SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
--------------------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 2002
Commission file number 33-96190
AEARO CORPORATION
(Exact name of registrant as specified in its charter)
------------------------
Delaware 13-3840450
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
5457 West 79th Street 46268
Indianapolis, Indiana (Zip Code)
(Address of principal executive offices)
(317) 692-6666
(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 X No __
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes__ No X
The number of shares of the registrant's common stock, par value $.01 per
share, outstanding as of February 13, 2003 was 101,912.5.
Aearo Corporation
TABLE OF CONTENTS
Form 10-Q for the Quarterly Period Ended December 31, 2002
PART I-FINANCIAL INFORMATION...................................................3
Item 1. Financial Statements...................................................3
Condensed Consolidated Balance Sheets - Assets.........................3
Condensed Consolidated Balance Sheets - Liabilities and
Stockholders' Equity...................................................4
Condensed Consolidated Statements of Operations........................5
Condensed Consolidated Statements of Cash Flows........................6
Notes To Condensed Consolidated Financial Statements...................7
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.................................................16
Item 3. Quantitative and Qualitative Disclosures About Market Risk............23
Item 4. Controls and Procedures...............................................25
PART II - OTHER INFORMATION...................................................26
Item 1. Legal Proceedings..................................................26
Item 2. Changes in Securities and Use of Proceeds..........................27
Item 3. Defaults Upon Senior Securities....................................27
Item 4. Submission of Matters to a Vote of Security Holders................27
Item 5. Other Information..................................................27
Item 6. Exhibits and Reports on Form 8-K...................................27
SIGNATURES....................................................................28
PART I-FINANCIAL INFORMATION
Item 1 Financial Statements
AEARO CORPORATION
Condensed Consolidated Balance Sheets - Assets
(Dollars in Thousands)
December 31, September 30,
2002 2002
------ -------
(Unaudited)
CURRENT ASSETS:
Cash and cash equivalents ............................. $ 16,099 $ 14,480
Accounts receivable (net of allowance for doubtful
accounts of $1,608 and $1,524, respectively)......... 39,014 46,478
Inventories ........................................... 37,521 33,161
Deferred and prepaid expenses ......................... 3,688 3,449
------ ------
Total current assets ................................ 96,322 97,568
------ ------
LONG TERM ASSETS:
Property, plant and equipment, net .................... 48,454 48,096
Intangible assets, net ................................ 125,592 121,979
Other assets .......................................... 2,704 2,526
------- -------
Total assets ...................................... $273,072 $270,169
======== ========
The accompanying notes are an integral part of these condensed consolidates
finanical statements.
-3-
AEARO CORPORATION
Condensed Consolidated Balance Sheets - Liabilities and Stockholders' Equity
(Dollars in Thousands)
December 31, September 30,
2002 2002
---------- ----------
(Unaudited)
CURRENT LIABILITIES:
Current portion of long-term debt .................... $ 14,481 $ 12,847
Accounts payable and accrued liabilities ............. 33,269 36,410
Accrued interest ..................................... 5,628 2,568
U.S. and foreign income taxes ........................ 1,741 1,156
--------- ---------
Total current liabilities ...................... 55,119 52,981
--------- ---------
Long-term debt ....................................... 179,644 182,715
Deferred income taxes ................................ 843 800
Other liabilities .................................... 12,621 12,129
--------- ---------
Total liabilities .............................. $ 248,227 $ 248,625
--------- ---------
COMMITMENTS AND CONTINGENCIES:
Preferred stock, $.01 par value-
(Redemption value of $112,901 and $109,480, respectively)
Authorized--200,000 shares
Issued and outstanding--45,000 shares ............... -- --
STOCKHOLDERS' EQUITY:
Common stock, $.01 par value-
Authorized--200,000 shares
Issued and outstanding--101,913 shares .............. 1 1
Additional paid-in capital ........................... 32,242 32,254
Retained earnings .................................... 7,867 6,825
Accumulated other comprehensive loss ................. (15,265) (17,536)
--------- ---------
Total stockholders' equity ..................... 24,845 21,544
--------- ---------
Total liabilities and stockholders' equity ..... $ 273,072 $ 270,169
========= =========
The accompanying notes are an integral part of these condensed consolidates
finanical statements.
-4-
Condensed Consolidated Statements of Operations
(DOLLARS IN THOUSANDS)
(Unaudited)
For the Three Months Ended
December 31,
------------------------
2002 2001
-------- ----------
NET SALES .............................................. $ 68,717 $ 61,643
COST OF SALES .......................................... 35,645 32,928
-------- --------
Gross profit .................................. 33,072 28,715
SELLING AND ADMINISTRATIVE ............................. 24,321 20,856
RESEARCH AND TECHNICAL SERVICES ........................ 1,583 1,369
AMORTIZATION OF INTANGIBLES ............................ 116 1,559
OTHER CHARGES, NET ..................................... 458 9
-------- --------
Operating income .............................. 6,594 4,922
INTEREST EXPENSE, NET .................................. 4,942 5,110
-------- --------
Income (loss) before provision for income taxes 1,652 (188)
PROVISION FOR INCOME TAXES ............................. 610 523
-------- --------
Net income (loss) ............................. $ 1,042 $ (711)
======== ========
The accompanying notes are an integral part of these condensed consolidates
finanical statements.
-5-
Condensed Consolidated Statements of Cash Flows
(DOLLARS IN THOUSANDS)
(Unaudited)
For the Three Months Ended
December 31,
---------------------
2002 2001
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) .................................................................. $ 1,042 $ (711)
Adjustments to reconcile net income (loss) to cash provided by operating activities-
Depreciation .................................................................... 2,659 2,375
Amortization of intangible assets and deferred financing costs .................. 516 1,866
Deferred income taxes ........................................................... -- 96
Other, net ...................................................................... 217 15
Changes in assets and liabilities-(net of effects of acquisitions)
Accounts receivable .......................................................... 8,145 7,443
Inventories .................................................................. (3,793) (1,073)
Accounts payable and accrued liabilities ..................................... (867) (1,017)
Other, net ................................................................... 265 (890)
-------- --------
Net cash provided by operating activities ............................... 8,184 8,104
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property, plant and equipment ......................................... (2,187) (1,811)
Cash paid for acquisitions ......................................................... (1,250) (730)
Proceeds provided by disposals of property, plant and equipment .................... 5 --
-------- --------
Net cash used by investing activities.................................................. (3,432) (2,541)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of senior subordinated debt .............................................. -- (2,000)
Repayment of term loans ............................................................ (3,164) (2,017)
Repayment of capital lease obligations ............................................. (49) (13)
Repayment of long-term debt ........................................................ (23) (35)
Other (12) (16)
-------- --------
Net cash used by financing activities ................................... (3,248) (4,081)
-------- --------
EFFECT OF EXCHANGE RATE CHANGES ON CASH ............................................... 115 301
-------- --------
INCREASE IN CASH AND CASH EQUIVALENTS ................................................. 1,619 1,783
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD ........................................ 14,480 18,233
-------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD .............................................. $ 16,099 $ 20,016
======== ========
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Capital lease obligations .......................................................... $ 430 $ 1,285
======== ========
CASH PAID FOR:
Interest ........................................................................... $ 1,541 $ 1,698
======== ========
Income taxes ....................................................................... $ 5 $ 433
======== ========
The accompanying notes are an integral part of these condensed consolidates
finanical statements.
-6-
AEARO CORPORATION
Notes To Condensed Consolidated Financial Statements
DECEMBER 31, 2002
(Unaudited)
1) CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
In the opinion of management, the accompanying unaudited condensed
consolidated financial statements contain all adjustments necessary to
present fairly, in accordance with accounting principles generally accepted
in the United States of America, the Company's financial position, results
of operations and cash flows for the interim periods presented. The results
of operations for the interim periods shown in this report are not
necessarily indicative of results for any future interim period or for the
entire year. These condensed consolidated financial statements do not
include all disclosures associated with annual financial statements and
accordingly should be read in conjunction with the consolidated financial
statements and notes thereto included in the Company's Annual Report on
Form 10-K405.
2) COMPANY BACKGROUND
Aearo Corporation, a Delaware corporation, and its direct wholly owned
subsidiary, Aearo Company, a Delaware corporation (collectively referred to
herein as the "Company") manufactures and sells products under the brand
names: AOSafety(R), E-A-R(R), and Peltor(R). These products are sold
through three reportable segments, which are Safety Products, Safety
Prescription Eyewear and Specialty Composites.
3) SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates. The preparation of the condensed consolidated financial
statements in conformity with accounting principles generally accepted in
the United States of America requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting periods. Actual results could differ from those
estimates.
Reclassifications. Certain amounts included in the prior period financial
statements may have been reclassified to conform to the current period
presentation. The reclassifications have no impact on net income (loss)
previously reported.
Revenue Recognition. The Company recognizes revenue when title and risk
transfer to the customer, which is generally when the product is shipped to
customers. At the time revenue is recognized, certain provisions may also
be recorded including an allowance for doubtful accounts. Allowance for
doubtful accounts is generally based on a percentage of aged receivables.
However, management judgment is involved with the final determination of
the allowance based on several factors including specific analysis of a
customer's credit worthiness, historical experience, changes in payment
history and general economic and market trends.
Foreign Currency Translation. Assets and liabilities of the Company's
foreign operations are translated at period-end exchange rates. Income and
expenses are translated at the approximate average rate during the period.
Foreign currency translation adjustments are recorded as a separate
component of stockholders' equity.
-7-
AEARO CORPORATION
Notes To Consolidated Condensed Financial Statements
DECEMBER 31, 2002
(Unaudited)
Foreign Currency Transactions. Foreign currency gains and losses arising
from transactions by any of the Company's subsidiaries are reflected in net
income (loss).
Shipping and Handling Fees and Costs. Shipping and handling costs include
payments to third parties for the delivery of products to customers, as
well as internal salaries and overhead costs incurred to store, move and
prepare finished products for shipment. Shipping and handling costs are
included with selling and administrative expenses in the accompanying
condensed consolidated statement of operations and totaled $4.5 million and
$4.0 million in the periods ended December 31, 2002 and 2001, respectively.
The Company recovers a portion of its shipping and handling costs from its
customers and records this recovery in net sales.
Income Taxes. Deferred tax assets and liabilities are determined based on
the difference between the financial statement and tax bases of assets and
liabilities using currently enacted tax rates.
Goodwill and Other Intangibles. Effective October 1, 2002, the Company
adopted Statement of Financial Accounting Standards ("SFAS") No 142,
"Goodwill and Other Intangibles". Under the provisions of SFAS No. 142,
goodwill and intangible assets that have indefinite useful lives are no
longer amortized but are tested at least annually for impairment. The
Company expects to complete the transitional impairment test for goodwill
by the end of the second quarter of fiscal 2003. Accordingly, the Company
has not yet determined what effect, if any, this impairment test will have
on the Company's earnings and financial position. Any impairment charge
resulting from the impairment test for goodwill will be recognized
effective October 1, 2002. Intangible assets that have finite useful lives
will continue to be amortized over their useful lives. As a result of the
non-amortization provisions of SFAS No. 142, the Company will no longer
record approximately $5.8 million of annual amortization relating to
goodwill and indefinite lived intangibles. The following presents
amortization expense and proforma net income for the three months ended
December 31, 2002 and 2001 as if SFAS No. 142 had been adopted (Dollars in
thousands):
2002 2001
-------- --------
Goodwill amortization $ -- $ 780
Trademark amortization $ -- $ 741
Other amortization $ 116 $ 38
Net income $ 1,042 $ 810
Other amortization relates to patents and non-compete agreements. The
Company amortizes these intangibles over their legal lives. The trademark
is deemed to have an indefinite useful life because it is expected to
generate cash flow indefinitely.
Asset Retirement Obligations. Effective October 1, 2002, the Company
adopted SFAS No. 143, "Accounting for Asset Retirement Obligations". SFAS
No. 143 requires the Company to record the fair value of liabilities
associated with the retirement of long-lived assets in the period in which
they are incurred. The adoption of SFAS No. 143 had no material impact on
the Company's results of operations or financial position.
Impairment or Disposal of Long-Lived Assets. Effective October 1, 2002, the
Company adopted SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets", which supercedes SFAS No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of". SFAS No. 144 retains the fundamental provisions with respect to the
recognition and measurement of long-lived asset impairment but does not
apply to goodwill and other intangibles assets. The adoption of SFAS No.
144 had no material effect on the Company's results of operations or
financial position.
Extinguishment of Debt. Effective October 1, 2002, the Company adopted SFAS
No. 145 "Rescission of Financial Accounting Standards Board ("FASB")
-8-
AEARO CORPORATION
Notes To Consolidated Condensed Financial Statements
DECEMBER 31, 2002
(Unaudited)
Statement No. 4, 44, and 62, Amendment of FASB Statement No. 13, and
Technical Corrections". This statement rescinds SFAS No. 4, "Reporting
Gains and Losses from Extinguishment of Debt", and an amendment of that
Statement, SFAS No. 64, "Extinguishments of Debt Made to Satisfy
Sinking-Fund Requirements". This Statement also rescinds SFAS No. 44,
"Accounting for Intangible Assets of Motor Carriers". This Statement amends
SFAS No. 13, "Accounting for Leases", to eliminate the inconsistency
between the required accounting for sales-leaseback transactions and the
required accounting for certain lease modifications that have economic
effects similar to sale-leaseback transactions. The adoption of SFAS No.
145 had no effect on the Company's results of operations or financial
position.
Exit or Disposal Activities. Effective October 1, 2002, the Company adopted
SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal
Activities". SFAS No. 146 requires that a liability for costs associated
with exit or disposal activities be recognized and measured at fair value
only when the liability is incurred. SFAS No. 146 is effective for exit or
disposal activities that are initiated after December 31, 2002. The
adoption of SFAS No. 146 did not have a material effect on the Company's
results of operations or financial position.
Stock-based Compensation. In December 2002, the FASB issued SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure, an
amendment of FASB Statement No. 123". SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method
of accounting for stock-based employee compensation. In addition, this
statement amends the disclosure requirements of SFAS No. 123 to require
prominent disclosures in both annual and interim financial statements about
the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The Company currently
accounts for stock-based compensation under the intrinsic method of
Accounting Principles Board ("APB") Opinion No. 25. The additional
disclosure requirements of SFAS No. 148 are effective for interim periods
beginning after December 15, 2002.
Disclosure Requirements for Guarantees. In November 2002, the FASB issued
FASB Interpretation ("FIN") No. 45, "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness
of Others". FIN No. 45 expands upon the disclosure requirements to be made
by a guarantor in its interim and annual financial statements regarding its
obligations under certain guarantees that it has issued. Additionally, FIN
No. 45 requires that the guarantor recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee. Footnote disclosures are required in interim and
year-end financial statements ending after December 15, 2002. Liability
recognition and measurement provisions apply prospectively to guarantees
issued or modified starting January 1, 2003. The Company does not expect
the adoption of FIN No. 45 to have a material impact on it financial
position or results of operations.
Consolidation of Variable Interest Entities. In January 2003, the FASB
issued FIN No. 46, "Consolidation of Variable Interest Entities, an
Amendment of ARB No. 51". FIN No. 46 addresses consolidation of business
enterprises of certain variable interest entities, and is effective for
variable interest entities created after January 1, 2003 and to variable
interest entities in which an enterprise obtains an interest after that
date. The Company does not expect the adoption of FIN No. 46 to have an
impact on its financial position or results of operations.
-9-
AEARO CORPORATION
Notes To Consolidated Condensed Financial Statements
DECEMBER 31, 2002
(Unaudited)
Accounting for Derivative Instruments and Hedging Activities. The Company
adopted the provisions of SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" on October 1, 2000. SFAS No. 133
requires that every derivative instrument be recorded in the balance sheet
as either an asset or a liability measured at its fair value.
The Company has formally documented its hedging relationships, including
identification of the hedging instruments and the hedge items, as well as
its risk management objectives and strategies for undertaking each hedge
transaction. From time to time the Company enters into forward foreign
currency contracts and interest rate swap and collar agreements, which are
derivatives as defined by SFAS No. 133. The Company enters into forward
foreign currency contracts to mitigate the effects of changes in foreign
currency rates on profitability and enters into interest rate swap and
collar agreements to hedge its variable interest rate risk. These
derivatives are cash flow hedges. For all qualifying and highly effective
cash flow hedges, the changes in the fair value of the derivatives are
recorded in other comprehensive income (loss). Amounts accumulated in other
comprehensive income (loss) will be reclassified as earnings when the
related product sales affect earnings for forward foreign currency
contracts. As a result of the forward foreign currency contracts, the
Company has recorded a derivative payable of $0.6 million at December 31,
2002. All forward foreign currency contracts will expire over the next six
months.
During the period ending December 31, 2002 the Company reclassified into
earnings a net loss of approximately $0.1 million resulting from the
exercise of forward foreign currency contracts. All forward foreign
currency contracts were determined to be highly effective; therefore no
ineffectiveness was recorded in earnings.
The Company also executes forward foreign currency contracts for up to
30-day terms to protect against the adverse effects that exchange rate
fluctuations may have on the foreign-currency-denominated trade activities
(receivables, payables and cash) of foreign subsidiaries. These contracts
have not been designated as hedges under SFAS No. 133 and accordingly, the
gains and losses on both the derivative and foreign-currency-denominated
trade activities are recorded as transaction adjustments in current
earnings. The impact on earnings was a loss of approximately $ 0.1 million
for the period ended December 31, 2002.
The Company also entered into an interest rate collar arrangement during
October 2001 to protect $25.0 million of adjustable Term Loan debt (as
defined below in Note 6). The fair value of the collar at December 31, 2002
was $0.1 million. The Company has not elected to take hedge accounting
treatment for the interest rate collar as defined under SFAS No. 133 and,
as a result, any fair value adjustment is charged directly to other income
(expense). Approximately $0.1 million was expensed during the quarter ended
December 31, 2002.
-10-
AEARO CORPORATION
Notes To Consolidated Condensed Financial Statements
DECEMBER 31, 2002
(Unaudited)
4) COMPREHENSIVE INCOME
Comprehensive income (loss) consisted of the following (Dollars in
thousands):
Three months ended
December 31,
------------------------
2002 2001
(Unaudited) (Unaudited)
--------- -------
Net income (loss) $ 1,042 $ (711)
Foreign currency translation adjustment 2,868 560
Unrealized gain (loss) on derivative
instruments (597) 209
--------- -------
Comprehensive income $ 3,313 $ 58
========= =======
5) INVENTORIES
Inventories consisted of the following (Dollars in thousands):
December 31, September 30,
2002 2002
-------- --------
(Unaudited)
Raw materials $ 8,630 $ 7,514
Work in process 10,131 10,196
Finished goods 18,760 15,451
-------- --------
$ 37,521 $ 33,161
======== ========
Inventories, which include materials, labor and manufacturing overhead, are
stated at the lower of cost or market, cost being determined using the
first-in, first-out method.
6) DEBT
The Company's debt structure includes: (a) $98.0 million of senior
subordinated notes (Notes) due 2005, which are publicly held and are
redeemable at the option of the Company, in whole or in part, at various
redemption prices, and (b) up to an aggregate of $135.0 million under a
credit agreement with various banks comprised of (i) a secured term loan
facility consisting of loans providing for up to $100.0 million of term
loans (collectively the Term Loans) with a portion of the Term Loans
denominated in foreign currencies, (ii) a secured revolving credit facility
(Revolving Credit Facility) providing for up to $30.0 million of revolving
loans for general corporate purposes and (iii) a U.K. overdraft facility of
up to an equivalent of $5.0 million in Great Britain Pounds for working
capital requirements as needed (collectively the Senior Bank Facilities).
The amount outstanding on the Term Loans at December 31, 2002, was
approximately $92.1 million. No amounts were outstanding under the
Revolving Credit Facility or the U.K. overdraft facility.
-11-
AEARO CORPORATION
Notes To Consolidated Condensed Financial Statements
DECEMBER 31, 2002
(Unaudited)
Under the terms of both the Senior Bank Facilities and the Notes indenture,
Aearo Company is required to comply with certain financial covenants and
restrictions. Aearo Company was in compliance with all financial covenants
and restrictions at December 31, 2002.
During the first quarter of fiscal 2002, the Company's Board of Directors
authorized management to repurchase, from time to time, a portion of the
Company's 12.5% Notes, subject to market conditions and other factors. No
assurances can be given as to whether or when or at what price such
repurchases will occur. Subsequently, pursuant to a first amendment to the
Senior Bank Facilities, the Company purchased and retired $2.0 million of
the Notes during the first quarter of fiscal 2002.
7) COMMITMENTS AND CONTINGENCIES
Lease Commitments. The Company leases certain transportation vehicles,
warehouse facilities, office space, and machinery and equipment under
cancelable and non-cancelable leases, most of which expire within 10 years
and may be renewed by the Company.
Contingencies Various lawsuits and claims arise against the Company in the
ordinary course of its business. Most of these lawsuits and claims are
products liability matters that arise out of the use of safety eyewear and
respiratory product lines manufactured by the Company as well as products
purchased for resale. In addition, the Company may be contingently liable
with respect to numerous lawsuits involving respirators sold by its
predecessors, American Optical Corporation and Cabot Corporation, arising
out of agreements entered into when the AOSafety(R) Division was sold by
American Optical Corporation to Cabot in April 1990 and when later sold by
Cabot to the Company in 1995. These lawsuits typically involve plaintiffs
alleging that they suffer from asbestosis or silicosis, and that such
condition results in part from respirators that were negligently designed
or manufactured. The defendants in these lawsuits are often numerous, and
include, in addition to respirator manufacturers, employers of the
plaintiffs and manufacturers of sand (used in sand blasting) and asbestos.
Responsibility for legal costs, as well as for settlements and judgments,
is shared contractually by the Company, Cabot, American Optical Corporation
and a prior owner of American Optical Corporation. Liability is allocated
among the parties based on the number of years each Company owned the
AOSafety Division and the alleged years of exposure of the individual
plaintiff. The Company's share of the contingent liability is further
limited by an agreement entered into between the Company and Cabot on July
11, 1995, as amended in 2002. This agreement provides that, so long as the
Company pays to Cabot an annual fee of $400,000, Cabot will retain
responsibility and liability for, and indemnify the Company against,
asbestos and silica-related legal claims asserted after July 11, 1995 and
alleged to have arisen out of the use of respirators while exposed to
asbestos or silica prior to January 1, 1997. To date, the Company has
elected to pay the annual fee. The Company could potentially be liable for
these exposures if the Company elects to discontinue its participation in
this arrangement, or if Cabot is no longer able to meet its obligations in
these matters. With these arrangements in place, however, the Company's
potential liability is limited to exposures alleged to have arisen from the
use of respirators while exposed to asbestos or silica on or after January
1, 1997. The Company also may be responsible for certain claims relating to
acquired companies other than the AOSafety(R) Division that are not covered
by, and are unrelated to, the agreement with Cabot.
At December 31, 2002, the Company has recorded liabilities of approximately
$4.6 million, which represents reasonable estimates of its probable
-12-
AEARO CORPORATION
Notes To Consolidated Condensed Financial Statements
DECEMBER 31, 2002
(Unaudited)
liabilities, for product liabilities substantially related to asbestos and
silica-related claims as determined by the Company in consultation with an
independent consultant. This reserve is re-evaluated periodically and
additional charges or credits to operations may result as additional
information becomes available. Consistent with the current environment
being experienced by companies involved in asbestos and silica-related
litigation, there has been an increase in the number of asserted claims
that could potentially involve the Company. Various factors increase the
difficulty in determining the Company's potential liability, if any, in
such claims, including the fact that the defendants in these lawsuits are
often numerous and the claims generally do not specify the amount of
damages sought. Additionally, the bankruptcy filings of other companies
with asbestos and silica-related litigation could increase the Company's
cost over time. In light of these and other uncertainties inherent in
making long-term projections, the Company has determined that the five-year
period through fiscal 2007 is the most reasonable time period for
projecting asbestos and silica-related claims and defense costs. It is
possible that the Company may incur liabilities in an amount in excess of
amounts currently reserved. However, taking into account currently
available information, historical experience, and the Cabot agreement, but
recognizing the inherent uncertainties in the projection of any future
events, it is management's opinion that these suits or claims should not
result in final judgments or settlements in excess of the Company's reserve
that, in the aggregate, would have a material effect on the Company's
financial condition, liquidity or results of operations.
8) SEGMENT REPORTING
The Company manufactures and sells products under the brand names:
AOSafety(R), E-A-R(R), and Peltor(R). These products are sold through three
reportable segments, which are Safety Products, Safety Prescription Eyewear
and Specialty Composites. The Safety Products segment manufactures and
sells hearing protection devices, non-prescription safety eyewear, face
shields, reusable and disposable respirators, hard hats and first aid kits.
The Safety Prescription Eyewear segment manufactures and sells prescription
eyewear products that are designed to protect the eyes from the typical
hazards encountered in the industrial work environment. The Company's
Safety Prescription Eyewear segment purchases component parts (lenses and
the majority of its frames) from various suppliers, grinds, shapes and
applies coatings to the lenses in accordance with the customer's
prescription, and then assembles the glasses using the customer's choice of
frame. The Specialty Composites segment manufactures a wide array of
energy-absorbing materials that are incorporated into other manufacturers'
products to control noise, vibration and shock.
Net Sales by Business Segment (Dollars in thousands):
Three Months Ended
December 31,
--------------------------------
2002 2001
---------------- -------------
(Unaudited) (Unaudited)
Safety Products $ 50,486 $ 45,006
Safety Prescription Eyewear 9,804 8,994
Specialty Composites 8,427 7,643
----------- ------------
Total $ 68,717 $ 61,643
=========== ============
-13-
AEARO CORPORATION
Notes To Consolidated Condensed Financial Statements
DECEMBER 31, 2002
(Unaudited)
Inter-segment sales from the Specialty Composites segment to the Safety
Products segment totaled $0.8 million and $0.7 million for the three months
ended December 31, 2002 and 2001, respectively. The inter-segment sales
value is determined at fully absorbed inventory cost at standard rates plus
25%.
EBITDA by Business Segment and reconciliation to income (loss) before
provision for income taxes (Dollars in thousands):
Three Months Ended
December 31,
------------------------------
2002 2001
---------- ----------
(Unaudited) (Unaudited)
Safety Products $ 8,984 $ 7,982
Safety Prescription Eyewear (81) 254
Specialty Composites 713 31
Reconciling Items 13 597
---------- ----------
Total EBITDA 9,629 8,864
Depreciation 2,659 2,375
Amortization 116 1,559
Non-operating Costs 260 8
Interest 4,942 5,110
---------- ----------
Income (loss) before
provision for income taxes $ 1,652 $ (188)
========== ==========
EBITDA is defined by the Company as earnings before interest, taxes,
depreciation, amortization, and non-operating income or expense.
Non-operating income or expense is further defined as extraordinary gains
or losses, or gains or losses from sales of assets other than in the
ordinary course of business. While the Company believes EBITDA is a useful
indicator of its ability to service debt, EBITDA should not be considered
as a substitute for net income (loss) determined in accordance with
accounting principles generally accepted in the United States of America as
an indicator of operating performance or as an alternative to cash flow as
a measure of liquidity. Investors should be aware that EBITDA as presented
above may not be comparable to similarly titled measures presented by other
companies and comparisons could be misleading unless all companies and
analysts calculate this measure in the same fashion.
9) RESTRUCTURING CHARGE
During fiscal 2001, the Company recorded an unusual charge of $11.4 million
relating to a restructuring plan announced by the Company to improve its
competitive position and long-term profitability. The plan includes the
closure of its Ettlingen, Germany plant, significantly reorganizing
operations at the Company's Varnamo, Sweden plant, rationalizing the
manufacturing assets and product mix of its Specialty Composites business
unit and a reduction of products and product lines.
The unusual charge included cash charges of $2.3 million, which includes
$1.8 million for severance and other separation costs to cover the
-14-
AEARO CORPORATION
Notes To Consolidated Condensed Financial Statements
DECEMBER 31, 2002
(Unaudited)
reduction of 5% of the Company's work force and $0.5 million for other
costs associated with this plan. The unusual charge also included non-cash
charges of $9.1 million, which includes $3.2 million for non-cancelable
long-term lease obligations, $2.9 million for asset impairments, $2.4
million for inventory disposals and $0.6 million related to the sale of the
Company's Ettlingen, Germany location.
During 2002, the Company reversed $0.6 million of reserves related to the
September 30, 2001 restructuring provision. The adjustment represents a
change in estimate of the plan for the disposal of certain items of
inventory and the closure of its Ettlingen, Germany plant. The portion
related to inventory of $0.5 million was classified as a reduction in cost
of sales with the remaining $0.1 million classified as operating expenses.
The following table displays the activity and balances of the restructuring
reserve account for the three months ended December 31, 2002 (Dollars in
thousands):
September 30, December 31,
2002 Charges 2002
--------- ----------- ----------
Employee termination costs $ 730 $ (129) $ 601
Lease agreements 2,352 (224) 2,128
Loss on disposal of assets 700 700
Other 47 (17) 30
--------- ----------- ----------
Total $ 3,829 $ (370) $ 3,459
========= =========== ==========
10) ACQUISITIONS
On October 7, 2002, the Company acquired Industrial Protection Products,
Inc. ("IPP") of Wilmington, Massachusetts for approximately $1.2 million.
The transaction was accounted for using the purchase method of accounting
in accordance with SFAS No. 141, "Business Combinations", and accordingly,
the operating results of IPP have been included with those of the Company
subsequent to October 7, 2002. If the acquisition had occurred at the
beginning of fiscal 2002, the proforma consolidated results would not be
materially different from actual results for the three months ended
December 31, 2001.
-15-
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with the Consolidated
Financial Statements of the Company, including notes thereto. This Report
contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
The Company's actual results could differ materially from those set forth in
such forward-looking statements. The factors that might cause such a difference
include, among others, the following: risks associated with indebtedness; risks
related to acquisitions; risks associated with the conversion to a new
management information system; high level of competition in the Company's
markets; importance and costs of product innovation; risks associated with
international operations; product liability exposure; unpredictability of patent
protection and other intellectual property issues; dependence on key personnel;
the risk of adverse effect of economic and regulatory conditions on sales; and
risks associated with environmental matters
Results of Operations
(Dollars in Thousands)
(Unaudited)
Three months ended December 31,
-------------------------------------------
2002 % 2001 %
--------- ------ --------- ------
Net Sales
Safety Products $ 50,486 73.5 $ 45,006 73.0
Safety Prescription Eyewear 9,804 14.3 8,994 14.6
Specialty Composites 8,427 12.2 7,643 12.4
--------- ------ --------- ------
Total net sales 68,717 100.0 61,643 100.0
Cost of Sales 35,645 51.9 32,928 53.4
--------- ------ --------- ------
Gross profit 33,072 48.1 28,715 46.6
Operating Expenses
Selling and administration 24,321 35.4 20,856 33.8
Research and technical services 1,583 2.3 1,369 2.2
Amortization 116 0.1 1,559 2.5
Other charges, net 458 0.7 9 --
--------- ------ --------- ------
Total operating expenses 26,478 38.5 23,793 38.6
Operating income 6,594 9.6 4,922 8.0
Interest expense, net 4,942 7.2 5,110 8.3
--------- ------ --------- ------
Income (loss) before provision for
income taxes 1,652 2.4 (188) (0.3)
Provision for income taxes 610 0.9 523 0.8
--------- ------ --------- -------
Net income (loss) $ 1,042 1.5 $ (711) (1.2)
========= ====== ========= =======
EBITDA $ 9,629 14.0 $ 8,864 14.4
========= ====== ========= =======
-16-
Results of Operations -- Three Months Ended December 31, 2002 Compared to
Three Months Ended December 31, 2001
Net Sales. Net sales in the three months ended December 31, 2002 increased
11.5% to $68.7 million from $61.6 million in the three months ended
December 31, 2001. The increase in net sales was primarily driven by volume
growth, the impact of acquisitions and foreign exchange. The Safety
Products segment net sales in the three months ended December 31, 2002
increased 12.2% to $50.5 million from $45.0 million in the three months
ended December 31, 2001. The increase in net sales was primarily due to
volume growth, the impact of acquisitions and foreign exchange. The
weakness of the U.S. dollar relative to other currencies had the impact of
increasing sales by $2.0 million in the three months ended December 31,
2002 as compared to the three months ended December 31, 2001. The Safety
Products segment sales included approximately $1.4 million of sales due to
acquisitions made in fiscal 2002. The Safety Prescription Eyewear segment
net sales in the three months ended December 31, 2002 increased 8.9% to
$9.8 million from $9.0 million in the three months ended December 31, 2001.
The Safety Prescription Eyewear segment net sales included approximately
$1.2 million of sales due to acquisitions made in fiscal 2002 as well as
the acquisition of Industrial Protection Products, Inc. on October 7, 2002.
Specialty Composites' net sales in the three months ended December 31, 2002
increased 10.5% to $8.4 million from $7.6 million in the three months ended
December 31, 2001. The increase was primarily driven by volume increases in
the truck market, the aircraft market and the electronics segment of the
precision equipment market, which includes computers and personal
communications system (PCS) applications.
Gross Profit. Gross profit in the three months ended December 31, 2002
increased 15.2% to $33.1 million from $28.7 million in the three months
ended December 31, 2001. The increase in gross profit is primarily due to
improved sales volumes, continued productivity improvements in
manufacturing operations, the impact of acquisitions and the effects of
foreign exchange. Gross profit as a percentage of net sales in the three
months ended December 31, 2002 improved to 48.1% as compared to 46.6% in
the three months ended December 31, 2001. The increase in the gross profit
percentage of net sales is primarily due to continued productivity
improvements in manufacturing operations.
Operating Expenses. Operating expenses in the three months ended December
31, 2002 increased 11.3% to $26.5 million from $23.8 million in the three
months ended December 31, 2001. The increase in operating expenses was
primarily driven by increased spending in selling and administrative and
other charges (income), net, partially offset by amortization expense.
Selling and administrative expenses included approximately $1.0 million of
expenses due to acquisitions and $0.5 million due to foreign exchange as
well as increased spending to support new product launches and build brand
support. Selling and administrative expenses as a percentage of net sales
increased to 35.4% in the three months ended December 31, 2002 as compared
to 33.8% in the three months ended December 31, 2001. Amortization expense
decreased approximately $1.4 million due the adoption of SFAS No. 142. SFAS
No. 142 requires the Company to no longer amortize goodwill and other
intangibles with indefinite useful lives. Had the provisions of SFAS No.
142 been adopted in the three months ended December 31, 2001, amortization
expense would have been reduced by approximately $1.4 million. Other
charges, net was $0.5 million for the three months ended December 31, 2002
as compared to no expense in the three months ended December 31, 2001. The
increase of $0.5 million was primarily driven by assets write-offs of $0.3
million and foreign currency transaction and hedge losses of $0.2 million.
-17-
Operating Income. Primarily as a result of the factors mentioned above,
operating income increased 34.0% to $6.6 million in the three months ended
December 31, 2002 from $4.9 million in the three months ended December 31,
2001. Operating income as a percentage of net sales in the three months
ended December 31, 2002 increased to 9.6% as compared to 8.0% in the three
months ended December 31, 2001.
Interest Expense, Net. Interest expense, net, in the three months ended
December 31, 2002 decreased 3.3% to $4.9 million from $5.1 million in the
three months ended December 31, 2001. The decrease is attributed to lower
weighted average borrowings and interest rates in effect for the three
months ended December 31, 2002 as compared to the three months ended
December 31, 2001.
Provision For Income Taxes. The provision for income taxes in the three
months ended December 31, 2002 was $0.6 million as compared to $0.5 million
in the three months ended December 31, 2001. The effective tax rate in the
three months ended December 31, 2002 and 2001 was different from the
statutory rate due to the mix of income between the Company's foreign and
domestic subsidiaries. The Company's foreign subsidiaries had taxable
income in their foreign jurisdictions while the Company's domestic
subsidiaries generated a net operating loss. The domestic subsidiaries have
net operating loss carry-forwards for income tax purposes. Due to the
uncertainty of realizing these tax benefits, the tax benefits generated by
the net operating losses have been fully offset by a valuation allowance.
Net Income (Loss). For the three months ended December 31, 2002 the Company
had net income of $1.0 million as compared to net loss of $0.7 million for
the three months ended December 31, 2001 for the reasons described above.
EBITDA. EBITDA is defined by the Company as earnings before interest,
taxes, depreciation, amortization, and non-operating income or expense.
Non-operating income or expense is further defined as extraordinary gains
or losses, or gains or losses from sales of assets other than in the
ordinary course of business. While the Company believes EBITDA is a useful
indicator of its ability to service debt, EBITDA should not be considered
as a substitute for net income determined in accordance with accounting
principles generally accepted in the United States of America as an
indicator of operating performance or as an alternative to cash flow as a
measure of liquidity. Investors should be aware that EBITDA as presented
below may not be comparable to similarly titled measures presented by other
companies and comparisons could be misleading unless all companies and
analysts calculate this measure in the same fashion.
-18-
EBITDA Calculation
(Dollars in Thousands)
Three Months Ended
December 31, Change
------------------- --------------------
2002 2001 Amount Percent
------- ------- -------- --------
Operating Income $ 6,594 $ 4,922 $ 1,672 34.0 %
Add Backs:
Depreciation 2,659 2,375 284 12.0
Amortization of Intangibles 116 1,559 (1,443) --
Non-operating costs, net 260 8 252 --
------- ------- -------- --------
EBITDA $ 9,629 $ 8,864 $ 765 8.6 %
By Segment
Safety Products 8,984 7,982 1,002 12.6 %
Safety Prescription Eyewear (81) 254 (335) --
Specialty Composites 713 31 682 --
Reconciling Items 13 597 (584) --
------- ------- -------- --------
$ 9,629 $ 8,864 $ 765 8.6 %
======= ======= ======== ========
EBITDA for the three months ended December 31, 2002 increased 8.6% to $9.6
million from $8.9 million for the three months ended December 31, 2001. The
increase was primarily due to increased volume, the impact of acquisitions,
the effects of foreign exchange and improved productivity. EBITDA as a
percentage of net sales in the three months ended December 31, 2002 was
14.0% as compared to 14.4% in the three months ended December 31, 2001. The
Safety Products segment EBITDA for the three months ended December 31, 2002
increased 12.6% to $9.0 million from $8.0 million in the three months ended
December 31, 2001. The increase was primarily due to increased volume, the
impact of new product launches and the positive effects of foreign
exchange. The Safety Prescription Eyewear segment EBITDA for the three
months ended December 31, 2002 was a loss of $0.1 million as compared to
income of $0.3 million in the three months ended December 31, 2001. The
decrease was primarily due to increased costs related to integration
efforts for acquisitions and the timing of benefits related to new eyewear
frame launch. The Specialty Composites segment EBITDA for the three months
ended December 31, 2002 increased to $0.7 million as compared to breakeven
in the three months ended December 31, 2001. The increase was primarily
driven by volume increases in the truck market, the aircraft market and the
electronics segment of the precision equipment market, which includes
computers and personal communications system (PCS) applications.
Effects of Changes in Exchange Rates
In general, the Company's results of operations are affected by changes in
exchange rates. Subject to market conditions, the Company prices its
products in Europe and Canada in local currency. While many of the
Company's selling and distribution costs are also denominated in these
-19-
currencies, a large portion of product costs are U.S. Dollar denominated.
As a result, a decline in the value of the U.S. Dollar relative to other
currencies can have a favorable impact on the profitability of the Company,
and an increase in the value of the U.S. Dollar relative to these other
currencies can have a negative effect on the profitability of the Company.
As a result of the acquisition of Peltor, the Company's operations are also
affected by changes in exchange rates relative to the Swedish Krona. In
contrast to the above, a decline in the value of the Krona relative to
other currencies can have a favorable impact on the profitability of the
Company and an increase in the value of the Krona relative to other
currencies can have a negative impact on the profitability of the Company.
The Company utilizes forward foreign currency contracts, and other hedging
instruments, to mitigate the effects of changes in foreign currency rates
on profitability.
Effects of Inflation
In recent years, inflation has been modest and has not had a material
impact upon the results of the Company's operations.
Effects of Economic Conditions
Softening of the North American economy began during the first fiscal
quarter of 2001. Since that time the overall economic downturn has resulted
in layoffs for many companies which has also had an impact on overall
consumer confidence. The announced layoffs have had a significant impact on
the number of employed industrial workers. Although the Company has
experienced improved revenue trends in the first quarter of fiscal 2003,
there can be no assurances, given the current economic conditions, that
these trends will be maintained for the remainder of the fiscal year.
Liquidity and Capital Resources
The Company's sources of funds have consisted primarily of operating cash
flow and debt financing. The Company's uses of those funds consist
principally of debt service, capital expenditures and acquisitions.
The Company's debt structure includes: (a) $98.0 million of senior
subordinated notes (Notes) due 2005, which are publicly held and are
redeemable at the option of the Company, in whole or in part, at various
redemption prices, and (b) up to an aggregate of $135.0 million under a
credit agreement with various banks comprised of (i) a secured term loan
facility consisting of loans providing for up to $100.0 million of term
loans (collectively the Term Loans) with a portion of the Term Loans
denominated in foreign currencies, (ii) a secured revolving credit facility
(Revolving Credit Facility) providing for up to $30.0 million of revolving
loans for general corporate purposes and (iii) a U.K. overdraft facility of
up to an equivalent of $5.0 million in Great Britain Pounds for working
capital requirements as needed (collectively the Senior Bank Facilities).
The amount outstanding on the Term Loans at December 31, 2002, was
approximately $92.1 million. No amounts were outstanding under the
Revolving Credit Facility or the U.K. overdraft facility.
Under the terms of both the Senior Bank Facilities and the Notes indenture,
Aearo Company is required to comply with certain financial covenants and
restrictions. Aearo Company was in compliance with all financial covenants
and restrictions at December 31, 2002.
During the first quarter of fiscal 2002, the Company's Board of Directors
authorized management to repurchase, from time to time, a portion of the
Company's 12.5% Notes, subject to market conditions and other factors. No
assurances can be given as to whether or when or at what price such
repurchases will occur. Subsequently, pursuant to a first amendment to the
Senior Bank Facilities, the Company purchased and retired $2.0 million of
the Notes during the first quarter of fiscal 2002.
-20-
Maturities under the Company's Term Loans are approximately: $9.6 million
for the remainder of fiscal 2003, $17.0 million in fiscal 2004 and $65.5
million thereafter. The Company is required to make interest payments with
respect to both the Senior Bank Facilities and the Notes. The Company's
Revolving Credit Facility and Term Loans mature in March 2005.
The Company's net cash provided by operating activities for the three
months ended December 31, 2002 totaled $8.2 million as compared to $8.1
million for the three months ended December 31, 2001. The increase of $0.1
million was due primarily to a $1.1 million improvement in net income
(loss) adjusted for cash and non-cash charges (depreciation, amortization,
deferred taxes and other) partially offset by a $1.0 million net change in
assets and liabilities. The Company's net changes in assets and liabilities
was primarily driven by a $2.7 million reduction of cash from inventory
partially offset by a $1.7 million increase in cash from receivables,
accounts payable and accrued liabilities and other.
Net cash used by investing activities was $3.4 million for the three months
ended December 31, 2002 as compared to $2.5 million for the three months
ended December 31, 2001. The increase of $0.9 million in net cash used by
investing activities is primarily attributed to an increase in acquisitions
of $0.5 million and an increase in capital expenditures of $0.4 million.
Net cash used by financing activities for the three months ended December
31, 2002 was $3.2 million compared with net cash used by financing
activities for the three months ended December 31, 2001 of $4.1 million.
The change of $0.9 million is primarily due to the repayment of term loans
in the three months ended December 31, 2002 as compared to the three months
ended December 31, 2001.
The Company maintains a noncontributory defined benefit cash balance
pension plan. The Company utilizes an outside actuarial firm to estimate
pension expense and funding based on various assumptions including the
discount rate and the expected long-term rate of return on plan assets. In
developing the expected long-term rate of return assumption, the Company's
management evaluates input from outside investment advisors and actuaries
as of the measurement date. Beginning in fiscal year 2000, the actual asset
returns for the Company's pension plan have been adversely affected by the
continued deterioration in the equity markets. During that time, the asset
returns on the Company's pension plan have been negative. Although
short-term trends have been negative, the Company believes that an 8.5%
long-term rate of return on plan assets is reasonable based on historical
trends over a 20-30 year period. The estimated effect of a 1% change in the
expected long-term rate of return on plan assets results in a $0.1 million
impact on pension expense. The discount rate has also declined during the
same period. The Company bases the discount rate on the Aa Corporate bond
yields. The estimated impact of a 1% change in the discount rate results in
a $0.2 million impact on pension expense.
The negative asset returns and declining discount rates are expected to
unfavorably impact the Company's pension expense and the funded status of
the pension plan. Under minimum funding rules, no additional pension
contributions are required to be made in fiscal 2003 however, contributions
may increase in future years. Due to the uncertainty of the future returns
of the equity and corporate bond markets, it is difficult to estimate the
impact of pension contributions in the future.
The Company has a substantial amount of indebtedness. The Company relies on
internally generated funds, and to the extent necessary, on borrowings
-21-
under the Revolving Credit Facility (subject to certain customary drawing
conditions) to meet its liquidity needs. The Company anticipates that
operating cash flow will be adequate to meet its operating and capital
expenditure requirements for the next several years, although there can be
no assurances that existing levels of sales and normalized profitability,
and therefore cash flow, will be maintained. In particular, during fiscal
2001 and 2002, the Company was affected by the significant slowdown in the
manufacturing sector of the economies in which the Company markets its
products that began in earnest during the first fiscal quarter of fiscal
2001, exacerbated by the impact of the terrorist events of September 11,
2001. As a result, it is expected that the Company will continue to operate
in a challenging sales environment. The Company expects to arrange for new
financing of both the Senior Bank Facilities and the Notes before maturity
of the Senior Bank Facilities in March 2005. There can be no assurances
that any additional financing or other sources of capital will be available
to the Company at acceptable terms, or at all. The inability to obtain
additional financing would have a material adverse effect on the Company's
business, financial condition and results of operations.
-22-
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The Company is exposed to market risks related to changes in foreign
currencies, interest rates and commodity pricing. The Company uses
derivatives to mitigate the impact of changes in foreign currencies and
interest rates. All derivatives are for purposes other than trading. The
Company adopted the provisions of SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" on October 1, 2000. The Company has
formally documented its hedging relationships, including identification of
hedging instruments and the hedge items, as well as its risk management
objectives.
Foreign Currency Risk
The Company's results of operations are subject to risks associated with
operating in foreign countries, including fluctuations in currency exchange
rates. While many of the Company's selling and distribution costs are
denominated in Canadian and European currencies, a large portion of product
costs are U.S. Dollar denominated. As a result, a decline in the value of
the U.S. Dollar relative to other currencies can have a favorable impact on
the profitability of the Company and an increase in the value of the U.S.
Dollar relative to these other currencies can have a negative effect on the
profitability of the Company. As a result of the acquisition of Peltor, the
Company's operations are also affected by changes in exchange rates
relative to the Swedish Krona. A decline in the value of the Krona relative
to other currencies can have a favorable impact on the profitability of the
Company and an increase in the value of the Krona relative to other
currencies can have a negative impact on the profitability of the Company.
To mitigate the effects of changes in foreign currency rates on
profitability the Company executes two hedging programs, one for
transaction exposures, and the other for cash flow exposures in European
operations. The Company utilizes forward foreign currency contracts for
transaction as well as cash flow exposures. For the three months ended
December 31, 2002, net transaction losses were $0.1 million and cash flow
hedge losses were $0.1 million. In addition, the Company limits the foreign
exchange impact on the balance sheet with foreign denominated debt in Great
Britain Pound Sterling, Euros and Canadian dollars.
SFAS No. 133 requires that every derivative instrument be recorded in the
balance sheet as either an asset or liability measured at its fair value.
As it relates to cash flow exposures in European operations, the Company
has recorded a derivative payable of $0.6 million as of December 31, 2002.
The forward foreign currency contracts will expire over the next six
months. Interest Rates
The Company is exposed to market risk changes in interest rates through its
debt. The Company utilizes interest rate instruments to reduce the impact
of either increases or decreases in interest rates on its floating rate
debt.
The Company has approximately $25.0 million of variable rate debt protected
under an interest rate collar arrangement through December 31, 2003. The
floor is set at 2% and the cap at 6.25%. The fair value of the collar at
December 31, 2002 was $0.1 million. The Company has not elected to take
hedge accounting treatment for the interest rate collar as defined under
SFAS No. 133 and, as a result, any fair value adjustment is charged
directly to other income (expense). Approximately $0.1 million was expensed
during the three months ended December 31, 2002.
The Company is of the opinion that it is well positioned to manage interest
exposures in the short term. The Company continues to monitor interest rate
movements and has mitigated the risks of potential interest rate
fluctuations through the use of the aforementioned interest rate
instruments.
Commodity Risk
The Company is subject to market risks with respect to industry pricing in
paper and crude oil as it relates to various commodity items. The Company
is also
-23-
exposed to market risks for electricity, fuel oil and natural gas consumed
in its operations. Items with potential risk of price volatility are
paperboard, packaging films, nylons, resins, propylene, ethylene,
plasticizer and freight. The Company manages pricing exposures on larger
volume commodities such as polycarbonate, polyols and polyvinyl chloride
via price negotiations utilizing alternative supplier competitive pricing.
The Company sources some products and parts from Far East sources where
resource availability, competition, and infrastructure stability has
provided a favorable purchasing environment. The Company does not enter
into derivative instruments to manage commodity risks.
-24-
Item 4. Controls and Procedures
Disclosure controls and procedures are defined by the Securities and
Exchange Commission as those controls and other procedures that are
designed to ensure that information required to be disclosed in the
Company's filings under the Securities Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the Securities
and Exchange Commission's rules and forms. The Company's Chief Executive
Officer and Chief Financial Officer have evaluated the Company's disclosure
controls and procedures within 90 days prior to the filing of this
Quarterly Report on Form 10-Q and have determined that such disclosure
controls and procedures are effective.
Subsequent to the Company's evaluation, there were no significant changes
in internal controls or other factors that could significantly affect
internal controls, including any corrective actions with regard to
significant deficiencies and material weaknesses.
-25-
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Various lawsuits and claims arise against the Company in the ordinary
course of its business. Most of these lawsuits and claims are products
liability matters that arise out of the use of safety eyewear and
respiratory product lines manufactured by the Company as well as products
purchased for resale. In addition, the Company may be contingently liable
with respect to numerous lawsuits involving respirators sold by its
predecessors, American Optical Corporation and Cabot Corporation, arising
out of agreements entered into when the AOSafety(R) Division was sold by
American Optical Corporation to Cabot in April 1990 and when later sold by
Cabot to the Company in 1995. These lawsuits typically involve plaintiffs
alleging that they suffer from asbestosis or silicosis, and that such
condition results in part from respirators that were negligently designed
or manufactured. The defendants in these lawsuits are often numerous, and
include, in addition to respirator manufacturers, employers of the
plaintiffs and manufacturers of sand (used in sand blasting) and asbestos.
Responsibility for legal costs, as well as for settlements and judgments,
is shared contractually by the Company, Cabot, American Optical Corporation
and a prior owner of American Optical Corporation. Liability is allocated
among the parties based on the number of years each Company owned the
AOSafety Division and the alleged years of exposure of the individual
plaintiff. The Company's share of the contingent liability is further
limited by an agreement entered into between the Company and Cabot on July
11, 1995, as amended in 2002. This agreement provides that, so long as the
Company pays to Cabot an annual fee of $400,000, Cabot will retain
responsibility and liability for, and indemnify the Company against,
asbestos and silica-related legal claims asserted after July 11, 1995 and
alleged to have arisen out of the use of respirators while exposed to
asbestos or silica prior to January 1, 1997. To date, the Company has
elected to pay the annual fee. The Company could potentially be liable for
these exposures if the Company elects to discontinue its participation in
this arrangement, or if Cabot is no longer able to meet its obligations in
these matters. With these arrangements in place, however, the Company's
potential liability is limited to exposures alleged to have arisen from the
use of respirators while exposed to asbestos or silica on or after January
1, 1997. The Company also may be responsible for certain claims relating to
acquired companies other than the AOSafety(R) Division that are not covered
by, and are unrelated to, the agreement with Cabot.
At December 31, 2002, the Company has recorded liabilities of approximately
$4.6 million, which represents reasonable estimates of its probable
liabilities, for product liabilities substantially related to asbestos and
silica-related claims as determined by the Company in consultation with an
independent consultant. This reserve is re-evaluated periodically and
additional charges or credits to operations may result as additional
information becomes available. Consistent with the current environment
being experienced by companies involved in asbestos and silica-related
litigation, there has been an increase in the number of asserted claims
that could potentially involve the Company. Various factors increase the
difficulty in determining the Company's potential liability, if any, in
such claims, including the fact that the defendants in these lawsuits are
often numerous and the claims generally do not specify the amount of
damages sought. Additionally, the bankruptcy filings of other companies
with asbestos and silica-related litigation could increase the Company's
cost over time. In light of these and other uncertainties inherent in
making long-term projections, the Company has determined that the five-year
period through fiscal 2007 is the most reasonable time period for
projecting asbestos and silica-related claims and defense costs. It is
-26-
possible that the Company may incur liabilities in an amount in excess of
amounts currently reserved. However, taking into account currently
available information, historical experience, and the Cabot agreement, but
recognizing the inherent uncertainties in the projection of any future
events, it is management's opinion that these suits or claims should not
result in final judgments or settlements in excess of the Company's reserve
that, in the aggregate, would have a material effect on the Company's
financial condition, liquidity or results of operations.
Item 2. Changes in Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
None
(b) Reports on Form 8-K
None
-27-
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.
Date: February 13, 2003 AEARO CORPORATION
/s/ Jeffrey S. Kulka
---------------------------
Jeffrey S. Kulka
Vice President, Chief Financial
Officer, Treasurer, and Secretary
(Principal Financial and
Accounting Officer)
-28-
CERTIFICATION
I, Michael A. McLain, Principal Executive Officer of Aearo Corporation,
certify that:
1. I have reviewed this quarterly report on Form 10-Q of Aearo Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or person performing the
equivalent functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: February 13, 2003
/s/ Michael A. McLain
-------------------------------
Michael A. McLain
Chief Executive Officer, President
and Chairman of the Board
(Principal Executive Officer)
-29-
CERTIFICATION
I, Jeffrey S. Kulka, Principal Financial Officer of Aearo Corporation,
certify that:
1. I have reviewed this quarterly report on Form 10-Q of Aearo Corporation;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or person performing the
equivalent functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
Date: February 13, 2003 /s/ Jeffrey S. Kulka
-------------------------
Jeffrey S. Kulka
Vice President, Chief Financial Officer,
Treasurer and Secretary
(Principal Financial Officer)
-30-