FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED APRIL 30, 2014 OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _________________ TO _________________.
Commission File Number 1-7891
DONALDSON COMPANY, INC.
(Exact name of registrant as specified in its charter)
Delaware
41-0222640
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)
1400 West 94th StreetMinneapolis, Minnesota 55431 (Address of principal executive offices, including zip code)
Registrant’s telephone number, including area code: (952) 887-3131
Not Applicable (Former name, former address and former fiscal year, if changed since last report)
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. x Yes o No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o(Do not check if a smaller reporting company)
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes x No
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: Common Stock, $5 Par Value –142,955,040 shares as of April 30, 2014.
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
DONALDSON COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
(Thousands of dollars, except share and per share amounts) (Unaudited)
Three Months EndedApril 30,
Nine Months EndedApril 30,
2014
2013
Net sales
$
624,234
619,371
1,805,240
1,804,354
Cost of sales
400,773
397,870
1,165,737
1,185,583
Gross profit
223,461
221,501
639,503
618,771
Operating expenses
130,727
122,914
382,914
375,455
Operating income
92,734
98,587
256,589
243,316
Interest expense
2,374
2,719
6,987
8,275
Other income, net
(3,822
)
(3,608
(10,249
(11,962
Earnings before income taxes
94,182
99,476
259,851
247,003
Income taxes
26,846
29,634
72,583
72,235
Net earnings
67,336
69,842
187,268
174,768
Weighted average shares - basic
145,310,710
148,136,620
146,543,727
148,404,503
Weighted average shares - diluted
147,339,425
150,234,445
148,608,748
150,591,003
Net earnings per share - basic
0.46
0.47
1.28
1.18
Net earnings per share - diluted
1.26
1.16
Dividends paid per share
0.14
0.10
0.41
0.28
See Notes to Condensed Consolidated Financial Statements.
2
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Thousands of dollars)(Unaudited)
Three Months Ended April 30,
Nine Months Ended April 30,
Foreign currency translation gain (loss)
21,291
(13,563
16,183
29,401
Net gain on hedging derivatives, net of deferred taxes of ($72), ($72), ($33) and ($269), respectively
117
13
53
144
Pension and postretirement liability adjustment, net of deferred taxes of $4,691, $7,682, $9,063 and $14,963, respectively
8,607
16,214
15,877
31,417
Total comprehensive income
97,351
72,506
219,381
235,730
3
CONDENSED CONSOLIDATED BALANCE SHEETS
(Thousands of dollars, except share amounts)(Unaudited)
April 30,2014
July 31,2013
Assets
Current assets
Cash and cash equivalents
238,222
224,138
Short-term investments
152,544
99,750
Accounts receivable, less allowance of $7,100 and $7,040
453,151
430,766
Inventories
254,213
234,820
Prepaids and other current assets
69,465
66,188
Total current assets
1,167,595
1,055,662
Property, plant, and equipment, at cost
1,091,111
1,025,013
Less accumulated depreciation
(650,114
(605,733
Property, plant, and equipment, net
440,997
419,280
Goodwill
168,144
165,568
Intangible assets, net
37,508
41,307
Other assets and deferred taxes
83,757
61,739
Total assets
1,898,001
1,743,556
Liabilities and shareholders’ equity
Current liabilities
Short-term borrowings
65,557
9,190
Current maturities of long-term debt
17,729
98,664
Trade accounts payable
192,631
186,460
Other current liabilities
183,155
182,121
Total current liabilities
459,072
476,435
Long-term debt
227,751
102,774
Deferred income taxes
31,876
23,604
Other long-term liabilities
53,139
55,556
Total liabilities
771,838
658,369
Shareholders’ equity
Preferred stock, $1.00 par value, 1,000,000 shares authorized, none issued
—
Common stock, $5.00 par value, 240,000,000 shares authorized, 151,643,194 shares issued
758,216
Retained earnings
675,386
532,307
Stock compensation plans
19,194
21,745
Accumulated other comprehensive loss
(5,360
(37,473
Treasury stock at cost, 6,468,944 and 5,490,725 shares
(321,273
(189,608
Total shareholders’ equity
1,126,163
1,085,187
Total liabilities and shareholders’ equity
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Operating Activities
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization
50,245
48,527
Changes in operating assets and liabilities
(5,764
(8,346
Tax benefit of equity plans
(8,119
(9,483
Stock compensation plan expense
9,474
7,363
Deferred taxes
(7,649
(4,037
Loss on sale of business
905
Other, net
3,746
8,597
Net cash provided by operating activities
230,106
217,389
Investing Activities
Net expenditures on property, plant, and equipment
(66,046
(69,425
Purchases of short-term investments
(108,864
(66,584
Proceeds from sale of short-term investments
61,179
97,365
Net cash used in investing activities
(113,731
(38,644
Financing Activities
Purchase of treasury stock
(165,871
(60,975
Proceeds from long-term debt
125,000
Repayments of long-term debt
(81,586
(1,093
Change in short-term borrowings
54,693
(66,530
Dividends paid
(59,675
(41,184
8,119
9,483
Exercise of stock options
13,035
12,131
Net cash used in financing activities
(106,285
(148,168
Effect of exchange rate changes on cash
3,994
7,622
Increase in cash and cash equivalents
14,084
38,199
Cash and cash equivalents, beginning of year
225,789
Cash and cash equivalents, end of period
263,988
5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note A – Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of Donaldson Company, Inc. and its subsidiaries (the Company) have been prepared in accordance with generally accepted accounting principles in the United States of America (U.S.) (U.S. GAAP) and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included and are of a normal recurring nature. Operating results for the three and nine month periods ended April 30, 2014 are not necessarily indicative of the results that may be expected for future periods. The year-end condensed balance sheet data was derived from audited financial statements but does not include all disclosures required by U.S. GAAP. For further information, refer to the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended July 31, 2013.
Note B – Inventories
The components of inventory as of April 30, 2014 and July 31, 2013 are as follows (thousands of dollars):
Raw materials
110,115
99,814
Work in process
24,930
29,097
Finished products
119,168
105,909
Total inventories
Note C – Accounting for Stock-Based Compensation
Stock-based compensation expense is recognized using the fair-value method for all awards. In addition to granting stock options, the Company also granted reload options during the nine months ended April 30, 2014. A reload stock option is granted for the number of shares tendered as payment for the exercise price and tax withholding obligation upon the exercise of a stock option with a reload provision. The option price of the reload option is equal to the market price of the stock on the date of exercise of the original option and will expire on the same date as the original option which was exercised. The Company determined the fair value of its option awards using the Black-Scholes option pricing model. The following assumptions were used to value the options, including reload options which generally have a shorter contractual life, granted during the nine months ended April 30, 2014: range of 4 years to 8 years expected life; expected volatility range of 21.0 percent to 28.0 percent; risk-free interest rate range of 1.21 percent to 2.83 percent; and annual dividend yield of 1.4 percent. The expected life for options granted during the period represents the period of time that the options are expected to be outstanding based on the contractual life and historical data of option holder exercise and termination behavior. Expected volatilities are based upon historical volatility of the Company’s stock over a period at least equal to the expected life of each option grant. Option grants have exercise prices equal to the fair market value of the Company’s stock on the date of grant. The weighted average fair value of options granted during the nine months ended April 30, 2014 and 2013 was $11.51 per share and $8.37 per share, respectively. For the three and nine months ended April 30, 2014, the Company recorded pre-tax stock-based compensation expense associated with stock options of $2.2 million and $8.3 million, respectively, and recorded $0.7 million and $2.7 million, respectively of related tax benefit. For the three and nine months ended April 30, 2013, the Company recorded pre-tax stock-based compensation expense associated with stock options of $1.4 million and $6.9 million, respectively, and recorded $0.4 million and $2.2 million, respectively, of related tax benefit.
6
The following table summarizes stock option activity during the nine months ended April 30, 2014:
OptionsOutstanding
Weighted AverageExercise Price
Outstanding at July 31, 2013
7,329,820
23.88
Granted
891,737
42.18
Exercised
(930,225
18.63
Canceled
(14,914
35.59
Outstanding at April 30, 2014
7,276,418
26.76
The total intrinsic value of options exercised during the nine months ended April 30, 2014 and 2013 was $19.8 million and $27.5 million, respectively.
The following table summarizes information concerning outstanding and exercisable options as of April 30, 2014:
Range of Exercise Prices
NumberOutstanding
WeightedAverageRemainingContractualLife (Years)
WeightedAverageExercisePrice
NumberExercisable
$0.00 to $16.69
1,050,081
1.41
15.92
$16.70 to $22.69
2,207,951
4.37
19.13
$22.70 to $28.69
405,114
3.67
23.01
$28.70 to $34.69
1,854,574
7.50
31.58
1,266,367
30.59
$34.70 and above
1,758,698
8.38
38.62
621,343
35.43
5.67
5,550,856
23.25
At April 30, 2014, the aggregate intrinsic value of options outstanding and exercisable was $111.7 million and $104.6 million, respectively.
As of April 30, 2014, there was $9.3 million of total unrecognized compensation expense related to non-vested stock options granted under the 2010 Master Stock Incentive Plan. This unvested expense is expected to be recognized during the remainder of Fiscal Years 2014, 2015, 2016, and 2017.
Note D – Net Earnings Per Share
The Company’s basic net earnings per share is computed by dividing net earnings by the weighted average number of outstanding common shares. The Company’s diluted net earnings per share is computed by dividing net earnings by the weighted average number of outstanding common shares and common share equivalents relating to stock options and stock incentive plans. Certain outstanding options were excluded from the diluted net earnings per share calculations because their exercise prices were greater than the average market price of the Company’s common stock during those periods. For the three and nine months ended April 30, 2014, there were 855,242 and 877,802 options excluded from the diluted net earnings per share calculation. For the three and nine months ended April 30, 2013, there were 29,800 and 80,486 options excluded from the diluted net earnings per share calculation.
The following table presents information necessary to calculate basic and diluted net earnings per common share (thousands, except per share amounts):
145,311
148,137
146,544
148,405
Common share equivalents
2,028
2,097
2,065
2,186
147,339
150,234
148,609
150,591
Net earnings for basic and diluted earnings per share computation
7
Note E – Shareholders’ Equity
The Company’s Board of Directors authorized the repurchase of 15.0 million shares of common stock on September 25, 2013. During the three months ended April 30, 2014, the Company repurchased 2,400,000 shares for $99.5 million at an average price of $41.48 per share. During the nine months ended April 30, 2014, the Company repurchased 4,039,000 shares for $165.9 million at an average price of $41.07 per share. As of April 30, 2014, the Company had remaining authorization to repurchase up to 11.3 million shares.
On May 21, 2014, the Company’s Board of Directors declared a cash dividend in the amount of $0.165 per common share, payable to stockholders of record on June 6, 2014. The dividend will be paid on June 20, 2014.
Note F – Accumulated Other Comprehensive Loss
In the first quarter of Fiscal 2014, the Company prospectively adopted guidance issued by the Financial Accounting Standards Board (FASB) that requires additional disclosure related to the impact of reclassification adjustments out of accumulated other comprehensive income or loss on net income. Changes in accumulated other comprehensive loss by component are as follows:
(Thousands of dollars)
Foreigncurrencytranslationadjustment (a)
Pensionbenefits
Derivativefinancialinstruments
Total
Three Months Ended April 30, 2014:
Balance as of January 31, 2014, net of tax
45,303
(80,442
(236
(35,375
Other comprehensive (loss) income before reclassifications and tax
11,314
275
32,880
Tax benefit (expense)
(3,967
(96
(4,063
Other comprehensive (loss) income before reclassifications, net of tax
7,347
179
28,817
Reclassifications, before tax
1,985
(86
1,899
(725
24
(701
Reclassifications, net of tax
1,260
(b)
(62
1,198
Other comprehensive (loss) income, net of tax
(c)
30,015
Balance at April 30, 2014, net of tax
66,594
(71,835
(119
Nine Months Ended April 30, 2014:
Balance as of July 31, 2013, net of tax
50,411
(87,712
(172
15,356
18,436
336
34,128
(6,725
(117
(6,842
11,711
219
27,286
827
6,505
(250
7,082
(2,339
84
(2,255
4,166
(166
4,827
32,113
(a)
Taxes are not provided on cumulative translation adjustments as substantially all translation adjustments relate to earnings that are intended to be indefinitely reinvested outside the U.S. Amounts were reclassified from accumulated other comprehensive loss to other income, net.
Primarily includes net amortization of prior service costs and actuarial losses included in net periodic benefit cost (see Note K) that were reclassified from accumulated other comprehensive loss to operating expenses or cost of sales.
Relates to foreign currency cash flow hedges that were reclassified from accumulated other comprehensive loss to other income, net (see Note L).
8
Note G – Segment Reporting
The Company has two reportable segments, Engine Products and Industrial Products. Corporate and Unallocated includes corporate expenses determined to be non-allocable to the segments such as interest income and interest expense. The Company is an integrated enterprise, characterized by substantial intersegment cooperation, cost allocations, and sharing of assets. Therefore, the Company does not represent that these segments, if operated independently, would report the operating profit and other financial information shown below. Segment detail is summarized as follows (thousands of dollars):
EngineProducts
IndustrialProducts
Corporate &Unallocated
TotalCompany
402,157
222,077
61,432
32,507
243
Three Months Ended April 30, 2013:
383,314
236,057
65,680
37,555
(3,759
1,160,948
644,292
170,799
91,682
(2,630
890,639
552,533
454,829
Nine Months Ended April 30, 2013:
1,107,814
696,540
152,129
102,709
(7,835
815,604
539,151
402,853
1,757,608
There were no Customers that accounted for over 10 percent of net sales for the three or nine months ended April 30, 2014 or 2013. There were no Customers that accounted for over 10 percent of gross accounts receivable as of April 30, 2014 or 2013.
Note H – Goodwill and Other Intangible Assets
Goodwill is assessed for impairment annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. The Company performed an impairment assessment during the third quarter of Fiscal 2014. The impairment assessment in the third quarter indicated that the estimated fair values of the reporting units to which goodwill is assigned continued to significantly exceed the corresponding carrying values of the respective reporting units, including recorded goodwill and, as such, no impairment existed. Following is a reconciliation of goodwill for the nine months ended April 30, 2014 (thousands of dollars):
TotalGoodwill
Balance as of July 31, 2013
72,321
93,247
Foreign exchange translation
331
2,245
2,576
Balance as of April 30, 2014
72,652
95,492
9
As of April 30, 2014, intangible assets were $37.5 million, a $3.8 million decrease from $41.3 million at July 31, 2013. The decrease in other intangible assets is primarily due to amortization of existing assets of $3.9 million, partially offset by foreign currency translation. There were no intangible asset additions during the nine months ended April 30, 2014. Expected amortization expense relating to existing intangible assets is as follows (in thousands):
Fiscal Year
Remaining 2014
1,291
2015
5,086
2016
5,084
2017
4,963
2018
3,481
2019
2,930
Thereafter
14,606
Note I – Guarantees
The Company and Caterpillar Inc. equally own the shares of Advanced Filtration Systems Inc. (AFSI), an unconsolidated joint venture, and guarantee certain debt of the joint venture. As of April 30, 2014, AFSI had $29.0 million of outstanding debt, of which the Company guarantees half. The Company had $0.9 million and $0.7 million of income, respectively, from this equity method investment during the three months ended April 30, 2014 and 2013. The Company recorded $2.2 million and $1.4 million of earnings from this equity method investment for the nine months ended April 30, 2014 and 2013, respectively. During the three and nine months ended April 30, 2014 and 2013, the Company also recorded royalty income of $1.7 million and $5.0 million, respectively, and $1.4 million and $4.4 million, respectively, related to AFSI.
As of April 30, 2014, the Company had a contingent liability for standby letters of credit totaling $7.8 million that have been issued and are outstanding. The letters of credit guarantee payment to third parties in the event the Company is in breach of insurance contract terms as detailed in each letter of credit. At April 30, 2014, there were no amounts drawn upon these letters of credit.
Note J – Warranty
The Company estimates warranty expense using quantitative measures based on historical warranty claim experience and evaluation of specific Customer warranty issues. Following is a reconciliation of warranty reserves for the nine months ended April 30, 2014 and 2013 (thousands of dollars):
April 30,
Beginning balance
10,526
10,905
Accruals for warranties issued during the reporting period
2,274
5,479
Accruals related to pre-existing warranties (including changes in estimates)
(452
(105
Less settlements made during the period
(3,270
(3,538
Ending balance
9,078
12,741
There were no significant specific warranty matters accrued for in the periods ended April 30, 2014 or 2013. The Company’s warranty matters are not expected to have a material impact on its results of operations, liquidity, or financial position.
Note K – Employee Benefit Plans
The Company and certain of its international subsidiaries have defined benefit pension plans for many of their hourly and salaried employees. There are two types of U.S. plans. The first type of U.S. plan is a traditional defined benefit pension plan primarily for production employees. The second is a plan for salaried workers that provides defined benefits pursuant to a cash balance feature whereby a participant accumulates a benefit comprised of a percentage of current salary that varies with years of service, interest credits, and transition credits. The international plans generally provide pension benefits based on years of service and compensation level.
10
Net periodic pension costs for the Company’s pension plans include the following components:
(thousands of dollars)
Net periodic cost:
Service cost
4,719
4,866
14,104
14,607
Interest cost
4,885
4,222
14,602
12,733
Expected return on assets
(7,691
(7,008
(22,970
(21,100
Prior service cost and transition amortization
147
162
443
482
Actuarial loss amortization
1,853
2,563
5,551
7,712
Net periodic benefit cost
3,913
4,805
11,730
14,434
The Company’s general funding policy for its pension plans is to make at least the minimum contributions as required by applicable regulations. Additionally, the Company may elect to make additional contributions up to the maximum tax deductible contribution. For the nine months ended April 30, 2014, the Company made contributions of $2.7 million to its non-U.S. pension plans and $0.5 million to its U.S. pension plans. The minimum funding requirement for the Company’s U.S. plans for Fiscal 2014 is $12.1 million. Per the Pension Protection Act of 2006, this obligation can be met with existing credit balances that resulted from payments above the minimum obligation in prior years. The Company plans to utilize existing credit balances to meet the minimum obligation. The Company currently estimates that it will contribute an additional $2.9 million to its non-U.S. pension plans during the remainder of Fiscal 2014.
In July 2013, the Company adopted a sunset freeze on its U.S. salaried pension plan. Effective August 1, 2013, the plan was frozen to any Employees hired on or after August 1, 2013. Effective August 1, 2016, Employees hired prior to August 1, 2013, will no longer continue to accrue Company contribution credits under the plan. In July 2013, the Company also announced that Employees hired on or after August 1, 2013, are eligible for a 3.0 percent annual Company retirement contribution in addition to the Company’s 401(k) match. Effective August 1, 2016, Employees hired prior to August 1, 2013, will be eligible for the 3.0 percent annual Company retirement contribution.
Note L – Fair Values
At April 30, 2014 and July 31, 2013, the Company’s financial instruments included cash and cash equivalents, accounts receivable, accounts payable, short-term borrowings, long-term debt, and derivative contracts. The fair values of cash and cash equivalents, accounts receivable, accounts payable, and short-term borrowings approximated carrying values because of the short-term nature of these instruments, and are classified as Level 1 in the fair value hierarchy. As of April 30, 2014, the estimated fair value of long-term debt with fixed interest rates was $237.1 million compared to the carrying value of $225.0 million and the estimated fair value of short-term debt with fixed interest rates was $16.1 million compared to the carrying value of $16.1 million. The fair value is estimated by discounting projected cash flows using the rate that similar amounts of debt could currently be borrowed, which is classified as Level 2 in the fair value hierarchy.
Derivative contracts are reported at their fair values based on third-party quotes. The fair values of the Company’s financial assets and financial liabilities listed below reflect the amounts that would be received to sell the assets or paid to transfer the liabilities in an orderly transaction between market participants at the measurement date (exit price). The fair values are based on inputs other than quoted prices that are observable for the asset or liability. These inputs include foreign currency exchange rates and interest rates. The financial assets and financial liabilities are primarily valued using standard calculations and models that use as their basis readily observable market parameters. Industry standard data providers are the primary source for forward and spot rate information for both interest rates and currency rates.
11
The following summarizes the Company’s fair value of outstanding derivatives at April 30, 2014 and July 31, 2013 on the balance sheets (thousands of dollars):
Significant Other Observable Inputs (Level 2)*
Asset derivatives recorded under the caption Prepaids and other current assets
Foreign exchange contracts
353
734
Liability derivatives recorded under the caption Other current liabilities
(860
(845
Forward exchange contracts - net liability position
(507
(111
*
Inputs to the valuation methodology of Level 2 assets include quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data by correlation or other means.
The Company holds equity method investments which are classified in other assets in the condensed consolidated balance sheets. The aggregate carrying amount of these investments was $20.1 million as of April 30, 2014, and $18.8 million as of July 31, 2013. These equity method investments are measured at fair value on a nonrecurring basis. The fair value of the Company’s equity method investments has not been estimated as there have been no identified events or changes in circumstance that would have had an adverse impact on the value of these investments. In the event that these investments were required to be measured, these investments would fall within Level 3 of the fair value hierarchy, due to the use of significant unobservable inputs to determine fair value, as the investments are privately-held entities without quoted market prices.
Goodwill and intangible assets are assessed for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company’s goodwill and intangible assets are not recorded at fair value as there have been no events or circumstances that would have an adverse impact on the value of these assets. In the event that an impairment was recognized, the fair value would be classified within Level 3 of the fair value hierarchy. Refer to Note H for further discussion of the annual goodwill impairment analysis and carrying values of goodwill and other intangible assets.
The Company assesses the impairment of property, plant, and equipment whenever events or changes in circumstances indicate that the carrying amount of property, plant, and equipment assets may not be recoverable. There were no impairment charges recorded during the three or nine months ended April 30, 2014 or 2013.
Note M – Commitments and Contingencies
Litigation The Company records provisions with respect to identified claims or lawsuits when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Claims and lawsuits are reviewed quarterly and provisions are taken or adjusted to reflect the status of a particular matter. The Company believes the recorded reserves in its condensed consolidated financial statements are adequate in light of the probable and estimable outcomes. The recorded liabilities were not material to the Company’s financial position, results of operations, or liquidity, and the Company does not believe that any of the currently identified claims or litigation will materially affect its financial position, results of operations, or liquidity.
12
Note N – Debt Issuance
On March 27, 2014, the Company issued $125.0 million of senior unsecured notes due March 27, 2024. The debt was issued at face value and bears interest payable semi-annually at an annual rate of interest of 3.72 percent. The proceeds from the notes were used to refinance existing debt and for general corporate purposes. The notes contain debt covenants specifically related to maintaining a certain leverage ratio as well as other covenants that, under certain circumstances, can restrict the Company’s ability to incur additional indebtedness, make investments and other restricted payments, create liens, and sell assets. As of April 30, 2014, the Company was in compliance with all such covenants.
Note O – Income Taxes
The effective tax rate for the three and nine months ended April 30, 2014, was 28.5 percent and 27.9 percent, respectively. The effective tax rate for the three and nine months ended April 30, 2013, was 29.8 percent and 29.2 percent, respectively. The decrease in our effective tax rate for the three months ended April 30, 2014, was primarily due to changes to the mix of earnings between tax jurisdictions. The decrease in our effective tax rate for the nine months ended April 30, 2014, was primarily due to a tax benefit associated with the favorable settlement of a tax audit. This benefit was partially offset by a tax expense related to an intercompany dividend and non-recurring tax benefits recorded during the prior year nine-month period primarily related to the expiration of some statutes of limitations, the retroactive reinstatement of the Research and Experimentation Credit in the U.S., and the tax impact of foreign dividend distributions.
The Company files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. With few exceptions, the Company is no longer subject to state and foreign income tax examinations by tax authorities for years before 2008. The United States Internal Revenue Service has completed examinations of the Company’s U.S. federal income tax returns through 2012.
At April 30, 2014, the total unrecognized tax benefits were $13.9 million and accrued interest and penalties on these unrecognized tax benefits were $1.1 million. The Company recognizes accrued interest related to unrecognized tax benefits in income tax expense. If the Company were to prevail on all unrecognized tax benefits recorded, substantially all of the unrecognized tax benefits would benefit the effective tax rate. With an average statute of limitations of about 5 years, up to $0.9 million of the unrecognized tax benefits could potentially expire in the next 12 month period unless extended by an audit. It is possible that quicker than expected settlement of either current or future audits and disputes would cause additional reversals of previously recorded reserves in the next 12 month period. Currently, the Company has approximately $0.2 million of unrecognized tax benefits that are in formal dispute with various taxing authorities related to transfer pricing and deductibility of expenses. Quantification of an estimated range and timing of future audit settlements cannot be made at this time.
Note P – New Accounting Standards Recently Adopted
In February 2013, the FASB updated the disclosure requirements for accumulated other comprehensive income (AOCI). The updated guidance requires companies to disclose amounts reclassified out of AOCI by component. The updated guidance does not affect how net income or other comprehensive income are calculated or presented. The updated guidance was effective for the Company beginning in the first quarter of Fiscal 2014. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements. For additional information, refer to Note F.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The Company is a worldwide manufacturer of filtration systems and replacement parts. The Company’s core strengths are leading filtration technology, strong Customer relationships, and its global presence. Products are manufactured at 39 plants around the world and through three joint ventures.
The Company has two reporting segments: Engine Products and Industrial Products. Products in the Engine Products segment consist of air filtration systems, exhaust and emissions systems, liquid filtration systems including hydraulics, fuel and lube, and replacement filters. The Engine Products segment sells to original equipment manufacturers (OEMs) in the construction, mining, agriculture, aerospace, defense, and truck markets, and to independent distributors, OEM dealer networks, private label accounts, and large equipment fleets. Products in the Industrial Products segment include dust, fume, and mist collectors, compressed air purification systems, air filtration systems for gas turbines, PTFE membrane-based products, and specialized air and gas filtration systems for applications including computer hard disk drives and semi-conductor manufacturing. The Industrial Products segment sells to various industrial dealers, distributors, OEMs of gas-fired turbines, and OEMs and end-users requiring clean air.
The following discussion of the Company’s financial condition and results of operations should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto and other financial information included elsewhere in this report.
Overview
The Company reported diluted net earnings per share of $0.46 for the third quarter of Fiscal 2014, consistent with the same period of the prior year. Net earnings for the current quarter were $67.3 million, compared to $69.8 million in the three months ended April 30, 2013. The Company reported sales in the third quarter of Fiscal 2014 of $624.2 million, an increase of 0.8 percent from $619.4 million in the third quarter of the prior year. The impact of foreign currency translation decreased reported sales by $0.6 million, or 0.1 percent, in the quarter.
The Company saw end market conditions remain mixed, as demand for its replacement filters continued to improve in both the Company’s Engine and Industrial segments, while conditions for new first-fit systems in the Company’s OEM markets recovered more slowly than the Company had anticipated. The Company’s Engine Products’ sales increased 4.9 percent from last year, driven by its Engine Aftermarket, which grew 10.4 percent and On-Road sales, which grew 9.2 percent, compared to the prior year period. The Company’s Industrial Products’ sales decreased 5.9 percent. Gas Turbine sales decreased 38.9 percent as a result of an anticipated slowdown in new project sales, but were partially offset by sales growth in the Company’s Industrial Filtration Solutions and Special Applications businesses, which grew 9.5 percent and 2.0 percent, respectively, compared to the prior year period.
The Company’s operating margin for the quarter decreased from 15.9 percent in the prior year quarter to 14.9 percent. Positively impacting operating margin were favorable mix impacts from the decline in large Gas Turbine project shipments and higher aftermarket sales. The Company also benefitted from its ongoing Continuous Improvement initiatives, which include Lean, Kaizen, Six Sigma, and cost reduction efforts. More than offsetting these margin improvements were slightly higher expenses from its multi-year implementation of a global enterprise resource planning system project (Global ERP Project) and increased incentive compensation. For additional information, refer to the gross margin and operating expenses discussions below.
Results of Operations
The Company’s overall sales increased compared to the third quarter of the prior year. The Company continues to see signs of stabilization in many of its equipment end-markets, while demand for replacement filters is growing. Compared to the prior year, the Company experienced a 38.9 percent decrease in its Gas Turbine sales from last year’s third quarter sales of $68.7 million. As we have discussed previously, we had a surge in our gas turbine shipments last year, and the overall industry is now absorbing that new electrical generation capacity, driving the current decrease over the prior year period. The Company’s sales decreased in Asia by $7.9 million, or 5.9 percent, offset by sales increases in Europe of $15.9 million, or 9.1 percent, and the Americas of $0.8 million, or 0.3 percent, compared to the third quarter of the prior year.
14
The impact of foreign currency translation during the third quarter of Fiscal 2014 decreased net sales by $0.6 million, or 0.1 percent, from the prior year third quarter. Although foreign currency translation had a minimal impact at the consolidated level, Europe experienced benefits from foreign currency translation, which was partially offset by negative foreign currency translation impacts in Asia and certain other emerging market economies. The impact of foreign currency translation on the year-to-date results as of the end of the third quarter of Fiscal 2014 decreased net sales by $16.2 million, or 0.9 percent. Worldwide sales for the third quarter of Fiscal 2014, excluding the impact of foreign currency translation, increased 0.9 percent from the third quarter of the prior year and year-to-date over the prior year. The impact of foreign currency translation decreased net earnings by $0.2 million, or 0.3 percent, and by $1.4 million, or 0.8 percent for the three and nine months ended April 30, 2014, respectively.
Although net sales excluding foreign currency translation and net earnings excluding foreign currency translation are not measures of financial performance under U.S. GAAP, the Company believes they are useful in understanding its financial results. Both measures enable the Company to obtain a more clear understanding of the operating results of its foreign entities without the varying effects that changes in foreign currency exchange rates may have on those results. A shortcoming of these financial measures is that they do not reflect the Company’s actual results under U.S. GAAP. Management does not intend for these items to be considered in isolation or as a substitute for the related U.S. GAAP measures.
Following is a reconciliation to the most comparable U.S. GAAP financial measure of these non-U.S. GAAP financial measures (millions of dollars):
Three Month Period
Nine Month Period
Net Sales
PercentChange inNet Sales
Period ended April 30, 2012
647.2
NA
1,836.4
Net sales change, excluding foreign currency translation impact
(17.8
(2.7
)%
(3.4
(0.1
Foreign currency translation impact
(10.0
(1.6
(28.6
Period ended April 30, 2013
619.4
(4.3
1,804.4
(1.7
5.4
0.9
%
17.0
(0.6
(16.2
(0.9
Period ended April 30, 2014
624.2
0.8
1,805.2
0.0
NetEarnings
PercentChange inNet Earnings
70.9
193.3
Net earnings change, excluding foreign currency translation impact
(0.4
(16.6
(8.6
(0.7
(1.0
(1.9
69.8
174.8
(9.6
(2.3
(3.3
13.9
8.0
(0.2
(0.3
(1.4
(0.8
67.3
(3.6
187.3
7.2
15
Gross margin was 35.8 percent for the third quarter of 2014, consistent with the prior year period. Gross margin was 35.4 percent year-to-date, compared to 34.3 percent in the prior year. The increase for the nine-month period is primarily attributable to positive mix impacts from the reduction in large Gas Turbine projects, and a higher percentage of replacement filter sales which was due to strong utilization of existing equipment in the field and new business gains. Overall, product mix had a positive 60 basis points impact on gross margin. In addition, ongoing Continuous Improvement initiatives improved gross margin by approximately 60 basis points compared to the prior year period. Offsetting these benefits was the 10 basis points impact on margin from higher incentive compensation costs and indirect costs as the Company made higher investments in engineering and operations. Additionally, there were $0.1 million of restructuring expenses in the quarter.
Purchased raw materials generally represent approximately 60 to 65 percent of the Company’s cost of sales. Of that amount, steel, including fabricated parts, represents approximately 25 percent. Filter media represents approximately 15 to 20 percent and the remainder is primarily made up of petroleum-based products and other components. The cost the Company paid for steel during the three months ended April 30, 2014 varied by grade, but in aggregate it increased slightly compared to the prior year. The Company’s cost of filter media also varies by type, but was generally flat compared to the third quarter of Fiscal 2013. The cost of petroleum-based products was generally flat over the prior year quarter. Currently, the market prices for steel and petroleum-based products are expected to increase slightly over the near term. The Company enters into selective supply arrangements with certain of our steel suppliers that allow us to reduce volatility in the Company’s costs. The Company currently has steel purchase arrangements in the U.S. with durations ranging from three months to five months for approximately 70 percent of its requirements. The Company believes these arrangements will help reduce the impact of an increasing steel market through July 2014. The Company does strive to recover or offset all material cost increases through selective price increases to its Customers and the Company’s Continuous Improvement initiatives, which include material substitution, process improvement, and product redesigns.
Operating expenses were $130.7 million for the third quarter, up 6.4 percent from $122.9 million in the prior year period. As a percent of sales, operating expenses for the third quarter were 20.9 percent, up from 19.8 percent of sales during the prior year quarter. The increase in operating expenses as a percent of sales was primarily due to higher compensation expenses, incremental expenses related to our Global ERP Project, and increased travel and business meeting expenses, which contributed 150 basis points in total. These increases were partially offset by lower pension, insurance, and warranty expenses, which reduced our operating expenses as a percent of sales by 40 basis points. Operating expenses year-to-date were $382.9 million, or 21.2 percent of sales, compared to $375.5 million, or 20.8 percent of sales, in the prior year.
Other income, net for the third quarter of Fiscal 2014 totaled $3.8 million, compared to $3.6 million in the third quarter of the prior year. Year-to-date other income totaled $10.2 million compared to $12.0 million reported in the prior year. The decrease was driven by $0.9 million of restructuring expenses related to the sale of a facility in Germany. In addition, the prior year included the impact of a favorable insurance recovery. These decreases were partially offset by an increase in foreign exchange gains of $1.3 million and an increase of $0.8 million in income generated from the Company’s joint venture with Caterpillar.
The effective tax rate for the three and nine months ended April 30, 2014 was 28.5 percent and 27.9 percent, respectively. The effective tax rate for the three and nine months ended April 30, 2013 was 29.8 percent and 29.2 percent, respectively. The decrease in our effective tax rate for the three months ended April 30, 2014 was primarily due to changes to the mix of earnings between tax jurisdictions. The decrease in our effective tax rate for the nine months ended April 30, 2014 was primarily due to a tax benefit associated with the favorable settlement of a tax audit. This benefit was partially offset by a tax expense related to an intercompany dividend and non-recurring tax benefits recorded during the prior year nine-month period primarily related to the expiration of some statutes of limitations, the retroactive reinstatement of the Research and Experimentation Credit in the United States, and the tax impact of foreign dividend distributions.
16
Operations by Segment
Following is financial information for the Company’s Engine and Industrial Products segments. Corporate and Unallocated includes corporate expenses determined to be non-allocable to the segments and interest income and expense. Segment detail is summarized as follows (thousands of dollars):
Following are net sales by product within the Engine and Industrial Products segments (thousands of dollars):
Engine Products segment:
Off-Road Products
88,791
93,797
260,302
268,056
On-Road Products
33,081
30,288
95,398
96,207
Aftermarket Products*
255,818
231,747
729,052
668,264
Aerospace and Defense Products
24,467
27,482
76,196
75,287
Total Engine Products segment
Industrial Products segment:
Industrial Filtration Solutions Products
137,364
125,447
401,642
386,475
Gas Turbine Products
42,005
68,733
110,106
182,295
Special Applications Products
42,708
41,877
132,544
127,770
Total Industrial Products segment
Total Company
Includes replacement part sales to the Company’s OEM Engine Products Customers.
17
Engine Products Segment For the third quarter of Fiscal 2014, worldwide Engine Products sales were $402.2 million, an increase of 4.9 percent from $383.3 million in the third quarter of the prior year, driven by a 10.4 percent increase in Aftermarket Products. Sales in Europe increased by 12.9 percent, partially due to positive impacts of foreign currency during the quarter, and 4.6 percent in the Americas, somewhat offset by a decrease in Asia of 1.2 percent due to the negative impacts of foreign currency compared to the same period in the prior year. The impact of foreign currency translation during the third quarter of Fiscal 2014 decreased sales by $1.9 million, or 0.5 percent. Year-to-date worldwide Engine Products sales were $1,160.9 million, an increase of 4.8 percent from $1,107.8 million in the prior year period, driven by a 9.1 percent increase in Aftermarket Products and a 1.2 percent sales increase in Aerospace and Defense Products. Sales in Europe and the Americas increased by 13.8 percent and 4.4 percent, respectively, partially offset by a decrease in Asia of 2.8 percent compared to the same period in the prior year. The impact of foreign currency translation on the year-to-date results as of the third quarter of Fiscal 2014 decreased sales by $15.8 million, or 1.4 percent.
For the three months ended April 30, 2014, earnings before income taxes as a percentage of Engine Product segment sales were 15.3 percent, a decrease from 17.1 percent in the prior year period. The decrease was primarily due to $2.0 million in incremental expenses related to incentive compensation, $0.6 million of incremental expenses related to the Company’s Global ERP project, and $0.1 million of restructuring expenses in the quarter. Year-to-date earnings before income taxes as a percentage of Engine Products segment sales were 14.7 percent, an increase from 13.7 percent in the prior year. The percentage earnings increase for the nine months ended April 30, 2014 was driven by improved fixed cost absorption, due to an increase in production volumes, and the positive mix impacts from higher aftermarket sales, partially offset by $6.7 million of incremental expenses related to incentive compensation, $2.1 million of incremental expenses related to the Company’s Global ERP project, and $0.9 million of restructuring expenses.
Worldwide sales of Off-Road Products in the current quarter were $88.8 million, a decrease of 5.3 percent from $93.8 million in the third quarter of the prior year. Sales of Off-Road Products were down 3.2 percent from the third quarter of the prior year in the Americas, 1.6 percent in Europe, and 14.6 percent in Asia. Year-to-date worldwide sales of Off-Road Products totaled $260.3 million, a decrease of 2.9 percent from $268.1 million in the prior year. Year-to-date sales of Off-Road Products were down 5.9 and 10.1 percent from the prior year in the Americas and Asia, respectively. These decreases were partially offset by an increase of 5.5 percent in Europe. For the three and nine months ended April 30, 2014, the sales decreases were driven by continued weakness in mining equipment markets and softening in the agricultural equipment market, which were partially offset by an improving construction equipment market and sales of new and additional products per vehicle in Europe.
Worldwide sales of On-Road Products in the current quarter were $33.1 million, an increase of 9.2 percent from $30.3 million in the third quarter of the prior year. Sales increased during the quarter 55.2 percent in Europe and 6.2 percent in Asia. The increase in the current quarter compared to the prior year period was due primarily to continued growth in Europe after the Euro VI diesel emissions regulations went into effect January 1, 2014. Year-to-date worldwide sales of On-Road Products were $95.4 million, a decrease of 0.8 percent from $96.2 million in the prior year. Year-to-date sales decreased 6.7 percent in the Americas and 5.1 percent in Asia, offset by a sales increase of 36.5 percent in Europe. For the nine months ended April 30, 2014, sales decreased primarily due to lower emissions sales in the Americas for an OEM program the Company no longer supplies totaling $5.0 million.
Worldwide sales of Aftermarket Products in the current quarter were $255.8 million, an increase of 10.4 percent from $231.7 million in the third quarter of the prior year. Aftermarket Products sales during the quarter increased 17.2 percent in Europe, 11.8 percent in the Americas, and 4.7 percent in Asia. Year-to-date, worldwide sales of Aftermarket Products were $729.1 million, an increase of 9.1 percent from $668.3 million in the prior year. Aftermarket Products sales increased 15.4 percent in Europe, 10.6 percent in the Americas, and 1.8 percent in Asia. Sales for the three and nine months ended April 30, 2014, were primarily driven by increases in utilization rates of equipment fleets, increased sales of the Company’s proprietary replacement filters, and expansion of the Company’s product portfolio and distribution. PowerCore brand replacement filter sales contributed $2.7 million to the increase over the prior year quarter and $10.5 million year-to-date.
18
Worldwide sales of Aerospace and Defense Products were $24.5 million, a decrease of 11.0 percent from $27.5 million in the third quarter of the prior year. Sales decreased 23.8 percent in the Americas, partially offset by a sales increase of 31.5 percent in Europe and 7.5 percent in Asia. For the three months ended April 30, 2014, the sales decreases were primarily due to the continued slowdown in U.S. military ground vehicle spending. Year-to-date worldwide sales of Aerospace and Defense Products were $76.2 million, an increase of 1.2 percent from $75.3 million in the prior year. Sales increased 30.7 percent in Europe, partially offset by a 6.3 percent sales decrease in the Americas and 21.6 percent in Asia. For the nine months ended April 30, 2014, the sales increases were mostly due to higher helicopter air filter sales, which increased $4.7 million, partially offset by the continued slowdown in U.S. military ground vehicle spending.
Industrial Products Segment For the current quarter, worldwide sales in the Industrial Products segment were $222.1 million, a decrease of 5.9 percent from $236.1 million in the third quarter of the prior year. This decrease was driven by a 38.9 percent decrease in Gas Turbine Products, partially offset by sales increases in Industrial Filtration Solutions Products and Special Applications Products of 9.5 percent and 2.0 percent, respectively. Sales in Asia and the Americas decreased by 10.7 percent, and 9.7 percent, respectively, partly due to the negative impacts of foreign currency translation in Asia, partially offset by a sales increase in Europe of 4.2 percent, which was partly due to positive impacts of foreign currency translation. The impact of foreign currency translation during the third quarter of Fiscal 2014 increased sales by $1.3 million, or 0.6 percent. Year-to-date global net sales were $644.3 million, a decrease of 7.5 percent from $696.5 million in the prior year. This decrease was driven by a 39.6 percent decrease in Gas Turbine Products, partially offset by sales increases in Industrial Filtration Solutions Products and Special Applications Products of 3.9 percent and 3.7 percent, respectively. Year-to-date sales in Asia, Europe, and the Americas decreased by 14.4 percent, 4.1 percent, and 3.7 percent, respectively, compared to the same period in the prior year. The impact of foreign currency translation on the year-to-date results decreased sales by $0.4 million, or 0.1 percent.
For the three months ended April 30, 2014, earnings before income taxes as a percentage of sales were 14.6 percent, a decrease from 15.9 percent in the prior year period due to lower sales, incremental expenses related to incentive compensation of $1.6 million, and the costs of the Company’s Global ERP Project of $0.3 million. Year-to-date earnings before income taxes as a percentage of Industrial Products segment sales were 14.2 percent, a decrease from 14.7 percent in the prior year. The earnings percentage decrease for the nine months ended April 30, 2014, was due to restructuring expenses primarily related to the sale of a facility in Germany, incremental expenses related to incentive compensation of $5.2 million, and the costs of the Company’s Global ERP Project of $1.1 million.
Worldwide sales of Industrial Filtration Solutions Products in the current quarter were $137.4 million, an increase of 9.5 percent from $125.4 million in the prior year. Sales increased in Asia, Europe, and the Americas by 20.2 percent, 11.2 percent, and 6.4 percent, respectively. Year-to-date worldwide sales of Industrial Filtration Solutions Products were $401.6 million, an increase of 3.9 percent from $386.5 million in the prior year. Sales increased 6.9 percent, 4.9 percent, and 2.4 percent in Europe, Asia, and the Americas, respectively. For the three and nine months ended April 30, 2014, the Company continued to experience mixed market conditions globally. Strong replacement air filter sales, due to improved manufacturing activity, were partially offset by continued soft new equipment sales, due to the continued weak capital spending environment, particularly in the Americas. The externally published durable goods index in the U.S., which has historically been a leading indicator for equipment sales, increased 6.6 percent during the third quarter of Fiscal 2014 as compared to last year.
Worldwide sales of the Company’s Gas Turbine Products in the third quarter were $42.0 million, a decrease of 38.9 percent compared to record sales of $68.7 million in the prior year quarter. Year-to-date global sales of the Company’s Gas Turbine Products were $110.1 million, a decrease of 39.6 percent compared to sales of $182.3 million in the prior year period. Gas Turbine Products sales are typically large systems and, as a result, the Company’s shipments and revenues fluctuate from period to period. Sales of Gas Turbine Products systems were down for the three and nine months ended April 30, 2014, primarily due to fewer shipments of large systems used in power generation.
19
Worldwide sales of Special Application Products were $42.7 million in the current quarter, an increase of 2.0 percent from $41.9 million in the prior year quarter. Sales increased by 8.5 percent and 5.8 percent in Europe and Asia, respectively, partially offset by a sales decrease of 13.7 percent in the Americas, from the prior year period. Year-to-date worldwide sales of Special Application Products were $132.5 million, an increase of 3.7 percent from $127.8 million in the prior year. Sales increased by 10.6 percent and 4.8 percent in Europe and Asia, respectively, partially offset by a sales decrease 6.0 percent in the Americas, from the prior year period. For the three and nine months ended April 30, 2014, the sales increases were driven by a worldwide increase in demand for the Company’s disk drive, semiconductor, and venting products, partially offset by weakness in industrial end-markets negatively impacting the Company’s membrane product sales.
Liquidity and Capital Resources
During the first nine months of Fiscal 2014, $230.1 million of cash was generated from operating activities, compared with $217.4 million in the prior year period. The current year had increases in accrued compensation and accounts payable of $28.1 million and $26.9 million compared to the prior year, respectively. These were partially offset by increases in inventory and receivables which used $37.5 million and $20.4 million, respectively, of cash compared to the prior year.
The Company’s inventory balance was $254.2 million as of April 30, 2014, as compared to $234.8 million as of July 31, 2013. This increase was driven by foreign currency translation as well as inventory build in anticipation of increased sales in late fiscal 2014 and early fiscal 2015. The Company’s accounts receivable balance was $453.2 million as of April 30, 2014, as compared to $430.8 million as of July 31, 2013. This increase was driven by the timing of receipt of payments from some of our larger Customers compared to the fourth quarter of the prior fiscal year as well as by impacts from foreign currency translation.
In the first nine months of Fiscal 2014, operating cash flows and cash on hand were used to repurchase 4,039,000 shares of treasury stock for $165.9 million, to make $66.0 million in capital investments, and to pay $59.7 million in dividends. For additional information regarding share repurchases see Part II, Item 2, “Unregistered Sales of Equity Securities and Use of Proceeds.”
At the end of the third quarter, the Company held $238.2 million in cash and cash equivalents, up from $224.1 million at July 31, 2013. Short-term investments were $152.5 million compared to $99.8 million at July 31, 2013. Short-term investments may change quarter to quarter based on maturity dates of existing investments, the Company’s outlook for cash needs, and available access to other sources of liquidity. The amount of unused lines of credit as of April 30, 2014 was approximately $487.4 million. Current maturities of long-term debt of $17.7 million at quarter-end decreased from $98.7 million at July 31, 2013, as the Company repaid $80.0 million of current maturities of long-term debt in the second quarter of the current fiscal year. Long-term debt of $227.8 million at April 30, 2014, increased from $102.8 million at July 31, 2013, due to the issuance of $125.0 million of senior unsecured notes during the quarter. Long-term debt represented 16.8 percent of total long-term capital, defined as long-term debt plus total shareholders’ equity, compared to 8.7 percent at July 31, 2013.
The majority of the Company’s cash and cash equivalents and short-term investments are held by its foreign subsidiaries, as over half of the Company’s earnings occur outside the U.S. Most of these funds are considered permanently reinvested outside the U.S., and will only be repatriated when it is tax effective to do so, as the cash generated from U.S. operations and the Company’s access to liquidity in the U.S. is anticipated to be sufficient for the U.S cash needs. If additional cash were required for the Company’s operations in the U.S. and funds were repatriated from certain foreign subsidiaries, the Company may be subject to additional U.S. taxes.
The Company’s general funding policy for its pension plans is to make at least the minimum contributions as required by applicable regulations. The Company may elect to make additional contributions up to the maximum tax deductible contribution. For the nine months ended April 30, 2014, the Company made contributions of $2.7 million to its non-U.S. pension plans and $0.5 million to its U.S. pension plans. The minimum funding requirement for the Company’s U.S. plans for Fiscal 2014 is $12.1 million. Per the Pension Protection Act of 2006, this obligation can be met with existing credit balances that resulted from payments above the minimum obligation in prior years. The Company plans to utilize existing credit balances to meet the minimum obligation. The Company currently estimates that it will contribute an additional $2.9 million to its non-U.S. pension plans during the remainder of Fiscal 2014.
20
The following table summarizes the Company’s contractual obligations as of April 30, 2014 (in thousands):
Payments Due by Period
Contractual Obligations
Less than 1 year
1 - 3 years
3 - 5 years
More than 5 years
Long-term debt obligations
241,135,341
16,135,341
100,000,000
125,000,000
Capital lease obligations
3,006,924
1,184,532
1,822,392
Interest on long-term debt obligations
66,493,738
10,217,385
20,301,353
12,725,000
23,250,000
Operating lease obligations
26,567,984
11,205,380
12,089,334
3,101,683
171,587
Purchase obligations (1)
165,333,069
155,839,144
9,471,075
3,973
18,877
Pension and deferred compensation (2)
114,965,607
15,485,238
14,370,718
14,298,127
70,811,524
Total (3)
617,502,663
210,067,020
58,054,872
130,128,783
219,251,988
(1)
Purchase obligations consist primarily of inventory, tooling, contract employment services, and capital expenditures. The Company’s purchase orders for inventory are based on expected Customer demand and quantities and dollar volumes are subject to change.
(2)
Pension and deferred compensation consists of long-term pension liabilities and salary and bonus deferrals elected by certain executives under the Company’s deferred compensation plan. Deferred compensation balances earn interest based on a treasury bond rate as defined by the plan (10-year treasury bond STRIP rate plus two percent for deferrals prior to January 1, 2011, and 10-year treasury bond rates for deferrals after December 31, 2010) and approved by the Human Resources Committee of the Board of Directors, and are payable at the election of the participants.
(3)
In addition to the above contractual obligations, the Company may be obligated for additional cash outflows of $15.0 million of potential tax obligations, including accrued interest and penalties. The payment and timing of any such payments is affected by the ultimate resolution of the tax years that are under audit or remain subject to examination by the relevant taxing authorities.
At April 30, 2014, the Company had a contingent liability for standby letters of credit totaling $7.8 million that have been issued and are outstanding. The letters of credit guarantee payment to third parties in the event the Company is in breach of insurance contract terms as detailed in each letter of credit. At April 30, 2014, there were no amounts drawn upon these letters of credit.
The Company has a five-year, multi-currency revolving credit facility with a group of banks under which the Company may borrow up to $250.0 million. The agreement provides that loans may be made under a selection of currencies and rate formulas including Base Rate Loans or LIBOR Rate Loans. The interest rate on each advance is based on certain market interest rates and leverage ratios. Facility fees and other fees on the entire loan commitment are payable over the duration of this facility. As of April 30, 2014, there was $60.0 million outstanding on this facility. The multi-currency revolving facility contains debt covenants specifically related to maintaining a certain interest coverage ratio, and a certain leverage ratio as well as other covenants that, under certain circumstances, can restrict the Company’s ability to incur additional indebtedness, make investments and other restricted payments, create liens, and sell assets. As of April 30, 2014, the Company was in compliance with all such covenants. The Company expects to remain in compliance with these covenants.
During the quarter, credit in the global credit markets was accessible and market interest rates remained low. The Company believes that its current financial resources, together with cash generated by operations, are sufficient to continue financing its operations for the next twelve months. There can be no assurance, however, that the cost or availability of future borrowings will not be impacted by future capital market disruptions.
The Company does not have any off-balance sheet arrangements, with the exception of the guarantee of 50 percent of certain debt of its joint venture, AFSI, as further discussed in Note I of the Company’s Notes to Condensed Consolidated Financial Statements.
21
New Accounting Standards Not Yet Adopted
In February 2013, the Financial Accounting Standards Board (FASB) issued guidance related to obligations resulting from joint and several liability arrangements for which the total amount of the obligation is fixed at the reporting date. This guidance is effective for the Company beginning the first quarter of Fiscal 2015. The adoption of this standard is not expected to have a material impact on the Company’s consolidated financial statements.
Critical Accounting Policies
There have been no material changes to the Company’s critical accounting policies as disclosed in the Company’s Annual Report on Form 10-K for the year ended July 31, 2013.
Outlook
•
We project our Company’s full fiscal year sales to be between $2.44 and $2.48 billion, or a slight increase over the prior year including the negative impact of foreign currency exchange rates. Our forecast is based on the Euro at US$1.35 and 102 Yen to the US$.
Our full-year operating margin forecast is 14.1 to 14.5 percent. Included in this forecast is approximately $22 million in operating expense increases for our Global ERP project and incentive compensation.
Our Fiscal 2014 tax rate is anticipated to be between 28 and 29 percent.
We forecast our full-year FY14 EPS to be between $1.69 and $1.77.
Cash generated by operating activities for Fiscal 2014 is projected to be between $310 and $330 million. Our capital spending for Fiscal 2014 is estimated to be approximately $90 million. Our share repurchase target remains at 4 percent of our diluted outstanding shares in FY14.
SAFE HARBOR STATEMENT UNDER THE SECURITIES REFORM ACT OF 1995
The Company, through its management, may make forward-looking statements reflecting the Company’s current views with respect to future events and financial performance. These forward-looking statements, which may be included in reports filed under the Securities Exchange Act of 1934, as amended (the Exchange Act), in press releases and in other documents and materials as well as in written or oral statements made by or on behalf of the Company, are subject to certain risks and uncertainties, including those discussed in Item 1A of the Company’s Annual Report on Form 10-K for the year ended July 31, 2013, which could cause actual results to differ materially from historical results or those anticipated. The words or phrases “will likely result,” “are expected to,” “will continue,” “estimate,” “project,” “believe,” “expect,” “anticipate,” “forecast” and similar expressions are intended to identify forward-looking statements within the meaning of Section 21E of the Exchange Act and Section 27A of the Securities Act of 1933, as amended, as enacted by the Private Securities Litigation Reform Act of 1995 (PSLRA). In particular, the Company desires to take advantage of the protections of the PSLRA in connection with the forward-looking statements made in this Quarterly Report on Form 10-Q, including those contained in the “Outlook” section of Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date such statements are made. In addition, the Company wishes to advise readers that the factors listed in Item 1A of the Company’s Annual Report on Form 10-K for the year ended July 31, 2013, as well as other factors, could affect the Company’s performance and could cause the Company’s actual results for future periods to differ materially from any opinions or statements expressed. These factors include, but are not limited to, risks associated with: world economic factors and the ongoing economic uncertainty, the reduced demand for hard disk drive products with the increased use of flash memory, the potential for some Customers to increase their reliance on their own filtration capabilities, currency fluctuations, commodity prices, political factors, the Company’s international operations, highly competitive markets, governmental laws and regulations, including the impact of the various economic stimulus and financial reform measures, the implementation of our new information technology systems, information security and data breaches, potential global events resulting in market instability including financial bailouts and defaults of sovereign nations, military and terrorist activities, health outbreaks, natural disasters, and other factors included in Item 1A of the Company’s Annual Report on Form 10-K for the year ended July 31, 2013. The Company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
22
Item 3. Quantitative and Qualitative Disclosures about Market Risk
There have been no material changes in the reported market risk of the Company since July 31, 2013. See further discussion of these market risks in the Company’s Annual Report on Form 10-K for the year ended July 31, 2013.
Item 4. Controls and Procedures
The Company is in the process of a multi-year implementation of a global enterprise resource planning, or ERP, system. In the second quarter of Fiscal 2014, the Company began deploying the system in certain operations, primarily in the Americas. The deployment continued in the third quarter of Fiscal 2014 to additional operations in the Americas. In response to business integration activities related to the new system, the Company is aligning and streamlining the design and operation of the financial reporting controls environment to be responsive to the changing operating environment.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The Company records provisions with respect to identified claims or lawsuits when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Claims and lawsuits are reviewed quarterly and provisions are taken or adjusted to reflect the status of a particular matter. The Company believes the recorded reserves in its consolidated financial statements are adequate in light of the probable and estimable outcomes. Any recorded liabilities were not material to the Company’s financial position, results of operations, or liquidity, and the Company does not believe that any of the currently identified claims or litigation will materially affect its financial position, results of operations or liquidity.
Item 1A. Risk Factors
There are inherent risks and uncertainties associated with the Company’s global operations that involve the manufacturing and sale of products for highly demanding Customer applications throughout the world. These risks and uncertainties could adversely affect the Company’s operating performances or financial condition. The “Risk Factors” section in the Company’s Annual Report on Form 10-K for the year ended July 31, 2013, includes a discussion of these risks and uncertainties.
23
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Repurchases of Equity Securities
The following table sets forth information in connection with purchases made by, or on behalf of, the Company or any affiliated purchaser of the Company, of shares of the Company’s common stock during the quarterly period ended April 30, 2014.
Period
Total Number of Shares Purchased (1)
Average Price Paid per Share
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs
February 1 - February 28, 2014
800,712
40.86
12,899,483
March 1 - March 31, 2014
484,826
42.22
467,411
12,432,072
April 1 - April 30, 2014
1,131,671
41.61
11,300,401
2,417,209
41.48
2,399,794
On September 27, 2013, the Company announced that the Board of Directors authorized the repurchase of up to 15.0 million shares of common stock. This repurchase authorization, which is effective until terminated by the Board of Directors, replaced the existing authority that was authorized on March 26, 2010. There were no repurchases of common stock made outside of the Company’s current repurchase authorization during the quarter ended April 30, 2014. However, the “Total Number of Shares Purchased” column of the table above includes 17,415 previously owned shares tendered by option holders in payment of the exercise price of options during the quarter. While not considered repurchases of shares, the Company does at times withhold shares that would otherwise be issued under equity-based awards to cover the withholding taxes due as a result of exercising stock options or payment of equity based awards.
Item 6. Exhibits
*3-A – Restated Certificate of Incorporation of Registrant as currently in effect (Filed as Exhibit 3-A to Form 10-Q Report for the Third Quarter ended January 31, 2012)
*3-B – Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock of Registrant, dated as of March 3, 2006 (Filed as Exhibit 3-B to 2011 Form 10-K Report)
*3-C – Amended and Restated Bylaws of Registrant (as of January 30, 2009) (Filed as Exhibit 3-C to Form 10-Q Report for the Third Quarter ended January 31, 2009)
*4 – **
*4-A – Preferred Stock Amended and Restated Rights Agreement between Registrant and Wells Fargo Bank, N.A., as Rights Agent, dated as of January 27, 2006 (Filed as Exhibit 4-A to 2011 Form 10-K Report)
10.1 – Note Purchase Agreement, dated as of March 27, 2014, by and among Donaldson Company, Inc. and the purchasers named therein (Filed as Exhibit 10.1 to the current report on Form 8-K filed April 2, 2014)
31-A – Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31-B – Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32 – Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101 – The following information from the Donaldson Company, Inc. Quarterly Report on Form 10-Q for the fiscal quarter ended April 30, 2014 as filed with the Securities and Exchange Commission, formatted in Extensible Business Reporting Language (XBRL): (i) the Condensed Consolidated Statements of Earnings, (ii) the Condensed Consolidated Balance Sheets, (iii) the Condensed Consolidated Statements of Comprehensive Income, (iv) The Condensed Consolidated Statements of Cash Flows and (v) the Notes to Condensed Consolidated Financial Statements.
____________________
25
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(Registrant)
Date: June 6, 2014
By:
/s/ William M. Cook
William M. Cook
Chairman, President and
Chief Executive Officer
(duly authorized officer)
/s/ James F. Shaw
James F. Shaw
Vice President,
Chief Financial Officer
(principal financial officer)
/s/ Melissa A. Osland
Melissa A. Osland
Corporate Controller
(principal accounting officer)
26