10-Q 1 a4504825.txt SOVEREIGN SPECIALTY CHEMICALS 10-Q ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 _______________ FORM 10-Q _______________ (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the quarterly period ended September 30, 2003 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 333-39373 SOVEREIGN SPECIALTY CHEMICALS, INC. (Exact Name of Registrant as Specified in Its Charter) _______________ Delaware 36-4176637 (State or Other Jurisdiction of Incorporation or Organization) (IRS Employer Identification No.) 225 W. Washington St. -- Ste. 1450, Chicago, IL 60606 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (312) 223-7970 Registrant's Web Address: sovereignsc.com 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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [ ] No [X] On October 30, 2003, the registrant had 1,441,189 shares of voting common stock outstanding and 730,182 shares of non-voting common stock outstanding. ================================================================================ 1

5 SOVEREIGN SPECIALTY CHEMICALS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2003 (Dollars in Thousands) 1. Summary of Significant Accounting Policies Basis of Presentation and Principles of Consolidation The consolidated financial statements as of and for the periods ended September 30, 2003 and 2002, respectively, include the accounts of Sovereign Specialty Chemicals, Inc. and its wholly owned subsidiaries (the "Company"). All significant intercompany balances and transactions have been eliminated. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Interim Financial Information The unaudited interim consolidated financial statements of the Company, in the opinion of management, reflect all necessary adjustments, consisting only of normal recurring adjustments, for a fair presentation of results as of the dates and for the interim periods covered by the financial statements. The results for the interim periods are not necessarily indicative of the results of operations to be expected for the entire year or any other interim period The unaudited interim consolidated financial statements of the Company have been prepared in conformity with generally accepted accounting principles and reporting practices. Certain information in footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles has been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission; however, the Company believes the disclosures are adequate to make the information not misleading. The unaudited interim consolidated financial statements contained herein should be read in conjunction with the audited financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2002. Reclassifications Certain prior year amounts have been reclassified to conform to current year presentation. 2. Plant Closure Costs In November 2002, the Company announced the closure of two of its higher-cost manufacturing plants in 2003. At the time of the announcement, the Cincinnati, Ohio plant employed 118 people, and primarily produced water-borne adhesives sold to the industrial market. Substantially all production from this plant has been transferred to the Company's plants in Greenville, South Carolina, and Carol Stream and Plainfield, Illinois progressively over the first nine months of 2003. Some of the technical, sales support, customer service, and administrative functions have been transitioned to other Company locations. Approximately 88 employees, in both manufacturing and support functions will be terminated as part of the closure. At September 30, 2003, 70 employees have been terminated under the announced plan. At the time of the November 2002 announcement, the Kapellen, Belgium plant employed 24 people and produced water-borne and hot-melt adhesives for the European packaging and converting market. This production has been shifted to the Newark, United Kingdom plant during the first nine months of 2003. Approximately 14 employees primarily in manufacturing functions have been terminated as part of the plant closure. A separate Kapellen office will continue to provide sales, technical and distribution support to continental Europe. 6 These closures include the termination of certain existing employees, the abandonment or sale at a loss of certain fixed assets, the disposal of certain inventory and the sale of certain buildings. As a result of the announced closures the Company recorded a charge of approximately $4.1 million in the fourth quarter of 2002 and an additional charge of $0.4 million in the first half of 2003, included in selling, general and administrative expense, relative to the following costs: termination benefits of $2.0 million, loss on fixed assets of $1.3 million and other exit costs of $1.2 million. Approximately $1.2 million of the termination benefits and $0.9 million of the other exit costs will be incurred over the next several quarters and are recorded in accrued and other long term liabilities on the balance sheet. The loss on fixed assets of $1.3 million is recorded in other long term liabilities. The following provides an analysis of the changes in the plant closure liability for the nine months ended September 30, 2003:

3. Inventories Inventories are summarized as follows:

4. Comprehensive Loss For the three and nine months ended September 30, 2003 and 2002, respectively, the calculation of comprehensive loss is as follows:

5. Segment Reporting The Company has two reportable segments: the Commercial segment and the Construction segment. Applications sold by the Commercial segment include flexible packaging adhesives and coatings for a number of applications, high performance, specialty adhesives and coatings for automotive, aerospace, manufactured housing and textile applications. Through the Construction segment, the Company manufactures and sells housing repair, remodeling and construction sealants and adhesives used in exterior and interior applications. The Company evaluates performance and defines segment profit based upon operating income. The reportable segments' accounting policies are the same as those of the Company as a whole. Segment profit is calculated as a reportable segment's operating income. Total segment profits exceed consolidated operating profits to the extent of unallocated corporate expenses included in selling, general and administrative expenses. Unallocated corporate expenses were $2.2 million and $6.8 million for the three and nine months ended September 30, 2003, respectively; and $2.8 million and $8.3 million for the three and nine months ended September 30, 2002. The reportable segments are each managed and measured separately primarily due to the differing customers, products sold and distribution channels. The reportable segments are as follows: 7

6. Goodwill On January 1, 2002, the Company adopted SFAS No. 142. The adoption of SFAS No. 142 eliminated the amortization of goodwill beginning January 1, 2002 and instead required that goodwill be tested annually for impairment. In connection with our adoption of SFAS No. 142, the transitional intangible asset impairment test required an impairment of goodwill charge of $27.6 million ($17.1 million, net of income tax benefit). The loss was recorded as a cumulative effect of change in accounting principle. The impairment loss and write-down of goodwill was recorded relative to the Company's European reporting unit of its Commercial Segment. Our assessment of the goodwill impairment charge for this reporting unit was reflective of both lower operating performance in Europe and the use of lower market multiples. The carrying value of goodwill associated with our other reporting units was not impaired. 7. Other Financial Information The Company is a holding company with no independent assets or operations. Certain of the Company's subsidiaries (Guarantor Subsidiaries) have guaranteed the Company's 11 7/8% Senior Subordinated Notes. Full separate financial statements of the Guarantor Subsidiaries have not been presented as the guarantors are wholly owned subsidiaries of the Company and the guarantees are full, unconditional and joint and several. Management does not believe that inclusion of such financial statements would be material to investors. The unaudited financial statement data as of September 30, 2003 and 2002, respectively of the Guarantor Subsidiaries and the non-guarantor subsidiaries are below. 8 The following sets forth the unaudited financial data at September 30, 2003 and for the three and nine months then ended.

10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis is provided to increase the understanding of, and should be read in conjunction with, the consolidated financial statements and accompanying notes included herein. General We were formed to acquire, consolidate and operate adhesives, sealants and coatings businesses in the highly fragmented adhesives, sealants and coatings business segment of the specialty chemical industry. We have grown through the acquisition and integration of businesses. From 1996 to 2002, we increased annual net sales through acquisitions and internal growth from $37.8 million to $361.1 million. We plan to continue our growth through a combination of new product development, continued market penetration, international expansion, and in the longer term, strategic acquisitions. The operating results of acquired businesses have been included in our consolidated operating results for all periods after their respective dates of acquisition. Summary of Critical Accounting Policies The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we continually evaluate our estimates. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. 11 We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition. Revenue is recognized when products are shipped to the customer and title transfers. Cost of Goods Sold. Cost of goods sold represents the actual cost of purchased raw materials, direct and indirect labor, warehousing and manufacturing overhead costs, including depreciation, utilized directly in the production of products for which revenue has been recognized. Selling, General & Administrative Expenses. Selling, general & administrative expenses generally are those costs not directly related to the production process and include all selling, marketing, research and development customer service expenses as well as expenses related to general management, finance and accounting, information services, human resources, legal and corporate overhead expense. Goodwill. Goodwill represents the excess of acquisition cost over the fair value of net assets acquired and was being amortized using the straight-line method over periods ranging from 15 to 25 years through December 31, 2001. Accumulated amortization of goodwill was $30.1 million at December 31, 2001. On January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets, which eliminated the amortization of goodwill and instead required that goodwill be tested for impairment at least annually. Reserve for Inventory Obsolescence. Our estimated reserves for obsolescence or unmarketable inventory is equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about market conditions, future demand and expected usage rates. We periodically review inventory and if applicable, record additional inventory write downs. If actual market conditions are less favorable than those projected by management and cause usage rates to vary from those estimated, additional inventory write-downs may be required, however these would not be expected to have a material adverse impact on our financial statements. Allowance for Doubtful Accounts. We maintain allowances for doubtful accounts for estimated losses resulting from the failure of our customers to make required payments. We evaluate the adequacy of our allowance for doubtful accounts and make judgments and estimates in determining the appropriate allowance at each reporting period. If a customer's financial condition were to deteriorate, additional allowances may be required. Segment Reporting We have two reportable segments: the Commercial segment and the Construction segment. Applications sold by the Commercial segment include flexible packaging adhesives and coatings for a number of applications, high performance specialty adhesives and coatings for automotive, aerospace, manufactured housing, and textile applications. Through the Construction segment, we manufacture and sell housing repair, remodeling and construction sealants and adhesives used in exterior and interior applications. We evaluate the performance of each segment based on operating income. Segment profit is calculated as a reportable segment's operating income. Total segment profits exceed consolidated operating profits to the extent of unallocated corporate expenses included in selling, general and administrative expenses. Unallocated corporate expenses were $2.2 million and $6.8 million for the three and nine months ended September 30, 2003, respectively; and $2.8 million and $8.3 million for the three and nine months ended September 30, 2002. Results of Operations Three months ended September 30, 2003 compared to three months ended September 30, 2002 Net Sales. Net sales were $98.7 million and $95.0 million for the three months ended September 30, 2003 and 2002, respectively. The third quarter 2003 net sales level represents an increase of $3.7 million or 3.8% from the prior year. This increase resulted from gains in the Construction segment that were partially offset by a decrease in net sales in the Commercial segment. Construction segment sales were $38.7 million in the third quarter of 2003, up $5.6 million, or 17% from the prior year reflecting sales increases in building material applications due to the continued strength in the housing market and increased sales to the retail do-it-yourself market. Commercial segment sales were $60.0 million in the third quarter of 2003, down $1.9 million, or 3.1% from the prior year due to declines in a number of end markets including transportation, industrial specialties, and flexible packaging. 12 Cost of Goods Sold. Cost of goods sold was $70.4 million for the three months ended September 30, 2003, an increase of $4.4 million, or 6.2% over third quarter 2002 cost of sales of $66.1 million. Gross profit for the three months ended September 30, 2003 was $28.3 million, a decrease of $0.6 million from the third quarter of 2002 gross profit of $28.9 million. Gross profit as a percentage of net sales decreased in the third quarter of 2003 to 28.7% from 30.5% in the third quarter of 2002. This reduction in gross profit percentage is related to increases in many raw material costs year over year. We continue to try to keep margins relatively stable despite raw material cost increases, through raw material substitutions where possible and through selling price increases where necessary. We also have partially offset the negative impact of raw material cost increases through reductions in manufacturing costs year over year. The manufacturing cost reductions have been attained through the implementation of lean manufacturing initiatives at many of our facilities. Selling, General and Administrative Expenses. Selling, general and administrative expenses were $18.2 million for the three months ended September 30, 2003, a decrease of $0.1 million, or 0.6% from the third quarter 2002 expenses of $18.3 million. As a percentage of net sales, selling, general and administrative expenses decreased to 18.5% for the third quarter of 2003 from 19.3% in the third quarter of 2002. This decrease is reflective of a management focus on internal cost containment as well as an effort to reduce professional fees and corporate overhead costs. Operating Income. Operating income was $10.1 million and $10.6 million for the three months ended September 30, 2003 and 2002, respectively. Operating income as a percentage of net sales was 10.2% and 11.2% for the three months ended September 30, 2003 and 2002, respectively. The decline in operating income is due primarily to increased raw material costs partially offset by reductions in manufacturing and selling, general and administrative costs as described above. Interest Expense. Net interest expense was $6.3 million for the three months ended September 30, 2003 and 2002, respectively. The impact of a decrease in our average outstanding level of variable rate debt quarter over quarter was offset by increased non-cash interest expense due to additional amortization of deferred financing cost and debt discounts and a slight increase in the weighted average interest rate on our variable rate debt. In December 2002, we refinanced $45.1 million of borrowings under our existing term loan under our credit agreement with $47.5 million of borrowings under a new term loan facility. The applicable margin or "spread" on the new term loan facility is 75 basis points higher than the applicable margin that was in effect for the existing term loan during most of 2002. As a result, in the absence of continued decreases in the interest rates on which our variable rate debt is based, we will expect to have an increase in the weighted average interest rate of our variable rate debt. Income tax expense (benefit). Income tax expense was $1.5 million for the three months ended September 30, 2003. Income tax expense was $1.7 million for the same period in 2002. Net income (loss). Net income for the quarters ended September 30, 2003 and 2002 was $2.3 million and $2.6 million, respectively. The decrease in net income from the prior year is due to items discussed above. Commercial Segment The following table presents net sales and segment profit, expressed in millions of dollars, and segment profit margin, which is segment profit expressed as a percentage of net sales:

13 Net sales were $60.0 million for the three months ended September 30, 2003, representing a $1.9 million decrease from third quarter 2002. This decrease was due primarily to declines in a number of end markets primarily transportation, industrial specialties, graphic arts, particularly high-end printing applications. Domestic net sales were $48.6 million and $50.3 million for the three months ended September 30, 2003 and 2002, respectively. The decrease in domestic net sales for the segment was $1.7 million with international sales declining by $0.2 million. Segment profit was $6.1 million for the third quarter, 2003 representing a $1.8 million and 23.0% decrease from the third quarter 2002. This was reflective of decreased net sales and raw material cost increases, partially offset through selling price increases and raw material substitution. Manufacturing costs have decreased year over year and as a percentage of net sales. This is due to cost inefficiencies in the quarter related to the transfer of production from two facilities described below and the implementation of lean manufacturing initiatives. We expect that manufacturing costs will significantly decrease year over year as a result of the transfer of production from these facilities. In November 2002, we announced the closure of two of our higher-cost manufacturing plants in 2003. At the time of the announcement, the Cincinnati, Ohio plant employed 118 people, and primarily produced water-borne adhesives sold to the industrial market. Substantially all production from this plant has been transferred to the our plants in Greenville, South Carolina, and Carol Stream and Plainfield, Illinois progressively over the first nine months of 2003. Some of the technical, sales support, customer service, and administrative functions have been transitioned to other of our locations. Approximately 88 employees, in both manufacturing and support functions will be terminated as part of the closure. At September 30, 2003, 70 employees have been terminated under the announced plan. At the time of the November 2002 announcement, the Kapellen, Belgium plant employed 24 people and produced water-borne and hot-melt adhesives for the European packaging and converting market. This production has been shifted to the Newark, United Kingdom plant during the first nine months of 2003. Approximately 14 employees primarily in manufacturing functions have been terminated as part of the plant closure. A separate Kapellen office will continue to provide sales, technical and distribution support to continental Europe. These closures include the termination of certain existing employees, the abandonment or sale at a loss of certain fixed assets, the disposal of certain inventory and the sale of certain buildings. As a result of the announced closures, we recorded a charge of approximately $4.1 million in the fourth quarter of 2002 and an additional charge of $0.4 million in the first half of 2003, included in selling, general and administrative expense, relative to the following costs: termination benefits of $2.0 million, loss on fixed assets of $1.3 million and other exit costs of $1.2 million. Approximately $1.2 million of the termination benefits and $0.9 million of the other exit costs will be incurred over the next several quarters and are recorded in accrued and other long term liabilities on the balance sheet. The loss on fixed assets of $1.3 million is recorded in other long term liabilities. Construction Segment The following table presents net sales and segment profit, expressed in millions of dollars, and segment profit margin, which is segment profit expressed as a percentage of net sales:

Net sales for the Construction segment were $38.7 million for the quarter ended September 30, 2003, representing a $5.6 million or 17% increase as compared to the third quarter 2002. This increase in sales in 2003 was primarily due to the sustained strength of its building materials end markets and strength at major retail accounts. Segment profit was $6.1 million and $5.4 million for the three months ended September 30, 2003 and 2002, respectively. The increase in segment profit was primarily due to increased sales for the segment. Manufacturing costs decreased in the current quarter, but this was more than offset by increased raw material costs. Selling, general and administrative expenses increased primarily as a result of increased marketing and selling expenses. 14 Nine months ended September 30, 2003 compared to nine months ended September 30, 2002 Net Sales. Net sales were $281.1 million and $276.7 million for the nine months ended September 30, 2003 and 2002, respectively. The net sales level represents an increase of $4.4 million or 1.6% over the prior year's comparable period. The increase resulted from gains in the Construction segment, largely offset by decreases in net sales in the Commercial segment. Construction segment sales were $104.1 million in the first nine months of 2003, up $12.3 million, or 13.4% from the prior year reflecting sales increases in building material applications as a result of continued strength in the housing market and increased sales to the retail do-it-yourself market. Commercial segment sales were $177.1 million in the first nine months of 2003, down $7.9 million, or 4.3% from the prior year as a result of declines in a number of end markets primarily industrial specialties, paper converting and graphic arts, particularly high-end printing applications. Cost of Goods Sold. Cost of goods sold was $202.7 million and $196.8 for the nine months ended September 30, 2003 and 2002, respectively. This represents an increase of $5.8 million, or 2.9% over the comparable period. Gross profit as a percentage of net sales decreased to 27.9% from 28.9% for the nine months ended September 30, 2003 and 2002, respectively. This reduction in gross profit percentage is related to increased raw material costs year over year. We continue to try to keep margins relatively stable despite raw material cost increases through raw material substitutions and selling price increases where possible. We have partially offset the negative impact of raw material cost increases through reductions in manufacturing costs as a percent of net sales year over year. This is as a result of the implementation of lean manufacturing initiatives at many of our facilities. Selling, General and Administrative Expenses. Selling, general and administrative expenses were $52.5 million and $53.7 million for the nine months ended September 30, 2003 and 2002, respectively. This represents a decrease of $1.2 million, or 2.2% from the comparable period. As a percentage of net sales, selling, general and administrative expenses decreased to 18.7% for the third quarter of 2003 from 19.4% in the third quarter of 2002. This decrease is reflective of a management focus on internal cost containment as well as an effort to reduce professional fees and corporate overhead costs. Included in the selling, general and administrative costs for the nine months ended September 30, 2003 are $0.4 million of additional severance related costs related to the Kapellan plant closure. Included in the selling, general and administrative costs for the nine months ended September 30, 2002 are $0.5 million of professional fees incurred related to financing alternatives and $0.4 million of costs associated with the hiring of a senior executive. Operating Income. Operating income was $26.0 million and $26.2 million for the nine months ended September 30, 2003 and 2002, respectively. This represents an increase of $0.2 million or 0.9% over the comparable period. Operating income as a percentage of net sales was 9.2% and 9.5% for the nine months ended September 30, 2003 and 2002, respectively. Interest Expense. Net interest expense was $19.1 million and $19.3 million for the nine months ended September 30, 2003 and 2002, respectively. The 1.0% decrease in interest expense was due primarily to a decrease in our average outstanding level of variable rate debt year over year offset largely by increased non-cash interest expense due to additional amortization of deferred financing cost and debt discounts and an increase in the weighted average interest rate on our variable rate debt to 6.0% from 5.8% in the first nine months of last year. In December 2002, we refinanced $45.1 million of borrowings under our existing term loan under our credit agreement with $47.5 million of borrowings under a new term loan facility. The applicable margin or "spread" on the new term loan facility is 75 basis points higher than the applicable margin that was in effect for the existing term loan during most of 2002. As a result, in the absence of continued decreases in the interest rates on which our variable rate debt is based, we will expect to have an increase in the weighted average interest rate of our variable rate debt in 2003. Income tax expense (benefit). Income tax expense was $3.1 million and $2.9 million for the nine months ended September 30, 2003 and 2002, respectively. Net income before cumulative effect of change in accounting principle. Net income before the cumulative effect of change in accounting principle for the nine months ended September 30, 2003 and 2002 was $3.7 million and $3.9 million, respectively. Cumulative effect of change in accounting principle. In connection with Company's completion of the transitional goodwill impairment test required by SFAS No. 142 at January 1, 2002, we recorded a $27.6 million ($17.1 million, net of income tax benefit) goodwill impairment loss and write-down of goodwill associated with our European reporting unit. Our assessment of our goodwill impairment for this reporting unit was reflective of both lower operating performance in Europe and the use of lower market multiples. The carrying value of goodwill associated with our other reporting units was not impaired. 15 Commercial Segment The following table presents net sales and segment profit, expressed in millions of dollars, and segment profit margin, which is segment profit expressed as a percentage of net sales

Net sales were $177.1 million and $184.9 million for the nine months ended September 30, 2003 and 2002, respectively. This represents a $7.8 million decrease from the comparable period. This decrease was primarily a result of declines in a number of end markets primarily paper converting and graphic arts, particularly high-end printing applications. Domestic net sales were $142.2 million and $150.7 million for the nine months ended September 30, 2003 and 2002, respectively. The decrease in domestic net sales for the segment of $8.5 million was offset somewhat by international sales increases of $0.6 million year over year. Segment profit was $17.5 million and $20.3 million for the nine months ended September 30, 2003 and 2002, respectively. This was reflective of decreased net sales, raw material cost increases, partially offset through selling price increases and raw material substitution. Manufacturing costs have decreased year over year and as a percentage of net sales. We expect that manufacturing costs will significantly decrease as a percentage of net sales going forward based on the transfer of production from the closed facilities and implementation of lean manufacturing initiatives. Declines in gross profit were partially offset by decreases in selling, general and administrative expenses. Construction Segment The following table presents net sales and segment profit expressed in millions of dollars and segment profit margin, which is segment profit expressed as a percentage of net sales:

Net sales for the Construction segment were $104.1 million and $91.8 million for the nine months ended September 30, 2003 and 2002, respectively. The $12.3 million and 13.4% increase in sales in 2003 was primarily a result of the sustained strength of its building materials end markets and strength at major retail accounts. Segment profit increased by $1.0 million or 6.9% as a result of higher sales volume offset largely by decreased gross profit margin due to raw material costs increases for which we have not been able to recover through increased selling prices. Manufacturing costs decreased as a percentage of net sales for the nine months ended September 30, 2003, but this was more than offset by the raw material margin compression. Selling, general and administrative expenses remained constant year over year as a percent of sales but increased in dollars primarily as a result of increased marketing and selling expenses. 16 Liquidity and Capital Resources Net cash used in operating activities for the nine months ended September 30, 2003 was $1.1 million. Net income, adjusted for non-cash charges, such as depreciation and amortization, amortization of deferred financing costs, deferred income taxes, and foreign currency gains/losses, accounted for approximately $13.5 million and $13.9 million of positive cash flow for the nine months ended September 30, 2003 and 2002, respectively. Cash flow provided from operations decreased as we increased inventory levels by $2.7 million and accounts receivable balances by $10.9 from December 31, 2002 levels. While accounts receivable and inventory balances at September 30, 2003 ($60.9 million and $31.2 million, respectively) are greater than at December 31, 2002, they compare more favorably to the levels at September 30, 2002 ($57.5 million and $34.6 million, respectively). We have maintained consistent days receivables and have been able to reduce inventory levels from the same period in the prior year. Net cash used in investing activities was $6.7 million and $4.4 million in the nine months ended September 30, 2003 and 2002, respectively, and resulted from additions to property, plant and equipment. Net cash provided by financing activities was $0.3 million for the nine months ended September 30, 2003. Credit Facilities Our credit agreement, as amended (Credit Agreement), provides for aggregate borrowings of $108.6 million. The Credit Agreement includes (1) a $50.0 million revolving credit facility (Credit Facility) (including letters of credit of up to $20 million), (2) Term Loan A with remaining outstanding balance of $11.1 million at September 30, 2003 and no capacity to borrow additional funds under that facility and (3) Term Loan B with an aggregate principal balance of $47.5 million at September 30, 2003 and no additional capacity to borrow additional funds under that facility. The Credit Facility matures December 30, 2005. Commitment fees on the unused portion of the Credit Facility of 0.375% to 0.050% are payable quarterly in arrears. At September 30, 2003, we had $14.4 million outstanding and $33.6 million in available borrowings under the Credit Facility (net of approximately $2.0 million outstanding letters of credit). Our effective interest rate for our borrowings under the Credit Agreement was 5.9% and 5.8%, for the nine months ended September 30, 2003 and 2002, respectively. Borrowings under the Credit Facility are available on a revolving basis and may be used for general corporate purposes, excluding, however, loans, advances and investments, including acquisitions, by the Company other than specified exceptions. On December 20, 2002 we amended our Credit Agreement and we refinanced $45.1 million of the $56.3 Term Loan A outstanding balance at that date with a new six year, $47.5 million Term Loan B facility. The Term Loan B includes a $2.4 million discount which is being amortized through interest expense over the life of the facility. The Term Loan B will mature December 30, 2007. Scheduled principal repayment under the Term Loan B facility for the years ending December 31, 2003 through 2006 will be $0.5 million per year payable quarterly. The remaining balance under Term Loan B, will be repaid in 2007. We have three scheduled quarterly payments in 2007 at the same rate of $0.5 million per year and a final payment due for the balance outstanding at December 30, 2007. There is no scheduled amortization for the $11.1 million outstanding under the Term Loan A for the years ending December 31, 2003 and 2004. The remaining $11.1 million drawn under Term Loan A will be repaid in 2005. Borrowings under the Credit Agreement bear interest at our option at a rate per annum equal to either (1) the higher of (a) the current base rate as offered by JPMorgan Chase or (b) 1/2 of 1% per annum above the federal funds rate plus, in either case, an applicable margin or (2) a Eurodollar rate plus an applicable margin. The applicable margin varies by facility. For amounts drawn under the Term Loan A and the Credit Facility the Eurodollar margin is 3.75% and the base rate margin is 2.75%. For amounts drawn under the Term Loan B facility, the Eurodollar margin is 4.50% and the base rate margin is 3.50%. Amounts outstanding under the Credit Facility, Term Loan A and Term Loan B bear interest, payable quarterly in the case of base rate advances and payable at the end of the relevant interest period of one, two, three or six months (or quarterly in certain cases) for all Eurodollar advances. Our credit ratings do not affect the interest rates for our borrowings under our Credit Agreement. 17 Our Singapore-based sales office has a facility providing for borrowings up to approximately $1.4 million in U.S. dollars and is secured by a letter of credit. Interest is payable at United States prime plus 1.0%. At September 30, 2003, approximately $1.4 million was drawn on the facility. At September 30, 2003, we had $14.4 million drawn under our Credit Facility, and approximately $2.0 million of outstanding letters of credit. At September 30, 2003, we had approximately $33.6 million of borrowing availability under the Credit Facility. Our Credit Agreement obligates us to make mandatory prepayments in certain circumstances with the proceeds of asset sales or issuance of capital stocks or indebtedness and with certain excess cash flow. Our Credit Agreement contains covenants that restrict our and our subsidiaries' ability to incur additional indebtedness, incur liens, dispose of assets, prepay or amend other indebtedness, pay dividends or purchase our stock, and change the business conducted by us or our subsidiaries. In addition, we must also comply with specified financial ratios and tests including maintenance of maximum total debt to EBITDA, maximum senior debt to EBITDA, minimum EBITDA to interest expense, and minimum asset coverage ratios (in each case, as defined in our credit agreement) and other covenants at the end of each fiscal quarter. The covenant ratio calculations in our credit agreement utilize non GAAP financial measures that are specifically defined in the Credit Agreement. At September 30, 2003, we were in compliance with all financial and other covenants as prescribed by the Credit Agreement. Each of these covenants continues for the term of the Credit Agreement either at the latest level, or a more restrictive level. Deterioration in our current operating performance could result in our failure to satisfy our financial covenants. A failure by us to satisfy the covenants under the Credit Agreement would trigger the lenders' right to require immediate repayment of all or part of the indebtedness; such acceleration, in turn, would also give rise to a right to require immediate repayment by holders of our subordinated notes. The Credit Facility, Term Loan A and Term Loan B are secured by a security interest in substantially all of our subsidiaries' assets, including pledges of the common stock of our subsidiaries. In addition, the Credit Facility, Term Loan A and Term Loan B are guaranteed by our subsidiaries. Some of our guarantees and pledges are in support of only offshore advances, if any, under the Credit Facility. Senior Subordinated Notes On December 30, 1999, SSCI Investors LLC, an entity owned by an investor group led by AEA Investors Inc., acquired approximately 75% of our outstanding capital stock directly from the former majority stockholder with the balance owned by other investors, including members of our current management team. SSCI Investors LLC's acquisition of our common stock constituted a change of control under the terms of the indenture relating to our 9 1/2% Senior Subordinated Notes due 2007 and, as a result, we were required to make an offer to purchase for cash any and all of the outstanding $125.0 million principal amount of 9 1/2% Senior Subordinated Notes for 101% of the principal amount thereof plus accrued and unpaid interest to the date of repurchase. The repurchase was completed on March 6, 2000 with the repurchase of the entire $125.0 million principal amount of 9 1/2% Senior Subordinated Notes for an aggregate purchase price of approximately $127.4 million which was financed with borrowings under the Credit Agreement. On March 29, 2000 we completed an issuance of $150.0 million in aggregate principal amount of 11 7/8% Senior Subordinated Notes due 2010 in a private placement to qualified institutional investors in accordance with Securities and Exchange Commission Rule 144A and outside of the United States in accordance with Regulation S under the Securities Act of 1933. The privately placed 11 7/8% Senior Subordinated Notes were subsequently exchanged for notes with substantially identical terms that were registered with the Securities and Exchange Commission. The cash proceeds from this private placement of notes of approximately $143.8 million were used to repay amounts drawn under our Credit Facilities for the repurchase of the 9 1/2% Senior Subordinated Notes and for general corporate purposes. At September 30, 2003 the aggregate principal amount of 11 7/8% Senior Subordinated Notes was $149.3 million. The 11 7/8% Senior Subordinated Notes mature on March 15, 2010. Interest is payable semi-annually in arrears each March 15 and September 15. On or after March 15, 2005, we may redeem these notes, at our option, in whole or in part, at specified redemption prices plus accrued and unpaid interest. The redemption price is 105.938% in 2005 and decreases in equal annual increments to 100.000% in 2008 and thereafter. In the event of a change in control, we would be required to offer to repurchase the notes at a price equal to 101.0% of the principal amount plus accrued and unpaid interest. The 11 7/8% Senior Subordinated Notes are our general obligations, subordinated in right of payment to all existing and future senior debt and are guaranteed by certain of our subsidiaries. The indenture under which the 11 7/8% Senior Subordinated Notes were issued contains certain covenants that, among other things, limit our ability to incur additional indebtedness, incur liens, dispose of assets, prepay or amend other indebtedness, pay dividends or purchase our stock, and engage in transactions with affiliates. 18 Liquidity and Capital Requirements We have a management agreement with AEA Investors Inc. under which we receive advisory and consulting services provided by AEA Investors LLC, the successor company to AEA Investors Inc. and sometimes referred to in this report collectively with its successor as AEA Investors. The management agreement provides for an annual aggregate fee of $1.0 million plus reasonable out-of-pocket costs and expenses. Interest payments on the amounts drawn under the Credit Agreement, as well as other indebtedness and obligations, represent significant obligations for us. Our remaining liquidity demands relate to capital expenditures and working capital needs. Our capital expenditures were approximately $6.6 million in 2002 and management currently anticipates capital expenditures will be approximately $8.0 million in 2003 and approximately $8.0 million in 2004. While we engage in ongoing evaluations of, and discussions with, third parties regarding possible acquisitions, as of the date of this report, we have no current expectations with respect to any acquisitions. Exclusive of the impact of any future acquisitions, joint venture arrangements or similar transactions, our management does not expect capital expenditure requirements to increase materially in the foreseeable future. The following summarizes certain of our contractual obligations at December 31, 2002, expressed in thousands of dollars, and the effect of such obligations are expected to have on our liquidity and cash flow in future periods. During the ordinary course of business, we enter into contracts to purchase raw materials and components for manufacture. In general, these commitments do not extend for more than a few months.

__________ (1) Represent principal amounts, but not interest. (2) Represents minimum future payments. Our primary sources of liquidity are cash flows from operations and borrowings under our Credit Agreement. Based on current and anticipated financial performance, we expect that cash flow from operations and borrowings under our Credit Agreement will be adequate to meet anticipated requirements for capital expenditures, working capital and scheduled interest payments, including interest payments on the amounts outstanding under the 11 7/8% Senior Subordinated Notes, the Credit Agreement and other indebtedness through September 30, 2004. Our ability to satisfy capital requirements will be dependent upon our future financial performance. Additionally our ability to repay or refinance our debt obligations will also be subject to economic conditions and to financial, business and other factors, many of which are beyond our control. Inflation After declining through early 2002, the costs of certain of our raw materials have increased. We expect that raw material costs have largely stabilized in the short term by mid 2003. In an attempt to offset these increases we raised selling prices selectively and executed raw material substitutions where possible. Historically, in aggregate, price increases have been sufficient to recover new raw material cost increases, but not to maintain margins. There can be no assurance as to our ability to recover additional cost increases through price increases in the future. 19 Forward-looking Statements Some of the information presented in, or connection with, this report include "forward-looking statements" based on our current expectations and projections about future events and involve potential risks and uncertainties. Our future results could differ materially from those discussed in this report. Some of the factors that could cause or contribute to such differences include: o changes in economic and market conditions that impact the demand for our products and services; o risks inherent in international operations, including possible economic, political or monetary instability; o uncertainties relating to our ability to consummate our business strategy, including realizing synergies and cost savings from the integration of acquired businesses or from plant closures. o the impact of new technologies and the potential effect of delays in the development or deployment of such technologies; and, o changes in raw material costs and our ability to adjust selling prices. You should not place undue reliance on these forward-looking statements, which are applicable only as of October 30, 2003. All written and oral forward-looking statements attributable to us are expressly qualified in their entirety by the foregoing factors and those identified in Exhibit 99.1 incorporated by reference into this report. We undertake no obligation to revise or update these forward-looking statements to reflect events or circumstances that arise after October 30, 2003 or to reflect the occurrence of unanticipated events. New risks emerge from time to time and it is not possible for us to predict all such risks, nor can we assess the impact of all such risks on our business or the extent to which any risks, or combination of risks, may cause actual results to differ materially from those contained in any forward-looking statement. Item 3. Quantitative and Qualitative Disclosures about Market Risk The principal market risks, which are potential losses in fair values, cash flows or earnings due to adverse changes in market rates and prices, to which we are exposed, as a result of our holdings of financial instrument and commodity positions, are: o interest rates on debt; o foreign exchange rates; and o commodity prices, which affect the cost of raw materials. Our financial instruments include short-term debt and long-term debt. Trade accounts payable and trade accounts receivable are not considered financial instruments for purposes of this item because their carrying amount approximate fair value. We do not maintain a trading portfolio and do not utilize derivative financial instruments to manage our market risks. In the future, we may enter into foreign exchange currency hedging agreements in connection with our international operations. Market Risk Management We have measured our market risk related to our financial instruments based on changes in interest rates and foreign currency rates utilizing a sensitivity analysis. The sensitivity analysis measures the potential loss in fair values, cash flows and earnings based on a hypothetical change (increase and decrease) in interest rates and a decline in the U.K. pound/dollar exchange rate. We used market rates as of September 30, 2003 on our financial instruments to perform the sensitivity analysis. We believe that these potential changes in market rates are reasonably possible in the near-term (one year or less). We have conducted an analysis of the impact of a 100 basis point change in interest rates and a 10% decline in the U.K. pound/dollar exchange rate, discussed below. Interest Rate Exposure Our primary interest rate exposure relates to our variable rate debt. We utilize a combination of variable rate debt, primarily under our Credit Agreement, and fixed rate debt, primarily under our 11 7/8% Senior Subordinated Notes. Our Credit Agreement requires that, at least 45% of our funded indebtedness be fixed-rate or subject to interest rate hedging agreements to reduce the risk associated with variable-rate debt. At September 30, 2003 approximately 69% of our funded indebtedness was fixed-rate. The variable rate debt is primarily exposed to changes in interest expense from changes in the U.S. prime rate, the federal funds effective rate and the Eurodollar borrowing rate, while the fixed rate debt is primarily exposed to changes in fair value from changes in medium term interest rates. Based on our indebtedness at September 30, 2003, we estimate that an immediate 100 basis point rise in interest rates would result in $0.7 million increase in interest expense for the period October 1, 2003 to September 30, 2004. For purposes of this estimate, we have assumed a constant level of variable rate debt and a constant interest rate over the period equal to those levels existing on September 30, 2003. 20 Currency Rate Exposure Our primary foreign currency exchange rate exposure relates to the U.K. pound which results in our exposure to changes in the dollar exchange rate. Our exposure to changes in U.S. dollar exchange rates with currencies other than the U.K. pound are not currently material. Changes in translation risk are reported as adjustments to stockholders' equity. We estimate that the impact of a 10% decline in the dollar/U.K. pound exchange rate from $1.65/(pound)1.00 to $1.48/(pound)1.00 at September 30, 2003 would result in a decrease in our earnings before taxes of $0.8 million for the period from October 1, 2003 to September 30, 2004. Commodities Risk We are subject to market risk with respect to commodities because our ability to recover increased raw materials costs through higher pricing may be limited by the competitive environment in which we operate. We use a broad variety of specialty and some commodity raw materials in our manufacturing processes. In 2002, we purchased about $195 million of raw materials including acrylic monomers and polymers, resins, natural and synthetic rubbers, solvents, and urethanes. Although these raw materials are derived from crude oil or natural gas, the raw materials are several manufacturing steps removed (downstream) from these basic feedstocks. As a result, the price of oil and gas will affect our costs for these raw materials both upward and downward, but the magnitude of change is diluted. We typically purchase strategic raw materials on a contract basis to moderate price changes during the contract period, however, prices can change significantly at the end of contract periods if supply shortages, feedstock cost pressures, or other unforeseen market conditions arise. Commodity raw materials are available from numerous independent suppliers, and specialty raw materials are usually available from several suppliers. We expect the cost of many raw materials to increase over the long term. In aggregate, we have had some success historically in passing on raw material cost increases through price increases to our customers over time under certain competitive market conditions, although not always in levels adequate to maintain margins.; we may not have success in the future. These sensitivity analyses are estimates and are based on certain simplifying assumptions. These analyses should not be viewed as predictive of our future financial performance. Additionally, we cannot provide any assurance that the actual impact in any particular year will not materially exceed the amounts indicated above. Item 4. Controls and Procedures We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us (including our consolidated subsidiaries) required to be included in our periodic SEC filings. There were no changes in our internal controls over financial reporting that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting. 21 PART II -- OTHER INFORMATION Item 1. Legal Proceedings None Item 2. Changes in Securities and Use of Proceeds None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 31.1 -- Certifications as required by Section 302(a) of the Sarbanes-Oxley Act of 2002 31.2 -- Certifications as required by Section 302(a) of the Sarbanes-Oxley Act of 2002 99.1 -- Cautionary Statements for Regarding Forward Looking Statements incorporated by reference to Exhibit 99.1 to the Company's Form 10-K dated March 14, 2003. (b) Reports on Form 8-K On July 31, 2003, we filed a current report of Form 8-K, Item 12. Disclosure of Results of Operations and Financial Condition, disclosing that we had issued a press release on July 31, 2003 to provide an update on our operating results for the quarter ended June 30, 2003. 22 SOVEREIGN SPECIALTY CHEMICALS, INC. Signatures Pursuant to the requirements 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. SOVEREIGN SPECIALTY CHEMICALS, INC. /s/ NORMAN E. WELLS JR. ------------------------------------------------------- Norman E. Wells Jr., Chairman, Chief Executive Officer (Principal Executive Officer) /s/ TERRY D. SMITH ------------------------------------------------------- Terry D. Smith, Vice President, Chief Financial Officer (Principal Financial Officer) Date: October 30, 2003 23

SOVEREIGN SPECIALTY CHEMICALS INC 10-Q