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FUEL SYSTEMS SOLUTIONS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) In this report, references to "Fuel Systems" or the "Company" and to first-person pronouns, such as "we", "our" and "us", refer to Fuel Systems Solutions, Inc. and its consolidated subsidiaries, unless the context otherwise requires. This discussion and analysis should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations set forth in Fuel Systems' Annual Report on Form 10-K for the year ended December 31, 2010. The Company's business is subject to seasonal influences. Therefore, operating results for any quarter are not indicative of the results that may be achieved for any subsequent quarter or for a full year. Forward-looking Statements This Quarterly Report on Form 10-Q, particularly Management's Discussion and Analysis of Financial Condition and Results of Operations that follows, contains forward-looking statements that involve risks and uncertainties. These forward-looking statements are not historical facts but rather are based on current expectations, estimates and projections about our industry, our beliefs and assumptions. We use words such as "anticipate," "expect," "intend," "plan," "believe," "seek," "estimate" and variations of these words and similar expressions in part to help identify forward-looking statements. These statements are not guarantees of future performance or promises of specific courses of action and instead are subject to certain risks, uncertainties and other factors, some of which are beyond our control, are difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. These risks and uncertainties and certain other factors which may impact our continuing business financial condition or results of operations, or which may cause actual results to differ from such forward-looking statements, include, but are not limited to, economic uncertainties caused by political instability in certain of the markets we do business in, our ability to realign costs with current market conditions, as well as the risks and uncertainties included in the section entitled "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2010 and our other periodic reports filed with the SEC. You should not place undue reliance on these forward-looking statements, which reflect our view only as of the date of the filing of this Quarterly Report on Form 10-Q. We do not undertake or plan to update or revise forward-looking statements to reflect actual results, changes in plans, assumptions, estimates or projections, or other circumstances occurring after the date of this Quarterly Report on Form 10-Q, even if such results, changes or circumstances make it clear that any forward-looking information will not be realized. If we make any future public statements or disclosures which modify or impact any of the forward-looking statements contained in this Quarterly Report on Form 10-Q, such statements or disclosures will be deemed to modify or supersede such statements in this Quarterly Report on Form 10-Q. 20-------------------------------------------------------------------------------- Table of Contents Overview We design, manufacture and supply alternative fuel components and systems for use in the transportation and industrial markets on a global basis, primarily outside the United States. Our components and systems control the pressure and flow of gaseous alternative fuels, such as propane and natural gas used in internal combustion engines. Our products improve efficiency, enhance power output and reduce emissions by electronically sensing and regulating the proper proportion of fuel and air required by the internal combustion engine. We also provide engineering and systems integration services to address our individual customer requirements for product performance, durability and physical configuration. For over 50 years, we have developed alternative fuel products. We supply our products and systems to the marketplace through a global distribution network of approximately 850 distributors and dealers in more than 65 countries and more than 175 original equipment manufacturers, or OEMs. We offer an array of components, systems and fully integrated solutions for our customers, including: • fuel delivery - pressure regulators, fuel injectors, flow control valves and other components designed to control the pressure, flow and/or metering of gaseous fuels; • electronic controls - solid-state components and proprietary software that monitor and optimize fuel pressure and flow to meet manufacturers' engine requirements; • gaseous fueled internal combustion engines - engines manufactured by OEMs that are integrated with our fuel delivery and electronic controls; • systems integration - systems integration support to integrate the gaseous fuel storage, fuel delivery and /or electronic control components and sub-systems to meet OEM and aftermarket requirements; • auxiliary power systems - fully integrated auxiliary power systems for truck and diesel locomotives; and • natural gas compressors - natural gas compressors and refueling systems for light and heavy duty refueling applications. Manufacturers of industrial mobile equipment and stationary engines are among the most active customers for our industrial products. Users of small and large industrial engines capitalize on the lower cost and pollutant benefits of using alternative fuels. For example, forklift and other industrial equipment users often use our products to operate equipment indoors resulting in lower toxic emissions. The wide availability of gaseous fuels in world markets combined with their lower emissions and cost compared to gasoline and diesel fuels is driving rapid growth in the global alternative fuel industry. Automobile manufacturers, taxi companies, transit and shuttle bus companies, and delivery fleets are among the most active customers for our transportation products where our largest markets are currently outside the United States. We recently completed the acquisitions of NaturalDrive, LLC ("NaturalDrive"), Productive Concepts International, LLC ("PCI") and Evotek LLC ("Evotek") (collectively referred to as "IMPCO Automotive Acquisitions") to expand our activities in the automotive market within the United States. The IMPCO Automotive Acquisitions equip our U.S. automotive business with the capabilities necessary to be a leader in this market. Evotek and NaturalDrive are strategic transactions that we believe position Fuel Systems to compete in the dedicated natural gas vehicle (NGV) OEM market emerging in the United States. PCI adds key technology and industry relationships to further our North American OEM and fleet market strategy, and also expands our vehicle modification and systems integration capabilities for a variety of alternative fuel applications, including hybrid, CNG, propane and dual-fuel diesel. We continue to believe fleet vehicles offer attractive opportunities for our gaseous fuel solutions in the U.S. We now have a full suite of automotive capabilities in this market, including a CARB certified, dedicated systems product line and in-house OEM systems engineering platform, enhancing our ability to leverage our existing relationships with fleet customers and other manufacturers as they roll out CNG and LPG versions of key fleet vehicles. In addition, to the IMPCO Automotive Acquisitions, we added Alternative Fuel Systems (2004) Inc. and purchased the remaining 50% interest in MTE S.r.l. in an effort to continue to expand our core businesses and geographic footprint. For the three months ended June 30, 2011 revenue increased approximately 16.9%, operating income decreased 31.2% and diluted EPS decreased by approximately 51.3% compared to the prior year. These results were driven primarily by the increase in our aftermarket business including kits to OEMs, our industrial business including our auxiliary power business and recent acquisitions partially offset by lower post-productions OEM ("DOEM") sales. This change in our product mix contributed to a lower gross margin. In addition, we have incurred higher operating expenses due to recent acquisitions as well as additional resources for research and development. For the six month ended June 30, 2011 revenue decreased approximately 20.7%, operating profit decreased 82.7% and diluted EPS decreased by approximately 89.4% compared to the prior year. These results were driven primarily by the expiration of the Italian government incentives which drove strong results in our BRC operations related to our DOEM sales for the prior year. Beginning in the second quarter of 2010 and continuing through subsequent quarters, our volumes for DOEM conversions decreased significantly. The expiration of the Italian government incentives were partially offset by increased activity in our IMPCO operations, our 21 -------------------------------------------------------------------------------- Table of Contents aftermarket business as well as acquisitions. Although our performance year over year reflects difficult comparisons, our sequential quarterly comparisons in 2011 show higher revenue, operating profit and diluted EPS. In addition, the sequential quarterly DOEM volumes remained relatively consistent. We expect lower DOEM volumes to continue throughout 2011. Net Cash provided by operations was $17.8 million and $9.7 million for the three and six months ended June 30, 2011, respectively. Our net cash position at June 30, 2011 of $95.6 million provides us with the adequate capital for working capital and general corporate purposes, which may include expansion of our business, additional repayment of debt and financing of future acquisitions of companies or assets. Recent Developments Purchase of remaining 50% interest in MTE S.r.l. On June 1, 2011, we purchased the remaining 50% ownership interest in MTE S.r.l. ("MTE"), for €7.5 million (approximately $10.7 million), of which €5.3 million (approximately $7.5 million), was paid on the closing date with the remaining balance of €2.2 million (approximately $3.2 million) classified as restricted cash in Other Current Assets until January 15, 2012 as a guarantee towards possible indemnification obligations of the seller. Further performance payments of up to €1.0 million (approximately $1.4 million) in cash may be made no later than 5 days after May 31, 2014 based on the achievement of 2012 and 2013 gross profit targets. The range of undiscounted amounts we may be required to pay for these earnout payments is between $0.0 and $1.4 million (€0.0 to €1.0 million). In accordance with the FASB issued authoritative guidance, we determined the fair value of the liability for the contingent consideration based on a probability-weighted discounted cash flow analysis. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement within the fair value hierarchy. The resultant probability-weighted cash flows were then discounted using a rate that reflects the uncertainty surrounding the expected outcomes, which the Company believes is appropriate and representative of a market participant assumption. Future changes to the fair value of the contingent consideration will be determined each period and charged to expense in the Consolidated Statements of Operations under operating expenses. As of the closing date of the acquisition, the MTE contingent consideration was assigned a preliminary fair value of approximately $0.4 million. Future changes to the fair value of the contingent consideration will be determined each period and charged to expense in the Consolidated Statements of Operations under operating expenses. Management believes that the model used in the determination of the fair value of the MTE contingent consideration agreement is sensitive to changes in the unobservable inputs on which it is based and their interrelationships, changes that may be driven by mutated market conditions, different demand level, alternative strategies that management may pursue, and other factors. As the Company previously had control of MTE prior to this acquisition, the results of MTE were consolidated within the BRC operation segment, the excess purchase price of the remaining 50% over the non-controlling interest is recorded to additional paid in capital. Acquisition of Alternative Fuel Systems (2004) Inc. On May 31, 2011, through our wholly owned subsidiary IMPCO Technologies, Inc. ("IMPCO US"), we acquired Alternative Fuel Systems (2004) Inc. ("AFS"), a developer and marketer of fuel management systems that enable internal combustion engines to operate on compressed natural gas. The aggregate purchase price for 100% of the equity of AFS was approximately $8.9 million in cash, net of cash acquired of approximately $0.7 million. The results of operations of AFS have been included in the accompanying consolidated statements of operations from the date of acquisition within the IMPCO operating segment. The purchase price has been allocated based on management's preliminary estimates as follows (in thousands): Inventory $ 1,300 Other tangible assets 1,276 Intangible assets subject to amortization 2,110 Goodwill 4,935 Total assets acquired 9,621 Less: total liabilities (680 ) Total net assets recorded $ 8,941 Of the $2.1 million of acquired intangible assets, $1.4 million relates to customer relationships with a useful life of approximately 7 years, $0.4 million to developed technology with a useful life of 6 years and $0.3 million to trademarks with a useful life of 6 years. The international presence of AFS specifically in the Asia automotive market as well as the ability to incorporate their products into the Company's existing supply chain were among the factors that contributed to a purchase price resulting in the recognition of goodwill of $4.9 million. The acquired goodwill is deductible for tax purposes. The above purchase price has been 22 -------------------------------------------------------------------------------- Table of Contents allocated based on an estimate of the fair values of assets acquired and liabilities assumed. Management is in the process of finalizing its valuations of certain intangible assets, thus the value of the consideration paid and the allocation of the purchase price are subject to refinement. Management has determined that the acquisition of AFS was a non-material business combination. As such, pro forma disclosures are not required and are not presented within this filing. Acquisition of NaturalDrive Partners LLC On April 18, 2011, through our wholly owned subsidiary IMPCO US, we completed the purchase of NaturalDrive, a premier alternative fuel automotive systems developer in North America that offers dedicated CNG and LPG conversion systems across multiple U.S. fleet vehicle platforms. The transaction is valued at $6.0 million, comprised of $4.5 million in cash and $1.5 million of Fuel Systems' stock paid at closing. More specifically, we issued 52,317 shares of common stock in a transaction exempt from registration under Section 4(2) of the Securities Act of 1933, as amended, since the issuance did not involve a public offering. The transaction also includes provisions for earn-out payments totaling up to $6.75 million in the form of Fuel Systems stock, which would be payable during the three years following closing based upon achievement of business volume and general milestones. The earn-out will be paid in three equal installments of $1.5 million no later than 90 days after the end of each calendar year beginning in 2011 if specified target customer volumes for the year are met, and reasonable progress is made on the general milestones. In the case the earn-out for a specific period is determined to be payable in accordance with the aforementioned target customer volumes and additional original equipment manufacturer value thresholds are met for the same period, the earn-out shares for the applicable period will be multiplied by a factor of 1.5 for purposes of determining the number of earn-out shares payable. The range of the undiscounted amounts the Company could be required to pay for these earnout payments is between $0.0 and $6.75 million. In accordance with the FASB issued authoritative guidance, Management determined the fair value of the liability for the contingent consideration based on a probability-weighted discounted cash flow analysis, contemplating various scenarios for the earnout levels, with probability ranging from approximately 10% to approximately 60%. This fair value measurement is based on significant inputs not observable in the market and thus represents a Level 3 measurement within the fair value hierarchy, which reflects management's own assumptions. The resultant probability-weighted cash flows were then discounted using a rate of approximately 13.0% over the earnout period that reflects the uncertainty surrounding the expected outcomes, and which we believe is appropriate and representative of a market participant assumption once considered the earnout conditions. As of the closing date of the acquisition, the NaturalDrive contingent consideration was assigned a preliminary fair value of approximately $1.4 million. Once management has finalized the purchase accounting for NaturalDrive, future changes to the fair value of the contingent consideration will be determined each period and charged to expense in the Consolidated Statements of Operations under operating expenses. Management believes that the model used in the determination of the fair value of the NaturalDrive contingent consideration agreement is sensitive to changes in the unobservable inputs on which it is based and their interrelationships, changes that may be driven by mutated market conditions, different demand level, alternative strategies that management may pursue, and other factors. The results of operations of NaturalDrive have been included in the accompanying consolidated statements of operations from the date of acquisition within the IMPCO operating segment. The purchase price has been allocated based on management's preliminary estimates as follows (in thousands): Total tangible assets $ 68 Intangible assets subject to amortization 5,650 Goodwill 1,730 Total assets acquired 7,448 Less: total liabilities (1,448 ) Total net assets recorded $ 6,000 Of the $5.7 million of acquired intangible assets, $4.8 million refers to existing technology with an estimated useful life of 8 years, $0.6 million to customer relationships with a useful life of approximately 6 years and $0.3 million to non-compete agreements with an estimated useful life of 4 years. The continued development of the U.S. alternative fuel market as well as potential legislative changes impacting this market were among the factors that contributed to a purchase price resulting in the recognition of goodwill of $1.7 million. The acquired goodwill is deductible for tax purposes. The above purchase price has been allocated based on an estimate of the fair values of assets acquired and liabilities assumed. We are in the process of finalizing our valuations of certain intangible assets, as well as of the contingent consideration; thus, the value of the consideration paid and the allocation of the purchase price are subject to refinement. Management has determined that the acquisition of NaturalDrive was a non-material business combination. As such, pro forma disclosures are not required and are not presented within this filing. 23-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to bad debts, goodwill, taxes, inventories, warranty obligations, long-term service contracts, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates under different assumptions or conditions. We believe that we have considered relevant circumstances that we may be currently subject to and the financial statements accurately reflect our estimate of the results of our operations, financial condition and cash flows for the periods presented. Our accounting for acquisitions involves significant judgments and estimates, including the fair value of certain forms of consideration, the fair value of acquired intangible assets, which involve projections of future revenue and cash flows, the fair value of other acquired assets and assumed liabilities, including potential contingencies, and the useful lives and, as applicable, the reporting unit, of the assets. Our financial position or results of operations may be materially impacted by changes in our initial assumptions and estimates relating to prior or future acquisitions. Our critical accounting policies are described in Management's Discussion and Analysis of Financial Condition included in our Annual Report on Form 10-K for the year ended December 31, 2010. There have been no material changes, subsequent to December 31, 2010, to information previously disclosed in our Annual Report on Form 10-K with respect to our critical accounting policies. Results of Operations - Three Months Ended June 30, 2011 REVENUES Three Months Ended June 30, Percent 2011 2010 Change Change IMPCO Operations $ 43,621 $ 29,750 $ 13,871 46.6 % BRC Operations 74,709 72,987 1,722 2.4 % Intersegment (1,732 ) (2,962 ) 1,230 41.5 % Total Revenues $ 116,598 $ 99,775 $ 16,823 16.9 % IMPCO Operations. The increase in revenue relates to an increase in demand in the industrial market of approximately $14.0 million which includes approximately $7.1 million from our auxiliary power unit business. Revenue associated with the automotive market remained relatively flat due in part to a decrease in the automotive market in Asia partially offset by an approximate $6.4 million increase in US automotive market primarily from the IMPCO Automotive Acquisitions. Included in the results discussed above are the strengthening of local currencies compared to the US dollar which positively impacted revenues by approximately $2.2 million for the three months ended June 30, 2011. BRC Operations. The increase in revenue in 2011 was due primarily to the strengthening of local currencies compared to the US dollar which positively impacted revenues by approximately $9.3 million for the three months ended June 30, 2011 as well as an improvement in aftermarket sales, including kits to OEMs, of approximately 36.6% partially offset by a decrease in sales for DOEM conversions. Volumes for the DOEM conversions decreased to approximately 6,500 for the second quarter 2011 compared to 19,000 conversions for the second quarter 2010 as the Italian automotive market adjusted to an environment without government incentives. The Company's product revenue by application across all business segments follows (in thousands): Three Months Ended June 30, Revenue: 2011 2010 Transportation $ 86,973 $ 84,485 Industrial 29,625 15,290 Total $ 116,598 $ 99,775 COST OF REVENUE 24 -------------------------------------------------------------------------------- Table of Contents Three Months Ended June 30, Percent 2011 2010 Change Change IMPCO Operations $ 34,257 $ 20,544 $ 13,713 66.7 % BRC Operations 55,257 53,505 1,752 3.3 % Total Cost of Revenues $ 89,514 $ 74,049 $ 15,465 20.9 % IMPCO Operations. The increase primarily relates to the increase in volume associated with the industrial market which includes our APU business as well as approximately $5.8 million increase in the US automotive market including the IMPCO Automotive Acquisitions, partially offset by the decrease in the Asian market. We expect the pressure on gross margins to continue until the volumes associated with the US automotive market increase which will better absorb fixed costs. BRC Operations. The increase of $1.8 million primarily relates to the strengthening of local currencies compared to the US dollar which increased cost of revenue by approximately $7.2 million for the three months ended June 30, 2011 as well as high volumes from aftermarket sales. These increases were almost entirely offset by the decrease in DOEM volumes, as well as lower compensation and related expenses. Compensation and related expenses include salaries, fringe benefits and variable compensation. Factory utilization and gross profit have been closely tied to DOEM volumes as well. The elimination of the Italian government incentives has significantly decreased volumes and factory utilization resulting in reduced gross profit levels. We expect pressure on gross profit margins to continue in 2011 due to lower DOEM volumes. RESEARCH & DEVELOPMENT Three Months Ended June 30, Percent 2011 2010 Change Change IMPCO Operations $ 3,607 $ 2,393 $ 1,214 50.7 % BRC Operations 3,554 2,586 968 37.4 % Total Research and Development $ 7,161 $ 4,979 $ 2,182 43.8 % IMPCO Operations. The increase relates to additional compensation and related expenses as well as outside services associated with the research and development for the US automotive market. BRC Operations. The increase relates to additional compensation and related expenses associated with the continued investment in various automotive projects including next generation products, OEM quality system solutions and expansion of current products as well as additional overhead costs associated with our new R&D facility in Italy. SELLING, GENERAL & ADMINISTRATIVE Three Months Ended June 30, Percent 2011 2010 Change Change IMPCO Operations $ 3,496 $ 3,355 $ 141 4.2 % BRC Operations 8,790 7,050 1,740 24.7 % Corporate 1,263 1,077 186 17.3 % Total Selling, General & Administrative $ 13,549 $ 11,482 $ 2,067 18.0 % IMPCO Operations. The increase relates primarily to additional costs associated with the IMPCO Automotive Acquisitions, partially offset by a reduction in the contingent consideration associated with the PCI acquisition of approximately $0.6 million. BRC Operations. The increase relates primarily the strengthening of local currencies compared to the US dollar of approximately $0.9 million as well as additional compensation and related expenses partially offset by lower consulting and outside services. Corporate Expenses. Corporate expenses consist of general and administrative expenses at the corporate level to support our business segments in areas such as executive management, finance, human resources, management information systems, legal and accounting services and investor relations. Corporate expenses increased due primarily to higher compensation costs. 25-------------------------------------------------------------------------------- Table of Contents OPERATING INCOME/(LOSS) Three Months Ended June 30, Percent 2011 2010 Change Change IMPCO Operations $ 1,766 $ 3,148 $ (1,382 ) (43.9 %) BRC Operations 5,871 7,194 (1,323 ) (18.4 %) Corporate Expenses (1) (1,263 ) (1,077 ) (186 ) (17.3 %) Total Operating Income $ 6,374 $ 9,265 $ (2,891 ) (31.2 %) (1) Represents corporate expense not allocated to either of the business segments. Operating income for the three months ended June 30, 2011 decreased for the reasons stated above. Other Income (Expense), Net Other income (expense) includes foreign exchange gains and losses between various other assets and liabilities to be settled in other currencies. For the three months ended June 30, 2011 we recognized less then $0.1 million in losses on foreign exchange compared to $0.2 million in losses on foreign exchange for the three months ended June 30, 2010. We cannot estimate or forecast the direction or the magnitude of any foreign exchange movements with any currency that we transact in; therefore, we do not measure or predict the future impact of foreign currency exchange rate movements on our consolidated financial statements. Provision for Income Taxes Income tax expense for the three months ended June 30, 2011 and 2010 was approximately $3.1 million and $1.8 million, representing an effective tax rate of 44.5% and 20.6%, respectively, and primarily consisted of the provision for our foreign operations. A full valuation allowance is maintained against the income tax benefits generated in the United States and certain foreign jurisdictions due to cumulative losses incurred in those jurisdictions, as we cannot conclude that such tax benefits meet the more likely than not threshold for realization. Accordingly, for the three months ended June 30, 2011, we have not recorded income tax benefits for losses incurred or significant income tax expense for income generated for such jurisdictions as such amounts will be offset by the valuation allowance. We operate in an international environment with significant operations in various locations outside of the United States, which have statutory tax rates that are different from the United States tax rate. Accordingly, the consolidated income tax rate is a composite rate reflecting the earnings in the various locations and the applicable rates. The change in the effective tax rate is primarily a result of the fluctuation of earnings in the various jurisdictions and losses incurred in the United States and certain foreign jurisdictions for which no tax benefit has been recorded. Results of Operations - Six Months Ended June 30, 2011 REVENUES Six Months Ended June 30, Percent 2011 2010 Change Change IMPCO Operations $ 81,787 $ 53,840 $ 27,947 51.9 % BRC Operations 129,350 212,112 (82,762 ) (39.0 %) Intersegment (3,721 ) (4,526 ) 805 17.8 % Total Revenues $ 207,416 $ 261,426 $ (54,010 ) (20.7 %) IMPCO Operations. The increase in revenue relates to an increase in demand in the industrial market of approximately $22.9 million which includes approximately $11.0 million from our auxiliary power unit business. In addition, the transportation business at IMPCO increased approximately $4.6 million which includes an approximate $11.1 million increase in US automotive market sales associated with IMPCO Automotive Acquisitions partially offset by the decrease in our Asian transportation market. Included in the results discussed above are the strengthening of local currencies compared to the US dollar which positively impacted revenues by approximately $2.8 million for the six months ended June 30, 2011. BRC Operations. The decrease in revenue in 2011 was due primarily to a decrease in sales for DOEM conversions partially offset by an approximately 32.3% improvement in aftermarket sales including kits to OEMs. Volumes for the DOEM conversions decreased to approximately 11,700 for the first six months of 2011 compared to 94,000 conversions for the first six months of 2010. 26-------------------------------------------------------------------------------- Table of Contents The strengthening of local currencies compared to the US dollar positively impacted revenues by approximately $9.9 million for the six months ended June 30, 2011. The Company's product revenue by application across all business segments follows (in thousands): Six Months Ended June 30, Revenue: 2011 2010 Transportation $ 154,361 $ 231,905 Industrial 53,055 29,521 Total $ 207,416 $ 261,426 COST OF REVENUE Six Months Ended June 30, Percent 2011 2010 Change Change IMPCO Operations $ 63,474 $ 38,041 $ 25,433 66.9 % BRC Operations 95,232 134,058 (38,826 ) (29.0 %) Total Cost of Revenues $ 158,706 $ 172,099 $ (13,393 ) (7.8 %) IMPCO Operations. The increase primarily relates to the increase in volume associated with the industrial market including our APU business as well as approximately $10.1 million increase in the US automotive market from the IMPCO Automotive Acquisitions. We expect the pressure on gross margins to continue until volumes associated with the US automotive market increase which will better absorb fixed costs. BRC Operations. The decrease of $38.8 million relates to the decrease in DOEM volumes, beginning in the second quarter 2010 and continuing into subsequent quarters, as well as lower compensation and related expenses. Compensation and related expenses include salaries, fringe benefits and variable compensation. Factory utilization and gross profit have been closely tied to DOEM volumes as well. The elimination of the Italian government incentives has significantly decreased volumes and factory utilization resulting in reduced gross profit levels. These decreases were partially offset by the increase in the aftermarket product costs due to higher volume. We expect pressure on gross profit margins to continue in 2011 due to lower DOEM volumes. The strengthening of local currencies compared to the US dollar increased cost of revenue by approximately $7.2 million for the six months ended June 30, 2011. RESEARCH & DEVELOPMENT Six Months Ended June 30, Percent 2011 2010 Change Change IMPCO Operations $ 7,249 $ 4,866 $ 2,383 49.0 % BRC Operations 6,299 4,549 1,750 38.5 % Total Research and Development $ 13,548 $ 9,415 $ 4,133 43.9 % IMPCO Operations. The increase relates to additional compensation and related expenses as well as outside services associated with the research and development for the US automotive market. BRC Operations. The increase relates to additional compensation and related expenses associated with the continued investment in various automotive projects including next generation products, OEM quality system solutions and expansion of current products as well as additional overhead costs associated with our new R&D facility. SELLING, GENERAL & ADMINISTRATIVE Six Months Ended June 30, Percent 2011 2010 Change Change IMPCO Operations $ 7,491 $ 6,894 $ 597 8.7 % BRC Operations 15,727 16,474 (747 ) (4.5 %) Corporate 2,586 2,593 (7 ) (0.3 %) Total Selling, General & Administrative $ 25,804 $ 25,961 $ (157 ) (0.6 %) 27 -------------------------------------------------------------------------------- Table of Contents IMPCO Operations. The increase relates primarily to additional costs associated with the IMPCO Automotive Acquisitions partially offset by a reduction in the contingent consideration associated with the PCI acquisition of approximately $0.6 million. BRC Operations. The decrease relates primarily to lower consulting and outside services as well as lower advertising partially offset by the strengthening of local currencies compared to the US dollar of approximately $0.8 million. Corporate Expenses. Corporate expenses consist of general and administrative expenses at the corporate level to support our business segments in areas such as executive management, finance, human resources, management information systems, legal and accounting services and investor relations. Corporate expenses remained relatively flat versus the prior year. OPERATING INCOME/(LOSS) Six Months Ended June 30, Percent 2011 2010 Change Change IMPCO Operations $ 2,711 $ 3,651 $ (940 ) 25.7 % BRC Operations 9,233 52,893 (43,660 ) (82.5 %) Corporate Expenses (1) (2,586 ) (2,593 ) 7 0.3 % Total Operating Income $ 9,358 $ 53,951 $ (44,593 ) (82.7 %) (1) Represents corporate expense not allocated to either of the business segments. Operating income for the six months ended June 30, 2011 decreased/increased for the reasons stated above. Other Income (Expense), Net Other income (expense) includes foreign exchange gains and losses between various other assets and liabilities to be settled in other currencies. For the six months ended June 30, 2011 we recognized approximately $0.4 million in losses on foreign exchange compared to $0.6 million in gains on foreign exchange for the six months ended June 30, 2010. We routinely conduct transactions in currencies other than our reporting currency, the U.S. dollar. We cannot estimate or forecast the direction or the magnitude of any foreign exchange movements with any currency that we transact in; therefore, we do not measure or predict the future impact of foreign currency exchange rate movements on our consolidated financial statements. Provision for Income Taxes Income tax expense for the six months ended June 30, 2011 and 2010 was approximately $5.4 million and $19.1 million, representing an effective tax rate of 55.9% and 35.1%, respectively, and primarily consisted of the provision for our foreign operations. A full valuation allowance is maintained against the income tax benefits generated in the United States and certain foreign jurisdictions due to cumulative losses incurred in those jurisdictions, as we cannot conclude that such tax benefits meet the more likely than not threshold for realization. Accordingly, for the six months ended June 30, 2011, we have not recorded income tax benefits for losses incurred or significant income tax expense for income generated for such jurisdictions as such amounts will be offset by the valuation allowance. We operate in an international environment with significant operations in various locations outside of the United States, which have statutory tax rates that are different from the United States tax rate. Accordingly, the consolidated income tax rate is a composite rate reflecting the earnings in the various locations and the applicable rates. The change in the effective tax rate is primarily a result of the fluctuation of earnings in the various jurisdictions and losses incurred in the United States and certain foreign jurisdictions for which no tax benefit has been recorded. Liquidity and Capital Resources Our primary sources of liquidity are cash provided by operating activities and debt financing. Additionally from time to time we raise funds from the equity capital markets to fund our working capital and general corporate purposes, which may include expansion of our business, additional repayment of debt and financing of future acquisitions of companies or assets. We believe the amounts available to us under our various credit agreements together with cash on hand will continue to allow us to meet our needs for working capital and other cash needs for worldwide operations for at least the next 12 months. For periods beyond 12 months, although we do not have any plans to do so, we may seek additional financing to fund future operations through future offerings of equity or debt 28 -------------------------------------------------------------------------------- Table of Contents securities or through agreements with corporate partners with respect to the development of our technologies and products. However, we can offer no assurances that we will be able to obtain additional funds on acceptable terms, if at all. Nevertheless, our ability to satisfy our working capital requirements will substantially depend upon our future operating performance (which may be affected by prevailing economic conditions), and financial, business and other factors, some of which are beyond our control. We continue to evaluate our need to increase liquidity. As of June 30, 2011 we had approximately $76.8 million of cash held in accounts outside the U.S. See Item 1A "Risk Factors" in our Annual Report on Form 10-K for additional information that could impact our liquidity and capital resources. As of June 30, December 31, 2011 2010 Cash and cash equivalents $ 106,889 $ 124,775 Current portion of term loans and debt 5,048 4,823 Long-term term and other loans 6,254 7,571 Total debt 11,302 12,394 Total Fuel Systems equity 351,183 334,806 Total capitalization (debt plus equity) $ 362,485 $ 347,200 Debt to total capitalization 3.1 % 3.6 % Net Cash (cash and cash equivalents less debt) $ 95,586 $ 112,381 Current assets $ 320,188 $ 306,928 Current liabilities $ 116,513 $ 96,079 Our debt to total capitalization ratio at June 30, 2011 decreased approximately 13.9% to 3.1% compared to December 31, 2010 as our total capitalization has increased by approximately $15.3 million or 4.4% compared to December 31, 2010. This was driven mostly by an increase in accumulated other comprehensive income in relation with foreign currency translation effect and an increase in earnings. Our ratio of current assets to current liabilities was approximately 3:1 at both June 30, 2011 and December 31, 2010, respectively. At June 30, 2011, our total working capital decreased by $7.1 million to $203.7 million from $210.8 million at December 31, 2010. This decrease is primarily due to the following: (1) a decrease of $17.9 million in cash; (2) an increase of $13.0 in accounts payable; and (3) an increase of $4.0 in accrued expenses, which all were partially offset by: (a) an increase $17.8 million in accounts receivable; and (b) and increase of $11.3 million in inventory. The following table provides a summary of our operating, investing and financing activities as follows: Six Months Ended June 30, 2011 2010 Net cash provided by (used in): Operating activities $ 9,725 $ 87,928 Investing activities (22,794 ) (10,178 ) Financing activities (10,116 ) (4,477 ) Effect on cash of changes in exchange rates 5,299 (13,435 ) Net (decrease) increase in cash and cash equivalents $ (17,886 ) $ 59,838 Cash Flow from Operating Activities. We prepare our statement of cash flows using the indirect method. Under this method, we reconcile net income to cash flows from operating activities by adjusting net income for those items that impact net income but may not result in actual cash receipts or payments during the period. These reconciling items include but are not limited to depreciation and amortization, provisions for inventory reserves and doubtful accounts; gains and losses from various transactions and changes in the consolidated balance sheet for working capital from the beginning to the end of the period. 2011 compared to 2010. In 2011, our net cash flow provided by operating activities was $9.7 million, a decrease of $78.2 million from the net cash flow provided by operating activity in the six months ended June 2010. This decrease was primarily driven by the decrease in sale for DOEM conversions, which resulted in lower net income for the period. In addition, cash in-flows associated with accounts receivable, inventory and taxes payable were lower in the six months ended June 2011 when compared to the same period in 2010. The impact to accounts receivable and taxes payable were driven primarily by the cash collected from elevate DEOM conversions in 2010 partially offset by the increase in the IMPCO operations in 2011. The change in inventory reflects increases in 29 -------------------------------------------------------------------------------- Table of Contents the US automotive market as well as the industrial market partially offset by lower DOEM conversions. These items were partially offset by higher cash flows associated with accounts payable due primarily to the increase in inventory. Cash Flow from Investing Activities. Our net cash used in investing activities consisted primarily of acquisitions as well as equipment and leasehold improvements expenditures. In 2011, we spent approximately $13.4 million on the acquisition of AFS and NaturalDrive, and recorded restricted cash of approximately $3.2 million in connection with the redemption of the non-controlling interest in MTE. Our equipment and leasehold additions were approximately $6.6 million. The majority of our equipment and leasehold improvements expenditures was within our BRC operations and related to increased purchases to expand our manufacturing capacity, with specific emphasis on our research and development center. In 2010, our equipment and leasehold additions were approximately $11.4 million primarily due to the continued expansion of our BRC operations. In addition, the Company obtained approximately $1.0 million of cash from the consolidation of a previously unconsolidated affiliate due to a change in control of the Board of Directors of this company. Cash Flow from Financing Activities. Our capitalization and financing strategy is intended to ensure that we are properly capitalized with the appropriate level of debt and available credit. In 2011, our financing activities include the redemption of the non-controlling interest in MTE for approximately $7.5 million, payments on our revolving lines of credit for approximately $0.4 million in connection with our BRC operations, as well as payments on term and other loans of approximately $2.1 million. In 2010, our financing activities included payments on revolving lines of credit for approximately $2.7 million, as well as payments on term and other loans of approximately $1.5 million. Credit Agreements Our debt payable is summarized as follows (in thousands): Available as of As of June 30, June 30, December 31, 2011 2011 2010 (a) Revolving lines of credit - Italy and Argentina $ 12,157 $ 338 $ 751 (b) Revolving lines of credit - USA 10,500 - - (c) Term loan - Intesa SanPaolo S.p.A. - 2,337 2,837 (d) Term loan - Banca IMI S.p.A. and Intesa SanPaolo S.p.A. - 7,195 7,731 (e) Other indebtedness 1,439 1,432 1,075 $ 24,096 11,302 12,394 Less: current portion 5,048 4,823 Non-current portion $ 6,254 $ 7,571 At June 30, 2011, the Company's weighted average interest rate on outstanding debt was 2.8%. The Company is party to numerous credit agreements and other borrowings. All foreign denominated revolving lines of credit have been converted using the average interbank currency rate at June 30, 2011. (a) Revolving Lines of Credit - Italy and Argentina The Company maintains various revolving lines of credit in Italy and Argentina. The revolving lines of credit in Italy include $3.6 million which is unsecured and $6.6 million which is collateralized by accounts receivable. The interest rates on these revolving lines of credit are fixed and variable and range from 2.5% to 5.5% as of June 30, 2011. At June 30, 2011 and December 31, 2010, there were no balances outstanding. The revolving lines of credit in Argentina consist of two lines for a total amount of availability of approximately $2.3 million. These lines are unsecured with approximately $0.3 million and $0.8 million outstanding at June 30, 2011 and December 31, 2010, respectively. At June 30, 2011, the interest rates for the lines of credit in Argentina were 3.5%. All lines are callable on demand. 30-------------------------------------------------------------------------------- Table of Contents (b) Revolving Line of Credit - USA As of June 30, 2011, the Company and IMPCO Technologies, Inc. ("IMPCO US") maintain an unsecured, revolving short term credit facility with Intesa SanPaolo S.p.A. ("Intesa") amounting to $10.5 million. IMPCO US intends to use the borrowings for its general corporate purposes and Fuel Systems guarantees IMPCO US's payments. At June 30, 2011 and December 31, 2010, there were no balances outstanding. The maximum aggregate principal amount of loans outstanding at any time is $10.5 million and the maturity date for the agreement is April 30, 2014. At the Company's option, the loans will bear interest on either the applicable LIBOR rate plus 2.0%, the bank's prime rate plus 1.0% or the bank's cost of funds rate plus 2.0%. The bank's prime rate is a floating interest rate that may change as often as once a day. If any amounts under a loan remain outstanding after the loan's maturity date, such amounts will bear interest at the bank's prime rate plus 2.0%. In addition, this revolving credit facility carries a commitment fee of 0.5% of the average daily unused amount. The line of credit contains quarterly covenants beginning September 30, 2009, which require the Company to maintain (1) a ratio of Net Debt/EBITDA for the then most recently concluded period of four consecutive fiscal quarters of the Company to be less than 2, (2) a consolidated net worth of at least $135 million, and (3) the Company shall not, and shall not permit any of its subsidiaries to create, incur, assume or permit to exist any Debt other than (i) debt of any such subsidiary owing to any other subsidiary or to the Company or (ii) debt for borrowed money in a total aggregate principal amount, the U.S. Dollar equivalent of which does not exceed $75 million. At June 30, 2011, the Company was in compliance with these covenants. (c) Term Loan - Intesa SanPaolo S.p.A. On June 26, 2007, BRC entered into a five and a half year unsecured term loan agreement with Intesa of Italy in which BRC received approximately $6.7 million. The payment terms are such that BRC will pay equal installments on a semi-annual basis throughout the term of the loan and interest based on six-month EURIBOR plus 0.4% per annum, which was 2.2% and 1.6% at June 30, 2011 and December 31, 2010, respectively. The loan agreement requires that BRC maintain a ratio of indebtedness to EBITDA, measured at each year end, of less than 1.25 to maintain this rate. At June 30, 2011 and December 31, 2010, BRC was in compliance with this covenant. In the event the ratio of indebtedness to EBITDA exceeds 2.5, the effective rate may adjust upward not to exceed six-month EURIBOR plus 1.2%, which was 3.0% at June 30, 2011. (d) Term Loan - Banca IMI S.p.A. and Intesa SanPaolo S.p.A. On December 22, 2008, MTM S.r.L. ("MTM"), a subsidiary of the Company, entered into a financing agreement with Banca IMI S.p.A. and Intesa pursuant to which MTM may borrow up to €15.0 million (approximately $21.6 million converted into U.S. dollars) to be used for acquisitions, as well as for investments in MTM's subsidiaries and certain capital expenditures for research and development. Approximately $7.2 million and $7.7 million were outstanding on this financing agreement as of June 30, 2011 and December 31, 2010, respectively. In addition, on May 28, 2009, MTM exercised its option to extend the maturity date of its borrowings under this financing agreement from June 22, 2009 to June 22, 2014. As specified in the financing agreement, MTM must make interest payments on June 30 and December 31 of each year beginning on June 30, 2009 and is obligated to repay the entire principal amount of the loan, €15.0 million, in ten equal semi-annual installments beginning on December 22, 2009 and ending on June 22, 2014. The loan contains semi-annual covenants beginning June 30, 2009 which require MTM to maintain (1) a ratio of indebtedness less cash and cash equivalents to rolling twelve month EBITDA of less than 2.5, (2) a ratio of indebtedness less cash and cash equivalents to equity of less than 1.0 and (3) a ratio of rolling twelve month EBITDA to net interest expense ratio greater than 5.0. In addition, the loan requires Mariano Costamagna (the Company's Chief Executive Officer) and his family to hold, directly or indirectly, 10% of the outstanding capital stock of the Company, unless the reduction in ownership is attributable to one or more issuances of the Company's capital stock or a merger or other fundamental corporate transaction which causes a variation in the outstanding capital stock. At June 30, 2011, MTM was in compliance with these covenants. The loan is collateralized by all of MTM's ownership interest in Distribuidora Shopping, a subsidiary of the Company, and all of Distribuidora Shopping's receivables. (e) Other indebtedness Other indebtedness includes capital leases and various term loans and lines of credits involving our foreign subsidiaries. These term loans and lines of credit are used primarily to fund the operations of these subsidiaries and bear interest ranged from 2.6% to 2.9%. Off-Balance Sheet Arrangements As of June 30, 2011, we had no off-balance sheet arrangements. 31-------------------------------------------------------------------------------- Table of Contents Contractual Obligations The following table contains supplemental information regarding total contractual obligations as of June 30, 2011: Payments Due by Period Six Months Ending (In thousands) December 31, Year Ending December 31, Contractual Obligations Total 2011 2012 2013 2014 2015 Thereafter Revolving lines of credit $ 338 $ 338 $ - $ - $ - $ - $ - Term and other loans - principal 10,660 2,365 4,318 2,456 1,259 61 201 Term and other loans - interest 462 137 190 94 25 7 9 Capital lease obligations (a) 359 134 94 98 33 - - Operating lease obligations (a) 40,987 4,677 8,273 7,694 6,575 4,293 9,475 Other long-term liabilities 257 16 18 19 19 20 165 Other and miscellaneous (a) 941 314 627 - - - - $ 54,004 $ 7,981 $ 13,520 $ 10,361 $ 7,911 $ 4,381 $ 9,850 (a) The capital lease obligations are undiscounted and represent total minimum lease payments. The operating lease obligations represent total minimum lease payments. The "other and miscellaneous" category includes obligations under employment contracts. |