Timken Company - 10-Q quarterly report FY

 

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THE TIMKEN COMPANY AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)

Note 1 — Basis of Presentation

The accompanying consolidated condensed financial statements (unaudited) for The Timken Company (the company) have been prepared in accordance with the instructions to Form 10-Q and do not include all of the information and footnotes required by the accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) and disclosures considered necessary for a fair presentation have been included. For further information, refer to the Consolidated Financial Statements and footnotes included in the company’s Annual Report on Form 10-K for the year ended December 31, 2005. Certain amounts in the 2005 Condensed Consolidated Financial Statements have been reclassified to conform to the 2006 presentation.

On January 1, 2006, the company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 123(R), “Share-Based Payment,” and elected to use the modified prospective transition method. The modified prospective method requires that compensation cost be recognized in the financial statements for all stock option awards granted after the date of adoption and for all unvested stock option awards granted prior to the date of adoption. In accordance with SFAS No. 123(R), prior period amounts were not restated. Prior to the adoption of SFAS No. 123(R), the company utilized the intrinsic-value based method of accounting under APB Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations, and adopted the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation.”

Under the company’s long-term incentive plan, shares of common stock have been made available to grant at the discretion of the Compensation Committee of the Board of Directors to officers and key associates in the form of stock option awards. Stock option awards have a ten year term and vest in 25% increments annually beginning on the date of grant. In addition to stock option awards, the company has granted restricted shares under the long-term incentive plan. Restricted shares vest in 25% increments annually beginning on the date of grant and have historically been expensed over the vesting period.

Prior to January 1, 2006, no stock-based compensation expense was recognized for stock option awards under the intrinsic-value based method. As a result of the adoption of SFAS No. 123(R), the company recognized additional compensation expense of $1.6 million before taxes, which reduced basic and diluted earnings per share by $0.01 for the three months ended March 31, 2006. The effect of net income and earnings per share as if the company had applied the fair value recognition provisions of SFAS No. 123 to all outstanding and nonvested stock option awards is as follows for the three months ended March 31, 2005:

The fair value for these stock option awards was estimated at the date of grant using a Black-Scholes option-pricing method.

Note 2 — Stock-Based Compensation (continued)

Following are the related assumptions under the Black-Scholes method:

Historical information was the primary basis for the selection of the expected dividend yield, expected volatility and the expected lives of the options. The dividend yield was revised in 2006 from five years’ quarterly dividends to the last dividend prior to the grant compared to the trailing 12 months’ daily stock prices. The risk-free interest rate was based upon yields of U.S. zero coupon issues and U.S. Treasury issues, with a term equal to the expected life of the option being valued, for 2006 and 2005, respectively. Effective 2006, forfeitures were estimated at 2%.

A summary of stock option award activity for the three-month period ended March 31, 2006 is as follows:

The total intrinsic value of stock option awards exercised during the three months ended March 31, 2006 and 2005 was $3.1 million and $6.1 million, respectively. Net cash proceeds from the exercise of stock options were $4.6 million and $10.0 million for the three months ended March 31, 2006 and 2005, respectively. Income tax benefits of $1.1 million and $1.5 million were realized from stock option exercises during the three months ended March 31, 2006 and 2005, respectively.

A summary of nonvested shares as of March 31, 2006, and changes during the quarter, is as follows:

Nonvested shares consist primarily of restricted shares for key employees and directors, and also include deferred shares.

The company recognized compensation expense of $2.2 million and $1.3 million for the three months ended March 31, 2006 and 2005, respectively, related to nonvested shares.

As of March 31, 2006, the company had unrecognized compensation expense of $35.0 million, before taxes, related to stock option awards and nonvested shares. The unrecognized compensation expense is expected to be recognized over a total weighted average period of two years.

An actual valuation of the inventory under the LIFO method can be made only at the end of each year based on the inventory levels and costs at that time. Accordingly, interim LIFO calculations must necessarily be based on management’s estimates of expected year-end inventory levels and costs. Because these are subject to many forces beyond management’s control, interim results are subject to the final year-end LIFO inventory valuation.

Short-term debt:

In January 2006, the company repaid, in full, the $23,000 balance outstanding of the revenue bonds held by PEL Technologies LLC (PEL), an equity investment of the company. Refer to Note 10 — Equity Investments for additional discussion of PEL’s debt, which is included above.

Borrowings under the Accounts Receivable Securitization financing agreement (Asset Securitization), which provides for borrowings up to $200 million subject to certain borrowing base limitations, are secured by certain trade receivables. Under the terms of the Asset Securitization, the company sells, on an ongoing basis, certain domestic trade receivables to Timken Receivables Corporation, a wholly owned consolidated subsidiary, that in turn uses the trade receivables to secure the borrowings, which are funded through a vehicle that issues commercial paper in the short-term market. As of March 31, 2006, there were no outstanding borrowings under this facility. A balance outstanding related to the Asset Securitization would be reflected on the company’s Consolidated Condensed Balance Sheet in short-term debt. The yield on the commercial paper, which is the commercial paper rate plus program fees, is considered a financing cost and is included in interest expense on the Consolidated Statement of Income. As of March 31, 2006, there were letters of credit totaling $15.3 million, which reduced the availability under the Asset Securitization to $184.7 million.

The lines of credit of the company’s European subsidiaries provide for borrowings up to $159.8 million. At March 31, 2006, the company had borrowings outstanding of $92.6 million, which reduced the availability under these facilities to $67.2 million.

The company has a $500 million Amended and Restated Credit Agreement (Senior Credit Facility) that matures on June 30, 2010. At March 31, 2006, the company had no outstanding borrowings under the Senior Credit Facility, and letters of credit totaling $65.0 million, which reduced the availability under the Senior Credit Facility to $435.0 million. Under the Senior Credit Facility, the company has two financial covenants: a consolidated leverage ratio and a consolidated interest coverage ratio. At March 31, 2006, the company was in full compliance with the covenants under the Senior Credit Facility and its other debt agreements.

In December 2005, the company entered into a $49.8 million unsecured loan in Canada. The principal balance of the loan is payable in full in December 2010. The interest rate is variable based on the Canadian LIBOR rate and interest payments are due quarterly.

The company’s provision for income taxes in interim periods is computed by applying an estimated annual effective tax rate against income before income taxes for the period. In addition, non-recurring or discrete items are recorded during the period in which they occur.

The effective tax rate for the first quarter of 2006 was lower than the U.S. Federal statutory tax rate due to tax benefits on foreign income, including the extraterritorial income exclusion on U.S. exports, tax holidays in China and the Czech Republic and earnings of certain foreign subsidiaries being taxed at a rate less than 35%, as well as the net favorable impact of other U.S. tax items, including tax reserve adjustments. These benefits were offset partially by taxes incurred on foreign remittances, U.S. state and local income taxes, and the inability to record a tax benefit for losses at certain foreign subsidiaries.

The effective tax rate for the first quarter of 2005 was higher than the U.S. Federal statutory tax rate due primarily to taxes incurred on foreign remittances, U.S. state and local income taxes, and the inability to record a tax benefit for losses at certain foreign subsidiaries. These additional taxes were offset partially by tax benefits on foreign income, including earnings of certain foreign subsidiaries being taxed at a rate less than 35%, tax holidays in China and the Czech Republic and the extraterritorial income exclusion on U.S. exports, as well as the aggregate tax benefit of other U.S. tax items.

The effective rate for the first quarter of 2006 was lower than the effective rate for the first quarter of 2005 due primarily to lower taxes on foreign earnings and the net favorable impact of certain discrete tax items, including tax reserve adjustments, recorded during the first quarter of 2006.

Impairment and restructuring charges by segment are comprised of the following:

For the three months ended March 31, 2006:

Restructuring charges related primarily to severance and related benefit costs for associates and exit costs as a result of the company’s automotive and industrial restructuring. There were no restructuring charges recorded for the three months ended March 31, 2005.

The rollforward of restructuring accruals is as follows:

In February 2006, the Company announced plans to rationalize production capacity at its Vierzon, France manufacturing facility in response to changes in customer demand for its products. Future service is required to receive severance and other benefits; therefore, those amounts will be accrued over the service period. No accrual has been recorded as of March 31, 2006 related to this program, which is expected to be completed in December 2006.

In 2005, the company recorded approximately $20,319 of severance and related benefit costs and $2,800 of exit costs related to the closure of manufacturing facilities in Clinton, South Carolina and administrative facilities in Torrington, Connecticut and Norcross, Georgia. These closures are part of the restructuring plans for the Automotive Group announced in July 2005. These restructuring efforts, along with other future actions, are targeted to deliver annual pretax savings of approximately $40,000 by the end of 2007, with expected net workforce reductions of approximately 400 to 500 positions and pretax costs of approximately $80,000 to $90,000 by the end of 2007. An additional $985 was recorded in the first quarter of 2006 primarily related to additional severance-related costs.

In addition, $770 of asset impairment and $2,239 of environmental exit costs were recorded in 2005 as a result of asset impairments related to the rationalization of the company’s three bearing plants in Canton, Ohio within the Industrial Group. On September 15, 2005, the company reached a new four-year agreement with the United Steelworkers of America, which went into effect on September 26, 2005, when the prior contract expired. This initiative is expected to deliver annual pretax savings of approximately $25,000 through streamlining operations and workforce reductions, with costs of approximately $35,000 to $40,000 over the next four years.

The primary measurement used by management to measure the financial performance of each Group is adjusted EBIT (earnings before interest and taxes, excluding the effect of amounts related to certain items that management considers not representative of ongoing operations such as impairment and restructuring, manufacturing rationalization expenses, allocated receipts received under the U.S. Continued Dumping and Subsidy Offset Act (CDSOA) and gain (loss) on the sale of non-strategic assets).

The changes in the carrying amount of goodwill for the three months ended March 31, 2006 are as follows:

The following table displays intangible assets as of March 31, 2006 and December 31, 2005:

Amortization expense for intangible assets was approximately $2,500 for the three months ended March 31, 2006 and is estimated to be approximately $8,400 annually for the next five years. The intangible assets subject to amortization acquired in the Torrington acquisition have useful lives ranging from two to 20 years with a weighted-average useful life of 12 years.

The balances related to investments accounted for under the equity method are reported in other non-current assets on the Condensed Consolidated Balance Sheet, which were approximately $20,100 and $19,900 at March 31, 2006 and December 31, 2005, respectively.

Equity investments are reviewed for impairment when circumstances (such as lower-than-expected financial performance or change in strategic direction) indicate that the carrying value of the investment may not be recoverable. If impairment does exist, the equity investment is written down to its fair value with a corresponding charge to the Consolidated Statement of Income. No impairments were recorded during the first quarter of 2006 relating to the company’s equity investments. In March 2006, the company sold a portion of CoLinx, LLC due to the addition of another company to the joint venture. CoLinx, a joint venture founded by Timken, SKF, INA and Rockwell Automation, provides shared e-commerce and logistics services.

During 2000, the company’s Steel Group invested in a joint venture, PEL, to commercialize a proprietary technology that converts iron units into engineered iron oxides for use in pigments, coatings and abrasives. In the fourth quarter of 2003, the company concluded its investment in PEL was impaired due to the following indicators of impairment: history of negative cash flow and losses; 2004 operating plan with continued losses and negative cash flow; and the continued required support from the company or another party.

In the fourth quarter of 2003, the company recorded a non-cash impairment loss of $45,700, which is reported in other expense — net on the Consolidated Statement of Income.

The company concluded that PEL was a variable interest entity and that the company is the primary beneficiary. In accordance with FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51,” the company consolidated PEL effective March 31, 2004. The adoption of FIN 46 resulted in a charge, representing the cumulative effect of change in accounting principle, of $948, which is reported in other expense — net on the Consolidated Statement of Income. Also, the adoption of FIN 46 increased the Condensed Consolidated Balance Sheet as follows: current assets by $1,659; property, plant and equipment by $11,333; short-term debt by $11,561; accounts payable and other liabilities by $659; and other non-current liabilities by $1,720. All of PEL’s assets are collateral for its obligations. Except for PEL’s indebtedness for which the company is a guarantor, PEL’s creditors have no recourse to the general credit of the company. In the first quarter of 2006, plans were finalized to liquidate the assets of PEL, and the company recorded a related gain of approximately $3,550. Fixed assets were sold to third parties through negotiated sales or through auction resulting in a gain on the sale of assets of approximately $1,950. Proceeds from the sales of those assets were used to pay down certain debt facilities with the remaining unpaid balances discharged by the creditors resulting in a gain on the forgiveness of debt of approximately $1,600. In January 2006, the company repaid, in full, the $23,000 balance outstanding of the revenue bonds held by PEL. The remaining assets, approximately $9,500 of land and buildings, will be exchanged in satisfaction of the mortgage of the assets in the third quarter of 2006.

The following table sets forth the net periodic benefit cost for the company’s retirement and postretirement benefit plans. The amounts for the three months ended March 31, 2006 are based on actuarial calculations prepared during 2005. Consistent with prior years, these calculations will be updated later in the year. These updated calculations may result in different net periodic benefit cost for 2006. The net periodic benefit cost recorded for the three months ended March 31, 2006 is the company’s best estimate of each period’s proportionate share of the amounts to be recorded for the year ended December 31, 2006.

Overview

The Timken Company is a leading global manufacturer of highly engineered anti-friction bearings and alloy steels and a provider of related products and services. Timken operates under three segments: Industrial Group, Automotive Group and Steel Group.

The Industrial and Automotive Groups design, manufacture and distribute a range of bearings and related products and services. Industrial Group customers include both original equipment manufacturers and distributors for agriculture, construction, mining, energy, mill, machine tooling, aerospace and rail applications. Automotive Group customers include original equipment manufacturers and suppliers for passenger cars, light trucks, and medium- to heavy-duty trucks. Steel Group products include steels of low and intermediate alloy, vacuum-processed alloys, tool steel and some carbon grades, in both solid and tubular sections, as well as custom-made steel products for both industrial and automotive applications, including bearings.

Net sales for the first quarter of 2006 were $1.347 billion, compared to $1.305 billion in the first quarter of 2005, an increase of 3.3%. For the first quarter of 2006, earnings per diluted share were $0.70 compared to $0.63 per diluted share for the first quarter of 2005.

The company’s first quarter results reflect the ongoing strength of industrial markets and the performance of the Steel Group. The company continued its focus to increase production capacity in targeted areas, including major capacity expansions for industrial products at several manufacturing locations around the world.

The company expects that the continued strength in industrial markets throughout 2006 should drive year-over-year volume and margin improvement. While global industrial markets are expected to remain strong, the improvements in the company’s operating performance will be partially constrained by investments in Project ONE and Asia growth initiatives.

In the first quarter of 2006, the Industrial Group’s net sales, excluding intersegment sales, increased 7.5% from the first quarter of 2005 to $503.4 million. The increase reflected higher volume, and the benefit of increased manufacturing capacity. All industrial end markets showed continued strength, with the highest growth in aerospace, distribution and heavy industry. The Industrial Group’s profitability in the first quarter of 2006 was negatively affected by higher manufacturing costs as a result of ramping up capacity, higher raw material and energy costs and planned investments in the Asia growth initiatives.

The Automotive Group’s net sales in the first quarter of 2006 of $421.0 million were flat compared to sales in the same period a year ago. Improved pricing was offset by volume declines relating to the North American light truck business. The Automotive Group had a loss in the first quarter of 2006. The positive impact of improved pricing and manufacturing performance were more than offset by higher raw material costs and an increase in the accounts receivable reserve related to automotive industry credit exposure.

In the first quarter of 2006, the Steel Group’s net sales, excluding intersegment sales, were $422.7 million, compared to

$415.8 million in the same period a year ago. The sales were driven by increased pricing and higher demand by customers in the aerospace, service center and energy sectors, which more than offset lower automotive sales. The Steel Group’s profitability for the first quarter of 2006 increased from the first quarter of 2005 as a result of price increases and favorable sales mix as well as continued strong plant utilization and manufacturing productivity.

The Statement of Income

The Industrial Group’s net sales in the first quarter of 2006 increased from the first quarter of 2005 as a result of higher volume, and the benefit of increased manufacturing capacity. All industrial end markets showed continued strength, with the highest growth in aerospace, distribution and heavy industry. The Automotive Group’s net sales in the first quarter of 2006 were flat compared to sales in the first quarter of 2005. Improved pricing was offset by volume declines relating to the North American light truck business. The Steel Group’s net sales in the first quarter of 2006 increased from the same period a year ago due to increased pricing and higher demand in the aerospace, service center and energy sectors, which more than offset lower automotive sales.

Gross profit benefited from favorable sales volume, price increases, and increased productivity, which offset higher manufacturing and energy costs. In the first quarter of 2006, manufacturing rationalization charges related to the rationalization of the company’s Canton, Ohio Industrial Group bearing facilities and rationalization of certain Automotive Group domestic manufacturing facilities. In the first quarter of 2005, manufacturing rationalization charges related primarily to the rationalization of the company’s Canton, Ohio bearing facilities.

The increase in selling, administrative and general expenses in the first quarter of 2006, compared to the first quarter of 2005, was due primarily to higher costs associated with investments in Project ONE and Asia growth initiatives as well as an increase in the accounts receivable reserve to reflect current automotive industry credit exposure.

In the first quarter of 2006, the manufacturing rationalization charges primarily related to the rationalization of certain Automotive Group domestic manufacturing facilities. In the first quarter of 2005, the manufacturing rationalization charges related to the rationalization of the Canton, Ohio Industrial Group bearing facilities.

Restructuring costs of $0.99 million recorded in the first quarter of 2006 related to severance ($0.97 million) and exit costs ($0.02 million) associated with the closure of Automotive Group manufacturing facilities in Clinton, South Carolina, and administrative facilities in Torrington, Connecticut and Norcross, Georgia. In addition, in the first quarter of 2006 the company announced a workforce reduction at its manufacturing facility in Vierzon, France. No restructuring costs were recorded in the first quarter of 2006 for this workforce reduction in France. These restructuring efforts, along with other future actions, are targeted to deliver annual pretax savings of approximately $40 million by the end of 2007, with expected net workforce reductions of approximately 400 to 500 positions and pretax costs of approximately $80 to $90 million.

Exit costs of $0.05 million were recorded in the first quarter of 2006 due to the rationalization of the company’s three Industrial Group bearing plants in Canton, Ohio. This initiative is expected to deliver annual pretax savings of approximately $25 million through streamlining operations and workforce reductions, with pretax restructuring costs of approximately $35 to $40 million over the next four years.

The restructuring accrual for the first quarter of 2006 and 2005 is included in accounts payable and other liabilities in the Condensed Consolidated Balance Sheet.

Interest expense for the first quarter of 2006 increased slightly, compared to the same period a year ago due to higher effective interest rates. Interest income increased due to higher cash balances and interest rates.

In the first quarter of 2006, $3.5 million of the gain on divestitures of non-strategic assets related to the sale of assets of PEL. In 2000, the company’s Steel Group invested in PEL, a joint venture to commercialize a proprietary technology that converts iron units into engineered iron oxide for use in pigments, coatings and abrasives. The company consolidated PEL effective March 31, 2004 in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 46. In 2006, the company will wind down the joint venture. Refer to Note 10 — Equity Investments for additional discussion.

In 2004, the company began the process of liquidating one of its inactive subsidiaries, British Timken Ltd., located in Duston, England. The company recorded additional non-cash charges on dissolution of $4.3 million in the first quarter of 2006.

For the first quarter of 2006 and 2005, respectively, other expense included donations, losses on disposal of assets, losses from equity investments, minority interests and foreign currency exchange losses.

The effective tax rate for the first quarter of 2006 was lower than the U.S. Federal statutory tax rate due to tax benefits on foreign income, including the extraterritorial income exclusion on U.S. exports, tax holidays in China and the Czech Republic and earnings of certain foreign subsidiaries being taxed at a rate less than 35%, as well as the net favorable impact of other U.S. tax items, including tax reserve adjustments. These benefits were offset partially by taxes incurred on foreign remittances, U.S. state and local income taxes, and the inability to record a tax benefit for losses at certain foreign subsidiaries.

The effective tax rate for the first quarter of 2005 was higher than the U.S. Federal statutory tax rate due primarily to taxes incurred on foreign remittances, U.S. state and local income taxes, and the inability to record a tax benefit for losses at certain foreign subsidiaries. These additional taxes were offset partially by tax benefits on foreign income, including earnings of certain foreign subsidiaries being taxed at a rate less than 35%, tax holidays in China and the Czech Republic and the extraterritorial income exclusion on U.S. exports, as well as the aggregate tax benefit of other U.S. tax items.

The effective rate for the first quarter of 2006 was lower than the effective rate for the first quarter of 2005 due primarily to lower taxes on foreign earnings and the net favorable impact of certain discrete tax items, including tax reserve adjustments, recorded during the first quarter of 2006.

The primary measurement used by management to measure the financial performance of each segment is adjusted EBIT (earnings before interest and taxes, excluding the effect of amounts related to certain items that management considers not representative of ongoing operations such as impairment and restructuring, manufacturing rationalization/reorganization costs, allocated receipts received or payments made under the U.S. Continued Dumping and Subsidy Offset Act (CDSOA) and gain (loss) on the sale of non-strategic assets. Refer to Note 8 — Segment Information for the reconciliation of adjusted EBIT by Group to consolidated income before income taxes.

Sales by the Industrial Group include global sales of bearings and other products and services (other than steel) to a diverse customer base, including: industrial equipment, construction and agriculture, rail, and aerospace and defense customers. The Industrial Group also includes aftermarket distribution operations, including automotive applications, for products other than steel.

The Industrial Group’s net sales for the first quarter of 2006 increased 7.5% from a year ago, reflecting increases in volume, and the benefit of increased manufacturing capacity. All industrial end markets showed continued strength, with the highest growth in aerospace, distribution and heavy industry. While net sales increased in the first quarter of 2006, adjusted EBIT margin was lower than the first quarter of 2005, as profitability was negatively impacted by higher manufacturing costs resulting from ramping up of capacity to meet customer demand and higher energy costs. The Industrial Group continues to focus on improving capacity utilization, product availability and customer service in response to strong industrial demand. During the first quarter of 2006, the Industrial Group continued its major capacity expansions at two large-bore bearings operations located in Ploiesti, Romania, and Randleman (Asheboro), North Carolina as well as the expansion of operations in Wuxi, China. The company expects the Industrial Group to benefit in 2006 from continued strength in global industrial markets and full-year margins to improve over 2005 levels as a result of volume, manufacturing performance and pricing actions.

The Automotive Group includes sales of bearings and other products and services (other than steel) to automotive original equipment manufacturers and suppliers. The Automotive Group’s net sales in the first quarter of 2006 were comparable to sales in the same period a year ago. Improved pricing was offset by volume declines relating to the North American light truck business. While the Automotive Group improved its control of manufacturing costs, profitability in the first quarter of 2006 was negatively impacted by the increase in reserves for automotive industry credit exposure of $3.5 million. The company expects the Automotive Group to improve performance throughout the rest of 2006 and anticipates that the Group will be profitable for the entire 2006 year.

During 2005, the company announced a restructuring plan as part of its effort to improve Automotive Group performance and address challenges in automotive markets. For the first quarter of 2006, the company recorded approximately $1.0 million of restructuring costs related to the closure of manufacturing facilities in Clinton, South Carolina and administrative facilities in Torrington, Connecticut and Norcross, Georgia. In addition, the company announced a workforce reduction at its manufacturing facility in Vierzon, France, in response to changes in customer demand for its product. The Automotive Group’s adjusted EBIT (loss) excludes these restructuring costs, as they are not representative of ongoing operations.

The Steel Group sells steels of low and intermediate alloy, vacuum-processed alloys, tool steel and some carbon grades in both solid and tubular sections, as well as custom-made steel products for both automotive and industrial applications, including bearings. In the first quarter of 2006, the Steel Group’s net sales were slightly higher compared to the first quarter of 2005. Net sales were driven by increased pricing and higher demand by customers in the aerospace, service center and energy sectors, which more than offset lower automotive sales. Although the Steel Group invoiced lower surcharges in 2006, compared to the first quarter of 2005 due to lower raw material costs, the Steel Group’s profitability for the first quarter of 2006 increased from the first quarter of 2005 as a result of price increases, favorable sales mix and continued strong plant utilization and manufacturing productivity. The company expects the rest of 2006 to show continued strength in industrial markets, especially in aerospace and energy. While scrap costs are expected to continue to decline, alloy and energy costs are expected to remain at historically high levels, which will continue to be offset with surcharges and price increases. Other costs, including labor and benefits, will be higher in 2006, and only partially offset by higher manufacturing productivity.

The Balance Sheet

Total assets as shown on the Condensed Consolidated Balance Sheet at March 31, 2006 increased by $90.1 million from December 31, 2005. This increase was due primarily to increased working capital required to support higher sales and foreign currency impact offset by lower property, plant and equipment — net.

Refer to the Consolidated Statement of Cash Flows for a discussion of the decrease in cash and cash equivalents. Net accounts receivable increased as a result of the higher sales in the first quarter of 2006 as compared to fourth quarter of 2005 and the impact of foreign currency translation, partially offset by the higher allowance for doubtful accounts. The increase in inventories was due primarily to higher volume, increased raw material costs and the impact of foreign currency translation. The increase in other current assets was driven by reclassification of PEL assets as “held for sale.” The increase in deferred income taxes was the result of reclassification of certain loss carryforwards from non-current deferred income tax asset.

The decrease in property, plant and equipment — net in the first quarter of 2006 was due primarily to depreciation more than offsetting the impact of capital spending and foreign currency translation.

The decrease in other intangible assets was due to the amortization expense recognized in the first quarter of 2006. The decrease in deferred income taxes was the result of reclassification of certain loss carryforwards to current deferred income tax asset. The majority of the increase in other non-current assets was due to an increase in long-term cash investments.

The increase in short-term debt was due to higher seasonal working capital requirements and increased sales volume. The increase in accounts payable and other liabilities was due primarily to the increase in purchasing volume to meet the higher production demand and the timing of payments to suppliers. The decrease in accrued expenses was the result of the payout of 2005 performance-based compensation in the first quarter of 2006 and the decrease in the current portion of accrued pension cost, based on the company’s estimate of contributions to pension plans in the next twelve months. The increase in income taxes is due primarily to the domestic income tax accrual and no payments being made in the first quarter of 2006.

The decrease in accrued pension cost in the first quarter of 2006 was due primarily to U.S.-based pension plan contributions partially offset by current year accruals for pension expense. The increase in accrued postretirement benefits cost was due primarily to higher expense accrued versus disbursements made in the first quarter of 2006.

The increase in common stock related to stock option exercises by employees and the related income tax benefits. Earnings invested in the business were increased in the first quarter of 2006 by net income of $65.9 million, partially reduced by dividends declared of $14.0 million. The decrease in accumulated other comprehensive loss was due primarily to the positive impact of the foreign currency translation. The increase in the foreign currency translation adjustment of $15.7 million was due to weakening of the U.S. dollar relative to other currencies, such as the Romanian lei, the Brazilian real and the Euro. See “Foreign Currency” for further discussion regarding the impact of foreign currency translation

Cash Flows

The net cash used by operating activities of $36.6 million increased from first quarter 2005 primarily as a result of a higher use of cash for accounts payable and accrued expenses. This use of cash in the first quarter of 2006 was due primarily to the payout of 2005 performance-based compensation in the first quarter and the contributions to the company’s U.S.-based pension plans, which more than offset the increase in payables to meet higher production volume. Excluding cash contributions to the company’s U.S.-based pension plans, accounts payable and accrued expenses were a source of cash of $15.7 million in the first quarter of 2006, compared to a source of cash of $71.5 million in the first quarter of 2005. The company made cash contributions to its U.S.-based pension plans in the first quarter of 2006 of $59.6 million, compared to $36.6 million in the first quarter of 2005. Accounts receivable was a use of cash of $70.3 million in the first quarter of 2006, compared to a use of cash of $82.2 million in the first quarter of 2005. Inventory was a use of cash of $37.9 million in the first quarter of 2006, compared to a use of cash of $75.8 million in the first quarter of 2005. Accounts receivable and inventory increased in the first quarter of 2006 due to higher sales volume.

The increase in net cash used by investing activities was due to higher capital expenditures in the first quarter of 2006.

Net cash provided by financing activities of $41.3 million related primarily to net borrowings on the company’s credit facilities offset by dividends paid in the first quarter of 2006. While the dividends paid in the first quarter of 2006 and 2005 were comparable, the proceeds from the exercise of stock options and the net borrowings on credit facilities were lower in the first quarter of 2006, compared to the first quarter of 2005.

Liquidity and Capital Resources

Total debt was $768.5 million at March 31, 2006, compared to $720.9 million at December 31, 2005. Net debt was $737.2 million at March 31, 2006, compared to $655.5 million at December 31, 2005. The net debt to capital ratio was 31.9% at March 31, 2006, compared to 30.5% at December 31, 2005.

Reconciliation of total debt to net debt and the ratio of net debt to capital:

The company presents net debt because it believes net debt is more representative of the company’s indicative financial position.

At March 31, 2006, the company had no outstanding borrowings under its $500 million Amended and Restated Credit Agreement (Senior Credit Facility), and letters of credit totaling $65.0 million, which reduced the availability under the Senior Credit Facility to $435.0 million. The Senior Credit Facility matures on June 30, 2010. Under the Senior Credit Facility, the company has two financial covenants: a consolidated leverage ratio and a consolidated interest coverage ratio. At March 31, 2006, the company was in full compliance with the covenants under the Senior Credit Facility and its other debt agreements. Refer to Note 4 — Financing Arrangements for further discussion.

There were no outstanding borrowings as of March 31, 2006 under the company’s Asset Securitization, which provides for borrowings up to $200 million, limited to certain borrowing base calculations, and is secured by certain domestic trade receivables of the company. There were letters of credit totaling $15.3 million, which reduced the availability under the Asset Securitization to $184.7 million.

The company expects that any cash requirements in excess of cash generated from operating activities will be met by the availability under its Asset Securitization and Senior Credit Facility. The company believes it has sufficient liquidity to meet its obligations through 2006.

Financing Obligations and Other Commitments

The company’s contractual debt obligations and contractual commitments outstanding as of March 31, 2006 are as follows:

The interest payments are related primarily to medium-term notes that mature over the next 28 years.

The company expects to make cash contributions of $160.2 million to its global defined benefit pension plans in 2006. In connection with the sale of the company’s Ashland, Ohio tooling plant in 2002, the company entered into a $25.9 million four-year supply agreement that expires on June 30, 2006, pursuant to which the company is obliged to purchase tooling.

During the first quarter of 2006, the company did not purchase any shares of its common stock as authorized under the company’s 2000 common stock purchase plan. This plan authorizes the company to buy in the open market or in privately negotiated transactions up to four million shares of common stock, which are to be held as treasury shares and used for specified purposes. This plan authorizes purchases up to an aggregate of $180 million. The company may exercise this authorization until December 31, 2006. The company does not expect to be active in repurchasing its shares under the plan in the near-term.

The company does not have any off-balance sheet arrangements with unconsolidated entities or other persons.

In November 2004, the FASB issued Statement of Financial Accounting Standard No. 151 (SFAS No. 151), “Inventory Costs, an amendment of ARB 43, Chapter 4.” SFAS No. 151 requires certain inventory costs to be recognized as current period expenses. SFAS No. 151 also provides guidance for the allocation of fixed production costs. This standard is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Accordingly, the company adopted this standard in 2006. The adoption of this standard did not have a material impact on the financial statements of the company.

In December 2004, FASB issued SFAS No. 123 (revised 2004), (SFAS No. 123(R)), “Share-Based Payment,” which requires the measurement and recognition of compensation expense based on estimated fair value for all share-based payment awards including grants of employee stock options. SFAS No. 123(R) supersedes the company’s previous accounting under Accounting Principles Board Opinion No. 25, (APB 25), “Accounting for Stock Issued to Employees”.

The company adopted the provisions of SFAS No. 123(R) using the modified prospective transition method beginning January 1, 2006. In accordance with that transition method, the company did not restate prior periods for the effect of compensation expense calculated under SFAS No. 123(R). The company selected the Black-Scholes option-pricing model as the most appropriate method for determining the estimated fair value of all of its awards. The adoption of SFAS No. 123(R) reduced income before income taxes for the first quarter of 2006 by $1.6 million. The adoption of SFAS No. 123(R) had no material effect on the Statement of Cash Flows for the three months ended March 31, 2006. See Note 2 — Stock-Based Compensation for more information on the impact of this new standard.

In November 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3 (FSP 123(R)), Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards. FSP 123(R)-3 provides an elective alternative transition

method for calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123(R). Companies may take up to one year from the effective date of FSP 123(R)-3 to evaluate the available transition alternatives and make a one-time election as to which method to adopt. The company is currently in the process of evaluating the alternative methods.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” which changes the accounting for and reporting of a change in accounting principle. This statement also carries forward the guidance from APB No. 20 regarding the correction of an error and changes in accounting estimates. This statement requires retrospective application to prior period financial statements of changes in accounting principle, unless it is impractical to determine either the period-specific or cumulative effects of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The adoption of this standard did not have a material impact on the financial statements of the company.

The company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The company reviews its critical accounting policies throughout the year. The company has concluded that there have been no changes to its critical accounting policies or estimates, as described in its Annual Report on Form 10-K for the year ended December 31, 2005, during the three months ended March 31, 2006.

Foreign Currency:

Assets and liabilities of subsidiaries are translated at the rate of exchange in effect on the balance sheet date; income and expenses are translated at the average rates of exchange prevailing during the quarter. Related translation adjustments are reflected as a separate component of accumulated other comprehensive loss. Foreign currency gains and losses resulting from transactions are included in the consolidated statement of income.

Foreign currency exchange losses included in the company’s operating results for the three months ended March 31, 2006 totaled $0.3 million, compared to a gain of $1.0 million during the three months ended March 31, 2005. For the three months ended March 31, 2006, the company recorded a positive non-cash foreign currency translation adjustment of $15.7 million that increased shareholders’ equity, compared to a negative non-cash foreign currency translation adjustment of $21.6 million that decreased shareholders’ equity in the three months ended March 31, 2005. The foreign currency translation adjustment for the three months ended March 31, 2006 were positively impacted by the weakening of the U.S. dollar relative to other currencies, such as the Romanian lei, the Brazilian real and the Euro.

On April 18, 2006, the company’s Board of Directors declared a quarterly cash dividend of $0.15 per share. The dividend will be paid on June 2, 2006 to shareholders of record as of May 19, 2006. This was the 336th consecutive dividend paid on the common stock of the company.

Forward Looking Statements

Certain statements set forth in this document (including the company’s forecasts, beliefs and expectations) that are not historical in nature are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995. In particular, the Management’s Discussion and Analysis contain numerous forward-looking statements. The company cautions readers that actual results may differ materially from those expressed or implied in forward-looking statements made by or on behalf of the company due to a variety of important factors, such as:

Additional risks relating to the company’s business, the industries in which the company operates or the company’s common stock may be described from time to time in the company’s filings with the SEC. All of these risk factors are difficult to predict, are subject to material uncertainties that may affect actual results and may be beyond the company’s control.

Except as required by the federal securities laws, the company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

Refer to information appearing under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-Q. Furthermore, a discussion of market risk exposures is included in Part II, Item 7A.— Quantitative and Qualitative Disclosure about Market Risk, of the company’s Annual Report on Form 10-K for the year ended December 31, 2005. There have been no material changes in reported market risk since the inclusion of this discussion in the Company’s Annual Report on Form 10-K referenced above.

As of the end of the period covered by this report, the company carried out an evaluation, under the supervision and with the participation of the company’s management, including the company’s principal executive officer and principal financial officer, of the effectiveness of the design and operation of the company’s disclosure controls and procedures (as defined by in Exchange Act Rule 13a-15(e)). Based upon that evaluation, the principal executive officer and principal financial officer concluded that the company’s disclosure controls and procedures were effective as of the end of the period covered by this report. During the company’s most recent fiscal quarter there have been no changes in the company’s internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the company’s internal control over financial reporting.

Item 1. Legal Proceedings

The company is normally involved in various claims and legal actions arising in the ordinary course of its business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the company’s consolidated financial position or results of operations.

The company is currently in discussions with the State of Ohio concerning a violation of Ohio air pollution control laws which was discovered by the company and voluntarily disclosed to the State of Ohio approximately eight years ago. Although no final settlement has been reached, the company believes that the final settlement will not be material to the company or have a material adverse effect on the company’s consolidated financial position or results of operations.

There have been no material changes to the risk factors included in the company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

Issuer of Purchases of Common Stock

The following table provides information about purchases by the company during the quarter ended March 31, 2006 of its common stock.