UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
For the quarterly period ended December 31, 2004
OR
For the transition period from to
Commission File number 1-4982
PARKER-HANNIFIN CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(IRS Employer
Identification No.)
Registrant’s telephone number, including area code: (216) 896-3000
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 Exchange Act). Yes x No ¨
Number of Common Shares outstanding at December 31, 2004 120,171,318
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED STATEMENT OF INCOME
(Dollars in thousands, except per share amounts)
(Unaudited)
Six Months Ended
December 31,
Net sales
Cost of sales
Gross profit
Selling, general and administrative expenses
Interest expense
Other (income) expense, net
Income from continuing operations before income taxes
Income taxes
Income from continuing operations
Income from discontinued operations
Net income
Basic earnings per share:
Net income per share
Diluted earnings per share:
Cash dividends per common share
See accompanying notes to consolidated financial statements.
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CONSOLIDATED BALANCE SHEET
(Dollars in thousands)
Current assets:
Cash and cash equivalents
Accounts receivable, net
Inventories:
Finished products
Work in process
Raw materials
Prepaid expenses
Deferred income taxes
Total current assets
Plant and equipment
Less accumulated depreciation
Goodwill
Intangible assets, net
Other assets
Net assets of discontinued operations
Total assets
Current liabilities:
Notes payable
Accounts payable, trade
Accrued liabilities
Accrued domestic and foreign taxes
Total current liabilities
Long-term debt
Pensions and other postretirement benefits
Other liabilities
Total liabilities
Serial preferred stock, $.50 par value; authorized 3,000,000 shares; none issued
Common stock, $.50 par value; authorized 600,000,000 shares; issued 120,403,088 shares at December 31 and 119,711,057 shares at June 30
Additional capital
Retained earnings
Unearned compensation related to guarantee of ESOP debt
Deferred compensation related to stock options
Accumulated other comprehensive (loss)
Less treasury shares, at cost: 231,770 shares at December 31 and 227,067 shares at June 30
Total shareholders’ equity
Total liabilities and shareholders’ equity
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CONSOLIDATED STATEMENT OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES
Adjustments to reconcile net income to net cash provided by operations:
Net (income) from discontinued operations
Depreciation
Amortization
Foreign currency transaction loss (gain)
(Gain) loss on sale of plant and equipment
Changes in assets and liabilities:
Inventories
Accrued payrolls and other compensation
Other accrued liabilities
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES
Acquisitions (less cash acquired of $2,522 in 2004)
Capital expenditures
Proceeds from sale of plant and equipment
Proceeds from sale of business
Other
Net cash (used in) investing activities
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from common share activity
Payments of (proceeds from) notes payable, net
Proceeds from long-term borrowings
Payments of long-term borrowings
Dividends
Net cash provided by (used in) financing activities
Net cash (used in) provided by discontinued operations
Effect of exchange rate changes on cash
Net (decrease) in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of period
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BUSINESS SEGMENT INFORMATION BY INDUSTRY
The Company operates in two principal business segments: Industrial and Aerospace. The Industrial Segment is the largest and includes a significant portion of International operations.
Industrial - This segment produces a broad range of motion control and fluid systems and components used in all kinds of manufacturing, packaging, processing, transportation, mobile construction, agricultural and military machinery and equipment. Sales are made directly to major original equipment manufacturers (OEMs) and through a broad distribution network to smaller OEMs and the aftermarket.
Aerospace - This segment designs and manufactures products and provides aftermarket support for commercial, military and general aviation aircraft, missile and spacecraft markets. The Aerospace Segment provides a full range of systems and components for hydraulic, pneumatic and fuel applications.
The Company also reports a Climate & Industrial Controls Segment and an Other Segment. The Climate & Industrial Controls Segment manufactures motion-control systems and components for use primarily in the refrigeration and air conditioning and transportation industries. The Other Segment consists of a business unit which designs and manufactures custom-engineered buildings. In December 2004, the Company divested the business unit which was included in the Other Segment which develops and manufactures chemical car care products and maintenance equipment. This business unit has been classified as discontinued operations for all periods presented.
Certain prior period amounts have been reclassified to conform to the current year presentation.
Business Segment Results by Industry
Industrial:
North America
International
Aerospace
Climate & Industrial Controls
Total
Segment operating income
Total segment operating income
Corporate general and administrative expenses
Income from continuing operations before interest expense and other
Other expense
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Dollars in thousands, except per share amounts
In the opinion of the Company, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position as of December 31, 2004, the results of operations for the three and six months ended December 31, 2004 and 2003 and cash flows for the six months then ended. These financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s 2004 Annual Report on Form 10-K. Interim period results are not necessarily indicative of the results to be expected for the full fiscal year.
The Company applies the intrinsic-value based method to account for stock options and makes no charges against earnings with respect to options granted. The following table illustrates the effect on net income and earnings per share as if the fair value based method had been applied to all outstanding and unvested awards in each period.
Net income, as reported
Add: Stock-based employee compensation expense included in reported net income, net of tax
Deduct: Total stock-based employee compensation expense determined under fair value method, net of tax
Pro forma net income
Earnings per share:
Basic – as reported
Basic – pro forma
Diluted – as reported
Diluted – pro forma
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Effective July 1, 2004, the Company adopted the provisions of FASB Staff Position No. FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.” The implementation of this accounting pronouncement did not have a material effect on the Company’s results of operations, financial position or cash flows.
In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, “Inventory Costs – an amendment of ARB No. 43, Chapter 4.” This Statement requires certain abnormal expenses (e.g., idle facility expense) be recognized as current-period charges. This Statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005 and is not expected to have a material effect on the Company’s results of operations, financial position or cash flows.
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004), “Share-Based Payment.” This Statement requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Statement is effective for the Company beginning July 1, 2005. The Company is currently reviewing various fair-value based measurement models to value its share-based payment transactions and it is unknown at this time whether the amounts reflected in footnote 2 will approximate the effect of the adoption of this Statement.
On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (the “Act”). The Act provides a deduction for income from qualified domestic production activities, which will be phased in from calendar 2005 through 2010. The Act also provides for a two-year phase-out of the existing extraterritorial income exclusion (ETI) for foreign sales that was viewed to be inconsistent with international trade protocols by the European Union. The Company has not yet completed its analysis of the net effect of the phase-out of the ETI and the phase-in of the new deduction but does not anticipate the net effect to have a material effect on the Company’s effective tax rate. In accordance with FASB Staff Position No. FAS 109-1, the impact of the new deduction will be reported in the period in which the deduction is claimed on the Company’s tax return. The Act also creates a temporary incentive for U.S. corporations to repatriate accumulated income earned abroad by creating an 85% dividends received deduction for certain dividends from controlled foreign corporations. The deduction is subject to a number of limitations and, at this time, uncertainty remains as to how to interpret numerous provisions in the Act. As such, the Company has not yet decided on whether, and to what extent, the Company might repatriate foreign earnings that have not yet been remitted to the U.S and therefore cannot estimate at this time the effect on income tax expense of any repatriation of accumulated foreign earnings.
In the ordinary course of business, the Company warrants its products against defect in design, materials and workmanship over various time periods. The warranty accrual as of December 31, 2004 and June 30, 2004 is immaterial to the financial position of the Company and the change in the accrual for the current quarter and first six months of fiscal 2005 is immaterial to the Company’s results of operations and cash flows.
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During the first quarter of fiscal 2005, the Company recognized an impairment loss of $8,766 ($5,470 after-tax or $.05 per share) related to a real estate investment. The impairment loss resulted from a cash flow analysis performed by the Company which indicated that the carrying value of the investment was not recoverable. The loss is reflected in the Other (income) expense, net caption in the Consolidated Statement of Income and in the Other caption in the Cash Flow From Investing Activities section of the Consolidated Statement of Cash Flows for the first six months of fiscal 2005.
The following table presents a reconciliation of the denominator of basic and diluted earnings per share for the three and six months ended December 31, 2004 and 2003.
Three Months Ended
Numerator:
Denominator:
Basic - weighted average common shares
Increase in weighted average from dilutive effect of exercise of stock options
Diluted - weighted average common shares, assuming exercise of stock options
Basic earnings per share from continuing operations
Diluted earnings per share from continuing operations
For the three months ended December 31, 2004 and 2003, 1,018 and 22,959 common shares subject to stock options, respectively, were excluded from the computation of diluted earnings per share because the effect of their exercise would be anti-dilutive. For the six months ended December 31, 2004 and 2003, 289,473 and 583,235 common shares subject to stock options, respectively, were excluded from the computation of diluted earnings per share because the effect of their exercise would be anti-dilutive.
The Company has a program to repurchase the Company’s common shares on the open market, at prevailing prices, and the systematic repurchase of up to $10 million in common shares each fiscal quarter. Repurchases are primarily funded from operating cash flows and the shares are initially held as treasury stock. During the three-month period ended December 31, 2004, the Company purchased 144,000 shares of its common stock at an average price of $70.05 per share. Year-to-date, the Company has purchased 321,700 shares at an average price of $62.56 per share.
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The Company’s items of other comprehensive income (loss) are foreign currency translation adjustments and unrealized gains (losses) on marketable equity securities. Comprehensive income for the three and six months ended December 31, 2004 and 2003 was as follows:
Foreign currency translation adjustments
Realized (gains) losses on marketable equity securities
Unrealized gains (losses) on marketable equity securities
Comprehensive income
The unrealized gains (losses) on marketable equity securities are net of taxes of $10 and $6,450 for the three and six months ended December 31, 2004, respectively, and $3,603 and $3,915 for the three and six months ended December 31, 2003, respectively. The realized (gains) losses on marketable equity securities are net of taxes of $4 and $21 for the three and six months ended December 31, 2004, respectively, and $609 for the three and six months ended December 31, 2003, respectively and are reflected in the Other (income) expense, net caption in the Consolidated Statement of Income.
During the second quarter of fiscal 2005, the Company recorded a $1,056 charge ($708 after-tax or $.01 per share) for the costs to structure its businesses in light of current and anticipated customer demand. The Company believes the realignment actions will positively impact future results of operations but will have no material effect on liquidity and sources and uses of capital. The charge primarily related to severance costs attributable to 35 employees in the Industrial Segment. A significant portion of the severance payments have been made with the remaining payments expected to be made by June 30, 2005. The business realignment costs are primarily presented in the Cost of sales caption in the Consolidated Statement of Income for the three months ended December 31, 2004.
During the first six months of fiscal 2005, the Company recorded charges of $2,515 ($1,618 after-tax or $.02 per share) for business realignment costs primarily related to the Industrial Segment. The business realignment costs are presented in the Consolidated Statement of Income for the six months ended December 31, 2004 as follows: $2,075 in Cost of sales and $440 in Selling, general and administrative expenses.
During the second quarter of fiscal 2004, the Company recorded a $3,654 charge ($2,448 after-tax or $.02 per share) for the costs to structure its businesses in light of current and anticipated customer demand. The Company believes the realignment actions will positively impact future results of operations but will have no material effect on liquidity and sources and uses of capital. The charge primarily related to severance costs attributable to 200 employees in the Industrial Segment. All severance payments have been made. The business realignment costs are primarily presented in the Cost of sales caption in the Consolidated Statement of Income for the three months ended December 31, 2003.
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During the first six months of fiscal 2004, the Company recorded charges of $10,594 ($7,098 after-tax or $.06 per share) for business realignment costs primarily related to the Industrial Segment. The business realignment costs are presented in the Consolidated Statement of Income for the three and six months ended December 31, 2003 as follows: $3,563 and $10,378, respectively, in Cost of sales, and $91 and $216, respectively, in Selling, general and administrative expenses.
The changes in the carrying amount of goodwill for the six months ended December 31, 2004 are as follows:
Balance June 30, 2004
Acquisitions
Foreign currency translation
Goodwill adjustments
Balance December 31, 2004
“Goodwill adjustments” primarily represent final adjustments to the purchase price allocation for acquisitions completed within the last twelve months.
Intangible assets are amortized on the straight-line method over their legal or estimated useful lives. The following summarizes the gross carrying value and accumulated amortization for each major category of intangible assets:
Patents
Trademarks
Engineering drawings and other
Total intangible amortization expense for the six months ended December 31, 2004 was $5,611. The estimated amortization expense for the five years ending June 30, 2005 through 2009 is $14,495, $15,311, $14,281, $13,291 and $12,459, respectively.
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Net periodic pension cost recognized included the following components:
Service cost
Interest cost
Expected return on plan assets
Net amortization and deferral and other
Net periodic benefit cost
Net amortization and deferral for the six months ended December 31, 2004 includes a curtailment loss of $4,610. The curtailment loss results from the recognition of unamortized prior service costs related to certain North American employees who have elected to terminate their participation in a defined benefit pension plan and receive future pension benefits under a defined contribution scheme.
Postretirement benefit cost included the following components:
In October 2004, the Company completed its acquisition of the Sporlan Valve Company. Sporlan is a manufacturer of refrigeration and air conditioning components, controls and systems. In November 2004, the Company acquired Acadia Elastomers Corporation, a producer of sealing solutions. Combined annual sales for these businesses and other businesses acquired during the quarter were approximately $320 million. Total purchase price for all businesses acquired during the second quarter of fiscal 2005 was approximately $487 million in cash and was funded from existing cash on hand and commercial paper borrowings. The results of operations for all acquisitions are included as of the respective dates of acquisition. The purchase price allocations for certain of the fiscal 2005 acquisitions are preliminary and may require subsequent adjustment.
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In December 2004, the Company divested a business unit which develops and manufactures chemical car care products and maintenance equipment. This business was part of the Other Segment for segment reporting purposes. The following results of operations for this business unit have been presented as discontinued operations for all periods presented.
Earnings before income taxes
Gain on disposal (net of taxes of $11,147)
As of December 31, 2004, there were no assets or liabilities remaining from the discontinued operations. The net assets of the discontinued operations as of June 30, 2004 primarily consisted of the following:
Accounts receivable
Inventory
Property, plant and equipment, net
Accounts payable
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FOR THE THREE AND SIX MONTHS ENDED DECEMBER 31, 2004
AND COMPARABLE PERIODS ENDED DECEMBER 31, 2003
OVERVIEW
The Company is a leading worldwide-diversified manufacturer of motion control technologies and systems, providing precision engineered solutions for a wide variety of commercial, mobile, industrial and aerospace markets. The Company’s order rates are highly indicative of the Company’s future revenues and thus a key metric for future performance. The Company publishes its order rates on a monthly basis. The lead time between the time an order is received and revenue is realized can range from one day to 12 weeks for commercial, mobile and industrial orders and three to 18 months for aerospace orders. The Company believes the leading economic indicators of these markets that have a strong correlation to the Company’s future order rates are the Institute of Supply Management (ISM) index of manufacturing activity with respect to commercial, mobile and industrial markets and aircraft miles flown, revenue passenger miles and Department of Defense spending for aerospace markets. An ISM index above 50 indicates that the manufacturing economy is expanding resulting in the expectation that the Company’s order rates in the commercial, mobile and industrial markets should be increasing. The ISM index at the end of December 2004 was 58.6 compared to 58.5 at the end of September 2004 and 61.1 at the end of June 2004. With respect to the aerospace market, aircraft miles flown and passenger miles have shown slight improvement over comparable fiscal 2004 levels and the Company anticipates that Department of Defense spending will remain at its current level or be down slightly in the near term.
The Company’s major opportunities for growth are as follows:
The financial condition of the Company remains strong as evidenced by the continued generation of substantial cash flows from operations, a debt to debt-equity ratio under 25 percent, ample borrowing capabilities and strong credit ratings.
Many acquisition opportunities remain available to the Company within its target markets. During the first half of fiscal 2005, the Company completed four acquisitions with combined annual revenues of approximately $320 million. Acquisitions will continue to be considered from time to time to the extent there is a strong strategic fit, while at the same time, maintaining the Company’s strong financial position. The Company will also continue to assess the strategic fit of its existing businesses and initiate efforts to divest businesses that are not considered to be a good long-term fit for the Company, as evidenced by the divestiture of the automotive chemical business unit in the current quarter.
Current challenges facing the Company include maintaining premier customer service levels while benefiting from strong customer demand, successfully matching price increases to raw material price increases and the rising costs related to employee retirement and health care benefits, insurance, and compliance with the provisions of the Sarbanes-Oxley Act and other corporate governance measures. The Company has implemented a number of strategic financial performance initiatives relating to growth and margin improvement in order to meet these challenges including strategic procurement, strategic pricing, lean manufacturing and business realignments.
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The discussion below is structured to provide a separate analysis of the Consolidated Statement of Income, Results by Business Segment, Balance Sheet and Statement of Cash Flows.
(dollars in millions)
Gross profit margin
Selling, general and administrative expenses, as a percent of sales
Effective tax rate from continuing operations
Income from continuing operations, as a percent of sales
Discontinued operations
Backlog
Net sales for the second quarter and first six months of fiscal 2005 increased 21.9 percent and 22.4 percent, respectively, over the comparable prior year sales amounts reflecting higher volume experienced in all Segments. Acquisitions made in the last 12 months and the effect of currency rate changes contributed to about one-half of the sales increase in the current-year quarter and about 40 percent of the increase for the first six months of fiscal 2005.
Gross profit margin increased in the second quarter and first six months of fiscal 2005 due to a combination of the increase in sales as well as the effects of the Company’s financial performance initiatives. Included are business realignment charges of $1.0 million and $3.6 million in the current-year quarter and prior-year quarter, respectively, and $2.1 million and $10.4 million for the first six months of fiscal 2005 and 2004, respectively (see Note 9 on page 9 for further discussion).
Selling, general and administrative expenses increased for the current-year quarter and first six months of fiscal 2005 primarily due to higher expenses related to employee health and welfare plans.
Interest expense for the current-year quarter was unchanged from the prior-year quarter and decreased 14.1 percent for the first six months of fiscal 2005. The decrease in expense is due to a combination of lower average debt outstanding and a lower average interest rate on outstanding debt. Interest expense for the first six months of fiscal 2004 included expenses associated with renewing the Company’s revolving credit agreement.
Other (income) expense, net for the first six months of fiscal 2005 included an $8.8 million expense related to the writedown of a real estate investment.
Effective tax rate from continuing operations for the current-year quarter and first six months of fiscal 2005 is lower primarily due to tax planning initiatives related to recent acquisitions. The Company is currently pursuing a research and development tax credit initiative with the Internal Revenue Service. A favorable result from this initiative will result in a lower effective tax rate for the balance of fiscal 2005.
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Income from continuing operations for the current-year quarter and first six months of fiscal 2005 was adversely affected by an additional expense of approximately $2.1 million and $7.8 million, respectively, related to domestic qualified defined benefit plans, resulting primarily from the amortization of actuarial losses. The additional pension expense for the first six months of fiscal 2005 includes the recognition of a one-time curtailment loss of $2.9 million.
Discontinued operations represents the operating results, net of tax, of the business unit divested in December 2004. The divested business unit develops and manufactures chemical car care products and maintenance equipment. Included in the discontinued operations amount for the three and six months ended December 31, 2004 is an after-tax gain on the sale of approximately $55.4 million.
Backlog increased from the prior year due to an increase in order rates throughout most businesses in the Aerospace and Industrial Segments. Backlog at June 30, 2004 was $2,202.9 million.
RESULTS BY BUSINESS SEGMENT
Industrial Segment
Operating income
Operating income, as a percent of net sales
The Industrial Segment operations experienced the following percentage changes in net sales in the current year compared to the equivalent prior-year period:
Industrial North America – as reported
Currency
Industrial North America – without acquisitions and currency
Industrial International – as reported
Industrial International – without acquisitions and currency
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Total Industrial Segment – as reported
Total Industrial Segment – without acquisitions and currency
The above presentation reconciles the percentage changes in net sales of the Industrial operations reported in accordance with U.S. GAAP to percentage changes in net sales adjusted to remove the effects of acquisitions made within the prior four fiscal quarters as well as the effects of currency exchange rates. The effects of acquisitions and currency exchange rates are removed to allow investors and the Company to meaningfully evaluate the percentage changes in net sales on a comparable basis from period to period.
Excluding the effects of acquisitions and currency-rate changes, the increase in Industrial North American net sales for the current-year quarter and first six months of fiscal 2005 primarily results from higher end-user demand experienced across all of the Industrial North American markets, particularly in the construction, agriculture, heavy-duty truck, mobile equipment and petrochemical markets. Excluding the effects of acquisitions and currency-rate changes, the increase in Industrial International net sales for the current-year quarter and first six months of 2005 is primarily attributed to higher volume across most markets in Europe, Latin America and the Asia Pacific region.
The increase in Industrial North American and Industrial International margins for the current-year quarter and first six months of fiscal 2005 is primarily due to the higher sales volume and benefits realized from the Company’s financial performance initiatives and benefits from past business realignment actions. Lower business realignment charges recorded during the first six months of fiscal 2005 versus fiscal 2004 also contributed to the margin improvement.
Included in Industrial North American operating income are business realignment charges of $0.4 million and $1.3 million in the current quarter and first six months of fiscal 2005, respectively, and $2.6 million and $6.3 million in the prior-year quarter and first six months of fiscal 2004, respectively. Included in Industrial International operating income are business realignment charges of $0.5 million and $1.1 million in the current quarter and first six months of fiscal 2005, respectively, and $0.2 million and $3.3 million in the prior-year quarter and first six months of fiscal 2004, respectively. The business realignment charges resulted from actions the Company took to structure the Industrial operations to operate in their evolving economic environment and primarily consisted of severance costs.
The increase in December 31, 2004 backlog from a year ago and the June 30, 2004 amount of $840.1 million is due to higher order rates experienced in virtually all of the markets of the Industrial North American and Industrial International operations.
The Company anticipates sales volume in the Industrial Segment for the remainder of fiscal 2005 will continue to exceed the amounts reported for fiscal 2004 as order rates in virtually all markets of the Industrial Segment continue to exceed prior period levels. The Company, however, cautions that the rate at which sales will exceed the prior year amounts may not remain at the current quarter rate of increase due to tougher year-over-year comparisons. Operating income is expected to increase over prior-year levels as a result of higher sales and the continued implementation of the Company’s financial performance initiatives and improvements stemming from recent business realignment actions. The Company expects to continue to take the actions necessary to structure appropriately the Industrial Segment operations to operate in their current economic environment. Such actions may include the necessity to record additional business realignment charges in fiscal 2005.
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Aerospace Segment
The increase in net sales in the Aerospace Segment for the current-year quarter and first six months of fiscal 2005 is primarily due to an increase in both commercial original equipment manufacturer (OEM) and aftermarket volume as well as an increase in military volume, particularly in the military aftermarket business. The higher margins for the current-year quarter and first six months of fiscal 2005 were primarily due to product mix as well as the overall higher sales volume partially offset by higher aircraft product liability insurance premiums.
The increase in backlog from a year ago is due to higher order rates experienced in both the commercial and military businesses. Shipments exceeded order rates for the first six months of fiscal 2005 resulting in the slight decline in backlog from the June 30, 2004 amount of $1,202.7 million. The Company expects an upward trend in commercial order rates for the balance of fiscal 2005 and expects order rates in the military market to remain at current levels.
Climate & Industrial Controls Segment
The Climate & Industrial Controls Segment operations experienced the following percentage changes in net sales in the current year compared to the equivalent prior-year period:
CIC Segment – as reported
CIC Segment – without acquisitions and currency
The above presentation reconciles the percentage changes in net sales of the Climate & Industrial Controls Segment reported in accordance with U.S. GAAP to percentage changes in net sales adjusted to remove the effects of acquisitions made within the prior four fiscal quarters as well as the effects of currency exchange rates. The effects of acquisitions and currency exchange rates are removed to allow investors and the Company to meaningfully evaluate the percentage changes in net sales on a comparable basis from period to period.
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Excluding the effects of acquisitions and currency-rate changes, the decrease in net sales in the Climate & Industrial Controls Segment for the current-year quarter is primarily due to lower end-user demand in the automotive market. The increase in net sales for the first six months of fiscal 2005 is primarily due to higher end-user demand in the commercial refrigeration and general industrial markets experienced earlier in the fiscal year. The decrease in margins in both the second quarter and first six months of fiscal 2005 is primarily due to unfavorable overhead absorption levels as compared to the prior-year periods as well as the absence of a government grant received in the prior year.
The higher backlog at December 31, 2004 and the June 30, 2004 amount of $112.0 million is due to acquisitions offsetting a decrease in order rates in both the automotive and residential air conditioning markets. For the remainder of fiscal 2005, business conditions in the Climate & Industrial Controls Segment are expected to be the same as those experienced in the first six months of fiscal 2005 with operating margins expected to remain at levels comparable to fiscal 2004.
Other Segment
The Other Segment consists of a business unit which designs and manufactures custom-engineered buildings.
The Other Segment operations experienced the following percentage changes in net sales in the current year compared to the equivalent prior-year period:
Other Segment – as reported
Other Segment – without currency
The above presentation reconciles the percentage changes in net sales of the Other Segment reported in accordance with U.S. GAAP to percentage changes in net sales adjusted to remove the effects of currency exchange rates. The effects of currency exchange rates are removed to allow investors and the Company to meaningfully evaluate the percentage changes in net sales on a comparable basis from period to period.
Excluding the effect of currency-rate changes, the increase in net sales and margins in the Other Segment is primarily due to higher demand for custom-engineered buildings as the economy in Europe continues to strengthen.
Corporate general and administrative expenses increased to $30.6 million and $56.0 million for the current-year quarter and first six months of fiscal 2005, respectively, compared to $25.1 million and $48.0 million for the prior-year quarter and first six months of fiscal 2004, respectively. As a percent of sales, corporate general and administrative expenses for the current-year quarter remained at 1.6 percent and decreased slightly to 1.4 percent for the first six months of fiscal 2005 compared to 1.5 percent for the first six months of fiscal 2004.
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Included in Other expense (in the Business Segment Results by Industry) in the current-year quarter are currency transaction losses of $3.3 million, $5.9 million of expense related to pensions and a $2.3 million LIFO adjustment. Included in Other expense for the first six months of fiscal 2005 are currency transaction losses of $10.0 million, an $8.8 million expense associated with the writedown of a real estate investment, and $16.6 million in expense relating to pensions.
DISCONTINUED OPERATIONS
In December 2004, the Company divested a business unit which develops and manufactures chemical car care products and maintenance equipment. This business unit was acquired by the Company in July 2000 as part of the Wynn’s International acquisition. The following results of operations of this business unit, previously included in the Other Segment, have been presented as discontinued operations in the financial statements for all periods presented.
Operating income, net of taxes
Gain on sale of discontinued operations, net of taxes
BALANCE SHEET
2004
June 30,
Plant and equipment, net of accumulated depreciation
Shareholders’ equity
Working capital
Current ratio
Accounts receivable are primarily receivables due from customers for sales of products ($1,008.2 million at December 31, 2004 and $1,039.1 million at June 30, 2004). Days sales outstanding relating to trade accounts receivable remained at 48 days during the first six months of fiscal 2005.
Inventories increased $143.7 million since June 30, 2004 primarily due to acquisitions and the effect of currency rate changes, with days supply increasing to 75 days from 67 days at June 30, 2004.
Plant and equipment, net of accumulated depreciation, increased primarily as a result of acquisitions.
Other assets decreased since June 30, 2004 primarily as a result of decreases in qualified benefit plan assets and other investment assets.
Accounts payable, trade decreased from June 30, 2004 across all the Company’s Segments due primarily to a reduction in production schedules due to the holiday season.
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Accrued liabilities decreased as a result of the payment of fiscal 2004 incentive compensation during the current-year first quarter partially offset by higher accrual rates for incentive compensation in fiscal 2005.
Accrued domestic and foreign taxes decreased primarily due to the payment of estimated income taxes for fiscal 2005 during the second quarter.
Due to the weakening of the dollar, foreign currency translation adjustments resulted in an increase in shareholders’ equity of $130.2 million during the first half of fiscal 2005. The translation adjustments primarily affected Accounts receivable, Inventories, Plant and equipment, Goodwill, Long-term debt, Accounts payable, trade and Accrued liabilities.
STATEMENT OF CASH FLOWS
Cash provided by (used in):
Operating activities
Investing activities
Financing activities
Effect of exchange rates
Cash flows from operating activities - The change in net cash provided by operating activities in fiscal 2005 is primarily due to an increase in net income and an increase in other assets, mostly offset by a decrease in working capital items, particularly Inventories, Accounts payable, trade and Accrued domestic and foreign taxes, and Net income from discontinued operations. Other assets increased primarily due to the decrease in qualified benefit plan assets.
Cash flow used in investing activities - The increase in the amount of cash used in investing activities in fiscal 2005 is attributable to an increase of $480.1 million spent on acquisitions, partially offset by proceeds of $120.0 million from the sale of a business.
Cash flow from financing activities - In fiscal 2005, the Company increased its outstanding borrowings by a net total of $42.9 million compared to a decrease of $409.0 million in fiscal 2004, primarily due to increased acquisition activity.
The Company’s goal is to maintain no less than an “A” rating on senior debt to ensure availability and reasonable cost of external funds. As a means of achieving this objective, the Company has established a financial goal of maintaining a ratio of debt to debt-equity of 34 to 37 percent.
Debt to Debt-Equity Ratio (dollars in millions)
Debt
Debt & equity
Ratio
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The Company has committed lines of credit totaling $1,025 million through two multi-currency unsecured revolving credit agreements with a group of banks, of which $970.3 million was available as of December 31, 2004. One agreement, totaling $625 million, expires in September 2008 and the other, totaling $400 million, expires in September 2009. The credit agreements support the Company’s commercial paper note program, which is rated A-1 by Standard & Poor’s, P-1 by Moody’s and F-1 by Fitch, Inc. These ratings are considered investment grade. The revolving credit agreements require facility fees of up to 8/100ths of one percent of the commitment per annum at the Company’s present rating level. The revolving credit agreements contain provisions that increase the facility fee of the credit agreement in the event the Company’s credit ratings are lowered. A lowering of the Company’s credit ratings would not limit the Company’s ability to use the credit agreements nor would it accelerate the repayment of any outstanding borrowings.
Included in Long-term debt are $407 million of Euro Notes that are due in November 2005. The settlement of this obligation is not expected to require the use of working capital in fiscal 2006 because the Company has both the intent and ability to refinance this debt on a long-term basis.
The Company’s revolving credit agreements and certain of its debt agreements contain financial and other covenants, the violation of which would limit or preclude the use of the agreements for future borrowings. The most restrictive financial covenant requires that the ratio of debt to total capitalization be less than 60 percent. As of December 31, 2004, the ratio of debt to total capitalization was 24.0 percent compared to 24.9 percent as of June 30, 2004. The Company is in compliance with all covenants and expects to remain in compliance during the term of the agreements.
FORWARD-LOOKING STATEMENTS
Forward-looking statements contained in this Report on Form 10-Q and other written reports and oral statements are made based on known events and circumstances at the time of release, and as such, are subject in the future to unforeseen uncertainties and risks. All statements regarding future performance, earnings projections, events or developments are forward-looking statements. It is possible that the future performance and earnings projections of the Company may differ materially from current expectations, depending on economic conditions within both its industrial and aerospace markets, and the Company’s ability to achieve anticipated benefits associated with announced realignment activities, strategic initiatives to improve operating margins and growth initiatives. A change in the economic conditions in individual markets may have a particularly volatile effect on segment performance. Among other factors which may affect future performance are:
The Company undertakes no obligation to update or publicly revise these forward-looking statements to reflect events or circumstances that arise after the date of this Report.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The Company enters into forward exchange contracts, costless collar contracts and cross-currency swap agreements to reduce its exposure to fluctuations in related foreign currencies. These contracts are with major financial institutions and the risk of loss is considered remote. The Company does not hold or issue derivative financial instruments for trading purposes. In addition, the Company’s foreign locations, in the ordinary course of business, enter into financial guarantees through financial institutions, which enable customers to be reimbursed in the event of nonperformance by the Company. The total carrying and fair value of open contracts and any risk to the Company as a result of these arrangements is not material to the Company’s financial position, liquidity or results of operations.
The Company’s debt portfolio contains variable rate debt, inherently exposing the Company to interest rate risk. The Company’s objective is to maintain a 60/40 mix between fixed rate and variable rate debt thereby limiting its exposure to changes in near-term interest rates. As of December 31, 2004, the Company has no interest rate swap agreements.
ITEM 4. CONTROLS AND PROCEDURES
The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the second quarter of fiscal 2005. Based on this evaluation, the principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures are effective.
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PART II - OTHER INFORMATION
Period
(c) TotalNumber ofSharesPurchased
as Part ofPubliclyAnnouncedPlans
or Programs (1)
(d)MaximumNumber (orApproximateDollarValue) ofShares thatMay Yet BePurchased
Under thePlans orPrograms
October 1, 2004 through October 31, 2004
November 1, 2004 through November 30, 2004
December 1, 2004 through December 31, 2004
Total:
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Candy M. Obourn
Hector R. Ortino
Nickolas W. Vande Steeg
Donald E. Washkewicz
For
Against
Abstain
Broker non-votes
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The Audit Committee and PwC have discussed PwC’s independence with respect to the Company in light of the foregoing. The Company and the Audit Committee will continue to monitor and assess the independence of PwC on an on-going basis.
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The following documents are furnished as exhibits and are numbered pursuant to Item 601 of Regulation S-K:
Exhibit 10
Exhibit 12
Exhibit 31(a)
Exhibit 31(b)
Exhibit 32
SIGNATURE
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.
(Registrant)
Timothy K. Pistell
Vice President - Finance and Administration and Chief Financial Officer
Date: February 3, 2005
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EXHIBIT INDEX
Description of Exhibit