-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, STnmqMLUK0W+mjf6J3h4FMU0JLSyxtEoJkt9Fcp5xuesMTHRV3QmojyHTnAiDWOz Aot1USFdUHXoDooloZ673Q== 0000949957-03-000010.txt : 20030814 0000949957-03-000010.hdr.sgml : 20030814 20030814152620 ACCESSION NUMBER: 0000949957-03-000010 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20030630 FILED AS OF DATE: 20030814 FILER: COMPANY DATA: COMPANY CONFORMED NAME: AEARO CORP CENTRAL INDEX KEY: 0000949957 STANDARD INDUSTRIAL CLASSIFICATION: MISCELLANEOUS MANUFACTURING INDUSTRIES [3990] IRS NUMBER: 133840356 STATE OF INCORPORATION: DE FISCAL YEAR END: 0930 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 033-96190 FILM NUMBER: 03847116 BUSINESS ADDRESS: STREET 1: 5457 W 79TH ST STREET 2: 8TH FL CITY: INDIANAPOLIS STATE: IN ZIP: 46268 BUSINESS PHONE: 3176926666 MAIL ADDRESS: STREET 1: 5457 W 79TH ST CITY: INDIANAPOLIS STATE: IN ZIP: 46268 FORMER COMPANY: FORMER CONFORMED NAME: CABOT SAFETY HOLDINGS CORP DATE OF NAME CHANGE: 19950828 10-Q 1 form10q_3rdfy03.txt Microsoft Word 10.0.2627; SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 -------------------- FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2003 Commission file number 33-96190 AEARO CORPORATION (Exact name of registrant as specified in its charter) ------------------------ Delaware 13-3840450 (State or other jurisdiction of incorporation or (IRS Employer Identification No.)organization) 5457 West 79th Street 46268 Indianapolis, Indiana (Zip Code) (Address of principal executive offices) (317) 692-6666 (Registrant's telephone number, including area code) ------------------------ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No___ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes No X ------ ---- The number of shares of the registrant's common stock, par value $.01 per share, outstanding as of August 14, 2003 was 101,912.5. Aearo Corporation TABLE OF CONTENTS Form 10-Q for the Quarterly Period Ended June 30, 2003 PART I-FINANCIAL INFORMATION..................................................3 - ---------------------------- Item 1. Financial Statements...............................................3 - ------- -------------------- Condensed Consolidated Balance Sheets - Assets.....................3 ---------------------------------------------- Condensed Consolidated Balance Sheets - Liabilities and Stockholders Equity.............................................................4 -------------------------------------------------------------------- Condensed Consolidated Statements of Operations....................5 ----------------------------------------------- Condensed Consolidated Statements of Cash Flows....................6 ----------------------------------------------- Notes To Condensed Consolidated Financial Statements...............7 ---------------------------------------------------- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.............................................16 - ------- -------------------------------------------------------------------- Item 3. Quantitative and Qualitative Disclosures About Market Risk........25 - ------- ---------------------------------------------------------- Item 4. Controls and Procedures...........................................27 - ------- ----------------------- PART II - OTHER INFORMATION..................................................28 - --------------------------- Item 1. Legal Proceedings.................................................28 - ------- ----------------- Item 2. Changes in Securities and Use of Proceeds.........................29 - ------- ----------------------------------------- Item 3. Defaults Upon Senior Securities...................................29 - ------- ------------------------------- Item 4. Submission of Matters to a Vote of Security Holders...............29 - ------- --------------------------------------------------- Item 5. Other Information.................................................29 - ------- ----------------- Item 6. Exhibits and Reports on Form 8-K..................................29 - ------- -------------------------------- SIGNATURES....................................................................30 - ---------- EXHIBIT INDEX.................................................................31 - ------------- - 1 - Part I-Financial Information Item 1. Financial Statements AEARO CORPORATION Condensed Consolidated Balance Sheets - Assets (Dollars in Thousands) June 30, September 30, 2003 2002 ------------- ------------- (Unaudited) CURRENT ASSETS: Cash and cash equivalents $ 15,057 $ 14,480 Accounts receivable (net of allowance for doubtful accounts of $2,087 and $1,524, respectively) 48,038 46,478 Inventories 37,275 33,161 Deferred and prepaid expenses 3,941 3,449 ----------- ------------ Total current assets 104,311 97,568 ----------- ------------ LONG TERM ASSETS: Property, plant and equipment, net 49,144 48,096 Intangible assets, net 138,978 121,979 Other assets 3,259 2,526 ----------- ------------ Total assets $ 295,692 $ 270,169 =========== ============
The accompanying notes are an integral part of these condensed consolidated financial statements. - 2 - AEARO CORPORATION Condensed Consolidated Balance Sheets - Liabilities and Stockholders' Equity (Dollars in Thousands) June 30, September 30, 2003 2002 ------------- -------------- (Unaudited) CURRENT LIABILITIES: Current portion of long-term debt $ 16,266 $ 12,847 Accounts payable and accrued liabilities 42,981 36,410 Accrued interest 5,628 2,568 U.S. and foreign income taxes 4,213 1,156 ------------- -------------- Total current liabilities 69,088 52,981 ------------- -------------- Long-term debt 173,910 182,715 Deferred income taxes 912 800 Other liabilities 13,508 12,129 ------------- -------------- Total liabilities $ 257,418 $ 248,625 ------------- -------------- COMMITMENTS AND CONTINGENCIES: Preferred stock, $.01 par value- (Redemption value of $120,068 and $109,480, respectively) Authorized--200,000 shares Issued and outstanding--45,000 shares - - STOCKHOLDERS' EQUITY: Common stock, $.01 par value- Authorized--200,000 shares Issued and outstanding--101,913 shares 1 1 Additional paid-in capital 32,224 32,254 Retained earnings 16,942 6,825 Accumulated other comprehensive loss (10,893) (17,536) -------------- --------------- Total stockholders' equity 38,274 21,544 ------------- -------------- Total liabilities and stockholders' equity $ 295,692 $ 270,169 ============= ==============
The accompanying notes are an integral part of these condensed consolidated financial statements. - 3 - Aearo Corporation Condensed Consolidated Statements of Operations (DOLLARS IN THOUSANDS) (Unaudited) ------------------------------------ ------------------------------------ For the Three Months Ended For the Nine Months Ended June 30, June 30, ---------------- ---------------- ---------------- ----------------- 2003 2002 2003 2002 NET SALES $ 86,723 $ 76,435 $ 232,126 $ 208,761 COST OF SALES 45,767 40,024 121,324 110,312 --------------- --------------- --------------- --------------- Gross profit 40,956 36,411 110,802 98,449 SELLING AND ADMINISTRATIVE 26,219 24,914 75,407 68,602 RESEARCH AND TECHNICAL SERVICES 1,462 1,493 4,671 4,251 AMORTIZATION OF INTANGIBLES 62 1,570 194 4,686 OTHER CHARGES 735 330 1,692 368 --------------- --------------- --------------- --------------- Operating income 12,478 8,104 28,838 20,542 INTEREST EXPENSE, NET 4,728 4,972 14,671 15,018 --------------- --------------- --------------- --------------- Income before provision for income taxes 7,750 3,132 14,167 5,524 PROVISION FOR INCOME TAXES 1,367 850 4,051 1,936 --------------- --------------- --------------- --------------- Net Income $ 6,383 $ 2,282 $ 10,116 $ 3,588 =============== =============== =============== ===============
The accompanying notes are an integral part of these condensed consolidated financial statements. - 4 - Aearo Corporation Condensed Consolidated Statements of Cash Flows (DOLLARS IN THOUSANDS) (Unaudited) For the Nine Months Ended June 30, ------------- ------------- 2003 2002 ------------- ------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 10,116 $ 3,588 Adjustments to reconcile net income to cash provided by operating activities- Depreciation 8,175 7,976 Amortization of intangible assets and deferred financing costs 1,422 5,842 Deferred income taxes (14) -- Other, net 386 288 Changes in assets and liabilities-(net of effects of acquisitions) Accounts receivable 2,015 (2,226) Inventories (1,083) (1,385) Accounts payable and accrued liabilities 5,261 829 Income taxes payable 3,013 478 Other, net (1,233) (499) ------------- ------------- Net cash provided by operating activities 28,059 14,891 ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES: Additions to property, plant and equipment (7,525) (5,846) Cash paid for acquisitions, net of cash acquired (11,062) (7,342) Proceeds provided by disposals of property, plant and equipment 22 13 ------------- ------------- Net cash used by investing activities (18,565) (13,175) ------------- ------------- CASH FLOWS FROM FINANCING ACTIVITIES: Repayment of notes -- (2,000) Repayment of term loans (9,580) (6,097) Repayment of capital lease obligations (164) (100) Repayment of long-term debt (57) (102) Other (30) (147) ------------- ------------- Net cash used by financing activities (9,831) (8,446) ------------- ------------- EFFECT OF EXCHANGE RATE CHANGES ON CASH 914 (44) ------------- ------------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 577 (6,774) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 14,480 18,233 ------------- ------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 15,057 $ 11,459 ============= ============= NON-CASH INVESTING AND FINANCING ACTIVITIES: Capital lease obligations $ 430 $ 1,421 ============= ============= CASH PAID FOR: Interest $ 10,538 $ 10,952 ============= ============= Income taxes $ 1,332 $ 1,536 ============= =============
The accompanying notes are an integral part of these condensed consolidated financial statements. - 5 - Aearo Corporation Notes To Condensed Consolidated Financial Statements June 30, 2003 (Unaudited) 1) CONDENSED CONSOLIDATED FINANCIAL STATEMENTS In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments necessary to present fairly, in accordance with accounting principles generally accepted in the United States of America, the Company's financial position, results of operations and cash flows for the interim periods presented. The results of operations for the interim periods shown in this report are not necessarily indicative of results for any future interim period or for the entire year. These condensed consolidated financial statements do not include all disclosures associated with annual financial statements and accordingly should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K405. 2) COMPANY BACKGROUND Aearo Corporation, a Delaware corporation, and its direct wholly owned subsidiary, Aearo Company, a Delaware corporation (collectively referred to herein as the "Company") manufactures and sells products under the brand names: AOSafety(R), E-A-R(R), and Peltor(R). These products are sold through three reportable segments, which are Safety Products, Safety Prescription Eyewear and Specialty Composites. 3) SIGNIFICANT ACCOUNTING POLICIES Use of Estimates. The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Revenue Recognition. The Company recognizes revenue when title and risk transfer to the customer, which is generally when the product is shipped to customers. At the time revenue is recognized, certain provisions may also be recorded including pricing discounts and incentives. In addition, an allowance for doubtful accounts is generally recorded based on a percentage of aged receivables. However, management judgment is involved with the final determination of the allowance based on several factors including specific analysis of a customer's credit worthiness, historical bad debt experience, changes in payment history and general economic and market trends. Foreign Currency Translation. Assets and liabilities of the Company's foreign operations are translated at period-end exchange rates. Income and expenses are translated at the approximate average rate during the period. Foreign currency translation adjustments are recorded as a separate component of stockholders' equity. Foreign Currency Transactions. Foreign currency gains and losses arising from transactions by any of the Company's subsidiaries are reflected in net income. Income Taxes. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates. Goodwill and Other Intangibles. Effective October 1, 2002, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangibles". Under the provisions of SFAS No. 142, goodwill and intangible assets that have indefinite useful lives are no longer amortized but are tested at least annually for impairment. The Company performed its first annual impairment test as of January 1, 2003 and determined there was no impairment. Intangible assets that have finite useful lives will continue to be amortized over their useful lives. As a result of the non-amortization provisions of SFAS No. 142, the - 6 - Company will no longer record approximately $5.8 million of annual amortization relating to goodwill and indefinite lived intangibles. Intangible assets increased $17.0 million during the nine month period ending June 30, 2003. Goodwill increased $16.5 million, of which, $10.1 million related to acquisitions and $6.4 million related to foreign exchange. The allocation of purchase price for acquisitions to goodwill is preliminary. Other intangibles increased $0.5 million due to non-compete agreements related to acquisitions. The following presents amortization expense and proforma net income for the three and nine months ended June 30, 2003 and 2002 as if SFAS No. 142 had been adopted (Dollars in thousands): Three Months Ended Nine Months Ended June 30, June 30, ----------------------- ----------------------- 2003 2002 2003 2002 ----------- ---------- ----------- --------- Net income as reported $ 6,383 $ 2,282 $ 10,116 3,588 Goodwill amortization -- 792 -- 2,350 Trademark amortization -- 742 -- 2,224 ---------- ---------- ----------- --------- Net income $ 6,383 $ 3,816 $ 10,116 8,162 ========== ========== =========== =========
The trademark is deemed to have an indefinite useful life because it is expected to generate cash flow indefinitely. Asset Retirement Obligations. Effective October 1, 2002, the Company adopted SFAS No. 143, "Accounting for Asset Retirement Obligations". SFAS No. 143 requires the Company to record the fair value of liabilities associated with the retirement of long-lived assets in the period in which they are incurred. The adoption of SFAS No. 143 had no material impact on the Company's results of operations or financial position. Impairment or Disposal of Long-Lived Assets. Effective October 1, 2002, the Company adopted SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which supercedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of". SFAS No. 144 retains the fundamental provisions with respect to the recognition and measurement of long-lived asset impairment but does not apply to goodwill and other intangibles assets. The adoption of SFAS No. 144 had no material effect on the Company's results of operations or financial position. Extinguishment of Debt. Effective October 1, 2002, the Company adopted SFAS No. 145 "Rescission of Financial Accounting Standards Board ("FASB") Statement No. 4, 44, and 62, Amendment of FASB Statement No. 13, and Technical Corrections". This statement rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt", and an amendment of that Statement, SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements". This Statement also rescinds SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers". This Statement amends SFAS No. 13, "Accounting for Leases", to eliminate the inconsistency between the required accounting for sales-leaseback transactions and the required accounting for certain lease modifications that have economic effects similar to sale-leaseback transactions. The adoption of SFAS No. 145 had no effect on the Company's results of operations or financial position. Financial Instruments with Characteristics of both Liabilities and Equity. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity". SFAS No. 150 establishes standards for how an issuer classifies and measures three classes of freestanding financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability or an asset in some circumstances. SFAS No. 150 was effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company has not entered into any financial instruments within the scope of SFAS No. 150 since May 31, 2003 and does not hold any significant financial instruments within its scope. - 7 - Exit or Disposal Activities. Effective October 1, 2002, the Company adopted SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities". SFAS No. 146 requires that a liability for costs associated with exit or disposal activities be recognized and measured at fair value only when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS No. 146 did not have a material effect on the Company's results of operations or financial position. Stock-based Compensation. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB Statement No. 123". SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company currently accounts for stock-based compensation under the intrinsic method of Accounting Principles Board ("APB") Opinion No. 25. The following table illustrates the effect on net income as if the fair value based method had been applied to all outstanding and unvested awards: (Dollars in thousands) Three Months Ended Nine Months Ended June 30, June 30, ------------------------ ---------------------- 2003 2002 2003 2002 ---------- ---------- ---------- ---------- Net income as reported $ 6,383 $ 2,282 $ 10,116 3,588 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax (37) (47) (141) (111) ---------- ---------- ---------- ----------- Net income $ 6,346 $ 2,235 $ 9,975 3,477 ========== ========== ========== ===========
Disclosure Requirements for Guarantees. In November 2002, the FASB issued FASB Interpretation ("FIN") No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". FIN No. 45 expands upon the disclosure requirements to be made by a guarantor in its interim and annual financial statements regarding its obligations under certain guarantees that it has issued. Additionally, FIN No. 45 requires that the guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. Footnote disclosures are required in interim and year-end financial statements ending after December 15, 2002. Liability recognition and measurement provisions apply prospectively to guarantees issued or modified starting January 1, 2003. The adoption of FIN No. 45 had no effect on the Company's results of operations or financial position. Consolidation of Variable Interest Entities. In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities, an Amendment of ARB No. 51". FIN No. 46 addresses consolidation of business enterprises of certain variable interest entities, and is effective for variable interest entities created after January 31, 2003 and to variable interest entities in which an enterprise obtains an interest after that date. The adoption of FIN No. 46 had no effect on the Company's results of operations or financial position. Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" requires that every derivative instrument be recorded in the balance sheet as either an asset or a liability measured at its fair value. The Company has formally documented its hedging relationships, including identification of the hedging instruments and the hedge items, as well as its risk management objectives and strategies for undertaking each hedge transaction. From time to time the Company enters into forward foreign currency contracts and interest rate swap and collar agreements, which are derivatives as defined by SFAS No. 133. The Company enters into forward foreign currency contracts to mitigate the effects of changes in foreign currency rates on profitability and enters into interest rate swap and collar agreements to hedge its variable interest rate risk. - 8 - These derivatives are cash flow hedges. For all qualifying and highly effective cash flow hedges, the changes in the fair value of the derivatives are recorded in other comprehensive income. Amounts accumulated in other comprehensive income will be reclassified as earnings when the related product sales affect earnings for forward foreign currency contracts. As a result of the forward foreign currency contracts, the Company has recorded a derivative payable of $0.5 million at June 30, 2003. All forward foreign currency contracts will expire over the next three months. During the three and nine month periods ending June 30, 2003, the Company reclassified into earnings a net loss of approximately $1.0 million and $1.7 million, respectively, resulting from the exercise of forward foreign currency contracts. All forward foreign currency contracts were determined to be highly effective; therefore no ineffectiveness was recorded in earnings. The Company also executes forward foreign currency contracts for up to 30-day terms to protect against the adverse effects that exchange rate fluctuations may have on the foreign-currency-denominated trade activities (receivables, payables and cash) of foreign subsidiaries. These contracts have not been designated as hedges under SFAS No. 133 and accordingly, the gains and losses on both the derivative and foreign-currency-denominated trade activities are recorded as transaction adjustments in current earnings. The impact on earnings was a gain of approximately $0.2 million for the three and nine month period ended June 30, 2003. The Company also entered into an interest rate collar arrangement during October 2001 to protect $25.0 million of adjustable Term Loan debt (as defined below in Note 6). The fair value of the collar at June 30, 2003 was a liability of $0.1 million. The Company has not elected to take hedge accounting treatment for the interest rate collar as defined under SFAS No. 133 and, as a result, any fair value adjustment is charged directly to other income (expense). There was no material impact on earnings for the three and nine month periods ended June 30, 2003. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities". SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". SFAS is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The Company does not expect the adoption of SFAS No. 149 to have a material impact on its results of operations or financial position. 4) COMPREHENSIVE INCOME Comprehensive income consisted of the following (Dollars in thousands): For the Three Months Ended For the Nine Months June 30, Ended June 30, ----------- ---------- ----------- ----------- 2003 2002 2003 2002 ----------- ---------- ---------- ----------- Net income $ 6,383 $ 2,282 $ 10,116 $ 3,588 Foreign currency translation adjustment 2,996 4,622 7,181 5,320 Unrealized gain (loss) on derivative instruments 116 (752) (538) (616) ---------- ---------- --------- ----------- Comprehensive income $ 9,496 $ 6,152 $ 16,759 $ 8,292 ========== ========== ========= ===========
- 9 - Inventories consisted of the following (Dollars in thousands): June 30, September 30, 2003 2002 ------------ ------------- Raw materials $ 8,871 $ 7,514 Work in process 12,222 10,196 Finished goods 16,182 15,451 ------------ ------------- $ 37,275 $ 33,161 ============ =============
Inventories, which include materials, labor and manufacturing overhead, are stated at the lower of cost or market, cost being determined using the first-in, first-out method. 6) DEBT The Company's debt structure includes: (a) $98.0 million of senior subordinated notes ("Notes") due 2005, which are publicly held and are redeemable at the option of the Company, in whole or in part, at various redemption prices, and (b) up to an aggregate of $135.0 million under a credit agreement with various banks comprised of (i) a secured term loan facility consisting of loans providing for up to $100.0 million of term loans (collectively the "Term Loans") with a portion of the Term Loans denominated in foreign currencies, (ii) a secured revolving credit facility ("Revolving Credit Facility") providing for up to $30.0 million of revolving loans for general corporate purposes and (iii) a U.K. overdraft facility of up to an equivalent of $5.0 million in Great Britain Pounds for working capital requirements as needed (collectively the "Senior Bank Facilities"). The amounts outstanding on the Term Loans at June 30, 2003 were approximately $88.1 million. No amounts were outstanding under the Revolving Credit or U.K. overdraft facilities. Under the terms of both the Senior Bank Facilities and the Notes indenture, Aearo Company is required to comply with certain financial covenants and restrictions. Aearo Company was in compliance with all financial covenants and restrictions at June 30, 2003. During the first quarter of fiscal 2002, the Company's Board of Directors authorized management to repurchase, from time to time, a portion of the Company's 12.5% Notes, subject to market conditions and other factors. No assurances can be given as to whether or when or at what price such repurchases will occur. Subsequently, pursuant to a first amendment to the Senior Bank Facilities, the Company purchased and retired $2.0 million of the Notes during the first quarter of fiscal 2002. 7) COMMITMENTS AND CONTINGENCIES Lease Commitments. The Company leases certain transportation vehicles, warehouse facilities, office space, and machinery and equipment under cancelable and non-cancelable leases, most of which expire within 10 years and may be renewed by the Company. Contingencies Various lawsuits and claims arise against the Company in the ordinary course of its business. Most of these lawsuits and claims are products liability matters that arise out of the use of safety eyewear and respiratory product lines manufactured by the Company as well as products purchased for resale. In addition, the Company may be contingently liable with respect to numerous lawsuits involving respirators sold by its predecessors, American Optical Corporation and Cabot Corporation, arising out of agreements entered into when the AOSafety(R) Division was sold by American Optical Corporation to Cabot in April 1990 and when later sold by Cabot to the Company in 1995. These lawsuits typically involve plaintiffs alleging that they suffer from asbestosis or silicosis, and that such condition results in part from respirators that were negligently designed or manufactured. The defendants in these lawsuits are often numerous, and include, in - 10 - addition to respirator manufacturers, employers of the plaintiffs and manufacturers of sand (used in sand blasting) and asbestos. Responsibility for legal costs, as well as for settlements and judgments, is shared contractually by the Company, Cabot, American Optical Corporation and a prior owner of American Optical Corporation. Liability is allocated among the parties based on the number of years each Company owned the AOSafety Division and the alleged years of exposure of the individual plaintiff. The Company's share of the contingent liability is further limited by an agreement entered into between the Company and Cabot on July 11, 1995, as amended in 2002. This agreement provides that, so long as the Company pays to Cabot an annual fee of $400,000, Cabot will retain responsibility and liability for, and indemnify the Company against, asbestos and silica-related legal claims asserted after July 11, 1995 and alleged to have arisen out of the use of respirators while exposed to asbestos or silica prior to January 1, 1997. To date, the Company has elected to pay the annual fee. The Company could potentially be liable for these exposures if the Company elects to discontinue its participation in this arrangement, or if Cabot is no longer able to meet its obligations in these matters. With these arrangements in place, however, the Company's potential liability is limited to exposures alleged to have arisen from the use of respirators while exposed to asbestos or silica on or after January 1, 1997. The Company also may be responsible for certain claims relating to acquired companies other than the AOSafety(R) Division that are not covered by, and are unrelated to, the agreement with Cabot. At June 30, 2003, the Company has recorded liabilities of approximately $4.8 million, which represents reasonable estimates of its probable liabilities for product liabilities substantially related to asbestos and silica-related claims as determined by the Company in consultation with an independent consultant. This reserve is re-evaluated periodically and additional charges or credits to operations may result as additional information becomes available. Consistent with the current environment being experienced by companies involved in asbestos and silica-related litigation, there has been an increase in the number of asserted claims that could potentially involve the Company. Various factors increase the difficulty in determining the Company's potential liability, if any, in such claims, including the fact that the defendants in these lawsuits are often numerous and the claims generally do not specify the amount of damages sought. Additionally, the bankruptcy filings of other companies with asbestos and silica-related litigation could increase the Company's cost over time. In light of these and other uncertainties inherent in making long-term projections, the Company has determined that the five-year period through fiscal 2007 is the most reasonable time period for projecting asbestos and silica-related claims and defense costs. It is possible that the Company may incur liabilities in an amount in excess of amounts currently reserved. However, taking into account currently available information, historical experience, and the Cabot agreement, but recognizing the inherent uncertainties in the projection of any future events, it is management's opinion that these suits or claims should not result in final judgments or settlements in excess of the Company's reserve that, in the aggregate, would have a material effect on the Company's financial condition, liquidity or results of operations. 8) SEGMENT REPORTING The Company manufactures and sells products under the brand names: AOSafety(R), E-A-R(R), and Peltor(R). These products are sold through three reportable segments, which are Safety Products, Safety Prescription Eyewear and Specialty Composites. The Safety Products segment manufactures and sells hearing protection devices, non-prescription safety eyewear, face shields, reusable and disposable respirators, hard hats and first aid kits. The Safety Prescription Eyewear segment manufactures and sells prescription eyewear products that are designed to protect the eyes from the typical hazards encountered in the industrial work environment. The Company's Safety Prescription Eyewear segment purchases component parts (lenses and the majority of its frames) from various suppliers, grinds, shapes and applies coatings to the lenses in accordance with the customer's prescription, and then assembles the glasses using the customer's choice of frame. The Specialty Composites segment manufactures a wide array of energy-absorbing materials that are incorporated into other manufacturers' products to control noise, vibration and shock. - 11 - Net Sales by Business Segment (Dollars in thousands): For the Three Months Ended For the Nine Months Ended June 30, June 30, ----------------------------- ---------------------------- 2003 2002 2003 2002 ------------- ------------ ------------ ----------- Safety Products $ 68,269 $ 55,034 $ 176,953 $ 150,417 Safety Prescription Eyewear 10,165 11,118 30,463 30,662 Specialty Composites 8,289 10,283 24,710 27,682 ------------- ------------ ------------ ----------- Total $ 86,723 $ 76,435 $ 232,126 $ 208,761 ============= ============ ============ ===========
Inter-segment sales of the Specialty Composites segment to the Safety Products segment totaled $0.7 million and $1.3 million for the three months ended June 30, 2003 and 2002, respectively. Inter-segment sales totaled $2.3 million and $2.6 million for the nine months ended June 30, 2003 and 2002, respectively. The inter-segment sales value is determined at fully absorbed inventory cost at standard rates plus 25%. Profit by Business Segment and reconciliation to income before provision for income taxes (Dollars in thousands): For the Three Months Ended For the Nine Months Ended June 30, June 30, -------------------------- --------------------------- 2003 2002 2003 2002 ----------- ----------- ----------- ------------ Safety Products $ 14,472 $ 10,590 $ 35,677 $ 29,268 Safety Prescription Eyewear 249 484 612 1,484 Specialty Composites 631 1,468 918 2,452 ----------- ----------- ----------- ------------ Segment profit 15,352 12,542 37,207 33,204 Depreciation 2,812 2,868 8,175 7,976 Amortization of intangibles 62 1,570 194 4,686 Interest 4,728 4,972 14,671 15,018 ----------- ----------- ----------- ------------ Income before provision for income taxes $ 7,750 $ 3,132 $ 14,167 $ 5,524 =========== =========== =========== ============
Segment profit is defined as operating income before depreciation, amortization, interest expense and income taxes and represents the measure used by the chief operating decision maker to assess segment performance and make decisions about the allocation of resources to business segments. 9) RESTRUCTURING CHARGE During fiscal 2001, the Company recorded a restructuring charge of $11.4 million relating to a plan announced by the Company to improve its competitive position and long-term profitability. The plan includes the closure of its Ettlingen, Germany plant, significantly reorganizing operations at the Company's Varnamo, Sweden plant, rationalizing the manufacturing assets and product mix of its Specialty Composites business unit and a reduction of products and product lines. The restructuring charge included cash charges of $2.3 million, which includes $1.8 million for severance and other separation costs to cover the reduction of 5% of the Company's work force and $0.5 million for other costs associated with this plan. The restructuring charge also included non-cash charges of $9.1 million, which includes $3.2 million for non-cancelable long-term lease obligations, $2.9 million for asset impairments, $2.4 million for inventory disposals and $0.6 million related to the sale of the Company's Ettlingen, Germany location, which is currently being marketed for sale. - 12 - During 2002, the Company reversed $0.6 million of reserves related to the September 30, 2001 restructuring provision. The adjustment represents a change in estimate of the plan for the disposal of certain items of inventory and the closure of its Ettlingen, Germany plant. The portion related to inventory of $0.5 million was classified as a reduction in cost of sales with the remaining $0.1 million classified as operating expenses. The following table displays the activity and balances of the restructuring reserve account for the nine months ended June 30, 2003 (Dollars in thousands): September 30, June 30, 2002 Charges 2003 ------------ ----------- ------------ Employee termination costs $ 730 $ (376) $ 354 Lease agreements 2,352 (672) 1,680 Loss on disposal of assets 700 700 Other 47 (45) 2 ------------ ----------- ------------ Total $ 3,829 $ (777) $ 2,736 ============ =========== ============
The Company expects the restructuring payments to be completed by the third quarter of fiscal 2005. 10). ACQUISITIONS On October 7, 2002, the Company acquired Industrial Protection Products, Inc. ("IPP") of Wilmington, Massachusetts for approximately $1.2 million. The transaction was accounted for using the purchase method of accounting in accordance with SFAS No. 141, "Business Combinations", and accordingly, the operating results of IPP have been included with those of the Company subsequent to October 7, 2002. If the acquisition had occurred at the beginning of fiscal 2002, the pro forma consolidated results would not be materially different from actual results for the nine months ended June 30, 2002. On March 14, 2003 the Company acquired VH Industries, Inc. ("VH") of Concord, North Carolina for approximately $11.5 million. VH Industries is a manufacturer of fall protection products sold under the SafeWaze trade name in the United States. The transaction was accounted for using the purchase method of accounting in accordance with SFAS No. 141, "Business Combinations", and accordingly, the operating results of VH have been included with those of the Company subsequent to March 14, 2003. The following unaudited pro forma information presents results as if the acquisition had occurred at the beginning of the respective periods (Dollars in thousands): Three Months Ended Nine Months Ended June 30, June 30, --------------------------- -------------------------- 2003 2002 2003 2002 ------------ ----------- ------------ ----------- Net sales as reported $ 86,723 $ 76,435 $ 232,126 208,761 Pro forma sales 86,723 79,427 236,616 216,527 Net income as reported $ 6,383 $ 2,282 $ 10,116 $ 3,588 Pro forma net income 6,383 2,847 10,804 4,749
11) SUBSEQUENT EVENTS On June 27, 2003, the Company signed an agreement with Cabot Corporation, subject to, among other things, the approval of the Company's bank lenders and receipt of financing, to redeem all of the common and preferred shares, including accrued dividends, held by Cabot for approximately $33.5 million. The Company - 13 - expects to finance the redemption with a combination of cash and additional borrowings. This transaction is expected to close during the 4th quarter. - 14 - Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the Consolidated Financial Statements of the Company, including notes thereto. This Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company's actual results could differ materially from those set forth in such forward-looking statements. The factors that might cause such a difference include, among others, the following: risks associated with indebtedness; risks related to acquisitions; risks associated with the conversion to a new management information system; high level of competition in the Company's markets; importance and costs of product innovation; risks associated with international operations; product liability exposure; unpredictability of patent protection and other intellectual property issues; dependence on key personnel; the risk of adverse effect of economic and regulatory conditions on sales; and risks associated with environmental matters. Critical Accounting Policies The Company's discussion and analysis of its financial condition and results of operations are based upon the Company's condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). GAAP requires the use of estimates, judgments, assumptions and subjective interpretations of accounting principles that affect the reported amounts of assets, liabilities, revenues and expenses. The Company believes its use of estimates and underlying accounting assumptions adhere to GAAP and are consistently applied. The Company revises its estimates and assumptions as new information becomes available. The Company believes that of its significant accounting policies (see Notes to the Consolidated Financial Statements in the Company's Annual Report on Form 10-K405) the following policies involve a higher degree of judgment and/or complexity. Income Taxes - The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes", which requires deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between book and tax bases of recorded assets and liabilities. SFAS No. 109 also requires deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. Recognition of a deferred tax asset is dependent on generating sufficient future taxable income in the United States prior to the expiration of the tax loss and credit carryforwards, which expire over various periods ranging from 2010 to 2021. In its evaluation of the adequacy of the valuation allowance, the Company assesses prudent and feasible tax planning strategies. Due to the uncertainties of realizing these tax benefits, the Company has recorded a full valuation allowance against these losses and credit carryforwards. The ultimate amount of deferred tax assets realized could be different from those recorded, as influenced by potential changes in enacted tax laws and the availability of future taxable income. Product Liabilities -The Company has established reserves for potential product liabilities that arise out of the use of the Company's products. A significant amount of judgment is required to quantify the Company's ultimate exposure in these matters and the valuation of reserves is estimated based on currently available information, historical experience and from time to time the Company may seek the assistance of an independent consultant. While the Company believes that the current level of reserves is adequate, changes in the future could impact these determinations. Restructuring - The Company recorded a restructuring charge in fiscal 2001 based on a plan to improve its competitive position and long-term profitability. The provision recorded was based on estimates of the expected costs associated with site closures, consolidation of products and product lines, disposal of assets, contract terminations or other costs directly related to the restructuring. To the extent that actual costs may - 15 - differ from amounts recorded, revisions to the estimated reserves would be required. A reduction of $0.6 million was made during fiscal 2002 to account for new information made available during that year. Pension Plan - The valuation of the Company's pension plan requires the use of assumptions and estimates that are used to develop actuarial valuations of expenses and assets/liabilities. These assumptions include discount rates, investment returns, projected salary increases and mortality rates. The actuarial assumptions used in the Company's pension reporting are reviewed annually and compared with external benchmarks to assure that they accurately account for future pension obligations. Changes in assumptions and future investment returns could potentially have a material impact on the Company's pension expense and funding requirements. Impairment of Long-Lived Assets - The Company evaluates long-lived assets, including other intangibles and related goodwill, of identifiable business activities for impairment when events or changes in circumstances indicate, in management's judgment, that the carrying value of such assets may not be recoverable. Cash flows used in the potential impairment evaluation are based on management's estimates and assumptions. Changes in business conditions could potentially require future adjustments to asset valuations. Revenue Recognition - The Company recognizes revenue when title and risk transfer to the customer, which is generally when the product is shipped to customers. At the time revenue is recognized, certain provisions may also be recorded including pricing discounts and incentives. In addition, an allowance for doubtful accounts is generally recorded based on a percentage of aged receivables. However, management judgment is involved with the final determination of the allowance based on several factors including specific analysis of a customer's credit worthiness, historical bad debt experience, changes in payment history and general economic and market trends. - 16 - Results of Operations -- Three Months Ended June 30, 2003 Compared to Three Months Ended June 30, 2002 Results of Operations (Dollars in Thousands) (Unaudited) Three Months Ended June 30, ----------------------------------------------------------------- 2003 % 2002 % -------------- -------------- -------------- ------------- Net Sales Safety Products $ 68,269 78.7 $ 55,034 72.0 Safety Prescription Eyewear 10,165 11.7 11,118 14.5 Specialty Composites 8,289 9.6 10,283 13.5 ----------- ----------- ----------- ----------- Total net sales 86,723 100.0 76,435 100.0 Cost of Sales 45,767 52.8 40,024 52.4 Gross profit 40,956 47.2 36,411 47.6 Operating Expenses- Selling and administrative 26,219 30.2 24,914 32.6 Research and technical services 1,462 1.7 1,493 2.0 Amortization of intangibles 62 -- 1,570 2.1 Other charges, net 735 0.9 330 -- ----------- ----------- ----------- ----------- Total operating expenses 28,478 32.8 28,307 37.0 Operating income 12,478 14.4 8,104 10.6 Interest expense, net 4,728 5.5 4,972 6.5 ----------- ----------- ----------- ----------- Income before provision for income taxes 7,750 8.9 3,132 4.1 Provision for income taxes 1,367 1.5 850 1.1 ----------- ----------- --- --- Net income $ 6,383 7.4 $ 2,282 3.0 =========== =========== =========== ===========
Net Sales. Net sales in the three months ended June 30, 2003 increased 13.5% to $86.7 million from $76.4 million in the three months ended June 30, 2002. The increase in net sales was primarily driven by the impact of foreign exchange, acquisitions and organic growth in the Safety Products segment was partially offset by declines in the Safety Prescription Eyewear and Specialty Composites segments. The weakness of the U.S. dollar relative to other currencies, and acquisitions, favorably impacted net sales by $4.9 million and $3.4 million, respectively. The Safety Products segment net sales in the three months ended June 30, 2003 increased 24.0% to $68.3 million from $55.0 million in the three months ended June 30, 2002. The increase in net sales resulted from a 10.1% increase due to organic growth, an 8.8% increase due to foreign exchange and a 5.2% increase due to acquisitions. The increase in organic growth is primarily due to product innovations. The Safety Prescription Eyewear segment sales for the three months ended June 30, 2003 decreased 8.6% to $10.2 million from $11.1 million in the three months ended June 30, 2002. The decrease in volume was partially offset by a 5.0% increase due to acquisitions. The Safety Prescription Eyewear segment sales have been negatively impacted by the continued reduction in manufacturing employment in North America. The Specialty Composites segment sales in the three months ended June 30, 2003 decreased 19.4% to $8.3 million from $10.3 million in the three months ended June 30, 2002. The decrease was - 17 - primarily driven by volume declines in the truck market and the electronics segment of the precision equipment market, which includes computers and personal communications system ("PCS") applications. Gross Profit. Gross Profit in the three months ended June 30, 2003 increased 12.5% to $41.0 million from $36.4 million in the three months ended June 30, 2002. The increase in gross profit is primarily due to productivity improvements, the impact of foreign exchange and acquisitions. Gross Profit as a percentage of net sales in the three months ended June 30, 2003 was 47.2% as compared to 47.6% in the three months ended June 30, 2002. The change in the gross profit percentage is primarily due to product mix. Operating Expenses. Operating expenses in the three months ended June 30, 2003 increased 0.6% to $28.5 million from $28.3 million in the three months ended June 30, 2002. The increase was primarily driven by an increase in selling and administrative expenses and other charges, net partially offset by a decrease in amortization expense. Selling and administrative expenses in the three months ended June 30, 2003 included approximately $0.8 million of incremental expenses due to acquisitions and $1.0 million due to the weakness of the U.S dollar. The increase in other charges, net was primarily driven by foreign exchange losses. Amortization expense decreased approximately $1.5 million due to the adoption of SFAS No. 142. SFAS No. 142 requires the Company to no longer amortize goodwill and other intangibles with indefinite useful lives. Had the provisions of SFAS No. 142 been adopted in the three months ended June 30, 2002, amortization expense would have been reduced by approximately $1.5 million. Selling and administrative expenses as a percentage of net sales decreased to 30.2% in the three months ended June 30, 2003 as compared to 32.6% in the three months ended June 30, 2002. Operating Income. Primarily as a result of the factors mentioned above, operating income increased 54.0% to $12.5 million in the three months ended June 30, 2003 from $8.1 million in the three months ended June 30, 2002. Operating income as a percentage of net sales in the three months ended June 30, 2003 increased to 14.4% as compared to 10.6% in the three months ended June 30, 2002. Interest Expense, Net. Interest expense, net in the three months ended June 30, 2003 decreased 4.9% to $4.7 million from $5.0 million in the three months ended June 30, 2002. Provision For Income Taxes. The provision for income taxes in the three months ended June 30, 2003 was $1.4 million as compared to $0.9 million in the three months ended June 30, 2002. The effective tax rates in the three months ended June 30, 2003 and 2002 was different from the statutory rate due to the mix of income between the Company's foreign subsidiaries and domestic subsidiaries. The Company's foreign subsidiaries had taxable income in their foreign jurisdictions while the Company's domestic subsidiaries generated net operating losses. The domestic subsidiaries have net operating loss carry-forwards for income tax purposes. Due to the uncertainty of realizing these tax benefits, the tax benefits generated by the net operating losses have been fully offset by a valuation allowance. Net Income. For the three months ended June 30, 2003 the Company had net income of $6.4 million as compared to $2.3 million for the three months ended June 30, 2002. - 18 - Results of Operations -- Nine Months Ended June 30, 2003 Compared to Nine Months Ended June 30, 2002 Results of Operations (Dollars in Thousands) (Unaudited) Nine Months Ended June 30, ------------------------------------------------------------------- 2003 % 2002 % ----------- ------------ ------------ ------------ Net Sales Safety Products $ 176,953 76.2 $ 150,417 72.1 Safety Prescription Eyewear 30,463 13.1 30,662 14.7 Specialty Composites 24,710 10.7 27,682 13.2 ----------- ----------- ----------- ----------- Total net sales 232,126 100.0 208,761 100.0 Cost of Sales 121,324 52.3 110,312 52.8 Gross profit 110,802 47.7 98,449 47.2 Operating Expenses- Selling and administrative 75,407 32.5 68,602 32.9 Research and technical services 4,671 2.0 4,251 2.0 Amortization of intangibles 194 0.1 4,686 2.2 Other charges, net 1,692 0.7 368 0.2 ----------- ----------- ----------- ----------- Total operating expenses 81,964 35.3 77,907 37.3 Operating income 28,838 12.4 20,542 9.8 Interest expense, net 14,671 6.3 15,018 7.2 ----------- ----------- ----------- ------------ Income before provision for income taxes 14,167 6.1 5,524 2.6 Provision for income taxes 4,051 1.7 1,936 0.9 ----------- ----------- ----- --- Net income 10,116 4.4 3,588 1.7 =========== =========== =========== ============
Net Sales. Net sales in the nine months ended June 30, 2003 increased 11.2% to $232.1 million from $208.8 million in the nine months ended June 30, 2002. The increase in sales was primarily driven by the impact of foreign exchange, organic growth in the Safety Products segment and acquisitions partially offset by volume declines in the Specialty Composites and Safety Prescription Eyewear segments. The weakness of the U.S. dollar relative to other currencies, and acquisitions, favorably impacted net sales by $10.9 million and $8.2 million, respectively. The Safety Products segment net sales in the nine months ended June 30, 2003 increased 17.6% to $177.0 million from $150.4 million in the nine months ended June 30, 2002. The increase in net sales resulted from a 6.9% increase due to organic growth, a 7.1% increase due to foreign exchange and a 3.6% increase due to acquisitions. The Safety Prescription Eyewear segment sales for the nine months ended June 30, 2003 decreased 0.6% to $30.5 million from $30.7 million in the nine months ended June 30, 2002. The decrease in net sales resulted from a 10.1% reduction in volume partially offset by a 9.0% increase from acquisitions and a 0.5 % increase due to foreign exchange. The reduction in volume experienced by the Safety Prescription Eyewear segment is a result of the continued decline in industrial manufacturing employment in North America. The Specialty Composites segment net sales in the nine months ended June 30, 2003 decreased 10.7% to $24.7 million from $27.7 million in the nine months ended June 30, 2002. The - 19 - decrease was primarily driven by volume declines in the automotive market, the truck market and the electronics segment of the precision equipment market, which includes computers and personal communications system ("PCS") applications. Gross Profit. Gross profit in the nine months ended June 30, 2003 increased 12.5% to $110.8 million from $98.4 million in the nine months ended June 30, 2002. The increase in gross profit is primarily due to the impact of foreign exchange, productivity improvements and acquisitions. Gross profit as a percentage of net sales in the nine months ended June 30, 2003 improved to 47.7% as compared to 47.2% in the nine months ended June 30, 2002. The increase in the gross profit as a percentage of net sales is primarily due to product mix, foreign exchange, and productivity improvements. Operating Expenses. Operating expenses in the nine months ended June 30, 2003 increased 5.2% to $82.0 million from $77.9 million in the nine months ended June 30, 2002. The increase in operating expenses was primarily driven by an increase in selling and administrative expenses, research and technical services and other charges, net partially offset by a decrease in amortization expense. Selling and administrative expenses included approximately $2.5 million of incremental expenses due to acquisitions, $2.5 million due to the weakness of the U.S dollar as well as increased spending for product launches and marketing support. Research and technical services expense increased $0.4 million related to new product development. The increase in other charges, net was primarily due to foreign exchange losses. Amortization expense decreased approximately $4.5 million due the adoption of SFAS No. 142. SFAS No. 142 requires the Company to no longer amortize goodwill and other intangibles with indefinite useful lives. Amortization expense would have been reduced by approximately $4.5 million had the provisions of SFAS No. 142 been adopted in the nine months ended June 30, 2002. Selling and administrative expenses as a percentage of net sales decreased to 32.5% in the nine months ended June 30, 2003 as compared to 32.9% in the nine months ended June 30, 2002. Operating Income. Primarily as a result of the factors mentioned above, operating income increased 40.4% to $28.8 million in the nine months ended June 30, 2003 from $20.5 million in the nine months ended June 30, 2002. Operating income as a percentage of net sales in the nine months ended June 30, 2003 increased to 12.4% as compared to 9.8% in the nine months ended June 30, 2002. Interest Expense, Net. Interest expense, net in the nine months ended June 30, 2003 decreased 2.3% to $14.7 million from $15.0 million in the nine months ended June 30, 2002. The decrease is attributed to lower weighted average borrowings and interest rates in effect for the nine months ended June 30, 2003 as compared to the nine months ended June 30, 2002. Provision For Income Taxes. The provision for income taxes increased to $4.1 million in the nine months ended June 30, 2003 from $1.9 million in the nine months ended June 30, 2002. The effective tax rates in the nine months ended June 30, 2003 and 2002 was different from the statutory rate due to the mix of income between the Company's foreign subsidiaries and domestic subsidiaries. The Company's foreign subsidiaries had taxable income in their foreign jurisdictions while the Company's domestic subsidiaries generated net operating losses. The domestic subsidiaries have net operating loss carry-forwards for income tax purposes. Due to the uncertainty of realizing these tax benefits, the tax benefits generated by the net operating losses have been fully offset by a valuation allowance. Net Income. For the nine months ended June 30, 2003 the Company had net income of $10.1 million as compared to $3.6 million for the nine months ended June 30, 2002. Effects of Changes in Exchange Rates In general, the Company's results of operations are affected by changes in exchange rates. Subject to market conditions, the Company prices its products in Europe and Canada in local currencies. While many of the - 20 - Company's selling and distribution costs are also denominated in these currencies, a large portion of product costs are U.S. Dollar denominated. As a result, a decline in the value of the U.S. Dollar relative to other currencies can have a favorable impact on the profitability of the Company and an increase in the value of the U.S. Dollar relative to these other currencies can have a negative effect on the profitability of the Company. Since the acquisition of Peltor, the Company's operations are also affected by changes in exchange rates relative to the Swedish Krona. In contrast to the above, a decline in the value of the Krona relative to other currencies can have a favorable impact on the profitability of the Company and an increase in the value of the Krona relative to other currencies can have a negative impact on the profitability of the Company. The Company utilizes forward foreign currency contracts and other hedging instruments to mitigate the effects of changes in foreign currency rates on profitability. Effects of Inflation In recent years, inflation has been modest and has not had a material impact upon the results of the Company's operations. Effects of Economic Conditions Softening of the North American economy began during the first fiscal quarter of 2001. Since that time the overall economic downturn has resulted in declines in manufacturing employment and overall consumer confidence. These reductions have had a significant impact on the revenues of the Safety Prescription Eyewear and Specialty Composites segments. The Safety Products segment, which has experienced revenue growth in the first nine months of fiscal 2003, has been able to offset these declines through continued product innovations. There can be no assurances, given the current economic conditions, that the Safety Products segment will maintain these trends for the remainder of this fiscal year and beyond. Liquidity and Capital Resources The Company's sources of funds have consisted primarily of operating cash flow and debt financing. The Company's uses of those funds consist principally of debt service, capital expenditures and acquisitions. The Company's debt structure includes: (a) $98.0 million of Senior Subordinated Notes ("Notes") due 2005, which are publicly held and are redeemable at the option of the Company, in whole or in part, at various redemption prices, and (b) up to an aggregate of $135.0 million under a credit agreement with various banks comprised of (i) a secured term loan facility consisting of loans providing for up to $100.0 million of term loans (collectively the "Term Loans") with a portion of the Term Loans denominated in foreign currencies, (ii) a secured revolving credit facility ("Revolving Credit Facility") providing for up to $30.0 million of revolving loans for general corporate purposes and, (iii) a U.K. overdraft facility of up to an equivalent of $5.0 million in Great Britain Pounds for working capital requirements as needed (collectively the "Senior Bank Facilities"). The amounts outstanding on the Term Loans at June 30, 2003 were approximately $88.1 million. No amounts were outstanding under the Revolving Credit or U.K. overdraft facilities. Under the terms of both the Senior Bank Facilities and the Notes indenture, Aearo Company is required to comply with certain financial covenants and restrictions. Aearo Company was in compliance with all financial covenants and restrictions at June 30, 2003. During the first quarter of fiscal 2002, the Company's Board of Directors authorized management to repurchase from time to time, a portion of the Company's Notes, subject to market conditions and other factors. No assurances can be given as to whether or when or at what price such purchases will occur. Subsequently, pursuant to a first amendment to the Senior Bank Facilities, the Company purchased and retired $2.0 million of the Notes during the first quarter of fiscal 2002. - 21 - Maturities under the Company's Term Loans are: approximately $3.2 million for the remainder of fiscal 2003, $17.3 million in fiscal 2004, and $67.6 million thereafter. The Company is required to make interest payments with respect to both the Senior Bank Facilities and the Notes. The Company's Revolving Credit Facility and Term Loans mature in March 2005. The Company's net cash provided by operating activities for the nine months ended June 30, 2003 totaled $28.1 million as compared to $14.9 million for the nine months ended June 30, 2002. The increase of $13.2 million was primarily due to a $10.8 million improvement in the Company's net changes in assets and liabilities and an increase of $2.4 million in net income adjusted for non-cash charges (depreciation, amortization, deferred taxes and other). The Company's net changes in assets and liabilities were primarily driven by an increase in cash from receivables, accounts payable, accrued liabilities, income taxes payable and inventory partially offset by a reduction of other, net. Net cash used by investing activities was $18.6 million for the nine months ended June 30, 2003 as compared to $13.2 million for the nine months ended June 30, 2002. The increase of $5.4 million in net cash used by investing activities is primarily attributed to an increase in acquisitions of $3.8 million and an increase in capital expenditures of $1.6 million. Net cash used by financing activities for the nine months ended June 30, 2003 was $9.8 million compared with net cash used by financing activities for the nine months ended June 30, 2002 of $8.4 million. The change of $1.4 million is primarily due to an increase in the repayment of Term Loans partially offset by no repayment for the Notes in the nine months ended June 30, 2003 as compared to the nine months ended June 30, 2002. On June 27, 2003, the Company signed an agreement with Cabot Corporation, subject to, among other things, the approval of the Company's bank lenders and receipt of financing, to redeem all of the common and preferred shares, including accrued dividends, held by Cabot for approximately $33.5 million. The Company expects to finance the redemption with a combination of cash and additional borrowings. This transaction is expected to close during the 4th quarter. The Company maintains a non-contributory defined benefit cash balance pension plan. The Company utilizes an outside actuarial firm to estimate pension expense and funding based on various assumptions including the discount rate and the expected long-term rate of return on plan assets. In developing the expected long-term rate of return assumption, the Company's management evaluates input from outside investment advisors and actuaries as of the measurement date. Beginning in fiscal year 2000, the actual assets returns for the Company's pension plan have been adversely affected by the continued deterioration in the equity markets. During that time, the asset returns on the Company's pension plan have been negative. Although short-term trends have been negative, the Company believes that an 8.5% long-term rate of return on plan assets is reasonable based on historical trends over a 20-30 year period. The estimated effect of a 1% change in the expected long-term rate of return on plan assets results in a $0.1 million impact on pension expense. The discount rate has also declined from 7.75% to 6.75% during the same period. The Company bases the discount rate on the Aa Corporate bond yields. The estimated impact of a 1% change in the discount rate results in a $0.2 million impact on pension expense. The negative asset returns and declining discount rates are expected to unfavorably impact the Company's pension expense and the funded status of the pension plan. Under minimum funding rules, no additional pension contributions are required to be made in fiscal 2003. However, contributions may increase in future years. Due to the uncertainty of the future returns of the equity and corporate bond markets, it is difficult to estimate the impact of pension contributions in the future. The Company has a substantial amount of indebtedness. The Company relies on internally generated funds, and to the extent necessary, on borrowings under the Revolving Credit Facility (subject to certain customary - 22 - drawing conditions) to meet its liquidity needs. The Company anticipates that operating cash flow will be adequate to meet its operating and capital expenditure requirements for the next several years, although there can be no assurances that existing levels of sales and normalized profitability, and therefore cash flow, will be maintained. In particular, since fiscal 2001, the Company has been affected by the significant slowdown in the manufacturing sector of the economies in which the Company markets its products and the related reductions in manufacturing employment, exacerbated by the impact of the terrorist events of September 11, 2001. The Company expects to arrange for new financing of both the Senior Bank Facilities and the Notes before the maturity of the Senior Bank Facilities in June 2005. There can be no assurances that any additional financing or other sources of capital will be available to the Company at acceptable terms, or at all. The inability to obtain additional financing would have a material adverse effect on the Company's business, financial condition and results of operations. - 23 - Item 3. Quantitative and Qualitative Disclosures About Market Risk The Company is exposed to market risks related to changes in foreign currencies, interest rates and commodity pricing. The Company uses derivatives to mitigate the impact of changes in foreign currencies and interest rates. All derivatives are for purposes other than trading. The Company adopted the provisions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" on October 1, 2000. The Company has formally documented its hedging relationships, including identification of hedging instruments and the hedge items, as well as its risk management objectives. Foreign Currency Risk The Company's results of operations are subject to risks associated with operating in foreign countries, including fluctuations in currency exchange rates. While many of the Company's selling and distribution costs are denominated in Canadian and European currencies, a large portion of product costs are U.S. Dollar denominated. As a result, a decline in the value of the U.S. Dollar relative to other currencies can have a favorable impact on the profitability of the Company and an increase in the value of the U.S. Dollar relative to these other currencies can have a negative effect on the profitability of the Company. Since the acquisition of Peltor, the Company's operations are also affected by changes in exchange rates relative to the Swedish Krona. In contrast with the above, a decline in the value of the Krona relative to other currencies can have a favorable impact on the profitability of the Company and an increase in the value of the Krona relative to other currencies can have a negative impact on the profitability of the Company. The Company executes two hedging programs, one for transaction exposures, and the other for cash flow exposures in European operations. The Company has utilized forward foreign currency contracts for transaction and cash flow exposures. During the nine months ended June 30, 2003, cash flow hedge losses were $1.7 million and gains on transaction exposures were $0.2 million. In addition, the Company limits foreign exchange impacts on the balance sheet with foreign denominated debt in Great Britain Pound Sterling, Euros and Canadian dollars. The Company adopted SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities" on October 1, 2000. SFAS No. 133 requires that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value. As a result of forward foreign currency contracts, the Company has recorded a derivative payable of $0.5 million as of June 30, 2003. The forward foreign currency contracts will expire over the next three months. Interest Rates The Company is exposed to market risk changes in interest rates through its debt. The Company utilizes interest rate instruments to reduce the impact of either increases or decreases in interest rates on its floating rate debt. As a result of the current economic slowdown and corresponding interest rate reductions, the Company entered into an interest rate collar arrangement in October 2001 to protect $25.0 million of the outstanding variable rate term loan debt from future interest rate volatility. The collar floor is set at 2% LIBOR (London Interbank Offering Rate) and cap at 6.25% LIBOR. The collar was not designated as a hedge under SFAS No. 133 and accordingly, the fair value of gains or losses was charged to earnings. The Company is of the opinion that it is well positioned to manage interest exposures in the short term. The Company continues to monitor interest rate movements and has mitigated the risks of potential interest rate fluctuations through the use of the aforementioned interest rate instruments. - 24 - Commodity Risk The Company is subject to market risks with respect to industry pricing in paper and crude oil as it relates to various commodity items. The Company is also exposed to market risks for electricity, fuel oil and natural gas consumed in its operations. Items with potential impact are paperboard, packaging films, nylons, resins, propylene, ethylene, plasticizer and freight. The Company manages pricing exposures on larger volume commodities such as polycarbonate, polyols and polyvinyl chloride via price negotiations utilizing alternative supplier competitive pricing. The Company sources some products and parts from Far East sources where resource availability, competition, and infrastructure stability has provided a favorable purchasing environment. The Company does not enter into derivative instruments to manage commodity risk. - 25 - Item 4. Controls and Procedures Disclosure controls and procedures are defined by the Securities and Exchange Commission as those controls and other procedures that are designed to ensure that information required to be disclosed in the Company's filings under the Securities Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. The Company's Chief Executive Officer and Chief Financial Officer have evaluated the Company's disclosure controls and procedures as of June 30, 2003 and have determined that such disclosure controls and procedures are effective. Changes in Controls and Procedures During the quarter ended June 30, 2003, there was no change in the Company's internal controls over financial reporting that has materially affected, or is reasonably likely to materially, affect the Company's internal control over financial reporting. - 26 - Part II - Other Information Item 1. Legal Proceedings Contingencies Various lawsuits and claims arise against the Company in the ordinary course of its business. Most of these lawsuits and claims are products liability matters that arise out of the use of safety eyewear and respiratory product lines manufactured by the Company as well as products purchased for resale. In addition, the Company may be contingently liable with respect to numerous lawsuits involving respirators sold by its predecessors, American Optical Corporation and Cabot Corporation, arising out of agreements entered into when the AOSafety(R) Division was sold by American Optical Corporation to Cabot in April 1990 and when later sold by Cabot to the Company in 1995. These lawsuits typically involve plaintiffs alleging that they suffer from asbestosis or silicosis, and that such condition results in part from respirators that were negligently designed or manufactured. The defendants in these lawsuits are often numerous, and include, in addition to respirator manufacturers, employers of the plaintiffs and manufacturers of sand (used in sand blasting) and asbestos. Responsibility for legal costs, as well as for settlements and judgments, is shared contractually by the Company, Cabot, American Optical Corporation and a prior owner of American Optical Corporation. Liability is allocated among the parties based on the number of years each Company owned the AOSafety Division and the alleged years of exposure of the individual plaintiff. The Company's share of the contingent liability is further limited by an agreement entered into between the Company and Cabot on July 11, 1995, as amended in 2002. This agreement provides that, so long as the Company pays to Cabot an annual fee of $400,000, Cabot will retain responsibility and liability for, and indemnify the Company against, asbestos and silica-related legal claims asserted after July 11, 1995 and alleged to have arisen out of the use of respirators while exposed to asbestos or silica prior to January 1, 1997. To date, the Company has elected to pay the annual fee. The Company could potentially be liable for these exposures if the Company elects to discontinue its participation in this arrangement, or if Cabot is no longer able to meet its obligations in these matters. With these arrangements in place, however, the Company's potential liability is limited to exposures alleged to have arisen from the use of respirators while exposed to asbestos or silica on or after January 1, 1997. The Company also may be responsible for certain claims relating to acquired companies other than the AOSafety(R) Division that are not covered by, and are unrelated to, the agreement with Cabot. At June 30, 2003, the Company has recorded liabilities of approximately $4.8 million, which represents reasonable estimates of its probable liabilities for product liabilities substantially related to asbestos and silica-related claims as determined by the Company in consultation with an independent consultant. This reserve is re-evaluated periodically and additional charges or credits to operations may result as additional information becomes available. Consistent with the current environment being experienced by companies involved in asbestos and silica-related litigation, there has been an increase in the number of asserted claims that could potentially involve the Company. Various factors increase the difficulty in determining the Company's potential liability, if any, in such claims, including the fact that the defendants in these lawsuits are often numerous and the claims generally do not specify the amount of damages sought. Additionally, the bankruptcy filings of other companies with asbestos and silica-related litigation could increase the Company's cost over time. In light of these and other uncertainties inherent in making long-term projections, the Company has determined that the five-year period through fiscal 2007 is the most reasonable time period for projecting asbestos and silica-related claims and defense costs. It is possible that the Company may incur liabilities in an amount in excess of amounts currently reserved. However, taking into account currently available information, historical experience, and the Cabot agreement, but recognizing the inherent uncertainties in the projection of any future events, it is management's opinion that these suits or claims should not result in final judgments or settlements in excess of the Company's reserve that, in the aggregate, would have a material effect on the Company's financial condition, liquidity or results of operations. - 27 - Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information On June 27, 2003, the Company signed an agreement with Cabot Corporation, subject to, among other things, the approval of the Company's bank lenders and receipt of financing, to redeem all of the common and preferred shares, including accrued dividends, held by Cabot for approximately $33.5 million. The Company expects to finance the redemption with a combination of cash and additional borrowings. This transaction is expected to close during the 4th quarter. Item 6. Exhibits and Reports on Form 8-K a) See Index of Exhibits on page 31 hereof. b) Reports on Form 8-K On May 15, 2003, the Company filed a Current Report on Form 8-K to announce its second quarter results of operations. On July 24, 2003, the Company filed a Current Report on Form 8-K to announce its third quarter results of operations and share redemption. - 28 - Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: August 14, 2003 AEARO CORPORATION /s/ Jeffrey S. Kulka ---------------------------------- Jeffrey S. Kulka Vice President, Chief Financial Officer, Treasurer, and Secretary (Principal Financial and Accounting Officer) - 29 - Exhibit Index EXHIBITS DESCRIPTION - --------- ------------ 31.1 Certification of Principal Executive Officer 31.2 Certification of Principal Financial Officer EX-99 3 ex312.txt CERTIFICATION I, Jeffrey S. Kulka, Principal Financial Officer of Aearo Corporation, certify that: I have reviewed this quarterly report on Form 10-Q of Aearo Corporation; Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this quarterly report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected , or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or person performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 14, 2003 /s/ Jeffery S. Kulka _________________________ Jeffrey S. Kulka Vice President, Chief Financial Officer Treasurer and Secretary (Principal Financial Officer) EX-99 4 ex311.txt CERTIFICATION I, Michael A. McLain, Principal Executive Officer of Aearo Corporation, certify that: I have reviewed this quarterly report on Form 10-Q of Aearo Corporation; Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this quarterly report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected , or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or person performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: August 14, 2003 /s/ Michael A. McLain ------------------------- Michael A. McLain Chief Executive Officer, President and Chairman of the Board (Principal Executive Officer) -----END PRIVACY-ENHANCED MESSAGE-----