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U.S. military, and if successful in competitive programs, we cannot determine the specific levels of effort likely under such military contracts.
An additional consideration and risk factor regarding the introduction of new vehicle versions for tactical wheeled vehicles is the U.S. military’s recent pronouncements that it is the Government’s preference to own technical data rights for new major end items of equipment and sub-systems, including the vehicle armoring packages. The Government’s intent to mitigate risk of limitations on producibility and to ensure commonality of armor components produced by multiple sources may negatively influence future manufacturing content and product pricing.
See risk factor ‘‘A Replacement of the HMMWV in the U.S. Military May Affect Our Results of Operations’’ under Item 1A in Part I of our Annual Report on Form 10-K for the year ended December 31, 2005.
(2) During the three months ended March 31, 2006, revenue from add-on armor components for fielded vehicles including add-on armor kits for the light, medium and heavy tactical truck fleet decreased 92%, compared to the three months ended March 31, 2005. Although we may receive additional add-on armor kit business in the future, the majority of armoring of fielded trucks has been completed. We also believe that the U.S. Military’s tactical wheeled vehicle procurement strategy includes replacement or additional production of current type medium or heavy trucks and these vehicles are also planned to receive armor subsystems in the future.
(3) Small armors protection insert (‘‘SAPI’’) plate volume increased by 83% in the three months ended March 31, 2006, compared to the three months ended March 31, 2005. The increase in volume was a result of: (1) increasing requirements by the U.S. military, (2) the ability of our industrial base to increase production capacity, and (3) our ability to qualify additional sources of supply.
Continued growth in the SAPI plate business is dependent upon the continued level of hostilities in Iraq and Afghanistan as well as the U.S. Government’s requirements for improved technology and performance of the SAPI plate. Future revenues may be constrained by our ability to procure certain raw materials necessary for the manufacture of the SAPI plate. See the risk factor ‘‘There are Limited Sources for Some of Our Raw Materials, Which May Significantly Curtail our Manufacturing Operations’’ under Item 1A in Part I of our Annual Report on Form 10-K for the year ended December 31, 2005.
(4) Outer tactical vest (‘‘OTV’’) units increased by 252% in the three months ended March 31, 2006, over the three months ended March 31, 2005. We experienced 177% unit growth in helmets. Also, our Modular Lightweight Load-Carrying Equipment (‘‘MOLLE’’) revenue increased 38%, and aerospace revenues increased 14%.
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months ended March 31, 2005. Commercial vehicle shipments decreased 23%, to 317 vehicles in the three months ended March 31, 2006, compared to 413 vehicles in the three months ended March 31, 2005. The Mobile Security’s internal revenue decline was primarily a result of a shortage of base units and model year changes in two significant product lines - the Chevrolet Surburban and the Mercedes S-Class. We expect the model changes to be complete by the middle of fiscal year 2006 and output to increase significantly in the second half of fiscal year 2006.
Cost of revenues. Cost of revenues increased $67.2 million, or 25%, to $340.8 million for the three months ended March 31, 2006, compared to $273.7 million for the three months ended March 31, 2005. As a percentage of total revenues, cost of revenues increased to 76.5% of total revenues for the three months ended March 31, 2006, from 75.0% for the three months ended March 31, 2005.
Gross margins in Aerospace & Defense were 20.1% for the three months ended March 31, 2006, compared to 22.0% for the three months ended March 31, 2005. This reduction was primarily due to: (1) an increased mix of lower-margin revenues from Medium Tactical Vehicle Replacement (‘‘MTVR’’) cabs; and (2) reduced SAPI plate margins related to changing product specifications.
Gross margins in Products were 39.0% for the three months ended March 31, 2006, compared to 37.3% for the three months ended March 31, 2005. Gross margins improved as a result of: (1) improved manufacturing efficiencies; (2) better utilization of lower-cost facilities; and (3) select selling price increases.
Gross margins in Mobile Security were 22.8% in the three months ended March 31, 2006, compared to 25.6% for the three months ended Mach 31, 2005. The decrease in margins was primarily due to decreased overhead absorption caused by reduced production throughput.
Selling, general and administrative expenses. Selling, general and administrative expenses increased $2.3 million, or 7%, to $36.1 million (8.1% of total revenues) for the three months ended March 31, 2006, compared to $33.8 million (9.3% of total revenues) for the three months ended March 31, 2005. The decrease as a percentage of total revenues was largely a function of our ability to achieve scale as revenues have increased.
Aerospace & Defense selling, general and administrative expenses increased $0.4 million, or 5%, to $9.2 million (2.7% of Aerospace & Defense revenues) for the three months ended March 31, 2006, compared to $8.8 million (3.3% of Aerospace & Defense revenues) for the three months ended March 31, 2005. The increase in selling, general and administrative expenses is due primarily to increased research and development expense, and other administrative expenses as a result of the increased size of the business. The decrease in selling, general and administrative expenses as a percentage of revenue was due to leveraging of the selling, general and administrative expenses over a larger revenue base.
Products selling, general and administrative expenses increased $2.6 million, or 19%, to $16.7 million (21.8% of Products revenues) for the three months ended March 31, 2006, compared to $14.1 million (22.3% of Products revenues) for the three months ended March 31, 2005. This increase is due primarily to the impact of acquisitions which amounted to $1.6 million, and increased selling expenses related to higher sales volumes. The decrease in selling, general and administrative expenses as a percentage of revenue was due to leveraging of the selling, general and administrative expenses over a larger revenue base.
Mobile Security selling, general and administrative expenses increased $0.9 million, or 24%, to $4.5 million (19.0% of Mobile Security revenues) for the three months ended March 31, 2006, compared to $3.6 million (10.0% of Mobile Security revenues) for the three months ended March 31, 2005. The increase in selling, general and administrative expense was primarily due to increased research and development costs, and increased selling and marketing costs. The increase in
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selling, general and administrative expenses as a percentage of revenues was due to the items listed above and the large decrease in revenues.
Corporate general and administrative expenses decreased $1.6 million, or 22%, to $5.7 million (1.3% of total revenues) for the three months ended March 31, 2006, compared to $7.3 million (2.0% of total revenues) for the three months ended March 31, 2005. This decrease in general and administrative expenses is primarily associated with reduced bonus provisions partially offset with increased expenses associated with the adoption of FAS 123R (expensing of stock options).
Amortization. Amortization expense increased $0.2 million, or 11%, to $2.3 million for the three months ended March 31, 2006, compared to $2.0 million for the three months ended March 31, 2005, primarily due to the acquisition of Second Chance in July 2005. Amortization expense is related to patents and trademarks with finite lives, and acquired amortizable intangible assets that meet the criteria for recognition as an asset apart from goodwill under SFAS 141.
Integration. Integration decreased $0.3 million, or 41%, to $0.5 million for the three months ended March 31, 2006, compared to $0.8 million for the three months ended March 31, 2005. Included in integration in the first quarter of 2006 were charges for the integration of Second Chance, which was acquired in the third quarter of 2005 and costs related to accounting, legal and other due diligence costs related to acquisitions that were not consummated. Included in integration in the first quarter of 2005 were charges primarily for Specialty Defense and Bianchi, which were acquired in the fourth quarter of 2004.
Operating income. Operating income increased $11.1 million, or 20%, to $65.8 million for the three months ended March 31, 2006, compared to $54.7 million in the three months ended March 31, 2005, due to the factors discussed above.
Interest expense, net. Interest expense, net, decreased $2.0 million, or 88%, to $0.3 million for the three months ended March 31, 2006, compared to $2.2 million for the three months ended March 31, 2005. This decrease is primarily due to an increase in interest income generated from the increase in investment yield from higher interest rates and the increase in investment balances primarily resulting from positive operating cash flow. This increase in interest income is partially offset by an increase in interest expense on our variable rate debt as a result of the increase in the six-month LIBOR. On September 2, 2003, we entered into interest rate swap agreements that effectively exchanged the 8.25% fixed rate on the 8.25% Notes for a variable rate of six-month LIBOR (5.1% at March 31, 2006, and 3.5% at March 31, 2005), set in arrears, plus a spread of 2.735% to 2.75%.
Other (income) expense, net. Other income, net, was $0.8 million for the three months ended March 31, 2006, and relates primarily to the expiration of our unexercised 1 million previously announced put option contracts on Company stock and dividends received on our equity based securities. Other expense, net, of $1.1 million for the three months ended March 31, 2005, relates primarily to the fair value loss on put options sold in various private transactions covering 2 million shares of Company stock. We had no remaining put options outstanding at March 31, 2006.
Income before provision for income taxes. Income before provision for income taxes increased $15.0 million, or 29%, to $66.3 million for the three months ended March 31, 2006, compared to $51.3 million for the three months ended March 31, 2005, due to the reasons discussed above.
Provision for income taxes. Provision for income taxes was $24.9 million for the three months ended March 31, 2006, compared to $20.3 million for the three months ended March 31, 2005. The effective tax rate was 37.5% for the three months ended March 31, 2006, compared to 39.5% for the three months ended March 31, 2005. The reduced tax rate relates primarily to an increase in our U.S. manufacturing tax deduction and increased Federal tax credits. The reduced tax rate also relates to the non-taxable nature of the fair value gain on put options in the three months ended March 31, 2006, compared to the non-deductible nature of the fair value loss on put options in the three months ended March 31, 2005.
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Net income. Net income increased $10.4 million, or 33%, to $41.4 million in the three months ended March 31, 2006, compared to $31.0 million in the three months ended in March 31, 2005, due to the factors discussed above.
LIQUIDITY AND CAPITAL RESOURCES
In March 2002, our Board of Directors approved a stock repurchase program authorizing the repurchase of up to a maximum 3.2 million shares of our common stock. In February 2003, the Board of Directors increased this stock repurchase program to authorize the repurchase, from time to time depending upon market conditions and other factors, of up to an additional 4.4 million shares. On March 25, 2005, our Board of Directors increased our existing stock repurchase program to enable us to repurchase, from time to time depending upon market conditions and other factors, up to an additional 3.5 million shares of its outstanding common stock. Through May 3, 2006, we repurchased 3.8 million shares of our common stock under the stock repurchase program at an average price of $12.49 per share, leaving us with the ability to repurchase up to an additional 7.3 million shares of our common stock. We did not repurchase any shares in the first quarter of fiscal 2006 or fiscal 2005. Repurchases may be made in the open market, in privately negotiated transactions utilizing various hedging mechanisms including, among others, the sale to third parties of put options on our common stock, or otherwise. At March 31, 2006, we had 35.4 million shares of common stock outstanding.
During fiscal 2005, we sold put options in various private transactions covering 3.5 million shares of Company stock for $6.6 million in premiums. During fiscal 2005, put options covering 2.5 million shares of Company stock expired unexercised leaving outstanding put options covering 1 million shares outstanding (2.8% of outstanding shares at December 31, 2005) at a weighted average strike price of $40.00 per share. In February 2006, the remaining outstanding put options covering 1 million shares expired unexercised. Accordingly, we recorded an additional $0.7 million in other income in the first quarter of fiscal 2006. The fair values of the put options of Company stock are obtained from our counter-parties and represent the estimated amount we would receive or pay to terminate the put options, taking into account the consideration we received for the sale of the put options. In fiscal 2005, we recognized fair value gains of $5.9 million recorded in other income, net, of which $4.8 million was recognized on the 2.5 million previously expired and unexercised put options.
We expect to continue our policy of repurchasing our common stock from time to time, subject to the restrictions contained in our secured revolving credit facility (the ‘‘Credit Facility’’) with Bank of America, N.A., Wachovia Bank, N.A. and a syndicate of other financial institutions arranged by Bank of America Securities, LLC; the indenture governing the 8¼% Senior Subordinated Notes due 2013 (the ‘‘8.25% Notes’’) and the indenture governing the 2.00% Senior Subordinated Convertible Notes due November 1, 2024 (the ‘‘2% Convertible Notes’’). Our Credit Facility permits us to repurchase shares of our common stock with no limitation if our ratio of Consolidated Senior Indebtedness to Consolidated earnings before interest, taxes, depreciation and amortization (‘‘EBITDA’’) (as such terms are defined in the Credit Facility) for any rolling twelve-month period is less than 1.00 to 1. When such ratio is greater than 1.00 to 1, our Credit Facility limits our ability to repurchase shares at $15.0 million. This basket resets to $0 each time the ratio is less than 1.00 to 1. As of March 31, 2006, such ratio was 0.04 to 1. Our indentures governing the 8.25% Notes and the 2% Convertible Notes also permit us to repurchase shares of our common stock, subject to certain limitations, as long as we satisfy the conditions to such repurchase contained therein.
On June 22, 2005, we implemented the 2005 Stock Incentive Plan. The 2005 Stock Incentive Plan authorizes the issuance of up to 2,500,000 shares of our common stock. Any shares of our common stock granted as restricted stock, performance stock or other stock-based awards will be counted against the shares authorized as one and eight-tenths (1.8) shares for every one share issued in connection with such award. The 2005 Stock Incentive Plan authorizes the granting of stock options, restricted stock, performance awards and other stock-based awards to employees, officers, directors
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and consultants, independent contractors and advisors of the Company and its subsidiaries. Upon adoption of our 2005 Stock Incentive Plan, we agreed to not grant awards under any of our pre-existing stock incentive plans.
On June 22, 2004, our stockholders approved an amendment to our Certificate of Incorporation, as amended, that increased the number of shares of our authorized capital stock to 80,000,000, of which 75,000,000 shares are designated as common stock and 5,000,000 shares are designated as preferred stock.
On October 29, 2004, we completed the placement of the 2% Convertible Notes. On November 5, 2004, Goldman, Sachs & Co. exercised its option to purchase an additional $45 million principal amount of the 2% Convertible Notes. The 2% Convertible Notes provide the holders with a seven year put option and are guaranteed by most of our domestic subsidiaries on a senior subordinated basis. The 2% Convertible Notes were initially rated B1/B+ by Moody’s Investors’ Service and Standard & Poor’s Rating Services, respectively. The 2% Convertible Notes will bear interest at a rate of 2.00% per year, payable on November 1 and May 1 of each year beginning on May 1, 2005, and ending on November 1, 2011. The 2% Convertible Notes will be subject to accretion of the principal amount beginning on November 1, 2011, at a rate that provides holders with an aggregate annual yield to maturity of 2.00%, as defined in the agreement. The 2% Convertible Notes will bear contingent interest during any six-month period beginning November 1, 2011, of 15 basis points paid in cash if the average trading price of the notes is above certain levels. The 2% Convertible Notes will be convertible, at the bond holder’s option at any time, initially at a conversion rate of 18.5151 shares of our common stock per $1,000 principal amount of notes, which is the equivalent conversion price of approximately $54.01 per share, subject to adjustment. Upon conversion, we will satisfy our conversion obligation with respect to the accreted principal amount of the notes to be converted in cash, with any remaining amount to be satisfied in shares of our common stock. The conversion rate will be subject to adjustment, without duplication, upon the occurrence of any of the following events: (1) stock dividends in common stock, (2) issuance of rights and warrants, (3) stock splits and combinations, (4) distribution of indebtedness, securities or assets, (5) cash distributions, (6) tender or exchange offers, and (7) repurchases of common stock. In accordance with U.S. GAAP, the 2% Convertible Notes are classified as short term debt as they can be converted at any time prior to maturity. We used a portion of the proceeds of the offering to fund the acquisition of Second Chance in July 2005, and for general corporate and working capital purposes, including the funding of capital expenditures. Funds that are not immediately used are invested in money market funds and other investment grade securities until needed.
On August 12, 2003, we completed a private placement of $150 million aggregate principal amount of the 8.25% Notes. The 8.25% Notes are guaranteed by most of our domestic subsidiaries on a senior subordinated basis. The 8.25% Notes were sold to qualified institutional investors in reliance on Rule 144A of the Securities Act of 1933, as amended, and to non-U.S. persons in reliance on Regulation S under the Securities Act of 1933, as amended. In 2004, after the completion of the private placement of the 8.25% Notes, we conducted an exchange offer pursuant to which holders of the privately placed 8.25% Notes exchanged such notes for 8.25% Notes registered under the Securities Act of 1933, as amended. The 8.25% Notes were initially rated B1/B+ by Moody’s Investors’ Service and Standard & Poor’s Rating Services, respectively. We used a portion of the funds to repay debt, acquire Simula, Inc., Hatch Imports, Inc., ODV, Inc., and Kleen-Bore, Inc., and we used the remaining proceeds of the offering to fund acquisitions and for general corporate and working capital purposes, including the funding of capital expenditures. On March 29, 2004, we completed a registered exchange offer for the 8.25% Notes and exchanged the 8.25% Notes for new 8.25% Notes that were registered under the Securities Act of 1933, as amended.
On September 2, 2003, we entered into interest rate swap agreements, which have been designated as fair value hedges as defined under SFAS 133 with a notional amount totaling
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$150 million. The agreements were entered into to exchange the fixed interest rate on our 8.25% Notes for a variable interest rate equal to six-month LIBOR, set in arrears, plus a spread ranging from 2.735% to 2.75% fixed semi-annually on the fifteenth day of February and August. The agreements are subject to other terms and conditions common to transactions of this type. In accordance with SFAS 133, changes in the fair value of the interest rate swap agreements offset changes in the fair value of the fixed rate debt due to changes in the market interest rate. For the three months ended March 31, 2006, the fair value for interest swaps changed in value by $3.1 million. At December 31, 2005, there was a $1.4 million asset included in other assets, which, as a result of the change in fair value, is a $1.7 million hedge liability at March 31, 2006. The agreements are deemed to be a perfectly effective fair value hedge, and, therefore, qualify for the short-cut method of accounting under SFAS 133. As a result, no ineffectiveness is expected to be recognized in our earnings associated with the interest rate swap agreements.
On August 12, 2003, in concert with our 8.25% Note offering, we entered into the Credit Facility. The Credit Facility consists of a five-year revolving credit facility, and, among other things, provides for (i) total maximum borrowings of $60 million, (ii) a $25 million sub-limit for the issuances of standby and commercial letters of credit, (iii) a $5 million sub-limit for swing-line loans, and (iv) a $5 million sub-limit for multi-currency borrowings. All borrowings under the Credit Facility will bear interest at either (i) a rate equal to LIBOR, plus an applicable margin ranging from 1.125% to 1.625%, (ii) an alternate base rate which will be the higher of (a) the Bank of America prime rate and (b) the Federal Funds rate plus 0.50%, or (iii) with respect to foreign currency loans, a fronted offshore currency rate, plus an applicable margin ranging from 1.125% to 1.625%, depending on certain conditions. The Credit Facility is guaranteed by certain of our direct and indirect domestic subsidiaries and is collateralized by, among other things, (i) a pledge of all of the issued and outstanding shares of stock or other equity interests of certain of our domestic subsidiaries, (ii) a pledge of 65% of the issued and outstanding voting shares of stock or other voting equity interests of certain of our direct and indirect foreign subsidiaries, (iii) a pledge of 100% of the issued and outstanding nonvoting shares of stock or other nonvoting equity interests of certain of our direct and indirect foreign subsidiaries, and (iv) a first priority perfected security interest on certain of our domestic assets and certain domestic assets of certain of our direct and indirect subsidiaries that will become guarantors of our obligations under the Credit Facility, including, among other things, accounts receivable, inventory, machinery, equipment, certain contract rights, intellectual property rights and general intangibles. On January 9, 2004, we amended our Credit Facility to broaden our ability to make additional open-market purchases of publicly-traded securities subject to certain limitations. On March 29, 2004, we amended our Credit Facility to allow us to pay dividends subject to certain limitations. On October 19, 2004, we amended our Credit Facility to allow us to subtract cash equivalents from total indebtedness in calculation of our compliance covenants. On April 14, 2005, we amended our credit agreement to amend the definition of cash equivalents to include auction rate securities held by our existing bank group. On July 26, 2005, we amended the Credit Facility to allow for advances, loans, extensions of credit to or any other investments in key suppliers of the Company in an aggregate amount not to exceed $15 million at any time outstanding for the purpose of facilitating the sale and purchase of goods and services to the Company. In addition, the amendment allows for leases or other dispositions of assets of not more than 10% of the consolidated EBITDA, as defined in the Credit Facility. At March 31, 2006, we had $54.4 million in availability under our Credit Facility, excluding $5.6 million in outstanding letters of credit.
As of March 31, 2006, we were in compliance with all of our negative and affirmative covenants contained in the Credit Facility and the indentures governing the 8.25% Notes and the 2% Convertible Notes.
Working capital was $430.4 million and $387.2 million as of March 31, 2006, and December 31, 2005, respectively. The increase in working capital is a function of the increase in
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current assets of $45.2 million primarily from increases in cash and cash equivalents, short-term investment securities and inventories partially offset by an increase in current liabilities of $2.0 million primarily from the net increase of accounts payable and accrued expenses. This increase is primarily to support the growth in demand for our force protection related products from the U.S. Department of Defense.
Net cash provided by operating activities was $28.3 million for the three months ended March 31, 2006, compared to $19.7 million for the three months ended March 31, 2005. Net cash provided by operating activities improved due to increased net income for the three months ended March 31, 2006, and was negatively impacted due to increases in working capital in both periods. Net cash used in investing activities was $403.5 million for the three months ended March 31, 2006, compared to $396.0 million for the three months ended March 31, 2005. The increase was primarily due to increased capital expenditures to support the revenue growth in the Aerospace & Defense Group. Net cash (used in) provided by financing activities was ($0.1) million for the three months ended March 31, 2006, compared to $5.4 million for the three months ended March 31, 2005. The decrease in the three months ended March 31, 2006, was primarily due to a reduction in the proceeds from the exercise of stock options and borrowings under lines of credit.
Our capital expenditures the three months ended March 31, 2006, were $9.2 million. Such expenditures included additional manufacturing, office space, manufacturing machinery and equipment, leasehold improvements, information technology and communications infrastructure equipment. Our fiscal 2006 capital expenditures are expected to be approximately $30.0 to $34.0 million.
On February 27, 2006, we announced that we signed a definitive agreement to acquire all of the outstanding stock of Stewart & Stevenson Services, Inc. (‘‘SVC’’), a leading manufacturer of military tactical wheeled vehicles including the FMTV, the U.S. Army's primary transport platform, for $35 per share in a cash merger transaction. The total value of the transaction is expected to be approximately $755 million after deducting SVC’s net cash balance which was $312 million as of January 31, 2006. The transaction is subject to SVC shareholder approval and other customary conditions. The transaction is expected to close May 2006. We expect to finance the transaction through available cash and with proceeds from pending senior credit facilities. On April 19, 2006, we announced that the U.S. Department of Justice and the U.S. Federal Trade Commission have granted early termination of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, in connection with our pending acquisition of SVC.
On February 28, 2006, Standard & Poor’s Ratings Services affirmed its B+ rating on our senior subordinated debt. Also on February 28, 2006, Moody's Investors Service announced that it will review our debt ratings for a possible downgrade on its B1 rating of our senior subordinated debt in the wake of our announcement that we have signed a definitive agreement to acquire all of the outstanding stock of SVC.
On April 7, 2006, we announced the acquisition of 100% of the stock of Swiss-Photonics AG. Swiss-Photonics, through its trade name, Projectina, manufactures, markets and distributes highly specialized document examination equipment used in verifying document authenticity and detecting counterfeit currency and crime lab microscopes used to evaluate ballistics and bullet casings. Projectina also develops optical subsystems for leading electronic original equipment manufacturers. Based in Heerbrugg, Switzerland, Projectina serves the forensics, homeland security and crime scene markets, predominantly in Europe and Asia. Projectina generated revenue of approximately $9.2 million in 2005.
We anticipate that the cash on hand, cash generated from operations, and available borrowings under the Credit Facility will enable us to meet liquidity, working capital and capital expenditure requirements during the next 12 months. We may, however, require additional financing to pursue our
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strategy of growth through acquisitions, including new senior credit facilities associated with our pending acquisition of SVC, and we are continuously exploring alternatives. If such financing is required, there are no assurances that it will be available, or if available, that it can be obtained on terms favorable to us or on a basis that is not dilutive to our stockholders.
See Part II Item 1 Legal Proceedings regarding outstanding legal matters.
FORWARD LOOKING AND CAUTIONARY STATEMENTS
Except for the historical information and discussions contained herein, statements contained in this Form 10-Q may constitute ‘‘forward looking statements’’ within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve a number of risks, uncertainties and other factors that could cause actual results to differ materially, including, but not limited to, our failure to continue to develop and market new and innovative products and services and to keep pace with technological change; competitive pressures; failure to obtain or protect intellectual property rights; the ultimate effect of various domestic and foreign political and economic issues on our business, financial condition or results of operations; quarterly fluctuations in revenues and volatility of stock prices; contract delays; cost overruns; our ability to attract and retain key personnel; currency and customer financing risks; dependence on certain suppliers, customers and availability of raw materials; changes in the financial or business condition of our distributors or resellers; our ability to successfully identify, negotiate and conclude acquisitions, alliances and other business combinations, and integrate past and future business combinations; regulatory, legal, political and economic changes; an adverse determination in connection with the Zylon® investigation being conducted by the U.S. Department of Justice and certain state agencies and/or other Zylon®-related litigation; and other risks, uncertainties and factors inherent in our business and otherwise discussed elsewhere in this Form 10-Q and in our other filings with the Securities and Exchange Commission or in materials incorporated therein by reference.
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QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
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| ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
As a result of our global operating and financial activities, we are exposed to changes in raw material prices, interest rates, foreign currency exchange rates and our stock price, which may adversely affect our results of operations and financial position. In seeking to minimize the risks and/or costs associated with such activities, we manage exposure to changes in raw material prices, interest rates, and foreign currency exchange rates through our regular operating and financing activities. We have entered into interest rate swap agreements to reduce our overall interest expense.
MARKET RATE RISK
The following discussion about our market rate risk involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates, foreign currency exchange rates, and equity security price risk as a result of the sale of put option on our Company stock.
Interest Rate Risk. Our exposure to market rate risk for changes in interest rates relates primarily to borrowings under our $150 million senior subordinated notes, our credit facilities and our short-term monetary investments. To the extent that, from time to time, we hold short-term money market instruments, there is a market rate risk for changes in interest rates on such instruments. To that extent, there is inherent rollover risk in the short-term money market instruments as they mature and are renewed at current market rates. The extent of this risk is not quantifiable or predictable, because of the variability of future interest rates and business financing requirements. However, there is only a remote risk of loss of principal in the short-term money market instruments. The main risk is related to a potential reduction in future interest income.
On September 2, 2003, we entered into interest rate swap agreements in which we effectively exchanged the $150 million fixed rate 8.25% interest on the senior subordinated notes for variable rates in the notional amount of $80 million, $50 million, and $20 million at six-month LIBOR, set in arrears, plus 2.75%, 2.75%, and 2.735%, respectively. The agreements involve receipt of fixed rate amounts in exchange for floating rate interest payments over the life of the agreement without an exchange of the underlying principal amount. The variable interest rates are fixed semi-annually on the fifteenth day of February and August each year through maturity. The six-month LIBOR rate was 5.3% on May 2, 2006. The maturity dates of the interest rate swap agreements match those of the underlying debt. Our objective for entering into these interest rate swaps was to reduce our exposure to changes in the fair value of senior subordinated notes and to obtain variable rate financing at an attractive cost. Changes in the six-month LIBOR would affect our earnings either positively or negatively. An assumed 100 basis point increase in the six-month LIBOR would increase our interest obligations under the interest rate swaps by approximately $1.5 million for a twelve month period.
In accordance with SFAS 133, we designated the interest rate swap agreements as perfectly effective fair value hedges and, accordingly, use the short-cut method of evaluating effectiveness. As permitted by the short-cut method, the change in fair value of the interest rate swaps will be reflected in earnings and an equivalent amount will be reflected as a change in the carrying value of the swaps, with an offset to earnings. There is no ineffectiveness to be recorded. For the three months ended March 31, 2006, the fair value for interest swaps changed in value by $3.1 million. At December 31, 2005, there was a $1.4 million asset included in other assets, which, as a result of the change in fair value, is a $1.7 million hedge liability at March 31, 2006.
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QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK — CONTINUED
We are exposed to credit-related losses in the event of nonperformance by counterparties to these financial instruments. However, counterparties to these agreements are major financial institutions and the risk of loss due to nonperformance is considered by management to be minimal. We do not hold or issue interest rate swap agreements or other derivative instruments for trading purposes.
Foreign Currency Exchange Rate Risk. The majority of our business is denominated in U.S. dollars. There are costs associated with our operations in foreign countries that require payments in the local currency. Where appropriate and to partially manage our foreign currency risk related to those payments, we receive payment from customers in local currencies in amounts sufficient to meet our local currency obligations. We do not use derivatives or other financial instruments to hedge foreign currency risk.
Marketable Security Price Risk. At March 31, 2006, our marketable securities had a fair value of $49.3 million, including an unrealized gain of $18.3 million. The estimated loss in the fair value resulting from a hypothetical 10% decrease in the price would have been $4.9 million.
Since the securities are classified as ‘‘available-for-sale,’’ adjustments to fair value of a temporary nature are reported in accumulated other comprehensive loss, and would not impact our results of operations or cash flows until such time that the securities are sold or that any impairment is determined to be other than temporary in nature.
Stock Price Risk. The fair values of the put options of Company stock are obtained from our counter-parties and represent the estimated amount we would receive or pay to terminate the put options, taking into account the consideration we received for the sale of the put options. As our stock price fluctuates the value of these contracts also fluctuates. We do not have any put options on Company stock outstanding at March 31, 2006.
RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS
We do business in numerous countries, including emerging markets in South America. We have invested resources outside of the United States and plan to continue to do so in the future. Our international operations are subject to the risk of new and different legal and regulatory requirements in local jurisdictions, tariffs and trade barriers, potential difficulties in staffing and managing local operations, potential imposition of restrictions on investments, potentially adverse tax consequences, including imposition or increase of withholding and other taxes on remittances and other payments by subsidiaries, and local economic, political and social conditions. Governments of many developing countries have exercised and continue to exercise substantial influence over many aspects of the private sector. Government actions in the future could have a significant adverse effect on economic conditions in a developing country or may otherwise have a material adverse effect on us and our operating companies. We do not have political risk insurance in the countries in which we currently conduct business, but periodically analyze the need for and cost associated with this type of policy. Moreover, applicable agreements relating to our interests in our operating companies are frequently governed by foreign law. As a result, in the event of a dispute, it may be difficult for us to enforce our rights. Accordingly, we may have little or no recourse upon the occurrence of any of these developments.
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| ITEM 4. | CONTROLS AND PROCEDURES |
Our management, including Warren B. Kanders, Chairman and Chief Executive Officer, and Glenn J. Heiar, Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on that evaluation, the Chairman and Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this quarterly report, our disclosure controls and procedures, which are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in applicable Securities and Exchange Commission rules and forms, were effective.
Our management, including our Chairman and Chief Executive Officer and Chief Financial Officer, has also evaluated our internal control over financial reporting to determine whether any changes occurred during the fiscal quarter covered by this quarterly report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Based on that evaluation, there has been no such change during the fiscal quarter covered by this quarterly report.
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PART II
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| ITEM 1. | LEGAL PROCEEDINGS |
On January 16, 1998, our Services Division ceased operations in Angola and subsequently became involved in various disputes with SHRM S.A. (‘‘SHRM’’), its minority joint venture partner, relating to the Angolan joint venture known as Defense System International Africa (‘‘DSIA’’). Since March 1998, we have been and continue to be involved in various legal proceedings before French courts with SHRM, which is part of the Compass Group, regarding damages from the circumstances under which DSIA ceased doing business in Angola due to the decree of the Angolan government expelling the employees of our Services Division from Angola. A possible loss estimate related to this case cannot be reasonably made and no accrual has been recorded.
Kroll, Inc. Matters
O'Gara-Hess & Eisenhardt Armoring do Brasil Ltda. ("OHE Brazil") was audited by the Brazilian federal tax authorities and the Company has been informed that they were assessed over 10 Million Reals (US $4.55 million based on the exchange rate as of March 31, 2006). In addition, in January 2004, OHE Brazil was audited and the Company has been informed that they were assessed over 20 Million Reals (US $9.1 million based on the exchange rate as of March 31, 2006) for activities that occurred prior to the Company's acquisition of the O'Gara Companies in 2001. OHE Brazil has appealed both tax assessments and the cases are pending. To the extent that there may be any liability resulting from such assessments, we believe that we are entitled to indemnification from Kroll, Inc. for up to $7.8 million under the terms of our purchase agreement dated April 20, 2001, because the events in question with respect to up to $7.8 million of such assessments occurred prior to our purchase of the O'Gara Companies from Kroll, Inc.
In December 2001, O'Gara-Hess & Eisenhardt France S.A., which was acquired from Kroll, Inc. ("OHE France") in August 2001, sold its industrial bodywork business operated under the name Labbe/Division de O'Gara Hess & Eisenhardt France/ Carrosserie Industrielle ("Carrosserie") to SNC Labbe. Subsequent to the sale, the members of Labbe Family Estate ("LFE"), who are joint owners of the leasehold interest upon which the Carrosserie business is operated, sued OHE France and SNC Labbe claiming the transfer of the leasehold was not valid because they did not give their consent to the transfer as allegedly required under the terms of the lease. LFE members sought to have OHE France, as sole tenant, maintain and repair the leased building with an estimated cost of between US $3.85 and US $7.4 million, based on the exchange rate as of March 31, 2006. In a decision dated February 28, 2006, the French "Tribunal de Grande Instance" (Court of First Degree) of Saint-Brieuc decided that the transfer of the leasehold was not valid regarding LFE members, but rejected their claim concerning the maintaining and repairing of the leased building. The court also decided that SNC Labbe was to indemnify the Company for all condemnations pursuant to its decision, including judicial fees and costs. An appeal is still possible against such court's decision and we are unable to predict the outcome of this matter and as such, no accrual has been made. In the meantime, actions have been undertaken in order to organize a new transfer of the leasehold in conformity with the applicable regulations. Such new transfer is currently pending and has not yet been completed. Although we do not have any insurance coverage for this matter, at this time, we do not believe this matter will have a material impact on our financial position, operations or liquidity.
Zylon®
In April, 2004, two class action lawsuits were filed against us in Florida state court by police organizations and individual police officers, alleging that ballistic-resistant soft body armor (vests) containing Zylon®, manufactured and sold by American Body Armor™, Safariland® and PROTECH®, failed to meet the warranties provided with the vests. On November 5, 2004, the Jacksonville, Florida (Duval County) Circuit Court gave final approval to a settlement reached with the SSPBA which provided that (i) purchasers of certain Zylon®-containing vest models could exchange their vests for
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other vests manufactured by the Company and, (ii) the Company would continue its internal used-vest testing program (VestCheck™). The other class action suit filed by NAPO, in Ft. Myers, Florida (Lee County), was voluntarily dismissed with prejudice on November 16, 2004.
On August 24, 2005, the United States Department of Justice, NIJ, released its Third NIJ Report. The Third NIJ Report contained, among other items, information and testing data on Zylon® and Zylon®-containing vests, and substantially modified compliance standards for all ballistic-resistant vests with the implementation of the NIJ 2005 Interim Requirements for Ballistic-Resistant Body Armor. As a result of the actions of the NIJ, the Company halted all sales or shipment of any Zylon®-containing vest models effective August 25, 2005, and immediately established a Supplemental Relief (renamed the ZVE) Program that provides either a cash or voucher option to those who purchased any Zylon®-containing vests from us through August 29, 2005. The ZVE Program, with the consent of the SSPBA, was given final approval by the Jacksonville, Florida Court on October 27, 2005.
We are also voluntarily cooperating with a request for documents and data received from the Department of Justice, which is reviewing the entire body armor industry’s use of Zylon®, and a subpoena served by the General Services Administration for information relating to Zylon®. On March 27, 2006, we entered into an agreement with the Department of Justice to toll the statute of limitations until September 30, 2006, with regard to possible civil claims the United States could assert against the Company with respect to certain body armor products made by us which contain Zylon®.
Other Matters
In addition to the above, in the normal course of business and as a result of previous acquisitions, we are subjected to various types of claims and currently have on-going litigation in the areas of product liability, general liability and intellectual property. Our products are used in a wide variety of law enforcement situations and commercial and private security environments. Some of our products can cause serious personal or property injury or death if not carefully and properly used by adequately trained personnel. We believe that we have adequate insurance coverage for most claims that are incurred in the normal course of business. In such cases, the effect on our financial statements is generally limited to the amount of our insurance deductible or self-insured retention. Our annual insurance premiums and self insurance retention amounts have risen significantly over the past several years and may continue to do so to the extent we are able to purchase insurance coverage. At this time, we do not believe any such claims or pending litigation will have a material impact on our financial position, operations and liquidity.
On February 9, 2006, we were notified by the IRS that our tax returns for the taxable years ended December 31, 2003 and 2004, had been selected for examination. We do not expect this examination will have a material impact on our financial position, operations or liquidity.
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| ITEM 6. | EXHIBITS |
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| (a) | Exhibits |
The following exhibits are filed as part of this quarterly report on Form 10-Q:
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| Exhibit No. | | Description |
| 31.1 | | Certification of Principal Executive Officer Pursuant to Rule 13a-14(a) (17 CFR 240.13a-14(a)). |
| 31.2 | | Certification of Principal Financial Officer Pursuant to Rule 13a-14(a) (17 CFR 240.13a-14(a)). |
| 32.1 | | Certification of Principal Executive Officer Pursuant to Rule 13a-14(b) (17 CFR 240.13a-14(b)) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350). |
| 32.2 | | Certification of Principal Financial Officer Pursuant to Rule 13a-14(b) (17 CFR 240.13a-14(b)) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350). |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
ARMOR HOLDINGS, INC.
/s/ Warren B. Kanders
Warren B. Kanders
Chairman and Chief Executive Officer
Dated: May 5, 2006
/s/ Glenn J. Heiar
Glenn J. Heiar
Chief Financial Officer
(Principal Financial Officer and Principal Accounting Officer)
Dated: May 5, 2006
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