UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission file number 0-8408

 

WOODWARD GOVERNOR COMPANY

(Exact name of registrant specified in its charter)

 

 

Registrant’s telephone number, including area code:

(815)877-7441

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definitions of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer þ          Accelerated filer o          Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

The aggregate market value of the voting and non-voting common equity stock held by non-affiliates, computed by reference to the price at which the common equity was last sold, or the average bid and ask price of such common equity, as of the last business day of our most recently completed second fiscal quarter, was $967,019,000 (such aggregate market value does not include voting stock beneficially owned by directors, officers, the Woodward Governor Company Profit Sharing Trust, Woodward Governor Company Deferred Shares Trust, or the Woodward Governor Company Charitable Trust).

 

There were 34,142,962 shares of common stock with a par value of $.0292 per share outstanding at November 20, 2006.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of our proxy statement for the 2006 annual meeting of shareholders to be held January 24, 2007, are incorporated by reference into Part III of this filing, to the extent indicated.

 

 

TABLE OF CONTENTS

 

 

Woodward Governor Company designs, manufactures, and services energy control systems and components for aircraft and industrial engines and turbines. Leading OEMs (original equipment manufacturers) throughout the world use our products and services in the power generation, aerospace, transportation, and process industries markets.

 

We were established in 1870 and incorporated in 1902. We serve global markets from locations worldwide and are currently headquartered in Rockford, Illinois. Our principal executive officers maintain offices in Fort Collins, Colorado, as well as Rockford, Illinois. We plan to change the designation of our corporate headquarters to Fort Collins, Colorado, effective January 1, 2007.

 

Our business is driven by the worldwide demand for efficient, low emission, long life, and high performance energy use in harsh and demanding environments. Energy control and optimization solutions are our strength. One of our key objectives is to accurately and precisely control energy to optimize the performance, reliability, emissions, and efficiency of our customers’ products.

 

 

We have two operating segments — Industrial Controls and Aircraft Engine Systems. Industrial Controls is focused on systems and components that provide energy control and optimization solutions for industrial markets, which includes power generation, transportation, and process industries. Aircraft Engine Systems is focused on systems and components that provide energy control and optimization solutions for the aerospace market.

 

Information about our operations in 2006 and outlook for the future, including certain segment information, is included in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operation.” Additional segment information and certain geographical information are included in the Notes to the Consolidated Financial Statements in “Item 8 — Financial Statements and Supplementary Data.” Other information about our business follows.

 

Industrial Controls

 

We provide components and integrated systems through Industrial Controls primarily to OEMs of diesel engines, industrial turbines, gas engines, compressors, generator sets, switchgear, and industrial vehicles. We also sell components as spares or replacements, and provide other related services to these customers and other customers. In 2006, our two largest customers were General Electric Company, which accounted for approximately 20% of Industrial Controls’ sales, and Caterpillar, Inc., which accounted for approximately 18% of Industrial Controls’ sales.

We generally sell Industrial Controls’ products and services directly to our OEM customers, although we also generate sales to end users through distributors, dealers, and independent service facilities, whom often serve the role of an equipment packager. We carry certain finished goods and component parts inventory to meet rapid delivery requirements of customers, primarily for aftermarket needs. We do not believe Industrial Controls’ sales are subject to significant seasonal variation.

 

We believe Industrial Controls has a significant competitive position within the market for components and integrated systems for diesel engines, turbines, gas engines, compressors, generator sets, and switchgears. While published information is not available in sufficient detail to enable an accurate assessment, we believe we hold a strong position among independent manufacturers for power generation, transportation, and process industries markets. We compete with as many as 10 independent manufacturers and with the in-house control operations of OEMs. Customers demand technological solutions to meet their needs for efficiency, reliability, and the ability to meet increasingly more stringent global emissions regulations. Companies compete on the basis of providing products that meet these needs, as well as on the basis of price, quality, and customer service. In our opinion, our prices are generally competitive, and our quality, customer service, and technology used in products are favorable competitive factors.

 

Industrial Controls’ backlog orders were approximately $140 million at October 31, 2006, approximately 93% of which we expect to fill by September 30, 2007. Last year, Industrial Controls’ backlog orders were approximately $119 million at October 31, 2005, approximately 99% of which we expected to fill by September 30, 2006. Backlog orders are not necessarily an indicator of future billing levels because of variations in lead times.

 

Aircraft Engine Systems

 

We provide components and integrated systems through Aircraft Engine Systems to OEMs of aircraft gas turbines for use in those turbines. We also sell components as spares or replacements, and provide repair and overhaul services to these customers and other customers. In 2006, our two largest customers were General Electric Company, which accounted for approximately 24% of Aircraft Engine Systems’ sales, and United Technologies, which accounted for approximately 17% of Aircraft Engine Systems’ sales.

 

We primarily sell Aircraft Engine Systems’ products and services directly to our customers, although we also generate some aftermarket sales through distributors, dealers, and independent service facilities. We carry certain finished goods and component parts inventory to meet rapid delivery requirements of customers, primarily for aftermarket needs. We do not believe Aircraft Engine Systems’ sales are subject to significant seasonal variation.

 

We believe Aircraft Engine Systems has a significant competitive position within the market for components and integrated systems for aircraft gas turbines. We compete with several other manufacturers, including divisions of OEMs of aircraft gas turbines. While published information is not available in sufficient detail to enable an accurate assessment, we do not believe any company holds a dominant competitive position. Companies compete principally on price, quality, and customer service. In our opinion, our prices are competitive, and our quality and customer service are favorable competitive factors.

 

Aircraft Engine Systems’ backlog orders were approximately $228 million at October 31, 2006, approximately 62% of which we expect to fill by September 30, 2007. Last year, Aircraft Engine Systems’ backlog orders were approximately $137 million at October 31, 2005, approximately 71% of which we expected to fill by September 30, 2006. Backlog orders are not necessarily an indicator of future billing levels because of variations in lead times.

 

Other Matters

 

Products for both Industrial Controls and Aircraft Engine Systems make use of several patents and trademarks of various durations that we believe are collectively important. However, we do not consider our business for either segment dependent upon any one patent or trademark.

 

For both segments, our products consist of mechanical, electronic, and electromagnetic components. Mechanical components are machined primarily from aluminum, iron, and steel. Generally there are numerous

sources for the raw materials and components used in our products, and they are believed to be sufficiently available to meet all requirements.

 

We spent approximately $60 million for company-sponsored research and development activities in 2006, $50 million in 2005 and $40 million in 2004. Both Industrial Controls and Aircraft Engine Systems incurred these expenses.

 

We do not believe that compliance with current Federal, State, or local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, will have any material effect on our capital expenditures, earnings, or competitive position. We are also not intending to incur material capital expenditures for environmental control facilities through September 30, 2007.

 

We employed about 3,700 people at October 31, 2006.

 

This report contains forward-looking statements and should be read with “Item 1A — Risk Factors.”

 

We maintain a website at www.woodward.com. Securities and Exchange Commission filings, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and proxy statements, are available on our website as soon as reasonably practicable after they are filed electronically with, or furnished to, the Securities and Exchange Commission. Shareholders may obtain, without charge, a single copy of Woodward’s 2006 annual report on Form 10-K upon written request to the Corporate Secretary, Woodward Governor Company, 5001 North Second Street, P.O. Box 7001, Rockford, Illinois, 61125-7001.

 

Investment in our securities involves risk. An investor or potential investor should consider the risks summarized in this section when making investment decisions regarding our securities.

 

Also, an investor should be aware that this annual report contains statements intended to be considered forward-looking statements and therefore entitled to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, including:

 

 

Forward-looking statements do not reflect historical facts. Rather, they are statements about future events and conditions and often include words such as “anticipate,” “believe,” “estimate,” “expect,” “forecast,” “intend,” “outlook,” “plan,” “project,” “target,” “can,” “could,” “may,” “should,” “will,” “would,” or similar expressions. Such statements reflect our expectations about the future only as of the date they are made. We are not obligated to, and we might not, update our forward-looking statements to reflect changes that occur after the date they are made. Furthermore, actual results could differ materially from projections or any other forward-looking statements regardless of when they are made.

 

Important factors that could individually, or together with one or more other factors, affect our business, results of operations and/or financial condition include, but are not limited to, the following:

 

Company Risks

 

Customers that account for a significant portion of our sales may change suppliers, insource production, or be less successful in the marketplace.

 

We have fewer customers than many other companies with similar sales volumes. Two customers accounted for 33% of our sales in 2006, each individually accounting for more than 10%. Our sales could decrease significantly if a large customer were to change suppliers, insource production, or be less successful in the markets in which it participates.

Sales may not achieve the level forecast.

 

We use inputs from various sources in developing our sales forecast, including customer and third-party forecasts of sales volumes and purchase requirements in our markets. Each of these sources could be overstated. In addition, general business and economic conditions and industry-specific business and economic conditions change over time, potentially resulting in lower sales.

 

Many of our expenses may not be able to be reduced in proportion to a sales shortfall.

 

Many of our expenses are relatively fixed in relation to changes in sales volumes. Some of these expenses are related to past capital expenditures or business acquisitions in the form of depreciation and amortization expense. Others are related to expenditures driven by levels of business activity other than the level of sales, including manufacturing overhead. As a result, we might be unable to reduce spending quickly enough to compensate for a reduction in sales, which would adversely affect our earnings.

 

Suppliers may be unable to provide us with materials of sufficient quality or quantity required to meet our production needs.

 

We are dependent upon suppliers for parts and raw materials used in the manufacture of components that we sell to our customers. We may experience a shortage of materials for various reasons, such as financial distress, work stoppages, natural disasters, or production difficulties that may affect one or more of our suppliers. A protracted interruption of supplies for any reason may adversely affect our financial condition and results of operations.

 

Product development activities may not be successful or may be more costly than currently anticipated.

 

Our business involves a significant level of product development activities, generally in connection with our customers’ own development activities. If these activities are not as successful as currently anticipated, or if they are more costly than currently anticipated, future sales and/or earnings could be lower.

 

Activities necessary to integrate an acquisition may result in costs in excess of current expectations or be less successful than anticipated.

 

We completed a business acquisition in October 2006 and we may acquire other businesses in the future. If actual integration costs are higher than amounts assumed, or we are unable to integrate the assets and personnel acquired in an acquisition as anticipated, our future earnings may be lower than anticipated.

 

Changes in the estimates of fair value of reporting units or of long-lived assets may result in future impairment charges.

 

Over time, the fair values of long-lived assets change. We test goodwill for impairment annually, and more often if circumstances require. We also test property, plant, and equipment, and other intangibles for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Future impairment charges may occur if estimates of fair values decrease, which will reduce future earnings.

 

Future subsidiary results may change the amount of valuation allowances provided for deferred income tax assets.

 

We establish valuation allowances to reflect the estimated amount of deferred tax assets that might not be realized. The underlying analysis is performed for individual tax jurisdictions, generally at a subsidiary level. Future subsidiary results, actual or forecasted, could change the outcome of our analysis and change the amount of valuation allowances provided for deferred income tax assets.

 

Manufacturing activities may result in future environmental liabilities.

 

We use hazardous materials in our manufacturing operations. We also own facilities that were formerly owned and operated by others that used hazardous materials. The risk that a release of hazardous materials has occurred in

the past, or will occur in the future, cannot be completely eliminated. As a result, we may need to undertake future environmental remediation activities that will negatively affect our future earnings and financial position.

 

Amounts accrued for contingencies may be inadequate to cover the amount of loss when the matters are ultimately resolved.

 

We are currently involved in pending or threatened litigation or other legal proceedings regarding employment, product liability, and contractual matters arising from the normal course of business. We accrue for individual matters that we believe are likely to result in a loss when ultimately resolved using estimates of the most likely amount of loss. There may be additional losses that have not been accrued that will reduce future earnings.

 

Changes in the legal environment in which we operate may affect future sales and expenses.

 

We operate in a number of countries and are affected by a variety of laws and regulations, including employment, import, export, business acquisitions, environmental, and taxation matters, among others. Unexpected changes in the legal environment may result in lower sales or increased expenses in the future.

 

Operations outside the United States may be subject to additional risks.

 

Our principal plants include facilities in China and Germany, as well as the United States. The operations outside the United States could be disrupted by a natural disaster, war, political unrest, terrorist activity, public health concerns, or other unforeseen events that would be less likely to occur in the United States. Disruption of an overseas operation could adversely affect our business, financial condition, and results of operations.

 

Changes in foreign currency exchange rates may decrease margins associated with our sales.

 

We have situations in which sales agreements and the related cost of sales are predominately denominated in different currencies. These may involve foreign sales and domestic costs, or vice versa. Each of these situations involve the risk that the margins associated with these sales could be lower than previous sales or forecasts because of changes in foreign currency exchange rates.

 

Changes in assumptions may increase the amount of retirement pension and healthcare benefit obligations and related expense.

 

Accounting for retirement pension and healthcare benefit obligations and related expense requires the use of assumptions, including a weighted-average discount rate, an expected long-term rate of return on assets, and a net healthcare cost trend rate, among others. Benefit obligations and benefit costs are sensitive to changes in these assumptions. As a result, assumption changes could result in increases in our obligation amounts and expenses.

 

Industry Risks

 

Competitors may develop breakthrough technologies that are adopted by our customers.

 

Many of the components and systems we sell are used in harsh environments with difficult emissions standards. The technological expertise we have developed and maintained could become less valuable if a competitor were to develop a breakthrough technology that would allow them to match the performance of existing technologies at a lower cost. A breakthrough technology could also accelerate the rate of change in customer demands beyond what existing technologies are capable of achieving.

 

Changes in competitor strategies may reduce the demand for our products.

 

Companies compete on the basis of providing products that meet the needs of customers, as well as on the basis of price, quality, and customer service. Changes in competitive conditions, including the availability of new products and services, the introduction of new channels of distribution, and changes in OEM and aftermarket pricing, could negatively affect future sales.

Unforeseen events may occur that significantly reduce commercial airline travel.

 

Our Aircraft Engine Systems segment accounted for 43% of our sales in 2006, with the majority of sales tied to commercial aviation. Market demand for our components and systems would be negatively affected by reductions in commercial airline travel. Certain events have had a notable negative effect on passenger flight miles in the past, such as the terrorist actions of 2001.

 

Increasing emission standards that drive certain product sales may be eased or delayed.

 

We sell components and systems that have been designed to meet demanding emission standards, including standards that have not yet been implemented but are intended to be soon. If the demands of these emission standards are eased, our future sales could be lower as potential customers select alternative products or delay adoption of our products.

 

Natural gas prices may increase significantly and disproportionately to other sources of fuels used for power generation.

 

Commercial producers of electricity use many of our components and systems, most predominately in their power plants that use natural gas as their fuel source. Commercial producers of electricity are often in a position to manage its use of different power plant facilities and make decisions based on operating costs. If natural gas prices were to increase significantly and disproportionately to other sources of fuels, it is likely that the use of our components and systems would decrease.

 

The U.S. Government may reduce defense funding or the mix of programs to which such funding is allocated.

 

The level of U.S. defense spending is subject to periodic congressional appropriation actions, which can change. The mix of programs to which such funding is allocated is also uncertain. A portion of our sales of components and systems is to the U.S. Government, primarily in the aerospace market. If the amount of spending was to decrease, or there was a shift from certain aerospace programs to other programs, our sales could decrease.

 

Changes in foreign currency exchange rates or in interest rates may reduce the demand for our products.

 

Changes in foreign currency exchange rates or in interest rates affects demand for capital purchases. Each of the markets in which we sell operates globally and is influenced by foreign currency exchange rates. Also, capital expenditures tend to decrease as interest rates and economic uncertainty rise.

 

Investment Risks

 

The historic market price of our common stock may not be indicative of future market prices.

 

The market price of our common stock changes over time. The selling price of our common stock ranged from a low of $25.10 per share to a high of $38.88 per share in 2006. The causes of stock price volatility are related to many factors both within and outside management’s control. As a result, we may not be

 

able to maintain or increase the value of our common stock.

 

The typical trading volume of our common stock may affect an investor’s ability to sell significant share holdings in the future without negatively affecting share price.

 

We currently have approximately 35 million shares of common stock outstanding. While the level of trading activity will vary by day, the typical trading level represents only a small percentage of shares outstanding. As a result, a seller of a significant number of shares in a short period of time could negatively affect our share price.

 

There are no unresolved comments from the staff of the U.S. Securities and Exchange Commission regarding the periodic or current reports that we filed under the Securities Exchange Act of 1934.

 

Our principal plants are as follows:

 

United States

 

Fort Collins, Colorado — Industrial Controls manufacturing and corporate offices

Loveland, Colorado — Industrial Controls manufacturing and partially leased to a third party

Niles, Illinois — Industrial Controls manufacturing Rockford, Illinois — Aircraft Engine Systems manufacturing and corporate offices

Rockton, Illinois — Aircraft Engine Systems manufacturing and repair and overhaul

Zeeland, Michigan — Aircraft Engine Systems manufacturing

Greenville, South Carolina (leased) — Industrial Controls manufacturing

 

Other Countries

 

Suzhou, Peoples’ Republic of China (leased) — Industrial Controls manufacturing

Aken, Germany (leased) — Industrial Controls manufacturing

Kempen, Germany — Industrial Controls manufacturing (acquired on October 31, 2006, subsequent to the year ended September 30, 2006)

Stuttgart, Germany (leased) — Industrial Controls manufacturing

Prestwick, Scotland, United Kingdom (leased) — Aircraft Engine Systems repair and overhaul

 

Our principal plants are suitable and adequate for the manufacturing and other activities performed at those plants, and we believe our utilization levels are generally high. With continuing advancements in manufacturing technology and operational improvements, we believe we can continue to increase production without additional plants.

 

In addition to the principal plants listed above, we own facilities in Japan, The Netherlands, and United Kingdom, and lease several facilities in locations worldwide, which are used primarily for sales and service activities. The United Kingdom facility also serves as a key development site for diesel fuel injection products.

 

We plan on changing the designation of our corporate headquarters from Rockford, Illinois to Fort Collins, Colorado, effective January 1, 2007. In recent years, we have maintained corporate offices for our principal executive officers in both locations. The address of our Fort Collins location is 1000 East Drake Road, Fort Collins, Colorado, 80525, and its phone number is (970) 498-5811.

 

We are currently involved in pending or threatened litigation or other legal proceedings regarding employment, product liability, and contractual matters arising from the normal course of business. These matters are discussed in the Notes to the Consolidated Financial Statements in “Item 8 — Financial Statements and Supplementary Data.” We currently do not have any administrative or judicial proceedings arising under any Federal, State, or local provisions regulating the discharge of materials into the environment or primarily for the purpose of protecting the environment.

 

There were no matters submitted to a vote of security holders during the fourth quarter of 2006.

 

(a) Our common stock is listed on the NASDAQ Global Select Market and at November 17, 2006, there were approximately 1,417 holders of record. Cash dividends were declared quarterly during 2006 and 2005. The amount of cash dividends per share and the high and low sales price per share for our common stock for each fiscal quarter in 2006 and 2005 are included in the Notes to the Consolidated Financial Statements in “Item 8 — Financial Statements and Supplementary Data.”

 

(b) Recent Sales of Unregistered Securities

 

Sales of common stock issued from treasury to one of the company’s directors during 2006 consisted of the following:

 

 

The securities were sold in reliance upon the exemption contained in Section 4(2) of the Securities Act of 1933.

 

(c) Issuer Purchases of Equity Securities

 

 

In addition to shares purchased as part of publicly announced plans or programs, we acquired 46,527 shares as payment for the exercise price of stock options exercised in December 2005. We also purchased shares on the open market related to the reinvestment of dividends for treasury stock held for deferred compensation of 1,467 in December 2005, 1,245 in March 2006, 1,282 in June 2006, and 1,217 in September 2006.

On July 25, 2006, the Board of Directors authorized the repurchase of up to $50 million of our outstanding shares of common stock on the open market and in private transactions over a three-year period that will end on July 25, 2009. There have been no terminations or expirations since the approval date.

 

On January 26, 2005, the Board of Directors authorized the repurchase of up to $30 million of our outstanding shares of common stock on the open market and in private transactions over a three-year period. This authorization was terminated on July 25, 2006, concurrent with the approval of a new stock repurchase authorization.

 

 

 

 

Notes:

 

 

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

 

OVERVIEW

 

Woodward designs, manufactures, and services energy control systems and components for aircraft and industrial engines and turbines. Leading OEMs throughout the world use our products and services in the power generation, process industries, transportation, and aerospace markets.

 

Our strategic focus is Energy Control and Optimization Solutions. The control of energy — fluid energy, combustion, electrical energy, and motion — is a growing requirement in the markets we serve. Our customers look to us to optimize the efficiency, emissions, and operations of power equipment. Our core technologies leverage well across our markets and customer applications, enabling us to develop and integrate cost-effective and state-of-the-art fuel, combustion, fluid, actuation, and electronic systems. We focus primarily on OEMs and equipment packagers, partnering with them to bring superior component and system solutions to their demanding applications.

 

We have two operating segments — Industrial Controls and Aircraft Engine Systems. Industrial Controls is focused on systems and components that provide energy control and optimization solutions for industrial markets, which includes power generation, transportation, and process industries. Aircraft Engine Systems is focused on systems and components that provide energy control and optimization solutions for the aerospace market. We use segment information internally to assess the performance of each segment and to make decisions on the allocation of resources.

 

Our sales and earnings have grown over the last four years. In 2006, our sales exceeded $850 million for the first time in our history and our net earnings were just short of $70 million. Our markets have substantially recovered from the declines that occurred in 2002 and 2003 and both of our segments benefited from these factors. In addition, net earnings for 2006 benefited from a change in the valuation allowance for deferred tax assets of $13.7 million.

 

Improvement of Industrial Controls’ earnings was a key objective for 2006, and its earnings nearly doubled from 5.4% of sales in 2005 to 10.3% in 2006. This improvement was driven by a manufacturing consolidation in 2005 and early 2006, supply chain productivity initiatives, and market and management-initiated changes in our product mix.

 

Aircraft Engine Systems continued to generate earnings within our targeted range of 20 to 22% of sales in 2006, and we are continuing to invest substantial amounts in research and development activities to sustain future

growth. Company-wide, our expenditures for research and development increased 20% in 2006 over 2005, largely the result of program wins in the aerospace market over the last few years.

 

Subsequent to the end of 2006, we acquired a business that had sales of $60 million in calendar year 2005. This business adds dimension and range to our core technologies and product portfolio for the power generation market, including protection and comprehensive control systems for power distribution applications and power inverters for wind turbines — areas we have targeted for growth.

 

At September 30, 2006, our total assets exceeded $735 million, including $84 million in cash, and our total debt was less than $74 million. We are well positioned to fund expanded research and development and to explore other investment opportunities consistent with our focused strategies.

 

The financial statements that are filed as part of this Form 10-K reflect the effects of the three-for-one stock split that became effective during 2006. Shareholders approved the split in January 2006.

 

In the sections that follow, we are providing information to help you better understand our critical accounting policies and market risks, our results of operations and financial condition, and the effects of recent accounting pronouncements. However, you should be aware that this discussion contains statements intended to be considered forward-looking statements and therefore entitled to the safe harbor provision of the Private Securities Litigation Reform Act of 1995. Information about forward-looking statements, including important factors that could affect our business, results of operations and/or financial condition, are included in “Item 1A — Risk Factors.”

 

CRITICAL ACCOUNTING POLICIES

 

We consider the accounting policies used in preparing our financial statements to be critical accounting policies when they are both important to the portrayal of our financial condition and results of operations, and require us to make difficult, subjective, or complex judgments. Critical accounting policies normally result from the need to make estimates about the effect of matters that are inherently uncertain. Management has discussed the development and selection of our critical accounting policies with the audit committee of the company’s Board of Directors, and the audit committee has reviewed the disclosures that follow.

 

In each of the following areas, our judgments, estimates, and assumptions are impacted by conditions that change over time. As a result, in the future there could be changes in our assets and liabilities, increases or decreases in our expenses, and additional losses or gains that are material to our financial condition and results of operations.

 

Goodwill

 

Goodwill, which is included in the segment assets of both Industrial Controls and Aircraft Engine Systems, totaled $132.1 million at September 30, 2006, representing 18% of total assets. We test goodwill for impairment on an annual basis and more often if circumstances require. Impairment tests performed during the three years ended September 30, 2006, have not resulted in any impairment losses.

 

Estimates and assumptions, the most important of which are used to estimate the fair value of reporting units within the company, affect the results of our goodwill impairment tests. To estimate the fair value of reporting units, we estimate future cash flows, discount rates, and transaction multiples that we believe a marketplace participant would use in an arm’s length transaction.

 

To assess the effect on our annual impairment tests in 2006 if different assumptions had been used, we separately measured the effects of a hypothetical 20% reduction in estimated cash flows, a 20% increase in the discount rates used, and a 20% reduction in the transaction multiples used. While each of these changes would have reduced the estimated fair value of reporting units within the company, none of them individually would have resulted in an impairment loss in 2006.

 

Other long-lived assets

 

As discussed here, our other long-lived assets consist of property, plant, and equipment, and other intangibles, which are included primarily in the segment assets of both Industrial Controls and Aircraft Engine Systems. Other long-lived assets totaled $195.9 million at September 30, 2006, and represented 27% of total assets. We depreciate

or amortize long-lived assets over their estimated useful lives. Depreciation and amortization expense associated with these assets totaled $29.0 million in 2006, $31.5 million in 2005, and $32.8 million in 2004. We also test long-lived assets for recoverability whenever events or changes in circumstances indicate that the carrying values may not be recoverable.

 

The selection of useful lives for depreciation and amortization purposes requires judgment. If we had increased the remaining useful life of all assets being depreciated and amortized by one year, depreciation and amortization expense would have decreased, and the year-end carrying value of long-lived assets would have increased, by approximately $3.5 million in 2006. Similarly, if we had decreased the remaining useful lives by one year, depreciation and amortization expense would have increased, and the year-end carrying value of long-lived assets would have decreased, by approximately $4.6 million in 2006. (The results of this sensitivity analysis ignore the impact of individual assets that might have become fully depreciated or amortized during 2006 had these hypothetical changes been made.)

 

The carrying value of a long-lived asset, or related group of assets, is reduced to its fair value whenever estimates of future cash flows are insufficient to indicate the carrying value is recoverable. We form judgments as to whether recoverability should be assessed, we estimate future cash flows and, if necessary, we estimate fair value. Fair value estimates are most often based on estimated future cash flows and assumed discount rates.

 

Deferred income tax asset valuation allowances

 

Valuation allowances for deferred income tax assets totaled $2.6 million at September 30, 2006, representing 3% of deferred income tax assets before the allowances. The net changes in the valuation allowances increased total comprehensive earnings (comprised of net earnings and foreign currency translation adjustments) by $15.2 million in 2006 and $0.9 million in 2005.

 

Deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Both positive and negative evidence are considered in forming our judgment as to whether a valuation allowance is appropriate, and more weight is given to evidence that can be objectively verified. Valuation allowances are reassessed whenever there are changes in circumstances that may cause a change in judgment. In 2006, additional objective evidence became available regarding earnings in tax jurisdictions that had unexpired net operating loss carryforwards that affected our judgment about the valuation allowance that existed at the beginning of the year. If we had made different judgments regarding the realizability of deferred tax assets, our valuation allowance and income tax expense may have been higher or lower than amounts reported.

 

Retirement pension and healthcare benefits

 

The cost of retirement pension and healthcare benefits is recognized over employee service periods using an actuarial-based attribution approach. Our net accrued benefit for these retirement benefits totaled $61.5 million at September 30, 2006, which represented 24% of total liabilities and consisted of the following (in millions):

 

The net periodic benefit cost associated with these liabilities totaled $4.4 million in 2006, which consisted of the following (in millions):

 

 

To determine our net accrued benefit and net periodic benefit cost, we form judgments about the best estimate for each assumption used in the actuarial computation. The most important assumptions that affect the computations are the discount rate, the expected long-term rate of return on plan assets, and the healthcare cost trend rate.

 

Our discount rate assumption is intended to reflect the rate at which the retirement benefits could be effectively settled based upon the assumed timing of the benefit payments. In the United States, we use the blended 40/60 Moody’s Baa/Aaa index, the Citigroup Pension Liability Index, and the 30-year U.S. treasury rate as benchmarks. In the United Kingdom, we use the AA corporate bond index (applicable for bonds over 15 years) and government bond yields (for bonds over 15 years) to determine a blended rate to use as the benchmark. In Japan, we use AA-rated corporate bond yields (for bonds of 12.5 years) as the benchmark. Our assumed rates do not differ significantly from any of these benchmarks.

 

We assumed weighted-average discount rates of 4.69% to determine our retirement pension benefit obligation at September 30, 2006, and 4.48% to determine the related service and interest costs in 2006. A 1.00% increase in these discount rates would have decreased the benefit obligation at the end of 2006 by $12.5 million and increased the total of service and interest costs by $0.7 million in 2006. Likewise, a 1.00% decrease in these discount rates would have increased the benefit obligation by $15.5 million and decreased the total of service and interest costs by $0.9 million in 2006.

 

We assumed weighted-average discount rates of 5.56% to determine our retirement healthcare benefit obligation at September 30, 2006, and 5.28% to determine the related service and interest costs in 2006. A 1.00% increase in these discount rates would have decreased the benefit obligation at the end of 2006 by $5.1 million and increased the total of service and interest costs by $0.1 million in 2006. Likewise, a 1.00% decrease in these discount rates would have increased the benefit obligation by $6.2 million and decreased the total of service and interest costs by $0.2 million in 2006.

 

The expected long-term rate of return on plan assets was based on our current asset allocations and the historical long-term performance for each asset class, as adjusted for existing market conditions. Information regarding our asset allocations is included in the Notes to Consolidated Financial Statements in “Item 8 — Financial Statements and Supplementary Data.” We assumed a weighted-average expected long-term rate of return on pension plan assets of 6.69% to determine our net periodic benefit cost in 2006. A 1.00% increase in the expected return would have decreased the net periodic benefit cost by $0.5 million in 2006. Likewise, a 1.00% decrease in the expected return would have increased the net periodic benefit cost by $0.5 million in 2006.

 

We assumed net healthcare cost trend rates of 10.00% in 2007, decreasing gradually to 5.00% in 2012, and remaining at 5.00% thereafter. A 1.00% increase in assumed healthcare cost trend rates would have increased the benefit obligation at the end of 2006 by $5.6 million and the total of the service and interest costs by $0.4 million in 2006. Likewise, a 1.00% decrease in the assumed healthcare cost trend rates would have decreased the benefit obligation by $4.8 million and the total of service and interest costs by $0.3 million in 2006.

 

Among the items affecting our net accrued retirement pension benefits were additional minimum pension liabilities necessary to reflect a liability amount at least equal to the accumulated benefit obligation on an individual plan basis. The total increase in minimum pension liabilities for 2006 was $1.6 million and was primarily reported in other comprehensive income, net of income taxes. Based on future plan asset performance and discount rates, additional adjustments to our net accrued benefit and equity may be required in the future.

MARKET RISKS

 

Our long-term debt is sensitive to changes in interest rates. We monitor trends in interest rates as a basis for determining whether to enter into fixed rate or variable rate debt agreements, the duration of such agreements, and whether to use hedging strategies. Our primary objective is to minimize our long-term costs of borrowing. At September 30, 2006, our long-term debt consisted of fixed rate agreements. As measured at September 30, 2006, a hypothetical 1% immediate increase in interest rates would reduce the fair value of our long-term debt by approximately $1.9 million.

 

Assets, liabilities, and commitments that are to be settled in cash and are denominated in foreign currencies for transaction purposes are sensitive to changes in currency exchange rates. We monitor trends in foreign currency exchange rates and our exposure to changes in those rates as a basis for determining whether to use hedging strategies. Our primary exposures are to the European Monetary Union euro and the Japanese yen. We do not have any derivative instruments associated with foreign currency exchange rates. A hypothetical 10% immediate increase in the value of the United States dollar relative to all other currencies, when applied to September 30, 2006, balances, would adversely affect our 2007 net earnings and cash flows by approximately $3.6 million. Last year, a hypothetical 10% immediate increase in the value of the United States dollar relative to all other currencies would have adversely affected our 2006 net earnings and cash flows by $2.2 million.

 

RESULTS OF OPERATIONS

 

Sales

 

 

2006 Compared to 2005

 

Consolidated net sales increased 3% in 2006 compared to 2005, attributable to the following (in millions):

 

 

Aircraft Engine Systems’ sales volume changes:  Aircraft Engine Systems’ improvement continues to reflect the effects of favorable trends in commercial aviation. Our commercial OEM sales have increased, driven by the higher production levels of narrow-body and wide-body aircraft by Boeing and Airbus, especially the A320 and Boeing 777. Orders for new aircraft by Asian airlines have been particularly strong. Regional jet production by Embraer and Bombardier was fairly similar to the prior year. Sales related to business jets were up slightly, and we anticipate additional growth in 2007 with the launches of the Cessna Mustang and Eclipse 500 jets. We also continued to see a trend toward higher revenue passenger miles experienced by commercial airlines and cargo growth, which drives aircraft usage and has a positive effect on our aftermarket sales. We estimate approximately half of Aircraft Engine Systems’ sales were aftermarket sales in 2006 and 2005. Sales for military applications in 2006 were similar to 2005 levels.

 

Price changes:  Price changes were made primarily in response to material cost increases in Industrial Controls. The material cost increases were related to price fluctuations of commodities from which mechanical, electronic, or electromagnetic components are produced.

 

Industrial Controls’ sales volume changes:  Overall, Industrial Controls sales volumes were near the same levels achieved a year ago. While shipment volumes increased for many of our products, we experienced lower sales of turbine combustion products used in power generation, alternative fuel systems that are sold to Chinese OEMs,

and pump sales to an Asian customer that secured an alternative source. In total, these decreases totaled approximately $38 million.

 

We believe the decrease in sales of turbine combustion products is related to inventory adjustments made by our largest customer. Customer inventory increased in 2004 and 2005 and was reduced in 2006. We believe their inventory is now at sustainable levels and will be replenished at approximately their rate of sales.

 

We have attributed the decrease in sales of alternative fuel systems for Chinese OEMs to production and ordering patterns typical in the Chinese market. Customers in China have shown a tendency to batch their orders and engine production in such a manner that results in greater variability than is typical among customers in other markets.

 

Increased sales of other products largely offset these decreases, including sales of process automation valves and actuators that targeted new applications for use in the process industry. The core technologies used in fluid systems, which have typically been applied to gas engines, gas and steam turbines, and compressors, can be applied to the balance of plant equipment in process automation applications. In 2006, we developed a new product for this adjacent market, generating sales of approximately $6 million.

 

Other increases in sales were primarily driven by increased demand for distributed power, marine, and heavy equipment applications.

 

2005 Compared to 2004

 

Consolidated net sales increased 17% in 2005 compared to 2004, attributable to the following (in millions):

 

 

Industrial Controls’ sales volume changes:  Industrial Controls benefited from a broad industrial recovery that included the segment’s power generation and transportation markets. We experienced higher demand for large gas turbine fuel nozzles — the area affected most by the severe market declines of 2002 and 2003 — driven in part by power generation improvement projects in Asia and Eastern Europe. We also won a number of new programs, including one for an alternative fuel engine used in Asia, which resulted in increased sales. Use of alternative fuels has increased in Asia in recent years due to more stringent environmental emission standards and the availability of natural gas as a fuel source in the region.

 

Aircraft Engine Systems’ sales volume changes:  Aircraft Engine Systems’ improvement reflects the effects of favorable trends in commercial aviation. We experienced modest growth in commercial OEM sales, as Boeing and Airbus ramped up their production levels for narrow- and wide-body aircraft. We also have seen a continuation of the trend toward higher revenue passenger miles experienced by commercial airlines and cargo growth, which has driven greater utilization of aircraft and higher aftermarket sales for us. We estimate approximately half of Aircraft Engine Systems’ sales were aftermarket sales in 2005 and 2004.

 

Costs and Expenses

 

2006 Compared to 2005

 

Cost of goods sold decreased 2% in 2006 as compared to 2005, attributable to the following (in millions):

 

 

The effect of increased sales volume on cost of goods sold was measured as if these costs increased in direct proportion to the sales volume increase.

 

Costs of goods sold benefited from the effects of Industrial Controls’ European consolidation, which we completed in March 2006. A more detailed discussion of the European consolidation is included under “Workforce Management Actions” below.

 

Variable compensation paid to members in direct and indirect manufacturing functions was lower in 2006 than in 2005. Each year, a portion of our members’ compensation will vary depending on performance-based factors.

 

The percent increase in Aircraft Engine Systems’ sales volume (7%) was greater than the percent increase in Industrial Controls’ sales volume (0%). However, Aircraft Engine Systems’ average margins are higher than those of Industrial Controls. As a result, the resulting change in segment sales mix decreased cost of goods sold in the analysis presented above.

 

We incurred cost of goods sold related to workforce management actions that totaled $1.7 million in 2005. These costs were largely attributable to termination benefits for members in direct and indirect manufacturing functions.

 

Selling, general, and administrative expenses increased 15% in 2006 as compared to 2005, attributable to the following (in millions):

 

 

We accrue for individual matters that we believe are likely to result in a loss when ultimately resolved using estimates of the most likely amount of loss, including accruals totaling $8.5 million in 2006. More information about contingencies is included under “Commitments and Contingencies” below.

 

At the beginning of 2006, we began to account for stock-based compensation using the fair value method of accounting as required under a new accounting standard. We used the intrinsic value method in previous years, under which we did not recognize compensation expense in association with options granted at or above the market price of our common stock at the date of grant. More information about the effect of this accounting change is included under “Stock-Based Compensation” below.

 

Research and development costs increased 20% in 2006 over 2005 attributable to the following (in millions):

 

 

Aircraft Engine Systems is developing new aircraft gas turbine programs for both commercial and military aircraft. Many of these development programs began in 2005 or earlier and were fully engaged throughout 2006. Most significantly we are developing components and an integrated fuel system for the new GEnx turbofan engine for the Boeing 787, Airbus A350, and Boeing 747-8, and components for the GE Rolls-Royce F136 engine that is one of two propulsion choices to power Lockheed’s Joint Strike Fighter aircraft, and components for the T700-GE-701D engine that will be used to upgrade the Sikorsky Black Hawk and Boeing Apache helicopters, among others.

We also increased development activities in Industrial Controls, most notably in conjunction with customers’ development programs as we work closely with our customers early in their own development and design stages, helping them by developing components and integrated systems that allow them to meet emissions requirements, increase fuel efficiency, and lower their costs. We also continue to develop products for the turbine auxiliary market. Turbine auxiliary applications offer multiple opportunities to leverage our existing hydraulic and electric actuation and valve technologies for off-engine applications.

 

Curtailment gain relates to an amount recognized in 2005 for the immediate effects of amendments to one of our retirement healthcare benefit plans. The amendment eliminated retirement healthcare benefits for members that did not attain age 55 and 10 years of service by January 1, 2006.

 

Interest and other income decreased in 2006 from 2005 primarily as a result of the 2005 sale of rights to our aircraft propeller synchronizer products to an unrelated third party, which resulted in a pre-tax gain of $3.8 million.

 

2005 Compared to 2004

 

Cost of goods sold increased 15% in 2005 as compared to 2004, attributable to the following (in millions):

 

 

The effect of increased sales on cost of goods sold was measured as if these costs increased in direct proportion to the 17% sales increase. However, there are many factors that affected cost of goods sold other than volume, the most important of which are discussed in the paragraphs that follow.

 

We incurred cost of goods sold related to workforce management actions that totaled $1.7 million in 2005 and $12.4 million in 2004, netting to a decrease of $10.7 million. These costs were largely attributable to termination benefits for members in direct and indirect manufacturing functions.

 

Variable compensation paid to members in direct and indirect manufacturing functions was higher in 2005 than in 2004. Each year, a portion of our members’ compensation will vary depending on performance-based factors, including consolidated financial results.

 

The percent increase in Industrial Controls sales (22%) was greater than the percent increase in Aircraft Engine Systems sales (8%). However, Industrial Controls’ average margins are not as high as those of Aircraft Engine Systems. As a result, the resulting change in segment sales mix increased cost of goods sold in the analysis presented above.

 

Among the other factors affecting cost of goods sold were the favorable operating leverage effect of the increased sales versus the fixed cost components of cost of goods sold, sales mix within each segment, and changes in material costs.

 

Selling, general, and administrative expenses increased 13% in 2005 as compared to 2004, attributable to the following (in millions):

 

 

Variable compensation paid to members in selling and administrative functions was higher in 2005 than in 2004, driven by performance-based factors, including consolidated financial results.

 

In 2005, we incurred significant expense in assessing our internal control over financial reporting, as required by the Sarbanes-Oxley Act of 2002. We also incurred higher external audit fees associated with the expanded audit scope required by the Act.

Among the other factors affecting selling, general, and administrative expenses are normal variations in legal and other professional services and gains and losses related to transactions denominated in foreign currencies.

 

Research and development costs increased 25% in 2005 over 2004 attributable to the following (in millions):

 

 

We increased development activities in Industrial Controls, most notably in combustion sensing technologies and in product development for the turbine auxiliary market. Turbine auxiliary applications offer multiple opportunities to leverage our existing hydraulic and electric actuation and valve technologies for off-engine applications. We also work closely with our customers early in their own development and design stages, helping them by developing components and integrated systems that allow them to meet emissions requirements, increase fuel efficiency, and lower their costs.

 

Aircraft Engine Systems’ development activities also increased, driven by new aircraft gas turbine programs for both commercial and military aircraft. Most significantly, we are developing components and an integrated fuel system for the new GEnx turbofan engine for the Boeing 787, Airbus A350, and Boeing 747 Advanced. We are also developing components for the GE Rolls-Royce F136 engine that is one of two propulsion choices to power Lockheed’s Joint Strike Fighter aircraft, and for the T700-GE-701D engine that will be used to upgrade the Sikorsky Black Hawk and Boeing Apache helicopters, among others.

 

Variable compensation paid to members that performed research and development activities was higher in 2005 than in 2004, driven by performance-based factors, including consolidated financial results.

 

Curtailment gain relates to an amount recognized in 2005 for the immediate effects of amendments to one of our retirement healthcare benefit plans. The amendment eliminated retirement healthcare benefits for members that will not attain age 55 and 10 years of service by January 1, 2006.

 

Interest and other income increased in 2005 over 2004 primarily as a result of the sale of rights to our aircraft propeller synchronizer products to an unrelated third party, which resulted in a pre-tax gain of $3.8 million. In addition, our interest income increased in 2005 over 2004 as a result of higher cash balances.

 

Sales associated with the aircraft propeller synchronizer products totaled approximately $2 million annually at the time we sold rights to the products to a third party.

 

Stock-Based Compensation

 

We adopted a new accounting standard for stock-based compensation beginning October 1, 2005 — Statement of Financial Accounting Standards No. 123R, “Share-Based Payment.” This standard requires us to measure employee compensation made in the form of stock-based instruments at the grant-date fair value of the stock-based award and to recognize the compensation over the requisite service period. Upon adoption, we used the modified prospective application transition method, under which prior periods are not restated in the financial statements.

 

Prior to October 1, 2005, we used the intrinsic value method to account for stock-based employee compensation under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and therefore we did not recognize compensation expense in association with options granted at or above the market price of our common stock at the date of grant.

 

The effect of adopting the new accounting standard on 2006 earnings was that earnings before income taxes were reduced by $2.9 million and net earnings were reduced by $1.8 million, or $0.05 per basic share and $0.05 per diluted share. Stock compensation is accounted for as a nonsegment expense. We expect stock compensation expense in 2007 to be at levels similar to the amount recognized in 2006, although actual amounts will depend upon a number of factors, including our common stock price at the date of grant.

 

If we had applied the provisions of the new accounting standard last year, our earnings before income taxes for 2005 would have been reduced by $2.4 million and our net earnings would have been reduced by $1.5 million, or $0.05 per basic share and $0.04 per diluted share.

Adoption of the new accounting standards also affected our presentation of cash flows. The change is related to tax benefits associated with tax deductions that exceed the amount of compensation expense recognized in financial statements. For 2006, cash flows from operating activities was reduced by $3.3 million and cash flow from financing activities was increased by $3.3 million from amounts that would have been reported prior to the accounting change.

 

At September 30, 2006, the amount of stock compensation expense that has not yet been recognized totaled $4.7 million. This amount is related to stock options that have been granted but have not yet vested.

 

Workforce Management Actions

 

 

The workforce management actions reflected in the preceding table, all of which are associated with Industrial Controls, are primarily related to the consolidation of manufacturing operations in The Netherlands and United Kingdom with existing operations in the United States and Germany. The actions also involve the consolidation of a small manufacturing operation in Japan with an existing operation in China and sales force reductions in The Netherlands. These actions were taken to streamline the organization by eliminating redundant manufacturing operations and to adjust the sales force in response to market shifts from Europe to Asia and North America. The actions were completed in March 2006. In total, approximately 250 positions were eliminated from the three locations.

 

Principally in 2004, we expensed a total of $15.9 million for these actions, which includes $12.0 million for member termination benefits under ongoing termination benefit plans, $2.1 million of contractual pension termination benefits, and $1.8 million for other costs primarily associated with moving equipment and inventory to other locations. With the exception of the contractual pension termination benefits, all expenses were cash expenses that were paid from available cash balances without the need for incremental borrowings.

 

In 2004, our expense for these actions totaled $13.8 million, which primarily consisted of member termination benefits related to ongoing termination benefit plans for member service through September 30, 2004. In addition, we expensed contractual pension termination benefits resulting from the retirement pension benefit plan provisions that provided early retirement benefits for certain plan participants in the event of a workforce management action.

 

Our expenses for these actions were $1.7 million in 2005 and $0.4 million in 2006, equal to the total amounts reflected in the preceding table. The expenses included member termination benefits that reflected amounts earned by members during their service periods in 2005 and 2006, additional contractual pension termination benefits for eligible participants, other costs primarily associated with moving equipment and inventory to other locations, and adjustments of amounts previously accrued for these actions. The accrual adjustments were made as a result of changes in estimates for termination benefits payable because of voluntary member resignations, the transfer of members to a third-party distributor, and more members electing early retirement options.

 

Although it is difficult to precisely estimate the savings that are uniquely related to these actions, we believe that current annual expense levels are $9.0 million to $11.0 million lower than they would have been prior to the actions. The lower expenses are primarily related to reductions in personnel costs, although savings in travel and other costs associated with the reduced headcount have also been realized. Of the total savings, approximately 90% affects cost of goods sold and 10% selling, general, and administrative expenses.

 

For 2004, the preceding table also reflects amounts related to previous actions of Industrial Controls, the most significant of which is a reduction in accrued member termination benefits of $0.7 million. This accrual reduction was a direct result of decisions to discontinue the remaining actions from the previous year given the newly-formed consolidation plans.

Earnings

 

 

2006 Compared to 2005

 

Industrial Controls’ segment earnings increased 93% in 2006 as compared to 2005, attributable to the following (in millions):

 

 

Selling price increases were made primarily to offset certain material cost increases, which were related to price fluctuations of commodities from which mechanical, electronic, or electromagnetic components are produced. Typically, selling price increases lag material cost increases for some period of time, which varies depending upon individual circumstances.

 

Industrial Controls’ earnings benefited from the effects of the European consolidation that we completed in March 2006. A more detailed discussion of the European consolidation is included under workforce management actions in a previous section of this discussion and analysis.

 

Variable compensation paid to Industrial Controls’ members was lower in 2006 than in 2005, driven by performance-based factors.

 

Industrial Controls’ research and development cost increases were discussed previously as part of costs and expenses.

 

Industrial Controls incurred costs related to workforce management actions that totaled $1.7 million in 2005.

 

Aircraft Engine Systems’ segment earnings in 2006 were about the same as in 2005, attributable to the following (in millions):

 

The effect of the increase in sales volume on Aircraft Engine Systems’ segment earnings was measured as if gross margins had increased in direct proportion to the sales volume increase without other changes. However, there are many factors that affected segment earnings other than volume, the most important of which are discussed in the paragraphs that follow.

 

Aircraft Engine Systems’ research and development cost increases were discussed previously as part of costs and expenses.

 

Aircraft Engine Systems sold the rights to its propeller synchronizer products to an unrelated third party in 2005, which resulted in a pre-tax gain of $3.8 million that year.

 

Variable compensation paid to Aircraft Engine Systems’ members was lower in 2006 than in 2005, driven by performance-based factors.

 

Nonsegment expenses increased 82% in 2006 as compared to 2005, attributable to the following (in millions):

 

 

We accrue for individual matters that we believe are likely to result in a loss when ultimately resolved using estimates of the most likely amount of loss, including accruals totaling $8.5 million in 2006. More information about contingencies is included under “Commitments and Contingencies” below.

 

At the beginning of 2006, we began to account for stock-based compensation using the fair value method of accounting as required under a new accounting standard. We used the intrinsic value method in previous years, under which we did not recognize compensation expense in association with options granted at or above the market price of our common stock at the date of grant. More information about the effect of this accounting change is included under “Stock-Based Compensation” above.

 

Among the other factors affecting nonsegment expenses are normal variations in legal and other professional services.

 

Curtailment gain was discussed previously as part of costs and expenses.

 

Income taxes were provided at an effective rate on earnings before income taxes of 17.3% in 2006 compared to 29.2% in 2005. The change in the effective tax rate was attributable to the following (as a percent of earnings before income taxes):

 

 

The 2006 change in the beginning-of-year valuation allowances reduced income tax expense by $13.7 million. Exclusive of this item, the effective tax rate for 2006 was 33.5%. We establish valuation allowances to reflect the estimated amount of deferred tax assets that might not be realized. Both positive and negative evidence are considered in forming our judgment as to whether a valuation allowance is appropriate, and more weight is given to evidence that can be objectively verified. Valuation allowances are reassessed whenever there are changes in circumstances that may cause a change in our judgments. In 2006, additional objective evidence became available regarding earnings in tax jurisdictions that have unexpired net operating loss carryforwards that affected our judgment about the valuation allowance.

 

Income taxes for both 2006 and 2005 were affected by changes in estimates of income taxes for previous years. In 2006, the changes were primarily related to the favorable resolution of certain tax matters. These changes reduced the effective tax rate for 2006 by approximately 1.3% of pretax earnings. In 2005, the changes in estimates were related to increases in the amount of certain credits claimed and changes in the amount of certain deductions

taken as compared to prior estimates. These changes reduced reported income taxes by $1.9 million in 2005, or approximately 2.5% of pretax earnings.

 

The effective tax rate comparison between 2006 and 2005 was affected by the expiration of the tax credit for increasing research activities, which expired on December 31, 2005.

 

Among the other changes in our effective tax rate were the effects of changes in the amounts of extraterritorial income exclusion and the effects of changes in the relative mix of earnings by tax jurisdiction, which affects the comparison of foreign and state income tax rates relative to the United States federal statutory rate.

 

2005 Compared to 2004

 

Industrial Controls’ segment earnings were $29 million in 2005 compared to $6 million in 2004. The change was attributable to the following (in millions):

 

 

The effect of the increase in sales volume on Industrial Controls’ segment earnings was measured as if gross margins (external net sales less external cost of goods sold) had increased in direct proportion to the sales volume increase without other changes. However, there are many factors that affected segment earnings other than volume, the most important of which are discussed in the paragraphs that follow.

 

Industrial Controls incurred costs related to workforce management actions that totaled $1.7 million in 2005 and $12.9 million in 2004, netting to a decrease of $11.2 million.

 

Variable compensation paid to Industrial Controls’ members was higher in 2005 than in 2004, driven by performance-based factors, including consolidated financial results.

 

Industrial Controls’ research and development cost increases were discussed previously as part of costs and expenses.

 

Among other factors affecting the comparison of Industrial Controls’ segment earnings between 2005 and 2004 were the favorable operating leverage effect of the increased sales versus the fixed cost components of cost of goods sold and other fixed expenses, sales mix, changes in material costs, normal variations in legal services, and losses related to transactions denominated in foreign currencies.

 

Aircraft Engine Systems’ segment earnings increased 8% in 2005 as compared to 2004, attributable to the following (in millions):

 

 

The effect of the increase in sales volume on Aircraft Engine Systems’ segment earnings was measured as if gross margins had increased in direct proportion to the sales volume increase without other changes. However, there are many factors that affected segment earnings other than volume, the most important of which are discussed in the paragraphs that follow.

 

Aircraft Engine Systems sold the rights to its propeller synchronizer products to an unrelated third party in 2005, which resulted in a pre-tax gain of $3.8 million.

 

Variable compensation paid to Aircraft Engine Systems’ members was higher in 2005 than in 2004, driven by performance-based factors, including consolidated financial results.

Aircraft Engine Systems’ research and development cost increases were discussed previously as part of costs and expenses.

 

Among other factors affecting the comparison of Aircraft Engine Systems’ segment earnings between 2005 and 2004 were the favorable operating leverage effect of the increased sales versus the fixed cost components of cost of goods sold and other fixed expenses.

 

Nonsegment expenses increased 48% in 2005 as compared to 2004, attributable to the following (in millions):

 

 

In 2005, we incurred significant expense in assessing our internal control over financial reporting, as required by the Sarbanes-Oxley Act of 2002. We also incurred higher external audit fees associated with the expanded audit scope required by the Act.

 

Variable compensation paid to corporate members was higher in 2005 than in 2004, driven by performance-based factors, including consolidated financial results.

 

Among the other factors affecting nonsegment expenses were normal variations in legal and other professional services.

 

Curtailment gain was discussed previously as part of costs and expenses.

 

Income taxes were provided at an effective rate on earnings before income taxes of 29.2% in 2005 compared to 36.3% in 2004. The change in the effective tax rate was attributable to the following (as a percent of earnings before income taxes):

 

 

Income taxes for 2005 were affected by changes in estimates of income taxes for previous years, which resulted from increases in the amounts of certain credits claimed and changes in the amounts of certain deductions taken. These changes reduced reported income taxes by $1.9 million, or 2.5% of earnings before income taxes.

 

The effects of foreign losses on income taxes increased our effective tax rate by 0.1% in 2005 compared to 2.1% in 2004. Foreign losses affect income taxes in situations in which we are unable to use the losses to offset earnings in particular tax jurisdictions, resulting in net operating loss carryforwards. In both years, we recorded a valuation allowance to reflect the estimated amount of deferred tax assets that may not be realized due to foreign net operating loss carryforwards.

 

The federal tax credit for 2005 for increasing research activities reduced our effective tax rate by 1.7% compared to 2004. The credit was based on the level of current year research costs relative to gross receipts and research costs in certain prior periods.

 

Among the other changes in our effective tax rate were the effects of changes in the relative mix of earnings by tax jurisdiction, which affected the comparison of foreign and state income tax rates relative to the United States federal statutory rate.

 

Subsequent Event

 

On October 31, 2006, we acquired 100 percent of the stock of SEG Schaltanlagen-Elektronik-Geräte GmbH & Co. KG (SEG) and a related receivable from SEG that was held by one of the sellers. Headquartered in Kempen, Germany, SEG is focused on the design and manufacture of a wide range of protection and comprehensive control systems for power generation and distribution applications, power inverters for wind turbines, and complete electrical systems for gas and diesel engine based power stations. The cost of this acquisition has not yet been

finalized, but is currently expected to be approximately $45 million, including the amount of outstanding borrowings assumed. The actual cost of the acquisition may be higher or lower than our current estimate based on the outcome of a purchase price adjustment procedure customary to purchase agreements and the final determination of the direct acquisition costs. SEG had sales of approximately $60 million in the year ended December 31, 2005. SEG will be part of the Industrial Controls segment, and we currently expect the acquisition to be accretive to earnings in 2007.

 

Outlook

 

Aerospace markets are on an upswing, and we currently anticipate Aircraft Engine Systems’ sales will increase 10-12% in 2007. These increases are expected for both OEM and aftermarket sales, with slightly more growth among OEMs. In relation to sales, our segment earnings are expected to remain relatively stable with 2006, between 20-22% of sales.

 

We expect more modest market growth in the industrial markets served by Industrial Controls. However, the business acquisition completed in October 2006 will allow Industrial Controls’ sales to exceed anticipated market growth rates. With the effects of the acquisition, we currently believe Industrial Controls’ sales will grow 13-16% in 2007. Segment earnings are expected to be between 10-12% of sales.

 

Overall, we anticipate company-wide sales growth of 12-15% and earnings of $2.05 to $2.15 per share in fiscal 2007, including the effects of the acquisition just completed.

 

FINANCIAL CONDITION

 

Assets

 

 

Industrial Controls’ segment assets at September 30, 2006, decreased over the prior year primarily as a result of lower levels of inventories and normal amortization of intangible assets.

 

Aircraft Engine Systems’ segment assets at September 30, 2006, increased over the prior year as a result of higher levels of business activity in 2006 and 2005, which resulted in higher accounts receivable and inventories. In addition, capital expenditures increased in 2006 to a level that exceeded depreciation expense, resulting in higher property, plant, and equipment.

 

Unallocated assets at September 30, 2006, increased over the prior year primarily because of changes in valuation allowances for deferred tax assets.

 

Other Balance Sheet Measures

 

 

Working capital (total current assets less total current liabilities) at September 30, 2006, increased over the prior year primarily as a result of increases in accounts receivable and a decrease in short-term borrowings.

 

Long-term debt, less current portion at September 30, 2006, decreased from the prior year to reflect the amount of long-term debt paid in 2006. The current portion of long-term debt remained approximately the same.

We currently have a revolving line of credit facility with a syndicate of U.S. banks totaling $100 million, with an option to increase the amount of the line to $175 million if we choose. The line of credit facility expires on March 11, 2010. In addition, we have other line of credit facilities, which totaled $17.7 million at September 30, 2006, that are generally reviewed annually for renewal. The total amount of borrowings under all facilities was $0.5 million at September 30, 2006. The weighted-average interest rate for outstanding borrowings under these line of credit facilities, which were in Japan at rates significantly lower than those typical in the United States, was 0.5% at September 30, 2006.

 

Provisions of debt agreements include covenants customary to such agreements that require us to maintain specified minimum or maximum financial measures and place limitations on various investing and financing activities. The agreements also permit the lenders to accelerate repayment requirements in the event of a material adverse event. Our most restrictive covenants require us to maintain a minimum consolidated net worth, a maximum consolidated debt to consolidated operating cash flow, and a maximum consolidated debt to EBITDA, as defined in the agreements. We were in compliance with all covenants at September 30, 2006.

 

Commitments and contingencies at September 30, 2006, include various matters arising from the normal course of business. We are currently involved in pending or threatened litigation or other legal proceedings regarding employment, product liability, and contractual matters arising from the normal course of business. We accrued for individual matters that we believe are likely to result in a loss when ultimately resolved using estimates of the most likely amount of loss, including accruals totaling $8.5 million that were recorded in 2006. There are also individual matters that we believe the likelihood of a loss when ultimately resolved is less than likely but more than remote, which were not accrued. While it is possible that there could be additional losses that have not been accrued, we currently believe the possible additional loss in the event of an unfavorable resolution of each matter is less than $10 million in the aggregate.

 

Among the legal proceedings referred to in the preceding paragraph, we were a defendant in a class action lawsuit filed in the U.S. District Court for Northern District of Illinois and received findings of the U.S. Equal Employment Opportunity Commission that alleged discrimination on the basis of race, national origin, and gender in our Winnebago County, Illinois, facilities. On October 5, 2006, a U.S. District Court Judge gave preliminary approval to a proposed $5 million settlement of the class action and EEOC matters. Accruals for the amount of the settlement and related legal expenses are included in our consolidated balance sheet at September 30, 2006.

 

We file income tax returns in various jurisdictions worldwide, which are subject to audit. We have accrued for our estimate of the most likely amount of expense that we believe may result from income tax audit adjustments.

 

We do not recognize contingencies that might result in a gain until such contingencies are resolved and the related amounts are realized.

 

In the event of a change in control of the company, we may be required to pay termination benefits to certain executive officers.

 

Shareholders’ equity at September 30, 2006, increased 11% over the prior year. Increases due to net earnings, sales of treasury stock, tax benefits applicable to stock options, and stock-based compensation were partially offset by purchases of treasury stock and dividend payments.

 

On January 26, 2005, the Board of Directors authorized the repurchase of up to $30 million of our outstanding shares of common stock on the open market and private transactions over a three-year period. This authorization was terminated on July 25, 2006, concurrent with the approval of a new stock repurchase authorization.

 

On July 25, 2006, the Board of Directors authorized the repurchase of up to $50 million of our outstanding shares of common stock on the open market and private transactions over a three-year period that will end on July 25, 2009.

In 2006, we purchased $21.5 million of our common stock under these authorizations as follows:

 

 

A three-for-one stock split was approved by shareholders at the 2005 annual meeting of shareholders on January 25, 2006. This stock split became effective for shareholders at the close of business on February 1, 2006. The effects of the stock split are reflected in the financial statements filed as part of this Form 10-K. In addition, in accordance with stock option plan provisions, the terms of all outstanding stock option awards were proportionally adjusted.

 

Contractual Obligations

 

 

The preceding table reflects contractual obligations at September 30, 2006, but excludes future interest payments associated with long-term debt and our retirement pension and retirement healthcare obligations. Our contributions to retirement pension benefit plans totaled $3.3 million in 2006 and $1.8 million in 2005, and we currently expect our contributions for 2007 will total approximately $3.0 million. Pension contributions in future years will vary as a result of a number of factors, including actual plan asset returns and interest rates.

 

Our contributions to retirement healthcare benefit plans totaled $3.0 million in 2006 and $2.4 million in 2005, and we currently estimate our contributions for 2007 will total approximately $3.4 million, less the amount of federal subsidies associated with our prescription drug benefits that we receive. Retirement healthcare contributions are made on a “pay-as-you-go” basis as payments are made to healthcare providers, and such contributions will vary as a result of changes in the future cost of healthcare benefits provided for covered retirees.

 

More information about our retirement benefit obligations is included in the notes to the consolidated financial statements in “Item 8 — Financial Statements and Supplementary Data.”

 

We enter into purchase obligations with suppliers in the normal course of business, on a short-term basis.

 

Cash Flows

 

 

2006 Compared to 2005

 

Net cash flows provided by operating activities increased 16% in 2006 over 2005. Cash receipts from customers and cash payments to suppliers and employees increased proportionately with the overall increase in sales. As a result, net cash flows were higher in 2006 than in 2005 because of the operating earnings generated on sales. In addition, income tax payments for 2006 were lower than 2005.

 

Net cash flows used in investing activities increased by $8.1 million in 2006 as compared to 2005. This reflected an increase in capital expenditures of $5.1 million and a decrease in proceeds from the sales of property, plant, and equipment. Aircraft Engine Systems accounted for most of the increase in capital expenditures, which related to equipment and facility upgrades. Proceeds from the sale of property, plant, and equipment were higher in 2005 than in 2006 because of sales related to the consolidation of our European facilities.

Net cash flows used in financing activities increased by $40.9 million in 2006 as compared to 2005. Net payments of borrowings were $22.5 million in 2006, compared to net proceeds from borrowings of $2.0 million in 2005. In addition, we increased the amount of cash used for the purchase of our common stock by $15.0 million in 2006 over 2005 and increased cash dividends by $1.9 million.

 

Our 2005 and 2006 purchases of common stock were primarily made in connection with authorizations by the Board of Directors made in January 26, 2005, and July 25, 2006. The Board terminated the 2005 authorization concurrent with their approval of the 2006 authorization. The 2006 authorization provides for the repurchase of up to $50 million of our common stock on the open market and private transactions over a three-year period. Approximately $43 million remains available for repurchase under the authorization at September 30, 2006.

 

2005 Compared to 2004

 

Net cash flows provided by operating activities decreased 19% in 2005 from 2004. Both operating cash receipts and disbursements increased in 2005 over 2004 due to higher sales volume. However, cash paid to employees and suppliers increased at a greater rate than cash collected from customers, reflecting normal variations in collection and payment patterns. In addition, income tax payments increased in 2005 over 2004, resulting in an income tax receivable position at September 30, 2005, compared to a payable position at September 30, 2004.

 

Net cash flows used in investing activities increased by $2.6 million in 2005 as compared to 2004. This reflected an increase in capital expenditures of $7.9 million, which was partially offset by the effects of changes in proceeds from the sale of property, plant, and equipment, and net payments associated with business acquisitions that were made in 2004.

 

Net cash flows used in financing activities decreased by $29.5 million between 2005 and 2004, primarily as a result of changes in borrowings. Net proceeds from borrowings totaled $2.0 million in 2005 compared to net payments of borrowings of $30.4 million in 2004. In addition, both proceeds from the sale of treasury stock, which were related to the exercise of stock options, and purchases of treasury stock were higher in 2005 than in 2004. The effect of these treasury stock transactions on cash flows resulted in net use of cash of $0.6 million in 2005 and a net source of cash of $1.3 million in 2004. Our dividend payments also increased by $1.0 million in 2005 over 2004 as a result of increases in our quarterly dividend rate.

 

The 2005 treasury stock purchases were made in connection with a Board authorization that expired in July 2006. The 2004 treasury stock purchases were made in connection with a Board authorization that expired in November 2004.

 

Outlook

 

Future cash flows from operations and available revolving lines of credit are expected to be adequate to meet our cash requirements over the next twelve months.

 

Payments of our $64 million of senior notes are due over the 2007 — 2012 timeframe. Also, we have a $100 million line of credit facility that includes an option to increase the amount of the line up to $175 million that does not expire until March 11, 2010. Also, the acquisition completed on October 31, 2006, as discussed under “Subsequent Events” above, was paid from available cash balances. Despite these factors, it is possible business acquisitions could be made in the future that would require amendments to existing debt agreements and the need to obtain additional financing.

 

Recent Accounting Pronouncements

 

A discussion of recent accounting pronouncements is included in the Notes to the Consolidated Financial Statements in “Item 8 — Financial Statements and Supplementary Data.”

 

Disclosures about market risk are included in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Market Risks.”

 

 

 

See accompanying Notes to Consolidated Financial Statements.

 

 

See accompanying Notes to Consolidated Financial Statements.