Pentair - 10-Q quarterly report FY

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filerþ     Accelerated filero     Non-accelerated filer o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

On October 27, 2006, 99,768,471 shares of the Registrant’s common stock were outstanding.

We prepared the unaudited condensed consolidated financial statements following the requirements of the Securities and Exchange Commission (“SEC”) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by accounting principles generally accepted in the United States can be condensed or omitted.

We are responsible for the unaudited financial statements included in this document. The financial statements include all normal recurring adjustments that are considered necessary for the fair presentation of our financial position and operating results. As these are condensed financial statements, one should also read our consolidated financial statements and notes thereto, which are included in our 2005 Annual Report on Form 10-K for the year ended December 31, 2005.

Revenues, expenses, cash flows, assets and liabilities can and do vary during each quarter of the year. Therefore, the results and trends in these interim financial statements may not be indicative of those for a full year.

Our fiscal year ends on December 31. We report our interim quarterly periods on a 13-week basis ending on a Saturday.

Certain reclassifications have been made to prior years’ condensed consolidated financial statements to conform to the current year’s presentation.

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 153, Exchanges of Nonmonetary Assets—An Amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions(“SFAS 153”). SFAS 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, Accounting for Nonmonetary Transactions, and replaces it with an exception for exchanges that do not have commercial substance. SFAS 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for the fiscal periods beginning after June 15, 2005 and we adopted it on January 1, 2006. The adoption of SFAS 153 did not have a material impact on our consolidated results of operations, financial condition, or cash flow.

In November 2004, the FASB issued SFAS No. 151, Inventory Costs—An Amendment of ARB No. 43, Chapter 4 (“SFAS 151”). SFAS 151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Among other provisions, the new rule requires that items such as idle facility expense, excessive spoilage, double freight, and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal” as stated in ARB No. 43. Additionally, SFAS 151 requires that the allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for fiscal years beginning after June 15, 2005 and we adopted it on January 1, 2006. The adoption of SFAS 151 did not have a material impact on our consolidated results of operations or financial condition.

In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“EITF 03-1”). EITF 03-1 provides guidance on other-than-temporary impairment models for marketable debt and equity securities accounted for under SFAS 115 and non-marketable equity securities accounted for under the cost method. The EITF developed a basic three-step model to evaluate whether an investment is other-than-temporarily impaired. In November 2005, the FASB approved the issuance of FASB Staff Position FAS No. 115-1 and FAS No. 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The FASB Staff Position (“FSP”) addresses when an investment is considered impaired, whether the impairment is other-than-temporary and the measurement of an impairment loss. The FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary. The FSP is effective for reporting periods beginning after December 15, 2005 and we adopted it on January 1, 2006. The adoption of EITF 03-1 did not have a material impact on our consolidated results of operations or financial condition.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (“SFAS 154”) which replaces Accounting Principles Board Opinion No. 20, Accounting Changes and SFAS No. 3,Reporting Accounting Changes in Interim Financial Statements—An Amendment of APB Opinion No. 28. SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 on January 1, 2006 did not have a material impact on our consolidated results of operations or financial condition.

In June 2005, the EITF reached a consensus on Issue No. 05-5, Accounting for Early Retirement or Postemployment Programs with Specific Features (such as Terms Specified in Altersteilzeit Early Retirement Arrangements) (“EITF 05-5”). EITF 05-5 addresses the accounting for the bonus feature in the German Altersteilzeit (“ATZ”) early retirement programs and requires recognition of the program expenses at the time the

ATZ contracts are signed. The EITF offers two transition alternatives, either cumulative effect or retrospective application. EITF 05-5 is effective for fiscal years beginning after December 15, 2005 and we adopted it on January 1, 2006. The adoption of EITF 05-5 did not have a material impact on our consolidated results of operations or financial condition.

In July 2006, the FASB issued FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes– an interpretation of FASB Statement 109 (“FIN 48”). FIN 48 prescribes a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements tax positions taken or expected to be taken on a tax return, including a decision whether to file or not to file a tax return in a particular jurisdiction. FIN 48 is effective for fiscal years beginning after December 15, 2006. If there are changes in net assets as a result of the application of FIN 48, these will be accounted for as an adjustment to retained earnings. We are currently assessing the impact of FIN 48 on our consolidated results of operations and financial condition.

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108,Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 addresses diversity in practice in quantifying financial statement misstatements. SAB 108 requires that a company quantify misstatements based on their impact on each of its financial statements and related disclosures. SAB 108 is effective for fiscal years ending after November 15, 2006, allowing a one-time transitional cumulative effect adjustment to retained earnings as of January 1, 2006 for errors that were not previously deemed material, but are material under the guidance in SAB 108. We are currently assessing the impact of adopting SAB 108 on our consolidated results of operations and financial condition.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of adopting SFAS 157 on our consolidated results of operations and financial condition.

In September 2006, the FASB issued SFAS No. 158, Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R) (“SFAS 158”). SFAS 158 requires that we recognize the overfunded or underfunded status of our defined benefit and retiree medical plans as an asset or liability in our 2006 year-end balance sheet, with changes in the funded status recognized through comprehensive income in the year in which they occur. We are currently evaluating the impact of adopting SFAS 158 on our consolidated results of operations and financial condition.

In the fourth quarter 2005, we adopted SFAS No. 123 (Revised 2004), Share-Based Payment (“SFAS 123R”), using the modified retrospective transition method as permitted by SFAS 123R. Under this transition method, we restated our 2005 interim financial statements. Total stock-based compensation expense was $5.6 million and $5.9 million for the three months ended September 30, 2006 and October 1, 2005, respectively, and $18.1 million and $19.2 million for the nine months ended September 30, 2006 and October 1, 2005, respectively.

Non-vested shares of our common stock were granted during the first nine months of 2006 to eligible employees with a vesting period of two to five years after issuance. The non-vested shares were granted at the market price on the date of grant and are expensed over the vesting period. Total compensation expense for non-vested share awards was $2.4 million and $2.0 million for the three months ended September 30, 2006 and October 1, 2005, respectively, and $7.2 million and $6.0 million for the nine months ended September 30, 2006 and October 1, 2005, respectively.

During the first nine months of 2006, option awards were granted under the Omnibus Stock Incentive Plan and the Outside Directors Nonqualified Stock Option Plan with an exercise price equal to the market price of our common stock on the date of grant. Option awards granted in the first nine months of 2006 under the Omnibus Stock Incentive Plan did not have a reload feature attached to the option. The options vest one-third each year over a three-year period and have a ten-year contractual term. Compensation expense equal to the grant date fair value is recognized for these awards over the vesting period. Certain option grants were reloaded during the first nine months of 2006 for individuals retiring shares to pay the exercise price of options granted prior to 2006. Reload options are vested and expensed immediately. Total compensation expense for stock option awards was $3.2 million and $3.9 million for the three months ended September 30, 2006 and October 1, 2005, respectively, and $10.9 million and $13.2 million for the nine months ended September 30, 2006 and October 1, 2005, respectively.

We estimated the fair value of each stock option award during the third quarter of 2006 and 2005 on the date of grant using a Black-Scholes option pricing model, modified for dividends and using the following assumptions:

The weighted-average fair value of options granted during the first nine months of 2006 and 2005 was $10.91 and $11.45 per share, respectively.

These estimates require us to make assumptions based on historical results, observance of trends in our stock price, changes in option exercise behavior, future expectations, and other relevant factors. If other assumptions had been used, stock-based compensation expense, as calculated and recorded under SFAS No. 123R, could have been affected.

We based the expected life assumption on historical experience as well as the terms and vesting periods of the options granted. The increase in the expected life in 2006 compared to 2005 was the result of a decrease in exercise activity and the stock price in the preceding year. For purposes of determining expected volatility, we considered a rolling-average of historical volatility measured over a period approximately equal to the expected option term. The risk-free rate for periods that coincide with the expected life of the options is based on the U.S. Treasury Department yield curve in effect at the time of grant.

Basic and diluted earnings per share were calculated using the following:

On August 31, 2006, we acquired as part of our Water Group the assets of Acu-Trol, Inc. (“Acu-Trol”) for $3.1 million in cash. Acu-Trol expands the integrated aquatic control systems offering of our pool business. Goodwill recorded as part of the initial purchase price allocation was $1.8 million, all of which is tax deductible. We continue to evaluate the purchase price allocation for the Acu-Trol acquisition and expect to revise the purchase price allocation as better information becomes available.

On June 23, 2006, we acquired as part of our Water Group the assets of Cozad & O’Hara of Cathedral City, Inc. (“Cozad & O’Hara”) for $0.5 million in cash plus a note payable and debt assumed of $0.6 million. Cozad & O’Hara expands the distribution channel of our pool tile

Intangible assets, other than goodwill, were comprised of:

Intangible asset amortization expense was $3.4 million and $2.9 million for the three months ended September 30, 2006 and October 1, 2005, respectively, and $10.0 million and $8.6 million for the nine months ended September 30, 2006 and October 1, 2005, respectively. The estimated future amortization expense for identifiable intangible assets during the remainder of 2006 and the next five years is as follows:

Debt and the average interest rate on debt outstanding is summarized as follows:

We have a multi-currency revolving Credit Facility (the “Credit Facility”) of $800 million expiring on March 4, 2010. The interest rate on the loans under the Credit Facility is LIBOR plus 0.625%. Interest rates and fees on the Credit Facility vary based on our credit ratings.

We are authorized to sell short-term commercial paper notes to the extent availability exists under the Credit Facility. We use the Credit Facility as back-up liquidity to support 100% of commercial paper outstanding. As of September 30, 2006, we had $208.9 million of commercial paper outstanding that matures within 52 days. All of the commercial paper was classified as long-term as we have the intent and the ability to refinance such obligations on a long-term basis under the Credit Facility.

We have $35 million of outstanding private placement debt maturing in May 2007. We classified this debt as long-term as of September 30, 2006 as we have the intent and ability to refinance such obligation on a long-term basis under the Credit Facility.

We were in compliance with all debt covenants as of September 30, 2006.

In addition to the Credit Facility, we have $25 million of uncommitted credit facilities, under which we had no borrowings as of September 30, 2006.

Long-term debt outstanding at September 30, 2006 matures on a calendar year basis as follows:

In September 2005, we entered into a $100 million interest rate swap agreement with several major financial institutions to exchange variable rate interest payment obligations for fixed rate obligations without the exchange of the underlying principle amounts in order to manage interest rate exposures. The effective date of the fixed rate swap was April 25, 2006. The swap agreement has a fixed interest rate of 4.68% and expires in July 2013. The fixed interest rate of 4.68% plus the .60% interest rate spread over LIBOR, results in an effective fixed interest rate of 5.28%. The fair value of the swap at September 30, 2006 was $1.9 million and was recorded in other assets.

The variable to fixed interest rate swap is designated as and is effective as a cash-flow hedge. The fair value of the swap is recorded on the balance sheet, with changes in fair values included in Other Comprehensive Income (“OCI”). Derivative gains and losses included in OCI are recorded in earnings at the time the related interest rate expense is recognized or the settlement of the related commitment occurs.

The provision for income taxes consists of provisions for federal, state and foreign income taxes. We operate in an international environment with operations in various locations outside the U.S. Accordingly, the consolidated income tax rate is a composite rate reflecting the earnings in the various locations and the applicable rates.

The effective income tax rate for the nine months ended September 30, 2006 was 30.3% compared to 35.8% for the nine months ended October 1, 2005. The tax rate for the first nine months of 2006 includes favorable adjustments in the third quarter related to prior years’ tax returns. Also included is a favorable adjustment in the second quarter primarily related to the resolution of an IRS exam for the periods of 2002-2003 and a favorable adjustment in the first quarter related to a prior year tax return. The 2005 effective tax rate included a second quarter unfavorable settlement related to a routine German tax examination for prior years which was partially offset by a first quarter favorable settlement of IRS examinations for the periods 1998-2001 and a third quarter favorable accrual adjustment related to a prior year tax return. We continue to actively pursue initiatives to reduce our effective tax rate. The tax rate in any quarter can be affected positively or negatively by adjustments that are required to be reported in the specific quarter of resolution.

Components of net periodic benefit cost for the three and nine months ended September 30, 2006 and October 1, 2005 were as follows:

Financial information by reportable segment for the three and nine months ended September 30, 2006 and October 1, 2005 is shown below:

Other operating loss is primarily composed of unallocated corporate expenses, costs related to our captive insurance subsidiary and our intermediate finance companies, and intercompany eliminations.

The changes in the carrying amount of service and product warranty accruals for the nine months ended September 30, 2006 and October 1, 2005 were as follows:

There have been no further material developments from the disclosures contained in our 2005 Annual Report on Form 10-K, other than those matters identified below.

Twenty-eight separate lawsuits involving 29 primary plaintiffs, a class action, and claims for indemnity by Celebrity Cruise Lines, Inc. (Celebrity) were brought against Essef Corporation (Essef) and certain of its subsidiaries prior to our acquisition of Essef in August 1999. The claims against Essef and its involved subsidiaries were based upon the allegation that Essef designed, manufactured, and marketed two sand swimming pool filters that were installed as a part of the spa system on the Horizon cruise ship, and allegations that the spa and filters contained Legionnaire’s disease bacteria that infected certain passengers on cruises from April 1994 through July 1994.

The individual and class claims by passengers were tried and resulted in an adverse jury verdict finding liability on the part of the Essef defendants (70%) and Celebrity and its sister company, Fantasia (together 30%). After expiration of post-trial appeals, we paid all outstanding punitive damage awards of $7.0 million in the Horizon cases, plus interest of approximately $1.6 million, in January 2004. All of the personal injury cases have now been resolved through either settlement or trial.

The only remaining unresolved claims in this case were those brought by Celebrity for damages resulting from the outbreak. Celebrity filed an amended complaint seeking attorney fees and costs for prior litigation as well as out-of-pocket losses, lost profits, and loss of business enterprise value. On June 28, 2006, the jury returned a verdict against the Essef defendants in the total amount of $193 million for its claims for out-of-pocket expenses ($10.4 million), lost profits ($47.6 million) and loss of business enterprise value ($135 million). The verdict is exclusive of pre-judgment interest and attorneys’ fees. We believe that the jury verdict is not consistent with the law nor the evidence offered at trial. We intend to argue all appropriate post-trial motions, or if unsuccessful to appeal any subsequent judgment, to reverse or substantially reduce this verdict, in particular the claims relating to lost profits and lost enterprise value. We anticipate that these post-trial motions will be heard in the fourth quarter of 2006.

We have assessed the impact of the verdict on our previously established reserves for this matter and, based on information available at this time, have deemed it unnecessary to adjust our reserves other than for quarterly interest accruals. First, several issues have not been addressed by the court, including whether Celebrity is entitled to recovery of its attorneys’ fees and related costs in the passenger claims phase of the case ($4.1 million), and, with respect to pre-judgment interest, the length of the interest period and the rate of interest on any eventual judgment. In addition, the court has not decided Essef’s contribution claim to reduce Celebrity’s recovery by 30% to account for its contributory negligence. Second, we believe that we will ultimately be successful in obtaining substantial relief from this misguided verdict. While we are not able to determine the amount of the eventual liability at this time, we believe that an appropriate result would be substantially less than the verdict the jury rendered.

If judgment were subsequently entered on this verdict and upheld on appeal as it currently stands, which we believe is unlikely to occur for the reasons noted above, the interest incurred through September 2006 would range from approximately $78 to $175 million, depending on interest rate and interest period used. In this worst case situation, the gross amount that we would have to pay in this matter would range from $271 to $368 million. While we believe the majority of the amount would be tax-deductible in the year paid or in subsequent years, we are still analyzing the tax impact of a loss of that magnitude. In addition to the impact of a loss on this matter on our earnings per share when recognized, we would also need to eventually borrow funds from our banks or other sources to pay any judgment finally determined after exhaustion of all appeals. We expect that we would have available adequate funds to allow us to do so, based on discussions with our lending sources and our estimates of the results of our business operations over the next two years.

During the period prior to final determination and payment of any ultimate recovery to Celebrity, we believe that we will be able to operate in the normal course of business, although interim acquisition plans and other discretionary spending may be reduced. Any final judgment paid would also increase our indebtedness or reduce cash available for other uses. Any such payment could impact our ability to execute our long-term strategic plans to their full extent, but we do not believe our ongoing financial and operational condition will be compromised.

We are occasionally a party to other litigation arising in the normal course of business. We regularly analyze current information and, as necessary, provide accruals for probable liabilities based on the expected eventual disposition of these matters. While it is possible that our cash flows and results of operations in a particular quarter or year could be materially affected by the one-time impacts of the resolution of such contingencies, it is the opinion of management that the ultimate disposition of these matters will not have a material impact on our financial position, or ongoing results of operations and cash flows.

The $250 million Senior Notes due 2009 are jointly and severally guaranteed by our domestic subsidiaries (the “Guarantor Subsidiaries”), each of which is directly or indirectly wholly-owned by Pentair (the “Parent Company”). The following supplemental financial information sets forth the condensed consolidated balance sheets as of September 30, 2006 and December 31, 2005, the related condensed consolidated statements of income for the three months and nine months ended September 30, 2006 and October 1, 2005, and statements of cash flows for the nine months ended September 30, 2006 and October 1, 2005, for the Parent Company, the Guarantor Subsidiaries, the non-guarantor subsidiaries and total consolidated Pentair and subsidiaries.