ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF
Unless
the context requires otherwise, references in this Item 2 to “we”, “us”, “our”
or the “Company” refer collectively to Regal Beloit Corporation and its
subsidiaries.
OVERVIEW
Excluding
HVAC, the end markets for the Company’s products continued to show strength
during the third quarter of 2007. Net sales increased 7.2% to $449.4
million from $419.3 million in the third quarter of 2006. Third
quarter 2007 sales included $28.3 million of sales related to the acquired
Fasco
and Jakel businesses.
Net
income increased 5.0% to $31.2 million in the third quarter of 2007 as compared
to $29.7 million in the comparable period last year. Diluted earnings
per share increased 3.4% to $0.92 in the third quarter of 2007 as compared
to
$0.89 for the comparable period of 2006.
RESULTS
OF OPERATIONS
Third
Quarter 2007 versus Third Quarter 2006
Sales
for
the quarter were $449.4 million, a 7.2% increase over the $419.3 million
reported for the third quarter of 2006. Third quarter 2007 sales
included $28.3 million of sales related to the acquired Fasco and Jakel
businesses.
In
the
Electrical Segment, sales increased 7.7%. The soft housing market and
a comparison to a strong 2006 that was favorably impacted by the SEER 13
legislation impacted sales in the HVAC business, which decreased 16.8%. The
sales for the remainder of the motor businesses increased 8.9%. Sales
for the power generation businesses increased 33.6%. Sales in the Mechanical
Segment for the quarter ended September 29, 2007 were 3.5% above the equivalent
period of 2006.
Gross
margin for the quarter was 23.7%, compared to 24.6% in the third quarter
of
2006. Material costs, including copper and aluminum, continued to
increase and had a significant impact on our gross margins during the
quarter. These costs were partially offset by new products,
productivity, pricing actions and positive product mix resulting in a net
0.9%
decrease in gross margin.
Operating
expenses were $53.3 million (11.9% of sales) in the third quarter of 2007
versus
$50.0 million (11.9% of sales) in third quarter of 2006. Third
quarter 2007 operating expenses included a $1.8 million expense to settle
the
Company’s litigation with Enron Wind. Income from operations was
$53.4 million versus $53.0 million in the third quarter of 2006. As a
percent of sales, income from operations was 11.9% in the third quarter of
2007
versus 12.7% for the third quarter of 2006. This decrease reflected
increased raw material costs partially offset by contributions from new
products, pricing actions, productivity, and the leveraging of fixed costs
.
Net
interest expense was $4.8 million versus $4.9 million in the third quarter
of
2006. The decrease reflected lower levels of average debt
outstanding, which was partially offset by higher interest rates.
The
tax
rate for the quarter was 34.2% versus 36.6% in the prior year period. The
tax
rate was impacted by the distribution of income, which was weighted more
to
lower tax rate countries than during the comparable period of 2006.
Net
income for the third quarter of 2007 was $31.2 million, an increase of 5.0%
versus the $29.7 million reported in same period of 2006. Fully
diluted earnings per share was $0.92 as compared to $0.89 per share reported
in
the third quarter of 2006. The average number of diluted shares was
34,104,123 during the third quarter of 2007 as compared to 33,440,015 during
the
comparable period last year.
Nine
Months Ended September 29, 2007 versus Nine Months Ended September 30,
2006
Sales
for
the nine months ended September 29, 2007 were $1,327.8 million, which is
a 6.0%
increase over the $1,252.9 million reported for the comparable period of
2006. The Fasco and Jakel businesses that were acquired on August 31,
2007 added $28.3 million to sales for the nine months ended September 29,
2007
versus the prior year comparable period. The sale of substantially
all of the assets of the Company’s cutting tool business (completed May 2006)
reduced 2007 sales by approximately $7.1 million. The Sinya motor
business reported sales of $60.3 million for the nine months ending September
29, 2007, as compared to $21.9 million from the acquisition date of May 1,
2006
through September 30, 2006.
Excluding
our HVAC business, we saw strong demand for our products throughout the first
nine months of 2007, driven by strong end market activity. Electrical
Segment sales increased 6.7% as compared to the first nine months of
2006. Sales for this segment showed strength in all product lines
except HVAC, which has been affected by a soft housing market in 2007 and
comparisons with a strong 2006 that was favorably impacted by the SEER 13
legislation. The Fasco and Jakel businesses that were acquired on
August 31, 2007 added $28.3 million to Electrical Segment sales for the nine
months ended September 29, 2007 versus the prior year comparable
period. Mechanical Segment sales for the first nine months of 2007
were comparable to sales for the first nine months of the prior year; however
sales for the nine months ended September 30, 2006 included $7.1 million
of
sales related to the Company’s cutting tools business. Substantially
all of the assets of the Company’s cutting tools business were sold in May,
2006.
Gross
margin for the nine months ended September 29, 2007 was 23.2%, which is 0.8%
points lower than the comparable period of 2006. Material costs had a
significant impact on the first nine months of 2007, partially offset by
the
contribution from new products, productivity efforts, pricing actions and
positive product mix across our entire business. The raw material
cost increases resulted primarily from increases in the costs of copper and
aluminum.
Operating
expenses were $147.1 million (11.1% of sales) versus $145.8 million (11.6%
of
sales) in the comparable period of 2006. Third quarter 2007 operating
expenses included a $1.8 million expense to settle the Company’s litigation with
Enron Wind. Included in operating expenses in the first nine months
of 2006 was a $1.6 million gain resulting from the sale of real property
in the
Mechanical Segment. Operating expenses for the first nine months of
2006 also included $2.0 million of incremental expense related to the Regal
Beloit Supplemental Executive Retirement Plan resulting from a change in
assumptions associated with retirement benefits for certain key
executives. Income from operations was $160.8 million versus $154.5
million in the comparable period of 2006, an increase of 4.1%. As a
percent of sales, income from operations was 12.1% for the nine months ended
September 29, 2007 versus 12.3% in the prior year.
Net
interest expense was $13.9 million versus $14.9 million in the comparable
period
of 2006. This decrease was driven by an average lower level of debt
outstanding, partially offset by an increase in interest rates.
LIQUIDITY
AND CAPITAL RESOURCES
Our
working capital was $385.7 million at September 29, 2007, a 21.8% increase
from
$316.6 million at year-end 2006. The $69.1 million increase was
driven by a $47.7 million working capital increase from the Fasco and Jakel
acquisitions. The ratio of our current assets to our current
liabilities (“current ratio”) was 2.2:1 at September 29, 2007 and December 30,
2006.
Net
cash
provided by operating activities was $168.3 million for the nine months ended
September 29, 2007 as compared to $52.8 million in the comparable period
of
2006. Net cash used in investing activities was $276.9 million in the
first nine months of 2007 as compared to the $38.9 million used in the prior
year. The increase was driven by the acquisitions of Fasco and Jakel
in the third quarter of 2007. Additions to property, plant and
equipment were $23.8 million in the first nine months of 2007, which was
$13.9
million less than the comparable period of 2006. Our cash provided by
financing activities was $126.1 million during the first nine months of 2007
versus $6.4 million used in the comparable period of 2006. The
increase in cash provided by financing activities is driven by a $250.0 million
increase in by long-term debt during the nine months ended September 29,
2007 as
compared to the first nine months of 2006. Offsetting this increase
was an additional $124.3 million of commercial paper and revolving credit
facility that were repaid during the nine months ended September 29, 2007
as
compared to the comparable period of 2006.
Our
outstanding long-term debt increased from $323.9 million at December 30,
2006 to
$497.3 million at September 29, 2007. Of our total long-term debt,
$121.0 million was outstanding under our $500.0 million unsecured revolving
credit facility that expires on April 30, 2012 (the “Facility”). The
Facility permits the Company to borrow at interest rates based upon a margin
above the London Inter-Bank Offered Rate (“LIBOR”), which margin varies with the
ratio of total funded debt to earnings before interest, taxes, depreciation
and
amortization (“EBITDA”) as defined in the Facility. These interest
rates also vary as LIBOR varies. We pay a commitment fee on the
unused amount of the Facility, which also varies with the ratio of our total
debt to our EBITDA.
During
the third quarter of 2007, in a private placement exempt from the registration
requirements of the Securities Act of 1933, as amended, the Company issued
and
sold $250.0 million of senior notes (the “Notes”). The Notes were
sold pursuant to a Note Purchase Agreement (the “Agreement”) by and among the
Company and the purchasers of the Notes. The Notes were issued and
sold in two series: $150.0 million in Floating Rate Series 2007A
Senior Notes, Tranche A, due August 23, 2014, and $100.0 million in Floating
Rate Series 2007A Senior Notes, Tranche B, due August 23, 2017. The
Notes bear interest at a margin over LIBOR, which margin varies with the
ratio
of the Company’s consolidated debt to consolidated EBITDA as defined in the
Agreement. These interest rates also vary as LIBOR
varies. The Agreement permits the Company to issue and sell
additional note series, subject to certain terms and conditions described
in the
Agreement, up to a total of $600.0 million in combined Notes.
The
Notes
and the Facility require us to meet specified financial ratios and to satisfy
certain financial condition tests. We were in compliance with all
debt covenants as of September 29, 2007.
In
addition to the Facility and the Notes, at September 29, 2007, we also had
$115.0 million of convertible senior subordinated debt outstanding at a fixed
interest rate of 2.75%, and $19.8 million of other debt. At September
29, 2007, our borrowing availability under the Facility was $373.3 million
based
on the Facility’s credit limit.
As
of
September 29, 2007, a foreign subsidiary of the Company had outstanding
$8.2
million denominated in U.S. dollars. The borrowings were made under a
$15.0 million unsecured credit facility which expires in December
2008. The notes are all short term and bear interest at a margin over
LIBOR.
CRITICAL
ACCOUNTING POLICIES
We
recognized revenue when all of the following have occurred: an
agreement of sale exists; pricing is determinable; collection is reasonably
assured; and product has been delivered and acceptance has occurred according
to
contract terms.
We
use
contracts and customer purchase orders to determine the existence of an
agreement of sale. We use shipping documents and customer acceptance,
when applicable, to verify delivery. We assess whether the sale price
is subject to refund or adjustment, and we assess collectibility based
on the
creditworthiness of the customer as well as the customer’s payment
history.
Returns,
Rebates and Incentives
Our
primary incentive program provides distributors with cash rebates or account
credits based on agreed amounts that vary depending on the end user or
original
equipment manufacturing (OEM) customer to whom our distributor ultimately
sells
the product. We also offer various other incentive programs that
provide distributors and direct sale customers with cash rebates, account
credits or additional products and services based on meeting specified
program
criteria. Certain distributors are offered a right to return product,
subject to contractual limitations.
We
record
accruals for customer returns, rebates and incentives at the time of revenue
recognition based primarily on historical experience. Adjustments to
the accrual may be required if actual returns, rebates and incentives differ
from historical experience or if there are changes to other assumptions
used to
estimate the accrual.
Impairment
of Long-Lived Assets or Goodwill and Other Intangibles
We
evaluate the recoverability of the carrying amount of long-lived assets
whenever
events or changes in circumstances indicate that the carrying amount of
an asset
may not be fully recoverable through future cash flows. We evaluate
the recoverability of goodwill and other intangible assets with indefinite
useful lives annually or more frequently if events or circumstances indicate
that an asset might be impaired. We use judgment when applying the
impairment rules to determine when an impairment is
necessary. Factors that could trigger an impairment review include
significant underperformance relative to historical or forecasted operating
results, a significant decrease in the market value of an asset or significant
negative industry or economic trends. We perform our annual
impairment test in accordance with SFAS 142,
“Goodwill and Other Intangible
Assets.”
Approximately
half of our domestic employees are covered by defined benefit pension plans
with
the remaining employees covered by defined contribution plans. Most
of our foreign employees are covered by government sponsored plans in the
countries in which they are employed. Our obligations under our
domestic defined benefit plans are determined with the assistance of actuarial
firms. The actuaries provide us with information and recommendations
regarding such factors as withdrawal rates and mortality rates. The
actuaries also provide us with information and recommendations from which
management makes further assumptions on such factors as the long-term expected
rate of return on plan assets, the discount rate on benefit obligations,
and
where applicable, the rate of annual compensation increases. Based
upon the assumptions made, the investments made by the plans, overall conditions
and movement in financial markets, particularly the stock market and how
actual
withdrawal rates, life-spans of benefit recipients, and other factors differ
from assumptions, annual expenses and recorded assets or liabilities of
these
defined benefit plans may change significantly from year
to year. Based on our annual review of actuarial
assumptions as well as historical rates of return on plan assets and existing
long-term bond rates, we set the long-term rate of return on plan assets
at 8.5%
and an average discount rate at 5.9% for our defined benefit plans as of
December 30, 2006.
We
operate in numerous taxing jurisdictions and are subject to regular examinations
by various U.S. Federal, state, and foreign jurisdictions for various tax
periods. Our income tax positions are based on research and
interpretations of the income tax laws and rulings in each of the jurisdictions
in which we do business. Due to the subjectivity of interpretations
of laws and rulings in each jurisdiction, the differences and interplay
in tax
laws between those jurisdictions as well as the inherent uncertainty in
estimating the final resolution of complex tax audit matters, our estimates
of
income tax liabilities may differ from actual payments or
assessments.
Use
of Estimates and Assumptions
The
preparation of our condensed consolidated financial statements in conformity
with accounting principles generally accepted in the United States requires
the
use of estimates and assumptions that affect the reported amounts of assets,
liabilities, revenues and expenses, and the related disclosure of contingent
assets and liabilities. Management bases its estimates on historical
experience and on other assumptions that are believed to be reasonable
under the
circumstances, the results of which form the basis for making judgments
about
the carrying value of assets and liabilities that are not readily apparent
from
other sources. Actual results may differ from these estimates under
different assumptions or conditions.
New
Accounting Pronouncements
In
February 2007, Financial Accounting Standards Board (“FASB”) issued Statement of
Financial Accounting Standard (SFAS) No. 159,
The Fair Value Option for
Financial Assets and Financial Liabilities, Including an Amendment of FASB
Statement No. 115
(“SFAS 159”). SFAS 159 permits entities to
choose to measure many financial instruments and certain other items generally
on an instrument-by-instrument basis at fair value that are not currently
required to be measured at fair value. SFAS 159 is intended to
provide entities with the opportunity to mitigate volatility in reported
earnings caused by measuring related assets and liabilities differently
without
having to apply complex hedge accounting provisions. SFAS 159 is
effective for the Company on January 1, 2008, although early adoption is
permitted. If the Company elects to adopt SFAS 159 early, it would
need to concurrently early adopt the provisions of Statement of Financial
Accounting Standard No. 157,
Fair Value Measurements
(“SFAS 157”),
which is described below. The Corporation is evaluating the
provisions of SFAS 159.
In
September 2006, the FASB issued SFAS 158,
Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans
(“SFAS
158”). SFAS 158 requires that companies prospectively recognize
through Accumulated Other Comprehensive Income the over funded or under
funded
status of their defined benefit plans as an asset or liability in
their balance sheets. The Company adopted SFAS 158 as of
December 30, 2006.
In
September 2006, the FASB issued SFAS 157,
Fair Value Measurements
(“SFAS 157”). SFAS 157 defines fair value, establishes a framework
for measuring fair value, and expands disclosures about fair value
measurements. SFAS 157 will be effective beginning in fiscal
2008. We are evaluating the new standard to determine the effect on
our financial statements and related disclosures.
In
June
2006, the FASB issued Interpretation No. 48,
Accounting for Uncertainty in
Income Taxes
(“FIN 48”). FIN 48 clarifies the accounting for
uncertainty in income taxes recognized in an enterprise’s financial statements
in accordance with FASB Statement No. 109,
Accounting for Income
Taxes
. FIN 48 prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a
tax
position taken or expected to be taken in a tax return. FIN 48 also
provides guidance on derecognition, classification, interest and penalties,
accounting in interim periods, disclosure and transition. The Company
adopted FIN 48 in the first quarter of 2007. See Note 12 to the
condensed consolidated financial statements.
ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
We
are
exposed to market risk relating to the Company’s operations due to changes in
interest rates, foreign currency exchange rates and commodity prices of
purchased raw materials. We manage the exposure to these risks
through a combination of normal operating and financing activities and
derivative financial instruments such as interest rate swaps, commodity
cash
flow hedges and foreign currency forward exchange contracts.
The
Company
is exposed to
interest rate risk on certain of its short-term and long-term debt obligations
used to finance our operations and acquisitions. At September 29,
2007, we had $123.8 million of fixed rate debt and $382.0 million of variable
rate debt, the latter subject to interest rate risk. As a result,
interest rate changes impact future earnings and cash flow assuming other
factors are constant. The Company utilizes interest rate swaps to
manage fluctuations in cash flows resulting from exposure to interest rate
risk
on forecasted variable rate interest payments. Details regarding the
instruments, as of September 29, 2007, are as follows:
Instrument
|
Notional
Amount
|
Maturity
|
|
Rate
Paid
|
|
|
Rate
Received
|
Fair
Value
Gain
(Loss)
|
Swap
|
$150.0
million
|
August
23,
2014
|
|
|
5.3
|
%
|
|
LIBOR
(3
month)
|
$(3.2)
million
|
Swap
|
$100.0
million
|
August
23,
2017
|
|
|
5.4
|
%
|
|
LIBOR
(3
month)
|
$(2.6)
million
|
A
hypothetical 10% change in
our weighted average borrowing rate on outstanding variable rate debt at
September 29, 2007, would result in a change in after-tax annualized earnings
of
approximately $0.4
million.
The
Company periodically enters into commodity futures and options hedging
transactions to reduce the impact of changing prices for certain commodities,
such as copper and aluminum. Contract terms of commodity hedge
instruments generally mirror those of the hedged item, providing a high degree
of risk reduction and correlation.
We
are
also exposed to foreign currency risks that arise from normal business
operations. These risks include the translation of local currency
balances of foreign subsidiaries, intercompany loans with foreign subsidiaries
and transactions denominated in foreign currencies. Our objective is
to minimize our exposure to these risks through a combination of normal
operating activities and the utilization of foreign currency contracts to
manage
our exposure on the transactions denominated in currencies other than the
applicable functional currency. Contracts are executed with
creditworthy banks and are denominated in currencies of major industrial
countries. It is our policy not to enter into derivative financial
instruments for speculative purposes. We do not hedge our exposure to
the translation of reported results of foreign subsidiaries from local currency
to United States dollars.
All
hedges are recorded on the balance sheet at fair value and are accounted
for as
cash flow hedges, with changes in fair value recorded in accumulated other
comprehensive income (“AOCI”) in each accounting period. An
ineffective portion of the hedge’s change in fair value, if any, is recorded in
earnings in the period of change. The impact due to ineffectiveness
was immaterial for all periods included in this report.
Derivative
commodity assets of $7.4 million and $1.7 million are recorded in current
assets
as of September 29, 2007, and December 30, 2006, respectively. The
unrealized gain on the effective portion of the contracts of $4.5 million
net of
tax and $1.0 million net of tax, as of September 29, 2007 and December 30,
2006,
was recorded in accumulated other comprehensive income.
The
Company uses a cash flow hedging strategy to protect against an increase
in the
cost of forecasted foreign currency denominated transactions. As of
September 29, 2007, derivative currency assets of $2.7 million and $0.6 million
are recorded in other current assets and other non-current assets,
respectively. At December 30, 2006, derivative currency assets of
$2.2 million and $1.0 million were recorded in other current assets and other
non-current assets, respectively. The unrealized gain on the
effective portion of the contracts of $2.0 million net of tax as of September
29, 2007, and December 30, 2006 was recorded in AOCI.
In
the
third quarter of 2007, the Company entered into pay fixed/receive LIBOR-based
floating interest rate swaps to manage fluctuations in cash flows resulting
from
interest rate risk. As of September 29, 2007, a interest rate swap liability
of
$5.8 million was included in other non-current liabilities. The
unrealized loss on the effective portion of the contracts of $3.7
million net of tax as of September 29, 2007 was recorded in AOCI.
The
net
AOCI balance of $2.8 million at September 29, 2007 is comprised of $6.0 million
of current deferred gains expected to be realized in the next year, and $3.2
of
non-current deferred losses. The impact of hedge ineffectiveness was
immaterial for all periods included in this report.