UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
|X| Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended September 30, 2002
------------------
or
|_| 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 1-11499
WATTS INDUSTRIES, INC.
----------------------
(Exact name of registrant as specified in its charter)
Delaware 04-2916536
-------- ----------
(State of incorporation) (I.R.S. Employer Identification No.)
815 Chestnut Street, North Andover, MA 01845
-------------------------------------- -----
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (978) 688-1811
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Class Outstanding at October 31, 2002
----- -------------------------------
Class A Common, $.10 par value 18,868,388
Class B Common, $.10 par value 8,185,224
WATTS INDUSTRIES, INC. AND SUBSIDIARIES
---------------------------------------
INDEX
-----
Part I. Financial Information Page #
--------------------- ------
Item 1. Financial Statements
--------------------
Consolidated Balance Sheets at September 30, 2002
(unaudited) and December 31, 2001 3
Consolidated Statements of Income for the Three Months
Ended September 30, 2002 and 2001 (unaudited) 4
Consolidated Statements of Income for the Nine Months
Ended September 30, 2002 and 2001 (unaudited) 5
Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 2002 and 2001 (unaudited) 6
Notes to Consolidated Financial Statements 7-16
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 17-25
Item 3. Quantitative and Qualitative Disclosures about Market Risk 25-26
Item 4. Controls and Procedures 26
Part II. Other Information
-----------------
Item 1. Legal Proceedings 27-28
Item 6. Exhibits and Reports on Form 8-K 29
Signatures 30
Certifications 31-32
Exhibit Index 33
PART I. FINANCIAL INFORMATION
---------------------
ITEM 1. FINANCIAL STATEMENTS
--------------------
WATTS INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Thousands, except share amounts)
(Unaudited)
Sept. 30, Dec. 31,
2002 2001
--------- ---------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents ............................................ $ 16,117 $ 11,997
Trade accounts receivable, less allowance for doubtful accounts of
$7,008 at September 30, 2002 and $6,070 at December 31, 2001 ...... 130,289 95,498
Inventories:
Raw materials ..................................................... 39,624 34,276
Work in process ................................................... 16,171 13,032
Finished goods .................................................... 74,149 68,556
--------- ---------
Total Inventories .............................................. 129,944 115,864
Prepaid expenses and other assets .................................... 9,204 7,087
Deferred income taxes ................................................ 26,428 25,329
Net assets held for sale ............................................. 2,293 349
--------- ---------
Total Current Assets .............................................. 314,275 256,124
--------- ---------
PROPERTY, PLANT AND EQUIPMENT:
Property, plant and equipment, at cost ............................... 241,792 218,235
Accumulated depreciation ............................................. (107,670) (89,629)
--------- ---------
Property, plant and equipment, net ................................ 134,122 128,606
--------- ---------
OTHER ASSETS:
Goodwill, net of accumulated amortization of $17,885 at
September 30, 2002 and at December 31, 2001 ....................... 158,117 124,544
Other ................................................................ 24,908 11,196
--------- ---------
TOTAL ASSETS .............................................................. $ 631,422 $ 520,470
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable ..................................................... $ 55,021 $ 42,873
Accrued expenses and other liabilities ............................... 67,243 55,930
Accrued compensation and benefits .................................... 14,978 11,033
Current portion of long-term debt .................................... 9,211 3,693
--------- ---------
Total Current Liabilities ......................................... 146,453 113,529
--------- ---------
LONG-TERM DEBT, NET OF CURRENT PORTION .................................... 159,978 123,212
DEFERRED INCOME TAXES ..................................................... 20,235 15,692
OTHER NONCURRENT LIABILITIES .............................................. 11,753 11,414
MINORITY INTEREST ......................................................... 10,614 7,309
STOCKHOLDERS' EQUITY:
Preferred Stock, $.10 par value; 5,000,000 shares authorized;
no shares issued or outstanding ................................... -- --
Class A Common Stock, $.10 par value; 80,000,000 shares authorized;
1 vote per share; issued and outstanding: 18,578,408 shares at
September 30, 2002 and 17,776,509 shares at December 31, 2001 ..... 1,858 1,778
Class B Common Stock, $.10 par value; 25,000,000 shares authorized;
10 votes per share; issued and outstanding: 8,185,224 shares at
September 30, 2002 and 8,735,224 shares at December 31, 2001 ...... 819 874
Additional paid-in capital ........................................... 40,716 37,182
Retained earnings .................................................... 254,363 233,761
Accumulated other comprehensive income/(loss) ........................ (15,367) (24,281)
--------- ---------
Total Stockholders' Equity ........................................ 282,389 249,314
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ................................ $ 631,422 $ 520,470
========= =========
See accompanying notes to consolidated financial statements.
3
WATTS INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Thousands, except per share amounts)
(Unaudited)
Three Months Ended
------------------------
Sept. 30, Sept. 30,
2002 2001
--------- ---------
Net sales ........................................ $ 159,811 $ 138,009
Cost of goods sold ............................... 106,304 91,066
--------- ---------
GROSS PROFIT ................................ 53,507 46,943
Selling, general & administrative expenses ....... 37,532 32,511
Restructuring .................................... 208 --
--------- ---------
OPERATING INCOME ............................ 15,767 14,432
--------- ---------
Other (income) expense:
Interest income ............................. (122) (264)
Interest expense ............................ 2,447 2,587
Other, net .................................. (39) 269
Minority interest ........................... 156 59
--------- ---------
2,442 2,651
--------- ---------
INCOME BEFORE INCOME TAXES .................. 13,325 11,781
Provision for income taxes ....................... 4,552 3,972
--------- ---------
NET INCOME .................................. $ 8,773 $ 7,809
========= =========
BASIC EARNINGS PER SHARE
NET INCOME .................................. $ .33 $ .29
========= =========
Weighted average number of shares ................ 26,717 26,527
========= =========
DILUTED EARNINGS PER SHARE
NET INCOME .................................. $ .32 $ .29
========= =========
Weighted average number of shares ................ 27,249 26,838
========= =========
Dividends per common share ................. $ .06 $ .06
========= =========
See accompanying notes to consolidated financial statements.
4
WATTS INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Thousands, except per share amounts)
(Unaudited)
Nine Months Ended
------------------------
Sept. 30, Sept. 30,
2002 2001
--------- ---------
Net sales ........................................ $ 454,636 $ 409,496
Cost of goods sold ............................... 299,418 269,540
--------- ---------
GROSS PROFIT ................................ 155,218 139,956
Selling, general & administrative expenses ....... 109,897 98,633
Restructuring .................................... 218 --
--------- ---------
OPERATING INCOME ............................ 45,103 41,323
--------- ---------
Other (income) expense:
Interest income ............................. (578) (518)
Interest expense ............................ 6,576 7,395
Other, net .................................. (164) 425
Minority interest ........................... 262 176
--------- ---------
6,096 7,478
--------- ---------
INCOME BEFORE INCOME TAXES .................. 39,007 33,845
Provision for income taxes ....................... 13,545 11,728
--------- ---------
NET INCOME .................................. $ 25,462 $ 22,117
========= =========
BASIC EARNINGS PER SHARE
NET INCOME .................................. $ .96 $ .83
========= =========
Weighted average number of shares ................ 26,630 26,497
========= =========
DILUTED EARNINGS PER SHARE
NET INCOME .................................. $ .94 $ .82
========= =========
Weighted average number of shares ................ 27,112 26,850
========= =========
Dividends per common share ................. $ .18 $ .18
========= =========
See accompanying notes to consolidated financial statements.
5
WATTS INDUSTRIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Thousands)
(Unaudited)
Nine Months Ended
--------------------
Sept. 30, Sept. 30,
2002 2001
-------- --------
OPERATING ACTIVITIES
Net income ...................................................... $ 25,462 $ 22,117
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation ................................................. 17,104 14,720
Amortization ................................................. 327 2,676
Deferred income taxes ........................................ 296 --
Gain/loss on disposal of assets .............................. (88) 32
Equity in undistributed earnings (loss) of affiliates ........ (105) 13
Changes in operating assets and liabilities, net of effects
from acquisitions and dispositions:
Accounts receivable ....................................... (23,788) 2,756
Inventories ............................................... (2,093) 403
Prepaid expenses and other assets ........................ (1,184) (860)
Accounts payable, accrued expenses and other liabilities .. 5,801 (8,413)
-------- --------
Net cash provided by operating activities ....................... 21,732 33,444
-------- --------
INVESTING ACTIVITIES
Additions to property, plant and equipment ...................... (16,967) (11,539)
Proceeds from sale of property, plant and equipment ............. 2,883 85
Business acquisitions, net of cash acquired ..................... (25,689) (43,377)
Decrease in other assets ........................................ 41 248
-------- --------
Net cash used in investing activities ........................... (39,732) (54,583)
-------- --------
FINANCING ACTIVITIES
Proceeds from long-term borrowings .............................. 94,858 96,704
Payments of long-term debt ...................................... (75,901) (68,972)
Proceeds from exercise of stock options ......................... 3,559 1,180
Dividends ....................................................... (4,860) (4,842)
Purchase of treasury stock ...................................... -- (360)
-------- --------
Net cash provided by financing activities ....................... 17,656 23,710
-------- --------
Effect of exchange rate changes on cash and cash equivalents ......... 1,858 (915)
Net cash provided by/(used in) discontinued operations ............... 2,606 (1,516)
-------- --------
CHANGE IN CASH AND CASH EQUIVALENTS ................................. 4,120 140
Cash and cash equivalents at beginning of period ..................... 11,997 15,235
-------- --------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ........................... $ 16,117 $ 15,375
======== ========
NON CASH INVESTING AND FINANCING ACTIVITIES
Acquisitions of businesses:
Fair value of assets acquired ................................ $ 65,479 $ 64,146
Cash Paid .................................................... 25,689 43,377
-------- --------
Liabilities Assumed .......................................... $ 39,790 $ 20,769
======== ========
See accompanying notes to consolidated financial statements.
6
WATTS INDUSTRIES, INC. AND SUBSIDIARIES
- ---------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
- ------------------------------------------------------
1. Basis of Presentation
In the opinion of management, the accompanying unaudited, consolidated
financial statements contain all necessary adjustments, consisting only of
adjustments of a normal recurring nature, to present fairly Watts Industries,
Inc.'s Consolidated Balance Sheet as of September 30, 2002 (unaudited), its
Consolidated Statements of Income for the three months and nine months ended
September 30, 2002 and 2001 (unaudited), and its Consolidated Statements of Cash
Flows for the nine months ended September 30, 2002 and 2001 (unaudited).
The balance sheet at December 31, 2001 has been derived from the audited
financial statements at that date. The accounting policies followed by the
Company are described in the December 31, 2001 financial statements which are
contained in the Company's December 31, 2001 Annual Report on Form 10-K. It is
suggested that the financial statements included in this report be read in
conjunction with the financial statements and notes included in the December 31,
2001 Annual Report on Form 10-K.
2. Accounting Policies
The Company's shipping costs included in selling, general and
administrative expense amounted to $5,087,000 and $5,459,000 for the three
months ended September 30, 2002 and 2001, respectively, and $15,262,000 and
$16,180,000 for the nine months ended September 30, 2002 and 2001, respectively.
The Company adopted Financial Accounting Standards Board Statement No.
141, "Business Combinations" ("FAS 141") in fiscal 2001 and Financial Accounting
Standards Board Statement No. 142, "Goodwill and Other Intangible Assets" ("FAS
142") on January 1, 2002. FAS 141 requires that the purchase method of
accounting be used for all business combinations initiated after June 30, 2001.
FAS 141 also specifies the criteria that intangible assets acquired in a
purchase method business combination must meet in order to be recognized and
reported apart from goodwill. FAS 142 requires that goodwill and intangible
assets with indefinite useful lives no longer be amortized, but instead be
tested for impairment, at least annually, in accordance with the provisions of
FAS 142. FAS 142 also requires that intangible assets with definite useful lives
be amortized over their respective estimated useful lives to their estimated
residual values and reviewed for impairment in accordance with Financial
Accounting Standards Board Statement No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets" ("FAS 144").
FAS 142 requires the Company to perform an assessment of whether there is
an indication that the remaining recorded goodwill is impaired as of the date of
adoption. This assessment involves a two-step transitional impairment test. To
accomplish this, the Company must identify its reporting units and determine the
carrying value of each reporting unit by assigning the assets and liabilities,
including the existing goodwill and intangible assets, to those reporting units
as of January 1, 2002. To the extent that a reporting unit's carrying amount
exceeds its fair value, an indication exists that the reporting unit's goodwill
may be impaired and the Company must perform the second step of the transitional
impairment test. Any transitional impairment loss will be recognized as a
cumulative effect of a change in accounting principle. In connection with the
adoption of FAS 142, the Company has completed the first step of the
transitional goodwill impairment test, which requires the Company to compare the
fair value of its reporting units to the carrying value of the net assets of the
respective reporting units as of January 1, 2002. Based on this analysis, the
Company has concluded that no impairment existed at the time of adoption, and
accordingly, the Company has not recognized any transitional impairment loss.
FAS 142 also requires goodwill to be tested annually and between annual
tests if events occur or circumstances change that would more likely than not
reduce the fair value of a reporting unit below its carrying amount. The Company
has elected to perform its annual tests for indications of goodwill impairment
as of the end of fiscal October of each year.
7
The effect of the adoption of the standard on prior period earnings,
excluding goodwill amortization expense, net of tax, is as follows:
Three Months Ended
------------------
September 30,
-------------
2002 2001
---- ----
(in thousands, except
per share information)
Net income....................................... $8,773 $7,809
Add back: goodwill amortization, net of tax...... -- 836
--------------------------
Adjusted net income.............................. $8,773 $8,645
==========================
Basic earnings per share:
Net income....................................... $.33 $.29
Goodwill amortization............................ -- .03
--------------------------
Adjusted net income.............................. $.33 $.32
==========================
Diluted earnings per share:
Net income....................................... $.32 $.29
Goodwill amortization............................ -- .03
--------------------------
Adjusted net income.............................. $.32 $.32
==========================
Nine Months Ended
-----------------
September 30,
-------------
2002 2001
---- ----
(in thousands, except
per share information)
Net income....................................... $25,462 $22,117
Add back: goodwill amortization, net of tax...... -- 2,361
--------------------------
Adjusted net income.............................. $25,462 $24,478
==========================
Basic earnings per share:
Net income....................................... $.96 $.83
Goodwill amortization............................ -- .09
--------------------------
Adjusted net income.............................. $.96 $.92
==========================
Diluted earnings per share:
Net income....................................... $.94 $.82
Goodwill amortization............................ -- .09
--------------------------
Adjusted net income.............................. $.94 $.91
==========================
8
The changes in the carrying amount of goodwill for the nine months ended
September 30, 2002 are as follows:
(in thousands)
Carrying amount as of December 31, 2001..................... $124,544
Goodwill acquired during the year........................... 29,697
Effect of change in rates used for translation.............. 3,876
----------------
Carrying amount as of September 30, 2002.................... $158,117
================
Amortized Intangible Assets (a):
As of September 30, 2002
------------------------
Gross Carrying Accumulated
Amount Amortization
------ ------------
(in thousands)
Patents................................... $8,285 $(3,338)
Other..................................... 12,642 (874)
----------------------------------
Total.................................. $20,927 $(4,212)
==================================
(a) as recognized in "Other Assets: "Other", in the consolidated balance
sheet
Aggregate amortization expense for amortized other intangible assets for
the nine months ended September 30, 2002 is $327,000. Additionally, future
amortization expense on other intangible assets approximates $163,000 for the
remainder of fiscal 2002, $567,000 for fiscal 2003, $500,000 for fiscal 2004 and
$487,000 for fiscal 2005 and 2006.
In August 2001, the FASB issued Financial Accounting Standards Board
Statement No. 143, "Accounting for Asset Retirement Obligations" ("FAS 143")
which requires companies to record the fair value of an asset retirement
obligation as a liability in the period it incurs a legal obligation associated
with the retirement of tangible long-lived assets that result from the
acquisition, construction, development and/or normal use of the assets. The
company must also record a corresponding increase in the carrying value of the
related long-lived asset and depreciate that cost over the remaining useful life
of the asset. The liability must be increased each period for the passage of
time with the offset recorded as an operating expense. The liability must also
be adjusted for changes in the estimated future cash flows underlying the
initial fair value measurement. Companies must also recognize a gain or loss on
the settlement of the liability. The provisions of FAS 143 are effective for
fiscal years beginning after June 15, 2002. At the date of the adoption of FAS
143, companies are required to recognize a liability for all existing asset
retirement obligations and the associated asset retirement costs. The Company is
currently evaluating the effect that the adoption of FAS 143 will have on its
results of operations and its financial position.
Effective January 1, 2002, the Company also adopted FAS 144, which
addresses the accounting and reporting for the impairment or disposal of
long-lived assets. FAS 144 supercedes Financial Accounting Standards Board
Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of" ("FAS 121") but retains many of the
fundamental provisions of FAS 121. FAS 144 also supercedes the accounting and
reporting provisions of Accounting Principles Board Opinion No. 30, "Reporting
the Results of Operations--Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions" ("APB 30") for the disposal of a segment of a business. However,
FAS 144 retains the requirements of APB 30 to report discontinued operations
separately and extends that reporting requirement to components of an entity
that has either been disposed of or is classified as held for sale. FAS 144
excludes goodwill and other intangibles that are not amortized from its scope.
For assets to be held and used, FAS 144 addresses the recoverability of an asset
or group of assets, clarifies how an impairment loss should be allocated, and
creates a requirement to use a fair value if market prices are not available and
uncertainties exist about the timing and amount of cash flows. For long-lived
assets to be disposed of by sale, FAS 144 establishes the criteria to be met to
qualify for this classification, defines the timing of
9
when the related sale must be consummated, eliminates the net realizable value
measurement approach for segments of a business and certain acquired assets in a
business combination, and defines costs to sell the asset. FAS 144 was effective
for fiscal years beginning after December 15, 2001 and its adoption was not
material to the Company's consolidated financial statements.
In April 2002, FAS No. 145, "Rescission of FASB Statements No. 4, 44 and
64, Amendment of FASB Statement No. 13, and Technical Corrections," was issued.
FAS 145 rescinds FAS 4 and FAS 64 related to classification of gains and losses
on debt extinguishment such that most debt extinguishment gains and losses will
no longer be classified as extraordinary. FAS 145 also amends FAS 13 with
respect to sales-leaseback transactions. The Company adopted the provisions of
FAS 145 effective April 1, 2002, and its adoption was not material to its
consolidated financial statements.
In July 2002, the FASB issued FAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." The principal difference between
this Statement and Issue 94-3 relates to its requirements for recognition of a
liability for a cost associated with an exit or disposal activity. This
Statement requires that a liability for a cost associated with an exit or
disposal activity be recognized when the liability is incurred. Under Issue
94-3, a liability for an exit cost as defined in Issue 94-3 was recognized at
the date of an entity's commitment to an exit plan. The provisions of this
statement are effective for exit or disposal activities that are initiated after
December 31, 2002.
3. Sales Incentives and Other
During 2000, the Financial Accounting Standards Board's Emerging Issues
Task Force (EITF) added to its agenda various revenue recognition issues that
could impact the income statement classification of certain promotional
payments. In May 2000, the EITF reached a consensus on Issue 00-14, "Accounting
for Certain Sales Incentives". EITF 00-14 addresses the recognition and income
statement classification of various sales incentives. The consensus became
effective in the first quarter of 2002 and was not material to the Company's
consolidated financial statements.
In April 2001, the EITF reached a consensus on Issue 00-25, "Vendor Income
Statement Characterization of Consideration to a Purchaser of the Vendor's
Products or Services". EITF 00-25 addresses the income statement classification
of consideration, other than that directly addressed in Issue 00-14, from a
vendor to a reseller, or another party that purchases the vendor's products. The
consensus became effective in the first quarter of 2002 and was not material to
the Company's consolidated financial statements.
4. Derivative Instruments
Certain forecasted transactions, primarily intercompany sales between the
United States and Canada, and assets are exposed to foreign currency risk. The
Company monitors its foreign currency exposures on an ongoing basis to maximize
the overall effectiveness of its foreign currency hedge positions. During the
nine months ended September 30, 2002, the Company used foreign currency forward
contracts as a means of hedging exposure to foreign currency risks. The
Company's foreign currency forwards have been designated and qualify as cash
flow hedges under the criteria of FAS 133. FAS 133 requires that changes in fair
value of derivatives that qualify as cash flow hedges be recognized in other
comprehensive income while the ineffective portion of the derivative's change in
fair value be recognized immediately in earnings. The net loss on these
contracts recorded in other comprehensive income during the quarter ended
September 30, 2002 was $51,000 and the net gain for the nine months ended
September 30, 2002 was $49,000. There were no ineffective amounts for the three
and nine months ended September 30, 2002.
The Company has used interest rate swaps as an economic hedge on
forecasted interest costs. During the quarter ended September 30, 2001, the
Company entered into an interest rate swap for its $75,000,000 notes. The
Company swapped the fixed interest rate of 8 3/8% to floating LIBOR plus 3.74%.
The term of the swap matched the maturity date of the notes (December 2003). On
August 5, 2002, the Company sold the swap and received $2,315,000 in cash. This
amount is being recognized as a deferred liability and is amortized over the
remaining term of the notes.
10
The Company also utilizes, on a limited basis, certain commodity
derivatives, primarily on copper used in its manufacturing process, to hedge the
cost of its anticipated production requirements. The Company did not utilize any
commodity derivatives for the three and nine-month periods ended September 30,
2002.
5. Restructuring
The Company is implementing a plan to consolidate several of its
manufacturing plants both in North America and Europe. At the same time it is
expanding its manufacturing capacity in China. The implementation of this
manufacturing restructuring plan began during the fourth quarter of fiscal 2001.
The projects, for which charges were recorded in the fourth quarter of fiscal
2001, are essentially complete. The Company decided to expand the scope of the
manufacturing restructuring plan and transfer certain production to low cost
manufacturing plants in Tunisia and Bulgaria. The criteria for recognition of
these expanded costs have not been met as of September 30, 2002. The expanded
plan is expected to be completed by the end of fiscal 2003. The Company
anticipates that the pre-tax cost of the manufacturing restructuring plan will
be $12,500,000. The Company recorded pre-tax manufacturing restructuring plan
costs of $5,831,000 in the fourth quarter of fiscal 2001, $651,000 in the third
quarter of 2002 and $2,331,000 in the nine months ended September 30, 2002. The
Company anticipates recording additional pre-tax costs of approximately
$1,600,000 in the fourth quarter of 2002 and $2,700,000 in 2003 as it continues
to implement the program. The manufacturing restructuring plan costs recorded in
2001 and the nine months in 2002 consist primarily of severance costs, asset
write-downs and accelerated depreciation. The severance costs, which have been
recorded as restructuring, are for 41 employees in manufacturing and
administration groups, 40 of whom have been terminated as of September 30, 2002.
Asset write-downs consist primarily of write-offs of inventory related to
product lines that the Company has discontinued as part of this restructuring
plan and they have been recorded in cost of goods sold. Accelerated depreciation
is based on shorter estimated useful lives of certain fixed assets and has been
recorded in cost of goods sold. The tax benefits of costs incurred and asset
write-downs will approximate the amount of cash outlays to implement this
program, which would allow the Company to complete the restructuring plan with a
minimum consumption of cash. The Company estimates an annual pre-tax savings of
approximately $5,000,000 following the completion of the plan.
Details of our manufacturing restructuring plan through September 30, 2002 are
as follows:
Initial Utilized Balance Additional Utilized Remaining
Provision During 2001 2001 Provisions During 2002 Balance
--------- ----------- ---- ---------- ----------- -------
(in thousands)
Restructuring/Other.... $1,454 $692 $762 $218 $586 $394
Asset Write-downs...... 4,300 4,300 -- 1,253 1,253 --
Other costs............ 77 77 -- 860 860 --
---------------------------------------------------------------------------------
Total.................. $5,831 $5,069 $762 $2,331 $2,699 $394
=================================================================================
11
6. Earnings per Share
The following tables set forth the reconciliation of the calculation of
earnings per share:
For the Three Months Ended September 30, 2002
---------------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------- ------
Basic EPS
Net Income.................. $8,773,000 26,716,744 $0.33
Effect of Dilutive Securities
Common Stock Equivalents.... -- 532,581 (0.01)
----------------------------------------------
Diluted EPS....................... $8,773,000 27,249,325 $0.32
==============================================
For the Three Months Ended September 30, 2001
---------------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------- ------
Basic EPS
Net Income.................. $7,809,000 26,527,312 $0.29
Effect of Dilutive Securities
Common Stock Equivalents.... -- 310,852 --
----------------------------------------------
Diluted EPS....................... $7,809,000 26,838,164 $0.29
==============================================
Stock options to purchase 758,803 shares of common stock were outstanding
at September 30, 2001, but were not included in the computation of diluted
earnings per share because the options' exercise price was greater than the
average market price of the common shares and therefore, the effect would have
been antidilutive.
For the Nine Months Ended September 30, 2002
--------------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------- ------
Basic EPS
Net Income.................. $25,462,000 26,629,981 $0.96
Effect of Dilutive Securities
Common Stock Equivalents.... -- 481,681 (0.02)
----------------------------------------------
Diluted EPS...................... $25,462,000 27,111,662 $0.94
==============================================
For the Nine Months Ended September 30, 2001
--------------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------- ------
Basic EPS
Net Income.................. $22,117,000 26,496,534 $0.83
Effect of Dilutive Securities
Common Stock Equivalent..... -- 352,972 (0.01)
----------------------------------------------
Diluted EPS....................... $22,117,000 26,849,506 $0.82
==============================================
Stock options to purchase 549,933 shares of common stock were outstanding at
September 30, 2001, but were not included in the computation of diluted earnings
per share because the options' exercise price was greater than the average
market price of the common shares and therefore, the effect would have been
antidilutive.
12
7. Segment Information
The following table presents certain operating segment information:
(in thousands)
Three months ended North
September 30, 2002: America Europe Asia Corporate Consolidated
- ------------------- ------- ------ ---- --------- ------------
Net Sales.......................... $114,135 $38,791 $6,885 $-- $159,811
Operating Income................... 14,863 4,016 529 (3,641) 15,767
Capital Expenditures............... 939 2,062 1,761 -- 4,762
Depreciation and Amortization...... 3,349 2,167 329 -- 5,845
Three months ended
September 30, 2001:
- -------------------
Net Sales.......................... $103,635 $31,474 $2,900 $-- $138,009
Operating Income................... 12,631 3,777 118 (2,094) 14,432
Capital Expenditures............... 1,927 544 131 -- 2,602
Depreciation and Amortization...... 3,895 1,699 185 -- 5,779
Nine months ended
September 30, 2002:
- -------------------
Net Sales.......................... $337,693 $102,006 $14,937 $-- $454,636
Operating Income................... 43,876 10,414 742 (9,929) 45,103
Capital Expenditures............... 4,352 5,396 7,219 -- 16,967
Depreciation and Amortization...... 11,152 5,455 824 -- 17,431
Identifiable Assets................ 378,686 205,358 47,378 -- 631,422
Nine months ended
September 30, 2001:
- -------------------
Net Sales.......................... $310,873 $89,249 $9,374 $-- $409,496
Operating Income................... 38,054 9,548 415 (6,694) 41,323
Capital Expenditures............... 8,532 1,623 1,384 -- 11,539
Depreciation and Amortization...... 11,969 4,883 544 -- 17,396
Identifiable Assets................ 349,395 162,368 24,651 -- 536,414
The above operating segments are presented on a basis consistent with the
presentation included in the Company's December 31, 2001 financial statements.
There have been no material changes in the identifiable assets of the individual
segments since December 31, 2001.
The corporate segment consists primarily of compensation expense for
corporate headquarters' staff, professional fees, including legal and audit, and
product and general liability insurances.
13
8. Other Comprehensive Income
The accumulated balances for the components of the Other Comprehensive
Income/(Loss) are:
Accumulated
Foreign Other
Currency Cash Flow Comprehensive
Translation Hedges Income/(Loss)
----------- ------ -------------
(in thousands)
Balance December 31, 2000....... $(19,728) -- $(19,728)
Change in period................ (5,034) 160 (4,874)
----------------------------------------------
Balance March 31, 2001.......... (24,762) 160 (24,602)
Change in period................ (1,969) (134) (2,103)
----------------------------------------------
Balance June 30, 2001........... (26,731) 26 (26,705)
Change in Period................ 4,770 29 4,799
----------------------------------------------
Balance September 30, 2001...... $(21,961) 55 $(21,906)
==============================================
Balance December 31, 2001....... $(24,281) -- $(24,281)
Change in period................ (1,761) 32 (1,729)
----------------------------------------------
Balance March 31, 2002.......... (26,042) 32 (26,010)
Change in period................ 12,458 68 12,526
----------------------------------------------
Balance June 30, 2002........... (13,584) 100 (13,484)
Change in period................ (1,832) (51) (1,883)
----------------------------------------------
Balance September 30, 2002...... $(15,416) 49 $(15,367)
==============================================
Accumulated other comprehensive income/(loss) in the Consolidated Balance
Sheets as of September 30, 2002 and December 31, 2001 consists of cumulative
translation adjustments and changes in the fair value of certain financial
instruments that qualify for hedge accounting as required by FAS 133. The
Company's total comprehensive income was as follows:
Three Months Ended
------------------
September 30,
-------------
2002 2001
---- ----
(in thousands)
Net income..................................................... $8,773 $7,809
Unrealized gains/(loss) derivative instruments, net of tax..... (51) 29
Foreign currency translation adjustments....................... (1,832) 4,770
-------------------
Total comprehensive income..................................... $6,890 $12,608
===================
Nine Months Ended
-----------------
September 30,
-------------
2002 2001
---- ----
(in thousands)
Net income..................................................... $25,462 $22,117
Unrealized gains derivative instruments, net of tax............ 49 55
Foreign currency translation adjustments....................... 8,865 (2,233)
---------------------
Total comprehensive income..................................... $34,376 $19,939
=====================
14
9. Acquisitions
On July 29, 2002 a wholly-owned subsidiary of the Company acquired F&R
Foerster and Rothmann GmbH located in Neuenburg am Rhein, Germany, for
approximately 2.3 million euro in cash. F&R manufactures and distributes a line
of gauges predominately to the French and German OEM markets. F&R's annual
revenue, prior to the acquisition, was approximately 4 million euro. The
September 30, 2002 Consolidated Balance Sheet of the Company contains a
preliminary purchase price allocation consistent with the guidelines in FAS 141
and FAS 142.
On July 15, 2002, a wholly-owned subsidiary of the Company acquired ADEV
Electronic SA located in Rosieres, France and its closely affiliated
distributor, E.K. Eminent A.B. located in Gothenburg, Sweden for approximately
12.9 million euro in cash. ADEV also has a low cost manufacturing facility
located in Tunisia. ADEV manufactures and distributes electronic systems
predominantly to the OEM market. Their product lines include thermostats and
controls for heating, ventilation and air conditioning, control systems for
hydronic and electric floor warming systems, and controls for other residential
applications. Eminent distributes electronic controls, mechanical thermostats
and other electric control related products throughout the European Nordic
countries. The two companies' combined annual revenue preceding the acquisition
was approximately 30 million euro. The September 30, 2002 Consolidated Balance
Sheet of the Company contains a preliminary purchase price allocation consistent
with the guidelines in FAS 141 and FAS 142.
On May 9, 2002, a wholly-owned subsidiary of the Company acquired Hunter
Innovations of Sacramento, California for $25 million, of which approximately
$10 million was paid in cash at the closing and the balance in interest bearing
notes, payable in equal installments over the next four years. Hunter
Innovations was founded in 1995 as a technology development company and has
developed a line of large backflow prevention devices that represent a
significant advance in technology. The improved product features that are
important to the backflow prevention markets include lighter weight, more
compact design, better flow characteristics, improved serviceability and
multiple end-connection and shutoff valve options. Hunter Innovations' sales
during the twelve months preceding the acquisition were approximately $1.5
million. Unlike most of our acquisitions, Hunter did not have significant
historical revenues or earnings. Nonetheless, the purchase price was based on
projected revenues and earnings as utilized in other acquisitions. During the
quarter ending September 30, 2002, the Company obtained a third party valuation
to allocate the purchase price. Consistent with the guidelines in FAS 141, the
allocation for goodwill was approximately $16.8 million and approximately $11.7
million was for intangibles, which are classified in "Other Assets: Other" in
the Company's Consolidated Balance Sheet as of September 30, 2002. Of the $11.7
million of acquired intangible assets, $9.2 million was assigned to unpatented
technology that are not subject to amortization and $2.5 million to patents
(twenty-year useful life). The $16.8 million of goodwill was assigned to the
North American segment, none of which is deductible for tax purposes.
On March 5, 2002, the Company entered into a joint venture with the Yuhuan
County Cheng Guan Metal Hose Factory ("Cheng Guan") located in Taizhou, Zhejiang
Province of the People's Republic of China. Cheng Guan, with annual sales prior
to the transaction of approximately $15 million, is a manufacturer of a variety
of plumbing products sold both into the Chinese domestic market and export
markets. Their product lines were contributed to the joint venture and include
hose, hose connectors, multi-layer tubing and stainless steel braided hose. The
joint venture is owned 60% by Watts and 40% by our Chinese partner. The Company
has invested $7.8 million to obtain this 60% interest. The September 30, 2002
Consolidated Balance Sheet of the Company contains a preliminary purchase price
allocation of the joint venture. The preliminary allocation for goodwill was
approximately $3 million and approximately $2 million was for other amortizable
intangibles, which are classified in "Other Assets: Other" in the Company's
Consolidated Balance Sheet as of September 30, 2002.
On September 28, 2001, a wholly-owned subsidiary of the Company acquired
the assets of the Powers Process Controls Division of Mark Controls Corporation,
a subsidiary of Crane Co. located in Skokie, Illinois and Mississauga, Ontario,
Canada for approximately $13 million in cash. Powers designs and manufactures
thermostatic mixing valves for personal safety and process control applications
in commercial and institutional facilities. It also manufactures control valves
and commercial plumbing brass products including shower valves and lavatory
faucets. Powers annualized sales prior to the acquisition were approximately $20
million.
15
On June 13, 2001, a wholly-owned subsidiary of the Company acquired
Premier Manufactured Systems, Inc., located in Phoenix, Arizona for
approximately $5 million in cash. Premier manufactures water filtration systems
for both residential and commercial applications and other filtration products
including under-the-counter ultraviolet filtration as well as a variety of
sediment and carbon filters. Premier's annualized sales prior to the acquisition
were approximately $10 million.
On June 1, 2001, a wholly-owned subsidiary of the Company acquired Fimet
S.r.l. (Fabbrica Italiana Manometri e Terometri) located in Milan, Italy and its
wholly-owned subsidiary, MTB AD, which is located in Bulgaria for approximately
$6 million in cash. The acquired business manufactures pressure and temperature
gauges for use in the HVAC market. Fimet's annualized sales prior to the
acquisition were approximately $9 million.
10. Debt Issuance
On February 28, 2002, the Company entered into a revolving credit facility
with a syndicate of banks (the "Revolving Credit Facility"), which replaced the
Company's $100 million (U.S.) facility and its 39,350,000 euro facility. The
Revolving Credit Facility provides for borrowings of up to $150 million (U.S.),
which includes a $100 million tranche for U.S. dollar borrowings and a $50
million tranche for euro based borrowings and matures in February 2005.
Approximately $46 million of borrowings under the Revolving Credit Facility were
used to repay amounts outstanding under the prior facilities. The Revolving
Credit Facility is being used to support the Company's acquisition program,
working capital requirements and for general corporate purposes.
Outstanding indebtedness under the Revolving Credit Facility bears
interest at one of three customary rates plus a margin of 100 basis points,
depending on the applicable base rate and the Company's bond rating. The average
interest rate for borrowings under the Revolving Credit Facility was
approximately 3.3% at September 30, 2002. The Revolving Credit Facility includes
operational and financial covenants customary for facilities of this type,
including, among others, restrictions on additional indebtedness, liens and
investments and maintenance of certain leverage ratios. As of September 30,
2002, the Company was in compliance with all covenants related to the Revolving
Credit Facility.
11. Contingencies
In April 1998, the Company became aware of a complaint that was filed
under seal in the State of California alleging violations of the California
False Claims Act (the "James Jones case"). The complaint alleges that a former
subsidiary of the Company sold products utilized in municipal water systems that
failed to meet contractually specified standards and falsely certified that such
standards had been met. The complaint further alleges that the municipal
entities have suffered tens of millions of dollars in damages as a result of
defective products and seeks treble damages, reimbursement of legal costs and
penalties. The original complaint has been amended, and the total number of
named plaintiffs is 161, 14 of which have intervened and 47 of which have been
ordered excluded from the case. In June 2001, the Company and the other
defendants reached a proposed settlement with the Los Angeles Department of
Water and Power ("LADWP"), one of the plaintiffs in the James Jones case, which
was approved by the California Superior Court on October 31, 2001 and by the Los
Angeles City Council on December 14, 2001. The other plaintiffs remain, and the
Company is vigorously contesting this matter.
The Company established initial reserves with respect to the James Jones
case in the amount of $10,170,000 after tax, which amount was approximately
$9,062,000 after tax as of September 30, 2002, and is classified under the item
"Accrued expenses and other liabilities" in the Company's Consolidated Balance
Sheet as of September 30, 2002. The Company presently believes, on the basis of
all available information, that these reserves are adequate to cover the
Company's probable and reasonably estimable losses resulting from the James
Jones case. However, litigation is inherently uncertain and the Company believes
that there exists a reasonable possibility that it may ultimately incur losses
in the James Jones case in excess of the amount accrued for that matter. The
Company is currently unable to make an estimate of the range of any additional
losses. See Part II, Item 1, Legal Proceedings.
Other lawsuits and proceedings or claims, arising from the ordinary course
of operations, are also pending or threatened against the Company and its
subsidiaries. Based on the facts presently known to it, the Company does not
believe that the ultimate outcome of these other litigation matters will have a
material adverse effect on its liquidity, financial condition or results of
operations.
16
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
-----------------------------------------------------------------------
OF OPERATIONS
-------------
Recent Developments
- -------------------
On August 7, 2002, the Company announced the appointment of a new Chief
Executive Officer, Patrick S. O'Keefe, to replace Timothy P. Horne who has
resigned his position as Chief Executive Officer and Chairman of the Board. Mr.
Horne will remain as a Director. The Board has nominated and elected Mr. Gordon
W. Moran as its non-executive Chairman. Mr. Moran has served on the Board since
1990. Mr. O'Keefe has also been elected to the Board.
On July 29, 2002 a wholly-owned subsidiary of the Company acquired F&R
Foerster and Rothmann GmbH ("F&R") located in Neuenburg am Rhein, Germany, for
approximately 2.3 million euro in cash. F&R manufactures and distributes a line
of gauges predominately to the French and German OEM markets. F&R's annual
revenue, prior to the acquisition, was approximately 4 million euro. The
September 30, 2002 Consolidated Balance Sheet of the Company contains a
preliminary purchase price allocation consistent with the guidelines in FAS 141
and FAS 142.
On July 15, 2002, a wholly-owned subsidiary of the Company acquired ADEV
Electronic SA ("ADEV") located in Rosieres, France and its closely affiliated
distributor, E.K. Eminent A.B. ("Eminent") located in Gothenburg, Sweden for
approximately 12.9 million euro in cash. ADEV also has a low cost manufacturing
facility located in Tunisia. ADEV manufactures and distributes electronic
systems predominantly to the OEM market. Their product lines include thermostats
and controls for heating, ventilation and air conditioning, control systems for
hydronic and electric floor warming systems, and controls for other residential
applications. Eminent distributes electronic controls, mechanical thermostats
and other electric control related products throughout the European Nordic
countries. The two companies' combined annual revenue preceding the acquisition
was approximately 30 million euro. The September 30, 2002 Consolidated Balance
Sheet of the Company contains a preliminary purchase price allocation consistent
with the guidelines in FAS 141 and FAS 142.
On May 9, 2002, a wholly-owned subsidiary of the Company acquired Hunter
Innovations of Sacramento, California for $25 million, of which approximately
$10 million was paid in cash at the closing and the balance in interest bearing
notes, payable in equal installments over the next four years. Hunter
Innovations was founded in 1995 as a technology development company and has
developed a line of large backflow prevention devices that represent a
significant advance in technology. The improved product features that are
important to the backflow prevention markets include lighter weight, more
compact design, better flow characteristics, improved serviceability and
multiple end-connection and shutoff valve options. Hunter Innovations' sales
during the twelve months preceding the acquisition were approximately $1.5
million. Unlike most of our acquisitions, Hunter did not have significant
historical revenues or earnings. Nonetheless, the purchase price was based on
projected revenues and earnings as utilized in other acquisitions. During the
quarter ending September 30, 2002, the Company obtained a third party valuation
to allocate the purchase price. Consistent with the guidelines in FAS 141, the
allocation for goodwill was approximately $16.8 million and approximately $11.7
million was for intangibles, which are classified in "Other Assets: Other" in
the Company's Consolidated Balance Sheet as of September 30, 2002. Of the $11.7
million of acquired intangible assets, $9.2 million was assigned to unpatented
technology that are not subject to amortization and $2.5 million to patents
(twenty-year useful life). The $16.8 million of goodwill was assigned to North
American segment, none, of which, is deductible for tax purposes.
On March 5, 2002, the Company entered into a joint venture with the Yuhuan
County Cheng Guan Metal Hose Factory ("Cheng Guan") located in Taizhou, Zhejiang
Province of the People's Republic of China. Cheng Guan, with annual sales prior
to the transaction of approximately $15 million, is a manufacturer of a variety
of plumbing products sold both into the Chinese domestic market and export
markets. Its product lines were contributed to the joint venture and include
hose, hose connectors, multi-layer tubing and stainless steel braided hose. The
joint venture is owned 60% by us and 40% by our Chinese partner. We have
invested $7.8 million to obtain this 60% interest. Our September 30, 2002,
Consolidated Balance Sheet contains a preliminary purchase price allocation of
the joint venture. The preliminary allocation for goodwill was approximately $3
million and approximately $2 million was for other amortizable
17
intangibles, which are classified in "Other Assets: Other" in the Company's
Consolidated Balance Sheet as of September 30, 2002.
As part of our $18.7 million capital expenditure budget for fiscal 2002,
we expected to invest approximately $9.0 million to establish a 100% controlled
bronze and brass manufacturing plant in Tianjin, China. We anticipate that the
construction of the plant will be completed in early 2003. Any remaining costs
will be disbursed over the next two quarters. As of September 30, 2002, we have
spent approximately $4.7 million.
The Company is implementing a plan to consolidate several of its
manufacturing plants both in North America and Europe. At the same time it is
expanding its manufacturing capacity in China. The implementation of this
manufacturing restructuring plan began during the fourth quarter of fiscal 2001.
The projects, for which charges were recorded in the fourth quarter of fiscal
2001, are essentially complete. The Company decided to expand the scope of the
manufacturing restructuring plan and transfer certain production to low cost
manufacturing plants in Tunisia and Bulgaria. The expanded plan is expected to
be completed by the end of fiscal 2003. The Company anticipates that the pre-tax
cost of the manufacturing restructuring plan will be $12,500,000. The Company
recorded pre-tax manufacturing restructuring plan costs of $5,831,000 in the
fourth quarter of fiscal 2001, $651,000 in the third quarter of 2002 and
$2,331,000 in the nine months ended September 30, 2002. The Company anticipates
recording additional pre-tax costs of approximately $1,600,000 in the fourth
quarter of 2002 and $2,700,000 in 2003 as it continues to implement the program.
The manufacturing restructuring plan costs recorded in 2001 and the nine months
in 2002 consist primarily of severance costs, asset write-downs and accelerated
depreciation. The severance costs, which have been recorded as restructuring,
are for 41 employees in manufacturing and administration groups, 40 of whom have
been terminated as of September 30, 2002. Asset write-downs consist primarily of
write-offs of inventory related to product lines that the Company has
discontinued as part of this restructuring plan and they have been recorded in
cost of goods sold. Accelerated depreciation is based on shorter estimated
useful lives of certain fixed assets and has been recorded in cost of goods
sold. The tax benefits of costs incurred and asset write-downs will approximate
the amount of cash outlays to implement this program, which would allow the
Company to complete the restructuring plan with a minimum consumption of cash.
The Company estimates an annual pre-tax savings of approximately $5,000,000
following the completion of the plan.
Results of Operations
- ---------------------
Three Months Ended September 30, 2002 Compared to Three Months Ended September
- ------------------------------------------------------------------------------
30, 2001
- --------
Net Sales. Net sales for the three months ended September 30, 2002 increased
$21,802,000 (15.8%) to $159,811,000 compared to $138,009,000 for the same period
in 2001. The increase in net sales is attributable to the following:
(in thousands)
Internal Growth..................... $5,559 4.0%
Acquisitions........................ 14,415 10.5%
Foreign Exchange.................... 1,828 1.3%
------------------------------
Total Change........................ $21,802 15.8%
==============================
The increase in internal growth of net sales is primarily due to increased
unit shipments into the North American do-it-yourself market. The growth in net
sales from acquired businesses is due to the inclusion of the net sales of
Powers Process Controls, acquired on September 28, 2001; Cheng Guan, our joint
venture, which we established on March 5, 2002; ADEV and Eminent, acquired on
July 15, 2002; and F&R, acquired on July 29, 2002. The increase in foreign
exchange is due primarily to the euro appreciating against the U.S. dollar
compared to the same period in 2001.
We monitor our net sales in three geographical segments: North America,
Europe and Asia. As outlined below, North America, Europe and Asia accounted for
71.4%, 24.3% and 4.3% of net sales, respectively, in the three
18
months ended September 30, 2002, compared to 75.1%, 22.8% and 2.1% of net sales,
respectively, in the three months ended September 30, 2001:
September 30, September 30, Change
------------- ------------- ------
2002 2001
---- ----
(in thousands)
North America........ $114,135 $103,635 $10,500
Europe............... 38,791 31,474 7,317
Asia................. 6,885 2,900 3,985
-----------------------------------------------
Total................ $159,811 $138,009 $21,802
===============================================
The increase in North America's net sales is due to the Powers Process
Controls acquisition and increased unit shipments in the do-it-yourself market.
The increase in Europe's net sales is primarily due to the ADEV, Eminent and F&R
acquisitions and to a lesser extent, the euro appreciating against the U.S.
dollar compared to the same period in 2001. The increase in Asia's net sales is
primarily due to the inclusion of our Cheng Guan joint venture.
Gross Profit. Gross profit for the three months ended September 30, 2002
increased $6,564,000 (14.0%) to $53,507,000 from $46,943,000 for the comparable
quarter last year and decreased as a percentage of net sales to 33.5% from
34.0%. We charged $312,000 of costs incurred due to our manufacturing
restructuring plan to cost of sales in the current quarter. Excluding the
manufacturing restructuring plan costs, our gross profit would have increased
$6,876,000 and decreased as a percentage of sales to 33.7% from 34.0%. The gross
profit increase is primarily attributable to inclusion of the acquired
companies. The gross profit percentage decrease is primarily due to lower gross
profit percentages of acquired companies partially offset by reduced spending in
manufacturing fixed overhead as well as improved efficiencies in manufacturing
compared to the comparable quarter last year.
Selling, General and Administrative Expense. Selling, general and administrative
expenses for the three months ended September 30, 2002 increased $5,021,000
(15.4%) to $37,532,000 compared to $32,511,000 for the same period in 2001. This
increase is attributable to the inclusion of selling, general and administrative
expenses of acquired companies, an increase in the cost of product and general
liability insurance and the euro appreciating against the U.S. dollar compared
to the prior period. We adopted FAS 142 "Goodwill and Other Intangible Assets"
on January 1, 2002, and accordingly did not record goodwill amortization for the
quarter ended September 30, 2002. We recorded goodwill amortization of $841,000
as part of our selling, general and administrative expenses in the quarter ended
September 30, 2001.
Restructuring Expense. The restructuring expense is for severance costs
associated with our manufacturing restructuring plan.
Operating Income. Operating income for the three months ended September 30,
2002, increased $1,335,000 (9.3%) to $15,767,000 compared to $14,432,000 for the
same period in 2001 due to increased gross profit and the cessation of goodwill
amortization, partially offset by increased selling, general and administrative
expenses. The manufacturing restructuring plan costs reduced operating income by
$520,000.
19
Our operating income by segment for the three months ended September 30,
2002, and 2001 was as follows:
September 30, September 30, Change
------------- ------------- ------
2002 2001
---- ----
(in thousands)
North America............ $14,863 $12,631 $2,232
Europe................... 4,016 3,777 239
Asia..................... 529 118 411
Corporate................ (3,641) (2,094) (1,547)
------------------------------------------------
Total.................... $15,767 $14,432 $1,335
================================================
The increase in North America is primarily due to the inclusion of
operating earnings of the Powers Process Controls acquisition. The increase in
Europe is primarily due to the inclusion of operating earnings of acquired
companies. Corporate expenses are primarily for compensation expense,
professional fees, including legal and audit expenses, product and general
liability insurances. The increase in corporate expenses is primarily due to
increased premiums for product and general liability insurance and
administrative start-up costs associated with our new manufacturing plant in
China.
Interest Expense. Interest expense decreased $140,000 in the quarter ended
September 30, 2002 to $2,447,000 compared to $2,587,000 for the same period in
2001, primarily due to lower interest rates on variable rate indebtedness
partially offset by increased indebtedness incurred to fund acquisitions. On
September 1, 2001, we entered into an interest rate swap on our $75,000,000 8
3/8% notes. The swap converted the interest from fixed to floating. On August 5,
2002, we sold the swap and received $2,315,000 in cash, which was recognized as
a deferred liability. In the quarter ended September 30, 2002, we reduced
interest expense by $327,000 by amortizing this deferred liability.
Income Taxes. Our effective tax rate for continuing operations increased to
34.2% from 33.7% for the three months ended September 30, 2002 and 2001,
respectively. The increase is primarily attributable to the increased earnings
in the North American segment, which has a higher tax rate than our other
segments, partially offset by the elimination of goodwill, which was not tax
deductible.
Net Income From Continuing Operations. Net income for the three months ended
September 30, 2002 increased $964,000 (12.3%) to $8,773,000, or $0.32 per common
share, compared to $7,809,000, or $0.29 per common share, for the three months
ended September 30, 2001 on a diluted basis.
Nine Months Ended September 30, 2002 Compared to Nine Months Ended September 30,
- --------------------------------------------------------------------------------
2001
- ----
Net Sales. Net sales for the nine months ended September 30, 2002 increased
$45,140,000 (11.0%) to $454,636,000 compared to $409,496,000 for the same period
in 2001. The increase in net sales is attributable to the following:
(in thousands)
Internal Growth................ $6,218 1.5%
Acquisitions................... 35,614 8.7%
Foreign Exchange............... 3,308 0.8%
-----------------------------------
Total Change................... $45,140 11.0%
===================================
The increase in internal growth of net sales is due to increased unit
shipments into the North American do-it-yourself market partially offset by
decreased unit shipments to North American plumbing and heating wholesalers. The
growth in net sales from acquired businesses is due to the inclusion of the net
sales of Powers Process Controls, acquired on September 28, 2001; Premier
Manufactured Systems, acquired on June 13, 2001; Fimet S.r.l., acquired on June
1, 2001; Cheng Guan, our joint venture, which we established on March 5, 2002;
ADEV and Eminent, acquired on July
20
14, 2002; and F&R, acquired on July 29, 2002. The increase in foreign exchange
is due primarily to the euro appreciating against the U.S. dollar compared to
the same period in 2001.
We monitor our net sales in three geographical segments: North America,
Europe and Asia. As outlined below, North America, Europe and Asia accounted for
74.3%, 22.4% and 3.3% of net sales, respectively, in the nine months ended
September 30, 2002, compared to 75.9%, 21.8% and 2.3% of net sales,
respectively, in the nine months ended September 30, 2001:
September 30, September 30, Change
------------- ------------- ------
2002 2001
---- ----
(in thousands)
North America........... $337,693 $310,873 $26,820
Europe.................. 102,006 89,249 12,757
Asia.................... 14,937 9,374 5,563
----------------------------------------------------
Total................... $454,636 $409,496 $45,140
====================================================
The increase in North America's net sales is due to the Powers Process
Controls and Premier acquisitions and increased unit shipments into the North
American do-it-yourself market partially offset by decreased unit shipments to
the North American plumbing and heating wholesalers. The increase in Europe's
net sales is due primarily to the Fimet, ADEV, Eminent and F&R acquisitions and
the euro appreciating against the U.S. dollar. The increase in Asia's net sales
is primarily due to the inclusion of our Cheng Guan joint venture.
Gross Profit. Gross profit for the nine months ended September 30, 2002
increased $15,262,000 (10.9%) to $155,218,000 from $139,956,000 for the
comparable period last year and decreased as a percentage of net sales to 34.1%
from 34.2%. We charged $1,873,000 of costs associated with our manufacturing
restructuring plan to cost of sales. Excluding the manufacturing restructuring
plan costs, our gross profit would have increased $17,135,000 and would have
increased as a percentage of sales to 34.6% from 34.2%. The gross profit
increase is primarily attributable to the inclusion of acquired companies. The
gross profit percentage increase is primarily attributable to reduced spending
in manufacturing fixed overhead as well as improved efficiencies in
manufacturing compared to the comparable period last year partially offset by
lower gross profit percentages from acquired companies.
Selling, General and Administrative Expense. Selling, general and administrative
expenses for the nine months ended September 30, 2002 increased $11,264,000
(11.4%) to $109,897,000 compared to $98,633,000 for the same period in 2001.
This increase is attributable to the inclusion of selling, general and
administrative expenses of acquired companies, an increase in the cost of
product and general liability insurance and start-up costs associated with our
regional distribution centers. We adopted FAS 142 "Goodwill and Other Intangible
Assets" on January 1, 2002 and accordingly did not record goodwill amortization
for the first nine months of 2002. We recorded goodwill amortization of
$2,376,000 as part of our selling, general and administrative expenses for the
nine months ended September 30, 2001.
Restructuring Expense. The restructuring expense is for severance costs
associated with our manufacturing restructuring plan.
Operating Income. Operating income for the nine months ended September 30, 2002,
increased $3,780,000 (9.2%) to $45,103,000 compared to $41,323,000 for the same
period in 2001 due to increased gross profit and the cessation of goodwill
amortization, partially offset by increased selling, general and administrative
expenses. The manufacturing restructuring plan costs reduced operating income by
$2,091,000.
21
Our operating income by segment for the nine months ended September 30,
2002, and 2001, were as follows:
September 30, September 30, Change
2002 2001 ------
---- ----
(in thousands)
North America........... $43,876 $38,054 $5,822
Europe.................. 10,414 9,548 866
Asia.................... 742 415 327
Corporate............... (9,929) (6,694) (3,235)
---------------------------------------------------
Total................... $45,103 $41,323 $3,780
===================================================
The increase in North America is due to increased gross profit, primarily
due to the inclusion of operating earnings of acquired companies. The increase
in Europe is due to the inclusion of the operating earnings of acquired
companies and by the euro appreciating against the U.S. dollar compared to the
prior year. Corporate expenses are primarily for compensation expense,
professional fees, including legal and audit expenses, product liability and
general liability insurances. The increase in corporate expenses is primarily
due to increased premiums for product and general liability insurance and
administrative start-up costs associated with our new manufacturing plant in
China.
Interest Expense. Interest expense decreased $819,000 in the nine months ended
September 30, 2002, to $6,576,000 compared to $7,395,000 for the same period in
2001, primarily due to lower interest rates on variable rate indebtedness,
partially offset by increased indebtedness incurred to fund acquisitions. On
September 1, 2001, we entered into an interest rate swap on our $75,000,000 8
3/8% notes. The swap converted the interest from fixed to floating. On August 5,
2002, we sold the swap and received $2,315,000 in cash, which was recognized as
a deferred liability. Interest expense for the nine months ended September 30,
2002, has been reduced by $1,318,000 by the effectiveness of the swap and by the
amortization of the deferred liability.
Income Taxes. Our effective tax rate for continuing operations remained at 34.7%
for the nine months ended September 30, 2002 and 2001, respectively. The rate
remains constant due to the elimination of goodwill amortization which was not
tax deductible, offset by a change in earnings mix to jurisdictions that have
higher tax rates.
Net Income From Continuing Operations. Net income for the nine months ended
September 30, 2002 increased $3,345,000 (15.1%) to $25,462,000, or $0.94 per
common share, compared to $22,117,000, or $0.82 per common share, for the nine
months ended September 30, 2001 on a diluted basis.
Liquidity and Capital Resources
- -------------------------------
During the nine month period ended September 30, 2002, we provided
$21,732,000 of cash flow from continuing operations. We spent $14,084,000 on
capital equipment for the nine months ended September 30, 2002, net of proceeds
of $2,883,000, primarily from the sale of a facility that was closed as part of
our manufacturing restructuring plan. Capital expenditures were primarily for
manufacturing machinery and equipment as part of our commitment to continuously
improve our manufacturing capabilities. Our net capital expenditure budget for
the twelve months ending December 31, 2002 is $18,700,000, which includes the
expected proceeds from the sale of two of our facilities that were closed as
part of our manufacturing restructuring plan. The largest component of this
budget is the establishment of a 100% controlled bronze and brass manufacturing
plant in Tianjin, China, for an estimated cost of $9,000,000, of which
approximately $4,700,000 was invested in the nine months ended September 30,
2002. In addition, during the nine months ended September 30, 2002, we invested
approximately $5,000,000 to establish our joint venture in China, $10,000,000 to
acquire Hunter Innovations, and approximately $10,500,000 for our three
acquisitions in Europe, ADEV, Eminent and F&R.
We had positive free cash flow of $2,788,000 (defined as net cash provided
by continuing operations minus capital expenditures and dividends plus proceeds
from sale of assets) during the nine months ended September 30, 2002
22
versus positive free cash flow of $17,148,000 in the comparable prior year
period. The decrease in free cash flow is attributable to a decrease in cash
provided by operations and increased capital spending compared to the comparable
period of fiscal 2001. The decrease in cash provided from operations is
primarily due to an increase in accounts receivable between September 30, 2002
and December 31, 2001. This increase in accounts receivable is due to increased
sales volume, a change in industry-wide payment terms from our largest customer
while remaining within normal industry standards, and the addition of
receivables from our Cheng Guan joint venture established in March 2002.
On September 6, 2002, we received $9,524,000 of cash from Zurich American
Insurance Company for reimbursement of defense costs incurred by us in the James
Jones case since April 23, 1998. This cash, net of tax, is classified as
discontinued operations in our Consolidated Statements of Cash Flows.
On February 28, 2002, we entered into a revolving credit facility with a
syndicate of banks (the "Revolving Credit Facility"), which replaced our $100.0
million (U.S.) facility and our 39.4 million euro facility. The Revolving Credit
Facility provides for borrowings of up to $150.0 million (U.S.), which includes
a $100.0 million tranche for U.S. dollar borrowings and a $50.0 million tranche
for euro-based borrowings and matures in February 2005. Approximately $46.0
million of borrowings under the Revolving Credit Facility were used to repay
amounts outstanding under the prior facilities. The Revolving Credit Facility is
being used to support our acquisition program, working capital requirements and
for general corporate purposes. As of September 30, 2002, long-term debt
included $69.9 million outstanding on the Revolving Credit Facility for both
U.S. dollar and euro-based borrowings.
Outstanding indebtedness under the Revolving Credit Facility bears
interest at one of three customary rates plus a margin of 100 basis points,
depending on the applicable base rate and our bond rating. The average interest
rate for borrowings under the Revolving Credit Facility was approximately 3.3%
at September 30, 2002. The Revolving Credit Facility includes operational and
financial covenants customary for facilities of this type, including, among
others, restrictions on additional indebtedness, liens and investments and
maintenance of certain leverage ratios. As of September 30, 2002, we were in
compliance with all covenants related to the Revolving Credit Facility.
Working capital (defined as current assets less current liabilities) as of
September 30, 2002 was $167.8 million compared to $142.6 million as of December
31, 2001. This increase is primarily due to the increase in accounts receivable.
The ratio of current assets to current liabilities was 2.1 to 1 as of September
30, 2002 compared to 2.3 to 1 as of December 31, 2001. Cash and cash equivalents
were $16.1 million as of September 30, 2002 compared to $12.0 million as of
December 31, 2001. The increase in long-term debt to $160.0 million as of
September 30, 2002 from $123.2 million as of December 31, 2001 was due to the
funding of acquisitions, the increase in working capital and debt incurred to
fund capital expenditures. Net debt to capitalization (defined as short and long
term interest-bearing liabilities less cash and cash equivalents as a percentage
of the sum of short and long term interest-bearing liabilities less cash and
cash equivalents plus total stockholders equity, including minority interest)
was 34.4% as of September 30, 2002 compared to 31.2% as of December 31, 2001.
We anticipate that available funds from current operations and other
sources of liquidity will be sufficient to meet current operating requirements
and anticipated capital expenditures for at least the next 24 months. However,
we may have to consider external sources of financing for any large future
acquisitions.
Our long-term financial obligations are presented in the following table:
Less than After
Total 1 year 1-3 years 4-5 years 5 years
----- ------ --------- --------- -------
(in thousands)
Long-term debt, including current maturities(a).... $169,189 $9,211 $154,296 $4,724 $958
Operating leases................................... 2,484 894 1,441 149 --
----------------------------------------------------------
Total.............................................. $171,673 $10,105 $155,737 $4,873 $958
==========================================================
(a) as recognized in the consolidated balance sheet
23
Letters of credit are purchased guarantees that ensure our performance or
payment to third parties in accordance with specified terms and conditions.
Amounts outstanding were approximately $19,551,000 as of September 30, 2002 and
$16,443,000 as of September 30, 2001. These instruments may exist or expire
without being drawn down. Therefore, they do not necessarily represent future
cash flow obligations.
Certain of our loan agreements contain covenants that require, among other
items, the maintenance of certain financial ratios and limit our ability to
enter into secured borrowing arrangements.
We from time to time are involved with environmental proceedings and other
legal proceedings and incur costs on an ongoing basis related to these matters.
We have not incurred material costs in fiscal 2002 in connection with any of
these matters. During the first nine months of 2002, we disbursed approximately
$3.1 million after-tax of defense and settlement costs related to the James
Jones case. In September 2002, we received $5.7 million after tax for
reimbursement of defense costs related to the James Jones case. These amounts
are recorded as discontinued operations in our consolidated statement of cash
flows. See Part II, Item 1, Legal Proceedings.
Critical Accounting Policies and Key Estimates
- ----------------------------------------------
Our management considers the following accounting policies and key
estimates as being critical in reporting our financial position and results of
operations.
o The proper application of revenue recognition criteria requires certain
judgments and estimates, including the assessment of credit risk and sales
return rates. Our management has used its best estimates based on historic
trends to establish these reserves.
o The valuation of inventory includes forecasted demand and anticipated
market pricing for our products.
o Contingencies and environmental remediation costs include estimates for
clean-up costs which could be paid over several years. Estimates are based
on management and legal counsel's best estimates of ultimate liability.
o The liability reserve for the James Jones case, included in discontinued
operations, is based on management and legal counsel's best estimate of
defense and settlement costs, taking into consideration the probable
number of parties involved in the suit and the recoveries received from
the Company's insurers.
o Product liability costs are estimated utilizing historic trends,
considering known insurance recoveries.
o In accounting for costs relating to the manufacturing restructuring plan,
certain estimates have been made in measuring the cost of the plan and the
impact on operations, including the estimated timing of facility closures.
Our management believes that the estimates and assessments inherent in the
application of these accounting policies have been applied on a reasonable
basis. Actual results could differ from these estimates and assumptions, which
could impact our financial position and results of operations.
New Accounting Standards
- ------------------------
In August 2001, the FASB issued Financial Accounting Standards Board
Statement No. 143, "Accounting for Asset Retirement Obligations" ("FAS 143")
which requires companies to record the fair value of an asset retirement
obligation as a liability in the period it incurs a legal obligation associated
with the retirement of tangible long-lived assets that result from the
acquisition, construction, development and/or normal use of the assets. The
company must also record a corresponding increase in the carrying value of the
related long-lived asset and depreciate that cost over the remaining useful life
of the asset. The liability must be increased each period for the passage of
time with the offset recorded as an operating expense. The liability must also
be adjusted for changes in the estimated future cash flows underlying the
initial fair value measurement. Companies must also recognize a gain or loss on
the settlement of the
24
liability. The provisions of FAS 143 are effective for fiscal years beginning
after June 15, 2002. At the date of the adoption of FAS 143, companies are
required to recognize a liability for all existing asset retirement obligations
and the associated asset retirement costs. We are currently evaluating the
effect that the adoption of FAS 143 will have on our results of operations and
our financial position.
Effective January 1, 2002, the Company also adopted FAS 144, which
addresses the accounting and reporting for the impairment or disposal of
long-lived assets. FAS 144 supercedes Financial Accounting Standards Board
Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed Of" ("FAS 121") but retains many of the
fundamental provisions of FAS 121. FAS 144 also supercedes the accounting and
reporting provisions of Accounting Principles Board Opinion No. 30, "Reporting
the Results of Operations--Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions" ("APB 30") for the disposal of a segment of a business. However,
FAS 144 retains the requirements of APB 30 to report discontinued operations
separately and extends that reporting requirement to components of an entity
that has either been disposed of or is classified as held for sale. FAS 144
excludes goodwill and other intangibles that are not amortized from its scope.
For assets to be held and used, FAS 144 addresses the recoverability of an asset
or group of assets, clarifies how an impairment loss should be allocated, and
creates a requirement to use a fair value if market prices are not available and
uncertainties exist about the timing and amount of cash flows. For long-lived
assets to be disposed of by sale, FAS 144 establishes the criteria to be met to
qualify for this classification, defines the timing of when the related sale
must be consummated, eliminates the net realizable value measurement approach
for segments of a business and certain acquired assets in a business
combination, and defines costs to sell the asset. FAS 144 was effective for
fiscal years beginning after December 15, 2001 and its adoption was not material
to our consolidated financial statements.
In April 2002, FAS No. 145, "Rescission of FASB Statements No. 4, 44 and
64, Amendment of FASB Statement No. 13, and Technical Corrections," was issued.
FAS 145 rescinds FAS 4 and FAS 64 related to classification of gains and losses
on debt extinguishment such that most debt extinguishment gains and losses will
no longer be classified as extraordinary. FAS 145 also amends FAS 13 with
respect to sales-leaseback transactions. The Company adopted the provisions of
FAS 145 effective April 1, 2002, and its adoption was not material to our
consolidated financial statements.
In July 2002, the FASB issued FAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." The principal difference between
this Statement and Issue 94-3 relates to its requirements for recognition of a
liability for a cost associated with an exit or disposal activity. This
Statement requires that a liability for a cost associated with an exit or
disposal activity be recognized when the liability is incurred. Under Issue
94-3, a liability for an exit cost as defined in Issue 94-3 was recognized as
the date of an entity's commitment to an exit plan. The provisions of this
statement are effective for exit or disposal activities that are initiated after
December 31, 2002.
Item 3. Quantitative and Qualitative Disclosures about Market Risks
-----------------------------------------------------------
We use derivative financial instruments primarily to reduce our exposure
to adverse fluctuations in foreign exchange rates, interest rates and prices of
certain raw materials used in the manufacturing process. We do not enter into
derivative financial instruments for trading purposes. As a matter of policy,
all derivative positions are used to reduce risk by hedging underlying economic
exposure. The derivatives we use are instruments with liquid markets.
Our consolidated earnings, which are reported in U.S. dollars, are subject
to translation risks due to changes in foreign currency exchange rates. However,
our overall exposure to such fluctuations is reduced by the diversity of our
foreign operating locations which encompass a number of different European
locations, Canada and China.
Our foreign subsidiaries transact most business, including certain
intercompany transactions, in foreign currencies. Such transactions are
principally purchases or sales of materials and are denominated in European
currencies or the U.S. or Canadian dollar. We use foreign currency forward
exchange contracts to manage the risk related to intercompany purchases that
occur during the course of a fiscal year and certain open foreign currency
denominated commitments to sell products to third parties.
25
We have historically had a very low exposure to changes in interest rates.
Interest rate swaps are used on a limited basis to mitigate the impact of
interest rate fluctuations on certain variable rate debt instruments. However,
our Revolving Credit Facility is subject to the impact of changes in interest
rates.
We purchase significant amounts of bronze ingot, brass rod and cast iron
which are utilized in manufacturing our many product lines. Our operating
results can be adversely affected by changes in commodity prices if we are
unable to pass on related price increases to our customers. We manage this risk
by monitoring related market prices, working with our suppliers to achieve the
maximum level of stability in their costs and related pricing, seeking
alternative supply sources when necessary and passing increases in commodity
costs to our customers, to the maximum extent possible, when they occur.
Additionally, on a limited basis, we use commodity futures contracts to manage
this risk.
Certain Factors Affecting Future Results
- ----------------------------------------
This report includes statements which are not historical facts and are
considered forward looking within the meaning of the Private Securities
Litigation Reform Act of 1995. These forward looking statements reflect the
Company's current views about future results of operation and other forward
looking information and may be identified by their use of words like "plan",
"believe", "expect", "will", "anticipate", "estimate" and other words of similar
meaning. You should not rely on forward looking statements, because the
Company's actual results may differ materially from those indicated by these
forward looking statements as a result of a number of important factors. These
factors include, but are not limited to, the following: loss of market share
through competition, introduction of competing products by other companies,
pressure on prices from competitors, suppliers, and/or customers, failure or
delay in developing new products, lack of acceptance of new products, failure to
manufacture products that meet required performance and safety standards,
foreign exchange fluctuations, cyclicality of industries, such as plumbing and
heating wholesalers and home improvements retailers, in which the Company
markets certain of its products, reductions in the supply of raw materials,
increases in the prices of raw materials, economic factors, such as the levels
of housing starts and remodeling, impacting the markets where the Company's
products are sold, manufactured, or marketed, environmental compliance costs,
product liability risks, the results and timing of the Company's manufacturing
restructuring plan, changes in the status of current litigation, including the
James Jones case, and other risks and uncertainties discussed under "Managements
Discussion and Analysis of Financial Condition and Results of Operation -
Certain Factors Affecting Future Results" in the Company's Annual Report on Form
10-K for the year ended December 31, 2001 filed with the Securities Exchange
Commission and other reports Watts files from time to time with the Securities
and Exchange Commission.
Item 4. Controls and Procedures
-----------------------
(a) Evaluation of disclosure controls and procedures.
As required by new Rule 13a-15 under the Securities Exchange Act of 1934,
within the 90 days prior to the date of this report, the Company carried out an
evaluation under the supervision and with the participation of the Company's
management, including the Company's Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of the Company's
disclosure controls and procedures. Based upon that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that the Company's
disclosure controls and procedures are effective to ensure that information
required to be disclosed by the Company in the reports it files or submits under
the Exchange Act is recorded, processed, summarized and reported, within the
time periods specified in the Securities and Exchange Commission's rules and
forms. In connection with the new rules, we currently are in the process of
further reviewing and documenting our disclosure controls and procedures,
including our internal controls and procedures for financial reporting, and may
from time to time make changes aimed at enhancing their effectiveness and to
ensure that our systems evolve with our business.
(b) Changes in internal controls.
None.
26
Part II
- -------
Item l. Legal Proceedings
-----------------
We are subject to a variety of potential liabilities connected with our
business operations, including potential liabilities and expenses associated
with possible product defects or failures and compliance with environmental
laws. We maintain product liability and other insurance coverage, which we
believe to be generally in accordance with industry practices. Nonetheless, such
insurance coverage may not be adequate to protect us fully against substantial
damage claims which may arise from product defects and failures.
James Jones Litigation
- ----------------------
On June 25, 1997, Nora Armenta (the "Relator") sued James Jones Company,
Watts Industries, Inc. (which formerly owned James Jones), Mueller Co. and Tyco
International (U.S.) in the California Superior Court for Los Angeles County
with a complaint that sought tens of millions of dollars in damages. By this
complaint and an amended complaint filed on November 4, 1998 ("First Amended
Complaint"), Armenta, a former employee of James Jones, sued on behalf of 34
municipalities as a qui tam plaintiff under the California False Claims Act (the
"Armenta case"). Late in 1998, the Los Angeles Department of Water and Power
("LADWP") intervened. In December 2000, the court allowed the Relator to file a
Second Amended Complaint, which added a number of new cities and water districts
as plaintiffs and brought the total number of plaintiffs to 161. On June 3,
2002, the California Superior Court excluded 47 cities from this total of 161.
The Relator was not able to obtain appellate modification of this order. To
date, 14 of the total number of plaintiffs have intervened.
The First Amended Complaint alleges that our former subsidiary (James
Jones Company) sold products that did not meet contractually specified standards
used by the named municipalities for their water systems and falsely certified
that such standards had been met. The Relator claims that these municipalities
were damaged by their purchase of these products and seeks treble damages, legal
costs, attorneys' fees and civil penalties under the False Claims Act.
The LADWP's intervention, filed on December 9, 1998, adopted the First
Amended Complaint and added claims for breach of contract, fraud and deceit,
negligent misrepresentation and unjust enrichment. The LADWP also sought past
and future reimbursement costs, punitive damages, contract difference in value
damages, treble damages, civil penalties under the False Claims Act and costs of
the suit.
One of the First Amended Complaint's allegations is the suggestion that
because some of the purchased James Jones products are out of specification and
contain more lead than the `85 bronze specified, a risk to public health might
exist. This contention is predicated on the average difference of about 2% lead
content in `81 bronze (6% to 8% lead) and `85 bronze (4% to 6% lead) alloys and
the assumption that this would mean increased consumable lead in public drinking
water. The evidence and discovery available to date indicate that this is not
the case.
In addition, bronze that does not contain more than 8% lead, like `81
bronze, is approved for municipal and home plumbing systems by municipalities
and national and local codes and the Federal Environmental Protection Agency
defines metal for pipe fittings with no more than 8% lead as "lead free" under
Section 1417 of the Federal Safe Drinking Water Act.
In June 2001, our company and the other defendants reached a proposed
settlement with the LADWP, one of the plaintiffs, which was approved by the
California Superior Court on October 31, 2001 and by the Los Angeles City
Council on December 14, 2001.
The plaintiff seeks three times an unspecified amount of actual damages
and alleges that the municipalities have suffered hundreds of millions of
dollars in damages. The plaintiff also seeks civil penalties of $10,000 for each
false claim and alleges that defendants are responsible for tens of thousands of
false claims. We settled with the City of Los Angeles, by far the most
significant city, for $5.7 million plus the Relator's statutory share and
attorneys' fees. Co-defendants will contribute $2 million toward this
settlement. The court has required the plaintiff to select cities with the
strongest claims to be tried first. After we settled with the City of Los
Angeles, the plaintiff made an offer to settle the
27
balance of this case for $121.9 million, which we have rejected. We have a
reserve in the amount of $9.1 million after-tax with respect to the James Jones
litigation in our consolidated balance sheet as of September 30, 2002. We
believe, on the basis of all available information, that this reserve is
adequate to cover our probable and reasonably estimable losses resulting from
the James Jones litigation. We have provided for our estimates of probable
losses for certain aspects of this case, which we believe are reasonably
estimable. For other aspects of this case, we are unable to estimate a range of
loss. However, litigation is inherently uncertain, and we believe that there
exists a reasonable possibility that we may ultimately incur losses in the James
Jones litigation in excess of the amount accrued. We are currently unable to
make an estimate of the range of any additional losses.
On February 14, 2001, Watts filed a complaint in the California Superior
Court against its insurers for coverage of the claims in the Armenta case. The
James Jones Company filed a similar complaint, the cases were consolidated, and
on October 30, 2001 the California Superior Court made a summary adjudication
ruling that Zurich American Insurance Company must pay all reasonable defense
costs incurred by us in the Armenta case since April 23, 1998 as well as our
future defense costs in this case until its final resolution. Zurich appealed
the October 30, 2001 ruling, and on March 7, 2002, the California Court of
Appeal granted Watts' motion to dismiss Zurich's appeal. After the trial court's
resolution of the coverage case, Zurich can then appeal this ruling. On
September 5, 2002, in compliance with the October 30, 2001 ruling, Zurich paid
Watts approximately $9.5 million of defense costs which includes 10% interest
that Watts had previously submitted to Zurich for payment. Zurich has asserted
that this amount is subject to reimbursement under Deductible Agreements between
Watts and Zurich. Management and counsel anticipate that the Company will still
be challenged but that it will ultimately prevail on this issue. On October 24,
2002, the California Superior Court made another summary adjudication ruling
that Zurich must indemnify and pay Watts for the amounts Watts must pay under
its settlement agreement with the City of Los Angeles. Zurich will be able to
appeal this ruling. We are currently unable to predict the outcome of the
litigation relating to the Los Angeles indemnification coverage. We intend to
continue to contest vigorously the Armenta case and its related litigation.
Asbestos Litigation
- -------------------
As of September 30, 2002, the Company was a defendant in approximately 55
actions filed in Mississippi and New Jersey state courts alleging injury or
death as a result of exposure to asbestos. These filings typically name multiple
defendants and are filed on behalf of many plaintiffs. They do not identify any
products of the Company as a source of asbestos exposure. Based on the facts
presently known to it, the Company does not believe this litigation will have a
material adverse effect on its liquidity, financial condition or results of
operations.
Environmental
- -------------
Our foundry and other operations, including our storage and disposal of
solid and hazardous wastes, are subject to various foreign, federal, state and
local laws and regulations relating to environmental matters. Compliance with
these laws and regulations requires us to incur expenses and monitor our
operations on an ongoing basis.
We are currently a party to or otherwise involved in various
administrative or legal proceedings under federal, state or local environmental
laws or regulations involving a limited number of our sites or third party
disposal sites. In addition, there may be soil or groundwater contamination at
current or previously owned or operated properties or at third party sites to
which our waste is sent for disposal. Based on facts presently known to us, we
do not believe that the outcome of these environmental proceedings or other
matters will have a material adverse effect on our liquidity, financial
condition or results of operations. Given the nature, history and scope of our
manufacturing operations, however, and given that there may be future changes to
laws or the enforcement thereof, there can be no assurance that we will not
become subject to other environmental proceedings or liabilities in the future
which may be material to us.
Other Litigation
- ----------------
Other lawsuits and proceedings or claims, arising from the ordinary course
of operations, are also pending or threatened against us and our subsidiaries.
Based on the facts presently known to us, we do not believe that the ultimate
outcome of these other litigation matters will have a material adverse effect on
our financial condition or results of operation.
28
Item 6. Exhibits and Reports on Form 8-K
--------------------------------
(a) The exhibits are furnished elsewhere in this report.
(b) Reports filed on Form 8-K during the Quarter ended September 30, 2002.
A Form 8-K was filed on August 9, 2002, under Item 9, attaching copies of
the Certifications submitted to the SEC by Chief Executive Officer, Patrick S.
O'Keefe and Chief Financial Officer, William C. McCartney of Watts Industries,
Inc. required by 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002.
A Form 8-K was filed on August 20, 2002, under Item 5, incorporating by
reference Watts Industries, Inc.'s August 15, 2002 press release announcing that
the SEC had commenced a civil action against Mr. Timothy P. Horne, a Director of
the Company, relating to his personal trading in the shares of Central Sprinkler
Corporation in May 1999.
29
SIGNATURES
----------
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
WATTS INDUSTRIES, INC.
Date: November 12, 2002 By: /s/ Patrick S. O'Keefe
------------------ ----------------------
Patrick S. O'Keefe
Chief Executive Officer
Date: November 12, 2002 By: /s/ William C. McCartney
----------------- ------------------------
William C. McCartney
Chief Financial Officer and Treasurer
30
WATTS INDUSTRIES, INC.
CERTIFICATION PURSUANT TO
SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002
CERTIFICATIONS
- --------------
I, Patrick S. O'Keefe, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Watts Industries, Inc.
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report is
being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 12, 2002
----------------- /s/ Patrick S. O'Keefe
----------------------
Patrick S. O'Keefe
Chief Executive Officer
31
WATTS INDUSTRIES, INC.
CERTIFICATION PURSUANT TO
SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002
CERTIFICATIONS
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I, William C. McCartney, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Watts Industries, Inc.
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of
the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 12, 2002
-----------------
/s/ William C. McCartney
-----------------------------
William C. McCartney
Chief Financial Officer and Treasurer
32
EXHIBIT INDEX
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Listed and indexed below are all Exhibits filed as part of this report.
Exhibit No. Description
- ----------- -----------
3.1 Restated Certificate of Incorporation, as amended. (1)
3.2 Amended and Restated By-Laws, as amended July 24, 2002
11 Computation of Earnings per Share (2)
(1) Incorporated by reference to the relevant exhibit to the
Registrant's Annual Report on Form 10-K filed with the
Securities and Exchange Commission on September 28,
1995.
(2) Incorporated by reference to the Notes to Consolidated
Financial Statements, Note 6, of this Report.