EX-13 11 v094142_ex13.htm Unassociated Document

FINANCIAL REVIEW
 
Report of Management
 
The Company’s management is responsible for the integrity and accuracy of the financial statements. Management believes that the financial statements for the three years ended September 30, 2007, have been prepared in conformity with U.S. generally accepted accounting principles appropriate in the circumstances. In preparing the financial statements, management makes informed judgments and estimates where necessary to reflect the expected effects of events and transactions that have not been completed. The Company’s disclosure controls and procedures ensure that material information required to be disclosed is recorded, processed, summarized and communicated to management and reported within the required time periods.
 
In meeting its responsibility for the reliability of the financial statements, management relies on a system of internal accounting control. This system is designed to provide reasonable assurance that assets are safeguarded and transactions are executed in accordance with management’s authorization and recorded properly to permit the preparation of financial statements in accordance with U.S. generally accepted accounting principles. The design of this system recognizes that errors or irregularities may occur and that estimates and judgments are required to assess the relative cost and expected benefits of the controls. Management believes that the Company’s accounting controls provide reasonable assurance that errors or irregularities that could be material to the financial statements are prevented or would be detected within a timely period.
 
The Audit Committee of the Board of Directors, which is composed solely of independent Directors, is responsible for overseeing the Company’s financial reporting process. The Audit Committee meets with management and the internal auditors periodically to review the work of each and to monitor the discharge by each of its responsibilities. The Audit Committee also meets periodically with the independent auditors who have free access to the Audit Committee and the Board of Directors to discuss the quality and acceptability of the Company’s financial reporting, internal controls, as well as non-audit-related services.
 
The independent auditors are engaged to express an opinion on the Company’s consolidated financial statements and on the Company’s internal control over financial reporting. Their opinions are based on procedures which they believe to be sufficient to provide reasonable assurance that the financial statements contain no material errors and that the Company’s internal controls are effective.
 
Management’s Report on Internal Control over Financial Reporting
 
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. With the participation of the Chief Executive Officer and the Chief Financial Officer, management conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework and the criteria established in Internal Control - Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management has concluded that internal control over financial reporting was effective as of September 30, 2007.
 
The Company’s auditor, KPMG LLP, an independent registered public accounting firm, has issued an audit report on the effectiveness of the Company’s internal control over financial reporting.
 
/s/ David N. Farr     /s/ Walter J. Galvin
David N. Farr    
Walter J. Galvin
Chairman of the Board, Chief Executive Officer, and President
    Senior Executive Vice President and Chief Financial Officer
   
 
 
20


 
Results of Operations
Years ended September 30 | Dollars in millions, except per share amounts
                       
 
   
   
   
   
CHANGE
 
 
CHANGE
 
 
 
 
2005
 
 
2006
 
 
2007
 
 
'05 - '06
 
 
'06 - '07
 
                                 
Net sales
 
$
17,305
   
20,133
   
22,572
   
16
%
 
12
%
Gross profit
 
$
6,183
   
7,168
   
8,111
   
16
%
 
13
%
Percent of sales
   
35.7
%
 
35.6
%
 
35.9
%
 
 
     
SG&A
 
$
3,595
   
4,099
   
4,593
             
Percent of sales
   
20.7
%
 
20.4
%
 
20.3
%
 
 
     
Other deductions, net
 
$
230
   
178
   
183
             
Interest expense, net
 
$
209
   
207
   
228
             
Earnings before income taxes
 
$
2,149
   
2,684
   
3,107
   
25
%
 
16
%
Net earnings
 
$
1,422
   
1,845
   
2,136
   
30
%
 
16
%
Percent of sales
   
8.2
% 
 
9.2
%
 
9.5
%
         
 
        
Earnings per share
 
$
1.70
   
2.24
   
2.66
   
32
%
 
19
%
Return on equity
   
19.4
%
 
23.7
%
 
25.2
%
           
Return on total capital
   
15.5
%
 
18.4
%
 
20.1
%
           
Net earnings and earnings per share for 2005 include a $63 million tax expense ($0.07 per share) for repatriation under the American Jobs Creation Act.
 
OVERVIEW
 
Emerson achieved record sales, earnings and earnings per share in the fiscal year ended September 30, 2007. For fiscal 2007, net sales were $22.6 billion, an increase of 12 percent; net earnings were $2.1 billion, an increase of 16 percent; and earnings per share were $2.66, an increase of 19 percent, over fiscal 2006. All of the business segments generated higher sales and earnings compared with the prior year. The Process Management, Network Power and Industrial Automation businesses drove gains in a favorable global economic environment as gross fixed investment expanded during 2007, while growth in the Climate Technologies and Appliance and Tools businesses was moderated by weakness in the U.S. consumer markets. Strong growth in Asia and Europe, acquisitions and favorable foreign currency translation contributed to these results. Profit margins remained strong primarily because of leverage on higher sales volume and benefits derived from previous rationalization actions. Emerson’s financial position remains strong and the Company generated substantial operating cash flow in 2007 of $3.0 billion, an increase of 20 percent, and free cash flow (operating cash flow less capital expeditures) of $2.3 billion, an increase of 22 percent.
 
NET SALES
 
Net sales for fiscal 2007 were a record $22.6 billion, an increase of approximately $2.4 billion, or 12 percent, over fiscal 2006, with international sales leading the overall growth. The consolidated results reflect increases in all five business segments with an approximate 7 percent ($1,359 million) increase in underlying sales (which exclude acquisitions, divestitures and foreign currency translation), a nearly 3 percent ($566 million) contribution from acquisitions, net of divestitures, and a more than 2 percent ($514 million) favorable impact from foreign currency translation. The underlying sales increase for fiscal 2007 was driven by international sales growth of 12 percent and a 2 percent increase in the United States. The U.S. results reflect a modest decline in the first quarter with moderate growth during the remainder of the year. The international sales increase primarily reflects growth in Asia (16 percent) and Europe (8 percent). The Company estimates that the underlying sales growth of approximately 7 percent primarily reflects an approximate 3 percent gain from volume, an approximate 2 percent impact from penetration gains and an approximate 2 percent impact from higher sales prices. 
 
Net sales for fiscal 2006 were $20.1 billion, an increase of approximately $2.8 billion, or 16 percent, over fiscal 2005, with both U.S. and international sales contributing to this growth. The consolidated results reflect increases in all five business segments with an underlying sales increase of more than 12 percent ($2,119 million), an approximate 4 percent ($766 million) contribution from acquisitions, net of divestitures, and a slightly unfavorable impact ($57 million) from foreign currency translation. The underlying sales increase of more than 12 percent was driven by 12 percent growth in the United States and a total international sales increase of 13 percent.
21

 
The U.S. market growth was very strong in the first half of 2006 and began to moderate toward the end of the fiscal year, while Europe grew stronger as the year progressed and finished very strong in the fourth quarter. The international sales increase primarily reflects growth in Asia (20 percent) and Europe (7 percent). The Company estimates that the underlying sales growth of more than 12 percent primarily reflects a nearly 9 percent gain from volume, an approximate 3 percent impact from penetration gains and a less than 1 percent impact from higher sales prices.
 
INTERNATIONAL SALES
 
International destination sales, including U.S. exports, increased approximately 22 percent including acquisitions, to $11.6 billion in 2007, representing 52 percent of the Company’s total sales. U.S. exports of $1,277 million were up 13 percent compared with 2006, reflecting the weaker U.S. dollar. International subsidiary sales, including shipments to the United States, were $10.5 billion in 2007, up 22 percent over 2006. Excluding the net 7 percent favorable impact from acquisitions, divestitures and foreign currency translation, international subsidiary sales increased 15 percent compared with 2006. Underlying destination sales grew 16 percent in Asia during the year, driven mainly by 12 percent growth in China, while sales grew 44 percent in the Middle East, 11 percent in Latin America and 8 percent in Europe.
 
International destination sales, including U.S. exports, increased approximately 17 percent, to $9.5 billion in 2006, representing 47 percent of the Company’s total sales. U.S. exports of $1,127 million were up 13 percent compared with 2005. International subsidiary sales, including shipments to the United States, were $8.7 billion in 2006, up 17 percent over 2005. Excluding the net 1 percent unfavorable impact from acquisitions, divestitures and foreign currency translation, international subsidiary sales increased 18 percent compared with 2005. Underlying destination sales grew 20 percent in Asia during the year, driven mainly by 19 percent growth in China, and 21 percent in Latin America and the Middle East, while sales grew 7 percent in Europe.
 
ACQUISITIONS AND DIVESTITURES
 
The Company acquired Damcos Holding AS (Damcos) and Stratos International, Inc. (Stratos), as well as several smaller businesses during 2007. Damcos supplies valve remote control systems and tank monitoring equipment to the marine and shipbuilding industries. Stratos is a designer and manufacturer of radio-frequency and microwave interconnect products. Total cash paid for these businesses (net of cash and equivalents acquired of approximately $40 million, and debt assumed of approximately $56 million) was approximately $295 million. Annualized sales for acquired businesses were $240 million in 2007.
 
During the fourth quarter of fiscal 2007, the Company entered into a definitive agreement to acquire Motorola Inc.’s Embedded Communications Computing (ECC) business for approximately $350 million in cash. ECC is a leading provider of embedded computing products to equipment manufacturers in telecommunications, medical imaging, defense and aerospace, and industrial automation. The transaction is expected to be completed by the end of calendar 2007 and is subject to customary closing conditions and regulatory approvals. ECC had 2006 revenue of approximately $520 million and will be included in the Network Power segment.
 
In 2007, the Company divested two small business units that had total annual sales of $113 million and $115 million for fiscal years 2006 and 2005, respectively. In the fourth quarter of 2006, the Company received approximately $80 million from the divestiture of the materials testing business, resulting in a pretax gain of $31 million ($22 million after-tax). The materials testing business represented total annual sales of approximately $58 million and $59 million in 2006 and 2005, respectively. These businesses were not reclassified as discontinued operations because of immateriality.
 
 
22

 
During 2006, the Company acquired Artesyn Technologies, Inc. (Artesyn), Knürr AG (Knürr) and Bristol Babcock (Bristol), as well as several smaller businesses. Artesyn is a global manufacturer of advanced power conversion equipment and board-level computing solutions for infrastructure applications in telecommunication and data-communication systems. Knürr is a manufacturer of indoor and outdoor enclosure systems and cooling technologies for telecommunications, electronics and computing equipment. Bristol is a manufacturer of control and measurement equipment for oil and gas, water and wastewater, and power industries. Total cash paid for these businesses (net of cash and equivalents acquired of approximately $120 million and debt assumed of approximately $90 million) was approximately $752 million. Annualized sales for acquired businesses were $920 million in 2006. See Note 3 for additional information regarding acquisitions and divestitures.
 
COST OF SALES
 
Costs of sales for fiscal 2007 and 2006 were $14.5 billion and $12.9 billion, respectively. Cost of sales as a percent of net sales was 64.1 percent for 2007, compared with 64.4 percent in 2006. Gross profit was $8.1 billion and $7.2 billion for fiscal 2007 and 2006, respectively, resulting in gross profit margins of 35.9 percent and 35.6 percent. The gross profit margin improvement was diminished as higher sales prices, together with the benefits received from commodity hedging of approximately $115 million, were substantially offset by higher material costs and wages. The increase in the gross profit amount primarily reflects higher sales volume, acquisitions, foreign currency translation and savings from cost reduction actions.
 
Costs of sales for fiscal 2006 and 2005 were $12.9 billion and $11.1 billion, respectively. Cost of sales as a percent of net sales was 64.4 percent for 2006, compared with 64.3 percent in 2005. Gross profit was $7.2 billion and $6.2 billion for fiscal 2006 and 2005, respectively, resulting in gross profit margins of 35.6 percent and 35.7 percent. The increase in the gross profit primarily reflects higher sales volume and acquisitions. The gross profit margin was unfavorably impacted as leverage on higher sales and benefits realized from productivity improvements were more than offset by higher costs for wages and benefits (pension), negative product mix, as well as the lower profit margin on recent acquisitions. Sales price increases initiated over the past year, together with the benefits received from commodity hedging of approximately $130 million, offset the higher level of raw material costs, but the margin was diluted.
 
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
 
Selling, general and administrative (SG&A) expenses for 2007 were $4.6 billion, or 20.3 percent of net sales, compared with $4.1 billion, or 20.4 percent of net sales for 2006. The increase of approximately $0.5 billion was primarily due to an increase in variable costs on higher sales volume, acquisitions, foreign currency translation and a $104 million increase in stock compensation (see Note 14). The reduction in SG&A as a percent of sales was primarily the result of leveraging fixed costs on higher sales, particularly in the Process Management and Network Power businesses.
 
SG&A expenses for 2006 were $4.1 billion, or 20.4 percent of net sales, compared with $3.6 billion, or 20.7 percent of net sales for 2005. The increase of approximately $0.5 billion was primarily due to the increase in variable costs on higher sales and acquisitions. The reduction in SG&A as a percent of sales was primarily the result of leveraging fixed costs on higher sales.
 
OTHER DEDUCTIONS, NET
 
Other deductions, net were $183 million in 2007, a $5 million increase from the $178 million in 2006. Gains in 2007 included approximately $32 million related to the sale of the Company’s remaining shares in MKS Instruments, Inc. (MKS) and approximately $24 million related to a payment received under the U.S. Continued Dumping and Subsidy Offset Act (Offset Act). Ongoing costs for the rationalization of operations were $83 million in 2007, compared with $84 million in 2006. The higher gains and lower other costs were more than offset by higher amortization of intangibles related to acquisitions.
 
Other deductions, net were $178 million in 2006, a $52 million decrease from the $230 million in 2005. The decrease primarily reflects $42 million of higher gains in 2006 compared with 2005 and lower rationalization costs. Gains in 2006 included approximately $31 million related to the divesture of the materials testing business and approximately $26 million related to the sale of shares in MKS. Ongoing costs for the rationalization of operations were $84 million in 2006, down from $110 million in 2005, reflecting lower costs, particularly for the Network Power segment. The higher gains and lower rationalization costs were partially offset by higher amortization of intangibles related to acquisitions. See Notes 4 and 5 for further details regarding other deductions, net and rationalization costs.
 
23

 
INTEREST EXPENSE, NET
 
Interest expense, net was $228 million, $207 million and $209 million in 2007, 2006 and 2005, respectively. The increase of $21 million from 2006 to 2007 was primarily due to higher average borrowings.
 
EARNINGS BEFORE INCOME TAXES
 
Earnings before income taxes were $3.1 billion for 2007, an increase of 16 percent, compared with $2.7 billion for 2006. The earnings results reflect increases in all five business segments, including $188 million in Process Management, $161 million in Network Power and $96 million in Industrial Automation. The higher earnings also reflect leverage from higher sales, benefits realized from cost containment, and higher sales prices, partially offset by higher raw material and wage costs.
 
Earnings before income taxes were $2.7 billion for 2006, an increase of 25 percent, compared with $2.1 billion for 2005. The earnings results reflect increases in all five business segments, including $207 million in Process Management, $111 million in Network Power and $105 million in Industrial Automation. The higher earnings also reflect leverage from higher sales, benefits realized from productivity improvements, and higher sales prices, partially offset by higher raw material, wage and benefit costs.
 
INCOME TAXES
 
Income taxes were $971 million, $839 million and $727 million for 2007, 2006 and 2005, respectively, resulting in effective tax rates of 31 percent, 31 percent and 34 percent. The change in the effective tax rate from 2005 to 2006 was primarily due to a 3 percentage point decrease resulting from a $63 million tax expense in 2005 related to the one-time opportunity during 2005 to repatriate foreign earnings at a favorable rate under the American Jobs Creation Act of 2004 (the Act). See Note 13 for further discussion regarding the impact of the Act.
 
NET EARNINGS, RETURN ON EQUITY AND RETURN ON TOTAL CAPITAL
 
Net earnings were a record $2.1 billion and earnings per share were a record $2.66 per share for 2007, increases of 16 percent and 19 percent, respectively, compared with net earnings and earnings per share of $1.8 billion and $2.24, respectively, in 2006. Net earnings as a percent of net sales were 9.5 percent in 2007 compared with 9.2 percent in 2006. The 19 percent increase in earnings per share also reflects the purchase of treasury shares. Return on stockholders’ equity (net earnings divided by average stockholders’ equity) reached 25.2 percent in 2007 compared with 23.7 percent in 2006. The Company achieved return on total capital of 20.1 percent in 2007 compared with 18.4 percent in 2006 (net earnings excluding interest income and expense, net of taxes, divided by average stockholders’ equity plus short- and long-term debt less cash and short-term investments). The Company consummated a two-for-one stock split in December 2006. All share and per share data have been restated to reflect this split.
 
Net earnings and earnings per share for 2006 increased 30 percent and 32 percent, respectively, to $1.8 billion and $2.24 per share, compared with $1.4 billion and $1.70 per share in 2005. Net earnings as a percent of net sales were 9.2 percent in 2006 compared with 8.2 percent in 2005. Net earnings for 2005 included a tax expense of $63 million, or $0.07 per share, related to the one-time opportunity to repatriate foreign earnings at a favorable rate. The 32 percent increase in earnings per share also reflects the purchase of treasury shares. Return on stockholders’ equity was 23.7 percent and 19.4 percent for 2006 and 2005, respectively. Return on total capital was 18.4 percent and 15.5 percent for 2006 and 2005, respectively.
 
 
24

 
Business Segments
 
PROCESS MANAGEMENT
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
CHANGE
 
CHANGE
 
(DOLLARS IN MILLIONS)
 
2005
 
2006
 
2007
 
'05 - '06
 
'06 - '07
 
Sales
 
$
4,200
   
4,875
   
5,699
   
16
%
 
17
%
Earnings
 
$
671
   
878
   
1,066
   
31
%
 
21
%
Margin
   
16.0
%
 
18.0
%
 
18.7
%
                      

 
2007 vs. 2006 - The Process Management segment sales were $5.7 billion in 2007, an increase of $824 million, or 17 percent, over 2006, reflecting higher volume and acquisitions. Nearly all of the businesses reported higher sales, with sales and earnings (defined as earnings before interest and taxes for the business segments discussion) particularly strong for the measurement, systems and valves businesses, reflecting very strong worldwide growth in oil and gas and power projects, and expansion in the Middle East. Underlying sales increased 11 percent, reflecting 8 percent from volume, and approximately 3 percent collectively from penetrating global markets and slightly higher sales prices. Foreign currency translation had a 4 percent ($169 million) favorable impact and the Bristol and Damcos acquisitions contributed 2 percent ($120 million). The underlying sales increase reflects growth in nearly all of the major geographic regions, including the United States (10 percent), Asia (12 percent), Europe (6 percent) and Latin America (6 percent), as well as the Middle East (63 percent), compared with the prior year. Earnings increased 21 percent to $1,066 million from $878 million in the prior year, primarily reflecting the higher sales volume and prices, as well as acquisitions. The margin increase reflects leverage on the higher sales and cost containment actions, which were partially offset by higher wages and an $11 million adverse commercial litigation judgment.
 
2006 vs. 2005 - Sales in the Process Management segment were $4.9 billion in 2006, an increase of $675 million, or 16 percent, over 2005, reflecting higher volume and acquisitions. All of the businesses, including measurement, valves and systems, reported higher sales and earnings because of worldwide growth in oil and gas and power projects, as well as expansion in China. The increasing demand for energy is driving capacity expansion and upgrades to existing facilities in the energy sector. Underlying sales increased 13 percent, driven by the strong market demand and aided by approximately 2 percent from penetration gains and price, while the Bristol, Tescom and Mobrey acquisitions contributed 3 percent ($147 million). The underlying sales increase reflects growth in all major geographic regions, including the United States (15 percent), Asia (15 percent), Latin America (20 percent) and Europe (6 percent), compared with 2005. Earnings increased 31 percent to $878 million from $671 million in 2005, primarily reflecting higher sales volume, as well as acquisitions. The margin increase was primarily due to leverage on higher sales. Sales price increases and material cost containment were offset by higher wages.
 
INDUSTRIAL AUTOMATION
                       
               
CHANGE
 
CHANGE
 
(DOLLARS IN MILLIONS)
 
2005
 
2006
 
2007
 
'05 - '06
 
'06 - '07
 
Sales
 
$
3,242
   
3,767
   
4,269
   
16
%
 
13
%
Earnings
 
$
464
   
569
   
665
   
23
%
 
17
%
Margin
   
14.3
%
 
15.1
%
 
15.6
%
                    
 
2007 vs. 2006 - The Industrial Automation segment increased sales by 13 percent to $4.3 billion in 2007, compared with $3.8 billion in 2006. Nearly all of the businesses reported higher sales in 2007, with particular strength in the power generating alternator, the electrical distribution and the electronic drives businesses, as the favorable economic environment for capital goods continued. The very strong growth in the U.S. and European alternator businesses was driven by increased demand for backup generators and alternative power sources, such as wind turbines. The underlying sales growth of 10 percent and the favorable impact from foreign currency translation of 4 percent ($143 million) was slightly offset by an unfavorable impact of 1 percent from divestitures, net of acquisitions. Underlying sales grew 13 percent internationally and 5 percent in the United States. The international sales growth primarily reflects increases in Europe (12 percent) and Asia (19 percent). The underlying growth reflects 7 percent from volume caused by increased global industrial demand and an approximate 3 percent combined positive impact from price and slight penetration gains. Earnings increased 17 percent to $665 million for 2007, compared with $569 million in 2006, reflecting leverage from higher sales volume and benefits from cost containment, as nearly all of the businesses reported higher earnings. The margin increase was primarily due to leverage on higher sales volume. The earnings increase was also aided by an approximate $24 million payment received by the power transmission business from dumping duties related to the Offset Act in the current year, compared with an $18 million payment received in 2006. Sales price increases were offset by higher material and wage costs, as well as unfavorable product mix.
 
25

 
2006 vs. 2005 - Sales in the Industrial Automation segment were $3.8 billion in 2006, an increase of 16 percent compared with 2005. Sales grew in all of the major geographic regions and in nearly all of the businesses, reflecting the continued favorable economic environment for capital goods. Underlying sales grew 11 percent; the Numatics, Saftronics and Jaure acquisitions contributed 6 percent ($208 million); and foreign currency translation had a 1 percent ($41 million) unfavorable impact. Underlying sales grew 12 percent in the United States and 11 percent internationally. The increase in international sales primarily reflects growth in Europe (10 percent) and Asia (13 percent). The results reflect growth in nearly all of the businesses, with particular strength in the power generating alternator and electrical distribution businesses. The underlying growth reflects both increased global industrial demand and a nearly 3 percent positive impact from price and penetration gains. In addition, the electrical distribution business’s strong growth was driven by increased demand in North America, particularly along the Gulf Coast of the United States. Earnings increased 23 percent to $569 million for 2006, compared with $464 million in 2005, reflecting higher sales volume and prices, as well as acquisitions. The margin increase was primarily due to leverage on higher sales volume. Sales price increases and benefits from prior cost reduction efforts were offset by higher material, wage and benefit (pension) costs, as well as dilution from acquisitions. The earnings increase was also aided by an approximate $18 million payment received by the power transmission business from dumping duties related to the Offset Act in 2006, compared with a $13 million payment received in 2005, and lower litigation settlement costs compared with 2005.
 
NETWORK POWER
                       
   
 
 
 
 
 
 
CHANGE
 
CHANGE
 
(DOLLARS IN MILLIONS)
 
2005
 
2006
 
2007
 
'05 - '06
 
'06 - '07
 
Sales
 
$
3,317
   
4,350
   
5,150
   
31
%
 
18
%
Earnings
 
$
373
   
484
   
645
   
30
%
 
33
%
Margin
   
11.2
%
 
11.1
%
 
12.5
%
           
 
2007 vs. 2006 - Sales in the Network Power segment increased 18 percent to $5.2 billion in 2007 compared with $4.4 billion in 2006. The sales increase was driven by continued strong demand in the uninterruptible power supplies, precision cooling and inbound power businesses and the full year impact of the Artesyn and Knürr acquisitions. Underlying sales grew 9 percent, while acquisitions, net of divestitures, contributed approximately 7 percent ($332 million) and favorable foreign currency translation had a 2 percent ($98 million) favorable impact. The underlying sales increase of 9 percent reflects a more than 5 percent gain from higher volume and a more than 3 percent impact from penetration gains, which were partially offset by a slight decline in sales prices. Geographically, underlying sales reflect a 20 percent increase in Asia, a 7 percent increase in the United States, while sales in Europe were flat compared with the prior year. The Company’s market penetration gains in China and other Asian markets continued. The U.S. growth reflects strong demand for data room and non-residential computer equipment. Earnings increased 33 percent, or $161 million, to $645 million, compared with $484 million in 2006, primarily because of the Artesyn and Knürr acquisitions and the higher sales volume. The margin increase reflects leverage on higher sales volume, savings from integrating acquisitions and improvement over the prior year in the DC power business. These benefits were partially offset by higher material and wage costs.
 
2006 vs. 2005 - The Network Power segment sales increased 31 percent to $4.4 billion in 2006 compared with $3.3 billion in 2005. End markets were strong across the segment with particular strength in the computing and data-center markets, which led to strong growth in the AC power system and precision cooling businesses. The sales increase reflects 21 percent growth in underlying sales and a 10 percent ($341 million) contribution from the Artesyn and Knürr acquisitions. The underlying sales increase of 21 percent reflects higher volume of approximately 23 percent, of which more than one-third is estimated to be from market penetration gains. These increases were partially offset by an estimated 2 percent impact from lower sales prices. Geographically, underlying sales reflect a 22 percent increase in the United States, a 37 percent increase in Asia (primarily China) and a 3 percent increase in Europe. The Company continues to build upon its Emerson Network Power China division resulting in market penetration in China and other Asian markets. Earnings increased 30 percent, or $111 million, to $484 million, compared with $373 million in 2005, primarily because of higher sales volume. The margin was primarily diluted by the Artesyn acquisition and declines in sales prices, partially offset by material cost containment. Negative product mix in the embedded power business and higher costs related to inventory and warranty in the North American DC power business in the fourth quarter also diluted the margin. Leverage on higher sales volume, savings from prior period cost reduction efforts and a $16 million reduction in rationalization costs versus 2005 mitigated the margin decline.
 
26

 
CLIMATE TECHNOLOGIES
                       
           
 
 
CHANGE
 
CHANGE
 
(DOLLARS IN MILLIONS)
 
2005
 
2006
 
2007
 
'05 - '06
 
'06 - '07
 
Sales
 
$
3,041
   
3,424
   
3,614
   
13
%
 
6
%
Earnings
 
$
453
   
523
   
538
   
15
%
 
3
%
Margin
   
14.9
%
 
15.3
%
 
14.9
%
           
 
2007 vs. 2006 - The Climate Technologies segment reported sales of $3.6 billion for 2007, representing a 6 percent improvement over 2006. Underlying sales increased approximately 1 percent, while acquisitions contributed 3 percent ($86 million) and foreign currency translation had a 2 percent ($53 million) favorable impact. Lower sales volume of 4 percent was more than offset by an approximate 5 percent combined positive impact from sales price increases and penetration gains. The underlying sales growth reflects a 16 percent increase in international sales, led by growth in Europe (18 percent) and Asia (17 percent). This growth was partially offset by a 7 percent decline in U.S. sales, which is primarily attributable to difficult comparisons to a very strong prior year for the air-conditioning compressor business (as noted below), as well as an impact from the downturn in the U.S. housing market. The volume decline in the U.S. air-conditioning business was only partially offset by a modest increase in U.S. refrigeration sales. The very strong growth in Europe and Asia reflects overall favorable market conditions, penetration in the European heat pump market, and penetration gains in Asia, particularly in digital scroll compressor products. Earnings increased 3 percent to $538 million in 2007 compared with $523 million in 2006, primarily because of savings from cost reduction efforts and lower restructuring costs of $5 million. The profit margin declined as the result of deleverage on the lower volume and an acquisition, while higher sales prices were offset by higher material and wage costs. The Company continued its capacity expansion begun last year in Mexico where the next generation scroll compressor design and hermetic motors for the North American market will be produced.
 
2006 vs. 2005 - Sales in the Climate Technologies segment were $3.4 billion in 2006, an increase of 13 percent compared with 2005. Underlying sales grew 13 percent, which reflects a 14 percent increase in the United States, a 20 percent increase in Europe and a 1 percent increase in Asia. The underlying sales growth was largely due to strong demand in the air-conditioning compressor business and an estimated 1 percent positive impact from higher sales prices. The volume increase of 12 percent, one-fourth of which is estimated to be from market share gains, was primarily related to scroll compressors. The air-conditioning compressor business was very strong during 2006 primarily because of demand relating to the transition in the United States to higher efficiency standards that became effective January 23, 2006, as well as weather related demand. Earnings increased 15 percent to $523 million in 2006 compared with $453 million in 2005, primarily due to higher volume. The margin increase reflects leverage on higher sales and savings from prior period cost reduction efforts, partially offset by higher wages and benefits (pension). The margin increase was negatively impacted as the higher sales prices were more than offset by higher material costs.
 
APPLIANCE AND TOOLS
               
 
 
 
 
 
 
 
 
 
 
 
 
CHANGE
 
CHANGE
 
(DOLLARS IN MILLIONS)
 
2005
 
2006
 
2007
 
'05 - '06
 
'06 - '07
 
Sales
 
$
4,008
   
4,313
   
4,447
   
8
%
 
3
%
Earnings
 
$
534
   
550
   
578
   
3
%
 
5
%
Margin
   
13.3
%
 
12.8
%
 
13.0
%
           
 
2007 vs. 2006 - Sales in the Appliance and Tools segment were $4.4 billion in 2007, a 3 percent increase from 2006. The sales increase reflects underlying sales growth of 1 percent, a favorable impact from foreign currency translation of 1 percent ($51 million) and a contribution from acquisitions of 1 percent ($37 million). The underlying sales increase of 1 percent reflects an estimated 4 percent decline in volume and an approximate 5 percent positive impact from higher sales prices. The results were mixed across the businesses for this segment. The tools and storage businesses showed moderate growth, while sales increased slightly in the motors businesses when compared with 2006. These increases were partially offset by declines in the appliance controls businesses. The growth in the tools businesses was driven by the professional tools and disposer businesses, reflecting the success of new product launches. The volume declines in the appliance controls and certain motors and storage businesses were primarily caused by the downturn in U.S. residential construction. International underlying sales increased 9 percent in total, while underlying sales in the United States were down 1 percent from the prior year. Earnings for 2007 were $578 million, a 5 percent increase from 2006. The earnings increases in tools and motor businesses were partially offset by declines in appliance component and certain storage businesses. Overall, the slight margin improvement primarily reflects the benefits from prior year actions, as well as lower restructuring inefficiencies and costs compared with the prior year. Sales price increases were offset by higher material (copper and other commodities) and wage costs, as well as deleverage from the lower volume.
 
27

 
2006 vs. 2005 - The Appliance and Tools segment sales increased 8 percent to $4.3 billion for 2006. This increase reflects 6 percent growth in underlying sales and a 2 percent ($62 million) contribution from the Do+Able acquisition. Sales grew in nearly all of the businesses with most experiencing moderate to strong growth. Particular strength in the tools, storage and hermetic motors businesses was partially offset by softness in the appliance component business. The hermetic motors business was very strong because of the air-conditioning demand during 2006. In addition, the storage businesses showed strong growth driven by the U.S. market. Strength in U.S. residential investment in the first half of 2006 and increased demand at major retailers resulted in continued growth in the storage businesses. The underlying sales increase reflects an estimated 3 percent growth from volume and an approximate 3 percent positive impact from price and penetration gains. Geographically, underlying sales increased 6 percent in the United States and 8 percent internationally. Earnings for 2006 were $550 million, an increase of 3 percent from 2005. The overall increase in profit was partially offset by declines in certain tools, storage and motors businesses, reflecting new product introduction costs in the disposer business, foreign currency losses in the tools and residential storage businesses and restructuring inefficiencies, including costs related to plant shutdown and ramp up of Mexican capacity in the tools and motors businesses. Overall, increases in sales prices were offset by higher raw material (particularly copper, steel and plastics), wage and benefit (pension) costs and negative product mix, diluting the profit margin.
 
Financial Position, Capital Resources and Liquidity
 
The Company continues to generate substantial cash from operations and is in a strong financial position with total assets of $20 billion and stockholders’ equity of $9 billion, and has the resources available for reinvestment in existing businesses, strategic acquisitions and managing the capital structure on a short- and long-term basis.
 
CASH FLOW
               
(DOLLARS IN MILLIONS)
 
2005
 
2006
 
2007
 
Operating Cash Flow
 
$
2,187
   
2,512
   
3,016
 
 Percent of sales
   
12.6
%
 
12.5
%
 
13.4
%
Capital Expenditures
 
$
518
   
601
   
681
 
 Percent of sales
   
3.0
%
 
3.0
%
 
3.0
%
Free Cash Flow (Operating Cash Flow Less Capital Expenditures)
 
$
1,669
   
1,911
   
2,335
 
 Percent of sales
   
9.6
%
 
9.5
%
 
10.3
%
Operating Working Capital
 
$
1,643
   
2,044
   
1,915
 
 Percent of sales
   
9.5
%
 
10.1
%
 
8.5
%
 
Emerson generated operating cash flow of $3.0 billion in 2007, a 20 percent increase from 2006, driven by higher net earnings. Cash flow in 2007 also reflects continued improvements in operating working capital management. Operating cash flow was $2.5 billion in 2006, a 15 percent increase from 2005, as higher net earnings were partially offset by additional working capital necessary to support the higher level of sales. At September 30, 2007, operating working capital as a percent of sales was 8.5 percent, compared with 10.1 percent and 9.5 percent in 2006 and 2005, respectively. Operating cash flow also reflects pension contributions of $136 million, $124 million and $124 million in 2007, 2006 and 2005, respectively.
 
28

Free cash flow (operating cash flow less capital expenditures) was $2.3 billion in 2007, compared with $1.9 billion and $1.7 billion in 2006 and 2005, respectively. The 22 percent increase in free cash flow in 2007 compared with 2006 and the 15 percent increase in 2006 compared with 2005 reflect the increases in operating cash flow, partially offset by higher capital spending. Capital expenditures were $681 million, $601 million and $518 million in 2007, 2006 and 2005, respectively. The increase in capital expenditures during 2007 compared with the prior year includes capacity expansion in the Process Management and Climate Technologies segments, while the increase in 2006 compared with 2005 was primarily due to capacity expansion and acquisitions in the Network Power segment. In 2008, the Company is targeting capital spending of approximately 3 percent of net sales. Cash paid in connection with Emerson’s acquisitions was $295 million, $752 million and $366 million in 2007, 2006 and 2005, respectively.
 
Dividends were $837 million ($1.05 per share, up 18 percent) in 2007, compared with $730 million ($0.89 per share) in 2006, and $694 million ($0.83 per share) in 2005. In November 2007, the Board of Directors voted to increase the quarterly cash dividend 14 percent to an annualized rate of $1.20 per share. In November 2006, the Company’s Board of Directors declared a two-for-one split of the Company’s common stock effected in the form of a 100 percent stock dividend to shareholders of record as of November 17, 2006, with a distribution date of December 11, 2006 (shares began trading on a post-split basis on December 12, 2006). In 2007, 18,877,000 shares were repurchased under the 2002 Board of Directors’ authorization; in 2006, 21,451,000 shares were repurchased, and in 2005, 20,071,000 shares were repurchased; 14.8 million shares remain available for repurchase under the 2002 authorization. Purchases of treasury stock totaled $849 million, $871 million and $671 million in 2007, 2006 and 2005, respectively.
 
LEVERAGE/CAPITALIZATION
               
(DOLLARS IN MILLIONS)
 
2005
 
2006
 
2007
 
Total Assets
 
$
17,227
   
18,672
   
19,680
 
Long-term Debt
 
$
3,128
   
3,128
   
3,372
 
Stockholders’ Equity
 
$
7,400
   
8,154
   
8,772
 
                     
Total Debt-to-Capital Ratio
   
35.6
%
 
33.1
%
 
30.1
%
Net Debt-to-Net Capital Ratio
   
27.7
%
 
28.1
%
 
23.6
%
Operating Cash Flow-to-Debt Ratio
   
53.4
%
 
62.4
%
 
79.9
%
Interest Coverage Ratio
   
9.8
   
12.9
   
12.9
 
 
Total debt was $3.8 billion, $4.0 billion and $4.1 billion for 2007, 2006 and 2005, respectively. During 2007, the Company issued $250 million of 5.125%, ten-year notes due December 2016 and $250 million of 5.375%, ten-year notes due October 2017. During 2006, $250 million of 6.3% notes matured. The total debt-to-capital ratio was 30.1 percent at year-end 2007, compared with 33.1 percent for 2006 and 35.6 percent for 2005. At September 30, 2007, net debt (total debt less cash and equivalents and short-term investments) was 23.6 percent of net capital, compared with 28.1 percent of net capital in 2006 and 27.7 percent of net capital in 2005. The operating cash flow-to-debt ratio was 79.9 percent, 62.4 percent and 53.4 percent in 2007, 2006 and 2005, respectively. The Company’s interest coverage ratio (earnings before income taxes and interest expense, divided by interest expense) was 12.9 times in 2007, compared with 12.9 times in 2006 and 9.8 times in 2005. The increase in the interest coverage ratio from 2005 to 2006 reflects higher earnings and lower average borrowings. See Notes 3, 8 and 9 for additional information. The Company’s strong financial position supports long-term debt ratings of A2 by Moody’s Investors Service and A by Standard and Poor’s.
 
At year-end 2007, the Company maintained a five-year revolving credit facility effective until April 2011 amounting to $2.8 billion to support short-term borrowings. The credit facility does not contain any financial covenants and is not subject to termination based on a change in credit ratings or a material adverse change. In addition, as of September 30, 2007, the Company could issue up to $1.75 billion in debt securities, preferred stock, common stock, warrants, share purchase contracts and share purchase units under the shelf registration statement filed with the Securities and Exchange Commission.
 
29

 
CONTRACTUAL OBLIGATIONS
 
At September 30, 2007, the Company’s contractual obligations, including estimated payments due by period, are as follows:
           
       
PAYMENTS DUE BY PERIOD
 
       
LESS THAN
 
 
 
 
 
MORE THAN
 
(DOLLARS IN MILLIONS)
 
TOTAL
 
1 YEAR
 
1-3 YEARS
 
3-5 YEARS
 
5 YEARS
 
Long-term Debt
 
$
3,623
   
251
   
1,074
   
287
   
2,011
 
Operating Leases
   
558
   
163
   
195
   
98
   
102
 
Purchase Obligations
   
1,720
   
1,156
   
387
   
177
   
-
 
Total
 
$
5,901
   
1,570
   
1,656
   
562
   
2,113
 
 
Purchase obligations consist primarily of inventory purchases made in the normal course of business to meet operational requirements. The above table does not include $2.0 billion of other noncurrent liabilities recorded in the balance sheet, as summarized in Note 17, which consist primarily of deferred income tax and retirement and postretirement plan liabilities, because it is not certain when these liabilities will become due. See Notes 10, 11 and 13 for additional information.
 
FINANCIAL INSTRUMENTS
 
The Company is exposed to market risk related to changes in interest rates, copper and other commodity prices and European and other foreign currency exchange rates, and selectively uses derivative financial instruments, including forwards, swaps and purchased options, to manage these risks. The Company does not hold derivatives for trading purposes. The value of market risk sensitive derivative and other financial instruments is subject to change as a result of movements in market rates and prices. Sensitivity analysis is one technique used to evaluate these impacts. Based on a hypothetical ten-percent increase in interest rates, ten-percent decrease in commodity prices or ten-percent weakening in the U.S. dollar across all currencies, the potential losses in future earnings, fair value and cash flows are immaterial. This method has limitations; for example, a weaker U.S. dollar would benefit future earnings through favorable translation of non-U.S. operating results and lower commodity prices would benefit future earnings through lower cost of sales. See Notes 1, 7, 8 and 9.
 
Critical Accounting Policies
 
Preparation of the Company’s financial statements requires management to make judgments, assumptions and estimates regarding uncertainties that affect the reported amounts of assets, liabilities, stockholders’ equity, revenues and expenses. Note 1 of the Notes to Consolidated Financial Statements describes the significant accounting policies used in preparation of the Consolidated Financial Statements. The most significant areas involving management judgments and estimates are described in the following paragraphs. Actual results in these areas could differ materially from management’s estimates under different assumptions or conditions.
 
REVENUE RECOGNITION
 
The Company recognizes nearly all of its revenues through the sale of manufactured products and records the sale when products are shipped and title passes to the customer and collection is reasonably assured. In certain instances, revenue is recognized on the percentage-of-completion method, when services are rendered, or in accordance with AICPA Statement of Position No. 97-2, “Software Revenue Recognition.” Sales sometimes include multiple items including services such as installation. In such instances, revenue assigned to each item is based on that item’s objectively determined fair value, and revenue is recognized individually for delivered items only if the delivered items have value to the customer on a standalone basis and performance of the undelivered items is probable and substantially in the Company’s control, or the undelivered items are inconsequential or perfunctory. Management believes that all relevant criteria and conditions are considered when recognizing sales.
 
30

 
INVENTORIES
 
Inventories are stated at the lower of cost or market. The majority of inventory values are based upon standard costs that approximate average costs, while the remainder are principally valued on a first-in, first-out basis. Standard costs are revised at the beginning of each fiscal year. The effects of resetting standards and operating variances incurred during each period are allocated between inventories and cost of sales. Management regularly reviews inventory for obsolescence to determine whether a write-down is necessary. Various factors are considered in making this determination, including recent sales history and predicted trends, industry market conditions and general economic conditions.
 
LONG-LIVED ASSETS
 
Long-lived assets, which include primarily goodwill and property, plant and equipment, are reviewed for impairment whenever events or changes in business circumstances indicate the carrying value of the assets may not be recoverable, as well as annually for goodwill. If the Company determines that the carrying value of the long-lived asset may not be recoverable, a permanent impairment charge is recorded for the amount by which the carrying value of the long-lived asset exceeds its fair value. Fair value is generally measured based on a discounted cash flow method using a discount rate determined by management to be commensurate with the risk inherent in the Company’s current business model. The estimates of cash flows and discount rate are subject to change depending on the economic environment, including such factors as interest rates, expected market returns and volatility of markets served. Management believes that the estimates of future cash flows and fair value are reasonable; however, changes in estimates could materially affect the evaluations. See Notes 1, 3 and 6.
 
RETIREMENT PLANS
 
Defined benefit plan expense and obligations are dependent on assumptions used in calculating such amounts. These assumptions include discount rate, rate of compensation increases and expected return on plan assets. In accordance with U.S. generally accepted accounting principles, actual results that differ from the assumptions are accumulated and amortized over future periods. While management believes that the assumptions used are appropriate, differences in actual experience or changes in assumptions may affect the Company’s retirement plan obligations and future expense. Effective for 2008, the discount rate for the U.S. retirement plans was adjusted to 6.25 percent based on the changes in market interest rates. Defined benefit pension plan expense is expected to decrease slightly in 2008. The Company contributed $136 million to defined benefit plans in 2007 and expects to contribute $50 million to $100 million in 2008. Effective September 30, 2007, the Company adopted the recognition and disclosure provisions of Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (FAS 158). This statement requires employers to recognize the funded status of defined benefit plans and other postretirement plans in the balance sheet and to recognize changes in the funded status through comprehensive income in the year in which they occur. The incremental effect of adopting FAS 158 resulted in a pre-tax charge to accumulated other comprehensive income of $522 million ($329 million after-tax). Also see Notes 10 and 11 for additional disclosures regarding the adoption. Effective for fiscal year 2009, FAS 158 requires plan assets and liabilities to be measured as of year-end, rather than the June 30 measurement date that the Company presently uses.
 
31

 
INCOME TAXES
 
Income tax expense and deferred tax assets and liabilities reflect management’s assessment of actual future taxes to be paid on items reflected in the financial statements. Uncertainty exists regarding tax positions taken in previously filed tax returns still under examination and positions expected to be taken in future returns. Deferred tax assets and liabilities arise due to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carryforwards. Deferred income taxes are measured using enacted tax rates in effect for the year in which the temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. Generally, no provision is made for U.S. income taxes on the undistributed earnings of non-U.S. subsidiaries. These earnings are permanently invested or otherwise indefinitely retained for continuing international operations. Determination of the amount of taxes that might be paid on these undistributed earnings if eventually remitted is not practicable. See Note 13.
 
The American Jobs Creation Act of 2004 (the Act) was signed into law on October 22, 2004. The Act repeals an export tax benefit, provides for a 9 percent deduction on U.S. manufacturing income, and allows the repatriation of foreign earnings at a reduced rate for one year, subject to certain limitations. When fully phased-in, management estimates that the repeal of the export tax benefit will be offset by the deduction on manufacturing income. During 2005, the Company repatriated approximately $1.4 billion ($1.8 billion in total) of cash from undistributed earnings of non-U.S. subsidiaries under the Act. As a result, the Company recorded a tax expense of $63 million, or $0.07 per share, in 2005.
 
NEW ACCOUNTING PRONOUNCEMENTS
 
In June 2006, the Financial Accounting Standards Board issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement 109” (FIN 48). FIN 48 addresses the accounting for uncertain tax positions that a company has taken or expects to take on a tax return. The Company has analyzed FIN 48, which is required to be adopted in the first quarter of fiscal 2008, and believes it will not have a material impact on the financial statements when finalized.
 
In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (FAS 157). FAS 157 defines fair value, establishes a formal framework for measuring fair value and expands disclosures about fair value measurements. The Company is in the process of analyzing the impact of FAS 157, which is effective for fiscal years beginning after November 15, 2007.
 
32

 

CONSOLIDATED STATEMENTS OF EARNINGS
 
EMERSON ELECTRIC CO. & SUBSIDIARIES
Years ended September 30 | Dollars in millions, except per share amounts
               
   
2005
 
2006
 
2007
 
Net sales
 
$
17,305
   
20,133
   
22,572
 
Costs and expenses:
                   
Cost of sales
   
11,122
   
12,965
   
14,461
 
Selling, general and administrative expenses
   
3,595
   
4,099
   
4,593
 
Other deductions, net
   
230
   
178
   
183
 
Interest expense (net of interest income: 2005, $34; 2006, $18; 2007, $33)
   
209
   
207
   
228
 
Earnings before income taxes 
   
2,149
   
2,684
   
3,107
 
Income taxes
   
727
   
839
   
971
 
Net earnings
 
$
1,422
   
1,845
   
2,136
 
                     
Basic earnings per common share
 
$
1.71
   
2.26
   
2.69
 
                     
Diluted earnings per common share
 
$
1.70
   
2.24
   
2.66
 
 
 
 
 
 
 
 
 
See accompanying Notes to Consolidated Financial Statements.

33


CONSOLIDATED BALANCE SHEETS
 
EMERSON ELECTRIC CO. & SUBSIDIARIES
September 30 | Dollars in millions, except per share amounts
           
ASSETS
 
2006
 
2007
 
Current assets
         
 Cash and equivalents
 
$
810
   
1,008
 
 Receivables, less allowances of $74 in 2006 and $86 in 2007
   
3,716
   
4,260
 
 Inventories:
             
 Finished products
   
887
   
884
 
 Raw materials and work in process
   
1,335
   
1,343
 
Total inventories
   
2,222
   
2,227
 
 Other current assets
   
582
   
570
 
 Total current assets
   
7,330
   
8,065
 
               
Property, plant and equipment
             
 Land
   
188
   
199
 
 Buildings
   
1,536
   
1,683
 
 Machinery and equipment
   
5,811
   
6,138
 
 Construction in progress
   
354
   
414
 
     
7,889
   
8,434
 
 Less accumulated depreciation
   
4,669
   
5,003
 
  Property, plant and equipment, net
   
3,220
   
3,431
 
               
Other assets
             
 Goodwill
   
6,013
   
6,412
 
 Other
   
2,109
   
1,772
 
 Total other assets
   
8,122
   
8,184
 
         
$
18,672
   
19,680
 
 
 
 
 
 
 
 
See accompanying Notes to Consolidated Financial Statements.

 
34

 
 

           
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
2006
 
2007
 
Current liabilities
         
 Short-term borrowings and current maturities of long-term debt
 
$
898
   
404
 
 Accounts payable
   
2,305
   
2,501
 
 Accrued expenses
   
1,933
   
2,337
 
 Income taxes
   
238
   
304
 
 Total current liabilities
   
5,374
   
5,546
 
Long-term debt
   
3,128
   
3,372
 
Other liabilities
   
2,016
   
1,990
 
               
               
Stockholders’ equity
             
 Preferred stock of $2.50 par value per share
             
Authorized 5,400,000 shares; issued - none
   
   
 
 Common stock of $0.50 par value per share
             
Authorized 1,200,000,000 shares; issued 953,354,012 shares; outstanding 804,693,798 shares
in 2006 and 788,434,076 shares in 2007
   
238
   
477
 
 Additional paid-in capital
   
161
   
31
 
 Retained earnings
   
11,314
   
12,536
 
 Accumulated other comprehensive income
   
306
   
382
 
     
12,019
   
13,426
 
 Less cost of common stock in treasury, 148,660,214 shares in 2006 and 164,919,936 shares in 2007
   
3,865
   
4,654
 
 Total stockholders’ equity
   
8,154
   
8,772
 
   
$
18,672
   
19,680
 

 

35


CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
 
EMERSON ELECTRIC CO. & SUBSIDIARIES
Years ended September 30 | Dollars in millions, except per share amounts
               
 
 
2005
 
2006
 
2007
 
Common stock
             
Beginning balance
 
$
238
   
238
   
238
 
Adjustment for stock split
   
-
   
-
   
239
 
Ending balance
   
238
   
238
   
477
 
Additional paid-in capital
                   
Beginning balance
   
87
   
120
   
161
 
Stock plans and other
   
33
   
41
   
31
 
Adjustment for stock split
   
-
   
-
   
(161
)
Ending balance
   
120
   
161
   
31
 
Retained earnings
                   
Beginning balance
   
9,471
   
10,199
   
11,314
 
Net earnings
   
1,422
   
1,845
   
2,136
 
Cash dividends (per share: 2005, $0.83; 2006, $0.89; 2007, $1.05)
   
(694
)
 
(730
)
 
(837
)
Adjustment for stock split
   
-
   
-
   
(77
)
Ending balance
   
10,199
   
11,314
   
12,536
 
Accumulated other comprehensive income
                   
Beginning balance
   
(88
)
 
(65
)
 
306
 
Foreign currency translation
   
11
   
175
   
459
 
Minimum pension liability (net of tax of: 2005, $10; 2006, $(71); 2007, $(1))
   
(18
)
 
121
   
2
 
Cash flow hedges and other (net of tax of: 2005, $(17); 2006, $(43); 2007, $29)
   
30
   
75
   
(56
)
Adjustment for adoption of FAS 158 (net of tax of: 2007, $193)
   
-
   
-
   
(329
)
Ending balance
   
(65
)
 
306
   
382
 
Treasury stock
                   
Beginning balance
   
(2,470
)
 
(3,092
)
 
(3,865
)
Acquired
   
(671
)
 
(871
)
 
(849
)
Issued under stock plans and other
   
49
   
98
   
60
 
Ending balance
   
(3,092
)
 
(3,865
)
 
(4,654
)
Total stockholders’ equity
 
$
7,400
   
8,154
   
8,772
 
                     
Comprehensive income
                   
Net earnings
 
$
1,422
   
1,845
   
2,136
 
Foreign currency translation
   
11
   
175
   
459
 
Minimum pension liability
   
(18
)
 
121
   
2
 
Cash flow hedges and other
   
30
   
75
   
(56
)
Total
 
$
1,445
   
2,216
   
2,541
 
 
See accompanying Notes to Consolidated Financial Statements.

36


CONSOLIDATED STATEMENTS OF CASH FLOWS
 
EMERSON ELECTRIC CO. & SUBSIDIARIES
Years ended September 30 | Dollars in millions
               
   
2005
 
2006
 
2007
 
Operating activities
             
Net earnings
 
$
1,422
   
1,845
   
2,136
 
Adjustments to reconcile net earnings to net cash provided by operating activities:
                   
Depreciation and amortization
   
562
   
607
   
656
 
Changes in operating working capital
   
110
   
(152
)
 
137
 
Pension funding
   
(124
)
 
(124
)
 
(136
)
Other
   
217
   
336
   
223
 
Net cash provided by operating activities
   
2,187
   
2,512
   
3,016
 
Investing activities
                   
Capital expenditures
   
(518
)
 
(601
)
 
(681
)
Purchases of businesses, net of cash and equivalents acquired
   
(366
)
 
(752
)
 
(295
)
Other
   
(12
)
 
137
   
106
 
Net cash used in investing activities
   
(896
)
 
(1,216
)
 
(870
)
Financing activities
                   
Net increase (decrease) in short-term borrowings
   
320
   
89
   
(800
)
Proceeds from long-term debt
   
251
   
6
   
496
 
Principal payments on long-term debt
   
(625
)
 
(266
)
 
(5
)
Dividends paid
   
(694
)
 
(730
)
 
(837
)
Purchases of treasury stock
   
(668
)
 
(862
)
 
(853
)
Other
   
15
   
32
   
5
 
Net cash used in financing activities
   
(1,401
)
 
(1,731
)
 
(1,994
)
Effect of exchange rate changes on cash and equivalents
   
(3
)
 
12
   
46
 
Increase (decrease) in cash and equivalents
   
(113
)
 
(423
)
 
198
 
Beginning cash and equivalents
   
1,346
   
1,233
   
810
 
Ending cash and equivalents
 
$
1,233
   
810
   
1,008
 
                     
Changes in operating working capital
                   
Receivables
 
$
(261
)
 
(246
)
 
(349
)
Inventories
   
8
   
(274
)
 
96
 
Other current assets
   
(44
)
 
36
   
36
 
Accounts payable
   
161
   
324
   
104
 
Accrued expenses
   
77
   
71
   
200
 
Income taxes
   
169
   
(63
)
 
50
 
   
 
$
110
   
(152
)
 
137
 
 
See accompanying Notes to Consolidated Financial Statements.

37


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
EMERSON ELECTRIC CO. & SUBSIDIARIES
Years ended September 30 | Dollars in millions, except per share amounts
 
(1) Summary of Significant Accounting Policies
 
PRINCIPLES OF CONSOLIDATION
 
The consolidated financial statements include the accounts of the Company and its controlled affiliates. Intercompany transactions, profits and balances are eliminated in consolidation. Other investments of 20 percent to 50 percent are accounted for by the equity method. Investments in nonpublicly-traded companies of less than 20 percent are carried at cost. Investments in publicly-traded companies of less than 20 percent are carried at fair value, with changes in fair value reflected in accumulated other comprehensive income.
 
FOREIGN CURRENCY TRANSLATION
 
The functional currency of a vast majority of the Company’s non-U.S. subsidiaries is the local currency. Adjustments resulting from the translation of financial statements are reflected in accumulated other comprehensive income.
 
CASH EQUIVALENTS
 
Cash equivalents consist of highly liquid investments with original maturities of three months or less.
 
INVENTORIES
 
Inventories are stated at the lower of cost or market. The majority of inventory values are based upon standard costs that approximate average costs, while the remainder are principally valued on a first-in, first-out basis. Standard costs are revised at the beginning of each fiscal year. The effects of resetting standards and operating variances incurred during each period are allocated between inventories and cost of sales.
 
PROPERTY, PLANT AND EQUIPMENT
 
The Company records investments in land, buildings, and machinery and equipment at cost. Depreciation is computed principally using the straight-line method over estimated service lives. Service lives for principal assets are 30 to 40 years for buildings and 8 to 12 years for machinery and equipment. Long-lived assets are reviewed for impairment whenever events or changes in business circumstances indicate that the carrying value of the assets may not be recoverable. Impairment losses are recognized based on fair value if expected future undiscounted cash flows of the related assets are less than their carrying values.
 
GOODWILL AND INTANGIBLE ASSETS
 
Assets and liabilities acquired in business combinations are accounted for using the purchase method and recorded at their respective fair values. Substantially all goodwill is assigned to the reporting unit that acquires a business. A reporting unit is an operating segment as defined in Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” or a business one level below an operating segment if discrete financial information is prepared and regularly reviewed by the segment manager. The Company conducts a formal impairment test of goodwill on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Under the impairment test, if a reporting unit’s carrying amount exceeds its estimated fair value, a goodwill impairment is recognized to the extent that the reporting unit’s carrying amount of goodwill exceeds the implied fair value of the goodwill. Fair values of reporting units are estimated using discounted cash flows and market multiples.
 
All of the Company’s intangible assets (other than goodwill) are subject to amortization. Intangibles consist of intellectual property (such as patents and trademarks), customer relationships and capitalized software and are amortized on a straight-line basis. These intangibles are also subject to evaluation for potential impairment if an event occurs or circumstances change that indicate the carrying amount may not be recoverable.
 
WARRANTY
 
The Company’s product warranties vary by each of its product lines and are competitive for the markets in which it operates. Warranty generally extends for a period of one to two years from the date of sale or installation. Provisions for warranty are determined primarily based on historical warranty cost as a percentage of sales or a fixed amount per unit sold based on failure rates, adjusted for specific problems that may arise. Product warranty expense is less than 1 percent of sales.
 

38

 
REVENUE RECOGNITION
 
The Company recognizes nearly all of its revenues through the sale of manufactured products and records the sale when products are shipped and title passes to the customer and collection is reasonably assured. In certain instances, revenue is recognized on the percentage-of-completion method, when services are rendered, or in accordance with AICPA Statement of Position No. 97-2, “Software Revenue Recognition.” Sales sometimes include multiple items including services such as installation. In such instances, revenue assigned to each item is based on that item’s objectively determined fair value, and revenue is recognized individually for delivered items only if the delivered items have value to the customer on a standalone basis and performance of the undelivered items is probable and substantially in the Company’s control, or the undelivered items are inconsequential or perfunctory. Management believes that all relevant criteria and conditions are considered when recognizing sales.
 
FINANCIAL INSTRUMENTS
 
All derivative instruments are reported on the balance sheet at fair value. The accounting for changes in fair value of a derivative instrument depends on whether it has been designated and qualifies as a hedge and on the type of hedge. For each derivative instrument designated as a cash flow hedge, the effective portion of the gain or loss on the derivative is deferred in accumulated other comprehensive income until recognized in earnings with the underlying hedged item. For each derivative instrument designated as a fair value hedge, the gain or loss on the derivative and the offsetting gain or loss on the hedged item are recognized immediately in earnings. Currency fluctuations on non-U.S. dollar obligations that have been designated as hedges on non-U.S. net asset exposures are included in accumulated other comprehensive income. Regardless of type, a fully effective hedge will result in no net earnings impact while the derivative is outstanding. To the extent that any hedge is ineffective at offsetting cash flow or fair value changes in the underlying hedged item, there could be a net earnings impact. Gains and losses from the ineffective portion of any hedge, as well as the gains and losses on derivative instruments not designated as a hedge, are recognized in the income statement immediately.
 
INCOME TAXES
 
No provision has been made for U.S. income taxes on the undistributed earnings of non-U.S. subsidiaries of approximately $2.6 billion at September 30, 2007. These earnings are permanently invested or otherwise indefinitely retained for continuing international operations. Determination of the amount of taxes that might be paid on these undistributed earnings if eventually remitted is not practicable.
 
COMPREHENSIVE INCOME
 
Comprehensive income is primarily comprised of net earnings and changes in foreign currency translation, minimum pension liability and cash flow hedges. Accumulated other comprehensive income, after-tax, consists of foreign currency translation credits of $728 and $269, pension and postretirement adjustments of $384 and $57, and cash flow hedges and other credits of $38 and $94 at September 30, 2007 and 2006, respectively.
 
FINANCIAL STATEMENT PRESENTATION
 
The preparation of the financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ from those estimates.
 
On December 11, 2006, a two-for-one split of the Company’s common stock was effected in the form of a 100 percent stock dividend (shares began trading on a post-split basis on December 12, 2006). This stock split resulted in the issuance of approximately 476.7 million additional shares of common stock and was accounted for by the transfer of approximately $161 from additional paid-in capital and $77 from retained earnings to common stock. All share and per share data have been retroactively restated to reflect this split.
 
Effective September 30, 2007, Emerson adopted the recognition and disclosure provisions of Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (FAS 158). This statement requires employers to recognize the over- or under-funded status of defined benefit plans and other postretirement plans in the balance sheet and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. The incremental effect of adopting FAS 158 was a reduction in other assets of $425, an increase in other liabilities of $97 and an after-tax charge to accumulated other comprehensive income of $329 (See Notes 10 and 11).
 
Certain prior year amounts have been reclassified to conform to the current year presentation.
 

39

 

(2) Weighted Average Common Shares
 
Basic earnings per common share consider only the weighted average of common shares outstanding while diluted earnings per common share consider the dilutive effects of stock options and incentive shares. Options to purchase approximately 1.1 million, 1.0 million and 5.1 million shares of common stock were excluded from the computation of diluted earnings per share in 2007, 2006 and 2005, respectively, because their effect would have been antidilutive. Reconciliations of weighted average common shares for basic earnings per common share and diluted earnings per common share follow:

               
(SHARES IN MILLIONS)
 
2005
 
2006
 
2007
 
Basic
   
829.9
   
816.5
   
793.8
 
Dilutive shares
   
7.8
   
8.0
   
10.1
 
Diluted
   
837.7
   
824.5
   
803.9
 
 
(3) Acquisitions and Divestitures
 
The Company acquired Damcos Holding AS (Damcos) during the second quarter of fiscal 2007, and Stratos International, Inc. (Stratos) during the fourth quarter of fiscal 2007. Damcos supplies valve remote control systems and tank monitoring equipment to the marine and shipbuilding industries and is included in the Process Management segment. Stratos is a designer and manufacturer of radio-frequency and microwave interconnect products and is included in the Network Power segment. In addition to Damcos and Stratos, the Company acquired several smaller businesses during 2007 mainly in the Process Management and Appliance and Tools segments. Total cash paid for these businesses (net of cash and equivalents acquired of approximately $40 and debt assumed of approximately $56) and annualized sales were approximately $295 and $240, respectively. Goodwill of $189 (none of which is expected to be deductible for tax purposes) and identifiable intangible assets (primarily technology and customer relationships) of $106, which are being amortized on a straight-line basis over a weighted-average life of nine years, were recognized from these transactions in 2007. Third-party valuations of assets are in-process; purchase price allocations are subject to refinement for fiscal year 2007 acquisitions.
 
During the fourth quarter of fiscal 2007, the Company entered into a definitive agreement to acquire Motorola Inc.’s Embedded Communications Computing (ECC) business for approximately $350 in cash. ECC is a leading provider of embedded computing products to equipment manufacturers in telecommunications, medical imaging, defense and aerospace, and industrial automation. The transaction is expected to be completed by the end of calendar 2007 and is subject to customary closing conditions and regulatory approvals. ECC had 2006 revenue of approximately $520 and will be included in the Network Power segment.
 
In 2007, the Company divested two small business units that had total annual sales of $113 and $115 for fiscal years 2006 and 2005, respectively. In the fourth quarter of 2006, the Company received approximately $80 from the divestiture of the materials testing business, resulting in a pretax gain of $31 ($22 after-tax). The materials testing business represented total annual sales of approximately $58 and $59 in 2006 and 2005, respectively. These businesses were not reclassified as discontinued operations because of immateriality.
 
The Company acquired Artesyn Technologies, Inc. (Artesyn) during the third quarter of fiscal 2006, and Knürr AG (Knürr) and Bristol Babcock (Bristol) during the second quarter of fiscal 2006. Artesyn is a global manufacturer of advanced power conversion equipment and board-level computing solutions for infrastructure applications in telecommunication and data-communication systems and is included in the Network Power segment. Knürr is a manufacturer of indoor and outdoor enclosure systems and cooling technologies for telecommunications, electronics and computing equipment and is included in the Network Power segment. Bristol is a manufacturer of control and measurement equipment for oil and gas, water and wastewater, and power industries and is included in the Process Management segment. In addition to Artesyn, Knürr and Bristol, the Company acquired several smaller businesses during 2006 mainly in the Industrial Automation and Appliance and Tools segments. Total cash paid for these businesses (net of cash and equivalents acquired of approximately $120 and debt assumed of approximately $90) and annualized sales were approximately $752 and $920, respectively. Goodwill of $481 ($54 of which is expected to be deductible for tax purposes) and identifiable intangible assets (primarily technology and customer relationships) of $189, which are being amortized on a straight-line basis over a weighted-average life of nine years, were recognized from these transactions in 2006.
 
40


 
The Company acquired Do+Able, a manufacturer of ready-to-assemble wood and steel home and garage organization and storage products, which is included in the Appliance and Tools segment, in the second quarter of 2005 and Numatics, a manufacturer of pneumatic and motion control products for industrial applications, which is included in the Industrial Automation segment, in the fourth quarter of 2005. In addition to Do+Able and Numatics, the Company acquired several smaller businesses during 2005, mainly in the Process Management and Appliance and Tools segments. Total cash paid (including assumed debt of approximately $100, which was repaid in October 2005) and annualized sales for these businesses were approximately $466 and $430, respectively. Goodwill of $236 ($58 of which is expected to be deductible for tax purposes) and identifiable intangible assets of $122, which are being amortized on a straight-line basis over a weighted-average life of ten years, were recognized from these transactions in 2005.
 
The results of operations of these businesses have been included in the Company’s consolidated results of operations since the respective dates of acquisition and prior to the respective dates of divestiture.
 
(4) Other Deductions, Net
 
Other deductions, net are summarized as follows:
                   
       
2005
 
2006
 
2007
 
Rationalization of operations
 
$
110
   
84
   
83
 
Amortization of intangibles (intellectual property and customer relationships)
   
28
   
47
   
63
 
Other
   
118
   
115
   
111
 
Gains, net
   
(26
)
 
(68
)
 
(74
)
 Total
 
$
230
   
178
   
183
 
 
Other is comprised of several items that are individually immaterial, including minority interest expense, foreign currency gains and losses, bad debt expense, equity investment income and losses, as well as one-time items, such as litigation and disputed matters, insurance recoveries and interest refunds.
 
Gains, net for 2007 includes the following items. The Company recorded gains of approximately $32 in 2007 related to the sale of its remaining 4.5 million shares of MKS Instruments, Inc. (MKS), a publicly-traded company. The Company also recorded a gain of approximately $24 in 2007 for payments received under the U.S. Continued Dumping and Subsidy Offset Act (Offset Act).
 
Gains, net for 2006 includes the following items. The Company recorded gains of approximately $26 in 2006 related to the sale of 4.4 million shares of MKS. In the fourth quarter of 2006, the Company recorded a pretax gain of approximately $31 related to the divesture of the materials testing business. Also during the fourth quarter of 2006, the Company recorded a pretax charge of $14 related to the write-down of two businesses that were sold in 2007 to their net realizable values. The Company also recorded a gain of approximately $18 in 2006 for payments received under the Offset Act.
 
Gains, net for 2005 includes the following items. An approximate $13 gain from the sale of a manufacturing facility and an approximate $13 gain for a payment received under the Offset Act were recorded in 2005.
 
(5) Rationalization of Operations
 
The change in the liability for the rationalization of operations during the years ended September 30 follows:
                   
 
 
2006
 
EXPENSE
 
PAID / UTILIZED
 
2007
 
Severance and benefits
 
$
31
   
40
   
43
   
28
 
Lease/contract terminations
   
12
   
4
   
8
   
8
 
Fixed asset write-downs
   
-
   
2
   
2
   
-
 
Vacant facility and other shutdown costs
   
1
   
8
   
8
   
1
 
Start-up and moving costs
   
1
   
29
   
30
   
-
 
       
$
45
   
83
   
91
   
37
 
 
 
41



                          
      
2005
 
EXPENSE
 
ACQUISITIONS
 
PAID / UTILIZED
 
2006
 
Severance and benefits
 
$
22
   
38
   
16
   
45
   
31
 
Lease/contract terminations
   
11
   
5
   
4
   
8
   
12
 
Fixed asset write-downs
   
-
   
2
   
-
   
2
   
-
 
Vacant facility and other shutdown costs
   
-
   
9
   
-
   
8
   
1
 
Start-up and moving costs
   
-
   
30
   
-
   
29
   
1
 
       
$
33
   
84
   
20
   
92
   
45
 
 
Rationalization of operations by segment is summarized as follows:
               
 
 
2005
 
2006
 
2007
 
Process Management
 
$
20
   
14
   
15
 
Industrial Automation
   
15
   
12
   
14
 
Network Power
   
35
   
19
   
23
 
Climate Technologies
   
15
   
14
   
9
 
Appliance and Tools
   
24
   
25
   
22
 
Corporate
   
1
   
-
   
-
 
 Total
 
$
110
   
84
   
83
 
 
Rationalization of operations comprises expenses associated with the Company’s efforts to continually improve operational efficiency and to expand globally in order to remain competitive on a worldwide basis. These expenses result from numerous individual actions implemented across the divisions on a routine basis. Rationalization of operations includes ongoing costs for moving facilities, starting up plants from relocation as well as business expansion, exiting product lines, curtailing/downsizing operations because of changing economic conditions, and other items resulting from asset redeployment decisions. Shutdown costs include severance, benefits, stay bonuses, lease/contract terminations and asset write-downs. Start-up and moving costs include employee training and relocation, movement of assets and other items. Vacant facility costs include security, maintenance and utility costs associated with facilities that are no longer being utilized.
 
During 2007, rationalization of operations primarily related to the exit of approximately 25 production, distribution, or office facilities, including the elimination of approximately 2,200 positions, as well as costs related to facilities exited in previous periods. Noteworthy rationalization actions during 2007 are as follows. Process Management included start-up costs related to capacity expansion in China to serve the Asian market, as well as severance and start-up and moving costs related to the movement of certain operations in Western Europe to Eastern Europe and Asia to improve profitability. Industrial Automation included severance and start-up and moving costs related to the consolidation of certain power transmission facilities in Asia and North America to obtain operational efficiencies and serve Asian and North American markets. Network Power included severance related to the closure of certain power conversion facilities acquired with Artesyn, as well as severance and start-up and moving costs related to the shifting of certain power systems production from the United States and Europe to Mexico to remain competitive on a global basis. Climate Technologies included start-up costs related to capacity expansion in Mexico and Eastern Europe to improve profitability and to serve these markets, and start-up and moving costs related to the consolidation of certain production facilities in the United States to obtain operational efficiencies. Appliance and Tools included severance and start-up and moving costs related to the consolidation of certain North American production, and severance related to the closure of certain motor production in Europe to remain competitive on a global basis. The Company expects rationalization expense for 2008 to be approximately $90 to $100, including the costs to complete actions initiated before the end of 2007 and actions anticipated to be approved and initiated during 2008.
 
During 2006, rationalization of operations primarily related to the exit of approximately 10 production, distribution, or office facilities, including the elimination of approximately 1,700 positions, as well as costs related to facilities exited in previous periods. Noteworthy rationalization actions during 2006 are as follows. Process Management included severance related to the shifting of certain regulator production from Western Europe to Eastern Europe. Industrial Automation included start-up and moving costs related to shifting certain motor production in Western Europe to Eastern Europe, China and Mexico to leverage costs and remain competitive on a global basis and to serve these markets. Network Power included severance related to the closure of certain power conversion facilities acquired with Artesyn, severance, start-up and vacant facility costs related to the consolidation of certain power systems operations in North America and the consolidation of administrative operations in Europe to obtain operational synergies. Climate Technologies included severance related to the movement of temperature sensors and controls production from Western Europe to China and start-up and moving costs related to a new plant in Eastern Europe in order to improve profitability. Appliance and Tools included primarily severance and start-up and moving costs related to the shifting of certain tool and motor manufacturing operations from the United States and Western Europe to China and Mexico in order to consolidate facilities and improve profitability.
 
42

During 2005, rationalization of operations primarily related to the exit of approximately 25 production, distribution, or office facilities, including the elimination of approximately 2,100 positions, as well as costs related to facilities exited in previous periods. Noteworthy rationalization actions during 2005 are as follows. Process Management included severance and plant closure costs related to consolidation of instrumentation plants within Europe and consolidation of valve operations within North America, the movement of major distribution facilities to Asia, as well as several other cost reduction actions. Network Power included severance and lease termination costs related to certain power systems operations in Western Europe shifting to China and Eastern Europe in order to leverage product platforms and lower production and engineering costs to remain competitive on a global basis. This segment also included severance and start-up and moving costs related to the consolidation of North American power systems operations into the Marconi operations acquired in 2004. Appliance and Tools included severance, plant closure costs and start-up and moving costs related to consolidating various industrial and hermetic motor manufacturing facilities for operational efficiency. Severance costs in this segment also related to shifting certain appliance control operations from the United States to Mexico and China in order to consolidate facilities and improve profitability.
 
(6) Goodwill and Other Intangibles
 
Acquisitions are accounted for under the purchase method, with substantially all goodwill assigned to the reporting unit that acquires the business. Under the annual impairment test, if a reporting unit’s carrying amount exceeds its estimated fair value, a goodwill impairment is recognized to the extent that the reporting unit’s carrying amount of goodwill exceeds the implied fair value of the goodwill. Fair values of reporting units are estimated using discounted cash flows and market multiples.
 
The change in goodwill by business segment follows:
                           
   
PROCESS
 
INDUSTRIAL
 
NETWORK
 
CLIMATE
 
APPLIANCE
     
   
MANAGEMENT
 
AUTOMATION
 
POWER
 
TECHNOLOGIES
 
AND TOOLS
 
TOTAL
 
Balance, September 30, 2005
 
$
1,699
   
997
   
1,780
   
380
   
623
   
5,479
 
Acquisitions
   
58
   
27
   
351
   
25
   
20
   
481
 
Divestitures
         
(24
)
 
(3
)
             
(27
)
Impairment
               
(5
)
             
(5
)
Foreign currency translation and other
   
21
   
16
   
39
   
3
   
6
   
85
 
Balance, September 30, 2006
 
$
1,778
   
1,016
   
2,162
   
408
   
649
   
6,013
 
Acquisitions
   
146
   
1
   
26
   
3
   
13
   
189
 
Divestitures
               
(5
)
             
(5
)
Impairment
         
(7
)
                   
(7
)
Foreign currency translation and other
   
61
   
60
   
76
   
9
   
16
   
222
 
Balance, September 30, 2007
 
$
1,985
   
1,070
   
2,259
   
420
   
678
   
6,412
 
 
The gross carrying amount and accumulated amortization of intangibles (other than goodwill) by major class follow:
                           
   
GROSS CARRYING AMOUNT
 
ACCUMULATED AMORTIZATION
 
NET CARRYING AMOUNT
 
     
2006
   
2007
   
2006
   
2007
   
2006
   
2007
 
Intellectual property and customer relationships
 
$
794
   
925
   
324
   
381
   
470
   
544
 
Capitalized software
   
647
   
729
   
484
   
558
   
163
   
171
 
   
$
1,441
   
1,654
   
808
   
939
   
633
   
715
 
 
Total intangible amortization expense for 2007, 2006 and 2005 was $131, $107 and $90, respectively. Based on intangible assets as of September 30, 2007, amortization expense will approximate $126 in 2008, $115 in 2009, $96 in 2010, $82 in 2011 and $72 in 2012.
 
43


(7) Financial Instruments
 
The Company selectively uses derivative financial instruments to manage interest costs, commodity prices and currency exchange risk. The Company does not hold derivatives for trading purposes. No credit loss is anticipated as the counterparties to these agreements are major financial institutions with high credit ratings.
 
To efficiently manage interest costs, the Company utilizes interest rate swaps as cash flow hedges of variable rate debt or fair value hedges of fixed rate debt. Also as part of its hedging strategy, the Company utilizes purchased option and forward exchange contracts and commodity swaps as cash flow or fair value hedges to minimize the impact of currency and commodity price fluctuations on transactions, cash flows, fair values and firm commitments. Hedge ineffectiveness during 2007, 2006 and 2005 was immaterial. At September 30, 2007, substantially all of the contracts for the sale or purchase of European and other currencies and the purchase of copper and other commodities mature within two years; contracts with a fair value of approximately $60 mature in 2008.
 
Notional transaction amounts and fair values for the Company’s outstanding derivatives, by risk category and instrument type, as of September 30, 2007 and 2006, are summarized as follows. Fair values of the derivatives do not consider the offsetting underlying hedged item.
           
   
  2006
 
2007
 
 
 
NOTIONAL
 
FAIR
 
NOTIONAL
 
FAIR
 
 
 
AMOUNT
 
VALUE
 
AMOUNT
 
VALUE
 
Foreign currency:
                 
Forwards
 
$
1,310
   
11
   
1,922
   
35
 
Options
 
$
4
   
-
   
266
   
2
 
Interest rate swaps
 
$
110
   
(4
)
 
113
   
(3
)
Commodity contracts
 
$
457
   
130
   
509
   
45
 
 
Fair values of the Company’s financial instruments are estimated by reference to quoted prices from market sources and financial institutions, as well as other valuation techniques. The estimated fair value of long-term debt (including current maturities) exceeded the related carrying value by $2 and $40 at September 30, 2007 and 2006, respectively. The estimated fair value of each of the Company’s other classes of financial instruments approximated the related carrying value at September 30, 2007 and 2006.
 
(8) Short-Term Borrowings and Lines of Credit
 
Short-term borrowings and current maturities of long-term debt are summarized as follows:
           
   
2006
 
2007
 
Current maturities of long-term debt
 
$
2
   
251
 
Commercial paper
   
819
   
113
 
Payable to banks
   
28
   
19
 
Other
   
49
   
21
 
Total
 
$
898
   
404
 
Weighted-average short-term borrowing interest rate at year-end
   
4.9
%
 
3.2
%
 

 
44

 
In 2000, the Company issued 13 billion Japanese yen of commercial paper and simultaneously entered into a ten-year interest rate swap, which fixed the rate at 2.2 percent.
 
At year-end 2007, the Company maintained a five-year revolving credit facility effective until April 2011 amounting to $2.8 billion to support short-term borrowings and to assure availability of funds at prevailing interest rates. The credit facility does not contain any financial covenants and is not subject to termination based on a change in credit ratings or a material adverse change. There were no borrowings against U.S. lines of credit in the last three years.
 
(9) Long-Term Debt
 
Long-term debt is summarized as follows:
           
   
2006
 
2007
 
5 1/2% notes due September 2008
 
$
250
   
250
 
5% notes due October 2008
   
175
   
175
 
5.85% notes due March 2009
   
250
   
250
 
7 1/8% notes due August 2010
   
500
   
500
 
5.75% notes due November 2011
   
250
   
250
 
4.625% notes due October 2012
   
250
   
250
 
4 1/2% notes due May 2013
   
250
   
250
 
5 5/8% notes due November 2013
   
250
   
250
 
5% notes due December 2014
   
250
   
250
 
4.75% notes due October 2015
   
250
   
250
 
5.125% notes due December 2016
   
-
   
250
 
5.375% notes due October 2017
   
-
   
250
 
6% notes due August 2032
   
250
   
250
 
Other
   
205
   
198
 
   
 3,130
   
3,623
 
Less current maturities
   
2
   
251
 
Total
 
$
3,128
   
3,372
 
 
During the first and third quarters of 2007, the Company issued $250 of 5.125%, ten-year notes, and $250 of 5.375%, ten-year notes, respectively, under a shelf registration statement filed with the Securities and Exchange Commission. During the fourth quarter of 2005, the Company issued $250 of 4.75%, ten-year notes under a shelf registration statement filed with the Securities and Exchange Commission. In 1999, the Company issued $250 of 5.85%, ten-year notes that were simultaneously swapped to U.S. commercial paper rates. The Company terminated the swap in 2001, establishing an effective interest rate of 5.7 percent.
 
Long-term debt maturing during each of the four years after 2008 is $474, $600, $37 and $250, respectively. Total interest paid related to short-term borrowings and long-term debt was approximately $242, $214 and $247 in 2007, 2006 and 2005, respectively.
 
As of September 30, 2007, the Company could issue up to $1.75 billion in debt securities, preferred stock, common stock, warrants, share purchase contracts and share purchase units under the shelf registration statement filed with the Securities and Exchange Commission. The Company may sell securities in one or more separate offerings with the size, price and terms to be determined at the time of sale. The net proceeds from the sale of the securities will be used for general corporate purposes, which may include, but are not limited to, working capital, capital expenditures, financing acquisitions and the repayment of short- or long-term borrowings. The net proceeds may be invested temporarily until they are used for their stated purpose.
 
45



(10) Retirement Plans
 
Retirement plan expense includes the following components:
                           
   
                   U.S. PLANS
 
                     NON-U.S. PLANS
 
   
2005
 
2006
 
2007
 
2005
 
2006
 
2007
 
Defined benefit plans:
                         
Service cost (benefits earned during the period)
 
$
48
   
58
   
43
   
14
   
19
   
21
 
Interest cost
   
145
   
145
   
159
   
31
   
32
   
38
 
Expected return on plan assets
   
(207
)
 
(202
)
 
(211
)
 
(27
)
 
(32
)
 
(38
)
Net amortization
   
64
   
100
   
87
   
13
   
16
   
11
 
Net periodic pension expense
   
50
   
101
   
78
   
31
   
35
   
32
 
Defined contribution and multiemployer plans
   
69
   
85
   
94
   
23
   
25
   
27
 
Total retirement plan expense
 
$
119
   
186
   
172
   
54
   
60
   
59
 
 
The reconciliations of the actuarial present value of the projected benefit obligations and of the fair value of plan assets for defined benefit pension plans follow:
           
   
                 U.S. PLANS
 
                  NON-U.S. PLANS
 
 
 
2006
 
2007
 
2006
 
2007
 
Projected benefit obligation, beginning
 
$
2,747
   
2,464
   
707
   
711
 
Service cost
   
58
   
43
   
19
   
21
 
Interest cost
   
145
   
159
   
32
   
38
 
Actuarial loss (gain)
   
(386
)
 
127
   
(53
)
 
10
 
Benefits paid
   
(122
)
 
(129
)
 
(29
)
 
(36
)
Acquisitions/divestitures, net
   
17
   
-
   
24
   
18
 
Foreign currency translation and other
   
5
   
14
   
11
   
75
 
Projected benefit obligation, ending
 
$
2,464
   
2,678
   
711
   
837
 
                           
Fair value of plan assets, beginning
 
$
2,566
   
2,785
   
492
   
555
 
Actual return on plan assets
   
233
   
475
   
37
   
50
 
Employer contributions
   
91
   
71
   
33
   
62
 
Benefits paid
   
(122
)
 
(129
)
 
(29
)
 
(36
)
Acquisitions/divestitures, net
   
16
   
-
   
18
   
1
 
Foreign currency translation and other
   
1
   
2