UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended JANUARY 1, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______ Commission file number: 33-80701 AAF-MCQUAY INC. -------------------------------------------------------------------- (Exact name of Registrant as Specified in Its Charter) DELAWARE 41-0404230 - ------------------------------- ------------------------------------ (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 215 CENTRAL AVENUE, LOUISVILLE, KENTUCKY 40208 - ---------------------------------------- ----- (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number, including area code (502) 637-0011 -------------- NOT APPLICABLE -------------------------------------------------------------------- Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report. Indicate by check whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /x/ No / / Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 2,497 shares of Common Stock, par value $100.00 per share, were outstanding as of January 28, 2000. INDEX AAF-MCQUAY INC. AND SUBSIDIARIES PAGE PART I - Financial Information..................................................... 3 - ------ Item 1. Financial Statements (unaudited).......................................... 3 Condensed Consolidated Balance Sheets as of - December 31, 1999 and June 30, 1999....................................... 3 Consolidated Statements of Operations - Three and Six Months Ended December 31, 1999 and 1998..................... 4 Condensed Consolidated Statements of Cash Flows - Six Months Ended December 31, 1999 and 1998............................... 5 Consolidated Statements of Comprehensive Income - Three and Six Months Ended December 31, 1999 and 1998..................... 6 Notes to the Consolidated Financial Statements............................ 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations....................................... 10 Item 3. Quantitative and Qualitative Disclosures about Market Risk................ 14 PART II - Other Information......................................................... 16 - ------- Item 1. Legal Proceedings......................................................... 16 Item 6. Exhibits and Reports on Form 8-K.......................................... 16 Signatures................................................................ 17 2 PART I: FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS AAF-MCQUAY INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) (dollars in thousands, except share data) DECEMBER 31, JUNE 30, 1999 1999 ---------------- -------------- ASSETS Current assets: Cash and cash equivalents................................................. $ 13,181 $ 9,168 Accounts receivable....................................................... 199,055 227,844 Inventories............................................................... 106,747 118,163 Other current assets...................................................... 5,855 6,754 --------- -------- Total current assets............................................... 324,838 361,929 Property, plant and equipment, net................................................. 132,120 145,086 Cost in excess of net assets acquired and other identifiable intangibles, net...... 220,625 228,906 Other assets and deferred charges.................................................. 19,003 19,274 --------- -------- Total assets....................................................... $ 696,586 $755,195 ========= ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Short-term borrowings..................................................... $ 68,982 $ 87,602 Current maturities of long-term debt...................................... 8,547 14,495 Accounts payable, trade................................................... 100,793 115,986 Accrued warranty.......................................................... 18,378 18,604 Other accrued liabilities................................................. 74,980 83,208 ---------- --------- Total current liabilities.......................................... 271,680 319,895 Long-term debt. 160,276 164,322 Deferred income taxes.............................................................. 33,330 34,676 Other liabilities.................................................................. 46,190 49,874 ---------- --------- Total liabilities.................................................. 511,476 568,767 Stockholders' equity: Preferred stock ($1 par value; 1,000 shares authorized, none issued)...... -- -- Common stock ($100 par value; 8,000 shares authorized, 2,497 shares issued and outstanding)........................................... 250 250 Additional paid-in capital................................................ 179,915 179,915 Retained earnings......................................................... 15,594 17,762 Accumulated other comprehensive loss...................................... (10,649) (11,499) ---------- --------- Total stockholders' equity......................................... 185,110 186,428 ---------- --------- Total liabilities and stockholders' equity......................................... $ 696,586 $755,195 ========= ======== See Notes to Consolidated Financial Statements 3 AAF-MCQUAY INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) (dollars in thousands) QUARTER ENDED SIX MONTHS ENDED DECEMBER 31, DECEMBER 31, --------------------------- ----------------------------- 1999 1998 1999 1998 ------------- ------------ ------------- ------------- Net Sales............................ $ 202,188 $ 215,715 $ 427,315 $ 467,115 Cost of Sales........................ 151,659 160,297 316,812 344,162 ------------- ------------ ------------- ------------- Gross Profit......................... 50,529 55,418 110,503 122,953 Operating Expenses: Selling, general and administrative.................. 44,333 48,792 94,201 104,631 Restructuring................... --- --- 178 751 Amortization of intangible assets.......................... 2,777 2,831 5,606 5,733 ------------- ------------- ------------- ------------- 47,110 51,623 99,985 111,115 ------------- ------------- ------------- ------------- Income from operations............... 3,419 3,795 10,518 11,838 Interest expense, net................ 5,546 5,738 11,419 12,244 Other (income) expense, net......... (220) (661) 1,862 (5,473) ------------- ------------ ------------- ------------- Income (loss) before income taxes.... (1,907) (1,282) (2,763) 5,067 Minority interest loss .............. (72) (50) (136) (40) Provision for income taxes........... (294) (613) (731) 916 ------------- ------------ ------------- ------------- Net income (loss).................... $ (1,685) $ (719) $ (2,168) $ 4,111 ============= ============ ============= ============= See Notes to Consolidated Financial Statements 4 AAF-MCQUAY INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (dollars in thousands) SIX MONTHS ENDED DECEMBER 31, ----------------------------- 1999 1998 ------------ ------------- Cash flows from operating activities Net income (loss) $ (2,168) $ 4,111 Adjustments to reconcile to cash from operating activities: Depreciation and amortization 15,121 13,658 Foreign currency transaction (gains) losses 122 (232) Restructuring spending ---- (3,764) Loss on sale of business 1,331 ---- Changes in operating assets and liabilities 9,623 1,750 ------------ ------------- Net cash from operating activities 24,029 15,523 Cash flows from investing activities: Capital expenditures, net (3,277) (9,931) Proceeds from sale of business 12,996 ---- ------------ ------------- Net cash from investing activities 9,719 (9,931) Cash flows from financing activities: Net borrowings (repayments) under short-term borrowing arrangements (18,620) 11,039 Payments on long-term debt (39,995) (17,243) Proceeds from issuance of long-term debt 30,000 --- Payments of debt issuance costs (1,334) --- ------------ ------------- Net cash from financing activities (29,949) (6,204) Effect of exchange rate changes on cash 214 135 ------------ ------------- Net increase (decrease) in cash and cash equivalents 4,013 (477) Cash and cash equivalents at beginning of period 9,168 9,697 ------------ ------------- Cash and cash equivalents at end of period $ 13,181 $ 9,220 ============ ============= See Notes to Consolidated Financial Statements 5 AAF-MCQUAY INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (unaudited) (dollars in thousands) QUARTER ENDED SIX MONTHS ENDED DECEMBER 31, DECEMBER 31, ----------------------------- -------------------------- 1999 1998 1999 1998 ------------- ------------- ------------ ----------- Net income (loss)................................ $ (1,685) $ (719) $ (2,168) $ 4,111 Other comprehensive income(loss):................ Foreign currency translation adjustments..... (1,771) (1,772) 21 1,342 Write off of accumulated foreign currency translation adjustments due to sale of business................................... 829 --- 829 --- ------------- ------------- ------------ ------------ Comprehensive income(loss)....................... $ (2,627) $ (2,491) $ (1,318) $ 5,453 ============= ============= ============ =========== See Notes to Consolidated Financial Statements 6 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION The consolidated financial statements include the accounts of the Company and all of its wholly-owned subsidiaries. All inter-company transactions have been eliminated. The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim reporting and with the instructions to Form 10-Q and Article 10 of Regulation S-K. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K (the "Annual Report") for the year ended June 30, 1999. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The accompanying financial statements reflect the statements of operations for the three and six months ended December 31, 1999 and December 31, 1998, the balance sheets at December 31, 1999 and June 30, 1999, and the consolidated statements of cash flows for the six months ended December 31, 1999 and December 31, 1998. The operating results for the six months ended December 31, 1999 are not necessarily indicative of the operating results that may be expected for the full year ending June 30, 2000. The Company's period end is the Saturday closest to December 31. For clarity in presentation all periods presented herein are shown to end on the last calendar day of the month. Certain reclassifications of amounts in the consolidated financial statements have been made to reflect comparability. During the first quarter of fiscal year 1999, the Company made a change in accounting estimate related to its warranty provision. The Company increased its warranty provision by $2.5 million due to current activity related to new product introductions and discontinued product lines. 2. INVENTORIES Inventories consist of the following: DECEMBER 31, JUNE 30, 1999 1999 ----------------- --------------- (DOLLARS IN THOUSANDS) FIFO Cost: Raw Materials.......................... $ 38,167 $ 39,838 Work-in-process........................ 23,430 25,884 Finished goods......................... 44,327 51,063 ------------- ------------- 105,924 116,815 LIFO adjustment........................ 823 1,348 ============= ============= $ 106,747 $ 118,163 ============= ============= 3. NET OTHER (INCOME)EXPENSE During the second quarter of fiscal year 2000, the Company had net other income of $0.2 million compared to $0.7 million in the second quarter of fiscal year 1999. Year-to-date the Company had other expense of $1.9 million as compared to other income of $5.5 million for the same period in fiscal year 1999. The year-to-date decrease is primarily related to events that occurred in the first quarters of fiscal years 2000 and 1999. In the first quarter of fiscal year 2000, the Company accrued a $1.3 million loss related to the sale of the commercial air conditioning and refrigeration operation in France in October 1999. Additionally, in conjunction with the Company's refinancing, discussed in Note 5, the Company wrote off certain unamortized income and debt issuance costs resulting in a charge of $0.3 million in the first quarter of fiscal year 2000. In the first quarter of fiscal year 1999 the Company recognized $2.9 million in other income as a result of favorable developments in the IRS audit and the tax indemnification settlement with former shareholders of the Company. The Company also recorded a $1.5 million gain related to the termination of a pension plan in Canada. The remaining components of other income and expenses resulted from foreign currency and equity affiliate transactions. 7 4. PROVISION FOR INCOME TAXES The tax provisions for the second quarter and six month periods ended December 31, 1999 and 1998 are based on the estimated effective tax rates applicable for the full years, and after giving effect to significant unusual items related specifically to the interim periods. The difference between the Company's reported tax provision, for the second quarter and six month periods ended December 31, 1999 and 1998, and the tax provision computed based on U.S. statutory rates is primarily attributable to nondeductible goodwill amortization and unbenefitted foreign losses. Additionally, the Company's effective tax rate for the second quarter and six month period ended December 31, 1999 reflects the effect of the sale of a foreign subsidiary. Also, the effective tax rate for the six months ended December 31, 1998 reflects the effect of the indemnification and the IRS Settlement. 5. DEBT AND FINANCIAL INSTRUMENTS On September 30, 1999, as further discussed in the Company's Form 10K, the Company entered into a new bank credit agreement. As a result of the bank credit agreement refinancing that took place, the Company wrote off certain unamortized debt issuance costs associated with the previous credit agreement. In addition, the balance of the unamortized income from early termination of the swap was eliminated. These actions resulted in net charge to other (income) expense of $0.3 million in the first quarter of fiscal year 2000. The Company secures pricing on a portion of its copper requirements through forward contracts executed with certain suppliers. At December 31, 1999, contracts for 3.5 million pounds of copper were in place. These contracts have various expiration dates through September 30, 2000. In January 2000, the Company entered into an interest rate swap transaction whereby the Company receives a fixed rate and pays a floating rate on the basis of 3-month LIBOR. The January 2000 swap has a three year term and a notional amount of $30 million and effectively converts a portion of the Company's fixed rate borrowings to a floating rate. 6. RESTRUCTURING As described in Note 10 of the Annual Report, the Company implemented several restructuring plans throughout fiscal year 1999 in both the Commercial Air Conditioning and Refrigeration and Filtration Products groups. Through December 31, 1999, the Company has spent $3.8 million of the $5.2 million restructuring reserve recorded in fiscal year 1999 primarily for severance arrangements. The Company continues to implement actions in accordance with the restructuring plan. 7. CONTINGENCIES ENVIRONMENTAL MATTERS - The Company is subject to potential liability under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, as amended (CERCLA), and other federal, state and local statutes and regulations governing the discharge of pollutants into the environment and the handling and disposal of hazardous substances and waste. These statutes and regulations, among other things, impose potential liability on the Company for the cost of remediation of contamination arising from the Company's past and present operations and from former operations of other entities at sites later acquired and now owned by the Company. Many of the Company's facilities have operated for many years, and substances which are or might be considered hazardous were generated, used, and disposed of at some locations, both on- and off-site. Therefore, it is possible that environmental liabilities in addition to those described in note 14 of the Annual Report may arise in the future. The Company records liabilities if, in management's judgment, environmental assessments or remedial efforts are probable and the costs can be reasonably estimated. These accrued liabilities are not discounted. Such estimates are adjusted if necessary based upon the completion of a formal study or the Company's commitment to a formal plan of action. 8 LITIGATION - The Company is involved in various lawsuits in the ordinary course of business. These lawsuits primarily involve claims for damages arising out of the use of the Company's products. The Company is also involved in litigation and administrative proceedings involving employment matters and commercial disputes. Some of these lawsuits include claims for punitive as well as compensatory damages. The Company is insured for product liability claims for amounts in excess of established deductibles and accrues for the estimated liability on a case-by-case basis up to the limits of the deductibles. All other claims and lawsuits are also handled on a case-by-case basis. The Company does not believe that the potential liability from the ultimate outcome of environmental and litigation matters will have a material adverse effect on it. 8. BUSINESS SEGMENTS INFORMATION The Company serves the global commercial heating, ventilation, air conditioning and refrigeration ("HVAC&R") industry with two industry segments: Commercial Air Conditioning and Refrigeration, the manufacture, sale and distribution of heating, ventilating, air conditioning, industrial refrigeration and freezing equipment products, and Filtration Products, the manufacture and sale of air filtration products and systems. Information relating to operations in each industry segment is as follows as of and for the three and six months ended December 31, 1999 and 1998: QUARTER ENDED SIX MONTHS ENDED DECEMBER 31, DECEMBER 31, CLASSIFIED BY INDUSTRY 1999 1998 1999 1998 ---------------------- ---- ---- ---- ---- (DOLLARS IN THOUSANDS) Net Sales: Commercial Air Conditioning and Refrigeration.... $ 121,555 $ 135,077 $ 269,455 $ 301,834 Filtration Products.............................. 80,996 83,478 158,733 171,923 Eliminations..................................... (363) (2,840) (873) (6,642) --------- --------- --------- --------- Total.................................... $ 202,188 $ 215,715 $ 427,315 $ 467,115 ========= ========= ========= ========= Operating Income (Loss): Commercial Air Conditioning and Refrigeration.... $ (1,579) $ (1,633) $ 594 $ 2,686 Filtration Products ............................. 4,988 4,834 10,290 9,333 Corporate 10 594 (366) (181) --------- --------- --------- --------- Total.................................... $ 3,419 $ 3,795 $ 10,518 $ 11,838 ========= ========= ========= ========= Depreciation/Amortization: Commercial Air Conditioning and Refrigeration.... $ 4,957 $ 4,191 $ 10,155 $ 8,401 Filtration Products.............................. 2,447 2,582 4,944 5,202 Corporate 8 27 22 55 --------- --------- --------- --------- Total.................................... $ 7,412 $ 6,800 $ 15,121 $ 13,658 ========= ========= ========= ========= Capital Expenditures: Commercial Air Conditioning and Refrigeration.... $ 402 $ 4,255 $ 1,845 $ 8,892 Filtration Products.............................. 597 435 1,432 1,039 --------- --------- --------- --------- Total.............................. $ 999 $ 4,690 $ 3,277 $ 9,931 ========= ========= ========= ========= The Company estimates corporate expenses and determines fixed allocations of these expenses for each business segment at the beginning of the fiscal year. Any over or under allocation of actual expenses incurred results in income or expense reported at the corporate level. A reconciliation of segment profit to the Company's earnings before taxes for each quarter is as follows: QUARTER ENDED SIX MONTHS ENDED DECEMBER 31, DECEMBER 31, 1999 1998 1999 1998 ---- ---- ---- ---- (DOLLARS IN THOUSANDS) Operating income from business segments $ 3,409 $ 3,201 $ 10,884 $ 12,019 Over (under) allocation of corporate expenses 10 594 (366) (181) Interest expense, net 5,546 5,738 11,419 12,244 Other (income) expense (220) (661) 1,862 (5,473) --------- --------- --------- -------- Income (loss) before income taxes $ (1,907) $ (1,282) $ (2,763) $ 5,067 ========= ========= ========= ======== 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS NET SALES were $202.2 million in the three months ended December 31, 1999, which represents a decrease of $13.5 million, or 6.3%, as compared to the same period in the prior year. Net sales were $427.3 million for the six months ended December 31, 1999, which represents a decrease of $39.8 million, or 8.5%, as compared to the same period in the prior year. The Company estimates that approximately $17.3 million of the year-to-date decrease in sales is attributable to having one less week of sales in the first quarter of fiscal year 2000 as compared to fiscal year 1999. Excluding the additional week, the year-to-date decrease in net sales is 4.8%. COMMERCIAL AIR CONDITIONING AND REFRIGERATION GROUP net sales for the three months ended December 31, 1999 decreased $13.5 million, or 10.0%, to $121.5 million. This decrease is primarily attributable to the sale of the commercial air conditioning and refrigeration operation in France in October 1999. The France operation contributed $12.5 million of sales volume in the second quarter of fiscal year 1999 as compared to no sales in the second quarter of fiscal year 2000 due to the sale. Additional decreases were seen in the chiller products and terminal air conditioning systems business units. Chiller product net sales decreased 13.8% in the second quarter of fiscal year 2000 compared to the second quarter of fiscal year 1999. This decrease was expected primarily as a result of the restructuring of the chiller business unit. Terminal air conditioning products net sales decreased 21.8% in the second quarter of fiscal 2000 as compared to the second quarter of fiscal year 1999 as a result of the product rationalization in North America and a related market reaction as a result of the changes in product offerings. The sales decreases noted were partially offset by increased sales in Applied Air Handling business unit as a result of strong demand for Vision-TM- air handlers, and increased sales from operations in the United Kingdom and Italy. Year-to-date sales decreased $32.4 million, or 10.7%, to $269.4 million. The Company estimates that approximately $11.4 million, or 35.2%, of the decrease is attributable to one less week of sales in the first quarter of fiscal 2000 as compared to the first quarter of fiscal 1999. The remaining decrease of $21.0 million is primarily attributable to the sale of the commercial air conditioning and refrigeration operation in France in October 1999, which contributed sales of $26.4 million in the first six months of fiscal year 1999 as compared to $11.6 million in the first six months of fiscal year 2000. Additional decreases were seen in the chiller products and terminal air conditioning systems business units. Chiller product year-to-date net sales decreased 15.5%. This decrease was expected primarily as a result of the restructuring of the chiller business unit. Terminal air conditioning products year to date net sales decreased 18.1% as a result of the product rationalization in North America and a related market reaction as a result of the changes in product offerings. The sales decreases noted were partially offset by increased sales from the operations in the United Kingdom and Italy. Backlog for the Commercial Air Conditioning and Refrigeration Group was $100.4 million at December 31, 1999 as compared to $133.7 and $127.3 million at June 30, 1999 and December 31, 1998, respectively. The decrease in backlog is attributable to a decrease in sales volume and the sale of the commercial air conditioning and refrigeration operation in France in October 1999. Excluding France backlog at June 30, 1999 and December 31, 1998, would have been $127.6 and $118.7 million, respectively. FILTRATION PRODUCTS GROUP net sales for the three months ended December 31, 1999 decreased $2.5 million, or 3.0%, to $81.0 million. The decrease is primarily attributable to continued slow MFAS sales in the United States due to soft market conditions and a decrease in air pollution control sales in Europe. Year-to-date sales decreased $13.2 million, or 7.7%, to $158.7 million. The Company estimates that approximately $6.0 million, or 45.5%, of the decrease is attributable to one less week of sales in the first quarter of fiscal 2000 as compared to the first quarter of fiscal 1999. The remaining decrease of $7.2 million is primarily attributable to continued slow MFAS sales in the United States due to soft market conditions and a decrease in air pollution control sales in Europe. GROSS PROFIT decreased to $50.5 million, or 25.0%, of sales for the three months ended December 31, 1999. Year-to-date gross profit decreased to $110.5 million, or 25.9%, of sales. In the Commercial Air 10 Conditioning and Refrigeration Group, year-to-date gross profit as a percentage of sales was 23.5% as compared to 24.7% for the same period in fiscal year 1999. This decrease in gross margin resulted primarily from unfavorable manufacturing performance. The Filtration Products Group's year-to-date gross profit as a percentage of sales increased from 28.1% in fiscal year 1999 to 29.5% for the same period in fiscal year 2000. This increase resulted from improved manufacturing performance and cost reduction programs. OPERATING EXPENSES were $47.1 million, or 23.3% of sales, for the second quarter of fiscal year 2000 versus $51.6 million, or 23.9% of sales, for the second quarter of fiscal year 1999. For the first half of fiscal years 2000 and 1999, operating expenses were $99.8 million, or 23.4% of sales, versus $110.4 million, or 23.6% of sales, respectively. Year-to-date, the Company estimates that approximately $4.1 million, or 38.7%, of the decrease is attributable to one less week of operating expenses in the first quarter of fiscal 2000 as compared to the first quarter of fiscal 1999. The remaining decrease of $6.5 million is primarily attributable to a reduction in commissions, selling and warranty expenses offset by an increase in depreciation expense related to the new Enterprise Resource Planning systems. INCOME FROM OPERATIONS for the second quarter and year-to-date decreased slightly as compared to the same periods in fiscal year 1999. For the second quarter income from operations decreased to $3.4 million, or 1.7% of sales, as compared to $3.8 million, or 1.8% of net sales, in the second quarter of fiscal 1999. Year-to-date income from operations decreased to $10.5 million as compared to $11.8 million but remained flat as a percent of sales at 2.5% in fiscal year 2000 and 1999. The Commercial Air Conditioning and Refrigeration Group's income from operations remained flat in the second quarter of fiscal year 2000 at $(1.6) million, or (1.3%) of sales, as compared $(1.6) million, or (1.2%) of sales in the second quarter of fiscal year 1999. Year-to-date income from operations decreased from $2.7 million, or 0.9% of sales, to $0.6 million, or 0.2% of sales, for the first six months of fiscal year 2000 as compared to the first six months of fiscal year 1999, respectively. The Filtration Products Group had an increase in income from operations in the second quarter of fiscal year 2000 from $4.8 million, or 5.8% of sales, to $5.0 million, or 6.2% of sales for the same period in fiscal year 1999. Year-to-date income from operations increased from $9.3 million, or 5.4% of sales, during the first six months of fiscal year 1999 to $10.3 million, or 6.5% of sales, for the first six months of fiscal year 2000. NET INTEREST EXPENSE decreased to $5.5 million and $11.4 million during the second quarter and six months ended December 31, 1999 from $5.7 million and $12.2 million for the comparable periods ended December 31, 1998. This decrease is primarily attributable lower debt levels as well as having one less week of activity in the first six months of fiscal year 2000 as compared to the first six months of fiscal year 1999. NET OTHER (INCOME) EXPENSE for the second quarter of fiscal year 2000 was income of $0.2 million compared to $0.7million in the second quarter of fiscal year 1999. Year-to-date the Company had expense of $1.9 million as compared to income of $5.5 million for the same period in fiscal year 1999. See Note 3 to the unaudited condensed financial statements for further discussion. LIQUIDITY AND CAPITAL RESOURCES The Company's liquidity needs are provided by cash generated from operating activities and supplemented when necessary by short-term credit facilities. During the first six months of fiscal year 2000, funds generated by operating activities were $24.0 million as compared to $15.5 million of funds generated in the prior fiscal year for the comparable period. During the first six months of fiscal year 2000, cash provided from investing activities was $9.7 million, which is comprised of proceeds from the sale of the Company's commercial air conditioning business in France for $13.0 million, reduced by capital expenditures of $3.3 million. Capital spending for the first six months has been reduced from $9.9 million in the prior year to $3.3 million this year due to lower spending on the information technology project which was completed in September 1999. On September 30, 1999, the Company refinanced its Bank Credit Agreement with a New Term Loan of $30 million and a new Revolving Credit Facility of $90 million ("New Bank Credit Agreement"). The New Bank Credit Agreement has a three-year term, was used to retire all obligations under the previous Bank Agreement and is designed to provide added flexibility and borrowing availability. The New Bank Credit Agreement also provides favorable interest rates and other fees compared to the previous Bank Credit Agreement. At December 31, 1999, remaining borrowing availability under the new Revolving Credit portion of the New 11 Bank Credit Agreement was $45 million. Total net payments on long term debt for the first six months were $10.0 million which is a result of new borrowing under the New Term Loan of $30.0 million, repayment of the balance on the previous Bank Term Loan of $37.3 million and other long term debt payments of $2.7 million. Cash of $18.6 million was used to reduce borrowings under short term borrowing arrangements during the six month period. Total debt of the Company was reduced from $266.4 million at June 30, 1999 to $237.8 million at December 31, 1999. A short-term credit facility provided to a subsidiary of the Company is supported by a letter of credit from O.Y.L. Industries Berhad (OYL) which expires on September 30, 2000. In addition, the Company has secured certain domestic letter of credit facilities totaling $13.5 million that are supported by a letter of credit from OYL which expires on March 21, 2000. Each of these support arrangements may be extended for additional time periods with the consent of OYL and the banks providing the facilities. On an ongoing basis the Company strives to evaluate its various businesses and product lines with the objective to enhance shareholder value. Consistent with this strategy, the Company intends to pursue global business opportunities that are synergistic with the Company's core businesses or exit low value added or non-synergistic operations. In October 1999, the Company sold the commercial air conditioning and refrigeration operation in France. The Company does not believe that the sale of the commercial air conditioning and refrigeration operation in France will have a material effect on the Company's future financial results. Management believes, based upon current levels of operations and forecasted earnings, that cash flow from operations, together with borrowings under the New Bank Credit Agreement and other short-term credit facilities, will be adequate to make payments of principal and interest on debt, to permit anticipated capital expenditures and to fund working capital requirements and other cash needs. Nevertheless, the Company will remain leveraged to a significant extent and its debt service obligations will continue to be substantial. If the Company's sources of funds were to fail to satisfy the Company's requirements, the Company may need to refinance its existing debt or obtain additional financing. There is no assurance that any such new financing alternatives would be available, and, in any case, such new financing (if available) would be expected to be more costly and burdensome than the debt agreements currently in place. YEAR 2000 By mid-December 1999, the Company had successfully completed its formal Year 2000 program, comprised of two major components. First, the Company completed its internal Year 2000 Compliance program which consisted of converting existing systems to Year 2000 Compliant status, primarily through implementing new state-of-the-art Enterprise Resource Planning (ERP) systems. Even before the Year 2000 program started, the Company's management believed that modernizing its information systems was critical for the Company's stable and efficient growth. This modernization, through ERP systems, also served as the basis of the Company's strategy for resolving its Year 2000 issues. The final ERP implementation was completed by month-end September 1999. Company expenditures for the new systems aggregated to approximately $27.0 million, from mid-1996 through total project completion at month-end September 1999. All other additional remedial actions beyond those required to install new ERP systems were completed on schedule by mid-December; expenditures for these actions (minor) were managed by the individual business units and recognized in operating expenses. Second, by mid-December the Company had completed its Year 2000 Business Continuity and Contingency Plans (BCCP), for each of its businesses, in the event that internal, external, or systemic failures occur on or about January 1, 2000. 12 All identified Year 2000 activities were completed according to the chart below: ------------------------------------ ------------------ ----------------- ----------------- ACTIVITY STATUS STARTING ENDING ------------------------------------ ------------------ ----------------- ----------------- Assessment and inventory Complete September 1997 January 1998 ------------------------------------ ------------------ ----------------- ----------------- Coordinator and Executive review Complete February 1998 May 1998 process ------------------------------------ ------------------ ----------------- ----------------- Industrial Refrigeration ERP Complete January 1997 April 1998 ------------------------------------ ------------------ ----------------- ----------------- Filtration Products ERP Complete April 1997 July 1999 ------------------------------------ ------------------ ----------------- ----------------- Commercial Air Conditioning ERP Complete September 1997 September 1999 ------------------------------------ ------------------ ----------------- ----------------- Product compliance Complete May 1998 March 1999 ------------------------------------ ------------------ ----------------- ----------------- Materials suppliers Complete June 1998 October 1999 ------------------------------------ ------------------ ----------------- ----------------- Other IT issues including third Complete September 1998 October 1999 parties ------------------------------------ ------------------ ----------------- ----------------- Equipment and facilities Complete September 1998 October 1999 ------------------------------------ ------------------ ----------------- ----------------- The Company believes the completed Year 2000 activities are adequate to address the Year 2000 risks faced by the Company. As of mid-January 2000, the Company had experienced no significant Year 2000 related problems. While the likelihood has greatly diminished, there still exists the possibility of failure by the Company's third party suppliers and/or service providers to produce or deliver critical components or to transport products/service. This could cause disruption in the Company's ability to manufacture and/or deliver timely its products to its customers, which could result in increased expenses, reduced billings and potential litigation. The precise costs associated with such risks are difficult to predict at this time. EURO CONVERSION Management has initiated an internal analysis of and planning for the effect the Euro will have on the operating and financial condition of the Company. The Euro is not expected to have a material effect on the Company's operating results or competitive position. The Company's financial systems are Euro compliant and opportunities will continue to be investigated for European-wide system infrastructures. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK There have been no material changes in the reported market risks since the end of the most recent fiscal year. See Note 5 to the Consolidated Financial Statements (unaudited) for disclosures of additional financial instruments that have been entered into by the Company since the end of the most recent fiscal year. FORWARD-LOOKING STATEMENTS When used in this report by management of the Company, from time to time, the words "believes," "anticipates," and "expects" and similar expressions are intended to identify forward-looking statements that involve certain risks and uncertainties. A variety of factors could cause actual results to differ materially from those anticipated in the Company's forward-looking statements, some of which include risk factors previously discussed in this and other SEC reports filed by the Company. These risk factors include, but are not limited to, general economic conditions, environmental laws and regulations, the weakening Asian markets, unforeseen competitive pressures, warranty expenses, market acceptance of new products, unseasonably cool spring or summer weather, a slow down in the chiller market, the inability to meet debt covenants, unforeseen difficulties in maintaining mutually beneficial relationships with strategic initiatives partners, the Year 2000 issue, and the results of restructuring activities. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date thereof. The Company undertakes no obligation to publicly release the results of any events or circumstances after the date hereof to reflect the occurrence of unanticipated events. 13 PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Not applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS NUMBER DESCRIPTION Exhibit 27 Financial Data Schedule (filed herewith) (b) REPORTS ON FORM 8-K There were no reports filed on Form 8-K during the period. 14 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. AAF-MCQUAY INC. DATE February 14, 2000 By: ____________________________ ---------------------- Bruce D. Krueger Vice President of Finance Principal Accounting Officer and Principal Financial Officer 15 Exhibit Index NUMBER DESCRIPTION 27 Financial Data Schedule 16