Woodward (WWD) 10-Q 2006 Q3 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2006

OR

o 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 0-8408

WOODWARD GOVERNOR COMPANY

(Exact name of registrant as specified in its charter)

Delaware	36-1984010
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

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

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

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yesþ Noo

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

Large accelerated filero       Accelerated filerþ       Non-accelerated filero

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yeso Noþ

     As of July 21, 2006, 34,206,737 shares of common stock with a par value of $.002917 cents per share were outstanding.

TABLE OF CONTENTS

	Page
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements		1
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		21
Item 3. Quantitative and Qualitative Disclosures About Market Risk		35
Item 4. Controls and Procedures		36
PART II – OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		37
Item 6. Exhibits		38
SIGNATURES		39
Restated Certificate of Incorporation
Certifications of Thomas A. Gendron
Certifications of Robert F. Weber, Jr.
Section 1350 Certifications

PART I — FINANCIAL INFORMATION

Item 1.Financial Statements

Consolidated Statements of Earnings WOODWARD

	(Unaudited)
	Three months
	ended June 30,
(In thousands except per share amounts)	2006			2005
Net sales	$	217,053		$	210,252
Costs and expenses:
Cost of goods sold		154,089			158,867
Selling, general, and administrative expenses		23,234			19,427
Research and development costs		16,793			12,811
Amortization of intangible assets		1,717			1,770
Curtailment gain		—			(7,825	)
Interest expense		1,299			1,461
Interest income		(754	)		(478	)
Other income		(1,072	)		(1,947	)
Other expense		168			678
Total costs and expenses		195,474			184,764
Earnings before income taxes		21,579			25,488
Income taxes		(7,339	)		5,742
Net earnings	$	28,918		$	19,746
Earnings per share:
Basic	$	0.84		$	0.58
Diluted		0.82			0.56
Weighted-average number of shares outstanding:
Basic		34,410			34,269
Diluted		35,254			35,190
Cash dividends per share	$	0.10		$	0.08

See accompanying Notes to Consolidated Financial Statements.

1

Consolidated Statements of Earnings WOODWARD

	(Unaudited)
	Nine months
	ended June 30,
(In thousands except per share amounts)	2006			2005
Net sales	$	621,604		$	610,196
Costs and expenses:
Cost of goods sold		448,055			459,660
Selling, general, and administrative expenses		69,548			57,683
Research and development costs		41,772			35,106
Amortization of intangible assets		5,230			5,326
Curtailment gain		—			(7,825	)
Interest expense		3,901			4,355
Interest income		(1,995	)		(1,515	)
Other income		(3,263	)		(8,318	)
Other expense		481			906
Total costs and expenses		563,729			545,378
Earnings before income taxes		57,875			64,818
Income taxes		5,064			20,098
Net earnings	$	52,811		$	44,720
Earnings per share:
Basic	$	1.53		$	1.31
Diluted		1.50			1.28
Weighted-average number of shares outstanding:
Basic		34,421			34,140
Diluted		35,268			35,058
Cash dividends per share	$	0.30		$	0.24

See accompanying Notes to Consolidated Financial Statements.

2

Consolidated Balance Sheets WOODWARD

	(Unaudited)
	At June		At September
(In thousands except per share amounts)	30, 2006		30, 2005
Assets
Current assets:
Cash and cash equivalents	$	66,938	$	84,597
Accounts receivable, less allowance for losses of $2,430 for June and $1,965 for September		109,930		107,403
Inventories		157,623		149,336
Income taxes receivable		2,897		5,330
Deferred income taxes		21,261		18,700
Other current assets		5,230		4,207
Total current assets		363,879		369,573
Property, plant, and equipment — net		117,066		114,787
Goodwill		131,748		131,035
Other intangibles — net		73,427		78,564
Deferred income taxes		12,469		2,310
Other assets		8,657		9,197
Total assets	$	707,246	$	705,466

Consolidated balance sheets continued on next page.

3

Consolidated Balance Sheets — Continued WOODWARD

	(Unaudited)
	At June		At September
(In thousands except per share amounts)	30, 2006		30, 2005
Liabilities and shareholders’ equity
Current liabilities:
Short-term borrowings	$	—	$	8,419
Current portion of long-term debt		14,590		14,426
Accounts payable		36,705		37,015
Accrued liabilities		57,672		68,647
Total current liabilities		108,967		128,507
Long-term debt, less current portion		59,402		72,942
Other liabilities		69,595		71,548
Commitments and contingencies
Shareholders’ equity represented by:
Preferred stock, par value $0.003 per share, authorized 10,000 shares, no shares issued		—		—
Common stock, par value $0.002917 per share, authorized 100,000 shares, issued 36,480 shares		106		106
Additional paid-in capital		30,536		25,854
Accumulated other comprehensive earnings		12,589		10,904
Deferred compensation		5,490		5,402
Retained earnings		467,736		425,568
		516,457		467,834
Less: Treasury stock, at cost, 2,288 shares for June and 2,154 shares for September		41,685		29,963
Treasury stock held for deferred compensation, at cost, 415 shares for June and September		5,490		5,402
Total shareholders’ equity		469,282		432,469
Total liabilities and shareholders’ equity	$	707,246	$	705,466

See accompanying Notes to Consolidated Financial Statements.

4

Consolidated Statements of Cash Flows WOODWARD

	(Unaudited)
	Nine months
	ended June 30,
(In thousands)	2006			2005
Cash flows from operating activities:
Net earnings	$	52,811		$	44,720
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization		22,340			24,286
Curtailment gain		—			(7,825	)
Net gain on sale of property, plant, and equipment		(186	)		(595	)
Stock compensation expense		2,253			—
Excess tax benefits from stock compensation		(2,547	)		—
Deferred income taxes		(13,364	)		3,322
Reclassification of unrealized losses on derivatives to earnings		214			240
Changes in operating assets and liabilities:
Accounts receivable		(1,860	)		3,894
Inventories		(7,559	)		(16,718	)
Accounts payable and accrued liabilities		(14,874	)		(5,717	)
Income taxes payable		7,026			(7,786	)
Other — net		(1,189	)		7,792
Total adjustments		(9,746	)		893
Net cash provided by operating activities		43,065			45,613
Cash flows from investing activities:
Payments for purchase of property, plant, and equipment		(19,661	)		(16,325	)
Proceeds from sale of property, plant, and equipment		695			3,246
Net cash used in investing activities		(18,966	)		(13,079	)
Cash flows from financing activities:
Cash dividends paid		(10,643	)		(8,419	)
Proceeds from sales of treasury stock		3,287			5,633
Purchases of treasury stock		(15,370	)		(3,791	)
Excess tax benefits from stock compensation		2,547			—
Net borrowings (payments) from borrowings under revolving lines		(8,475	)		609
Payments of long-term debt		(13,535	)		—
Net cash used in financing activities		(42,189	)		(5,968	)
Effect of exchange rate changes on cash		431			(790	)
Net change in cash and cash equivalents		(17,659	)		25,776
Cash and cash equivalents, beginning of year		84,597			48,895
Cash and cash equivalents, end of period	$	66,938		$	74,671
Supplemental cash flow information:
Interest paid	$	5,208		$	5,411
Income taxes paid		12,648			22,122

See accompanying Notes to Consolidated Financial Statements.

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Notes to Consolidated Financial Statements

(1) Overview:

The consolidated balance sheet as of June 30, 2006, the consolidated statements of earnings for the three and nine-month periods ended June 30, 2006 and 2005, and the consolidated statements of cash flows for the nine-month periods ended June 30, 2006 and 2005, were prepared by the company without audit. The September 30, 2005, consolidated balance sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. Information in this Form 10-Q report is based in part on estimates and is subject to year-end adjustments and audit. In our opinion, we have made all adjustments necessary to present fairly the company’s financial position as of June 30, 2006, the results of its operations for the three and nine-month periods ended June 30, 2006 and 2005, and its cash flows for the nine-month periods ended June 30, 2006 and 2005. All such adjustments were of a normal and recurring nature. The statements were prepared following the accounting policies described in the company’s 2005 annual report on Form 10-K and should be read with the notes to consolidated financial statements in the annual report. The consolidated statements of earnings for the three and nine-month periods ended June 30, 2006, are not necessarily indicative of the results to be expected for other interim periods or for the full year.

A three-for-one stock split was approved by shareholders at the 2005 annual meeting of shareholders on January 25, 2006. The stock split became effective for shareholders at the close of business on February 1, 2006. The number of shares and per share amounts reported in these consolidated financial statements have been updated from amounts reported prior to February 1, 2006, to reflect the effects of the split. In addition, in accordance with stock option plan provisions, the terms of all outstanding stock option awards were proportionally adjusted.

(2) Stock-based compensation:

We have granted stock options to key management members and directors of the company. These options are generally granted with an exercise price equal to the market price of our stock at the date of grant, a four year graded vesting schedule, and a term of ten years. Vesting would be accelerated in the event of retirement, disability, or death of a participant, or change in control of the company.

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Notes to Consolidated Financial Statements (Continued)

Provisions governing our stock option grants are included in the 2006 Omnibus Incentive Plan and the 2002 Stock Option Plan. The 2006 Plan was approved by shareholders and became effective on January 25, 2006. No grants were issued in January 2006, and no further grants will be made under the 2002 Plan. The 2006 Plan made 3,705,000 shares available for grants made on or after January 25, 2006, to members and directors of the company, subject to annual award limits as specified in the Plan.

We adopted the provisions of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment”, beginning October 1, 2005, using the modified prospective transition method. This statement requires us to measure the cost of employee services in exchange for an award of equity instruments based on the grant-date fair value of the award and to recognize cost over the requisite service period. Under the modified prospective transition method, financial statements for periods prior to the date of adoption are not adjusted for the change in accounting.

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.

As a result of adopting the new standard, earnings before income taxes for the three months ended June 30, 2006, decreased by $680,000, and net earnings decreased by $422,000, or $0.01 per basic share and $0.01 per diluted share. These results reflect stock compensation expense of $680,000 and tax benefits of $258,000 for the period. Earnings before income taxes for the nine months ended June 30, 2006, decreased by $2,253,000, and net earnings decreased by $1,397,000, or $0.04 per basic share and $0.04 per diluted share. These results reflect stock compensation expense of $2,253,000 and tax benefits of $856,000 for the period.

Adoption of the new standard also affected our consolidated statements 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 the nine months ended June 30, 2006, cash flow from operating activities was reduced by $2,547,000 and cash flow from financing activities was increased by $2,547,000 from amounts that would have been reported if we had not adopted the new accounting standard.

Concurrent with our adoption of the new statement, we began to use the non-substantive vesting period approach for attributing stock compensation to individual periods. The nominal vesting period approach was used in determining the stock compensation

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Notes to Consolidated Financial Statements (Continued)

expense for our pro forma net earnings disclosure for the three and nine months ended June 30, 2005, presented in a table that follows. The change in the attribution method will not affect the ultimate amount of stock compensation expense recognized, but it has accelerated the recognition of such expense for non-substantive vesting conditions, such as retirement eligibility provisions. Under both approaches, we elected to recognize stock compensation on a straight-line basis for options with graded vesting schedules. As a result of the change in attribution method, earnings before income taxes for the three months ended June 30, 2006, were increased by approximately $4,000, and net earnings were increased by $3,000, which had no effect on basic and diluted earnings per share. Earnings before income taxes for the nine months ended June 30, 2006 were reduced by approximately $264,000, and net earnings were reduced by $164,000, or $0.01 per basic share and no effect per diluted share.

The following table presents a reconciliation of reported net earnings and per share information to pro forma net earnings and per share information that would have been reported if the fair value method had been used to account for stock-based employee compensation last year:

	Three months			Nine months
(In thousands except per	ended June			ended June
share amounts)	30, 2005			30, 2005
Reported net earnings	$	19,746		$	44,720
Stock-based compensation expense using the fair value method, net of income tax		(377	)		(1,080	)
Pro forma net earnings	$	19,369		$	43,640
Reported net earnings per share amounts:
Basic	$	0.58		$	1.31
Diluted		0.56			1.28
Pro forma net earnings per share amounts:
Basic	$	0.57		$	1.28
Diluted		0.55			1.25

The fair value for options granted during the nine months ended June 30, 2006, and the year ended September 30, 2005, was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions by grant year:

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Notes to Consolidated Financial Statements (Continued)

	Nine months ended June		Year ended September
	30, 2006		30, 2005
Expected term	7 years		7 years
Expected volatility:
Range used	37	%	37% – 38	%
Weighted-average	37	%	37.7	%
Expected dividend yield:
Range used	1.73	%	1.65% – 1.73	%
Weighted-average	1.73	%	1.70	%
Risk-free interest rate:
Range used	4.48% – 4.57	%	3.98% – 4.18	%

Historical company information was the primary basis for the selection of the expected term, expected volatility, and expected dividend yield assumptions. The risk-free interest rate was selected based on yields from U.S. Treasury zero-coupon issues with a remaining term equal to the expected term of the options being valued.

Changes in outstanding stock options for the nine months ended June 30, 2006, were as follows:

				Weighted-
				Average
				Exercise
	Number			Price
Balance at September 30, 2005		2,998,869		$	13.96
Options granted		365,400			27.01
Options exercised		(364,576	)		10.38
Options forfeited		(2,250	)		15.62
Balance at June 30, 2006		2,997,443		$	15.99

At June 30, 2006, there was $5,375,000 of unrecognized compensation cost related to nonvested awards, which we expect to recognize over a weighted-average period of 1.4 years.

Information about stock options that are vested or are expected to vest and that are exercisable at June 30, 2006, follows:

				Weighted-
		Weighted-		Average	Aggregate
		Average		Remaining	Intrinsic
		Exercise		Life in	Value
Options	Number	Price		Years	($000’s)
Vested or expected to vest	2,905,862	$	15.75	5.4	$	42,889
Exercisable	2,047,792		12.84	4.0		36,192

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Notes to Consolidated Financial Statements (Continued)

The weighted-average grant-date fair value of options granted was $10.44 for the nine months ended June 30, 2006, and $9.24 for the nine months ended June 30, 2005. Other information for the three and nine-month periods follows:

	Three months ended				Nine months ended
	June 30,				June 30,
(In thousands)	2006		2005		2006		2005
Total fair value of shares vested	$	—	$	—	$	2,547	$	1,960
Total intrinsic value of options exercised		325		3,723		7,055		7,237
Cash received from exercises of stock options		158		2,401		3,270		5,485
Tax benefit realized from exercise of stock options		123		1,354		2,645		2,659

(3) Earnings per share:

	Three months				Nine months
(In thousands, except per share	ended June 30,				ended June 30,
amounts)	2006		2005		2006		2005
Net earnings(A)	$	28,918	$	19,746	$	52,811	$	44,720
Determination of shares:
Weighted-average shares of common stock outstanding (B)		34,410		34,269		34,421		34,140
Assumed exercise of stock options		844		921		847		918
Weighted-average shares of common stock outstanding assuming dilution (C)		35,254		35,190		35,268		35,058
Net earnings:
Basic per share amount (A/B)	$	.84	$	0.58	$	1.53	$	1.31
Diluted per share amount (A/C)		.82		0.56		1.50		1.28

The weighted-average shares of common stock outstanding included the following weighted-average shares held for deferred compensation obligations:

	Three months				Nine months
	ended June 30,				ended June 30,
	2006		2005		2006		2005
Weighted-average shares held for deferred compensation		413,949		400,977		413,720		384,174

The following stock options were outstanding during the three and nine months ended June 30, 2006 and 2005, but were not included

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Notes to Consolidated Financial Statements (Continued)

in the computation of diluted earnings per share because their inclusion would have been anti-dilutive:

	Three months				Nine months
	ended June 30,				ended June 30,
	2006		2005		2006		2005
Options		410,400		—		339,264		306,900

(4) New accounting standard

In June 2006, the Financial Accounting Standards Board issued FASB interpretation No. 48, “Accounting for Uncertainty in Income Taxes.” The Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement of Financial Accounting Standard No. 109, “Accounting for Income Taxes,” and will be effective for our year ending September 30, 2008, although earlier application is encouraged. The Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation also provides guidance on the derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We are currently evaluating the effects this Interpretation will have on our financial statements.

(5) Taxes:

The effective tax rate for the nine months ended June 30, 2006, was 8.7% and the effective tax rate for the year ended September 30, 2005, was 29.2%. The change in the effective tax rate from last year’s full year rate to this year’s nine-month rate was attributable to the following (as a percent of earnings before income taxes):

•	Adjustments of the beginning-of-the-year balance of a valuation allowance for deferred tax assets	(23.7	%)
•	Change in estimates of taxes in the nine months ended June 30, 2006 for previous years	(2.5	%)
•	Change in estimates of taxes in the year ended September 30, 2005 for previous years	2.5	%
•	Expiration of tax credit for increasing research activities (expired on December 31, 2005)	1.3	%
•	Changes in the extraterritorial income exclusion	1.2	%
•	Other changes, net	0.7	%

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

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Notes to Consolidated Financial Statements (Continued)

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 judgments. In the three months ended June 30, 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. As a result, the valuation allowance for deferred tax assets, which had a balance of $17,769,000 at September 30, 2005, was reduced by $13,710,000 at June 30, 2006.

The changes in estimates of income taxes in the nine months ended June 30, 2006, were primarily related to the favorable resolution of certain tax matters during the three-month period ended June 30, 2006.

The changes in estimates of income taxes in the year ended September 30, 2005, were recognized in the three months ended June 30, 2005, and resulted from increases in the amount of certain credits claimed and changes in the amount of certain deductions taken as compared to prior estimates.

(6) Inventories:

	At June		At September
(In thousands)	30, 2006		30, 2005
Raw materials	$	5,226	$	4,876
Component parts		95,847		97,429
Work in process		33,197		28,326
Finished goods		23,353		18,705
	$	157,623	$	149,336

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Notes to Consolidated Financial Statements (Continued)

(7) Property, plant, and equipment:

	At June		At September
(In thousands)	30, 2006		30, 2005
Land	$	9,770	$	9,766
Buildings and equipment		157,354		153,567
Machinery and equipment		248,805		238,550
Construction in progress		2,763		4,905
		418,692		406,788
Less accumulated depreciation		301,626		292,001
Property, plant, and equipment — net	$	117,066	$	114,787

	Three months				Nine months
	ended June 30,				ended June 30,
(In thousands)	2006		2005		2006		2005
Depreciation expense	$	5,871	$	5,794	$	17,110	$	18,960

(8) Goodwill:

(In thousands)
Industrial Controls:
Balance at September 30, 2005	$	68,913
Foreign currency exchange rate changes		713
Balance at June 30, 2006	$	69,626
Aircraft Engine Systems:
Balance at September 30, 2005 and June 30, 2006	$	62,122
Consolidated:
Balance at September 30, 2005	$	131,035
Foreign currency exchange rate changes		713
Balance at June 30, 2006	$	131,748

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Notes to Consolidated Financial Statements (Continued)

(9) Other intangibles — net:

	At June			At September
(In thousands)	30, 2006			30, 2005
Industrial Controls:
Customer relationships:
Amount acquired	$	37,387		$	37,387
Accumulated amortization		(10,764	)		(8,814	)
		26,623			28,573
Other:
Amount acquired		31,491			31,207
Accumulated amortization		(12,505	)		(10,194	)
		18,986			21,013
Total	$	45,609		$	49,586
Aircraft Engine Systems:
Customer relationships:
Amount acquired	$	28,547		$	28,547
Accumulated amortization		(7,692	)		(6,979	)
		20,855			21,568
Other:
Amount acquired		11,785			11,785
Accumulated amortization		(4,822	)		(4,375	)
		6,963			7,410
Total	$	27,818		$	28,978
Consolidated:
Customer relationships:
Amount acquired	$	65,934		$	65,934
Accumulated amortization		(18,456	)		(15,793	)
		47,478			50,141
Other:
Amount acquired		43,276			42,992
Accumulated amortization		(17,327	)		(14,569	)
		25,949			28,423
Total	$	73,427		$	78,564

Amortization expense associated with current intangibles is expected to be approximately $7,000,000 for 2006, $6,600,000 for 2007, $5,800,000 for 2008, $5,500,000 for 2009, and $5,300,000 for 2010.

(10) Accrued liabilities:

	At June 30,		At September 30,
(In thousands)	2006		2005
Salaries and other member benefits	$	22,333	$	40,629
Warranties		5,450		5,692
Contingent legal matters		8,500		—
Taxes, other than on income		3,133		4,828
Other items — net		18,256		17,498
	$	57,672	$	68,647

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Notes to Consolidated Financial Statements (Continued)

Salaries and other member benefits include accrued termination benefits totaling $4,935,000 at September 30, 2005. These accrued termination benefits were in Industrial Controls. Changes in accrued termination benefits for the nine months ended June 30, 2006 were as follows:

(In thousands)
Balance at September 30, 2005	$	4,935
Expense:
Cost of goods sold		69
Selling, general, and administrative expenses		1
Payments and other settlements		(4,916	)
Accrual adjustments		—
Foreign currency exchange rate changes		(89	)
Balance at June 30, 2006	$	—

The amounts expensed during the nine-month period were for termination benefits earned by members over the period and are primarily related to the consolidation of one of the European manufacturing operations with existing operations. This action was taken to streamline the organization by eliminating redundant manufacturing operations and is complete. The total expense for this action was $15,763,000, which included $12,010,000 for termination benefits, $1,800,000 for contractual pension termination benefits, and other costs primarily associated with moving equipment and inventory to other locations totaling $1,953,000.

Provisions of our sales agreements include product warranties customary to such agreements. We establish accruals for specifically identified warranty issues that are probable to result in future costs. We also accrue for warranty costs on a non-specific basis whenever past experience indicates a normal and predictable pattern exists. A reconciliation of accrued product warranties from September 30, 2005, to June 30, 2006, follows:

(In thousands)
Balance at September 30, 2005	$	5,692
Accruals related to warranties issued during the period		4,217
Adjustments to pre-existing warranty liabilities		(996	)
Settlements of amounts accrued		(3,501	)
Foreign currency exchange rate changes		38
Balance at June 30, 2006	$	5,450

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Notes to Consolidated Financial Statements (Continued)

(11) Retirement benefits:

We provide various benefits to eligible members of our company, including pension benefits associated with defined benefit plans and retirement healthcare benefits. Components of net periodic benefit cost and company contributions for these plans were as follows:

	Three months						Nine months
	ended June 30,						ended June 30,
(In thousands)	2006			2005			2006			2005
Retirement pension benefits – United States:
Components of net periodic benefit cost:
Interest cost	$	285		$	270		$	856		$	810
Expected return on plan assets		(294	)		(272	)		(884	)		(816	)
Recognized losses		63			37			189			111
Net periodic benefit cost	$	54		$	35		$	161		$	105
Contributions by the company	$	—		$	—		$	—		$	—
Retirement pension benefits – other countries:
Components of net periodic benefit cost:
Service cost	$	281		$	471		$	900		$	1,480
Interest cost		538			506			1,623			1,581
Expected return on plan assets		(488	)		(498	)		(1,474	)		(1,556	)
Amortization of unrecognized transition obligation		22			23			68			74
Recognized losses		98			132			297			414
Recognized prior service costs		(2	)		(2	)		(6	)		(6	)
Net periodic benefit cost	$	449		$	632		$	1,408		$	1,987
Contributions by the company	$	423		$	324		$	1,020		$	1,029

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Notes to Consolidated Financial Statements (Continued)

(11) Retirement benefits (continued):

	For the three						For the nine
	months ended						months ended
	June 30,						June 30,
(In thousands)	2006			2005			2006			2005
Retirement healthcare benefits:
Components of net periodic benefit cost:
Service cost	$	96		$	285		$	287		$	1,611
Interest cost		688			845			2,066			3,054
Recognized losses		299			407			897			1,107
Recognized prior service costs		(630	)		(461	)		(1,890	)		(715	)
Curtailment gain		—			(7,825	)		—			(7,825	)
Net periodic benefit cost	$	453		$	(6,749	)	$	1,360		$	(2,768	)
Contributions by the company	$	892		$	677		$	2,160		$	1,598

We paid prescription drug benefits of $614,000 during the three months and $1,792,000 during the nine months ended June 30, 2006. We expect to pay additional prescription drug benefits of approximately $448,000 during the fourth quarter of 2006. We are entitled to a federal subsidy under the Medicare Prescription Drug, Improvement and Modernization Act of 2003. We did not receive a federal subsidy for the nine months ended June 30, 2006, but we currently expect to receive $627,000 during the year ending September 30, 2006.

We expect contributions by the company for retirement pension benefits will be $0 in the United States and $2,072,000 in other countries in 2006. We also expect contributions by the company for retirement healthcare benefits will be $3,557,000 in 2006, less amounts received as federal subsidies.

The curtailment gain reflected in the table above is related to amendments of one of our retirement healthcare benefit plans, which reduced the number of individuals who will qualify for benefits in future periods. These amendments also reduced our net periodic benefit cost over amounts that would have been recognized prior to the amendments.

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Notes to Consolidated Financial Statements (Continued)

(12) Accumulated other comprehensive earnings:

Accumulated other comprehensive earnings, which totaled $12,589,000 at June 30, 2006, consisted of the following items:

	At or for the
	nine months
	ended June 30,
(In thousands)	2006
Accumulated foreign currency translation adjustments:
Balance at beginning of year	$	14,575
Translation adjustments		2,504
Taxes associated with translation adjustments		(951	)
Balance at end of period	$	16,128
Accumulated unrealized derivative losses:
Balance at beginning of year	$	(661	)
Reclassification to interest expense		214
Taxes associated with interest reclassification		(82	)
Balance at end of period	$	(529	)
Accumulated minimum pension liability adjustments:
Balance at beginning and end of period	$	(3,010	)

(13) Total comprehensive earnings:

	Three months					Nine months
	ended June 30,					ended June 30,
(In thousands)	2006		2005			2006		2005
Net earnings	$	28,918	$	19,746		$	52,811	$	44,720
Other comprehensive earnings:
Foreign currency translation adjustments		1,969		(2,133	)		1,553		(90	)
Reclassification of unrealized losses on derivatives to earnings		44		51			132		149
Minimum pension liability adjustment		—		—			—		4
Total comprehensive earnings	$	30,931	$	17,664		$	54,496	$	44,783

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Notes to Consolidated Financial Statements (Continued)

(14) Commitments and Contingencies:

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 $8,500,000 that were made in the nine months ended June 30, 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 $10,000,000 in the aggregate.

Among the current legal proceedings referred to in the preceding paragraph, we are 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 allege discrimination on the basis of race, national origin, and gender in our Winnebago County, Illinois, facilities. We believe there are meritorious defenses to the charges and claims that were asserted and, based on management’s judgment, we are pursuing the actions necessary to resolve these matters in the best interest of our shareholders.

We also 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 expenses that we believe will 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.

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WOODWARD
Notes to Consolidated Financial Statements (Continued)

(15) Segment information:

	Three months				Nine months
	ended June 30,				ended June 30,
(In thousands)	2006		2005		2006		2005
Industrial Controls:
External net sales	$	137,930	$	136,592	$	394,419	$	394,978
Intersegment sales		519		317		1,367		787
Segment earnings		16,406		9,469		41,058		24,619
Aircraft Engine Systems:
External net sales	$	79,123	$	73,660	$	227,185	$	215,218
Intersegment sales		1,619		609		3,733		2,421
Segment earnings		14,753		14,321		45,619		48,555

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

	Three months						Nine months
	ended June 30,						ended June 30,
(In thousands)	2006			2005			2006			2005
Total segment earnings	$	31,159		$	23,790		$	86,677		$	73,174
Unallocated corporate expenses		(9,035	)		(5,144	)		(26,896	)		(13,341	)
Curtailment gain		—			7,825			—			7,825
Interest expense and income		(545	)		(983	)		(1,906	)		(2,840	)
Consolidated earnings before income taxes	$	21,579		$	25,488		$	57,875		$	64,818

Segment assets were as follows:

	At June		At September
(In thousands)	30, 2006		30, 2005
Industrial Controls	$	365,127	$	370,220
Aircraft Engine Systems		220,878		208,140

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

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

Overview

Our business is focused on the design, manufacture, and servicing of energy control systems and components for aircraft and industrial engines and turbines. To penetrate our target markets — power generation, process industries, transportation, and aerospace — our strategy focuses on maintaining and developing technologies that are used in the development of components and integrated systems for power equipment used by customers worldwide.

We have two operating segments — Industrial Controls and Aircraft Engine Systems. Industrial Controls is focused on the technologies, components, integrated systems, power equipment, and customers for industrial markets, which includes power generation, process industries, and transportation. Aircraft Engine Systems is focused on the technologies, components, integrated systems, power equipment, and customers 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.

Industrial Controls’ earnings have improved significantly for the third quarter and first nine months as compared to the same periods a year ago. As a percent of sales, Industrial Controls’ segment earnings were 10.4% in the first nine months this year compared to 6.2% in the same period last year. Improving Industrial Controls’ profitability has been a priority for us for several quarters. Perhaps the most visible action has been the consolidation of operations in Europe, which was completed at the end of March 2006.

Aircraft Engine Systems’ earnings were slightly improved from last year’s third quarter results. For the nine-month period, Aircraft Engine Systems’ earnings decreased $2.9 million; however, its first quarter results last year included a $3.8 million gain on the sale of product rights.

Nonsegment expenses included $8.5 million for accruals related to pending legal matters in the first nine months this year, including $3.5 million that was recognized in the third quarter. Nonsegment expenses were also affected by a change in accounting for stock-based compensation. We adopted new accounting rules for stock-based compensation at the beginning of this year. If we had applied the provisions of the new accounting rules last year, our earnings before

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income taxes would have decreased $0.6 million in last year’s third fiscal quarter and $1.7 million in last year’s first nine months. These decreases are equivalent to net earnings reductions of $0.4 million, or $0.01 per diluted share, in last year’s third fiscal quarter and $1.1 million, or $0.03 per diluted share, in last year’s first nine months.

Our income taxes in the third quarter benefits from a $13.7 million change in valuation allowances for deferred tax assets.

At June 30, 2006, our total assets were $708 million, including $67 million in cash and cash equivalents, and our total debt was $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-Q reflect the effects of the three-for-one stock split that became effective during our second fiscal quarter. Shareholders approved the split in January 2006.

In the sections that follow, we are providing information to help you better understand factors that may affect our future results, our critical accounting policies and market risks, our results of operations, and financial condition.

Factors That May Affect Future Results

This Form 10-Q contains forward-looking statements, including:

• Projections of sales, earnings, cash flows, or other financial items;

• Descriptions of our plans and objectives for future operations;

• Forecasts of future economic performance; and

• Descriptions of assumptions underlying the above items.

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,” “intend,” “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 statement 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 are in the management’s discussion and analysis in our 2005 annual report on Form 10-K for the year ended September 30, 2005.

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discussion and analysis in our 2005 annual report on Form 10-K for the year ended September 30, 2005.

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. In each of the areas that were identified as critical accounting policies, 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. Our critical accounting policies are discussed more fully in the management’s discussion and analysis in our 2005 annual report on Form 10-K for the year ended September 30, 2005.

Market Risks

Our long-term debt is sensitive to changes in interest rates. Also, 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. These market risks are discussed more fully in the management’s discussion and analysis in our 2005 annual report on Form 10-K for the year ended September 30, 2005.

Results of Operations

Sales

	Three months				Nine months
	ended June 30,				ended June 30,
(In thousands)	2006		2005		2006		2005
External net sales:
Industrial Controls	$	137,930	$	136,592	$	394,419	$	394,978
Aircraft Engine Systems		79,123		73,660		227,185		215,218
Consolidated net sales	$	217,053	$	210,252	$	621,604	$	610,196

Industrial Controls’ external net salesin the three months and nine months ended June 30, 2006, were near the levels achieved in the same periods a year ago. While shipment volumes increased for many of our products, we experienced lower sales of alternative fuel systems that are sold to

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Chinese OEMs, which we believe is related to the 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 quarterly variability than is typical among customers in other markets. Aside from volume factors, changes in foreign currency translation rates also had the effect of reducing reported sales this year as compared to a year ago.

Aircraft Engine Systems’ external net salesincreased in both the three months and nine months ended June 30, 2006. Boeing and Airbus, the leading OEMs of narrow- and wide-body aircraft, have both increased their production levels. We believe these increases were largely driven by orders from commercial airlines headquartered in Asia. We also believe higher revenue passenger miles are being experienced by commercial airlines generally, which drives aircraft usage and has a positive effect on our aftermarket sales.

Costs and Expenses

	Three months						Nine months
	ended June 30,						ended June 30,
(In thousands)	2006			2005			2006			2005
Cost of goods sold	$	154,089		$	158,867		$	448,055		$	459,660
Sales, general, and administrative expenses		23,234			19,427			69,548			57,683
Research and development costs		16,793			12,811			41,772			35,106
Curtailment gain		—			(7,825	)		—			(7,825	)
All other expense items		3,184			3,909			9,612			10,587
Interest and other income		(1,826	)		(2,425	)		(5,258	)		(9,833	)
Consolidated costs and expenses	$	195,474		$	184,764		$	563,729		$	545,378

Cost of goods soldas a percentage of sales decreased in both the three months and nine months ended June 30, 2006, as compared to the same periods last year. Cost of goods sold represented 71.0% of sales in the three-month period and 72.1% in the nine-month period, both improvements from the prior year in which cost of goods sold represented 75.6% in the three-month period and 75.3% in the six-month period. We attribute the improvement to normal variability in sales mix and productivity improvements. The productivity improvements included the favorable effects of the consolidation of European operations and other actions taken to improve Industrial Controls’ performance.

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Sales, general, and administrative expensesincreased in both the three months and nine months ended June 30, 2006, as compared to the same periods last year. The increase was primarily due to accruals related to pending legal matters of a contingent nature, a higher level of professional services as compared to a year ago, and a change in accounting for stock-based compensation. The extent to which we use professional services varies on a quarterly basis, and expenses are recognized in the period services are provided. Contingencies and stock-based compensation are discussed more fully in separate sections of this management’s discussion and analysis.

Research and developmentincreased in both the three months and nine months ended June 30, 2006, as compared to the same periods last year, reflecting higher levels of development activity in both segments. Among other programs, Aircraft Engine Systems continues to develop components and the 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 and T700-GE-701D engine for use in military applications. Industrial Controls is also developing products in conjunction with customers’ development programs, as well as developing 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 gainrelates 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 had not attained age 55 and 10 years of service by January 1, 2006. In addition to the immediate recognition of a curtailment gain, net periodic benefit costs were reduced from amounts that would have been recognized prior to the amendments.

Interest and other incomedecreased in the nine-month period ended June 30, 2006, as compared to the same period last year. Last years’ nine-month results included a first quarter pre-tax gain of $3.8 million from the sale of rights to our aircraft propeller synchronizer products to an unrelated 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

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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 earnings for the three months ended June 30, 2006, was that earnings before income taxes were reduced by $0.7 million and net earnings were reduced by $0.4 million, or $0.01 per basic share and $0.01 per diluted share. The effect for the nine months ended June 30, 2006, was that earnings before income taxes were reduced by $2.3 million and net earnings were reduced by $1.4 million, or $0.04 per basic share and $0.04 per diluted share. Stock compensation is accounted for as a nonsegment expense. We expect stock compensation expense in the immediate future to be at levels similar to the amount recognized in the first nine months.

If we had applied the provisions of the new accounting standard last year, our earnings before income taxes for the three months ended June 30, 2005, would have been reduced by $0.6 million and our net earnings would have been reduced by $0.4 million, or $0.01 per basic share and $0.01 per diluted share. For the nine months ended June 30, 2005, our earnings before income taxes would have been reduced by $1.7 million and our net earnings would have been reduced by $1.1 million, or $0.03 per basic share and $0.03 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 the nine months ended June 30, 2006, cash flow from operations was reduced by $2.5 million and cash flow from financing activities was increased by $2.5 million from amounts that would have been reported prior to the accounting change.

At June 30, 2006, the amount of stock compensation expense that has not yet been recognized totaled $5.4 million. This amount is related to stock options that have been granted but have not yet vested. We currently expect to recognize an additional $0.7 million of stock compensation for these options over the remainder of the year ending September 30, 2006.

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Workforce Management Actions

	Three months					Nine months
	ended June 30,					ended June 30,
(In thousands)	2006		2005			2006		2005
Member termination benefits— Industrial Controls	$	—	$	469		$	70	$	1,341
Member termination benefits adjustments — Industrial Controls		—		943			—		943
Member termination benefits adjustments — Industrial Controls		—		(83	)		—		(2,198	)
Total workforce management costs, net of adjustments	$	—	$	1,329		$	70	$	86

The amounts expensed during the nine months ended June 30, 2006, were for termination benefits earned by members over the period and are primarily related to the consolidation of one of the European manufacturing operations with existing operations in Industrial Controls. This action was taken to streamline the organization by eliminating redundant manufacturing operations and was complete by March 31, 2006. These actions are discussed more fully in the management’s discussion and analysis in our 2005 annual report on Form 10-K for the year ended September 30, 2005.

The 2005 costs, which are related to the same actions referenced in the preceding paragraph, were for termination benefits that were earned by members during the three and nine-month periods ended June 30, 2005, and for adjustments of amounts previously accrued for the 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 at a lower cost.

Since the inception of these workforce management actions through June 30, 2006, we expensed $15.8 million, which includes $12.0 million for member termination benefits under ongoing termination benefit plans, $1.8 million of contractual pension termination benefits, and $2.0 million for other costs primarily associated with moving equipment and inventory to other locations. With the exception of the $1.8 million for contractual pension termination benefits, all expenses were cash expenses that have been paid from available cash balances in 2005 and 2006 without the need for additional borrowings.

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Although it is difficult to precisely estimate the savings that are uniquely related to these actions, we believe that current 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. The effect of these actions is considered as part of our outlook for the year, which is discussed more fully in a separate section of this management’s discussion and analysis.

Earnings

	Three months						Nine months
	ended June 30,						ended June 30,
(In thousands)	2006			2005			2006			2005
Segment earnings:
Industrial Controls	$	16,406		$	9,469		$	41,058		$	24,619
Aircraft Engine Systems		14,753			14,321			45,619			48,555
Total segment earnings		31,159			23,790			86,677			73,174
Nonsegment expenses		(9,035	)		(5,144	)		(26,896	)		(13,341	)
Curtailment gain		—			7,825			—			7,825
Interest expense and income		(545	)		(983	)		(1,906	)		(2,840	)
Consolidated earnings before income taxes		21,579			25,488			57,875			64,818
Income taxes		(7,339	)		5,742			5,064			20,098
Consolidated net earnings	$	28,918		$	19,746		$	52,811		$	44,720

Industrial Controls’ segment earningsincreased in both the three months and nine months ended June 30, 2006, as compared to the same periods last year. Changes in sales mix and productivity improvements were the primary drivers for the increase in earnings this year over last year. Industrial Controls had a higher gross margin (external net sales less external cost of goods sold) as a percent of sales in both the three-month and nine-month periods this year. We attribute the change in Industrial Controls’ sales mix to normal variation in the timing of shipments and the productivity improvements to specific actions taken to improve Industrial Controls’ performance, including the favorable effects of the consolidation of European operations. In addition, Industrial Controls’ workforce management actions resulted in $1.3 million of expense in last year’s third quarter. Workforce management actions are

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discussed more fully in a separate section of this management’s discussion and analysis.

Aircraft Engine Systems’ segment earningsincreased slightly in the three months ended June 30, 2006, and decreased in the nine months ended June 30, 2006, as compared to the same periods last year. Last year’s nine-month earnings included a gain of $3.8 million from the sale of product rights, accounting for most of the year-over-year change. In addition, Aircraft Engine Systems has achieved higher gross margins this year in both the three and nine-month periods as a result of increased sales, which have been largely offset by higher research and development costs. The increase in Aircraft Engine Systems’ research and development costs was discussed more fully in a separate section of this management’s discussion and analysis.

Nonsegment expensesincreased in both the three months and nine months ended June 30, 2006, as compared to the same period a year ago. We accrued $3.5 million related to pending legal matters of a contingent nature in this year’s three-month period and $8.5 million in this year’s nine-month period. Contingencies are discussed more fully in separate sections of this management’s discussion and analysis. In addition, nonsegment expenses have increased because of a higher level of professional services this year as compared to a year ago and a change in accounting for stock-based compensation. The level of professional services varies on a quarterly basis, and expenses are recognized in the period services are provided. Stock-based compensation is discussed more fully in a separate section of this management’s discussion and analysis.

Curtailment gainwas discussed previously in this management’s discussion and analysis.

Income taxeswere provided at an effective rate on earnings before income taxes of 8.7% for the nine months ended June 30, 2006, which included the effect of changes in valuation allowances for deferred tax assets. The tax rate for the year ended September 30, 2005, was 29.2%. The changes in valuation allowances reduced income tax expense by $13.7 million, representing 23.7% of pretax earnings. Exclusive of this item, the effective tax rate for the nine-month period was 32.4%.

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 our third quarter, additional objective evidence became available regarding earnings in tax jurisdictions that have unexpired net operating loss

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carryforwards that affected our judgment about the valuation allowance.

In addition, income taxes in the third quarter of both 2006 and 2005 included the effects of changes in estimates of income taxes for previous years. In 2006, the changes were primarily related to the favorable resolution of certain tax matters in the third quarter. These changes reduced the effective tax rate for the nine-month period by approximately 2.5% 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 the effective tax rate for the year ended September 30, 2005, by approximately 2.5% of pretax earnings.

Aside from changes in valuation allowances for deferred tax assets and changes in estimates related to previous years, the remaining difference in the effective tax rate for the nine-month period compared to the full year last year is primarily related to the expiration of the tax credit for increasing research activities (which expired on December 31, 2005) and changes in the amounts of extraterritorial income exclusion. Both of these factors increased our effective tax rate.

Outlook:Our outlook for the year ending September 30, 2006, is consistent with what we previously reported, with sales growth of 3% to 6% and earnings per share of $1.67 to $1.75 per diluted share, before the effects of accruals for pending legal matters and changes in valuation allowances for deferred tax assets.

Our sales growth expectation is based on our belief that Aircraft Engine Systems’ sales will grow between 7% and 9%. We now believe Industrial Controls’ sales will be approximately the same as last year.

Our earnings expectation is a result of the expected companywide sales increase and improvements in Industrial Controls’ segment earnings. We anticipate that Industrial Controls’ segment earnings will increase to approximately 10% of sales on average for fiscal year 2006. Among other factors, the improvement in Industrial Controls’ earnings includes savings resulting from the consolidation of our European operations, which were discussed more fully in another section of this management’s discussion and analysis. Aircraft Engine Systems’ segment earnings are expected to remain near the levels achieved in the last two years in relation to its sales.

Our net earnings expectation for the year includes expense for stock compensation that resulted from the adoption of a

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new accounting standard at the beginning of the year. Had we adopted the provisions of the new standard last year, our net earnings for the year ended September 30, 2005, would have decreased by $0.03 per diluted share. Stock compensation is discussed more fully in a separate section of this management’s discussion and analysis.

The accruals for pending legal matters and changes in valuation allowances for deferred tax assets are discussed more fully in separate sections of this management’s discussion and analysis.

Financial Condition

Assets

	June 30,		September 30,
(In thousands)	2006		2005
Industrial Controls	$	365,127	$	370,220
Aircraft Engine Systems		220,878		208,140
Nonsegment assets		121,241		127,106
Consolidated total assets	$	707,246	$	705,466

Industrial Controls’ segment assetsdecreased in the nine months ended June 30, 2006, due primarily to depreciation and amortization of property, plant, and equipment, and intangibles.

Aircraft Engine Systems’ segment assetsincreased in the nine months ended June 30, 2006, primarily due to increases in accounts receivables and inventories. Both of these increases were due to an increased level of sales that occurred near June 30, 2006, as compared to September 30, 2005.

Nonsegment assetsdecreased in the nine months ended June 30, 2006, primarily reflecting a decrease in cash and cash equivalents and an increase in deferred tax assets. Changes in cash for the nine-month period and changes in valuation allowances for deferred tax assets are discussed more fully in separate sections of this management’s discussion and analysis.

Other Balance Sheet Measures

	June 30,		September 30,
(In thousands)	2006		2005
Working capital	$	254,912	$	241,066
Long-term debt, less current portion		59,402		72,942
Other liabilities		69,595		71,548
Shareholders’ equity		469,282		432,469

Working capital(current assets less current liabilities) increased in the nine months ended June 30, 2006, primarily as a result of a decrease in accrued liabilities, the effect of which was partially offset by a reduction in cash and cash

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equivalents. Accruals associated with variable compensation plans accumulate throughout the year and are paid in our first quarter. Similarly, accruals associated with certain defined benefit retirement plan contributions accumulate throughout the year and are paid in our second quarter.

Long-term debtdecreased in the nine months ended June 30, 2006, as a result of payments during the period. 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 $26.4 million at September 30, 2005, that are generally reviewed annually for renewal.

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 June 30, 2006.

Commitments and contingenciesat June 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. 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 $8,500,000 that were made in the nine months ended June 30, 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 current legal proceedings referred to in the preceding paragraph, we are 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 allege discrimination on the basis of race, national origin, and gender in our Winnebago County, Illinois, facilities. We believe there are meritorious defenses to the charges and claims that were asserted and, based on management’s judgment, we are pursuing

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the actions necessary to resolve these matters in the best interest of our shareholders.

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 will 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’ equityincreased in the nine months ended June 30, 2006. Increases due to net earnings, sales of treasury stock, stock compensation expense, and excess tax benefits from stock compensation during the nine months were partially offset by purchases of treasury stock and cash 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. Through June 30, 2006, we purchased $21.9 million of our common stock under this authorization at an average price per share of $30.04. This authorization was terminated on July 25, 2006, concurrent with the approval of a new stock repurchase authorization. No purchases were made under this authorization from June 30, 2006, through the date of its termination.

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.

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-Q. In addition, in accordance with stock option plan provisions, the terms of all outstanding stock option awards were proportionally adjusted.

Contractual Obligations

(In thousands for the
year(s) ending September			2007/		2009/
30,)	2006		2008		2010		Thereafter
Long-term debt principal	$	14,426	$	28,852	$	21,428	$	21,429
Operating leases		3,600		5,000		3,000		2,000
Purchase obligations		76,357		1,070		—		—

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The above table reflects contractual obligations at September 30, 2005, but excludes our retirement pension and retirement healthcare benefit obligations. Our contributions to retirement pension benefit plans totaled $1.8 million in 2005 and $3.1 million in 2004, and we currently expect our contributions for 2006 will total approximately $2.1 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 obligations totaled $2.4 million in 2005 and $2.6 million in 2004, and we currently estimate our contributions for 2006 will total approximately $3.6 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 Notes to Consolidated Financial Statements in “Item 1 – Financial Statements.”

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

Cash Flows

	Nine months
	ended June 30,
(In thousands)	2006			2005
Net cash provided by operating activities	$	43,065		$	45,613
Net cash used in investing activities		(18,966	)		(13,079	)
Net cash used in financing activities		(42,189	)		(5,968	)

Net cash flows provided by operating activitiesdecreased by 6% in the nine months ended June 30, 2006, as compared to the same period a year ago. Both operating cash receipts and disbursements increased in the nine months this year compared to last year. However, cash paid to employees and suppliers increased at a greater rate than cash collected from customers, most significantly because variable compensation earned in 2005 and paid in 2006 was higher than variable compensation earned in 2004 and paid in 2005.

Net cash flows used in investing activitiesincreased by $5.9 million in the nine months ended June 30, 2006, as compared to the same period a year ago. Capital expenditures were higher in the nine-month period this year as a result of investments to support higher sales and new programs. In addition, proceeds from the sale of property, plant, and equipment were higher in the nine-month period last year

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because of actions related to the consolidation of our European facilities.

Net cash flows used in financing activitiesincreased by $36.2 million in the nine months ended June 30, 2006, as compared to the same period a year ago. Debt principal payments were higher this year, in part due to payments associated with senior notes, which became payable for the first time in this year’s nine-month period. In addition, there was an increase in the purchase of treasury stock, which were primarily associated with a stock repurchase authorization.

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. No purchases were made under this authorization from June 30, 2006, through the date of its termination.

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.

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 senior notes, which totaled $64.3 million at June 30, 2006, 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. 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 FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” is included in the Notes to Consolidated Financial Statements in “Item 1 – Financial Statements.”

Item 3.Quantitative and Qualitative Disclosures About Market Risk

Our long-term debt is sensitive to changes in interest rates. Also, assets, liabilities and commitments that are to be settled in cash and are denominated in foreign currencies are sensitive to changes in currency exchange rates. These market risks are discussed more fully in the management’s discussion and analysis in our 2005 annual report on Form 10-K for the year ended September 30, 2005.

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Item 4.Controls and Procedures

We have established disclosure controls and procedures, which are designed to ensure that information required to be disclosed in reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. These disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that we file or submit under the Act is accumulated and communicated to management, including our principal executive officer (Thomas A. Gendron, president and chief executive officer) and principal financial officer (Robert F. Weber, Jr., chief financial officer and treasurer), as appropriate to allow timely decisions regarding required disclosures.

Thomas A. Gendron, our president and chief executive officer, and Robert F. Weber, Jr., our chief financial officer and treasurer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Form 10-Q. Based on their evaluation, they concluded that our disclosure controls and procedures were effective in achieving the objectives for which they were designed as described in the preceding paragraph.

Furthermore, there have been no changes in our internal control over financial reporting during the fiscal quarter covered by this Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds

					(c) Total		(d)
					number of		Approximate
					shares		dollar value
					purchased		of shares
					as part of		that may yet
	(a) Total				publicly		be purchased
	number of		(b) Average		announced		under the
	shares		price paid		plans or		plans or
Period	purchased		per share		programs		programs
April 1, 2006 through April 30, 2006		11,249	$	33.70		11,249	$	21,225,295
May 1, 2006 through May 31, 2006		400,446	$	32.67		400,446	$	8,141,464
June 1, 2006 through June 30, 2006		1,282		—		—	$	8,141,464

The shares purchased in June were purchased on the open market and are related to the reinvestment of dividends for treasury shares held for deferred compensation.

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. No purchases were made under this authorization from June 30, 2006, through the date of its termination.

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.

Sales of common stock issued from treasury to one of the company’s directors during the nine months ended June 30, 2006, consisted of the following:

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	Total number
	of shares		Consideration
Date	purchased		received
December 2, 2005		297	$	8,019
February 1, 2006		132		4,004
May 1, 2006		180		5,990

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

Item 6.Exhibits

     (a) Exhibits Filed as Part of this Report:

(3	)	(i)	Restated Certificate of Incorporation
(31	)	(i)	Rule 13a-14(a)/15d-14(a) certifications of Thomas A. Gendron.
		(ii)	Rule 13a-14(a)/15d-14(a) certifications of Robert F. Weber, Jr.
(32	)	(i)	Section 1350 certifications.

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SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	WOODWARD GOVERNOR COMPANY
Date: July 31, 2006	/s/ THOMAS A. GENDRONThomas A. Gendron, President
	and Chief Executive Officer
Date: July 31, 2006	/s/ ROBERT F. WEBER, JR.
	Robert F. Weber, Jr., Chief
	Financial Officer and Treasurer

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