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

FORM 10-Q

For the quarterly period ended March 31, 2003

OR

For the transition period from                              to                             

Commission file number 0-8408

WOODWARD GOVERNOR COMPANY
(Exact name of registrant as specified in its charter)

5001 North Second Street, Rockford, Illinois 61125-7001
(Address of principal executive offices)

(815) 877-7441
(Registrant's telephone number, including area code)

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý    No o

        As of April 28, 2003, 11,233,853 shares of common stock with a par value of $.00875 cents per share were outstanding.

TABLE OF CONTENTS

PART I—FINANCIAL INFORMATION

Item 1.    Financial Statements

Statements of Consolidated Earnings
Woodward Governor Company and Subsidiaries

See accompanying Notes to Consolidated Financial Statements.

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Statements of Consolidated Earnings
Woodward Governor Company and Subsidiaries

See accompanying Notes to Consolidated Financial Statements.

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Consolidated Balance Sheets
Woodward Governor Company and Subsidiaries

Consolidated balance sheets continued on next page.

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Consolidated Balance Sheets—Continued
Woodward Governor Company and Subsidiaries

See accompanying Notes to Consolidated Financial Statements.

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Statements of Consolidated Cash Flows
Woodward Governor Company and Subsidiaries

See accompanying Notes to Consolidated Financial Statements.

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Notes to Consolidated Financial Statements

(1)  Overview:

        The consolidated balance sheet as of March 31, 2003, the statements of consolidated earnings for the three and six-month periods ended March 31, 2003 and 2002, and the statements of consolidated cash flows for the six-month periods ended March 31, 2003 and 2002, were prepared by the company without audit. The September 30, 2002, consolidated balance sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. Information in this 10-Q report is based in part on estimates and is subject to year-end adjustments and audit. In our opinion, the figures reflect all adjustments necessary to present fairly the company's financial position as of March 31, 2003, the results of its operations for the three and six-month periods ended March 31, 2003 and 2002, and its cash flows for the six-month periods ended March 31, 2003 and 2002. All such adjustments were of a normal and recurring nature. The statements were prepared following the accounting policies described in the company's 2002 annual report on Form 10-K and should be read with the Notes to Consolidated Financial Statements on pages 33-43 of the 2002 annual report to shareholders. The statements of consolidated earnings for the three and six-month periods ended March 31, 2003, are not necessarily indicative of the results to be expected for other interim periods or for the full year.

(2)  Cumulative effect of accounting change:

        We adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets," and the transition provisions of Statement of Financial Accounting Standards No. 141, "Business Combinations," on October 1, 2001. As a result of adopting these new standards, we completed the transitional goodwill impairment reviews required by the new standards and recognized an aftertax loss of $2,489,000 as a cumulative effect of an accounting change in 2002. In performing our impairment reviews, we estimated the fair values of the various reporting units using a present value method that discounted future cash flows as we expect marketplace participants would, and we further assessed the reasonableness of the estimates by using valuation methods based on market multiples. The resulting loss, which was related to an Industrial Controls reporting unit, was incurred to reduce goodwill to its implied fair value.

(3)  Earnings per share:

        The following stock options were outstanding during the three and six months ended March 31, 2003 and 2002, but were not included in the computation of diluted earnings per share because the options' exercise prices were greater than the average market price of the common shares during the respective periods:

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(4)  Inventories:

(5)  Goodwill:

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(6)  Other intangibles—net:

        Amortization expense associated with current intangibles is expected to be approximately $4,100,000 for each year 2003-2006 and approximately $3,900,000 in 2007.

(7)  Accounts payable and other accrued expenses:

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        Included in salaries and other member benefits are accrued termination benefits totaling $4,493,000 for 236 members at March 31, 2003, and $1,389,000 for 36 members at September 30, 2002. The table below indicates the termination benefits activity, by segment, for the six months ended March 31, 2003.

        The termination benefits accrued for by Industrial Controls impacted various manufacturing, selling, and administrative expenses at locations worldwide and were made to better align staffing levels with expected demands. For Aircraft Engine Systems, the majority of the accrued termination benefits were associated with the consolidation of our servovalve manufacturing operations in Buffalo, New York, into our Rockford, Illinois, manufacturing facility to achieve additional production cost efficiencies. The remaining reductions were made to better align staffing levels with expected demand.

        Provisions of our sales agreements include product warranties customary to such agreements. We establish accruals for specifically identified warranty issues that are probable to result in future costs. We also accrue for warranty costs on a non-specific basis whenever past experience indicates a normal and predictable pattern exists. A reconciliation of accrued product warranties from September 30, 2002, to March 31, 2003, follows:

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(8)  Deferred Compensation Plan

        We maintain a deferred compensation plan for key management members of the company. Individual member balances are accounted for as if they were held in specified investments, including common stock of the company. Deferred compensation balances are payable upon the retirement or other termination of a participating member, or as otherwise specified by plan documents. To the extent that balances are deemed invested in the common stock of the company, these payments are payable in actual shares of common stock. All remaining balances are payable in cash.

        Deferred compensation obligations are reported as a component of equity or as an accrued expense. In 2003, we contributed 123,000 shares of common stock of the company into a trust established for the future settlement of deferred compensation obligations that are payable in actual shares of our common stock. Common stock held by the trust is reflected in the consolidated balance sheet as treasury stock for deferred compensation, and the related deferred compensation obligation is reflected as a separate equity instrument. The amounts recognized in both equity accounts are equal to the fair value of the common shares at the date of contribution, and neither account will be adjusted for subsequent changes in fair value. All deferred compensation balances payable in cash are reflected in the consolidated balance sheet as an accrued liability at fair value.

(9)  Stock option plan:

        We have a stock option plan covering key management members and directors of the company. Options granted under the plan generally have a term of 10 years and vest evenly at the end of each year over four years from the date of grant. There were 2,100,000 shares of common stock authorized for issuance under the plan at March 31, 2003. We use the intrinsic value method to account for stock-based employee compensation under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and therefore we do not recognize compensation expense in association with options granted at or above the market price of our common stock at the date of grant. The following table presents a reconciliation of reported net earnings and per share information to pro forma net earnings and per share information that would have been reported if the fair value method had been used to account for stock-based employee compensation:

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(10) Accumulated other comprehensive earnings:

        Accumulated other comprehensive earnings, which totaled $4,655,000 at March 31, 2003, consisted of the following items:

(11) Total comprehensive earnings:

(12) Contingencies

        We have entered into agreements with certain executive officers under which we would pay termination benefits under certain circumstances in the event of a change in control of the company.

        We are currently involved in matters of litigation arising from the normal course of business, including certain environmental and product liability matters. We have accruals of approximately $1,000,000 at March 31, 2003, related to such matters. These accruals are based on our current estimate of the most likely amount of losses that we believe will be incurred. These amounts have been included in accounts payable and accrued expenses.

        We have been designated a "de minimis potentially responsible party" with respect to the cost of investigation and environmental cleanup of certain third-party sites. Our current accrual for these matters is based on costs incurred to date that we have been allocated and our estimate of the most likely future investigation and cleanup costs. There is, as in the case of most environmental litigation, the possibility that under joint and several liability we could be required to pay more than our allocated share of costs.

        It is our opinion, after consultation with legal counsel, that additional liabilities, if any, resulting from these matters are not expected to have a material adverse effect on our financial condition, although such matters could have a material effect on our quarterly or annual operating results and cash flows when resolved in a future period.

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(13) Segment information:

        The difference between the total of segment earnings and the statements of consolidated earnings follows:

        Segment assets were as follows:

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Item 2    Management's Discussion and Analysis of Financial Condition and Results of Operations

        We prepared the following discussion and analysis to help you better understand our results of operations and financial condition. This discussion should be read with the consolidated financial statements.

        This discussion and analysis should also be read with the cautionary statement of our 2002 annual report to shareholders, which was filed with our Form 10-K for the year ended September 30, 2002. This discussion and analysis contains forward-looking statements, including financial projections, our plans and objectives for the future, expectations for future economic performance, and various other assumptions relating to the future. While such statements reflect our current expectations, all such statements involve risks and uncertainties. Actual results could differ materially from projections or any other forward-looking statement, and we have no obligation to update our forward-looking statements. Important factors that could cause results to differ materially from those projected or otherwise stated are identified in the cautionary statement of our 2002 annual report to shareholders.

Results of Operations

        Our results of operations are discussed and analyzed by segment. We have two operating segments—Industrial Controls and Aircraft Engine Systems. Industrial Controls provides energy control systems and components primarily to OEMs (original equipment manufacturers) of industrial engines, turbines, and other power equipment. Aircraft Engine Systems provides energy control systems and components primarily to OEMs of aircraft engines.

        We use segment earnings internally to assess the performance of each segment and for making decisions on the allocation of resources. Total segment earnings do not reflect all expenses of the company and are before the cumulative effect of an accounting change. Nonsegment expenses, including income taxes, and the accounting change are separately discussed and analyzed.

Industrial Controls

        External net sales for Industrial Controls decreased in both the three months and six months ended March 31, 2003, as compared to the same periods last year. This decrease was the result of a severe decline in domestic capital spending on power generation equipment—particularly large turbines—and a downturn in industrial markets generally.

        Industrial Controls' had segment losses in the three months and six months ended March 31, 2003, as compared to segment earnings in the same periods last year. Results were significantly impacted by the reverse leverage effect of reduced sales volume versus fixed costs and development costs considered necessary to satisfy core customers' current and future requirements.

        Included as part of segment earnings (losses) were certain workforce management costs that we incurred in connection with reductions in our workforce. This year, the reductions impacted various manufacturing, selling, and administrative functional areas at locations worldwide, and were made to better align staffing levels with expected demands. Last year, the reductions were primarily the result of consolidating certain manufacturing and administrative locations into fewer locations. Our workforce management costs were reflected in the following financial lines of the statements of consolidated earnings:

        In addition, we incurred $1.0 million for lease termination expenses in the three months and six months ended March 31, 2003.

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        Outlook:    Conditions in industrial markets have continued to deteriorate and it has become increasingly difficult to anticipate future sales levels. Given the sustained decline in our primary industrial markets, we now anticipate the decline in full year earnings from 2002 to 2003 will be at least 70%. Final results could be impacted if there are unanticipated further declines in sales and if additional cost savings measures become necessary.

Aircraft Engine Systems

        External net sales for Aircraft Engine Systems decreased in both the three months and six months ended March 31, 2003, as compared to the same periods last year. These decreases reflect weakness in the commercial aviation industry. Commercial aftermarket sales held up better than OEM sales, and military sales accounted for a slightly increased proportion of external net sales.

        Aircraft Engine Systems' segment earnings decreased in both the three months and six months ended March 31, 2003, as compared to the same periods last year. Cost management and productivity initiatives taken during 2002 enabled margins to remain near last year's levels, despite continuing pricing pressures.

        Included as part of segment earnings were certain workforce management costs that we incurred in connection with reductions in our workforce. The majority of these reductions are associated with the consolidation of our servovalve manufacturing operations in Buffalo, New York, into our Rockford, Illinois, manufacturing facility to achieve additional production cost efficiencies. The remaining reductions were made to better align staffing levels with expected demand. Our workforce management costs were reflected in the following financial lines of the statements of consolidated earnings:

        The consolidation of our servovalve manufacturing operations referred to above is expected to generate annual cost savings of approximately $2.5 million once the consolidation has been completed. The total cost of the consolidation has been estimated at $4.0 million, of which $2.8 million was recognized in the first six months this year (including $2.3 million of workforce management costs). The remaining expenses are expected to be recognized over the last two quarters of the year.

        Outlook:    For 2003, we currently expect Aircraft Engine Systems' sales to decrease about 5% from 2002 and segment earnings to decrease about 15% to 20% from 2002. Our segment earnings outlook includes costs associated with the Buffalo consolidation referred to above.

Nonsegment Expenses