Rockwell Automation - 10-Q quarterly report FY

In the opinion of management of Rockwell Automation, Inc. (the Company or Rockwell Automation), the unaudited condensed consolidated financial statements contain all adjustments, consisting solely of adjustments of a normal recurring nature, necessary to present fairly the financial position, results of operations, and cash flows for the periods presented. These statements should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended September 30, 2004. The results of operations for the three- and nine-month periods ended June 30, 2005 are not necessarily indicative of the results for the full year. Certain prior year amounts have been reclassified to conform to the current year presentation.

In September 2004, we sold our FirstPoint Contact business. FirstPoint Contact is classified as a discontinued operation in the condensed consolidated financial statements for all periods presented.

Sales of products and services, representing approximately 90% of our consolidated sales, are recorded when all of the following have occurred: an agreement of sale exists; pricing is fixed or determinable; collection is reasonably assured; and product has been delivered and acceptance has occurred, as may be required according to contract terms, or services have been rendered.

We recognize substantially all of the remainder of our sales on construction-type contracts using either the percentage-of-completion or completed contract methods of accounting. We record sales relating to these contracts using the percentage-of-completion method when we determine that progress towards completion is reasonably and reliably estimable; we use the completed contract method for all others. Under the percentage-of-completion method, we recognize sales and gross profit as work is performed using either (i) the relationship between actual costs incurred and total estimated costs at completion or (ii) units-of-delivery. Under the percentage-of-completion method, we adjust sales and gross profit for revisions of estimated total contract costs or revenue in the period the change is identified. We record estimated losses on contracts when they are identified.

We use contracts and customer purchase orders to determine the existence of an agreement of sale. We use shipping documents and customer acceptance, when applicable, to verify delivery. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectibility based on the creditworthiness of the customer as determined by credit evaluations and analysis, as well as the customer’s payment history.

Shipping and handling costs billed to customers are included in sales and the related costs are included in cost of sales in the Condensed Consolidated Statement of Operations.

Our primary incentive program provides distributors with cash rebates or account credits based on agreed amounts that vary depending on the end user or original equipment manufacturer (OEM) customer to whom our distributor ultimately sells the product. We also offer various other incentive programs that provide distributors and direct sale customers with cash rebates, account credits or additional products and services based on meeting specified program criteria. Certain distributors are offered a right to return product, subject to contractual limitations.

We record accruals for customer returns, rebates and incentives at the time of revenue recognition based primarily on historical experience. Returns, rebates and incentives are recognized as a reduction of sales if distributed in cash or customer account credits. Rebates and incentives are recognized in cost of sales for additional products and services to be provided. Amounts are accrued at the time of recognition of our sale to a distributor or direct sale customer. Accruals are reported as a current liability in our balance sheet or, where a right of set-off exists, as a reduction of accounts receivable.

Cash and cash equivalents include time deposits and certificates of deposit with original maturities of three months or less.

Receivables are stated net of allowances for doubtful accounts of $23.8 million at June 30, 2005 and $25.2 million at September 30, 2004. In addition, receivables are stated net of unissued credits related to customer returns, rebates and incentives of $10.3 million at June 30, 2005 and $7.8 million at September 30, 2004.

Properties are stated net of accumulated depreciation of $1,379.4 million at June 30, 2005 and $1,335.2 million at September 30, 2004.

At the end of each interim reporting period, we estimate the effective tax rate expected to be applicable for the full fiscal year. The rate determined is used in providing for income taxes on a year-to-date basis, excluding the effect of significant unusual or extraordinary items or items that are reported net of their related tax effects. The tax effect of significant unusual or extraordinary items are recognized in the period in which they are realizable.

Tax benefits related to claims are recognized when they become probable and reasonably estimable.

We present basic and diluted earnings per share (EPS) amounts. Basic EPS is calculated by dividing net income by the weighted average number of common shares outstanding during the applicable period. Diluted EPS amounts are based upon the weighted average number of common and common equivalent shares outstanding during the applicable period. The difference between basic and diluted EPS is attributable solely to stock options. We use the treasury stock method to calculate the effect of outstanding stock options. Stock options for which the exercise price exceeds the average market price (out-of-the-money options) over the applicable period have an antidilutive effect on EPS, and accordingly, are excluded from the calculation of diluted EPS. For the three- and nine-month periods ended June 30, 2005, options for 18,000 and 14,767 shares, respectively, were excluded from the diluted EPS calculation because they were antidilutive. For the three- and nine-month periods ended June 30, 2004, options for approximately 100,000 shares were excluded from the diluted EPS calculation because they were antidilutive.

During the 2005 third quarter, the Company declared a dividend of $0.225 per share payable June 6, 2005 to shareowners of record on May 16, 2005 and also declared a fourth quarter 2005 dividend of $0.225 per share payable September 6, 2005 to shareowners of record on August 15, 2005. During the 2004 third quarter, the Company declared a dividend of $0.165 per share payable June 7, 2004 and also declared a fourth quarter 2004 dividend of $0.165 per share payable September 7, 2004.

We account for stock-based compensation in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Stock options are granted at prices equal to the fair market value of our common stock on the grant dates; therefore we do not recognize compensation expense in connection with stock options granted to employees. We recognize compensation expense on grants of restricted stock during the period of the employee’s service. The following table illustrates the effect on net income and earnings per share as if the fair value-based method provided by Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, had been applied for all outstanding and unvested awards in each period (in millions, expect per share amounts):

Pro forma net income for the nine-month period ended June 30, 2005 includes an additional $4.9 million after tax of compensation expense, recognized in the second quarter of 2005, for retirement eligible stock option plan participants. Previously we reported compensation expense for these participants over the vesting period. Stock options granted to retirement eligible plan participants who retire under our retirement plans on or after the first anniversary of the grant date continue to vest post-retirement in accordance with plan provisions and agreements related thereto. If the plan participant retires less than twelve months from the grant date, the options under that grant are forfeited. Stock compensation expense on grants to plan participants who are retirement eligible on the grant date or who will be retirement eligible in less than twelve months from the grant date is now reported in pro forma net income over the twelve month period from the grant date. Stock compensation expense on grants to plan participants who become retirement eligible twelve or more months after the grant date is reported in pro forma net income over the period from grant date to the retirement eligibility date.

Pro forma net income for the nine months ended June 30, 2004 includes $3.6 million after tax of expense related to performance-vesting options  that  vested  in  the  first  quarter  of  2004  as a result of the  market  price  of  our  common  stock reaching a specified level for a pre-determined  period of time.

In June 2005, the Financial Accounting Standards Board (FASB) issued staff position 143-1,Accounting for Electronic Equipment Waste Obligations (FSP 143-1). FSP 143-1 addresses accounting for obligations associated with the European Union’s directive on the disposal of electrical and electronic equipment waste. We adopted FSP 143-1 effective for the third quarter of 2005. The effect of the adoption on our financial statements and related disclosures is not significant.

In March 2005, the FASB issued Interpretation No. 47 (FIN 47) to clarify the guidance included in SFAS No. 143, Accounting for Asset Retirement Obligations. FIN 47 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. If amounts cannot be reasonably estimated, certain disclosures will be required about the unrecognized asset retirement obligations. The interpretation is required to be adopted in the first quarter of 2006. We are currently evaluating the interpretation to determine the effect on our financial statements and related disclosures.

In December 2004, the FASB issued the revised SFAS No. 123, Share-Based Payment (SFAS 123(R)). SFAS 123(R) requires compensation costs related to share-based payment transactions, including stock options and restricted stock, to be recognized in the financial statements. Compensation cost will be measured based on the grant-date fair value of the instruments issued using an option pricing model and will be recognized over the requisite service period. We are required to implement SFAS 123(R) for our 2006 fiscal year. SFAS 123(R) will apply to all awards granted after the implementation date and to previously-granted awards unvested as of the implementation date. The effect of adoption of SFAS 123(R) is currently estimated to be approximately $15 to $20 million ($0.08 to $0.11 per share) after-tax for 2006. However, our actual share-based compensation expense in 2006 will depend on a number of factors, including the amount of awards granted and the fair value of those awards at the time of grant.

In November 2004, the FASB issued SFAS No. 151, Inventory Costs (SFAS 151). SFAS 151 requires that abnormal amounts of idle facility expense, freight, handling costs and spoilage be recognized as current-period charges. Further, SFAS 151 requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. Unallocated overheads must be recognized as an expense in the period in which they are incurred. SFAS 151 is effective for inventory costs incurred beginning in the first quarter of 2006. We do not believe the adoption of SFAS 151 will have a material effect on our financial statements and related disclosures.

Inventories are reported net of the allowance for excess and obsolete inventory of $46.3 million at June 30, 2005 and $46.2 million at September 30, 2004.

The Allen-Bradley, Reliance and Dodge trademarks have been determined to have an indefinite life, and therefore are not subject to amortization.

Estimated amortization expense is $23.2 million in 2005, $20.0 million in 2006, $19.9 million in 2007, $19.3 million in 2008 and $15.6 million in 2009.

We performed the annual evaluation of our goodwill and indefinite life intangible assets for impairment as required by SFAS No. 142, Goodwill and Other Intangible Assets, during the second quarter of 2005 and concluded that no impairments existed.

We record a liability for product warranty obligations at the time of sale to a customer based upon historical warranty experience. Most of our products are covered under a warranty period that runs for twelve months from either the date of sale or from installation to an end-user or OEM customer. We also record a liability for specific warranty matters when they become known and reasonably estimable. Our product warranty obligations are included in Other current liabilities in the Condensed Consolidated Balance Sheet.

In September 2002, we entered into an interest rate swap contract (the Swap) that effectively converted our $350 million aggregate principal amount of 6.15 percent notes, payable in 2008, to floating rate debt based on six-month LIBOR. The floating rate was 5.30 percent at June 30, 2005 and 4.27 percent at September 30, 2004. The fair value of the Swap, based upon quoted market prices for contracts with similar maturities, was a liability of $2.6 million at June 30, 2005 and an asset of $3.7 million at September 30, 2004. As permitted by SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), as amended, we have designated the Swap as a fair value hedge. In accordance with SFAS 133, the carrying value of the underlying debt was decreased to $347.4 million in the Condensed Consolidated Balance Sheet at June 30, 2005 and increased to $353.7 million in the Condensed Consolidated Balance Sheet at September 30, 2004, with the corresponding offset recorded within Other liabilities and Other assets in the respective Condensed Consolidated Balance Sheet.

At September 30, 2004, we had $675.0 million of unsecured committed credit facilities, with $337.5 million expiring in October 2004 and $337.5 million expiring in October 2005. On October 26, 2004, we entered into a five-year $600.0 million unsecured revolving credit facility. It replaced both the facility expiring on that date and the facility expiring in October 2005 (which we cancelled on that date). Borrowings under our existing credit facility bear interest based on short-term money market rates in effect during the period the borrowings are outstanding. This facility is available for general corporate purposes, including support for our commercial paper borrowings. The terms of our credit facility contain a covenant under which we would be in default if our debt-to-total capital ratio were to exceed 60 percent. In addition to our $600.0 million credit facility, short-term unsecured credit facilities are available to foreign subsidiaries. Borrowings under our credit facilities during the nine months ended June 30, 2005 were not significant.

In the first nine months of 2005, we made a voluntary contribution of $50.0 million to our U.S. qualified pension plan trust. In the first nine months of 2004, we made voluntary contributions of $125.0 million to our U.S. qualified pension plan trust.

We own 50 percent of Rockwell Scientific Company LLC (RSC). This ownership interest is accounted for using the equity method. Our investment in RSC of $59.8 million at June 30, 2005 and $57.5 million at September 30, 2004 is included in Other assets in the Condensed Consolidated Balance Sheet.

We have an agreement with RSC pursuant to which RSC performs research and development services for us through 2005. We are obligated to pay RSC a minimum of $2.5 million for such services in 2005. We incurred $0.7 million in the three-month period ended June 30, 2005 and $2.1 million in the nine-month period ended June 30, 2005, and $0.8 million in the three-month period ended June 30, 2004 and $2.1 million in the nine-month period ended June 30, 2004 for research and development services performed by RSC. At June 30, 2005, the amounts due to or from RSC were not significant. At September 30, 2004, the amount due to RSC for research and development services was $0.7 million. At September 30, 2004, the amount due from RSC for cost sharing arrangements was not significant.

We share equally with Rockwell Collins, Inc. (Rockwell Collins), which owns 50 percent of RSC, in providing a $6.0 million line of credit to RSC which bears interest at the greater of our or Rockwell Collins’ commercial paper borrowing rate. At June 30, 2005 and September 30, 2004, there were no outstanding borrowings on the line of credit. In addition, we and Rockwell Collins each guarantee one-half of a lease agreement for one of RSC’s facilities. The total future minimum lease payments under the lease are $4.9 million. The lease agreement has a term that ends in December 2011.

We own 25 percent of CoLinx, LLC (CoLinx), a company that provides logistics and e-commerce services. This ownership interest is accounted for using the equity method. We paid CoLinx $5.0 million in the three-month period ended June 30, 2005 and $13.5 million in the nine-month period ended June 30, 2005 and $5.0 million in the three-month period ended June 30, 2004 and $13.3 million in the nine-month period ended June 30, 2004 primarily for logistics services. In addition, CoLinx paid us $0.7 million in the three-month period ended June 30, 2005 and $2.1 million in the nine-month period ended June 30, 2005 and $0.7 million in the three-month period ended June 30, 2004 and $2.0 million in the nine-month period ended June 30, 2004 for the use of facilities we own and other services. The amounts due to or from CoLinx at June 30, 2005 and September 30, 2004 were not significant.

In connection with the divestiture of certain businesses in prior years, we retained tax liabilities and the rights to tax refunds for periods prior to the respective divestitures. As a result, from time to time, we may receive refunds or may be required to make payments related to tax matters associated with these divested businesses. Amounts recorded for these matters are based on estimates. We review and revise these estimates as appropriate to take into account all information we have available. Actual amounts received or paid could differ materially from those estimates and would accordingly result in an adjustment to results of operations in the period the refunds are received or payments are made.

In the nine months ended June 30, 2005, we recognized a net tax benefit of $19.7 million in income from continuing operations ($0.10 per share) and $18.8 million in income from discontinued operations ($0.10 per share) related to current and former businesses. The net tax benefits included in income from continuing operations are primarily related to the resolution of claims and other tax matters in connection with the closure of the federal audit cycle for the years 1998 through 2002. In addition, these net tax benefits include the effect of the true-up of estimated tax audit contingency accruals in connection with closure of the 1998 through 2002 audit. The net tax benefits included in discontinued operations relate primarily to the closure of the 1998 through 2002 audit ($7.5 million) and to a prior year state tax refund of a divested business.

We made a cash payment of $37.6 million in the third quarter of 2005 and expect to receive cash of $9.7 million in the fourth quarter of 2005 in connection with closure of the 1998 through 2002 audit.

In the nine months ended June 30, 2004, we recognized tax benefits of $38.8 million ($0.20 per share) in income from continuing operations, of which $34.4 million ($0.18 per share) was recognized during the third quarter of 2004. The benefits recognized relate primarily to resolution of non-U.S. tax matters, an agreement with a taxing authority related to the treatment of an investment, and state tax benefits associated with a previously reported U.S. research and experimentation tax credit settlement.

Like thousands of other companies, we (including our subsidiaries) have been named as a defendant in lawsuits alleging personal injury as a result of exposure to asbestos that was used in certain components of our products many years ago. Currently there are thousands of claimants in lawsuits that name us, together with hundreds of other companies, as defendants. The great bulk of the complaints, however, do not identify any of our products or specify which of these claimants, if any, were exposed to asbestos attributable to our products; and past experience has shown that the vast majority of the claimants will never identify any of our products. In addition, when our products appear to be identified, they are frequently from divested businesses, and we are indemnified for most of the costs. For those claimants who do show that they worked with our products, we nevertheless believe we have meritorious defenses, in substantial part due to the integrity of our products, the encapsulated nature of any asbestos-containing components, and the lack of any impairing medical condition on the part of many claimants. We defend those cases vigorously. Historically, we have been dismissed from the vast majority of these claims with no payment to claimants.

We have maintained insurance coverage that we believe covers indemnity and defense costs, over and above self-insured retentions, for most of these claims. We initiated litigation in the Milwaukee County Circuit Court on February 12, 2004 to enforce the insurance policies against Nationwide Indemnity Company and Kemper Insurance, the insurance carriers that provided liability insurance coverage to our former subsidiary Allen-Bradley. As a result of this litigation, which is now settled, the insurance carriers have paid a total of $15.9 million for past defense and indemnity costs, and have agreed to pay for the substantial majority of future defense and indemnity costs for Allen-Bradley asbestos claims, subject to policy limits. If either carrier becomes insolvent, we may be required under preference laws to refund the amounts that we have collected and will continue to collect in the applicable preference period prior to the insolvency. If either carrier becomes insolvent or the policy limits of either carrier are exhausted, our share of future defense and indemnity costs may increase. However, coverage under excess policies may be available to pay some or all of these costs.

The uncertainties of asbestos claim litigation and the long term solvency of our insurance carriers make it difficult to predict accurately the ultimate outcome of asbestos claims. That uncertainty is increased by the possibility of adverse rulings or new legislation affecting asbestos claim litigation or the settlement process. Subject to these uncertainties and based on our experience defending asbestos claims, we do not believe these lawsuits will have a material adverse effect on our financial condition.

We have, from time to time, divested certain of our businesses. In connection with the divestiture of our former aerospace and defense businesses (the A&D Business) to The Boeing Company (Boeing), we agreed to indemnify Boeing for certain matters related to operations of the A&D Business for periods prior to the divestiture. In connection with the spin-offs of our former automotive component systems business, semiconductor systems business and Rockwell Collins avionics and communications business, the spun-off companies have agreed to indemnify us for substantially all contingent liabilities related to the respective businesses, including environmental and intellectual property matters.

In connection with the divestitures of certain of our businesses, there may be lawsuits, claims and proceedings instituted or asserted against us related to the period that we owned the businesses. In addition, we have guaranteed performance and payment under certain contracts of divested businesses.

In many countries we provide a limited intellectual property indemnity as part of our terms and conditions of sale. We also at times provide limited intellectual property indemnities in other contracts with third parties, such as contracts concerning: the development and manufacture of our products; the divestiture of businesses; and the licensing of intellectual property. Due to the number of agreements containing such provisions, we are unable to estimate the maximum potential future payments. However, we believe that future payments, if any, would not be material to our business or financial condition.

Various other lawsuits, claims and proceedings have been or may be instituted or asserted against us relating to the conduct of our business, including those pertaining to product liability, intellectual property, environmental, safety and health, employment and contract matters. Although we cannot predict the outcome of litigation with certainty and some lawsuits, claims, or proceedings may be disposed of unfavorably to us, we believe the matters that are pending or asserted will not have a material adverse effect on our business or financial condition.

The following is a summary of the composition of income from discontinued operations included in the Condensed Consolidated Statement of Operations (in millions):

The nine months ended June 30, 2005 included a net tax benefit related to resolution of certain prior year tax matters and a state tax refund of a divested business. See Note 10 for additional information.

During the nine months ended June 30, 2005, we received $25.8 million of cash related to state tax refunds for prior periods. The corresponding income was recognized in the fourth quarter of 2004 and the first quarter of 2005. This amount is included in the Condensed Consolidated Statement of Cash Flows as Cash Provided by Discontinued Operations.

In the first quarter of 2004, we recorded a benefit of $7.6 million ($4.6 million after tax) as a result of a final judgment in a defense claim legal proceeding related to our former operation of the Rocky Flats facility of the Department of Energy. This amount is in addition to income of $7.3 million ($4.4 million after tax) recognized in the fourth quarter of 2003 related to the Rocky Flats defense claim legal proceeding. In March 2004, we received $15.1 million related to this matter. This amount is included, net of the related tax, in the Condensed Consolidated Statement of Cash Flows as Cash Provided by Discontinued Operations.

In the fourth quarter of 2004, we sold our former FirstPoint Contact business. The results of operations of FirstPoint Contact for 2004 are reflected in Income from Discontinued Operations in the Condensed Consolidated Statement of Operations.

Summarized results of FirstPoint Contact are as follows (in millions):

Among other considerations, we evaluate performance and allocate resources based upon segment operating earnings before income taxes, interest expense, costs related to corporate offices, nonrecurring special charges, gains and losses from the disposition of businesses, earnings and losses from equity affiliates that are not considered part of the operations of a particular segment and incremental acquisition related expenses resulting from purchase accounting adjustments such as intangible asset amortization, depreciation, inventory and purchased research and development charges. Depending on the product, we record intersegment sales either at a market price or cost plus a mark-up, which does not necessarily represent a market price.