| STEWART & STEVENSON SERVICES INC Item 1A Risk Factors |
| Potential Sale of the Company: For additional information with respect to the potential merger with Armor Holdings, see the second paragraph of “Item 1 |
| ” Risks of Dependence on Government and Failure to Obtain New Government Contracts: Because the US government is one of our key customers, decreased government spending or termination of significant government programs could adversely affect our business |
| US government contracts account for a substantial portion of our annual revenues and operating income |
| In November 2004, we began full rate production under a third multi-year contract with the US Army that provides for continued production of the FMTV through September 2008 at an initial contract value of dlra1dtta1 billion, excluding the exercise of any production options |
| Funding of the FMTV contract beyond September 2007 is subject to the inherent uncertainties of Congressional appropriations |
| As is typical of multi-year defense contracts that may be canceled or adjusted by the government, the FMTV contract must be funded annually by the US Army and may be terminated at any time for the convenience of the government |
| If the FMTV contract is terminated, other than for our default (in which event there could be serious adverse consequences and claims made against us), the contract includes a provision under which we will be reimbursed for certain allowable costs, but not necessarily for all costs incurred |
| We have realized and expect to continue to realize lower margins under the third multi-year contract than under the FMTV contract completed in the fourth quarter of Fiscal 2004 |
| There can be no assurance as to whether future governmental spending will adequately support our business in this area, and substantial decreases in government spending, the loss of the US government as a customer or the cancellation of key significant government programs could materially and adversely affect our operations |
| Even if government spending in general continues at current levels, we are not assured that we can compete effectively as to the receipt of specific government orders and contract awards or as to the timing thereof |
| The US Army is our primary customer, accounting for over 85prca of our sales from continuing operations |
| The loss of this customer would have a material adverse effect on our consolidated financial condition and results of operations |
| In our forward-looking statements, we have assumed that we will continue to have satisfactory performance in our government contracting business |
| Inherent Risks of Government Contracts: Government contracts present us with numerous special risks that are inherent in their nature and that could adversely affect our operations |
| Major contracts for military systems are often “fixed-price” contracts that are performed over extended periods of time and are subject to changes in scope of work and delivery schedules |
| Pricing negotiations on changes and settlement of claims often extend over prolonged periods of time |
| Our ultimate profitability on such contracts may depend on the eventual outcome of an equitable settlement of contractual issues with the US government |
| Furthermore, there are significant risks in projecting actual costs on multi-year fixed-price government contracts because of unforeseen factors, including price and wage inflation and supply shortages |
| While we attempt to negotiate supply contracts with key suppliers that are synchronized with our long-term fixed-price obligations, we are not able to do that with a precision that eliminates risks that our actual costs of necessary items will not exceed the costs taken into account in the original contract pricing |
| Further, as to some suppliers and some items we do not have contracts that are synchronized at all with our long-term fixed-price obligations |
| As to such items, which include raw materials such as steel, as to which there have been recent substantial price increases, we are at continuous risk that we will have cost increases that were not taken into account in our contract pricing |
| Our government contract operations are subject to US government investigations of business practices and cost classifications from which legal or administrative proceedings can result |
| Based on government procurement regulations, under certain circumstances a contractor can be fined, as well as suspended or debarred from government contracting |
| In that event, we would also be prohibited from selling equipment or services to customers that depend on loans or financial commitments from the Export Import Bank, Overseas Private Investment Corporation and similar government agencies during a suspension or debarment |
| In such events we might otherwise not be able to receive the benefits of federal assistance payments during a suspension or debarment |
| The US Customs Service and the Department of Justice have conducted an investigation of potential violations by us of laws relating to the export of controlled military vehicles, weapons mounting systems and firearms |
| Such investigation could result in the filing of civil or administrative sanctions against us and/or individual employees, and could result in a suspension or debarment |
| In our forward-looking statements, we have assumed our reasonable management of risks inherent in our government contracting business, and that we will not experience a materially adverse outcome in any US government investigations |
| Risks of Supply Interruptions: The FMTV incorporates engines, transmissions, axles and a number of other components that are specified by the US Army and are available only from the source or sources selected by the US Army |
| Identifying additional or replacement suppliers approved by the US Army for any of the numerous components used in the FMTV may not be accomplished quickly or on commercially reasonable terms, if at all |
| In addition to suppliers specified by the US Army, we 5 ______________________________________________________________________ use other suppliers for certain components of the FMTV, some of which are small businesses that are not well capitalized |
| In the event we were unable to mitigate the impact or find an alternate supplier in a timely manner, significant interruption in the supply of any of these components, for any reason, including insolvency of a supplier, work stoppages at suppliers and transportation interruptions, could involve significant additional costs and result in delays in production and product deliveries and could have a material adverse effect on our results of operations |
| In our forward-looking statements, we have assumed that we will not experience significant supply interruptions |
| Risks Associated with Distributed Energy Solutions Business: In the third quarter of Fiscal 2003, we announced our plans to exit the turnkey engineering, procurement, and construction, or EPC, activities of the Distributed Energy Solutions segment |
| Since that time, we have incurred significant losses in the process of exiting this business related to the completion of remaining construction projects, costs to satisfy customer warranty obligations, valuation adjustments related to the liquidation of inventory and costs associated with the settlement of customer disputes |
| During the fourth quarter of Fiscal 2004, we reached the point in this wind down effort in which we are substantially complete with our construction activities, and as a result, the identified assets, liabilities and results of operations for that segment have been reported as discontinued operations |
| We continue to have substantial risk with respect to the performance on such contracts, including warranty, product performance and other contractual obligations, as well as certain claims and litigation that have arisen against us with respect to contracts entered into in past years |
| While we have recognized all known estimated losses on these uncompleted contracts, warranty obligations and other customer disputes, continued uncertainty remains related to the execution of the remaining obligations |
| These uncertainties may result in additional unexpected losses until all contractual issues are resolved and remaining obligations are completed |
| Additionally, we expect to continue to recognize some general and administrative costs required to support the remaining warranty and contract performance aspects of this business |
| We are also obligated to execute under certain fixed-price operation and/or maintenance contracts related to previously completed EPC projects, which have terms potentially extending up to five years |
| We have assumed in our forward-looking statements that we will be able to manage this circumstance in an overall satisfactory manner, having already taken significant charges with respect to these matters in prior years |
| The terms of these contracts require us to guarantee the price of products and services we provide and to assume the risk that the costs to provide such products and services will be greater than anticipated |
| The profitability of these contracts is therefore dependent on the ability to reasonably predict the costs associated with performing the contracts |
| These costs may be affected by a variety of factors, some of which are beyond our control |
| For example, US manufacturers and distributors of steel products, which are used in many of our products, have in recent years experienced difficulties with the pricing and availability of steel |
| The volatility of steel prices and increase in steel demand worldwide has had and is expected to continue to have a negative effect on our expected costs under certain of our fixed-price contracts in the near future |
| Our failure to accurately estimate the resources required for a project, or our failure to complete our contractual obligations in a manner consistent with the project plan upon which our fixed-price contract was based, could adversely affect our profitability and could have a material adverse effect on our business, financial condition and results of operations |
| In recent years, as a result of incurring greater costs than were taken into account in original contract pricing, we have incurred significant losses on certain EPC projects in our discontinued Distributed Energy Solutions business |
| In our forward-looking statements, we have assumed that fixed-price contracts will have no further material adverse impact on our business, financial condition or results of operations |
| Risks as to Rising Steel Prices: While noted above generally in connection with other risk factors, we specifically note that since early 2004, manufacturers and distributors of steel, which is used in many of our products, have experienced sharply increased prices and limited availability of steel and component parts containing steel |
| These increased steel prices have had and are expected to continue to have a negative impact on our margins in the near future, particularly on fixed-price contracts and other contracts for which we are unable to pass such cost increases on to our customers |
| If these steel price conditions continue, and if we are unable to raise our prices to keep pace with the material cost increases, our operating margins and results of operations could be adversely impacted in future periods |
| Risks as to Cost Controls: As a manufacturing and service company operating within “tight” margins, with substantial facilities and inventories, our operations have been, and can be, adversely affected by our inability to control costs and to accurately estimate and plan our costs |
| We continuously endeavor to implement cost identification, estimation and savings measures in our operations |
| Our forward-looking statements assume that we will be able to contain our costs and expense increases at reasonable levels consistent with expected revenues |
| Risks of Dependence on Third Party for Support Services: In connection with the disposition of the Engineered Products and Power Products businesses, including a significant portion of our information technology assets and personnel, we entered into 6 ______________________________________________________________________ a transition services agreement with the buyer of those businesses pursuant to which the buyer is obligated to provide certain support services to us in the areas of information technology, telecommunications, accounting and payroll, record retention, tax compliance assistance and operational support for up to 18 months following the sale of those businesses, depending on the particular service |
| Because we no longer own the assets or employ the personnel necessary to perform those services, we are substantially dependent on the buyer to provide such support services |
| The buyer’s failure to provide these services to us in a timely manner, or at all, could have material adverse effect on our business, operating results and financial condition |
| Risk of a Decline in Defense Spending: Our government contracts are dependent upon the US defense budget |
| Since the invasion of Iraq by the US and other forces in March 2003, we have benefited from an upward trend in overall defense spending |
| Under the Bush Administration’s fiscal 2007 budget, the defense budget is expected to continue to increase through fiscal year 2009 |
| However, future defense spending could be negatively impacted by several factors, including, but not limited to, the US government’s budget deficits, a change in spending priorities and the costs of sustaining the US military operations in Iraq and Afghanistan |
| A decrease in US government defense spending or changes in spending allocation could result in a material decrease to our sales, earnings and cash flow |
| Risks of General Economic Conditions: Our operations are to some extent dependent for success on the general economic well-being of the United States and certain international markets |
| A general economic downturn could adversely affect government military spending which could impact demand for our products and services |
| Although economic activity has improved in recent years, general economic conditions remain uncertain, particularly in light of the war in Iraq, other international tensions and related factors |
| If the US or world economies decline or fail to further recover, the demand for our products and services could be adversely affected, thus adversely affecting our financial condition and results of operations |
| Further, other general market conditions such as increased inflation and higher interest rates could also adversely impact our results of operations |
| In our forward-looking statements, we have assumed that general market conditions will not worsen in Fiscal 2006 and that we are not entering a down-cycle in our markets or a period of significantly increasing inflation and interest rates |
| Risk of Competition: Our international and domestic competitors may use their resources and product and service offerings to increase competition, both in terms of pricing and product and service offerings, thereby reducing our market shares and/or sales and profitability |
| Some of our existing and potential competitors have substantially greater marketing, financial and technical resources than we have, and these resources might be used in effective competition with us |
| We have assumed in our forward-looking statements that we will continue to be a reasonably effective competitor in our markets |
| Risks Relating to Technology: Our business will suffer if we are unable to keep up with rapid technological change and product development |
| Our success will depend on our ability to anticipate changes in technology and industry requirements and to respond to technological developments on a timely basis, either internally or through strategic alliances |
| We will likely be constantly threatened by current competitors or new market entrants who may develop new technologies or products or establish new standards that could render our products less marketable or obsolete |
| Thus, we can offer no assurances that we will be successful in developing and marketing, on a timely and cost effective basis, products or product enhancements that respond to our competition, to technological developments, to changing industry standards and to marketplace acceptability |
| We have assumed in our forward-looking statements that we can reasonably keep pace with our competitors in technology changes and product development |
| Risks Relating to Personnel: Labor shortages and our inability to recruit and retain key employees and workers could limit our operations and increase our labor costs and, in turn, adversely affect our results of operations |
| Our manufacturing operations are substantially dependent upon our ability to recruit and retain key managers and qualified machinists, welders, factory workers and other laborers |
| A strong labor market can adversely impact us by limiting our manufacturing capacity or resulting in significantly increased wages and other benefits to attract additional key employees and workers |
| We have assumed in our forward-looking statements that we will continue to be able to recruit and retain necessary personnel at overall costs that are comparable with our ability to produce revenues |
| Risks of Claims and Litigation: Outcomes of pending litigation and governmental proceedings, as well as future unexpected litigation and legal disputes could have a material adverse impact on our operations |
| If we experience materially adverse outcomes or other unexpected results in our existing litigation and government proceedings, which in turn have a material adverse effect on our results of operations, the accuracy of our forward-looking statements would be affected |
| Similarly, if we experience in the future new, unexpected litigation or adverse results from new, unexpected litigation, there could also be a material adverse effect on our results, again affecting the accuracy of our forward-looking statements |
| Our forward-looking statements assume that there will be no materially adverse unexpected outcomes or results that we have not already adequately provided for |
| 7 ______________________________________________________________________ Risks of Product Defects: Our customers often require demanding specifications for product performance and reliability |
| Because many of our products are complex and often use state-of-the-art components, processes, and techniques, undetected errors and design flaws may occur |
| Product defects result in higher product service, warranty and replacement costs and may cause damage to our customer relationships and industry reputation, all of which may negatively impact our results of operations |
| We have assumed in our forward-looking statements that we will not in the future incur material difficulties with respect to product defects and warranty claims |
| Risks as to Foreign Sales and Global Trade Matters: Foreign sales are subject to special risks inherent in doing business outside of the United States, including the risk of war, terrorist activities, civil disturbances, embargoes, and government activities, all of which may disrupt markets |
| Foreign sales are also generally subject to the risk of compliance with additional laws, including tariff regulations and import and export restrictions |
| Sales in certain foreign countries require prior US government approval in the form of an export license |
| We cannot assure you that we will not experience difficulties in connection with future foreign sales |
| Moreover, changes in global trade policies in our markets could impact our sales in these markets |
| We have assumed in our forward-looking statements that there will be no material changes in global trade policies, such as embargoes, new and large tariffs or other tax assessments and the like or other new and material restrictions on trade that apply in particular to our operations |
| Risks as to Acquisitions and Restructuring Activities: Our success is dependent upon the integration of newly acquired businesses with our existing businesses |
| Our success is also dependent upon executing our restructuring plans in such a manner that we extricate value from facility closures and product offering and business exits, and that we structure continuing business activities in an efficient and tactical manner |
| This process involves some amount of realignment and reintegration of business processes |
| There can be no assurance as to the ultimate success of our integration and realignment efforts |
| Our forward-looking statements assume the successful integration of acquired businesses and realigned business activities and their future contribution to our operations |
| Risks as to Currency Fluctuations: A material change in currency exchange rates in our markets could affect our future results as well as affect the carrying values of certain of our assets |
| World currencies have been subject to volatility in recent years |
| The US dollar has continued to weaken somewhat against other key currencies (particularly the Euro and the British pound) in recent years |
| While a weakened US dollar is not necessarily adverse to our business in general, it could be generally adverse for the US economy in a number of ways, including putting upward pressure on interest rates |
| In addition, our UK manufacturing operation primarily conducts its business in British pounds sterling, but a portion of its costs are in Euros |
| Consequently, significant weakening of the UK pound in relation to the Euro would negatively impact the profitability of our UK operation |
| Significant weakening of the UK pound in relation to the US dollar would reduce the carrying value of our UK assets, and would negatively impact the US dollar-equivalent values of revenues and profits of our UK operation |
| Our forward-looking statements assume no material impact from future changes in currency exchange rates |
| Risks as to Environmental and Safety Matters: Our operations and products, and the use thereof, are regulated under a number of federal, state, local and foreign environmental laws and regulations, which govern, among other things, the discharge of hazardous materials into the air and water as well as the handling, storage and disposal of hazardous materials |
| Compliance with these environmental laws is a major consideration in the manufacturing of our products and in their servicing and distribution, as we use and generate hazardous substances and wastes in our manufacturing operations and as we may be subject to material financial liability for any investigation and clean-up of such hazardous materials |
| In addition, many of our current and former properties are or have been used for industrial purposes |
| Accordingly, we also may be subject to financial liabilities relating to the investigation and remediation of hazardous materials resulting from the action of previous owners or operators of industrial facilities on those sites |
| Liability in many instances may be imposed on us regardless of the legality of the original actions relating to hazardous or toxic substances or whether or not we knew of, or were responsible for, the presence of those substances |
| We are also subject to various federal, state, local and foreign laws and regulations relating to safety and health conditions in our manufacturing facilities and with respect to our products and the use thereof |
| Those laws and regulations may also subject us to material financial penalties or liabilities for any noncompliance, as well as potential business disruption if any portion of any of our facilities is required to be temporarily closed as a result of any violation of those laws and regulations |
| Any financial liability or business disruption from environmental, health or safety issues could have a material adverse effect on our financial condition and results of operations |
| Our forward-looking statements assume no material adverse impact from environmental and safety issues |