NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Exhibit 13(g)
Cleveland-Cliffs Inc and Consolidated Subsidiaries
ACCOUNTING POLICIES
BASIS OF CONSOLIDATION: The consolidated financial statements include the
accounts of the Company and its majority-owned subsidiaries, and references to
the "Company" include the Company and consolidated subsidiaries. "Investments in
Associated Companies" are comprised of partnerships and unconsolidated companies
("ventures") which the Company does not control. Such investments are accounted
by the equity method and include, where appropriate, capitalized interest
incurred during the construction phase of qualifying assets (see Note B). The
Company's share of earnings of mining partnerships and companies from which the
Company purchases iron ore production is credited to "Cost of Goods Sold and
Operating Expenses" upon sale of the product. Pre-operating expenses incurred
during construction of the Trinidad reduced iron project are charged to "Other
Expenses" as incurred.
BUSINESS: The Company's dominant business is the production and sale of iron ore
pellets to integrated steel companies. The Company controls, develops, and
leases reserves to mine owners; manages and owns interests in mines; sells iron
ore; and owns interests in ancillary companies providing services to the mines.
Iron ore production activities are conducted in the United States and Canada.
Iron ore is marketed in North America and Europe. The three largest steel
company customers' contribution to the Company's revenues were 20 percent, 13
percent and 10 percent in 1997; 15 percent, 12 percent and 11 percent in 1996;
and 17 percent, 11 percent and 10 percent in 1995.
The Company also has an equity interest in an international joint venture,
located in Trinidad and Tobago, to produce and market reduced iron briquettes.
The venture is under construction and is scheduled to start-up, as planned, in
the fourth quarter 1998. (See Note B - Reduced Iron.)
The Australian Savage River Mines operation terminated production, as planned,
in December, 1996 and shipped its remaining inventory during the first quarter
of 1997. The wholly-owned Australian operations had total revenues and pre-tax
operating profit of $10.9 million and $4.6 million, $58.4 million and $20.2
million, and $47.2 million and $12.9 million, in 1997, 1996 and 1995,
respectively. Total consolidated Australian assets were $24.9 million at
December 31, 1996 (none at December 31, 1997).
On March 25, 1997, the remaining assets (including $8.6 million cash) of Savage
River Mines and all related environmental and rehabilitation obligations were
transferred to the Tasmanian government. As a result of completion of the
transaction, the Company recorded a $3.2 million after-tax ($5.0 million
pre-tax) reversal of Savage River closedown obligations recorded in prior years.
REVENUE RECOGNITION: Revenue is recognized on sales of products when title has
transferred and on services when services have been performed.
Royalty revenue from the Company's share of ventures' production is recognized
when the product is sold. Royalty revenue from ventures' other participants is
recognized on production.
45
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
BUSINESS RISK: The North American steel industry experienced high operating
rates and generally positive financial results in 1997, 1996 and 1995. The
Company's integrated steel company partners and customers have generally
improved their financial condition over the three-year period as a result of
continued earnings and increased equity capital.
In recent years, the improvement in most steel companies' financial positions
has significantly reduced the major business risk faced by the Company, i.e.,
the potential financial failure and shutdown of significant customers or
partners with a resulting unmitigated loss of ore sales or royalty and
management fee income.
If any such shutdown were to occur without mitigation through replacement sales
or cost reduction, it would represent a significant adverse financial
development to the Company. The iron mining business has high operating leverage
because fixed costs are a large portion of the cost structure. Therefore,
unmitigated loss of sales or other income due to failure of a customer or
partner would have an adverse income effect proportionately greater than the
revenue effect.
McLouth Steel Products Company ("McLouth"), previously a significant customer,
ceased operations on March 15, 1996 after filing for protection under the U.S.
Bankruptcy Code on September 29, 1995. Although sales to McLouth in 1996 were
only .3 million tons prior to shutdown in the first quarter, compared to 1.3
million tons for the full year 1995, sales of remaining available tons were made
to other customers. During 1997, the Company received cash of $1.1 million and
property in satisfaction of its secured claim resulting from the June 26, 1996
bankruptcy court approved sale of McLouth's assets.
USE OF ESTIMATES: The preparation of financial statements, in conformity with
generally accepted accounting principles, 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 those estimated.
CASH EQUIVALENTS: The Company considers investments in highly liquid debt
instruments with an initial maturity of three months or less, or with put
options exercisable in three months or less, to be cash equivalents (see Note
A - Accounting Policy and Disclosure Changes).
INVESTMENTS: The Company determines the appropriate classification of debt and
equity securities at the time of purchase and reevaluates such designation as of
each financial statement date. Securities are classified as held-to-maturity
when the Company has the intent and ability to hold the securities to maturity.
Held-to-maturity securities are stated at cost and investment income is
included in earnings. Certain highly liquid securities are classified as trading
securities, and are stated at fair value with unrealized holding gains and
losses included in income. Securities that are not classified as
held-to-maturity or trading are classified as available-for-sale.
Available-for-sale securities are carried at fair value, with the unrealized
holding gains and losses, net of tax, reported as a separate component of
shareholders' equity.
46
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
DERIVATIVE FINANCIAL INSTRUMENTS: The Company does not engage in acquiring or
issuing derivative financial instruments for trading purposes. Derivative
financial instruments, in the form of forward currency exchange contracts, are
used by the Company to manage foreign exchange risks. These forward exchange
contracts are hedging transactions that have been entered into with the
objective of managing the risk of exchange rate fluctuations with respect to the
ordinary local currency obligations of the Company's operations. Gains and
losses are recognized in the same period as the hedged transaction.
INVENTORIES: Product inventories, primarily finished products, are stated at the
lower of cost or market. The cost of product inventories is determined using the
last-in, first-out ("LIFO") method. The excess of current cost over LIFO cost of
product inventories was $2.9 million at December 31, 1997 and 1996. The cost of
other inventories is determined by the average cost method.
PROPERTIES: Properties are stated at cost. Depreciation of plant and equipment
is computed principally by the straight-line method based on estimated useful
lives, not to exceed the life of the operating unit, and is not reduced when
operating units are temporarily idled. Depreciation on buildings, mining and
processing equipment is provided over the following estimated useful lives:
Buildings 45 Years
Mining Equipment 10-20 Years
Processing Equipment 15-45 Years
Depletion of mineral lands is computed using the units of production method
based upon proven mineral reserves.
ENVIRONMENTAL REMEDIATION COSTS: The Company accrues environmental remediation
obligations when the obligations are probable and can be reasonably estimated.
Costs of future expenditures are not discounted to their present value.
Recoveries from insurance companies or other parties are not recognized until
they become probable.
STOCK COMPENSATION: The Company applies the provisions of the Accounting
Principles Board Opinion No. 25 ("APB 25") and related Interpretations in
accounting for its stock option plans. Accordingly, compensation expense is not
recognized for stock options when the stock option price at the grant date is
equal to or greater than the fair market value of the stock at that date.
EXPLORATION, RESEARCH AND DEVELOPMENT COSTS: Exploration, research and
continuing development costs of mining properties are charged to operations as
incurred. Development costs which benefit extended periods are deferred and
amortized over the period of benefit. At December 31, 1997, deferred development
costs were less than $.5 million.
INCOME PER COMMON SHARE: Basic income per common share is based on the average
number of common shares outstanding during each period. Diluted income per
common share is based on the average number of common shares outstanding during
each period, adjusted for the effect of outstanding stock options, restricted
stock and performance shares.
47
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
RECLASSIFICATIONS: Certain prior year amounts have been reclassified to conform
to current year classifications.
NOTE A - ACCOUNTING POLICY AND DISCLOSURE CHANGES
In June, 1997, the Company redefined its accounting policy for cash equivalents
to include highly liquid debt instruments with a put option. Included in cash
equivalents at December 31, 1997 are $4.9 million ($13.1 million at December 31,
1996 - reclassified) variable rate demand notes. These investments are revalued
every seven days and can be put with seven days notice. The notes are guaranteed
by letters of credit from highly rated financial institutions. The carrying
value of these instruments approximates fair value on the reporting dates.
In October, 1996, Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position 96-1,
"Environmental Remediation Liabilities," the purpose of which is to improve the
manner in which existing authoritative accounting literature is applied in
recognizing, measuring and disclosing environmental remediation liabilities. The
adoption of this statement in the first quarter of 1997 did not have a
significant effect on the Company's consolidated financial statements.
In February, 1997, the Financial Accounting Standards Board ("FASB") issued
Statement 128, "Earnings per Share," which simplifies the standards for
computing earnings per share and makes them comparable to international
standards. Under the new requirements, basic earnings per share approximates
previously reported earnings per share, and diluted earnings per share takes
into account the effect on average common shares of stock options, restricted
stock and performance shares. The statement was adopted in December, 1997 and
earnings per share for all prior periods presented have been restated.
In June, 1997, the FASB issued Statement 130, "Reporting Comprehensive Income,"
which establishes standards for the reporting and display of comprehensive
income and its components in a full set of financial statements. The standard is
effective for years beginning after December 15, 1997. Management is evaluating
disclosure alternatives of this statement.
In June, 1997, the FASB issued Statement 131, "Disclosures About Segments of an
Enterprise and Related Information." This Statement, effective for years
beginning after December 15, 1997, changes the way that segment information is
defined and reported in annual and interim financial statements. Under current
accounting standards, the Company's operations are considered to be a single
reportable segment. Management is evaluating the new standard and has not yet
determined what effect, if any, it may have on future disclosure.
48
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
NOTE B - INVESTMENTS IN ASSOCIATED COMPANIES
NORTH AMERICAN IRON ORE
- -----------------------
The Company's investments in the ventures are accounted by the equity method and
consist of its 40 percent interest in Tilden Mining Company L.C. ("Tilden"),
22.5625 percent interest in Empire Iron Mining Partnership ("Empire"), 15
percent interest in Hibbing Taconite Company ("Hibbing"), and 22.78 percent
(7.69 percent in 1996 and 1995) interest in Wabush Mines ("Wabush"). These
ventures are managed by the Company in North America. The other interests are
owned by U.S. and Canadian integrated steel companies.
Following is a summary of combined financial information of the operating
ventures:
(In Millions)
-------------------------------------------
1997 1996 1995
-------- -------- ------
INCOME
Gross revenue $1,027.0 $1,043.7 $1,025.9
Equity income 111.1 121.0 143.3
======== ======== ========
FINANCIAL POSITION
Properties - net $ 713.8 $ 745.6 $ 761.5
Other assets 173.9 163.4 138.6
Debt obligations -- -- (22.5)
Other liabilities (217.7) (204.9) (163.9)
-------- -------- --------
Net assets $ 670.0 $ 704.1 $ 713.7
======== ======== ========
Company's equity in
underlying net assets $ 196.7 $ 189.2 $ 195.7
Company's investment $ 160.8 $ 147.5 $ 152.0
======== ======== ========
The Company manages and operates all of the ventures and leases or subleases
mineral rights to certain ventures. In addition, the Company is required to
purchase its applicable current share, as defined, of the production decided by
the venture participants. The Company purchased $243.3 million in 1997 (1996-
$228.0 million; 1995-$217.8 million) of iron ore from certain ventures. During
1997, the Company earned royalties and management fees of $47.5 million (1996-
$51.5 million; 1995-$49.5 million) from ventures, of which $11.8 million in 1997
(1996-$14.4 million; 1995-$13.7 million) was the Company's share as a
participant in the ventures. The payments made by the Company, as a participant
in the ventures, are reflected in royalties and management fees revenue and cost
of goods sold upon the sale of the product.
49
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
Costs and expenses incurred by the Company, on behalf of the ventures, are
charged to such ventures in accordance with management and operating agreements.
The Company's equity in the income of the ventures is credited to the cost of
goods sold and includes the amortization to income of the difference of the
Company's equity in the underlying net assets and its investment on the
straight-line method based on the useful lives of the underlying assets. The
difference between the Company's equity in underlying net assets and recorded
investment results from the assumption of interests from former participants in
the ventures, acquisitions, and reorganizations. The Company's equity in the
income of ventures was $23.1 million in 1997 (1996-$24.1 million; 1995-$24.3
million).
The Company acquired Inland Steel Company's ("Inland") 15.1 percent interest in
the Wabush Mines iron ore joint venture in Canada for $15.0 million effective
January 1, 1997. The acquisition raises the Company's interest in the Company-
managed venture to 22.78 percent. Depending on the magnitude of future tonnage,
additional payments to Inland may be required, but are not expected to be
material in any year.
The Company's effectively serviced share of long-term obligations of ventures,
including the current portion, was $4.9 million as of December 31, 1997 (1996-
$2.9 million), principally capitalized leases.
REDUCED IRON
- ------------
On April 15, 1996, the Company announced an international joint venture to
produce and market premium quality reduced iron briquettes to the steel
industry. All project documents were executed on May 8, 1996. The venture's
participants, through subsidiaries, are the Company, 46.5 percent; The LTV
Corporation ("LTV"), 46.5 percent; and Lurgi AG of Germany, 7 percent. The
Company manages the project, located in Trinidad and Tobago, and will be
responsible for sales by the venture company, Cliffs and Associates Limited. The
total project is estimated to cost $160.0 million of which project capital
expenditures are estimated to be $142.5 million, with actual expenditures of
$77.0 million and $28.2 million in 1997 and 1996, respectively, and estimated
1998 expenditures of $37.3 million. The Company's share of capital expenditures
is estimated to be $66.3 million, of which $35.8 million was spent in 1997,
$13.1 million in 1996 and $17.4 million is expected to be spent in 1998. No
project financing will be used. The facilities are scheduled to start-up, as
planned, in the fourth quarter of 1998.
The Company's investment in the venture is accounted by the equity method. The
investment at December 31, 1997 was $57.5 million ($14.4 million at December 31,
1996) and includes capitalized interest on qualifying assets of $2.6 million
($.3 million - 1996). A pre-operating loss of $1.5 million in 1997 (none in
1996) resulting from cost incurred during the construction period has been
included in other expenses.
50
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
NOTE C - INVESTMENTS
Following is a summary of investment securities:
(In Millions)
-------------------------------------
Gross Estimated
Unrealized Fair
Cost (Losses) Value
---- -------- -----
December 31, 1997
- ------------------
Long-Term Investments
- ---------------------
Available-for-Sale
------------------
LTV Common Stock $11.5 $(3.2) $ 8.3
===== ===== =====
December 31, 1996*
- ------------------
Long-Term Investments
- ---------------------
Available-for-Sale
------------------
LTV Common Stock $11.5 $(1.5) $10.0
Held-to-Maturity
----------------
Australian Government Securities .8 -- .8
----- ----- -----
Total Long-Term Investments $12.3 $(1.5) $10.8
===== ===== =====
Marketable Securities
- ---------------------
Debt Instruments
----------------
Available-for-Sale $ 4.0 $ -- $ 4.0
===== ===== =====
* Reclassified - see Note A - Accounting Policy and Disclosure Changes.
In 1997 and 1996, $.8 million and $3.8 million of Australian government
securities, respectively, matured and were converted to cash and cash
equivalents. The redemption of these investments, previously classified as held-
to-maturity securities, did not result in the recognition of a gain or loss.
NOTE D - RESERVE FOR CAPACITY RATIONALIZATION
The Company initially established a reserve of $70 million in 1983 to provide
for expected costs of reorienting its mining joint ventures and facilities to
adjust to changed market conditions. During 1990, the Company increased the
reserve by $24.7 million as a result of a restructuring of Savage River Mines
under which the previous participants in the venture paid $19.0 million to the
Company for closedown obligations. In 1997, $13.8 million was charged to the
reserve including a $5.0 million recovery of closedown provision for Savage
River Mines. During 1996, $1.1 million was charged to the reserve, and during
1995, $.5 million was credited to the reserve. The balance principally for the
permanent shutdown of the Republic Mine, at December 31, 1997 was $19.9 million,
with $7.1 million classified as a reduction of other current assets. The
Republic Mine shutdown was announced on January 30, 1996. Site expenditures are
expected to be completed by 2002.
51
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
NOTE E - ENVIRONMENTAL RESERVES
The Company has a formal code of environmental conduct which promotes
environmental protection and restoration. The Company's obligations for known
environmental problems at active mining operations, idle and closed mining
operations and other sites have been recognized based on estimates of the cost
of investigation and remediation at each site. If the cost can only be estimated
as a range of possible amounts with no specific amount being most likely, the
minimum of the range is accrued in accordance with generally accepted accounting
principles. Estimates may change as additional information becomes available.
Actual costs incurred may vary from the estimates due to the inherent
uncertainties involved. Any potential insurance recoveries have not been
reflected in the determination of the financial reserves.
The Company provided $1.4 million and $2.4 million of additional environmental
reserves in 1997 and 1996, respectively. The additional environmental provisions
reflect the Company's continuing review of estimated investigation and
remediation expense at all known sites. Payments in 1997 were $2.4 million (1996
- - $1.6 million).
At December 31, 1997, the Company had an environmental reserve of $22.7 million
($23.7 million at December 31, 1996), of which $3.3 million was classified as
current. The reserve includes the Company's obligations related to:
- Federal and State Superfund and Clean Water Act sites where the
Company is named as a potentially responsible party, including
Cliffs-Dow and Kipling sites in Michigan and the Rio Tinto mine
site in Nevada, all of which sites are independent of the
Company's iron mining operations. The reserves are based on
engineering studies prepared by outside consultants engaged by the
potentially responsible parties. The Company continues to evaluate
the recommendations of the studies and other means for site
clean-up. Significant site clean-up activities have taken place at
Cliffs-Dow and Rio Tinto.
- Wholly-owned active and idle operations, including Northshore mine
and Silver Bay power plant in Minnesota. The Northshore/Silver Bay
reserve is based on an environmental investigation conducted by
the Company and an outside consultant in connection with the 1994
acquisition.
- Other sites, including former operations, for which reserves are
based on the Company's estimated cost of investigation and
remediation of sites where expenditures may be incurred.
52
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
NOTE F - LONG-TERM OBLIGATIONS
Long-term debt of the Company consists of $70 million of senior unsecured notes
payable to an insurance company group. The proceeds from these notes were used
to retire existing notes held by another group of insurance companies in
December, 1995. The current notes, due in December, 2005, have a fixed interest
rate of 7.0 percent and replaced notes which had an average interest rate of
8.77 percent. The retiring of the notes resulted in an extraordinary charge of
$3.1 million after-tax ($4.8 million before-tax) in 1995. The senior unsecured
note agreement requires the Company to meet certain covenants related to net
worth ($229.1 million at December 31, 1997), leverage, and other provisions. The
Company was in compliance with the debt covenants at December 31, 1997.
The Company's $100 million revolving credit agreement was amended in June, 1997
to extend the expiration date by one year to March 1, 2002, and to reduce
interest rates and fees. No borrowings are outstanding under this agreement.
Additionally, the Company, including its share of the ventures, has outstanding
$5.2 million of unsecured letters of credit.
NOTE G - LEASE OBLIGATIONS
The Company and its managed ventures lease certain mining, production, data
processing and other equipment under operating leases. The Company's operating
lease expense, including its share of the ventures, was $8.7 million in 1997,
$7.6 million in 1996 and $6.9 million in 1995.
The Company's share of properties of the Company's managed ventures at December
31, 1997 and 1996 included $8.0 million and $4.5 million, respectively, of
production equipment and service vehicles acquired under capital leases. The
Company's share of accumulated amortization of capital leases included in
respective allowances for depreciation, was $3.3 million and $2.0 million at
December 31, 1997 and 1996, respectively.
The Company's share of future minimum payments under capital leases and
noncancellable operating leases at December 31, 1997 was:
(In Millions)
---------------------
Year Ending Capital Operating
December 31 Leases Leases
----------- ------- ---------
1998 $1.7 $ 9.0
1999 1.5 8.1
2000 1.4 7.0
2001 .9 5.5
2002 .5 3.7
2003 and thereafter .4 6.8
---- -----
Total minimum lease payments 6.4 $40.1
=====
Amounts representing interest 1.1
----
Present value of net minimum lease payments $5.3
====
53
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
The Company's share of ventures lease obligations are largely non-recourse to
the Company.
NOTE H - RETIREMENT BENEFITS
Pensions
- --------
The Company and its managed ventures sponsor defined benefit pension plans
covering substantially all employees. The plans are noncontributory and benefits
generally are based on employees' years of service and average earnings for a
defined period prior to retirement.
Components of the pension cost (credit), including the Company's proportionate
share of the costs of ventures, were as follows:
(In Millions)
---------------------------------
1997 1996 1995
-------- -------- ------
Service cost $ 3.6 $ 3.8 $ 3.4
Interest cost 13.7 13.2 15.3
Actual (return) on plan assets (40.2) (32.4) (42.6)
Net amortization and deferral 20.5 14.4 22.7
------ ------ ------
Total pension cost (credit) $ (2.4) $ (1.0) $ (1.2)
====== ====== ======
Most of the Company's pension funds are held in diversified collective trusts
with the funds contributed by participants in the ventures. Plan assets
principally include diversified marketable equity securities and corporate and
government debt securities, which are selected by professional asset managers.
The following table presents a reconciliation of the funded status of the
Company's plans, including its proportionate share of the plans of ventures, at
December 31, 1997 and 1996:
(In Millions)
--------------------------
1997 1996
------- -------
Plan assets at fair value $ 270.6 $ 247.9
Actuarial present value of benefit
obligation:
Vested benefits 161.1 152.1
Nonvested benefits 20.3 21.5
------- -------
Accumulated benefit obligation 181.4 173.6
Effect of projected compensation levels 14.8 14.0
------- -------
Projected benefit obligation 196.2 187.6
------- -------
Plan assets in excess of projected
benefit obligation 74.4 60.3
Unrecognized prior service costs 5.7 7.0
Unrecognized net asset at date of adoption
of FAS 87, net of amortization (21.2) (23.7)
Unrecognized net (gain) (24.6) (14.1)
------- -------
Prepaid cost $ 34.3 $ 29.5
======= =======
54
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
At December 31, 1997 and 1996, the Company recorded an intangible asset and an
additional liability of $1.5 million and $2.3 million, respectively, for certain
plans where the fair value of plan assets was less than the accumulated benefit
obligation.
The discount rate and weighted average rate of increase in compensation levels
used in determining the actuarial present value of the projected benefit
obligation were 7.25 percent and 4.29 percent at December 31, 1997 (7.75 percent
and 4.30 percent at December 31, 1996), respectively. The expected long-term
rate of return assumption utilized for determining pension cost (credit) for the
years 1997, 1996 and 1995 was 8.75 percent, 8.75 percent and 8.5 percent,
respectively. The assumption was increased to 9.0 percent on December 31, 1997
for year 1998 pension cost (credit) determination.
The Company makes annual contributions to the plans within income tax
deductibility restrictions in accordance with the requirements of the Employee
Retirement Income Security Act of 1974. For Plan Year 1997 (largely funded in
calendar year 1998), the Company plans to contribute $2.9 million, including its
share of ventures' funding, a decrease of $.1 million from Plan Year 1996. In
the event of plan termination, the sponsors could be required to fund shutdown
and early retirement obligations which are not included in the accumulated
benefit obligation.
Other Postretirement Benefits ("OPEB")
- --------------------------------------
In addition to the Company's defined benefit pension plans, the Company and its
managed ventures currently provide retirement health care and life insurance
benefits to most full-time employees who meet certain length of service and age
requirements (a portion of which are pursuant to collective bargaining
agreements). These benefits are provided through programs administered by
insurance companies whose charges are based on the benefits paid during the
year. If such benefits are continued, most active employees would become
eligible for these benefits when they retire.
The following table presents a reconciliation of the funded status of the
Company's OPEB obligations, including its proportionate share of the obligations
of ventures, at December 31, 1997 and 1996:
(In Millions)
---------------------
1997 1996
------ -------
Accumulated postretirement benefit obligation:
Retirees $ 55.9 $ 54.6
Fully eligible active plan participants 9.3 6.2
Other active plan participants 23.2 20.7
------ ------
Total obligation 88.4 81.5
Plan assets (17.3) (14.3)
------ ------
Accumulated postretirement benefit cost
obligation in excess of plan assets 71.1 67.2
Unrecognized prior service (cost) (.7) (.1)
Unrecognized gain 3.6 6.5
------ ------
Accrued postretirement benefit cost $ 74.0 $ 73.6
====== ======
55
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
Net periodic postretirement benefit cost, including the Company's proportionate
share of the costs of ventures, includes the following components:
(In Millions)
-------------------------
1997 1996 1995
------ ------ -----
Service cost $ 1.3 $ 1.3 $ 1.2
Interest cost 6.2 5.9 5.8
Return on plan assets (1.0) (.9) (.6)
Net amortization and deferral -- -- (.4)
----- ----- -----
Net periodic postretirement benefit cost $ 6.5 $ 6.3 $ 6.0
===== ===== =====
The Company's medical cost trend rate assumption reflects projected medical cost
growth of 7.5 percent in 1998, decreasing by .5 percent per year to a growth
rate of 5 percent for the year 2003 and annually thereafter. The medical cost
trend rate assumption has a significant effect on the amounts reported. For
example, changing the assumed medical cost trend rate by one percentage point in
each year would change the accumulated postretirement benefit obligation, as of
December 31, 1997 by $13.1 million, and the aggregate of the service and
interest cost components of net periodic postretirement benefit cost for 1997 by
$1.2 million. Amounts include the Company's proportionate share of the costs of
ventures.
Plan assets include deposits relating to funded life insurance contracts that
are available to fund retired employees' life insurance obligations.
Additionally, as part of the 1993 labor contracts at Empire, Hibbing, and
Tilden, Voluntary Employee Benefit Association Trusts ("VEBAs") were
established. Funding of the VEBAs began in 1994 to cover a portion of the
postretirement benefit obligations of these ventures. As a participant, the
Company's minimum annual contribution is $.7 million per year. The Company's
estimated actual contribution will approximate $1.5 million per year based on
its share of tons produced. The discount rate used in determining the
accumulated postretirement benefit obligation was 7.25 percent at December 31,
1997 (7.75 percent and 7.25 percent at December 31, 1996 and 1995,
respectively). The expected long-term rate of return on life insurance contract
deposits was increased to 6.5 percent at December 31, 1997, from 6.0 percent at
December 31, 1996. The expected return on VEBAs was increased to 8.0 percent at
December 31, 1997 from 7.75 percent at December 31, 1996.
56
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
NOTE I - INCOME TAXES
Significant components of the Company's deferred tax assets and liabilities as
of December 31, 1997 and 1996 are as follows:
(In Millions)
----------------
1997 1996
----- -----
Deferred tax assets:
Postretirement benefits other than pensions $22.3 $21.2
Other liabilities 14.7 18.8
Reserve for capacity rationalization 8.0 8.2
Deferred development -- 8.0
Product inventories 4.2 1.9
Other 2.4 4.5
----- -----
Total deferred tax assets 51.6 62.6
Deferred tax liabilities:
Investment in ventures 23.0 25.2
Other 17.9 21.1
----- -----
Total deferred tax liabilities 40.9 46.3
----- -----
Net deferred tax assets $10.7 $16.3
===== =====
The components of provisions for income taxes before the extraordinary item are
as follows:
(In Millions)
----------------------------------
1997 1996 1995
------ ------ ------
Current $11.9 $23.6 $11.9
Deferred 5.8 10.9 (1.2)
----- ----- -----
$17.7 $34.5 $10.7
===== ===== =====
In 1997, the Company and the Internal Revenue Service reached agreement settling
issues raised during the examination of the Company's federal income tax returns
for the tax years 1991 and 1992. As a result of the settlement and its related
impact on the tax years 1993 through 1995, the Company made additional tax and
interest payments of $3.3 million and is entitled to tax and interest refunds of
$.8 million. Additionally, a reversal of prior years' tax accruals of $5.6
million was recorded.
In 1995, a tax settlement was reached resolving audit issues previously arising
from the Company's restructuring program in the late 1980s. The settlement
resulted in the Company making additional tax and interest payments of $11.8
million, recording a tax credit of $12.2 million in 1995, and entitling the
Company to refunds of $5.3 million in subsequent years.
The provision for income taxes included Australian federal income taxes of $2.1
million, $7.5 million, and $3.7 million for the years 1997, 1996 and 1995,
respectively.
57
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
The reconciliation of effective income tax rate before the extraordinary item
and United States statutory rate is as follows:
1997 1996 1995
---- ---- ----
Statutory tax rate 35.0% 35.0% 35.0%
Increase (decrease) due to:
Percentage depletion in excess
of cost depletion (5.8) (5.9) (7.8)
Effect of foreign taxes 3.0 5.3 1.7
Prior years' tax adjustment (10.0) (.2) (15.2)
Other items - net 2.2 2.0 1.3
---- ---- ----
Effective tax rate 24.4% 36.2% 15.0%
===== ===== =====
Prior years' tax adjustments in 1997 and 1995 include the effects of the $5.6
million and $12.2 million tax credits, respectively.
NOTE J - FAIR VALUES OF FINANCIAL INSTRUMENTS
The carrying amount and fair value of the Company's financial instruments at
December 31, 1997 were as follows:
(In Millions)
------------------------------
Carrying Fair
Amount Value
-------- -------
Cash and cash equivalents $115.9 $115.9
Long-term investments 8.3 8.3
Long-term debt 70.0 70.7
The fair value of the Company's long-term debt was determined based on a
discounted cash flow analysis and estimated borrowing rates.
The Company had $22.0 million and $7.1 million of Canadian forward currency
exchange contracts at December 31, 1997 and 1996, respectively, and $2.7 million
at December 31, 1996 (none in 1997) of Australian forward currency exchange
contracts. The fair value of the Canadian currency exchange contracts, which
have varying maturity dates to December 1, 1998, was estimated to be $21.3
million, based on the December 31, 1997 forward rates.
NOTE K - STOCK PLANS
The 1987 Incentive Equity Plan authorized the Company to make grants and awards
of stock options, stock appreciation rights and restricted or deferred stock
awards to officers and key employees, for up to 750,000 Common Shares (plus an
additional 89,045 Common Shares reserved for issuance, but not issued, under the
Company's 1979 Restricted Stock Plan). During the term of the Plan, 838,144
Common Shares were granted or awarded. Under the terms of the Plan, effective
April 29, 1997, no further grants or awards may be made from this Plan.
58
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- Continued
Cleveland-Cliffs Inc. and Consolidated Subsidiaries
The 1992 Incentive Equity Plan was amended in May, 1997 to authorize the Company
to issue up to 1,150,000 Common Shares (previously 595,000 Common Shares) upon
the exercise of Options Rights, as Restricted Shares, in payment of Performance
Shares or Performance Units that have been earned, as Deferred Shares, or in
payment of dividend equivalents paid with respect to awards made under the Plan.
Such shares may be shares of original issuance or treasury shares or a
combination of both.
Stock options may be granted at a price not less than the fair market value of
the stock on the date the option is granted and must be exercisable not later
than ten years and one day after the date of grant. Stock appreciation rights
may be granted either at or after the time of grant of a stock option. Common
Shares may be awarded or sold to certain employees with restrictions as to
disposition over specified periods. The market value of restricted stock awards
and Performance Shares is charged to expense over the vesting period.
The 1996 Nonemployee Directors' Compensation Plan authorizes the Company to
issue up to 50,000 Common Shares to nonemployee Directors. The Plan provides for
the grant of 1,000 Restricted Shares to nonemployee Directors first elected
after June 30, 1995 and also provides that nonemployee Directors must take at
least 50 percent of their annual retainer and may elect to take the balance of
their retainer and all other fees in Common Shares. The Restricted Shares vest
five years from the date of award.
In accordance with the provisions of FASB Statement 123, "Accounting for Stock-
Based Compensation," ("Statement 123") the Company has elected to continue
applying the provisions of APB 25 and related Interpretations in accounting for
its stock-based compensation plans. Accordingly, the Company does not recognize
compensation expense for stock options when the stock option price at the grant
date is equal to or greater than the fair market value of the stock at that
date. However, the Company recorded $3.0 million, $2.7 million, and $1.3 million
in 1997, 1996 and 1995, respectively, relating to other stock-based
compensation.
Statement 123 requires pro forma information on net income and earnings per
share as if the fair value method for valuing stock options, as prescribed by
Statement 123, had been applied. The Company's pro forma information follows:
1997 1996 1995
------ ------ -----
Net Income (Millions) $54.9 $61.2 $57.9
Earnings Per Share:
Basic $4.83 $5.28 $4.84
Diluted $4.79 $5.25 $4.82
The fair value of these options was estimated at the date of grant using a
Black-Scholes option pricing model with the following weighted-average
assumptions for 1997, 1996 and 1995:
59
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
1997 1996 1995
------ ------ -----
Risk-free Interest Rate 6.04% 6.04% 6.15%
Dividend Yield 2.97% 3.00% 3.01%
Volatility Factor - Market
Price of Company's Common Stock .221 .220 .227
Expected Life of Options - Years 4.31 4.23 2.81
Compensation costs included in the pro forma information reflect fair values
associated with options granted after January 1, 1995. Pro forma information may
not be indicative of future pro forma information applicable to future
outstanding awards.
Stock option, restricted stock award, and performance share activities under the
Company's 1987 and 1992 Incentive Equity Plans, and the 1996 Nonemployee
Directors' Compensation Plan are summarized as follows:
1997 1996 1995
---------------------- --------------------- ---------------------
Weighted- Weighted- Weighted-
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
-------- -------- ------ -------- --------- ----------
Stock options:
Options outstanding
beginning of year 157,425 $35.99 72,775 $23.66 82,182 $22.19
Granted during the year 114,950 43.38 109,500 44.82 5,000 39.55
Exercised (3,000) 21.52 (6,250) 20.29 (14,407) 20.77
Cancelled (16,750) 43.95 (18,600) 45.00 -- --
------- ------- -------
Options outstanding
at end of year 252,625 39.00 157,425 35.99 72,775 23.66
Options exercisable
at end of year 96,925 31.10 72,525 25.45 72,775 23.66
Restricted awards:
Awarded and restricted
at beginning of year 39,665 10,854 13,264
Awarded during the year 13,200 30,000 --
Vested (816) (1,189) (2,410)
Cancelled (2,600) -- --
------- ------- -------
Awarded and restricted
at end of year 49,449 39,665 10,854
Performance shares:
Allocated at beginning of year 145,167 88,767 41,317
Allocated during the year 63,126 57,400 47,450
Issued (45,293) -- --
Forfeited (2,000) (1,000) --
------- ------- -------
Allocated at end of year 161,000 145,167 88,767
Required retainer and voluntary shares:
Awarded at beginning of year 3,150 -- --
Awarded during the year 4,540 3,150 --
Issued (3,142) -- --
------- ------- -------
Awarded at end of year 4,548 3,150 --
Reserved for future grants
or awards at end of year 718,640 339,007 469,457
Weighted-average fair value of
options granted during the year $8.65 $8.75 $6.48
60
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
Exercise prices for options outstanding as of December 31, 1997 ranged from
$8.51 to $45.00, with 75 percent of options outstanding having exercise prices
in the range of $40.00 to $45.00 per share. The weighted-average remaining
contractual life of options outstanding is 7.4 years at December 31, 1997.
NOTE L - SHAREHOLDERS' EQUITY
As of December 31, 1997, the Company is authorized to issue up to 500,000 shares
of Class A voting preferred stock, without par value, and up to 4,000,000 shares
of Class B non-voting preferred stock, without par value.
On September 9, 1997, the Company announced the adoption of a new share purchase
rights ("Rights") plan that replaced an existing rights plan that expired on
September 18, 1997. The Rights plan became effective September 19, 1997. A Right
is attached to each of the Company's Common Shares outstanding or subsequently
issued. Each Right entitles the holder to buy from the Company one-hundredth of
one (.01) Common Share at an exercise price per whole share of $160.00. The
Rights expire on September 19, 2007 and are not exercisable until the occurrence
of certain triggering events, which include the acquisition of, or a tender or
exchange offer for, 20 percent or more of the Company's Common Shares. There are
approximately 168,000 Common Shares reserved for these Rights. The Rights become
exercisable if a person or group acquires, or tenders for, 20 percent or more of
the Company's Common Shares. The Company is entitled to redeem the Rights at one
cent per Right upon the occurrence of certain events.
Through December 31, 1997, the Company has purchased 893,400 of its Common
Shares at a total cost of $35.2 million (1997 - 113,100 shares, $4.9 million;
1996 - 495,800 shares, $19.5 million; 1995 - 284,500 shares, $10.8 million) or
an average price of $39.41 per share under its announced program to repurchase
up to 1.5 million Common Shares in the open market or in negotiated
transactions.
NOTE M - EARNINGS PER SHARE
The following table provides a reconciliation for the computation of basic and
diluted earnings per share from continuing operations:
(In Millions, Except Per Share)
-------------------------------
1997 1996 1995
---- ---- ----
Net Income From Continuing Operations,
before Extraordinary Item $ 54.9 $ 61.0 $ 60.9
Basic Weighted-Average Shares 11.4 11.6 11.9
Effect of Dilutive Shares:
Stock Options/Performance Shares .1 .1 .1
------ ------ ------
Diluted Weighted-Average Shares 11.5 11.7 12.0
====== ====== ======
Basic Earnings per Share $ 4.83 $ 5.26 $ 5.10
====== ====== ======
Diluted Earnings per Share $ 4.80 $ 5.23 $ 5.08
====== ====== ======
61
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cleveland-Cliffs Inc and Consolidated Subsidiaries
NOTE N - LITIGATION
The Company and its managed ventures are periodically involved in litigation
incidental to their operations. Management believes that any pending litigation
will not result in a material liability in relation to the Company's
consolidated financial statements.
62