Woodward - 10-Q quarterly report FY

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

See accompanying Notes to Consolidated Financial Statements.

See accompanying Notes to Consolidated Financial Statements.

See accompanying Notes to Consolidated Financial Statements.

See accompanying Notes to Consolidated Financial Statements.

      The consolidated balance sheet as of June 30, 2005, the statements of consolidated earnings for the three and nine-month periods ended June 30, 2005 and 2004, and the statements of consolidated cash flows for the nine-month periods ended June 30, 2005 and 2004, were prepared by the company without audit. The September 30, 2004, consolidated balance sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. Information in this 10-Q report is based in part on estimates and is subject to year-end adjustments and audit. In our opinion, the figures reflect all adjustments necessary to present fairly the company’s financial position as of June 30, 2005, the results of its operations for the three and nine-month periods ended June 30, 2005 and 2004, and its cash flows for the nine-month periods ended June 30, 2005 and 2004. All such adjustments were of a normal and recurring nature. The statements were prepared following the accounting policies described in the company’s 2004 annual report on Form 10-K/A Amendment No. 1 and should be read with the Notes to Consolidated Financial Statements on pages 38-58 of the 2004 annual report to shareholders. The statements of consolidated earnings for the three and nine-month periods ended June 30, 2005, are not necessarily indicative of the results to be expected for other interim periods or for the full year.

      We use the intrinsic value method to account for stock-based employee compensation under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and therefore we do not recognize compensation expense in association with options granted at or above the market price of our common stock at the date of grant. The following table presents a reconciliation of reported net earnings and per share information to pro forma net earnings and per share information that would have been reported if the fair value method had been used to account for stock-based employee compensation:

      We recognize sales when delivery of product has occurred or services have been rendered and there is persuasive evidence of a sales arrangement, selling prices are fixed or determinable, and collectibility from the customer is reasonably assured. We consider product delivery to have occurred when the customer has taken title and assumed the risks and rewards of ownership of the products. Most of our sales are made directly to customers that use our products, although we also sell products to distributors, dealers, and independent service facilities. Sales terms for distributors, dealers, and independent service facilities are identical to our sales terms for direct customers. We account for payments made to customers as a reduction of revenue unless

      In November 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 151, “Inventory Costs.” The Statement clarifies that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) should be recognized as current-period charges. This Statement also requires that allocations of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The Statement becomes effective for our fiscal year beginning October 1, 2005. We currently do not expect that application of this Statement will have any material effect on our financial statements.

      In December 2004, the Financial Accounting Standards Board issued a revised Statement of Financial Accounting Standards No. 123, “Share-Based Payment.” Among its provisions, the revised Statement will require us to measure the cost of employee services in exchange for an award of equity instruments based on the grant-date fair value of the award and to recognize the cost over the requisite service period. In accordance with a Securities and Exchange Commission rule issued in April 2005, this revised Statement becomes effective for our fiscal year beginning October 1, 2005, although early adoption is allowed. As described in Note 2 to these financial statements, we currently use the intrinsic value method to account for stock-based employee compensation. As a result, adoption of this revised Statement is expected to reduce our net earnings in interim and annual periods after adoption. We believe the best indication of the approximate immediate net earnings effect of adopting the provisions of this revised Statement may be determined by reviewing Note 2 to these financial statements and Note 1 to Consolidated Financial Statements on page 39 of the 2004 annual report to shareholders, which was filed with our Form 10-K/A Amendment No. 1 for the year ended September 30, 2004. These notes show that net earnings would have decreased by $0.02 per diluted share for the quarter ended June 30, 2005, $0.08 per diluted share for the nine months ended June 30, 2005, and $0.11 per diluted share for the year ended September 30, 2004. We expect to adopt this revised Statement effective with our fiscal year beginning October 1, 2005.

      Income taxes in the three months and nine months ended June 30, 2005, were affected by changes in estimates of income taxes for previous periods. The changes in estimates resulted from increases in the amount of certain credits claimed or expected to be claimed, and changes in the amount of certain deductions taken or expected to be taken. A reconciliation of our effective income tax rate for the year ended September 30, 2004, to the effective income tax rates for the three months and nine months ended June 30, 2005, follows:

      The following stock options were outstanding during the three and nine months ended June 30, 2005 and 2004, but were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares during the respective periods:

      Amortization expense associated with current intangibles is expected to be approximately $7,100,000 for 2005, $7,000,000 for 2006, $6,600,000 in 2007, $5,900,000 for 2008, and $5,500,000 for 2009.

      Salaries and other member benefits include accrued termination benefits totaling $6,527,000 at June 30, 2005 and $12,000,000 at September 30, 2004. These accrued termination benefits were for the Industrial Controls segment. Changes in accrued termination benefits for the nine months ended June 30, 2005 were as follows:

      The amounts expensed during the nine-month period were for termination benefits earned by members over the period and are primarily related to the consolidation of two European manufacturing operations with existing operations. This action is being taken to streamline the organization by eliminating redundant manufacturing operations and is expected to be substantially complete by March 31, 2006. The total expense for this action is currently estimated to be approximately $15,400,000, of which $13,969,000 was recognized through June 30, 2005. The remaining estimated amount of $1,431,000 is for termination benefits that will be earned by members over their remaining service period and for other costs primarily associated with moving equipment and inventory to other locations. The accrual adjustments reflected in the preceding table were made as a result of changes in estimates for termination benefits payable. These estimates changed because of voluntary member resignations, the currently expected transfer of members to a third-party distributor, and more members electing early retirement options at a lower cost.

      Provisions of our sales agreements include product warranties customary to such agreements. We establish accruals for specifically identified warranty issues that are probable to result in future costs. We also accrue for warranty costs on a non-specific basis whenever past experience indicates a normal and predictable

      We provide various benefits to eligible members of our company, including pension benefits associated with defined benefit plans and retirement healthcare benefits. Components of net periodic benefit cost and company contributions for these plans were as follows:

      The curtailment gain reflected above is related to amendments of one of our retirement healthcare benefit plans reducing the number of individuals who will qualify for benefits in future periods. These amendments will also reduce our future net periodic benefit cost over amounts that would have been recognized prior to the amendments. We currently expect the net periodic benefit cost associated with our retirement healthcare benefits to be approximately $620,000 over the remainder of 2005.

      Accumulated other comprehensive earnings, which totaled $12,101,000 at June 30, 2005, consisted of the following items:

      We are currently involved in pending or threatened litigation or other legal proceedings regarding employment, product liability, and contractual matters arising from the normal course of business. We accrued for individual matters that we believe are likely to result in a loss when ultimately resolved using estimates of the most likely amount of loss. There are also individual matters that we believe the likelihood of a loss when ultimately resolved is less than likely but more than remote, which were not accrued. While it is possible that there could be additional losses that have not been accrued, we currently believe the possible additional loss in the event of an unfavorable resolution of each matter is less than $5,000,000 in the aggregate.

      We also file income tax returns in various jurisdictions worldwide, which are subject to audit. We have accrued for our estimate of the most likely amount of expenses that we believe will result from income tax audit adjustments.

      We do not recognize contingencies that might result in a gain until such contingencies are resolved and the revenues are realized.

      In the event of a change in control of the company, we may be required to pay termination benefits to certain executive officers.

      The difference between the total of segment earnings and the statements of consolidated earnings follows:

      Segment assets were as follows:

      We prepared the following discussion and analysis to help you better understand our financial condition, changes in our financial condition, and results of operations. This discussion should be read with the consolidated financial statements.

      Our business is focused on the design, manufacture, and servicing of energy control systems and components for aircraft and industrial engines, turbines, and other power equipment. We use technologies in the areas of fuel systems, combustion control, electronic controls and software, and systems integration to develop components and integrated systems that we sell to OEMs (original equipment manufacturers) for use in power equipment for the power generation, process industries, transportation, and aerospace markets.

      We have two operating segments — Industrial Controls and Aircraft Engine Systems. Industrial Controls provides energy control systems and components primarily to OEMs of industrial engines, turbines, and other power equipment. Aircraft Engine Systems provides energy control systems and components primarily to OEMs of aircraft turbines. We use segment information internally to assess the performance of each segment and to make decisions on the allocation of resources.

      In recent years there has been volatility in the markets we serve and our results reflect that volatility. We have seen improved market conditions that began in the second half of 2004, which largely offset the declines that began in 2002. Our third quarter and first nine months of 2005 reflected improved market conditions over the corresponding periods a year ago.

      The changes in our markets have affected our decisions in managing our workforce. We are implementing actions in 2005 and the first half of 2006 to consolidate certain manufacturing operations in The Netherlands, United Kingdom, and Japan with existing operations in the United States, Germany, and China. Once fully implemented, we expect these actions will generate annual savings of $9 million to $11 million on a pretax basis. The related cost for the actions is currently estimated at $15.4 million. We recognized approximately $14.0 million of this cost through the third fiscal quarter of 2005.

      Our effective income tax rate for the three and nine months ended June 30, 2004, is below the rate that we expect will apply to the full year as a result of changes in estimates of income taxes provided for previous periods. The changes in estimates resulted from increases in the amount of certain credits claimed or expected to be claimed, and changes in the amount of certain deductions taken or expected to be taken. For the three-month period, the changes in estimates reduced reported income tax expense by $2.9 million, or the equivalent of 11.5% of pretax earnings. For the nine-month period, the changes in estimates reduced reported income tax expense by $1.9 million, or the equivalent of 3.0% of pretax earnings. We anticipate the applicable tax rate for our fourth quarter will be 34.0%.

      In the sections that follow, we are providing information to help you better understand factors that may affect our future results, our critical accounting policies and market risks, our results of operations and financial condition, and the effects of recent accounting pronouncements.

      This Form 10-Q contains forward-looking statements, including:

      Forward-looking statements do not reflect historical facts. Rather, they are statements about future events and conditions and often include words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,”

“plan,” “project,” “target,” “can,” “could,” “may,” “should,” “will,” “would” or similar expressions. Such statements reflect our expectations about the future only as of the date they are made. We are not obligated to, and we might not, update our forward-looking statements to reflect changes that occur after the date they are made. Furthermore, actual results could differ materially from projections or any other forward-looking statement regardless of when they are made.

      Important factors that could individually, or together with one or more other factors, affect our business, results of operations and/or financial condition are discussed more fully in the Management Discussion and Analysis on pages 15-16 of our 2004 annual report to shareholders, which was filed with our Form 10-K/ A Amendment No. 1 for the year ended September 30, 2004.

      We consider the accounting policies used in preparing our financial statements to be critical accounting policies when they are both important to the portrayal of our financial condition and results of operation, and require us to make difficult, subjective, or complex judgments. Critical accounting policies normally result from the need to make estimates about the effect of matters that are inherently uncertain. Management has discussed the development and selection of our critical accounting policies with the audit committee of the company’s Board of Directors. In each of the areas that were identified as critical accounting policies, our judgments, estimates, and assumptions are impacted by conditions that change over time. As a result, in the future there could be changes in our assets and liabilities, increases or decreases in our expenses, and additional losses or gains that are material to our financial condition and results of operations. Our critical accounting policies are discussed more fully in the Management Discussion and Analysis on pages 16-19 of our 2004 annual report to shareholders, which was filed with our Form 10-K/ A Amendment No. 1 for the year ended September 30, 2004.

      Our long-term debt is sensitive to changes in interest rates. Also, assets, liabilities, and commitments that are to be settled in cash and are denominated in foreign currencies for transaction purposes are sensitive to changes in currency exchange rates. These market risks are discussed more fully in the Management Discussion and Analysis on page 19 of our 2004 annual report to shareholders, which was filed with our Form 10-K/ A Amendment No. 1 for the year ended September 30, 2004. However, we currently do not have any existing interest rate swap agreements.

      Consolidated net sales increased in both the three months and nine months ended June 30, 2005, as compared to the same periods a year ago. Industrial Controls benefited from a broad industrial recovery that encompassed power generation and transportation, including the mobile industrial and marine markets. In particular, we have experienced higher demand for large gas turbine combustion products — the area affected most by the severe market declines of 2002 and 2003 — in the first nine months this year as compared to last year. The highest levels of increased demand have occurred in Asia and Eastern Europe, which was driven by infrastructure improvement projects in those regions.

      Aircraft Engine Systems’ improvements reflect the favorable trends in commercial aviation. We experienced modest growth in commercial OEM sales, as Boeing and Airbus ramped up their production levels for narrow and wide body aircraft. Also, there has been increased demand for commercial aftermarket spare parts and repair and overhaul services.

      Cost of goods sold increased in both the three months and nine months ended June 30, 2005, compared to the same periods last year, primarily as a result of increased sales. For the quarter, cost of goods sold represented 75.6% of sales this year and 75.0% last year. For the nine months, cost of goods sold represented 75.3% of sales this year and 74.8% last year. As a percent of sales, Industrial Controls’ cost of goods sold are higher than Aircraft Engine Systems and, for both the three-month and nine-month periods, Industrial Controls sales increased at a greater rate than Aircraft Engine Systems.

      Research and development increased in both the three months and nine months ended June 30, 2005, as compared to the same periods last year. An increase in the level of research and development activities began in the last half of fiscal 2004. We continue to work closely with our customers and actively pursue opportunities that require development of new components and systems for future engines and turbines.

      Curtailment gain refers to the amount recognized in this year’s third quarter to account for the immediate effects of amendments to one of our retirement healthcare benefit plans. The amendment eliminated retirement healthcare benefits for members that will not attain age 55 and 10 years of service by January 1, 2006. In addition to the immediate recognition of a curtailment gain, our future net periodic benefit costs will be reduced from amounts that would have been recognized prior to the amendments. For the fourth quarter of fiscal 2005, we expect the reduction to be approximately $1.4 million.

      Interest and other income increased in both the three months and nine months ended June 30, 2005, compared to the same periods last year. The three-month increase was primarily related to gains on the sale of equipment and higher interest income due to increased cash balances. These factors affected the nine-month period as well. In addition, this year’s nine-month period was affected by the sale of rights to our aircraft propeller synchronizer product line to an unrelated third party, which resulted in a pre-tax gain of $3.8 million. Prior to the sale, the product line generated annual sales of approximately $2.0 million.

      Workforce management costs in the three months and nine months ended June 30, 2005, are primarily related to the consolidation of manufacturing operations in The Netherlands and United Kingdom with existing operations in the United States and Germany. We are also consolidating a small manufacturing operation in Japan with an existing operation in China and are making sales force reductions in The  Netherlands. These actions are discussed more fully in the Management Discussion and Analysis on pages 24-25 of our 2004 annual report to shareholders, which was filed with our Form 10-K/ A Amendment No. 1 for the year ended September 30, 2004.

      The amounts reflected in the preceding table for fiscal 2005 include costs for termination benefits earned by members during the three and nine-month service periods ended June 30, 2005, and for adjustments of amounts previously accrued for these actions. The accrual adjustments were made as a result of changes in estimates for termination benefits payable. These estimates changed because of voluntary member resignations, the transfer of members to a third-party distributor, and more members electing early retirement options at a lower cost. The related costs of facility consolidation consist of such items as moving and installing equipment, moving inventory, and travel for those members being trained in the transferred manufacturing processes.

      The total expense for these current actions is currently estimated to be approximately $15.4 million, of which $14.0 million has been recognized through June 30, 2005. By fiscal year, we recognized $13.8 million of expense in 2004 and $0.2 million of expense in the first nine months of 2005. The remaining estimated amount of $1.4 million is for termination benefits that will be earned by members over their remaining service period and for other costs primarily associated with moving inventory and equipment to other locations. We expect to expense the $1.4 million over the next three quarters.

      Our cash expenses for the 2004 actions are expected to total $13.6 million, and have been or will be paid from available cash balances in 2005 and 2006 without the need for additional borrowings. The remaining $1.8 million was for non-cash contractual pension termination benefits, which was recognized in last fiscal year’s fourth quarter.

      Once fully implemented, our annual savings are expected to range from $9.0 million to $11.0 million as compared to amounts that would have been incurred prior to the actions. These savings are primarily related to reduced personnel costs, although we anticipate some savings in travel and other costs due to the reduced headcount. Of the total savings, approximately 90% is expected to affect cost of goods sold and 10% selling, general, and administrative expenses. Although some savings have occurred in the third quarter of fiscal 2005, increased savings will begin to be recognized in the fourth quarter of 2005, increasing gradually through the end of the second quarter of 2006 when we expect to begin realizing the full savings level.

      We currently plan to continue to use the facilities and equipment located in The Netherlands, United Kingdom, and Japan after the actions are completed. We own all three facilities, and each of them will have ongoing sales and service activities. In addition, the facility in the United Kingdom will remain a key development site for diesel fuel injection products. We expect to move manufacturing equipment used by the three locations to other facilities.

      The amounts reflected in the preceding table for the three and nine months ended June 30, 2004, were related to actions initiated in fiscal 2003, discussed more fully in the Management Discussion and Analysis on pages 24-25 of our 2004 annual report to shareholders, which was filed with our Form 10-K/ A Amendment No. 1 for the year ended September 30, 2004. We attributed last year’s accrual reduction to increased production levels and the decision to retain certain members to meet increased demand.

      Industrial Controls’ segment earnings increased in both the three months and nine months ended June 30, 2005, as compared to the same periods last year. The effects of higher sales were partially offset by higher research and development expenses for both the three and nine-month periods this year as compared to last year. In addition, selling, general, and administrative expenses were lower for this year’s three-month period.

      Industrial Controls’ gross margin (external net sales less external cost of goods sold) increased by approximately $6.2 million in this year’s third quarter as compared to the same quarter last year. For the first nine months, the increase was $15.4 million over last year. For both periods, the higher gross margins were due to the year-over-year increase in sales.

      Industrial Controls’ research and development costs increased approximately $1.4 million in this year’s third quarter and $4.1 million in this year’s first nine months as compared to the same periods a year ago, reflecting higher development activity and normal variations in the timing of project expenditures.

      Industrial Controls’ selling, general, and administrative expenses decreased approximately $1.5 million in this year’s third quarter and increased $0.3 million in this year’s first nine months as compared to the same periods a year ago. These changes are primarily attributable to normal variations in legal and other professional services and gains and losses related to transactions denominated in foreign currencies. As a percent of sales, these expenses were 8.0% in this year’s third quarter, down from 11.0% from the third quarter last year, and 8.8% in this year’s first nine months, down from 11.0% in last year’s first nine months.

      Industrial Controls’ workforce management actions resulted in $1.3 million of expense in this year’s third quarter. Because of adjustments made in the second quarter, the actions resulted in only $0.1 million of expense in the nine months ended June 30, 2005. These actions are discussed more fully in a separate section of this management’s discussion and analysis.

      Aircraft Engine Systems’ segment earnings decreased in the three months ended June 30, 2005. The effects of higher sales were offset by quarterly variations in sales mix, which resulted in lower comparative gross margins as a percent of sales, and increased product development activity. Segment earnings increased in the nine months ended June 30, 2005, as compared to the same period last year. The increase was due to higher sales and a gain on the sale of certain product line rights, which more than offset the costs of increased product development activity.

      Aircraft Engine Systems sold the rights to its propeller synchronizer product line in the first quarter this year, generating a gain of $3.8 million. Prior to the sale, the product line generated annual sales of approximately $2.0 million.

      Aircraft Engine Systems’ research and development increased approximately $0.9 million in this year’s third quarter and $1.7 million in this year’s first nine months as compared to the same periods a year ago, reflecting higher development activity and normal variations in the timing of project expenditures.

      Nonsegment expenses increased in both the three months and nine months ended June 30, 2005, as compared to the same periods a year ago. The most significant reasons for the increases are due to the assessment and audit of internal controls over financial reporting, which is required by the Sarbanes-Oxley Act of 2002, and higher variable compensation expense.

      Curtailment gain was discussed in another section of this management’s discussion and analysis.

      Income taxes in the three months and nine months ended June 30, 2005, were affected by changes in estimates of income taxes for previous periods. The changes in estimates resulted from increases in the amounts of certain credits claimed or expected to be claimed, and changes in the amounts of certain deductions taken or expected to be taken. These changes reduced reported income tax expense by 11.5% of pretax earnings, or $2,923,000, in the three months ended June 30, 2005, and by 3.0% of pretax earnings, or $1,940,000, in the nine months ended June 30, 2005. A reconciliation of our effective income tax rate for the year ended September 30, 2004, to the effective income tax rates for the three months and nine months ended June 30, 2005, follows:

      We anticipate the applicable rate for our fourth quarter will be 34.0%.

     Outlook: Over the past two years, our industrial and aircraft engine markets have experienced impressive recoveries in demand, which helped us increase revenues and improve earnings. Indications suggest that the strength will continue in both markets. However, some of our industrial customers are experiencing production capacity limitations and supply constraints from other suppliers. Although we are well positioned for increased capacity, these constraints may moderate the rate of sales growth we have seen over the past two years, which would influence our revenue growth.

      We currently estimate that our earnings for fiscal year 2005 will be in the range of $4.70 to $4.85 per share. This represents an increase from the previous estimate included in our Form 10-Q last quarter. The increase was largely driven by the effects of the pretax curtailment gain of $7.8 million and the change in estimates of income taxes of $1.9 million that were recognized in the third quarter. The effect of the pretax gain on the sale of product line rights of $3.8 million that was recognized in the first quarter was included in both our previous estimate and our current estimate.

      Nonsegment assets increased in the nine months ended June 30, 2005, primarily because of an increase in cash and cash equivalents. Net cash flows provided by operations during the period exceeded net cash used in investing and financing activities.