UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF
THE SECURITIES AND EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JULY 31, 2004 Commission file number 000-21109
CUNO INCORPORATED
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(Exact name of registrant as specified in its charter)
Delaware 06-1159240
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
400 Research Parkway, Meriden, Connecticut 06450
- ------------------------------------------ -----------------
(Address of principal executive offices) (Zip Code)
(203) 237-5541
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Registrant's telephone number, including area code
Not Applicable
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Former name, former address and former fiscal year, if changed since last
report.
Indicate by check mark 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 periods 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 by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
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.
Common Stock, $0.001 Par Value -- 16,961,527 shares as of July 31, 2004
CUNO INCORPORATED
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (Unaudited)
Consolidated Statements of Income 1-2
Consolidated Balance Sheets 3
Consolidated Statements of Cash Flows 4
Notes to Unaudited Condensed Consolidated Financial Statements 5-13
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations 14-26
Item 3. Quantitative and Qualitative Disclosures About Market Risk 27
Item 4. Controls and Procedures 28
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K 29-34
CUNO INCORPORATED
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(dollars in thousands, except share and per-share amounts)
THREE MONTHS ENDED
JULY 31,
2004 2003
------------ ------------
Net sales $ 89,945 $ 74,965
Operating expenses:
Cost of products sold 50,275 41,088
Selling, general and administrative 22,539 18,826
Research, development and engineering 4,327 3,855
------------ ------------
77,141 63,769
------------ ------------
Operating income 12,804 11,196
Nonoperating income (expense):
Interest expense (67) (159)
Interest and other income, net 154 180
------------ ------------
87 21
------------ ------------
Income before income taxes 12,891 11,217
Income taxes 4,288 3,750
------------ ------------
Net income $ 8,603 $ 7,467
============ ============
Basic earnings per common share $ 0.51 $ 0.45
Diluted earnings per common share $ 0.50 $ 0.44
Basic shares outstanding 16,714,250 16,685,602
Diluted shares outstanding 17,160,384 17,088,250
See accompanying notes.
-1-
CUNO INCORPORATED
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(dollars in thousands, except share and per-share amounts)
NINE MONTHS ENDED
JULY 31,
2004 2003
------------ ------------
Net sales $ 248,099 $ 210,707
Less costs and expenses:
Cost of products sold 134,504 115,798
Selling, general and administrative expenses 65,287 54,853
Research, development and engineering 12,552 10,897
------------ ------------
212,343 181,548
------------ ------------
Operating income 35,756 29,159
Nonoperating income (expense):
Interest expense (237) (440)
Interest and other income, net 520 361
------------ ------------
283 (79)
------------ ------------
Income before income taxes 36,039 29,080
Provision for income taxes 11,987 9,921
------------ ------------
Net income $ 24,052 $ 19,159
============ ============
Basic earnings per common share $ 1.44 $ 1.15
Diluted earnings per common share $ 1.41 $ 1.13
Basic shares outstanding 16,698,648 16,629,302
Diluted shares outstanding 17,068,215 17,000,649
See accompanying notes.
-2-
CUNO INCORPORATED
CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
(unaudited)
JULY 31, OCTOBER 31,
2004 2003
--------- --------
ASSETS
Current assets
Cash and cash equivalents $ 54,030 $ 57,603
Accounts receivable, less allowances for
doubtful accounts of $1,888 and $1,705, respectively 74,067 59,658
Inventories, net 39,448 31,058
Deferred income taxes 9,494 9,020
Prepaid expenses and other current assets 7,019 4,306
--------- ---------
Total current assets 184,058 161,645
Noncurrent assets
Deferred income taxes 1,395 1,340
Goodwill 30,999 28,489
Prepaid pension costs 7,923 7,923
Other noncurrent assets 9,598 3,551
Property, plant and equipment, net 90,448 85,060
--------- ---------
Total assets $ 324,421 $ 288,008
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Current portion of long-term debt $ 227 $ 849
Bank loans 11,270 11,804
Accounts payable 28,549 20,850
Accrued payroll and related taxes 15,695 17,456
Other accrued expenses 9,694 10,443
Accrued income taxes 5,741 2,558
--------- ---------
Total current liabilities 71,176 63,960
Noncurrent liabilities
Long-term debt, less current portion 602 401
Deferred income taxes 10,922 9,862
Accrued pension liability 5,680 5,457
Other long-term liabilities 463 -
--------- ---------
Total noncurrent liabilities 17,667 15,720
STOCKHOLDERS' EQUITY
Preferred Stock, $.001 par value; 2,000,000 shares
authorized, no shares issued - -
Common Stock, $.001 par value; 50,000,000 shares authorized,
16,961,527 and 16,863,482 shares issued 17 17
Treasury Stock, at cost (2,747 shares) (57) (57)
Additional paid-in-capital 57,584 53,787
Unearned compensation (1,714) (784)
Accumulated other comprehensive loss --
Foreign currency translation adjustments 3,614 3,282
Fair value of derivative financial instruments, net 12 13
Minimum pension liability, net (2,049) (2,049)
--------- ---------
1,577 1,246
Retained earnings 178,171 154,119
--------- ---------
Total stockholders' equity 235,578 208,328
--------- ---------
Total liabilities and stockholders' equity $ 324,421 $ 288,008
========= =========
See accompanying notes.
-3-
CUNO INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(dollars in thousands)
NINE MONTHS ENDED
JULY 31,
2004 2003
--------- --------
OPERATING ACTIVITIES
Net income $ 24,052 $ 19,159
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 8,275 7,272
Noncash compensation recognized under employee stock plans 632 407
Losses (gains) on sales of property, plant and equipment 143 (13)
Pension funding less than (in excess of) expense 261 (5,997)
Deferred income taxes 693 (120)
Changes in operating assets and liabilities, net of acquisitions:
Accounts receivable (14,033) (6,425)
Inventories (8,485) (338)
Prepaid expenses and other current assets (4,651) (1,009)
Accounts payable and accrued expenses 5,357 (1,601)
Accrued income taxes 2,951 4,291
-------- --------
Net cash provided by operating activities 15,195 15,626
INVESTING ACTIVITIES
Proceeds from sales of property, plant and equipment 13 35
Acquisition of companies, net of cash acquired (4,720) (149)
Capital expenditures (13,276) (12,420)
Other, net (1,291) (339)
-------- --------
Net cash used for investing activities (19,274) (12,873)
FINANCING ACTIVITIES
Principal payments on long-term debt (900) (2,069)
Proceeds from short-term debt 198 829
Principal payments on short-term debt (612) (1,116)
Net borrowings (repayments) under short-term bank loans 99 (1,622)
Proceeds from stock options exercised 1,126 1,193
-------- --------
Net cash used for financing activities (89) (2,785)
Effect of exchange rate changes on cash and cash equivalents 595 1,112
-------- --------
Net change in cash and cash equivalents (3,573) 1,080
Cash and cash equivalents -- beginning of period 57,603 40,872
-------- --------
Cash and cash equivalents -- end of period $ 54,030 $ 41,952
======== ========
See accompanying notes.
-4-
CUNO INCORPORATED
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unless otherwise noted, amounts in thousands, except share and per-share
amounts)
JULY 31, 2004
NOTE 1 - ORGANIZATION AND ACCOUNTING POLICIES
CUNO Incorporated (the "Company", "CUNO", or "we") designs, manufactures
and markets a comprehensive line of filtration products for the separation,
clarification and purification of liquids and gases. Our products, which include
proprietary depth filters and semi-permeable membrane filters, are sold in the
potable water, healthcare and fluid processing markets throughout the world.
The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States of America for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do
not include all of the information and footnotes required by accounting
principles generally accepted in the United States of America for annual
financial statements. In the opinion of management, all adjustments which are of
a normal recurring nature considered necessary for a fair presentation of the
financial position and results of operations for the interim periods set forth
herein have been included. The accounts of the Company and all of its
subsidiaries are included in the consolidated financial statements. All
significant intercompany accounts and transactions are eliminated in
consolidation. Operating results for the interim periods are not necessarily
indicative of the results that may be expected for the full year. These interim
unaudited financial statements should be read in conjunction with the Company's
Annual Report on Form 10-K for the year ended October 31, 2003.
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the amounts reported in
the financial statements and disclosures made in the accompanying notes to the
financial statements. Actual results could differ from those estimates.
Certain prior year amounts have been reclassified to conform to current
year presentation.
INVENTORIES:
Inventories are stated at the lower of cost or market. Inventories in the
United States of America are primarily valued by the last-in, first-out (LIFO)
cost method. The methods used for all other inventories are first-in, first-out
(FIFO) and average cost. An actual valuation of inventory under the LIFO method
can be made only at the end of each year based on the inventory levels and costs
at that time. Accordingly, interim LIFO calculations must necessarily be based
on our estimates of expected year-end inventory levels and costs. Because these
are subject to many factors beyond management's control, interim results are
subject to the final year-end LIFO inventory valuation.
Inventories consist of the following:
JULY 31, OCTOBER 31,
2004 2003
---------- ----------
(unaudited)
Raw materials $ 15,861 $ 13,112
Work-in-process 3,881 3,992
Finished goods 19,706 13,954
-------- ---------
$ 39,448 $ 31,058
======== =========
5
ACCOUNTS PAYABLE
At July 31, 2004 and October 31, 2003, approximately $4,195 and $2,294,
respectively, representing book overdrafts of cash accounts, were reclassified
to accounts payable.
OTHER INCOME:
Interest and other income (expense), net consisted of the following:
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
2004 2003 2004 2003
--------- -------- ------- -------
Interest income $ 156 $ 159 $ 576 $ 433
Exchange gains (losses) 35 (24) 33 (101)
(Losses) gains on sale of
property, plant and equipment (6) 6 (36) 13
Other, net (31) 39 (53) 16
-------- -------- ------- --------
$ 154 $ 180 $ 520 $ 361
======== ======== ======= ========
EARNINGS PER SHARE:
Basic earnings per common share is based on net income divided by the
weighted average number of common shares outstanding during the period. Diluted
earnings per common share is based on net income divided by the weighted average
number of common shares outstanding during the period, including the effect of
stock equivalents, where such effect is dilutive. Earnings per share for the
three months ended July 31, 2004 and 2003 is calculated as follows:
JULY 31, JULY 31,
2004 2003
----------- -----------
NUMERATOR:
Net income $ 8,603 $ 7,467
=========== ===========
DENOMINATORS:
Weighted average shares outstanding 16,714,250 16,685,602
DENOMINATOR FOR BASIC EARNINGS PER SHARE 16,714,250 16,685,602
=========== ===========
Weighted average shares outstanding 16,714,250 16,685,602
Effect of dilutive employee stock options 284,197 379,424
Effect of dilutive restricted shares 161,937 23,224
----------- -----------
DENOMINATOR FOR DILUTED EARNINGS PER SHARE 17,160,384 17,088,250
=========== ===========
Basic earnings per share $ 0.51 $ 0.45
Diluted earnings per share $ 0.50 $ 0.44
Approximately zero and 44,000 shares related to options to purchase common
stock and unvested restricted stock were excluded from the computations of
diluted earnings per share for the three-months ended July 31, 2004 and 2003,
respectively, because the exercise price was greater than the average market
price of the common stock during the periods.
6
Earnings per share for the nine months ended July 31, 2004 and 2003 is
calculated as follows:
JULY 31, JULY 31,
2004 2003
----------- -----------
NUMERATOR:
Net income $ 24,052 $ 19,159
=========== ===========
DENOMINATORS:
Weighted average shares outstanding 16,698,648 16,629,302
DENOMINATOR FOR BASIC EARNINGS PER SHARE 16,698,648 16,629,302
=========== ===========
Weighted average shares outstanding 16,698,648 16,629,302
Effect of dilutive employee stock options 213,138 348,076
Effect of dilutive restricted shares 156,429 23,271
----------- -----------
DENOMINATOR FOR DILUTED EARNINGS PER SHARE 17,068,215 17,000,649
=========== ===========
Basic earnings per share $ 1.44 $ 1.15
Diluted earnings per share $ 1.41 $ 1.13
Approximately zero and 68,695 shares related to options to purchase common
stock and unvested restricted stock were excluded from the computations of
diluted earnings per share for the nine-months ended July 31, 2004 and 2003,
respectively, because the exercise price was greater than the average market
price of the common stock during the periods
COMPREHENSIVE INCOME:
Total comprehensive income was comprised of the following:
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
2004 2003 2004 2003
------- ------- ------ -------
Net income $ 8,603 $ 7,467 $ 24,052 $ 19,159
Other comprehensive income (loss):
Change in fair value of derivative
financial instruments, net of deferred
income taxes of $20, $48, $49 and (24) 69 76 (87)
$60
(Losses) gains related to derivative financial
instruments reclassified into earnings from
other comprehensive income, net of deferred
income taxes of $9, $9, $45 and $46 12 (12) (77) 67
Foreign currency translation adjustments (726) 180 332 5,920
------- ------- -------- --------
Total comprehensive income $ 7,865 $ 7,704 $ 24,383 $ 25,059
======= ======= ======== ========
7
EMPLOYEE STOCK OPTIONS:
The Company has stock option plans under which employees and directors
have options to purchase Common Stock. The Company applies APB 25, "Accounting
for Stock Issued to Employees" and related interpretations in accounting for its
stock option plans. The Company has adopted those provisions of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (FAS 123) and Statement of Financial Accounting Standards No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure - an
amendment of Statement of Financial Accounting Standards No. 123", which require
the disclosure of pro forma effects on net income and earnings per share as if
compensation cost had been recognized based upon the fair value method at the
date of grant for options awarded.
Pro forma information regarding net income and earnings per share is
required by FAS 123, which requires that the information be determined as if we
had accounted for our employee stock options under the fair-value method of FAS
123. The fair value for the options granted during the following periods were
estimated at the date of grant using the Black-Scholes pricing model with the
following weighted average assumptions:
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
2004 2003 2004 2003
------ ------- -------- -------
Volatility N/A 32.99% 29.43% 29.49%
Risk-free interest rate N/A 2.92% 3.44% 3.58%
Expected option life N/A 5 years 5 years 5 years
Dividend yield N/A - - -
N/A -- There were no stock option grants during the quarter ended July 31,
2004.
The following table illustrates the effect on net income and earnings per
share as if compensation cost had been recognized based on the fair value of the
options at the grant dates for awards under those plans consistent with FAS 123,
as amended, using the Black-Scholes fair value method for option pricing.
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
2004 2003 2004 2003
--------- --------- ---------- ----------
Net income, as reported $ 8,603 $ 7,467 $ 24,052 $ 19,159
Add: Stock-based compensation expense included in reported net
income, net of income taxes 147 88 423 264
Deduct: Total stock-based compensation expense determined under fair
value based method for all awards, net of income taxes 606 526 1,842 1,606
--------- --------- ---------- ----------
Pro forma net income $ 8,144 $ 7,029 $ 22,633 $ 17,817
========= ========= ========== ==========
Earnings per share:
Basic - as reported $ 0.51 $ 0.45 $ 1.44 $ 1.15
Basic - pro forma $ 0.49 $ 0.42 $ 1.36 $ 1.07
Diluted - as reported $ 0.50 $ 0.44 $ 1.41 $ 1.13
Diluted - pro forma $ 0.47 $ 0.41 $ 1.33 $ 1.05
8
NEWLY ISSUED ACCOUNTING STANDARDS
In December 2003, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 132 (revised 2003),
"Employers' Disclosures about Pensions and Other Postretirement Benefits". This
standard revises employers' disclosures about pension plans and other
postretirement benefit plans. It does not change the measurement or recognition
of those plans as required by SFAS No. 87, "Employers' Accounting for Pensions",
SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined
Benefit Pension Plans and for Termination Benefits", and SFAS No. 106,
"Employers' Accounting for Postretirement Benefits Other Than Pensions". This
standard retains the disclosure requirements contained in SFAS No. 132,
"Employers' Disclosures about Pensions and Other Postretirement Benefits", which
it replaces. It requires additional disclosures to those in the original SFAS
No. 132 about the assets, obligations, cash flows and net periodic benefit cost
of defined benefit pension plans and other defined benefit postretirement plans.
The provisions of SFAS No. 132 remain in effect until the provisions of SFAS No.
132 (revised 2003) are adopted. SFAS No. 132 (revised 2003) is generally
effective for fiscal years ending after December 15, 2003. The interim-period
disclosures required by SFAS No. 132 (revised 2003) are effective for interim
periods beginning after December 15, 2003 and are reflected herein in Note 3 -
Benefit Plans. The Company does not expect the adoption of this standard in
fiscal year 2004 to have an impact on the Company's financial position or
results of operations.
NOTE 2 - GOODWILL AND INTANGIBLE ASSETS
Goodwill amounted to $30,999 and $28,489 at July 31, 2004 and October 31,
2003, respectively. The increase in goodwill was primarily driven by an
acquisition of a manufacturing company in the U.S. and two small distributor
acquisitions in Europe, which resulted in additional goodwill of $2,108. Changes
in foreign exchange rates also favorably impacted carrying values of goodwill.
Other intangible assets, which are included in "Other noncurrent assets",
amounted to $5,534 and $2,075 at July 31, 2004 and October 31, 2003,
respectively. The increase in other intangible assets was related primarily to
an acquisition of a manufacturing company in the U.S. and two small distributor
acquisitions in Europe in which we allocated approximately $3,580 to intangible
assets, relating mainly to technology, customer lists and non-compete
agreements. Amortization expense for the three and nine-month periods ended July
31, 2004 amounted to $125 and $265, respectively. Other changes reflect the
impact of fluctuations in foreign exchange rates.
NOTE 3 - BENEFIT PLANS
Components of Net Periodic Benefit Cost are as follows:
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
2004 2003 2004 2003
------ ------- -------- --------
Service cost $ 683 $ 544 $ 2,049 $ 1,632
Interest cost 633 586 1,899 1,758
Expected return on plan assets (823) (885) (2,469) (2,655)
Amortization of transition asset 20 18 60 54
Amortization of prior service cost 102 32 306 96
Amortization of net loss 141 140 423 420
----- ------ ------- -------
Net periodic benefit cost $ 756 $ 435 $ 2,268 $ 1,305
===== ====== ======= =======
During the three and nine months ended July 31, 2004, employer
contributions of $666 and $2,007, respectively, were made to the pension plans.
We currently anticipate contributing an additional $624 to fund our pension
plans in fiscal 2004 for a total expected contribution of $2,631.
9
The pension assumptions used to determine our October 31, 2003 plan
liabilities and the fiscal 2004 pension expense are as follows:
US PLANS JAPAN PLANS
-------- -----------
Weighted-average discount rate 6.20% 2.00%
Rates of increases in compensation levels 4.00% 2.25%
Expected long-term rate of return on assets 8.75% 4.75%
We determine our assumptions based on current economic and market data, as
well as expectations of future economic and market data. Included in our
analysis are company-specific considerations, such as current and future
investment allocations, participant demographics, and employee compensation
strategies.
Pension expense for fiscal 2004 is determined at the beginning of the
fiscal year and expensed ratably throughout the year. The total pension expense
to be recognized in 2004 will amount to approximately $3.0 million ($1.7 million
in fiscal 2003). We made an incremental cash contribution of $6.0 million in the
first quarter of fiscal 2003 and generally make normal cash contributions to the
Plans in an amount equivalent to the annual expense.
NOTE 4 - ACQUISITIONS
During the nine months ended July 31, 2004, we completed the acquisition
of a manufacturing company in the U.S. and two distributor acquisitions in
Europe for total consideration of $4,720. The amount of goodwill and other
intangible assets recorded in connection with these acquisitions amounted to
$2,108 and $3,580, respectively. None of these acquisitions had a material
impact on the Company's historical financial statements or pro forma operating
results.
NOTE 5 - SEGMENT DATA
Segment information has been prepared in accordance with Statement of
Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information." CUNO is organized into five geographic
segments, as the Company's chief operating decision makers are responsible for
managing our global operations based on geographic regions. Our geographic
segments include: North America, Europe, Japan, Asia/Pacific and Latin America.
Each of these operations are led and managed by a local General Manager who is
responsible for the profitability of their respective geographic segment. Each
of these geographic operations in turn manufactures and sells products into our
three main filtrations markets; potable water, healthcare and fluid processing.
Each geographic segment manufactures and sells products in each of the three
markets. The geographic segment managers are responsible for managing their
respective resources with oversight and review by the CEO.
The Company does not present segment information by market as our
individual market focus is limited to worldwide sales, with assigned
responsibility for expanding worldwide sales within each respective market.
10
Financial information by geographic operating segments is summarized
below:
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
2004 2003 2004 2003
-------- -------- --------- ---------
NET SALES:
Europe $ 20,363 $ 16,704 $ 57,421 $ 45,416
Japan 13,491 8,902 34,705 25,647
Asia/Pacific 12,273 9,221 34,720 26,882
Latin America 3,687 3,296 10,656 8,493
-------- -------- --------- ---------
Subtotal - Foreign sales 49,814 38,123 137,502 106,438
North America 54,135 46,746 150,460 133,623
Intercompany sales (14,004) (9,904) (39,863) (29,354)
-------- -------- --------- ---------
Total net sales $ 89,945 $ 74,965 $ 248,099 $ 210,707
======== ======== ========= =========
Our sales by market are summarized below:
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
2004 2003 2004 2003
------- ------- -------- --------
NET SALES:
Potable Water $42,471 $34,606 $115,264 $ 96,301
Fluid Processing 22,658 19,040 64,072 55,117
Healthcare 24,816 21,319 68,763 59,289
------- ------- -------- --------
Total net sales $89,945 $74,965 $248,099 $210,707
======= ======= ======== ========
Our operating income by segment is detailed below:
THREE MONTHS ENDED NINE MONTHS ENDED
JULY 31, JULY 31,
2004 2003 2004 2003
-------- -------- -------- --------
OPERATING INCOME:
North America $ 5,605 $ 6,716 $ 18,682 $ 18,045
Europe 1,701 1,936 4,774 4,146
Japan 3,139 906 5,645 2,393
Asia/Pacific 1,892 1,346 5,504 3,686
Latin America 467 292 1,151 889
-------- -------- -------- --------
Segment total 12,804 11,196 35,756 29,159
-------- -------- -------- --------
Interest expense (67) (159) (237) (440)
Other, net 154 180 520 361
-------- -------- -------- --------
Income before income taxes $ 12,891 $ 11,217 $ 36,039 $ 29,080
======== ======== ======== ========
Interest expense and other income (expense) have not been allocated to
segments.
11
Our assets by segment are detailed below:
JULY 31, OCTOBER 31,
2004 2003
--------- -----------
ASSETS:
North America $ 211,027 $ 197,374
Europe 59,719 46,643
Japan 37,277 30,788
Asia/Pacific 26,480 20,531
Latin America 12,422 11,702
General Corporate 54,030 57,604
Eliminations and other (76,534) (76,634)
--------- ---------
Total Assets $ 324,421 $ 288,008
========= =========
General corporate assets (principally cash) are not allocated to segments.
NOTE 6 - COMMITMENTS AND CONTINGENCIES
The Company is subject to various legal actions, governmental audits, and
proceedings relating to various matters incidental to its business including
product liability and environmental claims. While the outcome of such matters
cannot be predicted with certainty, in the opinion of management, after
reviewing such matters and consulting with our counsel and considering any
applicable insurance or indemnifications, any liability which may ultimately be
incurred is not expected to materially affect the consolidated financial
position, cash flows or results of operations of the Company.
Currently, we have self-insurance limits for workers' compensation,
product liability and employee medical claims. Our workers' compensation
policies have per-individual deductibles of $350, our product liability policy
has a $250 per claim deductible and our medical plan for employees has a
stop-loss of $200 per individual.
During the second quarter of fiscal 2004, we entered into a new, exclusive
distribution agreement with a major retailer. Inclusive with this agreement is a
requirement to buy-back certain non-CUNO inventory over the remainder of fiscal
2004. The amount of inventory that we will be required to buy back is based on
future levels of such inventory on hand at the time the customer receives the
first shipment of CUNO manufactured product. In the third quarter of 2004, we
purchased approximately $250 (net realizable value) of inventory in connection
with this agreement. Additional future amounts of this purchase commitment are
not reasonably estimable; furthermore, the fair market value of certain
purchased inventory may be below the actual price paid by the Company at the
time of purchase. In addition, we expect to spend approximately $1,000 during
fiscal 2004 to install in-store promotional kiosks to promote these products. Of
this amount, approximately $642 has been spent as of July 31, 2004.
12
NOTE 7 - PRODUCT WARRANTY
We warrant our products against defects in design, materials, and
workmanship, generally for periods ranging from one to three years, although
warranty periods on certain product lines extend up to ten years. A provision
for estimated future costs related to these warranties is recorded on a monthly
basis and is included in cost of goods sold. Activity related to the product
warranty liability was as follows:
NINE MONTHS ENDED YEAR ENDED
JULY 31, OCTOBER 31,
2004 2003
----------------- -----------
Balance at beginning of year $ 817 $ 785
Provision for warranty obligations 734 818
Settlements made (578) (816)
Changes in foreign exchange rates 2 30
------- -------
Balance at end of period $ 975 $ 817
======= =======
NOTE 8 - SUBSEQUENT EVENTS
On August 2, 2004 we completed the acquisition of WTC Industries, Inc.
This transaction was completed following the approval by a majority of WTC's
shareholders at a special meeting held on July 29, 2004.
Under the terms of the transaction, CUNO paid WTC's stockholders $39.87 in
cash for each WTC share outstanding. WTC option and warrant holders received a
cash payment based on the difference between $39.87 per share and the exercise
price of their options and warrants. The aggregate consideration for the
outstanding WTC shares (including payments for the settlement of outstanding
stock options and warrants) was approximately $115 million (including the
assumption of WTC's outstanding bank debt and all acquisition-related fees and
expenses). CUNO funded the acquisition with a combination of existing cash and
bank borrowings under a new unsecured, variable-rate, unsecured five-year
$120 million revolving credit facility that was arranged with a syndicate of
banks.
13
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
(amounts in thousands, except share and per-share amounts, unless otherwise
noted)
Management's discussion and analysis of financial condition and results of
operations ("MD&A") is provided as a supplement to the accompanying unaudited
interim condensed consolidated financial statements and footnotes to provide an
understanding of our financial position, changes in our financial position and
results of our operations. Our MD&A is organized as follows:
- COMPANY OVERVIEW. This section provides a general description of our
business.
- COMPANY RISK FACTORS. This section describes the material risks
inherent in our business that investors should be aware of.
- CAUTION CONCERNING FORWARD-LOOKING STATEMENTS. This section
discusses how certain forward-looking statements made by us
throughout the MD&A and elsewhere in this report are based on
management's present expectations about future events and are
inherently susceptible to uncertainty and changes in circumstances.
- CRITICAL ACCOUNTING POLICIES. This section discusses those
accounting policies that are both considered important to our
financial statements and require significant judgment and estimates
on the part of management in their application.
- RESULTS OF OPERATIONS. This section provides an analysis of our
results of operations for the three and nine months ended July 31,
2004 and 2003, including a brief description of transactions and
events that impact the comparability of these results.
- FINANCIAL POSITION AND LIQUIDITY. This section provides an analysis
of our cash position and cash flows, as well as a discussion of our
financing arrangements.
Other information is presented in Items 3, 4 and elsewhere as follows:
- QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK. This
section discusses information about the various market risks we are
exposed to as of the end of the latest fiscal period presented.
- CONTROLS AND PROCEDURES. This section discusses the conclusions of
our executive officer and principal financial officer about the
effectiveness of our disclosure controls and procedures.
COMPANY OVERVIEW
CUNO is a world leader in the designing, manufacturing and marketing of a
comprehensive line of filtration products for the separation, clarification and
purification of liquids and gases. Our products, which include proprietary depth
filters and semi-permeable membrane filters, are used in the potable water,
fluid processing, and healthcare markets. These products, most of which are
disposable, effectively remove contaminants that range in size from molecules to
sand particles. Our sales are approximately balanced between domestic and
international markets. Our objective is to provide high value-added products and
premium customer service. Our proprietary manufacturing processes result in
products that lower customers' operating expenses and improve the quality of
customers' end products by providing longer lasting, higher quality and more
efficient filters.
14
COMPANY RISK FACTORS
RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS
Approximately 50% of our net sales are derived from international
operations. Consequently, our reported financial results may be adversely
affected by significant fluctuations in the value of the US dollar in comparison
to local currencies in the countries in which we operate outside the US. We
manufacture products in Japan, China, Brazil, France, Singapore and Australia.
Our international operations may be affected by economic, political and
governmental conditions in some of the countries where we have manufacturing
facilities or where our products are sold. In addition, changes in economic or
political conditions in any of the countries in which we operate could result in
unfavorable taxation policies, exchange rates, new or additional currency or
exchange controls, governmental regulations, credit risks, or other restrictions
being imposed on the operations of the Company or expropriation.
PATENTS AND PROPRIETARY TECHNIQUES
We have a broad patent portfolio as well as other proprietary information
and manufacturing techniques and have applied, and will continue to apply, for
patents to protect our technology. The Company's success depends in part upon
our ability to protect our technology and proprietary products under US and
foreign patent and other intellectual property laws. Trade secrets and
confidential know-how which are not patented are protected through
confidentiality agreements, contractual provisions and internal Company
administrative procedures. There can be no assurance that such arrangements will
provide meaningful protection for the Company in the event of any unauthorized
use or disclosure. There can be no assurance that third parties will not assert
infringement claims against the Company or that a license or similar agreement
will be available on reasonable terms in the event of an unfavorable ruling on
any such claim. In addition, any such claim may require the Company to incur
litigation expenses or subject the Company to liabilities.
TECHNOLOGICAL AND REGULATORY CHANGE
The filtration and separations industry is characterized by changing
technology, competitively imposed process standards and regulatory requirements,
each of which influences the demand for our products and services. Changes in
legislative, regulatory or industrial requirements or competitive technologies
may render certain of our filtration and separations products and processes
obsolete. Acceptance of new products may also be affected by the adoption of new
government regulations requiring stricter standards. The Company's ability to
anticipate changes in technology and regulatory standards and to develop and
introduce new and enhanced products successfully on a timely basis are
significant factors in our ability to grow and to remain competitive. Similar to
all companies, we are also subject to the risks generally associated with new
product introductions and applications, including lack of market acceptance,
delays in product development and failure of products to operate properly.
COMPETITION
The filtration and separations markets in which we compete are highly
competitive. We compete with many domestic and international companies in the
global markets. The principal methods of competition in the markets in which we
compete are product specifications, performance, quality, knowledge, reputation,
technology, distribution capabilities, service and price.
INFLATION
Inflation had a negligible effect on our operations. We estimate that
inflationary effects, in the aggregate, were generally recovered or offset
through increased pricing or cost reductions in all periods presented.
KEY CUSTOMERS AND SUPPLIERS
We have multi-year contracts and arrangements in place with several of our
major customers and suppliers. These contracts and arrangements help us
effectively plan and manage our operations. Since the markets for our products
are dynamic, these contracts and arrangements are continually evolving as we are
sensitive to the changing needs of our customers and the ongoing performance of
our suppliers. There is no assurance, however, that these
15
contracts and arrangements will be renewed, will not be terminated prematurely
or revised to take into consideration the evolving nature of our relationships
with our customers and suppliers.
CAUTION CONCERNING FORWARD-LOOKING STATEMENTS
Because we want to provide shareholders with more meaningful and useful
information, this quarterly report contains statements relating to future events
and the predicted performance of CUNO Incorporated (the "Company", "CUNO", or
"we") which may constitute forward-looking statements, as defined under the
Private Securities Litigation Act. We have tried, wherever possible, to identify
these "forward looking" statements by using words such as "anticipate,"
"believe," "estimate," "expect" and similar expressions. These statements
reflect our current beliefs and are based on information currently available to
us. Accordingly, these statements are subject to risks and uncertainties which
could cause our actual results performance or achievements to differ materially
from those expressed in, or implied by, these statements. These risks and
uncertainties include the following: economic and political conditions in the
foreign countries in which we conduct a substantial part of our operations and
other risks associated with international operations including taxation
policies, credit risk, exchange rate fluctuations and the risk of expropriation;
our ability to protect our technology, proprietary products and manufacturing
techniques; volumes of shipments of our products, changes in our product mix and
product pricing; continuing beneficial relationships with customers; costs of
raw materials; the rate of economic and industry growth in the United States and
the other countries in which we conduct our business; changes in technology,
changes in legislative, regulatory or industrial requirements and risks
generally associated with new product introductions and applications; and
domestic and international competition in our global markets. We assume no
obligation to publicly release revisions to the forward-looking statements to
reflect new events or circumstances.
CRITICAL ACCOUNTING POLICIES
The Securities and Exchange Commission ("SEC") defines the most critical
accounting policies as the ones that are most important to the portrayal of a
company's financial condition and operating results, and require management to
make its most difficult, subjective or complex judgments, often as a result of
the need to make estimates about the effect of matters that are inherently
uncertain. Based on this definition, our most critical accounting policies
include: revenue recognition, accounting for depreciation and amortization,
employee benefits, contingencies, allowance for doubtful accounts, income taxes,
and stock based compensation. The methods, estimates and judgments we use in
applying these most critical accounting policies have a significant impact on
the results we report in our financial statements. There were no changes in
accounting policies or significant changes in accounting estimates during the
current period. All of our critical accounting policies and significant
estimates have been discussed with the Audit Committee of the Board of
Directors. We have not made any significant changes to our critical accounting
policies or estimates since year end.
Revenue Recognition -- We recognize revenue in accordance with SEC Staff
Accounting Bulletin No. 101 "Revenue Recognition" ("SAB 104"). SAB 104 requires
that four basic criteria be met before revenue can be recognized: 1) there is
evidence that an arrangement exists; 2) delivery has occurred; 3) the fee is
fixed or determinable; and 4) collectibility is reasonably assured. We recognize
revenue upon determination that all criteria for revenue recognition have been
met.
16
Depreciation and Amortization - We depreciate our property, plant and
equipment using the straight-line method over the estimated useful life of the
asset. These periods range as follows:
Land improvements 10 - 20 years
Buildings and additions 30 - 40 years
Machinery and equipment 5 - 20 years
We amortize our patents and other amortizable intangible assets
over their estimated useful lives. The straight line method of amortization is
used unless another method is more appropriate and reliable in reflecting the
pattern in which the asset provides economic benefits. These periods generally
range from 10 - 20 years.
We review the carrying values of intangibles and long-lived assets on an
annual basis. In addition, in the event that facts and circumstances indicate
that the carrying value of intangibles and long-lived assets or other assets may
be impaired at any other time, an evaluation is performed. Our evaluations
compare the estimated future undiscounted cash flows associated with the asset
to the asset's carrying amount.
Employee Benefits - We account for our pension plans in accordance with
SFAS No. 87, "Employer's Accounting for Pensions". In applying this accounting
practice, assumptions are made regarding the valuation of benefit obligations
and the performance of plan assets.
The primary assumptions are as follows:
- Weighted average discount rate - this rate is used to estimate the
current value of future benefits. This rate is adjusted based on
movements in long-term interest rates.
- Expected long-term rate of return on assets - this rate is used to
estimate future growth in investments and investment earnings. The
expected return is based upon a combination of historical market
performance and anticipated future returns for a portfolio
reflecting the mix of equity, debt and other investments indicative
of our plan assets.
- Rates of increase in compensation levels - this rate is used to
estimate projected annual pay increases, which are used to determine
the wage base used to project employees' pension benefits at
retirement.
We determine these assumptions based on consultations with our
outside actuaries and investment advisors. Any variance in the above assumptions
could have a significant impact on future recognized pension costs, assets and
obligations.
Contingencies, Claims and Assessments -- From time to time, we are
involved with contingencies, claims, and assessments. We use both in-house and
outside legal counsel to assess the probability of loss. The Company establishes
an accrual for specific contingencies, claims and assessments when both of the
following conditions are present: a loss is deemed probable and the amount of
the anticipated loss can be reasonably estimated. There can be no assurance that
the ultimate resolution of these contingencies, claims, and assessments will not
differ materially from our estimates.
Allowance for Bad Debts -- The allowance for doubtful accounts is
established to represent our best estimate of the net realizable value of the
outstanding accounts receivable balances. We estimate our allowance for doubtful
accounts based on past due amounts and historical write-off experience, as well
as trends and factors surrounding the credit risk of specific customers. In an
effort to identify adverse trends, we perform periodic credit evaluations of our
customers and ongoing account balance reviews and agings of receivables. Amounts
are considered past due when payment has not been received within the time frame
of the credit terms extended. Write-offs are charged directly against the
allowance for doubtful accounts and occur only after all collection efforts have
17
been exhausted. Actual write-offs and adjustments could differ from the
allowance estimates due to unanticipated changes in the business environment as
well as factors and risks surrounding specific customers.
Income Taxes - We estimate and use our expected annual effective income
tax rate to accrue income taxes on an interim basis. We update these estimates
quarterly. We record valuation allowances to reduce our deferred income tax
assets to an amount that we believe is more likely than not to be realized. We
consider estimated future taxable income and ongoing prudent and feasible tax
planning strategies in assessing the need for a valuation allowance. If we were
to determine that we will not realize all or part of our deferred income tax
assets in the future, we would make an adjustment to the carrying value of the
deferred income tax asset, which would be reflected as an income tax expense.
Conversely, if we were to determine that we will realize a deferred income tax
asset, which currently has a valuation allowance, we would reverse the valuation
allowance which would be reflected as an income tax benefit in our financial
statements.
We take tax positions in our worldwide corporate income tax filings based
on careful interpretations of global statutes, rules, regulations and court
decisions that may be applied and interpreted differently by various taxing
jurisdictions. These taxing jurisdictions may or may not challenge our
application and interpretation of a wide body of tax jurisprudence. However, we
do not anticipate that any sustained challenge by any taxing jurisdiction will
have a material adverse effect on our financial position or net income.
Stock Based Compensation - We currently account for our stock option
awards under the recognition and measurement principles of APB Opinion No. 25,
"Accounting for Stock Issued to Employees", and related interpretations. No
stock-based employee compensation cost pertaining to stock options is reflected
in net income, as all options granted under our plans had exercise prices equal
to the market value of the underlying common stock on the date of grant.
Restricted share grants awarded to employees are included in earnings as an
expense over the vesting period of the award.
RESULTS OF OPERATIONS
THREE MONTH PERIOD ENDED JULY 31, 2004 VS. THREE MONTH PERIOD ENDED JULY 31,
2003
OVERVIEW
During the third quarter of fiscal 2004, CUNO's sales and net income grew
by 20 percent and 15 percent, respectively. This growth was positively
influenced by the overall weakness of the U.S. dollar. U.S. sales were up 15
percent and were led by the potable water market. Overseas sales were likewise
very strong (up 20 percent in local currency), reflecting broad strength in the
potable water market and overall strong sales in Japan (up 40 percent in local
currency). Although our sales increased significantly, our margins decreased due
primarily to start-up costs associated with a new distribution agreement
involving potable water products with a major retailer. Our ongoing sales to
retailers within the potable water market and future sales attributable to our
recent acquisition of WTC Industries Inc. will generally carry lower gross
margins than historically reported.
Going forward, business and market uncertainties may affect results. See
"Company Risk Factors" above and Management's Discussion and Analysis in our
Annual Report on Form 10-K for the fiscal year ended October 31, 2003 for a full
discussion of the key factors which affect our business and operating results.
18
Below is a summary of selected consolidated earnings information:
THREE MONTHS ENDED
JULY 31,
2004 2003 CHANGE
-------- -------- -------
Net sales $89,945 $74,965 20.0%
Cost of products sold 50,275 41,088 22.4%
Gross profit 39,670 33,877 17.1%
Gross margin percent 44.1% 45.2% 110 bpt
Selling, general and administrative 22,539 18,826 19.7%
SG&A as a percent of sales 25.1% 25.1% --
Operating income 12,804 11,196 14.4%
Operating margin 14.2% 14.9% 70 bpt
Effective tax rate 33.3% 33.4% 10 bpt
Net income $ 8,603 $ 7,467 15.2%
Diluted earnings per share $ 0.50 $ 0.44 13.6%
BUSINESS ENVIRONMENT
Our geographic and market diversity help limit the impact of any one
market or the economy of any single country on our consolidated results. The
uncertainty of the economic conditions in various markets and geographic regions
in which we compete is likely to continue to present challenges to our business
near term. The U.S. Dollar was weaker compared to most of the currencies in
countries we conduct business in during the third quarter of 2004 compared to
the third quarter of 2003. We translate revenue and expense accounts at the
average exchange rates during the periods presented.
NET SALES
Net sales were $89.9 million in the third quarter of fiscal 2004
representing a 20.0 percent increase over 2003's third quarter sales of $75.0
million. This increase can generally be attributed to an increase in the unit
volume of worldwide sales. Had currency values been unchanged from the third
quarter of 2003, net sales in the third quarter of 2004 would have been $2.0
million lower than the reported sales of $89.9 million, or 17.3 percent greater
overall.
The following table displays the Company's sales by geographic segment:
THREE MONTHS ENDED CURRENCY
JULY 31, PERCENT ADJUSTED
2004 2003 CHANGE CHANGE
------- --------- ------- --------
North America $46,357 $ 40,386 14.8% 14.8%
Europe 16,560 14,465 14.5% 8.6%
Japan 13,168 8,778 50.0% 40.1%
Asia/Pacific 10,558 8,139 29.7% 24.2%
Latin America 3,302 3,197 3.3% 9.5%
------- --------- ---- ----
Total sales $89,945 $ 74,965 20.0% 17.3%
======= ========= ==== ====
19
North American sales increased 14.8 percent in the third quarter of 2004
as compared to the same quarter in 2003. The majority of this increase was
attributable to potable water and reflects sales related to a new, exclusive
distribution agreement with a major retailer. North American fluid processing
sales were up 17.5 percent, primarily reflecting the overall strengthening of
the U.S. economy during this period. North American healthcare sales increased
modestly due primarily to a reduction in diagnostic sales. European sales
increased 8.6 percent in local currency as compared to the same period in 2003.
Sales were generally strong in all European markets during the quarter. Sales in
Japan were up 40.1 percent in local currency, led by very strong sales growth of
food and beverage filters used in the healthcare market for filtration of summer
bottled drinks. Asia/Pacific sales were up 24.2 percent excluding changes in
currency values, primarily reflecting strong sales growth in the potable water
market in that region. Third quarter 2004 Latin American sales were up 9.5
percent when expressed in local currency, due primarily to new product sales
associated with a new customer in the potable water market, offset by more
moderate sales in the healthcare and fluid processing markets due to the
difficult economic environment in the region.
The following table displays the Company's sales by market:
THREE MONTHS ENDED CURRENCY
JULY 31, PERCENT ADJUSTED
2004 2003 CHANGE CHANGE
------- --------- ------- --------
Potable Water $42,471 $34,606 22.7% 22.0%
Fluid Processing 22,658 19,040 19.0% 14.8%
Healthcare 24,816 21,319 16.4% 12.1%
------- ------- ---- ----
Total sales $89,945 $74,965 20.0% 17.3%
======= ======= ==== ====
The strength in the potable water market was broad geographically, driven
largely by strong overseas sales (up 27.3 percent in local currency) and strong
sales growth in North America (up 20.7 percent) associated with OEM customers,
direct marketing companies, and appliance manufacturers. Fluid Processing sales
were up 17.5 percent in the U.S. due in part to the strong economy during the
period and were up 13.7 percent overseas on a local currency basis. Worldwide
healthcare sales were up 12.1 percent in local currency, reflecting broad
geographic strength, but down in the U.S. due to a reduction in diagnostic
sales.
GROSS PROFIT
Gross profit increased $5.8 million to $39.7 million in the third quarter
of 2004 from $33.9 million in the third quarter of 2003. Gross profit as a
percentage of net sales (gross margin) decreased during that same period from
45.2 percent in 2003 to 44.1 percent in 2004. This decrease is primarily
attributable to start-up costs associated with a new distribution agreement with
a major retailer within potable water and generally lower gross margins on sales
to retailers within the potable water market.
Although we are under pressure to maintain competitive prices with our
customers, we pursue various supply-chain management initiatives designed to
lower our production costs. In addition, we have ongoing programs to modernize
our manufacturing facilities to further gain efficiencies.
OPERATING EXPENSES
Selling, general and administrative expenses (SG&A) were up 19.7 percent,
comparable to the 20.0 percent sales growth rate in the quarter. Similarly, SG&A
expenses were unchanged as a percentage of sales - 25.1 percent of sales in both
the third quarter of fiscal 2004 and 2003. Because of CUNO's international
operations, the weaker U.S. dollar serves to increase the consolidated U.S.
dollar reported SG&A expense. In addition, increased structural costs (including
medical, pension, insurance and depreciation expenses) continue to impact our
overall SG&A expenses.
20
Research, development and engineering expenses (incurred primarily in the
U.S. and to a lesser extent in Europe) increased 12.2 percent to $4.3 million in
the third quarter of 2004, reflecting our continued focus on the development of
new products and technologies. In the third quarter of 2004, we received
approximately $0.1 million in RD&E cost reimbursements from a new customer.
Excluding this reimbursement, RD&E would have increased 15.7 percent. As a
percentage of sales, RD&E expenses were 5.0 percent of sales in the third
quarter of fiscal 2004 (adjusted for the reimbursement) compared to 5.1 percent
of sales in the third quarter of fiscal 2003.
OPERATING INCOME
As a result of the above, operating income increased $1.6 million, or 14.4
percent, to $12.8 million or 14.2 percent of sales in the third quarter of
fiscal 2004 compared to $11.2 million or 14.9 percent of sales in the third
quarter of 2003.
Our operating income by segment is detailed below:
THREE MONTHS ENDED
JULY 31, DOLLAR PERCENT
2004 2003 CHANGE CHANGE
------- -------- -------- -------
OPERATING INCOME:
North America $ 5,605 $ 6,716 ($1,111) (16.5%)
Europe 1,701 1,936 (235) (12.1%)
Japan 3,139 906 2,233 246.5%
Asia/Pacific 1,892 1,346 546 40.6%
Latin America 467 292 175 59.9%
------- ------- ------
Total $12,804 $11,196 $1,608 14.4%
------- ------- ------
The decrease in operating income in North America was driven by start-up
costs associated with a new distribution agreement with a major retailer within
potable water and a reduction in diagnostic sales (which generally carry higher
margins). The results of our foreign operations are heavily dependent on the
relationship of their functional currency compared to the U.S. Dollar. We
translate our foreign revenue and expense accounts into U.S. Dollars using the
average exchange rate for the period. European sales increased 8.6 percent on a
local currency basis, while the Euro strengthened approximately 5 percent
(average third quarter of 2004 versus average third quarter of 2003). However,
Europe's operating income fell by 12 percent due to higher SG&A expenses
associated with incremental advertising costs and increased staffing. Sales in
Japan were up 40.1 percent on a local currency basis, and the Yen strengthened 7
percent versus the U.S. Dollar quarter over quarter (allowing fixed costs to be
spread over a large sales base). Asia/Pacific sales were up 24.2 percent quarter
over quarter, and the Australian Dollar strengthened approximately 7 percent in
comparison (approximately 50 percent of our sales in the region are denominated
in Australian Dollars). Local currency sales in Latin America increased 9.5
percent and the Brazilian Real weakened approximately 6 percent quarter over
quarter - these factors helped to increase operating profit a modest $0.2
million.
INCOME TAXES
The Company's effective income tax rate for the third quarter of 2004 was
33.3 percent compared to 33.4 percent in the third quarter of 2003. Our tax rate
is impacted by the change in the mix of income attributed to the various
countries in which we do business. We expect our fourth quarter tax rate to
increase due to the non-deductible amortization of intangibles associated with
our August 2, 2004 acquisition of WTC Industries Inc. We have not completed our
valuation of intangibles related to this acquisition at this time.
As of July 31, 2004, the Company had a full valuation allowance against
approximately $1.1 and $0.3 million of NOLs in China and Germany, respectively.
Our China operations are start-up in nature with a history of
21
losses (no profit has been earned since inception in 2001) and our German
operation has incurred losses in three out of the past four fiscal years. The
remaining countries in which we carry valuation allowances against NOLs are
generally operations which are new to CUNO, have a history of losses, or are in
volatile economic regions of the world.
NINE MONTH PERIOD ENDED JULY 31, 2004 VS. NINE MONTH PERIOD ENDED JULY 31, 2003
OVERVIEW
During the first nine months of fiscal 2004, CUNO's sales and earnings
grew at a strong double-digit pace. This growth was favorably impacted by the
overall weakness of the U.S. Dollar and strong worldwide sales in the potable
water market (up 16.9 percent on a currency adjusted basis) and overseas sales
in general (up 12.9 percent). Our margins improved due primarily to the benefit
of incremental sales volume, offset in part by increased start-up costs
associated with a major new retail vendor within potable water in the latter
part of the period, increasing sales to retail establishments within potable
water (which generally carry lower margins) and increased structural costs such
as pension and depreciation. Our ongoing sales to retailers within the potable
water market and future sales attributable to our recent acquisition of WTC
Industries will generally carry lower gross margins than historically reported.
Going forward, business and market uncertainties may affect results. See
"Company Risk Factors" above and Management's Discussion and Analysis in our
Annual Report on Form 10-K for the fiscal year ended October 31, 2003 for a full
discussion of the key factors which affect our business and operating results.
Below is a summary of selected consolidated earnings information:
NINE MONTHS ENDED
JULY 31,
2004 2003 CHANGE
--------- --------- ------
Net sales $248,099 $210,707 17.7%
Cost of products sold 134,504 115,798 16.2%
Gross profit 113,595 94,909 19.7%
Gross margin percent 45.8% 45.0% 80 bpt
Selling, general and administrative 65,287 54,853 19.0%
SG&A as a percent of sales 26.3% 26.0% 30 bpt
Operating income 35,756 29,159 22.6%
Operating margin 14.4% 13.8% 60 bpt
Effective tax rate 33.3% 34.1% 80 bpt
Net income $ 24,052 $ 19,159 25.5%
Diluted earnings per share $ 1.41 $ 1.13 24.8%
BUSINESS ENVIRONMENT
Our geographic and market diversity helps limit the impact of any one
market or the economy of any single country on our consolidated results. The
uncertainty of the economic conditions in various markets and geographic regions
in which we compete is likely to continue to present challenges to our business
near term. The U.S. Dollar was weaker compared to most of the currencies in
countries we conduct business in during the first nine months of 2004 compared
to the first nine months of 2003. We translate revenue and expense accounts at
the average exchange rates during the periods presented.
22
NET SALES
Net sales were $248.1 million in the first nine months of fiscal 2004
representing a 17.7 percent increase over 2003's sales of $210.7 million. This
increase can generally be attributed to an increase in the unit volume of
worldwide sales. Had currency values been unchanged from the first nine months
of 2003, net sales in the first nine months of 2004 would have been $11.9
million lower than the reported sales of $248.1 million, or 12.1 percent greater
overall.
The following table displays the Company's sales by geographic segment:
NINE MONTHS ENDED CURRENCY
JULY 31, PERCENT ADJUSTED
2004 2003 CHANGE CHANGE
-------- -------- --------- ---------
North America $127,283 $114,273 11.4% 11.4%
Europe 46,516 38,520 20.8% 7.9%
Japan 33,897 25,345 33.7% 22.0%
Asia/Pacific 30,649 24,509 25.1% 12.0%
Latin America 9,754 8,060 21.0% 10.6%
-------- -------- ---- ----
Total sales $248,099 $210,707 17.7% 12.1%
======== ======== ==== ====
North American sales increased 11.4 percent in the first nine months of
2004 as compared to the same period in 2003. Stronger potable water market sales
were responsible for the majority of this growth in North America during this
time period. Potable water continues to achieve strong sales of its series of
filters designed for customers who serve various channels of distribution with
final sales to U.S. residential consumers. European sales increased 7.9 percent
in local currency as compared to the same period in 2003. Potable water sales
were particularly strong in the period reflecting greater demand for our
products serving the OEM and appliance markets. Sales in Japan were up 22.0
percent in local currency led by very strong sales growth of food and beverage
filters used in the healthcare market for filtration of summer bottled drinks as
well as increased fluid processing sales. Asia/Pacific sales were up 12.0
percent in local currency. Sales were especially strong in the fluid processing
and water markets in Asia. Latin American sales were up 10.6 percent when
expressed in local currency due primarily to new product sales associated with a
relatively new customer in the potable water market.
The following table displays the Company's sales by market:
NINE MONTHS ENDED CURRENCY
JULY 31, PERCENT ADJUSTED
2004 2003 CHANGE CHANGE
-------- -------- --------- --------
Potable Water $115,264 $ 96,301 19.7% 16.9%
Fluid Processing 64,072 55,117 16.2% 8.5%
Healthcare 68,763 59,289 16.0% 7.6%
-------- -------- ---- ----
Total sales $248,099 $210,707 17.7% 12.1%
======== ======== ==== ====
The strength in the potable water market was broad geographically, driven
largely by strong overseas sales (up 23.8 percent in local currency) and strong
sales growth in North America (up 15.3 percent) associated with OEM customers,
direct marketing companies, and appliance manufacturers. Fluid Processing sales
were up 8.9 percent in the U.S. and up 8.4 percent overseas on a local currency
basis. Healthcare sales were up 12.2 percent overseas on a local currency basis
but flat in the U.S. due primarily to a reduction in diagnostic sales.
GROSS PROFIT
23
Gross profit increased $18.7 million to $113.6 million in the first nine
months of 2004 from $94.9 million in the first nine months of 2003. Gross profit
as a percentage of net sales (gross margin) increased during that same period
from 45.0 percent in 2003 to 45.8 percent in 2004. This increase is primarily
attributable to the overall increase in the volume of sales (sales up 17.7
percent during the period), offset by start-up costs attributable to a new
retail customer within the potable water market.
Although we are under pressure to maintain competitive prices with our
customers, we pursue various supply-chain management initiatives designed to
lower our production costs. In addition, we have ongoing programs to modernize
our manufacturing facilities to further gain efficiencies.
OPERATING EXPENSES
Selling, general and administrative expenses (SG&A) were up 19.0 percent,
somewhat in excess of the 17.7 percent sales growth rate. Because of CUNO's
international operations, the weaker U.S. dollar served to increase the
consolidated U.S. dollar reported SG&A expense. SG&A expenses were 26.3 percent
of sales in the first nine months of 2004 compared to 26.0 percent of sales in
the first nine months of 2003. In addition, rising structural costs (such as
medical, pension, insurance and depreciation expenses) impacted overall SG&A
expenses. For example, pension expenses increased from $1.3 million in the first
nine months of 2003 to $2.3 million in the first nine months of 2004.
Research, development and engineering expenses (incurred primarily in the
US and to a lesser extent in Europe) increased 15.2 percent to $12.6 million in
the first nine months of 2004, reflecting our continued focus on the development
of new products and technologies. In the first nine months of 2004 and 2003, we
received approximately $0.4 million and $0.5 million, respectively, in RD&E cost
reimbursements from new customers. As a percentage of sales, RD&E expenses were
5.2 percent of sales in the first nine months of fiscal 2004 compared to 5.4
percent of sales in the first nine months of fiscal 2003 (both percentages
adjusted for reimbursements discussed above).
OPERATING INCOME
As a result of the above, operating income increased $6.6 million, or 22.6
percent, to $35.8 million or 14.4 percent of sales in the first nine months of
fiscal 2004 compared to $29.2 million or 13.8 percent of sales in the first nine
months of 2003.
Our operating income by segment is detailed below:
NINE MONTHS ENDED
JULY 31, DOLLAR PERCENT
2004 2003 CHANGE CHANGE
------- ------- ------ -------
OPERATING INCOME:
North America $18,682 $18,045 $ 637 3.5%
Europe 4,774 4,146 628 15.1%
Japan 5,645 2,393 3,252 135.9%
Asia/Pacific 5,504 3,686 1,818 49.3%
Latin America 1,151 889 262 29.5%
------- ------- ------
Total $35,756 $29,159 $6,597 22.6%
------- ------- ------
The increase in operating income in the U.S. was driven by the 11.4
percent increase in sales, offset by certain new customer start-up costs and
structural costs discussed above. The results of our foreign operations are
heavily dependent on the relationship of their functional currency compared to
the U.S. Dollar. We translate our foreign revenue and expense accounts into U.S.
Dollars using the average exchange rate for the period. European
24
sales increased 7.9 percent on a local currency basis, while the Euro
strengthened approximately 11 percent (average first nine months of 2004 versus
average first nine months of 2003) - these factors drove the increase in
Europe's operating income. Sales in Japan were up 22.0 percent on a local
currency basis, and the Yen strengthened versus the U.S. Dollar approximately 9
percent period over period. Asia/Pacific sales were up 12.0 percent on a local
currency basis, and the Australian Dollar strengthened approximately 17 percent
in comparison (approximately 50 percent of our sales in the region are
denominated in Australian Dollars). Local currency sales in Latin America
increased 10.6 percent and the Brazilian Real strengthened approximately 11
percent.
INCOME TAXES
The Company's effective income tax rate for the first nine months of 2004
was 33.3 percent compared to 34.1 percent in the first nine months of 2003. The
decrease in our effective tax rate was driven by the expanded availability and
utilization of certain state credits in the U. S. and foreign tax planning
initiatives. Also, our tax rate is impacted by the change in the mix of income
attributed to the various countries in which we do business. We expect our
fourth quarter tax rate to increase due to the non-deductible amortization of
intangibles associated with our August 2, 2004 acquisition of WTC Industries
Inc., although we have not completed our valuation of intangibles related to
this acquisition at this time.
As of July 31, 2004, the Company had a full valuation allowance against
approximately $1.1 and $0.3 million of NOLs in China and Germany, respectively.
Our China operations are start-up in nature with a history of losses (no profit
has been earned since inception in 2001) and our German operation has incurred
losses in three out of the past four fiscal years. The remaining countries in
which we carry valuation allowances against NOLs are generally operations which
are new to CUNO, have a history of losses, or are in volatile economic regions
of the world.
FINANCIAL POSITION AND LIQUIDITY
We assess liquidity in terms of the Company's ability to generate cash to
fund our operating and investing activities. Of particular importance to the
management of liquidity are cash flows generated by operating activities,
capital expenditure levels, and adequate bank financing alternatives.
We manage our worldwide cash requirements considering the cost
effectiveness of the funds available from the many subsidiaries through which we
conduct our business. We believe that our existing cash and cash equivalents
position ($54.0 million at July 31, 2004) and available sources of liquidity
(approximately $24.3 million of available, uncommitted, unused worldwide
short-term lines of credit) are sufficient to meet current and anticipated
requirements for the foreseeable future. We do not rely on commercial paper or
off-balance sheet financing arrangements for our liquidity needs nor do we have
any investments in special purpose entities ("SPEs"), or variable interest
entities ("VIEs").
On August 2, 2004 we completed our acquisition of WTC Industries, Inc. The
aggregate consideration paid was approximately $115 million (including all
transaction related fees and expenses). We also completed a variable-rate,
five-year $120 million revolving credit facility. We utilized $89 million from
this revolver to fund the costs of the aforementioned acquisition (remainder of
approximately $26 million was funded with available cash on hand).
We continue to invest in R&D to provide future sources of revenue through
the development of new products, as well as through additional uses for existing
products. Our efforts are spread across the various markets in which we compete,
with particular emphasis on new products and technologies in Healthcare and the
improvement in design and function of products within Potable Water. We consider
R&D and the development of new products and technologies an integral part of our
growth strategy and a core competence of the Company.
25
Likewise, we continue to invest in capital expenditures in order to expand
and modernize manufacturing facilities around the globe. We currently have plans
to expand manufacturing lines in Brazil, China, and Australia in order to meet
product demands around the globe. In addition, new manufacturing lines and
processes are being installed in the U.S. to benefit the potable water, fluid
processing, and healthcare markets.
A summary of Cash Flow section totals follows:
NINE MONTHS ENDED
JULY 31,
2004 2003
--------- ---------
CASH PROVIDED BY (USED FOR):
Operating activities $ 15,195 $ 15,626
Investing activities (19,274) (12,873)
Financing activities (89) (2,785)
Effect of exchange rate changes on cash and cash
equivalents 595 1,112
OPERATING ACTIVITIES
Net cash provided by operating activities decreased by $431 due primarily to: \
- Increased net income of $4,893 in 2004
- Increases in accounts receivable and inventories due to the overall
increase in sales
- An incremental $6,000 contribution to our US pension plans in the
first quarter of 2003
- Timing in the payments of accounts payable and accrued expenses
INVESTING ACTIVITIES
Net cash used for investing activities increased by $6,401 due primarily to:
- Increase in cash paid for acquisitions, net of cash acquired, of
$4,571
- Increase in capital expenditures of $856
FINANCING ACTIVITIES
Net cash used for financing activities decreased by $2,696 due primarily to:
- Decrease in net borrowings under short-term bank loans of $1,721 due
primarily to the timing of certain cash payments
- Decrease in long term debt payments in 2004 of $1,169
The effect of exchange rate changes on cash and cash equivalents decreased $517
due to the fact that the U.S. Dollar strengthened more during the nine months
ended July 31, 2004 compared to the nine months ended July 31, 2003.
Contractual Obligations and Commercial Commitments
Below is a table detailing, by maturity date, our Contractual Obligations
and Commercial Commitments as of October 31, 2003:
OBLIGATIONS AND
COMMITMENTS 2004 2005 2006 2007 2008 THEREAFTER
- ----------------- ------- ------- ------- ------ ------ ----------
Bank loans $11,804 $ -- $ -- $ -- $ -- $ --
Long-term debt 849 143 151 76 10 21
Operating leases 2,895 2,487 2,241 2,011 1,613 --
------- ------- ------- ------ ------ ----------
Total $15,548 $ 2,630 $ 2,392 $2,087 $1,623 $ 21
======= ======= ======= ====== ====== ==========
26
Also, see fiscal 2004 changes in bank loans and long-term debt detailed on
the Consolidated Statements of Cash Flows for the nine months ended July 31,
2004. On August 2, 2004 we completed our acquisition of WTC Industries, Inc. The
aggregate consideration paid was approximately $115 million (including all
acquisition related fees and expenses). We also completed a variable-rate,
unsecured, five-year $120 million unsecured, revolving credit facility. We
utilized $89 million from this revolver to help fund the costs of the
aforementioned acquisition (remainder of approximately $26 million was funded
with available cash on hand).
We had no material qualifying long-term purchase obligations at October
31, 2003 and through the interim period in 2004. Our U.S. pension plans require
no minimum amount of funding in 2004. We plan to contribute approximately $971
to our Japanese pension plan in fiscal 2004.
During the second quarter of fiscal 2004, we entered into a new, exclusive
distribution agreement with a major retailer. Inclusive with this agreement is a
requirement to buy-back certain non-CUNO inventory over the remainder of fiscal
2004. The amount of inventory that we will be required to buy back is based on
future levels of such inventory on hand at the time the customer receives the
first shipment of CUNO manufactured product. In the third quarter of 2004, we
purchased approximately $250 (net realizable value) of inventory in connection
with this agreement. Additional future amounts of this purchase commitment are
not reasonably estimable; furthermore, the fair market value of certain
purchased inventory may be below the actual price paid by the Company at the
time of purchase. In addition, we expect to spend approximately $1,000 during
fiscal 2004 to install in-store promotional kiosks to promote these products. Of
this amount, approximately $642 has been spent as of July 31, 2004.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The overall objective of our financial risk management program is to seek
a reduction in the potential negative earnings effects from changes in foreign
exchange and interest rates arising from business activities. We manage these
financial exposures through operational means and by utilizing available
financial instruments. Practices may change as economic conditions change.
Foreign Currency Risk
Our earnings and cash flows are subject to fluctuations due to changes in
foreign currency exchange rates. We utilize forward foreign exchange contracts
to hedge specific exposures relating to intercompany payments, certain firm
sales commitments and anticipated, but not yet committed, intercompany sales
(primarily parent company export sales to subsidiaries at pre-established U.S.
dollar prices) and other specific and identified exposures. The terms of the
forward foreign exchange contracts are generally matched to the underlying
transaction being hedged, and are typically under one year.
Because such contracts are directly associated with identified
transactions, they are an effective hedge against fluctuations in the value of
the foreign currency underlying the transaction. All of our foreign exchange
contracts are accounted for at fair value based on readily available market
price quotations. We generally do not hedge overseas sales denominated in
foreign currencies or translation exposures. Further, we do not enter into
financial instruments for speculation or trading purposes.
We utilize bank loans and other debt instruments throughout our worldwide
operations. To mitigate foreign currency risk, such debt is generally
denominated in the underlying local currency of the affiliate. In certain
limited and specific circumstances, we will manage risk by denominating a
portion of debt outstanding in a currency other than the local currency.
ITEM 4. CONTROLS AND PROCEDURES
27
(a) Our chief executive officer and chief financial officer performed an
evaluation of our disclosure controls and procedures as of July 31, 2004 (the
"Evaluation Date"). Based on that evaluation, our chief executive officer and
chief financial officer concluded that our disclosure controls and procedures
were effective and sufficient to ensure that the information required to be
disclosed in the reports that we file under the Securities Exchange Act of 1934
is recorded, processed, summarized, and reported within the time periods
specified in the SEC's rules and forms.
(b) There have been no significant changes in our internal controls since
the Evaluation Date. We are not aware of any significant change in any other
factors that could significantly affect our internal controls subsequent to the
Evaluation Date.
28
PART II
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report.
Exhibit 31.1 - Certification of Mark G. Kachur pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
Exhibit 31.2 - Certification of Frederick C. Flynn, Jr. pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002
Exhibit 32.1 - Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
Exhibit 32.2 - Certification Pursuant to 18 U.S.C. Section 1350, as
Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
We filed a Report on Form 8-K, dated May 19, 2004, under "Item 7 --
Financial Statements and Exhibits," reporting our financial results for
the quarter ended April 30, 2004.
We filed a Report on Form 8-K, dated May 26, 2004, under "Item 5 --
Other Events" reporting that we signed a definitive merger agreement to
acquire WTC Industries.
We filed a Report on Form 8-K, dated May 27, 2004, under "Item 12 --
Other Information" to release supplemental information pertaining to our
recent agreement to acquire WTC Industries. This information was made
available on our website and was referred to in our press release dated
May 26, 2004 disclosing the merger agreement and the public conference
call on May 27, 2004 discussing the merger agreement.
We filed a Report on Form 8-K, dated August 2, 2004, under "Item 2 -
Acquisition or Disposition of Assets" reporting that we completed our
acquisition of WTC Industries.
(c) Material Contracts
10.31 Revolving Credit Agreement
29
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.
CUNO INCORPORATED
Date August 25, 2004
By /s/Mark G. Kachur
---------------------
Mark G. Kachur
Chairman of the Board of Directors,
President and Chief Executive Officer
By /s/ Frederick C. Flynn, Jr.
---------------------------
Frederick C. Flynn, Jr.
Senior Vice President -
Finance and Administration,
Chief Financial Officer and Assistant Secretary
30