UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
For the fiscal year ended December 31, 2005
OR
For the transition period from to
Commission file number 1-13782
WESTINGHOUSE AIR BRAKE TECHNOLOGIES CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(IRS Employer
Identification No.)
1001 Air Brake Avenue
Wilmerding, Pennsylvania 15148
Securities registered pursuant to Section 12(b) of the Act:
Title of Class
Name of Exchange on which registered
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No ¨.
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes ¨ No þ.
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 report) and (2) has been subject to such filing requirements for at least the past 90 days. Yes þ No ¨.
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨.
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):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act. Yes ¨ No þ.
The registrant estimates that as of June 30, 2005, the aggregate market value of the voting shares held by non-affiliates of the registrant was approximately $914 million based on the closing price on the New York Stock Exchange for such stock.
As of March 13, 2006, 48,370,264 shares of Common Stock of the registrant were issued and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Proxy Statement for the registrant’s Annual Meeting of Stockholders to be held on May 17, 2006 are incorporated by reference into Part III of this Form 10-K.
TABLE OF CONTENTS
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PART I
General
Westinghouse Air Brake Technologies Corporation, doing business as Wabtec Corporation, is a Delaware corporation with headquarters at 1001 Air Brake Avenue in Wilmerding, Pennsylvania. Our telephone number is 412-825-1000, and our website is located at www.wabtec.com. All references to “we”, “our”, “us”, the “Company” and “Wabtec” refer to Westinghouse Air Brake Technologies Corporation and its subsidiaries. Originally founded by George Westinghouse in 1869, Westinghouse Air Brake Company (“WABCO”) was formed in 1990 when it acquired certain assets and operations from American Standard, Inc. (ASI). In 1999, WABCO merged with MotivePower Industries, Inc. (“MotivePower”) and adopted the name Wabtec.
Today, Wabtec is one of the world’s largest providers of value-added, technology-based equipment and services for the global rail industry. We believe we hold about a 50% market share in North America for our primary braking-related equipment and a No. 1 or 2 positions in North America for most of our other product lines. Our highly engineered products, which are intended to enhance safety, improve productivity and reduce maintenance costs for customers, can be found on virtually all U.S. locomotives, freight cars and subway cars. In 2005, the Company had sales of $1 billion and net income of $56 million. Sales of aftermarket parts and services represented about 50% of total sales in 2005.
Management and insiders of the Company own approximately 6% of Wabtec’s outstanding shares, with the balance held by investment companies and individuals. Executive management incentive compensation focuses on earnings, cash flow, working capital and economic profit targets to align management interests with those of outside shareholders.
Industry Overview
The Company primarily serves the worldwide freight and passenger transit rail industries. The worldwide market for rail equipment has been estimated at about $70 billion annually, and it is estimated to grow at about 4% annually for the next five years. Our operating results are largely dependent on the level of activity, financial condition and capital spending plans of the global railroad industry. Many factors influence the industry, including general economic conditions; rail traffic, as measured by freight tonnage and passenger ridership; government investment in public transportation; and investment in new technologies by freight and passenger rail systems. Customers outside of North America accounted for about 24% of Wabtec’s sales in 2005.
In North America, railroads carry about 42% of intercity freight, as measured by ton-miles, which is more than any other mode of transportation. They are an integral part of the continent’s economy and transportation system, serving nearly every industrial, wholesale and retail sector. Through direct ownership and operating partnerships, U.S. railroads are part of an integrated network that includes railroads in Canada and Mexico, forming what is regarded as the world’s most-efficient and lowest-cost freight rail service. There are more than 500 railroads operating in North America, with the largest railroads, referred to as “Class I,” accounting for more than 90% of the industry’s revenues. Although the railroads carry a wide variety of commodities and goods, coal is the single-largest item, representing about 40% of carloadings in 2005. Intermodal traffic—the movement of trailers or containers by rail in combination with another mode of transportation—has been the railroads’ fastest-growing market segment in the past 10 years. Railroads operate in a competitive environment, especially with the trucking industry, and are always seeking ways to improve safety, cost and reliability. New technologies offered by Wabtec and others in the industry can provide some of these benefits.
Outside of North America, many of the rail systems have historically been focused on passenger transit, rather than freight. In recent years, however, railroads in countries such as Australia, India and China have been investing capital to expand and improve both their freight and passenger rail systems. Throughout the world, government-owned railroads are being sold to private owners, who often look to improve the efficiency of the
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rail system by investing in new equipment and new technologies. These investment programs represent additional opportunities for Wabtec to provide products and services.
Demand for our freight related products and services in North America is driven by a number of factors, including:
In the U.S., passenger transit is a $32 billion industry, dependent largely on funding from federal, state and local governments, and from fare box revenues. With about 40% of the nation’s passenger transit vehicles, New York City is the largest passenger transit market in the U.S., but most major cities offer either rail or bus transit services.
Demand for North American passenger transit products is driven by a number of factors, including:
Business Segments and Products
We provide our products and services through two principal business segments, the Freight Group and the Transit Group. The Freight Group manufactures and services components for new and existing freight cars and locomotives, while the Transit Group does the same for passenger transit vehicles, typically subway cars and buses. Both business segments serve original equipment manufacturers (OEMs) and provide aftermarket sales and services, with the aftermarket accounting for about 50% of net sales. In 2005, the Freight Group accounted for 77% of our total net sales, and the Transit Group accounted for the remaining 23%. In 2005, the Freight Group generated 53% of its net sales from the aftermarket and 47% of its net sales from the OEMs and Class I
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railroads. The Transit Group generated 41% of its net sales from the aftermarket and 59% of its net sales from OEMs. A summary of our leading product lines across both of our business segments is outlined below.
We manufacture, sell and service high-quality electronics for railroads in the form of on-board systems and braking for locomotives and freight cars. We harden our products to protect them from severe conditions, including extreme temperatures and high-vibration environments. Recently, we have concentrated our new product development on extending electronic technology to braking and control systems.
We have become a leader in the rail industry by capitalizing on the strength of our existing products, technological capabilities and new product innovation. Our new product development effort has focused on electronic technology for brakes and controls. Over the past several years, we introduced a number of significant new products including electronic brakes and Positive Train Control equipment that encompasses onboard digital data and global positioning communication protocols. The Transit Group also focuses on new product development and has introduced a number of new products during the past several years. Supported by our technical staff of over 500 engineers and specialists, we have extensive experience in a broad range of product lines, which enables us to provide comprehensive, systems-based solutions for our customers. We currently own over 1,000 active patents worldwide and 500 U.S. patents. During the last three years, we have filed for more than 150 U.S. patents in support of our new and evolving product lines.
For additional information on our business segments, see Note 19 of “Notes to Consolidated Financial Statements” included in Part IV, Item 15 of this report.
Competitive Strengths
Our key strengths include:
Breadth of product offering with a stable mix of OEM and aftermarket business. We believe that our substantial installed base of products to the OEMs is a significant competitive advantage for providing
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products and services to the aftermarket because end-users often look to purchase safety and performance-related replacement parts from the original supplier. In addition, we believe our product portfolio is one of the broadest in the rail industry, as we offer a wide selection of quality parts, components and assemblies across the entire train. Over the last several years, approximately 50% of our total net sales have come from our aftermarket products and services business.
Business strategy
Using the Wabtec Performance System (“WPS”), we intend to generate sufficient cash to invest in our growth strategies, as outlined below. Through WPS, we believe we can build on what we consider to be a leading position as a low-cost producer in the industry while maintaining world-class product quality, technology and customer responsiveness. Through WPS and employee-directed initiatives such as Kaizen, a Japanese-developed
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team concept, we continuously strive to improve quality, delivery and productivity, and to reduce costs. These efforts enable us to streamline processes, improve product quality and customer satisfaction, reduce product cycle times and respond more rapidly to market developments. Over time, we expect these lean initiatives to enable us to increase profit margins, which would improve cash flow and strengthen our ability to invest in the following growth strategies:
Backlog
In 2005, 50% of our sales came from aftermarket orders. Aftermarket orders typically carry lead times of less than 30 days, so they are not recorded in backlog for a significant period of time. As such, the Company’s backlog is primarily an indicator of future original equipment sales, not expected aftermarket activity.
The Company’s contracts are subject to standard industry cancellation provisions, including cancellations on short notice or upon completion of designated stages. Substantial scope-of-work adjustments are common. For these and other reasons, completion of the Company’s backlog may be delayed or cancelled. The railroad industry, in general, has historically been subject to fluctuations due to overall economic conditions and the level of use of alternative modes of transportation.
The backlog of customer orders as of December 31, 2005, and December 31, 2004, and the expected year of completion are as follows.
TotalBacklog
12/31/05
12/31/04
In thousands
Other
Years
Freight Group
Transit Group
Total
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At December 31, 2005, the Company’s backlog including customer option orders exceeded $1 billion.
Engineering and Development
To execute our strategy to develop new products, we invest in a variety of engineering and development activities. For the fiscal years ended December 31, 2005, 2004, and 2003, we invested about $32.8 million, $33.8 million and $32.9 million, respectively, on product development and improvement activities. Approximately 40% of these costs comprise activities solely devoted to new product development in any given year. These engineering and development expenditures, in total, represent about 3.2%, 4.1% and 4.6% of net sales for the same periods, respectively. Sometimes we conduct specific research projects in conjunction with universities, customers and other railroad product suppliers.
Our engineering and development program is largely focused upon train control and new braking technologies, with an emphasis on applying electronics to traditional pneumatic equipment. Electronic braking has been used in the transit industry for a long time, but freight railroads have been slower to accept the technology due to issues over interoperability, connectivity and durability. We are proceeding with efforts to enhance the major components for existing hard-wired braking equipment and development of new electronic technologies for the freight railroads.
We use our Product Development System (PDS) to develop and monitor new product programs. The system requires the product development team to follow consistent steps throughout the development process, from concept to launch, to ensure the product will meet customer expectations and internal profitability targets.
Intellectual Property
We have more than 1,000 active patents worldwide. We also rely on a combination of trade secrets and other intellectual property laws, nondisclosure agreements and other protective measures to establish and protect our proprietary rights in our intellectual property.
Certain trademarks, among them the name WABCO®, were acquired or licensed from American Standard Inc. in 1990 at the time of our acquisition of the North American operations of the Railway Products Group of American Standard. Other trademarks have been developed through the normal course of business, or acquired as a part of our ongoing merger and acquisition program.
We are a party, as licensor and licensee, to a variety of license agreements. We do not believe that any single license agreement is of material importance to our business or either of our business segments as a whole.
We entered into a license agreement with Faiveley Transport (formerly SAB WABCO Holdings B.V.) on December 31, 1993, pursuant to which Faiveley Transport granted us a license to the intellectual property and know-how related to the manufacturing and marketing of certain disc brakes, tread brakes and low noise and resilient wheel products. SAB WABCO Holdings B.V. was a former affiliate of Wabtec, since both were owned by the same parent company in the early 1990s. The Faiveley Transport license expired December 31, 2005, and was not renewed. The Company does not believe the expiration of this license will have a material impact on its results of operations.
We have issued licenses to the two sole suppliers of railway air brakes and related products in Japan, Nabtesco and Mitsubishi Electric Company. The licensees pay annual license fees to us and also assist us by acting as liaisons with key Japanese passenger transit vehicle builders for projects in North America. We believe that our relationships with these licensees have been beneficial to our core transit business and customer relationships in North America.
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Customers
Our customers include railroads throughout North America, as well as in the United Kingdom, Australia, Europe, South Africa and India; manufacturers of transportation equipment, such as locomotives, freight cars, subway vehicles and buses; lessors of such equipment; and passenger transit authorities, primarily those in North America.
In 2005, about 76% of our sales were to customers in North America, but we also shipped products to 89 countries throughout the world. About 50% of our sales were in the aftermarket, with the rest of our sales to OEMs of locomotives, freight cars, subway vehicles and buses.
Our top five customers, Electro-Motive Diesel, General Electric Transportation Systems, Burlington Northern Santa Fe, Bombardier and National Steel Car accounted for 24% of our net sales in 2005. No one customer represents 10% or more of consolidated sales. We believe that we have strong relationships with all of our key customers.
Competition
We believe that we hold about a 50% market share in North America for our primary braking-related equipment and a No. 1 or No. 2 market positions in North America for most of our other product lines. Nonetheless, we operate in a highly competitive marketplace. Price competition is strong because we have a relatively small number of customers and they are very cost-conscious.
In addition to price, competition is based on product performance and technological leadership, quality, reliability of delivery, and customer service and support. Our principal competitors vary to some extent across product lines, but most competitors are smaller, privately held companies. Within North America, New York Air Brake Company, a subsidiary of the German air brake producer Knorr-Bremse AG, is our principal overall OEM competitor. Our competition for locomotive, freight and passenger transit service and repair is primarily from the railroads’ and passenger transit authorities’ in-house operations, Electro-Motive Diesel, General Electric Transportation Systems, and New York Air Brake/Knorr. We believe our key strengths, which include leading market positions in core products, breadth of product offering with a stable mix of OEM and aftermarket business, leading design and engineering capabilities, significant barriers to entry and an experienced management team enable us to compete effectively in this marketplace.
Employees
At December 31, 2005, we had 5,229 full-time employees, approximately 41% of whom were unionized. A majority of the employees subject to collective bargaining agreements are within North America and these agreements generally extend through late 2006, 2007 and 2009.
We consider our relations with our employees and union representatives to be good, but cannot assure that future contract negotiations will be favorable to us.
Regulation
In the course of our operations, we are subject to various regulations of agencies and other entities. In the United States, these include principally the FRA and the AAR.
The FRA administers and enforces federal laws and regulations relating to railroad safety. These regulations govern equipment and safety standards for freight cars and other rail equipment used in interstate commerce.
The AAR oversees a wide variety of rules and regulations governing safety and design of equipment, relationships among railroads with respect to railcars in interchange and other matters. The AAR also certifies
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railcar builders and component manufacturers that provide equipment for use on railroads in the United States. New products generally must undergo AAR testing and approval processes.
As a result of these regulations and regulations in other countries in which we derive our revenues, we must maintain certain certifications as a component manufacturer and for products we sell.
Effects of Seasonality
Our business is not typically seasonal, although the third quarter results may be impacted by vacation and plant shutdowns at several of our major customers during this period.
Environmental Matters
Information on environmental matters is included in Note 18 of “Notes to Consolidated Financial Statements” included in Part IV, Item 15 of this report.
Available Information
We maintain an Internet site at www.wabtec.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as well as the annual report to stockholders and other information, are available free of charge on this site. The Internet site and the information contained therein or connected thereto are not incorporated by reference into this Form 10-K. Our Corporate Governance Guidelines, the charters of our Audit, Compensation and Nominating and Corporate Governance Committees, our Code of Conduct, which is applicable to all employees, and our Code of Ethics for Senior Officers, which is applicable to all of our executive officers, are also available free of charge on this site and are available in print to any shareholder who requests them.
We are dependent upon key customers.
We rely on several key customers who represent a significant portion of our business. For the fiscal year ended December 31, 2005, our top five customers, Electro-Motive Diesel, General Electric Transportation Systems, Burlington Northern Santa Fe, Bombardier and National Steel Car, accounted for 24% of our net sales. While we believe our relationships with our customers are generally good, our top customers could choose to reduce or terminate their relationships with us. In addition, many of our customers place orders for products on an as needed basis and operate in cyclical industries and, as a result, their order levels have varied from period to period in the past and may vary significantly in the future. Such customer orders are dependent upon their markets and customers, and may be subject to delays and cancellations. As a result of our dependence on our key customers, we could experience a material adverse effect on our business, results of operations and financial condition if we lost any one or more of our key customers or if there is a reduction in their demand for our products.
Our business operates in a highly competitive industry.
We operate in a competitive marketplace and face substantial competition from a limited number of established competitors in the United States and abroad, some of which may have greater financial resources than us. Price competition is strong and, coupled with the existence of a limited number of cost conscious purchasers, has historically limited our ability to increase prices. In addition to price, competition is based on product performance and technological leadership, quality, reliability of delivery and customer service and support. There can be no assurance that competition in one or more of our markets will not adversely affect us and our results of operations.
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We intend to pursue future acquisition strategies that involve a number of inherent risks, any of which may cause us not to realize anticipated benefits.
One aspect of our business strategy is to selectively pursue acquisitions, joint ventures and other business combinations that we believe will improve our market position and realize operating synergies, operating expense reductions and overhead cost savings. Acquisitions, joint ventures and other business combinations involve inherent risks and uncertainties, any one of which could have a material adverse effect on our business and results of operations, including:
We cannot assure you that we will be able to consummate any future acquisitions, joint ventures or other business combinations. If we are unable to identify suitable acquisition candidates or to consummate synergistic and strategic acquisitions, we may be unable to fully implement our business strategy and our business and results of operations may be adversely affected as a result. In addition, our ability to engage in strategic acquisitions will be dependent on our ability to raise substantial capital, and we may not be able to raise the funds necessary to implement our acquisition strategy on terms satisfactory to us, if at all.
As we introduce new products and services, a failure to predict and react to consumer demand could adversely affect our business.
We have dedicated significant resources to the development, manufacturing and marketing of new products. Decisions to develop and market new transportation products are typically made without firm indications of customer acceptance. Moreover, by their nature, new products may require alteration of existing business methods or threaten to displace existing equipment in which our customers may have a substantial capital investment. There can be no assurance that any new products that we develop will gain widespread acceptance in the marketplace or that such products will be able to compete successfully with other new products or services that may be introduced by competitors.
Our revenues are subject to cyclical variations in the railway and passenger transit markets and changes in government spending.
The railway industry historically has been subject to significant fluctuations due to overall economic conditions, the level of use of alternate methods of transportation and the levels of federal, state and local government spending on railroad transit projects. In economic downturns, railroads have deferred, and may defer, certain expenditures in order to conserve cash in the short term. Reductions in freight traffic may reduce demand for our replacement products.
The passenger transit railroad industry is also cyclical. New passenger transit car orders vary from year to year and are influenced greatly by major replacement programs and by the construction or expansion of transit systems by transit authorities. A substantial portion of our net sales has been, and we expect that a material portion of our future net sales may be, derived from contracts with metropolitan transit and commuter rail authorities and Amtrak. To the extent that future funding for proposed public projects is curtailed or withdrawn altogether as a result of changes in political, economic, fiscal or other conditions beyond our control, such projects may be delayed or cancelled, resulting in a potential loss of business for us, including transit aftermarket and new transit car orders. There can be no assurance that economic conditions will be favorable or that there will not be significant fluctuations adversely affecting the industry as a whole and, as a result, us.
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Prolonged unfavorable economic and market conditions could adversely affect our business.
Unfavorable general economic and market conditions in the United States and internationally (including as a result of terrorist activities and the military response by the United States and other countries) could have a negative impact on our sales and operations. To the extent that these factors result in continued instability of capital markets, shortages of raw materials or component parts, longer sales cycles, deferral or delay of customer orders or an inability to market our products effectively, our business and results of operations could be materially adversely affected.
A growing portion of our sales may be derived from our international operations, which exposes us to certain risks inherent in doing business on an international level.
In fiscal year 2005, 24% of our consolidated net sales were derived from sales outside of North America and we intend to continue to expand our international operations in the future. We currently conduct our international operations through a variety of wholly and majority-owned subsidiaries and joint ventures in Australia, Canada, China, France, India, Italy, Mexico and the United Kingdom. As a result, we are subject to various risks, any one of which could have a material adverse effect on those operations and on our business as a whole, including:
In addition, certain jurisdictions have laws that limit the ability of non-U.S. subsidiaries and their affiliates to pay dividends and repatriate cash flows.
We may incur increased costs due to fluctuations in interest rates and foreign currency exchange rates.
In the ordinary course of business, we are exposed to increases in interest rates that may adversely affect funding costs associated with variable-rate debt and changes in foreign currency exchange rates. We may seek to minimize these risks through the use of interest rate swap contracts and currency hedging agreements. There can be no assurance that any of these measures will be effective. Any material changes in interest or exchange rates could result in material losses to us.
We may have liability arising from asbestos litigation.
Actions have been filed against the Company and certain of its affiliates in various jurisdictions across the United States by persons alleging bodily injury as a result of exposure to asbestos-containing products. Since 2000, the number of such claims has increased. Most of these claims have been made against our wholly-owned subsidiary, Railroad Friction Products Corporation (RFPC), and are based on a product sold by RFPC before we acquired American Standard, Inc.’s (ASI) 50% interest in RFPC in 1990. We acquired the remaining interest in RFPC in 1992. These claims include a suit against RFPC and its insurers seeking coverage under RFPC’s insurance policies. On April 17, 2005, the claim against the Company contending that the Company assumed ASI’s liability for asbestos claims arising from exposure to RFPC’s products was resolved in the Company’s favor.
Most of these claims, including all of the RFPC claims, are submitted to insurance carriers for defense and indemnity or to non-affiliated companies that retain the liabilities for the asbestos-containing products at issue. We cannot, however, assure that all these claims will be fully covered by insurance or that the indemnitors will remain financially viable. Our ultimate legal and financial liability with respect to these claims, as is the case with other pending litigation, cannot be estimated.
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We are subject to a variety of environmental laws and regulations.
We are subject to a variety of environmental laws and regulations governing discharges to air and water, the handling, storage and disposal of hazardous or solid waste materials and the remediation of contamination associated with releases of hazardous substances. We believe our operations currently comply in all material respects with all of the various environmental laws and regulations applicable to our business; however, there can be no assurance that environmental requirements will not change in the future or that we will not incur significant costs to comply with such requirements.
Our manufacturer’s warranties may expose us to potentially significant claims.
We warrant the workmanship and materials of many of our products. Accordingly, we are subject to a risk of product liability or warranty claims in the event that the failure of any of our products results in personal injury or death, or does not conform to our customers’ specifications. In addition, in recent years, we have introduced a number of new products for which we do not have the same level of historical warranty experience. Although we have not had any material product liability or warranty claims made against us and we currently maintain liability insurance coverage, we cannot assure you that product liability claims, if made, would not exceed our insurance coverage limits or that insurance will continue to be available on commercially acceptable terms, if at all. The possibility exists for these types of warranty claims to result in costly product recalls, significant repair costs and damage to our reputation.
Labor disputes may have a material adverse effect on our operations and profitability.
We collectively bargain with labor unions that represent approximately 41% of our employees. Our current collective bargaining agreements generally extend through late 2006, 2007 and 2009. Failure to reach an agreement could result in strikes or other labor protests which could disrupt our operations. If we were to experience a strike or work stoppage, it would be difficult for us to find a sufficient number of employees with the necessary skills to replace these employees. We cannot assure you that we will reach any such agreement or that we will not encounter strikes or other types of conflicts with the labor unions of our personnel. Such labor disputes could have an adverse effect on our business, financial condition or results of operations, could cause us to lose revenues and customers and might have permanent effects on our business.
From time to time we are engaged in contractual disputes with our customers.
From time to time, we are engaged in contractual disputes with our customers regarding routine delivery and performance issues as well as adjustments for design changes and related extra work. These disputes are generally resolved in the ordinary course of business without having a material adverse impact on us.
Our indebtedness could adversely affect our financial health.
At December 31, 2005, we have total debt of $150 million. If it becomes necessary to access our available borrowing capacity under the Refinancing Credit Agreement, along with carrying the $150 million 6 7/8% senior notes, being indebted could have important consequences to us. For example, it could:
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The indenture for our $150 million 6 7/8% senior notes due 2013 and our Refinancing Credit Agreement contain various covenants that limit our management’s discretion in the operation of our businesses.
The indenture governing the notes and our credit agreement contain various covenants that limit our management’s discretion.
The Refinancing Credit Agreement limits the Company’s ability to declare or pay cash dividends and prohibits the Company from declaring or making other distributions, subject to certain exceptions. The Refinancing Credit Agreement contains various other covenants and restrictions including the following limitations: incurrence of additional indebtedness; mergers, consolidations and sales of assets and acquisitions; additional liens; sale and leasebacks; permissible investments, loans and advances; certain debt payments; capital expenditures; and imposes a minimum interest expense coverage ratio and a maximum debt to cash flow ratio.
The indenture under which the senior notes were issued contains covenants and restrictions which limit among other things, the following: the incurrence of indebtedness, payment of dividends and certain distributions, sale of assets, change in control, mergers and consolidations and the incurrence of liens.
None.
Facilities
The following table provides certain summary information about the facilities owned or leased by the Company. The Company believes that its facilities and equipment are generally in good condition and that, together with scheduled capital improvements, they are adequate for its present and immediately projected needs. Leases on the facilities are long-term and generally include options to renew. The Company’s corporate headquarters are located at the Wilmerding, Pa., site.
Location
Primary Use
Segment
Own/Lease
Approximate
Square Feet
Domestic
Wilmerding, PA
Boise, ID
Lexington, TN
Jackson, TN
Chicago, IL
Laurinburg, NC
Greensburg, PA
Germantown, MD
Willits, CA
Kansas City, MO
Columbia, SC
Cedar Rapids, IA
Racine, WI
Carson City, NV
Harvey, IL
Boulder, CO
Naperville, IL
Spartanburg, SC
Buffalo Grove, IL
Plattsburgh, NY
Elmsford, NY
Baltimore, MD
Sun Valley, CA
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Atlanta, GA
San Pablo, CA
Glastonbury, CT
Mountaintop, PA
International
Doncaster, UK
Stoney Creek (Ontario), Canada
Avellino, Italy
Wallaceburg (Ontario), Canada
San Luis Potosi, Mexico
Montefredane, Italy
Wetherill Park, Australia
Kolkata, India
Schweighouse, France
Tottenham, Australia
Lachine (Quebec), Canada
Calgary (Alberta), Canada
Sydney, Australia
Essen, Germany
Aachen, Germany
Vierzon, France
Barcelona, Spain
St. Laurent (Quebec), Canada
Jiangsu, China
Sassuolo, Italy
Pointe-aux-Trembles (Quebec), Canada
Information with respect to legal proceedings is included in Note 18 of “Notes to Consolidated Financial Statements” included in Part IV, Item 15 of this report.
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EXECUTIVE OFFICERS
The following table provides information on our executive officers. They are elected periodically by our Board of Directors and serve at its discretion.
Name
Position
William E. Kassling
Albert J. Neupaver
Alvaro Garcia-Tunon
Anthony J. Carpani
Patrick D. Dugan
Timothy J. Logan
James E. McClaine
Barry L. Pennypacker
George A. Socher
Scott E. Wahlstrom
Timothy R. Wesley
William E. Kassling has been a director and Chairman of the Board of Directors since 1990. He served as Chief Executive Officer from 1990 until February 2001 and from May 2004 through January 2006. Mr. Kassling was also President of the Company from 1990 through February 1998 and from May 2004 through January 2006. From 1984 until 1990 he headed the Railway Products Group of American Standard Inc. Between 1980 and 1984 he headed American Standard’s Building Specialties Group, and between 1978 and 1980 he headed Business Planning for American Standard. Mr. Kassling is a director of Smartops, Inc., Pittsburgh Penguins, Scientific-Atlanta, Inc. and Parker Hannifin Corporation.
Albert J. Neupaverjoined the Company on February 1, 2006 as President and Chief Executive Officer and a director. Prior to joining Wabtec, Mr. Neupaver had been with AMETEK, Inc. for 18 years, the last nine as President of the Electromechanical Group of AMETEK, Inc.
Alvaro Garcia-Tunon has been Senior Vice President, Chief Financial Officer and Secretary of the Company since March 2003. Mr. Garcia-Tunon was Senior Vice President, Finance of the Company from November 1999 until March 2003 and Treasurer of the Company from August 1995 until November 1999.
Anthony J. Carpani has been Vice President-Group Executive since June 2000. Previously, Mr. Carpani was Managing Director of our Australian-based subsidiary, F.I.P. Ltd. (formerly known as Futuris Brakes, International) from 1992 until June 2000.
Patrick D. Dugan joined Wabtec as Vice President and Corporate Controller in November 2003. Prior to joining Wabtec, Mr. Dugan served as Vice President and Chief Financial Officer of CWI International, Inc. from December 1996 to November 2003. Prior to 1996, he worked for PricewaterhouseCoopers providing business assurance and advisory services.
Timothy J. Logan has been the Vice President-Group Executive since August 1996. Previously, from 1987 until August 1996, Mr. Logan was Vice President, International Operations for Ajax Magnethermic Corporation and from 1983 until 1987 he was President of Ajax Magnethermic Canada, Ltd.
James E. McClaine joined Wabtec with the Pulse Electronics acquisition in 1995 and became President of Wabtec’s Railway Electronics division. Mr. McClaine has been Vice President-Group Executive since 2004.
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Barry L. Pennypacker has been Vice President-Group Executive since February 2004. Previously, from 1999 until 2004, Mr. Pennypacker was Vice President of Quality and Performance Systems. From 1997 to 1999, Mr. Pennypacker was director of manufacturing of Stanley Works. He has been a practitioner of lean manufacturing principles for almost 20 years in both private and public organizations.
George A. Socher has been Vice President-Internal Audit and Taxation, of the Company since November 1999. From July 1995 until November 1999, Mr. Socher was Vice President and Corporate Controller of the Company.
Scott E. Wahlstrom has been Vice President-Human Resources, since November 1999. Previously, Mr. Wahlstrom was Vice President, Human Resources & Administration of MotivePower Industries, Inc. from August 1996 until November 1999. From September of 1994 until August of 1996, Mr. Wahlstrom served as Director of Human Resources for MotivePower Industries, Inc.
Timothy R. Wesley has been Vice President-Investor Relations and Corporate Communications since November 1999. Previously, Mr. Wesley was Vice President, Investor and Public Relations of MotivePower Industries, Inc. from August 1996 until November 1999. From February 1995 until August 1996, he served as Director, Investor and Public Relations of MotivePower Industries, Inc. From 1993 until February 1995, Mr. Wesley served as Director, Investor and Public Relations of Michael Baker Corporation.
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PART II
The Common Stock of the Company is listed on the New York Stock Exchange. As of March 13, 2006, there were 48,370,264 shares of Common Stock outstanding held by 917 holders of record. The high and low sales price of the shares and dividends declared per share were as follows:
2005
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
2004
The Company’s credit agreement restricts the ability to make dividend payments, with certain exceptions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and see Note 9 of “Notes to Consolidated Financial Statements” included in Part IV, Item 15 of this report.
At the close of business on March 13, 2006, the Company’s Common Stock traded at $31.33 per share.
During the year ended December 31, 2005, there were no repurchases made by us or on our behalf or any “affiliated purchaser” of shares of our common stock registered by the Company pursuant to Section 12 of the Securities Exchange Act of 1934, as amended.
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The following table shows selected consolidated financial information of the Company and has been derived from audited financial statements. This financial information should be read in conjunction with, and is qualified by reference to, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements of the Company and the Notes thereto included elsewhere in this Form 10-K.
In thousands, except per share amounts
Income Statement Data
Net sales
Gross profit
Operating expenses (1)
Merger and restructuring charge
Income from operations
Interest expense, net
Other expense, net
Income from continuing operations before cumulative effect of accounting change
(Loss) income from discontinued operations (net of tax)
(Loss) gain on sale of discontinued operations (net of tax) (2)
Income before cumulative effect of accounting change
Net income (loss) (3)
Diluted Earnings per Common Share
Cash dividends declared per share
Fully diluted shares outstanding
Balance Sheet Data
Total assets
Cash
Total debt
Shareholders’ equity
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OVERVIEW
Wabtec is one of the world’s largest providers of value-added, technology-based products and services for the global rail industry. Our products are found on virtually all locomotives, freight cars, subway cars and buses in the U.S., as well as in certain markets throughout the world. Our products enhance safety, improve productivity and reduce maintenance costs for customers, and many of our core products and services are essential in the safe and efficient operation of freight rail and passenger transit vehicles.
Wabtec is a global company with operations in 11 countries. In 2005, about 76 percent of the Company’s revenues came from its North American operations, and Wabtec also sold products or services in 89 countries around the world.
Management Review of 2005 and Future Outlook
Wabtec’s long-term financial goals are to generate free cash flow in excess of net income, maintain a strong credit profile while minimizing our overall cost of capital, increase margins through strict attention to cost controls, and increase revenues through a focused growth strategy. In addition, management monitors the Company’s short-term operational performance through measures such as quality and on-time delivery.
In 2005, we achieved the following:
We achieved these results despite higher raw material costs and despite the negative impact of foreign currency exchange rates, especially on the Company’s Canadian operations.
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Freight rail industry statistics, such as carloadings and orders for new freight cars, improved in 2005. For example, carloadings increased to a record 17.2 million, 0.9% higher than 2004, as the freight railroads benefited from the strengthening economy in the U.S. As shown below, deliveries of new freight cars increased to 68,657 in 2005, and orders increased to 80,703. As a result, at year-end the backlog of freight cars ordered was 69,408, its highest level since 1998. Sales in our freight segment have benefited from that trend. Following are quarterly freight car statistics for the past three years:
First quarter 2003
Second quarter 2003
Third quarter 2003
Fourth quarter 2003
First quarter 2004
Second quarter 2004
Third quarter 2004
Fourth quarter 2004
First quarter 2005
Second quarter 2005
Third quarter 2005
Fourth quarter 2005
Source: Railway Supply Institute
The following is a summary of freight car, locomotive and transit car deliveries for the industry:
Freight car
Transit
Locomotive
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Source: Railway Supply Institute and Company Estimates
Carloadings and Intermodal Units Originated have increased over the past three years reflecting higher rail traffic and ultimately better opportunities for maintenance and aftermarket sales for the Company:
Carloadings Originated (in thousands):
2003
Intermodal Units Originated (in thousands):
Source: Association of American Railroads—Weekly Rail Traffic
In 2006, we expect demand for locomotives, freight cars and transit vehicles to remain at about the same levels as 2005. We expect demand in the aftermarket to remain strong, due to continued growth in rail traffic and passenger transit ridership.
In 2006 and beyond, we will continue to face many challenges, including increased costs for raw materials, especially steel; higher costs for medical and insurance premiums; and foreign currency fluctuations. In addition, we face general economic risks, as well as the risk that our customers could curtail spending on new and existing equipment. Risks associated with our four-point growth strategy include the level of investment that customers are willing to make in new technologies developed by the industry and the Company, and risks inherent in global expansion. When necessary, we will modify our financial and operating strategies to reflect changes in market conditions and risks.
The Company continues to evaluate possible restructuring actions that, if taken, would be expected to result in ongoing benefits, but would require significant one-time charges against income.
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RESULTS OF OPERATIONS
The following table shows our Consolidated Statements of Operations for the years indicated.
In millions
Cost of sales
Selling, general and administrative expenses
Engineering expenses
Amortization expense
Total operating expenses
Income from continuing operations before income taxes
Income tax expense
Income from continuing operations
Discontinued operations (net of tax)
Net income
2005 COMPARED TO 2004
The following table summarizes the results of operations for the period:
Net sales increased by $212 million from $822 million in 2004 to $1,034 million in 2005, primarily as a result of volume increases in freight car deliveries, strong demand for locomotive components, the acquisition of the friction product assets of Rutgers Rail S.p.A. (“CoFren”) and the ramp-up of a locomotive module contract in 2005. Aftermarket parts sales also increased because of strong carloadings and intermodal units originated. The Company did not realize any significant net sales improvement because of price increases or foreign exchange. Net income for 2005 was $55.8 million or $1.17 per diluted share. Net income for 2004 was $32.4 million or $0.71 per diluted share. This increase in net income was primarily due to increased sales.
The following table shows the Company’s net sales by business segment:
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Net sales. Net sales for 2005 increased $212 million, or 25.8%, as compared to 2004. The Freight Group’s increased sales reflected higher sales of certain components to international markets; higher demand for pneumatic air brake components related to increased deliveries of freight cars; sales of about $25 million from the CoFren acquisition in the first quarter of 2005; and sales from a locomotive module contract. Industry deliveries of new freight cars for 2005 increased to 68,657 units as compared to 46,292 in 2004. Transit Group sales were slightly higher mostly due to increased OEM demand.
Gross profit. Gross profit increased to $259.6 million in 2005 compared to $205.2 million in 2004. Gross profit is dependent on a number of factors including pricing, sales volume and product mix. In 2005, gross profit, as a percentage of sales, was 25% compared to 25% in 2004. The increase in gross profit percentage is primarily due to increased sales and the Company’s cost-improvement programs. The Company is taking action to improve margins in future quarters, including price increases and ongoing initiatives to increase productivity and efficiency.
The Company recorded a loss provision of $1.6 million in the first quarter of 2005 related to a contract to assemble locomotive modules in our Boise, Idaho facility. This provision was based upon customer purchase orders for units expected to be unprofitable and other specific contract costs. During the third quarter of 2005, as a result of the termination of the contract and improvements in cost, the entire reserve was reversed to earnings. However, as a result of the termination of agreement, the Company charged to expense $1.2 million of pre-production costs originally capitalized in 2004, which was being amortized along with delivery of the modules contract, and $161,000 of other costs. This contract termination potentially reduces the number of locomotive modules the Company may supply to the customer but has allowed for price increases on current and future orders. Other issues reducing gross profit percentage include severance and relocation costs of $1.9 million related to the consolidation of several production facilities and the writedown of fixed assets of $1 million from the closure of certain foundry operations.
The provision for warranty expense was $7.1 million lower than the prior-year, which positively impacted gross profit. The provision for warranty expense is lower due to improved warranty performance at three business units and lower charges for certain specific products. Overall, our warranty reserve decreased in 2005 by $1.3 million as warranty claims paid were more than warranty expense.
The following table shows our operating expenses:
Operating expenses. Operating expenses increased $8.6 million in 2005 as compared to 2004. Operating expenses are higher in 2005 due to the addition of CoFren, a $1 million reserve for a note receivable that is considered uncollectible and overall higher costs from inflation and sales activity. 2004 included a $3.2 million unfavorable litigation ruling to GETS-GS which the Company disagrees with and intends to contest. As a percentage of sales, total operating expense declined to 15.3% in 2005 from 18.2 % in 2004.
Income from operations. Income from operations totaled $101.3 million (or 9.8% of sales) in 2005 compared with $55.4 million (or 6.7% of sales) in 2004. Higher operating income resulted primarily from higher sales in 2005.
Interest expense, net. Interest expense decreased 24.7% in 2005 as compared 2004 primarily due to the Company’s lower debt level during 2005 and higher interest income.
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Other expense, net. The Company recorded a foreign exchange loss of $3.3 million and $1.2 million, respectively, in 2005 and 2004, due to the effect of currency exchange rate changes on intercompany transactions that are non U.S. dollar denominated amounts and charged or credited to earnings.
Income taxes. The effective income tax rate was 35.6% for 2005. In 2004, Wabtec recorded a $4.9 million tax benefit after resolving certain tax issues from prior years. Without this benefit, the overall effective income tax rate was 36.5% for 2004. The 2005 rate was lower due to increased income in lower tax jurisdictions.
Net income. Net income for 2005 increased $23.3 million, compared with 2004. The increase was due to higher sales.
2004 COMPARED TO 2003
Net sales increased by 14.5% from $717.9 million in 2003 to $822 million in 2004, primarily as a result of volume increases in freight car, locomotive and transit car deliveries. Aftermarket part sales increased because of carloadings and intermodal units originated. The Company did not realize any significant net sales improvement because of price increases or foreign exchange. Net income for 2004 was $32.4 million, or $0.71 per diluted share. Net income for 2003 was $22.7 million, or $0.52 per diluted share. This increase in net income was primarily due to increased sales and a favorable tax benefit.
Net sales. Net sales for 2004 increased $104.1 million, or 14.5%, as compared to 2003. The Freight Group’s increased sales reflected higher sales of certain components to international markets, higher demand for pneumatic air brake components related to increased delivery of freight cars and locomotives and greater demand for friction products due to overall increased rail traffic in 2004. Industry deliveries of new freight cars for 2004 increased to 46,292 units as compared to 31,400 in 2003. The Transit Group’s increased sales were due to increased deliveries under existing contracts and higher aftermarket sales.
Gross profit. Gross profit increased to $205.2 million in 2004 compared to $189.5 million in 2003. Gross profit is dependent on a number of factors including pricing, sales volume and product mix. Gross profit, as a percentage of sales, was 25% compared to 26.4% in 2003. The decrease in gross profit percentage is primarily due to increased manufacturing costs because of higher raw material prices, higher medical costs for retiree health plans and the negative impact of foreign exchange rates on the Company’s Canadian operations. Other issues reducing gross profit percentage include inefficiencies relating to the closing and relocation of an
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electronics plant from Canada to the U.S., the establishment of a $970,000 reserve to reflect future environmental monitoring at our Boise facility, fixed asset impairment charges of $1.3 million, and the start up of low-margin rail door contracts in the Transit Group. Also, the provision for warranty expense increased $4.4 million in 2004 compared to 2003. The provision for warranty expense was higher due to a combination of higher sales requiring additional reserves and charges for certain specific products. Although the warranty provision increased in 2004, warranty claims decreased resulting in an overall increase of $4.1 million in our warranty reserves. The Company is taking action to improve margins in future quarters, including price increases and ongoing initiatives to increase productivity and efficiency.
Operating expenses. Operating expenses increased $10.1 million in 2004 as compared to 2003 including a $3.2 million unfavorable litigation ruling to GETS-GS which the Company disagrees with and intends to contest. Other costs comprising the increase include restructuring costs at the Company’s electronics unit, higher medical and insurance claims experience, foreign exchange costs and overall higher costs from inflation and sales activity. These increases were partially offset by reduced amortization expense. Amortization expense decreased due to certain intangible assets having been fully amortized.
Income from operations. Income from operations totaled $55.4 million (or 6.7% of sales) in 2004 compared with $49.8 million (or 6.9% of sales) in 2003. Higher operating income resulted from increased sales in 2004 partially offset by higher operating expenses.
Interest expense, net. Interest expense increased 3.7% in 2004 as compared to 2003 primarily due to the Company’s sale of senior notes in August 2003. These notes, while resulting in higher interest expense for 2004, enabled the Company to convert short-term, variable-rate debt into fixed-rate debt at an attractive long-term interest rate.
Other expense, net. The Company incurred foreign exchange losses of $1.2 million and $2.8 million, respectively, in 2004 and 2003, due to the effect of currency exchange rate changes on intercompany transactions that are non U.S. dollar denominated amounts and charged or credited to earnings.
Income taxes. Income tax expense in 2004 includes a tax benefit of $4.9 million primarily related to the reversal of certain items that had previously been provided for that were closed from further regulatory examination. The effective income tax rate, not including the aforementioned tax benefit, remains unchanged and was 36.5% for 2004 and 2003.
Net income. Net income for 2004 increased $9.7 million, compared with 2003. The increase was due to higher sales and the tax benefit mentioned above, partially offset by other items including the unfavorable GETS-GS litigation ruling, increased environmental reserve and higher manufacturing costs.
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Liquidity and Capital Resources
Liquidity is provided primarily by operating cash flow and borrowings under the Company’s unsecured credit facility with a consortium of commercial banks (“credit agreement”). The following is a summary of selected cash flow information and other relevant data:
Cash provided by (used for):
Operating activities
Investing activities
Financing activities:
Debt paydown
Earnings before interest, taxes, depreciation and amortization (EBITDA)
Management uses EBITDA as a measure of liquidity. The following is a reconciliation of EBITDA to net cash provided by operating activities:
Net cash provided by operating activities
Change in operating assets and liabilities
Change from discontinued operations
Interest expense
EBITDA is defined as earnings before deducting interest expense, income taxes and depreciation and amortization. Although EBITDA is not a measure of performance calculated in accordance with generally accepted accounting principles, management believes that it is useful to an investor in evaluating Wabtec because it is widely used as a measure to evaluate a Company’s operating performance and ability to service debt. Financial covenants in our credit facility include ratios based on EBITDA. EBITDA does not purport to represent cash generated by operating activities and should not be considered in isolation or as substitute for measures of performance in accordance with generally accepted accounting principles. In addition, because EBITDA is not calculated identically by all companies, the presentation here may not be comparable to other similarly titled measures of other companies. Management’s discretionary use of funds depicted by EBITDA may be limited by working capital, debt service and capital expenditure requirements, and by restrictions related to legal requirements, commitments and uncertainties.
Operating activities. Operating cash flow in 2005 was $84.1 million as compared to $52.9 million in 2004. Net income was approximately $23.3 million higher in 2005 than 2004. Working capital increased and used operating cash of $18.7 million, as receivables increased $67 million and inventory increased $13.9 million, offset by an increase in accounts payable and accruals of $58.8 million and a decrease in other current assets of $3.4 million. Deferred and accrued income taxes increased operating cash flows by $14 million and $1.5 million, respectively in 2005, while they remained relatively unchanged in 2004. The remaining source of operating cash is due to depreciation and amortization and a net decrease in other assets less other liabilities in 2005.
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Operating cash flow in 2004 was $52.9 million as compared to $55.9 million in 2003. Net income was approximately $9.7 million higher in 2004 than 2003. Working capital decreased resulting in an increase of operating cash flow of $6.2 million, as accounts payable and accruals increased $26.1 million, offset by an increase in receivables, inventory and other current assets of $10.8 million, $5.2 million and $3.9 million, respectively. Deferred and accrued income taxes remained relatively unchanged compared to an $8.8 million decrease in 2003. The remaining use of operating cash is due to a net increase in the other assets less other liabilities in 2004. Working capital remained relatively unchanged in 2003, as receivables and inventory increased $13.2 million, and accounts payable increased $14.1 million.
Investing activities. In 2005 and 2004, cash used in investing activities was $57.6 million and $17.8 million, respectively. In 2005, we acquired the assets of Rutgers Rail S.p.A. for $35.9 million, net of cash received. The remaining use of cash consisted almost entirely of capital expenditures, net of disposals. In 2003 cash used in investing activities was $12.5 million.
Capital expenditures for continuing operations were $22.7 million, $19.3 million and $17.5 million in 2005, 2004 and 2003, respectively. The majority of capital expenditures for these periods relates to upgrades to and replacement of existing equipment.
Financing activities. In 2005, cash provided by financing activities was $28 million compared to cash used for financing activities of $18.5 million in 2004.
The Company realized proceeds of $30.1 million from the exercise of stock options during 2005. During 2004, long term debt was reduced by $40.1 million. The Company also realized proceeds of $23 million from the exercise of stock options during 2004. In 2003, the Company issued $150 million of Senior Notes due in August 2013 (“the Notes”). The Notes were issued at par and interest accrues at 6.875% and is payable semi-annually on January 31 and July 31 of each year. The proceeds were used to repay debt outstanding under the Company’s then existing bank credit agreement, and for general corporate purposes.
The Notes are senior unsecured obligations of the Company and rank pari passu with all existing and future senior debt and senior to all our existing and future subordinated indebtedness of the Company. The indenture under which the Notes were issued contains covenants and restrictions which limit among other things, the following: the incurrence of indebtedness, payment of dividends and certain distributions, sale of assets, change in control, mergers and consolidations and the incurrence of liens. The Company is in compliance with these measurements and covenants and expects that these measurements will not be any type of limiting factor in executing our operating activities.
In November 2003, the Company issued common stock in connection with the registration and sale of stock by certain selling shareholders. The Company issued 726,900 shares of common stock realizing total proceeds of about $10 million. See “Prospectus Summary—Recent Development.”
The following table shows outstanding indebtedness at December 31, 2005 and 2004. The revolving credit agreement and other term loan interest rates are variable and dependent on market conditions.
Revolving credit agreement
6.875% senior notes, due 2013
Less—current portion
Long-term portion
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Cash balance at December 31, 2005 and 2004 was $141.4 million and $95.3 million, respectively.
On February 1, 2005, the Company completed the acquisition of assets of Rutgers Rail S.p.A., a business with operations in Italy, Germany, France and Spain. The acquisition was accounted for as a purchase and accordingly, the purchase price has been allocated to the respective assets and liabilities based upon their estimated fair values as of the acquisition date. Operating results were included in the consolidated statement of operations from the acquisition date forward. The new company formed to hold the newly purchased assets is named CoFren S.r.l. (“CoFren”). CoFren is one of the leading manufacturers of brake shoes, disc pads and interior trim components for rail applications in Europe. The purchase price was $35.9 million, net of cash received, resulting in additional goodwill of $5.7 million.
Refinancing Credit Agreement. In January 2004, the Company refinanced its existing unsecured revolving credit agreement with a consortium of commercial banks. This “Refinancing Credit Agreement” provided a $175 million five-year revolving credit facility expiring in January 2009. In November 2005, the Company entered into an amendment to the Refinancing Credit Agreement which, among other things, extended the expiration of the agreement until December 2010. At December 31, 2005, the Company had available bank borrowing capacity, net of $26.4 million of letters of credit, of approximately $148.6 million, subject to certain financial covenant restrictions.
Refinancing Credit Agreement borrowings bear variable interest rates indexed to the indices described below. The Company did not borrow under the Refinancing Credit Agreement during the year ended December 31, 2005.
Under the Refinancing Credit Agreement, we may elect a base interest rate or an interest rate based on the London Interbank Offered Rates of Interest (“LIBOR”). The base interest rate is the greater of LaSalle Bank National Association’s prime rate or the federal funds effective rate plus 0.5% per annum. The LIBOR rate is based on LIBOR plus a margin that ranges from 62.5 to 175 basis points depending on the Company’s consolidated total indebtedness to cash flow ratios. The current margin is 62.5 basis points.
The Refinancing Credit Agreement contains customary events of default, including payment defaults, failure of representations or warranties to be true in any material respect, covenant defaults, defaults with respect to other indebtedness of the Company, bankruptcy, certain judgments against the Company, ERISA defaults and “change of control” of the Company. The Refinancing Credit Agreement includes the following covenants: a minimum interest coverage ratio of 3, maximum debt to cash flow ratio of 3.25 and a minimum net worth of $180 million plus 50% of consolidated net income since September 30, 2003. The Company is in compliance with these measurements and covenants and expects that these measurements will not be any type of limiting factor in executing our operating activities. See Note 9 of “Notes to Consolidated Financial Statements” included in Part IV, Item 15 of this report.
Management believes that based on current levels of operations and forecasted earnings, cash flow and liquidity will be sufficient to fund working capital and capital equipment needs as well as meeting debt service requirements. If sources of funds were to fail to satisfy the Company’s cash requirements, the Company may need to refinance our existing debt or obtain additional financing. There is no assurance that such new financing alternatives would be available, and, in any case, such new financing, if available, would be expected to be more costly and burdensome than the debt agreements currently in place.
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Effects of Inflation
In general, inflation has not had a material impact on the Company’s results of operations. Some of our labor contracts contain negotiated salary and benefit increases and others contain cost of living adjustment clauses, which would cause our labor cost to automatically increase if inflation were to become significant. However, higher costs of metals have reduced gross margin. Other areas of higher costs include medical benefits for active and retired employees.
Contractual Obligations and Off-Balance Sheet Arrangements
The Company is obligated to make future payments under various contracts such as debt agreements, lease agreements and have certain contingent commitments such as debt guarantees. The Company has grouped these contractual obligations and off-balance sheet arrangements into operating activities, financing activities, and investing activities in the same manner as they are classified in the Statement of Consolidated Cash Flows to provide a better understanding of the nature of the obligations and arrangements and to provide a basis for comparison to historical information. The table below provides a summary of contractual obligations and off-balance sheet arrangements as of December 31, 2005:
Operating activities:
Unconditional purchase obligations (1)
Long-term purchase obligations (1)
Operating leases (2)
Pension benefit payments (3)
Postretirement benefit payments (4)
Interest payments (5)
Long-term debt (6)
Dividends to shareholders (7)
Investing activities:
Capital projects (8)
Other:
Standby letters of credit (9)
Guarantees (10)
Annual payments to participants are expected to continue into the foreseeable future at the amounts or ranges noted. Postretirement payments are based on actuarial estimates using current assumptions for
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discount rates and health care costs. See further disclosure in Note 10 of the “Notes to Consolidated Financial Statements” included in Part IV, Item 15 of this report.
Obligations for operating activities. The Company has entered into $5.8 million of material long-term non-cancelable materials and supply purchase obligations. Operating leases represent multi-year obligations for rental of facilities and equipment. Estimated pension funding and post retirement benefit payments are based on actuarial estimates using current assumptions for discount rates, expected return on long-term assets, rate of compensation increases and health care cost trend rates. Benefits paid for pension obligations were $7.5 million and $6.1 million in 2005 and 2004, respectively. Benefits paid for post retirement plans were $2.7 million and $3.6 million in 2005 and 2004, respectively.
Obligations for financing activities. Cash requirements for financing activities consist primarily of long-term debt repayments, interest payments and dividend payments to shareholders. The Company has historically paid quarterly dividends to shareholders, subject to quarterly approval by our Board of Directors, currently at a rate of $1.9 million annually.
In 2001, the Company sold a subsidiary to that unit’s management team. As part of the sale, the Company guaranteed approximately $3 million of bank debt of the buyer, which was used for the purchase financing. This debt was refinanced in June 2005, and Wabtec’s guarantee was reduced to $721,000. Management has no reason to believe that this debt will not be repaid or refinanced.
The Company arranges for performance bonds to be issued by third party insurance companies to support certain long term customer contracts. At December 31, 2005, initial value of performance bonds issued on the Company’s behalf is about $74.7 million.
Obligations for investing activities. The Company typically spends approximately $15 million to $25 million a year for capital expenditures, primarily related to facility expansion efficiency and modernization, health and safety, and environmental control. The Company expects annual capital expenditures in the future will be within this range.
Forward Looking Statements
We believe that all statements other than statements of historical facts included in this report, including certain statements under “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” may constitute forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. Although we believe that our assumptions made in connection with the forward-looking statements are reasonable, we cannot assure you that our assumptions and expectations are correct.
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These forward-looking statements are subject to various risks, uncertainties and assumptions about us, including, among other things:
Economic and industry conditions
Operating factors
Competitive factors
Political/governmental factors
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Transaction or commercial factors
Statements in this 10-K apply only as of the date on which such statements are made, and we undertake no obligation to update any statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.
Critical Accounting Policies
The preparation of the financial statements in accordance with generally accepted accounting principles requires management to make judgments, estimates and assumptions regarding uncertainties that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses. Areas of uncertainty that require judgments, estimates and assumptions include the accounting for derivatives, environmental matters, warranty reserves, the testing of goodwill and other intangibles for impairment, proceeds on assets to be sold, pensions and other postretirement benefits, and tax matters. Management uses historical experience and all available information to make these judgments and estimates, and actual results will inevitably differ from those estimates and assumptions that are used to prepare the Company’s financial statements at any given time. Despite these inherent limitations, management believes that Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) and the financial statements and related footnotes provide a meaningful and fair perspective of the Company. A discussion of the judgments and uncertainties associated with accounting for derivatives and environmental matters can be found in Notes 2 and 18, respectively, in the “Notes to Consolidated Financial Statements” included in Part IV, Item 15 of this report.
A summary of the Company’s significant accounting policies is included in Note 2 in the “Notes to Consolidated Financial Statements” included in Part IV, Item 15 of this report. Management believes that the application of these policies on a consistent basis enables the Company to provide the users of the financial statements with useful and reliable information about the Company’s operating results and financial condition.
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Inventories are stated at the lower of cost or market.
Inventory is reviewed to ensure that an adequate provision is recognized for excess, slow moving and obsolete inventories.
Cost is determined under the first-in, first-out (FIFO) method. Inventory costs include material, labor and overhead.
The Company compares inventory components to prior year sales history and current backlog and anticipated future requirements. To the extent that inventory parts exceed estimated usage and demand, a reserve is recognized to reduce the carrying value of inventory. Also, specific reserves are established for known inventory obsolescence.
If the market value of our products were to decrease due to changing market conditions, the Company could be at risk of incurring the cost of additional reserves to adjust inventory value to a market value lower than stated cost.
If our estimates regarding sales and backlog requirements are inaccurate, we may be exposed to the expense of increasing our reserves for slow moving and obsolete inventory.
Management considers historical experience and all available information at the time the fair values of its business are estimated. However, actual amounts realized may differ from those used to evaluate the impairment of goodwill.
If actual results are not consistent with our assumptions and judgments used in estimating future cash flows and asset fair values, we may be exposed to additional impairment losses that could be material to our results of operations.
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Significant judgments and estimates are used in determining the liabilities and expenses for pensions and other postretirement benefits.
The rate used to discount future estimated liabilities is determined considering the rates available at year-end on debt instruments that could be used to settle the obligations of the plan. The long-term rate of return is estimated by considering historical returns and expected returns on current and projected asset allocations and is generally applied to a five-year average market value of assets.
Management uses its best judgment in the determination of these amounts. However, the liabilities ultimately realized and paid are dependent on various matters including the resolution of the tax audits in the various affected tax jurisdictions and may differ from the amounts recorded.
An adjustment to the estimated liability would be recorded through income in the period in which it becomes probable that the amount of the actual liability differs from the recorded amount.
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Provisions are made currently for estimated losses on uncompleted contracts.
Interest Rate Risk
In the ordinary course of business, we are exposed to risks that increases in interest rates may adversely affect funding costs associated with variable-rate debt. There was no outstanding variable rate debt at December 31, 2005 and 2004. Management had entered into pay-fixed, receive-variable interest rate swap contracts that mitigated the impact of variable-rate debt interest rate increases. These interest rate swap contracts were terminated in 2004. In 2003, we had concluded that our swap contracts qualified for “special cash flow hedge accounting” which permitted recording the fair value of the swap and corresponding adjustment to other comprehensive income on the balance sheet.
Foreign Currency Exchange Risk
We occasionally enter into several types of financial instruments for the purpose of managing our exposure to foreign currency exchange rate fluctuations in countries in which we have significant operations. As of December 31, 2005, we had several such instruments outstanding to hedge currency rate fluctuation in 2006.
We entered into foreign currency forward contracts to reduce the impact of changes in currency exchange rates. Forward contracts are agreements with a counterparty to exchange two distinct currencies at a set exchange rate for delivery on a set date at some point in the future. There is no exchange of funds until the delivery date. At the delivery date we can either take delivery of the currency or settle on a net basis. All outstanding forward contracts are for the sale of U.S. Dollars (USD) and the purchase of Canadian Dollars (CAD). As of December 31, 2005, we had forward contracts with a notional value of $24 million CAD (or $19.3 million U.S.), with an average exchange rate of $0.80 USD per $1 CAD, resulting in the recording of a current asset and an increase in comprehensive income of $877,000, net of tax.
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We are also subject to certain risks associated with changes in foreign currency exchange rates to the extent our operations are conducted in currencies other than the U.S. dollar. For the year ended December 31, 2005, approximately 64% of Wabtec’s net sales are in the United States, 11% in Canada, 1% in Mexico, and 24% in other international locations, primarily Europe. (See Note 19 of “Notes to Consolidated Financial Statements” included in Part IV, Item 15 of this report).
Our market risk exposure is not substantially different from our exposure at December 31, 2004.
Recent Accounting Pronouncements
In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 151, “Inventory Costs—an Amendment of ARB No. 43, Chapter 4.” This standard provides clarification that abnormal amounts of idle facility expense, freight, handling costs and spoilage should be recognized as current period charges. Additionally, this standard requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this standard are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not expect the adoption of SFAS 151 to have a material impact on the Company’s financial position or results of operations.
In December 2004, the FASB issued Statement of Financial Accounting Standard No. 123 (revised 2004) “Share-Based Payment.” This Statement replaces FASB Statement No. 123 and supersedes APB Opinion No. 25. No. 123(R) eliminates the ability to account for share-based compensation transactions using the intrinsic method currently used by the Company. FASB No. 123(R) requires such transactions be accounted for using a fair-value-based method that would result in expense being recognized in the Company’s financial statements. The Company will be required to adopt No. 123(R) in the first quarter of 2006 as a result of an extension granted by the Securities and Exchange Commission on April 14, 2005. The adoption of No. 123(R) is expected to reduce quarterly earnings by approximately $0.01 per share in 2006.
In December 2004, the FASB issued Staff Position (“FSP”) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.” FSP 109-2 provides guidance under SFAS No. 109, “Accounting for Income Taxes” with respect to recording the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the “Jobs Act”) on enterprises’ income tax expense and deferred tax liability. The Jobs Act was enacted on October 22, 2004. FSP 109-2 states that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the impact of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying SFAS No. 109. The Company evaluated the impact of the repatriation provisions and has not adjusted its tax expense or deferred tax liability to reflect the repatriation provisions of the Jobs Act.
In March 2005, the FASB issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations.” This statement requires companies to recognize a liability for the fair value of a legal obligation to perform asset retirement activities that are conditional on a future event if the amount can be reasonably estimated. The provisions of this statement are effective for years ending after December 15, 2005. The Company does not expect the adoption of FASB 47 to have a material impact on the Company’s financial position or results of operations.
In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 requires retrospective application to financial statements of prior periods for changes in accounting principle that are not adopted prospectively. This statement is effective for fiscal years beginning after December 15, 2005. The Company does not expect the adoption of SFAS 154 to have a material impact on the Company’s financial position or results of operations.
Financial statements and supplementary data are set forth in Item 15, of Part IV hereof.
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There have been no disagreements with our independent public accountants.
Evaluation of Disclosure Controls and Procedures
Wabtec’s principal executive officer and its principal financial officer have evaluated the effectiveness of Wabtec’s “disclosure controls and procedures,” (as defined in Exchange Act Rule 13a-15(e)) as of December 31, 2005. Based upon their evaluation, the principal executive officer and principal financial officer concluded that Wabtec’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by Wabtec in the reports filed or submitted by it under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and to provide reasonable assurance that information required to be disclosed by Wabtec in such reports is accumulated and communicated to Wabtec’s management, including its principal executive officer and principal finance officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting
There was no change in Wabtec’s “internal control over financial reporting” (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the quarter ended December 31, 2005, that has materially affected, or is reasonably likely to materially affect, Wabtec’s internal control over financial reporting. Management’s annual report on internal control over financial reporting and the attestation report of the registered public accounting firm are included in Part IV, Item 15 of this report.
Management’s Report on Internal Control over Financial Reporting
Management’s Report on Internal Control Over Financial Reporting appears on page 38 and is incorporated herein by reference.
Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting
Ernst & Young’s attestation report on Management’s Report on Internal Control Over Financial Reporting appears on page 40 and is incorporated herein by reference.
PART III
Items 10 through 14.
In accordance with the provisions of General Instruction G to Form 10-K, the information required byItem 10 (Directors and Executive Officers of the Registrant),Item 11 (Executive Compensation),Item 12 (Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters),Item 13 (Certain Relationships and Related Transactions) andItem 14 (Principal Accountant Fees and Services) is incorporated herein by reference from the Company’s definitive Proxy Statement for its Annual Meeting of Stockholders to be held on May 17, 2006. The definitive Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2005. Information relating to the executive officers of the Company is set forth in Part I.
Wabtec has adopted a Code of Ethics for Senior Officers which is applicable to all of our executive officers. As described in Item 1 of this report the Code of Ethics for Senior Officers is posted on our website at www.wabtec.com. In the event that we make any amendments to or waivers from this code, we will disclose the amendment or waiver and the reasons for such on our website.
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PART IV
The financial statements, financial statement schedules and exhibits listed below are filed as part of this annual report:
(a)
Management’s Reports to Westinghouse Air Brake Technologies Corporation Shareholders
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
Consolidated Statements of Operations for the three years ended December 31, 2005, 2004 and 2003
Consolidated Statements of Cash Flows for the three years ended December 31, 2005, 2004 and 2003
Consolidated Statements of Shareholders’ Equity for the three years ended December 31, 2005, 2004 and 2003
(b)
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40
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MANAGEMENT’S REPORTS TO WABTEC SHAREHOLDERS
Management’s Report on Financial Statements and Practices
The accompanying consolidated financial statements of Westinghouse Air Brake Technologies Corporation and subsidiaries (the “Company”) were prepared by management, which is responsible for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles and include amounts that are based on management’s best judgments and estimates. The other financial information included in the 10-K is consistent with that in the financial statements.
Management also recognizes its responsibility for conducting the Company’s affairs according to the highest standards of personal and corporate conduct. This responsibility is characterized and reflected in key policy statements issued from time to time regarding, among other things, conduct of its business activities within the laws of host countries in which the Company operates and potentially conflicting outside business interests of its employees. The Company maintains a systematic program to assess compliance with these policies.
Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, management has conducted an assessment, including testing, using the criteria in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s system of internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting standards. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management has excluded CoFren S.r.l. (“CoFren”) from its assessment of internal controls over financial reporting as of December 31, 2005 because CoFren was acquired by the Company in a purchase business combination effective February 1, 2005. CoFren is a wholly owned subsidiary whose total assets and net sales represent 9.6% and 2.5%, respectively, of the related consolidated financial statement amounts as of and for the year ended December 31, 2005.
Based on its assessment, management has concluded that the Company maintained effective internal control over financial reporting as of December 31, 2005, based on criteria in Internal Control-Integrated Framework issued by the COSO. Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included herein.
Management’s Certifications
The certifications of the Company’s Chief Executive Officer and Chief Financial Officer required by the Sarbanes-Oxley Act have been included in Exhibits 31 and 32 in the Company’s 10-K. In addition, in 2005, the Company’s Chief Executive Officer provided to the New York Stock Exchange the annual CEO certification regarding the Company’s compliance with the New York Stock Exchange’s corporate governance listing standards.
By
/s/ ALBERT J. NEUPAVER
/s/ ALVAROGARCIA-TUNON
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Westinghouse Air Brake Technologies Corporation:
We have audited the accompanying consolidated balance sheets of Westinghouse Air Brake Technologies Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Westinghouse Air Brake Technologies Corporation and subsidiaries as of December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Westinghouse Air Brake Technologies Corporation’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 6, 2006 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Pittsburgh, Pennsylvania
March 6, 2006
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON
INTERNAL CONTROL OVER FINANCIAL REPORTING
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Westinghouse Air Brake Technologies Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Westinghouse Air Brake Technologies Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
As indicated in the accompanying Management’s Report on Internal Control over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of CoFren S.r.l., which is included in the 2005 consolidated financial statements of Westinghouse Air Brake Technologies Corporation and constituted 9.6% of total assets as of December 31, 2005 and 2.5% of net sales for the year then ended. Management did not assess the effectiveness of internal control over financial reporting at this entity because CoFren S.r.l. was acquired by the Company in a purchase business combination effective February 1, 2005. Our audit of internal control over financial reporting of Westinghouse Air Brake Technologies Corporation also did not include an evaluation of the internal control over financial reporting of CoFren S.r.l.
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In our opinion, management’s assessment that Westinghouse Air Brake Technologies Corporation maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Westinghouse Air Brake Technologies Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Westinghouse Air Brake Technologies Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2005 and our report dated March 6, 2006 expressed an unqualified opinion thereon.
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CONSOLIDATED BALANCE SHEETS
In thousands, except share and par value
Assets
Current Assets
Cash and cash equivalents
Accounts receivable
Inventories
Deferred income taxes
Total current assets
Property, plant and equipment
Accumulated depreciation
Property, plant and equipment, net
Other Assets
Goodwill
Other intangibles, net
Other noncurrent assets
Total other assets
Total Assets
Liabilities and Shareholders’ Equity
Current Liabilities
Accounts payable
Accrued income taxes
Customer deposits
Accrued compensation
Accrued warranty
Other accrued liabilities
Total current liabilities
Long-term debt
Reserve for postretirement and pension benefits
Commitments and contingencies
Notes payable
Other long-term liabilities
Total liabilities
Shareholders’ Equity
Preferred stock, 1,000,000 shares authorized, no shares issued
Common stock, $.01 par value; 100,000,000 shares authorized: 66,174,767 shares issued and 48,002,819 and 46,192,223 outstanding at December 31, 2005 and 2004, respectively
Additional paid-in capital
Treasury stock, at cost, 18,171,948 and 19,982,544 shares, at December 31, 2005 and 2004, respectively
Retained earnings
Accumulated other comprehensive loss
Total shareholders’ equity
Total Liabilities and Shareholders’ Equity
The accompanying notes are an integral part of these statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS
In thousands, except per share data
Other income and expenses
Earnings Per Common Share
Basic
(Loss) income from discontinued operations
Diluted
Weighted average shares outstanding
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CONSOLIDATED STATEMENTS OF CASH FLOWS
Operating Activities
Adjustments to reconcile net income to cash provided by operations:
Depreciation and amortization
Results of discontinued operations, net of tax
Discontinued operations
Changes in operating assets and liabilities, net of acquisitions
Accrued liabilities and customer deposits
Other assets and liabilities
Investing Activities
Purchase of property, plant and equipment
Proceeds from disposal of property, plant and equipment
Acquisitions of businesses, net of cash acquired
Net cash used for investing activities
Financing Activities
Repayments of credit agreements
Borrowings of senior notes
Repayments of other borrowings
Stock issuance
Proceeds from treasury stock from stock based benefit plans
Cash dividends
Net cash provided by (used for) financing activities
Effect of changes in currency exchange rates
Increase in cash
Cash, beginning of year
Cash, end of year
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CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
Balance, December 31, 2002
Cash dividends ($0.04 dividend per share)
Proceeds from treasury stock issued from the exercise of stock options and other benefit plans, net of tax
Compensatory stock granted through a Rabbi Trust
Translation adjustment
Unrealized gains on foreign exchange contracts, net of $135 tax
Unrealized gains on derivatives designated and qualified as cash flow hedges, net of $496 tax
Additional minimum pension liability, net of $(728) tax
Total comprehensive income
Balance, December 31, 2003
Unrealized gains on foreign exchange contracts, net of $1,925 tax
Unrealized gains on derivatives designated and qualified as cash flow hedges, net of $119 tax
Additional minimum pension liability, net of $(2,178) tax
Balance, December 31, 2004
Unrealized losses on foreign exchange contracts, net of $(1,556) tax
Additional minimum pension liability, net of $(3,531) tax
Balance, December 31, 2005
The accompanying notes are an integral part of these statements
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Wabtec is one of the world’s largest providers of value-added, technology-based products and services for the global rail industry. Our products are found on virtually all U.S. locomotives, freight cars and passenger transit vehicles, as well as in certain markets throughout the world. Our products enhance safety, improve productivity and reduce maintenance costs for customers, and many of our core products and services are essential in the safe and efficient operation of freight rail and passenger transit vehicles.
Principles of Consolidation. The consolidated financial statements include the accounts of the Company and its majority owned subsidiaries. Such statements have been prepared in accordance with generally accepted accounting principles. Sales between subsidiaries are billed at prices consistent with sales to third parties and are eliminated in consolidation.
Cash Equivalents. Cash equivalents are highly liquid investments purchased with an original maturity of three months or less.
Allowance for Doubtful Accounts. The allowance for doubtful accounts receivable reflects our best estimate of probable losses inherent in our receivable portfolio determined on the basis of historical experience, specific allowances for known troubled accounts and other currently available evidence. The allowance for doubtful accounts was $4.1 million and $2 million as of December 31, 2005 and 2004, respectively.
Inventories. Inventories are stated at the lower of cost or market. Cost is determined under the first-in, first-out (FIFO) method. Inventory costs include material, labor and overhead.
Property, Plant and Equipment. Property, plant and equipment additions are stated at cost. Expenditures for renewals and improvements are capitalized. Expenditures for ordinary maintenance and repairs are expensed as incurred. The Company provides for book depreciation principally on the straight-line method. Accelerated depreciation methods are utilized for income tax purposes.
Leasing Arrangements. The Company conducts a portion of its operations from leased facilities and finances certain equipment purchases through lease agreements. In those cases in which the lease term approximates the useful life of the leased asset or the lease meets certain other prerequisites, the leasing arrangement is classified as a capital lease. The remaining arrangements are treated as operating leases.
Intangible Assets. Goodwill and other intangible assets with indefinite lives are not amortized. Other intangibles (with definite lives) are amortized on a straight-line basis over their estimated economic lives. Goodwill and indefinite lived intangible assets are reviewed annually for impairment and more frequently when indicators of impairment are present. Amortizable intangible assets are reviewed for impairment when indicators of impairment are present.
The evaluation of impairment involves comparing the current fair value of the business to the recorded value (including goodwill). The Company uses a combination of a guideline public company market approach and a discounted cash flow model (“DCF model”) to determine the current fair value of the business. A number
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
of significant assumptions and estimates are involved in the application of the DCF model to forecasted operating cash flows, including markets and market share, sales volume and pricing, costs to produce and working capital changes. Management considers historical experience and all available information at the time the fair values of its business are estimated. However, actual fair value that could be realized could differ from those used to evaluate the impairment of goodwill.
Warranty Costs. Warranty costs are accrued based on management’s estimates of repair or upgrade costs per unit and historical experience. Warranty expense was $7.8 million, $14.9 million and $10.5 million for 2005, 2004 and 2003, respectively. Warranty reserves were $16.2 million and $17.4 million at December 31, 2005 and 2004, respectively.
Deferred Compensation Agreements. In May 1998, a consensus on Emerging Issues Task Force Issue No. 97-14, “Accounting for Deferred Compensation Arrangements Where Amounts Earned Are Held in a Rabbi Trust and Invested” (“EITF 97-14”), was issued. The adoption of EITF 97-14 required the Company to record as treasury stock the historical value of the Company’s stock maintained in its deferred compensation plans.
Income Taxes. Income taxes are accounted for under the liability method. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws. The provision for income taxes includes federal, state and foreign income taxes.
Stock-Based Compensation. The Company uses the intrinsic value based method of accounting for stock-based compensation and does not recognize compensation expense for the issuance of options with an exercise price equal to or greater than the market price of the stock at the time of grant.
Had compensation expense for these plans been determined based on the fair value at the grant dates for awards, the Company’s net income and earnings per share would be as set forth in the following table. For purposes of pro forma disclosures, the estimated fair value is amortized to expense over the options’ vesting period.
For the year ended
December 31,
In thousands, except per share
As reported
Stock based compensation under FAS123, net of tax
Pro forma
Basic earnings per share
Diluted earnings per share
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For purposes of presenting pro forma results, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
Dividend yield
Risk-free interest rate
Stock price volatility
Expected life (years)
Financial Derivatives and Hedging Activities. The Company periodically enters into interest rate swap agreements to reduce the impact of interest rate changes on its variable rate borrowings. Interest rate swaps are agreements with a counterparty to exchange periodic interest payments (such as pay fixed, receive variable) calculated on a notional principal amount. The interest rate differential to be paid or received is recognized as interest expense. The Company has concluded its interest rate swap contracts qualify for “special cash flow hedge accounting” which permit recording the fair value of the swap and corresponding adjustment to other comprehensive income (loss) on the balance sheet. The interest rate swaps were terminated in 2004.
The Company also entered into foreign currency forward contracts to reduce the impact of changes in currency exchange rates. Forward contracts are agreements with a counterparty to exchange two distinct currencies at a set exchange rate for delivery on a set date at some point in the future. There is no exchange of funds until the delivery date. At the delivery date the Company can either take delivery of the currency or settle on a net basis. All outstanding forward contracts are for the sale of U.S. Dollars (USD) and the purchase of Canadian Dollars (CAD). As of December 31, 2005, the Company had forward contracts with a notional value of $24 million CAD (or $19.3 million U.S.), with an average exchange rate of $0.80 USD per $1 CAD, resulting in the recording of a current asset and an increase in comprehensive income of $877,000, net of tax.
Foreign Currency Translation. Assets and liabilities of foreign subsidiaries, except for the Company’s Mexican operations whose functional currency is the U.S. Dollar, are translated at the rate of exchange in effect on the balance sheet date while income and expenses are translated at the average rates of exchange prevailing during the year. Foreign currency gains and losses resulting from transactions, and the translation of financial statements are recorded in the Company’s consolidated financial statements based upon the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 52, “Foreign Currency Translation.” The effects of currency exchange rate changes on intercompany transactions and balances of a long-term investment nature are accumulated and carried as a component of shareholders’ equity. The effects of currency exchange rate changes on intercompany transactions that are non U.S. dollar denominated amounts are charged or credited to earnings. Foreign exchange intercompany transaction losses recognized in income were $3.3 million, $1.2 million and $2.8 million for 2005, 2004 and 2003, respectively.
Other Comprehensive Income (Loss). Comprehensive income (loss) is defined as net income and all other non-owner changes in shareholders’ equity. The Company’s accumulated other comprehensive income (loss) consists of foreign currency translation adjustments, foreign currency hedges, foreign exchange contracts and pension related adjustments.
Revenue Recognition. Revenue is recognized in accordance with Staff Accounting Bulletins (SABs) 101, “Revenue Recognition in Financial Statements” and 104 “Revision of Topic 13.” Revenue is recognized when products have been shipped to the respective customers, title has passed and the price for the product has been determined.
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The Company recognizes revenues on long-term contracts based on the percentage of completion method of accounting. The units-of-delivery method or other output-based measures, as appropriate, are used to measure the progress toward completion of individual contracts. Contract revenues and cost estimates are reviewed and revised at a minimum quarterly and adjustments are reflected in the accounting period as such amounts are determined. Provisions are made currently for estimated losses on uncompleted contracts.
Certain pre-production costs relating to long-term production and supply contracts have been deferred and will be recognized over the life of the contracts. Deferred pre-production costs were $4.9 million, $5.3 million and $3.4 million at December 31, 2005, 2004 and 2003, respectively.
Significant Customers and Concentrations of Credit Risk. The Company’s trade receivables are primarily from rail and transit industry original equipment manufacturers, Class I railroads, railroad carriers and commercial companies that utilize rail cars in their operations, such as utility and chemical companies. No one customer accounted for more than 10% of the Company’s consolidated net sales in 2005, 2004 and 2003.
Shipping and Handling Fees and Costs. All fees billed to the customer for shipping and handling are classified as a component of net revenues. All costs associated with shipping and handling is classified as a component of cost of sales.
Research and Development. Research and development costs are charged to expense as incurred. For the years ended December 31, 2005, 2004 and 2003, the Company incurred costs of approximately $32.8 million, $33.8 million and $32.9 million, respectively.
Employees. As of December 31, 2005, approximately 41% of the Company’s workforce was covered by collective bargaining agreements. These agreements are generally effective through 2006, 2007 and 2009.
Earnings Per Share.Basic earnings per common share are computed by dividing net income applicable to common shareholders by the weighted-average number of shares of common stock outstanding during the year. Diluted earnings per common share are computed by dividing net income applicable to common shareholders by the weighted average number of shares of common stock outstanding adjusted for the assumed conversion of all dilutive securities (such as employee stock options).
Reclassifications. Certain prior year amounts have been reclassified, where necessary, to conform to the current year presentation.
Use of Estimates. The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual amounts could differ from the estimates. On an ongoing basis, management reviews its estimates based on currently available information. Changes in facts and circumstances may result in revised estimates.
Recent Accounting Pronouncements. In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 151, “Inventory Costs—an Amendment of ARB No. 43, Chapter 4.” This standard provides clarification that abnormal amounts of idle facility expense, freight, handling costs and spoilage should be recognized as current period charges. Additionally, this standard requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this standard are effective for
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inventory costs incurred during fiscal years beginning after June 15, 2005. The Company is currently evaluating the effect of this standard on the Company’s financial statements and results of operations.
On February 1, 2005, the Company completed the acquisition of the assets of Rütgers Rail S.p.A, a business with operations in Italy, Germany, France and Spain. The acquisition was accounted for as a purchase and accordingly, the purchase price was allocated to the respective assets and liabilities based upon their estimated fair values as of the acquisition date. Operating results were included in the consolidated statement of operations from the acquisition date forward. The new company formed to hold the newly purchased assets of Rütgers Rail S.p.A. is named CoFren S.r.l. (“CoFren”). CoFren is one of the leading manufacturers of brake shoes, disc pads and interior trim components for rail applications in Europe. The purchase price was $35.9 million, net of cash received, resulting in additional goodwill of $5.7 million.
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The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of the acquisition:
Current assets
Property, plant & equipment
Intangible assets
Assets held for sale
Total Assets Acquired
Current liabilities
Total Liabilities Assumed
Net Assets Acquired
Of the $5.4 million of acquired intangible assets, exclusive of goodwill, $3.5 million was assigned to customer relationships, $1.2 million was assigned to patents, $412,000 was assigned to trademarks and $324,000 was assigned to backlog.
The following Unaudited pro forma financial information presents income statement results as if the acquisition had occurred January 1, 2003:
With the acquisition of Rutgers Rail, S.p.A., the Company decided to offer for sale a certain product division. As part of the purchase accounting, the net amount of this division has been revalued to its estimated net realizable value and has been classified as assets held for sale, which is included in Other noncurrent assets on the balance sheet.
On November 1, 2001, the Company completed the sale of certain assets to GE Transportation Systems (GETS) for $238 million in cash. The assets sold primarily included locomotive aftermarket products and services for which Wabtec was not the original equipment manufacturer. Under the terms of the sales agreement, the Company has agreed to indemnify GETS for, among other things, certain potential third party, off site environmental cleanup or remediation costs. The Company has purchased an insurance policy to mitigate its exposure for the environmental indemnities.
In the fourth quarter of 2001, the Company decided to exit other businesses and put these businesses up for sale. As of December 31, 2003, one of the businesses had not sold. The Company actively solicited but did not receive any reasonable offers to purchase the asset and, in response, had reduced the price. The asset is no longer being actively marketed and as a result, the Company reclassed the business to continuing operations in the fourth quarter of 2003. Such reclassification had no material impact on the financial statements. In the fourth quarter of 2005, the Company decided to liquidate our bus door joint venture in China.
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In accordance with SFAS 144, “Accounting for Impairment or Disposal of Long-Lived Assets”, the operating results of these businesses have been classified as discontinued operations for all years presented and are summarized as of December 31, as follows:
(Loss)/income before income taxes
Income tax (benefit)/expense
(Loss)/income from discontinued operations
Interest paid during the year
Income taxes paid during the year
Business acquisitions:
Fair value of assets acquired
Liabilities assumed
Cash paid
Less cash acquired
Net cash paid
Noncash investing and financing activities:
Deferred compensation
Treasury stock
In 2005, the Company recorded restructuring and impairment charges relating to consolidating facilities, relocating a product line from Canada to the U.S., completing a data center migration and closing a foundry operation. $4.1 million of costs were expensed, consisting of severance costs of $1.2 million for 60 employees, relocation and other costs of $630,000 and asset writeoffs of $2.3 million. All but $1 million of these severance costs were paid for in 2005. Of these costs, $2.9 million was charged to cost of sales and $1.2 million was charged to selling, general and administrative expenses. During 2004, the Company wrote down $1.3 million of various assets.
The components of inventory, net of reserves, were:
Raw materials
Work-in-process
Finished goods
Total inventory
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The major classes of depreciable assets are as follows:
Machinery and equipment
Buildings and improvements
Land and improvements
Locomotive leased fleet
PP&E
Less: accumulated depreciation
The estimated useful lives of property, plant and equipment are as follows:
Land improvements
Depreciation expense was $21.7 million, $22.8 million and $21 million for 2005, 2004 and 2003, respectively.
Goodwill and other intangible assets with indefinite lives are no longer amortized. Instead, they are subject to periodic assessments for impairment by applying a fair-value-based test. The fair value of these reporting units was determined using a combination of discounted cash flow analysis and market multiples based upon historical and projected financial information. Goodwill still remaining on the balance sheet is $118.2 million and $113.5 million at December 31, 2005 and 2004, respectively.
As of December 31, 2005 and 2004, the Company’s trademarks had a net carrying amount of $19.9 million and $19.6 million, respectively, and the Company believes these intangibles have an indefinite life. Intangible assets of the Company, other than goodwill and trademarks, consist of the following:
Patents and other, net of accumulated amortization of $24,923 and $22,459
Customer relationships, net of accumulated amortization of $145 and $0
Covenants not to compete, net of accumulated amortization of $8,304 and $8,263
Intangible pension asset
The Company reassessed the useful lives and the classification of its identifiable assets and determined that they continue to be appropriate. The weighted average useful life of patents was 13 years, customer relationships was 20 years and of covenants not to compete was five years.
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Amortization expense for intangible assets was $3.1 million, $2.4 million and $3.4 million for the years ended December 31, 2005, 2004, and 2003, respectively. Amortization expense for the five succeeding years is as follows (in thousands):
2006
2007
2008
2009
2010
The change in the carrying amount of goodwill by segment for the year ended December 31, 2005 is as follows:
Balance at December 31, 2004
Addition of CoFren
Foreign currency impact
Long-term debt consisted of the following:
6.875% Senior notes, due 2013
Refinancing Credit Agreement
In January 2004, the Company refinanced its existing unsecured revolving credit agreement with a consortium of commercial banks. This “Refinancing Credit Agreement” provided a $175 million five-year revolving credit facility expiring in January 2009. In November 2005, the Company entered into an amendment to the Refinancing Credit Agreement which, among other things, extended the expiration of the agreement until December 2010. At December 31, 2005, the Company had available bank borrowing capacity, net of $26.4 million of letters of credit, of approximately $148.6 million, subject to certain financial covenant restrictions.
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The Refinancing Credit Agreement contains customary events of default, including payment defaults, failure of representations or warranties to be true in any material respect, covenant defaults, defaults with respect to other indebtedness of the Company, bankruptcy, certain judgments against the Company, ERISA defaults and “change of control” of the Company. The Refinancing Credit Agreement includes the following covenants: a minimum interest coverage ratio of 3, maximum debt to cash flow ratio of 3.25 and a minimum net worth of $180 million plus 50% of consolidated net income since September 30, 2003. The Company is in compliance with these measurements and covenants.
6.875% Senior Notes Due August 2013
In August 2003, the Company issued $150 million of Senior Notes due in 2013 (“the Notes”). The Notes were issued at par. Interest on the Notes accrues at a rate of 6.875% per annum and is payable semi-annually on January 31 and July 31 of each year. The proceeds were used to repay debt outstanding under the Company’s existing credit agreement, and for general corporate purposes.
The Notes are senior unsecured obligations of the Company and rank pari passu with all existing and future senior debt and senior to all our existing and future subordinated indebtedness of the Company. The indenture under which the Notes were issued contains covenants and restrictions which limit among other things, the following: the incurrence of indebtedness, payment of dividends and certain distributions, sale of assets, change in control, mergers and consolidations and the incurrence of liens.
Scheduled principal repayments of outstanding loan balances required as of December 31, 2005 are as follows:
Future years
The Company sponsors defined benefit pension plans that cover certain U.S., Canadian and United Kingdom employees and which provide benefits of stated amounts for each year of service of the employee.
In addition to providing pension benefits, the Company has provided certain unfunded postretirement health care and life insurance benefits for a portion of North American employees. In January 1995 the postretirement health care and life insurance benefits for U.S. salaried employees was modified to discontinue benefits for employees who had not attained the age of 50 by March 31, 1995. The Company is not obligated to pay health care and life insurance benefits to individuals who had retired prior to 1990.
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The Company uses a December 31 measurement date for the U.S. and Canadian plans. The U.K. plan uses an October 31 measurement date.
Obligations and Funded Status
Defined Benefit Plans
Change in projected benefit obligation
Obligation at beginning of year
Service cost
Interest cost
Participant contributions
Special termination benefits
Plan amendment
Plan curtailments
Actuarial loss
Benefits paid
Expenses paid
Effect of currency rate changes
Obligation at end of year
Change in plan assets
Fair value of plan assets at beginning of year
Actual gain on plan assets
Employer contribution
Administrative expenses
Fair value of plan assets at end of year
Funded status
Funded status at year end
Unrecognized net actuarial loss
Unrecognized prior service cost (credit)
Unrecognized transition obligation
Effect of currency exchange rates
Prepaid (accrued) benefit cost
Amounts recognized in the statement of financial position include:
Prepaid pension cost
Intangible asset
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The accumulated benefit obligation for all defined benefit pension plans was $142.1 million and $126.1 million at December 31, 2005 and 2004, respectively.
The aggregate projected benefit obligation and fair value of plan assets for the pension plans with benefit obligations in excess of plan assets were $153.3 million and $120.3 million, respectively, as of December 31, 2005; and $135.7 million and $104.4 million, respectively, as of December 31, 2004. The aggregate accumulated benefit obligation and fair value of plan assets for the pension plans with accumulated benefit obligations in excess of plan assets were $142.1 million and $120.3 million, respectively, as of December 31, 2005; and $122 million and $100.2 million, respectively, as of December 31, 2004.
The components of prepaid (accrued) benefit costs by country are as follows:
U.S. plan
Canadian plans
U.K. plan
Components of Net Periodic Benefit Costs
Expected return on plan assets
Net amortization/deferrals
Net periodic benefit cost
An increase in the minimum pension liability resulted in a charge to shareholders’ equity, net of tax, of $6.1 million in 2005 and $3.8 million in 2004.
Assumptions
Weighted average assumptions used to determine benefit obligations are as follows:
Discount rate
Rate of compensation increase
The discount rate is based on settling the pension obligation with high grade, high yield corporate bonds, and the rate of compensation increase is based on actual experience.
Weighted average assumptions used to determine the net periodic benefit costs are as follows:
Expected long-term rate of return
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The expected return on plan assets is based on historical performance as well as expected future rates of return on plan assets considering the current investment portfolio mix and the long-term investment strategy.
The assumed health care cost trend rate grades from an initial rate of 9.71% to an ultimate rate of 4.98% in six years. A 1% increase in the assumed health care cost trend rate will increase the amount of expense recognized for the postretirement plans by approximately $364,000 for 2006, and increase the service and interest cost components of the accumulated postretirement benefit obligation by approximately $6.8 million. A 1% decrease in the assumed health care cost trend rate will decrease the service and interest cost components of the expense recognized for the postretirement plans by approximately $297,000 for 2006, and decrease the accumulated postretirement benefit obligation by approximately $5.6 million.
Pension Plan Assets
The composition of all plan assets consists primarily of equities, corporate bonds, governmental notes and temporary investments. This Plan’s asset allocations at the respective measurement dates for 2005 by asset category are as follows:
Asset Category
Equity securities
Debt securities
Other, including cash equivalents
Investment policies are determined by the respective Plan’s Pension Committee and set forth in its Investment Policy. Pursuant to the Investment Policy for the U.S., the investment strategy is to use passive index funds managed by the Bank of New York. The target asset allocation and composite benchmarks for U.S. plans include the following:
Asset Allocation
Composite Benchmark
Category
Benchmark
Bonds
Large Cap Stocks
International Stocks
Small Cap Stocks
The Company is evaluating allocation policies for its plans in Canada and the U.K. Rebalancing of the asset allocation occurs on a quarterly basis.
Cash Flows
The Company’s funding methods are based on governmental requirements and differ from those methods used to recognize pension expense, which is primarily based on the projected unit credit method applied in the accompanying financial statements. The Company expects to contribute $8.9 million to the pension plan during 2006 and expects this level of funding to continue in future periods.
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Benefit payments expected to be paid to plan participants are as follows:
Year ended December 31,
2011 through 2015
In May 2004, the FASB issued FSP 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (FSP FAS 106-2). This Act was signed into law by the President on December 8, 2003 and introduces a prescription drug benefit plan under Medicare Part D as well as a federal subsidy to sponsors of retiree health benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. FSP 106-2 provides guidance on how companies should account for the impact of the Act on their postretirement health care plans. To encourage employers to retain or provide postretirement drug benefits, beginning in 2006 the federal government will provide non-taxable subsidy payments to employers that sponsor prescription drug benefits to retirees that are actuarially equivalent to the Medicare benefit. FSP 106-2 is effective for interim or annual financial statements beginning after June 15, 2004. The adoption of FSP 106-2 did not have a significant impact on the Company’s financial position or results of operations.
Defined Contribution Plans
The Company also participates in certain 401(k) and multiemployer pension plans. Costs recognized under these plans are summarized as follows:
Multi-employer pension and health & welfare plans
401(k) savings and other defined contribution plans
The 401(k) savings plan is a participant directed defined contribution plan that holds shares of the Company’s stock. At December 31, 2005 and 2004, the plan held on behalf of its participants about 646,000 shares with a market value of $17.4 million, and 695,000 shares with a market value of $14.8 million, respectively.
Additionally, the Company has stock option based benefit and other plans further described in Note 13.
The Company is responsible for filing consolidated U.S., foreign and combined, unitary or separate state income tax returns. The Company is responsible for paying the taxes relating to such returns, including any subsequent adjustments resulting from the redetermination of such tax liabilities by the applicable taxing
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authorities. The components of the income (loss) from continuing operations before provision for income taxes for the Company’s domestic and foreign operations for the years ended December 31 are provided below:
Foreign
No provision has been made for U.S., state, or additional foreign taxes related to undistributed earnings of $57 million of foreign subsidiaries which have been or are intended to be permanently re-invested.
The 2004 Jobs Creation Act and FSP 109-2 state that an enterprise is allowed time beyond the financial reporting period of enactment to evaluate the effect of the Jobs Act on its plan for reinvestment or repatriation of foreign earnings for applying SFAS No. 109. The Company has completed its evaluation of the impact of the repatriation provisions. Accordingly as provided for in FSP 109-2, the Company has not adjusted its tax expense or deferred tax liability to reflect repatriation provisions of the 2004 Jobs Creation Act.
The consolidated provision (credit) for income taxes included in the Statement of Income consisted of the following:
Current taxes
Federal
State
Deferred taxes
Total provision (credit)
Consolidated income tax provision (credit) is included in the Statement of Income as follows:
Continuing operations
Income (loss) from discontinued operations—
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A reconciliation of the United States federal statutory income tax rate to the effective income tax rate on continuing operations for the years ended December 31 is provided below:
U. S. federal statutory rate
State taxes
Adjustment to prior year matters
Change in valuation allowance
Deferred rate/balance adjustment
Foreign tax credits
Research and development credit
Other, net
Effective rate
The overall effective income tax rate in 2004 includes a tax benefit of $4.9 million, which is primarily related to the reversal of certain items that had previously been provided for and that have been closed from further regulatory examination.
Deferred income taxes result from temporary differences in the recognition of income and expense for financial and income tax reporting purposes. These deferred income taxes will be recognized as future tax benefits or costs when the temporary differences reverse.
Components of deferred tax assets and (liabilities) were as follows:
Deferred income tax assets (liabilities):
Accrued expenses and reserves
Deferred comp/employee benefits
Pension
Inventory
Warranty reserve
Environmental reserve
Federal net operating loss
State net operating loss
Plant, property & equipment
Intangibles
Federal credits
State credits
Foreign credits
Foreign net operating loss
Foreign deferred net items
Gross deferred income tax assets
Valuation allowance
Total deferred income tax assets
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A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The Company has recorded a valuation allowance of $15.1 million for certain state and foreign net operating loss carryforwards and deferred tax assets anticipated to produce no tax benefit. State and foreign net operating loss carryforwards exist in the amount of $169 million and $10 million, respectively, and are set to expire in various periods from 2006 to 2025. A valuation allowance exists and/or has been established for certain of these net operating loss carryforwards.
Federal tax credits exist of approximately $5 million which are comprised of Research and Experimentation credits available through 2025 and Alternative Minimum Tax credits available indefinitely. State tax credits of approximately $361,000 are available and consist of various Machinery & Equipment, Research and Experimentation, and Jobs related credits.
The computation of earnings per share from continuing operations is as follows:
Income from continuing operations applicable to common shareholders
Divided by:
Basic earnings from continuing operations per share
Divided by the sum of:
Assumed conversion of dilutive stock options
Diluted shares outstanding
Diluted earnings from continuing operations per share
Options to purchase approximately 13,000, 589,000 and 646,000 shares of Common Stock were outstanding in 2005, 2004 and 2003, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise price exceeded the average market price of the common shares.
Stock Options. Under the 2000 Stock Incentive Plan (the 2000 Plan), the Company may grant options to employees for an initial amount of 1.1 million shares of Common Stock. This amount is subject to annual modification based on a formula. Under the formula, 1.5% of total common shares outstanding at the end of the preceding fiscal year are added to shares available for grant under the 2000 Plan. Based on the adjustment, the Company had approximately 1.1 million shares available for 2005 grants and has available approximately 700,000 shares through the end of fiscal 2006. The shares available for grants on any given date may not exceed 15% of Wabtec’s total common shares outstanding. Generally, the options become exercisable over a three-year vesting period and expire ten years from the date of grant.
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As part of a long-term incentive program, in 1998, the Company granted options to purchase up to 500,020 shares, to certain executives under a plan that preceded the 2000 Plan. The option price is $20 per share. The options vest 100% after eight years and are subject to accelerated vesting after three years if the Company achieves certain earnings targets as established by the compensation committee of the board of directors. No further grants may be made under this plan.
The Company also has a non-employee directors’ stock option plan under which 500,000 shares of Common Stock are reserved for issuance. Through year-end 2005, the Company granted nonqualified stock options to non-employee directors to purchase a total of 176,000 shares.
Subsequent to year end, the Company issued approximately 200,000 shares of restricted stock to certain officers and employees which vest over four years.
Employee Stock Purchase Plan. In 1998, the Company adopted an employee discounted stock purchase plan (DSPP). The DSPP had 500,000 shares available for issuance. Participants can purchase the Company’s common stock at 85% of the lesser of fair market value on the first or last day of each offering period. Stock outstanding under this plan at December 31, 2005 was 172,503 shares.
A summary of the Company’s stock option activity and related information for the years indicated follows:
Beginning of year
Granted
Exercised
Canceled
End of year
Exercisable at end of year
Available for future grant
Weighted average fair value of options granted during the year
The following table summarizes information about stock options outstanding at December 31, 2005:
Number
Outstanding
As of 12/31/05
Weighted Average
Remaining
Contractual Life
Exercise Price
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The components of accumulated other comprehensive loss were:
Foreign currency translation adjustment
Unrealized gains on foreign exchange contracts, net of tax of $504 and $2,060
Additional minimum pension liability, net of tax of $(15,132) and $(11,601)
Total accumulated other comprehensive loss
The Company leases office and manufacturing facilities under operating leases with terms ranging from one to 15 years, excluding renewal options.
The Company has sold remanufactured locomotives to various financial institutions and leased them back under operating leases with terms from five to 20 years.
Total net rental expense charged to operations in 2005, 2004, and 2003 was $7.2 million, $7.8 million and $6.9 million, respectively. Certain of the Company’s equipment rental obligations under operating leases pertain to locomotives, which are subleased to customers under both short-term and long-term agreements. The amounts above are shown net of sublease rentals of $2.9 million, $2.2 million and $2.8 million for the years 2005, 2004 and 2003, respectively.
Future minimum rental payments under operating leases with remaining noncancelable terms in excess of one year are as follows:
Real
Estate
Sublease
Rentals
2011 and after
In 2001, the Company sold the operating assets and liabilities of a non-core business unit to that business unit’s management team. As part of the sale, Wabtec has guaranteed approximately $721,000 of bank debt of the buyer, which assists the buyer with certain working capital requirements. The Company has no reason to believe that this debt will not be repaid or refinanced.
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The following table reconciles the changes in the Company’s product warranty reserve as follows:
Balance at beginning of period
Warranty expense
Warranty payments
Balance at end of period
The Company’s authorized capital stock includes 1,000,000 shares of preferred stock. The Board of Directors has the authority to issue the preferred stock and to fix the designations, powers, preferences and rights of the shares of each such class or series, including dividend rates, conversion rights, voting rights, terms of redemption and liquidation preferences, without any further vote or action by the Company’s shareholders. The rights and preferences of the preferred stock would be superior to those of the common stock. At December 31, 2005 and 2004 there was no preferred stock issued or outstanding.
The Company is subject to a variety of environmental laws and regulations governing discharges to air and water, the handling, storage and disposal of hazardous or solid waste materials and the remediation of contamination associated with releases of hazardous substances. The Company believes its operations currently comply in all material respects with all of the various environmental laws and regulations applicable to our business; however, there can be no assurance that environmental requirements will not change in the future or that we will not incur significant costs to comply with such requirements.
Under terms of the purchase agreement and related documents for the 1990 Acquisition, American Standard, Inc. (“ASI”) has indemnified the Company for certain items including, among other things, certain environmental claims the Company asserted prior to 2000. If ASI was unable to honor or meet these indemnifications, the Company would be responsible for such items. In the opinion of management, ASI currently has the ability to meet its indemnification obligations.
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The Company recorded a loss provision of $1.6 million in the first quarter of 2005 related to a contract to assemble locomotive modules in our Boise, Idaho facility. This provision was based upon customer purchase orders for units expected to be unprofitable and other specific contract costs. During the third quarter of 2005, as a result of the termination of the contract and improvements in cost, the entire reserve was reversed to earnings. Also, during the third quarter the Company expensed $1.2 million of capitalized pre-production costs and recognized $161,000 of other costs. This contract termination potentially reduces the number of locomotive modules the Company may supply to the customer but immediately allows for price increases on current and future orders.
The Company is subject to a RCRA Part B Closure Permit (“the Permit”) issued by the Environmental Protection Agency (EPA) and the Idaho Department of Health and Welfare, Division of Environmental Quality relating to the monitoring and treatment of groundwater contamination on, and adjacent to, the MotivePower Industries (Boise, Idaho) facility. In compliance with the Permit, the Company has completed the first phase of an accelerated plan for the treatment of contaminated groundwater, and continues onsite and offsite monitoring for hazardous constituents. An additional $970,000 was accrued in 2004 based on our refined estimates of ongoing monitoring costs. The Company reevaluated the reserve and reversed $280,000 to earnings in 2005. In total, the Company has accrued $702,000 at December 31, 2005, the estimated remaining costs for remediation and monitoring. The Company was in compliance with the Permit at December 31, 2005.
Foster Wheeler Energy Corporation (“FWEC”) the seller of the Mountaintop, Pennsylvania property to the predecessor of one of the Company’s subsidiaries in 1989, agreed to indemnify the Company’s predecessor and its successors and assigns against certain identified environmental liabilities for which FWEC executed a Consent Order Agreement with the Pennsylvania Department of Environmental Protection (PADEP) and EPA. Management believes that this indemnification arrangement is enforceable for the benefit of the Company and that FWEC has the financial resources to honor its obligations under this indemnification arrangement.
Prior to the Company’s acquisition of Young Radiator, Young agreed to clean up alleged contamination on a prior production site in Mattoon, Illinois. The Company is in the process of remediating the site with the state of Illinois and now estimates the costs to remediate the site to be approximately $5,000 which has been accrued at December 31, 2005.
Young ceased manufacturing operations at its Racine, Wisconsin facility in the early 1990s. Investigations prior to the acquisition of Young revealed some levels of contamination on the Racine property and the Company has begun remediation efforts. The Company has initiated a comprehensive site evaluation with the state of Wisconsin and believes this governing body is generally in agreement with the findings. The Company has accrued approximately $126,000 at December 31, 2005 as its estimate of the remaining remediation costs.
On November 3, 2000, the Company settled a suit brought against it in 1999 by GE-Harris Railway Electronics, L.L.C. and GE-Harris Railway Electronics Services, L.L.C. (collectively “GE-Harris”). On September 20, 2002, a motion in that lawsuit was filed by the successor to GE-Harris, GE Transportation Services Global Signaling, L.L.C. (“GETS-GS”). The motion by GETS-GS contended that the Company is acting beyond authority granted in the parties’ November 2000 settlement and license agreement and in contempt of the consent order that concluded the suit at that time.
In support of its motion, GETS-GS pointed principally to sales and offers to sell certain railway brake equipment, including distributed power equipment, to Australian customers. In August 2004, the United States District Court for the District of Delaware ruled partially in favor of GETS-GS ordering the Company to pay compensatory damages for lost licensing profits related to the above mentioned distributed power equipment contracts and reimbursement for reasonable attorneys’ fees and expenses. While the Company disagrees with the ruling and intends to continue to contest this ruling, this liability of $3.2 million was recognized in 2004 as a component of selling, general and administrative expense. Should an option be exercised by the Company’s Australian customers for additional shipments of products under the same distributed power contracts, an
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additional $2.7 million of compensatory damages could be owed to GETS-GS. The additional liability will not be recognized by the Company until and if such option is exercised.
The Company has other contingent obligations relating to certain sales leaseback transactions, for locomotives that were assumed in connection with the MotivePower merger in 1999, for which reserves of $3.3 million have been established.
In April 2005, Amtrak decided to suspend its Acela Express train service due to cracks in the spokes of some of the cars’ brake discs. Wabtec did not design or supply the braking system for the Acela cars. The braking system was supplied by Knorr Brake Corporation and the brake discs were designed by Faiveley Transport. Wabtec did provide, and machined approximately one-third of the brake discs for the cars and assisted Amtrak and others, including Bombardier Corporation, Alstom Transportation Inc., Knorr and Faiveley, in their evaluation and investigation of the brake disc cracks. Amtrak claims approximately $30 million in damages due to the suspension of the Acela service, which was resumed on a limited basis in July, and complete service was resumed in September. Wabtec has received notice of a potential claim for damages from Knorr and, in turn, has provided notice of a potential claim for damages to Faiveley. Wabtec does not believe that it has any material liability with regard to this matter.
In March 2006, management began an internal investigation related to business transactions conducted by a subsidiary, Pioneer Friction Limited (“Pioneer”), in West Bengal, India. Through an internal compliance review, management discovered that disbursements were made which may be in violation of applicable laws and regulations. Pioneer is a fourth-tier subsidiary of Wabtec; two of the intermediate subsidiaries are Australian companies which are, in turn, owned by a U.S. holding company.
While the transactions are inconsequential and not material to the overall operations of Wabtec, they may result in potential penalties. Management has not concluded its investigation, but has informed Wabtec’s Audit Committee, Board of Directors, and the appropriate authorities. Wabtec has not recorded a reserve related to this matter as of December 31, 2005, because the Company’s potential exposure cannot be estimated based on management’s current assessment of the situation.
From time to time the Company is involved in litigation relating to claims arising out of its operations in the ordinary course of business. As of the date hereof, the Company is involved in no litigation that the Company believes will have a material adverse effect on its financial condition, results of operations or liquidity.
Wabtec has two reportable segments—the Freight Group and the Transit Group. The key factors used to identify these reportable segments are the organization and alignment of the Company’s internal operations, the nature of the products and services and customer type. The business segments are:
Freight Group manufactures products and provides services geared to the production and operation of freight cars and locomotives, including braking control equipment, on-board electronic components and train coupler equipment. Revenues are derived from OEM sales of components and locomotives, aftermarket sales and freight car repairs and services. All of the assets sold to GETS were part of the Freight Group.
Transit Group consists of products for passenger transit vehicles (typically subways, rail and buses) that include braking, coupling and monitoring systems, climate control and door equipment engineered to meet individual customer specifications. Revenues are derived from OEM and aftermarket sales as well as from repairs and services.
The Company evaluates its business segments’ operating results based on income from operations. Corporate activities include general corporate expenses, elimination of intersegment transactions, interest income and expense and other unallocated charges. Since certain administrative and other operating expenses and other items have not been allocated to business segments, the results in the below tables are not necessarily a measure computed in accordance with generally accepted accounting principles and may not be comparable to other companies.
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Segment financial information for 2005 is as follows:
Sales to external customers
Intersegment sales/(elimination)
Total sales
Income (loss) from operations
Interest expense and other
Income (loss) from continuing operations before income taxes
Capital expenditures
Segment assets
Segment financial information for 2004 is as follows:
Segment financial information for 2003 is as follows:
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The following geographic area data as of and for the years ended December 31, 2005, 2004 and 2003, respectively, includes net sales based on product shipment destination and long-lived assets, which consist of plant, property and equipment, net of depreciation, resident in their respective countries:
United States
Canada
Mexico
United Kingdom
Other international
Export sales from the Company’s United States operations were $105.6 million, $81.6 million and $59.2 million for the years ending December 31, 2005, 2004 and 2003, respectively.
The estimated fair values and related carrying values of the Company’s financial instruments are as follows:
Foreign exchange contracts
6.875% senior notes
The fair value of the Company’s foreign exchange contracts and senior notes were based on dealer quotes and represent the estimated amount the Company would pay to the counterparty to terminate the agreements.
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Effective August 2003, the Company issued $150 million of Senior Notes due in 2013 (“The Notes”). The obligations under the Notes are fully and unconditionally guaranteed by all U.S. subsidiaries as guarantors. In accordance with positions established by the Securities and Exchange Commission, the following shows separate financial information with respect to the parent, the guarantor subsidiaries and the non-guarantor subsidiaries. The principal elimination entries eliminate investment in subsidiaries and certain intercompany balances and transactions.
Balance Sheet for December 31, 2005:
Accounts Receivable
Other Current Assets
Total Current Assets
Net Property, Plant and Equipment
Investment in Subsidiaries
Other Long Term Assets
Intercompany
Long-Term Debt
Other Long Term Liabilities
Total Liabilities
Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
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Balance Sheet for December 31, 2004:
Income Statement for the Year Ended December 31, 2005:
Net Sales
Cost of Sales
Gross Profit (Loss)
Operating Expenses
Operating (Loss) Profit
Interest (Expense) Income
Other (Expense) Income
Equity Earnings
Pretax Income (Loss)
Income Tax Benefit (Expense)
Income from Continuing Operations
Discontinued Operations
Net Income (Loss)
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Income Statement for the Year Ended December 31, 2004:
Income Statement for the Year Ended December 31, 2003:
Gross (Loss) Profit
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Condensed Statement of Cash Flows for the Year Ended December 31, 2005:
Net Cash Provided by (Used in) Operating Activities
Net Cash Used in Investing Activities
Net Cash Provided by (Used in) Financing Activities
Effect of Changes in Currency Exchange Rates
Increase (Decrease) in Cash
Cash at Beginning of Period
Cash at End of Period
Condensed Statement of Cash Flows for the Year Ended December 31, 2004:
Net Cash (Used in) Provided by Financing Activities
(Decrease) Increase in Cash
Condensed Statement of Cash Flows for the Year Ended December 31, 2003:
Increase in Cash
77
The components of other expense are as follows:
Foreign currency loss
Other miscellaneous income (expense)
Total other expense
First
Quarter
Second
Third
Fourth
Operating income
Basic earnings from continuing operations per common share
Diluted earnings from continuing operations per common share
Income from continuing operations before taxes
Income from discontinued operations (net of tax)
The Company operates on a four-four-five week accounting calendar, and accordingly, the quarters end on or about March 31, June 30 and September 30. The fiscal year ends on December 31.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
WESTINGHOUSE AIR BRAKE
TECHNOLOGIES CORPORATION
Albert J. Neupaver,
President and Chief Executive Officer
Date: March 16, 2006
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated.
Signature and Title
Date
/S/ ALBERT J. NEUPAVER
President, Chief Executive Officer and Director
/S/ WILLIAM E. KASSLING,
William E. Kassling,
Chairman of the Board and Director
/S/ ROBERT J. BROOKS
Robert J. Brooks,
Director
/S/ KIM G. DAVIS
Kim G. Davis,
/S/ EMILIO A. FERNANDEZ
Emilio A. Fernandez,
/S/ LEE B. FOSTER
Lee B. Foster,
/S/ MICHAEL W. D. HOWELL
Michael W. D. Howell,
/S/ JAMES V. NAPIER
James V. Napier,
/S/ GARY C. VALADE
Gary C. Valade,
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SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
For each of the three years ended December 31
Warranty and overhaul reserves
Allowance for doubtful accounts
Valuation allowance-taxes
Inventory reserves
Merger and restructuring reserve
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EXHIBITS
81
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