UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2006
OR
For the transition period from to
Commission file number: 1-13782
WESTINGHOUSE AIR BRAKE TECHNOLOGIES CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
1001 Air Brake Avenue
Wilmerding, PA
412-825-1000
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
Outstanding at November 7, 2006
[Common Stock, $.01 par value per share]
WESTINGHOUSE AIR BRAKE
TECHNOLOGIES CORPORATION
September 30, 2006 FORM 10-Q
TABLE OF CONTENTS
PART I—FINANCIAL INFORMATION
Item 1.
Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005
Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005
Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005
Notes to Condensed Consolidated Financial Statements
Item 2.
Item 3.
Item 4.
Item 1A.
Item 6.
2
CONDENSED CONSOLIDATED BALANCE SHEETS
In thousands, except shares and par value
Assets
Current Assets
Cash and cash equivalents
Accounts receivable
Inventories
Deferred income taxes
Other current assets
Total current assets
Property, plant and equipment
Accumulated depreciation
Property, plant and equipment, net
Other Assets
Goodwill
Other intangibles, net
Other noncurrent assets
Total other assets
Total Assets
Liabilities and Shareholders’ Equity
Current Liabilities
Accounts payable
Accrued income taxes
Customer deposits
Accrued compensation
Accrued warranty
Other accrued liabilities
Total current liabilities
Long-term debt
Reserve for postretirement and pension benefits
Other long-term liabilities
Total liabilities
Shareholders’ Equity
Preferred stock, 1,000,000 shares authorized, no shares issued
Common stock, $.01 par value; 100,000,000 shares authorized: 66,174,767 shares issued and 48,358,702 and 48,002,819 outstanding at September 30, 2006 and December 31, 2005, respectively.
Additional paid-in capital
Treasury stock, at cost, 17,816,065 and 18,171,948 shares, at September 30, 2006 and December 31, 2005, respectively
Retained earnings
Accumulated other comprehensive loss
Total shareholders’ equity
Total Liabilities and Shareholders’ Equity
The accompanying notes are an integral part of these statements.
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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
Unaudited
Three Months Ended
September 30
Nine Months Ended
In thousands, except per share data
Net sales
Cost of sales
Gross profit
Selling, general and administrative expense
Engineering expense
Amortization expense
Total operating expenses
Income from operations
Other income and expenses
Interest income (expense), net
Other expense, net
Income from continuing operations before income taxes
Income tax expense
Income from continuing operations
Discontinued operations
Loss from discontinued operations (net of tax)
Net income
Earnings Per Common Share
Basic
Loss from discontinued operations
Diluted
Weighted average shares outstanding
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
September 30,
In thousands
Operating Activities
Stock-based compensation expense
Adjustments to reconcile net income to net cash provided by operations:
Depreciation and amortization
Excess income tax benefits from exercise of stock options
Changes in operating assets and liabilities
Accrued liabilities and customer deposits
Other assets and liabilities
Net cash provided by operating activities
Investing Activities
Purchase of property, plant and equipment
Disposals of property, plant and equipment
Acquisition of business, net of cash received
Sale of discontinued operations
Net cash used for investing activities
Financing Activities
Repayments of long term debt
Proceeds from the issuance of treasury stock for stock options and other benefit plans
Repurchase of stock (502,400 shares at an average price of $26.90 per share)
Cash dividends ($0.03 per share for the nine months ended September 30, 2006 and 2005)
Net cash provided by financing activities
Effect of changes in currency exchange rates
(Decrease) increase in cash
Cash, beginning of year
Cash, end of period
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006 (UNAUDITED)
1. BUSINESS
Wabtec is one of the world’s largest providers of value-added, technology-based products and services for the global rail industry. Our products are found on virtually all U.S. locomotives, freight cars and passenger transit vehicles, as well as in more than 90 countries throughout the world. Our products enhance safety, improve productivity and reduce maintenance costs for customers, and many of our core products and services are essential in the safe and efficient operation of freight rail and passenger transit vehicles. Wabtec is a global company with operations in 11 countries. In the first nine months of 2006, about 34 percent of the Company’s revenues came from outside the U.S.
2. ACCOUNTING POLICIES
Basis of Presentation The unaudited condensed consolidated interim financial statements have been prepared in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission and include the accounts of Wabtec and its majority owned subsidiaries. These condensed interim financial statements do not include all of the information and footnotes required for complete financial statements. In management’s opinion, these financial statements reflect all adjustments of a normal, recurring nature necessary for a fair presentation of the results for the interim periods presented. Results for these interim periods are not necessarily indicative of results to be expected for the full year.
The Company operates on a four-four-five week accounting quarter, and accordingly, the quarters end on or about March 31, June 30, September 30 and December 31.
The notes included herein should be read in conjunction with the audited consolidated financial statements included in Wabtec’s Annual Report on Form 10-K for the year ended December 31, 2005. The December 31, 2005 information has been derived from the Company’s December 31, 2005 Annual Report on Form 10-K.
Revenue Recognition Revenue is recognized in accordance with Staff Accounting Bulletins (SABs) 101, “Revenue Recognition in Financial Statements” and 104, “Revision of Topic 13”. Revenue is recognized when products have been shipped to the respective customers, title has passed and the price for the product has been determined.
The Company recognizes revenues on long-term contracts based on the percentage of completion method of accounting. The units-of-delivery method or other measures, as appropriate, are used to measure the progress toward completion of individual contracts. Contract revenues and cost estimates are reviewed and revised at a minimum quarterly and adjustments are reflected in the accounting period as such amounts are determined. Provisions are made currently for estimated losses on uncompleted contracts.
Certain pre-production costs relating to long-term production and supply contracts have been deferred and will be recognized over the life of the contracts. Deferred pre-production costs were $6.1 million and $4.9 million at September 30, 2006 and December 31, 2005, respectively.
Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual amounts could differ from the estimates. On an ongoing basis, management reviews its estimates based on currently available information. Changes in facts and circumstances may result in revised estimates.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Stock-Based Compensation Effective January 1, 2006, Wabtec adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment,” which requires the company to recognize compensation expense for stock-based compensation based on the grant date fair value. This expense must be recognized ratably over the requisite service period following the date of grant. Wabtec has elected the modified prospective transition method for adoption, and prior periods financial statements have not been restated. Prior to January 1, 2006, Wabtec accounted for stock-based compensation in accordance with the provisions of Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees,” and related interpretations.
Pro Forma Effect Prior to the Adoption of SFAS No. 123(R) Wabtec’s net income and earnings per share for 2005 would have been reduced to the pro forma amounts shown below if compensation expense had been determined based on the fair value at the grant dates in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation”.
In thousands, except per share
Three months ended
September 30, 2005
Nine months ended
Net income as reported
Stock based compensation expense under FAS123, net of tax of $150 and $498
Pro forma
Basic earnings per share
As reported
Diluted earnings per share
Stock-Based Plans Stock options have been granted at not less than market prices on the dates of grant. Generally, the options become exercisable over a three-year vesting period and expire 10 years from the date of grant. In January 2006, Wabtec granted 32,000 stock options to certain individuals. The Company has now adopted a non-vested stock plan and issued 200,500 awards to executives in February 2006. The non-vested stock generally vests over four years from the date of grant. In addition, the Company established in 2004, a stock-based incentive plan for eligible employees. The plan provides stock awards which vest upon attainment of certain three year performance targets. Wabtec also sponsors an employee stock purchase plan, whereby participants can purchase the Company’s common stock at a discount of about 15% of the lesser of fair market value on the first or last day of each offering period.
Stock based compensation was $7.7 million and $1.6 million for the nine months ended September 30, 2006 and 2005, respectively. The accounting for the non-vested stock and the stock awards under the incentive plan was not impacted significantly by the adoption of FAS 123(R). In addition, compensation expense of $849,000 was recorded for the nine months ended September 30, 2006 related to the expensing of stock options in accordance with FAS 123(R). At September 30, 2006, unamortized compensation expense related to those stock options, non-vested shares and stock awards expected to vest totaled $12.9 million and will be recognized over a weighted average period of 1.5 years.
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The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
Three and nine months ended
Dividend yield
Risk-free interest rate
Stock price volatility
Expected life (years)
The dividend yield is based on the Company’s dividend rate and the current market price of the underlying common stock at the date of grant. Expected life in years is determined from historical stock option exercise data. Expected volatility is based on the historical volatility of Wabtec stock. The risk-free interest rate is based on the U.S. Treasury bond rates for the expected life of the option.
The following table summarizes the stock option activity and related information for the period indicated:
Weighted Average
Remaining
Contractual Life
Aggregateintrinsic value
(in thousands)
Beginning of year—January 1, 2006
Granted
Exercised
Canceled
Year to date—September 30, 2006
Exercisable
Weighted average fair value of options granted during 2006
The following table summarizes the non-vested stock and stock awards activity and related information for the period indicated:
Non-Vested
Stock
Awards
Weighted
Average FMV
Outstanding at January 1, 2006
Outstanding at September 30, 2006
As of September 30, 2006, stock awards issued under the incentive plan are awarded but not vested. These stock awards will vest based upon the achievement of certain financial goals for each three year periods ending December 31, 2006, 2007 and 2008, respectively. The stock awards included in the table above represent the maximum number of shares that may ultimately vest. As of September 30, 2006, based on the Company’s performance, we estimate that the majority of these stock awards will vest and have recorded compensation expense accordingly. If our estimate of the number of these stock awards expected to vest changes in a future accounting period, compensation expense could be reduced and will be recognized over the remaining vesting period.
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Financial Derivatives and Hedging Activities The Company has entered into foreign currency forward contracts to reduce the impact of changes in currency exchange rates. Forward contracts are agreements with counterparty to exchange two distinct currencies at a set exchange rate for delivery on a set date at some point in the future. There is no exchange of funds until the delivery date. At the delivery date the Company can either take delivery of the currency or settle on a net basis. All outstanding forward contracts are for the sale of U.S. Dollars (USD) and the purchase of Canadian Dollars (CAD). As of September 30, 2006, the Company had forward contracts with a notional value of $15.0 million CAD (or $12.6 million U.S.), with an average exchange rate of $.84 USD per $1 CAD, resulting in the recording of a current asset and an increase in comprehensive income of $732,000, net of tax.
Foreign Currency Translation Assets and liabilities of foreign subsidiaries, except for the Company’s Mexican operations whose functional currency is the U.S. Dollar, are translated at the rate of exchange in effect on the balance sheet date while income and expenses are translated at the average rates of exchange prevailing during the year. Foreign currency gains and losses resulting from transactions, and the translation of financial statements are recorded in the Company’s consolidated financial statements based upon the provisions of SFAS No. 52, “Foreign Currency Translation.” The effects of currency exchange rate changes on intercompany transactions and balances of a long-term investment nature are accumulated and carried as a component of shareholders’ equity. The effects of currency exchange rate changes on intercompany transactions that are non U.S. dollar denominated amounts are charged or credited to earnings. Foreign exchange loss was $124,000 and $1.5 million for the three months ended September 30, 2006 and 2005, respectively, and $1.1 million and $3.1 million for the nine months ended September 30, 2006 and 2005, respectively.
Other Comprehensive Income (Loss) Comprehensive income (loss) is defined as net income and all other non-owner changes in shareholders’ equity. The Company’s accumulated other comprehensive income (loss) consists of foreign currency translation adjustments, foreign currency hedges and pension related adjustments. Changes in the table below, adjust components of accumulated other comprehensive income (loss). Total comprehensive income was:
Foreign currency translation adjustment
Unrealized (loss) gain on foreign exchange contracts, net of tax
Total comprehensive income
As reflected on the balance sheet, components of accumulated other comprehensive (loss) income consist of the following:
Unrealized gains on foreign exchange contracts, net of tax
Additional minimum pension liability, net of tax
Total accumulated comprehensive loss
Reclassifications Certain prior year amounts have been reclassified where necessary, to conform to the current year presentation.
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Recent Accounting Pronouncements In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109.” FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that it has taken or expects to take on a tax return. FIN 48 is effective in the first quarter of 2007. The company is currently evaluating the impact of this statement on its financial statements.
In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 158, “Employers’ 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 an employer to recognize the funded status of each of its defined pension and postretirement benefit plans as a net asset or liability in its statement of financial position with an offsetting amount in accumulated other comprehensive income, and to recognize changes in that funded status in the year in which changes occur through comprehensive income. This requirement becomes effective for the Company for its December 31, 2006 year-end. The provisions of SFAS 158 are to be applied on a prospective basis; therefore, prior periods presented will not be restated. The Company is currently evaluating the impact of this pronouncement on its statement of financial position.
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 in generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of this standard apply to other accounting pronouncements that require or permit fair value measurements. SFAS 157 becomes effective for Wabtec on January 1, 2008. Upon adoption, the provisions of SFAS 157 are to be applied prospectively with limited exceptions. The adoption of SFAS 157 is not expected to have a material impact on the Company’s consolidated financial statements.
3. ACQUISITIONS AND DISCONTINUED OPERATIONS
On February 1, 2005, the Company completed the acquisition of the assets of Rütgers Rail S.p.A, a business with operations in Italy, Germany, France and Spain. The acquisition was accounted for as a purchase and accordingly, the purchase price was allocated to the respective assets and liabilities based upon their estimated fair values as of the acquisition date. Operating results were included in the consolidated statement of operations from the acquisition date forward. The new company formed to hold the newly purchased assets of Rütgers Rail S.p.A. is named CoFren S.r.l. (“CoFren”). CoFren is one of the leading manufacturers of brake shoes, disc pads and interior trim components for rail applications in Europe. The purchase price was $35.9 million, net of cash received, resulting in additional goodwill of $5.7 million.
For pro forma purposes, this acquisition would only impact the results for the nine months ended September 30, 2005, as CoFren was included in its entirety for all periods beginning afterwards. The following unaudited pro forma financial information presents income statement results as if the acquisition had occurred January 1, 2005:
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With the acquisition of Rütgers Rail, S.p.A., the Company decided to offer for sale a non-core product division. As part of the purchase accounting, the net amount of this division had been revalued to its estimated net realizable value and had been classified as assets held for sale, which is included in other noncurrent assets on the balance sheet.
At March 31, 2006, the sale of this division was completed for approximately $2.0 million in cash, subject to a working capital adjustment which is expected to be finalized with the buyer in the fourth quarter. The assets sold primarily included transit car interior products and services for customers located in Europe. This sale resulted in a loss of approximately $740,000 subject to the working capital adjustment mentioned earlier. Also, in the fourth quarter of 2005, the Company decided to liquidate its bus door joint venture in China.
In accordance with SFAS 144, “Accounting for Impairment or Disposal of Long-Lived Assets”, the operating results of these businesses have been classified as discontinued operations for all years presented and are summarized as of December 31, as follows:
Three Months
Ended
Nine Months
Loss before income taxes
Income tax income (expense)
Effective October 9, 2006, Wabtec acquired Schaefer Equipment, Inc., manufacturer of forged brake rigging components, for $36.0 million in cash. Schaefer’s products include a wide variety of forged components for body-mounted and truck-mounted braking systems. Schaefer Equipment will operate as a business of Wabtec’s Freight Group.
4. INVENTORIES
The components of inventory, net of reserves, were:
Raw materials
Work-in-process
Finished goods
Total inventory
5. RESTRUCTURING AND IMPAIRMENT CHARGES
On July 19, 2006, the Board of Directors approved a restructuring plan to improve the profitability and efficiency of certain business units. As part of the plan, Wabtec downsized two of its Canadian plants, in Stoney Creek and Wallaceburg, by moving certain products to lower-cost facilities and outsourcing. Wabtec recorded expenses of $6.8 million in the 2006 third quarter for restructuring and other expenses, as a result of the approval of this plan. These expenses were comprised of the following components: $1.5 million for employee severance
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costs associated with approximately 240 salaried and hourly employees located at our Wallaceburg and Stoney Creek locations; $2.0 million of pension curtailment for those employees; $2.9 million related to asset impairments for structures, machinery, and equipment; and $540,000 for goodwill impairment specific to the Wallaceburg facility. As of September 30, 2006, the employees associated with the restructuring program had been terminated and none of the severance has been paid. Severance costs are contractual liabilities and payment is dependent on the waiver by, or expiration of certain seniority rights of, those employees.
The restructuring plan will result in additional expenses in the first half of 2007 of $1.5 million, pre-tax, primarily for pension-related settlement charges. Pension funding will be subject to regulatory review and approval, and funding is anticipated to be made in the first half of 2007.
In the first six months of 2005, the Company recorded restructuring and asset impairment charges totaling $2.3 million related to consolidating two U.K. facilities into one, relocating a product line from Canada to the U.S., and completion of a data center migration. These charges consisted of severance costs of $593,000 for 43 employees, relocation and other costs of $469,000 and asset impairment of $1.2 million. All but $418,000 of these costs were paid for in the first nine months of 2005.
In the fourth quarter of 2005, the Company recorded restructuring charges of about $800,000 relating to consolidating two Australian facilities into one. As of September 30, 2006, these costs have not been paid.
6. INTANGIBLES
Goodwill on the balance sheet is $118.7 million at September 30, 2006 and $118.2 million at December 31, 2005.
As of September 30, 2006 and December 31, 2005, the Company’s trademarks had a net carrying amount of $20.0 million and $19.9 million, respectively, and the Company believes these intangibles have an indefinite life. Intangible assets of the Company, other than goodwill and trademarks, consist of the following:
Patents and other, net of accumulated amortization of $26,834 and $24,923
Customer relationships, net of accumulated amortization of $283 and $145
Covenants not to compete, net of accumulated amortization of $8,324 and $8,304
Intangible pension asset
Total
The weighted average useful life of patents was 13 years, customer relationships were 20 years and covenants not to compete was five years. Amortization expense for intangible assets was $1.1 million and $2.5 million for the three and nine months ended September 30, 2006, and $704,000 and $2.3 million for the three and nine months ended September 30, 2005.
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The change in the carrying amount of goodwill by segment for the nine months ended September 30, 2006 is as follows:
Balance at December 31, 2005
Goodwill Impairment
Foreign currency impact
Balance at September 30, 2006
7. LONG-TERM DEBT
Long-term debt consisted of the following:
6.875% Senior Notes
Less—current portion
Long-term portion
Refinancing Credit Agreement
In January 2004, the Company refinanced its existing unsecured revolving credit agreement with a consortium of commercial banks. This “Refinancing Credit Agreement” provided a $175 million five-year revolving credit facility expiring in January 2009. In November 2005, the Company entered into an amendment to the Refinancing Credit Agreement which, among other things, extended the expiration of the agreement until December 2010. At September 30, 2006, the Company had available borrowing capacity, net of $23.7 million of letters of credit, of approximately $151.3 million, subject to certain financial covenant restrictions.
Refinancing Credit Agreement borrowings bear variable interest rates indexed to the indices described below. The Company did not borrow under the Refinancing Credit Agreement during the nine months ended September 30, 2006 or during the year ended December 31, 2005.
Under the Refinancing Credit Agreement, the Company may elect a base interest rate or an interest rate based on the London Interbank Offered Rates of Interest (“LIBOR”). The base rate is the greater of LaSalle Bank National Association’s prime rate or the federal funds effective rate plus 0.5% per annum. The LIBOR rate is based on LIBOR plus a margin that ranges from 62.5 to 175 basis points depending on the Company’s consolidated total indebtedness to cash flow ratios. The current margin is 62.5 basis points.
The Refinancing Credit Agreement limits the Company’s ability to declare or pay cash dividends and prohibits the Company from declaring or making other distributions, subject to certain exceptions. The Refinancing Credit Agreement contains various other covenants and restrictions including the following limitations: incurrence of additional indebtedness; mergers, consolidations and sales of assets and acquisitions; additional liens; sale and leasebacks; permissible investments, loans and advances; certain debt payments; capital expenditures; and imposes a minimum interest expense coverage ratio and a maximum debt to cash flow ratio.
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The Refinancing Credit Agreement contains customary events of default, including payment defaults, failure of representations or warranties to be true in any material respect, covenant defaults, defaults with respect to other indebtedness of the Company, bankruptcy, certain judgments against the Company, ERISA defaults and “change of control” of the Company. The Refinancing Credit Agreement includes the following covenants: a minimum interest coverage ratio of three, maximum debt to cash flow ratio of 3.25 and a minimum net worth of $180 million plus 50% of consolidated net income since September 30, 2003. The Company is in compliance with these measurements and covenants.
6 7/8% Senior Notes Due August 2013
In August 2003, the Company issued $150 million of Senior Notes due in 2013 (“Notes”). The Notes were issued at par. Interest on the Notes will accrue at a rate of 6.875% per annum and is payable semi-annually on January 31 and July 31 of each year. The proceeds were used to repay debt outstanding under the Company’s existing credit agreement, and for general corporate purposes.
The Notes are senior unsecured obligations of the Company and rank pari passu with all existing and future senior debt and are senior to all our existing and future subordinated indebtedness of the Company. The indenture under which the Notes were issued contains covenants and restrictions which limit among other things, the following: the incurrence of indebtedness, payment of dividends and certain distributions, sale of assets, change in control, mergers and consolidations and the incurrence of liens.
On July 31, 2006, the Board of Directors authorized the repurchase of up to $50 million of the Company’s outstanding shares. The Company intends to purchase these shares on the open market or in negotiated or block trades. No time limit was set for the completion of the program which is permitted under the Refinancing Credit Agreement, as well as the 6 7/8% Senior Notes currently outstanding. During the third quarter 2006, 502,400 shares were repurchased at an average price of $26.90 per share.
8. EMPLOYEE BENEFIT PLANS
The Company sponsors defined benefit pension plans that cover certain U.S., Canadian and United Kingdom employees and which provide benefits of stated amounts for each year of service of the employee.
In thousands, except percentages
Net periodic benefit cost
Service cost
Interest cost
Expected return on plan assets
Net amortization/deferrals
Assumptions
Discount rate
Expected long-term rate of return
Rate of compensation increase
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The Company’s funding methods are based on governmental requirements and differ from those methods used to recognize pension expense. The Company expects to contribute $9.4 million to the pension plans during 2006 but expects that this level of funding will decrease in future periods. Rebalancing of the asset allocation occurs on a quarterly basis.
In addition to providing pension benefits, the Company has provided certain unfunded postretirement health care and life insurance benefits for a portion of North American employees. The Company is not obligated to pay health care and life insurance benefits to individuals who had retired prior to 1990.
9. INCOME TAXES
The overall effective income tax rate was 30.5% and 34.2% for the three and nine months ended September 30, 2006 and 34.9% and 35.8% for the three and nine months ended September 30, 2005, respectively. During the quarter ended September 30, 2006, approximately $1.4 million of tax benefit was recognized related to the release of tax contingency reserves.
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10. EARNINGS PER SHARE
The computation of earnings per share is as follows:
Income from continuing operations applicable to common shareholders
Divided by
Basic earnings from continuing operations per share
Divided by sum of the
Conversion of dilutive stock options / non-vested stock
Diluted shares outstanding
Diluted earnings from continuing operations per share
11. WARRANTIES
The following table reconciles the changes in the Company’s product warranty reserve:
Balance at December 31, 2005 and 2004, respectively
Warranty provision
Warranty claim payments
Balance at September 30, 2006 and 2005, respectively
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12. COMMITMENTS AND CONTINGENCIES
Claims have been filed against the Company and certain of its affiliates in various jurisdictions across the United States by persons alleging bodily injury as a result of exposure to asbestos-containing products. Since 2000, the number of such claims has increased and the resolution of these claims may take a significant period of time. Most of these claims have been made against our wholly owned subsidiary, Railroad Friction Products Corporation (RFPC), and are based on a product sold by RFPC prior to the time that the Company acquired any interest in RFPC. On April 17, 2005, a claim against the Company by a former stockholder of RFPC contending that the Company assumed that entity’s liability for asbestos claims arising from exposure to RFPC’s product was resolved in the Company’s favor.
Most of these claims, including all of the RFPC claims, are submitted to insurance carriers for defense and indemnity or to non-affiliated companies that retain the liabilities for the asbestos-containing products at issue. We cannot, however, assure that all these claims will be fully covered by insurance or that the indemnitors will remain financially viable. Our ultimate legal and financial liability with respect to these claims, as is the case with other pending litigation, cannot be estimated.
It is Management’s belief that the potential range of loss for asbestos-related bodily injury cases is not reasonably determinable at present for a variety of factors, including: (1) the limited asbestos case settlement history of the Company’s wholly owned subsidiary, Railroad Friction Products Corporation (RFPC); (2) the unpredictable nature of personal injury litigation in general; and (3) the uncertainty of asbestos litigation in particular. Despite this uncertainty, and although the results of the Company’s operations and cash flows for any given period could be adversely affected by asbestos-related lawsuits, Management believes that the final resolution of the Company’s asbestos-related cases will not be material to the Company’s overall financial position, results of operations and cash flows. In general, this belief is based upon: (1) Wabtec’s and RFPC’s limited history of settlements and dismissals of asbestos-related cases to date; (2) the inability of many plaintiffs to establish any exposure or causal relationship to RFPC’s product; and (3) the inability of many plaintiffs to demonstrate any identifiable injury or compensable loss.
More specifically, as to RFPC, Management’s belief that any losses due to asbestos-related cases would not be material is also based on the fact that RFPC owns insurance which provides coverage for asbestos-related bodily injury claims. To date, RFPC’s insurers have provided RFPC with defense and indemnity in these actions. As to Wabtec and its divisions, Management’s belief that asbestos-related cases will not have a material impact is also based on its position that it has no legal liability for asbestos-related bodily injury claims, and that the former owners of Wabtec’s assets retained asbestos liabilities for the products at issue. To date, Wabtec has been able to successfully defend itself on this basis, including two arbitration decisions and a judicial opinion, all of which confirmed Wabtec’s position that it did not assume any asbestos liabilities from the former owners of certain Wabtec assets. Although Wabtec has incurred defense and administrative costs in connection with asbestos bodily injury actions, these costs have not been material, and the company has no information that would suggest these costs would become material in the foreseeable future.
The GETS-GS litigation described in the Company’s Annual Report on Form 10-K for the Year Ended December 31, 2005 was settled in April of 2006 for $3.8 million, which had been reserved for in prior years.
In April 2005, Amtrak decided to suspend its Acela Express train service due to cracks in the spokes of some of the cars’ brake discs. Amtrak’s Acela service was resumed on a limited basis in July, 2005, and complete service was resumed in September, 2005. Wabtec did not design or supply the braking system for the Acela cars. The braking system was supplied by Knorr Brake Corporation and the brake discs were designed by
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Faiveley Transport. Wabtec did provide and machined approximately one-third of the brake discs for the cars and assisted Amtrak and others, including Bombardier Corporation, Alstom Transportation Inc., Knorr and Faiveley, in their evaluation and investigation of the brake disc cracks.
On July 11, 2005 Wabtec received a written notice of a potential claim for damages from Knorr and on March 2, 2006 received a notice from Knorr in which Knorr stated that Amtrak is of the view that it may have warranty claims against Wabtec, Knorr, and Faiveley. Neither Knorr notice specified any amount or range of claims against the Company, although Knorr has indicated that it expects the Company to participate in any financial settlement arising from the alleged defects and failures of the Acela brake discs. Wabtec, in turn, has forwarded Knorr’s notices to Faiveley and has notified Faiveley of potential claims by Wabtec against Faiveley.
In a presentation provided to Wabtec and Faiveley on August 22, 2006, Bombardier claimed that it has reached a settlement with Amtrak and Knorr related to the suspension of Amtrak’s Acela service. Bombardier has alleged that it has incurred damages of approximately $38 million, and has been assigned the rights to pursue additional claims by Amtrak and Knorr of approximately $17 million and $10 million, respectively. Wabtec has contacted Faiveley, asserting that Faiveley is fully responsible for any claims made by Bombardier, including the assigned claims of Amtrak and Knorr. Wabtec does not believe that it has any material legal liability with regard to this matter.
In March 2006, management began an internal investigation related to business transactions conducted by a subsidiary, Pioneer Friction Limited (“Pioneer”), in West Bengal, India. Through an internal compliance review, management discovered that disbursements were made which may be in violation of applicable laws and regulations. Pioneer is a fourth-tier subsidiary of Wabtec; two of the intermediate subsidiaries are Australian companies which are, in turn, owned by a U.S. holding company.
While the transactions are inconsequential and not material to the overall operations of Wabtec, they may result in potential penalties. Management has concluded its investigation, and has notified Wabtec’s Audit Committee, Board of Directors, and the appropriate authorities of its findings. Wabtec has not recorded a reserve related to this matter as of September 30, 2006; because the Company’s potential exposure cannot be estimated based on management’s assessment of the situation.
The Company is subject to a number of other commitments and contingencies as described in its Annual Report on Form 10-K for the Year Ended December 31, 2005, filed on March 16, 2006. During the first nine months of 2006, there were no material changes other than what is discussed above to the information described in Note 18 therein.
13. SEGMENT INFORMATION
Wabtec has two reportable segments—the Freight Group and the Transit Group. The key factors used to identify these reportable segments are the organization and alignment of the Company’s internal operations, the nature of the products and services, and customer type. The business segments are:
Freight Group manufactures products and provides services geared to the production and operation of freight cars and locomotives, including braking control equipment, on-board electronic components and train coupler equipment. Revenues are derived from OEM sales, aftermarket sales and freight car repairs and services.
Transit Group consists of products for passenger transit vehicles and locomotives (typically subways, commuter rail and buses) that include braking, coupling, monitoring systems, climate control and door equipment engineered to meet individual customer specifications, as well as commuter rail locomotives. Revenues are derived from OEM and aftermarket sales as well as from repairs and services.
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The Company evaluates its business segments’ operating results based on income from operations. Corporate activities include general corporate expenses, elimination of intersegment transactions, interest income and expense and other unallocated charges. Since certain administrative and other operating expenses and other items have not been allocated to business segments, the results in the following tables are not necessarily a measure computed in accordance with generally accepted accounting principles and may not be comparable to other companies.
Beginning with the first quarter of 2006, the Company transferred certain operations from the Freight to the Transit Group to reflect a shift in the markets and customers served by those operations. For the three month period ended September 30, 2005, this reclassification increased Transit Group sales by about $22 million and income from continuing operations before income taxes by $2.7 million. For the nine month period ended September 30, 2005, this reclassification increased Transit Group sales by about $63 million and income from continuing operations before income taxes by $8.0 million. Prior period results have been adjusted for comparability purposes.
Segment financial information for the three months ended September 30, 2006 is as follows:
Sales to external customers
Intersegment sales/(elimination)
Total sales
Income (loss) from operations
Interest income (expense) and other
Income (loss) from continuing operations before income taxes
Freight Group income from continuing operations before income taxes included the $6.8 million restructuring expense recorded in the three months ended September 30, 2006.
Segment financial information for the three months ended September 30, 2005 is as follows:
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Segment financial information for the nine months ended September 30, 2006 is as follows:
Freight Group income from continuing operations before income taxes included the $6.8 million restructuring expense recorded in the nine months ended September 30, 2006.
Segment financial information for the nine months ended September 30, 2005 is as follows:
Sales by product for the three months ended September 30, is as follows:
Brake Products
Freight Electronics & Specialty Products
Remanufacturing, Overhaul & Build
Transit Products
Other
Total Sales
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Sales by product for the nine months ended September 30, is as follows:
14. GUARANTOR SUBSIDIARIES FINANCIAL INFORMATION
Effective August 2003, the Company issued $150 million of Senior Notes due in 2013 (“Notes”). The obligations under the Notes are fully and unconditionally guaranteed by all U.S. subsidiaries as guarantors. In accordance with positions established by the Securities and Exchange Commission, the following shows separate financial information with respect to the parent, the guarantor subsidiaries and the non-guarantor subsidiaries. The principal elimination entries eliminate investment in subsidiaries and certain intercompany balances and transactions.
Balance Sheet as of September 30, 2006:
Cash
Accounts Receivable
Other Current Assets
Total Current Assets
Net Property, Plant and Equipment
Investment in Subsidiaries
Intangibles
Other Long Term Assets
Intercompany
Long-Term Debt
Other Long Term Liabilities
Total Liabilities
Stockholders’ Equity
Total Liabilities and Stockholders’ Equity
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Balance Sheet as of December 31, 2005:
Income Statement for the Three Months Ended September 30, 2006:
Net Sales
Cost of Sales
Gross Profit (Loss)
Operating Expenses
Operating Profit (Loss)
Interest (Expense) Income
Other (Expense) Income
Equity Earnings
Income (Loss) From Continuing Operations Before Income Taxes
Income Tax Benefit (Expense)
Income (Loss) From Continuing Operations
Discontinued Operations
Net Income (Loss)
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Income Statement for the Three Months Ended September 30, 2005:
Income Statement for the Nine Months Ended September 30, 2006:
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Income Statement for the Nine Months Ended September 30, 2005:
Condensed Statement of Cash Flows for the Nine Months Ended September 30, 2006:
Net Cash Provided by (Used in) Operating Activities
Net Cash (Used in) Provided by Investing Activities
Net Cash Provided by (Used in) Financing Activities
Effect of Changes in Currency Exchange Rates
Increase (Decrease) in Cash
Cash at Beginning of Period
Cash at End of Period
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Condensed Statement of Cash Flows for the Nine Months Ended September 30, 2005:
Net Cash Used in Investing Activities
15. OTHER EXPENSE
The components of other expense are as follows:
Ended September 30,
Foreign currency loss
Other miscellaneous expense (income)
Total other expense
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The following discussion should be read in conjunction with the information in the unaudited condensed consolidated financial statements and notes thereto included herein and Westinghouse Air Brake Technologies Corporation’s Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in its 2005 Annual Report on Form 10-K, filed March 16, 2006.
OVERVIEW
Management Review and Outlook
Wabtec’s long-term financial goals are to generate free cash flow in excess of net income, maintain a strong credit profile while minimizing our overall cost of capital, increase margins through strict attention to cost controls, and increase revenues through a focused growth strategy. In addition, management monitors the Company’s short-term operational performance through measures such as quality and on-time delivery.
Freight rail industry statistics, such as carloadings and orders for new freight cars, are continuing to improve in 2006. Through the first nine months of 2006, deliveries of new freight cars increased 12% and orders increased 40%, compared to the same period in 2005. As a result, at September 30, 2006, the backlog of freight cars ordered was 88,116. Sales in our freight segment have benefited from that trend. Following are quarterly freight car statistics for the past three years:
First quarter 2004
Second quarter 2004
Third quarter 2004
Fourth quarter 2004
First quarter 2005
Second quarter 2005
Third quarter 2005
Fourth quarter 2005
First quarter 2006
Second quarter 2006
Third quarter 2006
Deliveries of transit cars were 918 and 819 for the years ended December 31, 2005 and 2004, respectively. Deliveries of locomotives were 1,106 and 1,202 for the years ended December 31, 2005 and 2004, respectively.
Source: Railway Supply Institute and Management Estimates (* Figures that do not roll forward period to period reflect minor adjustments subsequent to that period from figures reported by the Railway Supply Institute.)
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Carloadings and Intermodal Units Originated have increased over the past three years reflecting higher rail traffic and ultimately better opportunities for maintenance and aftermarket sales for the Company:
Carloadings Originated (in thousands):
2004
2005
2006
Intermodal Units Originated (in thousands):
Source: Association of American Railroads—Weekly Rail Traffic
In addition to this cyclical rebound in orders and rail traffic, we expect to generate future increases in sales and earnings from executing our four-point growth strategy:
In 2006 and beyond, we will continue to face many challenges, including increased costs for raw materials, especially steel; higher costs for medical and insurance premiums; and foreign currency fluctuations. In addition, we face general economic risks, as well as the risk that our customers could curtail spending on new and existing equipment. Risks associated with our four-point growth strategy include the level of investment that customers are willing to make in new technologies developed by the industry and the Company, and risks inherent in global expansion. When necessary, we will modify our financial and operating strategies to reflect changes in market conditions and risks.
On July 19, 2006, the Board of Directors approved a restructuring plan to improve the profitability and efficiency of certain business units. As part of the plan, Wabtec downsized two of its Canadian plants, in Stoney Creek and Wallaceburg, by moving certain products to lower-cost facilities and outsourcing. Wabtec recorded expenses of $6.8 million in the 2006 third quarter for restructuring and other expenses, as a result of the approval of this plan. These expenses were comprised of the following components: $1.5 million for employee severance costs associated with approximately 240 salaried and hourly employees located at our Wallaceburg and Stoney Creek locations; $2.0 million of pension curtailment for those employees; $2.9 million related to asset impairments for structures, machinery, and equipment; and $540,000 for goodwill impairment specific to the Wallaceburg facility. As of September 30, 2006, the employees associated with the restructuring program had been terminated and none of the severance has been paid. Severance costs are contractual liabilities and payment is dependent on the waiver by or expiration of certain seniority rights of those employees.
The restructuring plan will result in the additional charges in the first half of 2007 of $1.5 million, pre-tax, primarily for pension-related settlement charges. Pension funding will be subject to regulatory review and approval and funding is anticipated to be made in the first half of 2007.
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RESULTS OF OPERATIONS
The following table shows our Consolidated Statements of Operations for the periods indicated.
In millions
Selling, general and administrative expenses
Engineering expenses
THIRD QUARTER 2006 COMPARED TO THIRD QUARTER 2005
The following table summarizes the results of operations for the period:
Net sales increased by $13.2 million to $268.9 million from $255.7 million for the three months ended September 30, 2006 and 2005, respectively. The increase is primarily related to increased sales from contracts to build locomotives of about $14 million and increased revenues from our electronics business unit of $17 million, partially offset by volume decreases of $15 million for certain freight components, and $7 million for the renovation of air conditioning units for transit cars. The Company did not realize any significant net sales improvement because of price increases or foreign exchange. Net income for the three months ended September 30, 2006 was $17.4 million or $0.35 per diluted share. Net income for the three months ended September 30, 2005 was $15.1 million or $0.31 per diluted share. As part of a restructuring plan, Wabtec recognized $6.8 million in the 2006 third quarter for restructuring and other charges. Net income improved primarily due to sales increases, consistent operating costs, lower interest expense of $2.2 million, reduced other expense of $1 million, and a tax benefit of $1.4 million that resulted from the resolution of certain tax issues from prior years. Offsetting these improvements was stock based compensation expense recognized under SFAS 123(R).
Net sales by segment Beginning with the first quarter of 2006, the Company transferred certain operations from the Freight to Transit Group to reflect a shift in the markets and customers served by those operations. Prior
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period results have been adjusted for comparability purposes. For the three-month period ended September 30, 2005, this reclassification increased Transit Group sales by about $22 million. The following table shows the Company’s net sales by business segment:
Freight Group
Transit Group
The Freight Group’s increased sales reflected increased sales of aftermarket parts offset by decreased OEM sales of certain freight components and locomotive module contracts. Transit Group sales were higher due to increased commuter locomotive revenues.
Gross profit Gross profit decreased to $66.2 million in the third quarter of 2006 compared to $67.0 million in the same period of 2005. Gross profit is dependent on a number of factors including pricing, sales volume and product mix. In the third quarter of 2006, gross profit, as a percentage of sales, was 24.6% compared to 26.2% in 2005. The restructuring plan charges impacted gross margin, with $6.3 million being recorded in cost of sales. Gross profit, as a percentage of sales, excluding these charges, would have been 27.0%, which improvement is due to a variety of factors including improved performance of a locomotive module contract which was profitable in the third quarter compared to a loss in the prior year same periods. For the three months ended September 30, 2006, the locomotive module contract overall improvement was $2.1 million from the losses realized in the prior year. The remaining improvement is due to cost savings realized from sourcing raw materials from lower cost suppliers, reduced labor costs, and continuing improvements in our manufacturing processes.
The provision for warranty expense was $1.8 million higher for the third quarter of 2006 compared to the same period in the prior year, which negatively impacted gross profit. The most significant reason for the increase is due to specific reserves related to certain transit door components of $1.4 million being recognized for our North America operations. In general, reserves, which are established based on historical claims as a percentage of revenue, were higher for the locomotive manufacture and overhaul business unit. Sales have increased resulting in a higher reserve compared to prior quarter. Overall, our warranty reserve increased at September 30, 2006 compared to September 30, 2005 by $3.4 million as reserves were established before claims were paid related to specific and general provisions discussed above.
Operating expenses The following table shows our operating expenses:
Percent
Change
Operating expenses increased $1.0 million in the third quarter of 2006 compared to the same period of 2005. These expenses were 15.1% and 15.5% of sales for the quarters ended September 30, 2006 and 2005, respectively. The increase is due to expense recognized in connection with the adoption of SFAS 123(R) and certain other share-based compensation accruals for long-term incentive plans. Stock based compensation was
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$1.7 million and $955,000 for the three months ended September 30, 2006 and 2005, respectively. Amortization expense increased in 2006 due to the $540,000 goodwill impairment related to the restructuring plan approved and implemented in the third quarter.
Income from operations Income from operations totaled $25.5 million (or 9.5% of sales) in the third quarter of 2006 compared with $27.3 million (or 10.7% of sales) in the same period of 2005. The decrease is due to increased sales and corresponding gross profit, offset by the $6.8 million restructuring charge described earlier.
Interest income (expense), net Interest income, net was $196,000 in the third quarter of 2006 compared to interest expense of $2.2 million in the same period of 2005 primarily due to the Company’s overall higher cash balances and rising interest rates, resulting in higher interest income.
Other income (expense), net The Company recorded a foreign exchange loss of $124,000 and $1.4 million, in the three months ended September 30, 2006 and 2005, respectively, due to the effect of currency exchange rate changes on intercompany transactions that are non U.S. dollar denominated amounts and charged or credited to earnings.
Income taxes The effective income tax rate was 30.5% and 34.9% for the third quarter of 2006 and 2005, respectively. During the third quarter of 2006, approximately $1.4 million of tax benefit was recognized related to the release of tax contingency reserves as the result of the closure of open tax years as well as settlements reached with taxing authorities.
Net income Net income for the third quarter of 2006 increased $2.3 million, compared with the same period of 2005. This increase is the result of higher sales, decreased interest expense, net, decreased foreign exchange loss, and lower income taxes, offset by decreased gross margin because of the $6.8 million restructuring charge and higher operating costs specific to the adoption of SFAS 123(R).
FIRST NINE MONTHS OF 2006 COMPARED TO FIRST NINE MONTHS OF 2005
Net sales increased by 3.5% from $793.2 million in the first nine months of 2005 to $763.8 million in the same period in 2006. The increase is primarily related to increased sales of locomotives of about $20 million and increased revenues from our services, radiator and electronics business units of $30 million, partially offset by volume decreases in transit related sales for doors and brakes; and certain overhaul contracts of $21 million. Net income for the first nine months of 2006 was $58.6 million or $1.20 per diluted share. Net income for the same period of 2005 was $39.5 million or $0.83 per diluted share. As part of a restructuring plan, Wabtec recognized $6.8 million in the 2006 third quarter for restructuring and other charges. Net income improved due to higher sales volume and gross profit on sales, lower interest expense of $5.6 million, reduced other expense of $1.8 million, and a tax benefit of $1.4 million that resulted from the resolution of certain tax issues from prior years. Offsetting these improvements was the increase of stock based compensation expense of about $6.1 million
Net sales by segment Beginning with the first quarter of 2006, the Company transferred certain operations from the Freight to the Transit Group to reflect a shift in the markets and customers served by those operations.
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Prior period results have been adjusted for comparability purposes. For the nine months ended September 30, 2005, this reclassification increased Transit Group sales by about $62 million. The following table shows the Company’s net sales by business segment:
The Freight Group’s increased sales reflected higher sales of aftermarket parts. Decreases in OEM sales for certain freight components and locomotive module contracts were offset by increased freight brake sales. Transit Group sales were slightly lower due to a decline in transit revenue while certain large transit car contracts ramp up for 2007.
Gross profit Gross profit increased to $218.0 million for the first nine months of 2006 compared to $190.2 million in the same period of 2005. Gross profit is dependent on a number of factors including pricing, sales volume and product mix. In the first nine months of 2006, gross profit, as a percentage of sales, was 27.5% compared to 24.9% in 2005. In the third quarter of 2006, restructuring plan expense of $6.3 million were recorded in cost of sales. 2006 gross profit, as a percentage of sales, excluding these charges, would have been 28.3%, which improvement is due to a variety of factors including improved performance of a locomotive module contract which was profitable for the first nine months of 2006 compared to a loss in the prior year same periods. Also, in the first nine months of 2005, the Company recorded $2.3 million in restructuring and asset impairment charges related to consolidating two U.K. facilities into one, relocating a product line from Canada to the U.S., and completion of a data center migration. 2005 gross profit, as a percentage of sales, excluding these charges, would have been 25.2%. The remaining improvement is due to cost savings realized from sourcing raw materials from lower cost suppliers, reduced labor costs, and continuing improvements in our manufacturing processes.
The provision for warranty expense was $4.2 million higher for the nine months of 2006 compared to the same period in the prior year, which negatively impacted gross profit. The most significant reason for the increase is due to specific reserves related to certain transit door components of $1.4 million being recognized for North America operations; and other freight components and electronic products. In general, reserves, which are established based on historical claims as a percentage of revenue, were higher for the locomotive manufacture and overhaul business unit, due to higher sales in that unit. Sales have increased resulting in a higher reserve compared to prior period. Overall, our warranty reserve increased at September 30, 2006 compared to September 30, 2005 by $3.4 million as reserves were established before claims were paid related to specific provisions discussed above.
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Operating expenses increased $6.6 million in the first nine months of 2006 compared to the same period of 2005. These expenses were 15.7% and 15.5% of sales for the first nine months ended September 30, 2006 and 2005, respectively. The increase is due primarily to expense recognized in connection with the adoption of SFAS 123(R) and certain other share-based compensation accruals for long-term incentive plans. During 2005, operating expenses included an information technology asset write-off of $1.1 million. Stock based compensation was $7.7 million and $1.6 million for the nine months ended September 30, 2006 and 2005, respectively. The primary reason for the increase in stock based compensation expense between years is the issuance of shares in 2006 under a non-vested stock plan.
Income from operations Income from operations totaled $93.1 million (or 11.7% of sales) in the first nine months of 2006 compared with $71.9 million (or 9.4% of sales) in the same period of 2005. This increase is due to increased sales and improved gross profit described earlier.
Interest expense, net Interest expense, net decreased 80.4% in the first nine months of 2006 compared to the same period of 2005 primarily due to the Company’s overall higher cash balances and rising interest rates, resulting in higher interest income.
Other income (expense), net The Company recorded a foreign exchange loss of $1.1 million and $3.1 million in the nine months ended September 30, 2006 and 2005, respectively, due to the effect of currency exchange rate changes on intercompany transactions that are non U.S. dollar denominated amounts and charged or credited to earnings.
Income taxes The effective income tax rate was 34.2% and 35.8% for the first nine months of 2006 and 2005, respectively. During the third quarter of 2006, approximately $1.4 million of tax benefit was recognized related to the release of tax contingency reserves.
Net income Net income for the first nine months of 2006 increased $19.1 million, compared with the same period of 2005. This increase is the result of higher sales, decreased interest expense, net, decreased foreign exchange loss, and lower income taxes, offset by decreased gross margin because of the $6.8 million restructuring charge and higher operating costs specific to the adoption of SFAS 123(R).
Liquidity and Capital Resources
Liquidity is provided primarily by operating cash flow and borrowing capacity under the Company’s unsecured credit facility with a consortium of commercial banks. The following is a summary of selected cash flow information and other relevant data.
Cash provided (used) by:
Operating activities
Investing activities
Financing activities
Net Change in Cash
Operating activities Cash provided by operations in the first nine months of 2006 was $109.9 million as compared to $47.3 million in the same period of 2005. This $62.1 million increase was the result of increased earnings as well as certain changes in operating assets and liabilities. Net income for the Company increased $19.1 million primarily as a result of improved profitability. Cash provided by accounts receivable improved operating cash flows by $78.4 million, and was the result of the Company collecting large customer receivables in 2006 for certain locomotive contracts. In particular, customer deposits from certain locomotive contracts
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accounted for the majority of the cash provided from operations. Accrued income taxes decreased operating cash flows by $5.5 million due to the timing of tax payments. Accounts payable and accrued liabilities were a use of cash by $31.7 million compared to the prior period as accounts payable and other certain liabilities were reduced based on the timing of certain payments.
Investing activities In the first nine months of 2006 and 2005, cash used in investing activities was $9.8 million and $51.8 million, respectively. In 2005, the Company acquired the assets of Rütgers Rail S.p.A. for $36.3 million, net of cash received. Capital expenditures were $13.5 million and $16.4 million in the first nine months of 2006 and 2005, respectively. The majority of capital expenditures for these periods related to upgrades to and replacement of existing equipment. Effective October 9, 2006, Wabtec acquired Schaefer Equipment, Inc., manufacturer of forged brake rigging components, for $36.0 million in cash.
Financing activities In the first nine months of 2006 and 2005, cash provided by financing activities was $3.0 million and $18.1 million, respectively. The cash provided in 2006 included $13.6 million of proceeds from the exercise of stock options and other benefit plans, offset by $1.5 million of dividend payments and $13.5 million for the repurchase of 502,400 shares of stock. The cash provided in 2005 included $19.6 million of proceeds from the exercise of stock options and other benefit plans, offset by $1.4 million of dividend payments.
The following table shows our outstanding indebtedness at September 30, 2006 and December 31, 2005.
6.875% Senior notes due 2013
Less-current portion
Cash balance at September 30, 2006 and December 31, 2005 was $247.6 million and $141.4 million, respectively.
In January 2004, the Company refinanced its existing unsecured revolving credit agreement with a consortium of commercial banks. This “Refinancing Credit Agreement” provided a $175 million five-year revolving credit facility expiring in January 2009. In November 2005, the Company entered into an amendment to the Refinancing Credit Agreement which, among other things, extended the expiration of the agreement until December 2010. At September 30, 2006, the Company had available bank borrowing capacity, net of $23.7 million of letters of credit, of approximately $151.3 million, subject to certain financial covenant restrictions.
Under the Refinancing Credit Agreement, the Company may elect a base interest rate or an interest rate based on the London Interbank Offered Rates of Interest (“LIBOR”). The base interest rate is the greater of LaSalle Bank National Association’s prime rate or the federal funds effective rate plus 0.5% per annum. The LIBOR rate is based on LIBOR plus a margin that ranges from 62.5 to 175 basis points depending on the Company’s consolidated total indebtedness to cash flow ratios. The current margin is 62.5 basis points.
The Refinancing Credit Agreement limits the Company’s ability to declare or pay cash dividends and prohibits the Company from declaring or making other distributions, subject to certain exceptions. The Refinancing Credit Agreement contains various other covenants and restrictions including the following
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limitations: incurrence of additional indebtedness; mergers, consolidations and sales of assets and acquisitions; additional liens; sale and leasebacks; permissible investments, loans and advances; certain debt payments; capital expenditures; and imposes a minimum interest expense coverage ratio and a maximum debt to cash flow ratio.
In August 2003, the Company issued $150 million of Senior Notes due in 2013 (the “Notes”). The Notes were issued at par. Interest on the notes accrues at a rate of 6.875% per annum and is payable semi-annually on January 31 and July 31 of each year. The proceeds were used to repay debt outstanding under the Company’s existing credit agreement, and for general corporate purposes.
The Company believes, based on current levels of operations and forecasted earnings, cash flow and liquidity will be sufficient to fund its working capital and capital equipment needs as well as to meet its debt service requirements. If the Company’s sources of funds were to fail to satisfy the Company’s cash requirements, the Company may need to refinance its existing debt or obtain additional financing. There is no assurance that such new financing alternatives would be available, and, in any case, such new financing, if available, would be expected to be more costly and burdensome than the debt agreements currently in place.
Forward Looking Statements
We believe that all statements other than statements of historical facts included in this report, including certain statements under “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” may constitute forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. Although we believe that our assumptions made in connection with the forward-looking statements are reasonable, we cannot assure you that our assumptions and expectations are correct.
These forward-looking statements are subject to various risks, uncertainties and assumptions about us, including, among other things:
Economic and industry conditions
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Operating factors
Competitive factors
Political/governmental factors
Transaction or commercial factors
Statements in this 10-Q apply only as of the date on which such statements are made, and we undertake no obligation to update any statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.
Critical Accounting Policies
The preparation of the financial statements in accordance with generally accepted accounting principles requires management to make judgments, estimates and assumptions regarding uncertainties that affect the
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reported amounts of assets and liabilities, disclosure of contingent assets and liabilities and the reported amounts of revenues and expenses. Areas of uncertainty that require judgments, estimates and assumptions include the accounting for derivatives, environmental matters, warranty reserves, the testing of goodwill and other intangibles for impairment, proceeds on assets to be sold, pensions and other postretirement benefits, and tax matters. Management uses historical experience and all available information to make these judgments and estimates, and actual results will inevitably differ from those estimates and assumptions that are used to prepare the Company’s financial statements at any given time. Despite these inherent limitations, management believes that Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) and the financial statements and related footnotes provide a meaningful and fair perspective of the Company. A discussion of the judgments and uncertainties associated with accounting for derivatives and environmental matters can be found in the “Notes to Consolidated Financial Statements” included elsewhere in this report.
On January 1, 2006, Wabtec adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment,” which requires the company to recognize compensation expense for stock-based compensation based on the fair value of the share-based employee grants. SFAS No. 123(R) revises SFAS No. 123 “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Wabtec elected the modified prospective application method for adoption, and prior periods financial statements have not been restated.
SFAS No. 123(R) requires Wabtec to recognize compensation expense for stock-based compensation ratably over the requisite service period based on the fair value of the grant. Using the Black Scholes pricing model, determining the fair value of stock options at grant date requires judgment including estimates for the average risk-free interest rate, expected volatility, expected exercise behavior, expected dividend yield, and expected forfeitures. If any of these assumptions differ significantly from actual, stock-based compensation expense could be impacted. Compensation expense for the Employee Stock Purchase Plan, and Non-Vested Stock awards are based on fair market values determined at the date of award. Prior to the adoption of SFAS No. 123(R), the company accounted for stock-based compensation in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations using the intrinsic value method, which resulted in no compensation cost for options granted.
Stock based compensation was $7.7 million and $1.6 million for the nine months ended September 30, 2006 and 2005, respectively. The primary reason for the increase in stock based compensation expense between years is the issuance of shares in 2006 under a non-vested stock plan and increased expense under a stock based incentive plan as a result of the improved performance of the Company. The accounting for the non-vested stock and the stock awards under the incentive plan was not impacted significantly by the adoption of FAS 123(R). In addition, compensation expense of $849,000 was recorded for the nine months ended September 30, 2006 related to the expensing of stock options in accordance with FAS 123(R).
The Company uses a Black-Scholes pricing model to estimate the fair value of stock options at grant date. Determining the fair value of stock options at grant date requires judgment, including estimates for the dividend yield, the average risk-free interest rate, expected volatility and expected life. The dividend yield is based on the Company’s dividend rate and the current market price of the underlying common stock. The risk-free interest rate is based on the U.S. Treasury bond rate for the expected life of the option. Expected life in years is determined from historical stock option exercise data. Expected volatility is based on the historical volatility of Wabtec stock. If any of these assumptions differ significantly from actual, stock-based compensation expense could be impacted.
Stock awards under the incentive plans vest upon the achievement of certain financial goals for each three year period ending at December 31, 2006, 2007 and 2008, respectively. We estimate that the majority of stock awards granted will vest and have recorded compensation expense accordingly. If our estimate of the number of these stock awards expected to vest changes in a future accounting period, compensation expense could be reduced and will be recognized over the remaining vesting period.
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A summary of the Company’s significant accounting policies is included in Note 2 in the “Notes to Consolidated Financial Statements” included elsewhere in this report. Management believes that the application of these policies on a consistent basis enables the Company to provide the users of the financial statements with useful and reliable information about the Company’s operating results and financial condition.
Description
Judgments and Uncertainties
Effect if Actual Results Differ From
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If actual results are notconsistent with our assumptionsand judgments used inestimating future cash flows andasset fair values, we may beexposed to additionalimpairment losses that could bematerial to our results ofoperations.
Significant judgments and estimates are used in determining the liabilities and expenses for pensions and other postretirement benefits.
The rate used to discount future estimated liabilities is determined considering the rates available at year-end on debt instruments that could be used to settle the obligations of the plan. The long-term rate of return is estimated by considering historical returns and expected returns on current and projected asset allocations and is generally applied to a five-year average market value of assets.
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An adjustment to the estimatedliability would be recordedthrough income in the period inwhich it becomes probable thatthe amount of the actual liabilitydiffers from the recordedamount.
Certain pre-production costs relating
to long term production and supply contracts have been deferred and will be recognized over the life of the contracts.
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Recent Accounting Pronouncements
See Notes 2 and 6 of “Notes to Condensed Consolidated Financial Statements” included elsewhere in this report.
Interest Rate Risk
In the ordinary course of business, Wabtec is exposed to risks that increases in interest rates may adversely affect funding costs associated with its variable-rate debt. There was no outstanding variable-rate debt at September 30, 2006.
Foreign Currency Exchange Risk
The Company occasionally enters into several types of financial instruments for the purpose of managing its exposure to foreign currency exchange rate fluctuations in countries in which the Company has significant operations. As of September 30, 2006, we had several such instruments outstanding to hedge currency rate fluctuation in 2006.
The Company entered into foreign currency forward contracts to reduce the impact of changes in currency exchange rates. Forward contracts are agreements with a counterparty to exchange two distinct currencies at a set exchange rate for delivery on a set date at some point in the future. There is no exchange of funds until the delivery date. At the delivery date we can either take delivery of the currency or settle on a net basis. All outstanding forward contracts and option agreements are for the sale of U.S. Dollars (USD) and the purchase of Canadian Dollars (CAD). As of September 30, 2006, the Company has forward contracts with a notional value of $15.0 million CAD (or $12.6 million U.S.), with an average exchange rate of $0.84 USD per $1 CAD, resulting in the recording of a current asset and an increase in comprehensive income of $732,000 net of tax.
Wabtec is also subject to certain risks associated with changes in foreign currency exchange rates to the extent its operations are conducted in currencies other than the U.S. dollar. For the first nine months of 2006, approximately 66% of Wabtec’s net sales are in the United States, 11% in Canada, 2% in Mexico, and 21% in other international locations, primarily Europe.
Wabtec’s principal executive officer and its principal financial officer have evaluated the effectiveness of Wabtec’s “disclosure controls and procedures,” (as defined in Exchange Act Rule 13a-15(e)) as of September 30, 2006. Based upon their evaluation, the principal executive officer and principal financial officer concluded that Wabtec’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by Wabtec in the reports filed or submitted by it under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and to provide reasonable assurance that information required to be disclosed by Wabtec in such reports is accumulated and communicated to Wabtec’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
There was no change in Wabtec’s “internal control over financial reporting” (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2006, that has materially affected, or is reasonably likely to materially affect, Wabtec’s internal control over financial reporting.
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PART II—OTHER INFORMATION
Except as disclosed in Note 12 of the Company’s Notes to Condensed Consolidated Financial Statements for the Quarterly Period Ended September 30, 2006, there have been no other material changes to report regarding the Company’s commitments and contingencies as described in Note 18 of the Company’s Annual Report on Form 10-K for the Year Ended December 31, 2005.
There have been no material changes in our risk factors from those disclosed in our 2005 Annual Report on Form 10-K.
Period
ApproximateDollar Valueof Shares
that May
Yet BePurchased
July 2, 2006 to July 29, 2006
July 30, 2006 to August 26, 2006
August 27, 2006 to September 30, 2006
On July 31, 2006, the Board of Directors authorized the repurchase of up to $50 million of the Company’s outstanding shares. The Company intends to purchase these shares on the open market or in negotiated or block trades. No time limit was set for the completion of the program which qualifies under the Refinancing Credit Agreement, as well as the 6 7/8% Senior Notes currently outstanding. During the third quarter 2006, 502,400 shares were repurchased at an average price of $26.90 per share.
The following exhibits are being filed with this report:
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Alvaro Garcia-Tunon,
Senior Vice President,
Chief Financial Officer and Secretary
November 9, 2006
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EXHIBIT INDEX
Description and Method of Filing
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