NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
June 30, 2006
NOTE A—BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three month period and the six month period ended June 30, 2006, are not necessarily indicative of the results that may be expected for the year ended December 31, 2006. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2005. The Company operates in only one business segment — industrial machine tools.
The consolidated balance sheet at December 31, 2005 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.
NOTE B—STOCK-BASED COMPENSATION
In December 2004, the Financial Accounting Standards Board (FASB) revised Statement of Financial Accounting Standards No. 123 (SFAS 123(R)), “Share-Based Payment,” which establishes accounting for share-based awards exchanged for employee services and requires companies to expense the fair value of these awards over the requisite employee service period. The accounting provisions of FAS 123(R) became effective for the Company beginning on January 1, 2006.
The Company adopted SFAS 123(R) on January 1, 2006, applying the modified prospective method. SFAS 123(R) requires all equity-based payments to employees, including grants of employee stock options, to be recognized in the statement of earnings based on the grant date fair value of the award. Under the modified prospective method the Company is required to record equity-based compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards outstanding at the date of adoption.
The Company did not issue any new stock options during the three month and six month periods ended June 30, 2006. In addition, all previously awarded stock option grants were fully vested at the date of the adoption of FAS 123(R). Therefore, the Company did not recognize any share-based compensation expense in the six month period ended June 30, 2006 based on stock options issued prior to January 1, 2006.
The Company did recognize share-based compensation expense in relation to restricted stock issued prior to January 1, 2006 and stock issued during the first half of 2006. As of December 31, 2005, the Company had 193,750 shares of restricted stock outstanding. During the six month period ended June 30, 2006, 28,734 shares vested with an intrinsic value of $0.5 million and 21,766 shares were forfeited. During the first six months of 2006, the Company granted 3,000 additional shares of restricted stock with a value of $53,880 which remains unvested as of June 30, 2006. Total share-based compensation expense (income) for the three months and six months ended June 30, 2006 was $61,948 and $57,444, respectively, relating to restricted stock. There were a total of 146,250 restricted shares outstanding at June 30, 2006. The compensation cost not yet recognized on these shares was $0.7 million, which will be amortized over a weighted average term of 3.3 years.
7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2006
NOTE B—STOCK-BASED COMPENSATION (Continued)
The Company uses the Black-Scholes option-pricing method of valuation for share-based option awards. In valuing the stock options, the Black-Scholes model incorporates assumptions about stock volatility, expected term of stock options, and risk free interest rate.
A summary of the stock option activity under the Incentive Stock Plan is as follows:
| | Three months ended
June 30, | | Six months ended
June 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
Shares at beginning of period | | 175,619 | | 229,786 | | 184,288 | | 235,918 | |
Shares granted | | — | | 4,500 | | — | | 4,500 | |
Weighted average price per share | | — | | $ | 14.80 | | — | | $ | 14.80 | |
Shares canceled, forfeited or exercised | | (13,500 | ) | (8,916 | ) | (22,169 | ) | (15,048 | ) |
Weighted average price per share | | $ | 18.66 | | $ | 8.87 | | $ | 15.52 | | $ | 8.52 | |
Shares at end of period | | 162,119 | | 225,370 | | 162,119 | | 225,370 | |
Weighted average price per share | | $ | 13.37 | | $ | 13.36 | | $ | 13.37 | | $ | 13.36 | |
At June 30, 2005, the Company accounted for restricted share grants and stock option grants under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. Prior to the implementation of FAS 123(R), stock-based employee compensation expense related to stock options was not generally reflected in net income, as all options granted under the Plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The Company amortizes compensation expense for restricted stock over the vesting period of the grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation for the three month and six month periods ended June 30, 2005, (in thousands, except per share data):
| | Three months ended
June 30, | | Six months ended
June 30, | |
| | 2005 | | 2005 | |
| | (dollars in thousands
except per share data) | |
Reported net income | | $ | 2,455 | | $ | 4,319 | |
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects | | 117 | | 216 | |
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax effects | | (138 | ) | (256 | ) |
Pro forma net income | | $ | 2,434 | | $ | 4,279 | |
Earnings per share: | | | | | |
Basic and Diluted — as reported | | $ | 0.28 | | $ | 0.49 | |
Basic — pro forma | | $ | 0.28 | | $ | 0.49 | |
Diluted — pro forma | | $ | 0.28 | | $ | 0.48 | |
8
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2006
NOTE B—STOCK-BASED COMPENSATION (Continued)
The following characteristics apply to the Plan stock options that are fully vested, as of June 30, 2006:
Number of options outstanding that are currently exercisable | | 162,119 |
Weighted-average exercise price of options currently exercisable | | $13.37 |
Aggregate intrinsic value of options currently exercisable | | $537,879 |
Weighted-average contractual term of options currently exercisable | | 4.83 years |
In 2005, the fair value of each employee option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used: risk-free rate of interest of 3.88%; dividend yield of 0.81%, with volatility of 0.342 and expected lives of 5 years.
NOTE C—WARRANTIES
The Company offers warranties for its products. The specific terms and conditions of those warranties vary depending upon the product sold and the country in which the Company sold the product. The Company generally provides a basic limited warranty, including parts and labor for a period of one year. The Company estimates the costs that may be incurred under its basic limited warranty, based largely upon actual warranty repair cost history, and records a liability in the amount of such costs in the month that product revenue is recognized. The resulting accrual balance is reviewed during the year. Factors that affect the Company’s warranty liability include the number of installed units, historical and anticipated rates of warranty claims, and cost per claim.
The Company also sells extended warranties for some of its products. These extended warranties usually cover a 12-24 month period that begins 0-12 months after time of sale. Revenues for these extended warranties are recognized monthly on a prorated basis until the warranty expires.
These liabilities are reported as accrued expenses on the Company’s consolidated balance sheet.
A reconciliation of the changes in the Company’s product warranty liability during the three month and six month periods ended June 30, 2006 and 2005 is as follows:
| | Three months ended
June 30, | | Six months ended
June 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
| | (dollars in thousands) | | (dollars in thousands) | |
Beginning balance | | $ | 1,661 | | $ | 1,405 | | $ | 1,503 | | $ | 1,449 | |
Provision for warranties | | 505 | | 622 | | 994 | | 897 | |
Warranties settlement costs | | (427 | ) | (440 | ) | (770 | ) | (705 | ) |
Other — currency translation impact | | 70 | | (75 | ) | 82 | | (129 | ) |
Quarter end balance | | $ | 1,809 | | $ | 1,512 | | $ | 1,809 | | $ | 1,512 | |
9
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2006
NOTE D—INVENTORIES
Inventories are summarized as follows (dollars in thousands):
| | June 30, | | December 31, | |
| | 2006 | | 2005 | |
Finished products | | $ | 55,845 | | $ | 50,620 | |
Work-in-process | | 35,753 | | 33,333 | |
Raw materials and purchased components | | 33,836 | | 33,083 | |
| | $ | 125,434 | | $ | 117,036 | |
NOTE E—INCOME TAXES
Hardinge continues to maintain a full valuation allowance on the tax benefits of its U.S. net deferred tax assets and the Company expects to continue to record a full valuation allowance on future tax benefits until an appropriate level of profitability in the U.S. is sustained. Additionally, until an appropriate level of profitability is reached, the Company does not expect to recognize any significant tax benefits in future results of operations. The Company also maintains a valuation allowance on its U.K. deferred tax asset for minimum pension liabilities.
Each quarter, the Company estimates its full year tax rate based upon its most recent forecast of full year anticipated results and adjusts year to date tax expense to reflect its full year anticipated tax rate.
NOTE F— DERIVATIVE FINANCIAL INSTRUMENTS
The Company accounts for derivative financial instruments in accordance with Financial Accounting Standards Board Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. The statement requires the Company to recognize all its derivative instruments on the balance sheet at fair value. Derivatives that are not qualifying hedges must be adjusted to fair value through income. If the derivative is a qualifying hedge, depending on the nature of the hedge, changes in the fair value of derivatives are either offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value is immediately recognized in earnings.
10
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2006
NOTE G—EARNINGS PER SHARE AND WEIGHTED AVERAGE SHARES OUTSTANDING
Earnings per share are computed in accordance with Statement of Financial Accounting Standards No. 128 Earnings per Share. Basic earnings per share are computed using the weighted average number of shares of common stock outstanding during the period. For diluted earnings per share, the weighted average number of shares includes common stock equivalents related primarily to restricted stock and stock options.
The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations required by SFAS No. 128:
| | Three months ended
June 30, | | Six months ended
June 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
| | (dollars in thousands) | |
Numerator: | | | | | | | | | |
Net income | | $ | 3,007 | | $ | 2,455 | | $ | 4,954 | | $ | 4,319 | |
Numerator for basic earnings per share | | 3,007 | | 2,455 | | 4,954 | | 4,319 | |
Numerator for diluted earnings per share | | 3,007 | | 2,455 | | 4,954 | | 4,319 | |
Denominator: | | | | | | | | | |
Denominator for basic earnings per share—weighted average shares (in thousands) | | 8,765 | | 8,767 | | 8,766 | | 8,756 | |
Effect of diluted securities: | | | | | | | | | |
Restricted stock and stock options (in thousands) | | 42 | | 62 | | 35 | | 84 | |
Denominator for diluted earnings per share—adjusted weighted average shares (in thousands) | | 8,807 | | 8,829 | | 8,801 | | 8,840 | |
| | | | | | | | | |
Basic earnings per share | | $ | 0.34 | | $ | 0.28 | | $ | 0.57 | | $ | 0.49 | |
Diluted earnings per share | | $ | 0.34 | | $ | 0.28 | | $ | 0.56 | | $ | 0.49 | |
11
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2006
NOTE H—REPORTING COMPREHENSIVE INCOME (LOSS)
During the three and six month periods ended June 30, 2006 and 2005, the components of total comprehensive income (loss) consisted of the following (dollars in thousands):
| | Three months ended
June 30, | | Six months ended
June 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
Net Income | | $ | 3,007 | | $ | 2,455 | | $ | 4,954 | | $ | 4,319 | |
Other Comprehensive Income (Loss): | | | | | | | | | |
Foreign currency translation adjustments | | 6,614 | | (7,462 | ) | 7,910 | | (12,036 | ) |
Foreign currency translation — pension | | (366 | ) | 203 | | (421 | ) | 323 | |
Unrealized (loss) gain on derivatives, net of tax: | | | | | | | | | |
Cash flow hedges | | (47 | ) | (91 | ) | (58 | ) | 317 | |
Net investment hedges | | (783 | ) | 1,373 | | (891 | ) | 2,193 | |
Other comprehensive income (loss) | | 5,418 | | (5,977 | ) | 6,540 | | (9,203 | ) |
Total Comprehensive Income (Loss) | | $ | 8,425 | | $ | (3,522 | ) | $ | 11,494 | | $ | (4,884 | ) |
Accumulated balances of the components of other comprehensive (loss) income consisted of the following at June 30, 2006 and December 31, 2005 (dollars in thousands):
| | Accumulated balances | |
| | June 30, | | Dec. 31, | |
| | 2006 | | 2005 | |
Accumulated Other Comprehensive Income (Loss): | | | | | |
Minimum pension liability (net of tax of $4,194 and $4,122, in 2006 and 2005 respectively) | | $ | (15,412 | ) | $ | (14,991 | ) |
Foreign currency translation adjustments | | 13,806 | | 5,896 | |
Unrealized gain (loss) on derivatives, net of tax: | | | | | |
Cash flow hedges, (net of tax of $643 and $570, respectively) | | 577 | | 635 | |
Net investment hedges, (net of tax of $715 and $715, respectively) | | (3,460 | ) | (2,569 | ) |
Accumulated Other Comprehensive (Loss) | | $ | (4,489 | ) | $ | (11,029 | ) |
NOTE I—GOODWILL AND OTHER INTANGIBLE ASSETS
The Company accounts for goodwill and intangibles in accordance with Statements of Financial Accounting Standards No. 141 (SFAS 141), Business Combinations, and No. 142 (SFAS 142), Goodwill and Other Intangible Assets. SFAS 142 prohibits the amortization of goodwill and intangible assets with indefinite useful lives. The statement requires that these assets be reviewed for impairment at least annually. Intangible assets with finite lives are amortized over their estimated useful lives.
The total carrying amount of goodwill was $19.0 million as of June 30, 2006 and $17.7 million as of December 31, 2005. The majority of this asset resulted from the acquisition of HTT Hauser Tripet Tschudin AG in 2000. The acquisition of the European sales and service operations of Bridgeport in 2004
12
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2006
NOTE I—GOODWILL AND OTHER INTANGIBLE ASSETS (Continued)
added $0.5 million to goodwill. The asset value of the goodwill increased by $1.1 million and $1.3 million, respectively, during the three month and six month periods ended June 30, 2006, with the entire change caused by the increased dollar value of the functional currency of the Company’s subsidiaries whose balance sheets include the goodwill.
The Company has completed annual impairment testing during the fourth quarter of 2005 and 2004 and determined that there has been no impairment of goodwill.
Other intangible assets include $6.7 million representing the value of the name, trademarks and copyrights associated with the former worldwide operations of Bridgeport, which were acquired in 2004. The Company will be using this brand name on all of its machining center lines in the future, and therefore, the asset has been determined to have an indefinite useful life. The asset will be reviewed annually for impairment under the provisions of SFAS 142.
Other intangible assets also include the $5.0 million purchase of the technical information of the Bridgeport knee-mill in January. The Company will amortize this asset over ten years.
NOTE J—PENSION AND POST RETIREMENT PLANS
The Company accounts for the pension plans and postretirement benefits in accordance with Statements of Financial Accounting Standards No. 87, Employers’ Accounting for Pensions and No. 106, Employers’ Accounting for Postretirement Benefits Other than Pensions. The following disclosures related to the pension and postretirement benefits are presented in accordance with Statements of Financial Accounting Standards No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits as revised.
A summary of the components of net periodic pension costs for the consolidated company for the three and six months ended June 30, 2006 and 2005 is presented below:
| | Pension Benefits | |
| | Three months ended | | Six months ended | |
| | June 30, | | June 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
| | (dollars in thousands) | |
Service cost | | $ | 822 | | $ | 773 | | $ | 1,644 | | $ | 1,556 | |
Interest cost | | 1,893 | | 1,889 | | 3,787 | | 3,800 | |
Expected return on plan assets | | (2,236 | ) | (2,248 | ) | (4,471 | ) | (4,525 | ) |
Amortization of prior service cost | | (32 | ) | (33 | ) | (65 | ) | (67 | ) |
Amortization of transition (asset) obligation | | (92 | ) | (92 | ) | (184 | ) | (186 | ) |
Amortization of (gain) loss | | 346 | | 179 | | 691 | | 361 | |
Net periodic benefit cost | | $ | 701 | | $ | 468 | | $ | 1,402 | | $ | 939 | |
13
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2006
NOTE J—PENSION AND POST RETIREMENT PLANS (Continued)
A summary of the components of net postretirement benefits costs for the consolidated company for the three and six months ended June 30, 2006 and 2005 is presented below:
| | Postretirement Benefits | |
| | Three months ended
June 30, | | Six months ended
June 30, | |
| | 2006 | | 2005 | |
| | (dollars in thousands) | |
Service cost | | $ | 8 | | $ | 20 | | $ | 16 | | $ | 40 | |
Interest cost | | 39 | | 90 | | 78 | | 180 | |
Amortization of prior service cost | | (126 | ) | (6 | ) | (253 | ) | (12 | ) |
Amortization of (gain) loss | | 10 | | 2 | | 21 | | 3 | |
Net periodic benefit (benefit) cost | | $ | (69 | ) | $ | 106 | | $ | (138 | ) | $ | 211 | |
The expected contributions to be paid during the year ending December 31, 2006 to the domestic defined benefit plan are $2.4 million. As of June 30, 2006, $0.9 million of contributions have been made to the domestic plan. The Company also provides defined benefit pension plans or defined contribution pension plans for its foreign subsidiaries. The expected contributions to be paid during the year ending December 31, 2006 to the foreign defined benefit plans are $2.0 million. For each of the Company’s foreign plans, employer and employee contributions are made on a monthly basis and are determined by applicable governmental regulations. As of June 30, 2006 and 2005, $1.1 million and $1.1 million of contributions have been made to the foreign plans, respectively.
On December 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) was passed which expands Medicare to include an outpatient prescription drug benefit beginning in 2006. To encourage employers to retain or provide postretirement drug benefits, beginning in 2006 the federal government will provide non-taxable subsidy payments to employers that sponsor prescription drug benefits to retirees that are “actuarially equivalent” to the Medicare benefit. In May 2004, the FASB issued Staff Position (FSP) No. FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003”, which provides guidance on how companies should account for the impact of the Act on its postretirement health care plans. Based on guidance available at this time, the plan is not expected to be actuarially equivalent to the Medicare benefit due to the fact that the employer’s premiums are capped at the level paid in 2001.
14
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2006
NOTE K—NEW ACCOUNTING STANDARDS
In November 2004, the FASB issued Statement of Financial Accounting Standards No. 151, Inventory Costs - An Amendment of ARB No. 43, Chapter 4. This statement amends ARB No. 43, Chapter 4, Inventory Pricing, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) should be recognized as current-period charges. Additionally, SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. As required by SFAS 151, the Company adopted this new accounting standard on January 1, 2006. The adoption did not have a material impact on the consolidated financial statements of the Company.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154 (SFAS 154), “Accounting Changes and Error Corrections.” SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement requires retrospective applications to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. In addition, this Statement requires that a change in depreciation, amortization or depletion for long-lived, non-financial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. This new accounting standard was effective January 1, 2006. The adoption of SFAS 154 had no impact on our financial statements.
In July 2006, the FASB issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 Accounting for Income Taxes.” FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact of FIN 48 on its consolidated results of operations and financial condition.
15
PART I - ITEM 2
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview. The following Management’s Discussion and Analysis (“MD&A”) is written to help the reader understand our company. The MD&A is provided as a supplement to, and should be read in conjunction with, our unaudited condensed financial statements, the accompanying condensed financial notes (“Notes”) appearing elsewhere in this report and our annual report on Form 10-K for the year ended December 31, 2005.
The Company’s primary business is manufacturing high-precision computer controlled material cutting and grinding machines and related accessories. We are geographically diversified with manufacturing facilities in the U.S., Switzerland, Taiwan, and China and with sales to most industrialized countries. Over 60% of our net sales are to customers outside North America, and approximately 57% of our employees are located outside of North America.
The Company’s machine products are considered to be capital goods and are part of what has historically been a highly cyclical industry. The U.S. market activity metric most closely watched by our management has been metal-cutting machine orders as reported by the Association of Manufacturing Technology (AMT), the primary industry group for U.S. machine tool manufacturers. Similar information regarding machine tool consumption in foreign countries is published in various trade journals.
Other closely followed U.S. market indicators are tracked to determine activity levels in U.S. manufacturing plants that might purchase our products. One such measurement is the PMI (formerly called the Purchasing Manager’s Index), as reported by the Institute for Supply Management. Another is capacity utilization of U.S manufacturing plants, as reported by the Federal Reserve Board.
Other key performance indicators are geographic distribution of sales and orders, gross margin as a percent of sales, income from operations, working capital changes and debt level trends. In an industry where constant product technology development has led to an average life of three to five years, effectiveness of technological innovation and development of new products are also key performance indicators.
Since the Company’s U.S. operations have experienced net losses from 2001 thru 2005, the Company recorded a deferred tax charge in September 2003 and established a valuation allowance offsetting our entire U.S. deferred tax asset in accordance with Statement of Financial Accounting Standards No. 109. The Company’s management team continues to believe that these deferred tax assets will be fully utilized as credits against tax expense on future taxable income prior to the assets expiring. The U.S. operations historically averaged $10.0 million annual pretax profit in the years 1990-2000 and the current tax law provides for a carry-forward period, which for our current U.S. deferred tax assets extends until 2021-2023. However the recovery of these tax assets is currently uncertain.
Foreign currency exchange rate changes can be significant to our reported financial results for several reasons. The Company’s primary competitors, particularly for the most technologically advanced products are now, largely, manufacturers in Japan, Germany, and Switzerland, which causes the worldwide valuation of the Japanese yen, Euro, and Swiss franc to be central to competitive pricing in all of our markets. Also, we translate the financial results of our Swiss, Taiwanese, Chinese, British, German and Canadian subsidiaries into U.S. dollars for consolidation and financial reporting purposes. Period to period changes in the exchange rate between their local currencies and the U.S. dollar may significantly affect comparative data. We also purchase computer controls and other components from suppliers throughout the world, and our purchase costs reflect these foreign currency exchange rate changes.
Pension liabilities have represented another significant uncertainty for the Company. We provide defined benefit pension plans for eligible employees in the U.S. (employees hired prior to March 1, 2004), Switzerland, England, and Taiwan. Changes in interest rates and equity market investment returns have
16
resulted in deferred pension charges to equity of $4.8 million for 2005. These non-cash charges were recorded in “other comprehensive income” in the equity section of the consolidated balance sheets. The underlying economic causes for these charges reflect a risk of increased future pension expense. Further large pension charges driven by declines in interest rates or lower than assumed investment returns may require the Company to negotiate changes to our current borrowing arrangements.
In January 2006, the Company executed its option to purchase the technical information of the Bridgeport knee-mill machine tools, related accessories and spare parts from BPT IP, LLC (“BPT”). BPT had granted the Company the exclusive right to manufacture and sell certain versions of the knee-mill machine tool, accessories and spare parts under Alliance Agreements dated October 29, 2002 and November 3, 2004. Per the Alliance Agreements, the Company agreed to pay BPT royalties based on a percentage of net sales attributable to the products, accessories and spare parts. Royalty expense under this agreement was $1.3 million in 2005. The purchase price for the technical information was $5.0 million which will be amortized over a ten-year period. The technical information purchased includes, but is not limited to, blueprints, designs, schematics, drawings, specifications, computer source and object codes, customer lists and proprietary rights and assets of a similar nature. Subsequent to this purchase, no further royalties will be paid to BPT.
Results of Operations
Summarized selected financial data for the three and six months ended June 30, 2006 and 2005:
| | Three months ended
June 30, | | Six months ended
June 30, | |
| | 2006 | | 2005 | | Change | | %
Change | | 2006 | | 2005 | | Change | | %
Change | |
| | (dollars in thousands, except per share data) | |
Net Sales | | $ | 78,518 | | $ | 73,527 | | $ | 4,991 | | 6.8 | % | $ | 153,954 | | $ | 141,575 | | $ | 12,379 | | 8.7 | % |
Gross Profit | | 23,586 | | 23,497 | | 89 | | .4 | % | 46,489 | | 44,611 | | 1,878 | | 4.2 | % |
Income from operations | | 5,307 | | 5,383 | | (76 | ) | (1.4 | )% | 8,949 | | 9,021 | | (72 | ) | (.8 | )% |
Profit before taxes | | 4,054 | | 4,517 | | (463 | ) | (10.3 | )% | 6,672 | | 7,451 | | (779 | ) | (10.5 | )% |
Net income | | 3,007 | | 2,455 | | 552 | | 22.5 | % | 4,954 | | 4,319 | | 635 | | 14.7 | % |
Diluted earnings per share | | $ | 0.34 | | $ | 0.28 | | $ | 0.06 | | | | $ | 0.56 | | $ | 0.49 | | $ | 0.08 | | | |
Weighted average shares outstanding (in thousands) | | 8,807 | | 8,829 | | | | | | 8,801 | | 8,840 | | | | | |
Gross Profit as % of net sales | | 30.0 | % | 32.0 | % | | | | | 30.2 | % | 31.5 | % | | | | |
Profit before taxes as % of net sales | | 5.2 | % | 6.1 | % | | | | | 4.3 | % | 5.3 | % | | | | |
Net income as % of net sales | | 3.8 | % | 3.3 | % | | | | | 3.2 | % | 3.1 | % | | | | |
Net Sales. Net sales for the three months ended June 30, 2006 were $78.5 million, an increase of $5.0 million or 6.8% compared to the three months ended June 30, 2005. Net sales for the six months ended June 30, 2006 were $154.0 million, an increase of $12.4 million or 8.7% compared to the six months ended June 30, 2005.
17
The table below summarizes net sales by geographical region for the three and six months ended June 30, 2006 compared to the same periods in 2005:
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| | (dollars in thousands) | |
Sales to Customers in: | | 2006 | | 2005 | | %
Change | | 2006 | | 2005 | | %
Change | |
North America | | $ | 28,246 | | $ | 26,292 | | 7.4% | | $ | 57, 427 | | $ | 50,756 | | 13.1% | |
Europe | | 31,687 | | 29,932 | | 5.9% | | 60,908 | | 61,046 | | (.2)% | |
Asia & Other | | 18,585 | | 17,303 | | 7.4% | | 35,619 | | 29,773 | | 19.6% | |
| | $ | 78,518 | | $ | 73,527 | | 6.8% | | $ | 153,954 | | $ | 141,575 | | 8.7% | |
Sales to customers in all regions increased in the second quarter of 2006 compared to the second quarter of 2005. Sales to customers in North America increased as a result of growth in the lathe product line. Sales to customers in Europe increased as a result of growth in both the milling and grinding product lines. Sales to customers in Asia & Other increased as a result of growth in both milling and lathe product lines.
Under U.S. accounting standards, results of foreign subsidiaries are translated into U.S. dollars at the average exchange rate during the periods presented. For the second quarter of 2006, the U.S. dollar strengthened by 1% against the Swiss Franc, 2% against the British Pound Sterling, 1% against the Euro and 2% against the New Taiwanese dollar, while it weakened by 11% against the Canadian dollar and 3% against the Chinese Renminbi compared to the average rates during the same period in 2005. The net of these foreign currencies relative to the U.S. dollar was an unfavorable impact of $0.3 million and $3.4 million on sales for the three and six months ended June 30, 2006 compared to the same periods in 2005.
Sales of machines accounted for 71% of net sales for the three months and six months ended June 30, 2006 compared to 71% and 70%, respectively, for the same periods of 2005. Sales of non-machine products and services consist of workholding repair parts, service and accessories.
Orders and Backlog: The table below summarizes orders by geographical region for the three and six months ended June 30, 2006 compared to the same periods in 2005:
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| | (dollars in thousands) | |
Orders from Customers in: | | 2006 | | 2005 | | %
Change | | 2006 | | 2005 | | %
Change | |
North America | | $ | 34,075 | | $ | 29,847 | | 14.2% | | $ | 63,182 | | $ | 56,474 | | 11.9% | |
Europe | | 33,467 | | 29,832 | | 12.2% | | 64,605 | | 61,216 | | 5.5% | |
Asia & Other | | 24,841 | | 16,997 | | 46.1% | | 41,326 | | 30,094 | | 37.3% | |
| | $ | 92,383 | | $ | 76,676 | | 20.5% | | $ | 169,113 | | $ | 147,784 | | 14.4% | |
Orders for the three months ended June 30, 2006 were $92.4 million, an increase of $15.7 million or 20.5% compared to the three months ended June 30, 2005. Orders for the six months ended June 30, 2006 were $169.1 million, an increase of $21.3 million or 14.4 % compared to the six months ended June 30, 2005.
Orders from customers in North America and Asia & Other increased as a result of expansion in the Company’s lathe product line and increased orders in the Company’s grinding products. Orders for the second quarter of 2006 included an order in the Asia & Other region valued at approximately $5.0 million that we anticipate will repeat in the third quarter of this year, but not in future quarters. The Company is continuing to invest in Asia through our Taiwanese and Chinese subsidiaries by increasing capacity, promotional expenses, and support personnel to take advantage of the strong sales growth opportunities in that area. European order growth was driven primarily by improvements in orders for the Company’s grinding product lines.
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Our consolidated backlog at June 30, 2006 was $88.8 million compared to $75.0 million at March 31, 2006.
Gross Profit . Gross Profit for the three months ended June 30, 2006 was $23.6 million, an increase of $.1 million or .4% compared to the three months ended June 30, 2005. Gross profit for the six months ended June 30, 2006 was $46.5 million, an increase of $1.9 million or 4.2% compared to the six months ended June 30, 2005. The increased gross profit is primarily due to the increased sales levels discussed above. Additionally, the weakening of foreign currencies relative to the U.S. dollar had an unfavorable impact of $0.2 million and $1.2 million on gross profit for the three and six months ended June 30, 2006 compared to the same periods in 2005. Gross margin for the three and six months ended June 30, 2006 was 30.0% and 30.2% of net sales, compared to 32.0% and 31.5% of net sales for the three and six months ended June 30, 2005. The decrease in gross profit margin for 2006 compared to 2005 was the result of changes in product mix and market mix. There were also increased sales through distributors which generally have lower gross profit margins but also incur lower SG&A expenses compared to sales by the Company’s direct sales force.
Selling, General and Administrative Expenses. Selling, general and administrative (SG&A) expenses were $18.3 million, or 23.3% of net sales for the three months ended June 30, 2006, an increase of $.2 million or .9% compared to $18.1 million or 24.6% of net sales for the three months ended June 30, 2005. SG&A expenses were $37.5 million or 24.4% of net sales for the six months ended June 30, 2006, compared to $35.6 million or 25.1% of net sales for the six months ended June 30, 2005. The increase in SG&A for the six months ended June 30, 2006 compared to the same period for the prior year is primarily attributable to increases in: commission expense of $739,000 due to higher sales; wages, pension and benefit costs of $791,000; tradeshow expenses of $428,000; and information technology expenses of $549,000; offset by decreases in selling and marketing expenses of $479,000; and other income and expenses of $78,000.
Income from Operations. As a result of the above, income from operations was $5.3 million, or 6.8% of net sales for the three months ended June 30, 2006, compared to $5.4 million or 7.3% of net sales for the three months ended June 30, 2005. Income from operations was $8.9 million or 5.8% of net sales for the six months ended June 30, 2006, compared to $9.0 million or 6.4% of net sales for the six months ended June 30, 2005.
Interest Expense & Interest Income. Interest expense includes interest payments under our credit facility, unrealized and realized gains or losses on our interest rate swap agreement and amortization of deferred financing costs associated with our credit facility. Interest expense was $1.3 million and $2.5 million for the three months and six months ended June 30, 2006 compared to $1.0 million and $1.9 million for the same periods in 2005. The increase was primarily due to higher average borrowings incurred to finance the purchase of the 49% minority interest in Hardinge Taiwan Limited, in December 2005, and the purchase of the technical information of the Bridgeport knee-mill machine tool business, in January 2006, as reported by the Company in prior filings with the Securities and Exchange Commission.
Income Taxes. The provision for income taxes was $1.0 million and $1.7 million for the three and six months ended June 30, 2006, compared to $1.3 million and $2.1 million for the three and six months ended June 30, 2005. The effective tax rate was 25.8% for the three and six months ended June 30, 2006, compared to 28.1% and 27.7% for the same periods in 2005. The effective tax rate is lower in 2006 due to the location of the pre-tax earnings including earnings in the U.S. which have been offset by previously unrecognized net operating loss carryforwards. Each quarter, an estimate of the full year tax rate is developed based upon anticipated annual results and an adjustment is made, if required, to the year-to-date income tax expense to reflect the full year anticipated effective tax rate. The Company expects the 2006 effective tax rate to be in the range of 25% to 26%.
In 2003, the Company recorded a valuation allowance for the full value of the deferred tax assets of our U.S. operations. Consistent with accounting for taxes under FAS109, no tax expense (benefits) were recorded as a result of the pre-tax income (loss) of the U.S. operations for 2006 or 2005 to offset the taxes accrued for pre-tax earnings from profitable foreign subsidiaries.
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Minority Interest In (Profit) of Consolidated Subsidiary. Until December 27, 2005, the Company owned 51% interest in Hardinge Taiwan Precision Machinery Limited, an entity that is recorded as a consolidated subsidiary. There is no minority interest reduction to consolidated net income in 2006 compared to a reduction of $.8 million and $ 1.1 million for the three and six months ended June 30, 2005.
Net Income. Net income for the three months ended June 30, 2006 was $3.0 million, or 3.8% of net sales, compared to $2.5 million, or 3.3% of net sales for the three months ended June 30, 2005. Net income for the six months ended June 30, 2006 was $5.0 million or 3.2% of net sales, compared to $4.3 million or 3.1% of net sales for the six months ended June 30, 2005. Diluted and basic earnings per share for the three months ended June 30, 2006 were $0.34 compared to $0.28 for the three months ended June 30, 2005. Diluted and basic earnings per share for the six months ended June 30, 2006 were $0.57 and $0.56 compared to $0.49 for the six months ended June 30, 2005.
Liquidity and Capital Resources
At June 30, 2006 cash and cash equivalents were $6.5 million compared to $6.6 million at December 31, 2005. The current ratio at June 30, 2006 was 2.53:1 compared to 2.65:1 at December 31, 2005.
Cash Flow Provided By (Used In) Operating Activities and Investing Activities:
Cash flow provided by (used in) operating and investing activities for the six months ended June 30, 2006 compared to the same period in 2005 are summarized in the table below:
| | Six months ended
June 30, | |
| | (dollars in thousands) | |
| | 2006 | | 2005 | |
Net cash provided by (used in) operating activities | | $ | 376 | | $ | (17,453 | ) |
Cash flow (used in) investing activities | | $ | (12,148 | ) | $ | (2,947 | ) |
Capital expenditures (included in investing activities) | | $ | (1,967 | ) | $ | (2,947 | ) |
Cash provided by operating activities was $0.4 million for the six months ended June 30, 2006 compared to cash used by operating activities of $17.5 million for the same period in 2005. This represents an increase in cash provided by operating activities of $17.8 million. The higher level of working capital required in 2005 was necessary to support the growth and integration of the Bridgeport product line acquired in the fourth quarter of 2004.
Cash used in investing activities was $12.1 million for the six months ended June 30, 2006 compared to $2.9 million for the same period in 2005. Investing activities were primarily related to the $5.1 million payment for the purchase of U-Sung Co., Ltd., which owned the land and building previously leased by Hardinge Taiwan, in the fourth quarter of 2005; the purchase of the technical information of the Bridgeport knee-mill machine tool business in the first quarter of 2006 for $5.0 million; and the final payment of $0.1 million on the purchase of the 49% interest in Hardinge Taiwan acquired in the fourth quarter of 2005. Capital expenditures for the six months ended June 30, 2005 were primarily for leasehold improvement costs to outfit a new demonstration and technical center, which houses the activities of Bridgeport operations in the UK.
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Cash Flow Provided by Financing Activities:
Cash flow provided by financing activities for the six months ended June 30, 2006 and 2005, are summarized in the table below:
| | Six months ended
June 30, | |
| | (dollars in thousands) | |
| | 2006 | | 2005 | |
Borrowings/(repayments) of long-term debt | | $ | 6,298 | | $ | 21,067 | |
Borrowings/(repayments) of short-term notes payable | | 5,921 | | 368 | |
Net (purchases)/sales of treasury stock | | (332 | ) | 210 | |
Payments of dividends | | (531 | ) | (532 | ) |
Net cash provided by financing activities | | $ | 11,356 | | $ | 21,113 | |
Cash flow provided by financing activities was $11.4 million for the six months ended June 30, 2006 compared to $21.1 million for the same period in 2005. Debt outstanding, including notes payable, was $80.0 million on June 30, 2006 compared to $67.1 million on June 30, 2005.
Credit Facilities:
The Company maintains a revolving loan agreement with a group of U.S. banks. This agreement, which expires in January 2011, provides for borrowings of up to $40.0 million, secured by substantially all of the Company’s domestic assets, other than real estate, and by a pledge of 65% of its investment in its major subsidiaries. Interest charged on this debt is based on London Interbank Offered Rates plus a spread which varies depending on the Company’s Debt to EBITDA (earnings before interest, taxes, depreciation and amortization) ratio. A commitment fee of 0.375% is payable on the unused portion of the facility. At June 30, 2006, borrowings under this agreement totaled $20.2 million.
The Company executed an amendment to the revolving loan agreement with the same banking group which provides an additional $20.0 million on the revolving loan agreement. This amendment is a temporary or bridge facility which was extended to December 29, 2006. At June 30, 2006, borrowings under this agreement totaled $14.3 million.
The Company also has a term loan with substantially the same security and financial covenants as provided under the revolving loan agreement described above. At June 30, 2006, the balance of the term loan was $22.8 million with quarterly principal payments of $1.2 million through December 2006 and $1.3 million from 2007 through December 2010.
The Company maintains an $8.0 million unsecured short-term line of credit from a bank with interest based on current prime. At June 30, 2006 borrowings under this line of credit were $4.5 million.
The Company’s Swiss subsidiaries maintain unsecured overdraft facilities with commercial banks, providing borrowing up to 16.5 million Swiss francs, which is equivalent to approximately $13.4 million at June 30, 2006. The borrowing limits on these facilities are reduced 0.1 million Swiss francs or approximately $0.1 million per quarter. At June 30, 2006, borrowings under the overdraft facilities totaled $5.8 million. The Company’s Swiss subsidiaries also have loan agreements with a Swiss bank, which provide for borrowings up to 11.5 million Swiss francs, which is equivalent to approximately $9.4 million at June 30, 2006. The borrowing limits on these facilities are reduced 0.3 million Swiss francs or approximately $0.2 million per year. At June 30, 2006, borrowings under the mortgage facilities totaled $5.3 million, which are secured by the real property owned by the Swiss subsidiaries.
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The Company’s U.K. subsidiary maintains an overdraft facility with a bank, providing borrowings up to 0.4 million pounds sterling, which is equivalent to approximately $0.6 million at June 30, 2006. At June 30, 2006, there were no borrowings under this facility. The Company’s U.K. subsidiary also has mortgage debt in the amount of 0.9 million pounds sterling, which is equivalent to approximately $1.6 million at June 30, 2006. Principal on the mortgage loan is repaid monthly in the amount of approximately 6 thousand pounds sterling, which is equivalent to approximately $10.7 thousand.
In June 2006 the Company’s Taiwan subsidiary entered into a credit facility with a bank secured by the real property owned by the Taiwan subsidiary which provides borrowings up to 180,000,000 New Taiwan dollars which is equivalent to approximately $5.6 million. At June 30, 2006 borrowings under this agreement were $5.6 million. Principal on the mortgage loan is repaid quarterly in the amount of 4.5 million New Taiwan dollars, which is equivalent to approximately $0.1 million.
Certain of these debt agreements require, among other things, that the company maintain specified levels of tangible net worth, working capital, and specified ratios of debt to EBITDA, and EBITDA minus capital expenditures to fixed charges. The Company was in compliance with all financial covenants at June 30, 2006.
In aggregate, these and other borrowing agreements provide for borrowing availability of up to $121.4 million, of which $80.0 million was borrowed at June 30, 2006. The Company believes that the currently available funds and credit facilities, along with internally generated funds, will provide sufficient financial resources for ongoing operations.
This report contains statements of a forward-looking nature relating to the financial performance of Hardinge Inc. Such statements are based upon information known to management at this time. The company cautions that such statements necessarily involve uncertainties and risk and deal with matters beyond the company’s ability to control, and in many cases the company cannot predict what factors would cause actual results to differ materially from those indicated. Among the many factors that could cause actual results to differ from those set forth in the forward-looking statements are fluctuations in the machine tool business cycles, changes in general economic conditions in the U.S. or internationally, the mix of products sold and the profit margins thereon, the relative success of the company’s entry into new product and geographic markets, the company’s ability to manage its operating costs, actions taken by customers such as order cancellations or reduced bookings by customers or distributors, competitors’ actions such as price discounting or new product introductions, governmental regulations and environmental matters, changes in the availability and cost of materials and supplies, the implementation of new technologies and currency fluctuations. Any forward-looking statement should be considered in light of these factors. The company undertakes no obligation to revise its forward-looking statements if unanticipated events alter their accuracy.
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PART I.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes to our market risk exposures during the first six months of 2006. For a discussion of our exposure to market risk, refer to Item 7A, Quantitative and Qualitative Disclosures About Market Risks, contained in our 2005 Annual Report on Form 10-K.
ITEM 4. CONTROLS AND PROCEDURES
The Company’s management, with the participation of the Company’s Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of June 30, 2006 and has concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2006. There were no changes in the Company’s internal control over financial reporting during the second quarter of 2006.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None
Item 1.a. Risk Factors
There is no change to the risk factors disclosed in the Company’s 2005 Annual Report on Form 10K.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None
Item 3. Default upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
The 2006 Annual Meeting of Shareholders of Hardinge Inc. was held on May 2, 2006. The following two Class III directors were elected to serve a three-year term: Douglas A. Greenlee and John J. Perrotti. Ernst & Young LLP were elected as the Company’s independent registered public accountants for the year 2006. All voting results were disclosed in the Company’s Form 10Q for March 31, 2006 filed with the Securities & Exchange Commission.
No other matters were presented for a vote at the meeting.
Item 5. Other Information
None
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