MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
The following discussion and analysis and information contained elsewhere in this report contain statements that constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may be identified by the use of predictive, future tense or forward looking terminology, such as “believes,” “anticipates,” “expects,” “estimates,” “intends,” “may,” “will” or similar terms. We caution that any such forward-looking statements are not guarantees of our future performance and involve significant risks and uncertainties, and that actual results may differ materially from those contained in the forward-looking statements as a result of various factors, which are more fully described in our 2006 Form 10-K filed with the Securities and Exchange Commission.
Business
We design, manufacture and market draglines, electric mining shovels and rotary blasthole drills (collectively, “machines”) used primarily by customers who mine copper, coal, oil sands and iron ore throughout the world. We also provide the aftermarket replacement parts and service for these machines in mining centers throughout the world, including Argentina, Australia, Brazil, Canada, Chile, China, India, Peru, South Africa and the United States. The largest markets for our mining equipment have historically been in Australia, Canada, South Africa, South America and the United States. In the future, we expect that Brazil, Canada, China and India will be increasingly important markets for us. We manufacture our original equipment products and the majority of our aftermarket parts at our facilities in South Milwaukee and Milwaukee, Wisconsin.
The market for our machines is closely correlated with customer expectations of sustained strength in prices of surface mined commodities. Growth in demand for these commodities is a function of, among other things, economic activity, population increases and continuing improvements in standards of living in many areas of the world. Market prices for copper, coal, iron ore and oil generally continued to be strong in 2005 and 2006, although certain commodity prices have recently moderated or declined slightly during 2006. Factors that could support sustained demand for these key commodities in 2007 include continued expected economic growth in China, India and the developing world, as well as renewed economic strength in industrialized countries. As of December 31, 2006, inquiries for machines in all three of our product lines remained at a high level despite the recent moderation in commodity prices. As of December 31, 2006, interest in our machines continued to be strong in the oil sands region of Western Canada, and inquiries related to coal, copper and iron ore mines in other areas of the world have also remained strong.
Our aftermarket parts and service operations, which have accounted for approximately 72% of our total sales over the past 10 years, tend to be more consistent than our machine sales. However, although strength in commodity markets in 2005 and 2006 positively affected our aftermarket sales, our total aftermarket sales decreased to approximately 65% of our sales during 2006 as a result of increased machine sales activity and are currently expected to be approximately 55% of our sales in 2007 based on end of year sales and quoting activity. Our complex machines are typically kept in continuous operation from 15 to 40 years by our customers, requiring regular maintenance and repair throughout their productive lives. The size of our installed base of surface mining equipment as of December 31, 2006 was almost $12.6 billion based on estimated replacement value. Our ability to provide on-time delivery of reliable parts
and prompt service are important drivers of our aftermarket sales. As of December 31, 2006, aftermarket orders and inquiries continued to remain at high levels as the existing installed fleet of our machines is operating at very high utilization levels due to the current demand and increased prices for related mined commodities.
A substantial portion of our sales and operating earnings is attributable to our operations located outside the United States. We generally sell our machines, including those sold directly to foreign customers, and most of our aftermarket parts in United States dollars. A portion of our aftermarket parts sales are also denominated in the local currencies of Australia, Brazil, Canada, Chile, South Africa and the United Kingdom. Aftermarket services are paid for primarily in local currency, which is naturally hedged by our payment of local labor in local currency. In the aggregate, approximately 74% of our 2006 sales were priced in United States dollars.
As of December 31, 2006, we anticipated increased sales activity for both our aftermarket parts sales and machine sales in 2007 relative to 2006. We expect machine sales to increase in 2007, driven by customer expectations of sustained strength in the copper, coal, oil sands and iron ore markets, ongoing and rapid industrialization in China and other parts of the developing world, demand for minerals in the developed world and the rising cost of non-coal energy sources. While we expect that the current commodity demand will continue for the near term, customers’ purchases of our original equipment products may lag behind such increases in commodity prices because of the time needed to acquire the appropriate mining permits and establish the relevant infrastructure. We also expect our aftermarket sales to increase as customers continue the trend of utilizing our parts and services in a broader range of applications on their installed base of equipment. Strong sales volume and demand as of the end of the year has caused us to hire new employees, and additional hiring is expected.
In response to sustained order strength, we are in the process of completing a multi-phase capacity expansion of our manufacturing facilities in South Milwaukee. The first phase of our expansion provided 110,000 square feet of new space for welding and machining of large electric mining shovel components north of Rawson Avenue and was substantially complete at the end of the third quarter of 2006. The second phase of our expansion program will further expand our new facility north of Rawson Avenue from 110,000 square feet to over 350,000 square feet of welding, machining and outdoor hard-goods storage space. Construction is expected to be completed in April 2007. We expect the aggregate cost of phase one and two of our expansion program to be approximately $54 million, which is being financed by borrowings under our revolving credit facility. The third phase of our expansion program, which we announced in July 2006, is intended to help us meet the continued growth of demand for our machines and their components. Phase three will include the renovation and expansion of manufacturing buildings and offices at our existing facilities south of Rawson Avenue. Our focus is on modernizing our facilities and improving manufacturing and administrative efficiencies. The steps for accomplishing phase three are scheduled to maximize manufacturing throughput during both the renovation and construction processes. We expect that phase three construction will cost approximately $58 million and is scheduled to be completed by the first quarter of 2008. Phase three is being financed by borrowings under our revolving credit facility.
When completed, we expect that the additional manufacturing capacity provided by our multi-phase expansion program will allow us to significantly increase the total number of electric mining shovels and draglines that we are able to produce in any given year.
Over the past three years, we have increased our gross profits by reducing manufacturing overhead variances, achieving productivity gains, improving machine margins and increasing higher margin aftermarket parts and services business. Through December 31, 2006, increasing
costs of steel and other raw materials have been offset by the higher selling prices of our products.
Pending Acquisition of DBT
On December 17, 2006, we signed a definitive agreement to acquire DBT GmbH (“DBT”), a subsidiary of RAG Coal International AG (“RAG”). DBT is a leading worldwide supplier of complete system solutions for underground coal mining and manufactures equipment including roof support systems, armored face conveyers, plows, shearers and continuous miners used primarily by customers who mine coal. We have agreed to pay $710.0 million in cash and issue to RAG 471,476 shares of our Class A common stock with an initial market value of $21 million (based on the average closing price of our Class A common stock for the 20-day trading period ended December 14, 2006). The transaction is subject to various closing conditions and regulatory approvals.
We have received a financing commitment from Lehman Brothers to fund the cash purchase price for the DBT transaction. We currently expect that this financing will provide us with up to $1.23 billion of senior secured credit facilities, including an $825 million term loan that we will use to finance the DBT acquisition and refinance existing debt, as well as a $400 million revolving credit facility to fund our ongoing capital needs. We are currently evaluating various more permanent capital structures that could include the issuance of a combination of debt and/or equity securities.
Key Measures
The following is a discussion of key measures which contributed to our operating results in 2006.
On-Time Delivery and Lead Times
Due to the high fixed cost structure of our customers, we believe that it is critical that we help them avoid equipment downtime. On-time delivery and reduced lead time of aftermarket parts and services allow our customers to reduce their equipment downtime and are therefore key measures of customer service, and we believe that these are fundamental drivers of our aftermarket sales. Our on-time delivery percentage in the aftermarket, based on achieved promised delivery dates to customers, was 86% for 2006, 92% for 2005 and 94% for 2004. The decrease in recent years was due to the increase in our sales volume and our capacity constraints. Customer delivery lead times increased in 2006 and are expected to continue to increase in 2007 due to the expected increase in sales volume and our capacity restraints. In addition to our multi-phase expansion program, which will increase our production capacity, we are in the process of implementing programs and identifying subcontract opportunities to improve our on-time deliveries and lead times.
Installed Base
Our almost $12.6 billion (calculated by estimated replacement value) installed base as of December 31, 2006, provides the foundation for our aftermarket sales. Over the life of a machine, customer purchases of aftermarket parts and services often exceed the original purchase price of the machine. Additionally, we realize higher margins on sales of our aftermarket parts and services than on sales of our machines. Moreover, because these machines tend to operate continuously in all market conditions, with expected lives ranging from 15 to 40 years, and have predictable parts and maintenance needs, our aftermarket business has historically been more stable and predictable than the market for our machines, which is closely correlated with expectations of sustained strength in commodity markets.
Research and Development
We believe that our technologically advanced products are a competitive advantage for us. As a result, we spend a significant amount on research and development to continue to maintain this advantage. Our research and development expenses for 2006 were $10.7 million, and we expect to maintain this level of research and development spending in 2007. We concentrate on producing technologically advanced and productive machines that allow our customers to conduct cost-efficient operations. We manufacture alternating current (“AC”) drive draglines and electric mining shovels and offer advanced computer control systems that allow technicians at our headquarters to remotely monitor and adjust the operating parameters of suitably equipped machines at locations around the world via the Internet. Our focus on incorporating advanced technologies such as AC drives and advanced controls has increased customer adoption of our product offerings. Further, we believe that these developments have contributed to increased demand for our aftermarket parts and service since we are well equipped to provide the more sophisticated parts, product technical knowledge and service required by customers who use more complex and efficient machines.
Backlog
Our relative backlog level allows us to more accurately forecast our upcoming sales and plan our production accordingly. Our backlog also provides us with a predictive level of future expected cash flows. Due to the high cost of some machines, our backlog is subject to volatility, particularly over relatively short periods. A portion of our backlog is related to multi-year contracts that will generate revenue in future years. The following table shows our backlog as of December 31, 2006, 2005 and 2004, as well as the portion of backlog which is or was expected to be recognized within 12 months of these dates:
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Next 12 months | | $ | 593,828 | | $ | 413,131 | | $ | 231,455 | |
Total | | $ | 894,749 | | $ | 658,612 | | $ | 436,317 | |
The increase in our backlog as of December 31, 2006 from December 31, 2005 was primarily due to an increase in new machine orders, which totaled $486.9 million for 2006. New machine orders in 2006 included an 8750AC dragline sale to a customer in Australia.
Inventory
Our proper management of our inventory levels can facilitate our on time deliveries and lead times. As of December 31, 2006, we had $176.3 million in inventory compared to $133.5 million as of December 31, 2005. Inventory levels have increased in support of our increased sales activity. Our inventory turned at an annual rate of 3.4 times in 2006 compared to 3.1 times during 2005. We calculate our inventory turns based on our cost of sales and our average inventory balance during the prior 12 months.
Warranty Claims
Product quality is another key driver of our customer’s satisfaction and, as a result, our sales. We use warranty claims as a percentage of total sales as one objective benchmark to
evaluate our product quality. During each of 2006, 2005 and 2004, our warranty claims as a percentage of total sales were less than 1%.
Productivity
Sales per full time equivalent employee is a measure of our operational efficiency. Our sales per full time equivalent employee were $.3 million for 2006, 2005 and 2004. We have attempted to increase our productivity in recent years, primarily through the application of worldwide sales and inventory ERP systems and personnel upgrades.
Results of Operations
2006 Compared to 2005
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| | 2006 | | 2005 | | % Change In Reported
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Sales | | $ | 738,050 | | | — | | $ | 575,042 | | | — | | | 28.4 | % |
Gross profit | | $ | 186,775 | | | 25.3 | % | $ | 137,431 | | | 23.9 | % | | 36.0 | % |
SG&A | | $ | 73,138 | | | 9.9 | % | $ | 54,354 | | | 9.5 | % | | 34.4 | % |
Operating earnings | | $ | 101,184 | | | 13.7 | % | $ | 74,051 | | | 12.9 | % | | 36.6 | % |
Net earnings | | $ | 70,344 | | | 9.5 | % | $ | 53,559 | | | 9.3 | % | | 31.2 | % |
Sales
Sales for 2006 were $738.0 million compared with $575.0 million for 2005, an increase of 28.4%. Sales of aftermarket parts and services for 2006 were $482.3 million, an increase of 22.3% from $394.4 million for 2005. Aftermarket sales increased in both the United States and international markets, reflecting our continuing initiatives and strategies to capture additional market share. Aftermarket sales remained strong as customers continued the trend of utilizing our parts and services in a broader range of applications on their installed fleet of machines which are operating at very high utilization levels. Machine sales for 2006 were $255.7 million, an increase of 41.6% from $180.6 million for 2005. The increase in our machine sales was due to sustained demand for commodities that are surface mined by our machines.
Gross Profit
Gross profit for 2006 was $186.8 million, or 25.3% of sales, compared with $137.4 million, or 23.9% of sales, for 2005. The increase in gross profit was primarily due to increased aftermarket and machine sales. Through December 31, 2006, increasing prices of steel and other raw materials have been offset by the higher selling prices of our products. The mix of machine and aftermarket sales impacts our gross margin as machine sales generally have lower gross margins than our aftermarket sales. Machine sales were 35% of our sales for 2006 compared to 31% for 2005. Gross profit for 2006 and 2005 was reduced by $.9 million and $1.5 million, respectively, of training costs for employees hired at our new manufacturing facility in Milwaukee. We are continuing to hire and train new employees to support our increased capacity initiatives. Gross profit for 2006 and 2005 was reduced by $5.2 million and $5.3 million, respectively, of additional depreciation expense as a result of the purchase price allocation to plant and equipment in connection with prior acquisitions of companies.
Selling, General and Administrative Expenses
Selling, general and administrative expenses for 2006 were $73.1 million, or 9.9% of sales, compared with $54.4 million, or 9.5% of sales, for 2005. Selling, general and administrative expenses for 2006 included $4.3 million related to non-cash stock-based employee compensation compared to $.2 million for 2005. In 2006, selling and administrative expenses increased as a result of our hiring of additional employees to support our projected sales growth and increased plant capacity. We expect continued increases in selling, general and administrative expenses due to increased sales volumes, but expect that these expenses to remain at 10% or less of sales. Foreign currency transaction losses for 2006 were $1.0 million compared with a gain of $1.0 million for 2005. We incurred approximately $.6 million and $1.2 million of consulting expenses during 2006 and 2005, respectively, related to Sarbanes-Oxley Section 404 compliance.
Research and Development Expenses
Research and development expenses for 2006 were $10.7 million compared with $7.2 million for 2005. The increase in 2006 was due to the continuing development of electrical and machine upgrade systems.
Operating Earnings
Operating earnings for 2006 were $101.2 million, or 13.7% of sales, compared with $74.1 million, or 12.9% of sales, for 2005. The improvement in 2006 was primarily due to increased gross profit resulting from increased sales volume.
Interest Expense
Interest expense for 2006 was $3.7 million compared with $4.9 million for 2005. We capitalized $.8 million of interest during 2006 as a part of the cost of our capacity expansion program. The remaining decrease in interest expense was primarily due to reduced average borrowings in 2006.
Income Taxes
Income tax expense for 2006 was $26.9 million compared to $15.4 million for 2005. U.S. and foreign taxes are calculated at applicable statutory rates. Income tax expense for 2006 was reduced by a net income tax benefit of approximately $4.3 million related to foreign tax credits. The foreign tax credits resulted from the completion of our evaluation of the potential to claim additional foreign tax credits generated in previous tax periods. The lower effective tax rate in 2006 was also due to the mix of our domestic and foreign earnings. Income tax expense for 2005 was reduced by a net income tax benefit of $7.0 million, which consisted of $1.8 million of foreign tax expense related to a foreign dividend distribution and the recognition of an income tax benefit of approximately $8.8 million related to foreign tax credits. Amounts included in income tax expense are further described in Note H to our consolidated financial statements. At December 31, 2006, we had available approximately $10.7 million of federal net operating loss carryforwards. These carryforwards are useable at the rate of $3.6 million per year.
2005 Compared to 2004
Sales
Sales for 2005 were $575.0 million compared with $454.2 million for 2004. Sales of aftermarket parts and services for 2005 were $394.4 million, an increase of 22.7% from $321.4 million for 2004. The increase in aftermarket sales reflected our continuing initiatives and
strategies to capture additional market share as well as continued strong commodity prices. Aftermarket sales increased in both the United States and international markets. Machine sales for 2005 were $180.6 million, an increase of 36.0% from $132.8 million for 2004. The increase in machine sales in 2005 was primarily due to increased electric mining shovel sales and the recognition of sales on two draglines that were sold in 2004. Approximately $6.5 million of the increase in sales for 2005 was attributable to a weakening United States dollar, which primarily impacted aftermarket sales (see “Foreign Currency Fluctuations” below).
Gross Profit
Gross profit for 2005 was $137.4 million, or 23.9% of sales, compared with $96.4 million, or 21.2% of sales, for 2004. The increase in our gross profit was primarily due to an increased sales volume and higher gross margins on both machines and aftermarket sales. Gross profit for 2005 was reduced by $1.5 million of training costs for employees hired at our new leased manufacturing facility. Gross profit for 2005 and 2004 was also reduced by $5.3 million and $5.2 million, respectively, of additional depreciation expense as a result of purchase price allocation to plant and equipment in connection with prior acquisitions of companies. Approximately $1.5 million of the increase in 2005 was attributable to a weakening United States dollar (see “Foreign Currency Fluctuations” below).
Selling, General and Administrative Expenses
Selling, general and administrative expenses for 2005 were $54.4 million, or 9.5% of sales, compared with $53.1 million, or 11.7% of sales, for 2004. Selling, general and administrative expense for 2005 included $.2 million related to non-cash stock-based employee compensation compared to $10.1 million for 2004. Non-cash stock compensation expense in 2004 primarily represented the charge recorded related to stock options issued prior to the completion of our initial public offering. Selling expenses for 2005 increased by $4.5 million from 2004 primarily due to increased sales efforts and higher foreign costs as a result of the weakened U.S. dollar, but remained relatively constant as a percentage of sales. Foreign currency transaction gains for 2005 were $1.0 million compared with gains of $2.7 million for 2004. We incurred approximately $1.2 million of consulting expenses during 2005 related to Sarbanes-Oxley Section 404 compliance.
Research and Development Expenses
Research and development expenses for 2005 were $7.2 million compared with $5.6 million for 2004. The increase in 2005 was in part due to the continuing development of electrical and machine upgrade systems.
Operating Earnings
Operating earnings for 2005 were $74.1 million, or 12.9% of sales, compared with $35.9 million, or 7.9% of sales, for 2004. Operating earnings for 2005 increased from 2004 due to increased gross profit resulting from increased sales volume and higher gross margins on both machines and aftermarket sales. Operating earnings for 2004 were reduced by $10.1 million of non-cash stock compensation expense. Approximately $.6 million of the increase in operating earnings for 2005 was attributable to a weakening United States dollar (see “Foreign Currency Fluctuations” below).
Interest Expense
Interest expense for 2005 was $4.9 million compared with $11.5 million for 2004. The decrease in interest expense in 2005 was primarily due to the refinancing of our capital structure in connection with our initial public offering.
Other Expense
Other expense for 2005 and 2004 was $1.0 million and $2.0 million, respectively. Included in the amount for 2004 was $.6 million of secondary common stock offering expenses. Debt issuance cost amortization was $1.0 million and $1.4 million for 2005 and 2004, respectively. These amounts included costs related to our credit facilities (see “Liquidity and Capital Resources-Financing Cash Flows” below).
Income Taxes
Income tax expense for 2005 was $15.4 million compared with $9.3 million for 2004. In 2005, U.S. taxable income exceeded available net operating loss carryforwards and income tax expense was recorded. Foreign taxes continue to be recorded at applicable statutory rates. Income tax expense for 2005 was reduced by a net income tax benefit of $7.0 million, which consisted of $1.8 million of foreign tax expense related to a foreign dividend distribution and the recognition of an income tax benefit of approximately $8.8 million related to foreign tax credits. During 2005, we began to quantify the amount of previously unclaimed foreign tax credits which we can utilize in part by amending historical income tax returns. As of December 31, 2005, we had approximately $14.3 million of federal net operating loss carryforwards.
Foreign Currency Fluctuations
The following table summarizes the approximate effect of changes in foreign currency exchange rates on our sales, gross profit and operating earnings for 2006, 2005 and 2004, in each case compared to the prior year:
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Increase in sales | | $ | 577 | | $ | 6,536 | | $ | 11,946 | |
Increase in gross profit | | | 321 | | | 1,528 | | | 2,103 | |
Increase in operating earnings | | | 304 | | | 573 | | | 246 | |
EBITDA
Earnings before interest, taxes, depreciation and amortization (“EBITDA”) for 2006, 2005 and 2004 was $116.0 million, $87.6 million and $48.2 million, respectively. EBITDA is presented because (i) we use EBITDA to measure our liquidity and financial performance and (ii) we believe EBITDA is frequently used by securities analysts, investors and other interested parties in evaluating the performance and enterprise value of companies in general, and in evaluating the liquidity of companies with significant debt service obligations and their ability to service their indebtedness. Our EBITDA calculation is not an alternative to operating earnings under accounting principles generally accepted in the United States of America (“GAAP”) as an indicator of operating performance or of cash flows as a measure of liquidity. The following table reconciles Net Earnings as shown in our Consolidated Statements of Earnings to EBITDA and reconciles EBITDA to Net Cash Provided by Operating Activities as shown in our Consolidated Statements of Cash Flows:
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Net earnings | | $ | 70,344 | | $ | 53,559 | | $ | 6,084 | |
Interest income | | | (663 | ) | | (669 | ) | | (316 | ) |
Interest expense | | | 3,693 | | | 4,865 | | | 11,547 | |
Income taxes | | | 26,930 | | | 15,358 | | | 9,276 | |
Depreciation | | | 12,892 | | | 11,681 | | | 11,061 | |
Amortization (1) | | | 2,827 | | | 2,788 | | | 3,194 | |
Loss on extinguishment of debt | | | — | | | — | | | 7,316 | |
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EBITDA (2) | | | 116,023 | | | 87,582 | | | 48,162 | |
Changes in assets and liabilities | | | (39,557 | ) | | (18,123 | ) | | (22,957 | ) |
Non-cash stock compensation expense | | | 4,284 | | | 180 | | | 10,076 | |
Loss on sale of fixed assets | | | 140 | | | 273 | | | 287 | |
Interest income | | | 663 | | | 669 | | | 316 | |
Interest expense | | | (3,693 | ) | | (4,865 | ) | | (11,547 | ) |
Income tax expense | | | (26,930 | ) | | (15,358 | ) | | (9,276 | ) |
Secondary offering expenses | | | — | | | — | | | 602 | |
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Net cash provided by operating activities | | $ | 50,930 | | $ | 50,358 | | $ | 15,663 | |
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Net cash used in investing activities | | $ | (70,603 | ) | $ | (22,109 | ) | $ | (6,706 | ) |
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Net cash provided by (used in) financing activities | | $ | 15,134 | | $ | (36,299 | ) | $ | 5,188 | |
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(1) | Includes amortization of intangible assets and debt issuance costs. |
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(2) | EBITDA for 2004 was reduced by expenses pursuant to a management services agreement with American Industrial Partners (“AIP”) as well as fees paid to AIP or its affiliates and advisors for services performed for us outside the scope of the management services agreement of $1.3 million. The management services agreement was terminated in July 2004. EBITDA for 2006, 2005 and 2004 was also reduced by severance expense of $1.4 million, $.5 million and $.4 million, respectively. |
Liquidity and Capital Resources
Cash Requirements
During 2007, we anticipate strong cash flows from operations due to continued strength in our aftermarket parts sales as well as continued high demand for our new machines. In expanding markets, customers are generally contractually obligated to make progress payments under purchase contracts for machine orders and certain large parts orders. As a result, we do not anticipate significant outside financing requirements to fund production of these machines and do not believe that new machine sales will have a material negative effect on our liquidity, although the issuance of letters of credit reduces the amount available for borrowings under our revolving credit facility. If additional borrowings are necessary during 2007, we believe we have sufficient capacity under our revolving credit facility (see “Financing Cash Flows” below).
Our 2006 capital expenditures were $74.4 million compared with $22.2 million for 2005. Included in capital expenditures for 2006 was approximately $56.2 million related to our expansion program, of which $3.0 million was paid in early 2007. The remaining expenditures consisted
primarily of production machinery at our main manufacturing facility. We expect capital expenditures in 2007 to remain near our 2006 level as we increase our manufacturing capacity and upgrade and replace our manufacturing equipment to support our increased sales activity. We believe cash flows from operating activities and funds available under our revolving credit facility, as well as governmental grants and other programs, will be sufficient to fund our expected capital expenditures in 2007.
As of December 31, 2006, there were $76.2 million of standby letters of credit outstanding under all of our bank facilities.
As of December 31, 2006, our long-term liabilities consisted primarily of warranty and product liability accruals and pension and postretirement benefit accruals. For 2007, we expect to contribute $9.2 million to our pension plans and $1.3 million for the payment of benefits from our postretirement benefit plan. As of December 31, 2006, our unfunded pension and postretirement benefit liability was $44.9 million.
Payments of warranty and product liability claims are not subject to a definitive estimate by year. We do not anticipate cash requirements for warranty claims to be materially different than historical funding levels. We do not expect to pay any material product liability claims in 2007.
In addition to the obligations noted above, we anticipate cash funding currently estimated requirements for interest, dividends and income taxes of approximately $5.7 million, $6.3 million and $37.1 million, respectively, during 2007.
We believe that cash flows from our operations and our revolving credit facility will be sufficient to fund our normal cash requirements for 2007. We also believe that cash flows from our operations will be sufficient to repay any borrowings under our revolving credit facility as necessary.
Sources and Uses of Cash
We had $9.6 million of cash and cash equivalents as of December 31, 2006. All of this cash is located at various subsidiaries and is used for working capital purposes. Cash receipts in the United States are applied against our revolving credit facility.
Operating Cash Flows
During 2006, we generated cash from operating activities of $50.9 million compared to $50.4 million in 2005. The increase in our cash flows from operating activities resulted primarily from increased sales activity.
Receivables
We recognize revenues on machine orders using the percentage of completion method. Accordingly, accounts receivable are generated when revenue is recognized, which can be before the funds are collected or, in some cases, before the customer is billed. As of December 31, 2006, we had $162.5 million of accounts receivable compared to $155.5 million of accounts receivable as of December 31, 2005. Receivables as of December 31, 2006 and 2005 included $77.0 million and $68.2 million, respectively, of revenues from long-term contracts which were not billable at these dates.
Liabilities to Customers on Uncompleted Contracts and Warranties
Customers generally make down payments at the time of the order for a new machine as well as progress payments throughout the manufacturing process. In accordance with Statement of Position No. 81-1, these payments are recorded as Liabilities to Customers on Uncompleted Contracts and Warranties.
Financing Cash Flows
Our credit agreement as of December 31, 2006, with GMAC Commercial Finance LLC as lead lender, provides for a revolving credit facility and expires on May 27, 2010. In 2006, the amount of the revolving credit facility was increased to $200.0 million from $120.0 million. Interest on borrowed amounts is subject to quarterly adjustments to prime or LIBOR rates as defined in the credit agreement. Borrowings under the revolving credit facility are subject to a borrowing base formula based on the value of eligible receivables and inventory. As of December 31, 2006, we had $78.8 million of borrowings under our revolving credit facility at a weighted average interest rate of 6.8%. The amount available for borrowings under the revolving credit facility as of December 31, 2006 was $69.7 million.
Our credit agreement contains covenants limiting our discretion with respect to key business matters and places significant restrictions on, among other things, our ability to incur additional indebtedness, create liens or other encumbrances, make certain payments or investments, loans and guarantees, and sell or otherwise dispose of assets and merge or consolidate with another entity. All of our domestic assets and the receivables and inventory of our Canadian subsidiary are pledged as collateral under the revolving credit facility. In addition, the outstanding capital stock of our domestic subsidiaries, as well as the capital stock of a majority of our foreign subsidiaries, are pledged as collateral. We are also required to maintain compliance with certain covenants, including a leverage ratio (as defined). We were in compliance with these covenants as of December 31, 2006.
Current Dividend Policy
In 2006, our Board of Directors authorized a 30% increase in our stockholders’ quarterly cash dividend to the amount of $.05 per share per quarter, subject to future authorization by our Board of Directors.
Contractual Obligations
The following table summarizes our contractual obligations as of December 31, 2006:
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Long-term debt | | $ | 82,476 | | $ | 210 | | $ | 1,078 | | $ | 79,523 | | $ | 1,665 | |
Short-term obligations | | | 121 | | | 121 | | | — | | | — | | | — | |
Purchase obligations (1) | | | 2,020 | | | 1,328 | | | 692 | | | — | | | — | |
Operating leases and rental and service agreements | | | 36,984 | | | 6,971 | | | 8,735 | | | 6,363 | | | 14,915 | |
Expansion project (2) | | | 13,975 | | | 13,975 | | | — | | | — | | | — | |
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Total | | $ | 135,576 | | $ | 22,605 | | $ | 10,505 | | $ | 85,886 | | $ | 16,580 | |
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(1) | Obligations related to purchase orders entered into in the ordinary course of business are excluded from the above table. Any amounts for which we are liable for goods or services received under purchase orders are reflected in the Consolidated Balance Sheets as accounts payable. |
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(2) | We are in the midst of a multi-phase expansion program at our South Milwaukee facility. We expect that the aggregate cost of phase one and two will be approximately $54 million, and that the cost of phase three will be approximately $58 million. We are financing the expansion program through working capital and funds available under our existing revolving credit facility as well as governmental grants and other programs. |
Critical Accounting Policies and Estimates
The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions about future events that affect the amounts reported in our financial statements and accompanying footnotes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results could differ from those estimates, and such differences may be material to the financial statements. The process of determining significant estimates is fact specific and takes into account factors such as historical experience, current and expected economic conditions, product mix, and in some cases, actuarial techniques. We evaluate these significant factors as facts and circumstances dictate. Historically, actual results have not differed significantly from those determined using estimates.
The following are the accounting policies that most frequently require us to make estimates and judgments and are critical to understanding our financial condition, results of operations and cash flows:
Revenue Recognition - Revenue from long-term sales contracts, such as for the manufacture of our machines and certain parts orders, is recognized using the percentage-of-completion method prescribed by Statement of Position No. 81-1 due to the length of time to fully manufacture and assemble our machines or replacement parts. We measure revenue recognized based on the ratio of estimated costs incurred to date in relation to total costs to be incurred. The percentage-of-completion method of accounting for these contracts most accurately reflects the status of these uncompleted contracts in our financial statements and most accurately measures the matching of revenues with expenses. We also have long-term maintenance and repair contracts with customers. Under these contracts, we provide all replacement parts, regular
maintenance services and necessary repairs for the excavation equipment at a particular mine with an on-site support team. In addition, some of these contracts call for our personnel to operate the equipment being serviced. Parts consumed and services provided are charged to cost of products sold and sales are calculated and recorded based on the parts and services utilization. The customer is billed monthly and a liability for deferred revenues is recorded if payments received exceed revenues recognized. At the time a loss on a contract becomes known, the amount of the estimated loss is recognized in our consolidated financial statements. Revenue from all other types of sales, primarily sales of aftermarket parts, net of estimated returns and allowances, is recognized in conformity with Staff Accounting Bulletin No. 104, when all of the following circumstances are satisfied: persuasive evidence of an arrangement exists, the price is fixed or determinable, collectibility is reasonably assured and delivery has occurred or services have been rendered. Criteria for revenue recognition is generally met at the time products are shipped, as the terms are FOB shipping point.
The complexity of the cost estimation process and all issues related to assumptions, risks and uncertainties inherent with the use of estimated costs in the percentage of completion method of accounting affect the amounts reported in our financial statements. A number of internal and external factors affect our cost of sales estimates, including engineering design changes, estimated future material prices and customer specification changes. If we had used different assumptions in the application of this and other accounting policies, it is likely that materially different amounts would be reported in the financial statements. Bid and proposal costs are expensed as incurred. A 1% change in the gross margin percentage on machines in progress at December 31, 2006 would have the effect of changing our gross profit by approximately $2.2 million.
Warranty - - Sales of our products generally carry typical manufacturers’ warranties, the majority of which cover products for one year, based on terms that are generally accepted in the marketplaces that we serve. We record provisions for estimated warranty and other related costs as revenue is recognized based on historical warranty loss experience and periodically adjust these provisions to reflect actual experience. Estimates used to determine the product warranty accruals are significantly impacted by the historical percentage of warranty claims costs to net sales. Over the last three years, this percentage has varied by approximately 0.1 percentage points compared to the warranty costs to net sales percentage during 2006. Holding other assumptions constant, if this estimated percentage were to increase or decrease 0.1 percentage points, our warranty expense for 2006 would increase or decrease by approximately $0.7 million.
Pension and Other Postretirement Benefits - In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS No. 158”). SFAS No. 158 requires an employer to recognize the over funded or under funded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. SFAS No. 158 also requires an employer to measure the funded status of a plan as of the date of its year-end balance sheet. We adopted the provisions of SFAS No. 158 as of December 31, 2006 as required.
We have several defined benefit pension plans that are separately funded. We also provide certain health care benefits to employees until age 65 and life insurance benefits for certain eligible retired United States employees. Several statistical and judgmental factors which attempt to anticipate future events are used in calculating the expense and liability related to these plans. These factors include assumptions about the discount rate, expected return on plan assets, rate of future compensation increases and health care cost trend rates, as we determine within certain guidelines. In addition, our actuarial consultants also use subjective factors such as withdrawal
and mortality rates to estimate these factors. The actuarial assumptions we use may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates, longer or shorter life spans of participants and changes in actual costs of health care. These differences may result in a significant impact to the amount of pension and other postretirement benefit expenses recorded by us.
In determining net periodic cost for pension benefits and for postretirement benefits other than pensions for 2006, our actuarial consultants used a 5.50% discount rate and an expected long-term rate of return on plan assets of 8.5%. The discount rate for 2006 was decreased from 5.75% in 2005 and the expected long-term rate of return on plan assets was decreased from 9.0% in 2005.
In selecting an assumed discount rate, we reviewed various corporate bond yields. The 8.5% expected long-term rate of return on plan assets is based on the average rate of earnings expected on the classes of funds invested or to be invested to provide for the benefits of these plans. This includes considering the trusts’ targeted asset allocation for the year and the expected returns likely to be earned over the next 20 years. The assumptions used for the return of each asset class are conservative when compared to long-term historical returns
The table below shows the effect that a 1% increase or decrease in the discount rate and expected rate of return on plan assets would have on our pension and other postretirement benefits obligations and costs:
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| | 2006 Benefit Cost
(Income)/Expense | | January 1, 2006 Benefit Obligation
Increase/(Decrease) | |
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| | One
Percentage-
Point Increase | | One
Percentage-
Point Decrease | | One
Percentage-
Point Increase | | One
Percentage-
Point Decrease | |
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| | (Dollars in thousands) | |
Pension benefits: | | | | | | | | | | | | | |
Assumed discount rate | | $ | (526 | ) | $ | 605 | | $ | (8,684 | ) | $ | 10,259 | |
Expected long-term rate of return on plan assets | | | (612 | ) | | 612 | | | N/A | | | N/A | |
Other postretirement benefits: | | | | | | | | | | | | | |
Assumed discount rate | | | (156 | ) | | 180 | | | (1,545 | ) | | 1,799 | |
Accounting for Uncertainty in Income Taxes -In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 is an interpretation of FASB Statement No. 109, “Accounting for Income Taxes,” and seeks to reduce the diversity in practice associated with certain aspects of measurement and recognition in accounting for income taxes. In addition, FIN 48 requires expanded disclosure with respect to the uncertainty in income taxes and is effective as of the beginning of 2007. We are currently evaluating the impact, if any, that FIN 48 will have on our financial statements.
Off Balance Sheet Arrangements
We do not have any off balance sheet financing arrangements that we believe have or are reasonably likely to have a current or future material effect on our financial condition.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our market risk is impacted by changes in interest rates and foreign currency exchange rates.
Interest Rates- Our interest rate exposure relates primarily to floating rate debt obligations in the United States. We manage borrowings under our credit agreement through the selection of LIBOR based borrowings or prime-rate based borrowings. If market conditions warrant, interest rate swaps may be used to adjust interest rate exposures, although none have been used to date. As of December 31, 2006, a sensitivity analysis was performed for our floating rate debt obligations. Based on these sensitivity analyses, we have determined that a 10% change in the weighted average interest rate as of December 31, 2006 would have the effect of changing our interest expense on an annual basis by approximately $.6 million.
Foreign Currency –We sell most of our machines, including those sold directly to foreign customers, and most of our aftermarket parts in United States dollars. A limited amount of aftermarket parts sales are denominated in the local currencies of Australia, Canada, South Africa, Brazil, Chile and the United Kingdom, which subjects us to foreign currency risk. Aftermarket sales and a portion of the labor costs associated with such activities are denominated or paid in local currencies. As a result, a relatively strong United States dollar could decrease the United States dollar equivalent of our sales without a corresponding decrease of the United States dollar value of certain related expenses. We utilize some foreign currency derivatives to mitigate foreign exchange risk.
Currency controls, devaluations, trade restrictions and other disruptions in the currency convertibility and in the market for currency exchange could limit our ability to timely convert sales earned abroad into United States dollars, which could adversely affect our ability to service our United States dollar indebtedness, fund our United States dollar costs and finance capital expenditures and pay dividends on our common stock.
Based on our derivative instruments outstanding as of December 31, 2006, a 10% change in foreign currency exchange rates would not have a material effect on our financial position, results of operations or cash flows.
