ITT INDUSTRIES INC - 10-Q Quarterly Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 1-5627

ITT INDUSTRIES, INC.

INCORPORATED IN THE STATE OF INDIANA 13-5158950
(I.R.S. Employer
Identification Number)

4 WEST RED OAK LANE, WHITE PLAINS, NY 10604
(Principal Executive Office)

TELEPHONE NUMBER: (914) 641-2000

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 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 [X] No [ ]

As of April 30, 2004, there were outstanding 92,615,401 shares of common
stock ($1 par value per share) of the registrant.

ITT INDUSTRIES, INC.

TABLE OF CONTENTS

1

PART I.

FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

The following unaudited consolidated condensed financial statements have
been prepared pursuant to the rules and regulations of the Securities and
Exchange Commission (SEC) and, in the opinion of management, reflect all
adjustments (which include normal recurring adjustments) necessary for a fair
presentation of the financial position, results of operations, and cash flows
for the periods presented. Certain information and note disclosures normally
included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America have been
condensed or omitted pursuant to such SEC rules. The Company believes that the
disclosures made are adequate to make the information presented not misleading.
Certain amounts in the prior periods' consolidated condensed financial
statements have been reclassified to conform to the current period presentation.
These financial statements should be read in conjunction with the financial
statements and notes thereto included in the Company's 2003 Annual Report on
Form 10-K.

ITT INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED INCOME STATEMENTS
(IN MILLIONS, EXCEPT PER SHARE)
(UNAUDITED)

- ---------------

The accompanying notes to consolidated condensed financial statements are an
integral part of the above income statements.
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ITT INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS
(IN MILLIONS, EXCEPT FOR SHARES AND PER SHARE)

- ---------------

The accompanying notes to consolidated condensed financial statements are an
integral part of the above balance sheets.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(IN MILLIONS)
(UNAUDITED)

- ---------------

The accompanying notes to consolidated condensed financial statements are an
integral part of the above cash flow statements.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

1) RECEIVABLES, NET

Net receivables consist of the following:

2) INVENTORIES, NET

Net inventories consist of the following:

3) PLANT, PROPERTY, AND EQUIPMENT, NET

Net plant, property, and equipment consist of the following:

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

4) SALES AND REVENUES AND COSTS OF SALES AND REVENUES

Sales and revenues and costs of sales and revenues consist of the
following:

The Defense Electronics & Services segment comprises $235.1 and $178.5 of
total service revenues for the three months ended March 31, 2004 and 2003,
respectively, and $161.9 and $118.3 of total costs of service revenues,
respectively, during the same period. The Fluid Technology segment comprises the
remaining balances of service revenues and costs of service revenues.

5) COMPREHENSIVE INCOME

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

6) EARNINGS PER SHARE

The following is a reconciliation of the shares used in the computation of
basic and diluted earnings per share for the three months ended March 31, 2004
and 2003:

The amounts of outstanding antidilutive common stock options excluded from
the computation of diluted earnings per share for the three months ended March
31, 2004 and 2003 were 0.0 and 1.5, respectively.

7) STOCK-BASED EMPLOYEE COMPENSATION

At March 31, 2004, the Company has one stock-based employee compensation
plan that is issuing new options and restricted shares. The Company also has two
stock-based employee compensation plans and two stock-based non-employee
director's compensation plans that have options and restricted shares
outstanding, but will not be issuing additional stock-based compensation. These
plans are described more fully in Note 20, "Shareholders' Equity," within the
Notes to Consolidated Financial Statements of the 2003 Annual Report on Form
10-K. The Company accounts for these plans under the recognition and measurement
principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees,"
and related interpretations. Had compensation expense for these plans been
determined based on the fair value recognition provisions of Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation," the Company's net income and earnings per share would have been
reduced to the following pro forma amounts:

The fair value of each option grant was estimated on the date of grant
using the Black-Scholes option-pricing model and the following weighted-average
assumptions for grants in the three months ended March 31, 2004 and 2003:
dividend yield of 1.40% and 1.58%, respectively; expected volatility of 25.84%
and 28.77%, respectively; expected life of six years; and risk-free interest
rates of 3.66% and 3.38%, respectively.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

The value of stock-based compensation that was recognized in selling,
general and administrative expenses within the Consolidated Condensed Income
Statements during the three month periods ended March 31, 2004 and 2003 was $0.1
and $0.2, respectively.

8) RESTRUCTURING AND ASSET IMPAIRMENT CHARGES

2004 RESTRUCTURING ACTIVITIES

During the first quarter of 2004, the Company recognized a $5.3 charge,
primarily for the planned severance of 103 employees. The actions by segment are
as follows:

- The Fluid Technology segment recorded $2.7 for the termination of 50
employees, including 15 factory workers and 35 office workers. Asset
write-offs and other costs totaling $0.4 and $0.1, respectively, were
also recognized during the quarter.

- The Electronic Components segment recorded $1.7 of the charge primarily
for the reduction of 35 employees, including 23 factory workers, 11
office workers and one management employee.

- The Motion & Flow Control segment recognized $0.2 for the termination of
16 employees, including three factory workers and 13 office workers.

- Corporate headquarters recorded $0.2 for the severance of one office
worker and one management employee.

2003 RESTRUCTURING ACTIVITIES

During the fourth quarter of 2003, the Company announced actions to reduce
operating costs primarily through the reduction of headcount. The new $15.4
restructuring charge primarily reflects the severance of 301 employees. The
actions by segment are as follows:

- The Electronic Components segment recorded $1.5 of the charge for the
termination of 132 employees, including 113 factory workers, 14 office
workers and five management employees.

- The Fluid Technology segment recognized $12.4 of the charge for the
severance of 134 employees, including 39 factory workers, 90 office
workers and five management employees. Lease and other costs represent
$0.3 of the charge. The segment also recorded a $0.2 charge associated
with the disposal of machinery and equipment.

- The Defense Electronics & Services segment recorded a $1.0 charge for the
severance of 35 employees, including seven factory workers, 19 office
workers and nine management employees.

In addition to the new restructuring actions announced during the fourth
quarter, the Motion & Flow Control segment recognized $0.5 of severance and
employee benefit costs related to actions announced during the first quarter and
the Electronic Components segment recognized $0.2 of outplacement related to
actions announced earlier in 2003.

During the third quarter of 2003, the Company announced actions to reduce
operating costs primarily through the reduction of headcount. The new $2.6
restructuring charge primarily reflects the planned severance of 72 employees.
The actions by segment are as follows:

- The Electronic Components segment recorded $1.2 of the charge for the
planned termination of 40 employees, including 15 factory workers and 25
office workers. The segment also recorded a $0.1 charge associated with
the disposal of machinery and equipment.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

- The Fluid Technology segment recognized a $0.5 charge for the planned
severance of 13 factory workers and 14 office workers. Lease and other
costs represent $0.4 of the charge.

- The Motion & Flow Control segment recorded a $0.4 charge for the planned
severance of one management employee and four office workers.

In addition to the new restructuring actions announced during the third
quarter, the Motion & Flow Control segment recognized $0.2 of severance and
employee benefit costs related to actions announced during the first quarter.

During the second quarter of 2003, the Company continued its program to
reduce structural costs and increase profitability. New restructuring actions
totaling $4.7 were announced during the period. The charge primarily reflected
the planned severance of 148 employees and the cancellation of an operating
lease. The actions by segment are as follows:

- The Electronic Components segment comprises $2.7 of the charge and the
actions taken at this segment include the planned termination of six
management employees, 19 factory workers and 71 office workers.

- The Motion & Flow Control segment recognized $1.0 for the planned
severance of 50 employees, including six management employees, 31 factory
workers and 13 office workers. Lease termination fees of $0.7 and asset
disposal costs of $0.1 were also reflected in the charge.

- At Corporate Headquarters, a charge of $0.2 was recorded for the planned
termination of one management employee and one office worker.

In addition to the new restructuring actions announced during the second
quarter, the Motion & Flow Control segment recognized $1.2 of severance and
employee benefit costs related to actions announced during the first quarter.

During the first quarter of 2003, the Company recorded a $9.0 restructuring
charge primarily for the planned severance of 465 persons. Severance of $8.3
represents the majority of the charge. The actions by segment are as follows:

- The Electronic Components segment recorded $6.8 of the charge for the
planned termination of 226 persons, comprised of 101 office workers, 116
factory workers and nine management employees. Idle facility costs of
$0.3 and asset disposal costs of $0.4 were also reflected in the charge.
The actions were prompted by management's projections of continued
weakness in certain businesses.

- Corporate Headquarters recorded $1.1 of the charge for the consolidation
of administrative tasks, including the planned termination of two
management employees.

- The Motion & Flow Control segment recorded $0.4 of the charge for the
planned termination of 237 employees, comprised of 21 office workers and
216 factory workers. The charge relates to the closure of a manufacturing
facility in Arkansas. The actions will be completed during 2003 and 2004
and the total estimated charge of approximately $2.6 will be recognized
ratably over the restructuring period as the terminations become
effective. Management deemed the restructuring actions necessary to
address the anticipated loss of certain platforms during the second half
of 2003.

Also during 2003, the Company recorded a $1.4 asset impairment charge
primarily for a technology license that will not be utilized based on
management's projections of future market conditions. The applicable assets were
written down to their fair values based on management's comparison of projected
future discounted cash flows generated by each asset to the applicable asset's
carrying value. These impairments were unrelated to the Company's restructuring
activities.
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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

The following is a rollforward of the accrued cash restructuring balances
for all restructuring plans.

During the first quarter of 2004, $0.2 and $0.4 of restructuring accruals
related to 2003 and 2001 restructuring actions, respectively, were reversed into
income. The reversals related to the 2003 actions primarily reflect lower than
anticipated severance costs on completed actions due to favorable employee
attrition at the Electronic Components segment. The reversals associated with
the 2001 actions represent lower than anticipated closed facility costs.

At December 31, 2003, the accrual balance for restructuring activities was
$20.1. Cash payments of $9.5 and an additional cash charge of $4.9 were recorded
in the first three months of 2004. The accrual balance at March 31, 2004 is
$14.4, which includes $12.7 for severance and $1.7 for facility carrying costs
and other.

As of December 31, 2003, remaining actions under restructuring activities
announced in 2003, 2002 and 2001 were to close one facility and reduce headcount
by 208. During the first three months of 2004, the Company reduced headcount by
177 persons related to all plans, leaving a balance of 131 planned reductions.
Actions announced during the first quarter of 2004 will be completed by the end
of the second quarter of 2004. Actions announced during 2003 will be
substantially completed by the end of the third quarter of 2004. All of the
actions contemplated under the 2002 and 2001 plans were substantially completed
in 2003. Closed facility expenditures and severance run-off related to the 2001
plan will continue to be incurred in 2004. Future restructuring expenditures
will be funded with cash from operations, supplemented, as required, with
commercial paper borrowings.

9) DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

The nature of the Company's business activities necessarily involves the
management of various financial and market risks, including those related to
changes in interest rates, currency exchange rates, and commodity prices. As
discussed more completely in Notes 1, "Accounting Policies", and 18, "Financial
Instruments," within the Notes to Consolidated Financial Statements of the 2003
Annual Report on Form 10-K, the Company uses derivative financial instruments to
mitigate or eliminate certain of those risks.

At March 31, 2004 and December 31, 2003, the values of the Company's
interest rate swaps were $100.3 and $81.6, including $8.1 and $4.0 of accrued
interest, respectively.

A reconciliation of current period changes contained in the accumulated
other comprehensive loss component of shareholders' equity is not required as no
material activity occurred during the first three months of 2004 and 2003.
Additional disclosures required by SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," as amended, are presented below.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

HEDGES OF FUTURE CASH FLOWS

At March 31, 2004 and December 31, 2003 the Company had no foreign currency
cash flow hedges outstanding.

HEDGES OF RECOGNIZED ASSETS, LIABILITIES AND FIRM COMMITMENTS

At March 31, 2004 and December 31, 2003, the Company had foreign currency
forward contracts with notional amounts of $73.0 and $81.1, respectively, to
hedge the value of recognized assets, liabilities and firm commitments. The fair
value of the 2004 and 2003 contracts were $(0.5) and $0.2 at March 31, 2004 and
December 31, 2003, respectively. The ineffective portion of changes in fair
values of such hedge positions reported in operating income during the first
three months of 2004 and 2003 amounted to $(0.1) and $0.0, respectively. There
were no amounts excluded from the measure of effectiveness.

The fair values associated with the foreign currency contracts have been
valued using the net position of the contracts and the applicable spot rates and
forward rates as of the reporting date.

10) GOODWILL AND OTHER INTANGIBLE ASSETS

The Company follows the provisions of Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets," which requires that
goodwill and indefinite-lived intangible assets be tested for impairment on an
annual basis, or more frequently if circumstances warrant. Annual goodwill
impairment tests were completed in the first quarters of 2004 and 2003 (as of
the beginning of the year) and it was determined that no impairment exists.

Changes in the carrying amount of goodwill for the quarter ended March 31,
2004, by business segment, are as follows:

Information regarding the Company's other intangible assets follows:

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

Amortization expense related to intangible assets for the three month
periods ended March 31, 2004 and 2003 was $0.7 and $0.4, respectively. Estimated
amortization expense for each of the five succeeding years is $3.0 per year.

11) DISCONTINUED OPERATIONS

In September of 1998, the Company completed the sales of its automotive
Electrical Systems business to Valeo SA for approximately $1,700 and its Brake
and Chassis unit to Continental AG of Germany for approximately $1,930. These
dispositions were treated as discontinued operations. In 1998, the Company
received notifications of claims from the buyers of the automotive business
requesting post-closing adjustments to the purchase prices under the provisions
of the sales agreements. In 1999, those claims were submitted to arbitration. In
2001 and early in 2002, both claims were favorably resolved.

At March 31, 2004, the Company had automotive discontinued operations
accruals of $186.1 that are primarily related to taxes ($154.2), product recalls
($7.8), environmental obligations ($14.2) and employee benefits ($9.9). During
the first quarter of 2004, the Company paid thirty six thousand dollars of its
automotive discontinued operations liabilities. The Company expects that it will
cash settle $154.2 of tax obligations in 2004 or 2005.

12) PENSION AND POSTRETIREMENT MEDICAL BENEFIT EXPENSES

The components of net periodic pension cost consist of the following:

Net periodic pension expense increased in the first quarter of 2004 as a
result of the lower discount rate adopted at year end 2003, higher average
foreign exchange rates, lower expected returns on assets as a result of the
operation of the asset smoothing method reflecting adverse financial experience
in 2002 and 2001 and a higher amortization of actuarial losses.

The Company contributed approximately $100.0 to its various plans during
the first quarter of 2004. Additional contributions totaling between $5.0 and
$10.0 are expected over the balance of 2004.

12

ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

The components of net periodic postretirement cost consist of the
following:

Net periodic expense decreased in the first quarter of 2004 as a result of
the higher than expected return on invested assets and lower than expected
benefit payments during 2003.

13) COMMITMENTS AND CONTINGENCIES

The Company and its subsidiaries are from time to time involved in legal
proceedings that are incidental to the operation of their businesses. Some of
these proceedings allege damages against the Company relating to environmental
liabilities, employment and pension matters, government contract issues and
commercial or contractual disputes, sometimes related to acquisitions or
divestitures. The Company will continue to vigorously defend itself against all
claims. Accruals have been established where the outcome of the matter is
probable and can be reasonably estimated. Although the ultimate outcome of any
legal matter cannot be predicted with certainty, based on present information
including the Company's assessment of the merits of the particular claim, as
well as its current reserves and insurance coverage, the Company does not expect
that such legal proceedings will have any material adverse impact on the cash
flow, results of operations or financial condition of the Company on a
consolidated basis in the foreseeable future.

ENVIRONMENTAL

The Company has accrued for environmental remediation costs associated with
identified sites consistent with the policy set forth in Note 1, "Accounting
Policies" in the Notes to Consolidated Financial Statements of the 2003 Annual
Report on Form 10-K. In management's opinion, the total amount accrued and
related receivables are appropriate based on existing facts and circumstances.
It is difficult to estimate the total costs of investigation and remediation due
to various factors, including incomplete information regarding particular sites
and other potentially responsible parties, uncertainty regarding the extent of
contamination and the Company's share, if any, of liability for such conditions,
the selection of alternative remedies, and changes in clean-up standards. In the
event that future remediation expenditures are in excess of amounts accrued,
management does not anticipate that they will have a material adverse effect on
the consolidated financial position, results of operations or cash flows.

In the ordinary course of business, and similar to other industrial
companies, the Company is subject to extensive and changing federal, state,
local, and foreign environmental laws and regulations. The Company has received
notice that it is considered a potentially responsible party ("PRP") at a
limited number of sites by the United States Environmental Protection Agency
("EPA") and/or a similar state agency under the Comprehensive Environmental
Response, Compensation and Liability Act ("CERCLA" or "Superfund") or its state
equivalent. As of March 31, 2004, the Company is responsible, or is alleged to
be responsible, for 104 environmental investigation and remediation sites in
various countries. In many of these proceedings, the

13

ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

Company's liability is considered de minimis. At March 31, 2004, the Company
calculated a best estimate of $108.0, which approximates its accrual, related to
the cleanup of soil and ground water. The low range estimate for its
environmental liabilities is $80.0 and the high range estimate for those
liabilities is $171.0. On an annual basis the Company spends between $8.0 and
$11.0 on its environmental remediation liabilities. These estimates, and related
accruals, are reviewed periodically and updated for progress of remediation
efforts and changes in facts and legal circumstances. Liabilities for
environmental expenditures are recorded on an undiscounted basis.

The Company is involved in an environmental proceeding in Glendale,
California relating to the San Fernando Valley aquifer. The Company is one of
numerous PRPs who are alleged by the EPA to have contributed to the
contamination of the aquifer. In January 1999, the EPA filed a complaint in the
United States District Court for the Central District of California against the
Company and Lockheed Martin Corporation, United States v. ITT Industries, Inc.
and Lockheed Martin Corp. CV99-00552 SVW AIJX, to recover costs it incurred in
connection with the foregoing. In May 1999, the EPA and the PRPs, including the
Company and Lockheed Martin, reached a settlement, embodied in a consent decree,
requiring the PRPs to perform additional remedial activities. Pursuant to the
settlement, the PRPs, including the Company, have constructed and are operating
a water treatment system. The operation of the water treatment system is
expected to continue until 2013. ITT and the other PRPs continue to pay their
respective allocated costs of the operation of the water treatment system and
the Company does not anticipate a default by any of the PRPs which would
increase its allocated share of the liability. As of March 31, 2004, the
Company's accrual for this liability was $10.9 representing its best estimate;
its low estimate for the liability is $7.4 and its high estimate is $16.4.

ITT Corporation operated a facility in Madison County, Florida from 1968
until 1991. In 1995, elevated levels of contaminants were detected at the site.
Since then, ITT has completed the investigation of the site in coordination with
state and federal environmental authorities and is in the process of evaluating
various remedies. A remedy for the site has not yet been selected. Currently,
the estimated range for the remediation is between $5.9 and $20.1. The Company
has accrued $10.5 for this matter, which approximates its best estimate.

The Company is involved with a number of PRPs regarding property in the
City of Bronson, Michigan operated by a former subsidiary of ITT Corporation,
Higbie Manufacturing, prior to the time ITT acquired Higbie. The Company and
other PRPs are investigating and remediating discharges of industrial waste
which occurred in the 1930's. The Company's current estimates for its exposure
are between $3.9 and $13.2. It has an accrual for this matter of $9.8 which
represents its best estimate of its current liabilities. The Company does not
anticipate a default on the part of the other PRPs.

In a suit filed in 1991 by the Company, in the California Superior Court,
Los Angeles County, ITT Corporation, et al. v. Pacific Indemnity Corporation et
al., against its insurers, the Company is seeking recovery of costs it incurred
in connection with its environmental liabilities including the three listed
above. Discovery, procedural matters, changes in California law, and various
appeals have prolonged this case. Currently, the matter is before the California
Court of Appeals from a decision by the California Superior Court dismissing
certain claims of the Company. The dismissed claims were claims where the costs
incurred were solely due to administrative (versus judicial) actions. A hearing
is expected in 2004. In the event the appeal is successful, the Company will
pursue the administrative claims against its excess insurers. During the course
of the litigation the Company has negotiated settlements with certain defendant
insurance companies and is prepared to pursue its legal remedies where
reasonable negotiations are not productive. A portion of the recoveries from the
insurance settlements have been placed in a trust and are used to reimburse the
Company for its environmental costs.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

PRODUCT LIABILITY

The Company and its subsidiary Goulds Pumps, Inc. ("Goulds") have been
joined as defendants with numerous other industrial companies in product
liability lawsuits alleging injury due to asbestos. These actions against the
Company have been managed by our historic product liability insurance carriers.
These claims stem primarily from products sold prior to 1985 that contained a
part manufactured by a third party, e.g., a gasket, which allegedly contained
asbestos. The asbestos was encapsulated in the gasket (or other) material and
was non-friable. In certain other cases, it is alleged that former ITT companies
were distributors for other manufacturers' products that may have contained
asbestos.

Frequently, the plaintiffs are unable to demonstrate any injury or do not
identify any ITT or Goulds product as a source of asbestos exposure. During
2003, ITT and Goulds resolved approximately 2,000 claims through settlement or
dismissal. The average amount of settlement per plaintiff has been nominal and
substantially all defense and settlement costs have been covered by insurance.
Based upon past claims experience, available insurance coverage, and after
consultation with counsel, management believes that these matters will not have
a material adverse effect on the Company's consolidated financial position,
results of operations, or cash flows.

The Company is involved in two actions, Cannon Electric, Inc. et al. v. Ace
Property & Casualty Company et al. Superior Court, County of Los Angeles, CA.,
Case No. BC 290354, and Pacific Employers Insurance Company et al., v. ITT
Industries, Inc., et al., Supreme Court, County of New York, N.Y., Case No.
03600463. The parties in both cases are seeking an appropriate allocation of
responsibility for the Company's historic asbestos liability exposure among its
insurers. The California action is filed in the same venue where the Company's
environmental insurance recovery litigation has been pending since 1991. Both
actions have been stayed to allow the parties to negotiate an acceptable
allocation arrangement. In April 2004, the Company and Ace Property & Casualty
Company entered into an agreement resolving both cases as they relate to Ace
Property & Casualty Company. The Company will pursue similar agreements with
several of its other insurers. In addition, Utica National, Goulds' historic
insurer, has requested that the Company negotiate a coverage in place agreement
to allocate the Goulds asbestos liabilities between insurance policies issued by
Utica and those issued by others. The parties are currently negotiating the
terms of such an agreement. The Company is continuing to receive the benefit of
insurance payments during the pendency of these proceedings. The Company
believes that these actions will not materially affect the availability of its
insurance coverage and will not have a material adverse effect on the Company's
consolidated financial position, results of operations or cash flows.

The Company is one of several defendants in a suit filed in El Paso, Texas,
Bund zur Unterstutzung Radargeschadigter et al. v. ITT Industries et al., Sup.
Ct., El Paso, Texas, C.A. No. 2002-4730. This Complaint, filed by both U.S. and
German citizens, alleges that ITT and four other major companies failed to warn
the plaintiffs of the dangers associated with exposure to x-ray radiation from
radar devices. The Complaint also seeks the certification of a class of
similarly injured persons. The Company's aviation insurers are contributing to
the defense of this matter. Management believes that this matter will not have a
material adverse effect on the Company's consolidated financial position,
results of operations or cash flows.

The Company has received notice of a product liability suit filed in
Superior Court of New York, Danis v. Rule Industries et al., Sup. Ct. N.Y., C.A.
No. 115975-02, seeking damages for injuries sustained in a boat explosion. The
suit contains a number of causes of action against various defendants including
the boat manufacturer, the marina operator, and individuals working at the
marina. As to the Company, the Complaint alleges that a fume detector,
manufactured by ITT's subsidiary Rule Industries, Inc. prior to the date the
Company acquired Rule, malfunctioned. The Company's insurer is on notice of this
matter. Management

15

ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

believes that this matter will not have a material adverse effect on the
Company's consolidated financial position, results of operations or cash flows.

The Company has received demands from U.S. Silica for partial indemnity
regarding personal injury actions alleging injury due to silica. In 1985, the
Company sold the stock of its subsidiary Pennsylvania Glass Sand to U.S. Silica.
As part of that transaction, the Company provided an indemnity to U.S. Silica
for silica personal injury suits. That indemnity expires in September 2005.
Costs incurred in these matters related to the defense, settlements or judicial
awards are allocated between U.S. Silica and the Company. The Company's
allocated portion is paid in part by its historic product liability carriers and
then shared pursuant to the Distribution Agreement. See "Company History and
Certain Relationships" within Part 1, Item 1 of the 2003 Annual Report on Form
10-K for a description of the Distribution Agreement. Management believes that
these matters will not have a material adverse effect on the Company's
consolidated financial position, results of operations or cash flows.

OTHER

The Company has received a Notice of Claim from Rayonier, Inc., a former
subsidiary of the Company's predecessor ITT Corporation. This claim stems from
the 1994 Distribution Agreement for the spinoff of Rayonier by ITT Corporation
and seeks an allocation of proceeds from certain settlements in connection with
the Company's environmental insurance recovery litigation. The parties are
seeking a resolution of this matter through arbitration. The Company believes
the claim is grossly overstated and will not have a material adverse effect on
the Company's consolidated financial position, results of operations or cash
flows.

14) GUARANTEES, INDEMNITIES AND WARRANTIES

GUARANTEES & INDEMNITIES

In September of 1998, the Company completed the sale of its automotive
electrical systems business to Valeo SA for approximately $1,700. As part of the
sale, the Company provided Valeo SA with representations and warranties with
respect to the operations of the Business, including: Conveyance of Title,
Employee Benefits, Tax, Product Liability, Product Recall, Contracts,
Environmental, Intellectual Property, etc. The Company also indemnified Valeo SA
for losses related to a misrepresentation or breach of the representations and
warranties. With a few limited exceptions, the indemnity periods within which
Valeo SA may assert new claims have expired. Under the terms of the sales
contract, the original maximum potential liability to Valeo SA on an
undiscounted basis is $680. However, because of the lapse of time, or the fact
that the parties have resolved certain issues, at March 31, 2004 the Company has
an accrual of $7.8 which is its best estimate of the potential exposure.

In September of 1998, the Company completed the sale of its brake and
chassis unit to Continental AG for approximately $1,930. As part of the sale,
the Company provided Continental AG with representations and warranties with
respect to the operations of that Business, including: Conveyance of Title,
Employee Benefits, Tax, Product Liability, Product Recall, Contracts,
Environmental, Intellectual Property, etc. The Company also indemnified
Continental AG for losses related to a misrepresentation or breach of the
representations and warranties. With a few limited exceptions, the indemnity
periods within which Continental AG may assert new claims have expired. Under
the terms of the sales contract, the original maximum potential liability to
Continental AG on an undiscounted basis is $950. However, because of the lapse
of time, or the fact that the parties have resolved certain issues, at March 31,
2004 the Company has an accrual of $14.2 which is its best estimate of the
potential exposure.

Since its incorporation in 1920, the Company has acquired and disposed of
numerous entities. The related acquisition and disposition agreements contain
various representation and warranty clauses and may provide
16

ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

indemnities for a misrepresentation or breach of the representations and
warranties by either party. The indemnities address a variety of subjects; the
term and monetary amounts of each such indemnity are defined in the specific
agreements and may be affected by various conditions and external factors. Many
of the indemnities have expired either by operation of law or as a result of the
terms of the agreement. The Company does not have a liability recorded for the
historic indemnifications and is not aware of any claims or other information
that would give rise to material payments under such indemnities. The Company
has separately discussed material indemnities provided within the last eight
years.

The Company provided three guarantees with respect to its real estate
development activities in Flagler County, Florida. Two of these guarantee bonds
were issued by the Dunes Community Development District (the District). The bond
issuances were used primarily for the construction of infrastructure, such as
water and sewage utilities and a bridge. The Company would be required to
perform under these guarantees if the District failed to provide interest
payments or principal payments due to the bond holders. The maximum amount of
the undiscounted future payments on these guarantees equal $28.9. At March 31,
2004, the Company does not believe that a loss contingency is probable for these
guarantees and therefore does not have an accrual recorded in its financial
statements. The third guaranty is a performance bond in the amount of $10.0 in
favor of Flagler County, Florida. The Company would be required to perform under
this guarantee if certain parties did not satisfy all aspects of the development
order, the most significant aspect being the expansion of a bridge. The maximum
amount of the undiscounted future payments on the third guarantee equals $10.0.
At March 31, 2004, the Company has an accrual related to the expansion of a
bridge in the amount of $10.0.

In December of 2002, the Company entered into a sales-type lease agreement
for its corporate aircraft and then leased the aircraft back under an operating
lease agreement. The Company has provided, under the agreement, a residual value
guarantee to the counterparty in the amount of $44.8, which is the maximum
amount of undiscounted future payments. The Company would have to make payments
under the residual value guarantee only if the fair value of the aircraft was
less than the residual value guarantee upon termination of the agreement. At
March 31, 2004, the Company does not believe that a loss contingency is probable
and therefore does not have an accrual recorded in its financial statements.

PRODUCT WARRANTIES

Accruals for estimated expenses related to warranties are made at the time
products are sold or services are rendered. These accruals are established using
historical information on the nature, frequency, and average cost of warranty
claims. The Company warrants numerous products, the terms of which vary widely.
In general, the Company warrants its products against defect and specific
nonperformance. In the automotive businesses, liability for product defects
could extend beyond the selling price of the product and could be significant if
the defect shuts down production or results in a recall. At March 31, 2004, the
Company has a product warranty accrual in the amount of $36.0.

17

ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

PRODUCT WARRANTY LIABILITIES

15) BUSINESS SEGMENT INFORMATION

Unaudited financial information of the Company's business segments for the
three months ended March 31, 2004 and 2003 were as follows:

(16) QUARTERLY FINANCIAL PERIODS

The Company's quarterly financial periods end on the Saturday before the
last day of the quarter, except for the last quarterly period of the fiscal
year, which ends on December 31st. For simplicity of presentation, the quarterly
financial statements included herein are presented as ending on the last day of
the quarter. The presentation is consistent for all periods.

18

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS

EXECUTIVE SUMMARY

The Company produced strong operating performance in the first quarter of
2004. Revenues grew 16.9% from the comparable prior year quarter. Acquisitions
and foreign currency contributed 6.7% of the growth and the remaining 10.2% of
the increase was attributable to higher volume in the Defense Electronics &
Services, Fluid Technology and Electronic Components segments. These results
reflect the strength of the Company's portfolio of businesses and the
introduction of new products. Based on these results and current/projected
market conditions, the Company projects full year 2004 revenue between $6,450
million and $6,600 million.

Operating income in the first quarter of 2004 was 17.6% higher than the
first quarter of 2003. The increase reflects higher volume, partially offset by
acquisition integration and start up costs primarily attributable to the
acquisition of WEDECO AG Water Technology. Management projects full year 2004
segment operating margin to be between 11.1% and 11.5%

Diluted earnings per share were $0.94 for the quarter and include the
impact of favorable tax settlements, $0.5, and restructuring $(0.3). Diluted
earnings per share for the comparable prior year quarter were $0.92 and include
the impact of favorable tax settlements, $0.17, and restructuring $(0.08). Full
year 2004 diluted earnings per share are projected to be between $4.40 and
$4.50.

The Company used $115.5 million of cash in operating activities. The
primary factors for this performance were a $100.0 million prepaid pension
contribution and a $158.3 million increase in accounts receivable, reflecting
increased sales volume and the timing of shipments. Net income generated from
continuing operations and an increase in accounts payable partially offset these
items. The Company projects cash from operating activities to be between $485.0
million and $535.0 million for the twelve months ended December 31, 2004.

THREE MONTHS ENDED MARCH 31, 2004 COMPARED WITH THREE MONTHS ENDED MARCH 31,
2003

Sales and revenues for the first quarter of 2004 were $1,515.9 million, an
increase of $219.5 million, or 16.9%, from the same period for 2003. Costs of
sales and revenues of $1,007.1 million for the first quarter of 2004 increased
$160.7 million, or 19.0%, from the comparable 2003 period. The increases in
sales and revenues and costs of sales and revenues are primarily attributable to
higher volume in the Defense Electronics & Services, Fluid Technology and
Electronic Components segments, contributions from acquisitions made by the
Fluid Technology segment and the impact of foreign currency translation. The
increase in costs of sales also reflects a change in product mix in the Defense
Electronics & Services segment.

Selling, general and administrative ("SG&A") expenses for the first quarter
of 2004 were $230.2 million, an increase of $29.9 million, or 14.9%, from the
first quarter of 2003. The increase in SG&A expenses was primarily due to
increased marketing expense in most segments, including expenses from two first
quarter acquisitions, higher general and administrative expenses and other
operating expenses. Higher general and administrative costs reflect additional
employee benefit costs, the cost of process improvement initiatives,
administrative expenses related to the two first quarter acquisitions and
increased other administrative expenses.

Research, development and engineering ("RD&E") expenses for the first
quarter of 2004 increased $15.3 million, or 11.8%, compared to the first quarter
of 2003. The increase is attributable to increased spending in all segments.

During the first quarter of 2004, the Company recorded a $5.3 million
restructuring charge to streamline its operating structure. The charge primarily
reflected the planned reduction of 103 persons. Additionally, $0.6 million of
restructuring accruals related to 2003 and 2001 restructuring actions were
reversed into income, as management determined that certain cash expenditures
would not be incurred. During the first

19

quarter of 2003, the Company recorded a $9.0 million restructuring charge to
reduce operating costs. The charge primarily reflected the planned reduction of
465 persons. Additionally, in 2003, the Company recorded an asset impairment
charge of $1.4 million primarily to write-off a technology license that will not
be utilized in the foreseeable future due to projected market conditions. Refer
to the section entitled "Status of Restructuring and Asset Impairments" and Note
8, "Restructuring and Asset Impairment Charges," in the Notes to Consolidated
Condensed Financial Statements for additional information.

Operating income for the first quarter of 2004 was $129.0 million, an
increase of $19.3 million, or 17.6%, over the first quarter of 2003. The
increase is primarily due to improved sales and revenues at each of the segments
offset by increased SG&A and RD&E expenses. Segment operating margin for the
first quarter of 2004 was 9.7%, which was 0.2% below the segment operating
margin for the comparable 2003 period. The decrease reflects the impact of Fluid
Technology acquisitions, which produced operating margins below the segment
average and changes in sales mix in the Fluid Technology segment, partially
offset by higher operating margins in the Defense Electronics & Services
segment.

Interest expense was $1.1 million (net of interest income of $5.3 million,
of which $4.3 million relates to a 2004 tax settlement) for the first quarter of
2004. The Company recognized $15.1 million of interest income during the first
quarter of 2003. The variance between years is primarily due to interest income
of $22.1 million related to a 2003 first quarter tax refund.

Income tax expense was $36.2 million in the first quarter of 2004, flat
with the comparable prior year period.

Income from continuing operations was $88.1 million, or $0.93 per diluted
share compared to $86.7 million or $0.92 per diluted share for the first quarter
of 2003. The increase reflects the results discussed above.

During the first quarter of 2004, the Company recognized $0.8 million of
income from discontinued operations. The income primarily relates to the receipt
of a tax refund pertaining to the Company's discontinued businesses.

Fluid Technology's sales and revenues and costs of sales and revenues
increased $71.3 million, or 14.2%, and $47.0 million, or 14.1%, respectively, in
the first quarter of 2004 compared to the first quarter of 2003. Higher organic
sales in the water/wastewater markets and industrial products businesses,
acquisition revenue from the water treatment business and the impact of foreign
currency translation were the primary factors for the increases. SG&A for the
first quarter of 2004 increased $22.6 million, or 22.3%, compared to 2003,
mainly due to increased advertising costs, sales commissions and administrative
costs in most businesses, and costs attributable to 2004 acquisitions. During
the first quarter of 2004, the segment recorded a $3.2 million restructuring
charge mainly related to a planned reduction in headcount (refer to the section
entitled "Status of Restructuring and Asset Impairments" and Note 8,
"Restructuring and Asset Impairment Charges," in the Notes to Consolidated
Condensed Financial Statements for additional information). Additionally, $0.2
million of restructuring accruals were reversed into income as closed facility
costs were less than initially anticipated. Operating income for the first
quarter of 2004 was down $3.4 million, or 6.0%, compared to the first quarter of
2003 due to the activities discussed above.

Defense Electronics & Services' sales and revenues and costs of sales and
revenues for the first quarter of 2004 increased $115.1 million, or 29.4%, and
$85.6 million, or 37.5%, respectively, from the comparable prior year period.
The increases are primarily due to higher volume in the night vision, aerospace
communications and systems businesses. Additionally, a change in product mix
also contributed to the increase in costs of sales and revenues. SG&A expenses
increased $5.3 million, or 19.3%, primarily due to increased employee benefit
and administrative costs and other operating expenses. RD&E expenses increased
$9.9 million, or 9.8%, due to increased spending in most businesses. Operating
income for the first quarter of 2004 was $48.7 million, an increase of $14.3
million, or 41.6%, compared to the same quarter in 2003. The increase reflects
the results discussed above.

Motion & Flow Control recorded sales and revenues and costs of sales and
revenues of $274.0 million and $198.6 million, respectively, during the first
quarter of 2004, reflecting increases of $15.9 million, or 6.2%, and
20

$10.8 million, or 5.8%, from the first quarter of 2003. The increases were
mainly due to higher volume in the motion control and leisure marine businesses
and the impact of foreign currency translation partially offset by volume
declines in the fluid handling business. SG&A expenses increased $2.5 million,
or 10.8%, reflecting higher marketing costs and administrative expenses in most
businesses and other operating expenses. During the first quarters of 2004 and
2003, the segment recorded $0.2 million and $0.4 million of restructuring
charges, respectively, mainly related to planned reductions in headcount (refer
to the section entitled "Status of Restructuring and Asset Impairments" and Note
8, "Restructuring and Asset Impairment Charges," in the Notes to Consolidated
Condensed Financial Statements for additional information). Operating income of
$39.1 million was $1.1 million, or 2.9%, higher in the first quarter of 2004
compared to the first quarter of 2003 primarily due to the items mentioned
above.

Electronic Components' sales and revenues of $161.8 million and costs of
sales and revenues of $112.5 million in the first quarter of 2004, increased
$17.0 million, or 11.7%, and $14.5 million, or 14.8%, respectively, from the
comparable prior year period. The increases reflect higher volume in most
businesses and the impact of foreign currency translation. SG&A expenses
increased $2.8 million due to increased marketing, employee benefit and
administrative expenses. During the first quarter of 2004, the segment recorded
a $1.7 million restructuring charge primarily relating to planned headcount
reductions. Additionally, $0.4 million of restructuring accruals were reversed
into income reflecting lower than anticipated severance costs. During the first
quarter of 2003, the segment recorded a $7.5 million restructuring charge
primarily relating to planned headcount reductions and a $1.4 million asset
impairment charge mainly to write-off a license agreement for technology, which
will not be utilized in the foreseeable future due to projected market
conditions (refer to the section entitled "Status of Restructuring and Asset
Impairments" and Note 8, "Restructuring and Asset Impairment Charges," in the
Notes to Consolidated Condensed Financial Statements for additional
information). Operating income for the first quarter of 2004 increased $5.7
million from the first quarter of 2003. The increase was due to the factors
discussed above.

Corporate expenses decreased $1.6 million in the first quarter of 2004,
primarily due to costs related to process improvement initiatives in 2003, lower
restructuring costs, ($1.1 million in 2003 versus $0.2 million in 2004), (refer
to the section entitled "Status of Restructuring and Asset Impairments" and Note
8, "Restructuring and Asset Impairment Charges," in the Notes to Consolidated
Condensed Financial Statements for additional information) and lower
administrative expenses.

STATUS OF RESTRUCTURING AND ASSET IMPAIRMENTS

2004 RESTRUCTURING ACTIVITIES

During the first quarter of 2004, the Company recognized a $5.3 million
charge, primarily for the planned severance of 103 employees. The actions by
segment are as follows:

- The Fluid Technology segment recorded $2.7 million for the termination of
50 employees, including 15 factory workers and 35 office workers. Asset
write-offs and other costs totaling $0.4 million and $0.1 million,
respectively, were also recognized during the quarter.

- The Electronic Components segment recorded $1.7 million of the charge
primarily for the reduction of 35 employees, including 23 factory
workers, 11 office workers and one management employee.

- The Motion & Flow Control segment recognized $0.2 million for the
termination of 16 employees, including three factory workers and 13
office workers.

- Corporate headquarters recorded $0.2 million for the severance of one
office worker and one management employee.

As of March 31, 2004, the Company had made $1.7 million of payments
attributable to the 2004 first quarter restructuring actions. Future
restructuring expenditures will be funded with cash from operations,
supplemented, as required, with commercial paper borrowings.

The projected future cash savings from the restructuring actions announced
during the first quarter of 2004 are approximately $5 million during 2004 and
$28 million between 2005 and 2009. The savings primarily
21

represents lower salary and wage expenditures and will be reflected in "Costs of
Sales and Revenues" and "Selling, General and Administrative Expenses."

2003 RESTRUCTURING ACTIVITIES

During the fourth quarter of 2003, the Company announced actions to reduce
operating costs primarily through the reduction of headcount. The new $15.4
million restructuring charge primarily reflects the planned severance of 301
employees. The actions by segment are as follows:

- The Electronic Components segment recorded $1.5 million of the charge for
the planned termination of 132 employees, including 113 factory workers,
14 office workers and five management employees.

- The Fluid Technology segment recognized $12.4 million of the charge for
the planned severance of 134 employees, including 39 factory workers, 90
office workers and five management employees. Lease and other costs
represent $0.3 million of the charge. The segment also recorded a $0.2
million charge associated with the disposal of machinery and equipment.

- The Defense Electronics & Services segment recorded a $1.0 million charge
for the planned severance of 35 employees, including seven factory
workers, 19 office workers and nine management employees.

The projected future cash savings from the restructuring actions announced
during the fourth quarter of 2003 are approximately $13 million during 2004 and
$53 million between 2005 and 2008. The savings primarily represents lower salary
and wage expenditures and will be reflected in "Costs of Sales and Revenues" and
"Selling, General and Administrative Expenses."

During the first quarter of 2004, the Company had made $5.1 million of
payments attributable to the 2003 fourth quarter restructuring actions. Future
restructuring expenditures will be funded with cash from operations,
supplemented, as required, with commercial paper borrowings.

In addition to the new restructuring actions announced during the fourth
quarter of 2003, the Motion & Flow Control segment recognized $0.5 million of
severance and employee benefit costs related to actions announced during the
first quarter and the Electronic Components segment recognized $0.2 million of
outplacement related to actions announced earlier in 2003.

During the third quarter of 2003, the Company announced additional actions
to reduce operating costs primarily through the reduction of headcount. The new
$2.6 million restructuring charge primarily reflects the planned severance of 72
employees. The actions by segment are as follows:

- The Electronic Components segment recorded $1.2 million of the charge for
the planned termination of 40 employees, including 15 factory workers and
25 office workers. The segment also recorded a $0.1 million charge
associated with the disposal of machinery and equipment.

- The Fluid Technology segment recognized a $0.5 million charge for the
planned severance of 13 factory workers and 14 office workers. Lease and
other costs represent $0.4 million of the charge.

- The Motion & Flow Control segment recorded a $0.4 million charge for the
planned severance of one management employee and four office workers.

The projected future cash savings from the restructuring actions announced
during the third quarter of 2003 are approximately $4 million during 2004 and
$16 million between 2005 and 2008. The savings primarily represents lower salary
and wage expenditures and will be reflected in "Costs of Sales and Revenues" and
"Selling, General and Administrative Expenses."

During the first quarter of 2004, the Company made $0.3 million of payments
attributable to the 2003 third quarter restructuring actions. Future
restructuring expenditures will be funded with cash from operations,
supplemented, as required, with commercial paper borrowings.

In addition to the new restructuring actions announced during the third
quarter of 2003, the Motion & Flow Control segment recognized $0.2 million of
severance and employee benefit costs related to actions announced during the
first quarter of 2003.
22

During the second quarter of 2003, the Company continued its program to
reduce structural costs and increase profitability. New restructuring actions
totaling $4.7 million were announced during the period. The charge primarily
reflected the planned severance of 148 employees and the cancellation of an
operating lease. The actions by segment are as follows:

- The Electronic Components segment comprises $2.7 million of the charge
and the actions taken at this segment include the planned termination of
six management employees, 19 factory workers and 71 office workers.

- The Motion & Flow Control segment recognized $1.0 million for the planned
severance of 50 employees, including six management employees, 31 factory
workers and 13 office workers. Lease termination fees of $0.7 million and
asset disposal costs of $0.1 million were also reflected in the charge.

- At Corporate Headquarters, a charge of $0.2 million was recorded for the
planned termination of one management employee and one office worker.

The projected future cash savings from the restructuring actions announced
during the second quarter of 2003 are approximately $8 million during 2004 and
$31 million between 2005 and 2008. The savings primarily represents lower salary
and wage expenditures and will be reflected in "Costs of Sales and Revenues" and
"Selling, General and Administrative Expenses."

During the first quarter of 2004, the Company made $0.2 million of payments
attributable to the 2003 second quarter restructuring actions. Future
restructuring expenditures will be funded with cash from operations,
supplemented, as required, with commercial paper borrowings.

In addition to the new restructuring actions announced during the second
quarter, the Motion & Flow Control segment recognized $1.2 million of severance
and employee benefit costs related to actions announced during the first quarter
of 2003.

During the first quarter of 2003, the Company recorded a $9.0 million
restructuring charge primarily for the planned severance of 465 persons.
Severance of $8.3 million represents the majority of the charge. The actions by
segment are as follows:

- The Electronic Components segment recorded $6.8 million of the charge for
the planned termination of 226 persons, comprised of 101 office workers,
116 factory workers and nine management employees. Idle facility costs of
$0.3 million and asset disposal costs of $0.4 million were also reflected
in the charge. The actions were prompted by management's projections of
continued weakness in certain businesses.

- Corporate Headquarters recorded $1.1 million of the charge for the
consolidation of administrative tasks, including the planned termination
of two management employees.

- The Motion & Flow Control segment recorded $0.4 million of the charge for
the planned termination of 237 employees, comprised of 21 office workers
and 216 factory workers. The charge relates to the closure of a
manufacturing facility in Arkansas. The actions will be completed during
2003 and 2004 and the total estimated charge of approximately $2.6
million will be recognized ratably over the restructuring period as the
terminations become effective. Management deemed the restructuring
actions necessary to address the anticipated loss of certain platforms
during the second half of 2003.

During the first quarter of 2004, the Company made $0.9 million of payments
attributable to the 2003 first quarter restructuring actions. Future
restructuring expenditures will be funded with cash from operations,
supplemented, as required, with commercial paper borrowings.

The projected future cash savings from the restructuring actions announced
during the first quarter of 2003 are approximately $8 million during 2004 and
$38 million between 2005 and 2008. The savings primarily represents lower salary
and wage expenditures and will be reflected in "Costs of Sales and Revenues" and
"Selling, General and Administrative Expenses."

23

The following table displays a rollforward of the restructuring accruals
for the 2003 restructuring programs (in millions):

During the first quarter of 2004, $0.2 of restructuring accruals related to
2003 restructuring actions were reversed into income. The reversals primarily
reflect lower than anticipated severance costs on completed actions due to
favorable employee attrition at the Electronic Components segment.

During the second half of 2003, $3.5 million of restructuring accruals
related to current year programs were reversed into income as a result of
quarterly reviews of the Company's remaining restructuring actions. The
reversals primarily reflect lower than anticipated severance costs on completed
actions due to favorable employee attrition at the Electronic Components
segment. Additionally, certain actions were not completed as they were no longer
deemed feasible. The Company also reversed other non-cash charges totaling $0.2
million.

During the first quarter of 2004, headcount was reduced by 91 persons and
the Company experienced employee attrition, leaving a balance of 98 planned
reductions related to the 2003 restructuring plans. In addition, one facility
remains to be closed related to 2003 restructuring plans. Actions announced
during 2003 will be substantially completed by the end of the third quarter of
2004.

2003 OTHER ASSET IMPAIRMENTS

During 2003, the Company recorded a $1.4 million asset impairment charge
primarily for the write-off of a technology license that will not be utilized
based on management's projections of future market conditions. The applicable
assets were written down to their fair values based on management's comparison
of projected future discounted cash flows generated by each asset to the
applicable asset's carrying value. These impairments were unrelated to the
Company's restructuring activities.

DISCONTINUED OPERATIONS

In September of 1998, the Company completed the sales of its automotive
Electrical Systems business to Valeo SA for approximately $1,700 million and its
Brake and Chassis unit to Continental AG of Germany for approximately $1,930
million. These dispositions were treated as discontinued operations. In
connection with the sale of these businesses, the Company established accruals
for taxes of $972.7 million, representation and warranty and contract purchase
price adjustments of $148.8 million, direct costs and other accruals of $102.0
million and environmental obligations of $16.1 million.

In 1998 and 1999, the Company received notifications of claims from the
buyers of the automotive businesses requesting post-closing adjustments to the
purchase prices under the provisions of the sales agreements. During 1999, those
claims were submitted to arbitration.

24

The following tables display a rollforward of the automotive discontinued
operations accruals from January 1, 2002 to March 31, 2004 (in thousands):

In the first quarter of 2002, the arbitrator ruled that Valeo SA must pay
the Company monies to settle the claim related to the sale of the Electrical
Systems business.

In 2003, the Company reassessed its obligations related to the disposal of
the automotive businesses and determined that it would spend $2.2 million less
on the disposition, related to favorable spending on professional fees and
adjustments to its environmental exposures. Based on this assessment, $2.2
million was reversed into the 2003 Consolidated Income Statement under income
from discontinued operations.

At March 31, 2004, the Company has automotive discontinued operations
accruals of $186.1 million that primarily relate to the following: taxes $154.2
million -- which are related to the original transaction and are recorded in
Accrued Taxes; product recalls $7.8 million -- related to nine potential product
recall issues which are recorded in Accrued Expenses; environmental obligations
$14.2 million -- for the remediation and investigation of groundwater and soil
contamination at thirteen sites which are recorded in Other Liabilities;
employee benefits $9.9 million -- for workers compensation issues which are
recorded in Accrued Expenses. In the first quarter of 2004, the Company made
immaterial payments for maters attributable to the automotive discontinued
operations. The Company expects that it will cash settle $154.2 million of tax
obligations in late 2004 or 2005. The Company projects that it will spend
between $3.0 million and $4.0 million in 2004 related to its remaining
automotive obligations.

LIQUIDITY AND CAPITAL RESOURCES

CASH FLOW OVERVIEW

The Company used $115.5 million of cash in operating activities. The
primary factors for the use of cash was the $158.3 million increase in accounts
receivable balances, reflecting higher volume and the timing of
25

sales, and a $100.0 million prepaid pension contribution made during the
quarter. The impact of these items was partially offset by income generated from
continuing operations.

The Company also spent $243.0 million on acquisitions, $39.6 million on the
repurchase of common stock, $29.0 million on capital expenditures, $14.8 million
on dividend payments and $35.5 million on the repayment of long-term debt. These
actions, as well as the cash used in operations, were financed primarily with
short term debt, cash on hand and cash received from the exercised stock
options.

Cash Flows: Cash used in operating activities during the first three
months of 2004 was $115.5 million, or a $100.2 million improvement over the
first quarter of 2003. The improvement is primarily attributable to a $100.0
million prepaid pension contribution in 2004 compared to a $200.0 million
prepaid pension contribution in the first quarter of 2003. Lower spending of
accrued expenses and higher accounts payable balances contributed to the
favorable variance with the first quarter of 2003. An increase in accounts
receivable balances was a use of an additional $58.6 million, partially
offsetting the improvement in cash used in operating activities. The increase
reflects higher volume and the timing of sales.

Status of Restructuring Activities: Restructuring payments during the
first three months of 2004 totaled $9.5 million and were comprised of $1.7
million of expenditures for the 2004 plan and $7.8 million of expenditures for
the 2003, 2002 and 2001 restructuring plans. All future payments are projected
to be paid with future cash from operating activities supplemented, as required,
by commercial paper borrowings.

Additions to Plant, Property and Equipment: Capital expenditures during
the first three months of 2004 were $29.0 million, an increase of $7.2 million
from the first three months of 2003. The increase was seen across several
business segments.

Acquisitions: During the three months of 2004, the Company spent $243.0
million primarily for the acquisitions of the following:

- WEDECO AG Water Technology ("WEDECO"), the world's largest manufacturer
of UV disinfection and ozone oxidation systems, which are alternatives to
chlorine treatment.

- Shanghai Hengtong Purified Water Development Co. Ltd. and Shanghai
Hengtong Water Treatment Engineering Co. Ltd. ("Hengtong"), a
Shanghai-based producer of reverse-osmosis, membrane and other water
treatment systems for the power, pharmaceutical, chemical and
manufacturing markets in China.

The excess of the purchase price over the fair value of net assets acquired of
$224.3 million was recorded as goodwill.

During the first quarter of 2003, the Company spent $35.1 million,
primarily for the acquisition of the VEAM/TEC division of the Northrop Grumman
Corporation ("VEAM"). VEAM is a designer and manufacturer of cylinder, filter
and fiber optic connectors for the military/aerospace, industrial, transit,
entertainment and nuclear markets. The excess of the purchase price over the
fair value of net assets acquired of $22.3 million was recorded as goodwill.

Divestitures: During the first quarter of 2004, the Company generated $2.6
million of cash proceeds primarily from the sale of two properties. In the first
quarter of 2003, the Company sold land for $7.3 million at Defense Electronics &
Services and $0.5 million from the sale of other plant, property and equipment.

Financing Activities: Debt at March 31, 2004 was $886.2 million, compared
with $602.4 million at December 31, 2003. Cash and cash equivalents were $199.1
million at March 31, 2004, compared to $414.2 million at December 31, 2003. The
change in debt and cash levels primarily reflects the Company's utilization of
cash from operating activities, including the $100.0 million prepaid pension
contribution, and the acquisition of WEDECO. In March 2004, the Company arranged
an additional revolving credit agreement of $0.4 billion to accommodate
additional acquisitions. As a result, the maximum amount of borrowing available
under the Company's revolving credit agreements, which provide back-up for the
Company's commercial paper program, at March 31, 2004, was $1.4 billion.
Borrowing through commercial paper and under the revolving credit agreements may
not exceed $1.4 billion in the aggregate outstanding at any time.

26

Status of Automotive Discontinued Operations: During the first quarter of
2004, the Company made immaterial payments for matters attributable to its
automotive discontinued operations. Tax obligations of $154.2 million are
expected to be resolved in late 2004 or 2005. In addition, the Company projects
between $3.0 million and $4.0 million of annual spending related to its
remaining automotive obligations. All payments are forecast to be paid with
future cash from operations supplemented, as required, by commercial paper
borrowings.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements, in conformity with generally
accepted accounting principles, requires management to make estimates and
assumptions that affect the reported value of assets and liabilities and the
disclosure of contingent assets and liabilities.

The Company has identified three accounting policies where estimates are
used that require assumptions or factors that are of an uncertain nature, or
where a different estimate could have been reasonably utilized or changes in the
estimate are reasonably likely to occur from period to period.

Environmental: Accruals for environmental matters are recorded on a site
by site basis when it is probable that a liability has been incurred and the
amount can be reasonably estimated. The Company calculates the liability by
utilizing a cost estimating and weighting matrix that separates costs into
recurring and non-recurring categories. The Company then uses internal and
external experts to assign confidence levels based on the site's development
stage, type of contaminant found, applicable laws, existing technologies and the
identification of other potentially responsible parties. This methodology
produces a range of estimates, including a best estimate. At March 31, 2004, the
Company's best estimate is $108.0 million, which approximates the accrual
related to the remediation of ground water and soil. The low range estimate for
environmental liabilities is $80.0 million and the high range estimate is $171.0
million. On an annual basis the Company spends between $8.0 million and $11.0
million on its environmental remediation liabilities. These estimates, and
related accruals, are reviewed periodically and updated for progress of
remediation efforts and changes in facts and legal circumstances. Liabilities
for environmental expenditures are recorded on an undiscounted basis.

The Company is currently involved in the environmental investigation and
remediation of 104 sites, including certain instances where it is considered to
be a potentially responsible party by the United States Environmental Protection
Agency ("EPA") or similar state agency.

At present, the Company is involved in litigation against its insurers for
reimbursement of environmental response costs. Recoveries from insurance
companies or other third parties are recognized in the financial statements when
it is probable that they will be realized.

In the event that future remediation expenditures are in excess of the
amounts accrued, management does not anticipate that they will have a material
adverse effect on the consolidated financial position, results of operations or
liquidity of the Company.

For additional details on environmental matters see Note 13, "Commitments
and Contingencies," in the Notes to the Consolidated Condensed Financial
Statements.

Employee Benefit Plans: The Company sponsors numerous employee pension and
welfare benefit plans. These plans utilize various assumptions in the
determination of projected benefit obligations and expense recognition related
to pension and other postretirement obligations. These assumptions include:
discount rates, expected rates of return on plan assets, rate of future
compensation increases, mortality, termination, and health care inflation trend
rates, some of which are disclosed in Note 19, "Employee Benefit Plans," within
the Notes to Consolidated Financial Statements of the 2003 Annual Report on Form
10-K.

KEY PENSION ASSUMPTIONS

The Company determines its expected return on plan assets assumption by
evaluating both historical returns and estimates of future returns.
Specifically, the Company analyzes the Plan's actual historical annual

27

return on assets over the past 10, 15, 20 and 25 years; makes estimates of
future returns using a Capital Asset Pricing Model; and evaluates historical
broad market returns over the past 75 years based on the Company's strategic
asset allocation, which is detailed in Note 19, "Employee Benefit Plans," in the
Notes to Consolidated Financial Statements of the 2003 Annual Report on Form
10-K.

Based on the approach described above, the Company estimates the long-term
annual rate of return on assets for domestic pension plans at 9.0%. For
reference, the Company's actual geometric average annual return on plan assets
for domestic pension plans stood at 10.1%, 11.2%, 11.8%, and 12.6%, for the past
10, 15, 20, and 25 year periods, respectively. The Company's weighted average
expected return on plan assets for all pension plans, including foreign
affiliate plans, at December 31, 2003, is 8.86%.

The Company utilizes the assistance of its plan actuaries in determining
the discount rate assumption. As a service to its clients, the plan actuaries
have developed and published an interest rate yield curve to enable companies to
make judgments pursuant to EITF Topic No. D-36, "Selection of Discount Rates
Used for Measuring Defined Benefit Pension Obligations and Obligations of Post
Retirement Benefit Plans Other Than Pensions." The yield curve is comprised of
AAA/AA bonds with maturities between zero and thirty years. The plan actuaries
then discount the annual benefit cash flows of the Company's pension plan using
this yield curve and develop a single-point discount rate matching the plan's
characteristics.

At December 31, 2003, the Company lowered the discount rate on all of its
domestic pension plans, which represent about 90% of the Company's total pension
obligations, from 6.50% to 6.25%. The Company's weighted average discount rate
for all pension plans, including foreign affiliate plans, at December 31, 2003,
is 6.18%.

At December 31, 2003, the Company also lowered its expected rate of future
compensation increases for its domestic plan participants to 4.5%, from 5.0%,
based on recent historical experience and expectations for future economic
conditions.

Management develops each assumption using relevant Company experience in
conjunction with market related data for each individual country in which such
plans exist. All assumptions are reviewed periodically with third party
actuarial consultants and adjusted as necessary.

PENSION PLAN ACCOUNTING AND INFORMATION

The Company's strategic asset allocation target for its U.S. domestic plans
apportions 70% of all assets to equity instruments and the remaining 30% to
fixed income instruments. At December 31, 2003, the Company's actual asset
allocation was 68.5% in equity instruments, 21.6% in fixed income instruments
and 9.7% in hedge funds, with the remainder in cash and other.

On an annual basis, the Company's long-term expected return on plan assets
will often differ from the actual return on plan assets. The chart below shows
actual returns versus the expected long-term returns for the Company's domestic
pension plans that are utilized in the calculation of the net periodic benefit
cost. For more information, please see Note 19, "Employee Benefit Plans," in the
Notes to Consolidated Financial Statements of the 2003 Annual Report on Form
10-K.

28

The Company's Defense Electronics & Services segment represents
approximately 50% of the active U.S. Salaried Plan participants. As a result,
the Company has sought and will continue to seek reimbursement from the
Department of Defense for a portion of its pension costs, in accordance with
government regulations. U.S. Government Cost Accounting Standards (CAS) govern
the extent to which pension costs are allocable to and recoverable under
contracts with the U.S. Government. Reimbursements of pension costs are made
over time through the pricing of the Company's products and services on U.S.
Government contracts.

Funding requirements under IRS rules are a major consideration in making
contributions to our pension plan. The Company contributed $206.3 million to the
U.S. Master Trust in 2003, and an additional $100.0 million in the first quarter
of 2004. As a result, the Company will not face material minimum required
contributions to its U.S. Salaried Plan in 2004 and 2005, under current IRS
contribution rules. Furthermore, we currently estimate that we will not make
significant additional contributions to the Company's U.S. Salaried Pension Plan
during the remainder of 2004.

Depending on market conditions, and assuming that current IRS contribution
rules continue to apply in the future, the Company estimates that it may be
required to contribute an additional zero to $400 million in the 2005 to 2006
timeframe.

FUNDED STATUS

Funded status is derived by subtracting the value of the projected benefit
obligations at December 31, 2003 from the end of year fair value of plan assets.
The Company's U.S. Salaried Pension Plan represents approximately 80% of the
Company's total pension obligation, and therefore the funded status of the U.S.
Salaried Pension Plan has a considerable impact on the overall funded status of
the Company's pension plans.

During 2003, the Company's U.S. Salaried Pension Plan assets grew by $647.0
million to $2,989.2 million at the end of 2003. This increase primarily
reflected return on assets of $659.0 million, and Company contributions of
$200.0 million, offset by payments to plan beneficiaries of $206.8 million.

Also during 2003, the projected benefit obligation for the U.S. Salaried
Pension Plan increased by $152.0 million to $3,448.8 million. The increase
included the $104.3 million impact of a 25 basis point decline in the discount
rate at year-end, as well as the $(28.3) million impact of a 50 basis point
decrease in the expected rate of future compensation increases. As a result, the
funded status for the Company's U.S. Salaried Plan improved by $495.4 million to
$(459.6) million at the end of 2003. Funded status for the Company's total
pension obligations, including foreign and affiliate plans, improved by $452.6
million to $(871.3) million at the end of 2003.

Funded status at the end of 2004 will depend primarily on the actual return
on assets during the year and the discount rate at the end of the year. The
Company estimates that every 25 basis points change in the discount rate impacts
the funded status of the U.S. Salaried Pension Plan, which represents about 80%
of the Company's pension obligations, by approximately $104 million. Similarly,
every five percentage point change in the actual 2004 rate of return on assets
impacts the same plan by approximately $150 million.

MINIMUM PENSION LIABILITY

SFAS No. 87, "Employers' Accounting for Pensions" ("SFAS No. 87"), requires
that a minimum pension liability be recorded if a plan's market value of assets
falls below the plan's accumulated benefit obligation.

In 2002, the combination of a decline in the discount rate and a decline in
assets caused several of the Company's plans to be in a deficit position.
Accordingly, during 2002, the Company recorded a total after-tax reduction of
$765.5 million to its total shareholders' equity. As a result of the improved
financial markets in 2003, the Company recorded a total after-tax increase of
$182.5 to its shareholders' equity at year-end 2003. It is important to note
that these actions did not cause a default in any of the Company's debt
covenants.

29

Future recognition of additional minimum pension liabilities will depend
primarily on the rate of return on assets and the prevailing discount rate.

PENSION EXPENSE

The Company uses the market-related value of assets method, as described in
paragraph 30 of SFAS No. 87, for the calculation of pension expense. This method
recognizes investment gains or losses over a five-year period from the year in
which they occur. In addition, in accordance with paragraph 32 of SFAS No. 87, a
portion of the Company's unrecognized net actuarial loss is amortized and this
cost is included in the net periodic benefit cost.

The Company recorded $33.0 million of net periodic pension cost ($35.4
million after considering the effects of curtailment losses) into its
Consolidated Income Statement in 2003, compared with pension income of $10.4
million in 2002. The 2003 net periodic pension cost reflected benefit service
cost of $73.3 million and interest cost on accrued benefits of $256.5 million,
offset by the expected return on plan assets of $327.0 million. In addition, the
2003 pension expense included $23.5 million of amortization of past losses, up
from $3.2 million in 2002. The primary drivers behind the increase in the net
periodic pension cost were the effect of the change in the discount rate, the
effect of the lowered assumption as to expected return on assets and the
increase in amortization of past losses in 2003.

In 2004, the Company expects to incur approximately $68.0 million of
pension expense that will be recorded into its Consolidated Income Statement.
The increase in pension expense is primarily due to the effect of the change in
discount rate and higher amortization of past losses. See Note 12, "Pension and
Postretirement Medical Benefit Expenses," in the Notes to Consolidated Condensed
Financial Statements for additional details, including pension expense incurred
during the first quarter.

Revenue Recognition: The Company recognizes revenue as services are
rendered and when title transfers for products, subject to any special terms and
conditions of specific contracts. For the majority of the Company's sales, title
transfers when products are shipped. Under certain circumstances, title passes
when products are delivered. In the Defense Electronics & Services segment,
certain contracts require the delivery, installation, testing, certification and
customer acceptance before revenue can be recorded. Further, some sales are
recognized when the customer picks up the product.

The Defense Electronics & Services segment typically recognizes revenue and
anticipated profits under long-term, fixed-price contracts based on units of
delivery or the completion of scheduled performance milestones. Estimated
contract costs and resulting margins are recorded in proportion to recorded
sales. During the performance of such contracts, estimated final contract prices
and costs (design, manufacturing, and engineering and development costs) are
periodically reviewed and revisions are made when necessary. The effect of these
revisions to estimates is included in earnings in the period in which revisions
are made. There were no material revisions to estimates in the covered periods.

Accruals for estimated expenses related to warranties are made at the time
products are sold or services are rendered. These accruals are established using
historical information on the nature, frequency and average cost of warranty
claims and estimates of future costs. Management believes the warranty accruals
are adequate; however, actual warranty expenses could differ from estimated
amounts. The accrual for product warranties at March 31, 2004 and 2003 was $36.0
million and $39.9 million, respectively. See Note 14, "Guarantees, Indemnities
and Warranties," in the Notes to Consolidated Condensed Financial Statements for
additional details.

ACCOUNTING PRONOUNCEMENTS

In December 2003, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 132 (revised December 2003), "Employers' Disclosures About Pensions and
Other Post Retirement Benefits." This revised SFAS retains the disclosure
requirements of SFAS 132. Additionally, the pronouncement requires additional
disclosures regarding the types of plan assets, investment strategy, measurement
dates, plan obligations, cash flows and components of net periodic benefit cost
recognized during interim periods for

30

defined benefit pension plans and other defined benefit post retirement plans.
The Company adopted this pronouncement effective December 31, 2003. Adoption did
not have a material impact on the financial statements of the Company.

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 hedging activities under SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No.
149 clarifies the circumstances under which a contract with an initial net
investment meets the characteristics of a derivative as discussed in SFAS No
133. In addition, SFAS No. 149 clarifies when a derivative contains a financing
component that warrants special reporting in the statement of cash flows. SFAS
No. 149 is effective for contracts entered into or modified after June 30, 2003,
and for hedging relationships designated after June 30, 2003. The adoption of
this interpretation did not have a material effect on the Company's financial
statements.

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity." SFAS
No. 150 requires certain financial instruments that embody obligations of the
issuer and have characteristics of both liabilities and equity to be classified
as liabilities. The provisions of SFAS No. 150 were effective for financial
instruments entered into or modified after May 31, 2003 and to all other
instruments that exist as of the beginning of the first interim financial
reporting period beginning after June 15, 2003. The Company did not have any
financial instruments that met the provisions of SFAS No. 150; therefore, the
adoption of this standard did not have a material effect on the Company's
financial statements.

In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" ("FIN 46"). FIN 46 requires unconsolidated variable
interest entities to be consolidated by their primary beneficiaries if the
entities do not effectively disperse the risks and rewards of ownership among
their owners and other parties involved. The provisions of FIN 46 are applicable
to all variable interest entities created after January 31, 2003 and variable
interest entities in which an enterprise obtains an interest after that date.
For variable interest entities created before January 31, 2003, the provisions
were effective December 31, 2003. The Company did not create or obtain any
variable interest entities during 2003. The Company elected early adoption of
the provisions of FIN 46 related to variable interest entities created prior to
January 31, 2003 as of July 1, 2003. The adoption of this interpretation did not
have a material effect on the Company's financial statements. In December 2003,
the FASB issued a revision to Interpretation No. 46; however, it had no impact
on ITT's adoption.

In January 2004, FASB Staff Position ("FSP") No. 106-1, "Accounting and
Disclosure Requirements Related to the Medicare Prescription Drug, Improvement
and Modernization Act of 2003" ("FSP No. 106-1") was issued. Subsequently, FSP
No. 106-b was issued, which amends FSP No. 106-1 and permits the deferral of
recognizing the effects of the Medicare Prescription Drug, Improvement and
Modernization Act of 2003 (the Act) in the accounting for postretirement health
care plans under SFAS No. 106, "Employers' Accounting for Postretirement
Benefits Other Than Pensions," and in providing disclosures related to the plan
required by SFAS No. 132. The deferral of the accounting for the Act continues
to apply until authoritative guidance is issued on the accounting for the
federal subsidiary provided by the Act or until certain other events requiring
plan remeasurement. The Company has elected the deferral provided by this FSP
and is evaluating the magnitude of the potential favorable impact of the subsidy
on the financial statements. The authoritative guidance, when issued, could
require a change to previously reported information. See Note 19, "Employee
Benefit Plans," in the Notes to Consolidated Financial Statements of the 2003
Annual Report on Form 10-K for discussion of postretirement benefits.

RISKS AND UNCERTAINTIES

ENVIRONMENTAL MATTERS

The Company is subject to stringent environmental laws and regulations that
affect its operating facilities and impose liability for the cleanup of past
discharges of hazardous substances. In the United States, these
31

laws include the Federal Clean Air Act, the Clean Water Act, the Resource
Conservation and Recovery Act, and the Comprehensive Environmental Response,
Compensation and Liability Act. Management believes that the Company is in
substantial compliance with these and all other applicable environmental
requirements. Environmental compliance costs are accounted for as normal
operating expenses.

In estimating the costs of environmental investigation and remediation, the
Company considers, among other things, regulatory standards, its prior
experience in remediating contaminated sites, and the professional judgment of
environmental experts. It is difficult to estimate the total costs of
investigation and remediation due to various factors, including incomplete
information regarding particular sites and other potentially responsible
parties, uncertainty regarding the extent of contamination and the Company's
share, if any, of liability for such problems, the selection of alternative
remedies, and changes in cleanup standards. When it is possible to create
reasonable estimates of liability with respect to environmental matters, the
Company establishes accruals in accordance with accounting principles generally
accepted within the United States. Insurance recoveries are included in other
assets when it is probable that a claim will be realized. Although the outcome
of the Company's various remediation efforts presently cannot be predicted with
a high level of certainty, management does not expect that these matters will
have a material adverse effect on the Company's consolidated financial position,
results of operations, or cash flows. For disclosure of the Company's
commitments and contingencies, see Note 21, "Commitments and Contingencies" in
the Notes to Consolidated Financial Statements of the 2003 Annual Report on Form
10-K.

FORWARD-LOOKING STATEMENTS

Certain material presented herein consists of forward-looking statements
which involve known and unknown risks, uncertainties and other important factors
that could cause actual results to differ materially from those expressed in or
implied from such forward-looking statements. Such factors include general
economic and worldwide political conditions, foreign currency exchange rates,
competition and other factors all as more thoroughly set forth in Item 1.
Business and Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations -- Forward-Looking Statements in the ITT Industries,
Inc. Form 10-K Annual Report for the fiscal year ended December 31, 2003 and
other of its filings with the Securities and Exchange Commission, to which
reference is hereby made.

32

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information called for by Item 3 is provided in Note 9, "Derivative
Instruments and Hedging Activities" in the Notes to Consolidated Condensed
Financial Statements herein. There has been no material change in the
information concerning market risk as stated in the Company's 2003 Annual Report
on Form 10-K.

ITEM 4. CONTROLS AND PROCEDURES

(a) The Chief Executive Officer and Chief Financial Officer of the Company
have evaluated the effectiveness of our disclosure controls and procedures (as
defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end
of the period covered by this report. Based on such evaluation, such officers
have concluded that, as of the end of the period covered by this report the
Company's disclosure controls and procedures are effective in identifying, on a
timely basis, material information required to be disclosed in our reports filed
or submitted under the Exchange Act.

(b) There have been no changes in our internal control over Financial
reporting during in the last fiscal quarter that have materially affected or are
reasonably likely to materially affect the Company's internal control over
financial reporting.

PART II.

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The following should be read in conjunction with Note 13 to the unaudited
interim consolidated condensed financial statements in Part I of this Report, as
well as Part I Item 3 of our Annual Report on Form 10-K for the year ended
December 31, 2003.

The Company and its subsidiaries from time to time are involved in legal
proceedings that are incidental to the operation of their businesses. Some of
these proceedings allege damages against the Company relating to environmental
liabilities, intellectual property matters, copyright infringement, personal
injury claims, employment and pension matters, government contract issues and
commercial or contractual disputes, sometimes related to acquisitions or
divestitures. The Company will continue to vigorously defend itself against all
claims. Although the ultimate outcome of any legal matter cannot be predicted
with certainty, based on present information including the Company's assessment
of the merits of the particular claim, as well as its current reserves and
insurance coverage, the Company does not expect that such legal proceedings will
have any material adverse impact on the cash flow, results of operations, or
financial condition of the Company on a consolidated basis in the foreseeable
future.

ITEM 2. CHANGES IN SECURITIES

ISSUER PURCHASES OF EQUITY SECURITIES

- ---------------

(1) All share repurchases were made in open-market transactions. None of these
transactions were made pursuant to a publicly announced repurchase plan.

(2) Average price paid per share is calculated on a settlement basis and
excludes commission.

No share repurchases were made pursuant to a publicly announced plan or
program. The Company's strategy for cash flow utilization is to pay dividends
first and then repurchase Company common stock to cover option exercises made
pursuant to the Company's stock option programs. The remaining cash is then
available for strategic acquisitions and discretionary repurchases of the
Company's common stock.

33

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) See the Exhibit Index for a list of exhibits filed herewith.

(b) ITT Industries furnished under Items 9 and 12, on April 22, 2004, a
copy of its press release announcing its financial results for the first quarter
of 2004 and updating its previously announced full year 2004 guidance on Form
8-K.

34

SIGNATURE

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.

ITT Industries, Inc.

(Registrant)

By /s/ MARK E. LANG
------------------------------------
Mark E. Lang
Vice President and Corporate
Controller
(Principal accounting officer)

May 7, 2004

35

EXHIBIT INDEX