UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
For the quarterly period ended December 31, 2006
OR
For the transition period from to
Commission File number 1-4982
PARKER-HANNIFIN CORPORATION
(Exact name of registrant as specified in its charter)
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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (check one):
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Number of Common Shares outstanding at December 31, 2006 115,771,243
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED STATEMENT OF INCOME
(Dollars in thousands, except per share amounts)
(Unaudited)
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)
ASSETS
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
Total assets
LIABILITIES
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
SHAREHOLDERS’ EQUITY
Serial preferred stock, $.50 par value; authorized 3,000,000 shares; none issued
Common stock, $.50 par value; authorized 600,000,000 shares; issued 120,683,890 shares at December 31 and 120,683,890 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: 4,912,647 shares at December 31 and 368,695 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
Stock-based compensation
Foreign currency transaction (gain) loss
(Gain) loss on sale of plant and equipment
Changes in assets and liabilities:
Inventories
Accrued payrolls and other compensation
Other accrued liabilities
Discontinued operations
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES
Acquisitions (less cash acquired of $1,050 in 2006 and $17,013 in 2005)
Capital expenditures
Proceeds from sale of plant and equipment
Proceeds from sale of businesses
Other
Net cash (used in) investing activities
CASH FLOWS FROM FINANCING ACTIVITIES
Net (payments for) proceeds from common share activity
Proceeds from notes payable, net
Proceeds from long-term borrowings
(Payments for) long-term borrowings
Dividends
Net cash (used in) provided by financing activities
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 three reportable business segments: Industrial, Aerospace and Climate & Industrial Controls. 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.
Climate & Industrial Controls - This segment manufactures motion-control systems and components for use primarily in the refrigeration and air conditioning and transportation industries.
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 (income) expense
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Dollars in thousands, except per share amounts
In the opinion of the management 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, 2006, the results of operations for the three and six months ended December 31, 2006 and 2005 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 2006 Annual Report on Form 10-K. Interim period results are not necessarily indicative of the results to be expected for the full fiscal year.
In order to bring the Consolidated Statement of Cash Flows presentation in compliance with Financial Accounting Standards Board (FASB) Statement No. 95, the Company has revised the Consolidated Statement of Cash Flows for the six months ended December 31, 2005 to separately disclose the operating, investing, and financing portions of the cash flows attributable to discontinued operations. The Company had previously reported these amounts on a combined basis. The revision resulted in a decrease in net cash provided by operating activities of $9.3 million and an increase in net cash used in investing activities of $0.1 million for the six months ended December 31, 2005.
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement 109” (FIN 48). FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company has not yet determined the effect on the Company’s financial position or results of operations of complying with the provisions of FIN 48.
In August 2006, the FASB issued FASB Statement No. 157, “Fair Value Measurements.” Statement No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. Statement No. 157 is effective for fiscal years beginning after November 15, 2007. The Company has not yet determined the effect on the Company’s financial position or results of operations of complying with the provisions of Statement No. 157.
In September 2006, the FASB issued FASB Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” Statement No. 158 amends FASB Statements No. 87, 88, 106 and 132R. Statement No. 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The funded status recognition provision is effective for the Company as of the end of the fiscal year ending June 30, 2007.
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Statement No. 158 also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial condition. The measurement date provision of Statement No. 158 is effective for the Company for the fiscal year ending June 30, 2009. The Company has not yet determined the effect on the Company’s financial position of complying with the provisions of Statement No. 158.
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, 2006 and June 30, 2006 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 2007 is immaterial to the Company’s results of operations and cash flows.
The following table presents a reconciliation of the numerator and denominator of basic and diluted earnings per share from continuing operations for the three and six months ended December 31, 2006 and 2005.
Three Months Ended
December 31,
Six Months Ended
Numerator:
Denominator:
Basic - weighted average common shares
Increase in weighted average from dilutive effect of equity-based awards
Diluted - weighted average common shares, assuming exercise of equity-based awards
Basic earnings per share from continuing operations
Diluted earnings per share from continuing operations
For the three months ended December 31, 2006 and 2005, 922,498 and 2,332,787 common shares subject to equity-based awards, 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, 2006 and 2005, 1,544,323 and 1,815,839 common shares subject to equity-based awards, respectively, were excluded from the computation of diluted earnings per share because the effect of their exercise would be anti-dilutive.
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The Company has a program to repurchase common shares of the Company. Under the program, the Company is authorized to repurchase an amount of common shares each fiscal year equal to the greater of 5 million shares or five percent of the shares outstanding as of the end of the prior fiscal year. Repurchases are funded primarily from operating cash flows, and the shares are initially held as treasury stock. The Company repurchased 2,377,627 shares of its common stock at an average price of $82.99 per share during the three-month period ended December 31, 2006. Fiscal year-to-date, the Company repurchased 5 million shares at an average price of $78.61 per share. On January 25, 2007, the Company’s Board of Directors approved an increase in the number of shares authorized for repurchase under this program so that, as of that date, the aggregate number of shares available for repurchase was equal to 10 million.
The Company’s primary items of other comprehensive income (loss) are foreign currency translation adjustments and unrealized gains (losses) on marketable equity securities and cash flow hedges. Comprehensive income for the three and six months ended December 31, 2006 and 2005 was as follows:
Foreign currency translation adjustments
Realized (gain) on marketable equity securities
Unrealized (loss) on marketable equity securities
Realized loss on cash flow hedges
Unrealized gain on cash flow hedges
Comprehensive income
Foreign currency translation adjustments are net of taxes of $6,808 and $5,296 for the three and six months ended December 31, 2006, respectively, and $346 and $1,925 for the three and six months ended December 31, 2005, respectively. The realized (gain) on marketable equity securities is net of taxes of $6 and $14 for the three and six months ended December 31, 2005, respectively, and is reflected in the Other (income) expense, net caption in the Consolidated Statement of Income. The unrealized (loss) on marketable equity securities is net of taxes of $2 for the six months ended December 31, 2005. The realized loss on cash flow hedges is net of taxes of $37 and $74 for the three and six months ended December 31, 2006, respectively, and $24 for the three and six months ended December 31, 2005, and is reflected in the Interest expense caption in the Consolidated Statement of Income. The unrealized gain on cash flow hedges is net of taxes of $2,800 and $3,116 for the three and six months ended December 31, 2005, respectively.
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During the second quarter of fiscal 2007, the Company recorded a $6,620 charge ($4,087 after-tax or $.03 per diluted 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 consists of severance costs and costs to relocate machinery and equipment. The severance costs are attributable to approximately 255 employees in the Industrial Segment. A portion of the severance payments have been made with the remaining payments expected to be made by June 30, 2007. The business realignment costs are presented in the Consolidated Statement of Income for the three months ended December 31, 2006 as follows: $5,653 in Cost of sales and $967 in Selling, general and administrative expenses.
During the first six months of fiscal 2007, the Company recorded charges of $10,445 ($6,448 after-tax or $.05 per diluted 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, 2006 as follows: $8,960 in Cost of sales and $1,485 in Selling, general and administrative expenses.
During the second quarter of fiscal 2006, the Company recorded a $3,914 charge ($2,442 after-tax or $.02 per diluted 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 consists of severance costs and costs to relocate machinery and equipment. The severance costs are attributable to 135 employees in the Industrial Segment. All severance payments have been made. The business realignment costs are presented in the Cost of sales caption in the Consolidated Statement of Income for the three months ended December 31, 2005.
During the first six months of fiscal 2006, the Company recorded charges of $6,684 ($4,174 after-tax or $.03 per diluted share) for business realignment costs related to the Industrial Segment and Climate & Industrial Controls Segment. The business realignment costs are presented in the Consolidated Statement of Income for the six months ended December 31, 2005 as follows: $5,776 in Cost of sales and $908 in Selling, general and administrative expenses.
The changes in the carrying amount of goodwill for the six months ended December 31, 2006 are as follows:
Balance June 30, 2006
Acquisitions
Foreign currency translation
Goodwill adjustments
Balance December 31, 2006
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“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
Customer lists and other
Total intangible amortization expense for the six months ended December 31, 2006 was $21,022. The estimated amortization expense for the five years ending June 30, 2007 through 2011 is $38,205, $35,448, $34,113, $33,662 and $30,552, respectively.
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
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Postretirement benefit cost recognized included the following components:
During the first six months of fiscal 2007, the Company made $111 million in voluntary contributions to its qualified defined benefit plans. The Company expects to contribute a total of approximately $190 million to its qualified defined benefit plans in fiscal 2007. The majority of the remaining contribution expected to be made in fiscal 2007 is discretionary.
In December 2005, the Company divested the Thermoplastics division. The Thermoplastics division was part of the Industrial Segment for segment reporting purposes. This divestiture resulted in a loss of $11,018 ($9,770 after-tax or $.08 per diluted share) and is reflected in Other (income) expense, net in the Consolidated Statement of Income
In August 2005, the Company divested the Astron Building business. This business was part of the Other Segment for segment reporting purposes. The results of operations for this business unit have been presented as discontinued operations for all periods presented. Included in the income from discontinued operations is an after-tax gain on disposal of $27,753.
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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, 2006
AND COMPARABLE PERIODS ENDED DECEMBER 31, 2005
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 provide a near-term perspective of the Company’s outlook particularly when viewed in the context of prior and future order rates. The Company publishes its order rates on a monthly basis. The lead time between the time an order is received and revenue is realized generally ranges from one day to 12 weeks for commercial, mobile and industrial orders and from one day 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 North American commercial, mobile and industrial markets should be positive year-over-year. The ISM index at the end of December 2006 was 51.4 compared to 53.8 at the end of June 2006. With respect to the aerospace market, aircraft miles flown and revenue passenger miles continue to show improvement over comparable fiscal 2006 levels while Department of Defense spending in fiscal 2007 is expected to increase slightly from its fiscal 2006 level.
The Company also believes that there is a high correlation between interest rates and industrial manufacturing activity. The Federal Reserve has not raised the federal funds rate during fiscal 2007 but did raise the federal funds rate eight times during fiscal 2006. Additional increases in interest rates could have a negative impact on industrial production thereby lowering future order rates.
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 of 25.9 percent, ample borrowing capabilities and strong credit ratings. Cash flows from operations for the first six months of fiscal 2007 were $307.6 million or 6.1% of sales after making $111 million in voluntary contributions to the Company’s qualified defined benefit plans.
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Many acquisition opportunities remain available to the Company within its target markets. During the first six months of fiscal 2007, the Company completed six acquisitions whose aggregate annual revenues were approximately $109 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.
The Company routinely faces challenges regarding improving premier customer service levels, managing changes in raw material prices and the rising expenses related to employee retirement and health care benefits. The Company is currently focused on maintaining its financial strength through the current Industrial North American slowdown, especially in the automotive and heavy-duty truck markets. 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 enterprise and business realignments.
The discussion below is structured to separately discuss 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
Backlog
Net sales for the current-year quarter and first six months of fiscal 2007 increased 16.4 percent and 18.5 percent, respectively, over the comparable prior-year net sales amounts reflecting higher volume experienced in all Segments. Acquisitions in the last 12 months contributed about 39 percent of the net sales increase in the current-year quarter and about 46 percent of the increase for the first six months of fiscal 2007. The effect of currency rate changes increased net sales by approximately $78 million and $118 million in the current-year quarter and first six months of fiscal 2007, respectively.
Gross profit margin increased for the current-year quarter and first six months of fiscal 2007 due to a combination of the increase in sales as well as the effects of the Company’s financial performance initiatives, especially in the Industrial International businesses. Included in gross profit are business realignment charges of $5.7 million and $3.9 million in the current-year quarter and prior-year quarter, respectively, and $9.0 million and $5.8 million for the first six months of fiscal 2007 and 2006, respectively.
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Selling, general and administrative expenses increased for the current-year quarter and first six months of fiscal 2007 primarily due to the higher sales volume, higher research and development expenses and higher incentive compensation.
Interest expense for the current-year quarter and first six months of fiscal 2007 increased primarily due to higher average debt outstanding.
Other (income) expense, net in the current-year quarter and first six months of fiscal 2007 included $6.2 million of income related to the final accounting for a divestiture completed in fiscal 2002. Other (income) expense, net for the first six months of fiscal 2007 included $4.6 million of income related to a litigation settlement. Other (income) expense, net for the prior-year quarter and first six months of fiscal 2006 included a loss of $11.0 million resulting from the divestiture of the Thermoplastics division.
Effective tax rate from continuing operations for the current-year quarter and first six months of fiscal 2007 reflects an $11.0 million benefit, $6.3 million of which relates to fiscal 2006, resulting from the renewal of the Federal Tax Credit for Increasing Research Activities.
Income from continuing operations for the current-year quarter and first six months of fiscal 2007 was positively affected by a decrease in expense of approximately $6.4 million and $11.9 million, respectively, related to qualified defined benefit plans, resulting primarily from changes in actuarial assumptions and the amortization of actuarial losses.
Discontinued operations represents the operating results and related gain on the sale, net of tax of the Astron Buildings business which was divested in August 2005. Included in discontinued operations for the six months ended December 31, 2005 is an after-tax gain on the sale of Astron of approximately $27.8 million. The gain is primarily attributable to foreign currency translation adjustments.
Backlog increased from the prior-year quarter due to an increase in order rates throughout most businesses in all Segments, especially in Industrial International. Backlog increased from the June 30, 2006 amount of $2,695.9 million primarily due to an increase in order rates in the Industrial International businesses.
RESULTS BY BUSINESS SEGMENT
Industrial Segment
Operating income
Operating income, as a percent of net sales
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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
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 foreign currency changes, the slight increase in Industrial North American sales for the current-year quarter and first six months of fiscal 2007 reflects higher end-user demand experienced across most of the Industrial North American markets, particularly in the construction, mining, microelectronics, oil and gas and general industrial machinery markets, partially offset by lower demand in the automotive market. The increase in Industrial International sales for the current-year quarter and first six months of fiscal 2007 is primarily attributed to higher volume across most markets in all regions, particularly in Europe and the Asia Pacific region.
The increase in Industrial North American margins for the first six months of fiscal 2007 and the increase in Industrial International margins for the current-year quarter and first six months of fiscal 2007 is primarily due to the higher sales volume, benefits realized from the Company’s financial performance initiatives and benefits from past business realignments. Industrial North American and Industrial International margins were negatively impacted by higher business realignment costs in the current-year quarter as compared to the prior-year quarter. Also, acquisitions, not yet fully integrated, negatively impacted Industrial International margins in the current-year quarter and both Industrial North American and Industrial International margins for the first six months of fiscal 2007.
The increase in backlog from a year ago is primarily due to higher order rates experienced in virtually all of the markets of the Industrial Segment with the largest portion of the increase being experienced in the Industrial International businesses. Backlog increased from the June 30, 2006 amount of $1,177.8 million primarily due to higher order rates in the Industrial International operations.
The Company anticipates Industrial North American sales for fiscal 2007 will exceed their fiscal 2006 level by less than one percent and Industrial International sales for fiscal 2007 will exceed their fiscal 2006 level by approximately 28 percent. Industrial North American operating margins in fiscal 2007 are
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expected to increase to a range of 14.8 percent to 15.2 percent and Industrial International operating margins are expected to range from 13.3 percent to 13.7 percent. 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 2007.
Aerospace Segment
The increase in sales in the Aerospace Segment for the current-year quarter and first six months of fiscal 2007 is primarily due to an increase in both commercial original equipment manufacturer (OEM) and aftermarket volume. The higher margins were primarily due to a higher concentration of sales occurring in the aftermarket businesses in the current-year quarter and first six months of fiscal 2007.
The increase in backlog from the prior-year quarter is due to higher order rates experienced in the commercial businesses. Shipments were about the same as order rates in the current-year quarter resulting in the slight increase in backlog from the June 30, 2006 amount of $1,328.3 million. For fiscal 2007, sales are expected to increase approximately nine percent from their fiscal 2006 level and operating margins are expected to range from 15.2 percent to 15.6 percent. Heavier commercial OEM volume in future product mix could result in lower margins.
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
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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.
Excluding the effects of acquisitions and foreign currency changes, the increase in sales in the Climate & Industrial Controls Segment for the first six months of fiscal 2007 is primarily due to higher end-user demand in the residential air conditioning market. The lower margins in the current-year quarter are primarily due to product mix as well as costs incurred to integrate recent acquisitions. The higher margins for the first six months of fiscal 2007 is primarily due to the higher sales volume and the absence of business realignment costs incurred in the first half of fiscal 2006.
The increase in backlog from the prior-year quarter is primarily due to acquisitions as well as higher order rates in the residential air conditioning market. Backlog declined slightly from the June 30, 2006 amount of $189.8 million primarily due to shipments exceeding new orders in the residential air conditioning market. For fiscal 2007, sales are expected to increase by approximately four percent from their fiscal 2006 level and operating margins are expected to be in a range of 7.1 percent to 7.5 percent. The Company expects to continue to take the actions necessary to structure appropriately the Climate & Industrial Controls Segment to operate in their current economic environment. Such actions may include the necessity to record additional business realignment charges in fiscal 2007.
Corporate general and administrative expenses were $44.0 million in the current-year quarter compared to $28.5 million in the prior-year quarter and were $80.6 million for the first six months of fiscal 2007 compared to $57.3 million for the first six months of fiscal 2006. As a percent of sales, corporate general and administrative expenses for the current-year quarter increased to 1.8 percent compared to 1.3 percent for the prior-year quarter and increased to 1.6 percent for the first six months of fiscal 2007 compared to 1.3 percent for the first six months of fiscal 2006. The higher expense in the current-year quarter and first six months of fiscal 2007 is primarily due to higher research and development expenses, fees for professional services and employee welfare and benefit expenses.
Included in Other (income) expense (in the Business Segment Results by Industry) for the current-year quarter and first six months of fiscal 2007 are $14.1 million and $16.0 million, respectively, of foreign currency transaction gains compared to a gain of $2.2 million in the prior-year quarter and a loss of $5.6 million for the first six months of fiscal 2006. Other (income) expense for the current-year quarter and first six months of fiscal 2007 includes $3.4 million and $8.9 million, respectively, of pension expense compared to $12.9 million and $25.2 million for the prior-year quarter and first six months of fiscal 2006, respectively. The decrease in expense primarily results from changes in actuarial assumptions and lower amortization of actuarial losses. Other (income) expense for the first six months of fiscal 2007 includes a gain of $4.6 million related to a litigation settlement and a gain of $6.2 million related to the final accounting for a divestiture completed in fiscal 2002. Other (income) expense for the first six months of fiscal 2006 includes a loss on a divestiture of $11.0 million.
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DISCONTINUED OPERATIONS
In August 2005, the Company divested its Astron Buildings business. The following results of operations for this business unit have been presented as discontinued operations for the six months ended December 31, 2005.
(in millions)
Operating income, net of taxes
Gain on sale of discontinued operations, net of taxes
BALANCE SHEET
Accounts receivable
Plant and equipment, net of accumulated depreciation
Shareholders’ equity
Working capital
Current ratio
Accounts receivable are primarily receivables due from customers for sales of product ($1,339.4 million at December 31, 2006 and $1,475.9 million at June 30, 2006). Accounts receivable decreased $68.1 million with days sales outstanding relating to trade accounts receivable decreasing to 49 days from 51 days at June 30, 2006.
Inventories increased $131.5 million since June 30, 2006, with days supply increasing to 71 days from 60 days at June 30, 2006. The increase in days supply of inventory during the first six months of fiscal 2007 is primarily due to a build in inventory in certain businesses in order to meet increasing customer demand.
Plant and equipment, net of accumulated depreciation increased primarily due to current-year acquisitions partially offset by depreciation exceeding capital expenditures.
Goodwill increased primarily as a result of current-year acquisitions.
Other assets increased since June 30, 2006 primarily as a result of $111.0 million in voluntary contributions that were made to the Company’s qualified defined benefit pension plans during the first six months of fiscal 2007.
Accounts payable, trade decreased $69.7 million from June 30, 2006 primarily due to the timing of payments for purchases.
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Accrued liabilities decreased $39.5 million primarily as a result of the payment of fiscal 2006 incentive compensation during the first six months of fiscal 2007 partially offset by current-year acquisitions.
Accrued domestic and foreign taxes decreased primarily due to timing of tax payments.
Due to the weakening of the dollar, foreign currency translation adjustments resulted in an increase in shareholders’ equity of $64.5 million during the first half of fiscal 2007. The translation adjustments primarily affected Accounts receivable, Inventories, Plant and equipment, Goodwill and Long-term debt.
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 decrease in net cash provided by operating activities in fiscal 2007 is primarily due to an increase in cash used to fund the Company’s qualified defined benefit plans as well as an increase in inventories.
Cash flow used in investing activities - The decrease in the amount of cash used in investing activities in fiscal 2007 is attributable primarily to a decrease in acquisition activity and the absence of proceeds from the sale of businesses partially offset by an increase in capital expenditures.
Cash flow from financing activities - The decrease in cash provided by financing activities from the prior year is due to common stock activity which used cash of $360.6 million in fiscal 2007 compared to providing cash of $1.8 million in fiscal 2006. The change in common stock activity in fiscal 2007 is primarily due to a higher level of repurchases of the Company’s common stock for treasury during the first six months of fiscal 2007 compared to the first six months of fiscal 2006.
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 no more than 37 percent.
Debt to Debt-Equity Ratio (in millions)
Debt
Debt & equity
Ratio
The Company has a line of credit totaling $1,025 million through a multi-currency revolving credit agreement with a group of banks, of which $654.1 million was available as of December 31, 2006. The Company has the right, no more than once a year, to increase the facility amount, in minimum increments of $25 million up to a maximum facility amount of $1,250 million. The credit agreement expires October 2011, however the Company has the right to request a one-year extension of the expiration date on an annual basis. The credit agreement supports 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 agreement requires a facility fee of
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5/100ths of one percent of the commitment per annum at the Company’s present rating level. The revolving credit agreement contains 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 agreement nor would it accelerate the repayment of any outstanding borrowings.
The Company’s revolving credit agreement and indentures governing certain debt agreements contain various covenants, the violation of which would limit or preclude the use of the revolving credit agreement for future borrowings, or might accelerate the maturity of the related outstanding borrowings covered by the indentures. At the Company’s present rating level, the most restrictive financial covenant provides that the ratio of secured debt to net tangible assets be less than 10 percent. As of December 31, 2006, the ratio of secured debt to net tangible assets was less than one percent. The Company is in compliance with all covenants and expects to remain in compliance during the term of the agreement and indentures.
NEW ACCOUNTING PRONOUNCEMENTS
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement 109” (FIN 48). FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company has not yet determined the effect on the Company’s financial position or results of operations of complying with the provisions of FIN 48.
In September 2006, the FASB issued FASB Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” Statement No. 158 amends FASB Statements No. 87, 88, 106 and 132R. Statement No. 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The funded status recognition provision is effective for the Company as of the end of the fiscal year ending June 30, 2007. Statement No. 158 also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial condition. The measurement date provision of Statement No. 158 is effective for the Company for the fiscal year ending June 30, 2009. The Company has not yet determined the effect on the Company’s financial position of complying with the provisions of Statement No. 158.
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 maintain and achieve anticipated benefits associated with announced realignment activities, strategic initiatives to improve operating margins and growth and innovation initiatives. A change in the economic conditions in individual markets may have a particularly volatile effect on segment performance.
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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.
The Company enters into forward exchange contracts and costless collar contracts 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.
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 2007. Based on this evaluation, the principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures are effective.
There has been no change in the Company’s internal control over financial reporting during the quarter ended December 31, 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II - OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Period
(c) Total Number ofShares Purchased
as Part of PubliclyAnnounced Plans
or Programs (1)
(d) Maximum Number(or Approximate DollarValue) of Shares thatMay Yet Be Purchased
Under the Plans orPrograms
October 1, 2006 through
October 31, 2006
November 1, 2006 through
November 30, 2006
December 1, 2006 through
December 31, 2006
Total:
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Item 4. Submission of Matters to a Vote of Security Holders.
Robert J. Kohlhepp
Giulio Mazzalupi
Klaus-Peter Müller
Markos I. Tambakeras
For
Against
Abstain
Broker non-votes
Item 6. Exhibits.
The following documents are furnished as exhibits and are numbered pursuant to Item 601 of Regulation S-K:
Exhibit 12
Exhibit 31(i)(a)
Exhibit 31(i)(b)
Exhibit 32
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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)
Date: February 2, 2007
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EXHIBIT INDEX
Exhibit No.
Description of Exhibit