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STANLEY BLACK & DECKER, INC. - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion contains statements reflecting the Company's views about its future performance that constitute "forward-looking statements" under the Private Securities Litigation Act of 1995. There are a number of important factors that could cause actual results to differ materially from those indicated by such forward-looking statements. Please read the information under the caption entitled "Cautionary Statement under the Private Securities Litigation Reform Act of 1995." Throughout this Management's Discussion and Analysis ("MD&A"), references to Notes refer to the "Notes To (Unaudited) Condensed Consolidated Financial Statements" in Part 1, Item 1 of this Form 10-Q, unless otherwise indicated. BUSINESS OVERVIEW Strategy The Company is a diversified global provider of power and hand tools, products and services for various industrial applications, mechanical access solutions (i.e. automatic doors and commercial locking systems), and electronic security and monitoring systems. The Company is continuing to pursue a diversification strategy that involves industry, geographic and customer diversification to foster sustainable revenue, earnings and cash flow growth. The Company has three primary acquisition growth platforms: Engineered Fastening, Infrastructure and Security. Furthermore, two aspects of the Company's vision are to be a consolidator within the tool industry and to increase its presence in emerging markets, with a goal of ultimately generating greater than 20% of annual revenues from emerging markets. The Company has made investments in its organic growth initiatives in order to drive growth across all of its businesses, and anticipates the majority of acquisition-related investments being within the three growth platforms previously mentioned. During 2013, the Company elected to place a temporary moratorium on acquisitions to focus on its near-term priorities of operational improvement, deleveraging through improved credit metrics and returning capital to shareholders. In the near-term, the Company is focused on improving the operating results of its Security business and improving the Company's operating leverage. In terms of capital allocation, the Company plans to return up to $1.5 billion of capital to shareholders through 2015 by extending its pause in strategic M&A activity, continued dividend growth, and repurchasing up to $1 billion in stock. Refer to the "Strategic Objectives" section of Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's Form 10-K for the year ended December 28, 2013 for additional strategic discussions. Segments The Company classifies its business into three reportable segments, which also represent its operating segments: Construction & Do-It-Yourself ("CDIY"), Industrial and Security. CDIY The CDIY segment is comprised of the Professional Power Tool business, the Consumer Products Group, which includes outdoor products, the Hand Tools & Storage business, and the Fastening & Accessories business. Revenues in the CDIY segment were $2.609 billion for the first six months of 2014, representing 47% of the Company's total revenues. The Professional Power Tool business sells professional grade corded and cordless electric power tools and equipment including drills, impact wrenches and drivers, grinders, saws, routers and sanders. The Consumer Products Group sells corded and cordless electric power tools sold primarily under the Black & Decker brand, lawn and garden products and home products. Lawn and garden products include hedge trimmers, string trimmers, lawn mowers, edgers, and related accessories. Home products include hand held vacuums, paint tools and cleaning appliances. The Hand Tools & Storage business sells measuring, leveling and layout tools, planes, hammers, demolition tools, knives, saws and chisels. Storage products include tool boxes, sawhorses and storage units. The Fastening and Accessories business sells pneumatic tools and fasteners including nail guns, nails, staplers and staples, concrete and masonry anchors, as well as power tool accessories which include drill bits, router bits, abrasives and saw blades. 27-------------------------------------------------------------------------------- Table of Contents Industrial The Industrial segment is comprised of the Industrial and Automotive Repair ("IAR"), Engineered Fastening and Infrastructure businesses. Industrial segment revenues were $1.741 billion for the first six months of 2014, representing 32% of the Company's total revenues. The IAR business sells professional hand tools, power tools and engineered storage solution products. The Engineered Fastening business primarily sells engineered fastening products and systems designed for specific applications. The product lines include stud welding systems, blind rivets and tools, blind inserts and tools, drawn arc weld studs, engineered plastic and mechanical fasteners, self-piercing riveting systems, precision nut running systems, micro fasteners, and high-strength structural fasteners. The Infrastructure business consists of the Oil & Gas and Hydraulics businesses. The product lines within the Infrastructure business include custom pipe handling machinery, joint welding and coating machinery, weld inspection services and hydraulic tools and accessories. Security The Security segment is comprised of the Convergent Security Solutions ("CSS") and Mechanical Access Solutions ("MAS") businesses. Revenues in the Security segment were $1.174 billion for the first six months of 2014, representing 21% of the Company's total revenues. The CSS business designs, supplies and installs electronic security systems and provides electronic security services, including alarm monitoring, video surveillance, fire alarm monitoring, systems integration and system maintenance. Purchasers of these systems typically contract for ongoing security systems monitoring and maintenance at the time of initial equipment installation. The business also sells healthcare solutions, which markets medical cabinets, asset tracking, infant protection, pediatric protection, patient protection, wander management, fall management, and emergency call products. The MAS business sells automatic doors, commercial hardware, locking mechanisms, electronic keyless entry systems, keying systems, tubular and mortise door locksets. Acquisitions 2013 Acquisitions In May 2013, the Company purchased a 60% controlling share in Jiangsu Guoqiang Tools Co., Ltd. ("GQ") for a total purchase price of $48.5 million, net of cash acquired. GQ is a manufacturer and seller of power tools, armatures and stators in both domestic and foreign markets. The acquisition of GQ complements the Company's existing power tools product offerings and further diversifies the Company's operations and international presence. GQ is headquartered in Qidong, China and has been consolidated into the Company's CDIY segment. In February 2013, the Company acquired a 100% ownership interest in Infastech for a total purchase price of $826.4 million, net of cash acquired. Infastech designs, manufactures and distributes highly-engineered fastening technologies and applications for a diverse blue-chip customer base in the industrial, electronics, automotive, construction and aerospace end markets. The acquisition of Infastech adds to the Company's strong positioning in specialty engineered fastening, an industry with solid growth prospects, and further expands the Company's global footprint with its strong concentration in fast-growing emerging markets. Infastech is headquartered in Hong Kong and has been consolidated into the Company's Industrial segment. Refer to Note F, Acquisitions of the Notes to (Unaudited) Condensed Consolidated Financial Statements for further discussion of the Company's acquisitions. Divestitures HHI and Tong Lung Residential Divestiture In December 2012, the Company sold HHI, including the residential portion of Tong Lung, to Spectrum for approximately $1.4 billion in cash. HHI is a provider of residential locksets, residential builders hardware and plumbing products marketed under the Kwikset, Weiser, Baldwin, Stanley, National and Pfister brands. The majority of the HHI business was part of the Company's Security segment, while the remainder was part of the Company's CDIY segment. The divestiture of the HHI 28-------------------------------------------------------------------------------- Table of Contents business is part of the continued diversification of the Company's revenue streams and geographic footprint consistent with the Company's strategic framework. The purchase and sale agreement stipulated that the sale occur in a First and Second Closing, for approximately $1.3 billion and approximately $94 million, respectively. The First Closing, which excluded the residential portion of the Tong Lung business, occurred on December 17, 2012. The Second Closing, which related to the residential portion of the Tong Lung business, occurred on April 8, 2013. The operating results of the residential portion of Tong Lung have been reported as discontinued operations in the Consolidated Financial Statements through the date of the sale. The net proceeds from this divestiture were used to repurchase $850 million of the Company's common stock and for debt reduction, to ensure the Company's leverage ratios remained in its target range. The Company used existing sources of liquidity to fund the Infastech acquisition described above. During the third quarter of 2013, the Company classified two small businesses within the Security and Industrial segments as held for sale based on management's intention to sell these businesses. The business within the Industrial segment was sold during the first quarter of 2014 and its operating results have been reported as discontinued operations through the date of the sale and for the three and six months ended June 29, 2013. The operating results of the business within the Security segment have been reported as discontinued operations for all periods presented. Certain Items Impacting Earnings Throughout MD&A, the Company has provided a discussion of the outlook and results both inclusive and exclusive of the merger and acquisition-related charges. Merger and acquisition-related charges relate primarily to the Black & Decker merger and Niscayah and Infastech acquisitions. The amounts and measures, including gross profit and segment profit, on a basis excluding such charges are considered relevant to aid analysis and understanding of the Company's results aside from the material impact of these charges, which have decreased significantly in 2014 as planned. In addition, these measures are utilized internally by management to understand business trends, as once the anticipated cost synergies from these acquisitions are realized, such charges are not expected to recur. The merger and acquisition-related and other charges are as follows: Second Quarter and Year-to-Date 2014 Merger and Acquisition-Related Charges The Company reported $4.1 million and $8.0 million in pre-tax charges in the second quarter and year-to-date 2014 periods, respectively, pertaining to merger and acquisition-related charges, which were comprised of the following: • $0.3 million and $1.4 million for the second quarter and year-to-date 2014 periods, respectively, reducing Gross Profit pertaining mainly to integration-related matters; • $5.3 million and $11.6 million for the second quarter and year-to-date 2014 periods, respectively, in SG&A primarily for integration-related administrative costs and consulting fees; • $0.2 million and $0.4 million for the second quarter and year-to-date 2014 periods, respectively, in Other, net primarily for deal transactions costs; and • $1.7 million and $5.4 million for the second quarter and year-to-date 2014 periods, respectively, in net restructuring credits primarily related to the elimination of excess severance accruals due to changes in initial estimates relating to prior year actions, partially offset by nominal severance and facility closure costs. The tax effect on the above net charges during the second quarter of 2014 was $5.3 million, resulting in after-tax charges of $9.4 million, or $0.06 per diluted share. The $5.3 million tax expense relates primarily to a change in the estimated tax benefit recognized on certain charges during the fourth quarter of 2013. On a year-to-date basis, the tax effect on the above net charges was $3.9 million, resulting in after-tax charges of $11.9 million, or $0.07 per diluted share. 29-------------------------------------------------------------------------------- Table of Contents Second Quarter and Year-to-Date 2013 Merger and Acquisition-Related Charges The Company reported $5.3 million and $111.4 million in pre-tax charges in the second quarter and year-to-date 2013 periods, respectively, pertaining to merger and acquisition-related charges which were comprised of the following: • $7.9 million and $21.2 million for the second quarter and year-to-date 2013 periods, respectively, reducing Gross Profit pertaining mainly to amortization of the inventory step-up adjustment for the Infastech acquisition; • $24.0 million and $58.3 million for the second quarter and year-to-date 2013 periods, respectively, in SG&A primarily for integration-related administrative costs and consulting fees, as well as employee related matters; • $4.3 million and $19.9 million for the second quarter and year-to-date 2013 periods, respectively, in Other, net predominately for deal transaction costs; and • $(30.9) million and $12.0 million for the second quarter and year-to-date 2013 periods, respectively, in restructuring (credits) / charges primarily for Niscayah-related restructuring charges and cost containment actions associated with the severance of employees, which were more than offset by a $44 million reversal in the second quarter of 2013 from the termination of a previously approved restructuring action due to a shifting political and economic landscape in certain European countries. The tax effect on the above net charges during the second quarter of 2013 was $9.1 million, resulting in after-tax earnings of $3.8 million, or $0.03 per diluted share. On a year-to-date basis, the tax effect on the above net charges was $34.1 million, resulting in after-tax charges of $77.3 million, or $0.49 per diluted share. 2014 Outlook This outlook discussion is intended to provide broad insight into the Company's near-term earnings and cash flow generation prospects. The Company expects diluted earnings per share to approximate $5.38 to $5.48 in 2014, inclusive of $25 million of pre-tax merger and acquisition-related charges primarily to support the Infastech acquisition. Excluding such charges, 2014 diluted earnings per share is expected to be in the range of $5.50 to $5.60. The diluted earnings per share range was raised from the previously communicated outlook based on stronger anticipated full year results primarily from the Company's Industrial businesses and further Company-wide indirect cost savings, which are expected to more than offset the impact of slightly lower full year organic sales growth due to the weather impact on the CDIY outdoor season and slower underlying emerging markets growth. The Company expects free cash flow to be at least $675 million, which includes approximately $250 million of merger and acquisition-related payments primarily relating to 2013 restructuring actions. As mentioned previously, the Company has decided to intensify its focus on increasing organic growth, concentrated in five major areas during the next few years: (1) increase presence in emerging markets in the Power Tools, Hand Tools and Commercial Hardware mid-price point categories, (2) create a "smart" tools and storage market using radio frequency identification ("RFID") and real-time locating system ("RTLS") technology, (3) leverage the AeroScout RTLS capability into the electronic security market including the acute care vertical within the Company's Healthcare business, (4) offshore oil and gas pipeline service revenue in the Company's Oil & Gas business, and (5) continue to identify and realize revenue synergies associated with several acquisitions and the Black & Decker Merger. From 2013 - 2015, the Company will invest approximately $150 million ($100 million of recurring operating expense and $50 million of capital) to support these initiatives. The Company expects that investment and achievement in these growth areas will generate approximately $850 million of incremental revenue and should increase its organic growth rate commensurately. RESULTS OF OPERATIONS Net Sales: Net sales were $2.886 billion in the second quarter of 2014 compared to $2.858 billion in the second quarter of 2013, representing an increase of $27.3 million, or 1%. Overall, the increase was primarily attributable to a 1% increase in price as volume, acquisitions and foreign currency were all relatively flat. The CDIY segment was relatively flat compared to the second quarter of 2013 as strong organic growth of 7% in Europe, mainly due to continued share gains from new product introductions across key regions and an expanding retail footprint, was offset by a delayed and shortened North American outdoor product season due to cold weather conditions. In the Industrial segment, organic sales grew approximately 3% relative to the second quarter of 2013 primarily due to higher volumes across all of the Industrial businesses. In the Security segment, sales were relatively flat compared to the second quarter of 2013 as organic growth of 2% in North America and emerging markets was offset by a 6% organic decline in Europe due to lower installation and recurring revenues, most notably in Southern Europe. 30-------------------------------------------------------------------------------- Table of Contents On a year-to-date basis, net sales totaled $5.525 billion, an increase of 4% compared to $5.333 billion in the first half of 2013. Acquisitions (primarily Infastech) provided a 3% increase while unfavorable effects of foreign currency fluctuations resulted in a 1% decrease. Organic growth of 2% in the first half of 2014 was mainly driven by CDIY, which achieved 3% organic growth due to strong results in Europe, and the Industrial segment, which grew 4% organically primarily as a result of strong performances by the IAR and Engineered Fastening businesses. Gross Profit: Gross profit was $1.053 billion, or 36.5% of net sales, in the second quarter of 2014 compared to $1.006 billion, or 35.2% of net sales, in the second quarter of 2013. Merger and acquisition-related charges, which reduced gross profit, were $0.3 million in the second quarter of 2014 and $7.9 million in the second quarter of 2013. Excluding these merger and acquisition-related charges, gross profit was 36.5% of net sales in 2014 compared to 35.5% of net sales in the prior year. The increase in the profit rate year over year reflects favorable impacts from price, supply chain productivity and indirect cost management which more than offset significant negative impacts from currency fluctuations. Year-to-date gross profit was $2.014 billion, or 36.4% of net sales, compared to $1.914 billion, or 35.9% of net sales, for the six month periods ended June 28, 2014 and June 29, 2013, respectively. Merger and acquisition-related charges, which reduced gross profit, were $1.4 million in the first half of 2014 and $21.2 million in the first half of 2013. Excluding these charges, gross profit was 36.5% of net sales in 2014 and 36.3% of net sales in 2013. The increase in the profit rate year over year reflects favorable impacts from price, supply chain productivity and indirect cost management which more than offset significant negative impacts from currency fluctuations and Security margin contraction. SG&A Expenses: SG&A, inclusive of the provision for doubtful accounts, was $662.9 million, or 23.0% of net sales, in the second quarter of 2014 compared to $677.2 million, or 23.7% of net sales, in the second quarter of 2013. Within SG&A, merger and acquisition-related compensation costs and integration-related expenses totaled $5.3 million in the second quarter of 2014 and $24.0 million in the second quarter of 2013. Excluding these merger and acquisition-related charges, SG&A was 22.8% of net sales in 2014 compared to 22.9% of net sales in the prior year. The increase in costs associated with strategic growth investments was offset by the impact of reduced indirect costs. On a year-to-date basis, SG&A, inclusive of the provision for doubtful accounts, was $1.311 billion, or 23.7% of net sales, in 2014 compared to $1.342 billion, or 25.2% of net sales, in 2013. Excluding merger and acquisition-related charges of $11.6 million and $58.3 million, respectively, during the first six months of 2014 and 2013, SG&A was 23.5% and 24.1% of net sales, respectively. Distribution center costs (i.e. warehousing and fulfillment facility and associated labor costs) are classified within SG&A. This classification may differ from other companies who may report such expenses within cost of sales. Due to diversity in practice, to the extent the classification of these distribution costs differs from other companies, the Company's gross margins may not be comparable. Corporate Overhead: The corporate overhead element of SG&A, which is not allocated to the business segments, amounted to $45.1 million, or 1.6% of net sales, in the second quarter of 2014 compared to $53.7 million, or 1.9% of net sales, in the second quarter of 2013. Excluding merger and acquisition-related charges, the corporate overhead element of SG&A was $42.1 million, or 1.5% of net sales, in the second quarter of 2014 compared to $39.5 million, or 1.4% of net sales, in the second quarter of 2013. On a year-to-date basis, the corporate overhead element of SG&A amounted to $81.6 million, or 1.5% of net sales, in 2014 compared to $122.7 million, or 2.3% of net sales, in the corresponding period of 2013. Excluding merger and acquisition related charges, the corporate overhead element of SG&A was $76.1 million, or 1.4% of net sales, and $83.0 million, or 1.6% of net sales, for the first six months of 2014 and 2013, respectively. Other, net: Other, net expense amounted to $58.7 million in the second quarter of 2014 compared to $71.4 million in the second quarter of 2013. On a year-to-date basis, Other, net expense amounted to $120.2 million in 2014 as compared with $142.3 million in 2013. These decreases were primarily driven by lower amortization expense and merger and acquisition-related costs in 2014 as compared to 2013. Interest, net: Net interest expense in the second quarter of 2014 was $40.3 million compared to $36.3 million in 2013. On a year-to-date basis, net interest expense was $81.2 million in 2014 as compared with $73.0 million in 2013. These increases in net interest expense were primarily attributable to the outstanding debt carrying higher interest rates during 2014 as compared to 2013. Income Taxes: The Company recognized income tax expense of $73.7 million and $120.5 million for the three and six months ended June 28, 2014, respectively, resulting in effective tax rates of 25.1% and 23.8%, respectively. The effective tax rates 31-------------------------------------------------------------------------------- Table of Contents differ from the U.S. statutory tax rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, the favorable settlement of several foreign income tax audits and the reversal of valuation allowances for certain foreign net operating losses which have become realizable. The Company recognized income tax expense of $54.4 million and $63.1 million for the three and six months ended June 29, 2013, respectively, resulting in effective tax rates of 21.6% and 18.3%, respectively. The effective tax rates differ from the statutory tax rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, the acceleration of certain tax credits, the recurring benefit of various foreign business integration structures and the reversal of certain foreign and U.S. state uncertain tax position reserves, related largely to statute expiration. Business Segment Results The Company's reportable segments are aggregations of businesses that have similar products, services and end markets, among other factors. The Company utilizes segment profit (which is defined as net sales minus cost of sales and SG&A aside from corporate overhead expense), and segment profit as a percentage of net sales to assess the profitability of each segment. Segment profit excludes the corporate overhead expense element of SG&A, Other-net (inclusive of intangible asset amortization expense), restructuring charges (credits), interest income, interest expense, and income tax expense. Corporate overhead is comprised of world headquarters facility expense, cost for the executive management team and the expense pertaining to certain centralized functions that benefit the entire Company but are not directly attributable to the businesses, such as legal and corporate finance functions. Refer to Note O, Restructuring Charges (Credits) of the Notes to (Unaudited) Condensed Consolidated Financial Statements for the amount of restructuring charges (credits), if applicable, attributable to each segment. As discussed previously, the Company's operations are classified into three business segments: CDIY, Industrial and Security. During the first quarter of 2014, the Company recast segment results for prior periods to align reporting with the current management of the Company's operations in the emerging markets to be comparable with the current year presentation. Accordingly, segment net sales and segment profit have been recast between the CDIY and Industrial segments. There is no impact to the Consolidated Financial Statements of the Company as a result of this segment realignment. CDIY: Second Quarter Year-to-Date (Millions of Dollars) 2014 2013 2014 2013 Net sales $ 1,394.6 $ 1,392.8 $ 2,609.4 $ 2,542.0 Segment profit $ 218.2 $ 209.9 $ 387.3 $ 375.9 % of Net sales 15.6 % 15.1 % 14.8 % 14.8 % CDIY net sales increased $1.8 million, or less than 1%, in the second quarter of 2014 compared to the second quarter of 2013. The slight increase was driven by 7% organic growth in Europe, which was mainly due to continued share gains from successful new product introductions across key regions and the benefits of an expanding retail footprint, and 1% organic growth in emerging markets despite challenging economic and political environments. Organic sales declined 2% in North America primarily due to the delayed start to the North American outdoor product season, which more than offset solid momentum in other categories. On a year-to-date basis, net sales increased $67.4 million, or 3%, in the first half of 2014 compared to the first half of 2013. Organic sales increased 3% primarily due to strong results in Europe and the emerging markets as discussed above, as well as modest organic growth in North America despite challenging weather conditions in the first half of 2014. Acquisitions contributed 1% of sales growth, which was offset by a 1% decline due to unfavorable changes in foreign currency. Segment profit for the second quarter of 2014 was $218.2 million, or 15.6% of net sales, compared to $209.9 million, or 15.1% of net sales, in the second quarter of 2013. Excluding merger and acquisition-related charges of $0.2 million, segment profit totaled $218.4 million, or 15.7% of net sales, for the second quarter of 2014 compared to $212.7 million, or 15.3% of net sales, in the second quarter of 2013 (excluding $2.8 million in merger and acquisition-related charges). The increase in the segment profit rate was attributed to the favorable impacts from price, supply chain productivity and indirect cost management which more than offset negative impacts from currency fluctuations. Year-to-date segment profit for CDIY was $387.3 million, or 14.8% of net sales, compared to $375.9 million, or 14.8% of net sales, for the corresponding 2014 period. Excluding $0.6 million in merger and acquisition-related charges, segment profit 32-------------------------------------------------------------------------------- Table of Contents amounted to $387.9 million, or 14.9% of net sales, in 2014 compared to $382.0 million, or 15.0%, in 2013 (excluding $6.1 million in merger and acquisition-related charges). The segment profit rate was relatively flat compared to 2013 primarily due to continued currency pressures and carryover investments in organic growth initiatives, which offset the positive impacts during 2014 from volume, productivity and SG&A cost reductions. Industrial: Second Quarter Year-to-Date (Millions of Dollars) 2014 2013 2014 2013 Net sales $ 889.2 $ 861.5 $ 1,741.2 $ 1,595.4 Segment profit $ 150.3 $ 117.6 $ 280.6 $ 207.0 % of Net sales 16.9 % 13.7 % 16.1 % 13.0 % Industrial net sales increased $27.7 million, or 3%, in the second quarter of 2014 from $861.5 million in the second quarter of 2013. The increase was primarily driven by a 2% increase in volume and a 1% increase in acquisitions. Price was up slightly and currency was relatively flat year over year. Engineered Fastening achieved organic growth of 2% driven by strong global automotive revenues in a number of regions, partially offset by weaker electronics volume. Organic sales for the Industrial and Automotive Repair business increased 2% as a result of new product introductions and continued strength within North American Mac Tools mobile distribution and Advanced Industrial Solutions. Infrastructure posted solid growth of 5% driven by strong results in the Oil & Gas business coupled with improving demand for hydraulic tools. On a year-to-date basis, net sales increased $145.8 million, or 9%, in the first half of 2014 compared to the first half of 2013. The Infastech acquisition increased sales by 5% while organic volume contributed 4% of sales growth primarily due to strong organic growth in the Engineered Fastening and IAR businesses. Price increased slightly year over year but was offset by currency headwinds. Industrial segment profit for the second quarter of 2014 was $150.3 million, or 16.9% of net sales, compared to $117.6 million, or 13.7% of net sales, in the second quarter of 2013. Excluding $1.2 million in merger and acquisition-related charges, segment profit was $151.5 million, or 17.0% of net sales, in the second quarter of 2014 and $123.7 million, or 14.4% of net sales, in the second quarter of 2013 (excluding $6.1 million in merger and acquisition-related charges). The year over year increase in segment profit rate was primarily due to favorable volume leverage, supply chain productivity gains, cost synergies and SG&A cost reductions, partially offset by negative impacts of foreign currency fluctuations. Year-to-date segment profit for Industrial was $280.6 million, or 16.1% of net sales, compared to $207.0 million, or 13.0% of net sales, for the corresponding 2013 period. Excluding $3.4 million in merger and acquisition-related charges, segment profit amounted to $284.0 million, or 16.3% of net sales, in 2014 compared to $225.5 million, or 14.1%, in 2013 (excluding $18.5 million in merger and acquisition-related charges). The segment profit rate improved on a year-to-date basis primarily due to the same factors that impacted the second quarter. Security: Second Quarter Year-to-Date (Millions of Dollars) 2014 2013 2014 2013 Net sales $ 601.7 $ 603.9 $ 1,174.4 $ 1,196.0 Segment profit $ 67.0 $ 54.7 $ 116.6 $ 112.1 % of Net sales 11.1 % 9.1 % 9.9 % 9.4 % Security net sales decreased $2.2 million, or less than 1%, in the second quarter of 2014 from $603.9 million in the second quarter of 2013. The slight decrease was primarily due to a 2% decline in volume, partially offset by 1% increases in both price and foreign currency translation. Organic growth within North America and emerging markets increased 2% due primarily to performance within the commercial electronics and automatic doors businesses. Organic sales in Europe declined 6% due primarily to lower installation and recurring revenues, most notably in Southern Europe. On a year-to-date basis, net sales decreased $21.6 million, or 1.8%, in the first half of 2014 compared to the first half of 2013. The decrease was primarily due to a 4% decline in volume, partially offset by 1% increases in both price and foreign currency translation. The decrease in sales volume was primarily attributable to adverse impacts from severe North America weather conditions in the first quarter of 2014 as well as lower installation and recurring revenues in Europe. 33-------------------------------------------------------------------------------- Table of Contents Segment profit for the second quarter of 2014 was $67.0 million, or 11.1% of net sales, compared to $54.7 million, or 9.1% of net sales, in the second quarter of 2013. Excluding merger and acquisition-related charges of $1.2 million, segment profit amounted to $68.2 million, or 11.3% of net sales, in the second quarter of 2014 compared to $63.5 million, or 10.5% of net sales, in the second quarter of 2013 (excluding $8.8 million in merger and acquisition-related charges). The year over year increase in segment profit was mainly attributable to improved operating performance within North America and emerging markets. Year-to-date segment profit for Security was $116.6 million, or 9.9% of net sales, compared to $112.1 million, or 9.4% of net sales, for the corresponding 2013 period. Excluding $3.5 million in merger and acquisition-related charges, segment profit amounted to $120.1 million, or 10.2% of net sales, in 2014 compared to $127.3 million, or 10.6% of net sales, in 2013 (excluding $15.2 million in merger and acquisition-related charges). The slight decrease in segment profit rate was mainly attributable to installation field inefficiencies and lower volumes in the Security Europe business, which more than offset improved operating performance within North America and emerging markets during the first half of 2014. RESTRUCTURING ACTIVITIES A summary of the restructuring reserve activity from December 28, 2013 to June 28, 2014 is as follows (in millions): December 28, Additions June 28, 2013 (Reversals), net Usage Currency 2014 2014 Actions Severance and related costs $ - $ 3.4 $ (2.9 ) $ (0.4 ) $ 0.1 Facility closures - 0.6 (0.4 ) - 0.2 Subtotal 2014 actions $ - $ 4.0 $ (3.3 ) $ (0.4 ) $ 0.3 Pre-2014 Actions Severance and related costs $ 172.2 $ (9.5 ) $ (50.2 ) $ (0.4 ) $ 112.1 Facility closures 21.6 0.1 (2.9 ) - 18.8 Subtotal Pre-2014 actions $ 193.8 $ (9.4 ) $ (53.1 ) $ (0.4 ) $ 130.9 Total $ 193.8 $ (5.4 ) $ (56.4 ) $ (0.8 ) $ 131.2 For the six months ended June 28, 2014, the Company recognized a net restructuring credit of $5.4 million. This amount reflects $3.4 million of net severance charges associated with the reduction of approximately 32 employees, which was more than offset by reversals of $9.5 million which represent the elimination of excess severance accruals due to changes in initial estimates relating to prior year actions. The Company also had net facility closure costs of $0.7 million. For the three months ended June 28, 2014, the Company recognized a net restructuring credit of $1.7 million. This amount reflects $1.2 million of net severance charges associated with the reduction of approximately 8 employees in the second quarter of 2014, which was more than offset by reversals of $2.7 million which represent the elimination of excess severance accruals due to changes in initial estimates relating to prior year actions. The Company also had $0.2 million of net facility closure reserve reductions in the second quarter of 2014. The majority of the $131.2 million of reserves remaining as of June 28, 2014 is expected to be utilized within the next 12 months. Segments: The $5.4 million net restructuring credit for the six months ended June 28, 2014 includes: $2.2 million of net reserve reductions pertaining to the CDIY segment; $0.4 million of net charges pertaining to the Industrial segment; $2.5 million of net reserve reductions pertaining to the Security segment; and $1.1 million of net reserve reductions pertaining to Corporate. The $1.7 million net restructuring credit for the three months ended June 28, 2014 includes: $0.9 million of net reserve reductions pertaining to the CDIY segment; $0.3 million of net charges pertaining to the Industrial segment; and $1.1 million of net reserve reductions pertaining to the Security segment. FINANCIAL CONDITION Liquidity, Sources and Uses of Capital: The Company's primary sources of liquidity are cash flows generated from operations and available lines of credit under various credit facilities. The Company's cash flows are presented on a consolidated basis and include cash flows from discontinued operations. Operating Activities: Cash flow provided by operations was $437.2 million in the second quarter of 2014 and $184.2 million in the second quarter of 2013. Cash inflows from working capital (accounts receivable, inventory, accounts payable and deferred revenue) were $55.9 million in the second quarter of 2014 compared to $67.6 million in the second quarter of 2013. Overall, 34-------------------------------------------------------------------------------- Table of Contents operating cash flows were higher in the second quarter of 2014 as compared to the second quarter of 2013 primarily due to an increase in earnings, the timing of employee benefit plan contributions and one-time payments made in the second quarter of 2013. Year-to-date cash flow provided by operations was $285.2 million in the first half of 2014 compared to $36.7 million in the corresponding period of 2013. The overall increase in operating cash flows in the first half of 2014 was primarily due to the same factors that impacted the second quarter, as discussed above. Furthermore, cash outflows from working capital were $274.4 million in the first half of 2014 compared to $127.4 million in 2013. The increase in working capital cash outflows was primarily driven by higher inventory purchases, primarily related to the CDIY business, to ensure customer needs are met in the second half of 2014. Free Cash Flow: Free cash inflow, as defined in the following table, was $375.8 million in the second quarter of 2014 compared to $104.2 million in the corresponding 2013 period. Free cash inflow on a year-to-date basis was $166.0 million in 2014 compared to an outflow of $119.9 million in 2013. Management considers free cash flow an important indicator of its liquidity, as well as its ability to fund future growth and provide a dividend to shareowners. Free cash flow does not include deductions for mandatory debt service, other borrowing activity, discretionary dividends on the Company's common stock and business acquisitions, among other items. Second Quarter Year-to-Date (Millions of Dollars) 2014 2013 2014 2013 Net cash provided by operating activities $ 437.2 $ 184.2 $ 285.2 $ 36.7 Less: capital expenditures (61.4 ) (80.0 ) (119.2 ) (156.6 ) Free cash inflow (outflow) $ 375.8 $ 104.2 $ 166.0 $ (119.9 ) Included in free cash flow are merger and acquisition-related charges and payments of $34.8 million and $86.6 million for the three and six months ended June 28, 2014, respectively, and $122.1 million and $216.6 million for the three and six months ended June 29, 2013, respectively. Based on its potential to generate cash flow from operations on an annual basis and credit position at June 28, 2014, the Company believes over the long term it has the financial flexibility to deploy capital to its shareowners' advantage through a combination of acquisitions, dividends, and potential future share repurchases. Investing Activities: Cash flow used in investing activities was $96.1 million in the second quarter of 2014 compared to $39.0 million in the second quarter of 2013. Year-to-date cash flow used in investing activities was $161.8 million and $980.6 million in the first half of 2014 and 2013, respectively. Cash outflows for business acquisitions were $909.9 million in the first half of 2013, primarily relating to the purchases of Infastech for $826.4 million, net of cash acquired, and GQ for $48.5 million, net of cash acquired. During the second quarter of 2013, the Company received $93.5 million in cash proceeds relating to the sale of the residential portion of the Tong Lung business. Capital and software expenditures were $61.4 million and $119.2 million for the three and six months ended June 28, 2014, respectively, compared to $80.0 million and $156.6 million for the three and six months ended June 29, 2013, respectively. Financing Activities: Cash flow used in financing activities was $268.3 million in the second quarter of 2014 compared to $120.3 million in the second quarter of 2013. Net repayments of short-term borrowings under the Company's commercial paper program were $199.7 million in the second quarter of 2014 compared to $60.1 million in the second quarter of 2013. Cash dividends were $78.4 million in the second quarter of both 2014 and 2013. Year-to-date cash flow used in financing activities was $107.1 million in the first half of 2014 compared to net proceeds of $841.8 million in the first half of 2013. Net proceeds from short-term borrowings under the Company's commercial paper program amounted to $82.6 million in 2014 compared to $1,270.4 million in 2013. The higher borrowings in the prior year were primarily as a result of the Infastech acquisition. Cash proceeds from the issuances of common stock were $27.6 million and $106.4 million in the first two quarters of 2014 and 2013, respectively. Cash dividends were $159.1 million in the first half of 2014 compared to $157.5 million in the first half of 2013. The Company paid $30.3 million related to the termination of interest rate swaps in February 2014. In January 2013, the Company elected to prepay the $350.0 million forward share purchase contract. 35-------------------------------------------------------------------------------- Table of Contents Credit Ratings & Liquidity: The Company maintains strong investment grade credit ratings from the major U.S. rating agencies on its senior unsecured debt (average A-), as well as its short-term commercial paper borrowings. There have been no changes to any of the ratings during 2014. Failure to maintain strong investment grade rating levels could adversely affect the Company's cost of funds, liquidity and access to capital markets, but would not have an adverse effect on the Company's ability to access committed credit facilities. On December 3, 2013, the Company issued $400.0 million 5.75% fixed-to-floating rate junior subordinated debentures maturing December 15, 2053 ("2053 Junior Subordinated Debentures") that bear interest at a fixed rate of 5.75% per annum, up to, but excluding December 15, 2018. From and including December 15, 2018, the 2053 Junior Subordinated Debentures will bear interest at an annual rate equal to three-month LIBOR plus 4.304%. The debentures subordination and long tenor provides significant credit protection measures for senior creditors and as a result, the debentures were awarded a 50% equity credit by S&P and Fitch, and a 25% equity credit by Moody's. The net proceeds of $392.0 million from the offering was primarily used to repay commercial paper borrowings. On December 3, 2013, the Company issued 3,450,000 Equity Units (the "Equity Units"), each with a stated value of $100 which are initially comprised of a 1/10, or 10%, undivided beneficial ownership in a $1,000 principal amount 2.25% junior subordinated note due 2018 and a forward common stock purchase contract (the "Equity Purchase Contract"). Each Equity Purchase Contract obligates the holders to purchase approximately 3.5 to 4.3 million common shares. The subordination of the notes in the Equity Units combined with the Equity Purchase Contracts resulted in the Equity Units being awarded a 100% equity credit by S&P, and a 50% equity credit by Moody's. The Company received approximately $334.7 million in cash proceeds from the Equity Units, net of underwriting discounts and commission, before offering expenses, and recorded $345.0 million in long-term debt. The proceeds were used primarily to repay commercial paper borrowings. In the fourth quarter of 2013, the Company extinguished $300 million of its Black & Decker Corporation 5.75% senior notes due 2016. The Company has a five year $1.5 billion committed credit facility (the "Credit Agreement"). Borrowings under the Credit Agreement may include U.S. Dollars up to the $1.5 billion commitment or in Euro or Pounds Sterling subject to a foreign currency sublimit of $400.0 million and bear interest at a floating rate dependent upon the denomination of the borrowing. Repayments must be made on June 27, 2018 or upon an earlier termination date of the Credit Agreement, at the election of the Company. In June 2014, the Company's $500.0 million 364 day committed credit facility (the "Facility") expired. The Facility was designated to be part of a liquidity back-stop for the Company's commercial paper program. Following an evaluation of the Company's liquidity position, the Company elected not to negotiate a new 364 day committed credit facility. The Company's $2.0 billion commercial paper program is still backed by its $1.5 billion Credit Agreement. As of June 28, 2014, the Company has not drawn on the Credit Agreement. Refer to Note H, Long-Term Debt and Financing Arrangements, and Note J, Equity Arrangements, in the Notes to (Unaudited) Condensed Consolidated Financial Statements for further discussion of the Company's financing arrangements. Cash and cash equivalents totaled $516 million as of June 28, 2014, comprised of $47 million in the U.S. and $469 million in foreign jurisdictions. As of December 29, 2013, cash and cash equivalents totaled $496 million, comprised of $57 million in the U.S. and $439 million in foreign jurisdictions. Concurrent with the Black & Decker merger, the Company made a determination to repatriate certain legacy Black & Decker foreign earnings, on which U.S. income taxes had not previously been provided. As a result of this repatriation decision, the Company has recorded approximately $432.5 million and $418.8 million of associated deferred tax liabilities at June 28, 2014 and December 28, 2013, respectively. Current plans and liquidity requirements do not demonstrate a need to repatriate other foreign earnings. Accordingly, all other undistributed foreign earnings of the Company are considered to be permanently reinvested, or will be remitted substantially free of additional tax, consistent with the Company's overall growth strategy internationally, including acquisitions and long-term financial objectives. No provision has been made for taxes that might be payable upon remittance of these undistributed foreign earnings. However, should management determine at a later point to repatriate additional foreign earnings, the Company would be required to accrue and pay taxes at that time. OTHER MATTERS Critical Accounting Estimates: There have been no significant changes in the Company's critical accounting estimates during the second quarter of 2014. Refer to the "Other Matters" section of Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's Form 10-K for the year ended December 28, 2013 for a discussion of the Company's critical accounting estimates. 36-------------------------------------------------------------------------------- Table of Contents |