Exhibit 13
MANAGEMENT'S DISCUSSION AND ANALYSIS
The following discussion should be read in conjunction with the consolidated
financial statements and notes thereto. The years 2006, 2005 and 2004 represent
the fiscal years ended September 30, 2006, 2005 and 2004, respectively, and are
used throughout the document. During 2005, the Company had a 2-for-1 stock split
which was effected as a 100 percent stock dividend and was paid on September 23,
2005 to shareholders of record as of September 9, 2005. The 2004 common stock
and per share amounts have been adjusted to reflect the stock split.
INTRODUCTION
ESCO Technologies Inc. and its wholly owned subsidiaries (ESCO, the Company) are
organized into three reporting units: Communications, Filtration/Fluid Flow, and
RF Shielding and Test (Test). The Company's business segments are comprised of
the following primary operating entities:
- - Communications: Distribution Control Systems, Inc. (DCSI), Hexagram, Inc.
(Hexagram), Nexus Energy Software, Inc. (Nexus), and Comtrak Technologies,
L.L.C. (Comtrak),
- - Filtration/Fluid Flow: PTI Technologies Inc. (PTI), VACCO Industries
(VACCO), and the Filtertek companies (Filtertek),
- - Test: EMC Group companies consisting primarily of ETS-Lindgren L.P. (ETS)
and Lindgren RF Enclosures, Inc. (Lindgren).
The Communications unit is a proven supplier of special purpose fixed network
communications systems for electric, gas and water utilities, including hardware
and software to support advanced metering applications. DCSI's Two-Way Automatic
Communications System, known as TWACS(R), is currently used for automatic meter
reading (AMR) and related advanced metering functions serving approximately 200
utilities, as well as having load management capabilities. Hexagram's STAR(R)
system, the premier wireless Advanced Metering Infrastructure (AMI), delivers
two-way and one-way operation on secure licensed radio frequencies for more than
100 utilities serving electric, gas and water customers. Nexus provides
best-in-class information solutions to more than 85 leading energy companies
that add value to existing billing and metering infrastructure to allow both the
utilities and their customers to better manage energy-driven transactions and
decision making. Comtrak's SecurVision(R) product line provides digital video
surveillance and security functions for large commercial enterprises and alarm
monitoring companies. The Filtration/Fluid Flow unit develops, manufactures and
markets a broad range of filtration products used in the purification and
processing of liquids and gases. These engineered filtration products utilize
membrane, precision screen and other technologies to protect critical processes
and equipment from contaminants. Major applications include the removal of
contaminants in fuel, lubrication and hydraulic systems, various health care
applications, industrial processing, satellite propulsion systems, and oil
processing. The Test unit is the industry leader in providing its customers with
the ability to identify, measure and contain magnetic, electromagnetic and
acoustic energy.
The divestiture of the Microfiltration and Separations businesses (MicroSep) was
completed during the third quarter of fiscal 2004. The MicroSep businesses
(previously included in the Filtration/Fluid Flow segment) included PTI Advanced
Filtration Inc. (PTA), PTI Technologies Limited (PTL) and PTI S.p.A. (PTB). The
MicroSep businesses are accounted for as "discontinued operations" in fiscal
2004.
ESCO continues to operate with meaningful growth prospects in its primary served
markets and with considerable financial flexibility. The Company continues to
focus on new products that incorporate proprietary design and process
technologies. Management is committed to delivering shareholder value through
internal growth, ongoing performance improvement initiatives, and selective
acquisitions.
HIGHLIGHTS OF 2006 OPERATIONS
- - Sales, net earnings and earnings per share were $458.9 million, $31.3
million and $1.19 per share, respectively.
- - Net cash provided by operating activities was $58.6 million.
- - At September 30, 2006, cash on hand was $36.8 million with no debt
outstanding.
- - The Company acquired Hexagram and Nexus for approximately $92 million in
cash.
- - DCSI's AMR product sales to TXU Electric Delivery Company (TXU) increased
to $27.1 million in 2006
from $7.2 million in 2005.
- - In November 2005, DCSI and Hexagram signed agreements to deliver AMI
equipment, software and services to Pacific Gas & Electric Company (PG&E)
for approximately nine million electric and gas customers over a five year
deployment period beginning in 2007. The total anticipated contract value
is expected to be up to approximately $535 million assuming full
deployment.
- - Successful deployment of upgraded TWACS system software called "TNG"
Versions 1.5 through 1.6.2 at PG&E.
RESULTS OF OPERATIONS
The following discussion refers to the Company's results from continuing
operations, except where noted. The MicroSep businesses are accounted for as
discontinued operations in 2004 in accordance with SFAS No. 144, "Accounting for
the Impairment or Disposal of Long-Lived Assets." Accordingly, amounts in the
financial statements and related notes for 2004 presented reflect discontinued
operations.
ACQUISITIONS
Effective February 1, 2006, the Company acquired the capital stock of Hexagram
for a purchase price of approximately $66 million. The acquisition agreement
also provides for contingent consideration of up to $6.3 million over a five
year period following the acquisition if Hexagram exceeds certain sales targets.
Hexagram is a radio-frequency (RF) fixed network AMR company headquartered in
Cleveland, Ohio. Hexagram broadens the Company's served market and provides an
RF based AMI system serving primarily gas and water utilities. Hexagram's annual
revenue over the past three years has been in the range of $20 million to $35
million. The operating results for Hexagram, since the date of acquisition, are
included within the Communications unit. The Company recorded approximately $51
million of goodwill and $3.5 million of trademarks as a result of the
transaction. The Company also recorded $6.6 million of identifiable intangible
assets consisting primarily of patents and proprietary know-how, customer
contracts, and order backlog which are being amortized on a straight-line basis
over periods ranging from six months to seven years.
Effective November 29, 2005, the Company acquired Nexus through an all cash for
shares merger transaction for approximately $29 million in cash plus contingent
cash consideration over the four year period following the merger if Nexus
exceeds certain sales targets. Nexus is a software company headquartered in
Wellesley, Massachusetts with annual revenues of approximately $10 million.
Nexus broadens the Company's served market and provides software solutions that
allow utilities to fully utilize the information produced by the Company's AMI
systems. The operating results for Nexus, since the date of acquisition, are
included within the Communications unit. The Company recorded approximately $24
million of goodwill as a result of the transaction. The Company also recorded
$2.7 million of identifiable intangible assets consisting of customer contracts
and backlog value which are being amortized on a straight-line basis over
periods ranging from one year to three years.
All of the Company's acquisitions have been accounted for using the purchase
method of accounting, and accordingly, the respective purchase prices were
allocated to the assets (including intangible assets) acquired and liabilities
assumed based on estimated fair values at the date of acquisition. The financial
results from these acquisitions have been included in the Company's financial
statements from the date of acquisition.
NET SALES
Fiscal year ended CHANGE Change
---------------------- 2006 2005
(Dollars in millions) 2006 2005 2004 VS. 2005 vs. 2004
------ ----- ----- -------- --------
Communications $156.2 138.0 137.8 13.2% 0.1%
Filtration/Fluid Flow 174.1 171.7 173.9 1.4% (1.3)%
Test 128.6 119.4 110.4 7.7% 8.2%
------ ----- ----- ---- ----
Total $458.9 429.1 422.1 6.9% 1.7%
====== ===== ===== ==== ====
COMMUNICATIONS
The $18.2 million or 13.2% increase in net sales in 2006 as compared to the
prior year was due to: Hexagram and Nexus sales of $18.6 million and $9.6
million, respectively; partially offset by an $8.6 million decrease in sales of
Comtrak's video security products; and $1.5 million of lower shipments of DCSI's
AMR products.
The $1.5 million decrease in sales of DCSI's AMR products in 2006 as compared to
2005 was due to: an increase in sales to TXU of $19.9 million and other investor
owned utilities (IOUs) of $3.0 million; offset by $16.2 million of lower AMR
product sales to the electric utility cooperative (COOP) market due to the
decrease in orders received during the second half of fiscal 2005; and an $8.1
million decrease in sales to Puerto Rico Electric Power Authority (PREPA) as the
contract nears
completion.
Comtrak's sales were $7.5 million, $16.1 million, and $5.6 million in 2006, 2005
and 2004, respectively. The decrease in sales in 2006 as compared to the prior
year was due to an acceleration of shipments in 2005 to meet the customer's
schedule. The increase in sales in 2005 versus 2004 was due to a delay in
deliveries in 2004 as a result of a significant customer requesting Comtrak to
modify its software operating system to provide enhanced "virus" protection
within the product.
The $0.2 million or 0.1% increase in Communications net sales in 2005 as
compared to the prior year was due to $10.5 million of higher shipments of
SecurVision(R) products. This increase was almost entirely offset by a $10.3
million decrease in sales of AMR products. The decrease in sales of AMR products
in 2005 versus 2004 was mainly due to the wind-down of a contract with PPL
Electric Utilities Corporation (PPL). Sales to PPL decreased $19.3 million in
2005 to $2.4 million from $21.6 million in 2004. Sales to other IOUs, such as
Bangor Hydro-Electric Company, Idaho Power Company, and PREPA decreased $17.9
million in 2005 versus 2004, and were partially offset by $7.2 million in sales
to TXU and $19.8 million of additional sales to the COOP market and other
customers.
FILTRATION/FLUID FLOW
Net sales in 2006 increased $2.4 million or 1.4% compared to 2005 primarily as a
result of higher commercial aerospace shipments at PTI of $5.6 million, a net
sales increase at Filtertek of $3.3 million driven by higher commercial
shipments, partially offset by lower defense spares and T-700 shipments at VACCO
of $6.6 million.
Net sales in 2005 decreased $2.2 million or 1.3% compared to 2004 primarily as a
result of lower defense spares shipments at VACCO of $4.3 million, a net sales
decrease at Filtertek of $0.5 million driven by lower automotive shipments,
partially offset by higher commercial and military aerospace shipments at PTI of
$2.6 million.
TEST
The net sales increase of $9.2 million or 7.7% in 2006 as compared to the prior
year was mainly due to: a $10.2 million increase in net sales from the Company's
U.S. operations driven by sales of additional test chambers and higher component
sales, a $0.6 million increase in net sales from the Company's Asian operations;
partially offset by a $1.6 million decrease in net sales from the Company's
European operations due to the prior year completion of several test chamber
projects.
The net sales increase of $9.0 million or 8.2% in 2005 as compared to 2004 was
mainly due to: an $11.5 million increase in net sales from the Company's U.S.
operations driven by the successful completion of the design on a large aircraft
chamber project, additional test chamber installations, higher component sales,
and the installation of several government shielding projects; a $4.3 million
increase in sales from the Company's Asian operations; partially offset by a
$6.9 million decrease in net sales from the Company's European operations due to
the completion of two large test chamber projects in 2004.
ORDERS AND BACKLOG
New orders received in 2006 were $479.2 million, resulting in an order backlog
of $253.4 million at September 30, 2006 as compared to an order backlog of
$233.1 million at September 30, 2005. In 2006, the Company recorded $187.5
million of new orders related to Communications products (including $19.0
million of new orders and $6.0 million of acquired backlog from Hexagram and
$16.7 million of new orders and $9.0 million of acquired backlog from Nexus),
$172.1 million related to Filtration products, and $119.6 million related to
Test products.
Within the Communications segment, DCSI received $129.3 million, $105.1 million
and $106.3 million of new orders for its AMR products in 2006, 2005 and 2004,
respectively. DCSI received $19.2 million of new orders from TXU in 2006. In
addition, in November 2005, DCSI signed an agreement to provide equipment,
software and services to PG&E with a potential contract value of up to
approximately $310 million covering up to five million electric endpoints over a
five-year deployment period beginning in 2007. DCSI received orders totaling
$4.2 million from PG&E under this agreement during 2006. Also, in November 2005,
Hexagram entered into a contract to provide equipment, software and services to
PG&E in support of the gas utility portion of PG&E's AMI project. The total
potential contract revenue from commencement through the five-year full
deployment is up to approximately $225 million. Hexagram received orders
totaling $0.7 million from PG&E under this agreement during 2006. See further
discussion under "Pacific Gas & Electric."
In 2005, the Company recorded $117.2 million of new orders related to
Communications products, $174.4 million related to Filtration products, and
$121.5 million related to Test products.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses (SG&A) were $106.9 million, or
23.3% of net sales in 2006, $84.2 million, or 19.6% of net sales in 2005, and
$77.3 million, or 18.3% of net sales in 2004.
The increase in SG&A expenses in 2006 as compared to the prior year was
primarily due to: $7.5 million of SG&A expenses related to Nexus; $6.8 million
of SG&A expenses related to Hexagram; $2.3 million of stock option expense and
higher costs related to engineering and new product development.
The increase in SG&A expenses in 2005 as compared to 2004 was primarily due to
an increase of $4.9 million associated with engineering, marketing and new
product development within the Communications segment in pursuit of the IOU
market.
AMORTIZATION OF INTANGIBLE ASSETS
Amortization of intangible assets was $6.9 million in 2006, $2.0 million in 2005
and $2.1 million in 2004. Amortization of intangible assets in 2006 included
$2.7 million of amortization of
acquired intangible assets related to the Hexagram and Nexus acquisitions, as
described in Note 2 to the Consolidated Financial Statements. The amortization
of acquired intangible assets related to Hexagram and Nexus are included in the
Corporate operating segment's results. The remaining amortization expenses
consist of other identifiable intangible assets (primarily software, patents and
licenses). In March 2006, the Company began amortizing DCSI's TNG software and
during 2006, the Company recorded $2.2 million of amortization related to its
TNG software.
OTHER (INCOME) AND EXPENSES, NET
Other (income) and expenses, net, were $(2.8) million, $(1.6) million and $0.6
million in 2006, 2005 and 2004, respectively. Other (income) and expenses, net,
in 2006 consisted primarily of the following items: $(1.8) million non-cash gain
representing the reversal of a liability related to an indemnification
obligation with respect to a previously divested subsidiary; $(2.3) million of
royalty income; partially offset by a $0.2 million charge related to the
termination of a subcontract manufacturer.
Other (income) and expenses, net, in 2005 consisted primarily of: $(2.2) million
of royalty income; and a $0.5 million charge related to the termination of a
supply agreement with a medical device customer.
Other (income) and expenses, net, in 2004 consisted primarily of: $0.8 million
of exit costs related to the Puerto Rico facility; a $(0.6) million gain from
the settlement of a claim related to a former defense subsidiary divested in
1999; and a $0.4 million charge for the settlement of a claim involving a former
defense subsidiary divested in 1996.
ASSET IMPAIRMENT -- 2005
In June 2005, the Company abandoned its plans to commercialize certain sensor
products within the Filtration/Fluid Flow segment. This action resulted in an
asset impairment charge of $0.8 million to write off certain patents and a
related licensing agreement to their respective fair market values. The Company
ended its development efforts on this program after it determined that the
market was not developing as quickly as anticipated and the expected costs and
time frame to fully commercialize the products were not acceptable.
EARNINGS BEFORE INTEREST AND TAXES (EBIT)
The Company evaluates the performance of its operating segments based on EBIT,
which the Company defines as earnings from continuing operations before interest
and taxes.
EBIT is not a defined GAAP measure. However, the Company believes that EBIT
provides investors and Management with a valuable and alternative method for
assessing the Company's operating results. Management evaluates the performance
of its operating segments based on EBIT and believes that EBIT is useful to
investors to demonstrate the operational profitability of the Company's business
segments by excluding interest and taxes, which are generally accounted for
across the entire company on a consolidated basis. EBIT is also one of the
measures Management uses to determine resource allocations and incentive
compensation.
Fiscal year ended CHANGE Change
---------------------- 2006 2005
(Dollars in millions) 2006 2005 2004 VS. 2005 vs. 2004
------ ----- ----- -------- --------
Communications $ 28.3 38.8 38.4 (27.1)% 1.0%
% of net sales 18.1% 28.1% 27.9% (10.0)% 0.2%
Filtration/Fluid Flow 19.5 22.4 21.8 (12.9)% 2.8%
% of net sales 11.2% 13.1% 12.5% (1.9)% 0.6%
Test 15.0 12.2 11.3 23.0% 8.0%
% of net sales 11.7% 10.2% 10.2% 1.5% --%
Corporate (15.2) (11.4) (11.8) 33.3% (3.4)%
------ ----- ----- ------- -----
Total $ 47.6 62.0 59.7 (23.2)% 3.9%
% of net sales 10.4% 14.4% 14.1% (4.0)% 0.3%
====== ===== ===== ======= =====
The reconciliation of EBIT to a GAAP financial measure is as follows:
(dollars in millions) 2006 2005 2004
------ ----- -----
EBIT $ 47.6 62.0 59.7
Add: Interest income 1.3 1.9 0.8
Less: Income taxes (17.6) (20.4) (22.7)
------ ----- -----
Net earnings from
continuing operations $ 31.3 43.5 37.8
====== ===== =====
COMMUNICATIONS
The decrease in EBIT in 2006 as compared to 2005 was due to: a $7.8 million
decrease at DCSI due to changes in product mix (IOU vs. COOP), charges related
to a terminated subcontract manufacturer, warranty costs and amortization of TNG
software; a $3.8 million decrease at Comtrak due to lower shipments; a $0.7
million loss at Nexus due to the timing of customer deployments and additional
SG&A spending related to engineering and new product initiatives; partially
offset by a $1.8 million contribution from Hexagram.
The increase in EBIT in 2005 as compared to the prior year was due to: a $4.6
million increase at Comtrak due to significantly higher shipments; partially
offset by a $4.2 million decrease at DCSI, which continued to increase its
engineering and new product development expenditures in order to accommodate the
growth in the AMR/AMI markets, and to further differentiate its technology from
the competition.
FILTRATION/FLUID FLOW
EBIT decreased in 2006 as compared to 2005 primarily due to: a $4.3 million
decrease at VACCO due to significantly lower defense spares shipments; a $1.4
million decrease at Filtertek partially due to increasing raw material costs on
petroleum based resins; partially offset by a $2.8 million increase at PTI due
to higher shipments of aerospace products. The 2005 operating results for
Filtertek included a $1.9 million gain related to the termination of a supply
agreement with a medical device customer that was not repeated in 2006.
EBIT increased in 2005 as compared to the prior year primarily due to: a $2.5
million increase at Filtertek, which included a $1.9 million gain related to the
termination of a supply agreement with a medical device customer; a $1.4 million
increase at PTI due to higher shipments of aerospace products; partially offset
by the $0.8 million asset impairment charge at PTI; and a $3.3 million decrease
at VACCO due to significantly lower defense spares shipments. In 2005, Filtertek
experienced an increase in its raw material costs on petroleum based resins
which negatively impacted EBIT.
TEST
The increase in EBIT in 2006 as compared to the prior year was mainly due to: a
$2.1 million increase in EBIT from the Company's U.S. operations driven by sales
of additional test chambers and higher component sales, a $0.4 million increase
in EBIT from the Company's European operations, and a $0.3 million increase in
EBIT from the Company's Asian operations.
EBIT in 2005 included: a $0.9 million increase in EBIT from the Company's U.S.
operations driven by favorable changes in sales mix resulting from additional
sales of antennas and other components partially offset by installation cost
overruns incurred on certain government shielding projects, as well as increased
material costs for steel and copper.
CORPORATE
Corporate office operating charges included in consolidated EBIT increased by
$3.8 million in 2006 as compared to 2005 mainly due to: $2.7 million of pre-tax
amortization of acquired intangible assets related to Nexus and Hexagram; $2.3
million of pre-tax stock option expense; partially offset by a $1.8 million
non-cash gain representing the reversal of a liability related to an
indemnification obligation with respect to a previously divested subsidiary.
Corporate office operating charges included in consolidated EBIT decreased by
$0.4 million in 2005 as compared to 2004. Fiscal 2005 included an increase of
$0.5 million for professional fees and 2004 included $0.9 million of severance
related costs not repeated in 2005. The "Reconciliation to Consolidated Totals
(Corporate)" in note 15 to the consolidated financial statements represents
Corporate office operating charges.
INTEREST INCOME
Interest income was $1.3 million in 2006, $1.9 million in 2005 and $0.8 million
in 2004. The decrease in interest income in 2006 as compared to 2005 was due to
lower average cash balances on hand resulting from the 2006 acquisitions. The
increase in interest income in 2005 as compared to the prior year was due to
higher average cash balances on hand during the year and a $0.2 million
refund of look back interest related to income taxes.
INCOME TAX EXPENSE
The effective tax rate for continuing operations in 2006 was 36.0% compared to
31.9% in 2005 and 37.6% in 2004. The increase in the effective tax rate in 2006
as compared to the prior year was due to: the effect of the foreign earnings
repatriation increased 2006 income tax expense by $2.4 million and the effective
rate by 4.8%; the adoption of SFAS 123(R) increased tax expense by $0.7 million
and the effective rate by 1.4%; the lower volume of profit contributions of the
Company's foreign operations (primarily Puerto Rico due to the lower sales to
PREPA) adversely impacted the tax rate; partially offset by the effect of a
favorable change in tax contingencies not related to the research tax credit
which decreased tax expense by $1.4 million and the effective tax rate by 2.9%
and the net effect of the research tax credit which favorably impacted tax
expense by $2.5 million and the effective tax rate by 5%. The decrease in the
effective tax rate for continuing operations in 2005 as compared to 2004 was due
to the timing and volume of profit contributions of DCSI's foreign operations
(Puerto Rico), which resulted in a 4.6% favorable adjustment to the Company's
foreign tax rate differential.
During 2006, the Company determined that state tax expense had not been
accurately recorded in the financial statements for years 2001 through 2005. The
effect in any individual prior year was not material to the Company's results of
operations, financial position or cash flows. The Company adopted the provisions
of SEC Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial
Statements" and recorded $2.4 million as a cumulative credit adjustment to 2006
beginning retained earnings.
CAPITAL RESOURCES AND LIQUIDITY
Working capital (current assets less current liabilities) decreased to $131.4
million at September 30, 2006 from $197.2 million at September 30, 2005. During
2006, cash and cash equivalents decreased $67.7 million, primarily due to the
$92 million spent on acquisitions.
The $15.0 million increase in accounts receivable at September 30, 2006 is
mainly due to: $8.3 million related to Nexus and Hexagram; and $5.7 million
related to the Filtration segment due to timing and volume of sales. The $2.3
million increase in inventories at September 30, 2006 is mainly due to a $4.4
million increase related to Hexagram, partially offset by a $3.8 million
decrease at DCSI. Accounts payable increased by $10.2 million at September 30,
2006, of which $3.0 million related to Nexus and Hexagram and $4.6 million
related to the timing of vendor payments at DCSI.
Net cash provided by operating activities was $58.6 million, $68.6 million and
$61.0 million in 2006, 2005 and 2004, respectively. The decrease in 2006 is
related to lower net earnings in the current year. The increase in 2005 as
compared to 2004 is the result of higher earnings and lower cash requirements
related to MicroSep.
Capital expenditures for continuing operations were $9.1 million, $8.8 million
and $10.8 million in 2006, 2005 and 2004, respectively. Major expenditures
included manufacturing equipment and facility modifications used in the
Filtration segment. There were no commitments outstanding that were considered
material for capital expenditures at September 30, 2006.
At September 30, 2006, intangible assets, net, of $59.2 million included $45.2
million of capitalized software. Approximately $40.0 million of the capitalized
software balance represents external development costs on software development
called "TNG" within the Communications segment to further penetrate the IOU
market. TNG is being deployed to efficiently handle the additional levels of
communications dictated by the size of the service territories and the frequency
of reads that are required under time-of-use or critical peak pricing scenarios
to meet the requirements of large IOUs. At September 30, 2006, the Company had
approximately $5 million of commitments related to TNG version 1.6.3 which is
expected to be spent over the next six months. The Company expects to spend up
to approximately $10 million in fiscal 2007 on TNG. Amortization of TNG is on a
straight-line basis over seven years and began in March 2006. The Company
recorded $2.2 million in amortization expense related to TNG during 2006.
At September 30, 2006, the Company had an available net operating loss (NOL)
carryforward for U.S. federal tax purposes of approximately $15 million. This
NOL will expire between 2019 and 2025, and will be available to reduce future
Federal income tax cash payments.
The closure and relocation of the Filtertek Puerto Rico facility was completed
in March 2004. The Puerto Rico facility is included in other current assets with
a carrying value of $3.6 million at
September 30, 2006. The facility is being marketed for sale.
During 2005, the Company reached a settlement in the defense of a certain
revenue-generating patent used in the Filtration business. Under the terms of
the agreement, the Company received a cash payment of $1.5 million, and in 2005
the Company recognized a gain of $0.3 million, after deducting $0.2 million of
professional fees related to the settlement. The unrecognized gain is being
recorded on a straight-line basis in Other (income) and expenses, net, over the
remaining patent life, through 2011.
In 2004, the Company received $2.1 million as final payment on the note
receivable from the sale of the Riverhead, NY, property which was sold in 1999.
PACIFIC GAS & ELECTRIC
In November 2005, DCSI entered into a contract to provide equipment, software
and services to Pacific Gas & Electric (PG&E) in support of the electric portion
of PG&E's Advanced Metering Infrastructure (AMI) project. PG&E's current AMI
project plan calls for the purchase of TWACS communication equipment for up to
approximately five million electric customers over a five-year period after the
commencement of full deployment. The total anticipated contract value from
commencement through the five-year full deployment period is expected to be up
to approximately $310 million. PG&E also has the right to purchase additional
equipment and services to support existing and new customers through the 20-year
term of the contract. Equipment will be purchased by PG&E only upon issuance of
purchase orders and release authorizations. PG&E will continue to have the right
to purchase products or services from other suppliers for the electric portion
of the AMI project. On July 20, 2006, the California Public Utilities Commission
approved PG&E's AMI project. DCSI has agreed to deliver to PG&E versions of its
newly developed TNG software as they become available and are tested. Delivery
of the final version for which DCSI has committed is currently anticipated in
the fourth quarter of fiscal 2007. In accordance with U.S. generally accepted
accounting standards, the Company will defer all revenue related to the DCSI
arrangement until all software is delivered and acceptance criteria have been
met. The contract provides for liquidated damages in the event of DCSI's late
development or delivery of hardware and software, and includes indemnification
and other customary provisions. The contract may be terminated by PG&E for
default, for its convenience and in the event of a force majeure lasting beyond
certain prescribed periods. The Company has guaranteed the obligations of DCSI
under the contract. If PG&E terminates the contract for its convenience, DCSI
will be entitled to recover certain costs.
In November 2005, Hexagram entered into a contract to provide equipment,
software and services to PG&E in support of the gas utility portion of PG&E's
AMI project. The total anticipated contract revenue from commencement through
the five-year full deployment is expected to be approximately $225 million. As
with DCSI's contract with PG&E, equipment will be purchased only upon issuance
of purchase orders and release authorizations, and PG&E will continue to have
the right to purchase products or services from other suppliers for the gas
utility portion of the AMI project. On July 20, 2006, the California Public
Utilities Commission approved PG&E's AMI project. The contract provides for
liquidated damages in the event of late deliveries, includes indemnification and
other customary provisions, and may be terminated by PG&E for default, for its
convenience and in the event of a force majeure lasting beyond certain
prescribed periods. The Company has guaranteed the performance of the contract
by Hexagram.
DIVESTITURES
Effective April 2, 2004, the Company completed the sale of PTI Advanced
Filtration Inc. (Oxnard, California) and PTI Technologies Limited (Sheffield,
England) to domnick hunter group plc for $18.0 million in cash. On June 8, 2004,
the Company completed the sale of PTI S.p.A. (Milan, Italy) to a group of
investors comprised of the subsidiary's senior management for $5.3 million. An
after-tax gain of $1.6 million related to the sale of these MicroSep businesses
is reflected in the Company's 2004 results in discontinued operations. These
businesses are accounted for as a discontinued operation in accordance with SFAS
144, "Accounting for the Impairment or Disposal of Long-Lived Assets," and
accordingly, amounts in the financial statements and related notes for 2004,
reflect discontinued operations presentation.
BANK CREDIT FACILITY
Effective October 6, 2004, the Company entered into a $100 million five-year
revolving bank credit facility with a $50 million increase option that has a
final maturity and expiration date of October 6, 2009. The credit facility is
available for direct borrowings and/or the issuance of letters of credit, and is
provided by a group of six banks, led by Wells Fargo Bank as agent.
The credit facility requires, as determined by certain financial ratios, a
commitment fee ranging from 17.5 to 27.5 basis points per annum on the unused
portion. The terms of the facility provide that interest on borrowings may be
calculated at a spread over the LIBOR or based on the prime rate, at the
Company's election. The credit facility is secured by the unlimited guaranty of
the Company's material domestic subsidiaries and a 65% pledge of the material
foreign subsidiaries' share equity. The financial covenants of the credit
facility include limitations on leverage, minimum consolidated EBITDA and
minimum net worth.
At September 30, 2006, the Company had approximately $99.2 million available to
borrow under the credit facility in addition to its $36.8 million cash on hand.
At September 30, 2006, the Company had no borrowings, and outstanding letters of
credit of $1.5 million ($0.8 million outstanding under the credit facility). As
of September 30, 2006, the Company was in compliance with all bank covenants.
Cash flow from operations and borrowings under the bank credit facility are
expected to provide adequate resources to meet the Company's capital
requirements and operational needs for the foreseeable future.
CONTRACTUAL OBLIGATIONS
The following table shows the Company's contractual obligations as of September
30, 2006:
(dollars in millions) Payments due by period
Less More
Contractual than 1 to 3 3 to 5 than
Obligations Total 1 year years years 5 years
- ----------- ----- ------ ------ ------ -------
Long-Term Debt
Obligation $ -- -- -- -- --
Capital Lease
Obligations 0.9 0.4 0.3 0.2 --
Operating Lease
Obligations 22.3 7.1 7.9 4.0 3.3
Purchase
Obligations(1) 5.0 5.0 -- -- --
----- ---- --- --- ---
Total $28.2 12.5 8.2 4.2 3.3
===== ==== === === ===
(1) A purchase obligation is defined as a legally binding and enforceable
agreement to purchase goods and services that specifies all significant
terms. Since the majority of the Company's purchase orders can be
cancelled, they are not included in the table above. TNG software
development costs through version 1.6.3 are included.
The Company has no off balance sheet arrangements outstanding at September 30,
2006.
SHARE REPURCHASES
In August 2006, the Company's Board of Directors authorized an open market
common stock repurchase program for up to 1.2 million shares, subject to market
conditions and other factors which covers the period through September 30, 2008.
There were no stock repurchases during fiscal 2006. The Company repurchased
670,072 and 312,400 shares in 2005 and 2004, respectively, under a previously
authorized program.
PENSION FUNDING REQUIREMENTS
The minimum cash funding requirements related to the Company's defined benefit
pension plans are zero in 2007, approximately $1 million in 2008 and
approximately $1 million in 2009. The Company made a voluntary cash contribution
of $1.4 million in 2006.
OTHER
Management believes that, for the periods presented, inflation has not had a
material effect on the Company's results of operations.
The Company is currently involved in various stages of investigation and
remediation relating to environmental matters. Based on current information
available, Management does not believe the aggregate costs involved in the
resolution of these matters will have a material adverse effect on the Company's
operating results, capital expenditures or competitive position.
MARKET RISK ANALYSIS
MARKET RISK EXPOSURE
Market risks relating to the Company's operations result primarily from changes
in interest rates and changes in foreign currency exchange rates.
At September 30, 2006 and 2005, the Company had no obligations related to
interest rate swaps. During 2004, in conjunction with the sale of PTI S.p.A.,
the Company repaid its $8.0 million Euro-denominated debt, and at the same time,
the Company terminated its $5.0 million interest rate swap obligation, resulting
in a cash payment of $0.1 million by the Company.
The Company is also subject to foreign currency exchange rate risk inherent in
its sales commitments, anticipated sales, anticipated purchases and assets and
liabilities denominated in currencies other than the U.S. dollar. The foreign
currency most significant to the Company's operations is the Euro. Net sales to
customers outside of the United States were $103.0 million, $103.8 million, and
$91.5 million in 2006, 2005 and 2004, respectively. The Company hedges certain
foreign currency commitments by purchasing foreign currency forward contracts.
The estimated fair value of open forward contracts at September 30, 2006 was not
material.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with GAAP requires
Management to make estimates and assumptions in certain circumstances that
affect amounts reported in the accompanying consolidated financial statements.
In preparing these financial statements, Management has made its best estimates
and judgments of certain amounts included in the financial statements, giving
due consideration to materiality. The Company does not believe there is a great
likelihood that materially different amounts would be reported under different
conditions or using different assumptions related to the accounting policies
described below. However, application of these accounting policies involves the
exercise of judgment and use of assumptions as to future uncertainties and, as a
result, actual results could differ from these estimates. The Company's senior
Management discusses the critical accounting policies described below with the
Audit and Finance Committee of the Company's Board of Directors on a periodic
basis.
The following discussion of critical accounting policies is intended to bring to
the attention of readers those accounting policies which Management believes are
critical to the Consolidated Financial Statements and other financial
disclosure. It is not intended to be a comprehensive list of all significant
accounting policies that are more fully described in Note 1 of Notes to
Consolidated Financial Statements.
REVENUE RECOGNITION
COMMUNICATIONS UNIT: Within the Communications unit, approximately 95% of the
unit's revenue arrangements (approximately 30% of consolidated revenues) contain
software components. Revenue under these arrangements is recognized in
accordance with Statement of Position 97-2 (SOP 97-2), "Software Revenue
Recognition," as amended by SOP 98-9, "Modification of SOP 97-2, Software
Revenue Recognition, with Respect to Certain Transactions." The application of
software revenue recognition requires judgment, including the determination of
whether a software arrangement includes multiple elements and estimates of the
fair value of the elements, or vendor-specific objective evidence of fair value
("VSOE"). Changes to the elements in a software arrangement, and the ability to
identify VSOE for those elements could materially impact the amount of earned
and/or deferred revenue. There have been no material changes to these estimates
for the financial statement periods presented and the Company believes that
these estimates generally should not be subject to significant variation in the
future. The remaining 5% of the unit's revenues represent products sold under a
single element arrangement and are recognized when products are delivered to
unaffiliated customers.
FILTRATION/FLUID FLOW UNIT: Within the Filtration/Fluid Flow operating unit,
approximately 75% of operating unit revenues (approximately 30% of consolidated
revenues) are recognized when products are delivered (when title and risk of
ownership transfers) or when services are performed for unaffiliated customers.
Approximately 25% of operating unit revenues (approximately 10% of consolidated
revenues) are recorded under the percentage-of-completion provisions of SOP
81-1, "Accounting for Performance of Construction-Type and Certain
Production-Type Contracts" because the Company manufactures complex products for
aerospace and military customers under production contracts. The
percentage-of-completion method of accounting involves the use of various
estimating techniques to project costs at completion. These estimates involve
various assumptions and projections relative to the outcome
of future events over a period of several years, including future labor
productivity and availability, the nature and complexity of the work to be
performed, availability of materials, the impact of delayed performance, and the
timing of product deliveries. These estimates are based on Management's judgment
and the Company's substantial experience in developing these types of estimates.
Changes in underlying assumptions/estimates may adversely affect financial
performance if they increase estimated project costs at completion, or
positively affect financial performance if they decrease estimated project costs
at completion. Due to the nature of these contracts and the operating unit's
cost estimating process, the Company believes that these estimates generally
should not be subject to significant variation in the future. There have been no
material changes to these estimates for the financial statement periods
presented. The Company regularly reviews its estimates to assess revisions in
contract values and estimated costs at completion.
TEST UNIT: Within the Test unit, approximately 60% of revenues (approximately
20% of consolidated revenues) are recognized when products are delivered (when
title and risk of ownership transfers) or when services are performed for
unaffiliated customers. Certain arrangements contain multiple elements which are
accounted for under the provisions of EITF 00-21, "Revenue Arrangements with
Multiple Deliverables." The application of EITF 00-21 requires judgment as to
whether the deliverables can be divided into more than one unit of accounting
and whether the separate units of accounting have value to the customer on a
stand-alone basis. Changes to these elements could affect the timing of revenue
recognition. There have been no material changes to these elements for the
financial statement periods presented.
Approximately 40% of the unit's revenues (approximately 10% of consolidated
revenues) are recorded under the percentage-of-completion provisions of SOP
81-1, "Accounting for the Performance of Construction-Type and Certain
Production-Type Contracts" due to the complex nature of the enclosures that are
designed and produced under these contracts. As discussed above, this method of
accounting involves the use of various estimating techniques to project costs at
completion, which are based on Management's judgment and the Company's
substantial experience in developing these types of estimates. Changes in
underlying assumptions/estimates may adversely or positively affect financial
performance. Due to the nature of these contracts and the operating unit's cost
estimating process, the Company believes that these estimates generally should
not be subject to significant variation in the future. There have been no
material changes to these estimates for the financial statement periods
presented. The Company regularly reviews its contract estimates to assess
revisions in contract values and estimated costs at completion.
INVENTORY
Inventories are valued at the lower of cost (first-in, first-out) or market
value. Management regularly reviews inventories on hand compared to historical
usage and estimated future usage and sales. Inventories under long-term
contracts reflect accumulated production costs, factory overhead, initial
tooling and other related costs less the portion of such costs charged to cost
of sales and any unliquidated progress payments. In accordance with industry
practice, costs incurred on contracts in progress include amounts relating to
programs having production cycles longer than one year, and a portion thereof
may not be realized within one year.
INCOME TAXES
The Company operates in numerous taxing jurisdictions and is subject to
examination by various U.S. Federal, state and foreign jurisdictions for various
tax periods. Additionally, the Company has retained tax liabilities and the
rights to tax refunds in connection with various divestitures of businesses in
prior years. The Company's income tax positions are based on research and
interpretations of the income tax laws and rulings in each of the jurisdictions
in which the Company does business. Due to the subjectivity of interpretations
of laws and rulings in each jurisdiction, the differences and interplay in tax
laws between those jurisdictions, as well as the inherent uncertainty in
estimating the final resolution of complex tax audit matters, Management's
estimates of income tax liabilities may differ from actual payments or
assessments.
While the Company has support for the positions taken on its tax returns, taxing
authorities are increasingly asserting alternate interpretations of laws and
facts, and are challenging cross jurisdictional transactions. Cross
jurisdictional transactions between the Company's subsidiaries involving
transfer prices for products and services, as well as various U.S. federal,
state and foreign tax matters, comprise the Company's income tax exposures.
Management regularly assesses the Company's position with regard to tax
exposures and records liabilities for these uncertain tax positions and related
interest and penalties, if any, according to the principles of SFAS No. 5,
"Accounting for Contingencies." The Company has recorded an accrual that
reflects Management's
estimate of the likely outcome of current and future audits. A final
determination of these tax audits or changes in Management's estimates may
result in additional future income tax expense or benefit.
At the end of each interim reporting period, Management estimates the effective
tax rate expected to apply to the full fiscal year. The estimated effective tax
rate contemplates the expected jurisdiction where income is earned, as well as
tax planning strategies. Current and projected growth in income in higher tax
jurisdictions may result in an increasing effective tax rate over time. If the
actual results differ from Management's estimates, Management may have to adjust
the effective tax rate in the interim period such determination is made.
Income taxes are accounted for under the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled. Deferred tax assets may be reduced by a valuation
allowance if it is more likely than not that some portion of all of the deferred
tax assets will not be realized. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income in the period that
includes the enactment date. The Company regularly reviews its deferred tax
assets for recoverability and establishes a valuation allowance when Management
believes it is more likely than not such assets will not be recovered, taking
into consideration historical operating results, expectations of future
earnings, tax planning strategies, and the expected timing of the reversals of
existing temporary differences.
GOODWILL AND OTHER LONG-LIVED ASSETS
In accordance with SFAS 142, Management annually reviews goodwill and other
long-lived assets with indefinite useful lives for impairment or whenever events
or changes in circumstances indicate the carrying amount may not be recoverable.
If the Company determines that the carrying value of the long-lived asset may
not be recoverable, a permanent impairment charge is recorded for the amount by
which the carrying value of the long-lived asset exceeds its fair value. Fair
value is measured based on a discounted cash flow method using a discount rate
determined by Management to be commensurate with the risk inherent in the
Company's current business model. The estimates of cash flows and discount rate
are subject to change due to the economic environment, including such factors as
interest rates, expected market returns and volatility of markets served.
Management believes that the estimates of future cash flows and fair value are
reasonable; however, changes in estimates could result in impairment charges.
SFAS 142 also requires that intangible assets with estimable useful lives be
amortized over their respective estimated useful lives to their estimated
residual values, and reviewed for impairment in accordance with SFAS 144.
PENSION PLANS AND OTHER POSTRETIREMENT BENEFIT PLANS
The measurement of liabilities related to pension plans and other
post-retirement benefit plans is based on Management's assumptions related to
future events including interest rates, return on pension plan assets, rate of
compensation increases, and health care cost trend rates. Actual pension plan
asset performance will either decrease or increase unamortized pension losses
that will affect net earnings in future years. Depending upon the performance of
the equity and bond markets in 2007, the Company could be required to record a
charge to equity. In addition, if the discount rate was decreased by 25 basis
points from 5.75% to 5.50%, the accumulated benefit obligation for the defined
benefit plan would increase by approximately $1.6 million and result in an
additional after-tax charge to shareholders' equity of approximately $1.0
million. The discount rate used in measuring the Company's pension and
postretirement welfare obligations was developed by matching yields of actual
high-quality corporate bonds to expected future pension plan cash flows (benefit
payments). Over 500 Aa-rated, non-callable bonds with a wide range of maturities
were used in the analysis. After using the bond yields to determine the present
value of the plan cash flows, a single representative rate that resulted in the
same present value was developed.
OTHER MATTERS
CONTINGENCIES
As a normal incident of the businesses in which the Company is engaged, various
claims, charges and litigation are asserted or commenced against the Company.
Lindgren is involved in a contract dispute with a prime contractor involving the
assertion of certain construction delay damages of
approximately $3.7 million. The project was completed in 2005. Lindgren
vigorously denies responsibility for this delay and for these damages, and has
asserted a claim against the prime contractor of $0.9 million based on damages
suffered by Lindgren. Lindgren continues to aggressively defend its position and
pursue its right to affirmative damages however, there can be no assurance of
the outcome at this time. In the opinion of Management, final judgments, if any,
which might be rendered against the Company are adequately reserved, covered by
insurance, or are not likely to have a material adverse effect on its financial
statements.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risks relating to the Company's operations result primarily from changes
in interest rates and changes in foreign currency exchange rates. At September
30, 2006 and 2005, the Company had no obligations related to interest rate
swaps. During 2004, in conjunction with the sale of PTI S.p.A., the Company
repaid its $8.0 million Euro-denominated debt and at the same time, the Company
terminated its $5.0 million interest rate swap obligation resulting in a cash
payment of $0.1 million by the Company. See further discussion in "Management's
Discussion and Analysis -- Market Risk Analysis" regarding the Company's market
risks.
CONTROLS AND PROCEDURES
The Company carried out an evaluation under the supervision of and with the
participation of Management, including the Company's Chief Executive Officer and
Chief Financial Officer, of the effectiveness of the design and operation of the
Company's disclosure controls and procedures as of the end of the period covered
by this report. Based upon that evaluation, the Company's Chief Executive
Officer and Chief Financial Officer concluded that the Company's disclosure
controls and procedures are effective excluding the Hexagram and Nexus
acquisitions. Disclosure controls and procedures are controls and procedures
that are designed to ensure that information required to be disclosed in company
reports filed or submitted under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported within time periods specified in
the Securities and Exchange Commission's rules and forms. There have been no
significant changes in the Company's internal controls or in other factors
during the period covered by this report that have materially affected, or are
reasonably likely to materially affect those controls and procedures.
NEW ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment" (SFAS
123(R)). This Statement replaces SFAS No. 123, "Accounting for Stock-Based
Compensation" and supersedes APB No. 25, "Accounting for Stock Issued to
Employees." SFAS 123(R) requires all stock-based compensation to be recognized
as an expense in the financial statements and that such cost be measured
according to the fair value of stock options. The Company adopted the provisions
of this Statement in the first quarter of fiscal 2006 on a prospective basis.
In December 2004, the FASB issued FASB Staff Position FAS 109-2, "Accounting and
Disclosure Guidance for the Foreign Earnings Repatriation Provision within the
American Jobs Creation Act of 2004 (FSP 109-2)." The American Jobs Creation Act
of 2004, (the "Act") provides for a special one-time deduction of 85 percent of
certain foreign earnings repatriated into the U.S. from non-U.S. subsidiaries
through September 30, 2006. During fiscal 2006, the Company repatriated $39.5
million of foreign earnings which qualify for the special one-time deduction.
Tax expense of $2.4 million was recorded in fiscal 2006 as a result of this
repatriation.
In June 2006, the FASB issued FASB Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109." This
Interpretation is effective for ESCO beginning October 1, 2007. This
Interpretation prescribes a recognition threshold and measurement process for
the financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. The Company is currently evaluating the
adoption of this Interpretation and does not currently have an estimate of the
impact on the consolidated financial statements.
In September 2006, the FASB issued SFAS No. 158, "Employer's Accounting for
Defined Benefit Pension and Other Postretirement Plans" (SFAS 158), which amends
SFAS 87 and SFAS 106 to require recognition of the overfunded or underfunded
status of pension and other postretirement benefit plans on the balance sheet.
Under SFAS 158, gains and losses, prior service costs and credits, and any
remaining transition amounts under SFAS 87 and SFAS 106 that have not yet been
recognized through net periodic benefit cost will be recognized in accumulated
other comprehensive income, net of tax effects. The measurement date -- the date
at which the benefit obligation and plan assets are measured -- is required to
be the Company's fiscal year-end, which is the date the Company currently uses.
SFAS 158 is effective for publicly held companies for fiscal years ending after
December 15, 2006. The adoption of SFAS 158 is not expected to have a material
impact to the Company's financial position or results of operations.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108,
"Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements" (SAB No. 108), which
addresses the diversity in practice in quantifying financial statement
misstatements and provides interpretative guidance regarding the consideration
given to prior year misstatements when determining materiality in current year
financial statements. During 2006, the Company adopted the provisions of SAB No.
108 and recorded $2.4 million as a cumulative credit adjustment to 2006
beginning retained earnings.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" (SFAS
157), which defines fair value in generally accepted accounting principles and
expands disclosures about fair value measurements. This Statement is effective
for financial statements issued for fiscal years beginning after November 15,
2007. The adoption of SFAS 157 is not expected to have a material impact to the
Company's financial position or results of operations.
FORWARD-LOOKING INFORMATION
Statements regarding future events and the Company's future results that are
based on current expectations, estimates, forecasts and projections about the
Company's performance and the industries in which the Company operates, the
Company's ability to utilize NOLs, adequacy of the Company's credit facility and
future cash flows, estimates of anticipated contract costs and revenues, the
timing, amount and success of claims for research credits, the success of
software development efforts and resulting costs, acceptance by PG&E of the
final version of DCSI's TNG software, growth in the AMR market, potential
customer contracts, the anticipated value of the PG&E contract, the outcome of
current litigation, claims and charges, recoverability of deferred tax assets,
continued reinvestment of foreign earnings, the impact of SFAS 158, future costs
relating to environmental matters, share repurchases, investments, sustained
performance improvement, performance improvement initiatives, growth
opportunities, new product development, the Company's ability to increase
shareholder value, acquisitions, and the beliefs and assumptions of Management
contained in the Letter to Our Shareholders (pages 1-2), the Report of the Chief
Financial Officer (page 12), and Management's Discussion and Analysis and other
statements contained herein which are not strictly historical are considered
"forward-looking statements" within the meaning of the safe harbor provisions of
the federal securities laws. Words such as expects, anticipates, targets, goals,
projects, intends, plans, believes, estimates, variations of such words, and
similar expressions are intended to identify such forward-looking statements.
Investors are cautioned that such statements are only predictions, speak only as
of the date of this report, and the Company undertakes no duty to update. The
Company's actual results in the future may differ materially from those
projected in the forward-looking statements due to risks and uncertainties that
exist in the Company's operations and business environment including, but not
limited to: actions by the California Public Utility Commission; PG&E's Board of
Directors or PG&E's management impacting PG&E's AMI projects; the timing and
success of DCSI's software development efforts; the timing and content of
purchase order releases under the PG&E contracts; and DCSI's and Hexagram's
successful performance of the PG&E contracts; the timing and execution of real
estate sales; termination for convenience of customer contracts; timing and
magnitude of future contract awards; weakening of economic conditions in served
markets; the success of the Company's competitors; changes in customer demands
or customer insolvencies; competition; intellectual property rights; technical
difficulties; the availability of selected acquisitions; the timing, pricing and
availability of shares offered for sale; delivery delays or defaults by
customers; performance issues with key customers, suppliers and subcontractors;
material changes in the costs of certain raw materials; the successful sale of
the Company's Puerto Rico facility; collective bargaining and labor disputes;
changes in laws and regulations including but not limited to changes in
accounting standards and taxation requirements; costs relating to environmental
matters; litigation uncertainty; and the Company's successful execution of
internal operating plans.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except per share amounts)
Years ended September 30, 2006 2005 2004
-------- ------- -------
Net sales $458,865 429,115 422,085
Costs and expenses:
Cost of sales 300,309 281,654 282,369
Selling, general and administrative expenses 106,882 84,241 77,296
Amortization of intangible assets 6,872 1,973 2,122
Interest income, net (1,286) (1,900) (844)
Other (income) and expenses, net (2,814) (1,550) 578
Asset impairment -- 790 --
-------- ------- -------
Total costs and expenses 409,963 365,208 361,521
-------- ------- -------
Earnings before income tax 48,902 63,907 60,564
Income tax expense 17,622 20,363 22,748
-------- ------- -------
Net earnings from continuing operations 31,280 43,544 37,816
Loss from discontinued operations,
net of tax benefit: 2004, $(1,295) -- -- (3,737)
Gain on sale of discontinued operations,
net of tax benefit: 2004, $(1,186) -- -- 1,592
-------- ------- -------
Net loss from discontinued operations -- -- (2,145)
-------- ------- -------
Net earnings $ 31,280 43,544 35,671
-------- ------- -------
Earnings per share:
Basic:
Continuing operations $ 1.22 1.71 1.47
Discontinued operations -- -- (0.09)
-------- ------- -------
Net earnings $ 1.22 1.71 1.38
-------- ------- -------
Diluted:
Continuing operations $ 1.19 1.66 1.42
Discontinued operations -- -- (0.08)
-------- ------- -------
Net earnings $ 1.19 1.66 1.34
-------- ------- -------
Average common shares outstanding (in thousands):
Basic 25,718 25,511 25,803
Diluted 26,386 26,306 26,648
======== ======= =======
See accompanying notes to consolidated financial statements.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
Years ended September 30, 2006 2005
-------- -------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 36,819 104,484
Accounts receivable, less allowance for doubtful accounts of
$798 and $585 in 2006 and 2005, respectively 83,816 68,819
Costs and estimated earnings on long-term contracts, less progress
billings of $4,405 and $7,033 in 2006 and 2005, respectively 1,345 4,392
Inventories 50,984 48,645
Current portion of deferred tax assets 24,251 25,271
Other current assets 10,042 8,394
-------- -------
Total current assets 207,257 260,005
-------- -------
PROPERTY, PLANT AND EQUIPMENT:
Land and land improvements 5,497 5,493
Buildings and leasehold improvements 46,089 42,918
Machinery and equipment 86,312 76,741
Construction in progress 1,444 1,108
-------- -------
139,342 126,260
Less accumulated depreciation and amortization 70,588 59,070
-------- -------
Net property, plant and equipment 68,754 67,190
Goodwill 143,450 68,880
Intangible assets, net 59,202 21,545
Other assets 10,031 6,152
-------- -------
$488,694 423,772
======== =======
See accompanying notes to consolidated financial statements.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
Years ended September 30, 2006 2005
-------- -------
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Short-term borrowings and current maturities of long-term debt $ -- --
Accounts payable 39,496 29,299
Advance payments on long-term contracts, less costs incurred of $19,532 and
$10,949 in 2006 and 2005, respectively 7,367 6,773
Accrued salaries 13,932 12,024
Accrued other expenses 15,100 14,661
-------- -------
Total current liabilities 75,895 62,757
-------- -------
Deferred revenue 7,458 3,134
Pension obligations 13,143 17,481
Other liabilities 15,764 9,376
Long-term debt -- --
-------- -------
Total liabilities 112,260 92,748
-------- -------
SHAREHOLDERS' EQUITY:
Preferred stock, par value $.01 per share, authorized 10,000,000 shares -- --
Common stock, par value $.01 per share, authorized 50,000,000 shares;
Issued 29,030,995 and 28,738,958 shares in 2006 and 2005, respectively 290 287
Additional paid-in capital 236,390 228,317
Retained earnings 193,046 159,363
Accumulated other comprehensive loss (2,070) (5,566)
-------- -------
427,656 382,401
Less treasury stock, at cost (3,166,026 and 3,175,626 common shares in
2006 and 2005, respectively) (51,222) (51,377)
-------- -------
Total shareholders' equity 376,434 331,024
-------- -------
$488,694 423,772
======== =======
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Accumulated
Common Stock Additional Other
(In thousands) --------------- Paid-In Retained Comprehensive Treasury
Years ended September 30, Shares Amount Capital Earnings Income (Loss) Stock Total
------ ------ ---------- -------- ------------- -------- -------
Balance, September 30, 2003 13,933 $139 216,506 80,292 (4,982) (16,566) 275,389
Comprehensive income:
Net earnings -- -- -- 35,671 -- -- 35,671
Translation adjustments -- -- -- -- 2,703 -- 2,703
Minimum pension liability, net of tax
of $815 -- -- -- -- (1,514) -- (1,514)
Interest rate swap adjustment
net of tax benefit of $(51) -- -- -- -- 95 -- 95
-------
Comprehensive income 36,955
-------
Stock options and stock compensation
plans, net of tax benefit of $(1,939) 216 3 5,205 -- -- 45 5,253
Purchases into treasury -- -- -- -- -- (9,981) (9,981)
------ ---- ------- ------- ------ ------- -------
Balance, September 30, 2004 14,149 142 221,711 115,963 (3,698) (26,502) 307,616
-------
Comprehensive income:
Net earnings -- -- -- 43,544 -- -- 43,544
Translation adjustments -- -- -- -- 680 -- 680
Minimum pension liability, net of tax
of $1,372 -- -- -- -- (2,548) -- (2,548)
-------
Comprehensive income 41,676
-------
Stock options and stock compensation
plans, net of tax benefit of $(3,032) 222 1 6,606 -- -- 53 6,660
Purchases into treasury -- -- -- -- -- (24,928) (24,928)
100 percent stock dividend 14,368 144 -- (144) -- -- --
------ ---- ------- ------- ------ ------- -------
Balance, September 30, 2005 28,739 287 228,317 159,363 (5,566) (51,377) 331,024
-------
SAB 108 Cumulative effect adjustment -- -- -- 2,403 -- -- 2,403
Comprehensive income:
Net earnings -- -- -- 31,280 -- -- 31,280
Translation adjustments -- -- -- -- 1,448 -- 1,448
Minimum pension liability, net of tax
of $(1,103) -- -- -- -- 2,048 -- 2,048
-------
Comprehensive income 34,776
-------
Stock options and stock compensation
plans, net of tax benefit of $(3,173) 292 3 8,073 -- -- 155 8,231
------ ---- ------- ------- ------ ------- -------
Balance, September 30, 2006 29,031 $290 236,390 193,046 (2,070) (51,222) 376,434
====== ==== ======= ======= ====== ======= =======
See accompanying notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOW
(Dollars in thousands)
Years ended September 30, 2006 2005 2004
--------- ------- -------
Cash flows from operating activities:
Net earnings $ 31,280 43,544 35,671
Adjustments to reconcile net earnings to net cash provided by
operating activities:
Loss from discontinued operations, net of tax -- -- 3,737
Gain on sale of discontinued operations, net of tax -- -- (1,592)
Asset impairment -- 790 --
Depreciation and amortization 17,303 12,184 11,888
Stock compensation expense 4,790 2,649 1,766
Changes in operating working capital 1,162 (4,634) (2,349)
Effect of deferred taxes on tax provision 3,596 15,221 14,056
Pension contributions (1,350) -- (900)
Change in deferred revenue and costs, net 1,133 396 --
Other 712 (1,594) 1,485
--------- ------- -------
Net cash provided by operating activities -- continuing operations 58,626 68,556 63,762
Net cash used by discontinued operations -- -- (2,735)
--------- ------- -------
Net cash provided by operating activities 58,626 68,556 61,027
--------- ------- -------
Cash flows from investing activities:
Acquisition of businesses, net of cash acquired (91,968) -- (294)
Proceeds from divestiture of businesses -- -- 23,275
Proceeds from note receivable -- -- 2,120
Capital expenditures -- continuing operations (9,117) (8,848) (10,823)
Capital expenditures -- discontinued operations -- -- (1,390)
Additions to capitalized software (27,977) (8,342) (8,299)
--------- ------- -------
Net cash provided (used) by investing activities (129,062) (17,190) 4,589
--------- ------- -------
Cash flows from financing activities:
Proceeds from long-term debt 52,000 -- 378
Principal payments on long-term debt -- continuing operations (52,000) (519) (516)
Principal payments on long-term debt -- discontinued operations -- -- (9,024)
Net decrease in short-term borrowings -- -- (10,000)
Purchases of common stock into treasury -- (24,928) (9,981)
Excess tax benefit from stock options exercised 1,569 -- --
Proceeds from exercise of stock options 2,761 3,037 3,027
Other (1,559) 3,247 1,496
--------- ------- -------
Net cash provided (used) by financing activities 2,771 (19,163) (24,620)
--------- ------- -------
Net (decrease) increase in cash and cash equivalents (67,665) 32,203 40,996
Cash and cash equivalents at beginning of year 104,484 72,281 31,285
--------- ------- -------
Cash and cash equivalents at end of year $ 36,819 104,484 72,281
--------- ------- -------
Changes in operating working capital:
Accounts receivable, net $ (10,029) 8,910 (8,350)
Costs and estimated earnings on long-term contracts, net 3,047 (1,916) 2,187
Inventories 1,822 (4,358) 4,145
Other current assets and current portion of deferred tax assets 737 (1,856) (2,405)
Accounts payable 7,675 (3,156) (2,485)
Advance payments on long-term contracts, net 594 2,468 3,161
Accrued expenses (2,684) (4,726) 1,398
--------- ------- -------
$ 1,162 (4,634) (2,349)
--------- ------- -------
Supplemental cash flow information:
Interest paid $ 456 33 402
Income taxes paid (including state, foreign & AMT) 10,768 6,269 4,974
========= ======= =======
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
A. PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of ESCO Technologies
Inc. (ESCO) and its wholly owned subsidiaries (the Company). All significant
intercompany transactions and accounts have been eliminated in consolidation.
Certain prior year amounts have been reclassified to conform with the 2006
presentation.
B. BASIS OF PRESENTATION
Fair values of the Company's financial instruments are estimated by reference to
quoted prices from market sources and financial institutions, as well as other
valuation techniques. The estimated fair value of each class of financial
instruments approximated the related carrying value at September 30, 2006 and
2005.
C. NATURE OF OPERATIONS
The Company has three industry operating units: Communications, Filtration/Fluid
Flow and Test. The Communications unit is a proven supplier of special purpose
communications systems for electric, gas and water utilities, including hardware
and software to support advanced metering applications. The Filtration/Fluid
Flow unit develops, manufactures and markets a broad range of filtration
products used in the purification and processing of liquids and gases. The Test
unit is an industry leader in providing its customers with the ability to
identify, measure and contain magnetic, electromagnetic and acoustic energy.
D. USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America (GAAP) requires Management to
make estimates and assumptions, including estimates of anticipated contract
costs and revenues utilized in the earnings process, that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates.
E. REVENUE RECOGNITION
COMMUNICATIONS UNIT: Within the Communications unit, approximately 95% of the
unit's revenue arrangements (approximately 30% of consolidated revenues) contain
software components. Revenue under these arrangements is recognized in
accordance with Statement of Position 97-2 (SOP 97-2), "Software Revenue
Recognition," as amended by SOP 98-9, "Modification of SOP 97-2, Software
Revenue Recognition, with Respect to Certain Transactions." The unit's software
revenue arrangements generally include multiple products and services, or
"elements" consisting of meter and substation hardware, meter reading system
software, program management support during the deployment period and software
support (post-contract customer support, "PCS"). These arrangements typically
require the Company to deliver software at the inception of the arrangement
while the hardware, and program management support are delivered over the
contractual deployment period. Software support is provided during deployment
and subsequent thereto. The software element included in such arrangements is
essential to the functionality of the hardware and, therefore, the hardware is
considered to be software-related. Hardware is considered a specified element in
the software arrangement and vendor-specific objective evidence of fair value
("VSOE") has been established for this element. VSOE for the hardware element is
determined based on the price when sold separately to customers. These revenue
arrangements are divided into separate units of accounting if the delivered
item(s) has value to the customer on a stand-alone basis, there is objective and
reliable evidence of the fair value of the undelivered item(s) and
delivery/performance of the undelivered item(s) is probable. For multiple
element arrangements, revenue is allocated to the individual elements based on
VSOE of the individual elements.
The application of these principles requires judgment, including the
determination of whether a software arrangement includes multiple elements and
estimates of the fair value of the elements. The VSOE of the undelivered
elements is determined based on the historical evidence of stand-alone sales of
these elements to customers. Hardware revenues are generally recognized at the
time of shipment or receipt by customer depending upon contract terms. VSOE
generally does not exist for the software element, therefore, the Company uses
the residual method to recognize revenue when
VSOE exists for all other undelivered elements. Under the residual method, the
fair value of the undelivered elements is deferred and the remaining portion of
the arrangement fee is recognized as revenue.
SOP 97-2 requires the seller of software that includes post-contract customer
support (PCS) to establish VSOE of the undelivered element of the contract in
order to account separately for the PCS revenue. The Company determines VSOE by
a consistent pricing of PCS and PCS renewals as a percentage of the software
license fees or by reference to contractual renewals, when the renewal terms are
substantive. Revenues for PCS are recognized ratably over the maintenance term
specified in the contract (generally in 12 monthly increments). Revenues for
program management support are recognized when services have been provided. The
Company determines VSOE for program management support based on hourly rates
when services are performed separately.
In November 2005, DCSI and Hexagram entered into arrangements with a large
utility company to provide software, program management services, training and
PCS that includes an option for the customer to purchase a significant quantity
of hardware over an initial deployment period of approximately five years and
subsequently over the remaining initial contract term of up to fifteen years.
The software, program management services and training will be delivered over
the initial hardware deployment period of approximately five years. PCS will be
provided at no charge during the first year of the initial deployment period,
after which it will be provided over subsequent annual periods throughout the
contract term if the customer chooses to continue PCS. Because the program
management services are based on a fixed price per month rather than on a time
and materials basis, the Company is unable to establish VSOE for the program
management services in this arrangement. The Company is able to establish VSOE
for the PCS based on contractual renewal rates that are consistent with other
arrangements and for the training based on pricing when sold separately. For the
DCSI arrangement, the pricing for the optional hardware includes a discount that
the Company has determined to be more-than-insignificant. In accordance with
applicable software revenue recognition guidance, the Company will defer all
revenue related to the DCSI arrangement until all software is delivered and
acceptance criteria have been met. At that time, revenue otherwise allocable to
the software, program management services, training and initial bundled PCS will
be reduced by the rate of the significant incremental discount offered on the
hardware products. The portion of the arrangement consideration allocated to the
significant incremental discount will be recognized ratably over the discount
period (up to twenty years) similar to a subscription. The remaining arrangement
consideration will be recognized ratably over the period the program management
services will be performed (the initial deployment period of approximately five
years). Additional annual fees are payable in each subsequent year that PCS is
provided and will be recognized over the respective PCS period. The amount paid
by the customer for optional purchases of hardware during the deployment period
related to both the DCSI and Hexagram arrangements will be recognized upon
delivery and acceptance, if applicable, assuming all other revenue recognition
criteria have been met.
Approximately 5% of unit revenues are recognized when products are delivered
(when title and risk of ownership transfers) or when services are performed for
unaffiliated customers. Products include the SecurVision(R) digital video
surveillance systems.
FILTRATION/FLUID FLOW UNIT: Within the Filtration/Fluid Flow operating unit,
approximately 75% of operating unit revenues (approximately 30% of consolidated
revenues) are recognized when products are delivered (when title and risk of
ownership transfers) or when services are performed for unaffiliated customers.
Approximately 25% of operating unit revenues (approximately 10% of consolidated
revenues) are recorded under the percentage-of-completion provisions of SOP
81-1, "Accounting for Performance of Construction-Type and Certain
Production-Type Contracts." Products accounted for under SOP 81-1 include the
design, development and manufacture of complex fluid control products, quiet
valves, manifolds and systems primarily for the aerospace and military markets.
For arrangements that are accounted for under SOP 81-1, the Company estimates
profit as the difference between total estimated revenue and total estimated
cost of a contract and recognizes these revenues and costs based on units
delivered. The percentage-of-completion method of accounting involves the use of
various techniques to estimate expected costs at completion.
TEST UNIT: Within the Test unit, approximately 60% of revenues (approximately
20% of consolidated revenues) are recognized when products are delivered (when
title and risk of ownership transfers) or when services are performed for
unaffiliated customers. Certain arrangements contain multiple elements which are
accounted for under the provisions of EITF 00-21, "Revenue Arrangements with
Multiple Deliverables." The multiple elements generally consist of materials and
installation services used in the construction and installation of standard
shielded enclosures to measure and contain magnetic and electromagnetic energy.
The installation process does not involve changes to the features or
capabilities of the equipment and does not require proprietary information about
the equipment in order for the installed equipment to perform to specifications.
There is objective and reliable evidence of fair value for each of the units of
accounting, as a result, the arrangement revenue is allocated to the separate
units of accounting based on their relative fair values. Typically, fair value
is the price of the deliverable when it is regularly sold on a stand-alone
basis.
Approximately 40% of the unit's revenues (approximately 10% of consolidated
revenues) are recorded under the percentage-of-completion provisions of SOP
81-1, "Accounting for the Performance of Construction-Type and Certain
Production-Type Contracts" due to the complex nature of the enclosures that are
designed and produced under these contracts. Products accounted for under SOP
81-1 include the construction and installation of complex test chambers to a
buyer's specifications that provide its customers with the ability to measure
and contain magnetic, electromagnetic and acoustic energy. As discussed above,
for arrangements that are accounted for under SOP 81-1, the Company estimates
profit as the difference between total estimated revenue and total estimated
cost of a contract and recognizes these revenues and costs based on either (a)
units delivered or (b) contract milestones.
If a reliable measure of output cannot be established (which applies in less
than 8% of Test unit revenues or 2% of consolidated revenues), input measures
(e.g., costs incurred) are used to recognize revenue. Given the nature of the
Company's operations related to these contracts, costs incurred represent an
appropriate measure of progress towards completion.
The percentage-of-completion method of accounting involves the use of various
techniques to estimate expected costs at completion. These estimates are based
on Management's judgment and the Company's substantial experience in developing
these types of estimates.
F. CASH AND CASH EQUIVALENTS
Cash equivalents include temporary investments that are readily convertible into
cash, such as Eurodollars, commercial paper and treasury bills with original
maturities of three months or less.
G. ACCOUNTS RECEIVABLE
Accounts receivable have been reduced by an allowance for amounts that the
Company estimates are uncollectible in the future. This estimated allowance is
based on Management's evaluation of the financial condition of the customer and
historical write-off experience.
H. COSTS AND ESTIMATED EARNINGS ON LONG-TERM CONTRACTS
Costs and estimated earnings on long-term contracts represent unbilled revenues,
including accrued profits, accounted for under the percentage-of-completion
method, net of progress billings.
I. INVENTORIES
Inventories are valued at the lower of cost (first-in, first-out) or market
value. Inventories under long-term contracts reflect accumulated production
costs, factory overhead, initial tooling and other related costs less the
portion of such costs charged to cost of sales and any unliquidated progress
payments. In accordance with industry practice, costs incurred on contracts in
progress include amounts relating to programs having production cycles longer
than one year, and a portion thereof will not be realized within one year.
J. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are recorded at cost. Depreciation and
amortization are computed primarily on a straight-line basis over the estimated
useful lives of the assets: buildings, 10-40 years; machinery and equipment,
5-10 years; and office furniture and equipment, 5-10 years. Leasehold
improvements are amortized over the remaining term of the applicable lease or
their estimated useful lives, whichever is shorter.
K. GOODWILL AND OTHER LONG-LIVED ASSETS
Goodwill represents the excess of purchase costs over the fair value of net
identifiable assets acquired in business acquisitions. The Company accounts for
goodwill as required by Statement of Financial Accounting Standards (SFAS) 142,
"Goodwill and Other Intangible Assets." Management annually reviews goodwill and
other long-lived assets with indefinite useful lives for impairment or whenever
events or changes in circumstances indicate the carrying amount may not be
recoverable.
If the Company determines that the carrying value of the long-lived asset may
not be recoverable, a permanent impairment charge is recorded for the amount by
which the carrying value of the long-lived asset exceeds its fair value. Fair
value is measured based on a discounted cash flow method using a discount rate
determined by Management to be commensurate with the risk inherent in the
Company's current business model. Other intangible assets represent costs
allocated to identifiable intangible assets, principally capitalized software,
patents, trademarks, and technology rights. See Note 5 regarding goodwill and
other intangible assets activity.
L. CAPITALIZED SOFTWARE
The costs incurred for the development of computer software that will be sold,
leased, or otherwise marketed are charged to expense when incurred as research
and development until technological feasibility has been established for the
product. Technological feasibility is typically established upon completion of a
detailed program design. Costs incurred after this point are capitalized on a
project-by-project basis in accordance with SFAS No. 86, "Accounting for the
Costs of Computer Software to be Sold, Leased or Otherwise Marketed." Costs that
are capitalized primarily consist of external development costs. Upon general
release of the product to customers, the Company ceases capitalization and
begins amortization, which is calculated on a project-by-project basis as the
greater of (1) the ratio of current gross revenues for a product to the total of
current and anticipated future gross revenues for the product or (2) the
straight-line method over the estimated economic life of the product. The
Company generally amortizes the software development costs over a three to seven
year period based upon the estimated future economic life of the product.
Factors considered in determining the estimated future economic life of the
product include anticipated future revenues, and changes in software and
hardware technologies. The carrying values of capitalized costs are evaluated
for impairment on an annual basis to determine if circumstances exist which
indicate the carrying value of the asset may not be recoverable. If expected
cash flows are insufficient to recover the carrying amount of the asset, then an
impairment loss is recognized to state the asset at its net realizable value.
M. IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF
Recoverability of assets to be held and used is measured by a comparison of the
carrying amount of an asset to future cash flows expected to be generated by the
asset. If such assets are considered to be impaired, the impairment to be
recognized is measured by the amount by which the carrying amount of the assets
exceeds the fair value of the assets. Assets to be disposed of are reported at
the lower of the carrying amount or fair value less costs to dispose.
N. INCOME TAXES
Income taxes are accounted for under the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled. Deferred tax assets may be reduced by a valuation
allowance if it is more likely than not that some portion or all of the deferred
tax assets will not be realized. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income in the period that
includes the enactment date. The Company regularly reviews its deferred tax
assets for recoverability and establishes a valuation allowance when Management
believes it is more likely than not such assets will not be recovered, taking
into consideration historical operating results, expectations of future
earnings, tax planning strategies, and the expected timing of the reversals of
existing temporary differences.
O. RESEARCH AND DEVELOPMENT COSTS
Company-sponsored research and development costs include research and
development and bid and proposal efforts related to the Company's products and
services. Company-sponsored product development costs are charged to expense
when incurred. Customer-sponsored research and development costs incurred
pursuant to contracts are accounted for similar to other program costs.
Customer-sponsored research and development costs refer to certain situations
whereby customers provide funding to support specific contractually defined
research and development costs. As the Company incurs costs under these specific
funding contracts, the costs are "inventoried" until billed to the customer for
reimbursement, consistent with other program costs. Once billed/invoiced, these
costs are transferred to accounts receivable until the cash is received from the
customer. All research and development costs incurred in excess of the
contractual funding amount, or costs
incurred outside the scope of the contractual research and development project,
are expensed as incurred.
P. FOREIGN CURRENCY TRANSLATION
The financial statements of the Company's foreign operations are translated into
U.S. dollars in accordance with SFAS 52 "Foreign Currency Translation" (SFAS
52). The resulting translation adjustments are recorded as a separate component
of accumulated other comprehensive income.
Q. EARNINGS PER SHARE
Basic earnings per share is calculated using the weighted average number of
common shares outstanding during the period. Diluted earnings per share is
calculated using the weighted average number of common shares outstanding during
the period plus shares issuable upon the assumed exercise of dilutive common
share options and vesting of performance-accelerated restricted shares using the
treasury stock method. On August 5, 2005, the Company's Board of Directors
approved a 2-for-1 stock split which was effected as a 100 percent stock
dividend and was paid on September 23, 2005 to shareholders of record as of
September 9, 2005. The 2004 common stock and per share amounts have been
adjusted to reflect the stock split.
The number of shares used in the calculation of earnings per share for each year
presented is as follows:
(In thousands) 2006 2005 2004
------ ------ ------
Weighted Average Shares
Outstanding -- Basic 25,718 25,511 25,803
Dilutive Options and performance-
accelerated restricted stock 668 795 845
------ ------ ------
Adjusted Shares -- Diluted 26,386 26,306 26,648
====== ====== ======
Options to purchase 264,430 shares at prices ranging from $42.99 - $54.88 were
outstanding during the year ended September 30, 2006, but were not included in
the respective computation of diluted EPS because the options' exercise price
was greater than the average market price of the common shares. Options to
purchase 34,967 shares at prices ranging from $35.18 - $50.26 were outstanding
during the year ended September 30, 2005, but were not included in the
respective computation of diluted EPS because the options' exercise price was
greater than the average market price of the common shares. Options to purchase
212,228 shares at prices ranging from $22.68 - $32.33 were outstanding during
the year ended September 30, 2004, but were not included in the respective
computation of diluted EPS because the options' exercise price was greater than
the average market price of the common shares. These options expire in various
periods through 2013. Approximately 9,000, 36,000 and 14,000 restricted shares
were outstanding but unearned at September 30, 2006, 2005 and 2004,
respectively, and, therefore, were not included in the respective years'
computations of diluted EPS.
R. SHARE-BASED COMPENSATION
Prior to October 1, 2005, the Company accounted for its stock option plans using
the intrinsic value method of accounting provided under APB Opinion No. 25,
"Accounting for Stock Issued to Employees," (APB 25) and related
interpretations, as permitted by FASB Statement No. 123, "Accounting for
Stock-Based Compensation," (SFAS 123) under which no compensation expense was
recognized for stock option grants. Accordingly, share-based compensation for
stock options was included as a pro forma disclosure in the financial statement
footnotes for periods prior to fiscal 2006.
Effective October 1, 2005, the Company adopted the fair value recognition
provisions of FASB Statement No. 123(R), "Share-Based Payment," (SFAS 123(R))
using the modified-prospective transition method. Under this transition method,
compensation cost recognized in fiscal 2006 includes:
a) compensation cost for all share-based payments granted through September 30,
2005, for which the requisite service period had not been completed as of
September 30, 2005, based on the grant date fair value estimated in accordance
with the original provisions of SFAS 123, and
b) compensation cost for all share-based payments granted subsequent to
September 30, 2005, based on the grant date fair value estimated in accordance
with the provisions of SFAS 123(R). Results for prior periods have not been
restated.
As a result of adopting SFAS 123(R) on October 1, 2005, the Company's net
earnings for the year ended September 30, 2006 were $2.3 million lower than if
it had continued to account for share-based compensation under APB 25.
The Company has various share-based plans which allow the Company to grant key
officers, managers and professional employees (1) options to purchase shares of
the Company's common stock, (2) stock appreciation rights with respect to all or
any part of the number of shares covered by the options, or (3)
performance-accelerated restricted shares (restricted shares) and other full
value awards. No stock appreciation rights have been awarded to date. In
addition, the Company provides compensation benefits to non-employee directors
under a non-employee directors compensation plan.
S. COMPREHENSIVE INCOME (LOSS)
SFAS 130, "Reporting Comprehensive Income" requires the Company to report
separately the translation adjustments of SFAS 52 defined above, and changes to
the minimum pension liability, as components of comprehensive income or loss.
Management has chosen to disclose the requirements of this Statement within the
Consolidated Statements of Shareholders' Equity.
Accumulated other comprehensive loss as shown on the consolidated balance sheet
of $(2.1) million and $(5.6) million at September 30, 2006 and 2005,
respectively, consisted of $4.5 million and $3.0 million related to currency
translation adjustments; $(6.6) million and $(8.6) million related to the
minimum pension liability, respectively.
T. DEFERRED REVENUE
Deferred revenue is recorded for products or services that have not been
provided but have been invoiced under contractual agreements or paid for by a
customer, or when products or services have been provided but the criteria for
revenue recognition have not been met. If there is a customer acceptance
provision or there is uncertainty about customer acceptance, revenue is deferred
until the customer has accepted the product or service. The current portion of
approximately $3.0 million is classified in accrued expenses on the Consolidated
Balance Sheet.
Deferred revenue also includes the long-term portion of unearned income related
to two intellectual property agreements. The amount is being amortized into
income on a straight-line basis over the remaining patent life through 2011. The
current portion of approximately $0.6 million is classified in accrued expenses
on the Consolidated Balance Sheet.
U. NEW ACCOUNTING STANDARDS
In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment" (SFAS
123(R)). This Statement replaces SFAS No. 123, "Accounting for Stock-Based
Compensation" and supersedes APB No. 25, "Accounting for Stock Issued to
Employees." SFAS 123(R) requires all stock-based compensation to be recognized
as an expense in the financial statements and that such cost be measured
according to the fair value of stock options. The Company adopted the provisions
of this Statement in the first quarter of fiscal 2006 on a prospective basis.
In December 2004, the FASB issued FASB Staff Position FAS 109-2, "Accounting and
Disclosure Guidance for the Foreign Earnings Repatriation Provision within the
American Jobs Creation Act of 2004" (FSP 109-2). The American Jobs Creation Act
of 2004, (the "Act") provides for a special one-time deduction of 85 percent of
certain foreign earnings repatriated into the U.S. from non-U.S. subsidiaries
through September 30, 2006. During fiscal 2006, the Company repatriated $39.5
million of foreign earnings which qualify for the special one-time deduction.
Tax expense of $2.4 million was recorded in fiscal 2006 as a result of this
repatriation.
In June 2006, the FASB issued FASB Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109." This
Interpretation is effective for ESCO beginning October 1, 2007. This
Interpretation prescribes a recognition threshold and measurement process for
the financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. The Company is currently evaluating the
adoption of this Interpretation and does not currently have an estimate of the
impact on the consolidated financial statements.
In September 2006, the FASB issued SFAS No. 158, "Employer's Accounting for
Defined Benefit Pension and Other Postretirement Plans" (SFAS 158), which amends
SFAS 87 and SFAS 106 to require recognition of the overfunded or underfunded
status of pension and other postretirement benefit plans on the balance sheet.
Under SFAS 158, gains and losses, prior service costs and credits, and any
remaining transition amounts under SFAS 87 and SFAS 106 that have not yet been
recognized through net periodic benefit cost will be recognized in accumulated
other comprehensive income, net
of tax effects. The measurement date -- the date at which the benefit obligation
and plan assets are measured -- is required to be the Company's fiscal year-end,
which is the date the Company currently uses. SFAS 158 is effective for
publicly-held companies for fiscal years ending after December 15, 2006. The
adoption of SFAS 158 is not expected to have a material impact to the Company's
financial position or results of operations.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108,
"Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements" (SAB No. 108), which
addresses the diversity in practice in quantifying financial statement
misstatements and provides interpretative guidance regarding the consideration
given to prior year misstatements when determining materiality in current year
financial statements. During 2006, the Company adopted the provisions of SAB No.
108 and recorded $2.4 million as a cumulative credit adjustment to 2006
beginning retained earnings.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" (SFAS
157), which defines fair value in generally accepted accounting principles and
expands disclosures about fair value measurements. This Statement is effective
for financial statements issued for fiscal years beginning after November 15,
2007. The adoption of SFAS 157 is not expected to have a material impact to the
Company's financial position or results of operations.
2. ACQUISITIONS
Effective February 1, 2006, the Company acquired the capital stock of Hexagram,
Inc. (Hexagram) for a purchase price of approximately $66 million. The
acquisition agreement also provides for contingent consideration of up to $6.25
million over the five year period following the acquisition if Hexagram exceeds
certain sales targets. Hexagram is an RF fixed network automatic meter reading
(AMR) company headquartered in Cleveland, Ohio. Hexagram broadens the Company's
served market and provides an RF based AMI system serving primarily gas and
water utilities. Hexagram's annual revenue over the past three years has been in
the range of $20 million to $35 million. The operating results for Hexagram,
since the date of acquisition, are included within the Communications unit. The
Company recorded $6.6 million of amortizable identifiable intangible assets
consisting primarily of patents and proprietary know-how, customer contracts,
and order backlog which are being amortized on a straight-line basis over
periods ranging from six months to seven years.
The following table summarizes the Company's estimates of the fair values of the
assets acquired and liabilities assumed at the date of acquisition and includes
subsequent adjustments to the allocation of purchase price.
Hexagram, Inc.
Assets Acquired and Liabilities Assumed
February 1, 2006
(Dollars in thousands)
Cash $ 2,128
Accounts receivable, net 3,267
Inventory 4,161
Other current assets 276
Property, plant and equipment 2,223
Deferred tax assets 735
Other assets 60
Intangible assets:
Trademarks 3,485
Patents 3,468
Customer contracts 2,378
Other 727
-------
10,058
Goodwill 51,202
Current liabilities (4,149)
Deferred tax liabilities (3,774)
Other long-term liabilities (116)
-------
Aggregate purchase price $66,071
=======
Effective November 29, 2005, the Company acquired Nexus Energy Software, Inc.
(Nexus) through an all cash for shares merger transaction for approximately $29
million in cash plus contingent cash consideration over the four year period
following the merger if Nexus exceeds certain sales targets. Nexus is a software
company headquartered in Wellesley, Massachusetts with annual revenues in the
past in excess of $10 million. Nexus broadens the Company's served market and
provides software solutions that allow utilities to fully utilize the
information produced by the Company's AMI systems. The operating results for
Nexus, since the date of acquisition, are included within the Communications
unit. The Company recorded $2.7 million of identifiable intangible assets
consisting primarily of customer contracts and order backlog which are being
amortized on a straight-line basis over periods ranging from one year to three
years. In connection with the acquisition of Nexus, the Company acquired
approximately $13 million of net operating loss carryforward that will expire
between 2017 and 2025 and is subject to a Section 382 limitation.
The following table summarizes the Company's estimates of the fair values of the
assets acquired and liabilities assumed at the date of acquisition and includes
subsequent adjustments to the allocation of purchase price.
Nexus Energy Software, Inc.
Assets Acquired and Liabilities Assumed
November 29, 2005
(Dollars in thousands)
Cash $ 440
Accounts receivable, net 1,701
Other current assets 228
Property, plant and equipment 965
Deferred tax assets 4,469
Other assets 176
Intangible assets:
Contracts/software 1,497
Backlog 1,064
Other 162
-------
2,723
Goodwill 23,434
Current liabilities (3,862)
Deferred tax liabilities (1,095)
Other long-term liabilities (180)
-------
Aggregate purchase price $28,999
=======
All of the Company's acquisitions have been accounted for using the purchase
method of accounting and accordingly, the respective purchase prices were
allocated to the assets (including intangible assets) acquired and liabilities
assumed based on estimated fair values at the date of acquisition. The financial
results from these acquisitions have been included in the Company's financial
statements from the date of acquisition. Pro forma financial information related
to the Nexus and Hexagram acquisitions was not presented as it was not
significant to the Company's results of operations. None of the goodwill
recorded as part of the Nexus or Hexagram acquisitions is expected to be
deductible for U.S. federal or state income tax purposes.
3. DISCONTINUED OPERATIONS
The MicroSep businesses consisted of PTI Advanced Filtration Inc., PTI
Technologies Limited, and PTI S.p.A. Effective April 2, 2004, the Company
completed the sale of PTI Advanced Filtration Inc. (Oxnard, California) and PTI
Technologies Limited (Sheffield, England) to domnick hunter group plc for $18
million in cash. On June 8, 2004, the Company completed the sale of PTI S.p.A.
(Milan, Italy) to a group of investors comprised of the subsidiary's senior
management for $5.3 million. An after-tax gain of $1.6 million related to the
sale of the MicroSep businesses is reflected in the Company's 2004 results in
discontinued operations.
The MicroSep businesses are accounted for as a discontinued operation in
accordance with SFAS 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets" (SFAS 144) and, accordingly, amounts in the financial
statements and related notes for all periods shown, reflect discontinued
operations presentation. The net sales from the MicroSep businesses were $29.4
million for the year ended September 30, 2004. The pre-tax loss from operations
from the MicroSep businesses was $5.0 million for the year ended September 30,
2004.
4. ASSET IMPAIRMENT
In June 2005, the Company abandoned its plans to commercialize certain sensor
products within the Filtration/Fluid Flow segment. This action resulted in an
asset impairment charge of $0.8 million to write off certain patents and a
related licensing agreement to their respective fair market values. The Company
ended its development efforts on this program after it determined that the
market was not developing as quickly as anticipated and the expected costs and
time frame to fully commercialize the products were not acceptable.
5. GOODWILL AND OTHER INTANGIBLE ASSETS
Included on the Company's Consolidated Balance Sheet at September 30, 2006 and
2005 are the following intangible assets gross carrying amounts and accumulated
amortization:
(Dollars in millions) 2006 2005
------ ----
Goodwill:
Gross carrying amount $152.4 77.8
Less: accumulated amortization 8.9 8.9
------ ----
Net $143.5 68.9
------ ----
Intangible assets with determinable lives:
Patents
Gross carrying amount $ 17.6 17.5
Less: accumulated amortization 13.9 13.1
------ ----
Net $ 3.7 4.4
------ ----
Capitalized software
Gross carrying amount $ 55.3 23.9
Less: accumulated amortization 10.1 6.8
------ ----
Net $ 45.2 17.1
------ ----
Other
Gross carrying amount $ 9.5 0.4
Less: accumulated amortization 2.8 0.3
------ ----
Net $ 6.7 0.1
------ ----
Intangible assets with indeterminable lives:
Trademarks $ 3.5 --
====== ====
The Company performed its annual evaluation of goodwill for impairment during
the fourth quarter of fiscal 2006 and concluded no impairment existed at
September 30, 2006. The changes in the carrying amount of goodwill attributable
to each business segment for the years ended September 30, 2006 and 2005 are as
follows:
Filtration/
(Dollars in millions) Communications Fluid Flow Test
-------------- ----------- ----
Balance as of September 30, 2005 $ -- 39.8 29.1
Acquisitions (Hexagram and Nexus) 74.6 -- --
----- ---- ----
Balance as of September 30, 2006 $74.6 39.8 29.1
===== ==== ====
Amortization expense related to intangible assets with determinable lives was
$6.9 million, $2.0 million and $2.1 million in 2006, 2005 and 2004,
respectively. The increase in amortization expense in 2006 as compared to the
prior year was due to $2.7 million of amortization related to the Nexus and
Hexagram acquired intangible assets and $2.2 million of amortization related to
the Company's TNG software. Patents are amortized over the life of the patents,
generally 17 years. Capitalized software is amortized over the estimated useful
life of the software, generally 3-7 years. Estimated intangible assets
amortization for fiscal year 2007 is approximately $11 million. Estimated
intangible asset amortization for fiscal years 2008 through 2011 is estimated at
approximately $12 million to $13 million per year. The increase in intangible
asset amortization is related to the additional costs associated with the TNG
software.
6. ACCOUNTS RECEIVABLE
Accounts receivable, net of the allowance for doubtful accounts, consist of the
following at September 30, 2006 and 2005:
(Dollars in thousands) 2006 2005
------- ------
Commercial $81,986 66,871
U.S. Government and prime contractors 1,830 1,948
------- ------
Total $83,816 68,819
======= ======
7. INVENTORIES
Inventories consist of the following at September 30, 2006 and 2005:
(Dollars in thousands) 2006 2005
------- ------
Finished goods $12,834 14,361
Work in process -- including
long-term contracts 13,211 12,512
Raw materials 24,939 21,772
------- ------
Total $50,984 48,645
======= ======
8. PROPERTY, PLANT AND EQUIPMENT
Depreciation expense from continuing operations of property, plant and equipment
for the years ended September 30, 2006, 2005 and 2004 was $10.4 million, $10.1
million and $9.5 million, respectively.
The closure and relocation of the Filtertek Puerto Rico facility was completed
in March 2004. The Puerto Rico facility is included in other current assets with
a carrying value of $3.6 million at September 30, 2006. The facility is being
marketed for sale.
The Company leases certain real property, equipment and machinery under
noncancelable operating leases. Rental expense under these operating leases for
the years ended September 30, 2006, 2005
and 2004 was $7.3 million, $6.3 million and $5.8 million, respectively. Future
aggregate minimum lease payments under operating leases that have initial or
remaining noncancelable lease terms in excess of one year as of September 30,
2006 are:
(Dollars in thousands)
Years ending September 30:
- --------------------------
2007 $ 7,112
2008 4,789
2009 3,128
2010 2,310
2011 and thereafter 4,935
-------
Total $22,274
=======
9. INCOME TAX EXPENSE
Total income tax expense for the years ended September 30, 2006, 2005 and 2004
was allocated as follows:
(Dollars in thousands) 2006 2005 2004
------- ------ ------
Income tax expense from continuing operations $17,622 20,363 22,748
Discontinued operations -- -- (2,481)
------- ------ ------
Total income tax expense $17,622 20,363 20,267
======= ====== ======
For the year ended September 30, 2006, pretax earnings related to United States
(U.S.) and foreign tax jurisdictions were $43.9 million and $5.0 million,
respectively. For the year ended September 30, 2005, pretax earnings related to
U.S. and foreign tax jurisdictions were $52.5 million and $11.4 million,
respectively. For the year ended September 30, 2004, pretax earnings related to
U.S. and foreign tax jurisdictions was $46.3 million and $9.6 million,
respectively.
The principal components of income tax expense from continuing operations for
the years ended September 30, 2006, 2005 and 2004 consist of:
(Dollars in thousands) 2006 2005 2004
------- ------ ------
Federal
Current (including Alternative Minimum Tax) $ 3,571 874 14,153
Deferred 10,291 15,313 3,641
State and local:
Current 2,673 2,414 3,259
Deferred (518) (21) 76
Foreign:
Current 1,213 1,854 1,752
Deferred 392 (71) (133)
------- ------ ------
Total $17,622 20,363 22,748
======= ====== ======
The actual income tax expense from continuing operations for the years ended
September 30, 2006, 2005 and 2004 differs from the expected tax expense for
those years (computed by applying the U.S. Federal corporate statutory rate) as
follows:
2006 2005 2004
---- ---- ----
Federal corporate statutory rate 35.0% 35.0% 35.0%
State and local, net of Federal benefits 2.4 2.4 3.5
Foreign -- Puerto Rico 0.5 (4.6) (3.1)
Foreign -- Other (0.5) (1.6) --
Foreign earnings repatriation 4.8 -- --
Research credit (5.0) -- --
SFAS 123(R) 1.4 -- --
Change in tax contingencies (2.9) -- --
Other, net 0.3 0.7 2.2
----- ----- -----
Effective income tax rate 36.0% 31.9% 37.6%
===== ===== =====
The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets and liabilities at September 30, 2006, and 2005 are
presented below.
(Dollars in thousands) 2006 2005
-------- -------
Deferred tax assets:
Inventories, long-term contract accounting,
contract cost reserves and others $ 1,858 3,159
Pension and other postretirement benefits 5,449 6,981
Net operating loss carryforward -- domestic 5,103 15,695
Net operating loss carryforward -- foreign 2,895 1,715
Capital loss carryforward 7,381 7,381
Other compensation-related costs
and other cost accruals 18,484 11,687
Research credit carryforward 6,635 --
-------- -------
Total deferred tax assets 47,805 46,618
Deferred tax liabilities:
Plant and equipment, depreciation methods,
acquisition asset allocations, and other (17,028) (12,926)
-------- -------
Net deferred tax asset before valuation allowance 30,777 33,692
Less valuation allowance (10,276) (9,096)
-------- -------
Net deferred tax assets $ 20,501 24,596
======== =======
Net deferred tax assets are classified in the Consolidated Balance Sheets as set
forth below.
(Dollars in thousands) 2006 2005
------- ------
Current portion of deferred tax assets $24,251 25,271
Deferred tax liabilities (non-current) --
Included in Other Liabilities (3,750) (675)
------- ------
Net deferred tax assets $20,501 24,596
======= ======
Management believes that, based on the Company's historical pretax income
together with the projection of future taxable income, and after consideration
of the valuation allowance, it is more likely than not that the Company will
realize the benefits of the net deferred tax assets existing at September 30,
2006. In order to realize this net deferred tax asset, the Company will need to
generate future taxable income of approximately $59 million, of which $15
million is required to be realized prior to the expiration of the NOL
carryforward in the United States. The expiration of the NOL carryforward is
between 2019 and 2025. The Company anticipates being able to utilize the NOL
carryforward to reduce future Federal income tax cash payments.
The Company has established a valuation allowance of $7.4 million against the
capital loss carryforward generated in 2004, as such loss carryforward may not
be realized in future periods. In addition, the Company has established a
valuation allowance against certain NOL carryforwards in foreign jurisdictions
which may not be realized in future periods. The valuation allowance established
against the foreign NOL carryforwards was $2.9 million and $1.7 million at
September 30, 2006 and 2005, respectively. The Company classifies its valuation
allowance related to deferred taxes on a pro rata basis. The Company
reclassified the current and long-term portion of its valuation allowance as of
September 30, 2005 to be consistent with the current year presentation.
On October 22, 2004, the President of the United States signed into law the
American Jobs Creation Act of 2004 (the "2004 Jobs Act"). The 2004 Jobs Act
repeals the extraterritorial income exclusion and provides for (i) a new
deduction for domestic manufacturing and production income, (ii) international
tax reforms, (iii) a temporary incentive for U.S. multinational companies to
reinvest
foreign earnings in the U.S., and (iv) numerous other business tax relief
provisions. The foreign earnings repatriation provision provides an 85%
dividends received deduction for certain dividends received from controlled
foreign corporations. In addition, in December 2004, the FASB issued FASB Staff
Position FAS 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings
Repatriation Provision within the American Jobs Creation Act of 2004" (2004 Jobs
Act). The Company repatriated $39.5 million of funds to reinvest in the U.S.
under the 2004 Jobs Act. Federal income taxes on the repatriated amounts were
based on the 5.25% effective statutory rate as provided in the 2004 Jobs Act,
plus applicable state income and foreign withholding taxes. Federal income taxes
and applicable withholding taxes of $2.4 million have been provided for in the
current year provision.
Under current law, the research credit expired for research expenditures
incurred after December 31, 2005. The Company began an analysis of available
research credits for the period beginning in 2000 and ending with the three
month period ended December 31, 2005. The Company expects that these research
credit claims will be approximately $2.5 million.
No deferred taxes have been provided on the accumulated unremitted earnings of
the Company's foreign subsidiaries as of September 30, 2006. The Company's
intention is to reinvest these earnings indefinitely. In the event these foreign
entities' earnings were distributed, it is estimated that U.S. taxes, net of
available foreign tax credits, of approximately $3.2 million would be due, which
would correspondingly reduce the Company's net earnings.
During 2006, the Company determined that state tax expense had not been
accurately recorded in the financial statements for years 2001 through 2005. The
effect in any individual prior year was not material to the Company's results of
operations, financial position or cash flows. The Company adopted the provisions
of SEC Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial
Statements" and recorded $2.4 million as a cumulative credit adjustment to 2006
beginning retained earnings.
The Company operates within multiple taxing jurisdictions and is subject to
audit in these jurisdictions. These audits can involve complex issues which may
require an extended period of time to resolve. The Company regularly reviews its
potential tax liabilities for tax years subject to audit. Changes in the
Company's potential tax liability occurred during the year ended September 30,
2006, and may occur in the future as the Company's assessment changes based on
examinations in various jurisdictions and/or changes in tax laws, regulations
and case law. Accordingly, the Company's estimate of income tax liabilities may
differ from actual payments or assessments.
10. DEBT
At September 30, 2006 and 2005, there were no outstanding borrowings under the
revolving credit facility. Effective October 6, 2004, the Company entered into a
$100 million five-year revolving bank credit facility with a $50 million
increase option that has a final maturity and expiration date of October 6,
2009. The credit facility is available for direct borrowings and/or the issuance
of letters of credit, and is provided by a group of six banks, led by Wells
Fargo Bank as agent. At September 30, 2006, the Company had approximately $99.2
million available to borrow under the credit facility in addition to $36.8
million cash on hand. At September 30, 2006, the Company had outstanding letters
of credit of $1.5 million ($0.8 million outstanding under the credit facility).
On February 1, 2006, the Company borrowed $47 million to partially fund the
acquisition of Hexagram which was subsequently repaid from the foreign cash
repatriation by March 31, 2006. The interest rate on this debt was approximately
5.3%. During April 2006, the Company borrowed $5 million which was subsequently
repaid prior to April 30, 2006. The interest rate on this debt was 7.75%.
The credit facility requires, as determined by certain financial ratios, a
commitment fee ranging from 17.5 to 27.5 basis points per annum on the unused
portion. The terms of the facility provide that interest on borrowings may be
calculated at a spread over the London Interbank Offered Rate (LIBOR) or based
on the prime rate, at the Company's election. The facility is secured by the
unlimited guaranty of the Company's material domestic subsidiaries and a 65%
pledge of the material foreign subsidiaries' share equity. The financial
covenants of the credit facility include limitations on leverage, minimum
consolidated EBITDA and minimum net worth.
During 2006 and 2005, the maximum aggregate short-term borrowings at any
month-end were $47 million and zero, respectively; the average aggregate
short-term borrowings outstanding based on month-end balances were $3.9 million
and zero, respectively; and the weighted average interest rates were 5.25%, not
applicable in 2005, and 1.87% in 2004. The letters of credit issued and
outstanding under the credit facility totaled $0.8 million and $1.4 million at
September 30, 2006, and 2005, respectively.
11. CAPITAL STOCK
The 29,030,995 and 28,738,958 common shares as presented in the accompanying
Consolidated Balance Sheets at September 30, 2006 and 2005 represent the actual
number of shares issued at the respective dates. The Company held 3,166,026 and
3,175,626 common shares in treasury at September 30, 2006 and 2005,
respectively.
In August 2006, the Company's Board of Directors authorized an open market
common stock repurchase program for up to 1.2 million shares, subject to market
conditions and other factors which covers the period through September 30, 2008.
There were no stock repurchases during fiscal 2006. The Company repurchased
670,072 and 312,400 shares in 2005 and 2004, respectively, under a previously
authorized program.
12. SHARE-BASED COMPENSATION
Prior to October 1, 2005, the Company accounted for its stock option plans using
the intrinsic value method of accounting provided under APB Opinion No. 25,
"Accounting for Stock Issued to Employees," (APB 25) and related
interpretations, as permitted by FASB Statement No. 123, "Accounting for
Stock-Based Compensation," (SFAS 123) under which no compensation expense was
recognized for stock option grants. Accordingly, share-based compensation for
stock options was included as a pro forma disclosure in the financial statement
footnotes for periods prior to fiscal 2006.
Effective October 1, 2005, the Company adopted the fair value recognition
provisions of FASB Statement No. 123(R), "Share-Based Payment," (SFAS 123(R))
using the modified-prospective transition method. Under this transition method,
compensation cost recognized in fiscal 2006 includes:
c) compensation cost for all share-based payments granted through September 30,
2005, for which the requisite service period had not been completed as of
September 30, 2005, based on the grant date fair value estimated in accordance
with the original provisions of SFAS 123, and
d) compensation cost for all share-based payments granted subsequent to
September 30, 2005, based on the grant date fair value estimated in accordance
with the provisions of SFAS 123(R). Results for prior periods have not been
restated.
As a result of adopting SFAS 123(R) on October 1, 2005, the Company's net
earnings for the year ended September 30, 2006 were $2.3 million lower than if
it had continued to account for share-based compensation under APB 25.
The Company has various share-based plans which allow the Company to grant key
officers, managers and professional employees (1) options to purchase shares of
the Company's common stock, (2) stock appreciation rights with respect to all or
any part of the number of shares covered by the options, or (3)
performance-accelerated restricted shares and other stock based awards. No stock
appreciation rights have been awarded to date. In addition, the Company provides
compensation benefits to non-employee directors under a non-employee directors
compensation plan. During fiscal 2004, the Board of Directors authorized and the
shareholders approved, the 2004 Incentive Compensation Plan, which states, in
part, that on February 5, 2004, there shall be added to the authorized shares
allocated 2,000,000 shares for the grant of stock options, stock appreciation
rights, performance-accelerated restricted stock, or other full value awards. Of
these, shares up to 600,000 may be utilized for performance-accelerated
restricted stock or other full value awards. At September 30, 2006, the maximum
number of full value shares available for issue under the 2004 Incentive
Compensation Plan and the 2001 Stock Incentive Plan was 600,000 and 330,032
shares, respectively.
STOCK OPTION PLANS
The Company's stock option awards are generally subject to graded vesting over a
three year service period. All outstanding options were granted at prices equal
to fair market value at the date of grant. The options granted prior to
September 30, 2003 have a ten-year contractual life from date of issuance,
expiring in various periods through 2013. Beginning in fiscal 2004, the options
granted have a five-year contractual life from date of issuance. Beginning with
fiscal 2006 awards, the Company recognizes compensation cost on a straight-line
basis over the requisite service period for the entire award. Prior to fiscal
2006, the Company calculated the pro forma compensation cost using the graded
vesting method (FIN 28 approach).
The fair value of each option award is estimated as of the date of grant using a
Black-Scholes option pricing model. The weighted average assumptions for the
periods indicated are noted below. Expected volatility is based on historical
volatility of ESCO's stock calculated over the expected term of the option. The
expected term was calculated in accordance with Staff Accounting Bulletin No.
107 using the simplified method for "plain-vanilla" options. The risk-free rate
for the expected term of the option is based on the U.S. Treasury yield curve in
effect at the date of grant. The fair value of each option grant is estimated on
the date of grant using the Black-Scholes option-pricing model with the
following weighted-average assumptions used for grants in 2006, 2005 and 2004,
respectively: expected dividend yield of 0% in all periods; expected volatility
of 28.0%, 23.5% and 21.4%; risk-free interest rate of 4.6%, 3.9% and 4.2%; and
expected term of 3.50 years, 3.58 years and 4.25 years.
Information regarding stock options awarded under the option plans is as
follows:
FY2006 FY2005 FY2004
---------------------- ---------------------- ----------------------
ESTIMATED Estimated Estimated
WEIGHTED Weighted Weighted
SHARES AVG. PRICE Shares Avg. Price Shares Avg. Price
--------- ---------- --------- ---------- --------- ----------
October 1 1,324,548 $20.48 1,356,094 $13.63 1,529,192 $10.89
Granted 328,080 $44.63 376,200 $35.55 291,600 $24.15
Exercised (232,371) $15.95 (388,340) $10.94 (385,166) $10.13
Cancelled (32,909) $35.77 (19,406) $24.96 (79,532) $16.26
--------- ------ --------- ------ --------- ------
September 30, 1,387,348 $26.60 1,324,548 $20.48 1,356,094 $13.63
At September 30,
Reserved for future grant 1,146,741 1,428,032 1,665,238
Exercisable 753,415 $16.46 755,612 $12.29 818,824 $ 9.71
========= ====== ========= ====== ========= ======
The aggregate intrinsic value of options exercised during 2006, 2005 and 2004
was $7.9 million, $12.4 million and $6.2 million, respectively. The aggregate
intrinsic value of stock options outstanding and exercisable at September 30,
2006 was $32.1 million and $22.7 million, respectively. The weighted-average
contractual life of stock options outstanding at September 30, 2006 was 3.75
years. The weighted-average fair value of stock options granted in 2006, 2005,
and 2004 was $12.17, $11.28, and $6.84, respectively.
Summary information regarding stock options outstanding at September 30, 2006 is
presented below:
Options Outstanding
---------------------------------------
Weighted-
Average Weighted
Number Remaining Average
Range of Outstanding at Contractual Exercise
Exercise Prices Sept. 30, 2006 Life Price
- --------------- -------------- ----------- --------
$ 4.59 - $10.72 215,244 3.0 years $ 7.21
$12.59 - $14.52 292,912 5.5 years $13.71
$17.16 - $32.32 229,371 2.7 years $23.34
$35.18 - $42.10 327,241 3.0 years $35.29
$42.99 - $54.88 322,580 4.2 years $44.74
--------- --------- ------
1,387,348 3.8 years $26.60
========= ========= ======
Exercisable Options Outstanding
-------------------------------
Weighted
Number Average
Range of Exercisable at Exercise
Exercise Prices Sept. 30, 2006 Price
- --------------- -------------- --------
$ 4.59 - $10.72 215,244 $ 7.21
$12.59 - $14.52 292,912 $13.71
$17.16 - $32.32 148,150 $22.88
$35.18 - $50.10 97,109 $35.42
------- ------
753,415 $16.46
======= ======
PERFORMANCE-ACCELERATED RESTRICTED SHARE AWARDS
The performance-accelerated restricted shares (restricted shares) vest over five
years with accelerated vesting if certain performance targets are achieved. In
these cases, if it is probable that the performance condition will be met, the
Company recognizes compensation cost on a straight-line basis over the shorter
performance period; otherwise, it will recognize compensation cost over the
longer service period. Compensation cost for all outstanding restricted share
awards is being recognized over the shorter performance period as it is probable
the performance condition will be met. The restricted share award grants were
valued at the stock price on the date of grant. Pre-tax compensation expense
related to the restricted share awards was $1.5 million, $1.9 million and $1.4
million for fiscal years ended September 30, 2006, 2005 and 2004, respectively.
The following summary presents information regarding outstanding restricted
share awards as of September 30, 2006 and changes during the period then ended:
Weighted
Shares Avg. Price
-------- ----------
Nonvested at October 1, 2005 238,436 $23.78
Granted 64,130 $43.02
Vested (118,736) $17.41
Cancelled (28,100) $36.16
-------- ------
Nonvested at September 30, 2006 155,730 $34.33
======== ======
NON-EMPLOYEE DIRECTORS PLAN
The non-employee directors compensation plan provides to each non-employee
director a retainer of 800 common shares per quarter. Compensation expense
related to the non-employee director grants was $1.0 million, $0.7 million and
$0.4 million for the years ended September 30, 2006, 2005 and 2004,
respectively.
The total share-based compensation cost that has been recognized in results of
operations and
included within SG&A was $4.8 million, $2.6 million and $1.8 million for the
years ended September 30, 2006, 2005 and 2004, respectively. The total income
tax benefit recognized in results of operations for share-based compensation
arrangements was $1.2 million, $1.0 million and $0.7 million for the years ended
September 30, 2006, 2005 and 2004, respectively. The Company has elected to use
tax law ordering rules when calculating the income tax benefit associated with
its share-based payment arrangements. In addition, the Company elected to use
the simplified method of calculating the pool of excess tax benefits available
to absorb tax deficiencies recognized subsequent to the adoption of SFAS No.
123(R)-3, "Transition Election related to Accounting for the Tax Effects of
Share-Based Payment Awards." As of September 30, 2006, there was $8.4 million of
total unrecognized compensation cost related to share-based compensation
arrangements. That cost is expected to be recognized over a weighted-average
period of 3.5 years.
PRO FORMA NET EARNINGS
The following table provides pro forma net earnings and earnings per share had
the Company applied the fair value method of SFAS 123 for the years ended
September 30, 2005 and 2004:
Pro forma (Unaudited)
(Dollars in thousands,
except per share amounts) 2005 2004
------- ------
Net earnings, as reported $43,544 35,671
Add: stock-based employee
compensation expense included
in reported net earnings, net of tax 1,165 866
Less: total stock-based employee
compensation expense determined
under fair value based methods, net of tax (3,476) (1,910)
------- ------
Pro forma net earnings $41,233 34,627
------- ------
Net earnings per share:
Basic -- as reported $ 1.71 1.38
Basic -- pro forma 1.62 1.34
Diluted -- as reported 1.66 1.34
Diluted -- pro forma 1.57 1.30
======= ======
13. RETIREMENT AND OTHER BENEFIT PLANS
Substantially all employees are covered by defined contribution pension plans
maintained by the Company for the benefit of its employees. Effective December
31, 2003, the Company's defined benefit plan was frozen and no additional
benefits will be accrued after that date. As a result, the accumulated benefit
obligation and projected benefit obligation are equal. These frozen retirement
income benefits are provided to employees under defined benefit pay-related and
flat-dollar plans, which are noncontributory. The annual contributions to
retirement plans equal or exceed the minimum funding requirements of the
Employee Retirement Income Security Act or applicable local regulations. In
addition to providing retirement income benefits, the Company provides unfunded
postretirement health and life insurance benefits to certain retirees. To
qualify, an employee must retire at age 55 or later and the employee's age plus
service must equal or exceed 75. Retiree contributions are defined as a
percentage of medical premiums. Consequently, retiree contributions increase
with increases in the medical premiums. The life insurance plans are
noncontributory and provide coverage of a flat dollar amount for qualifying
retired employees.
The Company uses a measurement date of September 30 for its pension and other
postretirement benefit plans. The Company has an accrued benefit liability of
$1.8 million and $1.9 million at September 30, 2006 and 2005, respectively,
related to its other postretirement benefit obligations. All other information
related to its postretirement benefit plans is not considered material to the
Company's results of operations or financial condition.
The following tables provide a reconciliation of the changes in the pension
plans and fair value of assets over the two-year period ended September 30,
2006, and a statement of the funded status as of September 30, 2006 and 2005:
Pension Benefits
----------------
(Dollars in millions) 2006 2005
----- ----
RECONCILIATION OF BENEFIT OBLIGATION
Net benefit obligation at beginning of year $50.2 45.0
Service cost -- --
Interest cost 2.6 2.6
Actuarial (gain) loss (2.9) 4.2
Plan amendments 0.1 --
Plan participant contributions -- --
Gross benefits paid (1.8) (1.6)
----- ----
Net benefit obligation at end of year $48.2 50.2
===== ====
Pension
Benefits
--------------
(Dollars in millions) 2006 2005
------ -----
RECONCILIATION OF FAIR VALUE OF PLAN ASSETS
Fair value of plan assets at beginning of year $32.7 31.1
Actual return on plan assets 2.6 3.0
Employer contributions 1.6 0.2
Plan participant contributions -- --
Gross benefits paid (1.8) (1.6)
----- ----
Fair value of plan assets at end of year $35.1 32.7
===== ====
Employer contributions and benefits paid under the pension plans include $0.2
million paid from employer assets in 2006 and 2005.
Pension
Benefits
--------------
(Dollars in millions) 2006 2005
------ -----
Funded Status
Funded status at end of year $(13.1) (17.5)
Unrecognized prior service cost 0.1 --
Unrecognized net actuarial (gain) loss 10.1 13.3
------ -----
Accrued benefit cost (2.9) (4.2)
------ -----
Amounts recognized in the Balance Sheet
consist of:
Accrued benefit cost (2.9) (4.2)
Additional minimum liability (10.3) (13.3)
Intangible asset 0.1 --
Accumulated other comprehensive income
(before tax effect) 10.2 13.3
------ -----
Accrued benefit liability $ (2.9) (4.2)
====== =====
A decrease of $3.0 million was included in other comprehensive income during
2006 arising from a change in the additional minimum liability.
The following table provides the components of net periodic benefit cost for the
plans for the years ended September 30, 2006, 2005 and 2004:
Pension Benefits
------------------
(Dollars in millions) 2006 2005 2004
---- ---- ----
Service cost $ -- -- 0.6
Interest cost 2.6 2.6 2.5
Expected return on plan assets (2.7) (2.9) (2.9)
Amortization of service costs -- -- --
Net actuarial (gain) loss 0.4 0.2 0.1
Net amortization and deferral -- -- --
---- ---- ----
Net periodic benefit cost 0.3 (0.1) 0.3
Defined contribution plans 2.9 2.4 1.9
---- ---- ----
Total $3.2 2.3 2.2
==== ==== ====
The following weighted-average assumptions were used to
determine the net periodic benefit cost for the pension plans:
2006 2005 2004
---- ---- ----
Discount rate 5.25% 6.00% 6.00%
Rate of increase in
compensation levels N/A N/A 4.00%
Expected long-term rate of
return on assets 8.25% 8.25% 8.25%
The following weighted-average assumptions were used to determine the net
periodic benefit obligations for the pension plans:
2006 2005
---- ----
Discount rate 5.75% 5.25%
Rate of increase in
compensation levels -- --
The assumed rate of increase in compensation levels is not applicable in 2005
and 2004 as the plan was frozen as of December 31, 2003.
The asset allocation for the Company's pension plans at the end of 2006 and
2005, the Company's acceptable range and the target allocation for 2007, by
asset category, follows:
Target Acceptable Percentage of
Allocation Range Plan at Year-end
---------- ---------- ----------------
ASSET CATEGORY 2007 2006 2005
- -------------- ---- ---- ----
Equity securities 60% 50-70% 66% 65%
Fixed income 40% 30-50% 32% 31%
Cash/cash equivalents 0% 0-5% 2% 4%
The Company's pension plan assets are managed by outside investment managers and
assets are rebalanced when the target ranges are exceeded. Pension plan assets
consist principally of marketable securities including common stocks, bonds, and
interest-bearing deposits. The Company's investment strategy with respect to
pension assets is to achieve a total rate of return (income and capital
appreciation) that is sufficient to accomplish the purpose of providing
retirement benefits to all eligible and future retirees of the pension plans.
The Company regularly monitors performance and compliance with investment
guidelines.
EXPECTED CASH FLOWS
Information about the expected cash flows for the pension and other
postretirement benefit plans follows:
Pension Other
(Dollars in millions) Benefits Benefits
-------- --------
Expected Employer Contributions -- 2007 $0.20.1
Expected Benefit Payments
2007 2.20.1
2008 2.30.1
2009 2.30.1
2010 2.40.1
2011 2.50.1
2012-2016 $14.3 0.6
14. OTHER FINANCIAL DATA
Items charged to operations during the years ended September 30, 2006, 2005 and
2004 included the following:
(Dollars in thousands) 2006 2005 2004
-------- ------- ------
Salaries and wages
(including fringes) $119,286 100,372 93,536
Maintenance and repairs 4,719 3,897 4,326
-------- ------- ------
Research and development
(R&D) costs:
Company-sponsored $ 20,043 16,829 12,201
Customer-sponsored 6,323 5,687 6,064
-------- ------- ------
Total R&D $ 26,366 22,516 18,265
Other engineering costs 9,069 7,763 9,636
-------- ------- ------
Total R&D and other
engineering costs $ 35,435 30,279 27,901
-------- ------- ------
As a % of net sales 7.7% 7.1% 6.6%
======== ======= ======
The increase in salaries and wages in 2006 compared to the prior years is mainly
due to the current year acquisitions of Nexus and Hexagram and the addition of
personnel at DCSI to support the near-term sales growth.
Customer-sponsored R&D is defined in note 1(O) of notes to consolidated
financial statements.
A reconciliation of the changes in accrued product warranty liability for the
years ended September 30, 2006, 2005, and 2004 is as follows:
2006 2005 2004
------- ------ ------
Balance as of October 1 $ 1,487 2,147 1,374
Additions charged to expense 2,357 1,108 3,206
Deductions (2,422) (1,768) (2,433)
------- ------ ------
Balance as of September 30 $ 1,422 1,487 2,147
======= ====== ======
15. BUSINESS SEGMENT INFORMATION
The Company is organized based on the products and services that it offers.
Under this organizational structure, the Company has three reporting units:
Communications, Filtration/Fluid Flow and RF Shielding and Test (Test). The
Communications unit is a proven supplier of special purpose fixed network
communications systems for electric, gas and water utilities, including hardware
and software to support advanced metering applications. DCSI's Two-Way Automatic
Communications System, known as TWACS(R), is currently used for automatic meter
reading (AMR) and related advanced metering functions serving approximately 200
utilities, as well as having load management capabilities. Hexagram's STAR(R)
system, the premier wireless Advanced Metering Infrastructure, delivers two-way
and one-way operation on secure licensed radio frequencies for more than 100
utilities serving electric, gas and water customers. Nexus provides
best-in-class information solutions to more than 85 leading energy companies
that add value to existing billing and metering infrastructure to allow both the
utilities and their customers to better manage energy-driven transactions and
decision making. Comtrak's SecurVision(R) product line provides digital video
surveillance and security functions for large commercial enterprises and alarm
monitoring companies. Filtration/Fluid Flow primary operations consist of: PTI
Technologies Inc. (PTI), VACCO Industries (VACCO) and Filtertek Inc.
(Filtertek). PTI and VACCO develop and manufacture a wide range of filtration
products and are leading suppliers of filters to the commercial and defense
aerospace, satellite and industrial markets. Filtertek develops and manufactures
a broad range of high-volume, original equipment manufacturer (OEM) filtration
products at its facilities in North America, South America and Europe. Each of
the components of the Filtration/Fluid Flow segment is presented separately due
to differing long-term economics. Test segment operations represent the EMC
Group, consisting primarily of EMC Test Systems, L.P. (ETS) and Lindgren RF
Enclosures, Inc. (Lindgren). The EMC Group is principally involved in the design
and manufacture of EMC test equipment, test chambers, and electromagnetic
absorption materials. The EMC Group also manufactures radio frequency (RF)
shielding products and components used by manufacturers of medical equipment,
communications systems, electronic products, and shielded rooms for high
security data processing and secure communication. Accounting policies of the
segments are the same as those described in the summary of significant
accounting policies in note 1 to the Consolidated Financial Statements.
In accordance with SFAS 131, the Company evaluates the performance of its
operating units based on EBIT, which is defined as: Earnings Before Interest and
Taxes. Intersegment sales and transfers are not significant. Segment assets
consist primarily of customer receivables, inventories, capitalized software and
fixed assets directly associated with the production processes of the segment.
Segment
depreciation and amortization is based upon the direct assets listed above.
NET SALES
(Dollars in millions)
Year ended September 30, 2006 2005 2004
- ------------------------ ------ ----- -----
Communications $156.2 138.0 137.8
------ ----- -----
PTI 46.4 40.7 38.1
VACCO 32.3 38.9 43.2
Filtertek 95.4 92.1 92.6
------ ----- -----
Filtration/Fluid Flow subtotal 174.1 171.7 173.9
Test 128.6 119.4 110.4
------ ----- -----
Consolidated totals $458.9 429.1 422.1
====== ===== =====
No customers exceeded 10% of net sales in the periods presented.
EBIT
(Dollars in millions)
Year ended September 30, 2006 2005 2004
- ------------------------ ------ ----- -----
Communications $ 28.3 38.8 38.4
------ ----- -----
PTI 6.6 3.8 2.4
VACCO 6.1 10.4 13.7
Filtertek 6.8 8.2 5.7
------ ----- -----
Filtration/Fluid Flow subtotal 19.5 22.4 21.8
Test 15.0 12.2 11.3
Reconciliation to consolidated
totals (Corporate) (15.2) (11.4) (11.8)
------ ----- -----
Consolidated EBIT 47.6 62.0 59.7
Add: interest income 1.3 1.9 0.8
------ ----- -----
Earnings before income tax $ 48.9 63.9 60.5
====== ===== =====
IDENTIFIABLE ASSETS
(Dollars in millions)
Year ended September 30, 2006 2005 2004
- ------------------------ ------ ----- -----
Communications $ 97.9 52.4 51.3
------ ----- -----
PTI 32.0 36.7 39.7
VACCO 15.7 19.7 21.8
Filtertek 62.9 91.5 93.0
------ ----- -----
Filtration/Fluid Flow subtotal 110.6 147.9 154.5
Test 50.3 80.7 75.1
Reconciliation to consolidated
totals (Corporate assets) 229.9 142.8 121.5
------ ----- -----
Consolidated totals $488.7 423.8 402.4
====== ===== =====
Corporate assets consist primarily of goodwill, deferred taxes, acquired
intangible assets and cash balances.
CAPITAL EXPENDITURES
(Dollars in millions)
Year ended September 30, 2006 2005 2004
- ------------------------ ---- ---- ----
Communications $3.4 1.9 1.5
---- --- ----
PTI 0.2 1.0 1.1
VACCO 1.0 0.7 0.6
Filtertek 3.8 4.0 6.7
---- --- ----
Filtration/Fluid Flow subtotal 5.0 5.7 8.4
Test 0.7 1.2 0.9
---- --- ----
Consolidated totals $9.1 8.8 10.8
==== === ====
DEPRECIATION AND AMORTIZATION
(Dollars in millions)
Year ended September 30, 2006 2005 2004
- ------------------------ ----- ---- ----
Communications $ 5.0 2.0 1.7
----- ---- ----
PTI 1.5 1.5 1.7
VACCO 0.7 0.7 0.7
Filtertek 6.0 6.2 6.0
----- ---- ----
Filtration/Fluid Flow subtotal 8.2 8.4 8.4
Test 1.3 1.4 1.4
Reconciliation to consolidated
totals (Corporate) 2.8 0.4 0.4
----- ---- ----
Consolidated totals $17.3 12.2 11.9
===== ==== ====
GEOGRAPHIC INFORMATION
NET SALES
(Dollars in millions)
Year ended September 30, 2006 2005 2004
- ------------------------ ------ ----- -----
United States $355.9 325.3 330.6
Europe 40.2 56.0 58.3
Far East 36.1 29.6 18.8
Other 26.7 18.2 14.4
------ ----- -----
Consolidated totals $458.9 429.1 422.1
====== ===== =====
LONG-LIVED ASSETS
(Dollars in millions)
Year ended September 30, 2006 2005 2004
- ------------------------ ----- ---- ----
United States $51.3 50.3 53.5
Europe 10.6 10.9 11.6
Other 6.9 6.0 4.0
----- ---- ----
Consolidated totals $68.8 67.2 69.1
===== ==== ====
Net sales are attributed to countries based on location of customer. Long-lived
assets are attributed to countries based on location of the asset.
16. COMMITMENTS AND CONTINGENCIES
At September 30, 2006, the Company had $1.5 million in letters of credit
outstanding as guarantees of contract performance. As a normal incidence of the
businesses in which the Company is engaged, various claims, charges and
litigation are asserted or commenced against the Company. Lindgren is involved
in a contract dispute with a prime contractor involving the assertion of certain
construction delay damages of approximately $3.7 million. The project was
completed in 2005. Lindgren vigorously denies responsibility for this delay and
for these damages, and has asserted a claim against the prime contractor of $0.9
million based on damages suffered by Lindgren. Lindgren continues to
aggressively defend its position and pursue its right to affirmative damages
however, there can be no assurance of the outcome at this time. With respect to
claims and litigation asserted or commenced against the Company, it is the
opinion of Management, that final judgments, if any, which might be rendered
against the Company are adequately reserved, covered by insurance, or are not
likely to have a material adverse effect on its financial condition or results
of operation.
17. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
FIRST SECOND THIRD FOURTH FISCAL
(Dollars in thousands, except per share amounts) QUARTER QUARTER QUARTER QUARTER YEAR
-------- ------- ------- ------- -------
2006
Net sales $ 90,586 122,884 123,626 121,769 458,865
Net earnings 2,204 7,343 11,163 10,570 31,280
-------- ------- ------- ------- -------
Basic earnings per share:
Net earnings .09 .29 .43 .41 1.22
Diluted earnings per share:
Net earnings $ .08 .28 .42 .40 1.19
======== ======= ======= ======= =======
2005
Net sales $104,375 106,160 108,800 109,780 429,115
Net earnings 10,523 10,427 12,401 10,193 43,544
-------- ------- ------- ------- -------
Basic earnings per share:
Net earnings .41 .41 .49 .40 1.71
Diluted earnings per share:
Net earnings $ .40 .40 .47 .39 1.66
======== ======= ======= ======= =======
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Company's Management is responsible for establishing and maintaining
adequate internal control over financial reporting (as defined in the Securities
Exchange Act Rule 13a-15(f)). Our internal control over financial reporting is
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles in the United States of
America.
Because of its inherent limitations, any system of internal control over
financial reporting, no matter how well designed, may not prevent or detect
misstatements due to the possibility that a control can be circumvented or
overridden or that misstatements due to error or fraud may occur that are not
detected. Also, because of changes in conditions, internal control effectiveness
may vary over time.
Management assessed the effectiveness of the Company's internal control over
financial reporting as of September 30, 2006 using criteria established in
Internal Control -- Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) and concluded that the Company
maintained effective internal control over financial reporting as of September
30, 2006 based on these criteria, subject to the scope limitation with respect
to Nexus and Hexagram as discussed in the following paragraph.
The Company acquired Nexus Energy Software, Inc. (Nexus) on November 29, 2005
and Hexagram, Inc. (Hexagram) on February 1, 2006. As permitted by SEC guidance,
Management excluded from its assessment of the effectiveness of the Company's
internal control over financial reporting as of September 30, 2006, Nexus' and
Hexagram's internal control over financial reporting. Total assets related to
Nexus as of September 30, 2006 were $3.7 million and revenues for the ten-month
period subsequent to the acquisition (November 29, 2005 to September 30, 2006)
were $9.6 million. Total assets related to Hexagram as of September 30, 2006
were $13.1 million and revenues for the eight-month period subsequent to the
acquisition (February 1, 2006 to September 30, 2006) were $18.6 million.
Our internal control over financial reporting as of September 30, 2006, as well
as our assessment of the effectiveness of our internal control over financial
reporting as of September 30, 2006, have been audited by KPMG LLP, an
independent registered public accounting firm, as stated in the report which is
included herein.
- ------------------------------------- ----------------------------------------
Victor L. Richey Gary E. Muenster
Chairman, Chief Executive Officer, Senior Vice President
and President and Chief Financial Officer
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
ESCO Technologies Inc.:
We have audited the accompanying consolidated balance sheets of ESCO
Technologies Inc. and subsidiaries (the Company) as of September 30, 2006 and
2005, and the related consolidated statements of operations, shareholders'
equity, and cash flows for each of the years in the three-year period ended
September 30, 2006. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to previously
present fairly, in all material respects, the financial position of ESCO
Technologies Inc. and subsidiaries as of September 30, 2006 and 2005, and the
results of their operations and their cash flows for each of the years in the
three-year period ended September 30, 2006, in conformity with U.S. generally
accepted accounting principles.
As discussed in Note 1 to the consolidated financial statements, the Company
adopted Statement of Financial Accounting Standards No. 123(R), "Share-Based
Payment" effective October 1, 2005 and the Company changed its method of
quantifying errors in 2006.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of ESCO
Technologies Inc.'s internal control over financial reporting as of September
30, 2006, based on criteria established in the Internal Control -- Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), and our report dated December 11, 2006, expressed an
unqualified opinion on management's assessment of, and the effective operation
of, internal control over financial reporting.
St. Louis, Missouri
December 11, 2006
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
ESCO Technologies Inc.:
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that ESCO
Technologies Inc. (the Company) maintained effective internal control over the
financial reporting as of September 30, 2006, based on criteria established in
the Internal Control -- Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (COSO). ESCO Technologies
Inc.'s management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
management's assessment and an opinion on the effectiveness of the Company's
internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards required that we
plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and the receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, management's assessment that ESCO Technologies Inc. maintained
effective internal control over financial reporting as of September 30, 2006, is
fairly stated, in all material respects, based on criteria established in the
Internal Control -- Integrated Framework issued by COSO. Also, in our opinion,
ESCO Technologies Inc. maintained, in all material respects, effective internal
control over financial reporting as of September 30, 2006, based on criteria
established in the Internal Control -- Integrated Framework issued by COSO.
The Company acquired Nexus Energy Software, Inc. (Nexus) on November 29, 2005
and Hexagram, Inc. (Hexagram) on February 1, 2006, and management excluded from
its assessment of the effectiveness of the Company's internal control over
financial reporting as of September 30, 2006, Nexus' and Hexagram's internal
control over financial reporting. Total assets related to Nexus as of September
30, 2006 of $3.7 million and revenues for the ten-month period subsequent to the
acquisition (November 29, 2005 to September 30, 2006) of $9.6 million and total
assets related to Hexagram as of September 30, 2006 of $13.1 million and
revenues for the eight-month period subsequent to the acquisition (February 1,
2006 to September 30, 2006) of $18.6 million were included in the consolidated
financial statements of ESCO Technologies Inc. and subsidiaries as of and for
the year ended September 30, 2006. Our audit of internal control over financial
reporting of ESCO Technologies Inc. also excluded an evaluation of the internal
control over financial reporting of Nexus and Hexagram.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheets of
ESCO Technologies Inc. and subsidiaries
as of September 30, 2006 and 2005, and the related consolidated statements of
operations, shareholders' equity and cash flows for each of the years in the
three-year period ended September 30, 2006, and our report dated December 11,
2006, expressed an unqualified opinion on those consolidated financial
statements.
St. Louis, Missouri
December 11, 2006
FIVE-YEAR FINANCIAL SUMMARY
(Dollars in millions, except per share amounts) 2006 2005 2004 2003 2002
------ ----- ----- ----- -----
For years ended September 30:
Net sales $458.9 429.1 422.1 396.7 316.6
Net earnings from continuing operations 31.3 43.5 37.8 26.7 23.3
Net earnings (loss) from discontinued operations -- -- (2.1) (66.5) (1.6)
Net earnings (loss) before accounting change 31.3 43.5 35.7 (39.7) 21.8
Net earnings (loss) 31.3 43.5 35.7 (41.1) 21.8
Earnings (loss) per share:
Basic:
Continuing operations 1.22 1.71 1.47 1.05 0.93
Discontinued operations -- -- (0.09) (2.62) (0.06)
Cumulative effect of accounting change, net of tax -- -- -- (0.06) --
------ ----- ----- ----- -----
Net earnings (loss) 1.22 1.71 1.38 (1.63) 0.87
Diluted:
Continuing operations 1.19 1.66 1.42 1.02 0.90
Discontinued operations -- -- (0.08) (2.53) (0.06)
Cumulative effect of accounting change, net of tax -- -- -- (0.06) --
------ ----- ----- ----- -----
Net earnings (loss) 1.19 1.66 1.34 (1.57) 0.84
As of September 30:
Working capital 131.4 197.2 165.2 120.5 112.6
Total assets 488.7 423.8 402.4 393.4 407.7
Long-term debt -- -- 0.4 0.5 0.5
Shareholders' equity $376.4 331.0 307.6 275.4 306.3
====== ===== ===== ===== =====
See notes 2 and 3 of notes to consolidated financial statements for discussion
of acquisition and divestiture activity.
COMMON STOCK MARKET PRICE
ESCO's common stock and associated preferred stock purchase rights (subsequently
referred to as common stock) are listed on the New York Stock Exchange under the
symbol "ESE." The following table summarizes the high and low prices of the
common stock for each quarter of fiscal 2006 and 2005. The prior year amounts
have been adjusted to reflect the 2-for-1 stock split which occurred on
September 23, 2005.
2006 2005
-------------- --------------
Quarter HIGH LOW High Low
- ------- ------ ----- ------ -----
First $50.75 32.57 $39.48 32.25
Second 52.76 43.84 42.43 34.49
Third 58.03 47.65 53.25 35.40
Fourth 58.42 45.30 56.23 47.18
ESCO historically has not paid cash dividends on its common stock. Management
continues to evaluate its cash dividend policy. There are no current plans to
initiate a dividend.
SHAREHOLDERS' SUMMARY
SHAREHOLDERS' ANNUAL MEETING
The Annual Meeting of the shareholders of ESCO Technologies Inc. will be held at
9:30 a.m. Friday, February 2, 2007, at the Company's Corporate headquarters,
9900A Clayton Road, St. Louis, Missouri 63124. Notice of the meeting and a proxy
statement were sent to shareholders with this Annual Report.
CERTIFICATIONS
Pursuant to New York Stock Exchange (NYSE) requirements, the Company submitted
to the NYSE the annual certifications, dated February 27, 2006 and March 3,
2005, by the Company's chief executive officer that he was not aware of any
violations by the Company of NYSE's corporate governance listing standards. In
addition, the Company filed with the Securities and Exchange Commission the
certifications by the Company's chief executive officer and chief financial
officer required under Section 302 of the Sarbanes-Oxley Act of 2002 as exhibits
to the Company's Forms 10-K for its fiscal years ended September 30, 2006 and
September 30, 2005.
10-K REPORT
A copy of the Company's 2006 Annual Report on Form 10-K filed with the
Securities and Exchange Commission is available to shareholders without charge.
Direct your written request to the Investor Relations Department, ESCO
Technologies Inc., 9900A Clayton Road, St. Louis, Missouri 63124. The Form 10-K
is also available on the Company's web site at www.escotechnologies.com.
INVESTOR RELATIONS
Additional investor-related information may be obtained by contacting the
Director of Investor Relations at (314) 213-7277 or toll free at (888) 622-3726.
Information is also available through the Company's web site at
www.escotechnologies.com or via e-mail to pmoore@escotechnologies.com.
TRANSFER AGENT AND REGISTRAR
Shareholder inquiries concerning lost certificates, transfer of shares or
address changes should be directed to:
Registrar and Transfer Company
10 Commerce Drive
Cranford, NJ 07016-3572
1 (800) 368-5948
E-mail: info@rtco.com
CAPITAL STOCK INFORMATION
ESCO Technologies Inc. common stock shares (symbol ESE) are listed on the New
York Stock Exchange. There were approximately 2,500 holders of record of shares
of common stock at September 30, 2006.
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
KPMG LLP
10 South Broadway, Suite 900
St. Louis, Missouri 63102