy on Pre-Approval of Services Provided by Independent Auditor Pursuant to the requirements of the Sarbanes-Oxley Act of 2002, the terms of the engagement of Eisner LLP are subject to specific pre-approval policies of the Audit Committee. All audit and permitted non-audit services to be performed by Eisner LLP require pre-approval by the Audit Committee in accordance with pre-approval policies established by the Audit Committee. The procedures require all proposed engagements of Eisner LLP for services of any kind be directed to the Company's General Counsel and then submitted for approval to the Audit Committee prior to the beginning of any service. 48 PART IV Item 15. Exhibits, Financial Statement Schedules (a)(1) The following financial statements are included in Part II, Item 8: Page Report of Independent Registered Public Accounting Firm 20 Financial Statements: Consolidated Balance Sheets - December 31, 2005 and 2004 21 Consolidated Statements of Operations and Comprehensive Income - Years ended December 31, 2005, 2004 and 2003 22 Consolidated Statements of Changes in Stockholders' Equity - Years ended December 31, 2005, 2004 and 2003 23 Consolidated Statements of Cash Flows - Years ended December 31, 2005, 2004 and 2003 24 Notes to Consolidated Financial Statements 25 (a)(2) Schedules have been omitted because they are not required or are not applicable, or the required information has been included in the financial statements or the notes thereto. (a)(3) See accompanying Index to Exhibits 49 SIGNATURE 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. FIVE STAR PRODUCTS, INC. Charles Dawson, President Dated: March 31, 2005 Signature Title Charles Dawson President, and Director (Principal Executive and Operating Officer) Jerome I. Feldman Chairman of the Board Bruce Sherman Executive Vice President, Sales and Director Steven Schilit Executive Vice President, Chief Operating Officer and Director Neal W. Collins Chief Financial Officer (Principal Financial and Accounting Officer) John Moran Director 50 INDEX TO EXHIBITS Exhibit No. Document 3. Amended Certificate of Incorporation of the Registrant. Incorporated herein by reference to Exhibit 3 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1996. 3.1 Amended By-laws of the Registrant. Incorporated herein by reference to Exhibit 3.1 of the Registrant's Annual Report on Form 10-K/A for the year ended December 31, 2003. 10. 1994 Stock Option Plan of the Registrant as amended on January 1, 2002. Incorporated herein by reference to Exhibit 10 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 2001. 10.1 Management Services Agreement, dated as of August 5, 1994, between GP Strategies Corporation and the Registrant. Incorporated herein by reference to Exhibit 10.3 of the Registrant's Registration Statement on Form S-1 filed on July 22, 1994, Registration Statement No. 33-78252. 10.2 Lease dated as of February 1, 1986 between Vernel Company and Five Star Group, Inc., as amended on July 25, 1994. Incorporated herein by reference to Exhibit 10.6 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1998. 10.3 Lease dated as of May 4, 1983 between Vornado, Inc., and Five Star Group, Inc. Incorporated herein by reference to Exhibit 10.7 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1998. 10.4 Lease Modification and Extension Agreement dated July 6, 1996 between Hanover Public Warehousing, Inc. and Five Star Group, Inc. Incorporated herein by reference to Exhibit 10.8 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1998. 10.5 Agreement between Five Star Group and Local No. 11 affiliated with International Brotherhood of Teamsters dated December 12, 2000. Incorporated herein by reference to Exhibit 10.7 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 2000. 10.6 Memorandum of Agreement by and between Five Star Group and Teamsters Local 11, affiliated with International Brotherhood of Teamsters dated December 12, 2003. Incorporated herein by reference to Exhibit 10.7 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 2003. 51 10.7 Loan and Security Agreement dated as of June 20, 2003 by and between the Registrant, as Borrower and Fleet Capital as Lender. Incorporated herein by reference to Exhibit 10.1 of the Registrant's Form 10-Q for the quarter ended June 30, 2003. 10.8 Agreement of Subordination & Assignment dated as of June 20, 2003 by JL Distributions, Inc., as Creditor in favor of Fleet Capital Corporation as Lender to Five Star Group, Inc. as Debtor. Incorporated herein by reference to Exhibit 10.2 of the Registrant's Form 10-Q for the quarter ended June 30, 2003. 10.9 First Modification Agreement dated as of May 28, 2004 by and between Five Star Group, Inc. as borrower and Fleet Capital Corporation, as Lender. Incorporated herein by reference to Exhibit 10.11 of the Registrant;s Form 10-K for the year ended December 31, 2004. 10.10 Second Modification Agreement dated as of March 22, 2005 by and between Five Star Group, Inc. as borrower and Fleet Capital Corporation, as Lender. Incorporated herein by reference to Exhibit 10.12 of the Registrant's Form 10-K for the year ended December 31, 2004. 10.11 Third Modification Agreement dated as of June 1, 2005 by and between Five Star Group, as borrower and fleet Capital Corporation, as Lender. Incorporated herein by reference to Exhibit 10.1 of the Registrant's Form 10-Q for the second quarter ended June 30, 2005. 10.12 Fourth Modification Agreement dated September 26, 2005, but effective as of August 1, 2005 by and between Five Star Group, Inc. as borrower and Fleet Capital Corporation, as Lender. Incorporated herein by reference to Exhibit 10.1 of the Registrant's Form 10-Q for the third quarter ended September 30, 2005. 10.13 Fifth Modification Agreement dated November 14, 2005 -Waiver of minimum Fixed Charge Coverage Ratio requirement for the three months ended September 30, 2005 by and between Five Star Group, Inc. as borrower and Fleet Capital Corporation, as Lender. Incorporated herein by reference to Exhibit 10.2 of the Registrant's Form 10-Q for the third quarter ended September 30, 2005. 10.14 Sixth Modification Agreement dated March 23, 2006 - Waiver of Fixed Charge Coverage for the fiscal quarter and fiscal year ending December 31, 2005 by and between Five Star Group, Inc. as borrower and Fleet Capital Corporation, as Lender.* 10.15 Amended Note in the amount fo $2,800,000 dated June 30, 2005 between the Registrant and National Patent Development Corporation. Incorporated herein by reference to Exchibit 10.2 of the Registrant's Form 10-Q for the second quarter ended June 30, 2005. 52 10.16 Consulting and Severance Agreement dated as of February 8, 2002 between the Registrant and Richard Grad. Incorporated herein by reference to Exhibit 10.11 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 2001. 10.17 Employment Agreement dated as of November 28, 2001 between the Registrant and Charles Dawson. Incorporated herein by reference to Exhibit 10.12 of the Registrant's Annual Repot on Form 10-K for the year ended December 31, 2001. 10.18 Employment Agreement dated as of November 28, 2001 between the Registrant and Bruce Sherman. Incorporated herein by reference to Exhibit 10.13 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 2001. 10.19 Employment Agreement dated as of November 28, 2001 between the Registrant and Steven Schilit. Incorporated herein by reference to Exhibit 10.14 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 2001. 10.20 Agreement dated as of January 22, 2004, between the Company and GP Strategies Corporation. Incorporated herein by reference to Exhibit 99(d) of the Registrant Schedule TO filed on February 6, 2004. 10.21 Tax Sharing Agreement dated as of February 1, 2004 between Registrant and GP Strategies Corporation. Incorporated herein by reference to Exhibit 10.19 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 2003. 14.1 Code of Ethics Policy. Incorporated herein by reference to Exhibit 14.1 of the Registrant's Annual Report on Form 10-K/A for the year ended December 31, 2003 21. Subsidiaries* 22. N/A 31.1 Certification of Chief Executive Officer* 31.2 Certification of Chief Financial Officer* 32.1 Certification Pursuant to 18 U.S.C. Section 1350* * Filed herewith 53