SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2003
Commission file number 33-96190
AEARO CORPORATION
(Exact name of registrant as specified in its charter)
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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)
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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 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 May 15, 2003 was 101,912.5.
Aearo Corporation
TABLE OF CONTENTS
Form 10-Q for the Quarterly Period Ended March 31, 2003
PART I-FINANCIAL INFORMATION...................................................3
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Item 1. Financial Statements................................................3
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Condensed Consolidated Balance Sheets - Assets......................3
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Condensed Consolidated Balance Sheets - Liabilities and Stockholders'
Equity..............................................................4
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Condensed Consolidated Statements of Operations.....................5
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Condensed Consolidated Statements of Cash Flows.....................6
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Notes To Condensed Consolidated Financial Statements................7
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Item 2. Management's Discussion and Analysis of Financial Condition and
- ------- Results of Operations..............................................16
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Item 3. Quantitative and Qualitative Disclosures About Market Risk.........25
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Item 4. Controls and Procedures............................................27
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PART II - OTHER INFORMATION...................................................28
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Item 1. Legal Proceedings..................................................28
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Item 2. Changes in Securities and Use of Proceeds..........................29
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Item 3. Defaults Upon Senior Securities....................................29
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Item 4. Submission of Matters to a Vote of Security Holders................29
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Item 5. Other Information..................................................29
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Item 6. Exhibits and Reports on Form 8-K...................................29
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SIGNATURES....................................................................30
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EXHIBIT INDEX.................................................................33
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PART I-FINANCIAL INFORMATION
Item 1. Financial Statements
AEARO CORPORATION
Condensed Consolidated Balance Sheets - Assets
(Dollars in Thousands)
March 31, September 30,
2003 2002
----------- --------------
(Unaudited)
CURRENT ASSETS:
Cash and cash equivalents $ 5,153 $ 14,480
Accounts receivable (net of allowance for doubtful accounts of
$1,895 and $1,524, respectively) 46,226 46,478
Inventories 37,617 33,161
Deferred and prepaid expenses 3,751 3,449
----------- --------------
Total current assets 92,747 97,568
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LONG TERM ASSETS:
Property, plant and equipment, net 48,309 48,096
Intangible assets, net 135,850 121,979
Other assets 2,825 2,526
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Total assets $ 279,731 $ 270,169
=========== ==============
The accompanying notes are an integral part of these condensed
consolidated financial statements.
- 3 -
AEARO CORPORATION
Condensed Consolidated Balance Sheets - Liabilities and Stockholders' Equity
(Dollars in Thousands)
March 31, September 30,
2003 2002
----------------- ----------------
(Unaudited)
CURRENT LIABILITIES:
Current portion of long-term debt $ 15,063 $ 12,847
Accounts payable and accrued liabilities 39,802 36,410
Accrued interest 2,566 2,568
U.S. and foreign income taxes 3,140 1,156
---------------- --------------
Total current liabilities 60,571 52,981
---------------- --------------
Long-term debt 176,637 182,715
Deferred income taxes 879 800
Other liabilities 12,857 12,129
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Total liabilities $ 250,944 $ 248,625
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COMMITMENTS AND CONTINGENCIES:
Preferred stock, $.01 par value-
(Redemption value of $116,429 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 32,233 32,254
Retained earnings 10,558 6,825
Accumulated other comprehensive loss (14,005) (17,536)
----------------- --------------
Total stockholders' equity 28,787 21,544
---------------- --------------
Total liabilities and stockholders' equity $ 279,731 $ 270,169
================ ==============
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
- 4 -
Condensed Consolidated Statements of Operations
(DOLLARS IN THOUSANDS)
(Unaudited)
For the Three Months Ended For the Six Months Ended
March 31, March 31,
------------------------------------ -----------------------------------
2003 2002 2003 2002
--------------- ---------------- ---------------- -----------------
NET SALES $ 76,686 $ 70,683 $ 145,403 $ 132,326
COST OF SALES 39,912 37,360 75,557 70,288
--------------- --------------- --------------- ---------------
Gross profit 36,774 33,323 69,846 62,038
SELLING AND ADMINISTRATIVE 24,867 22,832 49,188 43,688
RESEARCH AND TECHNICAL SERVICES 1,626 1,389 3,209 2,758
AMORTIZATION OF INTANGIBLES 16 1,557 132 3,116
OTHER CHARGES 499 29 957 38
--------------- --------------- --------------- ---------------
Operating income 9,766 7,516 16,360 12,438
INTEREST EXPENSE, NET 5,001 4,936 9,943 10,046
--------------- --------------- --------------- ---------------
Income before provision for income taxes
4,765 2,580 6,417 2,392
PROVISION FOR INCOME TAXES 2,074 563 2,684 1,086
--------------- --------------- --------------- ---------------
Net Income $ 2,691 $ 2,017 $ 3,733 $ 1,306
=============== =============== =============== ===============
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
- 5 -
Condensed Consolidated Statements of Cash Flows
(DOLLARS IN THOUSANDS)
(Unaudited)
For the Six Months Ended
March 31,
2003 2002
--------------- ----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 3,733 $ 1,306
Adjustments to reconcile net income to cash provided by operating activities-
Depreciation 5,363 5,108
Amortization of intangible assets and deferred financing costs 943 3,890
Deferred income taxes (7) 104
Other, net 273 248
Changes in assets and liabilities-(net of effects of acquisitions)
Accounts receivable 2,722 1,772
Inventories (2,069) 224
Accounts payable and accrued liabilities (380) (4,726)
Income taxes payable 2,011 (349)
Other, net (807) (746)
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Net cash provided by operating activities 11,782 6,831
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CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property, plant and equipment (4,339) (3,964)
Cash paid for acquisitions, net of cash acquired (11,062) (4,342)
Proceeds provided by disposals of property, plant and equipment 6 12
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Net cash used by investing activities (15,395) (8,294)
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CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from revolving credit facility, net 500 --
Repayment of bonds -- (2,000)
Repayment of term loans (6,332) (4,024)
Repayment of capital lease obligations (106) (53)
Repayment of long-term debt (31) (70)
Other (20) (126)
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Net cash used by financing activities (5,989) (6,273)
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EFFECT OF EXCHANGE RATE CHANGES ON CASH 275 238
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DECREASE IN CASH AND CASH EQUIVALENTS (9,327) (7,498)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 14,480 18,233
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CASH AND CASH EQUIVALENTS, END OF PERIOD $ 5,153 $ 10,735
============= =============
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Capital lease obligations $ 430 $ 1,285
============= =============
CASH PAID FOR:
Interest $ 9,118 $ 9,346
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Income taxes $ 747 $ 1,248
============= =============
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
- 6 -
AEARO CORPORATION
Notes To Condensed Consolidated Financial Statements
MARCH 31, 2003
(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.
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 bad debt 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.
Foreign Currency Transactions. Foreign currency gains and losses arising
from transactions by any of the Company's subsidiaries are reflected in net
income.
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 enacted tax rates.
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
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AEARO CORPORATION
Notes To Condensed Consolidated Financial Statements
MARCH 31, 2003
(Unaudited)
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 performed its first
annual impairment test as of January 1, 2003 and determined there was no
impairment. 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 and six months ended March 31, 2003 and 2002 as if SFAS No. 142
had been adopted (Dollars in thousands):
Three Months Ended Six Months Ended
March 31, March 31,
-------------------------- -------------------------
2003 2002 2003 2002
------------ ----------- ----------- ----------
Net income as reported $ 2,691 $ 2,017 $ 3,733 1,306
Goodwill amortization -- 778 $ -- 1,558
Trademark amortization -- 741 $ -- 1,482
------------ ----------- ----------- ----------
Net income $ 2,691 $ 3,536 $ 3,733 4,346
============ =========== =========== ==========
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") 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.
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
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AEARO CORPORATION
Notes To Condensed Consolidated Financial Statements
MARCH 31, 2003
(Unaudited)
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 following table illustrates the effect on net income as if
the fair value based method had been applied to all outstanding and unvested
awards:
(Dollars in thousands)
Three Months Ended Six Months Ended
March 31, March 31,
------------------------ ------------------------
2003 2002 2003 2002
----------- --------- ----------- -----------
Net income as reported $ 2,691 $ 2,017 $ 3,733 $ 1,306
Add: Total stock-based employee compensation expense
determined under intrinsic value method for all
awards, net of tax Add: - -
Deduct: Total stock-based employee compensation
expense determined under fair value based method for
all awards, net of tax (74) (94)
----------- ---------- ----------- -----------
Net income $ 2,654 $ 1,970 $ 3,659 $ 1,212
=========== ========== =========== ===========
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 adoption of FIN No. 45 had no effect on the Company's 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 31, 2003 and to variable interest entities in which an
enterprise obtains an interest after that date. The adoption of FIN No. 46 had
no effect on its financial position or results of operations.
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
- 9 -
AEARO CORPORATION
Notes To Condensed Consolidated Financial Statements
MARCH 31, 2003
(Unaudited)
Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities" 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. Amounts
accumulated in other comprehensive income 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 $0.7 million at March 31, 2003. All forward
foreign currency contracts will expire over the next six months.
During the three and six month period ending March 31, 2003, the Company
reclassified into earnings a net loss of approximately $0.5 million and $0.6
million, respectively 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. There was no impact on earnings for
the period ended March 31, 2003.
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 March 31, 2003 was a liability of $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). There was no
impact on earnings for the three and six month period ended March 31, 2003.
4) COMPREHENSIVE INCOME
Comprehensive income consisted of the following (Dollars in thousands):
For the Three Months Ended For the Six Months
March 31, Ended March 31,
------------------------- ------------------------
2003 2002 2003 2002
----------- ---------- --------- -----------
Net income $ 2,691 $ 2,017 $ 3,733 $ 1,306
Foreign currency translation adjustment 1,317 160 4,185 698
Unrealized gain (loss) on derivative
instruments (57) (95) (654) 136
---------- ---------- --------- -----------
Comprehensive income $ 3,951 $ 2,082 $ 7,264 $ 2,140
========== ========== ========= ===========
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
- 10 -
AEARO CORPORATION
Notes To Condensed Consolidated Financial Statements
MARCH 31, 2003
(Unaudited)
5) INVENTORIES
Inventories consisted of the following (Dollars in thousands):
March 31, September 30,
2003 2002
---------------- ----------------
Raw materials $ 8,175 $ 7,514
Work in process 11,148 10,196
Finished goods 18,294 15,451
--------------- ---------------
$ 37,617 $ 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 amounts outstanding on the Term Loans and the Revolving Credit Facility
at March 31, 2003 were approximately $89.2 million and $0.5 million,
respectively. No amounts were outstanding under 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 March 31, 2003.
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.
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
- 11 -
AEARO CORPORATION
Notes To Condensed Consolidated Financial Statements
MARCH 31, 2003
(Unaudited)
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 March 31, 2003, the Company has recorded liabilities of approximately
$4.7 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
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
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
- 12 -
AEARO CORPORATION
Notes To Condensed Consolidated Financial Statements
MARCH 31, 2003
(Unaudited)
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):
For the Three Months Ended For the Six Months Ended
March 31, March 31,
---------------------------- ----------------------------
2003 2002 2003 2002
------------- ------------- ------------ -----------
Safety Products $ 58,198 $ 50,377 $ 108,684 $ 95,383
Safety Prescription Eyewear 10,494 10,550 20,298 19,544
Specialty Composites 7,994 9,756 16,421 17,399
------------- ------------- ------------ -----------
Total $ 76,686 $ 70,683 $ 145,403 $ 132,326
============= ============= ============ ===========
Inter-segment sales of the Specialty Composites segment to the Safety
Products segment totaled $0.8 million and $0.6 million for the three months
ended March 31, 2003 and 2002, respectively. Inter-segment sales totaled
$1.6 million and $1.3 million for the six months ended March 31, 2003 and
2002, respectively. The inter-segment sales value is determined at fully
absorbed inventory cost at standard rates plus 25%.
Profit by Business Segment and reconciliation to income before provision
for income taxes (Dollars in thousands):
For the Three Months Ended For the Six Months Ended
March 31, March 31,
--------------------------- --------------------------
2003 2002 2003 2002
------------- ------------ ----------- -------------
Safety Products $ 12,059 $ 10,013 $ 21,013 $ 18,431
Safety Prescription Eyewear 416 752 357 1,099
Specialty Composites 11 1,041 485 1,132
------------- ------------ ----------- -------------
Segment profit 12,486 11,806 21,855 20,662
Depreciation 2,704 2,733 5,363 5,108
Amortization of intangibles 16 1,557 132 3,116
Interest 5,001 4,936 9,943 10,046
------------- ------------ ----------- -------------
Income before provision for income taxes $ 4,765 $ 2,580 $ 6,417 $ 2,392
============= ============ =========== =============
Segment profit is defined as operating income before depreciation,
amortization and interest expense and represents the measure used by the
chief operating decision maker to assess segment performance and make
decisions about the allocation of resources to business segments.
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
- 13 -
AEARO CORPORATION
Notes To Condensed Consolidated Financial Statements
MARCH 31, 2003
(Unaudited)
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
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 six months ended March 31, 2003 (Dollars in
thousands):
September 30, March 31,
2002 Charges 2003
------------- ------------- ------------
Employee termination costs $ 730 $ (304) $ 426
Lease agreements 2,352 (448) 1,904
Loss on disposal of assets 700 700
Other 47 (25) 22
------------- ------------- ------------
Total $ 3,829 $ (777) $ 3,052
============= ============= ============
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 pro forma consolidated results would not be
materially different from actual results for the six months ended March 31,
2002.
On March 14, 2003 the Company acquired VH Industries, Inc. ("VH") of
Concord, North Carolina for approximately $11.5 million. VH Industries is a
manufacturer of fall protection products sold under the SafeWaze trade name
in the United States. 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 VH have been
included with those of the Company subsequent to March 14, 2003.
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
- 14 -
AEARO CORPORATION
Notes To Condensed Consolidated Financial Statements
MARCH 31, 2003
(Unaudited)
The following unaudited pro forma information presents results as if the
acquisition had occurred at the beginning of the respective periods
(Dollars in thousands):
Three Months Ended Six Months Ended
March 31, March 31,
----------------------- ---------------------
2003 2002 2003 2002
---------- ---------- ---------- ----------
Net sales as reported $ 76,686 $ 70,683 $ 145,403 132,326
Pro forma sales 79,408 73,402 150,465 137,099
Net income as reported $ 2,691 $ 2,017 $ 3,733 1,306
Pro forma net income 3,187 2,536 4,267 1,930
The accompanying notes are an intregal part of these condensed
consolidated financial statements.
- 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.
Critical Accounting Policies
The Company's discussion and analysis of its financial condition and results of
operations are based upon the Company's condensed consolidated financial
statements, which have been prepared in accordance with accounting principles
generally accepted in the United States of America (GAAP). GAAP requires the use
of estimates, judgments, assumptions and subjective interpretations of
accounting principles that affect the reported amounts of assets, liabilities,
revenues and expenses. The Company believes its use of estimates and underlying
accounting assumptions adhere to GAAP and are consistently applied. The Company
revises its estimates and assumptions as new information becomes available.
The Company believes that of its significant accounting policies (see Notes to
the Consolidated Financial Statements in the Company's Annual Report on Form
10-K405) the following policies involve a higher degree of judgment and/or
complexity.
Income Taxes - The Company accounts for income taxes in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for
Income Taxes", which requires deferred tax assets and liabilities be recognized
using enacted tax rates for the effect of temporary differences between book and
tax bases of recorded assets and liabilities. SFAS No. 109 also requires
deferred tax assets be reduced by a valuation allowance if it is more likely
than not that some portion or all of the deferred tax assets will not be
realized. Recognition of a deferred tax asset is dependent on generating
sufficient future taxable income in the United States prior to the expiration of
the tax loss and credit carryforwards, which expire over various periods ranging
from 2010 to 2021. In its evaluation of the adequacy of the valuation allowance,
the Company assesses prudent and feasible tax planning strategies. Due to the
uncertainties of realizing these tax benefits, the Company has recorded a full
valuation allowance against these losses and credit carryforwards. The ultimate
amount of deferred tax assets realized could be different from those recorded,
as influenced by potential changes in enacted tax laws and the availability of
future taxable income.
Product Liabilities -The Company has established reserves for potential product
liabilities that arise out of the use of the Company's products. A significant
amount of judgment is required to quantify the Company's ultimate exposure in
these matters and the valuation of reserves is estimated based on currently
available information, historical experience and from time to time the Company
may seek the assistance of an independent consultant. While the Company believes
that the current level of reserves is adequate, changes in the future could
impact these determinations.
Restructuring - The Company recorded an unusual charge in fiscal 2001 based on a
restructuring plan to improve its competitive position and long-term
profitability. The provision recorded was based on estimates of the expected
costs associated with site closures, consolidation of products and product
lines, disposal of assets, contract terminations or other costs directly related
to the restructuring. To the extent that actual costs
- 16 -
may differ from amounts recorded, revisions to the estimated reserves would be
required. A reduction of $0.6 million was made during fiscal 2002 to account for
new information made available during that year.
Pension Plan - The valuation of the Company's pension plan requires the use of
assumptions and estimates that are used to develop actuarial valuations of
expenses and assets/liabilities. These assumptions include discount rates,
investment returns, projected salary increases and mortality rates. The
actuarial assumptions used in the Company's pension reporting are reviewed
annually and compared with external benchmarks to assure that they accurately
account for future pension obligations. Changes in assumptions and future
investment returns could potentially have a material impact on the Company's
pension expense and funding requirements.
Impairment of Long-Lived Assets - The Company evaluates long-lived assets,
including other intangibles and related goodwill, of identifiable business
activities for impairment when events or changes in circumstances indicate, in
management's judgment, that the carrying value of such assets may not be
recoverable. Cash flows used in the potential impairment evaluation are based on
management's estimates and assumptions. Changes in business conditions could
potentially require future adjustments to asset valuations.
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 customers credit
worthiness, historical bad debt experience, changes in payment history and
general economic and market trends.
- 17 -
Results of Operations -- Three Months Ended March 31, 2003 Compared to Three
Months Ended March 31, 2002
Results of Operations
(Dollars in Thousands)
(Unaudited)
Three Months Ended March 31,
---------------------------------------------------------------------
2003 % 2002 %
Safety Products $ 58,198 75.9 $ 50,377 71.3
Safety Prescription Eyewear 10,494 13.7 10,550 14.9
Specialty Composites 7,994 10.4 9,756 13.8
----------- ----------- ----------- -----------
Total net sales 76,686 100.0 70,683 100.0
Cost of Sales 39,912 52.0 37,360 52.9
Gross profit 36,774 48.0 33,323 47.1
Operating Expenses-
Selling and administrative 24,867 32.4 22,832 32.3
Research and technical services 1,626 2.1 1,389 2.0
Amortization of intangibles 16 -- 1,557 2.2
Other charges, net 499 0.7 29 --
----------- ----------- ----------- -----------
Total operating expenses 27,008 35.2 25,807 36.5
Operating income 9,766 12.7 7,516 10.6
Interest expense, net 5,001 6.5 4,936 7.0
----------- ----------- ----------- -----------
Income before provision for income taxes 4,765 6.2 2,580 3.7
Provision for income taxes 2,074 2.7 563 0.8
----------- ----------- ----------- -----------
Net income $ 2,691 3.5 $ 2,017 2.9
=========== =========== =========== ===========
Net Sales. Net sales in the three months ended March 31, 2003 increased 8.5% to
$76.7 million from $70.7 million in the three months ended March 31, 2002. The
increase in net sales was primarily driven by the impact of foreign exchange and
acquisitions as organic growth in the Safety Products segment was partially
offset by declines in the Safety Prescription Eyewear and Specialty Composites
segments. The weakness of the U.S. dollar relative to other currencies, and
acquisitions, favorably impacted net sales by $4.0 million and $2.1 million,
respectively. The Safety Products segment net sales in the three months ended
March 31, 2003 increased 15.5% to $58.2 million from $50.4 million in the three
months ended March 31, 2002. The increase in net sales resulted from a 5.6%
increase due to organic growth, a 7.8% increase due to foreign exchange and a
2.1% increase due to acquisitions. The Safety Prescription Eyewear segment sales
for the three months ended March 31, 2003 decreased 0.5% to $10.5 million from
$10.6 million in the three months ended March 31, 2002. The decrease in volume
was mostly offset by a 10.1% increase due to acquisitions. The Safety
Prescription Eyewear segment sales have been negatively impacted by the
continued reduction in manufacturing employment in North America. The Specialty
Composites segment sales in the three months ended March 31, 2003 decreased
18.1% to $8.0 million from $9.8 million in the three months ended March 31,
2002. The decrease was primarily driven by volume declines in the truck market
and the electronics segment of the precision equipment market, which includes
computers and personal communications system (PCS) applications.
- 18 -
Gross Profit. Gross Profit in the three months ended March 31, 2003 increased
10.4% to $36.8 million from $33.3 million in the three months ended March 31,
2002. The increase in gross profit is primarily due to product mix, productivity
improvements, the impact of foreign exchange and acquisitions. Gross Profit as a
percentage of net sales in the three months ended March 31, 2003 improved to
48.0% as compared to 47.1% in the three months ended March 31, 2002. The
increase in gross profit is primarily due to product mix, productivity
improvements and the impact of foreign exchange.
Operating Expenses. Operating expenses in the three months ended March 31, 2003
increased 4.7% to $27.0 million from $25.8 million in the three months ended
March 31, 2002. The increase was primarily driven by an increase in selling and
administrative expenses and other charges, net partially offset by a decrease in
amortization expense. Selling and administrative expenses in the three months
ended March 31, 2003 included approximately $0.7 million of incremental expenses
due to acquisitions, $0.9 million due to the weakness of the U.S dollar as well
as increased spending to support new product launches and build brand awareness.
The increase in other charges, net was primarily driven by foreign exchange
losses in the three months ended March 31, 2003 as compared to foreign exchange
gains in the three months ended March 31, 2002. Amortization expense decreased
approximately $1.6 million due to 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 March 31, 2002, amortization expense would have been reduced
by approximately $1.5 million. Selling and administrative expenses as a
percentage of net sales increased to 32.4% in the three months ended March 31,
2003 as compared to 32.3% in the three months ended March 31, 2002.
Operating Income. As a result of the factors mentioned above, operating income
increased 30.0% to $9.8 million in the three months ended March 31, 2003 from
$7.5 million in the three months ended March 31, 2002. Operating income as a
percentage of net sales in the three months ended March 31, 2003 increased to
12.7% as compared to 10.6% in the three months ended March 31, 2002.
Interest Expense, Net. Interest expense, net in the three months ended March 31,
2003 increased 1.3% to $5.0 million from $4.9 million in the three months ended
March 31, 2002.
Provision For Income Taxes. The provision for income taxes in the three months
ended March 31, 2003 was $2.1 million as compared to $0.6 million in the three
months ended March 31, 2002. The effective tax rate in the three months ended
March 31, 2003 and 2002 was different from the statutory rate due to the mix of
income between the Company's foreign subsidiaries 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. For the three months ended March 31, 2003 the Company had net income
of $2.7 million as compared to $2.0 million for the three months ended March 31,
2002.
- 19 -
Results of Operations -- Six Months Ended March 31, 2003 Compared to Six Months
Ended March 31, 2002
Results of Operations
(Dollars in Thousands)
(Unaudited)
Six Months Ended March 31,
---------------------------------------------------------
2003 % 2002 %
----------- ------------ ------------ -----------
Safety Products $ 108,684 74.7 $ 95,383 72.1
Safety Prescription Eyewear 20,298 14.0 19,544 14.8
Specialty Composites 16,421 11.3 17,399 13.1
----------- ----------- ----------- -----------
Total net sales 145,403 100.0 132,326 100.0
Cost of Sales 75,557 52.0 70,288 53.1
Gross profit 69,846 48.0 62,038 46.9
Operating Expenses-
Selling and administrative 49,188 33.8 43,688 33.0
Research and technical services 3,209 2.2 2,758 2.1
Amortization of intangibles 132 0.1 3,116 2.4
Other charges, net 957 0.7 38 --
----------- ----------- ----------- -----------
Total operating expenses 53,486 36.8 49,600 37.5
Operating income 16,360 11.2 12,438 9.4
Interest expense, net 9,943 6.8 10,046 7.6
----------- ----------- ----------- -----------
Income before provision for income taxes 6,417 4.4 2,392 1.8
Provision for income taxes 2,684 1.8 1,086 0.8
----------- ----------- ----------- -----------
Net income 3,733 2.6 1,306 1.0
=========== =========== =========== ===========
Net Sales. Net sales in the six months ended March 31, 2003 increased 9.9% to
$145.4 million from $132.3 million in the six months ended March 31, 2002. The
increase in sales was primarily driven by the impact of foreign exchange,
organic growth in the Safety Products segment and acquisitions partially offset
by volume declines in the Specialty Composites and Safety Prescription Eyewear
segments. The weakness of the U.S. dollar relative to other currencies, and
acquisitions, favorably impacted net sales by $6.0 million and $4.8 million,
respectively. The Safety Products segment net sales in the six months ended
March 31, 2003 increased 13.9% to $108.7 million from $95.4 million in the six
months ended March 31, 2002. The increase in net sales resulted from a 5.1%
increase due to organic growth, a 6.2% increase due to foreign exchange and a
2.7% increase due to acquisitions. The Safety Prescription Eyewear segment sales
for the six months ended March 31, 2003 increased 3.9% to $20.3 million from
$19.5 million in the six months ended March 31, 2002. The increase in net sales
resulted from an 11.4% increase due to acquisitions and a 0.3% increase due to
foreign exchange partially offset by a 7.8% reduction in volume. The reduction
in volume experienced by the Safety Prescription Eyewear segment is a result of
the continued decline in industrial manufacturing employment in North America.
The Specialty Composites segment net sales in the six months ended March 31,
2003 decreased 5.6% to $16.4 million from $17.4 million in the six months ended
March 31, 2002. The decrease was primarily driven by volume declines in the
automotive market, the truck market and the
- 20 -
electronics segment of the precision equipment market, which includes computers
and personal communications system (PCS) applications.
Gross Profit. Gross profit in the six months ended March 31, 2003 increased
12.6% to $69.8 million from $62.0 million in the six months ended March 31,
2002. The increase in gross profit is primarily due to product mix, the impact
of foreign exchange, productivity improvements and acquisitions. Gross profit as
a percentage of net sales in the six months ended March 31, 2003 improved to
48.0% as compared to 46.9% in the six months ended March 31, 2002. The increase
in the gross profit as a percentage of net sales is primarily due to product
mix, foreign exchange, and productivity improvements.
Operating Expenses. Operating expenses in the six months ended March 31, 2003
increased 7.8% to $53.5 million from $49.6 million in the six months ended March
31, 2002. The increase in operating expenses was primarily driven by an increase
in selling and administrative expenses, research and technical services and
other charges, net partially offset by a decrease in amortization expense.
Selling and administrative expenses included approximately $1.7 million of
incremental expenses due to acquisitions, $1.5 million due to the weakness of
the U.S dollar as well as increased spending for product launches and marketing
support. Research and technical services expense increased $0.5 million related
to new product development. The increase in other charges, net was primarily due
to foreign exchange losses in the six months ended March 31, 2003 as compared to
foreign exchange gains in the six months ended March 31, 2002. Amortization
expense decreased approximately $3.0 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 six months ended March 31, 2002, amortization expense would
have been reduced by approximately $3.0 million. Selling and administrative
expenses as a percentage of net sales increased to 33.8% in the six months ended
March 31, 2003 as compared to 33.0% in the six months ended March 31, 2002.
Operating Income. As a result of the factors mentioned above, operating income
increased 31.5% to $16.4 million in the six months ended March 31, 2003 from
$12.4 million in the six months ended March 31, 2002. Operating income as a
percentage of net sales in the six months ended March 31, 2003 increased to
11.2% as compared to 9.4% in the six months ended March 31, 2002.
Interest Expense, Net. Interest expense, net in the six months ended March 31,
2003 decreased 1.0% to $9.9 million from $10.0 million in the six months ended
March 31, 2002.
Provision For Income Taxes. The provision for income taxes increased to $2.7
million in the six months ended March 31, 2003 from $1.1 million in the six
months ended March 31, 2002. The effective tax rate in the six months ended
March 31, 2003 and 2002 was different from the statutory rate due to the mix of
income between the Company's foreign subsidiaries 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. For the six months ended March 31, 2003 the Company had net income
of $3.7 million as compared to $1.3 million for the six months ended March 31,
2002.
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 currencies. While many of the Company's selling and
distribution costs are also denominated in these 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
- 21 -
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. Since 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 many
companies announcing layoffs 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 half of fiscal 2003, there can be no assurances,
given the current economic conditions, that these trends will be maintained for
the remainder of the 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 amounts outstanding on the Term Loans and the Revolving Credit
Facility at March 31, 2003 were approximately $89.2 million and $0.5 million,
respectively. No amounts were outstanding under 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 March 31, 2003.
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 purchases
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.
Maturities under the Company's Term Loans are: approximately $6.4 million for
the remainder of fiscal 2003, $17.0 million in fiscal 2004, and $65.8 million
thereafter. The Company is required to make interest
- 22 -
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 six months ended
March 31, 2003 totaled $11.8 million as compared to $6.8 million for the six
months ended March 31, 2002. The increase of $5.0 million was primarily due to a
$5.4 million improvement in the Company's net changes in assets and liabilities
partially offset by a $0.4 million decrease in net income adjusted for non-cash
charges (depreciation, amortization, deferred taxes and other). The Company's
net changes in assets and liabilities were primarily driven by an increase in
cash from receivables, accounts payable, accrued liabilities and income taxes
payable partially offset by a reduction of cash for inventory.
Net cash used by investing activities was $15.4 million for the six months ended
March 31, 2003 as compared to $8.3 million for the six months ended March 31,
2002. The increase of $7.1 million in net cash used by investing activities is
primarily attributed to an increase in acquisitions of $6.8 million and an
increase in capital expenditure of $0.3 million.
Net cash used by financing activities for the six months ended March 31, 2003
was $6.0 million compared with net cash used by financing activities for the six
months ended March 31, 2002 of $6.3 million. The change of $0.3 million is
primarily due to the $0.5 million proceeds from the Revolving Credit Facility as
the increase in the repayment for term loans was offset by no repayment for
bonds in the six months ended March 31, 2003 as compared to the six months ended
March 31, 2002.
The Company maintains a non-contributory 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 assets 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 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, since fiscal 2001, the Company has been affected by the
significant slowdown in the manufacturing sector of the economies in which the
Company markets its products and the related reductions in manufacturing
employment, exacerbated by the impact of the terrorist events of September 11,
2001. The Company expects to arrange for new financing of both the Senior Bank
Facilities and the Notes before the maturity of the Senior Bank Facilities in
March 2005. There can be no assurances that any
- 23 -
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.
- 24 -
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. Since the acquisition of Peltor, the Company's
operations are also affected by changes in exchange rates relative to the
Swedish Krona. In contrast with 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 executes two hedging programs, one for transaction exposures, and the
other for cash flow exposures in European operations. The Company has utilized
forward foreign currency contracts for transaction and cash flow exposures.
During the six months ended March 31, 2003, cash flow hedge gains were $0.6
million and there was no impact on earnings for transaction exposures. In
addition, the Company limits foreign exchange impact on the balance sheet with
foreign denominated debt in Great Britain Pound Sterling, Euros and Canadian
dollars.
The Company adopted 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
liability measured at its fair value. As a result of forward foreign currency
contracts, the Company has recorded a derivative payable of $0.7 million as of
March 31, 2003. 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.
As a result of the current economic slowdown and corresponding interest rate
reductions, the Company entered into an interest rate collar arrangement in
October 2001 to protect $25.0 million of the outstanding variable rate term loan
debt from future interest rate volatility. The collar floor is set at 2% LIBOR
(London Interbank Offering Rate) and cap at 6.25% LIBOR. The collar was not
designated as a hedge under SFAS No. 133 and accordingly, the fair value of
gains or losses was charged to earnings.
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.
- 25 -
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
exposed to market risks for electricity, fuel oil and natural gas consumed in
its operations. Items with potential impact 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 risk.
- 26 -
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.
Changes in Controls and Procedures
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.
- 27 -
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
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 March 31, 2003, the Company has recorded liabilities of approximately $4.7
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 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.
- 28 -
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
None.
- 29 -
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: May 15, 2003 AEARO CORPORATION
/s/ Jeffrey S. Kulka
---------------------------------------
Jeffrey S. Kulka
Vice President, ChiefFinancial Officer,
Treasurer, and Secretary
(Principal Financial and Accounting Officer)
- 30 -
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: May 15, 2003
/s/ Michael A. McLain
-------------------------
Michael A. McLain
Chief Executive Officer, President and Chairman
of the Board
(Principal Executive Officer)
- 31 -
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: May 15, 2003
/s/ Jeffrey S. Kulka
-------------------------
Jeffrey S. Kulka
Vice President, Chief Financial Officer,
Treasurer and Secretary
(Principal Financial Officer)
- 32 -
EXHIBIT INDEX
EXHIBITS DESCRIPTION
- 33 -