UNITED STATESSECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
For the quarterly period ended June 30, 2003
OR
For the transition period from to
Commission file number 0-8408
WOODWARD GOVERNOR COMPANY (Exact name of registrant as specified in its charter)
5001 North Second Street, Rockford, Illinois 61125-7001 (Address of principal executive offices)
(815) 877-7441 (Registrant's telephone number, including area code)
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 ý No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o
As of July 28, 2003, 11,130,213 shares of common stock with a par value of $.00875 cents per share were outstanding.
TABLE OF CONTENTS
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PART I—FINANCIAL INFORMATION
Item 1. Financial Statements
Statements of Consolidated EarningsWoodward Governor Company and Subsidiaries
See accompanying Notes to Consolidated Financial Statements.
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Consolidated Balance SheetsWoodward Governor Company and Subsidiaries
Consolidated balance sheets continued on next page.
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Consolidated Balance Sheets—ContinuedWoodward Governor Company and Subsidiaries
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Statements of Consolidated Cash FlowsWoodward Governor Company and Subsidiaries
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Notes to Consolidated Financial Statements
(1) Overview:
The consolidated balance sheet as of June 30, 2003, the statements of consolidated earnings for the three and nine-month periods ended June 30, 2003 and 2002, and the statements of consolidated cash flows for the nine-month periods ended June 30, 2003 and 2002, were prepared by the company without audit. The September 30, 2002, 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, 2003, the results of its operations for the three and nine-month periods ended June 30, 2003 and 2002, and its cash flows for the nine-month periods ended June 30, 2003 and 2002. All such adjustments were of a normal and recurring nature. The statements were prepared following the accounting policies described in the company's 2002 annual report on Form 10-K and should be read with the Notes to Consolidated Financial Statements on pages 33-43 of the 2002 annual report to shareholders. The statements of consolidated earnings for the three and nine-month periods ended June 30, 2003, are not necessarily indicative of the results to be expected for other interim periods or for the full year.
(2) Business acquisitions:
On May 30, 2003, we acquired 100 percent of the common stock of Synchro-Start Products, Inc. and its results were included in the consolidated financial statements since that date. Synchro-Start designs and manufactures actuators, solenoids, and controls for industrial engines and equipment. We made the acquisition to expand our position in the small, high-speed diesel engine market.
The purchase price for the shares, which was paid in cash, was $49,750,000. This price may increase or decrease based on a purchase price adjustment procedure customary to share purchase agreements. We expect cash settlement of any purchase price adjustment will be completed before the end of December 2003.
Our allocation of the purchase price has not been completed. In addition to a potential purchase price adjustment, we are in the process of obtaining third-party valuations for property, plant, and equipment and other intangibles. As a result, our preliminary allocation of the purchase price is subject to change. On a preliminary basis, the fair values of the assets acquired and liabilities assumed at the date of acquisition were estimated as follows:
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Goodwill was assigned to Industrial Controls and is expected to be fully deductible for income taxes purposes.
If we had completed the acquisition on October 1, 2002, results of operations would not have been materially different from amounts reported in the statements of consolidated earnings.
(3) Cumulative effect of accounting change:
We adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets," and the transition provisions of Statement of Financial Accounting Standards No. 141, "Business Combinations," on October 1, 2001. As a result of adopting these new standards, we completed the transitional goodwill impairment reviews required by the new standards and recognized an aftertax loss of $2,489,000 as a cumulative effect of an accounting change in 2002. In performing our impairment reviews, we estimated the fair values of the various reporting units using a present value method that discounted future cash flows as we expect marketplace participants would, and we further assessed the reasonableness of the estimates by using valuation methods based on market multiples. The resulting loss, which was related to an Industrial Controls reporting unit, was incurred to reduce goodwill to its implied fair value.
(4) Earnings per share:
The following stock options were outstanding during the three and nine months ended June 30, 2003 and 2002, 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 or because the effect of a net loss was antidilutive during the respective periods:
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(5) Inventories:
(6) Goodwill:
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(7) Other intangibles—net:
Amortization expense associated with current intangibles is expected to be approximately $4,100,000 for each year 2003-2006 and approximately $3,900,000 in 2007.
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(8) Accounts payable and other accrued expenses:
Included in salaries and other member benefits are accrued termination benefits totaling $2,965,000 for 109 members at June 30, 2003, and $1,389,000 for 36 members at September 30, 2002. The table below indicates the termination benefits activity for the nine months ended June 30, 2003.
Termination benefits accrued by Industrial Controls impacted various manufacturing, selling, and administrative expenses at locations worldwide and were made to better align staffing levels with
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expected demands. For Aircraft Engine Systems, the majority of the accrued termination benefits were associated with the consolidation of our servovalve manufacturing operations in Buffalo, New York, into our Rockford, Illinois, manufacturing facility to achieve additional production cost efficiencies. The remaining reductions were made to better align staffing levels with expected demand. We expect all terminations to be completed before December 31, 2003.
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 pattern exists. A reconciliation of accrued product warranties from September 30, 2002, to June 30, 2003, follows:
(9) Deferred Compensation Plan
We maintain a deferred compensation plan for key management members of the company. Individual member balances are accounted for as if they were held in specified investments, including common stock of the company. Deferred compensation balances are payable upon the retirement or other termination of a participating member, or as otherwise specified by plan documents. To the extent that balances are deemed invested in the common stock of the company, these payments are payable in actual shares of common stock. All remaining balances are payable in cash.
Deferred compensation obligations are reported as a component of equity or as an accrued expense. In 2003, we contributed 123,771 shares of common stock of the company into a trust established for the future settlement of deferred compensation obligations that are payable in actual shares of our common stock. Common stock held by the trust is reflected in the consolidated balance sheet as treasury stock for deferred compensation, and the related deferred compensation obligation is reflected as a separate component of equity. The amounts recognized in both equity accounts are equal to the fair value of the common shares at the date of contribution, and neither account will be adjusted for subsequent changes in fair value. All deferred compensation balances payable in cash are reflected in the consolidated balance sheet as an accrued liability at fair value.
(10) Stock option plan:
We have a stock option plan covering key management members and directors of the company. Options granted under the plan generally have a term of 10 years and vest evenly at the end of each year over four years from the date of grant. There were 2,100,000 shares of common stock authorized for issuance under the plan at June 30, 2003. 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
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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:
(11) Accumulated other comprehensive earnings:
Accumulated other comprehensive earnings, which totaled $8,596,000 at June 30, 2003, consisted of the following items:
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(12) Total comprehensive earnings:
(13) Contingencies
We have entered into agreements with certain executive officers under which we would pay termination benefits under certain circumstances in the event of a change in control of the company.
We are currently involved in matters of litigation arising from the normal course of business, including certain environmental and product liability matters. We have accruals of approximately $1,000,000 at June 30, 2003, related to such matters. These accruals are based on our current estimate of the most likely amount of losses that we believe will be incurred. These amounts have been included in accounts payable and accrued expenses.
We have been designated a "de minimis potentially responsible party" with respect to the cost of investigation and environmental cleanup of certain third-party sites. Our current accrual for these matters is based on costs incurred to date that we have been allocated and our estimate of the most likely future investigation and cleanup costs. There is, as in the case of most environmental litigation, the possibility that under joint and several liability we could be required to pay more than our allocated share of costs.
It is our opinion, after consultation with legal counsel, that additional liabilities, if any, resulting from these matters are not expected to have a material adverse effect on our financial condition, although such matters could have a material effect on our quarterly or annual operating results and cash flows when resolved in a future period.
(14) Segment information:
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The difference between the total of segment earnings and the statements of consolidated earnings follows:
Segment assets were as follows:
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Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations
We prepared the following discussion and analysis to help you better understand our results of operations and financial condition. This discussion should be read with the consolidated financial statements.
This discussion and analysis should also be read with the cautionary statement of our 2002 annual report to shareholders, which was filed with our Form 10-K for the year ended September 30, 2002. This discussion and analysis contains forward-looking statements, including financial projections, our plans and objectives for the future, expectations for future economic performance, and various other assumptions relating to the future. While such statements reflect our current expectations, all such statements involve risks and uncertainties. Actual results could differ materially from projections or any other forward-looking statement, and we have no obligation to update our forward-looking statements. Important factors that could cause results to differ materially from those projected or otherwise stated are identified in the cautionary statement of our 2002 annual report to shareholders.
Results of Operations
Our results of operations are discussed and analyzed by segment. We have two operating segments—Industrial Controls and Aircraft Engine Systems. Industrial Controls provides energy control systems and components primarily to OEMs (original equipment manufacturers) of industrial engines, turbines, and other power equipment. Aircraft Engine Systems provides energy control systems and components primarily to OEMs of aircraft engines.
We use segment earnings internally to assess the performance of each segment and for making decisions on the allocation of resources. Total segment earnings do not reflect all expenses of the company and are before the cumulative effect of an accounting change. Nonsegment expenses, including income taxes, and the accounting change are separately discussed and analyzed.
Industrial Controls
External net sales for Industrial Controls decreased in both the three months and nine months ended June 30, 2003, as compared to the same periods last year. This decrease was the result of a severe decline in domestic capital spending on power generation equipment—particularly large turbines—and a downturn in industrial markets generally.
Industrial Controls had segment losses in the three months and nine months ended June 30, 2003, as compared to segment earnings in the same periods last year. Results were significantly impacted by the reverse leverage effect of reduced sales volume versus fixed costs and development costs considered necessary to satisfy core customers' current and future requirements.
Included as part of segment earnings (loss) were certain workforce management costs that we incurred in connection with reductions in our workforce. This year, the reductions impacted various manufacturing, selling, and administrative functional areas at locations worldwide, and were made to better align staffing levels with expected demands. Last year, the reductions were primarily the result of consolidating certain manufacturing and administrative locations into fewer locations. Our workforce
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management costs were reflected in the following financial lines of the statements of consolidated earnings:
In addition, we expensed $1.1 million for the write-off of certain advance license fees and $0.7 million associated with the transfer of an overseas pension to a different plan in the three months and nine months ended June 30, 2003. The write-off of advance license fees was related to licensed technology we are no longer using. We also expensed $1.0 million for lease termination expenses in the nine months ended June 30, 2003.
On May 30, 2003, we acquired Synchro-Start Products Inc. to expand our position in the small, high-speed diesel engine market. Synchro-Start designs and manufactures actuators, solenoids, and controls for industrial engines and equipment. The acquired business is expected to add approximately $30,000,000 of revenue in fiscal year 2004 and is expected to be accretive to earnings in the first full year.
Our cost of Synchro-Start totaled $49.8 million and we recorded $40.0 million as goodwill, which is expected to be fully deductible for income tax purposes. However, we have not yet completed a final allocation of the purchase price and a further price adjustment is possible under the terms of the purchase agreement. As a result, the amounts recorded are subject to adjustment. We do not anticipate adjustments to the purchase price to be significant. However, we are in the process of obtaining third-party valuations for property, plant, and equipment and other intangibles. As a result, it is possible that the amount allocated to these assets could change, which would increase or reduce the amount of goodwill.
Aircraft Engine Systems
External net sales for Aircraft Engine Systems decreased in both the three months and nine months ended June 30, 2003, as compared to the same periods last year. These decreases reflect weakness in the commercial aviation industry. This weakness was exacerbated by the war in Iraq as well as concerns about Severe Acute Respiratory Syndrome (SARS). Generally, commercial aftermarket sales have held up better than OEM sales, and military sales accounted for a slightly increased proportion of external net sales.
Aircraft Engine Systems' segment earnings decreased in both the three months and nine months ended June 30, 2003, as compared to the same periods last year. These decreases were attributed to the lower sales volumes. Cost management and productivity initiatives taken during 2002 enabled margins to remain at the levels reported, despite continuing pricing pressures.
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Included as part of segment earnings were certain workforce management costs that we incurred in connection with reductions in our workforce. The majority of the reductions for 2003 are associated with the consolidation of our servovalve manufacturing operations in Buffalo, New York, into our Rockford, Illinois, manufacturing facility to achieve additional production cost efficiencies. The remaining reductions in 2003, as well as 2002, were made to better align staffing levels with expected demand. Our workforce management costs were reflected in the following financial lines of the statements of consolidated earnings:
The workforce management costs that were associated with the servovalve consolidation and are reflected in the table above totaled approximately $0.4 million for the three months ended and $2.7 million for the nine months ended June 30, 2003. In addition, we expensed other costs associated with the servovalve consolidation, such as equipment moving costs and travel costs associated with training of Rockford members, that totaled approximately $1.5 million for the three months ended and $2.0 million for the nine months ended June 30, 2003. We now believe the total cost of the consolidated will be approximately $5.5 million. We expect to complete the consolidation in the fourth quarter and anticipate that this action will generate annual cost savings of $2.5 million.
Nonsegment Expenses
Corporate expenses increased in the three months ended June 30, 2003, and decreased in the nine months ended June 30, 2003, as compared to the same periods last year. The three-month increase and nine-month decrease is primarily the result of changes in deferred compensation expense. Certain key management members may elect to defer the payment of a portion of their compensation to future periods. These deferrals are recorded as deferred compensation, and individual member balances are increased or decreased as if they were held in specified investments, principally common stock of the company.
In February 2003, we contributed common stock of the company to a trust established specifically for the future settlement of certain deferred compensation obligations that are payable in actual shares of our common stock. To the extent that shares are held in this trust, it is not necessary to record deferred compensation expense for changes in the fair value of the underlying common stock. As a result, we expect the volatility in our deferred compensation expense to be reduced in future periods.
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Consolidated Earnings
Earnings (loss) before the cumulative effect of accounting change decreased in both the three months and nine months ended June 30, 2003, as compared to the same periods last year. Income taxes generally reflect an effective tax rate of 38.0%, except that income taxes for the nine months ended June 30, 2002, were impacted by a reduction in valuation allowances provided on deferred tax assets. (The reduction in valuation allowances was associated with a transfer of our interest in a joint venture.)
The cumulative effect of accounting change reflected in last year's nine-month period is related to our October 1, 2001, adoption of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets". We completed the transitional goodwill impairment reviews required by the new standards and determined that one of our Industrial Controls' reporting units had a goodwill carrying value that exceeded its estimated implied fair value. The cumulative effect of accounting change reflects the write-down of the goodwill, net of income taxes, to its implied fair value. In performing our impairment reviews, we estimated the fair value of the various reporting units using a present value method that discounted future cash flows as we expect marketplace participants would, and we further assessed the reasonableness of the estimates by using valuation methods based on market multiples.
Outlook: With the outlook for our key target markets and the global economy highly uncertain, forecasting near-term revenues and earnings is inherently difficult. However, we currently believe that earnings for 2004 will exceed those of 2003, attributable to market share gains, cost reductions, and acquisitions.
With respect to cost reductions, we took a series of actions this year that are expected to reduce our 2004 operating costs by at least $20 million while helping us to preserve our position, implement our strategies, and sharpen our focus on core capabilities. These actions included better aligning capacity with sales volume, integrating various Industrial Controls and Aircraft Engine Systems processes, and consolidating global purchasing.
Financial Condition
Our discussion and analysis of financial condition is presented by segment for assets. We also separately discuss and analyze other balance sheet measures and cash flows. Together, this discussion
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and analysis will help you assess our liquidity and capital resources, as well as understand changes in our financial condition.
Assets
Industrial Controls' segment assets increased in the nine months ended June 30, 2003, primarily as a result of our acquisition of Synchro-Start Products Inc. Nonsegment assets decreased in the nine months ended June 30, 2003, primarily due to changes in deferred income taxes and reduced cash levels.
Other Balance Sheet Measures
Increases in working capital (current assets less current liabilities) from September 30, 2002, are primarily attributable to reductions in accrued expenses for variable compensations plans and certain defined contribution plans, which accumulate throughout the year and are paid in our first quarter. We also contributed treasury stock to a trust for certain deferred compensation obligations, the impact of which was to reclassify a portion of our deferred compensation accrual from a liability account to a separate component of equity.
On November 19, 2002, our Board of Directors authorized the repurchase of up to $20 million of Woodward common stock from time to time in open market and private transactions over the following two years. In the nine months ended June 30, 2003, we purchased $9.5 million of Woodward stock.
In the nine months ended June 30, 2003, we contributed $4.3 million of treasury stock to a trust established for certain deferred compensation obligations. The deferred compensation obligation related to these shares of stock is classified as a separate component of equity in the June 30, 2003 consolidated balance sheet.
We currently have a revolving line of credit facility with a syndicate of U.S. banks totaling $100 million, with an option to increase the amount of the line to $175 million if we desire. This line of credit facility expires on March 14, 2006. In addition, we have other lines of credit facilities (which totaled $56.4 million at September 30, 2002) that are generally reviewed annually for renewal. The total amount of borrowings under these facilities was $49.9 million at June 30, 2003.
Provisions of debt agreements include covenants customary to such agreements that require us to maintain specified minimum or maximum financial measures and place limitations on various investing
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and financing activities. The agreements also permit the lenders to accelerate repayment requirements in the event of a material adverse event. Our most restrictive covenants require us to maintain a minimum consolidated net worth, a maximum consolidated debt to consolidated operating cash flow, a maximum consolidated debt to EBITDA, and a minimum EBIT to consolidated interest expense ratio, as defined in the agreements. At September 30, 2002, we had the ability to pay dividends and purchase the company's common stock up to $109.2 million.
We are currently involved in matters of litigation arising from the normal course of business, including certain environmental and product liability matters. Further discussion of these matters is in Note 10 in the notes to the consolidated financial statements.
Cash Flows
Net cash provided by operating activities decreased in the first nine months this year as compared to the first nine months last year. The cash effects of the decrease in earnings were partially offset by the cash effects of the normal variability among operating assets and liabilities.
Net cash used in investing activities increased in the first nine months this year as compared to the first nine months last year. We completed one business acquisition in the nine-month period this year at a cost of $49.5 million as compared to two business acquisitions in the nine-month period last year at a total cost of $25.8 million. Partially offsetting this increase were lower capital expenditures in this year's nine-month period as compared to the same period last year.
Net cash from financing activities changed in the first nine months this year as compared to last year primarily because of two reasons: First, we increased our debt by $31.5 million in the nine-month period this year as compared to a net decrease of $2.8 million in the same period last year. The amount of cash provided by operating activities in this year's nine-month period was insufficient to cover the business acquisitions, capital expenditures, treasury stock purchases, and cash dividends made during the same nine-month period. Second, we purchased $9.5 million of Woodward common stock in this year's nine-month period. In November 2002, our Board of Directors authorized the repurchase of up to $20 million of Woodward stock from time to time in open market and private transactions over the following two years.
Outlook: Future cash flows from operating activities and available revolving lines of credit are expected to be adequate to meet our cash requirements over the next twelve months. Our financing activities in 2002 have enhanced our liquidity for several years by delaying principal payment requirements for $60 million of debt from the fiscal 2002-2003 timeframe to the fiscal 2006-2012 timeframe, and by adding an additional $15 million of debt to the extended timeframe. Also, in this year's second quarter, we replaced a $150 million revolving line of credit facility that was due to expire on June 15, 2003, with a new line of credit facility. Our new facility, which expires on March 14, 2006, is for $100 million and has an option that permits us to increase the amount of the line up to $175 million. Despite these factors, it is possible business acquisitions could be made in the future that would require amendments to existing debt agreements and/or additional financing.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
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 are sensitive to changes in currency exchange rates. These market risks are discussed more fully in the Management Discussion and Analysis on pages 26-27 of our 2002 annual report to shareholders, which was filed with our Form 10-K for the year ended September 30, 2002.
Item 4. Controls and Procedures
We have established disclosure controls and procedures, which are designed to ensure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934 are recorded, processed, summarized, and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms.
John A. Halbrook, our chairman of the board and chief executive officer, and Stephen P. Carter, our executive vice president, chief financial officer and treasurer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Form 10-Q. Based on their evaluation, they concluded that our disclosure controls and procedures were effective in achieving the objectives for which they were designed.
Furthermore, there have been no changes in our internal control over financial reporting during the fiscal quarter covered by this Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II—OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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