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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 June 30, 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 incorporation or (IRS
Employer Identification No.)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 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 August 14, 2003 was 101,912.5.
Aearo Corporation
TABLE OF CONTENTS
Form 10-Q for the Quarterly Period Ended June 30, 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
----------------------------------------------------
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.................................................................31
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Part I-Financial Information
Item 1. Financial Statements
AEARO CORPORATION
Condensed Consolidated Balance Sheets - Assets
(Dollars in Thousands)
June 30, September 30,
2003 2002
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(Unaudited)
CURRENT ASSETS:
Cash and cash equivalents $ 15,057 $ 14,480
Accounts receivable (net of allowance for doubtful accounts of
$2,087 and $1,524, respectively) 48,038 46,478
Inventories 37,275 33,161
Deferred and prepaid expenses 3,941 3,449
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Total current assets 104,311 97,568
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LONG TERM ASSETS:
Property, plant and equipment, net 49,144 48,096
Intangible assets, net 138,978 121,979
Other assets 3,259 2,526
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Total assets $ 295,692 $ 270,169
=========== ============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
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AEARO CORPORATION
Condensed Consolidated Balance Sheets - Liabilities and Stockholders' Equity
(Dollars in Thousands)
June 30, September 30,
2003 2002
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(Unaudited)
CURRENT LIABILITIES:
Current portion of long-term debt $ 16,266 $ 12,847
Accounts payable and accrued liabilities 42,981 36,410
Accrued interest 5,628 2,568
U.S. and foreign income taxes 4,213 1,156
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Total current liabilities 69,088 52,981
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Long-term debt 173,910 182,715
Deferred income taxes 912 800
Other liabilities 13,508 12,129
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Total liabilities $ 257,418 $ 248,625
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COMMITMENTS AND CONTINGENCIES:
Preferred stock, $.01 par value-
(Redemption value of $120,068 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 32,224 32,254
Retained earnings 16,942 6,825
Accumulated other comprehensive loss (10,893) (17,536)
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Total stockholders' equity 38,274 21,544
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Total liabilities and stockholders' equity $ 295,692 $ 270,169
============= ==============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
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Aearo Corporation
Condensed Consolidated Statements of Operations
(DOLLARS IN THOUSANDS)
(Unaudited)
------------------------------------ ------------------------------------
For the Three Months Ended For the Nine Months Ended
June 30, June 30,
---------------- ---------------- ---------------- -----------------
2003 2002 2003 2002
NET SALES $ 86,723 $ 76,435 $ 232,126 $ 208,761
COST OF SALES 45,767 40,024 121,324 110,312
--------------- --------------- --------------- ---------------
Gross profit 40,956 36,411 110,802 98,449
SELLING AND ADMINISTRATIVE 26,219 24,914 75,407 68,602
RESEARCH AND TECHNICAL SERVICES 1,462 1,493 4,671 4,251
AMORTIZATION OF INTANGIBLES 62 1,570 194 4,686
OTHER CHARGES 735 330 1,692 368
--------------- --------------- --------------- ---------------
Operating income 12,478 8,104 28,838 20,542
INTEREST EXPENSE, NET 4,728 4,972 14,671 15,018
--------------- --------------- --------------- ---------------
Income before provision for income taxes
7,750 3,132 14,167 5,524
PROVISION FOR INCOME TAXES 1,367 850 4,051 1,936
--------------- --------------- --------------- ---------------
Net Income $ 6,383 $ 2,282 $ 10,116 $ 3,588
=============== =============== =============== ===============
The accompanying notes are an integral part of these condensed consolidated
financial statements.
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Aearo Corporation
Condensed Consolidated Statements of Cash Flows
(DOLLARS IN THOUSANDS)
(Unaudited)
For the Nine Months Ended
June 30,
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2003 2002
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CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 10,116 $ 3,588
Adjustments to reconcile net income to cash provided by operating activities-
Depreciation 8,175 7,976
Amortization of intangible assets and deferred financing costs 1,422 5,842
Deferred income taxes (14) --
Other, net 386 288
Changes in assets and liabilities-(net of effects of acquisitions)
Accounts receivable 2,015 (2,226)
Inventories (1,083) (1,385)
Accounts payable and accrued liabilities 5,261 829
Income taxes payable 3,013 478
Other, net (1,233) (499)
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Net cash provided by operating activities 28,059 14,891
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CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property, plant and equipment (7,525) (5,846)
Cash paid for acquisitions, net of cash acquired (11,062) (7,342)
Proceeds provided by disposals of property, plant and equipment 22 13
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Net cash used by investing activities (18,565) (13,175)
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CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of notes -- (2,000)
Repayment of term loans (9,580) (6,097)
Repayment of capital lease obligations (164) (100)
Repayment of long-term debt (57) (102)
Other (30) (147)
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Net cash used by financing activities (9,831) (8,446)
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EFFECT OF EXCHANGE RATE CHANGES ON CASH 914 (44)
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INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 577 (6,774)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 14,480 18,233
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CASH AND CASH EQUIVALENTS, END OF PERIOD $ 15,057 $ 11,459
============= =============
NON-CASH INVESTING AND FINANCING ACTIVITIES:
Capital lease obligations $ 430 $ 1,421
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CASH PAID FOR:
Interest $ 10,538 $ 10,952
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Income taxes $ 1,332 $ 1,536
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The accompanying notes are an integral part of these condensed consolidated
financial statements.
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Aearo Corporation
Notes To Condensed Consolidated Financial Statements
June 30, 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 pricing discounts and incentives. In addition, an
allowance for doubtful accounts is generally recorded 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.
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
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Company will no longer record approximately $5.8 million of annual
amortization relating to goodwill and indefinite lived intangibles.
Intangible assets increased $17.0 million during the nine month period ending
June 30, 2003. Goodwill increased $16.5 million, of which, $10.1 million
related to acquisitions and $6.4 million related to foreign exchange. The
allocation of purchase price for acquisitions to goodwill is preliminary.
Other intangibles increased $0.5 million due to non-compete agreements
related to acquisitions. The following presents amortization expense and
proforma net income for the three and nine months ended June 30, 2003 and
2002 as if SFAS No. 142 had been adopted (Dollars in thousands):
Three Months Ended Nine Months Ended
June 30, June 30,
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2003 2002 2003 2002
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Net income as reported $ 6,383 $ 2,282 $ 10,116 3,588
Goodwill amortization -- 792 -- 2,350
Trademark amortization -- 742 -- 2,224
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Net income $ 6,383 $ 3,816 $ 10,116 8,162
========== ========== =========== =========
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.
Financial Instruments with Characteristics of both Liabilities and Equity. In
May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity". SFAS No. 150
establishes standards for how an issuer classifies and measures three classes of
freestanding financial instruments with characteristics of both liabilities and
equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability or an asset in some circumstances. SFAS No. 150
was effective for financial instruments entered into or modified after May 31,
2003, and otherwise is effective at the beginning of the first interim period
beginning after June 15, 2003. The Company has not entered into any financial
instruments within the scope of SFAS No. 150 since May 31, 2003 and does not
hold any significant financial instruments within its scope.
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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 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 Nine Months Ended
June 30, June 30,
------------------------ ----------------------
2003 2002 2003 2002
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Net income as reported $ 6,383 $ 2,282 $ 10,116 3,588
Deduct: Total stock-based employee compensation
expense determined under fair value based method for
all awards, net of tax (37) (47) (141) (111)
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Net income $ 6,346 $ 2,235 $ 9,975 3,477
========== ========== ========== ===========
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 results of
operations or financial position.
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 the Company's results of operations or financial position.
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.
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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 $0.5 million at June 30, 2003. All forward foreign currency contracts
will expire over the next three months.
During the three and nine month periods ending June 30, 2003, the Company
reclassified into earnings a net loss of approximately $1.0 million and $1.7
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. The impact on earnings was a gain
of approximately $0.2 million for the three and nine month period ended June 30,
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 June 30, 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 material impact on earnings for the three and nine month periods ended June
30, 2003.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities". SFAS No. 149 amends and
clarifies accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities under SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS is
generally effective for contracts entered into or modified after June 30, 2003
and for hedging relationships designated after June 30, 2003. The Company does
not expect the adoption of SFAS No. 149 to have a material impact on its results
of operations or financial position.
4) COMPREHENSIVE INCOME
Comprehensive income consisted of the following (Dollars in thousands):
For the Three Months Ended For the Nine Months
June 30, Ended June 30,
----------- ---------- ----------- -----------
2003 2002 2003 2002
----------- ---------- ---------- -----------
Net income $ 6,383 $ 2,282 $ 10,116 $ 3,588
Foreign currency translation adjustment 2,996 4,622 7,181 5,320
Unrealized gain (loss) on derivative
instruments 116 (752) (538) (616)
---------- ---------- --------- -----------
Comprehensive income $ 9,496 $ 6,152 $ 16,759 $ 8,292
========== ========== ========= ===========
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Inventories consisted of the following (Dollars in thousands):
June 30, September 30,
2003 2002
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Raw materials $ 8,871 $ 7,514
Work in process 12,222 10,196
Finished goods 16,182 15,451
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$ 37,275 $ 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 at June 30, 2003 were approximately $88.1 million. No amounts were
outstanding under the Revolving Credit or U.K. overdraft facilities.
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 June 30, 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.
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
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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 June 30, 2003, the Company has recorded liabilities of approximately $4.8
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 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.
- 11 -
Net Sales by Business Segment (Dollars in thousands):
For the Three Months Ended For the Nine Months Ended
June 30, June 30,
----------------------------- ----------------------------
2003 2002 2003 2002
------------- ------------ ------------ -----------
Safety Products $ 68,269 $ 55,034 $ 176,953 $ 150,417
Safety Prescription Eyewear 10,165 11,118 30,463 30,662
Specialty Composites 8,289 10,283 24,710 27,682
------------- ------------ ------------ -----------
Total $ 86,723 $ 76,435 $ 232,126 $ 208,761
============= ============ ============ ===========
Inter-segment sales of the Specialty Composites segment to the Safety
Products segment totaled $0.7 million and $1.3 million for the three months
ended June 30, 2003 and 2002, respectively. Inter-segment sales totaled $2.3
million and $2.6 million for the nine months ended June 30, 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 Nine Months Ended
June 30, June 30,
-------------------------- ---------------------------
2003 2002 2003 2002
----------- ----------- ----------- ------------
Safety Products $ 14,472 $ 10,590 $ 35,677 $ 29,268
Safety Prescription Eyewear 249 484 612 1,484
Specialty Composites 631 1,468 918 2,452
----------- ----------- ----------- ------------
Segment profit 15,352 12,542 37,207 33,204
Depreciation 2,812 2,868 8,175 7,976
Amortization of intangibles 62 1,570 194 4,686
Interest 4,728 4,972 14,671 15,018
----------- ----------- ----------- ------------
Income before provision for income taxes $ 7,750 $ 3,132 $ 14,167 $ 5,524
=========== =========== =========== ============
Segment profit is defined as operating income before depreciation,
amortization, interest expense and income taxes 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.
9) RESTRUCTURING CHARGE
During fiscal 2001, the Company recorded a restructuring charge of $11.4
million relating to a 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 restructuring 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 restructuring 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, which is currently being marketed for sale.
- 12 -
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 nine months ended June 30, 2003 (Dollars in thousands):
September 30, June 30,
2002 Charges 2003
------------ ----------- ------------
Employee termination costs $ 730 $ (376) $ 354
Lease agreements 2,352 (672) 1,680
Loss on disposal of assets 700 700
Other 47 (45) 2
------------ ----------- ------------
Total $ 3,829 $ (777) $ 2,736
============ =========== ============
The Company expects the restructuring payments to be completed by the third
quarter of fiscal 2005.
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 nine months ended June 30, 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 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 Nine Months Ended
June 30, June 30,
--------------------------- --------------------------
2003 2002 2003 2002
------------ ----------- ------------ -----------
Net sales as reported $ 86,723 $ 76,435 $ 232,126 208,761
Pro forma sales 86,723 79,427 236,616 216,527
Net income as reported $ 6,383 $ 2,282 $ 10,116 $ 3,588
Pro forma net income 6,383 2,847 10,804 4,749
11) SUBSEQUENT EVENTS
On June 27, 2003, the Company signed an agreement with Cabot Corporation,
subject to, among other things, the approval of the Company's bank lenders and
receipt of financing, to redeem all of the common and preferred shares,
including accrued dividends, held by Cabot for approximately $33.5 million. The
Company
- 13 -
expects to finance the redemption with a combination of cash and
additional borrowings. This transaction is expected to close during the 4th
quarter.
- 14 -
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 a restructuring charge in fiscal 2001 based
on a 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 may
- 15 -
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 pricing discounts and incentives. In addition, an allowance
for doubtful accounts is generally recorded 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.
- 16 -
Results of Operations -- Three Months Ended June 30, 2003 Compared to Three
Months Ended June 30, 2002
Results of Operations
(Dollars in Thousands)
(Unaudited)
Three Months Ended June 30,
-----------------------------------------------------------------
2003 % 2002 %
-------------- -------------- -------------- -------------
Net Sales
Safety Products $ 68,269 78.7 $ 55,034 72.0
Safety Prescription Eyewear 10,165 11.7 11,118 14.5
Specialty Composites 8,289 9.6 10,283 13.5
----------- ----------- ----------- -----------
Total net sales 86,723 100.0 76,435 100.0
Cost of Sales 45,767 52.8 40,024 52.4
Gross profit 40,956 47.2 36,411 47.6
Operating Expenses-
Selling and administrative 26,219 30.2 24,914 32.6
Research and technical services 1,462 1.7 1,493 2.0
Amortization of intangibles 62 -- 1,570 2.1
Other charges, net 735 0.9 330 --
----------- ----------- ----------- -----------
Total operating expenses 28,478 32.8 28,307 37.0
Operating income 12,478 14.4 8,104 10.6
Interest expense, net 4,728 5.5 4,972 6.5
----------- ----------- ----------- -----------
Income before provision for income taxes 7,750 8.9 3,132 4.1
Provision for income taxes 1,367 1.5 850 1.1
----------- ----------- --- ---
Net income $ 6,383 7.4 $ 2,282 3.0
=========== =========== =========== ===========
Net Sales. Net sales in the three months ended June 30, 2003 increased 13.5% to
$86.7 million from $76.4 million in the three months ended June 30, 2002. The
increase in net sales was primarily driven by the impact of foreign exchange,
acquisitions and 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 $4.9 million and $3.4 million,
respectively. The Safety Products segment net sales in the three months ended
June 30, 2003 increased 24.0% to $68.3 million from $55.0 million in the three
months ended June 30, 2002. The increase in net sales resulted from a 10.1%
increase due to organic growth, an 8.8% increase due to foreign exchange and a
5.2% increase due to acquisitions. The increase in organic growth is primarily
due to product innovations. The Safety Prescription Eyewear segment sales for
the three months ended June 30, 2003 decreased 8.6% to $10.2 million from $11.1
million in the three months ended June 30, 2002. The decrease in volume was
partially offset by a 5.0% 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 June 30, 2003 decreased 19.4% to $8.3 million
from $10.3 million in the three months ended June 30, 2002. The decrease was
- 17 -
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.
Gross Profit. Gross Profit in the three months ended June 30, 2003 increased
12.5% to $41.0 million from $36.4 million in the three months ended June 30,
2002. The increase in gross profit is primarily due to productivity
improvements, the impact of foreign exchange and acquisitions. Gross Profit as a
percentage of net sales in the three months ended June 30, 2003 was 47.2% as
compared to 47.6% in the three months ended June 30, 2002. The change in the
gross profit percentage is primarily due to product mix.
Operating Expenses. Operating expenses in the three months ended June 30, 2003
increased 0.6% to $28.5 million from $28.3 million in the three months ended
June 30, 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 June 30, 2003 included approximately $0.8 million of incremental expenses
due to acquisitions and $1.0 million due to the weakness of the U.S dollar. The
increase in other charges, net was primarily driven by foreign exchange losses.
Amortization expense decreased approximately $1.5 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 June 30, 2002, amortization
expense would have been reduced by approximately $1.5 million. Selling and
administrative expenses as a percentage of net sales decreased to 30.2% in the
three months ended June 30, 2003 as compared to 32.6% in the three months ended
June 30, 2002.
Operating Income. Primarily as a result of the factors mentioned above,
operating income increased 54.0% to $12.5 million in the three months ended June
30, 2003 from $8.1 million in the three months ended June 30, 2002. Operating
income as a percentage of net sales in the three months ended June 30, 2003
increased to 14.4% as compared to 10.6% in the three months ended June 30, 2002.
Interest Expense, Net. Interest expense, net in the three months ended June 30,
2003 decreased 4.9% to $4.7 million from $5.0 million in the three months ended
June 30, 2002.
Provision For Income Taxes. The provision for income taxes in the three months
ended June 30, 2003 was $1.4 million as compared to $0.9 million in the three
months ended June 30, 2002. The effective tax rates in the three months ended
June 30, 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 net operating losses. 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 June 30, 2003 the Company had net income
of $6.4 million as compared to $2.3 million for the three months ended June 30,
2002.
- 18 -
Results of Operations -- Nine Months Ended June 30, 2003 Compared to Nine Months
Ended June 30, 2002
Results of Operations
(Dollars in Thousands)
(Unaudited)
Nine Months Ended June 30,
-------------------------------------------------------------------
2003 % 2002 %
----------- ------------ ------------ ------------
Net Sales
Safety Products $ 176,953 76.2 $ 150,417 72.1
Safety Prescription Eyewear 30,463 13.1 30,662 14.7
Specialty Composites 24,710 10.7 27,682 13.2
----------- ----------- ----------- -----------
Total net sales 232,126 100.0 208,761 100.0
Cost of Sales 121,324 52.3 110,312 52.8
Gross profit 110,802 47.7 98,449 47.2
Operating Expenses-
Selling and administrative 75,407 32.5 68,602 32.9
Research and technical services 4,671 2.0 4,251 2.0
Amortization of intangibles 194 0.1 4,686 2.2
Other charges, net 1,692 0.7 368 0.2
----------- ----------- ----------- -----------
Total operating expenses 81,964 35.3 77,907 37.3
Operating income 28,838 12.4 20,542 9.8
Interest expense, net 14,671 6.3 15,018 7.2
----------- ----------- ----------- ------------
Income before provision for income taxes 14,167 6.1 5,524 2.6
Provision for income taxes 4,051 1.7 1,936 0.9
----------- ----------- ----- ---
Net income 10,116 4.4 3,588 1.7
=========== =========== =========== ============
Net Sales. Net sales in the nine months ended June 30, 2003 increased 11.2% to
$232.1 million from $208.8 million in the nine months ended June 30, 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 $10.9 million and $8.2 million,
respectively. The Safety Products segment net sales in the nine months ended
June 30, 2003 increased 17.6% to $177.0 million from $150.4 million in the nine
months ended June 30, 2002. The increase in net sales resulted from a 6.9%
increase due to organic growth, a 7.1% increase due to foreign exchange and a
3.6% increase due to acquisitions. The Safety Prescription Eyewear segment sales
for the nine months ended June 30, 2003 decreased 0.6% to $30.5 million from
$30.7 million in the nine months ended June 30, 2002. The decrease in net sales
resulted from a 10.1% reduction in volume partially offset by a 9.0% increase
from acquisitions and a 0.5 % increase due to foreign exchange. 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 nine months ended June 30, 2003
decreased 10.7% to $24.7 million from $27.7 million in the nine months ended
June 30, 2002. The
- 19 -
decrease was primarily driven by volume declines in the automotive market, the
truck 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 nine months ended June 30, 2003 increased
12.5% to $110.8 million from $98.4 million in the nine months ended June 30,
2002. The increase in gross profit is primarily due to the impact of foreign
exchange, productivity improvements and acquisitions. Gross profit as a
percentage of net sales in the nine months ended June 30, 2003 improved to 47.7%
as compared to 47.2% in the nine months ended June 30, 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 nine months ended June 30, 2003
increased 5.2% to $82.0 million from $77.9 million in the nine months ended June
30, 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 $2.5 million of
incremental expenses due to acquisitions, $2.5 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 $0.4 million related
to new product development. The increase in other charges, net was primarily due
to foreign exchange losses. Amortization expense decreased approximately $4.5
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.
Amortization expense would have been reduced by approximately $4.5 million had
the provisions of SFAS No. 142 been adopted in the nine months ended June 30,
2002. Selling and administrative expenses as a percentage of net sales decreased
to 32.5% in the nine months ended June 30, 2003 as compared to 32.9% in the nine
months ended June 30, 2002.
Operating Income. Primarily as a result of the factors mentioned above,
operating income increased 40.4% to $28.8 million in the nine months ended June
30, 2003 from $20.5 million in the nine months ended June 30, 2002. Operating
income as a percentage of net sales in the nine months ended June 30, 2003
increased to 12.4% as compared to 9.8% in the nine months ended June 30, 2002.
Interest Expense, Net. Interest expense, net in the nine months ended June 30,
2003 decreased 2.3% to $14.7 million from $15.0 million in the nine months ended
June 30, 2002. The decrease is attributed to lower weighted average borrowings
and interest rates in effect for the nine months ended June 30, 2003 as compared
to the nine months ended June 30, 2002.
Provision For Income Taxes. The provision for income taxes increased to $4.1
million in the nine months ended June 30, 2003 from $1.9 million in the nine
months ended June 30, 2002. The effective tax rates in the nine months ended
June 30, 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 net operating losses. 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 nine months ended June 30, 2003 the Company had net income
of $10.1 million as compared to $3.6 million for the nine months ended June 30,
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
- 20 -
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 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 declines in
manufacturing employment and overall consumer confidence. These reductions have
had a significant impact on the revenues of the Safety Prescription Eyewear and
Specialty Composites segments. The Safety Products segment, which has
experienced revenue growth in the first nine months of fiscal 2003, has been
able to offset these declines through continued product innovations. There can
be no assurances, given the current economic conditions, that the Safety
Products segment will maintain these trends for the remainder of this fiscal
year and beyond.
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 at June 30, 2003 were
approximately $88.1 million. No amounts were outstanding under the Revolving
Credit or U.K. overdraft facilities.
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 June 30, 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 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.
- 21 -
Maturities under the Company's Term Loans are: approximately $3.2 million for
the remainder of fiscal 2003, $17.3 million in fiscal 2004, and $67.6 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 nine months
ended June 30, 2003 totaled $28.1 million as compared to $14.9 million for the
nine months ended June 30, 2002. The increase of $13.2 million was primarily due
to a $10.8 million improvement in the Company's net changes in assets and
liabilities and an increase of $2.4 million 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, income taxes
payable and inventory partially offset by a reduction of other, net.
Net cash used by investing activities was $18.6 million for the nine months
ended June 30, 2003 as compared to $13.2 million for the nine months ended June
30, 2002. The increase of $5.4 million in net cash used by investing activities
is primarily attributed to an increase in acquisitions of $3.8 million and an
increase in capital expenditures of $1.6 million.
Net cash used by financing activities for the nine months ended June 30, 2003
was $9.8 million compared with net cash used by financing activities for the
nine months ended June 30, 2002 of $8.4 million. The change of $1.4 million is
primarily due to an increase in the repayment of Term Loans partially offset by
no repayment for the Notes in the nine months ended June 30, 2003 as compared to
the nine months ended June 30, 2002.
On June 27, 2003, the Company signed an agreement with Cabot Corporation,
subject to, among other things, the approval of the Company's bank lenders and
receipt of financing, to redeem all of the common and preferred shares,
including accrued dividends, held by Cabot for approximately $33.5 million. The
Company expects to finance the redemption with a combination of cash and
additional borrowings. This transaction is expected to close during the 4th
quarter.
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 from 7.75% to 6.75% 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
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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 June 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.
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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 nine months ended June 30, 2003, cash flow hedge losses were $1.7
million and gains on transaction exposures were $0.2 million. In addition, the
Company limits foreign exchange impacts 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 $0.5 million as of
June 30, 2003. The forward foreign currency contracts will expire over the next
three 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.
- 24 -
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.
- 25 -
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 as of June 30, 2003
and have determined that such disclosure controls and procedures are effective.
Changes in Controls and Procedures
During the quarter ended June 30, 2003, there was no change in the Company's
internal controls over financial reporting that has materially affected, or is
reasonably likely to materially, affect the Company's internal control over
financial reporting.
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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 June 30, 2003, the Company has recorded liabilities of approximately $4.8
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.
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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
On June 27, 2003, the Company signed an agreement with Cabot Corporation,
subject to, among other things, the approval of the Company's bank lenders and
receipt of financing, to redeem all of the common and preferred shares,
including accrued dividends, held by Cabot for approximately $33.5 million. The
Company expects to finance the redemption with a combination of cash and
additional borrowings. This transaction is expected to close during the 4th
quarter.
Item 6. Exhibits and Reports on Form 8-K
a) See Index of Exhibits on page 31 hereof.
b) Reports on Form 8-K
On May 15, 2003, the Company filed a Current Report on Form
8-K to announce its second quarter results of operations.
On July 24, 2003, the Company filed a Current Report on Form
8-K to announce its third quarter results of operations and
share redemption.
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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: August 14, 2003 AEARO CORPORATION
/s/ Jeffrey S. Kulka
----------------------------------
Jeffrey S. Kulka
Vice President, Chief Financial
Officer, Treasurer, and
Secretary
(Principal Financial and Accounting Officer)
- 29 -
Exhibit Index
EXHIBITS DESCRIPTION
- --------- ------------
31.1 Certification of Principal Executive Officer
31.2 Certification of Principal Financial Officer