The accompanying condensed consolidated financial statements were prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company may not, however, be able to continue as a going concern. The realization of assets and the satisfaction of liabilities in the normal course of business are dependent on, among other things, the Company’s ability to continue to operate profitably, to generate cash flows from operations, asset sales and collections of receivables to fund its obligations, including those resulting from asbestos related liabilities, as well as the Company’s ability to maintain credit facilities and bonding capacity adequate to conduct its business. Despite reporting earnings for the six months ended June 25, 2004, the Company incurred significant operating losses in each of the years in the three-year period ended December 26, 2003 and has a shareholders’ deficit of $856,600 as of June 25, 2004. The Company has substantial debt obligations including its Senior Credit Facility and, during 2002, it was unable to comply with certain debt covenants under the previous revolving credit agreement. As described in more detail below, the Company received waivers of covenant violations and ultimately negotiated new credit facilities in August 2002. In November 2002, the new Senior Credit Facility was amended to provide for the exclusion of up to $180,000 of gross pretax charges recorded in the third quarter of 2002 and up to an additional $63,000 in pretax charges related to specific contingencies through December 2003, if incurred, for covenant calculation purposes. In March 2003, the Senior Credit Facility was again amended to provide further covenant relief by modifying certain definitions of financial measures utilized in the calculation of the financial covenants and the minimum EBITDA and senior debt ratio. The credit facilities were also amended in July 2003 to provide waivers of the applicable sections of the Senior Credit Facility to permit the exchange offers described elsewhere in this report, other internal restructuring transactions as well as transfers, cancellations and setoffs of certain intercompany obligations. There is no assurance that the Company will be able to comply with the terms of the Senior Credit Facility, as amended, and other debt agreements during 2004.
Management’s current forecast indicates that the Company will be in compliance with the financial covenants contained in its Senior Credit Facility through the facility’s maturity in April 2005. In connection with the proposed exchange offer discussed below, the Company intends to seek a new multi-year revolving credit agreement and letter of credit facility. If the equity for debt exchange offer is not completed, the Company would be obligated, in April 2005, to repay the $115,900 of term loans and revolving credit borrowings and to replace the letters of credit of $73,100 outstanding under the Senior Credit Facility as of June 25, 2004. Therefore, the Company needs to successfully complete the equity for debt exchange offer and to finalize the new revolving credit agreement discussed above, or to repay, refinance, or replace the Senior Credit Facility at or prior to its maturity. However, there can be no assurance that the actual financial results will match the forecasts, that the Company will be able to comply with the covenants, that the equity for debt exchange offer and new revolving credit facility will be completed, or that the Company will be able to repay, refinance, or replace the Senior Credit Facility at or prior to its maturity.
One of the Company’s foreign subsidiaries is a party to two Euro-denominated performance bond facilities with financial institutions that contain covenants. The covenants include (i) a limitation on the amount of dividends to 75% of the subsidiary’s annual earnings and (ii) a requirement that the payment of dividends and certain restricted payments be subject to the subsidiary having minimum equity ratios, calculated as equity divided by total assets each as defined in the facilities. In addition, the facilities require the subsidiary to maintain a minimum equity ratio. The covenants are tested quarterly.
One of the performance bond facilities is dedicated to a specific project and, as of June 25, 2004, had performance bonds outstanding equivalent to approximately $40,000 (none of which has been drawn). The second facility is a general performance bond facility and, as of June 25, 2004, had performance bonds outstanding in favor of several clients equivalent to approximately $12,000 (none of which has been drawn).
As a result of operating losses at the foreign subsidiary during the second quarter of 2004, the equity of the Company’s subsidiary fell below the minimum equity ratios, breaching the covenants contained in the performance bond facilities. On August 6, 2004 and August 9, 2004, the Company’s foreign subsidiary obtained waivers from the financial institutions providing the performance bond facilities. The waiver for the project specific performance bond facility requires that the foreign subsidiary make no dividends or other restricted payments, including inter-company loans, debt service on existing inter-company loans, royalties, and management fees, for as long as the foreign subsidiary’s equity remains below the minimum amounts and the performance bonds are outstanding. The waiver for the general performance bond facility is effective through October 31, 2004. After October 31, 2004, the Company’s subsidiary will be required to be in compliance with the required minimum equity ratio or obtain a further waiver. The Company plans to negotiate to obtain a further waiver or amendment prior to October 31, 2004. In the event that the Company is unable to obtain a further waiver or amendment, it will pursue a replacement for this bonding facility. In addition, the subsidiary has sufficient cash on hand to collateralize the obligations supported by the performance bonds in the event it is unable to obtain a waiver or an alternative bonding facility. Therefore the Company believes this matter will not have an adverse impact on its forecasted liquidity.
The foreign subsidiary’s inability to pay dividends and restricted payments because of its failure to remain in compliance with the minimum equity ratio covenants is reflected in the Company’s liquidity forecasts.
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The Company’s U.S. operations, which include the corporate functions, are cash flow negative and are expected to continue to incur negative cash flow due to a number of factors including costs related to the Company’s indebtedness, obligations to fund U.S. pension plans, and other expenses related to corporate functions and other corporate overhead.
Management closely monitors liquidity and updates its U.S. liquidity forecasts weekly. These forecasts cover, among other analyses, existing cash balances, cash flows from operations, cash repatriations and loans from non-U.S. subsidiaries, asset sales, collections of receivables and claims recoveries, working capital needs and unused credit line availability. The Company’s cash flow forecasts continue to indicate that sufficient cash will be available to fund the Company’s U.S. and foreign working capital needs through June 2005, provided the Company successfully completes the equity for debt exchange offer and the new revolving credit agreement. Ensuring adequate domestic liquidity remains a priority for the Company’s management, however, there can be no assurance that the cash amounts realized and/or timing of the cash flows will match the Company’s forecast.
As of June 25, 2004, the Company had aggregate indebtedness of approximately $1,017,000. A breakdown of the debt is provided in the Financial Condition Section. Details about specific debt instruments are also provided later in this section.
As of June 25, 2004, the Company had cash and cash equivalents on hand, short-term investments, and restricted cash totaling $404,700, compared to $430,200 as of December 26, 2003. Of the $404,700 total at June 25, 2004, approximately $327,200 was held by foreign subsidiaries. The Company is sometimes required to cash collateralize bonding or certain bank facilities and such amounts are included in restricted cash. The amount of restricted cash at June 25, 2004 was $57,500, of which $53,100 relates to the non-U.S. operations.
The corporate debt must be funded primarily with distributions from the Company’s foreign subsidiaries. The Company also requires cash distributions from its non-U.S. subsidiaries in the normal course of its operations to meet its U.S. operations’ minimum working capital needs. The Company’s current 2004 forecast assumes total cash repatriation from its non-U.S. subsidiaries of approximately $76,000 from royalties, management fees, intercompany loans, debt service on intercompany loans, and dividends. In the first six months of 2004 and the full year of 2003, the Company repatriated approximately $43,000 and $100,000, respectively, from its non-U.S. subsidiaries.
There can be no assurance that the forecasted foreign cash repatriation will occur, as there are significant contractual and statutory restrictions on the Company’s ability to repatriate funds from its non-U.S. subsidiaries. These subsidiaries need to keep certain amounts available for working capital purposes, to pay known liabilities, and for other general corporate purposes. Such amounts exceed, and are not directly comparable to, the foreign component of restricted cash previously noted. In addition, certain of the Company’s non-U.S. subsidiaries are parties to loan and other agreements with covenants, and are subject to statutory requirements in their jurisdictions of organization that restrict the amount of funds that such subsidiaries may distribute. Distributions in excess of these specified amounts would violate the terms of the agreements or applicable law, which could result in civil or criminal penalties. The repatriation of funds may also subject those funds to taxation. As a result of these factors, the Company may not be able to repatriate and utilize funds held by its non-U.S. subsidiaries in sufficient amounts to fund its U.S. working capital requirements, to repay debt, or to satisfy other obligations of its U.S. operations, which could limit the Company’s ability to continue as a going concern.
Commercial operations under a domestic contract retained by the Company in connection with the sales of assets of the Foster Wheeler Environmental Corporation (“Environmental”), as described further in Note 10 to the condensed consolidated financial statements, commenced in January 2004. The plant processes low-level nuclear waste for the U.S. Department of Energy (“DOE”). The Company funded the plant’s construction costs and operates the facility. The majority of the Company’s invested capital was recovered during the early stages of processing the waste materials. This project successfully processed sufficient quantities of material during the first three months of 2004 to recover the capital recovery originally forecasted to be received during the first nine months of 2004. At June 25, 2004, the project generated a year to date net cash flow of approximately $49,000. The net cash flow forecasted for 2004 from this project is now approximately $50,000.
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On February 26, 2004, the California Public Utilities Commission approved certain changes to Pacific Gas and Electric Company’s rates. As relevant to the Company’s subsidiary’s Martinez Project, the E-20T rate has been decreased by approximately 15% retroactive to January 1, 2004, having a negative effect on the subsidiary’s 2004 cash flow and earnings. This rate change has been reflected in the Company’s liquidity forecast.
There can be no assurance that cash amounts realized and/or timing of the cash flows will match the Company’s forecast.
On June 11, 2004, the Company launched its offer to exchange equity for all of the existing $175,000 trust preferred securities, $210,000 Convertible Subordinated Notes (“Convertible Notes”) and $114,100 Subordinated Robbins Exit Funding Obligations (“Robbins Bonds”), and to exchange equity and debt for all of the existing $200,000 Senior Notes (the “Senior Notes”). The Company eventually concluded that certain of the holders would not participate in the exchange offer unless they were offered a greater portion of the voting equity of the Company. Accordingly, the Company and certain of its subsidiaries revised the terms of the exchange offer and filed post-effective amendments to the registration statement on July 8, 2004, July 9, 2004 and July 23, 2004. On July 30, 2004, the Securities and Exchange Commission (“SEC”) declared the Company’s registration statement effective. The Company is distributing revised offering materials and expects to complete the exchange offer during the third quarter of 2004. The Company entered into a lock-up agreement in connection with the exchange offer. The Company has the right to terminate the lock-up agreement if its board of directors determines that doing so is required by their fiduciary duty to the Company, provided that it pays a termination fee of the lesser of (1) 2.5% of the principal amount of securities subject to the lock-up or (2) $10,000, which fee has not been included in the Company’s liquidity forecast.
On February 5, 2004, the Company announced, in support of its restructuring activities, that a number of institutional investors committed to provide $120,000 of new financing due 2011 in a private transaction with the Company to replace amounts outstanding under the term loan and the revolving credit facility portions of its Senior Credit Facility. This commitment is contingent upon the completion of the proposed exchange offer. The Company discontinued its previously announced plans to divest one of its European operating units.
The total amount of debt and trust preferred securities subject to the proposed exchange offer is approximately $700,000. Interest expense incurred on this debt in 2003 totaled approximately $55,000. The Company anticipates that both total debt and related interest expense would be significantly reduced upon completion of the debt exchange offer. There can be no assurance that the Company will complete the proposed exchange offer. The failure by the Company to achieve its cash flow forecast or to complete the exchange offer on acceptable terms would have a material adverse effect on the Company’s financial condition. These matters raise substantial doubt about the Company’s ability to continue as a going concern.
In August 2002, the Company finalized a Senior Credit Facility with its lender group. This facility included a $71,000 term loan, a $69,000 revolving credit facility, and a $149,900 letter of credit facility, which expires on April 30, 2005. The Senior Credit Facility is secured by the assets of the domestic subsidiaries, the stock of the domestic subsidiaries, and, in connection with Amendment No. 3 discussed below, 100% of the stock of the first-tier foreign subsidiaries. The Senior Credit Facility has no scheduled repayments prior to maturity on April 30, 2005. The agreement requires prepayments from proceeds of assets sales, the issuance of debt or equity, and from excess cash flow. The Company retained the first $77,000 of such amounts and also retains a 50% share of the balance. With the Company’s sale of the Environmental net assets on March 7, 2003, and an interest in a corporate office building on March 31, 2003, the $77,000 threshold was exceeded. Accordingly, principal prepayments of $12,300 and $11,800 were made on the term loan in the first six months of 2004 and during the full year of 2003, respectively, as a result of asset sales during those periods.
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The financial covenants in the Senior Credit Facility include a maximum senior leverage ratio and a minimum EBITDA. Compliance with these covenants is measured quarterly. The EBITDA covenant requires the actual average rolling four quarter EBITDA, as defined in the Senior Credit Facility, to meet minimum EBITDA targets. The senior leverage covenant compares actual average rolling EBITDA, as defined in the Senior Credit Facility, to actual total senior debt. The resultant multiple of debt to EBITDA must be less than maximum amounts specified in the Senior Credit Facility. Management’s current forecast indicates that the Company will be in compliance with these covenants through June 2005 provided the Company successfully completes the equity for debt exchange offer. However, there can be no assurance that the actual results will match to forecasts or that the Company will not violate the covenants.
Amendment No. 1 to the Senior Credit Facility, obtained on November 8, 2002, provides for the exclusion of up to $180,000 of gross pretax charges recorded by the Company in the third quarter of 2002 for covenant calculation purposes. The amendment further provides that up to an additional $63,000 in pretax charges related to specific contingencies may be excluded from the covenant calculation through December 31, 2003, if incurred. As of December 26, 2003, $31,000 of the contingency risks was favorably resolved, and additional project reserves were established for $32,000 leaving a contingency balance of $0.
Amendment No. 2 to the Senior Credit Facility, entered into on March 24, 2003, modifies (i) certain definitions of financial measures utilized in the calculation of the financial covenants and (ii) the Minimum EBITDA and Senior Debt Ratio, as specified in section 6.01 of the Credit Agreement. In connection with this amendment of the Credit Agreement, the Company made a prepayment of principal in the aggregate amount of $10,000 in March 2003.
Amendment No. 3 to the Senior Credit Facility, entered into on July 14, 2003, modified certain affirmative and negative covenants to permit the exchange offer described elsewhere in this report, other internal restructuring transactions as well as transfers, cancellations and setoffs of certain intercompany obligations. The terms of the amendment called for the Company to pay a fee equal to 5% of the lenders’ credit exposure since it had not made a required prepayment of principal under the Senior Credit Facility of $100,000 on or before March 31, 2004. The Company paid the required fee of $13,600 on March 31, 2004. The annual interest rate on borrowings under the Senior Credit Facility has increased and will continue to increase an additional 0.5% each quarter until the Company repays $100,000 of indebtedness under the Senior Credit Facility.
Amendment No. 4 to the Senior Credit Facility, entered into on October 30, 2003, modified certain definitions and representations to allow for the maintenance and administration of certain bank accounts of the Company.
Amendment No. 5 to the Senior Credit Facility, entered into on May 14, 2004, amended and waived certain affirmative and negative covenants necessary to permit the exchange offer described elsewhere in this document as well as to allow for a reduction of $25,000 in the Company’s letter of credit facility. In consideration for the amendments and waivers obtained in this amendment, the Company is obligated to pay, on November 30, 2004, a fee equal to 1.25% of the lenders’ outstanding letter of credit exposure and a further fee equal to 0.75% of the lenders’ outstanding letter of credit exposure for each additional month thereafter through the expiration date of the Senior Credit Facility of April 2005.
Holders of the Company’s Senior Notes due November 15, 2005 have a security interest in the stock and debt of certain of Foster Wheeler LLC’s subsidiaries and on facilities owned by Foster Wheeler LLC or its subsidiaries that exceed 1% of consolidated net tangible assets, in each case to the extent such stock, debt and facilities secure obligations under the revolving portion of the Senior Credit Facility. The term loan and the obligations under the letter of credit facility (collectively approximating $120,000 as of June 25, 2004) have priority to the Senior Notes in these assets while the security interest of the Senior Notes ranks equally and ratably with $69,000 of revolving credit borrowings under the Senior Credit Facility.
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The Company finalized a sale/leaseback arrangement for an office building at its corporate headquarters in the third quarter of 2002. Under this arrangement, the Company leases the facility to the Company, for an initial non-cancelable period of 20 years. The proceeds from the sale/leaseback were sufficient to repay the balance outstanding under a previous operating lease arrangement of $33,000 for a second corporate office building. The long-term capital lease obligation of $44,400 as of June 25, 2004 is included in capital lease obligations in the accompanying condensed consolidated balance sheet. The Company entered into a binding agreement in the first quarter 2004 to sell a second corporate office building. The sale closed in the second quarter 2004 and generated net cash proceeds of $16,400. Of this amount, 50% was used to prepay amounts outstanding under the term loan portion of the Se nior Credit Facility in the second quarter 2004.
In the third quarter of 2002, the Company also entered into a receivables financing arrangement of up to $40,000. The funding available to the Company is dependent on the amount and characteristics of the domestic receivables. The amount available to the Company fluctuates daily, but the Company estimates that approximately $10,000 will be available during 2004. This financing arrangement expires in August 2005 and is subject to covenant compliance. The financial covenants commenced at the end of the first quarter of 2003 and include a senior leverage ratio and a minimum EBITDA level. Noncompliance with the financial covenants allows the lender to terminate the arrangement and accelerate any amounts then outstanding. During the second quarter of 2004, the Company executed an agreement to lower the maximum borrowing availability under this facility to $30,000, effective May 28, 2004, thereby reducing future unused commitment fees. As of June 25, 2004 and December 26, 2003, the Company had $0 borrowings outstanding under this facility. The Company has agreed to terminate this facility upon completion of the proposed exchange offer.
On January 26, 2004, subsidiaries in the U.K. entered into a two-year revolving credit facility with Saberasu Japan Investments II B.V. in the Netherlands. The facility provides for up to $45,000 of additional revolving loans available to provide working capital, which may be required by these subsidiaries as they seek to grow the business by pursuing a larger volume of lump sum EPC contracts. The facility is secured by substantially all of the assets of these subsidiaries and is subject to covenant compliance. Such covenants include a minimum EBITDA level and a loan to EBITDA ratio. As of June 25, 2004, the facility remained undrawn.
Since January 15, 2002, the Company has exercised its right to defer payments on the junior subordinated debentures underlying the 9.00% Preferred Capital Trust I securities and, as a result, to defer payments on those securities. The aggregate liquidation amount of the trust preferred securities is $175,000. The Senior Credit Facility, as amended, requires the Company to defer the payment of the dividends on the trust preferred securities and no dividends were paid during the first two quarters of 2004. As of June 25, 2004, the amount of dividends deferred plus accrued interest approximates $47,700.
The Senior Credit Facility, the sale/leaseback arrangement, and the receivables financing arrangement have quarterly debt covenant requirements. Management’s forecast indicates that the Company will be in compliance with the debt covenants through April 2005, provided the company successfully completes the equity for debt exchange offer. However, there can be no assurance that the Company will comply with the covenants. If the Company violates a covenant under the Senior Credit Facility, the sale/leaseback arrangement or the receivables financing arrangement, repayment of amounts borrowed under such agreements could be accelerated. Acceleration of these facilities would result in a cross default under the following agreements: the Senior Notes, the Convertible Notes, the trust preferred securities, the Robbins Bonds and certain of the special-purpose project debt facilities, which would allow such debt to be accelerated as well. The total amount of Foster Wheeler Ltd. debt that could be accelerated is $913,700 as of June 25, 2004.
The debt covenants and the potential payment acceleration requirements raise substantial doubts about the Company’s ability to continue as a going concern. The condensed consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
The Company’s operations used cash of approximately $16,100 during the first six months of 2004. The improvement in cash used in operations in the first six months of 2004 compared to the same period of 2003 was primarily due to recovery of working capital from the DOE project previously noted. During the twelve months ended December 26, 2003, the Company used cash for operations of $62,100.
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The Company’s working capital varies from period to period depending on the mix, stage of completion and commercial terms and conditions of the Company’s contracts. Working capital needs increased in prior years as a result of the Company satisfying requests from its customers for more favorable payment terms under contracts. Such requests generally include reduced advance payments and less favorable payment schedules to the Company. As previously noted, Management forecasts that there will be sufficient liquidity to meet the Company’s operating requirement through June 2005, provided the Company successfully completes the equity for debt exchange offer.
Restricted cash at June 25, 2004 consists of approximately $4,200 held primarily by special purpose entities and restricted for debt service payments, approximately $52,000 that was required to collateralize letters of credit and bank guarantees, and approximately $1,300 of client escrow funds. Domestic restricted cash totals approximately $4,400, which relates to funds held primarily by special purpose entities and restricted for debt service payments and client escrow funds. Foreign restricted cash totals approximately $53,100 and is comprised of cash collateralized letters of credit and bank guarantees and client escrow funds.
During the first and second quarters of 2004, the E&C’s Italian business unit sold the development rights to certain power projects in Italy. The Company’s share of the proceeds from the sales, prior to repaying any borrowings under the Senior Credit Facility, approximated $10,500 in the first quarter of 2004 and $8,700 in the second quarter of 2004. While the sale of the power project development rights is recorded as one-time gains in the first and second quarters of 2004, the business in Italy has historically developed and sold such project rights, and is continuing to actively develop other project rights that are expected to be offered for sale in the future. The first quarter sale was executed through a joint venture and the Company does not have immediate access to the funds. Management forecasts that the sales proceeds will be distributed to the joint venture owners in the first half of 2005.
The Company retained from the Environmental sale, as further discussed in Note 10 to the condensed consolidated financial statements, a long-term contract with a government agency that is to be completed in four phases. The first phase was for the design, permitting and licensing of a spent fuel facility. This phase was completed for a price of $66,700. The first phase of this project was profitable, but the close-out of this phase resulted in increased costs. Profit reversal of $11,900 was recorded in 2003. Approximately $7,900 and $3,300 of this charge were expended in 2003 and the first six months of 2004, respectively, and the remaining $700 of the charge will be expended throughout the balance of 2004. The Company has submitted requests for equitable adjustment related to this contract and, at June 25, 2004 and December 26, 2003, the Company’s financial statements reflect anticipated collection of $0 from these requests for equitable adjustment.
The second phase of the contract is billed on a cost plus fee basis and is expected to conclude in 2004. In this phase, the Company must respond to any questions regarding the initial design included in phase one. Phase three, which is for the construction, start-up and testing of the facility for a fixed contractual price of $114,000, subject to escalation, and is contractually scheduled to commence in late 2004. The actual commencement of this phase will be delayed as a result of the significant delay in the issuance of the NRC license for the facility. This delay will also result in additional facility costs. The Company anticipates submitting requests for equitable adjustment to compensate for such delays and additional costs upon receipt of the NRC facility license. This phase will begin with the purchase of long lead items followed by the construction activities. Construction is expected to last two years and requires that a subsidiary of the Company fund the construction cost. Foster Wheeler USA Corporation, the parent company of Environmental, provided a performance guarantee on the project. In addition, a surety bond for the full contract price is required. The cost of the facility is expected to be recovered in the first nine months of operations under phase four, during which a subsidiary of the Company will operate the facility at fixed rates, subject to escalation, for approximately four years. The Company and the government agency have engaged in discussions about possibly restructuring or terminating subsequent phases of the contract. If the project were to proceed, the Company intends to seek third party financing to fund the majority of the construction costs, but there can be no assurance that the Company will secure such financing on acceptable terms, or at all. There also can be no assurance that the Company will be able to obtain the required surety bond. If the Company cannot obtain third party financing or the required surety bond, the Company’s participation would be uncertain. This could have a material adverse effect on the Company’s financial condition, results of operations, and cash flow. No claims have been raised by the government agency against the Company. The ultimate potential liability to the Company would arise in the event that the government agency terminates the contract (for example, due to the Company’s inability to continue with the contract) and re-bids the contract under its exact terms and the resulting cost to the government agency is greater than it would have been under the existing terms with the Company. The Company does not believe a claim is probable and is unable to estimate the possible loss that could occur as a result of any claims. Additionally, the Company believes that it has good legal defenses should the government agency decide to pursue any action.
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During the first six months of 2004, the Company settled several domestic contract disputes and was required to pay portions of settlements finalized in 2003. Net settlement proceeds of $8,200 were collected by the Company in the first six months of 2004. During 2003, the Company collected approximately $39,000 in net proceeds from domestic contract dispute settlements. An additional $2,000 will be paid by the Company over the balance of 2004 under terms of the 2003 settlement agreements.
In July 2003, several subsidiaries of the Company and Liberty Mutual Insurance Company (“Liberty Mutual”), one of its insurers, entered into a settlement and release agreement that resolves the coverage litigation between the subsidiaries and Liberty Mutual in state courts in both New York and New Jersey. The agreement provides for a buy-back of insurance policies and the settlement of all disputes between the subsidiaries and Liberty Mutual with respect to asbestos-related claims. The agreement requires Liberty Mutual to make payments over a nineteen-year period, subject to annual caps, which payments decline over time, into a special account, established to pay the subsidiaries’ indemnity and defense costs for asbestos claims. These payments, however, may not be available to fund the subsidiaries’ required contributions to any national settlement trust that may be established by future federal legislation. In July 2003, the subsidiaries received an initial payment under the agreement of approximately $6,000, which was used to pay asbestos-related defense and indemnity costs.
In September 2003, the Company’s subsidiaries entered into a settlement and release agreement that resolved coverage litigation between them and certain London Market and North River Insurers. This agreement provided for a cash payment of $5,900, which has been received by the subsidiaries, and additional amounts which have been deposited in a trust for use by the subsidiaries for future defense and indemnity costs.
The Company recorded a non-cash charge of $68,100 in the fourth quarter 2003 to increase the valuation allowance for insurance claims receivable. The charge was due to the Company receiving a somewhat larger number of claims in 2003 than had been expected, which resulted in an increase in the projected liability related to asbestos and because of the insolvency of an insurance carrier in the fourth quarter of 2003.
In January 2004, the Company’s subsidiaries entered into a settlement and release agreement that resolved coverage litigation between them and Hartford Accident and Indemnity Company and certain of its affiliates. This agreement provided for a cash payment of $5,000, which has been received by the subsidiaries, an additional amount which has been deposited in a trust for use by the subsidiaries and a further amount to be deposited in that trust in 2005.
In March 2004, the Company’s subsidiaries and two asbestos insurance carriers entered into settlement and release agreements that resolved coverage litigation between the subsidiaries and the insurance carriers. The agreements provided for a buy-back of insurance policies and the settlement of all disputes between the subsidiaries and the insurance carriers with respect to asbestos-related claims. The agreements resulted in the insurance carriers making payments into a trust, established to pay the subsidiaries’ indemnity and defense costs for asbestos claims. As a result of these settlements, the Company reversed $11,700 of the $68,100 non-cash charge previously recorded in the fourth quarter of 2003.
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In May 2004, the Company’s subsidiaries and two asbestos insurance carriers entered into two additional settlement and release agreements. The agreements resulted in the insurance carriers making payments to the Company to pay the subsidiaries’ indemnity and defense costs for asbestos claims. As a result of these settlements, the Company reversed an additional $1,700 of the $68,100 non-cash charge previously recorded in the fourth quarter of 2003. The Company projects that it will not be required to fund any asbestos liabilities from its cash flow before 2010.
It is customary in the industries in which the Company operates to provide letters of credit, bank guarantees or performance bonds in favor of clients to secure obligations under contracts. The Company and its subsidiaries traditionally obtained letters of credit or bank guarantees from its banks, or performance bonds from a surety on an unsecured basis. Due to the Company’s financial condition and current credit ratings, as well as changes in the bank and surety markets, the Company and its subsidiaries are now required in certain circumstances to provide security to banks and the surety to obtain new letters of credit, bank guarantees and performance bonds. Certain of the Company’s European subsidiaries are required to cash collateralize their bonding requirements. (Refer to Note 2, “Restricted Cash” and “Restricted Net Assets”). If the Company is unable to provide sufficient collateral to secure the letters of credit, bank guarantees and performance bonds, its ability to enter into new contracts could be materially limited. Providing collateral increases working capital needs and limits the ability to repatriate funds from operating subsidiaries.
On April 10, 2003 and October 28, 2003, the Board of Directors approved changes to the Company’s domestic employee benefits program, including the pension, postretirement medical, and 401(k) plans. The changes were made following an independent review of the Company’s domestic employee benefits which assessed the Company’s benefit program against that of the marketplace and its competitors. The principal changes consist of the following: the U.S. pension plan was frozen as of May 31, 2003, which means participants will not be able to increase the amount earned under the terms of the plan; the number of employees eligible for the postretirement medical plan will be reduced and the costs and benefits of the plan will be adjusted; and the 401(k) plan will be enhanced to increase the level of employer matching contribution. The net effect of these changes is expected to positively impact the financial condition of the Company through reduced costs and reduced cash outflow. The Company anticipates a savings in expenses over what would have been paid if the plans were not amended of approximately $10,000 per year. The savings commenced in 2004. The Company froze the Supplemental Employee Retirement Plan (“SERP”) and in April 2003 issued accreting letters of credit to certain employees. At June 25, 2004, letters of credit totaling $1,500 were outstanding under the SERP curtailment.
The Company maintains several defined benefit pension plans in its North American, United Kingdom, South African, and Canadian operations. Funding requirements for these plans are dependent, in part, on the performance of global equity markets and the discount rates used to calculate the present value of the liability. The poor performance of the global equity markets during recent years and low interest rates are expected to significantly increase the funding requirements for these plans in 2004 and 2005. The non-U.S. plans are funded from the local operating cash flows while funding for the U.S. plans is included within the U.S. working capital requirements previously noted. The U.S. pension plans are frozen and the United Kingdom’s plan is now closed to new entrants. The South African and Canadian plans are relatively immaterial in size. The liability interest rate used to calculate the U.S. funding requirement is established by the U.S. Government. The U.S. Congress previously passed legislation that temporarily increased the liability interest rate and thereby reduced the present value liability and corresponding funding requirements. This increased liability interest rate expired at the end of 2003. The U.S. Congress passed legislation amending the funding requirements. The funding requirement for the U.S. plans will approximate $29,200 in 2004 and $21,400 in 2005, versus $13,800 in 2003. The new legislation reduced the 2004 and 2005 funding requirements by approximately $7,800 and $12,600, respectively. The funding amounts incorporate the savings achieved through the modification of the Company’s domestic pension plans discussed above, but are subject to change as the performance of the plans’ investments and the liability interest rates fluctuate, and as the Company’s workforce demographics change. The next update will occur no later than the first quarter 2005.
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On November 14, 2003, the New York Stock Exchange (“NYSE”) de-listed the Company’s common stock as well as its related security, 9.00% FW Preferred Capital Trust I based on the Company’s inability to meet its listing criteria. The common stock and the 9.00% FW Preferred Capital Trust I securities are quoted on the Over-the-Counter Bulletin Board (“OTCBB”).
Under Bermuda law, the consent of the Bermuda Monetary Authority (“BMA”) is required prior to the transfer by non-residents of Bermuda of a Bermuda company’s shares. Since becoming a Bermuda company, Foster Wheeler has relied on an exemption from this rule provided to NYSE-listed companies. Due to the Company’s de-listing, this exemption was no longer available. To address this issue, the Company obtained the consent of the BMA to transfers between non-residents for so long as the Company’s shares continue to be quoted in the Pink Sheets or on the OTCBB. The Company believes that this consent will continue to be available.
The Board of Directors of the Company discontinued the common stock dividend in July 2001. The Company is currently prohibited from paying dividends under the Senior Credit Facility, as amended. Accordingly, the Company paid no dividends on common shares during the first six months of 2004 and does not expect to pay dividends on the common shares for the foreseeable future.
Backlog and New Orders Booked
The elapsed time from the award of a contract to completion of performance may be up to four years. The dollar amount of backlog is not necessarily indicative of the future earnings of the Company related to the performance of such work. The backlog of unfilled orders includes amounts based on signed contracts as well as agreed letters of intent which management has determined are likely to be performed. Although backlog represents only business that is considered firm, cancellations or scope adjustments may occur. Due to factors outside the Company’s control, such as changes in project schedules or project cancellations, the Company cannot predict with certainty the portion of backlog to be performed in a given year. Backlog is adjusted to reflect project cancellations, deferrals, sale of subsidiaries and revised project scope and cost.
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| Backlog | $ | 2,276,900 | | $ | 3,345,300 | | $ | (1,068,400 | ) | -31.9 | % | $ | 2,276,900 | | $ | 3,345,300 | | $ | (1,068,400 | ) | -31.9 | % |
| New orders | $ | 707,100 | | $ | 647,100 | | $ | 60,000 | | 9.3 | % | $ | 1,337,000 | | $ | 1,123,400 | | $ | 213,600 | | 19.0 | % |
As of June 25, 2004, approximately $1,124,900 or 49% of the consolidated backlog was from lump-sum work. As of June 27, 2003, approximately $1,658,800 or 50% of the consolidated backlog was from lump-sum work. Approximately $491,900 or 44% of the 2004 lump-sum backlog is attributable to the Energy Group. This compares to $930,600 or 56% as of June 27, 2003.
The reduction in backlog is attributable to both the E&C and Energy Groups’ operations as the level of operating revenues exceeded new orders during the last twelve months.
A total of 82% of new orders for the first six months of 2004 were for projects awarded to the Company’s subsidiaries located outside of the United States compared to 71% in first six months of 2003. Approximately 46% of new orders for the first six months of 2004 are lump sum contracts compared to 33% in the first six months of 2003. Key geographic regions contributing to new orders awarded in 2004 were Europe, the United States, the Middle East and Asia. The increase in new orders was primarily due to the winning of three significant larger E&C awards in Europe, and one in the USA, but was partially offset by a decline in the Energy Group. Additional information is included in the group discussions below.
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New order levels remain a concern as management believes the financial condition of the Company is having a negative impact with some clients. The Company established new, formalized internal reporting requirements in the second quarter of 2003 that closely monitors E&C man-hours in backlog and a new metric, Foster Wheeler scope.
Foster Wheeler scope is defined as the dollar value of backlog excluding costs incurred by Foster Wheeler as agent or as principal on a reimbursable basis (i.e., flow-through costs). Foster Wheeler scope measures the component of backlog with mark-up, and corresponds to Foster Wheeler services plus fees for reimbursable contracts, and total selling price for lump-sum contracts.
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| E&C manhours in quarter-end backlog (in thousands)* | | 4,899 | | | 4,696 | | | 203 | | 4.3 | % |
| Foster Wheeler scope in quarter-end backlog ** | $ | 1,324,000 | | $ | 1,747,500 | | $ | (423,500 | ) | -24.2 | % |
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| * | Excludes retained Foster Wheeler Environmental processing facility. |
| ** | Excludes Foster Wheeler Power Systems and Foster Wheeler Environmental processing facilities. |
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The decline in Foster Wheeler scope is attributable to both the Energy and E&C Groups.
Additional information is included in the group discussions below.
Engineering and Construction Group (E&C)
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| Backlog | $ | 1,586,900 | | $ | 2,188,600 | | $ | (601,700 | ) | -27.5 | % | $ | 1,586,900 | | $ | 2,188,600 | | $ | (601,700 | ) | -27.5 | % |
| New orders | $ | 601,900 | | $ | 460,400 | | $ | 141,500 | | 30.7 | % | $ | 1,075,400 | | $ | 723,200 | | $ | 352,200 | | 48.7 | % |
E&C manhours in quarter-end backlog
(in thousands)* | | 4,899 | | | 4,696 | | | 203 | | 4.3 | % | | 4,899 | | | 4,696 | | | 203 | | 4.3 | % |
Foster Wheeler scope in
quarter-end backlog * | $ | 725,100 | | $ | 682,600 | | $ | 42,500 | | 6.2 | % | $ | 725,100 | | $ | 682,600 | | $ | 42,500 | | 6.2 | % |
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| * | Excludes retained Foster Wheeler Environmental processing facility. |
Overall, the level of bookings rose significantly compared to 2003. This increase is primarily attributable to the European Operations. Approximately 62% of E&C backlog at June 25, 2004 and 58% of new orders for the first six months of 2004 were from cost reimbursable plus fee contracts. This compares to 69% and 71% for the corresponding period of 2003, respectively. Approximately 90% of E&C backlog at June 25, 2004 and 93% of new orders for the first six months of 2004 are for projects located outside North America. This compares to 87% and 95% for the corresponding period of 2003, respectively.
The Company believes higher expectations for world economic growth in 2004, in particular in the U.S. and Asia, did generally boost the confidence of oil, gas and chemical companies. Although new orders increased, the Company’s backlog continues to reflect the residual effects of weak investment over the last several years in many of the market sectors served by the E&C Group. Depressed oil refining margins discouraged investment in 2003 and this has impacted the current backlog, although the Company continued to win business for environmentally mandated clean fuels projects. The refinery and petrochemical markets were most active in the Middle East.
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The Company believes that the ongoing economic recovery in the United States has boosted prospects for growth in global trade, especially in Asia, in 2004. Growth in global trade is expected to impact the E&C industry in which the Company operates by, among other things, firming up the demand for oil and gas which management believes will help sustain higher energy prices and correspondingly drive demand for the Company’s business. Additionally, the Company believes gas to liquids plants may develop as a strong market segment. The Company anticipates investment in oil and gas production facilities will grow in the Middle East, Russia and the Caspian region. The liquid natural gas industry (“LNG”) continues to evidence intentions to develop the infrastructure to increase LNG imports to the United States. In addition, the ongoing economic recovery is also expected to increase demand for petrochemical products. The Company anticipates investment in new capacity to continue and be heavily concentrated in the Middle East and China, although the latter country’s demand for imports may encourage some investment in other parts of Asia. The Company anticipates increased petrochemical investment in 2005. As the Company previously anticipated, there appears to be a slowing of clean fuels projects at refineries in Europe and the U.S. as legislative demands are met. However, several Middle East countries have begun planning large investment programs to upgrade their refineries in order to meet the demands of clean fuels export markets. This follows a period of low refinery investment in that region. The pharmaceutical industry continues to invest but at a reduced level owing to excess production capacity following a series of mergers. In general, the Company believes the underlying growth in demand for pharmaceutical products should result in increased investment in the latter part of 2005 and 2006, and that the most significant investment will likely be spread across the U.S., Europe and Singapore. The Company presently expects that the growth in new orders resulting from these improved economic conditions will be realized in 2005 rather than in 2004.
Many of the target markets noted above require lump-sum contracts and the Company expects to increase the number of lump-sum contracts in the future and the number of countries where it is willing to execute lump-sum contracts.
On March 11, 2004, the Company’s U.K. subsidiary was awarded a contract by the Coalition Provisional Authority to undertake oil sector program management support services in Iraq. Mobilization of personnel to Iraq has been minimized until the security situation in Iraq improves.
During the second quarter of 2004, the Company’s U.K. subsidiary was also awarded two significant cost reimbursable plus fee projects in Saudi Arabia and the Company’s Italian subsidiary was awarded a major lump sum turnkey power plant project in Italy.
Energy Group
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| Backlog | $ | 692,800 | | $ | 1,163,600 | | $ | (470,800 | ) | -40.5 | % | $ | 692,800 | | $ | 1,163,600 | | $ | (470,800 | ) | -40.5 | % |
| New orders | $ | 105,200 | | $ | 187,400 | | $ | (82,200 | ) | -43.9 | % | $ | 261,500 | | $ | 397,500 | | $ | (136,000 | ) | -34.2 | % |
| Foster Wheeler scope in quarter-end backlog * | $ | 598,900 | | $ | 1,064,900 | | $ | (466,000 | ) | -43.8 | % | $ | 598,900 | | $ | 1,064,900 | | $ | (466,000 | ) | -43.8 | % |
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| * | Excludes Foster Wheeler Power Systems own and operate plants |
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The Energy Group’s backlog was $692,800 at June 25, 2004, representing a 41% decrease from June 27, 2003. Several large Heat Recovery Steam Generators and Selective Catalytic Reduction contracts were not replaced in 2003, thereby decreasing backlog in 2004. In addition, the supply and erect portions of a major contract anticipated to be released to the Finnish operation in the first half of 2004 were delayed and are now anticipated for the fourth quarter of 2004. The preliminary engineering for this project has been completed and an advance payment has been received for the supply and erect portions of the project.
The decline in new orders for the three and six months ended June 25, 2004 of $82,200 or 44% and $136,000 or 34% respectively is primarily a result of the depressed power market in North America. Approximately 70% of Energy backlog at June 25, 2004 and 58% of new orders for the first six months of 2004 were from lump-sum projects as compared to 73% and 41% in the corresponding period of 2003, respectively. Approximately 50% of Energy backlog at June 25, 2004, and 39% of new orders for the first six months of 2004, were for projects located outside North America as compared to 61% and 28% in the corresponding period of 2003, respectively. The decrease in the relative percentage of business outside North America reflects the slow power market in Europe.
Foster Wheeler scope declined $466,000 or 44%, as of June 25, 2004 as compared to June 27, 2003 and as expected is in line with the 41% decrease in backlog.
The North American power market continues to suffer from relatively slow economic growth, over capacity, and the financial difficulties of independent power producers. In 2004, maintenance and service contracts will continue to be the growth opportunities in the North American power market. Supply opportunities for new equipment associated with solid fuel boiler contracts are expected to be limited in the short term except for growth opportunities in circulating fluidized bed boilers which are expected to continue in certain European and Asian markets. Selected opportunities in environmental retrofits are expected to continue. The solid fuel power market in Europe is also depressed reflecting, in part, uncertainty about pending emission standards.
Other Matters
The ultimate legal and financial liability of the Company in respect to all claims, lawsuits and proceedings cannot be estimated with certainty. As additional information concerning the estimates used by the Company becomes known, the Company reassesses its position both with respect to gain contingencies and accrued liabilities and other potential exposures. Estimates that are particularly sensitive to future change relate to legal matters that are subject to change as events evolve and as additional information becomes available during the administration and litigation processes.
In the ordinary course of business, the Company and its subsidiaries enter into contracts providing for assessment of damages for nonperformance or delays in completion. Suits and claims have been or may be brought against the Company by customers alleging deficiencies in either equipment design or plant construction. Based on its knowledge of the facts and circumstances relating to the Company’s liabilities, if any, and to its insurance coverage, management of the Company believes that the disposition of such suits will not result in charges materially in excess of amounts provided in the accounts.
Inflation
The effect of inflation on the Company’s revenues and earnings is expected to be minimal. Although a majority of the Company’s revenues are realized under long-term contracts, the selling prices of such contracts, established for deliveries in the future, generally reflect estimated costs to complete in these future periods. In addition, some contracts provide for price adjustments through escalation clauses.
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Application of Critical Accounting Estimates
The Company’s condensed consolidated financial statements are presented in accordance with accounting principles generally accepted in the United States of America. Management and the Audit Committee of the Board of Directors approve the critical accounting policies.
Highlighted below are the accounting policies that management considers significant to the understanding and operations of the Company’s business as well as key estimates that are used in implementing the policies.
Revenue Recognition
Revenues and profits on long-term fixed-price contracts are recorded under the percentage-of-completion method. Progress towards completion is measured using physical completion of individual tasks for all contracts with a value of $5,000 or greater. Progress toward completion of fixed-priced contracts with a value under $5,000 is measured using the cost-to-cost method.
Revenues and profits on cost reimbursable contracts are recorded as the costs are incurred. The Company includes flow-through costs consisting of materials, equipment and subcontractor costs as revenue on cost-reimbursable contracts when the Company is responsible for the engineering specifications and procurement for such costs.
Contracts in progress are stated at cost, increased for profits recorded on the completed effort, or decreased for estimated losses, less billings to the customer and progress payments on uncompleted contracts. Negative balances are presented as “estimated costs to complete long-term contracts.”
The percentage-of-completion method is the preferable method of revenue recognition as set forth in the American Institute of Certified Public Accountants (“AICPA”) Statement of Position 81-1 (“SOP 81-1”), “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.”
The Company has thousands of projects in both reporting segments that are in various stages of completion. Such contracts require estimates to determine the appropriate final estimated cost (“FEC”), profits, revenue recognition, and the percentage complete. In determining the FEC, the Company uses significant estimates to forecast quantities to be expended (i.e. man-hours, materials and equipment), the costs for those quantities (including exchange rate fluctuations), and the schedule to execute the scope of work including allowances for weather, labor and civil unrest. Many of these estimates cannot be based on historical data as most contracts are unique, specifically designed facilities. In determining the revenues, the Company must estimate the percentage complete, the likelihood of the client paying for the work performed, and the cash to be received net of any taxes ultimately due or withheld in the country where the work is performed. Projects are reviewed on an individual basis and the estimates used are tailored to the specific circumstances. Significant judgment is exercised by management in establishing these estimates as all possible risks cannot be specifically quantified.
The percentage-of-completion method requires that adjustments or revaluations to estimated project revenues and costs, including estimated claim recoveries, be recognized on a cumulative basis, as changes to the estimates are identified. Revisions to project estimates are made on an individual project basis as additional information becomes available throughout the life cycle of contracts. If the FEC to complete long-term contracts indicates a loss, provision is made immediately for the total loss anticipated. Profits are accrued throughout the life of the project based on the percentage complete. The project life cycle, including the warranty commitments, can be up to six years in duration.
The recent financial results and the resultant intervention actions initiated by management evidence the fact that the estimates can be significantly different from the actual results. When these adjustments are identified near or at the end of a project, the full impact of the change in estimate would be recognized as a change in the margin on the contract in that period. This can result in a material impact on the Company’s results for a single reporting period. In accordance with the accounting and disclosure recommendations of SOP 81-1 and Accounting Principles Board Opinion No. 20, “Accounting Changes,” the Company reviews its contracts monthly. As a result of this process in the second quarter of 2004, seventy individual projects had final estimated profit revisions exceeding $500. These revisions resulted from events such as earning project incentive bonuses, executing services and purchasing third party materials and equipment at costs differing from previously estimated, and the successful testing of completed facilities which in turn eliminates completion and warranty risks. The aggregate dollar value of the accrued contract profit resulting from these estimate changes during the second quarter of 2004 amounted to a net of $47,800.
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Claims Recognition
Claims are amounts in excess of the agreed contract price (or amounts not included in the original contract price) that a contractor seeks to collect from clients or others for delays, errors in specifications and designs, contract terminations, change orders in dispute or unapproved as to both scope and price or other causes of unanticipated additional costs. The Company records claims in accordance with paragraph 65 of the AICPA SOP 81-1. This statement of position states that recognition of amounts as additional contract revenue related to claims is appropriate only if it is probable that the claims will result in additional contract revenue and if the amount can be reliably estimated. Those two requirements are satisfied by management’s determination of the existence of all of the following conditions: the contract or other evidence provides a legal basis for the claim; additional costs are caused by circumstances that were unforeseen at the contract date and are not the result of deficiencies in the contractor’s performance; costs associated with the claim are identifiable or otherwise determinable and are reasonable in view of the work performed; and the evidence supporting the claim is objective and verifiable. If such requirements are met, revenue from a claim is recorded to the extent that contract costs relating to the claim have been incurred. The amounts recorded, if material, are disclosed in the notes to the financial statements. Costs attributable to claims are treated as costs of contract performance as incurred.
In 2002, the Company revised its estimates of claim revenues to reflect recent adverse recovery experience due to management’s desire to monetize claims, and the poor economic conditions impacting the markets served by the Company. As a result, pretax charges approximating $136,200 were recorded in 2002. As claims are settled, differences between the claim specific amounts reflected in the financial statements and the settlements are recorded as gains or losses. The Company continues to actively pursue claims remaining open and, in 2003 recoveries of $1,500 were recognized as income when collected. At December 26, 2003, the Company had no claims and no requests for equitable adjustment recorded. At June 25, 2004, the Company had claims of $2,300 and no requests for equitable adjustment recorded. Company policy requires all new claims in excess of $500 to be formally reviewed and approved by the corporate chief financial officer prior to being recorded in the financial results.
Asbestos
The Company has recorded total liabilities of $532,900, comprised of an estimated liability relating to open (outstanding) claims of approximately $318,900 and an estimated liability relating to future unasserted claims of approximately $214,000. Of the total, $60,000 is recorded in accrued expenses and $472,900 is recorded in asbestos-related liability on the condensed consolidated balance sheet. These estimates are based upon the following information and/or assumptions: number of open claims; forecasted number of future claims; estimated average cost per claim by disease type; and the breakdown of known and future claims into disease type. The total estimated liability includes both the estimate of forecasted indemnity amounts and forecasted defense expenses. Total estimated defense costs and indemnity payments are estimated to be incurred through the year 2018, during which period new claims are expected to decline from year to year. Recently received claims also suggest that the percentage of claims to be closed without payment of indemnity costs should increase as claims are resolved during the next few years. The Company believes that it is likely that there will be new claims filed after 2018, but in light of uncertainties inherent in long-term forecasts, the Company does not believe that it can reasonably estimate defense and/or indemnity costs which might be incurred after 2018. Nonetheless, the Company plans to update its forecasts periodically to take into consideration its future experience and other considerations such as legislation to update its estimate of future costs and expected insurance recoveries. Historically, defense costs have represented approximately 22% of total costs. Through June 25, 2004, total indemnity costs paid, prior to insurance recoveries, were approximately $404,000 and total defense costs paid were approximately $112,000.
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The Company has recorded assets of $515,400 relating to probable insurance recoveries, of which approximately $60,000 is recorded in accounts and notes receivables, and $455,400 is recorded as long-term. The asset is an estimate of recoveries from insurers based upon assumptions relating to cost allocation and resolution of pending proceedings with certain insurers, as well as recoveries under settlements with other insurers.
As of June 25, 2004, approximately $231,000 was contested by the Company’s subsidiaries’ insurers in ongoing litigation. The litigation relates to the proper allocation of the coverage liability among the subsidiaries’ various insurers and the subsidiaries as self-insurers. The Company believes that any amounts that its subsidiaries might be allocated as self-insurers would be immaterial. Based on the nature of the litigation and the opinions received from outside counsel, the Company believes that the possibility of not recovering the full amount of the asset is remote.
In July 2003, several subsidiaries of the Company and Liberty Mutual, one of its insurers, entered into a settlement and release agreement that resolves the coverage litigation between the subsidiaries and Liberty Mutual in state courts in both New York and New Jersey. The agreement provides for a buy-back of insurance policies and the settlement of all disputes between the subsidiaries and Liberty Mutual with respect to asbestos-related claims. The agreement requires Liberty Mutual to make payments over a nineteen-year period, subject to annual caps, which payments decline over time, into a special account, established to pay the subsidiaries’ indemnity and defense costs for asbestos claims. These payments, however, may not be available to fund the subsidiaries’ required contributions to any national settlement trust that may be established by future federal legislation. In July 2003, the subsidiaries received an initial payment under the agreement of approximately $6,000, which was used to pay asbestos-related defense and indemnity costs.
In September 2003, the Company’s subsidiaries entered into a settlement and release agreement that resolved coverage litigation between them and certain London Market and North River Insurers. This agreement provided for a cash payment of $5,900, which has been received by the subsidiaries, and additional amounts which have been deposited in a trust for use by the subsidiaries for future defense and indemnity costs.
The Company recorded a non-cash charge of $68,100 in the fourth quarter 2003 to increase the valuation allowance for insurance claims receivable. The charge was due to the Company receiving a somewhat larger number of claims in 2003 than had been expected, which resulted in an increase in the projected liability related to asbestos and because of the insolvency of an insurance carrier in the fourth quarter of 2003.
In January 2004, the Company’s subsidiaries entered into a settlement and release agreement that resolved coverage litigation between them and Hartford Accident and Indemnity Company and certain of its affiliates. This agreement provided for a cash payment of $5,000, which has been received by the subsidiaries, an additional amount which has been deposited in a trust for use by the subsidiaries and a further amount to be deposited in that trust in 2005.
In March 2004, the Company’s subsidiaries and two asbestos insurance carriers entered into settlement and release agreements that resolved coverage litigation between the subsidiaries and the insurance carriers. The agreements provided for a buy-back of insurance policies and the settlement of all disputes between the subsidiaries and the insurance carriers with respect to asbestos-related claims. The agreements resulted in the insurance carriers making payments into a trust, established to pay the subsidiaries’ indemnity and defense costs for asbestos claims. As a result of these settlements, the Company reversed $11,700 of the $68,100 non-cash charge recorded in the fourth quarter of 2003.
In May 2004, the Company’s subsidiaries and two asbestos insurance carriers entered into two additional settlement and release agreements. The agreements resulted in the insurance carriers making payments to the Company to pay the subsidiaries’ indemnity and defense costs for asbestos claims. As a result of these settlements, the Company reversed an additional $1,700 of the $68,100 non-cash charge previously recorded in the fourth quarter of 2003. The Company projects that it will not be required to fund any asbestos liabilities from its cash flow before 2010.
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Management of the Company has considered the asbestos litigation and the financial viability and legal obligations of its subsidiaries’ insurance carriers and believes that except for those insurers which have become or may become insolvent for which a reserve has been provided, the insurers or their guarantors will continue to adequately fund claims and defense costs relating to asbestos litigation. The average cost per closed claims since 1993 is $1.9.
It should be noted that the estimates of the assets and liabilities related to asbestos claims and recovery are subject to a number of uncertainties that may result in significant changes in the current estimates. Among these are uncertainties as to the ultimate number of claims filed, the amounts of claim costs, the impact of bankruptcies of other companies currently involved in litigation, the Company’s subsidiaries’ ability to recover from their insurers, uncertainties surrounding the litigation process from jurisdiction to jurisdiction and from case to case, as well as potential legislative changes. If the number of claims received in the future exceeds the Company’s estimate, it is likely that the costs of defense and indemnity will similarly exceed the Company’s estimates. These factors are beyond the Company’s control and could have a material adverse effect on the Company’s financial condition, results of operations, and cash flows.
The Company’s subsidiaries have been effective in managing the asbestos litigation in part because (1) the Company’s subsidiaries have access to historical project documents and other business records going back more than 50 years, allowing them to defend themselves by determining if they were present at the location that is the cause of the alleged asbestos claim and, if so, the timing and extent of their presence, (2) the Company’s subsidiaries maintain good records on insurance policies and have identified policies issued since 1952, and (3) the Company’s subsidiaries have consistently and vigorously defended these claims which has resulted in dismissal of claims that are without merit or settlement of claims at amounts that are considered reasonable.
Pension
The calculations of pension liability, annual service cost, and cash contributions required rely heavily on estimates about future events often extending decades into the future. Management is responsible for establishing the estimates used and major estimates include:
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| • | The annual inflation percentage |
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| • | The discount rate used to present value the future obligations |
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| • | The expected long-term rate of return on plan assets |
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| • | The selection of the actuarial mortality tables |
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| • | The plan’s demographics |
Management utilizes its business judgment in establishing these estimates. The estimates can vary significantly from the actual results and management cannot provide any assurance that the estimates used to calculate the pension liabilities included herein will approximate actual results. The volatility between the assumptions and actual results can be significant. For example, the rate of return performance by the global equity markets during 2000-2002 was significantly worse than expected, while the rate of return on the equity markets in 2003 was better than expected. The expected long-term rate of return on plan assets is developed using a weighted-average methodology, blending the expected returns on each class of investment in the plans’ portfolio. The expected returns by asset class are developed considering both past performance and future considerations. The long-term rate of return is reviewed annually by the Company for its funded plans and adjusted, if required. The weighted-average expected long-term rate of return on plan assets has declined from 9.3% to 7.9% over the past three years. Returns on the Company’s pension plan assets in the United States from 2000 through 2002 were less than the estimates by approximately $100,000. A reduction in the U.S. interest rate serving as the basis for the discount rate assumptions during the same three years accounted for an approximate $40,000 increase in the Company’s calculated liability.
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Pension liability calculations are normally updated annually at each year-end, but may be updated in interim periods if any major plan amendments or curtailments occur. The Company’s liability calculation is reflected in the financial statements herein.
Long-Lived Asset Accounting
The Company accounts for its long-lived assets as assets to be held and used. Management periodically reviews subsidiaries for impairment as required under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” using an undiscounted cash flow analysis. These reviews require estimating the costs to operate and maintain the facilities over an extended period that could approximate 25 years or more. Estimates are made regarding the costs to maintain and replace equipment throughout the facilities, period operating costs, the production quantities and revenues, and the ability by clients to financially meet their obligations. If a formal decision is made by management to sell an asset, a discounted cash flow methodology is utilized for such assessment.
Certain special-purpose subsidiaries in the Energy Group are reimbursed by customers for their costs, including amounts related to principal repayments of non-recourse project debt, for building and operating certain facilities over the lives of the non-cancelable service contracts. The Company records revenues relating to debt repayment obligations on these contracts on a straight-line basis over the lives of the service contracts, and records depreciation of the facilities on a straight-line basis over the estimated useful lives of the facilities, after consideration of the estimated residual value.
Income Taxes
Deferred income taxes are provided on a liability method whereby deferred tax assets/liabilities are established for the difference between the financial reporting and income tax basis of assets and liabilities, as well as operating loss and tax credit carryforwards. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.
Investment tax credits are accounted for by the flow-through method whereby they reduce income taxes currently payable and the provision for income taxes in the period the assets giving rise to such credits are placed in service. To the extent such credits are not currently utilized on the Company’s tax return, deferred tax assets, subject to considerations about the need for a valuation allowance, are recognized for the carryforward amounts.
In the fourth quarter of 2001, the Company established a valuation allowance of $194,600, primarily for domestic deferred tax assets under the provisions of SFAS No. 109. Such action was required due to the losses from domestic operations experienced in the three most recent fiscal years. For statutory purposes, the majority of the deferred tax assets for which a valuation allowance was provided do not begin to expire until 2020 and beyond, based on the current tax laws. Based on the establishment of the valuation allowance, the Company does not anticipate recognizing a provision for federal income taxes on domestic operations until some time subsequent to the successful completion of the proposed restructuring.
If the Company completes the proposed exchange offer as discussed in Note 1, it will be subject to substantial limitations on the use of pre-exchange losses and credits to offset U.S. federal taxable income in any post-exchange year. Since a valuation allowance has already been reflected to offset these losses and credits, this limitation will not result in a significant write-off by the Company.
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Performance Improvement Intervention
In March 2002, the Company initiated a comprehensive plan to enhance cash generation and to improve profitability. The operating performance portion of the plan concentrated on the quality and quantity of backlog, the execution of projects in order to achieve or exceed the profit and cash targets and the optimization of all non-project related cash sources and uses, including cost reductions. In connection with this plan, a group of outside consultants was hired for the purpose of carrying out a performance improvement intervention. The tactical portion of the performance improvement intervention concentrates on booking current projects, and generating incremental cash from high leverage opportunities such as overhead reductions, procurement, and accounts receivable. The systemic portion of the performance improvement intervention concentrates on sales effectiveness, estimating, bidding, and project execution procedures. Management believes the turnaround of the Energy Group’s North American operating unit is in large part the result of the intervention activities.
Code of Ethics
The Company maintains a code of ethics for all employees, including executive management. No exceptions or waivers were made to the code of ethics during the first half of 2004.
Accounting Developments
In January 2003, the FASB issued FASB Interpretation (“FIN”) 46, “Consolidation of Variable Interest Entities.” This interpretation requires consolidation by business enterprises of variable interest entities, which have one or both of the following characteristics:
| | • | The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interest that will absorb some or all of the expected losses of the entity; and |
| | | |
| | • | The equity investors lack one or more of the following essential characteristics of a controlling financial interest: a) the direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights; b) the obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to finance its activities; and c) the right to receive expected residual returns of the entity if they occur, which is the compensation for the risk of absorbing the expected loss. |
FIN 46 applied immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. On October 9, 2003, the effective date of FIN 46 for variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003 was deferred until the end of the first interim or annual period ending after March 15, 2004.
The Company adopted the provisions of this interpretation in the first quarter of 2004. The adoption did not result in the consolidation of any previously unconsolidated variable interest entities. However, the adoption did result in the de-consolidation of a subsidiary trust, which issued mandatorily redeemable preferred securities. This had no impact on the Company’s consolidated debt as the intercompany debt to the subsidiary became third party debt upon de-consolidation.
In December 2003, the FASB issued SFAS No. 132R “Employers’ Disclosure about Pensions and Other Postretirement Benefits.” SFAS No. 132R requires the following disclosures: (1) the dates on which plan assets and obligations are measured, (2) segregation of the market values of plan assets into broad asset categories, (3) a narrative description of the investment policy of plan assets, (4) a narrative description for the basis for the development of the expected long-term rate of return of plan assets, (5) expected cash contributions to be made to the plans over the next fiscal year and (6) expected benefit payments for each of the next ten fiscal years. These changes are effective for fiscal years ending after December 15, 2003, with the exception of (1) expected benefit payments and (2) foreign plans which are delayed until fiscal years ending after June 15, 2004. SFAS No. 132R requires disclosure of two items in quarterly interim reports. These quarterly requirements are the disclosure of net benefit cost and contributions made during the fiscal year. The Company adopted the disclosure requirements of this standard, including the foreign plans.
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On January 12, 2004, the FASB issued FASB Staff Position (“FSP”) No. 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.” FSP No. 106-1 permitted employers that sponsor postretirement benefit plans that provide prescription drug benefits to retirees to make a one-time election to defer accounting for any effects of the Medicare Prescription Drug Improvement and Modernization Act of 2003 (the “Act”). Without FSP No. 106-1, plan sponsors would have been required under SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other than Pensions,” to account for the effects of the Act in the fiscal period that includes December 8, 2003, the date President Bush signed the Act into law. On May 19, 2004, the FASB issued FSP No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.” FSP No. 106-2 supercedes FSP No. 106-1. In accordance with FSP No. 106-2, the accumulated postretirement benefit obligation and the net periodic postretirement benefit cost in the condensed consolidated financial statements or accompanying notes do not reflect any amounts associated with the subsidy because the Company is unable to conclude whether the benefits provided by the plan are actuarially equivalent to Medicare Part D under the Act. The provisions of FSP No. 106-2 are effective for the Company’s first interim period ending September 24, 2004. The Company is currently assessing the impact of the Act and whether its postretirement plan should be amended in consideration of the new legislation.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF FW PREFERRED CAPITAL TRUST I
(in thousands of dollars)
FW Preferred Capital Trust I (“the Capital Trust”) is a 100% indirectly owned finance subsidiary of the Company which issued the $175,000 Trust Preferred Securities (the “Trust Securities”). The Capital Trust invested the proceeds from the Trust Securities in an equal principal amount of 9.0% junior subordinated deferrable interest debentures (the “Debentures”) of Foster Wheeler LLC. Prior to December 27, 2003 the Capital Trust was consolidated in the financial statements of the Company and the Trust Securities were presented as mandatorily redeemable preferred securities of subsidiary trust holding solely junior subordinated deferrable interest debentures in the condensed consolidated balance sheet. The accumulated undistributed quarterly distributions were presented on the condensed consolidated balance sheet as deferred accrued mandatorily redeemable preferred security distributions of subsidiary trust. The distributions expense on the Trust Securities was presented as mandatorily redeemable preferred security distributions of subsidiary trust on the condensed consolidated statement of operations and comprehensive loss.
In the quarter ended March 26, 2004, the Company adopted FIN 46, “Consolidation of Variable Interest Entities,” for variable interest entities formed prior to February 1, 2003. In accordance with the provisions of FIN 46, the Company determined that (i) the Capital Trust is a variable interest entity and (ii) the Company is not the primary beneficiary. Accordingly, the Company de-consolidated the Capital Trust as of December 27, 2003. The Company’s condensed consolidated balance sheet now reflects Foster Wheeler LLC’s obligations to the Capital Trust as subordinated deferrable interest debentures and deferred accrued interest on subordinated deferrable interest debentures. The interest expense on the Debentures is presented on the condensed consolidated statement of operations and comprehensive loss as interest expense on subordinated deferrable interest debentures.
The following is Management’s Discussion and Analysis of certain significant factors that have affected the financial condition and results of operations of the Capital Trust for the periods indicated below. This Management’s Discussion and Analysis and other sections of this Report on Form 10-Q contain forward-looking statements that are based on management’s assumptions, expectations and projections about the Capital Trust. Such forward-looking statements by their nature involve a degree of risk and uncertainty.
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Overview – The Capital Trust
The financial condition and results of operations of the Capital Trust are dependent on the financial condition and results of operations of Foster Wheeler Ltd. and Foster Wheeler LLC since the Capital Trust’s only assets are the Debentures. The Capital Trust’s only source of income and cash is the interest income on the Debentures. These Debentures have essentially the same terms as the Trust Securities. Therefore, the Capital Trust can only make payments on the Trust Securities if Foster Wheeler LLC first makes payments on the Debentures.
Since January 15, 2002, Foster Wheeler LLC has exercised its right to defer payments on the Debentures. Foster Wheeler Ltd.’s Senior Credit Facility, as amended, requires that the payment of the dividends on the Trust Securities continue to be deferred; accordingly, no dividends were paid during the first quarter 2004.
Results of Operations – The Capital Trust
Three months and six months ended June 25, 2004 compared to the three and six months ended June 27, 2003
| | Three Months Ended | | | Six Months Ended | |
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| | June 25, | | June 27, | | | | | % | | | June 25, | | June 27, | | | | | % | |
| | 2004 | | | 2003 | | Change | | Change | | | 2004 | | | 2003 | | Change | | Change | |
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| |
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| |
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| Change in valuation | | | | | | | | | | | | | | | | | | | | | | | |
| allowance | $ | 21,000 | | $ | 22,050 | | $ | (1,050 | ) | -4.8 | % | | $ | 36,400 | | $ | 29,400 | | $ | 7,000 | | 23.8 | % |
| Preferred security | | | | | | | | | | | | | | | | | | | | | | | |
| distributions expense | $ | 4,901 | | $ | 4,487 | | $ | 414 | | 9.2 | % | | $ | 9,693 | | $ | 8,859 | | $ | 834 | | 9.4 | % |
The valuation allowance on the investment in subordinated deferrable interest debentures and related interest income receivable was established based on the financial condition of Foster Wheeler LLC and Foster Wheeler Ltd. and Foster Wheeler LLC’s decision to exercise its right to defer payments on the subordinated deferrable interest debentures since January 15, 2002. The change in the valuation allowance for the three and six months ended June 25, 2004 and 2003, resulted from an increase in the market price of the Trust Securities, which is deemed a proxy for the fair value of the subordinated deferrable interest debentures. The market price per security of the Trust Securities was $8.20 as of June 25, 2004, $5.20 as of March 26, 2004, $3.00 as of December 26, 2003, $5.55 as of June 27, 2003, $2.40 as of March 28, 2003 and $1.35 as of December 27, 2002.
The preferred security distributions expense represents the accrual for cash distributions due on the Trust Securities. Distributions accrue at an annual rate of 9% on the $175,000 liquidation amount of the Trust Securities, compounded quarterly. Additionally, deferred distributions accrue interest at an annual rate of 9%, compounded quarterly, as well. Accordingly, the increase in preferred security distributions expense for the three and six months ended June 25, 2004, resulted from the accrual on the undistributed preferred security distributions. As noted previously, the Capital Trust has deferred the distributions on the Trust Securities in conjunction with Foster Wheeler LLC’s decision to defer interest payments on the Debentures since January 15, 2002.
Financial Condition – The Capital Trust
The investment in subordinated deferrable interest debentures of Foster Wheeler LLC increased by $21,000 and $36,400 for the three and six months ended June 25, 2004, respectively, as a result of a decrease in the valuation allowance. The change in the required valuation allowance resulted from an increase in the market price of the Trust Securities, which is deemed a proxy for the fair value of the subordinated deferrable interest debentures.
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The increase in the deferred accrued mandatorily redeemable preferred security distributions from 2003 to 2004 results from the deferral of distributions on the Trust Securities in conjunction with Foster Wheeler LLC’s decision to defer interest payments on the Debentures since January 15, 2002. During this deferral period, distributions on Trust Securities will continue to accrue at an annual rate of 9%, compounded quarterly. Additionally, deferred distributions accrue interest at an annual rate of 9%, compounded quarterly, as well.
The preferred securities holders’ deficit for the six months ended June 25, 2004 decreased by $26,700, due solely to the net earnings for the period.
Liquidity and Capital Resources – The Capital Trust
The Capital Trust’s ability to continue as a going concern is dependent on Foster Wheeler Ltd.’s and Foster Wheeler LLC’s ability to continue as a going concern as the Capital Trust’s only asset is the Debentures. Foster Wheeler LLC, an indirect wholly owned subsidiary of the Company, is essentially a holding company which owns the stock of various subsidiary companies, and is included in the condensed consolidated financial statements of the Company. As previously discussed, Foster Wheeler Ltd. may not be able to continue as a going concern. Refer to the previous discussion of Foster Wheeler Ltd.’s liquidity and capital resources.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
(in thousands of dollars)
Management’s strategy for managing transaction risks associated with currency fluctuations is for each operating unit to enter into derivative transactions, such as forward foreign exchange agreements, to hedge its exposure on contracts into the operating unit’s functional currency. The Company utilizes all such financial instruments solely for hedging. Corporate policy prohibits the speculative use of such instruments. The Company is exposed to credit loss in the event of nonperformance by the counter parties to such financial instruments. To minimize this risk, the Company enters into these financial instruments with financial institutions that are primarily rated A or better by Standard & Poor’s or A2 or better by Moody’s. The geographical diversity of the Company’s operations mitigates to some extent the effects of the currency translation exposure. However, the Company maintains substantial operations in Europe and is subject to translation risk for the Euro and the pound Sterling. No significant unhedged assets or liabilities are maintained outside the functional currency of the operating subsidiaries. Accordingly, translation exposure is not hedged.
Interest Rate Risk - The Company is exposed to changes in interest rates primarily as a result of its borrowings under its Revolving Credit Agreement and its variable rate project debt. If market rates average 1% more in 2004 than in 2003, the Company’s interest expense for the next twelve months would increase, and income before tax would decrease by approximately $1,300. This amount has been determined by considering the impact of the hypothetical interest rates on the Company’s variable-rate balances as of June 25, 2004. In the event of a significant change in interest rates, management would likely take action to further mitigate its exposure to the change. However, due to uncertainty of the specific actions that would be taken and their possible effects, the sensitivity analysis assumes no changes in the Company’s financial structure.
Foreign Currency Risk - The Company has significant overseas operations. Generally, all significant activities of the overseas affiliates are recorded in their functional currency, which is generally the currency of the country of domicile of the affiliate. This results in a mitigation of the potential impact of earnings fluctuations as a result of changes in foreign exchange rates. In addition, in order to further mitigate risks associated with foreign currency fluctuations, the affiliates of the Company enter into foreign currency exchange contracts to hedge the exposed contract value back to their functional currency. As of June 25, 2004, the Company had approximately $43,500 of foreign exchange contracts outstanding. These contracts mature in 2004. The contracts have been established by various international subsidiaries to sell a variety of currencies and either receive their respective functional currency or other currencies for which they have payment obligations to third parties. The Company does not enter into foreign currency contracts for speculative purposes.
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Inflation
The effect of inflation on the Company’s revenues and earnings is expected to be minimal. Although a majority of the Company’s revenues are made under long-term contracts, the selling prices of such contracts, established for deliveries in the future, generally reflect estimated costs to complete in these future periods. In addition, some contracts provide for price adjustments through escalation clauses.
ITEM 4. CONTROLS AND PROCEDURES
(in thousands of dollars)
Included as Exhibits 31.1 and 31.2 are the Certifications that are required under Section 302 of the Sarbanes-Oxley Act of 2002. This section of the Report contains information concerning the controls evaluation referred to in the Section 302 Certifications and the information contained herein should be read in conjunction with the Certifications.
Internal controls are designed with the objective of ensuring that assets are safeguarded, transactions are authorized, and financial reports are prepared on a timely basis in accordance with accounting principles generally accepted in the United States. The disclosure controls and procedures are designed to comply with the regulations established by the SEC.
Disclosure controls and procedures mean controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Exchange Act is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure.
Internal controls over financial reporting and disclosure controls and procedures, no matter how designed, have limitations. It is the Company’s intent that the internal controls be conceived to provide reasonable assurance that the objectives of the controls are met. Management plans to continue its review of internal controls and disclosure procedures on an ongoing basis.
The Company initiated a detailed review of internal controls over financial reporting in the third and fourth quarters of 2002. The review included evaluation of the Company’s contracting policies and procedures relating to bidding and estimating practices. Among other things, these reviews included evaluation of the Company’s reserving practices for bad debts and uncollectible accounts receivables, warranty costs, change orders and claims. Management, with approval of the Audit Committee of the Board of Directors, enhanced its policies and established more formalized and higher level approvals for setting and releasing project contingencies and reserves, establishing claims and change orders, and requires that all claims to be recorded in excess of $500 be reviewed and approved in advance by the Company’s chief financial officer.
Management strengthened the Company’s financial controls and supplemented its financial and management expertise in 2002 and 2003. This included expanding the scope of the internal audit function.
The Company outsourced its internal audit function to Deloitte & Touche LLP in the fourth quarter of 2002. Outsourcing internal audit allowed access to a world-class organization with skilled professionals and the latest information technology audit resources. Key objectives of the revised internal audit function include:
| | • | Focusing resources on improving operational and financial performance in areas of highest risk; |
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| | • | Reviewing and strengthening existing internal controls; |
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| | • | Mitigating the risk of internal control failures; and |
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| | • | Ensuring best practices are implemented across all business units. |
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In the second quarter of 2004, the Company decided to transition to a co-source arrangement with Deloitte & Touche. A Company employee now leads the internal audit function, but it is supported by the Deloitte & Touche organization.
The Company formed a disclosure review committee in the first quarter of 2003. The purpose of the committee is to evaluate, review and modify as necessary the disclosure controls and procedures designed to ensure that information required to be disclosed in the Company’s periodic reports is recorded, processed, summarized and reported accurately in all material respects within the time periods required by the SEC’s rules and forms.
Management also amended the composition of the boards of directors of the major operating companies to include at least three corporate executives. One of the corporate executives is also chairman of the disclosure committee. The Company believes that these changes in corporate governance will enhance the disclosure controls because critical operating information and strategic actions authorized will now involve the chairman of the disclosure committee. Internal controls have been enhanced by these corporate governance changes.
Management began the formal documentation of the Company’s worldwide internal controls in 2003 as part of new requirements under the Sarbanes-Oxley legislation. This process has moved to the testing phase, which will continue throughout 2004.
During the second quarter of 2004, management placed the leadership of all Energy Group operating companies under the leadership of its North American Power management team. A new Chief Financial Officer was added to the existing financial team in its European Power operating unit, and a new Chief Financial Officer was appointed to the Engineering and Construction Group’s Asia Pacific operating unit. Management believes these and other staff changes will enhance internal and disclosure controls.
The Company’s financial reporting requirements increased significantly as a result of the SEC requirements relating to the security interest granted to the Senior Note holders in August 2002, and from the financial reporting requirements relating to the proposed exchange offer and restructuring process. Nine additional sets of audited financial statements for subsidiary companies (including three years comparable results) were required for 2002 and the first nine months of 2003. The additional year-end financial statements were erroneously omitted from the Company’s 2002 10-K filing as the result of an oversight. The Company had a process in place both internally and externally whereby this evaluation was made and an error occurred in the evaluation process. The preparation of these additional financial statements began near the end of the third quarter of 2003 in connection with the preparation of the amended 2002 10-K, which was filed on December 19, 2003. In addition, the Company’s accounting workload increased due to its operational restructuring and certain potential divestitures pursued in the second half of 2003, which were later discontinued. Early in the fourth quarter of 2003, a key financial officer responsible for the preparation of the nine sets of subsidiary financial statements resigned. As a result of all of these factors taken together, during the fourth quarter of 2003, the Company’s remaining permanent corporate accounting staff was not structured to address this increased workload under the deadlines required. The Company hired temporary professional personnel to assist with the process. Because the temporary personnel were unfamiliar with the Company’s operations, this resulted in inefficiencies in the financial reporting process. The external auditors notified the Audit Committee of the Board of Directors on December 16, 2003 that they believed the insufficient staffing levels in the corporate accounting department represented a “material weakness” in the preparation of the subsidiary financial statements, but noted that this did not constitute a material weakness for the Company’s consolidated financial statements. A material weakness is defined as “a condition in which the design or operation of one or more of the internal control components does not reduce to a relatively low level the risk that misstatements caused by error or fraud in amounts that would be material in relation to the financial statements being audited may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions.” The Company has assigned the highest priority to the assessment of this internal control deficiency and has taken actions it believes necessary to address this material weakness, but the Company believes additional time must pass in order for the additional staff to become fully trained and integrated into its operations and to evidence that the additional staff is performing as intended.
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The initiatives associated with implementation of the Sarbanes Oxley legislation require the Company to increase the quantity and quality of its financial professionals throughout the world. This is a management objective for 2004.
On March 3, 2004, in connection with its audit of the Company’s financial statements for fiscal 2003, the Company’s external auditors notified the Audit Committee of the Board of Directors that they believed the lack of formal process in place for senior financial management to review assumptions and check calculations on a timely basis relating to the Company’s asbestos liability and asset balances represented a “material weakness” in the internal controls for the preparation of the Company’s consolidated financial statements for 2003. In order to meet the accelerated deadline for filing its 10-K, in connection with the preparation of its 2003 consolidated financial statements, the Company submitted its calculations and assumptions relating to asbestos liability and related assets to the external auditors for their review prior to being fully reviewed by senior management. As a result, the external auditors noted a proposed change in an assumption used to calculate liability that had not been approved by senior management and also noted a mechanical error in calculating the number of open claims. Prior to December 26, 2003, the Company followed an informal process whereby its senior management reviewed asbestos assumptions and calculations after they were prepared by the Company’s internal asbestos matters team. Until his retirement at the end of fiscal 2003, the Company’s General Counsel, a member of senior management, led this process. Following his retirement, as well as the departure in January of 2004 of the Company’s Chief Financial Officer, as discussed above this process was not followed. In response, the Company corrected the mechanical error in its calculation and determined not to make the proposed change in the assumption.
Estimating the Company’s obligations arising from asbestos litigation, and the amounts of related insurance recoveries is a complex process involving many different assumptions about future events extending well into the future. These assumptions are developed by management together with its internal and external asbestos litigation team based on historical data regarding asbestos claims made against the Company, recoveries sought and settlement and trial resolution data. As these factors vary over any given period, the assumptions about future periods used to calculate the Company’s asbestos liabilities are adjusted correspondingly. The Company’s process of having its senior management review these assumptions was not followed in connection with the preparation of the 2003 financial statements. In their March 3, 2004 letter, the external auditors recommended that the assumptions and calculations prepared by members of the Company’s asbestos litigation team be reviewed carefully by the Chief Accounting Officer of the Company and that all significant assumptions and estimates, including changes thereof, be approved by the Chief Financial and Chief Executive Officers of the Company prior to the asbestos calculations being submitted to the external auditor. The Company agreed with these suggestions and has adopted them both in connection with the 2003 audit and going forward. All asbestos estimates and assumptions included in the accompanying financial statements for the first six months of 2004 have been subjected to appropriate review by senior management.
The Company has taken a series of actions it believes will address the material weaknesses described above. In the second quarter of 2004, the Company has hired additional permanent staff to address the identified material weaknesses, but believes additional time must pass in order for the additional staff to become fully trained and integrated into the Company’s operations and to evidence that the additional staff and controls are performing as intended. If the Company is unable to successfully address the identified material weaknesses in its internal controls, its ability to report financial results on a timely and accurate basis may be adversely affected.
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Although the foregoing material weaknesses were identified, the Company’s management concluded that its disclosure controls and procedures were effective as of the end of fiscal 2003 and the first fiscal quarter of 2004. Prior to reaching this conclusion, management through its Disclosure Committee, undertook a review of its disclosure controls and procedures. The review identified what management believed to be evidence of a comprehensive disclosure control structure. Management also carefully evaluated the two material weaknesses as well as the error that caused the omission of the additional subsidiary financial statements in the initial filing of the 2002 Form 10-K during the first quarter of 2003 as discussed above. Management concluded that the Company’s disclosure controls and procedures were effective on the evaluation dates at the end of each quarterly period during 2003 based on its belief that although an error had occurred which resulted in the additional subsidiary financial statements being omitted from the 2002 10-K, the design of its disclosure controls and procedures taken as a whole were effective. Management viewed the omission as an isolated error not a systemic problem. With respect to the staffing issue, management noted that the issue was raised prior to the end of the fiscal 2003 and before the audit process for the year had begun, and that the process for preparing the additional sets of financial statements had been changed prior to year-end. The revised process included a thorough review by experienced accounting and tax personnel of the Company of the work prepared by temporary staff, prior to submission to the external auditors. Management concluded the necessary actions had been taken to eliminate the staffing material weakness, although more time is needed to train and integrate these new employees. With respect to the material weakness identified in the Company’s asbestos calculation process, management took note of the informal process followed in prior periods. Management noted that this process was used in prior periods and that its external auditors did not note it as a reportable condition or material weakness during those periods. Management noted that the fact that the process was not followed led to the material weakness. The Company agreed to formalize the process, in accordance with its external auditor’s suggestion. However, management also believed that the process itself would have been sufficient had it been followed. The Company’s management believes that a control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. With this in mind, and looking at the design and operation of the Company’s disclosure controls and procedures as a whole, management concluded, notwithstanding the material weaknesses described above and after taking into account the remedial measures taken as of the end of fiscal 2003 and the first fiscal quarter of 2004, that they were effective on such dates.
One of the Company’s foreign subsidiaries is a party to a project-specific, Euro-denominated performance bonding facility, which as of June 25, 2004 had the equivalent of approximately $40 million of performance bonds (none of which has been drawn) outstanding. This bonding facility prohibits the subsidiary from making any dividends or other restricted payments unless it maintains a minimum equity ratio (calculated by dividing equity by total assets (each as defined in the facility)). In addition, the facility requires the subsidiary to maintain a minimum equity ratio, compliance with which is tested quarterly. As a result of operating losses at the subsidiary during the second quarter of 2004, the subsidiary’s equity ratio fell below the required minimum, breaching the equity ratio covenant under the facility. On August 6, 2004, the Company obtained a waiver from each of the institutions party thereto that provides that the remedy for falling below the minimum equity ratio is the agreement on the subsidiary’s part that, for so long as the facility is in place, it will not make any dividends or other restricted payments until the equity ratio has returned to the required minimum. The ability to make these payments was already restricted by an existing covenant in the facility, and is therefore already included in the Company’s liquidity analysis. The Company believes that this restriction on dividends and other restricted payments to the Company by this subsidiary will not have an adverse impact on its forecasted liquidity. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations --Liquidity” for further discussion of the Company’s liquidity.
In early August, in connection with its review of the performance bonding facility described above, the Company became aware for the first time that that same subsidiary was also in breach under a minimum equity ratio covenant contained in a separate performance bonding facility with one of the same financial institutions. This facility had the equivalent of approximately $12 million of performance bonds (none of which has been drawn) outstanding as of June 25, 2004 and is used for general purposes. The equity ratio covenant contained in this facility requires the subsidiary to maintain a minimum equity ratio (calculated by dividing equity by total assets (each as defined in the facility)). As a result of operating losses at the subsidiary during the second quarter of 2004, the subsidiary’s equity ratio fell below the required minimum, breaching the equity ratio covenant under the facility. On August 9, the subsidiary obtained a waiver of this covenant through October 31, 2004 from the financial institution that is a party to the agreement in question. After October 31, 2004, the subsidiary will be required to have its equity ratio return to the required minimum or to obtain a further waiver. The Company plans to negotiate to obtain a further waiver or amendment prior to October 31, 2004. In the event that the Company is unable to obtain a further waiver or amendment, it will pursue a replacement for this bonding facility. In addition, the subsidiary has sufficient cash on hand to collateralize the obligations supported by the performance bonds in the event it is unable to obtain a waiver or an alternative bonding facility. Therefore, the Company believes that this matter will not have an adverse impact on its forecasted liquidity. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations --Liquidity” for further discussion of the Company’s liquidity.
In response to its discovery of this breach at such a late date, the Company undertook a review of its procedures relating to the monitoring of, and reporting of defaults under, its subsidiaries financial covenants globally. Although the management of the subsidiary in question was aware of the covenant’s existence, it did not fully understand its implications. As a consequence, it did not notify the corporate center of the Company on a timely basis of the breach of the covenant. Further, the corporate center of the Company did not independently detect the breach on a timely basis. Management concluded that the failure to detect the covenant breach on a timely basis was the result of a deficiency in its disclosure controls and procedures, which are intended to be designed to ensure that this type of breach is detected on a timely basis. After reviewing its controls and procedures relating to covenant monitoring and reporting as of the end of fiscal 2003 and each of the two fiscal quarters in 2004, management concluded that the deficiency arose in February of 2004. Prior to February 2004, the Company’s treasurer maintained an inventory of, and actively tested and analyzed, the financial covenants and the potential consequences to the Company and its subsidiaries of a failure to comply with such covenants. As of the end of fiscal 2003, this covenant inventory included both of the covenants in the performance bonding facilities discussed above. However, the Company’s treasurer left the Company at the end of January 2004. Following his departure, although the Company fully tested and analyzed its domestic financial covenants, the covenant inventory that included the foreign subsidiary’s covenants was not fully tested and analyzed against the quarter’s financial results by the Company at the corporate center level. Management believes that had the compensating control of the corporate center’s covenant monitoring process been continued in the first two quarters of 2004, the breach would have been detected by the Company on a timely basis.
The Company has given this issue the highest priority and is in the process of updating its disclosure controls and procedures relating covenant compliance. In order to address this issue, the Company intends to:
| | • | comprehensively review and update its covenant inventory; |
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| | • | upgrade the reporting procedure at the subsidiary level on a global basis; and |
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| | • | ensure the quarterly global covenant monitoring process by its corporate center is properly implemented. |
| | | |
The Company expects that it will have these actions completed well before the end of the third quarter.
Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that, based on the deficiency in the Company’s covenant compliance disclosure controls described above, the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were not effective as of June 25, 2004 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. In addition, in light of the new information that has come to their attention as a result of the Company’s review of its disclosure controls and procedures undertaken in connection with its second fiscal quarter, the Company’s principal executive officer and principal financial officer have revised their previous conclusions and have concluded that the Company’s disclosure controls and procedures as of the end of the first fiscal quarter in 2004 were not effective for the reasons described above. However, the Company’s principal executive officer and principal financial officer noted that the Company is actively seeking to remedy this deficiency and did not note any other deficiencies in the Company’s disclosure controls and procedures during their evaluation.
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Safe Harbor Statement
Management’s Discussion and Analysis of Financial Condition and Results of Operations, other sections of this Report on Form 10-Q and other reports and oral statements made by representatives of the Company from time to time may contain forward-looking statements that are based on management’s assumptions, expectations and projections about the Company and the various industries within which the Company operates. These include statements regarding the Company’s expectation regarding revenues (including as expressed by its backlog), its liquidity, the outcome of litigation and legal proceedings and recoveries from customers for claims, and the costs of current and future asbestos claims and the amount and timing of insurance recoveries. Such forward-looking statements by their nature involve a degree of risk and uncertainty. The Company cautions that a variety of important factors could cause business conditions and results to differ materially from what is contained in forward-looking statements, including, but not limited to, the following:
| | • | changes in the rate of economic growth in the United States and other major international economies; |
| | | |
| | • | changes in investment by the power, oil & gas, pharmaceutical, chemical/petrochemical and environmental industries; |
| | | |
| | • | changes in the financial condition of our customers; |
| | | |
| | • | changes in regulatory environment; |
| | | |
| | • | changes in project design or schedules; |
| | | |
| | • | contract cancellations; |
| | | |
| | • | changes in estimates made by the Company of costs to complete projects; |
| | | |
| | • | changes in trade, monetary and fiscal policies worldwide; |
| | | |
| | • | currency fluctuations; |
| | | |
| | • | war and/or terrorist attacks on facilities either owned or where equipment or services are or may be provided; |
| | | |
| | • | outcomes of pending and future litigation, including litigation regarding the Company’s liability for damages and insurance coverage for asbestos exposure; |
| | | |
| | • | protection and validity of patents and other intellectual property rights; |
| | | |
| | • | increasing competition by foreign and domestic companies; |
| | | |
| | • | compliance with debt covenants; |
| | | |
| | • | monetization of certain Power System facilities; |
| | | |
| | • | implementation of its restructuring plan; |
| | | |
| | • | recoverability of claims against customers; and |
| | | |
| | • | changes in estimates used in its critical accounting policies. |
Other factors and assumptions not identified above were also involved in the formation of these forward-looking statements and the failure of such other assumptions to be realized as well as other factors may also cause actual results to differ materially from those projected. Most of these factors are difficult to predict accurately and are generally beyond the control of the Company. The reader should consider the areas of risk described above in connection with any forward-looking statements that may be made by the Company.
The Company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. The reader is advised, however, to consult any additional disclosures the Company makes in proxy statements, quarterly reports on Form 10-Q, annual reports on Form 10-K and current reports on Form 8-K filed with the Securities and Exchange Commission.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Refer to Note 3 to the Condensed Consolidated Financial Statements presented in Part I, Item 1 of this Quarterly Report on Form 10-Q for a discussion of legal proceedings, which is incorporated by reference in this Part II.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Exhibits
| Exhibit No. | | Exhibits |
| |
|
| | | |
| 10.1 | | Employment Agreement between Foster Wheeler Ltd. and John T. La Duc dated as of April 14, 2004. (Filed as Exhibit 99.2 to Foster Wheeler Ltd.’s Form 8-K, filed on April 15, 2004, and incorporated herein by reference). |
| | | |
| 10.2 | | Change of Control Employment Agreement between Foster Wheeler Inc. and John T. La Duc dated as of April 14, 2004. (Filed as Exhibit 99.3 to Foster Wheeler Ltd.’s Form 8-K, filed on April 15, 2004, and incorporated herein by reference). |
| | | |
| 10.3 | | Employment Agreement between Foster Wheeler Ltd. and Brian K. Ferraioli dated as of April 27, 2004 and effective as of December 1, 2003. (Filed as Exhibit 10.8 to Foster Wheeler Ltd.’s Form 10-Q for the quarter ended March 26, 2004, filed on May 5, 2004, and incorporated herein by reference). |
| | | |
| 10.4 | | Change of Control Agreement between Foster Wheeler Inc. and Brian K. Ferraioli effective as of December 1, 2003. (Filed as Exhibit 10.9 to Foster Wheeler Ltd’s. Form 10-Q for the quarter ended March 26, 2004, filed on May 5, 2004, and incorporated herein by reference). |
| | | |
| 10.5 | | Amendment No. 5 and Waiver, dated as of May 14, 2004, to the Third Amended and Restated Term Loan and Revolving Credit Agreement, dated as of August 2, 2002, among Foster Wheeler LLC, the Borrowing Subsidiaries (as defined therein), the Guarantors party thereto, the Lenders party thereto and Bank of America, N.A., as Administrative Agent and Collateral Agent and Banc of America Securities LLC, as Lead Arranger and Book Manager (Filed as Exhibit 99.1 to Foster Wheeler Ltd.’s Form 8-K, filed on May 20, 2004, and incorporated herein by reference). |
| | | |
| 10.6 | | Form of Third Amendment to the Employment Agreement between Foster Wheeler Ltd. and Raymond J. Milchovich. (Filed as Exhibit 99.1 to Foster Wheeler Ltd.’s Form 8-K, filed on July 23, 2004, and incorporated herein by reference). |
| | | |
| 12.1 | | Statement of Computation of Consolidated Ratio of Earnings to Fixed Charges |
| | | |
| 31.1 | | Section 302 Certification of Raymond J. Milchovich |
| | | |
| 31.2 | | Section 302 Certification of John T. La Duc |
| | | |
| 32.1 | | Certification of Raymond J. Milchovich Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| | | |
| 32.2 | | Certification of John T. La Duc Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
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Reports on Form 8-K
| Report Date | | Description |
| |
|
| April 9, 2004 | | The Company, filed in contemplation of its proposed exchange offer and related registration statement on Form S-4 (No. 333-107054), revised financial statements due to Foster Wheeler LLC’s plans to issue 10.5% Senior Secured Notes due 2011, Series A (Item 5). |
| | | |
| April 14, 2004 | | The Company announced that its Annual General Meeting of Shareholders would be held later in the year, pending consummation of the Company’s recently announced proposed equity for debt exchange offer (Items 5 and 7). |
| | | |
| April 14, 2004 | | The Company announced the appointment of John T. La Duc as Executive Vice President and Chief Financial Officer and filed an Employment and Change of Control Agreement (Items 5 and 7). |
| | | |
| May 5, 2004 | | The Company announced its financial results for the First Quarter of 2004 and posted its conference call script (Items 7, 9 and 12). |
| | | |
| May 14, 2004 | | The Company announced that it entered into Amendment No. 5 and Waiver to the Third Amended and Restated Term Loan and Revolving Credit Agreement (Items 5 and 7). |
| | | |
| May 24, 2004 | | The Company filed unaudited interim financial statements in connection with its proposed exchange offer and the related registration on Form S-4 (No. 333-107054) and S-2 (No. 333-114400) (Item 5). |
| | | |
| July 8, 2004 | | In connection with its proposed exchange offer and the related registration on Form S-4 (No. 333-107054), the Company filed its current risk factors (Item 5). |
| | | |
| July 23, 2004 | | The Company filed a Form of Third Amendment to the Employment Agreement between Foster Wheeler Ltd. and Raymond J. Milchovich (Items 5 and 7). |
| | | |
| August 4, 2004 | | The Company announced its financial results for the Second Quarter of 2004 (Items 7, 9 and 12). |
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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.
| | FOSTER WHEELER LTD. |
| |
|
| | (Registrant) |
| | |
| | |
| Date: August 9, 2004 | /s/ RAYMOND J. MILCHOVICH |
| |
|
| | Raymond J. Milchovich |
| | Chairman, President and |
| | Chief Executive Officer |
| | |
| | |
| Date: August 9, 2004 | /s/ JOHN T. LA DUC |
| |
|
| | John T. La Duc |
| | Executive Vice President and |
| | Chief Financial Officer |
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