August 23, 2006
United States Securities and Exchange Commission
Division of Corporate Finance
100 F Street, N.E., Mail Stop 7010
Washington, DC 20549-7010
Attn: Ms. Nili Shah, Accounting Branch Chief
RE: Tecumseh Products Company
Form 10-K for the Fiscal Year Ended December 31, 2005
Filed March 15, 2006
Form 10-Q for the Fiscal Quarter Ended March 31, 2006
File No. 0-452
Dear Ms. Shah:
This letter is in response to your comment letter dated July 26, 2006, addressed
to Mr. Todd W. Herrick, Chief Executive Officer of Tecumseh Products Company.
Your comments are reproduced below, followed in each case by Tecumseh's response
in italics.
Form 10-K for the year ended December 31, 2005
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations, page 23 of annual report
Adequacy of Liquidity Sources, page 35 of annual report
1. We note that you were required to amend your debt covenants for your
Senior Guaranteed Notes and your Revolving Credit Facility for your
quarters ended June 30, 2005 and September 30, 2005 to lessen the debt
covenants. We further note that you defaulted on your amended debt
covenants for the quarter ended December 31, 2005 due to continued
deterioration of your operating results. To cure the default, you
refinanced your debt instruments on February 3, 2006. As such, in
future filings please include your EBITDA and fixed charge coverage
amounts compared to the debt covenant requirements for the most recent
period presented, unless management believes that the likelihood of
default is remote. See Section 501.03 of the Financial Reporting
Codification. You should also state whether or not you are in
compliance with your debt covenants for the most recent period and
whether you will be able to cure the default that occurred as of
December 31, 2005 with the less restrictive debt covenants within the
next 12 months. Refer to EITF 86-30 and SFAS 78 for guidance. Finally,
please state the amount available under your credit agreements that
would not result in a violation of your debt covenants.
Response to SEC Letter of July 26, 2006
Page 2 of 29
ANSWER: The Company agrees that the suggested disclosures of
identifying the specific amounts of the covenants under our debt
arrangements and available borrowing would be useful disclosures and
have included such disclosures in the June 30, 2006 Form 10-Q and will
include such disclosures in our future filings. The Company has also
stated that we are in compliance with all covenants at June 30, 2006,
and discussed future expected compliance or events that could lead to
non-compliance. As well, as a matter of record, the amounts of the
covenants were included in the credit agreements that were filed as
Exhibits in the 2005 Form 10-K and in the Current Report on Form 8-K
filed February 9, 2006.
We would also like to provide further clarification of the language
included in the Form 10-K for the year ended December 31, 2005. It
would have been more accurate to indicate that "the further
deterioration of results in the fourth quarter resulted in projections
that the Company would be in violation of the amended EBITDA covenant;
therefore, the Company sought alternative financing which was
successfully obtained on February 3, 2006."
The new debt agreements replaced the old debt and had less restrictive
covenants for which management projected future compliance at the
compliance date three months after the balance sheet date as required
by EITF 86-30. With the replacement of the debt, the need to cure the
violation of the covenants associated with the previous financing
arrangement was no longer necessary.
Off-Balance Sheet Arrangements and Aggregate Contractual Obligations, page 36 of
annual report
2. In future filings, please revise your table of contractual obligations
as follows:
- To increase transparency of cash flow, please include scheduled
interest payments in your table. To the extent that the interest
rates are variable and unknown, you may use your judgment to
determine whether or not to include estimates of future variable
rate interest payments in the table or in a footnote to the
table. Regardless of whether you decide to include variable rate
estimated interest payments in the table or in a footnote, you
should provide appropriate disclosure with respect to your
assumptions.
- To the extent that you are in the position of paying cash rather
than receiving cash under your interest rate swaps, please
disclose estimates of the amounts you will be obligated to pay.
ANSWER: We agree with the staff's comments and will include such
disclosures in the Company's Annual Report on Form 10-K for the year
ended December 31, 2006.
Response to SEC Letter of July 26, 2006
Page 3 of 29
Note 1. Accounting Policies, page 49 of annual report
3. We note that you use the US dollar as the functional currency at
certain Mexican operations. If material, please tell us your
consideration of each of the indicators listed in Appendix A of SFAS
52 in determining that the functional currency of these operations is
the US dollar. If you have determined that these operations are not
material, please provide us with your analysis of the quantitative and
qualitative factors in SAB 99. Your quantitative analysis should
consider the materiality of the revenue, operating income, net income,
assets, and liabilities of these operations.
ANSWER: The Company operates two production facilities for the
Electrical Components group in Mexico. One is located in Juarez and
the other in Piedras Negras. Both of the operations are Maquiladora
operations that assemble components that are manufactured elsewhere
both inside and outside of the Company. Neither operation has external
sales; accordingly, the best measure of their relative size is total
assets. Total assets at December 31, 2005 were $25.2 million and $19.7
million for Juarez and Piedras Negras, respectively, and represented
1.4% and 1.1% of total assets of the Company respectively.
The Company assessed the appropriate functional currency for these
operations in accordance with the guidance of SFAS 52, Appendix A.
Pursuant to Appendix A, an entity's functional currency is the
currency of the primary economic environment in which the entity
operates; normally, that is the currency of the environment in which
an entity primarily generates and expends cash. (Appendix A, par. 39).
As part of the Company's analysis, the following considerations were
evaluated in determining that the functional currency of the two
Mexican operations was the U.S. dollar.
A. Cash flow and financing indicators
The cash from customers for sales made by the parent is received
in the Company's U.S. bank accounts and cash disbursements,
except for labor and other minor plant operating costs, which are
paid in U.S. dollars from the Company's U.S. bank accounts. Labor
and local cost components represent less than 35% of the total
cost of the product as the most significant cost is in materials
that are purchased by the U.S. parent in U.S. dollars. The
operations do not have independent financing arrangements and
receive their funding from the U.S. parent entity.
B. Sales price and sales market indicators
The operations do not have independent sales and maintain no
sales forces. The majority of products are sold in the U.S. after
being transferred back to a Tecumseh U.S. business unit. All such
transactions, including the transfer of parts to the plant and
the return of finished goods, are denominated in U.S. dollars.
Response to SEC Letter of July 26, 2006
Page 4 of 29
C. Expense indicators
Labor and local cost components represent less than 35% of the
total cost of the product as the most significant cost is in
materials that are purchased by the U.S. parent in U.S. dollars.
D. Intercompany transactions and arrangement indicators
The operations do not have independent financing arrangements and
receive their funding from the U.S. parent entities. There are
significant intercompany sales and purchases that are denominated
in U.S. dollars.
Based upon the factors considered in accordance with the guidance
provided in SFAS 52 Appendix A, the Company has concluded that the
U.S. dollar is the appropriate functional currency for the Mexican
operations.
4. It appears that you have investments in equity and debt securities
that are within the scope of SFAS 115. It does not appear that you
have stated your accounting policy for such instruments. Please tell
us why you do not believe such disclosures, as well as those included
in paragraphs 19-22 of SFAS 115, are required. If you decide you are
required to state your policy for accounting for these investments,
please provide us with the disclosure you intend to include in future
filings.
ANSWER: The Company, from time to time, may have securities that fall
within the scope of SFAS 115. The line item "Unrealized gain (loss) on
investment holdings" disclosed in Note 2 represents the accounting for
the unrealized gains/losses associated with a single investment in the
stock of Kulthorn Kirby Public Company Limited. The investment was
originally made in 1979 in a non-public predecessor company. In 1991,
Kulthorn Kirby became a public company that was thinly traded on the
Thai Stock Exchange. The Company sold its shares in the first quarter
of 2006 to other investors who maintain a business relationship with,
or investments in, Kulthorn Kirby. Given the materiality of the
investment to the consolidated balance sheet ($1.1 million initial
investment), and the fact that the Company, as a matter of policy,
does not invest in marketable securities, we did not include
disclosures of the Company's investment policy and other disclosures
required by SFAS 115.
As the Company does not currently hold, nor does it intend to hold
securities that meet the definition of a marketable equity or debt
security as defined in SFAS 115, the Company does not believe
additional disclosure is warranted but would include such disclosure
should material investments subject to SFAS 115 exist in the future.
Response to SEC Letter of July 26, 2006
Page 5 of 29
Note 4. Goodwill and Other Intangible Assets, page 55 of annual report
5. We note that in the second quarter of fiscal year 2005, you recognized
a goodwill impairment charge of $108 million for your FASCO reporting
unit, which is part of your Electrical Components reportable segment.
There is a concern that investors may have been surprised by this
charge, which is 13.3% of total stockholders' equity as of December
31, 2005 and 61.8% of fiscal year 2005 operating loss. Item 303 of
Regulation S-K requires MD&A disclosure of material uncertainties
unless management has concluded that the uncertainty is not reasonably
likely to materially impact future operating results. Potential asset
write-offs are, inherently, uncertainties over the recoverability of
recorded assets and may require specific disclosure prior to the
period of the impairment charge. See the guidance in Sections 501.02
and 501.12.b.3 of the Financial Reporting Codification, as well as in
SAB Topic 5:P.4. Also, Section 216 of the Financial Reporting
Codification states that "registrants have an obligation to forewarn
public investors of the deteriorating conditions which, unless
reversed, may result in a subsequent write-off. This includes an
obligation to provide information regarding the magnitude of exposure
to loss."
In reading your prior disclosures, there does not appear to be any
disclosure regarding the implications of adverse events and/or
underperformance in the Electrical Components reportable segment.
Specifically, in your Form 10-K filed on March 16, 2005, you note that
the lower results were partly due to the Electrical Components
segment. However, the following discussion appears to indicate that
the lower results are due to a need to restructure older operations.
During fiscal year 2004 through the first quarter of fiscal year 2005,
you did engage in restructuring/plant closures activities in an effort
to address the operational difficulties Electrical Components may have
been having. From your discussion in "outlook" in this Form 10-K, you
state your expectation that the Electrical Components results will
improve due to "lower amortization of intangible assets, the benefits
of 2004 restructuring activities, and higher selling prices." This
disclosure may indicate to an investor that management has no
uncertainties with regards to the recoverability of Electrical
Components' long-lived assets, considering the lack of disclosure
stating otherwise. Finally, your Critical Accounting Policies and
Estimates do not include any disclosure with regards to the amount of
headroom between the estimated fair value and the carrying value of
your reporting units. The lack of disclosure may indicate to an
investor that the estimated fair value of the reporting unit exceeds
the carrying value in a sufficient amount that goodwill impairment is
not reasonably possible.
In your Form 10-Q filed on May 6, 2005, you do note, "[t]he results
for the quarter within certain of our businesses were below the
forecasts utilized in testing goodwill for impairment at December 31,
2004. While the Company expects results in the second quarter to
continue to lag those forecasts, it is the forecasted results for the
second half of the year and subsequent years that remain key to the
Company's impairment test." While this disclosure notifies an investor
of a potential uncertainty, the disclosure does not provide investors
with any sense of which reporting units are at risk for the goodwill
impairment. In the "Outlook" section you also state, "Improvements are
expected in the second half of the year compared to the prior year
based upon more aggressive cost cutting, particularly in the Engine &
Power Train and Electrical Components businesses."
Response to SEC Letter of July 26, 2006
Page 6 of 29
Please clarify for us why there apparently was no specific, prior
disclosure regarding a material uncertainty over the recoverability of
the Electrical Components reportable segment and/or FASCO reporting
unit goodwill asset. Describe the specific factors considered by
management at May 6, 2005 in assessing the likelihood of future
goodwill impairment.
ANSWER: The Electrical Components segment was formed at December 31,
2002 concurrent with the acquisition of FASCO Motors Group ("FASCO").
As more fully described in the response to Staff Comment No. 6, for
the years ended December 31, 2004 and 2003, the Company's estimate of
fair value for this segment exceeded its carrying value by
approximately $37 million and $159 million, respectively. This segment
was generating positive operating profits and substantial cash flows
in 2004 and 2003, and although reported 2004 operating profit was
below 2003, the cash flows and business prospects appeared to support
the carrying value of the segment including the substantial amount of
goodwill associated with the segment (goodwill approximated 50% of the
segment's book value at December 31, 2004 and 2003).
Accordingly, although results in 2004 were below 2003 for the
Electrical Components segment, management did not believe at the time
of the filing of the Form 10-K for the year ended December 31, 2004
that conditions would continue to deteriorate such that in 2005, the
third year after the acquisition of FASCO, a material impairment of
goodwill would become apparent. Sales were relatively flat compared to
2003, after a significant decline from pre-acquisition levels, and the
segment's management plan for 2005 demonstrated an expectation of
sales growth. In addition, the margin decline experienced in 2004 from
2003, which was largely attributable to the rising costs of copper and
non-recurring costs associated with a product design change for an
automotive customer, was expected to improve based upon announced
price increases and expected cost improvements from the restructuring
activities.
At March 31, 2005, reported sales for this segment of $100.2 million
and operating loss of $1.1 million were well below the three months
ended March 31, 2004 by $6.8 million and $4.5 million, respectively.
The disclosed reasons in MD&A for the decline in operating income were
"lower sales volumes, higher commodity costs in excess of pricing
recoveries, and unanticipated operational inefficiencies related to
the closure of the St. Clair facility, partially offset by lower
amortization of intangible assets". Given that the December 31, 2004
annual goodwill assessment indicated that the estimated fair value of
the segment exceeded book value by $36.9 million, management did not
believe the cash flow associated with the $4.5 million decline in
operating profit indicated an impairment at March 31, 2005,
particularly because some of the factors for the decline appeared to
be temporary. Management of the operating unit believed that a
significant portion of the sales decline was due to timing of sales in
advance of price increases, and other sales being delayed into later
quarters. However, given the possibility that the change could be
other than timing or temporary, we considered it appropriate to
provide more disclosure regarding the potential impairment of FASCO's
goodwill in footnote 5 of the Quarterly Report on Form 10-Q for the
three months ended March 31, 2005 as follows:
Response to SEC Letter of July 26, 2006
Page 7 of 29
The results for the quarter within certain of our business units
were below the forecasts utilized in testing goodwill for
impairment at December 31, 2004. While the Company expects
results in the second half of the year and subsequent years to
lag those forecasts, it is the forecasted results for the second
half of the year and the subsequent years that remain key to the
Company's impairment test. While management does not believe the
business decline experienced during the first quarter will have
permanence which would represent a triggering event for interim
evaluation of the recoverability of goodwill, further
deterioration of results below forecasts for the second quarter
may require the Company to conduct an impairment test during the
second quarter 2005 (outside of the annual testing date of
December 31) with a better view of the Company's cost cutting
activities, pricing actions, and possibly revised discount rates.
While the Company has not begun any further impairment testing at
this time, an impairment could result during the second quarter
of 2005, if such an analysis is warranted. It is not reasonably
possible to estimate the amount of impairment, if any; however,
such loss could be material."
The Company believes this first quarter 2005 disclosure notifies the
investor of a potential uncertainty to goodwill, of which as disclosed
in Note 5, the Electrical Components segment comprised approximately
90% of the total.
6. There is a concern about whether the disclosures in your fiscal year
2005 Form 10-K fully explain the goodwill impairment charge.
Specifically, you attribute the need for an interim impairment test to
the failure to achieve the business plan for two consecutive quarters
and expected future market conditions. You also state that the
impairment at the FASCO reporting unit is due to the deterioration of
volumes and inability to recover higher commodity and transportation
costs through price increases. Given that the impairment charge
eliminated approximately 13% of your stockholders equity balance as of
December 31, 2005, substantive and informative disclosure is required
that clearly identifies the specific facts and circumstances that
caused management to change its cash flow forecasts and recognize the
impairment charge. In this regard, we note the requirements of
paragraph 47.a. of SFAS 142 and Sections 501.12.b.4 and 501.14 of the
Financial Reporting Codification. At a minimum, such disclosure should
clarify/address the following:
A. Please clarify when the deterioration of volumes and FASCO's
inability to recover higher commodity and transportation
costs through price increases developed. Given the lack of
disclosure regarding these events and the uncertainty of the
recoverability of FASCO's assets in your 2004 Form 10-K, it
is unclear whether these events are specific to the first
half of 2005 or have been developing over time.
ANSWER: The deterioration of FASCO's overall volumes was not evident
until the second quarter of 2005. Fourth quarter 2004 sales in dollars
had exceeded 2003 fourth quarter sales by $0.7 million. However, after
further analysis of the first quarter 2005 results, we realized that
some of the FASCO's fourth quarter 2004 sales were the result of
customers buying ahead of price increases scheduled to go into effect
on January 1, 2005. In addition, copper, which is a significant input
into the production of an electric motor, had risen steadily during
2004 and into 2005 as noted in the following table of spot prices.
Response to SEC Letter of July 26, 2006
Page 8 of 29
(In $ per cwt. Source: American Metal Market - AMM Market Guide).
Copper
------
January 1, 2004 104.30
April 1, 2004 137.10
July 1, 2004 120.50
October 1, 2004 140.00
January 1, 2005 148.70
April 1, 2005 151.05
July 1, 2005 155.35
As illustrated, copper commodity price increases were impacting this
unit and FASCO experienced significant resistance from some of its
customers in passing along its price increases. During the second
quarter of 2005, we concluded that certain conditions could no longer
be assumed to be temporary with respect to our long range
expectations. Specifically, commodity prices continued to grow to
unprecedented levels, and despite proposed price increases, those
price increases could not be utilized indefinitely to maintain
margins. Note that the Company initially expected the price of copper
to return to levels consistent with 2004 during 2005. Further, it
became apparent that the pricing of Asian produced products was not
keeping pace with the rate of commodity cost increases. In addition,
the Company saw additional sales declines in the second quarter of
2005 in the automotive market due to a weakening in the overall market
conditions in this segment. The Company also concluded that certain of
the declines experienced in the gear motor business that were expected
to be temporary would likely be permanent. Finally, new sales that
were expected to produce sales growth, or at least be offsets to other
declines, did not materialize when the products could no longer meet
customer price targets given the escalation in commodity costs. As a
result, the Company utilized lower sales and margin assumptions over
the duration of the projected cash flow model in assessing impairment
at June 30, 2005.
As noted in the response to Staff Comment No.5, the Company's estimate
of fair value for this segment exceeded its carrying value by
approximately $37 million and $159 million at December 31, 2004 and
2003, respectively. The Electrical Components segment was generating
positive operating profits and substantial cash flows in 2004 and
2003, and although reported 2004 operating profit was below 2003, the
cash flows and business prospects appeared to support the carrying
value of the segment including the substantial amount of goodwill
associated with the segment (goodwill approximated 50% of the
segment's book value at December 31, 2004 and 2003).
Response to SEC Letter of July 26, 2006
Page 9 of 29
Accordingly, although results in 2004 were below 2003 for the
Electrical Components segment, management did not believe at the time
of the filing of the Form 10-K for the year ended December 31, 2004
that conditions would continue to deteriorate such that in 2005, the
third year after the acquisition of FASCO, a material impairment of
goodwill would become apparent. It was the more rapid change in
conditions which culminated in the second quarter of 2005 that
necessitated the reevaluation of the projected cash flow model that
ultimately drove the impairment conclusion.
B. Your recognition of a goodwill impairment charge during the
quarter ended June 30, 2005, appears inconsistent with your
disclosures in other filings. You state that the failure to
achieve the business plan for two consecutive quarters
resulted in the need for a SFAS 142 impairment test.
However, your first quarter 2005 Form 10-Q disclosures
suggest that you already anticipated this failure.
Specifically, in your first quarter 2005 Form 10-Q, you
provided guidance that the Electrical Components segment was
not going to achieve the business plan for the second
quarter of fiscal 2005, but that your second half of fiscal
2005 and thereafter were key to your impairment tests as of
December 31, 2004. Accordingly, please clarify the specific
events that developed in the quarter ended June 30, 2005 to
trigger the SFAS 142 impairment test. Also, what were the
specific changes in market conditions that you identified in
the second quarter of 2005 that are expected to occur going
forward that would significantly change your forecasted cash
flows for FASCO? Compliance with the guidance in paragraph
28 of SFAS 142 should be clearly evident.
ANSWER: While more specific information is provided in
responses to the staff's questions under other bullet
points, the Company did not believe that its projected
shortfall of second quarter results at March 31, 2005 would
necessarily create a triggering event. At March 31, 2005,
the Company believed that the factors it was experiencing
that led to lower sales and margins would be temporary in
nature over the life of the model used to project discounted
cash flows. We believed that the factors were temporary, and
we expected that successful actions such as pricing changes,
cost reductions and new sales would place the business back
on track with its longer range projections. The disclosure
indicated that in transitioning back to expected long range
results, the second quarter would still lag, but that by the
time we reached later quarters such results would be
expected to be back on track. In Note 5, "Goodwill and Other
Intangible Assets" from our Form 10-Q dated March 31, 2005,
we tried to identify that it is the assessment of
"permanence" that is the triggering event and not merely the
level of second quarter results. Specifically, we stated
that "further deterioration of results below revised
forecasts for the second quarter may require the Company to
conduct an impairment test in the second quarter."
Accordingly, the reason for the impairment charge at June
30, 2005 was the realization that some of these factors were
in fact more permanent in nature than previously thought and
therefore had to be reflected in all future periods of the
discounted cash flow model. The reason for the triggering of
the assessment at June 30, 2005, was not that second quarter
results lagged our original projections (those used to
measure potential impairment at December 31, 2004), but that
the second quarter results lagged our revised expectation
established at March 31, 2005 as we had warned. Had second
quarter results been in line with these March 31, 2005
expectations, which were below the December 31, 2004
expectations for the second quarter, then we would have been
able to conclude that the factors were indeed temporary and
that the transition back to originally expected profit
levels was underway.
Response to SEC Letter of July 26, 2006
Page 10 of 29
C. How is a downward adjustment in forecasted cash flows
consistent with your disclosures that Electrical Components'
results were expected to improve in the second half of the
year? While your second quarter of fiscal year 2005 Form
10-Q does not provide any expectations regarding the future
results of Electrical Components segment, you do note in
your fiscal year 2005 Form 10-K that Electrical Components
has demonstrated monthly year over year improvement since
August 2005 and is expected to continue.
ANSWER: The Electrical Components group had declining
results when compared to prior year periods in the third and
fourth quarters of 2004, due to the factors cited in the
2004 10-K. In particular, several of those factors were
considered temporary. For example, price increases that were
being implemented were expected to improve margins that had
shrunk as a result of the escalating cost of commodities. In
the first and second quarters of 2005 results fell short of
the expectations due to the factors noted above. Despite
results falling short of plan in the first half of year, the
Company still expected the segment results in the latter
half of 2005 to exceed those of 2004 when they had been
depressed by escalating commodity prices. However, even
though improvement was expected in year over year results in
the second half of the year, those improvements were less
than expected at the beginning of 2005 due to the factors
experienced in the first half of 2005. Stated more simply,
second half 2005 results were better than prior year but
still short of the expectations reflected in the December
31, 2004 evaluation of goodwill.
D. The revised forecasts of June 30, 2005 that resulted in the
goodwill impairment charge appear inconsistent with the
Electrical Components segment's performance. Specifically,
the SFAS 131 footnote disclosure in your 2005 Form 10-K only
reflects a 3% decrease in Electrical Components' external
sales from 2003 to 2005. Further, the Electrical Components
segment generated operating income for each of the three
years ended December 31, 2005. Further, although Electrical
Components incurred a $1.1 million operating loss in the
quarter immediately preceding the goodwill impairment
charge, it generated operating profit of $0.2 million for
the quarter in which the charge was recognized and $4.8
million in the quarter subsequent to the charge. Based on
the Electrical Components operating results and related
disclosures within MD&A, it is not obvious why $108 million
of goodwill was found to be impaired as of June 30, 2005.
Response to SEC Letter of July 26, 2006
Page 11 of 29
ANSWER: The staff has noted that operating income in the
quarter preceding the impairment was a loss of $1.1 million,
while the quarter in which the impairment was recorded was
income of $0.2 million. Some of the change in sequential
quarter over quarter profitability was due to seasonal
factors and not solely due to fundamental changes in
profitability levels. In addition, while the Electrical
Components group generated operating income for the three
years ended December 31, 2005, such income, while positive,
was not of sufficient size to ultimately support the
carrying value of the goodwill when the Company, using its
best judgment, reflected current operating conditions at
June 30, 2005 into its long range projections.
While sales only declined 3% when comparing 2005 to 2003, it
is important to note the performance of sales in the first
quarter and first six months of 2005 in comparison to both
the prior year and with respect to the goodwill impairment
projections / management budget. At the first quarter, sales
were 6.4% below the prior year and in the second quarter
2.7% below the prior year, and in both cases below budget by
a greater amount. Additionally, unit volumes declined by
more than 3% but were mitigated in dollar terms by increases
due to currency translation.
At March 31, 2005 the extent to which the sales shortfall
might be permanent versus temporary was not clear due to
cited factors such as the unanticipated drop in sales
volumes in reaction to price increases. It was at this point
when we felt it would be necessary to warn readers that
results fell short of projections used to value goodwill.
However, until such time as we could judge whether such
volume declines were more than just temporary, we were not
prepared to adjust our longer term expectation of sales in
the goodwill impairment projection. As noted above, we
believed at that time that comparison of actual second
quarter results to our revised projections for that quarter
would help us decide whether 1) we had reached a triggering
event, and 2) whether such factors affecting profitability
had a greater amount of permanence.
E. What were the significant, critical accounting assumptions
that differed between the impairment tests conducted at
December 31, 2004 and at June 30, 2005 for FASCO that
resulted in an impairment charge of $108 million? What was
the basis for the changes in these assumptions? Quantify the
material growth rate, discount rate, and historical and
forecast cash flow measures that supported the FASCO
reporting unit goodwill impairment tests completed at each
date.
ANSWER: We conducted our test for goodwill impairment at
December 31, 2004 in accordance with our policies and
methodologies and used Strategic Business Unit management
business plans and projections as the basis for expected
future cash flows. In evaluating such business plans for
reasonableness in the context of their use for predicting
discounted cash flows in our impairment model, we evaluated
whether there was a reasonable basis for differences between
actual results of the preceding year and projected results
for the upcoming years. In evaluating these projected cash
flows, we used our best judgment to separate which factors
were permanent versus temporary. For example, during 2004,
the cost of copper had escalated by 42.6% when compared to
the price at January 1, 2004. The
Response to SEC Letter of July 26, 2006
Page 12 of 29
Electrical Components Group had maintained very few hedges
with respect to copper through forward purchase contracts.
Thus, as the cost of copper rose throughout 2004, the group
was at a competitive disadvantage in comparison to those
companies that had purchased copper forwards. In evaluating
the subsequent year it was reasonable to assume that other
competitors' forward purchases would expire and higher
pricing would be available in the market. The trend in sales
volume was a similar issue. The Company had been involved in
restructuring activities which included the closure of one
facility and the moving of its productive assets to Mexico.
In the course of this move, the Company lost sales due to
its inability to deliver products to its customers. At
December 31, 2004, the Company had to assess to what extent
such sales losses were temporary and which might become
permanent.
As noted below under a separate bullet point, the operation
suffered a distinct drop in cash flows in 2005 from levels
in 2004 and 2003. The timing of the recognition of the
impairment was driven by changes in the underlying
assumptions for future cash flows that changed as we gained
more insight into sales patterns and margins. As noted in
our first quarter disclosure, the business segment was
experiencing lower overall sales that not only were lower
than the prior period, but also lower than what was expected
per management's plan and the projected sales that were used
in the December 31, 2004 projections for evaluating goodwill
impairment.
After second quarter results were complete, and again sales
were both short of prior year and short of our revised
projections for the quarter, we obtained more insight into
the sales declines. At this point, the sales declines in the
residential and commercial and the gear motor markets were
deemed to be more than just temporary and conditions in the
automotive market were worsening. Sales that the Company
expected to achieve based upon discussions with some
customers were not materializing and sales at other
customers were not rebounding to prior year levels. In
addition, pricing actions that had been employed throughout
2004 and the beginning of 2005 were not keeping pace with
further commodity cost increases and it was suspected that
Chinese competitors might be able to sustain an advantage in
material costs due to apparent subsidies. Accordingly, the
Company questioned whether it would ever be able to fully
recover the commodity cost increases through pricing
actions. It was at this point that the Company felt it
necessary to reassess expected longer term sales volumes and
ongoing sustainable margins in the higher cost environment.
The new projections reflecting different sales levels and
margins resulted in the assessed impairment at June 30,
2005.
See response to comment 6G below for discussion of growth
rates, discount rates and cash flow indicators.
F. Does FASCO have any remaining goodwill and/or identifiable
intangible assets as of June 30, 2005 and December 31, 2005?
If yes, what are those amounts?
Response to SEC Letter of July 26, 2006
Page 13 of 29
ANSWER: The following table reflects goodwill and other
intangible assets associated with FASCO, as included in the
Company's consolidated balance sheet at June 30, 2005 and
December 31, 2005 (amounts in millions):
December 31, 2005 June 30, 2005
----------------- -------------
Goodwill $108.9 $108.9
Trade name 16.9 16.9
Customer relationships 31.2 32.7
Technology 6.7 9.9
G. For all of your reporting units by reportable segment, what
is the estimated fair value versus the carrying value for
each of the three years ended December 31, 2005? For
reporting units with declining fair values and/or values
close to carrying value, the amounts should have been
disclosed in addition to the amount of long-lived assets and
goodwill at risk.
ANSWER: Overview
In performing the annual assessment of the carrying value of
goodwill the Company first identifies the reporting units
within the segments, as disclosed in the company's annual
report on Form 10-K for the year ended December 31, 2005,
where goodwill is recorded. At December 31, 2005 there were
four reporting units within three segments for which
goodwill was recorded, and at December 31, 2004 and 2003
there were five reporting units within four segments for
which goodwill was recorded. Following is a discussion by
segment with respect to the Company's annual assessment of
the carrying value of goodwill. The estimated value referred
to in the following discussion is a result of using a
forecasted discounted cash flow analysis which is the
Company's practice.
Response to SEC Letter of July 26, 2006
Page 14 of 29
Compressor Segment
The two reporting units within the Compressor segment for
which goodwill is recorded are referred to as "India" and
"Europe" and their operations represent approximately 31% of
the segment. Note that during each of the two years in the
period ended December 31, 2005 the only change in goodwill
was related to the effect of translation. Following is a
summary of the results of the annual assessment (amounts in
millions):
2005 2004 2003
------ ------ -----
India:
Goodwill $ 6.9 $ 7.1 $ 6.8
Book value 60.5 65.2 64.5
Estimated value 107.8 146.7 98.4
Excess 47.4 81.4 33.9
Europe:
Goodwill $ 10.0 $ 11.5 $10.6
Book value 77.3 80.1 92.2
Estimated value 84.7 110.0 92.2
Excess 7.4 29.9 --
As disclosed in the Company's Annual Report on Form 10-K for
the year ended December 31, 2003, it was determined that
goodwill amounting to $29.5 million associated with the
Company's European compressor business was impaired. Based
on subsequent annual goodwill impairment tests, there have
not been any further indicators of an impairment; however,
as illustrated in the table above, the excess of fair value
over carrying value declined significantly as of December
31, 2005 when compared to December 31, 2004. Accordingly,
the Company expanded its disclosures in its Quarterly Report
on Form 10-Q for the three and six months ended June 30,
2006. Refer to the response to comment 6H for changes to be
reflected in future filings.
Electrical Segment
The FASCO reporting unit comprises substantially all the
operations of this segment and the goodwill in this unit was
a result of the acquisition of FASCO on December 31, 2002.
Other than the $108 million impairment recognized in the
second quarter 2005, the only other changes in goodwill were
related to purchase price adjustments. Following is a
summary of the results of the annual assessment as well as
selected information from the segment footnote included in
the table entitled "Reported cash flow indicators" (amounts
in millions):
Response to SEC Letter of July 26, 2006
Page 15 of 29
2005 2004 2003
------ ------ ------
Goodwill $108.9 $216.9 $217.7
Book value 310.8 427.6 407.2
Estimated value 383.5 464.5 565.8
Excess 72.7 36.9 158.6
Discount rate 9.25 10.0 10.0
Residual growth rate 3.0 3.0 3.0
Last Twelve Months Ended
-------------------------------------
12/31 6/30 3/31 12/31 12/31
2005 2005 2005 2004 2003
----- ----- ----- ----- -----
Reported cash flow indicators:
Operating income $ 7.5 $ 3.1 $ 6.8 $11.3 $16.9
Depr./amort. 21.0 25.3 26.2 27.8 29.6
Capex (7.7) (4.3) (4.5) (3.6) (5.0)
----- ----- ----- ----- -----
Net cash flow indicator $20.8 $24.1 $28.5 $36.5 $41.3
Pumps Segment
The Little Giant reporting unit comprised approximately 90%
of this segment and was the reporting unit to which the
goodwill was attributable. Goodwill during the 2003 through
2005 period remained unchanged. Following is a summary of
the results of the annual assessment (amounts in millions):
2005 2004 2003
----- ------ ------
Goodwill $ 5.1 $ 5.1 $ 5.1
Book Value 35.8 45.2 53.1
Estimated Value 99.2 127.6 115.8
Excess 63.4 82.4 62.7
As disclosed in the June 30, 2006 Form 10-Q, the Company
recognized a pre-tax gain of $69.8 million associated with
the completed disposition of Little Giant in the second
quarter of 2006. Additional pre-tax gains approximating $8.5
million, associated with the curtailment of Little Giant
employee benefit liabilities retained by the Company, will
be recognized in subsequent periods.
Response to SEC Letter of July 26, 2006
Page 16 of 29
Engine & Power Train Segment
There is one reporting unit within the Engine & Power Train
segment for which goodwill is recorded. It is referred to as
"Motoco" and its operations represent approximately 8.5% of
the segment. Note that during each of the two years in the
period ended December 31, 2004 the only change in goodwill
was related to the effect of translation. Following is a
summary of the results of the annual assessment (amounts in
millions):
2005 2004 2003
---- ----- -----
Goodwill $ -- $ 2.9 $ 2.5
Book value n/a 26.4 24.2
Estimated value n/a 36.8 78.6
Excess n/a 10.4 54.4
At December 31, 2004 and 2003 goodwill associated with
Motoco represented approximately 2% of the Company's total
goodwill.
For the year ended December 31, 2005 Motoco's operating loss
was $3.4 million compared to planned operating income of
$0.6 million. This deterioration and decisions made in the
fourth quarter regarding where certain products will be
produced in future years coupled with uncertainty as to the
Company's ability to bring costs down enough to meet
previous cash flow forecasts resulted in our determination
that the goodwill (which then aggregated $2.7 million) was
fully impaired.
H. Your critical accounting estimates section should disclose
how you estimate fair value; significant assumptions related
to your estimates, uncertainties associated with your
assumptions, and risks of changes to your assumptions; and a
sensitivity analysis depicting the effect of a 1% change in
these assumptions.
ANSWER: The Company's current critical accounting estimate
in the Annual Report on Form 10-K includes a discussion of
the fact that the Company estimates fair value of its
reporting units using estimated discounted future cash
flows. In future filings on Form 10-K, the Company will
expand this disclosure to include disclosure of significant
assumptions and any uncertainties that surround those
significant assumptions. Further, the Company will include a
sensitivity analysis depicting the effect of a 1% change in
these assumptions in its Annual Report on Form 10-K for the
year ended December 31, 2006. As of June 30, 2006, a 1%
increase in the discount rate used in the December 2005
forecasted discounted cash flow analysis would have an
impact of approximately $52 million on the estimated fair
value of the reporting unit within the Electrical Components
segment with goodwill and would not result in an impairment
at June 30, 2006. A
Response to SEC Letter of July 26, 2006
Page 17 of 29
1% increase in the discount rate used in the December 2005
forecasted discounted cash flow analysis for the Europe
reporting unit within the Compressor segment, that has
goodwill aggregating $10 million, would have an impact of
approximately $11 million on the estimated fair value of
this reporting unit and would result in the need for
management to perform a step 2 analysis and could result in
an impairment. We will include this disclosure in future
filings.
Note 5. Income Taxes, page 58
7. We note the increase in your deferred tax asset valuation allowance of
$70 million in 2005. Please tell us why you do not consider your
deferred tax asset valuation allowance a critical accounting estimate.
In addition, please tell us the specific events that arose in 2005
that resulted in the need for a valuation allowance in 2005, as
compared to prior periods. Finally, please tell us, in detail, your
consideration of paragraph 21 of SFAS 109 in determining that the
likelihood of realization of $171.7 million of deferred tax asset is
more likely than not. For example, please clarify whether the taxable
temporary differences giving rise to the $168.3 million of deferred
tax liabilities will reverse in the same period and jurisdiction and
is of the same character as the temporary differences giving rise to
the deferred tax assets.
ANSWER: We acknowledge that income taxes and the need for a valuation
allowance against deferred tax assets is a critical accounting policy
and estimate. Income tax balances and valuation allowance assessments
are closely monitored by the Company and its Audit Committee despite
the fact that a disclosure of this analysis was not included by the
Company in its Form 10-K. As such, we have added the disclosure of the
policy to our Form 10-Q for the three and six months ended June 30,
2006 and will include it in future filings.
With respect to the recording of valuation allowances, during the
third quarter of 2005, the Company increased the valuation allowance
recorded against net deferred tax assets in both Brazil and the United
States. The decision to increase the valuation allowance in those
jurisdictions was based on management's review of all available
evidence, both positive and negative, to determine whether, based on
the weight of that evidence, a valuation allowance was needed.
The following factors were identified as sufficient negative evidence
that led management to believe it was more likely than not that the
deferred tax assets would not be realized as of September 30, 2005:
- During 2004, the Company's U.S. operations began to show
cumulative pre-tax book losses over a three-year period.
- Although the Company had significant amounts of pre-tax
income in the past, the cumulative three-year loss called
for an additional amount of skepticism to be applied to the
assumptions used in determining whether it was "more likely
than not" that these assets would be utilized.
- At the end of 2004, the Company was still reporting a modest
amount of U.S. taxable income.
Response to SEC Letter of July 26, 2006
Page 18 of 29
To make its assessment of utilization, management looked at whether or
not sufficient taxable income of the appropriate character could be
generated in the U.S. operations within the allowable carry-back and
carry-forward periods provided for under U.S. tax law. One source of
income that was considered was the availability of tax planning
strategies that would allow the Company to repatriate its foreign
earnings in a tax efficient manner and which would also be consistent
with management's plans to realign its business.
Early in 2004, the Company started to examine various tax planning
ideas that would generate sufficient U.S. taxable income to allow the
Company to recover its net deferred tax assets recorded in the U.S.
tax jurisdiction. Historically, the Company's Brazilian compressor
business produced significant profits from manufacturing and exporting
its products around the globe. During 2003 and 2004, the Brazilian
compressor business reported the following profits before taxes
respectively, $53.6 million and $52.1 million. As part of a planned
global business realignment, management made the decision to manage
its sales activities for its compressor business located abroad
through a U.S. based trading company. The added benefit of this
strategy was to shift profits attributable to the export activities
previously undertaken by the Brazilian compressor business to the U.S.
trading company, whose profits management estimated would be
sufficient to utilize the U.S. deferred tax assets. As previously
stated, the Brazilian operations provided significant profits in the
past and were forecasting continued profitability into the future.
Therefore, the Company began steps to implement the trading company
strategy in 2004. The expected impact, at that time, on profits was to
shift approximately $26 million of income annually from Brazil to the
U.S. The Company determined this strategy was both prudent and
feasible given that the plan was within management's control and could
be implemented at their discretion.
As a result, it was concluded that the significant negative evidence
present at December 31, 2004 was overcome and no increase to the
valuation allowance was necessary against the U.S.'s net deferred tax
assets.
During the first six months of 2005, however, profits from Brazil's
compressor business were not meeting management's profit plans for the
year, but the unit was still profitable and its revised profit
forecast for the full year was still sufficient to allow for taxable
income in Brazil. As the Company monitored its forecast for the year,
it still believed there was sufficient income in Brazil to transfer to
the U.S. through the planned-for trading company. The decrease in the
Brazilian unit's profits was primarily attributable to the following
two factors: (1) the advance of Brazil's currency, the real, against
the dollar and (2) the increase in raw materials prices including
copper, which is a critical component in manufacturing compressors.
Response to SEC Letter of July 26, 2006
Page 19 of 29
The increasing value of the Brazilian currency against the U.S. dollar
and the euro negatively impacted the compressor business's profits
since its sales were denominated in dollars or euros and its costs
were primarily paid in Brazilian real. The Company was not able to
increase its price to its customers to account for the foreign
exchange losses and the commodity price increases.
In the third quarter of 2005 the real increased in value by 5.9%
against the U.S. dollar and 6.3% against the euro, leading management
to revise its profit forecasts for the Brazilian compressor business.
The revised forecast indicated a full-year loss that could no longer
sustain the profit shift attributable to the trading company strategy.
The Brazilian operations no longer forecasted profits and the Company,
therefore, increased its valuation allowances accordingly.
Based on the significant negative evidence that existed as of the
third quarter of 2005, including cumulative losses in recent years, as
well as the lack of prudent and feasible tax planning opportunities,
management believed it was not more likely than not that the deferred
tax assets would be realized and therefore recorded a full valuation
allowance against the U.S. and certain Brazilian net deferred tax
assets.
As of December 31, 2005 the company reported total deferred tax assets
of $171.7 million and total deferred tax liabilities of $168.3 million
for a net deferred tax asset of $3.4 million. Paragraph 21 of SFAS 109
states that "future realization of the tax benefit of an existing
deductible temporary difference, or carry-forward, ultimately depends
on the existence of sufficient taxable income of the appropriate
character within the carry-back, carry-forward period available under
the tax law."
In determining the likelihood of realization of the Company's deferred
tax assets, consideration was given to whether the deferred tax
liabilities would reverse in the same period, jurisdiction and would
be of the same character as the temporary differences giving rise to
the deferred tax assets. It was determined that the deferred
liabilities would result in realization of a portion of the deferred
tax assets recorded.
Note 10. Environmental Matters, page 64 of annual report
8. We note that subsequent to the signing of the "Liability Transfer
Agreement" you derecognized the $39.2 million liability related to the
Sheboygan River Site along with the gain contingency you had
recognized. In your footnote disclosure, you further state, "these
arrangements do not constitute a legal discharge or release of the
Company's liabilities with respect to the Site." With regards to your
HARP remediation, we also note you have derecognized the liability for
this loss contingency based on the agreement with TRC. You also state,
"the arrangements with TRS and the WDNR do not constitute a legal
discharge or release of the Company's liabilities." As such, please
tell us how you determined it was appropriate to derecognize these
liabilities based on the requirements set forth in paragraph 16 of
SFAS 140.
Response to SEC Letter of July 26, 2006
Page 20 of 29
ANSWER: The accounting treatment for these two liability transfer
agreements was recorded in accordance with "Extinguishment of a
Liability" provisions of SFAS 140. Under SFAS 140, par. 16 b, a
liability is extinguished when the debtor is legally released from
being the primary obligor under the liability, either judicially or by
the creditor. In the case of the Sheboygan River Site, the
creditor/obligee is the U.S. Environmental Protection Agency. At the
time that the Company signed the Liability Transfer Agreement with
Pollution Risk Services, LLC (PRS), the Company had yet to execute an
amended consent decree with the EPA and have it entered with the
Department of Justice whereby PRS would be formally recognized as the
primary obligor. Accordingly, the Company did not derecognize the
liability at the time of the execution of the Liability Transfer
Agreement, but alternatively recognized the $39 million payment under
the agreement as an asset. During the fourth quarter of 2005, the
Company and the U.S. EPA executed an amended consent decree, which
among other terms, recognized PRS as a Potentially Responsible Party
and the primary obligor for the clean-up. Accordingly, the Company
derecognized the liability. However, even though the Company is no
longer the primary obligor, it is still contingently liable if PRS and
the insurer, CHUBB, were to fail to perform. Accordingly, the
continued disclosure is intended to inform the reader of the remaining
contingency to which the Company is subject. The accounting for this
contingency is in accordance with SFAS 5, Accounting for
Contingencies. The Company monitors the status of the environmental
clean-up efforts and has currently assessed the likelihood that the
Company will be required to make additional payments related to this
environmental contingency as remote.
With respect to the HARP site, the creditor/obligee is the Wisconsin
Department of Natural Resources. Under this arrangement, the consent
decree recognizing TRC as the primary obligor occurred concurrently
with the execution of the Liability Transfer Agreement. Like the
Sheboygan arrangement, the Company is contingently liable should TRC
and the insurer, AIG, fail to perform. The accounting for this
contingency is in accordance with SFAS 5, Accounting for
Contingencies. The Company monitors the status of the environmental
clean-up efforts and has currently assessed the likelihood that the
Company will be required to make additional payments related to this
environmental contingency as remote.
Note 11. Commitments and Contingencies, page 66 of annual report
9. We note that you are the subject of class actions and asbestos-related
claims that you believe are incidental to your business and have not
provided any of the disclosures in accordance with Questions 2 and 3
of SAB Topic 5:Y. In SAB Topic 5:Y, we clearly state that we believe
that product and environmental remediation liabilities typically are
of such significance that detailed disclosures regarding judgments and
assumptions underlying the recognition and measurement of the
liabilities are necessary to prevent the financial statements from
being unclear and to inform readers fully regarding the range of
reasonably possible outcomes that could have a material effect on a
registrant's financial condition, results of operations, or liquidity.
As such, please explain to us how you concluded that no additional
disclosures are required by SAB Topic 5:Y for your asbestos-related
claims. If you determine that additional disclosures are required by
SAB Topic 5:Y, please provide us with such disclosures.
Response to SEC Letter of July 26, 2006
Page 21 of 29
ANSWER: The Company is named in a number of asbestos related claims
and in all cases, the Company has been named within a long list of
co-defendants. In addition, all the suits have been initiated by a
limited number of plaintiff's law firms. The Company has been largely
successful to date in defending itself against these suits and has
been dismissed in several of the cases.
The asbestos that was present in the Company's products was primarily
in gaskets in the Company's engine and compressor products. For
compressors, any asbestos fibers were sealed in gaskets within a
sealed hermetic steel compressor. These compressors were not
serviceable by opening the product; therefore, it is not likely that
anyone ever received enough exposure for the Company to be a source of
illness. Typically, the lawsuits involving compressors come from
individuals who worked in the HVAC industry and the Company appears to
be included merely based on its association with supplying compressors
to the industry. Typically, the lawsuits involving engines come from
individuals with long work histories where exposure to other asbestos
products is easily established, but with a claim to occasionally
repairing Tecumseh engines, or other outdoor product equipment. Not
all Tecumseh gaskets contained asbestos, and many gaskets were metal
encased, prohibiting release of asbestos fibers. The Company can
present medical testimony that an individual has an almost zero
probability of asbestos exposure and, again, it is not likely that
anyone ever received enough exposure for the Company to be a source of
illness. The Company has also been named in some cases involving
Little Giant Pump Company but no asbestos containing products have
been identified and was named in one case involving FASCO, which was
subsequently dismissed, again without identification of an
asbestos-containing product.
To date, the Company has been named in a total of 78 such asbestos
cases. To date, the Company has been dismissed from 17 of these cases.
To date, we have only paid a settlement in one case for a total of
$35,000. In the settled case, while management believes we would
likely have prevailed, it was determined to be more cost effective to
settle and avoid further fees and costs and avoid the potential for an
adverse jury verdict.
Based upon the above information, we do not believe asbestos
litigation is significant to the Company. However, we felt it would be
prudent to at least include disclosure that the Company has been named
in these types of lawsuits
Note 13. Guarantees and Warranties, page 69 of annual report
10. In future filings, please ensure that your warranty disclosure
includes all of the information required by paragraphs 13 and 14 of
FIN 45. Specifically, state the length of your warranties for each
type of product; the aggregate changes in the liability for accruals
related to product warranties issued during the reporting period; and
the aggregate changes in the liability for accruals related to
pre-existing warranties. Please provide us with the disclosure you
intend to include in future filings.
Response to SEC Letter of July 26, 2006
Page 22 of 29
ANSWER: We agree that the disclosures required by paragraphs 13 and 14
of FIN 45 would enhance the Company's currently disclosed information
and have provided the following disclosure in the Company's Form 10-Q
for the three and six month periods ended June 30, 2006.
Reserves are recorded on the Consolidated Balance Sheet to reflect the
Company's contractual liabilities relating to warranty commitments to
customers. Warranty coverage is provided for a period of twenty months to
two years from date of manufacture for compressors; ninety days to three
years from date of purchase for electrical components; one year from date
of delivery for engines; and one year from date of sale for pumps. An
estimate for warranty expense is recorded at the time of sale, based on
historical warranty return rates and repair costs.
Changes in the carrying amount and accrued product warranty costs for the
six months ended June 30, 2006 and 2005 are summarized as follows:
Six Months Six Months
Ended Ended
(Dollars in millions) June 30, 2006 June 30, 2005
------------- -------------
Balance at January 1 $29.4 $ 38.1
Settlements made (in cash or in kind) (7.6) (12.1)
Current year accrual 5.4 6.7
Adjustments to pre-existing warranties 2.8 (1.4)
Effect of foreign currency translation 0.2 (0.4)
Sale of Little Giant Pump Company (2.7) --
----- ------
Balance at June 30 $27.5 $ 30.9
===== ======
At June 30, 2006, $23.1 million was included in current liabilities and
$4.4 million was included in noncurrent liabilities.
11. We note that your warranty expense for fiscal years 2004 and 2005 are
for the same amount. It is unclear to us why your warranty expense
would remain constant, even though net sales decreased by 3.4% for
fiscal year 2005 from fiscal year 2004 with significant fluctuations
in volume. In addition, we note that you have been unable to pass
along significant increases in the raw material costs. As such, please
provide us with a detailed explanation of how you determine the amount
of your warranty liability. Please also tell us why you do not believe
this to be a critical accounting estimate even though warranty expense
for fiscal year 2005 was 11.3% of operating loss. In addition, you
should include disclosure within MD&A to address the trends regarding
your warranty provision and liability and to provide a more
comprehensive explanation of your estimate of the warranty accrual in
light of the fact that your warranty expense was 11.3% of your fiscal
year 2005 operating loss.
ANSWER: Provision is made for the estimated cost of maintaining
product warranties at the time the product is sold, based on
historical claims experience by product line. If appropriate, further
provision may be made to make adjustments for product recalls or any
commensurate one-time experiences. Historically, warranty expense and
the
Response to SEC Letter of July 26, 2006
Page 23 of 29
variability in determining the amount of liability to recognize were
not deemed to be as sensitive or critical as those items that the
Company has chosen to include as a critical accounting estimate.
The result of warranty expense amounting to 11.3% of operating loss is
more a function of the Company having operating results that reflect
the netting of certain operations in an operating profit position
against others being in an operating loss position. We believe a more
appropriate measure is the cost of warranty in relation to sales. In
2005, warranty expense amounted to 1.06% of revenue while in 2004
warranty expense as a percentage of revenue aggregated 1.03%. In
addition, the liability only represents 3% of total liabilities in
2005 and 3.6% in 2004. The Company's SBU's sell a large number of
homogeneous products for which an extensive warranty experience exists
for the Company to estimate the amount of expected warranty costs
associated with sold product. The adjustments to pre-existing
warranties noted above relates to a higher-than-expected initial
incidence rate for a specific product produced by the Company's
Brazilian Compressor operations. Under the Company's quantitative
approach to the computation/estimate of the liability, we do not
believe there is much judgment that could be introduced to create
significant variability to earnings. Accordingly, we do not believe
this accounting estimate, and its resulting variability, provides much
insight into results from operations with the exception of when
abnormal events occur that result in costs beyond our normal warranty
terms. When such events occur, we disclose such events within our
MD&A.
Item 15. Exhibits and Financial Statement Schedules, page 77 of annual
report
12. In future filings, please disclose as an exhibit or note to your
financial statements your schedule of valuation and qualifying
accounts for each income statement period, as required by Rule 5-04 of
Regulation S-X. At a minimum, we would expect this schedule to include
your valuation allowances related to accounts receivable and deferred
tax assets and your restructuring reserves. Your filing should include
an opinion from your independent accountants covering this schedule.
ANSWER: The Company historically did not file this schedule because
the only valuation account was the Company's allowance for bad debts,
which was not significant given the very small amount of bad debt
expense that the Company has experienced. Since that point, the
Company has added other valuation accounts, like those cited.
Accordingly, we agree that the financial schedule should be filed and
will include such schedule in the Company's Annual Report on Form 10-K
for 2006 and forward.
Exhibit 31
13. In future filings, please discontinue inclusion of the certifying
individual's title in the first line of the 302 certification. The
Final Release Number 33-8238 requires that only the name of the
certifying individual be included in this line.
ANSWER: In future filings, we will discontinue the inclusion of the
certifying individual's title in the first line of the 302
certification as instructed.
Response to SEC Letter of July 26, 2006
Page 24 of 29
Form 10-Q for the quarter ended March 31, 2006
8. Debt, page 10
14. Citing relevant accounting literature, please tell us how you
accounted for your refinancing of your Senior Guaranteed Notes and
Revolving Credit Facility during the first quarter of 2006. In
particular, please tell us whether you recognized a gain or loss on
extinguishment and if so, the components of that gain or loss, such as
write off of discounts and write offs of deferred financing fees.
ANSWER: We accounted for the repayment of the old debt (Senior
Guaranteed Notes and Revolving Credit Agreement) as an extinguishment
of debt in accordance with SFAS 140 as the creditors were paid in
full. We considered EITF 96-16 as to whether the refinancing amounted
to a modification and concluded that the refinancing was not a
modification because 1) terms substantially changed such that the
present value of cash flows changed by more than 10%, and 2) the
creditor group substantially changed as only two out of 17 creditors
from the old financing arrangement participated in the new
arrangement.
As an extinguishment, $0.9 million of unamortized debt issuance costs
net of unamortized gains from previously terminated swap agreements
related to the Senior Guaranteed Notes and Revolving Credit Agreement
were written off to interest expense in the first quarter 2006. In
addition, debt issuance costs of $7.0 million related to the
origination of the new financing arrangement entered into on February
6, 2006 were capitalized. We have added the above explanation of the
accounting treatment to the debt footnote included in our Form 10-Q
for the quarter ended June 30, 2006.
10. Income Taxes, page 13
15. Citing relevant accounting literature, please explain, in detail, the
basis for your recognition of the $5.6 million tax benefit in the
first quarter of 2006. In addition, please address the following:
A. You state in your Form 8-K filed May 4, 2006, that you
reversed $5.6 million of your deferred tax asset valuation
allowance due to the deferred tax liability that was
generated by the transactions in other comprehensive income.
Please confirm to us that the temporary differences that
gave rise to this deferred tax liability will reverse in the
same time period and jurisdiction and are of the same
character as the temporary differences that give rise to the
deferred tax assets for which you reversed the valuation
allowance.
ANSWER: For the three-month period ended March 31, 2006, the
Company reported a tax benefit for its current year losses
attributable to U.S. continuing operations, which is equal
to the tax expense reflected in other comprehensive income
reported in the same period. For the three-month period
ended March 31, 2006, income taxes also reflected the impact
of foreign operations in those jurisdictions whose results
continue to be tax affected as they are profitable or where
sufficient negative evidence does not exist to warrant a
valuation allowance.
Response to SEC Letter of July 26, 2006
Page 25 of 29
The Company's provision for income taxes for the period
ended March 31, 2006 was computed by applying the statutory
tax rate against income (loss) from continuing operations
for the period and is applied by tax jurisdiction. Under
Accounting Principle Board Opinion No. 28, "Interim
Financial Reporting", the Company is required to adjust its
effective tax rate each three-month period to be consistent
with the estimated annual effective tax rate. The Company is
also required to record the tax impact of certain unusual or
infrequently occurring items, including changes in judgment
about valuation allowances and effects of changes in tax
laws or rates, in the interim period in which they occur.
The Company previously reported a full valuation against its
net deferred tax assets in the U.S., which was established
in the third quarter 2005. The full valuation allowance
established against the U.S. net deferred tax assets was
based upon the Company's cumulative history of losses from
U.S. operations and the lack of positive evidence about
future events that would produce sufficient U.S. source
income to allow for their recovery. For the three-month
period ended March 31, 2006, the Company continued to report
losses in the U.S. from continuing operations; therefore,
income taxes for the same period included the impact of
maintaining a full valuation allowance against the Company's
net deferred tax assets in the U.S.
For the same three-month period ended March 31, 2006 the
Company also recognized other U.S. income in the form of
other comprehensive income that is taxable in the U.S.
jurisdiction. The Company reported a loss from continuing
operations and reported income in OCI. Pursuant to SFAS No.
109, Paragraph 35, the Company must allocate income tax
expense or benefit ". . . among continuing operations,
discontinued operations, extraordinary items, and items
charged or credited directly to shareholders' equity
(paragraph 36)," which includes gains and losses included in
OCI but excluded in net income.
Generally, the tax effect of income from items other than
continuing operations are not taken into account when
computing the tax effect of pretax income or loss from
continuing operations. However, the exception relates to a
situation in which an enterprise reports a zero total tax
provision and incurs a loss from continuing operations and
income related to other items such as an extraordinary item
or discontinued operations. In that situation, paragraph 140
of SFAS 109 requires that all items (including extraordinary
items, discontinued operations, and so forth) be considered
for purposes of determining the amount of tax benefit that
results from a loss from continuing operations and that
should be allocated among continuing operations.
Response to SEC Letter of July 26, 2006
Page 26 of 29
A FASB staff representative addressed this issue in EITF
D-32, which states the approach taken in SFAS No. 109;
Paragraph 140 ". . . was made to be consistent with the
approach in Statement 109 to consider the tax consequences
of taxable income expected in future years in assessing the
realizability of deferred tax assets."
In the U.S., the Company anticipates ordinary loss for the
year ended December 31, 2006 and had an ordinary loss for
the first quarter. Given that Tecumseh recorded a full
valuation allowance, no tax benefit for the losses should
normally be recognized.
However, since Tecumseh reported a loss from continuing
operations and income in OCI for the quarter ended March 31,
2006, tax expense/benefit was allocated to each item. Tax
expense was recorded in OCI related to translation gains on
unremitted earnings and a tax benefit was recorded on the
loss in continuing operations to offset the expense recorded
in OCI. The net result was an effective rate in the U.S. of
0%.
The tax effect of the cumulative translation adjustments
relate to the U.S. tax jurisdiction and the temporary
differences that gave rise to this deferred tax liability
will reverse in the same time period and jurisdiction and
are of the same character as the temporary differences that
gave rise to the deferred tax assets for which valuation
allowance was reversed.
B. Excluding the $5.6 million tax benefit, you would have had
an effective tax rate of 0%. We assume that you have
estimated your annual effective tax rate to be 0%,
suggesting that you do not expect any of the deferred tax
assets generated in 2006 to be realizable. If so, please
tell us your basis for this estimate. As part of your
response, please reconcile the projections you considered in
determining that none of your deferred tax assets will be
realizable with the fact that you appear to have concluded
that the remaining amounts of goodwill on your balance sheet
are recoverable.
ANSWER: As stated in our response to Question #5, the
Company determined its deferred tax assets were not
realizable as of the third quarter of 2005. This
determination did not change as of March 31, 2006 as the
Company still believed it was more likely than not that its
deferred tax assets would not be realized.
In arriving at that conclusion, management reviewed all
available evidence, both positive and negative, to determine
whether, based on the weight of that evidence, a valuation
allowance was needed. For the current and prior two periods,
the Company is in a cumulative book loss position. The
cumulative three-year loss is significant negative evidence
that calls for an additional amount of skepticism to be
applied to the assumptions used in determining whether it is
"more likely than not" that these assets will be utilized.
Response to SEC Letter of July 26, 2006
Page 27 of 29
Whenever significant negative evidence is present, such as
cumulative losses in recent years, determination of the
amount of valuation allowance necessary to reduce the
deferred tax asset to an amount that is more likely than not
to be realized usually will require estimates of future
income. Unlike an SFAS 142 analysis, the evidence of
recoverability must be weighted. The weight given to the
potential effect of negative and positive evidence should be
commensurate with the extent to which it can be objectively
verified. In other words, a company with negative evidence
should look to its recent operating history in order to
determine how much, if any, income is expected in future
years.
This analysis differs from the goodwill impairment analysis
and will, therefore, lead to different results.
14. Subsequent Event, page 15
16. We note that you are voluntarily recalling approximately 170,000
engines because of a potential fire hazard. However, it does not
appear that you have included any disclosure for this loss contingency
in your first quarter of fiscal year 2005 Form 10-Q. Please tell us
why you believe such disclosure was not required. Please also tell us
the estimate cost of this recall, when you determined the estimated
cost and the period in which you recognized the estimated cost.
ANSWER: The press release from the CPSC that was issued on April 4,
2006 was released well after the incident had occurred and substantial
remedies had been undertaken by the Company. Despite the press
release's reference to 170,000 affected engines, we estimate that a
maximum of 119,000 engines were sold to consumers. During the fourth
quarter of 2005, the Company had already contained approximately
54,000 engines within the OEM's and Retailer's warehouses and stores
and affected inspections on those engines. Approximately 1.1% of those
inspected engines exhibited fuel line detachment.
At December 31, 2005, the Company had incurred a total of
approximately $221,000 to complete the repairs to the contained
engines and accrued an additional $3.6 million in the fourth quarter
of 2005 relative to estimated response costs from OEM and Retailers
not yet finalized and to provide for the expected costs of service
repairs for those consumers who would actually return engines pursuant
to the recall.
The Company did not make reference to a recall at December 31, 2005
because the Company and the CPSC had not yet determined the
appropriate remedy for the engine population. Although there were over
170,000 engines potentially with the fuel line defect, nearly
one-third of the population was contained within the OEM and Retailer
network, with an experience rating of only 1.1% fuel line detachment.
As stated above, the Company incurred $3.8 million in expense in 2005
related to the product recall involving approximately 170,000 engines.
An additional $4.2 million was expensed in 2005 to address a product
recall for a Manual Standard Transmission product. Therefore, the
Company made the following reference in the December 31, 2005
financial statements:
Response to SEC Letter of July 26, 2006
Page 28 of 29
The decline in year to date results reflected increases in commodity
costs of $12.4 million and other costs of $22.3 million, including the
cost of $8.0 million associated with two product recalls.
Item 2 Management's Discussion and Analysis of the Financial Condition and
Results of Operations, page 16
Liquidity and Capital Resources, page 21
17. We note that accounts receivable is 12.4% of your total assets as of
March 31, 2006. In addition, accounts receivable increased 10% from
December 31, 2005, which appears to be disproportionate to your net
sales trends. Net sales increased 1.3% for three months ended March
31, 2006 compared to prior year period. As such, in future filings,
please include an analysis of days sales outstanding for each period
presented and a discussion and analysis of the increase in accounts
receivable in excess of net sales growth. Refer to instruction 5 to
Item 303(A) of Regulation S-K for guidance.
ANSWER: The trend noted by the staff is not the result of an unusual
lengthening of accounts receivable terms or uncollected amounts. The
increase in receivables of $21.5 million between March 31, 2006 and
December 31, 2005 is consistent with the normal seasonal pattern of
our sales.
Based upon our internal computation of days sales outstanding
(computed before giving effect to receivables sold in Brazil) DSO
actually improved from 66 days at March 31, 2005 versus 56 days at
March 31, 2006. The improvement is attributable to a concerted effort
on the part of all major operating segments of the Company, most
particularly the Compressor Group, which improved its DSO to 57 days
versus 72 days at March 31, 2005.
We agree with the staff that the suggested disclosures will help the
reader to differentiate the effects of seasonality from other
underlying factors and, accordingly, we have added the recommended
disclosures to our Quarterly Report on Form 10-Q for the three and six
months ended June 30, 2006.
Response to SEC Letter of July 26, 2006
Page 29 of 29
Tecumseh Products Company acknowledges that:
- The Company is responsible for the adequacy and accuracy of the
disclosure in the finding;
- Staff comments or changes to disclosure in response to staff comments
do not foreclose the Commission from taking any action with respect to
the filing; and
- The Company may not assert staff comments as a defense in any
proceeding initiated by the Commission or any person under the federal
securities laws of the United States.
Regards,
TECUMSEH PRODUCTS COMPANY
/s/ James S. Nicholson
- ------------------------------------
James S. Nicholson
Vice President, Treasurer and Chief
Financial Officer