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BARNES GROUP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) OVERVIEW Please refer to the Overview in the Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's Annual Report on Form 10-K for the year ended December 31, 2013. The Annual Report on Form 10-K and other documents related to the Company are located on the Company's website: www.bginc.com. Second Quarter 2014 Highlights In the second quarter of 2014, sales increased by $54.7 million, or 20.4% from the second quarter of 2013, to $322.1 million. This increase was driven primarily by a $35.7 million sales contribution from the Männer Business. Organic sales increased by $16.3 million, or 6.1%, with growth in both the Industrial and Aerospace segments. Operating income in the second quarter of 2014 increased 25.5% to $45.4 million from the second quarter of 2013 and operating margin increased from 13.5% to 14.1%. Operating income benefited from the profit contribution of both the Männer Business and increased organic sales, partially offset by $1.9 million of short-term purchase accounting adjustments related to the acquisition of the Männer Business and $2.3 million of pre-tax restructuring charges related to the closure of production operations at the facility in Saline, Michigan. In March 2014, the Company authorized the closure of production operations ("Saline operations") at its Associated Spring facility located in Saline, Michigan ("the Closure"). The Saline operations primarily manufactured certain automotive engine valve springs. The Closure occurred during the second quarter of 2014, however certain other facility Closure costs, including the transfer of machinery and equipment, will continue through the remainder of 2014. In June 2014, the Company entered into a Component Repair Program ("CRP") with its customer, General Electric ("GE"). This CRP provides for, among other items, the right to sell certain aftermarket component repair services for CFM56 engines directly to other customers as one of a few GE licensed suppliers. In addition, this CRP extends existing contracts under which the Company currently provides these services directly to GE. As consideration for these rights, the Company agreed to pay $80,000. The Company has paid $41,000 in the second quarter of 2014 and the remaining payments of $20,000 and $19,000 will be paid in the fourth quarter of 2014 and the second quarter of 2015, respectively. RESULTS OF OPERATIONS Net Sales Three months ended June 30, Six months ended June 30, (in millions) 2014 2013 Change 2014 2013 Change Industrial 212.8 170.6 42.2 24.7 % 416.7 336.1 80.6 24.0 % Aerospace $ 109.3 $ 96.8 $ 12.5 12.9 % $ 217.5 $ 194.9 $ 22.6 11.6 % Intersegment sales - - - - % - - - - % Total $ 322.1 $ 267.4 $ 54.7 20.4 % $ 634.2 $ 530.9 $ 103.2 19.4 % The Company reported net sales of $322.1 million in the second quarter of 2014, an increase of $54.7 million or 20.4%, from the second quarter of 2013. The acquisition of the Männer Business in 2013 provided $35.7 million of net sales during the second quarter of 2014. Organic sales increased by $16.3 million, which included an increase of $3.8 million at Industrial and an increase of $12.5 million at Aerospace. The weakening of the U.S. dollar against foreign currencies increased net sales by approximately $2.7 million. The Company reported net sales of $634.2 million in the first half of 2014, an increase of $103.2 million or 19.4%, from the first half of 2013. The acquisition of the Männer Business in 2013 provided $73.7 million of net sales during the first half of 2014. Organic sales increased by $26.0 million, which included an increase of $3.4 million at Industrial and an increase of $22.6 million at Aerospace. The weakening of the U.S. dollar against foreign currencies increased net sales by approximately $3.5 million. 22 --------------------------------------------------------------------------------Expenses and Operating Income Three months ended June 30, Six months ended June 30, (in millions) 2014 2013 Change 2014 2013 Change Cost of sales $ 211.7 $ 177.4 $ 34.3 19.3 % $ 426.3 $ 355.1 $ 71.1 20.0 % % sales 65.7 % 66.3 % 67.2 % 66.9 % Gross profit (1) $ 110.4 $ 90.0 $ 20.4 22.7 % $ 207.9 $ 175.8 $ 32.1 18.3 % % sales 34.3 % 33.7 % 32.8 % 33.1 % Selling and administrative expenses $ 65.0 $ 53.8 $ 11.2 20.7 % $ 127.4 $ 114.7 $ 12.7 11.1 % % sales 20.2 % 20.1 % 20.1 % 21.6 % Operating income $ 45.4 $ 36.1 $ 9.2 25.5 % $ 80.5 $ 61.1 $ 19.4 31.8 % % sales 14.1 % 13.5 % 12.7 % 11.5 % (1) Sales less cost of sales. Cost of sales in the second quarter of 2014 increased 19.3% from the 2013 period, while gross profit margin increased from 33.7% in the 2013 period to 34.3% in the 2014 period. Gross margins improved at Industrial and declined at Aerospace. The acquisition of the Männer Business resulted in a higher percentage of sales being driven by Industrial during the 2014 period. Gross profit benefits from the Männer Business were partially offset by the $0.6 million of short-term purchase accounting adjustments related to the acquisition of the Männer Business and charges of $2.2 million related to the Closure of the Saline operations. Selling and administrative expenses in the second quarter of 2014 increased 20.7% from the 2013 period due primarily to the incremental operations of the Männer Business, $1.3 million of short-term purchase accounting adjustments related to the acquisition of the Männer Business and $0.1 million of charges related to the Closure of the Saline operations. As a percentage of sales, selling and administrative costs increased slightly from 20.1% in the second quarter of 2013 to 20.2% in the 2014 period. Operating income in the second quarter of 2014 increased 25.5% to $45.4 million from the second quarter of 2013 and operating income margin increased from 13.5% to 14.1%. Cost of sales in the first half of 2014 increased 20.0% from the 2013 period, while gross profit margin decreased slightly from 33.1% in the 2013 period to 32.8% in the 2014 period. Gross margins declined at both Industrial and Aerospace during the first half of 2014. The acquisition of the Männer Business resulted in a higher percentage of sales being driven by Industrial during the 2014 period. Gross profit benefits from the Männer Business were partially offset by the $3.9 million of short-term purchase accounting adjustments related to the acquisition of the Männer Business and charges of $4.4 million related to the Closure of the Saline operations. Selling and administrative expenses in the first half of 2014 increased 11.1% from the 2013 period due primarily to the incremental operations of the Männer Business, $2.9 million of short-term purchase accounting adjustments related to the acquisition of the Männer Business and $0.6 million of charges related to the Closure of the Saline operations. Operating income during the first half of 2013 also included $10.5 million of non-recurring stock compensation expenses related to the modification of outstanding equity awards granted to the former Chief Executive Officer ("CEO Transition Costs"). As a percentage of sales, selling and administrative costs decreased from 21.6% in the first half of 2013 to 20.1% in the 2014 period. Operating income in the first half of 2014 increased 31.8% to $80.5 million from the first half of 2013 and operating income margin increased from 11.5% to 12.7%. Interest expense Interest expense decreased by $0.4 million and $1.5 million in the second quarter and the first half of 2014, respectively, compared to prior year amounts. The decrease during the first half of 2014 was primarily the result of lower average interest rates, partially offset by higher average borrowings. Other expense (income), net Other expense (income), net in the second quarter of 2014 was $0.8 million compared to $0.5 million in the second quarter of 2013. In the first half of 2014, other expense (income), net was $1.0 million compared to $1.5 million in the first half of 2013. Income Taxes The Company's effective tax rate from continuing operations for the first half of 2014 was 27.8% compared with 52.7% in the first half of 2013 and 32.8% for the full year 2013 which includes the impact of $16.4 million of tax expense related to the April 16, 2013 U.S. Court Decision (see Note 15 of the Consolidated Financial Statements). Excluding the impact of the U.S. 23 -------------------------------------------------------------------------------- Tax Court Decision, the Company's effective tax rate from continuing operations for full year 2013 was 17.5%. The increase in the first half 2014 effective tax rate from the full year 2013 rate, as adjusted for the U.S. Tax Court Decision, is primarily due to a change in the mix of earnings attributable to higher-taxing jurisdictions or jurisdictions where losses cannot be benefited in 2014, the expiration of certain tax holidays and the increase in the planned repatriation of a portion of current year foreign earnings to the U.S. The Industrial and Aerospace segments were previously awarded international tax holidays. All of the tax holidays for which the Company currently receives benefit are expected to expire in 2014 through 2016. On April 16, 2013, the United States Tax Court rendered an unfavorable decision in the matter Barnes Group Inc. and Subsidiaries v. Commissioner of Internal Revenue ("Tax Court Decision"). The Tax Court rejected the Company's objections and imposed penalties. The case involved IRS proposed adjustments of approximately $16.4 million, plus a 20% penalty and interest for the tax years 1998, 2000 and 2001. The case arose out of an Internal Revenue Service ("IRS") audit for the tax years 2000 through 2002. The adjustment relates to the federal taxation of foreign income of certain foreign subsidiaries. The Company filed an administrative protest of these adjustments. In the third quarter of 2009, the Company was informed that its protest was denied and a tax assessment was received from the Appeals Office of the IRS. Subsequently, in November 2009, the Company filed a petition against the IRS in the United States Tax Court, contesting the tax assessment. A trial was held and all briefs were filed in 2012. In April 2013 the Tax Court Decision was then issued rendering an unfavorable decision against the Company and imposing penalties. As a result of the unfavorable Tax Court Decision, the Company recorded an additional tax charge during 2013 for $16.4 million. In November 2013, the Company made a cash payment of approximately $12.7 million related to tax, interest and penalties and utilized a portion of its net operating losses. The Company also submitted a notice of appeal of the Tax Court Decision to the United States Court of Appeals for the Second Circuit. The Company filed its opening brief with the United States Court of Appeals for the Second Circuit on February 13, 2014. During the second quarter of 2014, the parties filed additional briefs. The Company does not expect a decision until 2015. Discontinued Operations In April 2013, the Company completed the sale of its Barnes Distribution North America business ("BDNA") to MSC Industrial Direct Co., Inc. ("MSC"). The results of BDNA were segregated and presented as discontinued operations during the first quarter of 2013. In the first half of 2013, the Company recorded a $198.2 million gain from discontinued operations. The gain relates to the net after-tax proceeds less the book value of the assets sold or otherwise disposed of and the income generated by the operations of BDNA, partially offset by charges related to the pension plans related to BDNA and a final adjustment related to a retained liability at the Barnes Distribution Europe business. See Note 2 of the Consolidated Financial Statements. 24--------------------------------------------------------------------------------Income and Income per Share Three months ended June 30, Six months ended June 30, (in millions, except per share) 2014 2013 Change 2014 2013 Change Income from continuing operations $ 30.2 $ 9.2 $ 21.0 NM $ 53.0 $ 24.6 $ 28.4 NM Income from discontinued operations, net of income taxes - 200.1 (200.1 ) NM - 198.2 $ (198.2 ) NM Net income $ 30.2 $ 209.3 $ (179.1 ) (85.6 )% $ 53.0 $ 222.8 $ (169.8 ) (76.2 )% Per common share: Basic: Income from continuing operations $ 0.55 $ 0.18 $ 0.37 NM $ 0.97 $ 0.46 $ 0.51 NM Income from discontinued operations, net of income taxes - 3.72 (3.72 ) NM - 3.65 (3.65 ) NM Net income $ 0.55 $ 3.90 $ (3.35 ) (85.9 )% $ 0.97 $ 4.11 $ (3.14 ) (76.4 )% Diluted: Income from continuing operations $ 0.54 $ 0.17 $ 0.37 NM $ 0.95 $ 0.45 $ 0.5 NM Income from discontinued operations, net of income taxes - 3.65 (3.65 ) NM - 3.59 (3.59 ) NM Net income $ 0.54 $ 3.82 $ (3.28 ) (85.9 )% $ 0.95 $ 4.04 $ (3.09 ) (76.5 )% Weighted average common shares outstanding: Basic 54.7 53.7 1.0 1.9 % 54.7 54.2 0.5 0.9 % Diluted 55.9 54.8 1.1 2.0 % 56.0 55.1 0.9 1.5 % NM - Not meaningful Basic and diluted income from continuing operations per common share increased for the three- and six- month periods as compared to 2013. The increases were directly attributable to the increases in income from continuing operations for the periods. Basic weighted average common shares outstanding increased due to the issuance of additional shares for employee stock plans and the issuance of 1,032,493 shares in connection with the acquisition of the Manner Business. The impact of these issuances was partially offset by the repurchase of 220,794 and 225,202 shares during the first half of 2014 and the second half of 2013, respectively, as part of the repurchase program. Diluted weighted average common shares outstanding increased primarily as a result of the increase in basic weighted average common shares outstanding and was also impacted by an increase in the dilutive effect of potentially issuable shares given an increase in the Company's stock price. Financial Performance by Business Segment Industrial Three months ended June 30, Six months ended June 30, (in millions) 2014 2013 Change 2014 2013 Change Sales $ 212.8 $ 170.6 $ 42.2 24.7 % $ 416.7 $ 336.1 $ 80.6 24.0 % Operating profit 28.8 20.9 7.8 37.5 % 48.1 35.5 12.6 35.5 % Operating margin 13.5 % 12.3 % 11.6 % 10.6 % Sales at Industrial were $212.8 million in the second quarter of 2014, a $42.2 million increase from the second quarter of 2013. The acquisition of the Männer Business in 2013 provided $35.7 million of sales. Organic sales increased by $3.8 million, or 2.2%, during the 2014 period, primarily due to favorable light vehicle and tool and die end-markets. Sales benefited from foreign currency translation which increased sales by approximately $2.7 million as the U.S. dollar weakened against foreign currencies. In the first half of 2014, this segment reported sales of $416.7 million, a 24.0% increase from the first half of 2013. The Männer Business contributed $73.7 million of sales. Organic sales increased by $3.4 million, or 1.0%, during the 2014 period. The impact of foreign currency translation increased sales by approximately $3.5 million. 25 -------------------------------------------------------------------------------- Operating profit in the second quarter of 2014 at Industrial was $28.8 million, an increase of $7.8 million from the second quarter of 2013. Operating profit benefited primarily from the profit contributions of the Männer Business and increased organic sales, partially offset by unfavorable pricing, $1.9 million of short-term purchase accounting adjustments related to the acquisition and $2.3 million of pre-tax restructuring charges related to the Closure of the Saline operations. Operating profit in the first half of 2014 was $48.1 million, an increase of $12.6 million from the first half of 2013. The increase was also driven by the profit contribution of the Männer Business and increased organic sales, partially offset by $6.8 million of short-term purchase accounting adjustments related to the acquisition and $5.1 million of pre-tax restructuring charges related to the Closure of the Saline operations. Operating income during the first quarter of 2013 included CEO transition costs of $6.6 million that were allocated to the Industrial segment. Outlook: In the Industrial manufacturing businesses, management is focused on generating organic sales growth through the introduction of new products and by leveraging the benefits of the diversified products and industrial end-markets in which its businesses have a global presence. The Company also remains focused on sales growth through acquisition and expanding geographic reach. Synventive, acquired in 2012, adds innovative products and services and has expanded the Company's global marketplace presence. The Männer Business, acquired in 2013, further provides additional differentiated products and services through the manufacture of high precision molds, valve gate hot runner systems, and system solutions for the medical/pharmaceutical, packaging, and personal care/health care industries. Our ability to generate sales growth is subject to economic conditions in the global markets served by all of our businesses. Order activity in certain end-markets may provide extended sales growth. Strategic investments in new technologies, manufacturing processes and product development are expected to provide incremental benefits in the long term. Operating profit is largely dependent on the sales volumes and mix within all businesses of the segment. Management continues to focus on improving profitability through leveraging organic sales growth, acquisitions, pricing initiatives, and productivity and process improvements. Costs associated with increases in new product and process introductions, strategic investments and the integration of acquisitions may negatively impact operating profit. Aerospace Three months ended June 30, Six months ended June 30, (in millions) 2014 2013 Change 2014 2013 Change Sales $ 109.3 $ 96.8 $ 12.5 12.9 % $ 217.5 $ 194.9 $ 22.6 11.6 % Operating profit 16.6 15.2 1.4 9.1 % 32.4 25.6 6.8 26.6 % Operating margin 15.2 % 15.7 % 14.9 % 13.1 % The Aerospace segment reported sales of $109.3 million in the second quarter of 2014, a 12.9% increase from the second quarter of 2013. Sales increases within the original equipment manufacturing ("OEM") business were partially offset by a decrease within the aftermarket business. Within aftermarket, a sales increase within the repair and overhaul business ("MRO") was more then offset by lower sales in the spare parts business. Increased sales within the OEM business reflected continued strength in demand for new engines, driven by increased commercial aircraft production. In the first half of 2014, this segment reported sales of $217.5 million, a 11.6% increase from the first half of 2013, primarily as a result of increased sales in the OEM manufacturing and the aftermarket repair and overhaul businesses, partially offset by lower sales within the spare parts business. Operating profit at Aerospace in the second quarter of 2014 increased 9.1% from the second quarter of 2013 to $16.6 million, driven primarily by the profit contributions of increased sales in the OEM business, partially offset by lower profits in the spare parts business and increased employee related costs, primarily due to incentive compensation as a result of the level of the Company's pre-established annual performance targets. Operating margin decreased from 15.7% in the 2013 period to 15.2% in the 2014 period. Operating profit in the first half of 2014 increased 26.6% from the first half of 2013 to $32.4 million, driven primarily by the profit contributions of increased sales in the OEM business, partially offset by lower profits in the spare parts business and increased employee related costs, primarily due to incentive compensation. Operating income during the first quarter of 2013 included CEO transition costs of $3.9 million that were allocated to the Aerospace segment. Outlook: Sales in the Aerospace OEM business are based on the general state of the aerospace market driven by the worldwide economy and are supported by its order backlog through participation in certain strategic commercial and military engine and airframe programs. Backlog in this business was $521.2 million at June 30, 2014, of which approximately 64% is expected to be shipped in the next 12 months. The Aerospace OEM business may be impacted by adjustments of customer inventory levels, commodity availability and pricing, changes in the content levels on certain platforms, including insourcing, changes in production schedules of specific engine and airframe programs, as well as the pursuit of new programs. Sales levels in the 26 -------------------------------------------------------------------------------- Aerospace aftermarket business are expected to be impacted by fluctuations in end-market demand, adjustments of customer inventory levels and changes in customer sourcing, such as deferred or limited maintenance activity during engine shop visits and the use of used material during the engine repair and overhaul process. Management continues to believe its Aerospace aftermarket business is competitively positioned based on well-established long-term customer relationships, including maintenance and repair contracts in the repair and overhaul business and long-term RSPs and CRPs, expanded capabilities and current capacity levels. Management is focused on growing operating profit at Aerospace primarily through leveraging organic sales growth, productivity initiatives, new product and process introductions and continued cost management. Operating profit is expected to be affected by the impact of changes in sales volume, mix and pricing, particularly as they relate to the highly profitable aftermarket RSP spare parts business, and investments made in each of its businesses. Management actively manages commodity price increases through pricing actions and other productivity initiatives. Costs associated with increases in new product and process introductions and the physical transfer of work to lower cost manufacturing regions may negatively impact operating profit. LIQUIDITY AND CAPITAL RESOURCES Management assesses the Company's liquidity in terms of its overall ability to generate cash to fund its operating and investing activities. Of particular importance in the management of liquidity are cash flows generated from operating activities, capital expenditure levels, dividends, capital stock transactions, effective utilization of surplus cash positions overseas and adequate lines of credit. The Company's ability to generate cash from operations in excess of its internal operating needs is one of its financial strengths. Management continues to focus on cash flow and working capital management, and anticipates that operating activities in 2014 will generate adequate cash. The Company closely monitors its cash generation, usage and preservation including the management of working capital to generate cash. As of March 20, 2014, the 3.375% Convertible Notes ("Notes") were subject to redemption at their par value at any time, at the option of the Company. The Notes are also eligible for conversion upon meeting certain conditions as provided in the indenture agreement including the closing stock price for 20 of the last 30 trading days in the preceding quarter being greater than or equal to 130% of the conversion price (the "conversion price eligibility requirement"). The eligibility for conversion is determined quarterly. During the first quarter of 2014, the Notes were not eligible for conversion. During the second quarter of 2014, the Notes were eligible for conversion due to meeting this conversion price eligibility requirement. On June 16, 2014, $0.2 million of the Notes (par value) were surrendered for conversion. On June 24, 2014, the Company exercised its right to redeem the remaining $55.4 million principal amount of the Notes, effective July 31, 2014. As such, the balance of these Notes and the related deferred tax balances are classified as current in the accompanying balance sheet as of June 30, 2014. The Company has elected to pay cash to holders of the Notes surrendered for conversion, including the value of any residual value shares of common stock that might be payable to the holders electing to convert their Notes into an equivalent share value. Under the terms of the indenture, the conversion value will be measured based upon a 20-day valuation period of the Company's stock price. An average stock price in excess of $28.31 during the valuation period would require a cash payment in excess of $55.6 million. For each $0.50 that the average stock price during the valuation period exceeds $28.31, the cash payment in excess of par would be approximately $1.0 million. As of July 16, holders of $32.9 million (par value) of Notes have surrendered their Notes for conversion. The Company intends to use borrowings under its Amended Credit facility to finance the redemption or conversion of the Notes. In September 2013, the Company entered into a second amendment to its fifth amended and restated revolving credit agreement (the "Amended Credit Agreement") and retained Bank of America, N.A. as Administrative Agent for the lenders. The Amended Credit Agreement extends the maturity date of the debt facility by two years from September 2016 to September 2018 and includes an option to extend the maturity date for an additional year, subject to certain conditions. The Amended Credit Agreement added a new foreign subsidiary borrower in Germany, Barnes Group Acquisition GmbH, maintained the borrowing availability of the Company at $750.0 million and added an accordion feature to increase this amount to $1,000.0 million. The borrowing availability of $750.0 million, pursuant to the terms of the Amended Credit Agreement, allows for Euro-denominated borrowings equivalent to $500.0 million. Euro-denominated borrowings are subject to foreign currency translation adjustments that are included within accumulated other non-owner changes to equity. The Company may exercise the accordion feature upon request to the Administrative Agent as long as an event of default has not occurred or is continuing. Borrowings under the Amended Credit Agreement continue to bear interest at LIBOR plus a spread ranging from 1.10% to 1.70%. The Company paid fees and expenses of $1.3 million in conjunction with executing the Amended Credit Agreement; such fees will be deferred and amortized into interest expense on the accompanying Consolidated Statements of Income through its maturity. 27-------------------------------------------------------------------------------- The Company's borrowing capacity remains limited by various debt covenants in the Amended Credit Agreement, certain of which were amended in September 2013. The Amended Credit Agreement requires the Company to maintain a ratio of Consolidated Senior Debt, as defined in the Amended Credit Agreement, to Consolidated EBITDA, as defined, of not more than 3.25 times at the end of each fiscal quarter ("Senior Debt Ratio"), a ratio of Consolidated Total Debt, as defined, to Consolidated EBITDA of not more than 4.00 times at the end of each fiscal quarter, and a ratio of Consolidated EBITDA to Consolidated Cash Interest Expense, as defined, of not less than 4.25 times at the end of each fiscal quarter. The Amended Credit Agreement also provides that in connection with certain permitted acquisitions with aggregate consideration in excess of $150.0 million, the Consolidated Senior Debt to EBITDA ratio and the Consolidated Total Debt to EBITDA ratio are permitted to increase to 3.50 times and 4.25 times, respectively, for a period of the four fiscal quarters ending after the closing of the acquisition. In October 2013, the Company completed the acquisition of the Männer Business, a permitted transaction pursuant to the terms of the Amended Credit Agreement. At June 30, 2014, the Company was in compliance with all financial covenants under the Amended Credit Agreement. The Company's most restrictive financial covenant is the Senior Debt Ratio which requires the Company to maintain a ratio of Consolidated Senior Debt to Consolidated EBITDA of not more than 3.50 times at June 30, 2014. The actual ratio at June 30, 2014 was 2.08 times. Operating cash flow may be supplemented with external borrowings to meet near-term business expansion needs and the Company's current financial commitments. The Company has assessed its credit facilities in conjunction with the September 27, 2013 refinancing and currently expects that its bank syndicate, comprised of 17 banks, will continue to support its Amended Credit Agreement which matures in September 2018. At June 30, 2014, the Company had $251.2 million unused and available for borrowings under its $750.0 million Amended Credit Facility, subject to covenants in the Company's debt agreements. At June 30, 2014, additional borrowings of $482.8 million of Total Debt and $352.5 million of Senior Debt would have been allowed under the financial covenants. The Company intends to use borrowings under its Amended Credit Facility to finance the redemption or conversion of the Notes. Additional funds may be used, as needed, to support the Company's ongoing growth initiatives. The Company believes its credit facilities and access to capital markets, coupled with cash generated from operations, are adequate for its anticipated future requirements. In 2012, the Company entered into five-year interest rate swap agreements transacted with three banks which together convert the interest on the first $100.0 million of borrowings under the Company's Credit Agreement from a variable rate plus the borrowing spread to a fixed rate of 1.03% plus the borrowing spread for the purpose of mitigating its exposure to variable interest rates. Any future acquisitions are expected to be financed through internal cash, borrowings and equity, or a combination thereof. Additionally, we may from time to time seek to retire or repurchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, under a Rule 10b5-1 trading plan, privately negotiated transactions or otherwise. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. Cash Flow Six months ended June 30, (in millions) 2014 2013 Change Operating activities $ 64.9 $ 65.5 $ (0.6 ) Investing activities (68.4 ) 519.0 (587.4 ) Financing activities (5.1 ) (471.3 ) 466.2 Exchange rate effect (0.1 ) (2.2 ) 2.1(Decrease)/increase in cash $ (8.6 ) $ 111.0 $ (119.7 ) Operating activities provided $64.9 million in cash in the first six months of 2014 and $65.5 million in the first six months of 2013. In the 2014 period, operating cash flows were positively impacted by improved operating performance, however this benefit was offset by an increase in cash used for working capital that was generated primarily by higher levels of sales growth relative to 2013. Higher levels of sales growth in 2014 resulted in an increase in receivables which generated a higher use of cash than in the comparable period. Investing activities in the 2014 period included a cash outflow of $41.0 million related to the CRP. See Note 6 of the Consolidated Financial Statements. Net cash proceeds of $541.0 million from the sale of BDNA are included in investing activities for the 2013 period. Investing activities in the 2014 and 2013 periods also included capital expenditures of $25.8 million and $20.4 million, respectively. The Company expects capital spending in 2014 to approximate $60 million. 28 -------------------------------------------------------------------------------- Financing activities in the first six months of 2014 included a net increase in borrowings of $23.1 million compared to a net decrease in borrowings of $403.4 million in the comparable 2013 period. The decrease in the 2013 period reflects the utilization of proceeds from the BDNA sale to reduce borrowings. Financing activities in the 2014 period included the payment of an assumed liability to the seller in connection with the acquisition of the Männer Business. Proceeds from the issuance of common stock were $9.4 million and $3.8 million in the 2014 and 2013 periods, respectively. During the six months ended June 30, 2014 and June 30, 2013, the Company repurchased 0.2 million and 2.1 million shares, respectively, of the Company's stock. The cost of the repurchases was $8.4 million in the 2014 period and $61.4 million in the 2013 period. Total cash used to pay dividends was $11.9 million in the 2014 period compared to $10.7 million in the 2013 period, primarily due to a dividend rate increase that was effective during the 2014 period. At June 30, 2014, the Company held $62.2 million in cash and cash equivalents, the majority of which was held by foreign subsidiaries. These amounts have no material regulatory or contractual restrictions and are expected to primarily fund international investments. During the second quarter of 2014, the Company repatriated $12.5 million of current year foreign earnings to the U.S. The Company maintains borrowing facilities with banks to supplement internal cash generation. At June 30, 2014, $498.8 million was borrowed at an interest rate of 1.47% under the Company's amended $750.0 million Credit Facility which matures in September 2018. In addition, as of June 30, 2014, the Company had $10.5 million in borrowings under short-term bank credit lines. At June 30, 2014, the Company's total borrowings were comprised of approximately 28% fixed rate debt and approximately 72% variable rate debt. The interest payments on approximately $100.0 million of the variable rate interest debt have been converted into payment of fixed interest plus the borrowing spread under the terms of the respective interest rate swaps that were executed in April 2012. Debt Covenants Borrowing capacity is limited by various debt covenants in the Company's debt agreements. As of June 30, 2014, the most restrictive financial covenant is included within the Amended Credit Agreement and requires the Company to maintain a maximum ratio of Consolidated Senior Debt, as defined, to Consolidated EBITDA, as defined, of not more than 3.25 times for the four fiscal quarters then ending. The Company's Amended Credit Agreement also contains other financial covenants that require the maintenance of a certain other debt ratio, Consolidated Total Debt, as defined, to Consolidated EBITDA of not more than 4.00 times and a certain interest coverage ratio, Consolidated EBITDA to Consolidated Cash Interest Expense, as defined, of at least 4.25 times, at June 30, 2014. The Amended Credit Agreement also provides that in connection with certain permitted acquisitions with aggregate consideration in excess of $150.0 million, the Consolidated Senior Debt to EBITDA ratio and the Consolidated Total Debt to EBITDA ratio are permitted to increase to 3.50 times and 4.25 times, respectively, for a period of the four fiscal quarters ending after the closing of the acquisition. On October 31, 2013, the Company completed the acquisition of the Männer Business, a permitted transaction pursuant to the terms of the Amended Credit Agreement. Following is a reconciliation of Consolidated EBITDA to the Company's net income (in millions): 29 -------------------------------------------------------------------------------- Four fiscal quarters ended June 30, 2014 Net income $ 100.7 Add back: Interest expense 11.6 Income taxes 28.2 Depreciation and amortization 76.5 Adjustment for non-cash stock based compensation 7.4 Amortization of Männer acquisition inventory step-up 7.2 Due diligence and transaction expenses 1.5 Adjustment for acquired businesses 12.4 Restructuring charges 3.4 Other adjustments (0.9 ) Consolidated EBITDA, as defined $ 247.9 Consolidated Senior Debt, as defined, as of June 30, 2014 $ 515.3 Ratio of Consolidated Senior Debt to Consolidated EBITDA 2.08 Maximum 3.50 Consolidated Total Debt, as defined, as of June 30, 2014 $ 570.9 Ratio of Consolidated Total Debt to Consolidated EBITDA 2.30 Maximum 4.25 Consolidated Cash Interest Expense, as defined, as of June 30, 2014 $ 10.7 Ratio of Consolidated EBITDA to Consolidated Cash Interest Expense 23.20 Minimum 4.25 The Amended Credit Agreement allows for certain adjustments within the calculation of the financial covenants. The adjustment for acquired businesses reflects the unaudited pre-acquisition operations of the Männer business for the four-month period ended October 31, 2013. The restructuring charges represent charges recorded in the first six months of 2014 related to the closure of production operations at the Associated Spring facility located in Saline, Michigan. Other adjustments primarily consist of net gains on the sale of assets. The Company's financial covenants are measured as of the end of each fiscal quarter. At June 30, 2014, additional borrowings of $482.8 million of Total Debt and $352.5 million of Senior Debt would have been allowed under the covenants. Senior Debt includes primarily the borrowings under the Credit Facility and the borrowings under lines of credit. The Company's unused credit facilities at June 30, 2014 were $251.2 million. OTHER MATTERS The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant accounting policies are disclosed in Note 1 of the Consolidated Financial Statements in the Company's Annual Report on Form 10-K for the year ended December 31, 2013. The most significant areas involving management judgments and estimates are described in Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's Annual Report on Form 10-K for the year ended December 31, 2013. There have been no material changes to such judgments and estimates. Actual results could differ from those estimates. Business Acquisitions and Goodwill: Goodwill is subject to impairment testing annually or earlier testing if an event or change in circumstances indicates that the fair value of a reporting unit has been reduced below its carrying value. Management completes their annual impairment assessment during the second quarter of each year. The Company utilizes the option to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test in accordance with the applicable accounting standards. Under the qualitative assessment, management considers relevant events and circumstances including but not limited to macroeconomic conditions, industry and market considerations, overall unit performance and events directly affecting a unit. If the Company determines that the two-step 30 -------------------------------------------------------------------------------- quantitative impairment test is required, management estimates the fair value of the reporting unit primarily using the income approach, which reflects management's cash flow projections, and also evaluates the fair value using the market approach. Inherent in management's development of cash flow projections are assumptions and estimates, including those related to future earnings and growth and the weighted average cost of capital. Based on this second quarter assessment, the estimated fair values of the Synventive and Männer reporting units, which were acquired in August 2012 and October 2013, respectively, exceeded their carrying values and the estimated fair value of the remaining reporting units significantly exceeded their carrying values. There was no goodwill impairment at any reporting units through June 30, 2014. Many of the factors used in assessing fair value are outside the control of management, and these assumptions and estimates can change in future periods as a result of both Company-specific and overall economic conditions. Management's quantitative assessment during the second quarter of 2014 included a review of the potential impacts of current and projected market conditions from a market participant's perspective on reporting units' projected cash flows, growth rates and cost of capital to assess the likelihood of whether the fair value would be less than the carrying value. While management expects future operating improvements at certain reporting units to result from improving end-market conditions, new product introductions and further market penetration, there can be no assurance that such expectations will be met or that the fair value of the reporting units will continue to exceed their carrying values. If the fair values were to fall below the carrying values, a non-cash impairment charge to income from operations could result. Recent Accounting Changes In April 2014, the Financial Accounting Standards Board (FASB) amended its guidance related to reporting discontinued operations. The amended guidance changes the criteria for determining which disposals can be presented as discontinued operations and modifies the related disclosure requirements. Under the amended guidance, a disposal of a component of an entity or a group of components of an entity is required to be reported in discontinued operations if the disposal represents a strategic shift that has (or will have) a major effect on an entity's operations and financial results and is disposed of or classified as held for sale. The guidance also requires several new disclosures. The guidance applies prospectively to new disposals and new classifications of disposal groups as held for sale after the effective date and is effective for annual and interim periods beginning after December 15, 2014, with early adoption permitted. The Company is evaluating this guidance and will apply the guidance in the event that the Company has a future disposal that qualifies as a discontinued operation or is classified as held for sale. In May 2014, the FASB amended its guidance related to revenue recognition. The amended guidance establishes a single comprehensive model for companies to use in accounting for revenue arising from contracts with customers and will supersede most of the existing revenue recognition guidance, including industry-specific guidance. The amended guidance clarifies that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In applying the amended guidance, an entity will (1) identify the contract(s) with a customer; (2) identify the performance obligations in the contract; (3) determine the transaction price; (4) allocate the transaction price to the contract's performance obligations; and (5) recognize revenue when (or as) the entity satisfies a performance obligation. The amended guidance applies to all contracts with customers except those that are within the scope of other topics in the FASB Accounting Standards Codification. The amended guidance is effective for annual reporting periods (including interim periods within those periods) beginning after December 15, 2016 for public companies. Early adoption is not permitted. Entities have the option of using either a full retrospective or modified approach to the amended guidance. The Company is evaluating this guidance and has not determined the impact that it may have on its financial statements nor decided upon the method of adoption. EBITDA EBITDA for the first six months of 2014 was $122.0 million compared to $409.2 million in the first six months of 2013. EBITDA is a measurement not in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The Company defines EBITDA as net income plus interest expense, income taxes and depreciation and amortization which the Company incurs in the normal course of business. The Company does not intend EBITDA to represent cash flows from operations as defined by GAAP, and the reader should not consider it as an alternative to net income, net cash provided by operating activities or any other items calculated in accordance with GAAP, or as an indicator of the Company's operating performance. The Company's definition of EBITDA may not be comparable with EBITDA as defined by other companies. Accordingly, the measurement has limitations depending on its use. The Company believes EBITDA is commonly used by financial analysts and others in the industries in which the Company operates and, thus, provides useful information to investors. Following is a reconciliation of EBITDA to the Company's net income (in millions): 31 -------------------------------------------------------------------------------- Six months ended June 30, 2014 2013 Net income $ 53.0 $ 222.8 Add back: Interest expense 6.1 7.6 Income taxes 20.4 147.7 Depreciation and amortization 42.5 31.1 EBITDA (1) $ 122.0 $ 409.2 (1) EBITDA of $409.2 million in 2013 includes a pre-tax gain of $313.5 million related to the sale of BDNA. FORWARD-LOOKING STATEMENTS Certain of the statements in this quarterly report contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements often address our expected future operating and financial performance and financial condition, and often contain words such as "anticipate," "believe," "expect," "plan," "strategy," "estimate," "project," and similar terms. These forward-looking statements do not constitute guarantees of future performance and are subject to a variety of risks and uncertainties that may cause actual results to differ materially from those expressed in the forward-looking statements. These include, among others: difficulty maintaining relationships with employees, including unionized employees, customers, distributors, suppliers, business partners or governmental entities; potential strikes or work stoppages; difficulties leveraging market opportunities; changes in market demand for our products and services; rapid technological and market change; the ability to protect intellectual property rights; introduction or development of new products or transfer of work; higher risks in international operations and markets; the impact of intense competition; and other risks and uncertainties described in documents filed with or furnished to the Securities and Exchange Commission ("SEC") by the Company, including, among others, those in the Management's Discussion and Analysis of Financial Condition and Results of Operations and Risk Factors sections of the Company's filings. The risks and uncertainties described in our periodic filings with the SEC include, among others, uncertainties relating to conditions in financial markets; currency fluctuations and foreign currency exposure; future financial performance of the industries or customers that we serve; our dependence upon revenues and earnings from a small number of significant customers; a major loss of customers; inability to realize expected sales or profits from existing backlog due to a range of factors, including insourcing decisions, material changes, production schedules and volumes of specific programs; the impact of government budget and funding decisions; changes in raw material or product prices and availability; integration of acquired businesses including the Männer business; restructuring costs or savings including those related to the closure of production operations at the Company's facility in Saline, Michigan; the continuing impact of strategic actions, including acquisitions, divestitures, restructurings, or strategic business realignments, and our ability to achieve the financial and operational targets set in connection with any such actions; the outcome of pending and future legal, governmental, or regulatory proceedings and contingencies and uninsured claims; future repurchases of common stock; future levels of indebtedness; and numerous other matters of a global, regional or national scale, including those of a political, economic, business, competitive, environmental, regulatory and public health nature. The Company assumes no obligation to update our forward-looking statements. |