EX-13 8 a07-5385_1ex13.htm EX-13

Exhibit 13

Financial Discussion

 

EXECUTIVE SUMMARY

 

This Financial Discussion should be read in conjunction with the information on Forward-Looking Statements and Risk Factors found at the end of the Financial Discussion.

 

2006 was an outstanding year for Ecolab. We achieved a strong financial performance including record net sales of $4.9 billion and improved operating income margins which drove 16 percent diluted earnings per share growth. We realized major competitive gains, made significant investments in our people and business, and further improved our long-term growth potential.

 

We exceeded all three of our long-term financial objectives:

 

 

2006 RESULTS

 

LONG-TERM OBJECTIVE

EPS Growth

 

16.3%

 

15%

ROBE

 

22.4%

 

20%

Balance Sheet

 

A

 

Investment Grade

 

OPERATING HIGHLIGHTS

 

·  We made important competitive gains in our market during 2006, creating enhanced global opportunities to pursue our Circle the Customer — Circle the Globe growth strategy as we believe Ecolab alone can offer consistent service around the globe.

 

·  We enjoyed double-digit sales and profit growth in the United States and improved sales and profit growth from our International operations.

 

·  In 2006 we continued our tradition of new product innovation building on our core product platforms. We introduced a product in our antimicrobial platform that reduces microbial contamination in ready-to-eat meat and poultry products, making them safer and contributing to a longer shelf life. To help reduce the risk of foodborne illness, we introduced the first EPA-registered antimicrobial product that reduces pathogens in fruit and vegetable process water at food processing plants. We also continued our efforts to customize solutions to meet specific customer needs through new programs.

 

·  We continued to make business acquisitions in order to broaden our product and service offerings in line with our Circle the Customer — Circle the Globe strategy. Details of these acquisitions are shown below.

 

·  We grew our industry-leading sales and service force by more than 500 people, to more than 13,400 strong, and made key investments in tools, training and technology to improve their sales productivity and effectiveness.

 

·  We made significant investments in our business systems that will drive competitive advantage in the future.

 

·  We continue to work to simplify and streamline our business processes, bolstering our ability to deliver growth more efficiently in the future.

 

FINANCIAL PERFORMANCE

 

·  Consolidated net sales reached a record of $4.9 billion for 2006, an increase of 8 percent over net sales of $4.5 billion in 2005.

 

·  Our operating income for 2006 increased 13 percent to a record $612 million.

 

·  Diluted net income per share increased 16 percent to $1.43 per share for 2006, compared to $1.23 per share in 2005.

 

·  Cash flow from operating activities reached a record $628 million in 2006 and allowed us to fund investments in our business operations, make business acquisitions, reacquire $283 million of our common stock and make a voluntary contribution of $45 million to our U.S. pension plan.

 

·  We increased our quarterly dividend rate for the fifteenth consecutive year. The dividend was increased 15 percent in December 2006 to an indicated annual rate of $0.46 per common share.

 

 

·  Our return on beginning shareholder’s equity (net income divided by beginning shareholder’s equity) rose to 22.4 percent in 2006, the fifteenth consecutive year in which we achieved our long-term financial objective of a 20 percent return on beginning shareholder’s equity.

 

·  Our balance sheet remained strong, maintaining our debt rating within the “A” categories of the major rating agencies during 2006. We also strengthened and solidified our capital structure, successfully refinancing a maturing debt instrument and lowering our future financing cost.

 

·  We adopted the provisions of Statement of Financial Accounting Standard No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS 158”) effective as of our 2006 year end. The impact of adopting SFAS 158 is reflected as a reduction in net assets on our balance sheet of $168 million, with no impact to the statements of income and cash flows. See Note 15 for more information on this adoption.

 

ACQUISITIONS

 

·  In June, we acquired Shield Medicare Ltd., based in the UK. With annual sales of $19 million, Shield is a leading provider of contamination control products for pharmaceutical, medical device and hospital clean rooms.

 

·  In September, we acquired DuChem Industries, Inc., a U.S. manufacturer and marketer of cleaning and sanitizing products for the food and beverage market. DuChem’s core focus is the protein (meat & poultry) market segment, and has annual sales of $10 million.

 

·  In September, we acquired Powles Hunt & Sons International Ltd’s UK commercial laundry business. With annual sales of $5 million, this acquisition will add scale to our textile care business in the UK.

 

2007 EXPECTATIONS

·  We look for continued momentum from our existing business, investments in our key growth drivers and from competitive gains achieved in 2006 to drive growth and market share opportunities in 2007.

17




·  We will continue to leverage our Circle the Customer — Circle the Globe growth strategy through cross-selling and enhanced marketing of our many product and service solutions under the Ecolab brand.

 

·  We will continue to invest in new product, system and service development in order to deliver improved value to our customers and thereby earn more of their business.

 

·  We plan to seek strategic business acquisitions which complement our growth strategy.

 

·  We will continue to work on streamlining our business processes in order to reduce costs and improve sustainability.

 

·  We intend to make significant investments in our business systems to drive growth in the future.

 

·  We will continue to work to deliver superior results to our customers, returns to shareholders and opportunity to our valued associates.

 

CRITICAL ACCOUNTING ESTIMATES

 

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). We have adopted various accounting policies to prepare the consolidated financial statements in accordance with U.S. GAAP. Our most significant accounting policies are disclosed in Note 2 of the notes to the consolidated financial statements.

 

Preparation of our consolidated financial statements, in conformity with U.S. GAAP, requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions to be made about matters that are highly uncertain at the time the accounting estimate is made, and (2) different estimates that the company reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, have a material impact on the presentation of the company’s results of operations.

 

Besides estimates that meet the “critical” estimate criteria, we make many other accounting estimates in preparing our financial statements and related disclosures. All estimates, whether or not deemed critical, affect reported amounts of assets, liabilities, revenues and expenses as well as disclosures of contingent assets and liabilities. Estimates are based on experience and other information available prior to the issuance of the financial statements. Materially different results can occur as circumstances change and additional information becomes known, even from estimates not deemed critical. Our critical accounting estimates include the following:

 

REVENUE RECOGNITION

 

We recognize revenue on product sales at the time title to the product and risk of loss transfers to the customer. We recognize revenue on services as they are performed. Our sales policies do not provide for general rights of return and do not contain customer acceptance clauses. We record estimated reductions to revenue for customer programs and incentive offerings including pricing arrangements, promotions and other volume-based incentives at the time the sale is recorded. Depending on market conditions, we may increase customer incentive offerings, which could reduce gross profit margins at the time the incentive is offered.

 

VALUATION ALLOWANCES AND ACCRUED LIABILITIES

 

We estimate sales returns and allowances by analyzing historical returns and credits, and apply these trend rates to the most recent 12 months’ future credits. We estimate the allowance for doubtful accounts by analyzing accounts receivable balances by age, applying historical write-off trend rates to the most recent 12 months’ sales, less actual write-offs to date. In addition, our estimates also include separately providing for 100 percent of specific customer balances when it is deemed probable that the balance is uncollectible. Actual results could differ from these estimates under different assumptions.

 

Estimates used to record liabilities related to pending litigation and environmental claims are based on our best estimate of probable future costs. Estimated future legal costs are expensed as incurred. We record the amounts that represent the points in the range of estimates that we believe are most probable or the minimum amounts when no amount within the range is a better estimate than any other amount. Potential insurance reimbursements are not anticipated in our accruals for environmental liabilities. While the final resolution of litigation and environmental contingencies could result in amounts different than current accruals, and therefore have an impact on our consolidated financial results in a future reporting period, we believe the ultimate outcome will not have a significant effect on our consolidated results of operations, financial position or cash flows.

 

ACTUARIALLY DETERMINED LIABILITIES

 

The measurement of our pension and postretirement benefit obligations are dependent on a variety of assumptions determined by management and used by our actuaries. These assumptions affect the amount and timing of future contributions and expenses.

 

The assumptions used in developing the required estimates include, among others, discount rate, projected salary and health financial care cost increases and expected return or earnings on assets. Beginning in 2005, the discount rate assumption for the U.S. Plans is calculated using a bond yield curve constructed from a large population of high-quality, non-callable, corporate bond issues with maturity dates of six months to thirty years. Bond issues in the population are rated no less than Aa by Moody’s Investor Services or AA by Standard & Poors. The discount rate is calculated by matching of the plan liability cash flows to the yield curve. Prior to 2005, the discount rate assumption was based on the investment yields available at year-end on corporate long-term bonds rated AA. Projected salary and health care cost increases are based on our long-term actual experience, the near-term outlook and assumed inflation. The expected return on plan assets reflects asset allocations, investment strategies and the views of investment advisors. The effects of actual results differing from our assumptions, as well as changes in assumptions, are reflected in the unrecognized actuarial loss and amortized over future periods and, therefore, generally affect our recognized expense in future periods. Our unrecognized actuarial loss on our U.S. qualified and nonqualified pension plans decreased to $189 million (before tax) due primarily to a better than expected return on plan assets and an increase in the discount rate at the end of 2006. As of December 31, 2006, this unrecognized loss is included on our balance sheet as a component of Accumulated Other Comprehensive Income due to the adoption of SFAS 158. Significant differences in actual experience or significant changes in assumptions may materially affect pension and other post-retirement obligations.

18




In determining our U.S. pension and postretirement obligations for 2006, our discount rate increased to 5.79 percent from 5.57 percent at year-end 2005. Our projected salary increase was unchanged at 4.32 percent and our expected return on plan assets used for determining 2006 expense remained unchanged at 8.75 percent.

 

The effect on 2007 expense of a decrease in the discount rate or expected return on assets assumption as of December 31, 2006 is shown below assuming no changes in benefit levels and no amortization of gains or losses for our major plans:

 

 

 

Effect on U.S. Pension Plan

 

 

 

 

 

Increase in

 

Higher

 

millions

 

Assumption

 

Recorded

 

2007

 

Assumption

 

Change

 

Obligation

 

Expense

 

 

 

 

 

 

 

 

 

Discount rate

 

-0.25 pts

 

$

30.8

 

$

4.2

 

Expected return on assets

 

-0.25 pts

 

N/A

 

$

1.9

 

 

 

 

Effect on U.S. Postretirement

 

 

 

Health Care Benefits Plan

 

 

 

 

 

Increase in

 

Higher

 

millions

 

Assumption

 

Recorded

 

2007

 

Assumption

 

Change

 

obligation

 

Expense

 

 

 

 

 

 

 

 

 

Discount rate

 

-0.25 pts

 

$

4.8

 

$

0.7

 

Expected return on assets

 

-0.25 pts

 

N/A

 

$

0.1

 

 

See Note 15 for further discussion concerning our accounting policies, estimates, funded status, planned contributions and overall financial positions of our pension and post-retirement plan obligations.

 

We are self-insured in North America for most workers compensation, general liability and automotive liability losses, subject to per occurrence and aggregate annual liability limitations. We are insured for losses in excess of these limitations. We have recorded both a liability and an offsetting receivable for amounts in excess of these limitations. We are also self-insured for health care claims for eligible participating employees, subject to certain deductibles and limitations. We determine our liabilities for claims incurred but not reported on an actuarial basis. A change in these assumptions would cause reported results to differ.

 

SHARE-BASED COMPENSATION

 

Effective October 1, 2005 we adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”) under the modified retrospective application method. All prior period financial statements were restated to recognize share-based compensation historically reported in the notes to the consolidated financial statements. As required by SFAS 123R, we measure compensation expense for share-based awards at fair value at the date of grant and recognize compensation expense over the service period for awards expected to vest. Upon adoption of SFAS 123R in the fourth quarter of 2005 we began using a lattice-based binomial model for valuing new stock option grants. We believe this model considers appropriate probabilities of option exercise and post-vesting termination which are more consistent with actual and projected experience, and therefore support more accurate valuation of a stock option. We also started using a forfeiture estimate for all share-based awards in the amount of compensation expense being recognized. This change from our historical practice of recognizing forfeitures as they occur did not result in the recognition of any cumulative adjustment to income.

 

Determining the fair value of share-based awards at the grant date requires judgment, including estimating expected volatility, exercise and post-vesting termination behavior, expected dividends and risk-free rates of return. Additionally, the expense that is recorded is dependent on the amount of share-based awards that is expected to be forfeited. If actual forfeiture results differ significantly from these estimates, share-based compensation expense and our results of operations could be impacted. For additional information on our stock incentive and option plans, including significant assumptions used in determining fair value, see Note 10.

 

INCOME TAXES

 

Judgment is required to determine the annual effective income tax rate, deferred tax assets and liabilities and any valuation allowances recorded against net deferred tax assets. Our effective income tax rate is based on annual income, statutory tax rates and tax planning opportunities available in the various jurisdictions in which we operate. We establish liabilities or reserves when we believe that certain positions are likely to be challenged by authorities and we may not succeed, despite our belief that our tax return positions are fully supportable. We adjust these reserves in light of changing facts and circumstances. Our annual effective income tax rate includes the impact of reserve provisions and changes to reserves that we consider appropriate. During interim periods, this annual rate is then applied to our year-to-date operating results. In the event that there is a significant one-time item recognized in our interim operating results, the tax attributable to that item would be separately calculated and recorded in the same period as the one-time item.

 

Tax regulations require items to be included in our tax returns at different times than the items are reflected in our financial statements. As a result, the effective income tax rate reflected in our financial statements differs from that reported in our tax returns. Some of these differences are permanent, such as expenses that are not deductible on our tax return, and some are temporary differences, such as depreciation expense. Temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax return in future years for which we have already recorded the tax benefit in our income statement. We establish valuation allowances for our deferred tax assets when the amount of expected future taxable income is not likely to support the utilization of the deduction or credit. Deferred tax liabilities generally represent items for which we have already taken a deduction in our tax return, but have not yet recognized that tax benefit in our financial statements. Undistributed earnings of foreign subsidiaries are considered to have been reinvested indefinitely or available for distribution with foreign tax credits available to offset the amount of applicable income tax and foreign withholding taxes that might be payable on earnings. It is impractical to determine the amount of incremental taxes that might arise if all undistributed earnings were distributed.

 

A number of years may elapse before a particular tax matter, for which we have established a reserve, is audited and finally resolved. The number of tax years with open tax audits varies depending on the tax jurisdiction. In the United States, during 2004, the Internal Revenue Service completed their field work examination of our tax returns for 1999 through 2001. We expect the final resolution for these returns by 2008. We also expect the Internal Revenue Service to complete their field work examination of our tax returns for 2002 through 2004 in 2007.

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While it is often difficult to predict the final outcome or the timing of resolution of any tax matter, we believe that our reserves reflect the probable outcome of known tax contingencies. Unfavorable settlement of any particular issue could result in additional tax expense and would require the use of cash. Favorable resolution could result in reduced income tax expense reported in the financial statements in the future. Our tax reserves are presented in the balance sheet within other non-current liabilities.

 

LONG-LIVED AND INTANGIBLE ASSETS

 

We periodically review our long-lived and intangible assets for impairment and assess whether significant events or changes in business circumstances indicate that the carrying value of the assets may not be recoverable. This could occur when the carrying amount of an asset exceeds the anticipated future undiscounted cash flows expected to result from the use of the asset and its eventual disposition. The amount of the impairment loss to be recorded, if any, is calculated as the excess of the asset’s carrying value over its estimated fair value. We also periodically reassess the estimated remaining useful lives of our long-lived assets. Changes to estimated useful lives would impact the amount of depreciation and amortization expense recorded in earnings. We have experienced no significant changes in the carrying value or estimated remaining useful lives of our long-lived assets.

 

We review our goodwill for impairment on an annual basis for all reporting units. If circumstances change significantly within a reporting unit, we would test for impairment prior to the annual test.

 

Goodwill and certain intangible assets are assessed for impairment using fair value measurement techniques. Specifically, goodwill impairment is determined using a two-step process. Both the first step of determining the fair value of a reporting unit and the second step of determining the fair value of individual assets and liabilities of a reporting unit (including unrecognized intangible assets) are judgmental in nature and often involve the use of significant estimates and assumptions. Estimates of fair value are primarily determined using discounted cash flows, market comparisons and recent transactions. These valuation methodologies use significant estimates and assumptions, which include projected future cash flows (including timing), discount rate reflecting the risk inherent in future cash flows, perpetual growth rate, and determination of appropriate market comparables. No impairments were recorded in 2006, 2005 or 2004 as a result of the tests performed. Of the total goodwill included in our consolidated balance sheet, 19 percent is recorded in our United States Cleaning & Sanitizing reportable segment, 5 percent in our United States Other Services segment and 76 percent in our International segment.

 

FUNCTIONAL CURRENCIES

 

In preparing the consolidated financial statements, we are required to translate the financial statements of our foreign subsidiaries from the currency in which they keep their accounting records, generally the local currency, into United States dollars. Assets and liabilities of these operations are translated at the exchange rates in effect at each fiscal year end. The translation adjustments related to assets and liabilities that arise from the use of differing exchange rates from period to period are included in accumulated other comprehensive income in shareholders’ equity. Income statement accounts are translated at average rates of exchange prevailing during the year. We evaluate our International operations based on fixed rates of exchange; however, the different exchange rates from period to period impact the amount of reported income from our consolidated operations.

 

RESULTS OF OPERATIONS

CONSOLIDATED

 

millions, except per share

 

2006

 

2005

 

2004

 

 

 

 

 

 

 

 

 

Net sales

 

$

4,896

 

$

4,535

 

$

4,185

 

Operating income

 

612

 

542

 

490

 

Net income

 

369

 

319

 

283

 

Diluted net income per common share

 

1.43

 

1.23

 

1.09

 

 

Our consolidated net sales for 2006 increased 8 percent over 2005. The components include 6 percent volume growth and 2 percent favorable effect from price changes. Acquisitions and divestitures and changes in currency translation did not have a significant impact on the consolidated sales growth rate.

 

 

2006

 

2005

 

2004

 

 

 

 

 

 

 

 

 

Gross profit as a percent of net sales

 

50.7

%

50.4

%

51.4

%

Selling, general & administrative expenses as a percent of net sales

 

38.2

%

38.4

%

39.6

%

 

Our consolidated gross profit margin (defined as gross profit divided by net sales) for 2006 increased from 2005, primarily driven by pricing and cost savings initiatives which more than offset higher delivered product costs during the year.

 

Selling, general and administrative expenses as a percentage of sales continued to improve in 2006. The improvement in the 2006 expense ratio is primarily due to increased sales leverage and cost saving programs which more than offset investments in the business.

 

 

 

2006

 

2005

 

2004

 

 

 

 

 

 

 

 

 

Operating income as a percent of net sales

 

12.5

%

12.0

%

11.7

%

 

Operating income increased 13 percent in 2006 over 2005. As a percent of sales, operating income also increased from 2005. The increase in operating income in 2006 is due to pricing, sales volume and cost reduction initiatives partially offset by higher delivered product costs as well as investments in the business.

 

Our net income was $369 million in 2006, an increase of 15 percent compared to $319 million in 2005. Net income in both years included items of a non-recurring nature that are not necessarily indicative of future operating results. Net income in 2006 included the benefit of a $1.8 million tax settlement for stewardship costs which was offset by a $2.8 million charge ($1.8 million net of tax benefit) in selling, general and administrative expense to recognize minimum royalties under a licensing agreement with no future benefit. Net income in 2005 included a tax charge of $3.1 million related to the repatriation of foreign earnings under the American Jobs Creation Act (AJCA). Excluding these items, net income increased 14 percent for 2006. This increase in net income reflects improved sales, gross margin and operating income growth. Currency translation positively impacted net income in 2006 by approximately $2 million. Our 2006 net income also benefited when compared to 2005 due to a lower overall effective income tax rate which was the result of international mix, lower international statutory rates and tax planning efforts.

20




2005 COMPARED WITH 2004

 

Our consolidated net sales for 2005 increased 8 percent to $4.5 billion compared to $4.2 billion in 2004. Acquisitions and divestitures increased consolidated net sales by 1 percent. Changes in currency translation also positively impacted the sales growth rate by 1 percent. Sales benefited from pricing, new account gains, new product and service offerings and investments in the sales-and-service-force.

 

Our consolidated gross profit margin for 2005 decreased from 2004. The decrease was primarily driven by higher delivered product costs, partially offset by pricing and cost savings programs.

 

Selling, general and administrative expenses as a percentage of sales improved for 2005 compared to 2004. The improvement in the 2005 expense ratio is primarily due to pricing, sales leverage and cost savings programs partially offset by investments in the sales-and-service force, research and development and technology.

 

Operating income for 2005 increased 11 percent over 2004. As a percent of sales, operating income also increased from 2004. The increase in operating income in 2005 is due to sales volume, pricing, cost reduction initiatives and lower share-based compensation expense, partially offset by higher delivered product costs as well as investments in the sales-and-service force, research and development and technology. Operating income also benefited from significant operating improvement at GCS Service in 2005.

 

Our net income was $319 million in 2005, an increase of 13 percent as compared to $283 million in 2004. Net income in both years included items of a non-recurring nature that are not necessarily indicative of future operating results. Net income in 2005 included a tax charge of $3.1 million related to the repatriation of foreign earnings under the AJCA. Net income in 2004 included benefits from a reduction in previously recorded restructuring expenses of $0.6 million (after tax) and a gain on the sale of a small international business of $0.2 million (after tax). Income tax expense and net income in 2004 also included a tax benefit of $1.9 million related to prior years. These benefits were more than offset by a charge of $1.6 million for in-process research and development as part of the acquisition of Alcide Corporation and a charge of $2.4 million (after tax) related to the disposal of a grease management product line. Excluding these items from both years, net income increased 14 percent for 2005. This increase in net income reflects improved operating income growth by most of our business units in the face of a challenging raw material cost environment. Currency translation positively impacted net income growth in 2005 by approximately $5 million. Our 2005 net income also benefited when compared to 2004 due to a lower overall effective income tax rate which was the result of a lower international rate, international mix and tax planning efforts. Excluding the items of a non-recurring nature previously mentioned, net income was 7 percent of net sales for both 2005 and 2004.

 

SEGMENT PERFORMANCE

 

Our operating segments have been aggregated into three reportable segments: United States Cleaning & Sanitizing, United States Other Services and International. We evaluate the performance of our International operations based on fixed management rates of currency exchange. Therefore, International sales and operating income totals, as well as the International financial information included in this financial discussion, are based on translation into U.S. dollars at the fixed currency exchange rates used by management for 2006. The difference between actual currency exchange rates and the fixed currency exchange rates used by management is included in “Effect of Foreign Currency Translation” within our operating segment results. All other accounting policies of the reportable segments are consistent with U.S. GAAP and the accounting policies of the company described in Note 2 of the notes to consolidated financial statements. Additional information about our reportable segments is included in Note 16 of the notes to consolidated financial statements.

 

SALES BY REPORTABLE SEGMENT

 

millions

 

2006

 

2005

 

2004

 

Net sales

 

 

 

 

 

 

 

United States

 

 

 

 

 

 

 

Cleaning & Sanitizing

 

$

2,152

 

$

1,952

 

$

1,797

 

Other Services

 

411

 

375

 

339

 

Total United States

 

2,563

 

2,327

 

2,136

 

International

 

2,261

 

2,137

 

2,038

 

Total

 

4,824

 

4,464

 

4,174

 

Effect of foreign currency translation

 

72

 

71

 

11

 

Consolidated

 

$

4,896

 

$

4,535

 

$

4,185

 

 

Percent Change From Prior Year

 

2006

 

2005

 

Net sales

 

 

 

 

 

United States

 

 

 

 

 

Cleaning & Sanitizing

 

10

%

9

%

Other Services

 

9

 

11

 

Total United States

 

10

 

9

 

International (management rates)

 

6

 

5

 

Consolidated (management rates)

 

8

 

8

 

Consolidated (public rates)

 

8

%

7

%

 

 

Sales of our United States Cleaning & Sanitizing operations increased 10 percent to $2.2 billion in 2006. Sales were driven by double-digit sales growth in our Institutional and Kay divisions, along with good growth from our Food & Beverage division. Institutional sales increased 11 percent in 2006, benefiting from significant new account gains during the year. Institutional results reflect sales growth into all end market segments, including double-digit growth in travel, casual dining and health care markets. Food & Beverage division sales increased 8 percent for 2006. The acquisition of DuChem added 1 percent and the remaining increase was due to double-digit gains in the meat & poultry market as well as good gains in the dairy, food

21




and soft drink markets. Kay recorded an 11 percent sales increase in 2006 led by gains in its core quickservice and food retail markets. Kay benefited from good ongoing demand from existing customers as well as new account gains.

 

 

Sales of our United States Other Services operations increased 9 percent in 2006. Pest Elimination continued its double-digit sales growth as sales rose 13 percent. Sales were driven by growth in both core pest elimination contract and non-contract services. Sales also benefited from new accounts and strong customer retention. GCS Service sales grew modestly as service and installed parts sales increased over last year. GCS Service continued to focus on infrastructure and process development that will improve competitive advantage and business scalability in the future.

 

 

Management rate sales of our International operations were $2.3 billion in 2006, an increase of 6 percent over 2005. Acquisitions and divestitures added 1 percent to the year over year sales growth in 2006. Sales in Europe increased 4 percent from 2005. Good sales growth in the United Kingdom was partially offset by slower sales growth in Germany, France and Italy. Europe also achieved geographic growth in 2006 through further expansion in eastern Europe. Asia Pacific sales grew 6 percent primarily driven by growth in China, Australia, Thailand and Hong Kong partially offset by weakness in Japan. Asia Pacific sales benefited from new corporate accounts and good results in the beverage and brewery segment. Latin America recorded strong 14 percent sales growth in 2006. The growth over last year was driven by results in Mexico, the Caribbean and Venezuela. Results were due to new account gains, growth of existing accounts and success with new programs. Sales in Canada increased 8 percent in 2006, reflecting good results from all divisions. Sales benefited from pricing, account retention and new business.

 

OPERATING INCOME BY REPORTABLE SEGMENT

 

millions

 

2006

 

2005

 

2004

 

Operating income

 

 

 

 

 

 

 

United States

 

 

 

 

 

 

 

Cleaning & Sanitizing

 

$

329

 

$

280

 

$

266

 

Other Services

 

39

 

36

 

21

 

Total United States

 

368

 

316

 

287

 

International

 

234

 

219

 

209

 

Total

 

602

 

535

 

496

 

Corporate

 

 

 

(4

)

Effect of foreign currency translation

 

10

 

7

 

(2

)

Consolidated

 

$

612

 

$

542

 

$

490

 

Operating income as a percent of net sales

 

 

 

 

 

 

 

United States

 

 

 

 

 

 

 

Cleaning & Sanitizing

 

15.3

%

14.3

%

14.8

%

Other Services

 

9.5

 

9.6

 

6.0

 

Total United States

 

14.4

 

13.6

 

13.4

 

International

 

10.3

 

10.3

 

10.2

 

Consolidated

 

12.5

%

12.0

%

11.7

%

 

Operating income of our United States Cleaning & Sanitizing operations increased 18 percent to $329 million in 2006. As a percentage of net sales, operating income increased to 15.3 percent in 2006 from 14.3 percent in 2005. Acquisitions and divestitures had no effect on the overall percentage increase in operating income. Operating income increased due to pricing, higher sales volume and improved cost efficiencies, which more than offset higher delivered product costs and investments in the business.

Operating income of our United States Other Services operations increased 8 percent to $39 million in 2006. As a percentage of net sales, operating income decreased slightly to 9.5 percent in 2006 from 9.6 percent in 2005. Double-digit operating income growth at Pest Elimination was offset by slow sales growth as well as investments in the GCS business. Operating income growth and operating income margin comparisons were also impacted by a $0.5 million regulatory expense in the second quarter of 2006 and a $0.5 million patent settlement benefit in the first quarter of 2005.

 

Management-rate based operating income of International operations rose 7 percent to $234 million in 2006. The International operating income margin was 10.3 percent in both 2006 and 2005. Acquisitions and divestitures occurring in 2006 and 2005 increased operating income growth by 1 percent over 2005. Operating income growth benefited from pricing, sales volume growth and cost efficiencies which more than offset higher delivered product costs and investments in the business.

 

Operating income margins of our International operations are generally less than those realized for our U.S. operations. The lower International margins are due to (i) the additional costs caused by the difference in scale of International operations where many operating locations are smaller in size, (ii) the additional cost of operating in numerous and diverse foreign jurisdictions and (iii) higher costs of importing raw materials and finished goods. Proportionately larger investments in sales, technical support and administrative personnel are also necessary in order to facilitate the growth of our International operations.

 

22




2005 COMPARED WITH 2004

 

Sales of our United States Cleaning & Sanitizing operations reached nearly $2.0 billion in 2005 and increased 9 percent over net sales of $1.8 billion in 2004. Acquisitions and divestitures increased sales by 1 percent for 2005. Sales benefited from double-digit organic growth in our Kay division, along with good growth in our Institutional and Food & Beverage divisions. This sales performance reflects increased account retention and penetration through enhanced service, new product and program initiatives and aggressive new account sales efforts. Institutional sales grew 7 percent in 2005 reflecting sales growth in all end market segments, including travel, casual dining, healthcare, and government markets. Food & Beverage sales increased 9 percent compared to 2004. Excluding the benefits of the 2004 Alcide acquisition, Food & Beverage sales increased 5 percent for 2005 primarily due to gains in the dairy, food and soft drink markets reflecting increasing penetration of existing corporate accounts as well as new business. Kay’s sales increased 11 percent, led by strong gains in sales to its core quickservice customers and in its food retail services business.

 

Sales of our United States Other Services operations increased 11 percent to $375 million in 2005. Pest Elimination had 12 percent sales growth including double-digit sales growth in both core pest elimination contract and non-contract services, such as bird and termite work, fumigation, one-shot services and its food safety audit business. GCS Service sales grew 8 percent in 2005 as service and installed parts sales increased over 2004. GCS continued to increase technician productivity and improve customer service satisfaction.

               

Management rate sales of our International operations were $2.1 billion in 2005, an increase of 5 percent over sales of $2.0 billion in 2004. Acquisitions and divestitures increased sales 1 percent in 2005. Sales in Europe, excluding acquisitions and divestitures, were up 2 percent from 2004. Sales were affected by an overall weak European economy, particularly in the major central countries. Sales in Asia Pacific, excluding acquisitions and divestitures, increased 7 percent. The growth was primarily driven by East Asia, including continued growth in China. Asia Pacific growth was driven by new corporate accounts and good results in the beverage and brewery segment. Latin America continued its double-digit sales growth as sales grew 15 percent over 2004, reflecting growth in all countries with Mexico, Chile and Argentina showing the strongest growth. Results were due to new account gains, growth of existing accounts and strong equipment sales. Sales in Canada increased 8 percent in 2005, reflecting good results from all divisions.

 

Operating income of our United States Cleaning & Sanitizing operations was $280 million in 2005, an increase of 5 percent from operating income of $266 million in 2004. As a percentage of net sales, operating income decreased from 14.8 percent in 2004 to 14.3 percent in 2005. Acquisitions and divestitures had no effect on the overall percentage increase in operating income. The increase in operating income in 2005 reflects the benefits of higher sales, pricing and lower share-based compensation expense being partially offset by higher delivered product costs. Operating income margins declined because the negative impact of higher delivered product costs more than offset the benefits of pricing, cost savings and sales leverage.

 

Operating income of United States Other Services operations increased 76 percent to $36 million in 2005. The operating income margin for United States Other Services increased to 9.6 percent in 2005 from 6.0 percent in 2004. Pest Elimination had double-digit operating income growth and GCS Service results reflect sharp profitability improvement in 2005. The increase in operating income for Pest Elimination was driven by strong sales and leverage of sales and administrative teams, with pricing and productivity improvements offsetting cost increases. GCS Service narrowed its operating loss substantially in 2005 due to good sales growth and operational improvements. GCS Service operating income growth also benefited from a favorable comparison to 2004 which included a sales decline, increased marketing expenses and higher than expected costs resulting from centralizing the parts and administration activities.

 

Management-rate based operating income of International operations rose 5 percent to $219 million in 2005 from operating income of $209 million in 2004. The International operating income margin was 10.3 percent in 2005 and 10.2 percent 2004. Excluding the impact of acquisitions and divestitures occurring in 2005 and 2004, operating income increased 3 percent over 2004. Sales growth, pricing, lower share-based compensation expense and cost efficiencies were partially offset by higher delivered product costs, unfavorable business mix and investments.

 

CORPORATE

 

We had no operating expenses in our corporate segment in 2006 or 2005 and $4.5 million in 2004. In 2004, corporate operating expense included a charge of $1.6 million for in-process research and development as part of the acquisition of Alcide Corporation and a charge of $4.0 million related to the disposal of a grease management product line, which were partially offset by $0.8 million of income for reductions in restructuring accruals and a $0.3 million gain on the sale of a small international business.

 

INTEREST AND INCOME TAXES

 

Net interest expense was $44 million for both 2006 and 2005. An increase in interest expense during 2006 was offset by higher interest income.

 

Net interest expense in 2005 decreased to $44 million compared to $45 million in 2004. The decrease was caused by higher interest income during the year due to increased levels of cash and cash equivalents and short-term investments offset partially by a small increase in interest expense.

 

Our effective income tax rate was 35.0 percent for 2006, compared with an effective income tax rate of 35.9 percent for 2005 and 36.4 percent in 2004. Reductions in our effective income tax rates over the last three years have primarily been due to favorable international mix, lower international statutory rates and the impact of tax planning efforts. Excluding the benefit of the $1.8 million tax settlement for stewardship costs and a $0.5 million benefit related to prior years, the estimated effective income tax rate was 35.4 percent for 2006. Excluding the effects of the $3.1 million tax charge related to the repatriation of foreign earnings under the AJCA and other onetime benefits, the estimated annual effective income tax rate for 2005 was 35.6 percent. Excluding the effects of special charges mentioned above in the corporate section and a $1.9 million tax benefit related to prior years, the estimated annual effective income tax rate was 36.7 percent for 2004.

 

23




FINANCIAL POSITION & LIQUIDITY

FINANCIAL POSITION

 

Our debt continued to be rated within the “A” categories by the major rating agencies during 2006. Significant changes in our financial position during 2006 included the following:

 

Total assets increased 16 percent to $4.4 billion as of December 31, 2006 from $3.8 billion at year-end 2005. Total assets increased primarily due to an increase in cash and cash equivalents resulting from $396 million of proceeds received from a new debt offering in December. Foreign currency translation added approximately $175 million to the value of non-U.S. assets on the balance sheet as the U.S. dollar weakened against foreign currencies, primarily the euro. Additionally, acquisitions added $83 million of assets.

 

Total liabilities increased $592 million in 2006. This included an increase in total debt discussed below and an increase of $81 million in post retirement healthcare and pension benefits due to the adoption of SFAS 158 as discussed in Note 15. Total liabilities also reflected an increase resulting from the effects of currency translation.

 

 

Total debt was $1.1 billion at December 31, 2006 and increased from total debt of $746 million at year-end 2005. This increase in total debt during 2006 was primarily due to the issuance of euro 300 million senior notes ($396 million as of December 31, 2006) to refinance our euronotes which became due in February 2007. The ratio of total debt to capitalization (total debt divided by the sum of shareholders’ equity plus total debt) was 39 percent at year-end 2006 and 31 percent at year-end 2005. The debt to capitalization ratio increased significantly in 2006, due to the new senior notes issued as well as a decrease in our equity of $168 million for a change in accounting due to the adoption of SFAS 158. Normalizing for these items, the total debt to capitalization would have been 27 percent for 2006. We view our debt to capitalization ratio as an important indicator of our creditworthiness.

 

CASH FLOWS

 

Cash provided by operating activities was $628 million for 2006, an increase over $590 million in 2005 and $571 million in 2004. The increase in operating cash flow for 2006 over 2005 reflects our higher net income offset partially by an increase in income tax payments and accounts receivable in 2006. The increase in operating cash flow for 2005 over 2004 is due to higher net income and improved collection of accounts receivable as well as better inventory management. Historically, we have had strong operating cash flows and we anticipate this will continue. We expect to continue to use this cash flow to acquire new businesses, repurchase our common stock, pay down debt and meet our ongoing obligations and commitments.

Cash used for investing activities decreased from 2005 due primarily to the timing of purchases and sales of short-term investments offset by higher acquisition activity, capital expenditures and capitalized software expenditures. Capital software expenditures increased due to investments in business systems. We expect capital software expenditures to increase significantly in 2007 as we continue to invest in our business systems.

 

Financing cash flow activity included cash proceeds from new senior note borrowings of $396 million, debt repayment and dividend payments. Share repurchases were $283 million in 2006, $213 million in 2005 and $165 million in 2004. These repurchases were funded with operating cash flows and cash from the exercise of employee stock options. In December 2004, we announced an authorization to repurchase up to 10 million shares of Ecolab common stock. In October 2006, we announced an authorization to repurchase up to 10 million additional shares of Ecolab common stock. As of December 31, 2006, approximately 12.9 million shares remained to be purchased under these authorizations. Shares are repurchased for the purpose of offsetting the dilutive effect of stock options and incentives and for general corporate purposes. During 2007, we expect to repurchase at least enough shares to offset the dilutive effect of stock options. Cash proceeds from the exercises as well as the tax benefits will provide a portion of the funding for this repurchase activity.

In 2006, we increased our indicated annual dividend rate for the fifteenth consecutive year. We have paid dividends on our common stock for 70 consecutive years. Cash dividends declared per share of common stock, by quarter, for each of the last three years were as follows:

 

 

FIRST

 

SECOND

 

THIRD

 

FOURTH

 

 

 

 

 

QUARTER

 

QUARTER

 

QUARTER

 

QUARTER

 

YEAR

 

2006

 

$

0.1000

 

$

0.1000

 

$

0.1000

 

$

0.1150

 

$

0.4150

 

2005

 

0.0875

 

0.0875

 

0.0875

 

0.1000

 

0.3625

 

2004

 

0.0800

 

0.0800

 

0.0800

 

0.0875

 

0.3275

 

 

LIQUIDITY AND CAPITAL RESOURCES

 

We currently expect to fund all of the requirements which are reasonably foreseeable for 2007, including scheduled debt repayments, new investments in the business, share repurchases, dividend payments, possible business acquisitions and pension contributions from operating cash flow, cash reserves and short-term borrowings.

 

In December 2006, we issued and sold in a private placement euro 300 million ($396 million as of December 31, 2006) aggregate principal amount of senior notes in two series: 4.355% Series A Senior Notes due 2013 in the aggregate principal amount of euro 125 million and 4.585% Series B Senior Notes due 2016 in the aggregate principal amount of euro 175 million (the “Notes),” pursuant to a Note Purchase Agreement dated July 26, 2006, between the company and the purchasers. The Notes are not subject to prepayment except where, in certain specified instances, we consolidate or merge all or substantially all of our assets with any other Person (as defined in the Note Purchase Agreement). Upon such consolidation or merger, we will offer to prepay all of the Notes at 100 percent of

 

24




the principal amount outstanding plus accrued interest. In the event of a default by the company under the Note Purchase Agreement, the Notes may become immediately due and payable for the unpaid principal amount, accrued interest and a make-whole amount determined as of the time of the default. The proceeds were used to repay our euro 300 million 5.375 percent euronotes which became due in February 2007.

 

While cash flows could be negatively affected by a decrease in revenues, we do not believe that our revenues are highly susceptible, in the short term, to rapid changes in technology within our industry. We have a $450 million U.S. commercial paper program and a $200 million European commercial paper program. Both programs are rated A-1 by Standard & Poor’s and P-1 by Moody’s. To support our commercial paper programs andother general business funding needs, we maintain a $450 million multi-year committed credit agreement which expires in June 2011 and under certain circumstances can be increased by $150 million for a total of $600 million. We can draw directly on the credit facility on a revolving credit basis. As of December 31, 2006, $30 million of this credit facility was committed to support outstanding U.S. commercial paper, leaving $420 million available for other uses. In addition, we have other committed and uncommitted credit lines of approximately $190 million with major international banks and financial institutions to support our general global funding needs. Additional details on our credit facilities are included in Note 6 of the notes to consolidated financial statements.

 

During 2006, we voluntarily contributed $45 million to our U.S. pension plan. In making this contribution, we considered the normal growth in accrued plan benefits, the impact of lower year-end discount rates on the plan liability and the tax deductibility of the contribution. We expect our combined U.S. qualified and nonqualified pension plan expense to decrease slightly to approximately $40 million in 2007 from $41 million in 2006, primarily due to expected returns on a higher level of plan assets and an increase in the discount rate from 5.57 percent to 5.79 percent for the 2007 expense calculation. The expected return on plan assets of 8.75 percent is consistent with 2006.

 

A schedule of our obligations under various notes payable, long-term debt agreements, operating leases with noncancelable terms in excess of one year, interest obligations and benefit payments are summarized in the following table:

 

 

 

PAYMENTS DUE BY PERIOD

 

THOUSANDS

 

 

 

LESS

 

 

 

 

 

MORE

 

 

 

 

 

THAN

 

1-3

 

3-5

 

THAN

 

Contractual Obligations

 

TOTAL

 

1 YEAR

 

YEARS

 

YEARS

 

5 YEARS

 

 

 

 

 

 

 

 

 

 

 

 

 

Note payable

 

$

109,100

 

$

109,100

 

$

 

$

 

$

 

Long-term debt

 

956,936

 

399,878

 

4,475

 

151,988

 

400,595

 

Operating leases

 

142,000

 

44,000

 

57,000

 

28,000

 

13,000

 

Interest*

 

223,347

 

34,172

 

64,250

 

54,290

 

70,635

 

Benefit payments**

 

760,000

 

52,000

 

123,000

 

138,000

 

447,000

 

Total contractual cash obligations

 

$

2,191,383

 

$

639,150

 

$

248,725

 

$

372,278

 

$

931,230

 

*                    Interest on variable rate debt was calculated using the interest rate at year-end 2006.

**             Benefit payments are paid out of the company’s pension and postretirement health care benefit plans.

We are not required to make any contributions to our U.S. pension and postretirement health care benefit plans in 2007, based on plan asset values as of December 31, 2006. Certain international pension benefit plans are required to be funded in accordance with local government requirements. We estimate contributions to be made to our international plans will approximate $20 million in 2007. These amounts have been excluded from the schedule of contractual obligations.

 

We lease sales and administrative office facilities, distribution center facilities, computers and other equipment under longer-term operating leases. Vehicle leases are generally shorter in duration. Vehicle leases have guaranteed residual value requirements that have historically been satisfied by the proceeds on the sale of the vehicles. No amounts have been recorded for these guarantees in the table preceding as we believe that the potential recovery of value from the vehicles when sold will be greater than the residual value guarantee.

Except for approximately $56 million of letters of credit supporting domestic and international commercial relationships and transactions, we do not have significant unconditional purchase obligations, or significant other commercial commitments, such as commitments under lines of credit, standby letters of credit, guarantees, standby repurchase obligations or other commercial commitments.

 

As of year-end 2006, we are in compliance with all covenants and other requirements of our credit agreements and indentures. Our $450 million multicurrency credit agreement, as amended and restated effective June 1, 2006, no longer includes a covenant regarding the ratio of total debt to capitalization. Our new euro 300 million senior notes include covenants regarding the amount of indebtedness secured by liens and subsidiary indebtedness allowed. Additionally, we do not have any rating triggers that would accelerate the maturity dates of our debt.

 

A downgrade in our credit rating could limit or preclude our ability to issue commercial paper under our current programs. A credit rating downgrade could also adversely affect our ability to renew existing, or negotiate new credit facilities in the future and could increase the cost of these facilities. Should this occur, we could seek additional sources of funding, including issuing term notes or bonds. In addition, we have the ability at our option to draw upon our $450 million committed credit facilities prior to their termination and, under certain conditions, can increase this amount to $600 million.

 

OFF-BALANCE SHEET ARRANGEMENTS

 

Other than operating leases, we do not have any off-balance sheet financing arrangements. See Note 12 for information on our operating leases. We do not have relationships with unconsolidated entities or financial partnerships, such as entities often referred to as “structured finance” or “special purposes entities”, which are sometimes established for the purpose of facilitating off-balance sheet financial arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

 

NEW ACCOUNTING PRONOUNCEMENTS

 

We adopted the provisions of SFAS 158 effective as of our 2006 year end. The impact of adopting SFAS 158 is reflected as a reduction in net assets on our balance sheet of $168 million, with no impact to the statements of income and cash flows. See Note 15 for more information on this adoption.

FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”) is effective  beginning January 1, 2007 with the cumulative effect of initially applying FIN 48 recognized as a

25




change in accounting principle recorded as an adjustment to opening retained earnings. We do not expect the impact of adoption to be material to our consolidated financial statements.

See Note 2 for additional information on these and other new accounting pronouncements.

 

MARKET RISK

 

We enter into contractual arrangements (derivatives) in the ordinary course of business to manage foreign currency exposure and interest rate risks. We do not enter into derivatives for trading purposes. Our use of derivatives is subject to internal policies that provide guidelines for control, counterparty risk and ongoing monitoring and reporting and is designed to reduce the volatility associated with movements in foreign exchange and interest rates on our income statement and cash flows.

 

We enter into forward contracts, swaps and foreign currency options to hedge certain intercompany financial arrangements, and to hedge against the effect of exchange rate fluctuations on transactions related to cash flows and net investments denominated in currencies other than U.S. dollars. At December 31, 2006, we had approximately $375 million notional amount of foreign currency forward exchange contracts with face amounts denominated primarily in euros.

 

We manage interest expense using a mix of fixed and floating rate debt. To help manage borrowing costs, we may enter into interest rate swap agreements. Under these arrangements, we agree to exchange, at specified intervals, the difference between fixed and floating interest amounts calculated by reference to an agreed-upon notional principal amount. At year-end 2006, we had an interest rate swap that converts approximately euro 78 million (approximately $103 million U.S. dollars) of our Euronote debt from a fixed interest rate to a floating or variable interest rate. This swap agreement expired in February 2007.

 

Based on a sensitivity analysis (assuming a 10 percent adverse change in market rates) of our foreign exchange and interest rate derivatives and other financial instruments, changes in exchange rates or interest rates would not materially affect our financial position and liquidity. The effect on our results of operations would be substantially offset by the impact of the hedged items.

 

FORWARD-LOOKING STATEMENTS AND RISK FACTORS

 

This financial discussion and other portions of this Annual Report to Shareholders contain various “Forward-Looking Statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include expectations concerning:

 

·  business progress and expansion,

·  business acquisitions,

·  currency translation,

·  cash flows,

·  debt repayments,

·  share repurchases,

·  global economic conditions,

·  pension expenses and potential contributions,

·  income taxes

·  and liquidity requirements.

 

Without limiting the foregoing, words or phrases such as “will likely result,” “are expected to,” “will continue,” “is anticipated,” “we believe,” “we expect,” “estimate,” “project” (including the negative or variations thereof) or similar terminology, general identify forward-looking statements. Forward-looking statements may also represent challenging goals for us. We caution that undue reliance should not be placed on such forward-looking statements, which speak only as of the date made. Some of the factors which could cause results to differ from those expressed in any forward-looking statements are set forth under Item 1A of our Form 10-K for the year ended December 31, 2006, entitled Risk Factors.

 

In addition, we note that our stock price can be affected by fluctuations in quarterly earnings. There can be no assurances that our earnings levels will meet investors’ expectations. We undertake no duty to update our Forward-Looking Statements.

26




Consolidated Statement of Income

 

Year ended December 31 (thousands, except per share)

 

2006

 

2005

 

2004

 

 

 

 

 

 

 

 

 

Net sales

 

$

4,895,814

 

$

4,534,832

 

$

4,184,933

 

 

 

 

 

 

 

 

 

Operating expenses

 

 

 

 

 

 

 

Cost of sales (including special charges (income) of ($106) in 2004)

 

2,416,058

 

2,248,831

 

2,033,492

 

Selling, general and administrative expenses

 

1,868,114

 

1,743,581

 

1,657,084

 

Special charges

 

 

 

 

 

4,467

 

Operating income

 

611,642

 

542,420

 

489,890

 

Interest expense, net

 

44,418

 

44,238

 

45,344

 

Income before income taxes

 

567,224

 

498,182

 

444,546

 

Provision for income taxes

 

198,609

 

178,701

 

161,853

 

Net income

 

$

368,615

 

$

319,481

 

$

282,693

 

 

 

 

 

 

 

 

 

Net income per common share

 

 

 

 

 

 

 

Basic

 

$

1.46

 

$

1.25

 

$

1.10

 

Diluted

 

$

1.43

 

$

1.23

 

$

1.09

 

 

 

 

 

 

 

 

 

Dividends declared per common share

 

$

0.4150

 

$

0.3625

 

$

0.3275

 

 

 

 

 

 

 

 

 

Weighted-average common shares outstanding

 

 

 

 

 

 

 

Basic

 

252,132

 

255,741

 

257,575

 

Diluted

 

257,144

 

260,098

 

260,407

 

 

The accompanying notes are an integral part of the consolidated financial statements.

27




Consolidated Balance Sheet

 

DECEMBER 31 (THOUSANDS, EXCEPT PER SHARE)

 

2006

 

2005

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

Current assets

 

 

 

 

 

Cash and cash equivalents

 

$

484,029

 

$

104,378

 

Short-term investments

 

 

 

125,063

 

Accounts receivable, net

 

867,541

 

743,520

 

Inventories

 

364,886

 

325,574

 

Deferred income taxes

 

86,870

 

65,880

 

Other current assets

 

50,231

 

57,251

 

Total current assets

 

1,853,557

 

1,421,666

 

Property, plant and equipment, net

 

951,569

 

868,053

 

Goodwill

 

1,035,929

 

937,019

 

Other intangible assets, net

 

223,787

 

202,936

 

Other assets, net

 

354,523

 

366,954

 

Total assets

 

$

4,419,365

 

$

3,796,628

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities

 

 

 

 

 

Short-term debt

 

$

508,978

 

$

226,927

 

Accounts payable

 

330,858

 

277,635

 

Compensation and benefits

 

252,686

 

214,131

 

Income taxes

 

17,698

 

39,583

 

Other current liabilities

 

392,510

 

361,081

 

Total current liabilities

 

1,502,730

 

1,119,357

 

Long-term debt

 

557,058

 

519,374

 

Postretirement health care and pension benefits

 

420,245

 

302,048

 

Other liabilities

 

259,102

 

206,639

 

Shareholders’ equity (a)

 

1,680,230

 

1,649,210

 

Total liabilities and shareholders’ equity

 

$

4,419,365

 

$

3,796,628

 

 

(a)             Common stock, 400,000 shares authorized, $1.00 par value, 251,337 shares issued and outstanding at December 31, 2006, 254,143 shares issued and outstanding at December 31, 2005.

 

The accompanying notes are an integral part of the consolidated financial statements.

28




Consolidated Statement of Cash Flows

 

YEAR ENDED DECEMBER 31 (THOUSANDS)

 

2006

 

2005

 

2004

 

 

 

 

 

 

 

 

 

OPERATING ACTIVITIES

 

 

 

 

 

 

 

Net income

 

$

368,615

 

$

319,481

 

$

282,693

 

Adjustments to reconcile net income to cash provided by operating activities:

 

 

 

 

 

 

 

Depreciation and amortization

 

268,569

 

256,935

 

246,954

 

Deferred income taxes

 

(18,806

)

(13,021

)

14,342

 

Share-based compensation expense

 

36,326

 

39,087

 

44,660

 

Excess tax benefits from share-based payment arrangements

 

(19,763

)

(11,682

)

(11,556

)

Disposal loss, net

 

387

 

 

 

3,691

 

Charge for in-process research and development

 

 

 

 

 

1,600

 

Other, net

 

1,282

 

(882

)

(2,507

)

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

Accounts receivable

 

(66,774

)

(44,839

)

(47,217

)

Inventories

 

(17,987

)

2,553

 

(5,481

)

Other assets

 

(27,138

)

(21,853

)

(31,723

)

Accounts payable

 

44,519

 

18,987

 

34,841

 

Other liabilities

 

58,334

 

45,370

 

40,611

 

Cash provided by operating activities

 

627,564

 

590,136

 

570,908

 

 

 

 

 

 

 

 

 

INVESTING ACTIVITIES

 

 

 

 

 

 

 

Capital expenditures

 

(287,885

)

(268,783

)

(275,871

)

Property disposals

 

25,622

 

21,209

 

18,373

 

Capitalized software expenditures

 

(33,054

)

(10,949

)

(9,688

)

Businesses acquired and investments in affiliates, net of cash acquired

 

(65,532

)

(26,967

)

(129,822

)

Sale of businesses and assets

 

1,802

 

1,441

 

3,417

 

Proceeds from sales and maturities of short-term investments

 

125,063

 

60,625

 

 

 

Purchases of short-term investments

 

 

 

(185,688

)

 

 

Cash used for investing activities

 

(233,984

)

(409,112

)

(393,591

)

 

 

 

 

 

 

 

 

FINANCING ACTIVITIES

 

 

 

 

 

 

 

Net borrowings (repayments) of notes payable

 

(47,712

)

96,683

 

(17,474

)

Long-term debt borrowings

 

396,150

 

4,664

 

7,325

 

Long-term debt repayments

 

(86,287

)

(5,710

)

(6,632

)

Reacquired shares

 

(282,764

)

(213,266

)

(165,414

)

Cash dividends on common stock

 

(101,174

)

(89,807

)

(82,419

)

Exercise of employee stock options

 

87,946

 

49,726

 

59,989

 

Excess tax benefits from share-based payment arrangements

 

19,763

 

11,682

 

11,556

 

Other, net

 

(2,283

)

 

 

(800

)

Cash used for financing activities

 

(16,361

)

(146,028

)

(193,869

)

 

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

2,432

 

(1,849

)

2,157

 

 

 

 

 

 

 

 

 

Increase (decrease) in cash and cash equivalents

 

379,651

 

33,147

 

(14,395

)

Cash and cash equivalents, beginning of year

 

104,378

 

71,231

 

85,626

 

Cash and cash equivalents, end of year

 

$

484,029

 

$

104,378

 

$

71,231

 

 

The accompanying notes are an integral part of the consolidated financial statements.

29




Consolidated Statement of Comprehensive Income and Shareholders' Equity

 

 

 

 

 

 

 

 

 

ACCUMULATED

 

 

 

 

 

 

 

 

 

ADDITIONAL

 

 

 

OTHER

 

 

 

 

 

 

 

COMMON

 

PAID-IN

 

RETAINED

 

COMPREHENSIVE

 

TREASURY

 

 

 

(THOUSANDS)

 

STOCK

 

CAPITAL

 

EARNINGS

 

INCOME (LOSS)

 

STOCK

 

TOTAL

 

Balance December 31, 2003

 

$

310,284

 

$

459,974

 

$

1,294,165

 

$

4,098

 

$

(747,440

)

$

1,321,081

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

282,693

 

 

 

 

 

282,693

 

Foreign currency translation

 

 

 

 

 

 

 

71,029

 

 

 

71,029

 

Other comprehensive loss

 

 

 

 

 

 

 

(2,674

)

 

 

(2,674

)

Minimum pension liability

 

 

 

 

 

 

 

(293

)

 

 

(293

)

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

350,755

 

Cash dividends declared

 

 

 

 

 

(84,410

)

 

 

 

 

(84,410

)

Stock options and awards

 

3,624

 

115,238

 

 

 

 

 

118

 

118,980

 

Business acquisitions

 

1,835

 

55,314

 

 

 

 

 

 

 

57,149

 

Reacquired shares

 

 

 

 

 

 

 

 

 

(165,414

)

(165,414

)

Balance December 31, 2004

 

315,743

 

630,526

 

1,492,448

 

72,160

 

(912,736

)

1,598,141

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

319,481

 

 

 

 

 

319,481

 

Foreign currency translation

 

 

 

 

 

 

 

(50,516

)

 

 

(50,516

)

Other comprehensive income

 

 

 

 

 

 

 

4,365

 

 

 

4,365

 

Minimum pension liability

 

 

 

 

 

 

 

(16,245

)

 

 

(16,245

)

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

257,085

 

Cash dividends declared

 

 

 

 

 

(92,728

)

 

 

 

 

(92,728

)

Stock options and awards

 

2,860

 

96,902

 

 

 

 

 

216

 

99,978

 

Reacquired shares

 

 

 

 

 

 

 

 

 

(213,266

)

(213,266

)

Balance December 31, 2005

 

318,603

 

727,428

 

1,719,201

 

9,764

 

(1,125,786

)

1,649,210

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

 

368,615

 

 

 

 

 

368,615

 

Foreign currency translation

 

 

 

 

 

 

 

65,776

 

 

 

65,776

 

Other comprehensive income

 

 

 

 

 

 

 

(3,352

)

 

 

(3,352

)

Minimum pension liability

 

 

 

 

 

 

 

(617

)

 

 

(617

)

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

430,422

 

Cumulative effect adjustment for adoption of SFAS 158

 

 

 

 

 

 

 

(168,083

)

 

 

(168,083

)

Cash dividends declared

 

 

 

 

 

(104,544

)

 

 

 

 

(104,544

)

Stock options and awards

 

3,975

 

140,745

 

 

 

 

 

960

 

145,680

 

Reacquired shares

 

 

 

 

 

 

 

 

 

(272,455

)

(272,455

)

Balance December 31, 2006

 

$

322,578

 

$

868,173

 

$

1,983,272

 

$

(96,512

)

$

(1,397,281

)

$

1,680,230

 

 

COMMON STOCK ACTIVITY

 

 

2006

 

2005

 

2004

 

 

 

COMMON

 

TREASURY

 

COMMON

 

TREASURY

 

COMMON

 

TREASURY

 

YEAR ENDED DECEMBER 31 (SHARES)

 

STOCK

 

STOCK

 

STOCK

 

STOCK

 

STOCK

 

STOCK

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shares, beginning of year

 

318,602,705

 

(64,459,800

)

315,742,759

 

(58,200,908

)

310,284,083

 

(52,867,561

)

Stock options

 

3,975,722

 

172,665

 

2,859,946

 

18,666

 

3,623,917

 

1,200

 

Stock awards, net issuances

 

 

 

49,519

 

 

 

34,689

 

 

 

24,460

 

Business acquisitions

 

 

 

 

 

 

 

 

 

1,834,759

 

 

 

Reacquired shares

 

 

 

(7,003,944

)

 

 

(6,312,247

)

 

 

(5,359,007

)

Shares, end of year

 

322,578,427

 

(71,241,560

)

318,602,705

 

(64,459,800

)

315,742,759

 

(58,200,908

)

 

The accompanying notes are an integral part of the consolidated financial statements.

30




Notes to Consolidated Financial Statements

 

1. NATURE OF BUSINESS

 

Ecolab Inc. (the “company”) develops and markets premium products and services for the hospitality, foodservice, healthcare and industrial markets.  The company provides cleaning and sanitizing products and programs, as well as pest elimination, maintenance and repair services primarily to hotels and restaurants, healthcare and educational facilities, quickservice (fast-food and convenience stores) units, grocery stores, commercial and institutional laundries, light industry, dairy plants and farms, food and beverage processors and the vehicle wash industry.

 

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

PRINCIPLES OF CONSOLIDATION

 

The consolidated financial statements include the accounts of the company and all majority-owned subsidiaries. International subsidiaries are included in the financial statements on the basis of their November 30 fiscal year-ends to facilitate the timely inclusion of such entities in the company’s consolidated financial reporting. All intercompany transactions and profits are eliminated in consolidation.

 

USE OF ESTIMATES

 

The preparation of the company’s financial statements requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from these estimates.

 

FOREIGN CURRENCY TRANSLATION

 

Financial position and results of operations of the company’s international subsidiaries generally are measured using local currencies as the functional currency. Assets and liabilities of these operations are translated at the exchange rates in effect at each fiscal year end. The translation adjustments related to assets and liabilities that arise from the use of differing exchange rates from period to period are included in accumulated other comprehensive income (loss) in shareholders’ equity. The cumulative translation gain as of year-end 2006, 2005 and 2004 was $57.0 million, $8.1 million and $87.1 million, respectively. Income statement accounts are translated at the average rates of exchange prevailing during the year. The different exchange rates from period to period impact the amount of reported income from the company’s international operations. Foreign currency translation positively impacted net income by approximately $2 million, $5 million and $11 million for the years ended December 31, 2006, 2005 and 2004, respectively.

 

RECLASSIFICATION

 

Capitalized software has been reclassified on the company’s  balance sheet from Other Assets to Property, Plant and Equipment. Prior period balance sheet amounts have also been reclassified to conform to the current year presentation. Net capitalized software was $54.7 million and $32.6 million at December 31, 2006 and 2005, respectively.

 

CASH AND CASH EQUIVALENTS

 

Cash equivalents include highly-liquid investments with a maturity of three months or less when purchased.

 

SHORT-TERM INVESTMENTS

 

Short-term investments at December 31, 2005 consist solely of auction-rate debt securities classified as available-for-sale, which are stated at estimated fair value. All of these securities held by the company as of December 31, 2005 have auction reset periods of 35 days or less and the carrying value approximates market value given the short reset periods. These investments were sold in the first quarter of 2006. No unrealized or realized gains or losses were recognized related to short-term investments during the years ended December 31, 2006 and 2005.

 

ALLOWANCE FOR DOUBTFUL ACCOUNTS

 

The company estimates the balance of allowance for doubtful accounts by analyzing accounts receivable balances by age and applying historical write-off trend rates to the most recent 12 months’ sales, less actual write-offs to date. The company estimates include separately providing for specific customer balances when it is deemed probable that the balance is uncollectible. Account balances are charged off against the allowance when it is probable the receivable will not be recovered.

 

The company’s allowance for doubtful accounts balance includes an allowance for the expected return of products shipped and credits related to pricing or quantities shipped of approximately $6 million and $5 million as of December 31, 2006 and 2005, respectively. This returns and credit activity is recorded directly to sales.

 

The following table summarizes the activity in the allowance for doubtful accounts:

 

THOUSANDS

 

2006

 

2005

 

 

 

 

 

 

 

Beginning balance

 

$

38,851

 

$

44,199

 

Bad debt expense

 

12,947

 

11,589

 

Write-offs

 

(17,483

)

(14,743

)

Other*

 

3,304

 

(2,194

)

Ending balance

 

$

37,619

 

$

38,851

 

*                    Other amounts are primarily the effects of changes in currency.

INVENTORY VALUATIONS

Inventories are valued at the lower of cost or market. Domestic chemical inventory costs are determined on a last-in, first-out (lifo) basis. Lifo inventories represented 28 percent and 32 percent of consolidated inventories at year-end 2006 and 2005, respectively. All other inventory costs are determined on a first-in, first-out (fifo) basis.

 

PROPERTY, PLANT AND EQUIPMENT

 

Property, plant and equipment are stated at cost. Merchandising equipment consists principally of various systems that dispense the company’s cleaning and sanitizing products and dishwashing machines. The dispensing systems are accounted for on a mass asset basis, whereby equipment is capitalized and depreciated as a group and written off when fully depreciated. The company capitalizes both internal and external costs of development or purchase of computer software for internal use. Costs incurred for data conversion, training and maintenance associated with capitalized software are expensed as incurred.

 

Depreciation is charged to operations using the straight-line method over the assets’ estimated useful lives ranging from 5 to 50 years for buildings and leaseholds, 3 to 11 years for machinery and equipment and 3 to 7 years for merchandising equipment and capital software.

31




Expenditures for repairs and maintenance are charged to expense as incurred. Expenditures for major renewals and betterments, which significantly extend the useful lives of existing plant and equipment, are capitalized and depreciated.

 

Upon retirement or disposition of plant and equipment, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in income.

 

GOODWILL AND OTHER INTANGIBLE ASSETS

 

Goodwill and other intangible assets arise principally from business acquisitions. Goodwill represents the excess of the purchase price over the fair value of identifiable net assets acquired. Other intangible assets primarily include customer relationships, trademarks, patents and other technology. The fair value of identifiable intangible assets is estimated based upon discounted future cash flow projections. Other intangible assets are amortized on a straight-line basis over their estimated economic lives. The weighted-average useful life of other intangible assets was 14 years as of December 31, 2006 and 2005.

 

The weighted-average useful life by type of asset at December 31, 2006 is as follows:

 

 

 

Number of Years

 

Customer relationships

 

12

 

Intellectual property

 

15

 

Trademarks

 

20

 

Other

 

7

 

 

The straight-line method of amortization reflects an appropriate allocation of the cost of the intangible assets to earnings in proportion to the amount of economic benefits obtained by the company in each reporting period. Total amortization expense related to other intangible assets during the years ended December 31, 2006, 2005 and 2004 was approximately $25.0 million, $23.5 million and $21.7 million, respectively. As of December 31, 2006, future estimated amortization expense related to amortizable other identifiable intangible assets will be:

 

thousands

 

 

 

2007

 

$

28,000

 

2008

 

28,000

 

2009

 

26,000

 

2010

 

24,000

 

2011

 

23,000

 

 

The company tests goodwill for impairment on an annual basis for all reporting units. Generally, the company’s reporting units are its operating segments. An impairment charge is recognized for the amount, if any, by which the carrying amount of goodwill exceeds its implied fair value. Fair values of reporting units are established using a discounted cash flow method. Where available and as appropriate comparative market multiples are used to corroborate the results of the discounted cash flow method. Based on the company’s testing, there has been no impairment of goodwill during the three years ended December 31, 2006. The company performs its annual goodwill impairment test during the second quarter. If circumstances change significantly within a reporting unit, the company would also test a reporting unit for impairment prior to the annual test.

 

LONG-LIVED ASSETS

 

The company periodically reviews its long-lived assets for impairment and assesses whether significant events or changes in business circumstances indicate that the carrying value of the assets may not be recoverable. An impairment loss may be recognized when the carrying amount of an asset exceeds the anticipated future undiscounted cash flows expected to result from the use of the asset and its eventual disposition. The amount of the impairment loss to be recorded, if any, is calculated by the excess of the asset’s carrying value over its fair value.

 

REVENUE RECOGNITION

 

The company recognizes revenue as services are performed or on product sales at the time title to the product and risk of loss transfers to the customer. The company’s sales policies do not provide for general rights of return and do not contain customer acceptance clauses. Trade accounts receivable are recorded at the invoiced amount and generally do not bear interest. The company records estimated reductions to revenue for customer programs and incentive offerings, including pricing arrangements, promotions and other volume-based incentives at the time the sale is recorded. The company also records estimated reserves for anticipated uncollectible accounts and for product returns and credits at the time of sale.

 

INCOME PER COMMON SHARE

 

The computations of the basic and diluted net income per share amounts were as follows:

 

thousands, except per share

 

2006

 

2005

 

2004

 

 

 

 

 

 

 

 

 

Net income

 

$

368,615

 

$

319,481

 

$

282,693

 

Weighted-average common shares outstanding

 

 

 

 

 

 

 

Basic

 

252,132

 

255,741

 

257,575

 

Effect of dilutive stock options and awards

 

5,012

 

4,357

 

2,832

 

Diluted

 

257,144

 

260,098

 

260,407

 

Net income per common share

 

 

 

 

 

 

 

Basic

 

$

1.46

 

$

1.25

 

$

1.10

 

Diluted

 

$

1.43

 

$

1.23

 

$

1.09

 

 

Restricted stock awards of 24,670 shares for 2006, 22,175 shares for 2005 and 62,300 shares for 2004 were excluded from the computation of basic weighted-average shares outstanding because such shares were not yet vested at those dates.

Stock options to purchase approximately 2.6 million shares for 2006, 7.1 million shares for 2005 and 4.2 million shares for 2004 were not dilutive and, therefore, were not included in the computations of diluted common shares outstanding.

 

SHARE-BASED COMPENSATION

 

Effective October 1, 2005, the company early-adopted Statement of Financial Accounting Standard No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123R”) under the modified retrospective application method. SFAS 123R requires the company to measure compensation expense for share-based awards at fair value at the date of grant and recognize compensation expense over the service period for awards expected to vest. As part of the transition to the new standard, all prior period financial statements were restated to recognize share-based compensation expense historically reported in the notes to the consolidated financial statements.

 

Effective with the company’s adoption of SFAS 123R, new stock option grants to retirement eligible recipients are attributed to

32




expense using the non-substantive vesting method and are fully expensed by the time recipients attain age 55 with at least 5 years of service. If the company had used the non-substantive vesting method during all periods, net income for 2006, 2005 and 2004 would have increased by approximately $2.7 million, $2.5 million and $5.2 million, respectively. In addition, the company previously accounted for forfeitures when they occurred. Commencing at the date of adoption, the company includes a forfeiture estimate in the amount of compensation expense being recognized. This change from the company’s historical practice of recognizing forfeitures as they occur did not result in the recognition of any cumulative adjustments to income. The company has used the actual tax effects of stock options and the transition guidance prescribed within SFAS 123R for establishing the pool of excess tax benefits (APIC Pool).

 

COMPREHENSIVE INCOME

 

Comprehensive income includes net income, foreign currency translation adjustments, minimum pension liabilities, gains and losses on derivative instruments designated and effective as cash flow hedges and nonderivative instruments designated and effective as foreign currency net investment hedges that are charged or credited to the accumulated other comprehensive income (loss) account in shareholders’ equity.

 

DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

 

The company uses foreign currency forward contracts, interest rate swaps and foreign currency debt to manage risks generally associated with foreign exchange rates, interest rates and net investments in foreign operations. The company does not hold derivative financial instruments of a speculative nature. On the date that the company enters into a derivative contract, it designates the derivative as (1) a hedge of (a) the fair value of a recognized asset or liability or (b) an unrecognized firm commitment (a “fair value” hedge), (2) a hedge of (a) a forecasted transaction or (b) the variability of cash flows that are to be received or paid in connection with a recognized asset or liability (a “cash flow” hedge); or (3) a foreign-currency fair-value or cash flow hedge (a “foreign currency” hedge). The company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. The company also formally assesses (both at the hedge’s inception and on an ongoing basis) whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the fair value or cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. When it is determined that a derivative is not (or has ceased to be) highly effective as a hedge, the company will discontinue hedge accounting prospectively. The company believes that on an ongoing basis its portfolio of derivative instruments will generally be highly effective as hedges.

 

All of the company’s derivatives are recognized on the balance sheet at their fair value. The earnings impact resulting from the change in fair value of the derivative instruments is recorded in the same line item in the consolidated statement of income as the underlying exposure being hedged.

 

NEW ACCOUNTING PRONOUNCEMENTS

 

In September 2006, the FASB issued SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB statements 87, 88, 106 and 132(R)” (“SFAS 158”). SFAS 158 requires the company to recognize on its balance sheet the funded status of the company’s defined benefit pension and post-retirement plans. SFAS 158 also requires that all benefit plans use the company’s fiscal year-end as its measurement date. As required, the company prospectively adopted SFAS 158 beginning with its 2006 year end. The effect of initially adopting SFAS 158 is reflected as a cumulative adjustment to Accumulated Other Comprehensive Income (Loss) net of applicable taxes in the year of adoption. The impact of adopting SFAS 158 is reflected as a reduction in net assets on the company’s balance sheet of $168 million, with no impact to the statement of income and cash flows. See Note 15 for additional information.

 

In September 2006, the FASB issued SFAS 157, “Fair Value Measurement”, which defines fair value, establishes a framework for measuring fair value and expanded disclosures about fair value measurement. Companies are required to adopt the new standard for fiscal periods beginning after November 15, 2007. The company is evaluating the impact of this standard and does not expect it will have a material impact on its consolidated financial statements.

 

In July 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertain tax positions in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. For each tax position the company will be required to recognize, in its financial statements, the largest tax benefit that is “more-likely-than-not” to be sustained on audit based solely on the technical merits of the position as of the reporting date. FIN 48 also provides guidance on new disclosure requirements, reporting and accrual of interest and penalties, accounting in interim periods, and transition. FIN 48 is effective beginning January 1, 2007 with the cumulative effect of initially applying FIN 48 recognized as a change in accounting principle recorded as an adjustment to opening retained earnings. The company does not expect the impact of adoption to be material to the company’s consolidated financial statements.

 

No other new accounting pronouncement issued or effective has had or is expected to have a material impact on the company’s consolidated financial statements.

 

3. SPECIAL CHARGES

 

Special charges in 2004 included a charge of $1.6 million for inprocess research and development related to the Alcide acquisition and a charge of $4.0 million on the disposal of a grease management product line, which were partially offset by $0.8 million of income for reductions in restructuring accruals and a $0.3 million gain on the sale of a small international business. For segment reporting purposes, these items have been included in the company’s corporate segment, which is consistent with the company’s internal management reporting.

 

4. RELATED PARTY TRANSACTIONS

 

Henkel KGaA (“Henkel”) beneficially owned 72.7 million shares, or approximately 28.9 percent, of the company’s outstanding common stock on December 31, 2006. Under a  stockholders’ agreement between the company and Henkel, Henkel is permitted ownership in the company of up to 35 percent of the company’s outstanding common stock. Henkel is also entitled to proportionate representation on the company’s board of directors.

33




 

In 2006, 2005 and 2004, the company and its affiliates sold products and services in the aggregate amounts of $5.7 million, $3.6 million and $3.2 million, respectively, to Henkel or its affiliates, and purchased products and services in the amounts of $66.0 million, $65.3 million and $70.9 million, respectively, from Henkel or its affiliates. The transactions with Henkel and its affiliates were made in the ordinary course of business and were negotiated at arm’s length.

 

5. BUSINESS ACQUISITIONS AND DISPOSITIONS

 

BUSINESS ACQUISITIONS

 

Business acquisitions made by the company during 2006, 2005 and 2004 were as follows:

 

 

 

 

 

 

 

ESTIMATED

 

 

 

 

 

 

 

ANNUAL SALES

 

BUSINESS

 

DATE OF

 

 

 

PRIOR TO

 

ACQUIRED

 

ACQUISITION

 

              SEGMENT              

 

ACQUISITION

 

 

 

 

 

 

 

(MILLIONS)

 

 

 

 

 

 

 

(UNAUDITED)

 

 

 

 

 

 

 

 

 

2006

 

 

 

 

 

 

 

Shield Medicare Ltd.

 

June 2006

 

International (Europe)

 

$19

 

 

DuChem Industries, Inc.

 

Sept. 2006

 

U.S. C&S
(Food & Beverage)

 

10

 

 

Powles Hunt & Sons International Ltd.

 

Sept. 2006

 

International (Europe)

 

5

 

 

2005

 

 

 

 

 

 

 

 

Associated Chemicals & Services, Inc.
(Aka Midland Research)

 

Jan. 2005

 

U.S. C&S (Water Care)

 

16

 

 

YSC Chemical Company

 

Feb. 2005

 

International (Asia Pacific)

 

3

 

 

Kilco Chemicals Ltd.

 

Apr. 2005

 

International (Europe)

 

5

 

 

2004

 

 

 

 

 

 

 

 

Nigiko

 

Jan. 2004

 

International
(Europe)

 

55

 

 

Daydots International

 

Feb. 2004

 

U.S. C&S
(Institutional)

 

22

 

 

Elimco

 

May 2004

 

International
(Europe)

 

4

 

 

Restoration and Maintenance unit of VIC International

 

June 2004

 

U.S. C&S
(Professional Products)

 

5

 

 

Alcide Corporation

 

July 2004

 

U.S. C&S
(Food & Beverage)

 

24

 

 

 

The total cash consideration paid by the company for acquisitions and investments in affiliates was approximately $66 million, $27 million and $130 million for 2006, 2005 and 2004, respectively. In addition, 1,834,759 shares of common stock were issued with a market value of $57 million in the Alcide acquisition in 2004, plus $23,000 of cash in lieu of fractional shares. Total cash paid in 2004 also includes payments of restructuring costs related to the acquisition of the remaining 50 percent interest in the former Henkel-Ecolab joint venture that were accrued in 2002. The aggregate purchase price has been reduced for any cash or cash equivalents acquired with the acquisitions.

 

These acquisitions have been accounted for as purchases and, accordingly, the results of their operations have been included in the financial statements of the company from the dates of acquisition. Net sales and operating income of these businesses were not significant to the company’s consolidated financial statements, therefore pro forma financial information is not presented.

 

Based upon purchase price allocations, the components of the aggregate purchase prices of the acquisitions made were as follows:

 

MILLIONS

 

2006

 

2005

 

2004

 

Net tangible assets acquired (liabilities assumed)

 

$

(6

)

$

 

$

14

 

Identifiable intangible assets

 

28

 

8

 

44

 

In-process research and development

 

 

 

 

 

2

 

Goodwill

 

44

 

19

 

127

 

Purchase price

 

$

66

 

$

27

 

$

187

 

 

The allocation of purchase price includes adjustments to preliminary allocations from prior periods, if any. During 2004, the company recorded a charge of $1.6 million for in-process research and development (“IPR&D”) as part of the allocation of purchase price in the Alcide acquisition. The value assigned to IPR&D is based on an independent appraiser’s valuation and was determined by identifying research projects in areas for which technological feasibility had not been established and no alternative uses for the technology existed. The values were determined by estimating the discounted amount of after-tax cash flows attributable to these projects. The future cash flows were discounted to present value utilizing a risk-adjusted rate of return that considered the uncertainty surrounding the successful development of the IPR&D.

34




The changes in the carrying amount of goodwill for each of the company’s reportable segments for the years ended December 31, 2006, 2005 and 2004 are as follows:

 

THOUSANDS

 

U.S.
CLEANING &
SANITIZING

 

U.S.
OTHER
SERVICES

 

TOTAL
U.S.

 

INTERNATIONAL

 

CONSOLIDATED

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance December 31, 2003

 

$

122,346

 

$

48,929

 

$

171,275

 

$

625,936

 

$

797,211

 

Goodwill acquired during year*

 

54,936

 

 

 

54,936

 

72,270

 

127,206

 

Goodwill allocated to business dispositions

 

(69

)

 

 

(69

)

(25

)

(94

)

Foreign currency translation

 

 

 

 

 

 

 

67,488

 

67,488

 

Balance December 31, 2004

 

177,213

 

48,929

 

226,142

 

765,669

 

991,811

 

Goodwill acquired during year*

 

12,639

 

595

 

13,234

 

6,162

 

19,396

 

Goodwill allocated to business dispositions

 

(130

)

 

 

(130

)

(376

)

(506

)

Foreign currency translation

 

 

 

 

 

 

 

(73,682

)

(73,682

)

Balance December 31, 2005

 

189,722

 

49,524

 

239,246

 

697,773

 

937,019

 

Goodwill acquired during year*

 

7,346

 

990

 

8,336

 

35,713

 

44,049

 

Goodwill allocated to business dispositions

 

 

 

 

 

 

 

(423

)

(423

)

Foreign currency translation

 

 

 

 

 

 

 

55,284

 

55,284

 

Balance December 31, 2006

 

$

197,068

 

$

50,514

 

$

247,582

 

$

788,347

 

$

1,035,929

 


*                    For 2006, 2005 and 2004, goodwill related to businesses acquired of $7.7 million, $3.5 million and $92.8 million, respectively, is expected to be tax deductible. Goodwill acquired in 2006, 2005 and 2004 also includes adjustments to prior year acquisitions.

BUSINESS DISPOSITIONS

 

The company had no significant business dispositions in 2006 or 2005. In April 2004, the company sold its grease management product line. This sale resulted in a loss of approximately $4.0 million ($2.4 million after tax). Sales of the grease management product line totaled approximately $20 million in 2003 and were included in the company’s U.S. Cleaning & Sanitizing operations. In 2004, the company also recognized a gain of $0.3 million ($0.2 million after tax) on the sale of a small Hygiene Services business in its International operations.

 

6. BALANCE SHEET INFORMATION

 

December 31 (thousands)

 

2006

 

2005

 

Accounts Receivable, Net

 

 

 

 

 

Accounts receivable

 

$

905,160

 

$

782,371

 

Allowance for doubtful accounts

 

(37,619

)

(38,851

)

Total

 

$

867,541

 

$

743,520

 

Inventories

 

 

 

 

 

Finished goods

 

$

199,516

 

$

177,574

 

Raw materials and parts

 

180,619

 

161,488

 

Excess of fifo cost over lifo cost

 

(15,249

)

(13,488

)

Total

 

$

364,886

 

$

325,574

 

Property, Plant and Equipment, Net

 

 

 

 

 

Land

 

$

30,851

 

$

32,164

 

Buildings and leaseholds

 

306,775

 

283,487

 

Machinery and equipment

 

630,821

 

617,408

 

Merchandising equipment

 

1,204,716

 

1,072,853

 

Capitalized software

 

72,904

 

68,062

 

Construction in progress

 

72,139

 

42,244

 

 

 

2,318,206

 

2,116,218

 

Accumulated depreciation

 

(1,366,637

)

(1,248,165

)

Total

 

$

951,569

 

$

868,053

 

Other Intangible Assets, Net

 

 

 

 

 

Cost

 

 

 

 

 

Customer relationships

 

$

217,423

 

$

176,778

 

Intellectual property

 

45,569

 

41,887

 

Trademarks

 

73,216

 

63,933

 

Other intangibles

 

11,624

 

7,459

 

 

 

347,832

 

290,057

 

Accumulated amortization

 

 

 

 

 

Customer relationships

 

(80,153

)

(55,328

)

Intellectual property

 

(17,254

)

(9,901

)

Trademarks

 

(23,542

)

(16,523

)

Other intangibles

 

(3,096

)

(5,369

)

Total

 

$

223,787

 

$

202,936

 

Other Assets, Net

 

 

 

 

 

Deferred income taxes

 

$

176,184

 

$

42,618

 

Pension

 

37,591

 

201,078

 

Sole supply fees

 

67,423

 

61,632

 

Other

 

73,325

 

61,626

 

Total

 

$

354,523

 

$

366,954

 

Short-Term Debt

 

 

 

 

 

Notes payable

 

$

109,100

 

$

146,725

 

Long-term debt, current maturities

 

399,878

 

80,202

 

Total

 

$

508,978

 

$

226,927

 

Other Current Liabilities

 

 

 

 

 

Discounts and rebates

 

$

190,434

 

$

152,774

 

Dividends payable

 

28,930

 

25,526

 

Other

 

173,146

 

182,781

 

Total

 

$

392,510

 

$

361,081

 

Long-Term Debt

 

 

 

 

 

4.355% series A senior notes, due 2013

 

$

165,062

 

$

 

4.585% series B senior notes, due 2016

 

231,088

 

 

6.875% notes, due 2011

 

149,356

 

149,356

 

5.375% euronotes, due 2007

 

397,415

 

355,246

 

7.19% senior notes, due 2006

 

 

74,673

 

Other

 

14,015

 

20,301

 

 

 

956,936

 

599,576

 

Long-term debt, current maturities

 

(399,878

)

(80,202

)

Total

 

$

557,058

 

$

519,374

 

Other Liabilities

 

 

 

 

 

Deferred income taxes

 

$

92,478

 

$

80,760

 

Income taxes payable — noncurrent

 

66,202

 

43,695

 

Other

 

100,422

 

82,184

 

Total

 

$

259,102

 

$

206,639

 

 

35




The company has a $450 million multicurrency credit agreement with a consortium of banks that has a term through June 1, 2011. Under certain circumstances, this credit agreement can be increased by $150 million for a total of $600 million. The company may borrow varying amounts in different currencies from time to time on a revolving credit basis. The company has the option of borrowing based on various short-term interest rates. Effective June 1, 2006, the credit agreement was amended and restated by, among other things, deleting the financial covenant regarding total debt to capitalization, increasing the lien basket from $75 million to $100 million and extending the term of the agreement from August 2009 to June 2011. No amounts were outstanding under this agreement at year-end 2006 and 2005.

 

The multicurrency credit agreement supports the company’s $450 million U.S. commercial paper program and its $200 million European commercial paper program. The company had $30.3 million in outstanding U.S. commercial paper at December 31, 2006, with an average annual interest rate of 5.3 percent. There was no U.S. commercial paper outstanding at December 31, 2005. The company had $88.2 million in outstanding European commercial paper at December 31, 2005, with an average annual interest rate of 2.4 percent. The company had no commercial paper outstanding under its European commercial paper program at December 31, 2006. Both programs were rated A-1 by Standard & Poor’s and P-1 by Moody’s as of December 31, 2006.

 

In December 2006, the company issued and sold in a private placement 300 million euro ($396 million as of December 31, 2006) aggregate principal amount of the company’s senior notes in two series: 4.355% Series A Senior Notes due 2013 in the aggregate principal amount of 125 million euro and 4.585% Series B Senior Notes due 2016 in the aggregate principal amount of 175 million euro, pursuant to a Note Purchase Agreement dated July 26, 2006, between the company and the purchasers. The company used the proceeds to repay its euro 300 million ($396 million as of December 31, 2006) 5.375 percent euronotes which became due in February 2007.

 

In January 2006, the company repaid the $75 million 7.19% senior notes which were due January 2006.

As of December 31, the weighted-average interest rate on notes payable was 6.0 percent in 2006, 3.9 percent in 2005 and 5.7 percent in 2004.

 

As of December 31, 2006, the aggregate annual maturities of long-term debt for the next five years were:

 

thousands

 

 

2007

 

$399,878

 

2008

 

2,830

 

2009

 

1,645

 

2010

 

1,277

 

2011

 

150,711

 

 

7. INTEREST

 

Interest expense was $51.3 million in 2006, $49.8 million in 2005 and $48.5 million in 2004. Interest income was $6.9 million in 2006, $5.6 million in 2005 and $3.2 million in 2004. Total interest paid was $50.6 million in 2006, $49.4 million in 2005 and $47.0 million in 2004.

 

8. FINANCIAL INSTRUMENTS

 

FOREIGN CURRENCY FORWARD CONTRACTS

 

The company has entered into foreign currency forward contracts to hedge transactions related to intercompany debt, subsidiary royalties, product purchases, firm commitments and other intercompany transactions. The company uses these contracts to hedge against the effect of foreign currency exchange rate fluctuations on forecasted cash flows. These contracts generally relate to the company’s European operations and are denominated in euros. The company had foreign currency forward exchange contracts that totaled approximately $375 million at December 31, 2006, $395 million at December 31, 2005 and $239 million at December 31, 2004. These contracts generally expire within one year. The gains and losses related to these contracts were included as a component of other comprehensive income until the hedged item is reflected in earnings. As of December 31, 2006, other comprehensive income includes a cumulative loss of $1.3 million related to these contracts.

 

INTEREST RATE SWAP AGREEMENTS

 

The company enters into interest rate swap agreements to manage interest rate exposures and to achieve a desired proportion of variable and fixed rate debt.

 

In May 2006, the company entered into two forward starting interest rate swap agreements in connection with the senior note private placement offering that convert euro 250 million (euro 125 million due December 2013 and euro 125 million due December 2016) of the private placement funding from a variable interest rate to a fixed interest rate. The interest rate swap agreements were designated as, and effective as a cash flow hedge of the private placement offering. In June 2006 the company closed the swap agreements. The decline in fair value of $2.1 million, net of tax, was recorded in other comprehensive income and will be recognized in earnings as part of interest expense as the forecasted transactions occur.

 

During 2002, the company entered into an interest rate swap agreement in connection with the issuance of its euronotes. This agreement converts approximately euro 78 million (approximately $103 million at year-end 2006) of the euronote debt from a fixed interest rate to a floating or variable interest rate and is effective until February 2007. This interest rate swap was designated as a fair value hedge and had a value of $1.7 million, $4.0 million and $7.0 million as of December 31, 2006, 2005 and 2004, respectively. The mark to market gain on this agreement has been recorded as part of interest expense and has been offset by the loss recorded in interest expense on the mark to market on this portion of the euronotes. There is no hedge ineffectiveness on this interest rate swap.

 

NET INVESTMENT HEDGES

 

The company designated all euro 300 million euronote debt as a hedge of existing foreign currency exposures related to net investments the company has in certain European subsidiaries. Accordingly, the transaction gains and losses that are designated and effective as hedges of the company’s net investments have been included as a component of the cumulative translation account within accumulated other comprehensive income (loss). Total transaction gains and losses related to the euronotes and charged to this shareholders’ equity account were a loss of $44.8 million in 2006, a gain of $45.7 million for 2005 and a loss of $39.6 million for 2004.

36




CREDIT RISK

 

The company is exposed to credit loss in the event of nonperformance of counterparties for foreign currency forward exchange contracts and interest rate swap agreements. The company monitors its exposure to credit risk by using credit approvals and credit limits and selecting major international banks and financial institutions as counterparties. The company does not anticipate nonperformance by any of these counterparties.

 

FAIR VALUE OF OTHER FINANCIAL INSTRUMENTS

 

The carrying amount and the estimated fair value of other financial instruments held by the company were:

 

December 31 (thousands)

 

2006

 

2005

 

 

 

 

 

 

 

Carrying amount

 

 

 

 

 

Cash and cash equivalents

 

$

484,029

 

$

104,378

 

Short-term investments

 

 

 

125,063

 

Accounts receivable

 

867,541

 

743,520

 

Notes payable

 

78,850

 

58,525

 

Commercial paper

 

30,250

 

88,200

 

Long-term debt (including current maturities)

 

956,936

 

599,576

 

Fair value

 

 

 

 

 

Long-term debt (including current maturities)

 

$

967,020

 

$

623,040

 

 

The carrying amounts of cash equivalents, short-term investments, accounts receivable, notes payable and commercial paper approximate fair value because of their short maturities.

 

The fair value of long-term debt is based on quoted market prices for the same or similar debt instruments.

 

9. SHAREHOLDERS’ EQUITY

 

Authorized common stock, par value $1.00 per share, was 400 million shares in 2006, 2005 and 2004. Treasury stock is stated at cost. Dividends declared per share of common stock were $0.4150 for 2006, $0.3625 for 2005 and $0.3275 for 2004.

 

The company has 15 million shares, without par value, of authorized but unissued preferred stock. Of these 15 million shares, 0.4 million shares were designated as Series A Junior Participating Preferred Stock and 14.6 million shares were undesignated.

 

In February 2006, the company’s Board of Directors authorized the renewal of the company’s shareholder rights plan. Under the company’s renewed shareholder rights plan, one preferred stock purchase right is issued for each outstanding share of the company’s common stock. A right entitles the holder, upon occurrence of certain events, to buy one one-thousandth of a share of Series A Junior Participating Preferred Stock at a purchase price of $135, subject to adjustment. The rights, however, do not become exercisable unless and until, among other things, any person or group acquires 15 percent or more of the outstanding common stock of the company, or the company’s board of directors declares a holder of 10 percent or more of the outstanding common stock to be an “adverse person” as defined in the rights plan. Upon the occurrence of either of these events, the rights will become exercisable for common stock of the company (or in certain cases common stock of an acquiring company) having a market value of twice the exercise price of a right. The rights provide that the holdings by Henkel KGaA or its affiliates at the time of the renewal of the rights plan, subject to compliance by Henkel with certain conditions, will not cause the rights to become exercisable nor cause Henkel to be an “adverse person.” The rights are redeemable under certain circumstances at one cent per right and, unless redeemed earlier, will expire on March 10, 2016.

 

The company reacquired 6,875,400 shares of its common stock in 2006, 5,974,300 shares in 2005 and 4,581,400 shares in 2004 through open and private market purchases. The company also reacquired 128,544 shares, 337,947 shares and 777,607 shares of its common stock in 2006, 2005 and 2004, respectively, related to the exercise of stock options and the vesting of stock awards. In December 2004, the company’s Board of Directors authorized the repurchase of up to 10 million shares of the company’s common stock, including shares to be repurchased under Rule 10b5-1. In October 2006, the company’s Board of Directors authorized the repurchase of up to 10 million additional shares of common stock, including shares to be repurchased under Rule 10b5-1. Shares are repurchased to offset the dilutive effect of stock options and incentives and for general corporate purposes. As of December 31, 2006, 12,926,000 shares remained to be purchased under the company’s repurchase authority. The company intends to repurchase all shares under this authorization, for which no expiration date has been established, in open market or privately negotiated transactions, subject to market conditions. The company expects to repurchase at least enough shares during 2007 to offset the dilutive effect of stock options, based on estimates of stock option exercises for 2007. Cash proceeds from the exercises as well as the tax benefits will provide a portion of the funding for this repurchase activity.

 

10. STOCK INCENTIVE AND OPTION PLANS

 

The company’s stock incentive and option plans provide for grants of stock options, stock awards and other incentives. Common shares available for grant as of December 31 were 11,689,435 for 2006, 12,748,989 for 2005 and 4,216,012 for 2004. Common shares available for grant reflect 12 million shares approved by shareholders in 2005 for issuance under the plans.

 

Almost all of the awards granted are non-qualified stock options granted to employees that vest annually in equal amounts over a three year service period. Options are granted to purchase shares of the company’s stock at the average daily share price on the date of grant. These options generally expire within ten years from the grant date. The company recognizes compensation expense for these awards on a straight-line basis over the three year vesting period, in accordance with SFAS 123R. Upon adoption of SFAS 123R, new stock option grants to retirement eligible recipients are attributed to expense using the non-substantive vesting method.

 

37




A summary of stock option activity and average exercise prices is as follows:

 

SHARES

 

2006

 

2005

 

2004

 

Granted

 

2,669,223

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