Sauer-Danfoss Inc. and Subsidiaries
Notes To Consolidated Financial Statements
(Dollars in thousands, except per share data)
(Unaudited)
1) Summary of Significant Accounting Policies -
Basis of Presentation and Principles of Consolidation –
The consolidated financial statements of Sauer-Danfoss Inc. and subsidiaries (the Company) included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission, and represent the consolidation of all companies in which the Company has a controlling financial ownership interest or a majority of the interest in earnings or losses. Certain information and disclosures normally included in comprehensive financial statements, prepared in accordance with U.S. gerneally accepted accounting principles, have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures are adequate to make the information presented not misleading. In the opinion of management, the financial statements reflect all adjustments, which are of a normal recurring nature, necessary to present fairly the Company’s consolidated financial position, results of operations and cash flows for the periods presented. It is suggested that these interim financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s latest annual report on Form 10-K as filed with the Securities and Exchange Commission on March 10, 2006.
Use of Estimates —
The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results may differ from those estimates.
New Accounting Principles –
Statement of Financial Accounting Standard (SFAS) No. 151, “Inventory Costs” amends Accounting Research Bulletin No. 43, Chapter 4 on inventory pricing to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials should be recognized as current period charges. In addition, SFAS No. 151 requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. The Company adopted SFAS No. 151 in the first quarter of 2006 with no material effect on the Company’s consolidated financial statements.
In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (FIN 48), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company does not expect the adoption of FIN 48 to have a material impact on financial reporting and is currently evaluating the impact, if any, the adoption of FIN 48 will have on the consolidated financial statements.
In June 2006, the FASB ratified Emerging Issues Task Force ("EITF") Issue No. 06–3, "How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (that is, Gross versus Net Presentation)", which allows companies to adopt a policy of presenting taxes in the income statement on either a gross or net basis. Taxes within the scope of this EITF would include taxes that are imposed on a revenue transaction between a seller and a customer. If such taxes are significant, the accounting policy should be disclosed as well as the amount of taxes included in the financial statements if presented on a gross basis. EITF 06–3 is effective for reporting periods beginning after December 15, 2006. The Company is currently assessing the impact, if any, of EITF Issue No. 06–03 on its consolidated financial statements.
In September 2006, the U.S. Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 108 (“SAB 108”), "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial
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Statements." SAB 108 requires quantification of financial statement misstatements based on the effects of the misstatements on each of the company's financial statements and the related financial statement disclosures. The Company does not expect SAB 108 to have a material impact on the consolidated financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006.
In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements” which clarifies the principle that fair value should be based on the assumptions that market participants would use when pricing an asset or liability. Additionally, it establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The Company has not yet determined the impact that the implementation of SFAS No. 157 will have on the consolidated financial statements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007.
In September 2006, the FASB issued SFAS No. 158, “Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of SFAS Nos. 87, 88, 106, and 132(R)”. This standard requires employers to recognize the underfunded or overfunded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in the funded status in the year in which the changes occur through accumulated other comprehensive income. Additionally, SFAS No. 158 requires employers to measure the funded status of a plan as of the date of its fiscal year-end. The Company expects its assets to decrease, liabilities to increase and accumulated other comprehensive income to decrease by approximately $9,000, $27,000 and $36,000 respectively due to the adoption of SFAS No. 158. The new reporting requirements and related new footnote disclosure rules of SFAS No. 158 are effective for fiscal years ending after December 15, 2006. The new measurement date requirement applies for fiscal years ending after December 15, 2008.
Reclassifications –
Certain previously reported amounts have been reclassified to conform to the current period presentation. Spare machining parts and perishable tooling totaling approximately $6,600 and $6,500 at September 30, 2006 and December 31, 2005, respectively, was reclassified from inventory to other assets.
2) Basic and Diluted Per Share Data -
Basic net income per common share is based on the weighted average number of shares of common stock outstanding for the period less restricted stock shares issued in connection with the Company’s long-term incentive plans and subject to risk of forfeiture. Diluted net income per common share assumes that outstanding common shares were increased by shares issuable upon (i) vesting of restricted stock shares, and (ii) granting of shares under the long-term incentive plans, after it becomes certain that the performance requirements needed to be met in accordance with the incentive plans will be achieved. Shares under both the restricted stock plan and the long-term incentive plan have an exercise price of zero.
The reconciliation of basic net income per common share to diluted net income per common share is shown in the following table for the three and nine month periods ended September 30, 2006 and 2005:
| | September 30, 2006 | | September 30, 2005 | |
| | Net Income | | Shares | | EPS | | Net Income | | Shares | | EPS | |
Three Months | | | | | | | | | | | | | |
Basic net income | | $ | 7,078 | | 47,705,779 | | $ | 0.15 | | $ | 4,292 | | 47,457,732 | | $ | 0.09 | |
Effect of dilutive securities: | | | | | | | | | | | | | |
Restricted stock | | — | | 19,989 | | — | | — | | 21,512 | | — | |
Performance units | | — | | 713,731 | | — | | — | | 392,373 | | — | |
Diluted net income | | $ | 7,078 | | 48,439,499 | | $ | 0.15 | | $ | 4,292 | | 47,871,617 | | $ | 0.09 | |
| | | | | | | | | | | | | |
Nine Months | | | | | | | | | | | | | |
Basic net income | | $ | 55,806 | | 47,698,015 | | $ | 1.17 | | $ | 34,664 | | 47,454,758 | | $ | 0.73 | |
Effect of dilutive securities: | | | | | | | | | | | | | |
Restricted stock | | — | | 21,761 | | — | | — | | 21,935 | | — | |
Performance units | | — | | 427,110 | | (0.01 | ) | — | | 268,057 | | — | |
Diluted net income | | $ | 55,806 | | 48,146,886 | | $ | 1.16 | | $ | 34,664 | | 47,744,750 | | $ | 0.73 | |
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3) Restructuring Charges -
In March 2006, the Company announced its plans to close the LaSalle, Illinois, plant, and discontinue production of certain product lines manufactured in Swindon, England. Certain products currently manufactured in LaSalle will be outsourced to reduce costs and increase efficiencies. The total cost of the restructuring activities at LaSalle and Swindon are expected to be approximately $8,500 and $4,800, respectively. Costs related to the LaSalle plant closing are included in the Propel segment and are anticipated to be completed by the end of the first quarter 2007. Costs related to the Swindon product line discontinuance are included in the Work Function segment and are anticipated to be completed by the end of the third quarter 2007. In addition the Propel and Controls segments have incurred costs related to smaller restructuring activities. Other than the accrual of employee termination costs, the restructuring charges are expensed as incurred. At September 30, 2006 the accrual on the balance sheet related to employee termination costs of $2,889. The only payment made in 2006 was $108 in the third quarter.
The following table summarizes the restructuring charges incurred in 2006:
| | Three Months ended September 30, 2006 | |
| | Propel | | Work Function | | Controls | | Total | |
Employee termination costs | | $ | 150 | | $ | 531 | | $ | 71 | | $ | 752 | |
Accelerated depreciation due to change in useful lives | | 784 | | — | | — | | 784 | |
Other | | 1,193 | | 24 | | 186 | | 1,403 | |
Total | | $ | 2,127 | | $ | 555 | | $ | 257 | | $ | 2,939 | |
| | Nine Months ended September 30, 2006 | |
| | Propel | | Work Function | | Controls | | Total | |
Employee termination costs | | $ | 1,636 | | $ | 1,290 | | $ | 71 | | $ | 2,997 | |
Property and equipment impairment and loss on disposal | | — | | 1,547 | | 108 | | 1,655 | |
Accelerated depreciation due to change in useful lives | | 2,028 | | — | | — | | 2,028 | |
Pension curtailment | | 1,551 | | — | | — | | 1,551 | |
Other | | 1,210 | | — | | 878 | | 2,088 | |
Total | | $ | 6,425 | | $ | 2,837 | | $ | 1,057 | | $ | 10,319 | |
Costs incurred during the three months ended September 30, 2006 consist of $2,772 and $167 included in cost of sales and selling, general and administrative expenses, respectively. Costs incurred during the nine months ended September 30, 2006 consist of $8,336, $328, and $1,655 included in cost of sales; selling, general and administrative expenses; and impairment charges and net (gain) loss on disposal of fixed assets, respectively. The amount for pension curtailment is the recognition of unamortized prior service costs related to the LaSalle pension plan.
4) Inventories-
The composition of inventories is as follows:
| | September 30, 2006 | | December 31, 2005 | |
Raw materials | | $ | 117,117 | | $ | 95,434 | |
Work in progress | | 55,597 | | 59,583 | |
Finished goods and parts | | 107,307 | | 98,530 | |
LIFO allowance | | (16,649 | ) | (14,642 | ) |
Total | | $ | 263,372 | | $ | 238,905 | |
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5) Gain on Sale of Assets Held for Sale -
In the second quarter of 2006 a parcel of undeveloped land previously classified as an asset held for sale was sold. The asset had a carrying value of approximately $3,000. The sale of the land resulted in total cash proceeds of approximately $3,100 and a net gain on sale of approximately $100. This gain is recorded in the impairment charges and net (gain) loss on disposal of fixed assets line of the consolidated statements of income and was recognized in the Controls Segment results.
6) Long-Term Incentive Plans -
Under the 1998 Long-Term Incentive Plan (1998 Incentive Plan), the Board of Directors is authorized to grant non-qualified stock options, incentive stock options, performance units, stock appreciation rights, restricted stock and performance shares to employees. Refer to Note 13 in the Notes to Consolidated Financial Statements in the Company’s 2005 annual report filed on Form 10-K for additional information. In February 2005 the Compensation Committee of the Board of Directors determined that all performance units outstanding at that time, in addition to the performance units granted in 2005, would be settled 100% in company stock with shares withheld having a value to meet the minimum statutory withholding requirements in the countries where the individual participants pay tax. Therefore these units are being accounted for as equity units with compensation expense recognized based on the fair value of the Company’s stock price at the grant or the modification date.
In December 2005, the Board of Directors approved the adoption of the Sauer-Danfoss Inc. 2006 Omnibus Incentive Plan (2006 Incentive Plan), which was approved by the stockholders at the annual meeting in June 2006. The 2006 Incentive Plan provides for grants similar to those under the 1998 Incentive Plan and qualifies certain awards for the performance-based exception to obtain favorable tax treatment. In February 2006 the Compensation Committee granted 346,013 performance units under the 2006 Incentive Plan, 260,862 of which would be settled 100% in company stock with shares withheld having a value to meet the minimum statutory withholding requirements and 85,151 performance units granted to certain individuals that would be settled in cash. The units to be settled in cash are accounted for as liability units, with the remainder of the units accounted for as equity units.
In accordance with SFAS No. 123R, “Share-Based Payment,” compensation expense is recognized over the vesting period of three years, measured based on the market price of the Company’s stock at the date of grant or modification, with an offsetting increase in additional paid-in capital. The expense related to the performance units granted under the 2006 Incentive Plan was based on the market price of the Company’s stock as of June 1, 2006, the time the 2006 Incentive Plan was approved by the Company’s stockholders. The expense related to the grants that will be settled in cash is based on the market price of the Company’s stock as of the balance sheet date. The Company recognized $1,494 and $5,795 of expense in the three month and nine month periods ended September 30, 2006, respectively, related to outstanding performance units granted under the 1998 Incentive Plan and the 2006 Incentive Plan. The Company recognized a tax benefit of approximately $523 and $2,028 on this expense during the three month and nine month periods ended September 30, 2006, respectively. The Company expects to recognize approximately $10,400 of additional expense through 2008 related to the outstanding performance units under these two plans.
The following charts summarize performance unit activity under the plans for the nine months ended September 30, 2006:
Equity Units | | Number | | Weighted Average
Grant Date Fair
Value | | Weighted Average
Vesting Period in
Years | |
Units Outstanding at January 1 | | 948,029 | | $ | 18.42 | | 2.8 | |
Units settled | | (257,164 | ) | 16.98 | | 2.0 | |
Units granted | | 260,862 | | 25.93 | | 3.0 | |
Units forfeited | | (11,540 | ) | 20.88 | | 3.0 | |
Units Outstanding at September 30 | | 940,187 | | $ | 20.86 | | 3.0 | |
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Cash Units | | Number | | Weighted Average
Fair Value | | Weighted Average
Vesting Period in
Years | |
Units Outstanding at January 1 | | — | | | | | |
Units granted | | 85,151 | | $ | 23.98 | | 3.0 | |
Units Outstanding at September 30 | | 85,151 | | $ | 23.98 | | 3.0 | |
7) Pension and Postretirement Benefits Other than Pensions –
Pension Benefits
The Company has noncontributory defined benefit plans covering a significant number of its employees. The benefits under these plans are based primarily on years of service and compensation levels. Pension expense for the three and nine months ended September 30, 2006 and 2005 for the defined benefit plans consists of the following components:
| | Three months ended September 30, | | Nine months ended September 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
Service cost | | $ | 1,245 | | $ | 1,359 | | $ | 3,596 | | $ | 3,968 | |
Interest cost | | 2,747 | | 3,089 | | 7,866 | | 9,091 | |
Expected return on plan assets | | (2,146 | ) | (2,500 | ) | (6,113 | ) | (7,289 | ) |
Amortization of prior service cost | | 134 | | 181 | | 1,932 | (1) | 529 | |
Amortization of net loss | | 655 | | 528 | | 1,883 | | 1,560 | |
Net periodic pension expense | | $ | 2,635 | | $ | 2,657 | | $ | 9,164 | | $ | 7,859 | |
(1) The 2006 amount includes $1,551 for the write-off of unamortized prior service costs related to the LaSalle pension plan. The write-off is part of the restructuring activities discussed in Note 3.
Postretirement Benefits
The Company provides health benefits for certain retired employees and certain dependents when the employee becomes eligible for these benefits by satisfying plan provisions that include certain age and service requirements. The components of the postretirement benefit expense of the Company-sponsored plans for the three and nine months ended September 30, 2006 and 2005 is as follows:
| | Three months ended September 30, | | Nine months ended September 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
Service cost | | $ | 142 | | $ | 155 | | $ | 423 | | $ | 465 | |
Interest cost | | 470 | | 438 | | 1,412 | | 1,313 | |
Net deferral and amortization | | 172 | | 135 | | 518 | | 406 | |
Postretirement benefit expense | | $ | 784 | | $ | 728 | | $ | 2,353 | | $ | 2,184 | |
8) Income Taxes -
The Company reversed $179 and $6,012 of valuation allowance on deferred tax assets during the three month and nine month periods ended September 30, 2006, respectively. Based on projected future taxable income and tax planning strategies, the Company expects that the deferred tax assets related to foreign and research tax credits in the U.S. will be utilized.
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9) Debt Agreement -
In the third quarter of 2006, the Company modified the existing Multicurrency Revolving Facility Agreement (the Agreement) which matures in December 2010. The modification of the agreement increased the amount the Company may borrow on a revolving basis from $250,000 to $300,000. In addition, the Agreement includes a new $50,000 term loan which expires in July 2013. Proceeds from the term loan were used to pay off a portion of the Company’s revolving credit balances. There were no changes to financial covenants, interest margins, or commitment fee provisions. The Company incurred $244 in debt issuance costs which were capitalized and are being amortized to interest expense over the remaining term of the Agreement.
10) Segment and Geographic Information -
The Company’s operating segments are organized around its various product lines of Propel, Work Function and Controls. Propel products include hydrostatic transmissions and related products that transmit power from the engine to the wheel to propel a vehicle. Work Function products include steering motors as well as gear pumps and motors that transmit power for the work functions of the vehicle. Controls products include electrohydraulic controls, microprocessors, electric drives and valves that control and direct the power of a vehicle. Segment costs in Global Services relate to internal global service departments and include costs such as consulting for special projects, development of the common business system, tax and accounting fees paid to outside third parties, certain insurance premiums, and amortization of intangible assets from certain business combinations.
The following table presents the significant items by operating segment for the results of operations for the three and nine month periods ended September 30, 2006 and 2005:
Three months ended
| | Propel | | Work
Function | | Controls | | Global
Services | | Total | |
September 30, 2006 | | | | | | | | | | | |
Trade sales | | $ | 166,627 | | $ | 113,178 | | $ | 102,090 | | $ | — | | $ | 381,895 | |
| | | | | | | | | | | |
Segment income (loss) | | 15,156 | | 6,311 | | 8,657 | | (15,268 | ) | 14,856 | |
Interest expense, net | | | | | | | | | | (4,293 | ) |
Minority interest | | | | | | | | | | (1,949 | ) |
Income before income taxes | | | | | | | | | | 8,614 | |
| | | | | | | | | | | |
Depreciation and amortization | | 10,964 | | 6,520 | | 4,558 | | 949 | | 22,991 | |
Capital expenditures | | 9,109 | | 6,659 | | 6,328 | | 765 | | 22,861 | |
| | | | | | | | | | | |
September 30, 2005 | | | | | | | | | | | |
Trade sales | | $ | 156,634 | | $ | 102,581 | | $ | 82,817 | | $ | — | | $ | 342,032 | |
| | | | | | | | | | | |
Segment income (loss) | | 18,202 | | 592 | | 6,268 | | (14,557 | ) | 10,505 | |
Interest expense, net | | | | | | | | | | (4,011 | ) |
Minority interest | | | | | | | | | | (1,525 | ) |
Income before income taxes | | | | | | | | | | 4,969 | |
| | | | | | | | | | | |
Depreciation and amortization | | 9,346 | | 6,806 | | 4,465 | | 1,639 | | 22,256 | |
Capital expenditures | | 9,831 | | 9,627 | | 1,358 | | 1,325 | | 22,141 | |
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Nine months ended
| | Propel | | Work
Function | | Controls | | Global
Services | | Total | |
September 30, 2006 | | | | | | | | | | | |
Trade sales | | $ | 655,435 | | $ | 359,292 | | $ | 320,983 | | $ | — | | $ | 1,335,710 | |
| | | | | | | | | | | |
Segment income (loss) | | 94,583 | | 18,233 | | 37,851 | | (45,958 | ) | 104,709 | |
Interest expense, net | | | | | | | | | | (13,323 | ) |
Minority interest | | | | | | | | | | (18,094 | ) |
Income before income taxes | | | | | | | | | | 73,292 | |
| | | | | | | | | | | |
Depreciation and amortization | | 31,829 | | 19,287 | | 12,955 | | 3,640 | | 67,711 | |
Capital expenditures | | 22,897 | | 25,846 | | 15,182 | | 1,284 | | 65,209 | |
| | | | | | | | | | | |
September 30, 2005 | | | | | | | | | | | |
Trade sales | | $ | 585,221 | | $ | 337,942 | | $ | 279,550 | | $ | — | | $ | 1,202,713 | |
| | | | | | | | | | | |
Segment income (loss) | | 88,745 | | 9,028 | | 24,665 | | (45,297 | ) | 77,141 | |
Interest expense, net | | | | | | | | | | (12,358 | ) |
Minority interest | | | | | | | | | | (15,415 | ) |
Income before income taxes | | | | | | | | | | 49,368 | |
| | | | | | | | | | | |
Depreciation and amortization | | 29,386 | | 20,886 | | 12,921 | | 4,246 | | 67,439 | |
Capital expenditures | | 24,911 | | 21,311 | | 12,541 | | 2,219 | | 60,982 | |
A summary of the Company’s net sales and long-lived assets by geographic area is presented below:
| | Net Sales (1) | | Long-Lived Assets (2) | |
| | Three months ended September 30, | | Nine months ended September 30, | | September 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | | 2006 | | 2005 | |
United States | | $ | 147,448 | | $ | 141,149 | | $ | 583,115 | | $ | 523,193 | | $ | 174,259 | | $ | 166,908 | |
Germany | | 46,526 | | 34,612 | | 136,432 | | 116,607 | | 59,140 | | 56,664 | |
Italy | | 26,654 | | 20,645 | | 89,408 | | 79,134 | | 30,701 | | 29,339 | |
France | | 20,488 | | 17,778 | | 71,593 | | 64,309 | | 907 | | 900 | |
Japan | | 17,672 | | 13,414 | | 54,392 | | 58,953 | | 4,659 | | 4,012 | |
United Kingdom | | 12,971 | | 19,461 | | 44,173 | | 45,735 | | 20,493 | | 17,584 | |
Sweden | | 15,180 | | 12,201 | | 51,923 | | 46,293 | | 6,610 | | 6,086 | |
Denmark (3) | | 6,840 | | 5,311 | | 20,846 | | 16,789 | | 197,187 | | 188,184 | |
Slovakia (3) | | 699 | | 307 | | 2,038 | | 883 | | 56,560 | | 50,992 | |
Other countries | | 87,417 | | 77,154 | | 281,790 | | 250,817 | | 78,695 | | 80,331 | |
Total | | $ | 381,895 | | $ | 342,032 | | $ | 1,335,710 | | $ | 1,202,713 | | $ | 629,211 | | $ | 601,000 | |
(1) Net sales are attributed to countries based on location of customer.
(2) Long-lived assets include property, plant and equipment net of accumulated depreciation, goodwill, intangible assets net of accumulated amortization, and certain other long-lived assets.
(3) Majority of this country’s sales are shipped outside of the home country where the product is produced.
No single customer accounted for 10% or more of total consolidated sales in any period presented.
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Sauer-Danfoss Inc. and Subsidiaries (the Company)
Safe Harbor Statement - - This Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as other portions of this quarterly report, contains certain statements that constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. All statements regarding future performance, growth, sales and earnings projections, conditions or developments are forward-looking statements. Words such as “anticipates,” “in the opinion,” “believes,” “intends,” “expects,” “may,” “will,” “should,” “could,” “plans,” “forecasts,” “estimates,” “predicts,” “projects,” “potential,” “continue,” and similar expressions may be intended to identify forward-looking statements.
Actual future results may differ materially from those described in the forward-looking statements due to a variety of factors, including the fact that the construction, road building and material handling markets specifically, have, in recent months, been stronger than in recent years. It is difficult to determine if past experience is a good guide to the future. While the economy in the U.S. was strong in the first half of the year, it showed some signs of weakening during the third quarter and remains unstable due to the uncertainty surrounding continued job creation, interest rates, crude oil prices, and the U.S. government’s stance on the weaker dollar. The economic situation in Europe has begun to improve in recent months, although that improvement may not continue. Any downturn in the Company’s business segments could adversely affect the Company’s revenues and results of operations. Other factors affecting forward-looking statements include, but are not limited to, the following: specific economic conditions in the agriculture, construction, road building, turf care, material handling and specialty vehicle markets and the impact of such conditions on the Company’s customers in such markets; the cyclical nature of some of the Company’s businesses; the ability of the Company to win new programs and maintain existing programs with its original equipment manufacturer (OEM) customers; the highly competitive nature of the markets for the Company’s products as well as pricing pressures that may result from such competitive conditions; the continued operation and viability of the Company’s significant customers; the Company’s execution of internal performance plans; difficulties or delays in manufacturing; cost-reduction and productivity efforts; competing technologies and difficulties entering new markets, both domestic and foreign; changes in the Company’s product mix; future levels of indebtedness and capital spending; claims, including, without limitation, warranty claims, field retrofit claims, product liability claims, charges or dispute resolutions; ability of suppliers to provide materials as needed and the Company’s ability to recover any price increases for materials in product pricing; the Company’s ability to attract and retain key technical and other personnel; labor relations; the failure of customers to make timely payment; any inadequacy of the Company’s intellectual property protection or the potential for third-party claims of infringement; global economic factors, including currency exchange rates; general economic conditions, including interest rates, the rate of inflation, and commercial and consumer confidence; energy prices; governmental laws and regulations affecting operations, including tax obligations; changes in accounting standards; worldwide political stability; the effects of terrorist activities and resulting political or economic instability; natural catastrophes; U.S. military action overseas; and the effect of acquisitions, divestitures, restructurings, product withdrawals, and other unusual events.
The Company cautions the reader that these lists of cautionary statements and risk factors may not be exhaustive. The Company expressly disclaims any obligation or undertaking to release publicly any updates or changes to these forward-looking statements that may be made to reflect any future events or circumstances.
About the Company
Sauer-Danfoss Inc. and subsidiaries (the Company) is a worldwide leader in the design, manufacture, and sale of engineered hydraulic and electronic systems and components that generate, transmit and control power in mobile equipment. The Company’s products are used by original equipment manufacturers (OEMs) of mobile equipment, including construction, road building, agricultural, turf care, material handling, and specialty equipment. The Company designs, manufactures and markets its products in the Americas, Europe and the Asia-Pacific regions, and markets its products throughout the rest of the world either directly or through distributors.
Executive Summary – Three months ended September 30, 2006
The nature of the Company’s operations as a global producer and supplier in the fluid power industry means the Company is impacted by changes in the local economies, including currency exchange rate fluctuations. In order to gain a better understanding of the Company’s base results, a financial statement user needs to understand the impact of those currency exchange rate fluctuations. The following table summarizes the Company’s third quarter 2006 and 2005 results from operations, separately identifying the impact of currency fluctuations. This analysis is more consistent with how the Company internally evaluates its results.
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(in millions) | | Three months
ended
September 30,
2005 | | Currency
fluctuations | | Underlying
increase
(decrease) | | Three months
ended
September 30, 2006 | |
Net sales | | $ | 342.0 | | $ | 10.6 | | $ | 29.3 | | $ | 381.9 | |
Gross profit | | 76.2 | | 3.0 | | 3.3 | | 82.5 | |
% of Sales | | 22.3 | % | | | | | 21.6 | % |
| | | | | | | | | |
Selling, general and administrative | | 50.9 | | 1.3 | | (1.2 | ) | 51.0 | |
Research & development | | 14.6 | | 0.4 | | 0.6 | | 15.6 | |
Total operating costs | | 65.5 | | 1.7 | | (0.6 | ) | 66.6 | |
Operating income | | $ | 10.7 | | $ | 1.3 | | $ | 3.9 | | $ | 15.9 | |
% of Sales | | 3.1 | % | | | | | 4.2 | % |
Net sales for the third quarter 2006 increased 9 percent over third quarter 2005, excluding the effects of currency, with all regions and segments contributing to the increase in sales. Sales were particularly strong in the European markets, which helped to offset a slowdown in the U.S. markets. The Controls segment experienced the strongest growth in sales with a 19 percent increase excluding the impacts of currency. This was followed by the Work Function and Propel segments with 6 percent and 4 percent increases, respectively, excluding the impacts of currency.
Contributing to the increase in operating income, excluding the effects of currency, was a $1.2 million decrease in selling, general, and administrative costs. This decrease can be attributed primarily to a $1.6 million decrease in costs associated with the implementation of a common company wide business system, as well as a $0.3 million decrease in incentive plan costs, and a $0.2 million decrease in outside service costs related to the assessment of internal controls under Section 404 of the Sarbanes-Oxley Act of 2002. These decreases were partially offset by $0.2 million in charges related to restructuring activities.
During the first quarter of 2006 the Company announced plans to close the LaSalle, Illinois plant, to discontinue the production of certain product lines currently manufactured in the Swindon, England plant, and to restructure certain activities in the Propel and Controls segments. The Company incurred a total of $2.9 million in restructuring charges in connection with these plans during the third quarter of 2006, $2.7 million was charged to cost of sales and $0.2 million was charged to selling, general and administrative expenses. Costs incurred include employee termination costs of $0.8 million, accelerated depreciation of $0.8 million, facilities moving costs of $0.9 million, and employee retraining costs of $0.4 million. Operating income excluding these costs as a percent of sales would be 5 percent for the three months ended September 30, 2006.
Following is a discussion of the Company’s operating results by market, region, and business segment.
Operating Results -Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005
Sales Growth by Market
The following table summarizes the Company’s sales growth by market. The table and following discussion is on a comparable basis, which excludes the effects of currency fluctuations.
| | Americas | | Asia-Pacific | | Europe | | Total | |
| | | | | | | | | |
Agriculture/Turf Care | | (6 | )% | (20 | )% | 0 | % | (5 | )% |
Construction/Road Building | | 1 | | (4 | ) | 18 | | 7 | |
Specialty | | 25 | | 44 | | 12 | | 17 | |
Distribution | | 17 | | 11 | | 12 | | 15 | |
Agriculture/Turf Care
The agricultural and turf care markets were down in the third quarter of 2006 compared to the third quarter of 2005. Strengthening of the agricultural market in Brazil and new product introductions benefited the Americas, however this was more than offset by a decline in the U.S. turf care market due to a leveling of demand for consumer zero-turn radius machines caused by a weak market as a result of earlier drought conditions in key geographic regions. Although the general market conditions in Europe are strengthening, the agricultural market remains flat. The decrease in the agricultural market in the Asia-Pacific region is due primarily to weakening
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markets in Japan resulting partly from decreases in government subsidies provided to farmers. The Asia-Pacific region contributes less than 5 percent of the sales in the agriculture and turf care markets, therefore the decrease in the Asia-Pacific region does not significantly impact the total market.
Construction/Road Building
Overall there was a modest increase in the construction and road building markets during the third quarter of 2006 compared to the third quarter of 2005. Europe is the largest contributor to the increase at 18 percent. This increase was driven by both the construction and road building markets and was due primarily to strengthening economic conditions in Europe as well as strong export markets. The 1 percent increase in sales in the Americas region is a reflection of modest increases in the construction market, offset by slight declines in the road building market due to uncertainty of oil prices. The Asia-Pacific construction and road building markets were down slightly due to weakening markets in Japan and Australia.
Specialty
Specialty vehicles are comprised of a variety of markets including forestry, material handling, marine, waste management and waste recycling. All regions contributed to the strong sales growth in the specialty markets in the third quarter. Growth in the aerial lift market is the main contributor to the overall 17 percent increase in sales for the third quarter. Telehandler, energy-related marine and offshore equipment, and mining applications are also strengthening.
Distribution
Products related to all of the above markets are also sold to distributors, who then serve smaller OEMs.
Business Segment Results
The following discussion of operating results by segment relates to information as presented in Note 10 in the Notes to the Consolidated Financial Statements. Segment income is defined as the respective segment’s portion of the total Company’s net income, excluding net interest expense, income taxes, minority interest, and global services expenses. Propel products include hydrostatic transmissions and related products that transmit the power from the engine to the wheel to propel a vehicle. Work Function products include steering motors as well as gear pumps and motors that transmit power for the work functions of the vehicle. Controls products include electrohydraulic controls, microprocessors, electric drives and valves that control and direct the power of a vehicle. The following table provides a summary of each segment’s sales and segment income, separately identifying the impact of currency fluctuations.
(in millions) | | Three months
ended September 30,
2005 | | Currency
fluctuations | | Underlying
increase (decrease) | | Three months
ended September 30,
2006 | |
Net sales | | | | | | | | | |
Propel | | $ | 156.6 | | $ | 3.0 | | $ | 7.0 | | $ | 166.6 | |
Work Function | | 102.6 | | 4.0 | | 6.6 | | 113.2 | |
Controls | | 82.8 | | 3.6 | | 15.7 | | 102.1 | |
| | | | | | | | | |
Segment income (loss) | | | | | | | | | |
Propel | | $ | 18.2 | | $ | 0.7 | | $ | (3.7 | ) | $ | 15.2 | |
Work Function | | 0.6 | | 0.1 | | 5.6 | | 6.3 | |
Controls | | 6.3 | | 0.7 | | 1.7 | | 8.7 | |
Global Services and other expenses, net | | (14.6 | ) | (0.3 | ) | (0.4 | ) | (15.3 | ) |
Propel Segment
The Propel segment experienced a 4 percent increase in sales, excluding the effects of currency fluctuations, in the third quarter 2006 compared to 2005. Despite strong sales, segment income decreased 20 percent in the quarter. Several factors contributed to this decrease. The Propel segment experienced a decline in gross margin during the quarter due to production inefficiencies associated with the recent implementation of the common business system in the U.S. as the sites adjusted to the new system. A total of seven U.S. locations implemented the system in June 2006, with the majority of the business at these locations affecting the Propel segment. In addition to the decreases in margins, segment income was negatively impacted by $1.1 million of retrofit charges and $2.1 million
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of restructuring charges. The Company announced plans to close the manufacturing facility in LaSalle, Illinois during 2006 along with certain other restructuring activities. Costs incurred in the third quarter of 2006 consist of employee severance costs of $0.1 million, accelerated depreciation of fixed assets of $0.8 million, facilities moving costs of $0.7 million, employee retraining costs of $0.4 million and other charges of $0.1 million.
Work Function Segment
Sales in the Work Function segment increased 6 percent, excluding the effects of currency fluctuations, in the third quarter of 2006. This increase in sales, along with improving margin percentages resulting from actions taken to address capacity constraints as well as expediting costs, contributed to segment income of $6.3 million in the third quarter of 2006, compared to income of $0.6 million in 2005. Third quarter 2006 segment income was negatively impacted by $0.6 million of employee severance related restructuring costs. In March 2006 the Company announced plans to discontinue production of certain product lines manufactured in the Swindon, England plant.
Controls Segment
Net sales in the Controls segment for third quarter 2006, excluding the effects of currency fluctuations, increased 19 percent compared to third quarter 2005. A combination of increased sales and a reduced general and administrative expenses resulted in a 27 percent increase in segment income for the quarter.
Global Services and other expenses, net
Segment costs in Global Services and other expenses, net, relate to internal global service departments, along with the operating costs of the Company’s executive office. Global services include such costs as consulting for special projects, tax and accounting fees paid to outside third parties, internal audit, certain insurance premiums, and the amortization of intangible assets from certain business combinations. Global services and other expenses remained nearly flat. Costs incurred related to the implementation of a common business system decreased $1.6 million and outside service costs related to the assessment of internal controls under Section 404 of the Sarbanes-Oxley Act of 2002 decreased $0.2 million. These decreases were partially offset by an additional $0.8 million loss on foreign currency exchange.
Income Taxes
The Company’s effective tax rate was 17.8 percent for the third quarter of 2006 compared to 13.6 percent for the same period in 2005. The third quarter effective tax rate is lower than the year to date effective tax rate because tax benefit associated with losses in higher rate jurisdictions offset income in lower tax jurisdictions during the quarter. In the third quarter of 2006 and to a much greater extent in 2005, tax expense was offset by the reversal of valuation allowances on deferred tax assets related to foreign and research credits that are now expected to be utilized.
Executive Summary – Nine months ended September 30, 2006
The following table summarizes the Company’s results from operations for the nine-month periods ended September 30, 2006 and 2005, separately identifying the impact of currency fluctuations. This analysis is more consistent with how the Company internally evaluates its results.
(in millions) | | Nine months
ended
September 30,
2005 | | Currency
Fluctuations | | Underlying
increase
(decrease) | | Nine months
ended
September 30,
2006 | |
Net sales | | $ | 1,202.7 | | $ | (10.7 | ) | $ | 143.7 | | $ | 1,335.7 | |
Gross profit | | 284.5 | | (3.3 | ) | 35.7 | | 316.9 | |
% of Sales | | 23.7 | % | | | | | 23.7 | % |
| | | | | | | | | |
Selling, general and administrative | | 164.9 | | (1.2 | ) | (0.7 | ) | 163.0 | |
Research & development | | 45.5 | | (0.4 | ) | 0.5 | | 45.6 | |
Total operating costs | | 210.4 | | (1.6 | ) | (0.2 | ) | 208.6 | |
Operating income | | $ | 74.1 | | $ | (1.7 | ) | $ | 35.9 | | $ | 108.3 | |
% of Sales | | 6.2 | % | | | | | 8.1 | % |
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Net sales for the nine months ended September 30, 2006 increased 12 percent over the nine months ended September 30, 2005, excluding the effects of currency, with all regions and segments contributing to the increase in sales. The increase in sales was due to overall strong economic conditions, price increases and higher sales volumes. The Controls segment experienced the strongest growth in sales. Margins remained flat year over year. Excluding restructuring costs and currency impacts, margins increased 1 percent.
Selling, general and administrative costs remained nearly flat during 2006 when compared to the same period in 2005. Costs associated with the implementation of a common company wide business system decreased $3.8 million during the nine months ended September 30, 2006 compared to the same time period in 2005. Outside service costs related to the assessment of internal controls under Section 404 of the Sarbanes-Oxley Act of 2002 decreased $2.7 million. These decreases were offset by a $2.1 million increase in incentive plan costs and $2.0 million in asset impairment and other charges related to restructuring activities.
The Company incurred a total of $10.3 million in restructuring charges during the first nine months of 2006. The Company announced plans to close the LaSalle, Illinois plant, to discontinue the production of certain product lines currently manufactured in the Swindon, England plant, and to restructure certain activities in the Propel and Controls segments. Costs incurred in connection with these restructurings include employee termination costs of $3.0 million, impairment of fixed assets of $1.7 million, pension curtailment charges of $1.6 million, accelerated depreciation of $2.0 million and other charges of $2.0 million.
Following is a discussion of the Company’s operating results by market, region, and business segment.
Operating Results - Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005
Sales Growth by Market
The following table summarizes the Company’s sales growth by market for the nine-month period ended September 30, 2006 compared to the nine-month period ended September 30, 2005. The table and following discussion excludes the effects of currency fluctuations.
| | Americas | | Asia-Pacific | | Europe | | Total | |
| | | | | | | | | |
Agriculture/Turf Care | | 6 | % | (26 | )% | 6 | % | 5 | % |
Construction/Road Building | | 15 | | 16 | | 18 | | 16 | |
Specialty | | 21 | | 28 | | 13 | | 16 | |
Distribution | | 19 | | 20 | | 3 | | 14 | |
Agriculture/Turf Care
The 6 percent increase in the agricultural and turf care markets in the Americas is primarily related to the turf care markets in the U.S. which were moderately strong through the first half of the year with some declines during the third quarter. The agricultural market in the Americas has remained nearly flat due in part to higher energy costs, particularly during the first half of 2006. Sales in the European market increased slightly compared to 2005 due primarily to strengthening economic conditions, particularly in Germany. The Asia-Pacific region contributes less than five percent of the sales in the agriculture and turf care markets and therefore the decrease in the Asia-Pacific region does not significantly impact the total market.
Construction/Road Building
All regions experienced strong sales increases in the construction and road building markets during 2006. The 15 percent increase in sales in the Americas region is primarily driven by increased production of skid steer loaders as well as increases in the production of crawlers for the roadbuilding market, particularly during the first half of the year. The Asia-Pacific market also benefited from the growth in the skid steer loader market, in addition to increased demand from the Chinese truck mixer market. The road building market in the Asia-Pacific region showed strong increases, mainly due to China’s focus on infrastructure spending. Growth in the European markets is the result of strong market conditions and strong export markets.
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Specialty
Specialty vehicles are comprised of a variety of markets including forestry, material handling, marine, waste management and waste recycling. All regions contributed to the sales growth in the specialty markets. Growth in the aerial lift market is the main contributor to the overall 16 percent increase in sales for the nine months ended September 30, 2006.
Distribution
Products related to all of the above markets are also sold to distributors, who then serve smaller OEMs.
Business Segment Results
The following discussion of operating results by segment relates to information as presented in Note 10 in the Notes to the Consolidated Financial Statements. Segment income is defined as the respective segment’s portion of the total Company’s net income, excluding net interest expense, income taxes, minority interest, and global service expenses. The following table provides a summary of each segment’s sales and segment income, separately identifying the impact of currency fluctuations.
(in millions) | | Nine months
ended September 30,
2005 | | Currency
fluctuations | | Underlying
increase (decrease) | | Nine months
ended September 30,
2006 | |
Net sales | | | | | | | | | |
Propel | | $ | 585.2 | | $ | (4.7 | ) | $ | 74.9 | | $ | 655.4 | |
Work Function | | 337.9 | | (3.8 | ) | 25.2 | | 359.3 | |
Controls | | 279.6 | | (2.2 | ) | 43.6 | | 321.0 | |
| | | | | | | | | |
Segment income (loss) | | | | | | | | | |
Propel | | $ | 88.7 | | $ | (0.6 | ) | $ | 6.5 | | $ | 94.6 | |
Work Function | | 9.0 | | (0.3 | ) | 9.5 | | 18.2 | |
Controls | | 24.7 | | (0.8 | ) | 14.0 | | 37.9 | |
Global Services and other expenses, net | | (45.3 | ) | 0.3 | | (1.0 | ) | (46.0 | ) |
Propel Segment
The Propel segment experienced strong growth, with a 13 percent increase in sales, excluding the effects of currency fluctuations, during the nine months ended September 30, 2006 compared to the same time period in 2005. Sales have increased due to both increased sales volumes and introduction of new products. Segment income was negatively impacted by $2.1 million retrofit costs and $6.4 million of restructuring charges. In March 2006 the Company announced plans to close the manufacturing facility in LaSalle, Illinois during 2006 along with certain other restructuring activities. Restructuring costs incurred in 2006 consist of employee severance costs of $1.6 million, pension curtailment charges of $1.6 million, accelerated depreciation of fixed assets of $2.0 million, and $1.2 million of other charges.
Work Function Segment
Sales in the Work Function segment increased 7 percent, excluding the effects of currency fluctuations, during the nine months ended September 30, 2006. Segment income increased by $9.5 million due to the increase in sales along with improving margin percentages resulting from actions taken to address capacity constraints as well as expediting costs. Segment income was negatively impacted by $2.8 million of restructuring costs. In March 2006 the Company announced plans to discontinue production of certain product lines manufactured in the Swindon, England plant. The Work Function segment incurred $1.3 million of employee severance costs and $1.5 million of fixed asset impairment charges related to the restructuring activities.
Controls Segment
Net sales in the Controls segment, excluding the effects of currency fluctuations, increased 16 percent during the nine months ended September 30, 2006 compared to the same period in 2005. Gross profit as a percent of sales increased 1 percent, excluding the impact of currency fluctuations. Operating costs during the nine months ended September 30, 2006 were $1.0 million lower primarily due to higher costs in 2005 for research and development spending for new products in development stage as well as start-up costs related to
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a new production facility in India. The increase in sales, increase in margins and decrease in operating costs contributed to a 56 percent increase in segment income.
Global Services and other expenses, net
Global Services costs increased $1.0 million, or 2 percent, during the nine months ended September 30, 2006 compared to the same period in 2005, excluding the effects of currency fluctuations. The increase is due to the change in transaction gains and losses on foreign currency transactions, which negatively affected other expenses by $6.7 million, as well as increased incentive costs. This increase was offset by a $3.8 million decrease in costs associated with the implementation of a common company wide business system and a decrease of $2.7 million in outside service costs related to the assessment of internal controls under Section 404 of the Sarbanes-Oxley Act of 2002.
Income Taxes
The Company’s effective tax rate was 23.9 percent for the nine months ended September 30, 2006 compared to 29.8 percent for the same period in 2005. The effective tax rate declined in 2006 because tax expense associated with income in the U.S. was offset by the reversal of valuation allowances of $6.0 million on deferred tax assets related to foreign and research credits that are now expected to be utilized. In addition, the Company’s effective tax rate can vary significantly from quarter to quarter due to the mix of earnings between the U.S. and Europe.
Order Backlog
The following table shows the Company’s order backlog at September 30, 2006 and 2005 and orders written in the nine-month periods ended September 30, 2006 and 2005, including the effect of currency fluctuations. Order backlog represents the amount of customer orders that have been received for future shipment.
(in millions) | | September 30,
2005 | | Currency
fluctuations | | Underlying
increase | | September 30,
2006 | |
Americas | | | | | | | | | |
Backlog | | $ | 300.5 | | $ | 0.1 | | $ | 5.7 | | $ | 306.3 | |
Orders Written | | 588.8 | | 2.1 | | 58.2 | | 649.1 | |
| | | | | | | | | |
Asia-Pacific | | | | | | | | | |
Backlog | | 23.1 | | 0.1 | | 8.4 | | 31.6 | |
Orders Written | | 98.8 | | (3.5 | ) | 11.1 | | 106.4 | |
| | | | | | | | | |
Europe | | | | | | | | | |
Backlog | | 155.4 | | 15.4 | | 25.1 | | 195.9 | |
Orders Written | | 552.1 | | (9.3 | ) | 95.0 | | 637.8 | |
| | | | | | | | | |
Total | | | | | | | | | |
Backlog | | 479.0 | | 15.6 | | 39.2 | | 533.8 | |
Orders Written | | 1,239.7 | | (10.7 | ) | 164.3 | | 1,393.3 | |
| | | | | | | | | | | | | |
Total order backlog at September 30, 2006 was $533.8 million, compared to $479.0 million at September 30, 2005. Excluding the effect of currency fluctuations, order backlog increased 8 percent. The increase in backlog at September 30, 2006 reflects the general overall economic strength across the various markets that the Company serves, with a particularly strong increase in Europe, 16 percent excluding currency impacts, due to the continued strengthening of the European economy.
New sales orders written in the nine months ended September 30, 2006 were $1,393.3 million, an increase of 12 percent over the $1,239.7 million of orders written in the nine months ended September 30, 2005. Excluding the impact of currency fluctuations, total orders written in the first nine months of 2006 increased 13 percent compared to orders written in the first nine months of 2005, contributing to the record sales for the nine months ended September 30, 2006.
Market Risk
The Company is exposed to various market risks, including changes in foreign currency exchange rates, interest rates, and material purchase prices.
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Foreign currency changes
The Company has operations and sells its products in many different countries of the world and therefore, conducts its business in various currencies. The Company’s financial statements, which are presented in U.S. dollars, can be impacted by foreign exchange fluctuations through both translation exposure and transaction risk. Translation exposure is when the financial statements of the Company, for a particular period or as of a certain date, may be affected by changes in the exchange rates that are used to translate the financial statements of the Company’s operations from foreign currencies into U.S. dollars. Transaction risk is the potential expense or income due to the Company receiving its sale proceeds or holding its assets in a currency different from that in which it pays its expenses and holds its liabilities. The Company had $3.7 million of expense related to transaction losses in the first nine months of 2006 compared to $3.0 million of income for the first nine months of 2005.
Fluctuations of currencies against the U.S. dollar can be substantial and therefore significantly impact comparisons with prior periods. The U.S. dollar weakened slightly compared to other currencies between December 31, 2005 and September 30, 2006.
In 2005 the Company began to enter into forward contracts to minimize the impact of currency fluctuations on cash flows related to forecasted sales denominated in currencies other than the functional currency of the selling location. The forecasted sales represent sales to both external and internal parties. Any effects of the forward contracts related to sales to internal parties are eliminated in the consolidation process until the related inventory has been sold to an external party. The forward contracts qualify for hedge accounting and therefore are subject to effectiveness testing at the inception of the contract and throughout the life of the contract. The fair value of forward contracts outstanding at September 30, 2006 was $0.4 million.
Interest Rates
The Company uses interest rate swap agreements on a limited basis to manage the interest rate risk on its total debt portfolio. The Company has not entered into any new interest rate swap agreements in 2006. Additional information regarding interest rate swaps is set forth in the Company’s most recent annual report filed on Form 10-K and is incorporated herein by reference. There has been no material change in this information.
Liquidity and Capital Resources
The Company’s principal sources of liquidity have continued to be from internally generated funds from operations and from borrowings under various credit facilities. The Company has multiple funding sources that have been and continue to be available; therefore, the Company expects to have sufficient sources of liquidity to meet its funding needs for the foreseeable future.
The Company has a multicurrency revolving credit facility (the facility) that was amended in July 2006 to permit unsecured borrowings up to $300.0 million through December 2010. As amended, the facility includes an additional $50.0 million term loan facility that matures in 2013. The Amended and Restated Credit Agreement is described and attached as an exhibit to the Company’s Form 8-K filed on August 3, 2006. At September 30, 2006 there was $102.7 million outstanding under the facility, compared to $98.3 million outstanding at December 31, 2005. The Company is in compliance with the financial covenants related to its debt facilities.
Cash Flow from Operations
Cash flow from operations was a record $154.0 million during the nine months ended September 30, 2006 compared to $97.6 million for the nine months ended September 30, 2005.
Changes in operating assets and liabilities resulted in $8.8 million cash provided during the nine months ended September 30, 2006 compared to $36.3 million of cash used during the nine months ended September 30, 2005. Increases in operating assets and liabilities in 2006 were mostly due to increases in accounts receivable and inventories resulting from higher sales volumes, offset by increases in accounts payable.
Total cash increased $10.7 million from December 31, 2005 to September 30, 2006. The majority of the increase is the result of increases in cash balances in China. At September 30, 2006 China held $18.5 million in cash, which is $8.0 million higher than the balance at December 31, 2005. Due to the structure the Company has in China and the nature of the governmental and other regulatory controls, it is difficult to move cash out of China for reasons other than payment for goods shipped into that country. As the Company continues to consider expanding its manufacturing capabilities in low cost regions, it will make every effort to utilize the cash balances in those regions.
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Cash Used in Investing Activities
Capital expenditures in the first nine months of 2006 were $65.2 million compared to $61.0 million in the first nine months of 2005. The increase is primarily due to investments to add production capacity, particularly in the Work Function segment which incurred $25.8 million, or 40% of the total $65.2 million in capital expenditures.
Cash Used in Financing Activities
The Company continues to pay a dividend to its stockholders on a quarterly basis. In the first quarter of 2006, the Board of Directors approved an increase to the quarterly dividend, raising it from $0.12 per share in 2005 to $0.14 per share in the first quarter of 2006. In the third quarter of 2006 the Board of Directors approved increasing the quarterly dividend to $0.16 per share, which will be paid out in the fourth quarter of 2006. Dividend payments during the first nine months of the year were $19.1 million in 2006 compared to $16.1 million in 2005. Net repayment of borrowings used $56.7 million of cash in the first nine months of 2006 compared to $10.5 million in 2005. In addition, the Company makes varying distributions to its minority interest partners from its various joint venture activities depending on the amount of undistributed earnings of the businesses and the needs of the partners.
Other Matters
Critical Accounting Estimates
In preparing its most recent annual report on Form 10-K, the Company disclosed information about critical accounting estimates the Company makes in applying its accounting policies. The Company has made no changes to the methods of application or the assumptions used in applying these policies from what was disclosed in its most recent annual report on Form 10-K.
New Accounting Principles
In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (FIN 48), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company does not expect the adoption of FIN 48 to have a material impact on financial reporting, and is currently evaluating the impact, if any, the adoption of FIN 48 will have on the consolidated financial statements.
In June 2006, the FASB ratified Emerging Issues Task Force (“EITF”) Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (that is, Gross versus Net Presentation)”, which allows companies to adopt a policy of presenting taxes in the income statement on either a gross or net basis. Taxes within the scope of this EITF would include taxes that are imposed on a revenue transaction between a seller and a customer. If such taxes are significant, the accounting policy should be disclosed as well as the amount of taxes included in the financial statements if presented on a gross basis. EITF 06-3 is effective for reporting periods beginning after December 15, 2006. The Company is currently assessing the impact, if any, of EITF Issue No. 06-03 on it’s consolidated financial statements.
In September 2006, the U.S. Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 requires quantification of financial statement misstatements based on the effects of the misstatements on each of the company's financial statements and the related financial statement disclosures. The Company does not expect SAB 108 to have a material impact on the consolidated financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”) which clarifies the principle that fair value should be based on the assumptions that market participants would use when pricing an asset or liability. Additionally, it establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The Company has not yet determined the impact that the implementation of SFAS No. 157 will have on the consolidated financial statements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007.
In September 2006, the FASB issued SFAS No. 158, “Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans an amendment of SFAS Nos. 87, 88, 106, and 132(R).” This standard requires employers to recognize the underfunded or overfunded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in the
22
funded status in the year in which the changes occur through accumulated other comprehensive income. Additionally, SFAS No. 158 requires employers to measure the funded status of a plan as of the date of its fiscal year-end. The Company expects its assets to decrease, liabilities to increase and accumulated other comprehensive income to decrease by approximately $9.0 million, $27.0 million, and $36.0 million, respectively due to the adoption of SFAS No. 158. The new reporting requirements and related new footnote disclosure rules of SFAS No. 158 are effective for fiscal years ending after December 15, 2006. The new measurement date requirement applies for fiscal years ending after December 15, 2008.
Non-Audit Services of Independent Registered Public Accounting Firm
The Company’s Independent Registered Public Accounting Firm, KPMG LLP, performs the following non-audit services that have been approved by the Audit Committee of the Board of Directors: international and U.S. tax planning and compliance services; expatriate tax services; statutory audits and related matters; and local tax and accounting technical support.
Outlook
Sales levels were at record levels for the first nine months of 2006. Although earnings in 2006 will continue to be negatively impacted by implementation costs related to the new common business system and targeted restructuring activities, the financial results for the full year are expected to surpass the 2005 financial results. Management of the Company expects the implementation of the common business system and the restructuring activities currently underway to have a positive impact on Company’s financial results starting in 2007 and beyond.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Information disclosing market risk is set forth in the Company’s most recent annual report filed on Form 10-K (Item 7A), and is incorporated herein by reference. There has been no material change in this information.
Item 4. Controls and Procedures
At the end of the period covered by this report, the Registrant carried out an evaluation under the supervision and with the participation of the Registrant’s management, including the Registrant’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Registrant’s disclosure controls and procedures. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Registrant’s disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that the Registrant files or submits under the Exchange Act is recorded, processed, summarized, and reported as required and within the time periods specified in the Securities and Exchange Commission’s rules and forms.
The Company implemented a new business system at seven of its U.S. locations, one Danish location and two Slovakian locations during 2006. This resulted in a number of controls being enhanced, such as certain manual processes being replaced with automated processing and system integrated account postings. In addition, user access controls and segregation of duties have been improved. While other controls within the system environment were changed as a result of this conversion, there were no changes to internal controls over financial reporting, other than those mentioned above, that have materially affected, or are reasonably likely to materially impact, the Company’s internal controls over financial reporting.
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PART II. OTHER INFORMATION
Item 6. Exhibits.
Exhibit
No. | | Description of Document |
| | |
10.1 | | The Second Amendment to Sauer-Danfoss Inc. 1998 Long-Term Incentive Plan is attached as Exhibit 10 to the Company's Form 8-K filed on August 24, 2006, and is incorporated herein by reference. |
10.2 | | Amended and Restated Credit Agreement dated as of July 28, 2006, by and among Sauer-Danfoss Inc., the subsidiary borrowers listed therein, the lenders listed therein, and JPMorgan Chase Bank, N.A., as Administrative Agent and Collateral Agent, is attached as Exhibit 10 to the Company’s Form 8-K filed on August 3, 2006, and is incorporated herein by reference. |
31.1 | | Certification by the Chief Executive Officer Pursuant to Rule 13a-14(a). |
31.2 | | Certification by the Chief Financial Officer Pursuant to Rule 13a-14(a). |
32.1 | | Certification by the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350. |
32.2 | | Certification by the Chief Financial Officer Pursuant to 18 U.S.C. Section 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.
| Sauer-Danfoss Inc. |
| |
| By | /s/ Kenneth D. McCuskey | |
| Kenneth D. McCuskey |
| Vice President and Chief Accounting Officer, Secretary |
| |
Date: November 3, 2006 | |
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