AZZ

AZZ INC 10-Q Summary: Period Ended August 31, 2006

Business Context and Reporting Period

This is a Quarterly Report (Form 10-Q) for AZZ INC, an accelerated filer incorporated in Texas. The report covers the three and six-month periods ended August 31, 2006 (Fiscal Year 2007). The company operates in two segments: Electrical and Industrial Products and Galvanizing Services. The fiscal year ends on the last day of February.

Key Financial Metrics

Segment Performance (Six Months):

• Electrical and Industrial Products: Revenue $68.0 million; Operating Income $9.2 million.
• Galvanizing Services: Revenue $47.3 million; Operating Income $15.0 million.

Material Changes vs. Prior Period

• Revenue Growth: Consolidated net revenues increased 31% for the quarter and 25% for the six-month period compared to the prior year. Galvanizing Services revenue surged 69% (quarter) and 50% (six months), driven by a 53% price increase to offset rising zinc costs and an 11% volume increase.
• Profitability: Net income increased significantly, with segment operating income rising 177% for the quarter and 125% for the six-month period. Operating margins in Galvanizing Services improved to 32% (vs. 17-20% prior year), though management notes this is aided by FIFO inventory accounting and may not be sustainable.
• Backlog: Backlog increased to $98.7 million as of August 31, 2006, a 29% increase from the prior year, driven by strong international bookings in high-voltage transmission and utility markets.
• Debt Reduction: Outstanding bank debt decreased to $15.5 million from $19.9 million at the end of the prior fiscal year, improving the long-term debt-to-equity ratio to 0.16:1.

Guidance, Outlook, and Risks

Management Commentary: Management attributes growth to strong market demand in power generation, transmission, and petroleum sectors. They emphasize cost containment and price escalation to recover material costs (copper, aluminum, steel, zinc). A new credit agreement ($50 million revolving line) was entered into in May 2006.

Accounting Changes: The company adopted FASB Statement No. 123R (Share-Based Payment) effective March 1, 2006. This resulted in a cumulative effect adjustment and increased compensation expenses, reducing net income by approximately $110,000 for the six-month period compared to the prior method.

Risks and Contingencies:

• Commodity Prices: Significant exposure to zinc, copper, aluminum, and steel prices. While price increases have been passed to customers, future ability to do so is not guaranteed.
• Inventory Accounting: Galvanizing margins are currently inflated by FIFO inventory accounting; LIFO application would have reduced profits by $6.4 million for the six-month period.
• Market Conditions: Dependence on power generation and industrial markets which are subject to economic fluctuations.

Investor Verification Checklist

• Sustainability of Margins: Verify if Galvanizing Services can maintain 32% margins as FIFO inventory benefits diminish and zinc costs rise.
• Backlog Conversion: Monitor the conversion rate of the $98.7 million backlog into revenue in upcoming quarters.
• Stock-Based Compensation: Review the impact of FAS 123R adoption on future earnings, noting $367,000 in unrecognized costs for 2006 SAR grants.
• Debt Covenants: Confirm continued compliance with the new Credit Agreement covenants (Leverage Ratio max 3.0:1, Fixed Charge Coverage min 1.5:1).
• Acquisition Costs: Note the $331,000 write-off of due diligence costs for a potential acquisition that did not proceed.