10-Q 1 a2048499z10-q.txt 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended MARCH 31, 2001 -------------- OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______ Commission file number: 33-80701 AAF-MCQUAY INC. -------------------------------------------------------------------------------- (Exact name of Registrant as Specified in Its Charter) DELAWARE 41-0404230 ----------------------------------- ----------------------------------- (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 10300 ORMSBY PARK PL. STE 600, LOUISVILLE, KENTUCKY 40223 ------------------------------------------------------ -------- (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number, including area code (502) 637-0011 ------------------ Not Applicable -------------------------------------------------------------------------------- Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report. Indicate by check 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 2,497 shares of Common Stock, par value $100.00 per share, were outstanding as of April 27, 2001. INDEX AAF-MCQUAY INC. AND SUBSIDIARIES

2 PART I: FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS AAF-MCQUAY INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited) (dollars in thousands, except share data)

See Notes to the Consolidated Financial Statements 3 AAF-MCQUAY INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited) (dollars in thousands)

See Notes to the Consolidated Financial Statements 4 AAF-MCQUAY INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (dollars in thousands)

See Notes to the Consolidated Financial Statements 5 AAF-MCQUAY INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (unaudited) (dollars in thousands)

See Notes to the Consolidated Financial Statements 6 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION The consolidated financial statements include the accounts of the Company and all of its wholly-owned subsidiaries. All inter-company transactions have been eliminated. The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim reporting and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been omitted. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K (the "Annual Report") for the year ended June 30, 2000. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The operating results for the nine months ended March 31, 2001 are not necessarily indicative of the operating results that may be expected for the full year ending June 30, 2001. The Company's period end is the Saturday closest to March 31. For clarity in presentation all periods presented herein are shown to end on the last calendar day of the month. Certain reclassifications of amounts in the consolidated financial statements have been made to reflect comparability. RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued Statement No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, which was amended by Statement Nos. 137 and 138, in June 1999 and June 2000, respectively. The Statement requires the Company to recognize all derivatives on the balance sheet at fair value. Derivatives that do not receive hedge accounting treatment are adjusted to fair value through income. If a derivative is a hedge, depending on the nature of the hedge, changes in the fair value of the derivative are either offset against the change in fair value of assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The adoption of Statement No. 133, as amended, on July 1, 2000 resulted in no cumulative effect of an accounting change being recognized in the consolidated statements of operations or comprehensive income. In December 1999, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101 REVENUE RECOGNITION IN FINANCIAL STATEMENTS ("SAB 101"). SAB 101 provides guidance on the recognition, presentation and disclosure of revenue in financial statements. The Company is in the process of completing its evaluation of the impact that SAB 101 will have on its earnings or financial position. The Company is required to adopt SAB 101 in the fourth quarter of fiscal 2001. 2. INVENTORIES

7 3. OTHER INCOME AND EXPENSE GAIN ON SALE OF PROPERTY In October 2000, the Company completed the sale of property in Dartford, United Kingdom associated with its industrial refrigeration business resulting in a gain of $4.5 million before taxes. Proceeds from the sale of approximately $6.9 million were used to reduce debt. OTHER (INCOME) EXPENSE, NET In the second and third quarters of fiscal 2001, the Company repurchased $8 million of its Senior Notes at a discount resulting in a net gain of approximately $0.4 million before taxes. See Note 5 for further discussion. During the first quarter of fiscal 2000, the Company accrued a $1.3 million loss related to the sale of the commercial air conditioning and refrigeration operation in France. Additionally, in conjunction with the Company's refinancing of certain debt, the Company wrote off certain unamortized debt issuance costs resulting in a charge of $0.3 million in the first quarter of fiscal 2000. 4. PROVISION FOR INCOME TAXES The tax provisions for the three month and nine month periods ended March 31, 2001 and 2000 are based on the estimated effective tax rates applicable for the full years, and after giving effect to significant unusual items related specifically to the interim periods. The difference between the Company's reported tax provision, for the three month and nine month periods ended March 31, 2001 and 2000, and the tax provision computed based on U.S. statutory rates is primarily attributable to nondeductible goodwill amortization and unbenefitted foreign losses. Additionally, the Company's effective tax rate for the three month and nine month periods ended March 31, 2000 reflects the effect of the sale of a foreign subsidiary. 5. DEBT AND FINANCIAL INSTRUMENTS In the second and third quarters of fiscal 2001, the Company repurchased a total of $8 million of its Senior Notes at a discount, resulting in a gain of approximately $0.4 million after write off of associated debt issuance costs. The Company plans to hold these repurchased notes until their maturity in February 2003. The balance of Senior Notes held outside the Company after the repurchase and included in the Company's long-term debt at March 31, 2001 was $117 million. In September 2000, the Company sold an interest rate floor with a notional amount of $30 million, which requires the Company to make payments if 3-month LIBOR falls below a certain level. Measurement dates and the maturity date match those contained in the January 2000 swap transaction described below. The Company received a payment of $165,000 as selling price for the floor. In January 2000, the Company entered into an interest rate swap transaction whereby the Company receives a fixed rate and pays a floating rate on the basis of 3-month LIBOR. The January 2000 swap has a three year term and a notional amount of $30 million and effectively converts a portion of the Company's fixed rate borrowings to a floating rate. Measurement dates and the maturity date of the swap match interest payment dates and maturity date of the Company's Senior Notes. The Company records its swap and floor in its balance sheet at fair market value. The net result of these positions recognized in operations for the nine months ended March 31, 2001 was income of $0.3 million. 6. RESTRUCTURING CHARGES During the second quarter of fiscal 2001, the Company approved and commenced additional restructuring actions in its United Kingdom Commercial Air Conditioning and Refrigeration Group, recording reserves of approximately $3.0 million. The $3.0 million reserve primarily represents severance accruals related to the elimination of approximately 110 employees in its air handling, plate freezer, and compressor manufacturing units. The Company has spent approximately $2.5 million of the recorded reserve through March 31, 2001. 8 During the third quarter of fiscal 2001, the Company approved and commenced additional restructuring actions in its Commercial Air Conditioning and Refrigeration Group primarily in the United Kingdom, recording reserves of approximately $0.6 million. The $0.6 million reserve primarily represents severance accruals related to the elimination of approximately 10 employees. The Company has spent approximately $0.2 million of the recorded reserve through March 31, 2001. During the first quarter of fiscal 2001, the Company approved and commenced restructuring actions in its Commercial Air Conditioning and Refrigeration and Filtration Products groups, recording reserves of $3.5 million. In July 2000, the Company announced its intention to close its manufacturing facility in Scottsboro, Alabama. Related to this closure, the Company recorded a restructuring reserve of $2.0 million primarily representing severance accruals related to the elimination of approximately 330 employees. In addition, the Company also recognized severance accruals approximating $1.5 million related to the elimination of approximately 60 employees in the Commercial Air Conditioning and Refrigeration Group in the United Kingdom and approximately 10 employees in the Filtration Products Group in Germany. Through March 31, 2001, the Company has spent approximately $3.0 million of the $3.5 million of reserves recorded in the first quarter of fiscal 2001. As described in Note 9 of the Annual Report, the Company implemented several restructuring plans throughout fiscal 2000 in both the Commercial Air Conditioning and Refrigeration and Filtration Products groups. Through March 31, 2001, the Company has spent $3.2 million of the $3.5 million restructuring reserves recorded in fiscal 2000 primarily for severance arrangements. All these restructuring efforts are expected to be completed by the end of fiscal 2001. 7. COMMITMENTS AND CONTINGENCIES PURCHASE COMMITMENTS- The Company secures pricing on a portion of its copper requirements through forward contracts executed with certain suppliers. At March 31, 2001, contracts for 2.3 million pounds of copper were in place. These contracts have various expiration dates through January 31, 2002. ENVIRONMENTAL MATTERS - The Company is subject to potential liability under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, as amended (CERCLA), and other federal, state and local statutes and regulations governing the discharge of pollutants into the environment and the handling and disposal of hazardous substances and waste. These statutes and regulations, among other things, impose potential liability on the Company for the cost of remediation of contamination arising from the Company's past and present operations and from former operations of other entities at sites later acquired and now owned by the Company. Many of the Company's facilities have operated for many years, and substances which are or might be considered hazardous were generated, used, and disposed of at some locations, both on- and off-site. Therefore, it is possible that environmental liabilities in addition to those described in Note 15 of the Annual Report may arise in the future. The Company records liabilities if, in management's judgment, environmental assessments or remedial efforts are probable and the costs can be reasonably estimated. These accrued liabilities are not discounted. Such estimates are adjusted if necessary based upon the completion of a formal study or the Company's commitment to a formal plan of action. LITIGATION - The Company is involved in various lawsuits in the ordinary course of business. These lawsuits primarily involve claims for damages arising out of the use of the Company's products. The Company is also involved in litigation and administrative proceedings involving employment matters and commercial disputes. Some of these lawsuits include claims for punitive as well as compensatory damages. The Company is insured for product liability claims for amounts in excess of established deductibles and accrues for the estimated liability on a case-by-case basis up to the limits of the deductibles. All other claims and lawsuits are also provided for on a case-by-case basis. The Company does not believe that the potential liability from the ultimate outcome of environmental and litigation matters will have a material adverse effect on its financial statements. 9 8. BUSINESS SEGMENTS INFORMATION The Company serves the global commercial heating, ventilation, air conditioning and refrigeration ("HVAC&R") industry with two industry segments: Commercial Air Conditioning and Refrigeration, the manufacture, sale and distribution of heating, ventilating, air conditioning, industrial refrigeration products, and Filtration Products, the manufacture and sale of air filtration products and systems. Information relating to operations in each industry segment is as follows as of and for the three and nine months ended March 31, 2001 and 2000:

The Company estimates corporate expenses and determines fixed allocations of these expenses for each business segment at the beginning of the fiscal year. Any over or under allocation of actual expenses incurred results in income or expense reported at the corporate level. A reconciliation of segment profit to the Company's earnings before taxes for each period is as follows:

10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS NET SALES were $211.0 million in the three months ended March 31, 2001, which represents a decrease of $4.1 million, or 1.9%, as compared to $215.1 million for the same period in the prior year. Net sales decreased $4.5 million, or 0.7% to $637.9 million from $642.4 million for the nine months ended March 31, 2001 and 2000, respectively. In October 1999, the Company sold its commercial air conditioning operation in France, which had sales of $11.6 million in the first nine months of fiscal 2000. Additionally, the Company estimates that sales have decreased by approximately $6.4 million and $26.9 million for the three months and nine months ending March 31, 2001, respectively, due to the impact of unfavorable currency trends in translating European sales. Excluding the net sales attributable to the operation in France for fiscal 2000 and currency impact, net sales for the three months and nine months ended March 31, 2001 increased $2.4 million or 1.1% and $34.1 million or 5.4%, respectively, as compared to the corresponding period of the prior year. COMMERCIAL AIR CONDITIONING AND REFRIGERATION GROUP net sales for the three months ended March 31, 2001 decreased $2.9 million, or 2.2%, to $126.7 million as compared to $129.6 million for the three months ended March 31, 2000. Additionally, the Company estimates that sales have decreased by approximately $2.6 million for the three months ended March 31, 2001 due to the impact of unfavorable currency trends in translating European sales. Excluding the currency impact, net sales for the three months ended March 31, 2001 are essentially flat with those of the comparable prior year quarter. Year-to-date sales decreased $8.6 million, or 2.1%, to $390.5 million from $399.1 million. This decrease is primarily attributable to the sale of the commercial air conditioning and refrigeration operation in France in October 1999. Additionally, the Company estimates that approximately $12.8 million of the decrease is due to the impact of unfavorable currency trends in translating European sales. Excluding these two items, net sales increased $15.9 million, or 4.1%. This increase is the result of a 3.8% increase in domestic sales and a 5.2% increase in international sales. The increase in domestic sales is primarily attributable to increased applied air handling product demand (principally rooftop and self-contained) and increased service revenue. Applied air handling sales increased 8.6% from the prior year, while service revenues increased 14.7%. The increase in international sales is primarily the result of consolidation of the Company's Spanish operation, which became a wholly owned subsidiary in July 2000. Backlog for the Commercial Air Conditioning and Refrigeration Group was $114 million at March 31, 2001 as compared to $124 million and $113 million at June 30, 2000 and March 31, 2000, respectively. FILTRATION PRODUCTS GROUP net sales for the three months ended March 31, 2001 increased $.5 million, or 0.5%, to $86.3 million as compared to $85.8 million for the three months ended March 31, 2000. The Company estimates that sales have decreased by approximately $3.8 million for the third quarter of fiscal 2001 due to the impact of unfavorable currency trends in translating European sales. Excluding the currency impact, net sales increased $4.3 million or 5.0%. This increase is the result of a 12.7% increase in domestic sales. International sales were flat with the prior year. The increase in domestic sales is primarily attributable to continued strong clean room sales and increased replacement air filter retail sales. Year-to-date sales increased $6.3 million, or 2.6%, to $250.9 million from $244.6 million for the nine months ended March 31, 2000. The Company estimates that sales have decreased by approximately $14.1 million for the first nine months of fiscal 2001 due to the impact of unfavorable currency trends in translating European sales. Excluding the currency impact, net sales increased $20.4 million or 8.3% for the nine months ended March 31, 2001 versus 2000. Domestic sales increased 6.9%, while international sales increased 8.5%. The increase in domestic sales is primarily attributable to strong clean room sales and Machinery Filtration and Acoustical Systems ("MFAS") activity, while the increase in international sales is attributable to improving market conditions in Asia and strong Air Pollution and Control Products and Systems ("APC") sales in Europe. 11 GROSS PROFIT increased to $54.9 million, or 26.0% of sales, for the three months ended March 31, 2001 as compared to $54.0 million, or 25.1% of sales, for the three months ended March 31, 2000. Year-to-date gross profit increased slightly to $166.0 million, or 26.0% of sales, from $164.5 million, representing 25.6% of sales, for the nine months ended March 31, 2000. In the Commercial Air Conditioning and Refrigeration Group, year-to-date gross profit as a percentage of sales was 24.9% as compared to 23.7% for the same period in fiscal 2000. This increase in gross margin resulted primarily from improved manufacturing efficiency in the domestic chiller business unit. The Filtration Products Group's year-to-date gross profit as a percentage of sales decreased from 28.6% in fiscal 2000 to 27.4% for the same period in fiscal 2001. This decrease is primarily the result of competitive pricing pressures in North America and Europe in the replacement filter business. OPERATING EXPENSES were $48.5 million, or 23.0% of sales, for the third quarter of fiscal 2001 versus $50.2 million, or 23.4% of sales, for the third quarter of fiscal 2000. For the first nine months of fiscal years 2001 and 2000, operating expenses were $148.0 million, or 23.2% of sales, versus $150.2 million, or 23.4% of sales, respectively. Excluding amortization and restructuring charges, year-to-date operating expenses were $132.5 million, or 20.8% of sales, versus $140.0 million, or 21.8% of sales. The decrease for the first nine months of fiscal 2001 compared to the first nine months of fiscal 2000 is primarily attributable to lower commissions due to favorable sales mix and continued focus on cost control. INCOME FROM OPERATIONS for the third quarter of fiscal 2001 and year-to-date increased as compared to the same periods in fiscal 2000. For the third quarter income from operations increased to $6.5 million, or 3.1% of sales, as compared to $3.7 million, or 1.7% of sales, in the third quarter of fiscal 2000. Year-to-date income from operations increased to $18.0 million, or 2.8% of sales, as compared to $14.3 million, or 2.2% of sales in fiscal 2000. Excluding amortization and restructuring charges, year-to-date income from operations increased to $33.5 million, or 5.2% of sales, compared to $24.5 million, or 3.8% of sales in the corresponding period of the prior year. The Commercial Air Conditioning and Refrigeration Group's income from operations improved in the third quarter of fiscal 2001 to $3.5 million, or 2.8% of sales, as compared to $1.9 million, or 1.5% of sales, in the third quarter of fiscal 2000, excluding amortization and restructuring charges. Year-to-date income from operations, excluding amortization and restructuring charges, increased from $5.9 million, or 1.5% of sales, to $16.7 million, or 4.3% of sales, for the first nine months of fiscal 2000 as compared to the first nine months of fiscal 2001, respectively. The Filtration Products Group income from operations, excluding amortization and restructuring charges, for the third quarter of fiscal 2001 increased from $6.0 million, or 6.9% of sales, in fiscal 2000 to $6.5 million, or 7.5% of sales. Year-to-date income from operations, excluding amortization and restructuring charges, decreased from $18.5 million, or 7.6% of sales, during the first nine months of fiscal 2000 to $17.9 million, or 7.1% of sales, for the first nine months of fiscal 2001. NET INTEREST EXPENSE decreased to $4.7 million and $15.0 million during the third quarter and nine months ended March 31, 2001 from $5.4 million and $16.8 million for the comparable periods ended March 31, 2000. Decrease in interest expense is attributable to lower debt levels. 12 NET OTHER (INCOME) EXPENSE was income of $0.4 million year-to-date as compared to expense of $1.8 million for the same period in fiscal 2000. See Note 3 to the unaudited consolidated financial statements for further discussion. LIQUIDITY AND CAPITAL RESOURCES The Company's liquidity needs are provided by cash generated from operating activities and supplemented when necessary by short-term credit facilities. During the first nine months of fiscal 2001, funds generated by operating activities were $13.5 million as compared to $32.5 million of funds generated in the prior fiscal year for the comparable period. Excluding the cash flow impact from the sale of the operation in France in October 1999, net cash flows from operations for fiscal 2000 were $28.0 million. During the first nine months of fiscal 2001, net cash from investing activities is comprised of $10.6 million in capital expenditures, partially offset by $6.9 million in cash proceeds from the sale of property in the United Kingdom. Capital spending for the first nine months increased from $5.5 million in the prior year to $10.6 million this year due to the relocation of the Scottsboro, Alabama operation to the consolidated air handling operation in Minnesota and new product development. On September 30, 1999, the Company refinanced its U.S. bank credit facilities with a Term Loan of $30 million and a Revolving Credit Facility of $90 million (" Bank Credit Agreement"). The Bank Credit Agreement has a three-year term, was used to retire all obligations under the previous bank agreement and is designed to provide added flexibility and borrowing availability. At March 31, 2001, remaining borrowing availability under the Revolving Credit portion of the Bank Credit Agreement was $42.0 million. Payments on long-term debt for the first nine months of fiscal 2001 were $6.3 million. In addition, as more fully discussed in Note 5 to the unaudited consolidated financial statements, the Company used cash of $7.4 million to repurchase $8.0 million in Senior Notes. Short-term borrowings increased by $2.5 million during the nine-month period. A short-term credit facility provided to a subsidiary of the Company is supported by a l11.5 million letter of credit from the Company's parent, O.Y.L. Industries Berhad (OYL), which expires on May 31, 2001. Approximately l8.4 million of this facility was utilized at March 31, 2001. This support arrangement may be extended for additional time periods with the consent of OYL and the bank providing the facilities. Management believes, based upon current levels of operations and forecasted earnings, that cash flows from operations, together with borrowings under the Bank Credit Agreement and other short-term credit facilities, will be adequate to make payments of principal and interest on debt, to permit anticipated capital expenditures and to fund working capital requirements and other cash needs. Nevertheless, the Company will remain leveraged to a significant extent and its debt service obligations will continue to be substantial. If the Company's sources of funds were to fail to satisfy the Company's requirements, the Company may need to refinance its existing debt or obtain additional financing. There is no assurance that any such new financing alternatives would be available, and, in any case, such new financing (if available) would be expected to be more costly and burdensome than the debt agreements currently in place. EURO CONVERSION Management has developed a plan for the effect of the Euro and is currently modifying and testing its systems in preparation for converting to the Euro effective July 1, 2001. The Euro conversion is not expected to have a material effect on the Company's operating results or competitive position. The Company will continue to investigate opportunities for European-wide system infrastructures. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK There have been no material changes in the reported market risks since the end of the most recent fiscal year. See Note 5 to the Consolidated Financial Statements (unaudited) for disclosures of additional financial instruments that have been entered into by the Company since the end of the most recent fiscal year. 13 FORWARD-LOOKING STATEMENTS When used in this report the words "believes," anticipates, "estimates", "plans" and "expects" and similar expressions are intended to identify forward-looking statements. These forward-looking statements are intended to provide management's current expectations or plans for the future operating and financial performance of the Company, based on assumptions currently believed to be valid. Readers are cautioned not to place undue reliance on them. A variety of factors could cause actual results to differ materially from those anticipated in the Company's forward-looking statements, some of which include risk factors previously discussed in this and other SEC reports filed by the Company. These risk factors include, but are not limited to, economic conditions in the United States, environmental laws and regulations, risks associated with currency fluctuations, a weakening in Latin America and Asian markets, unforeseen competitive pressures, warranty expenses, market acceptance of new products, unseasonably cool spring or summer weather, unforeseen difficulties in maintaining mutually beneficial relationships with strategic partnerships and alliances, and the results of restructuring activities. Forward-looking statements speak only as of the date on which those statements are made. The Company undertakes no obligation to update any forward-looking statements to reflect unanticipated events or circumstances occurring after that date. 14 PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Not applicable. ITEM 6(b). REPORTS ON FORM 8-K There were no reports filed on Form 8-K during the period. 15 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. AAF-MCQUAY INC. DATE May 11, 2001 By: /s/ BRUCE D. KRUEGER ---------------- ---------------------------- Bruce D. Krueger Vice President of Finance (Principal Financial and Chief Accounting Officer) 16

AAF MCQUAY INC 10-Q