UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 27, 2012.

Or

¨    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission file number  1-6357

 

ESTERLINE TECHNOLOGIES CORPORATION

(Exact name of registrant as specified in its charter)

 

		Delaware		13-2595091
		(State or other Jurisdiction		(I.R.S. Employer
		of incorporation or organization)		Identification No.)

500  108th Avenue N.E., Bellevue, Washington 98004

(Address of principal executive offices)(Zip Code)

Registrant’s telephone number, including area code (425) 453-9400

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ      No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   þ      No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  þ        Accelerated filer  ¨        Non-accelerated filer  ¨        Smaller reporting company  ¨

                                             (Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨     No  þ

As of August 28, 2012, 30,857,658 shares of the issuer’s common stock were outstanding.

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PART I – FINANCIAL INFORMATION

 

Item 1.

Financial Statements

ESTERLINE TECHNOLOGIES CORPORATION

CONSOLIDATED BALANCE SHEET

As of July 27, 2012 and October 28, 2011

(In thousands, except share amounts)

 

 

 

		July 27, 2012				October 28, 2011
ASSETS			(Unaudited)
Current Assets
Cash and cash equivalents		$	213,073			$	185,035
Cash in escrow			5,014				5,011
Accounts receivable, net of allowances
of $9,397 and $7,063			333,815				369,826
Inventories
Raw materials and purchased parts			145,446				130,445
Work in process			175,504				187,922
Finished goods			89,565				84,181
			410,515				402,548
Income tax refundable			10,409				2,857
Deferred income tax benefits			46,078				48,251
Prepaid expenses			23,872				19,245
Other current assets			2,651				6,540
Total Current Assets			1,045,427				1,039,313
Property, Plant and Equipment			685,259				669,920
Accumulated depreciation			330,208				301,504
			355,051				368,416
Other Non-Current Assets
Goodwill			1,076,874				1,163,725
Intangibles, net			608,416				693,915
Debt issuance costs, net of accumulated
amortization of $4,108 and $2,700			9,294				10,695
Deferred income tax benefits			88,208				79,605
Other assets			18,756				22,917
		$	3,202,026			$	3,378,586

 

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ESTERLINE TECHNOLOGIES CORPORATION

CONSOLIDATED BALANCE SHEET

As of July 27, 2012 and October 28, 2011

(In thousands, except share amounts)

 

 

 

		July 27, 2012				October 28, 2011
LIABILITIES AND SHAREHOLDERS’ EQUITY			(Unaudited)
Current Liabilities
Accounts payable		$	109,936			$	119,888
Accrued liabilities			268,889				270,422
Credit facilities			127				5,000
Current maturities of long-term debt			12,521				11,595
Deferred income tax liabilities			3,503				9,538
Federal and foreign income taxes			13,713				1,918
Total Current Liabilities			408,689				418,361
Long-Term Liabilities
Credit facilities			300,000				360,000
Long-term debt, net of current maturities			619,753				660,028
Deferred income tax liabilities			208,702				238,709
Pension and post-retirement obligations			89,770				107,877
Other liabilities			34,180				19,693
Shareholders’ Equity
Common stock, par value $.20 per share,
authorized 60,000,000 shares, issued and outstanding 30,855,583 and 30,613,448 shares			6,171				6,123
Additional paid-in capital			566,893				551,703
Retained earnings			1,058,696				1,007,821
Accumulated other comprehensive loss			(100,496	)			(2,812	)
Total Esterline shareholders’ equity			1,531,264				1,562,835
Noncontrolling interests			9,668				11,083
Total Shareholders’ Equity			1,540,932				1,573,918
		$	3,202,026			$	3,378,586

 

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ESTERLINE TECHNOLOGIES CORPORATION

CONSOLIDATED STATEMENT OF OPERATIONS

For the Three and Nine Month Periods Ended July 27, 2012 and July 29, 2011

(Unaudited)

(In thousands, except per share amounts)

 

		Three Months Ended								Nine Months Ended
		July 27,         2012				July 29,         2011				July 27,         2012				July 29,         2011
Net Sales		$	485,949			$	409,512			$	1,461,662			$	1,215,588
Cost of Sales			313,853				265,973				946,962				778,980
			172,096				143,539				514,700				436,608
Expenses
Selling, general & administrative			91,869				76,418				285,516				214,919
Research, development
& engineering			27,198				23,075				83,138				63,945
Gain on settlement of contingency			0				0				(11,891	)			0
Goodwill impairment			52,169				0				52,169				0
Other income			(1,263	)			(6,366	)			(1,263	)			(6,366	)
Total Expenses			169,973				93,127				407,669				272,498
Operating Earnings from
Continuing Operations			2,123				50,412				107,031				164,110
Interest Income			(109	)			(658	)			(320	)			(1,428	)
Interest Expense			12,159				10,286				35,171				28,381
Loss on Extinguishment of Debt			0				0				0				831
Income (Loss) from Continuing Operations
Before Income Taxes			(9,927	)			40,784				72,180				136,326
Income Tax Expense			6,963				2,821				20,677				22,323
Income (Loss) from Continuing Operations
Including Noncontrolling Interests			(16,890	)			37,963				51,503				114,003
Income Attributable to
Noncontrolling Interests			(214	)			(222	)			(628	)			(328	)
Income (Loss) from Continuing Operations
Attributable to Esterline			(17,104	)			37,741				50,875				113,675
Loss from Discontinued Operations
Attributable to Esterline, Net of Tax			0				(46	)			0				(75	)
Net Earnings (Loss) Attributable to Esterline		$	(17,104	)		$	37,695			$	50,875			$	113,600
Earnings (Loss) Per Share Attributable to Esterline – Basic:
Continuing operations		$	(.55	)		$	1.23			$	1.66			$	3.73
Discontinued operations			.00				.00				.00				.00
Earnings (Loss) Per Share Attributable
to Esterline – Basic		$	(.55	)		$	1.23			$	1.66			$	3.73
Earnings (Loss) Per Share Attributable to Esterline – Diluted:
Continuing operations		$	(.55	)		$	1.21			$	1.63			$	3.65
Discontinued operations			.00				.00				.00				.00
Earnings (Loss) Per Share Attributable
to Esterline – Diluted		$	(.55	)		$	1.21			$	1.63			$	3.65

 

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ESTERLINE TECHNOLOGIES CORPORATION

CONSOLIDATED STATEMENT OF CASH FLOWS

For the Nine Month Periods Ended July 27, 2012 and July 29, 2011

(Unaudited)

(In thousands)

 

		Nine Months Ended
		July 27, 2012				July 29, 2011
Cash Flows Provided (Used) by Operating Activities
Net earnings including noncontrolling interests		$	51,503			$	113,928
Adjustments to reconcile net earnings including
noncontrolling interests to net cash provided
(used) by operating activities:
Depreciation and amortization			79,265				56,738
Deferred income taxes			(19,636	)			823
Share-based compensation			7,686				5,781
Gain on settlement of contingency			(11,891	)			0
Goodwill impairment			52,169				0
Working capital changes, net of effect of acquisitions
Accounts receivable			20,975				34,625
Inventories			(27,494	)			(34,924	)
Prepaid expenses			(5,423	)			(1,528	)
Other current assets			188				(1,565	)
Accounts payable			(2,466	)			383
Accrued liabilities			16,923				1,773
Federal and foreign income taxes			2,151				3,577
Other liabilities			(15,074	)			(20,112	)
Other, net			2,371				(1,040	)
			151,247				158,459
Cash Flows Provided (Used) by Investing Activities
Purchases of capital assets			(39,456	)			(35,227	)
Proceeds from sale of capital assets			1,139				913
Escrow deposit			0				(14,000	)
Acquisitions, net of cash acquired			0				(811,914	)
			(38,317	)			(860,228	)

 

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ESTERLINE TECHNOLOGIES CORPORATION

CONSOLIDATED STATEMENT OF CASH FLOWS

For the Nine Month Periods Ended July 27, 2012 and July 29, 2011

(Unaudited)

(In thousands)

 

		Nine Months Ended
		July 27, 2012				July 29, 2011
Cash Flows Provided (Used) by Financing Activities
Proceeds provided by stock issuance under
employee stock plans			7,331				13,244
Excess tax benefits from stock options exercised			221				1,830
Dividends paid to noncontrolling interests			0				(238	)
Debt and other issuance costs			0				(5,374	)
Proceeds from credit facilities			127				395,000
Proceeds from issuance of long-term debt			0				179,975
Repayment of long-term debt and credit facilities			(104,131	)			(118,158	)
Proceeds from government assistance			17,203				14,950
			(79,249	)			481,229
Effect of Foreign Exchange Rates on Cash			(5,643	)			6,258
Net Increase (Decrease) in Cash and Cash Equivalents			28,038				(214,282	)
Cash and Cash Equivalents – Beginning of Period			185,035				422,120
Cash and Cash Equivalents – End of Period		$	213,073			$	207,838
Supplemental Cash Flow Information
Cash Paid for Interest		$	27,039			$	21,722
Cash Paid for Taxes			37,554				25,407

 

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ESTERLINE TECHNOLOGIES CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For the Three and Nine Month Periods Ended July 27, 2012 and July 29, 2011

 

1.

The consolidated balance sheet as of July 27, 2012, the consolidated statement of operations for the three and nine month periods ended July 27, 2012, and July 29, 2011, and the consolidated statement of cash flows for the nine month periods ended July 27, 2012, and July 29, 2011, are unaudited but, in the opinion of management, all of the necessary adjustments, consisting of normal recurring accruals, have been made to present fairly the financial statements referred to above in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the above statements do not include all of the footnotes required for complete financial statements. The results of operations and cash flows for the interim periods presented are not necessarily indicative of results that can be expected for the full year.

 

2.	The notes to the consolidated financial statements in the Company’s Annual Report on Form 10-K for the fiscal year ended October 28, 2011, provide a summary of significant accounting policies and additional financial information that should be read in conjunction with this Form 10-Q.

 

3.

The timing of the Company’s revenues is impacted by the purchasing patterns of customers and, as a result, revenues are not generated evenly throughout the year. Moreover, the Company’s first fiscal quarter, November through January, includes significant holiday periods in both Europe and North America.

 

4.

In June 2011 the Financial Accounting Standards Board (FASB) amended requirements for the presentation of other comprehensive income (OCI), requiring presentation of comprehensive income in either a single, continuous statement of comprehensive income or on separate but consecutive statements, the statement of operations and the statement of OCI. The amendment is effective for the Company at the beginning of fiscal year 2013, with early adoption permitted. The adoption of this guidance will not impact the Company’s financial position, results of operations or cash flows and will only impact the presentation of OCI on the financial statements.

 

5.

Basic earnings per share is computed on the basis of the weighted average number of shares outstanding during the year. Diluted earnings per share includes the dilutive effect of stock options. Common shares issuable from stock options excluded from the calculation of diluted earnings per share because they were anti-dilutive were 303,100 in the third fiscal quarter of 2011. Shares used for calculating earnings per share are disclosed in the following table.

 

 

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6.	The Company’s comprehensive income (loss) is as follows:

 

(In thousands)		Three Months Ended								Nine Months Ended
		July 27,   2012				July 29, 2011				July 27, 2012				July 29, 2011
Net Earnings (Loss)		$	(17,104	)		$	37,695			$	50,875			$	113,600
Change in Fair Value of Derivative
Financial Instruments, Net of Tax (1)			(5,343	)			(5,370	)			(4,958	)			(325	)
Pension and Post-retirement
Obligations, Net of Tax (2)			1,760				1,248				4,074				1,940
Foreign Currency Translation
Adjustment			(60,938	)			(26,247	)			(96,800	)			47,521
Comprehensive Income (Loss)		$	(81,625	)		$	7,326			$	(46,809	)		$	162,736

 

(1)

Net of tax benefit of $2,296 and $2,201 for the third fiscal quarter of 2012 and 2011, respectively. Net of tax (expense) benefit of $2,388 and $(4) for the first nine months of fiscal 2012 and 2011, respectively.

 

(2)

Net of tax expense of $(929) and $(714) for the third fiscal quarter of 2012 and 2011, respectively. Net of tax expense of $(2,341) and $(1,406) for the first nine months of fiscal 2012 and 2011, respectively.

The Company’s accumulated other comprehensive loss is comprised of the following:

 

(In thousands)		July 27,         2012				October 28, 2011
Net unrealized gain (loss) on derivative contracts		$	(936	)		$	4,022
Pension and post-retirement obligations			(71,397	)			(75,471	)
Currency translation adjustment			(28,163	)			68,637
Total accumulated other comprehensive loss		$	(100,496	)		$	(2,812	)

 

7.

On July 26, 2011, the Company acquired the Souriau Group (Souriau) for approximately $726.7 million, including cash of $17.8 million. Souriau is a leading global supplier of highly engineered connectors for harsh environments serving aerospace, defense & space, power generation, rail, and industrial equipment markets. Souriau is included in the Sensors & Systems segment.

The following summarizes the allocation of the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition. The fair value adjustment for inventory was $41.7 million, which has been recognized as cost of goods sold over 4.5 months, the estimated inventory turnover. The purchase price includes the value of future development of existing technologies, the introduction of new technologies, and the addition of new customers. These factors resulted in recording goodwill of $376.9 million. The amount allocated to goodwill is not deductible for income tax purposes.

 

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Pro Forma Financial Information

The following pro forma financial information shows the results of continuing operations for the three and nine months ended July 29, 2011, as though the acquisition of Souriau had occurred at the beginning of the fiscal year. The pro forma financial information includes, where applicable, adjustments for: (i) the amortization of acquired intangible assets, (ii) additional interest expense on acquisition-related borrowings and (iii) the income tax effect on the pro forma adjustments. The pro forma financial information below is presented for illustrative purposes only and is not necessarily indicative of the operating results that would have been achieved had the acquisition been completed as of the date indicated above or the results that may be obtained in the future.

 

On December 30, 2010, the Company acquired Eclipse Electronic Systems, Inc. (Eclipse) for $123.8 million. The purchase price includes cash of $14.0 million in contingent consideration, which was deposited in an escrow account and will be paid to the seller if certain performance objectives are met over the three-year period. The estimated fair value of the contingent consideration was $13.4 million at the date of acquisition. On February 2, 2012, the Company paid the initial $5.0 million of three installments totaling $14.0 million of contingent consideration. As of July 27, 2012, the estimated fair value of the contingent consideration was $8.4 million. Eclipse is a designer and manufacturer of embedded communication intercept receivers for signal intelligence applications. Eclipse is included in the Avionics & Controls segment.

The following summarizes the allocation of the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition. The purchase price includes the value of future development of existing technologies, the introduction of new technologies, and the addition of new customers. These factors resulted in recording goodwill of $67.9 million. The amount allocated to goodwill is not deductible for income tax purposes.

 

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8.

During the third fiscal quarter of 2012, management performed a Step One impairment test for Racal Acoustics, included in the Avionics & Controls segment, upon identification of an indicator of impairment. Racal Acoustics’ third quarter forecast projected an operating loss for fiscal 2012. Additionally, management determined that requirements for hearing protection devices for the U.S. Army would not recover in the five-year planning horizon in light of the cancellation of certain programs that include Racal Acoustics’ products, and the expected decline in demand for Racal Acoustics’ products from the U.S. armed forces, as well as a global slowdown in defense spending. As required under U.S. GAAP, a Step Two impairment test was required because the current fair value of the business using a discounted cash flow and market approach was less than its carrying amount of the business. Under Step Two, the fair value of all of Racal Acoustics’ assets and liabilities were estimated, including tangible assets, existing technology, and trade names, for the purpose of deriving an estimate of the implied fair value of goodwill. The implied fair value of the goodwill was then compared to the recorded goodwill to determine the amount of the impairment. Assumptions used in measuring the value of these assets and liabilities included the discount rates, royalty rates, and obsolescence rates used in valuing the intangible assets, and pricing of comparable transactions in the market in valuing the tangible assets. The excess of the carrying amount of goodwill over the implied fair value of goodwill resulted in an impairment charge of $52.2 million. There were no impairments on Racal Acoustics’ other long-lived assets subject to amortization at July 27, 2012.

 

9.

The income tax rate (before the goodwill impairment charge) was 16.6% and 16.4% for the first nine months of fiscal 2012 and 2011, respectively. The income tax rate for the first nine months of fiscal 2012 (after the goodwill impairment charge) was 28.6%. In the first nine months of fiscal 2012, the Company recognized $7.2 million of discrete tax benefits principally related to three items. The first item was a $2.3 million tax benefit due to a change in French tax laws associated with the holding company structure and the financing of the Souriau acquisition. The second item was a $2.9 million reduction of net deferred tax liabilities as a result of the enactment of tax laws reducing the U.K. statutory income tax rate. The third item was a $1.7 million tax benefit as a result of reconciling the prior year’s income tax return to the U.S. income tax provision.

In the first nine months of fiscal 2011, the Company recognized $11.0 million of discrete tax benefits principally related to three items. The first item was approximately $3.3 million of tax benefits due to the retroactive extension of the U.S. federal research and experimentation credits and the release of a valuation allowance related to a net operating loss of an acquired subsidiary. The second item was approximately $5.6 million of tax benefits associated with net operating losses of an acquired subsidiary as a result of concluding a tax examination. The third item was approximately $3.2 million of net reduction of deferred tax liabilities as a result of the enactment of tax laws reducing the U.K. statutory income tax rate.

The income tax rate differed from the statutory rate in the first nine months of fiscal 2012 and 2011, as both years benefited from various tax credits and certain foreign interest expense deductions.

It is reasonably possible that within the next twelve months approximately $5.6 million of tax benefits associated with research and development tax credits, capital and operating losses that are currently unrecognized could be recognized as a result of settlement of examinations and/or the expiration of a statute of limitations.

 

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10.

As of July 27, 2012, the Company had three share-based compensation plans, which are described below. The compensation cost that has been charged against income for those plans for the first nine months of fiscal 2012 and 2011 was $7.7 million and $5.8 million, respectively. During the first nine months of fiscal 2012 and 2011, the Company issued 242,135 and 333,128 shares, respectively, under its employee stock plans.

Employee Stock Purchase Plan (ESPP)

The ESPP is a “safe-harbor” designed plan whereby shares are purchased by participants at a discount of 5% of the market value on the purchase date and, therefore, compensation cost is not recorded under the ESPP.

Equity Incentive Plan

Under the equity incentive plan, option exercise prices are equal to the fair market value of the Company’s common stock on the date of grant. The Company granted 343,400 and 316,300 options to purchase shares in the nine month periods ended July 27, 2012, and July 29, 2011, respectively. The weighted-average grant date fair value of options granted during the nine month periods ended July 27, 2012, and July 29, 2011, was $24.33 and $32.58 per share, respectively.

The fair value of each option granted by the Company was estimated using a Black-Scholes pricing model which uses the assumptions noted in the following table. The Company uses historical data to estimate volatility of the Company’s common stock and option exercise and employee termination assumptions. The risk-free rate for the contractual life of the option is based on the U.S. Treasury zero coupon issues in effect at the time of the grant.

 

Employee Sharesave Scheme

The Company offers shares under its employee sharesave scheme for U.K. employees. This plan allows participants the option to purchase shares at a 5% discount of the market price of the stock as of the beginning of the offering period. The term of these options is three years. The sharesave scheme is not a “safe-harbor” design, and therefore, compensation cost is recognized on this plan. Under the sharesave scheme, option exercise prices are equal to the fair market value of the Company’s common stock on the date of grant. The Company granted 45,063 and 9,956 options in the first nine month periods ended July 27, 2012, and July 29, 2011, respectively. The weighted-average grant date fair value of options granted during the nine month periods ended July 27, 2012, and July 29, 2011, were $19.85 and $26.14 per share, respectively.

The fair value of the awards under the employee sharesave scheme was estimated using a Black-Scholes pricing model which uses the assumptions noted in the following table. The risk-free rate for the contractual life of the option is based on the U.S. Treasury zero coupon issues in effect at the time of grant.

 

 

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11.	The Company’s pension plans principally include a U.S. pension plan maintained by Esterline and a non-U.S. plan maintained by CMC Electronics, Inc. (CMC). Components of periodic pension cost consisted of the following:

 

The Company’s principal post-retirement plans include non-U.S. plans, which are non-contributory healthcare and life insurance plans. The components of expense of these other retirement benefits consisted of the following:

 

 

12.

In March 2011, the Company entered into a secured credit facility for $460 million made available through a group of banks. The credit facility is secured by substantially all of the Company’s assets and interest is based on standard inter-bank offering rates. The credit facility expires in March 2016. The spread ranges from LIBOR plus 1.5% to LIBOR plus 2.25% depending on the leverage ratios at the time the funds are drawn. At the same time as the Company entered into the $460 million secured credit facility, the Company repaid its U.S. Term Loan for $118.8 million. At July 27, 2012, the Company had $300.0 million outstanding under the secured credit facility at an initial interest rate of LIBOR plus 2.0% or currently 2.25%.

In July 2011, the Company amended the secured credit facility to provide for a €125.0 million term loan (Euro Term Loan) to Esterline Technologies Europe Limited. The interest rate spread on the Euro Term Loan will range from Euro LIBOR plus 1.5% to Euro LIBOR plus 2.25% depending on the leverage ratios at the time the funds are drawn. At July 27, 2012, the Company had €83.0 million outstanding or $102.3 million under the Euro Term Loan at an interest rate of Euro LIBOR plus 2.0% or currently 2.33%. The loan amortizes at 1.25% of the outstanding balance quarterly through March 2016, with the remaining balance due in July 2016.

Based on quoted market prices, the fair value of the Company’s $250.0 million 7.0% Senior Notes due August 2020 was $276.6 million and $263.1 million as of July 27, 2012, and October 28, 2011, respectively. The fair value of the Company’s $175.0 million 6.625% Senior Notes due March 2017 was $181.3 million and $175.0 million as of July 27, 2012, and October 28, 2011, respectively. The carrying amounts of the secured credit facility and Euro Term Loan due 2016 approximate fair value. Estimates of fair value for the Senior Notes are based on Level 2 inputs as defined in the fair value hierarchy.

 

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13.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A fair value hierarchy has been established that prioritizes the inputs to valuation techniques used to measure fair value. An asset’s or liability’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The hierarchy of fair value measurements is described below:

Level 1 – Valuations are based on quoted prices that the Company has the ability to obtain in actively traded markets for identical assets and liabilities. Since valuations are based on quoted prices that are readily and regularly available in an active market or exchange traded market, a valuation of these instruments does not require a significant degree of judgment.

Level 2 – Valuations are based on quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

Level 3 – Valuations are based on model-based techniques for which some or all of the assumptions are obtained from indirect market information that is significant to the overall fair value measurement and which require a significant degree of management judgment.

The following table sets forth the Company’s financial assets and liabilities that were measured at fair value on a recurring basis by level within the fair value hierarchy at July 27, 2012, and October 28, 2011.

 

The Company’s embedded derivatives are the result of entering into sales or purchase contracts that are denominated in a currency other than the Company’s functional currency or the supplier’s or customer’s functional currency. The fair value is determined by calculating the difference between quoted exchange rates at the time the contract was entered into and the period end exchange rate. These contracts are categorized as Level 2 in the fair value hierarchy.

The Company’s derivative contracts consist of foreign currency exchange contracts and interest rate swap agreements. These derivative contracts are over the counter and their fair value is determined using modeling techniques that include market inputs such as interest rates, yield curves, and currency exchange rates. These contracts are categorized as Level 2 in the fair value hierarchy.

The Company’s contingent purchase obligation consists of additional consideration in connection with the acquisition of Eclipse. The contingent consideration will be paid to the seller if certain performance objectives are met over the three-year period. The value recorded on the balance sheet was derived from the estimated probability that the performance objectives will be met by the end of the three-year period. The contingent purchase obligation is categorized as Level 3 in the fair value hierarchy. The Company paid $5.0 million of the contingent purchase consideration in the second fiscal quarter of 2012.

 

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14.

The Company uses derivative financial instruments in the form of foreign currency forward exchange contracts and interest rate swap contracts for the purpose of minimizing exposure to changes in foreign currency exchange rates on business transactions and interest rates, respectively. The Company’s policy is to execute such instruments with banks the Company believes to be creditworthy and not to enter into derivative financial instruments for speculative purposes. These derivative financial instruments do not subject the Company to undue risk, as gains and losses on these instruments generally offset gains and losses on the underlying assets, liabilities, or anticipated transactions that are being hedged.

All derivative financial instruments are recorded at fair value in the Consolidated Balance Sheet. For a derivative that has not been designated as an accounting hedge, the change in the fair value is recognized immediately through earnings. For a derivative that has been designated as an accounting hedge of an existing asset or liability (a fair value hedge), the change in the fair value of both the derivative and underlying asset or liability is recognized immediately through earnings. For a derivative designated as an accounting hedge of an anticipated transaction (a cash flow hedge), the change in the fair value is recorded on the Consolidated Balance Sheet in Accumulated Other Comprehensive Income (AOCI) to the extent the derivative is effective in mitigating the exposure related to the anticipated transaction. The change in the fair value related to the ineffective portion of the hedge, if any, is immediately recognized in earnings. The amount recorded within AOCI is reclassified into earnings in the same period during which the underlying hedged transaction affects earnings.

The fair values of derivative instruments are presented on a gross basis, as the Company does not have any derivative contracts which are subject to master netting arrangements. At July 27, 2012, the Company does not have any hedges with credit-risk-related contingent features or that required the posting of collateral. The cash flows from derivative contracts are recorded in operating activities in the Consolidated Statement of Cash Flows.

Foreign Currency Forward Exchange Contracts

The Company transacts business in various foreign currencies which subjects the Company’s cash flows and earnings to exposure related to changes in foreign currency exchange rates. These exposures arise primarily from purchases or sales of products and services from third parties. Foreign currency forward exchange contracts provide for the purchase or sale of foreign currencies at specified future dates at specified exchange rates and are used to offset changes in the fair value of certain assets or liabilities or forecasted cash flows resulting from transactions denominated in foreign currencies. At July 27, 2012, and October 28, 2011, the Company had outstanding foreign currency forward exchange contracts principally to sell U.S. dollars with notional amounts of $414.0 million and $431.2 million, respectively. These notional values consist primarily of contracts for the European euro, British pound sterling and Canadian dollar, and are stated in U.S. dollar equivalents at spot exchange rates at the respective dates.

Interest Rate Swaps

The Company manages its exposure to interest rate risk by maintaining an appropriate mix of fixed and variable rate debt, which over time should moderate the costs of debt financing. When considered necessary, the Company may use financial instruments in the form of interest rate swaps to help meet this objective. In November 2010, the Company entered into an interest rate swap agreement for $100.0 million of the $175.0 million Senior Notes due in 2017. The swap agreement exchanged the fixed interest rate of 6.625% for a variable interest rate on the $100.0 million of the principal amount outstanding. The variable interest rate is based upon LIBOR plus 4.865% and was 5.312% at July 27, 2012. The fair value of the Company’s interest rate swap was a $2.1 million asset at July 27, 2012, and was estimated by discounting expected cash flows using market interest rates. The Company records interest receivable and interest payable on interest rate swaps on a net basis. In December 2010, the Company entered into an interest rate swap agreement for $75.0 million of the $175.0 million Senior Notes due in 2017. The swap agreement exchanged the fixed interest rate of 6.625% for a variable interest rate on the $75.0 million of the principal amount outstanding. The variable interest rate is based upon LIBOR plus 4.47% and was 4.917% at July 27, 2012. The fair value of the Company’s interest rate swap was a $2.1 million asset at July 27, 2012, and was estimated by discounting expected cash flows using market interest rates. The Company recognized a net interest receivable of $1.1 million at July 27, 2012.

 

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Embedded Derivative Instruments

The Company’s embedded derivatives are the result of entering into sales or purchase contracts that are denominated in a currency other than the Company’s functional currency or the supplier’s or customer’s functional currency.

Net Investment Hedge

In July 2011, the Company entered into a Euro Term Loan for €125.0 million under the secured credit facility. The Company designated the Euro Term Loan a hedge of the investment in a certain French business unit. The foreign currency gain or loss that is effective as a hedge is reported as a component of other comprehensive income in shareholders’ equity. To the extent that this hedge is ineffective, the foreign currency gain or loss is recorded in earnings. There was no ineffectiveness since inception of the hedge.

Fair Value of Derivative Instruments

Fair values of derivative instruments in the Consolidated Balance Sheet at July 27, 2012, and October 28, 2011, consisted of:

 

The effect of derivative instruments on the Consolidated Statement of Operations for the three and nine month periods ended July 27, 2012, and July 29, 2011, consisted of:

 

 

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During the first nine months of fiscal 2012 and 2011, the Company recorded a loss of $9.2 million and a gain of $3.1 million, respectively, on foreign currency forward exchange contracts that have not been designated as an accounting hedge. These foreign currency exchange gains are included in selling, general and administrative expense.

There was no significant impact to the Company’s earnings related to the ineffective portion of any hedging instruments during the first nine months of fiscal 2012 and 2011. In addition, there was no significant impact to the Company’s earnings when a hedged firm commitment no longer qualified as a fair value hedge or when a hedged forecasted transaction no longer qualified as a cash flow hedge during the first nine months of fiscal 2012 and 2011.

Amounts included in AOCI are reclassified into earnings when the hedged transaction settles. The Company expects to reclassify approximately $3.6 million of net loss into earnings over the next 12 months. The maximum duration of the Company’s foreign currency cash flow hedge contracts at July 27, 2012, is 23 months.

 

15.	Segment information:

Business segment information for continuing operations includes the segments of Avionics & Controls, Sensors & Systems and Advanced Materials.

 

 

(1)

Includes a $52.2 million impairment charge against Racal Acoustics’ goodwill.

 

16.

Prior to the March 2007 acquisition of CMC, CMC was involved in a transaction in which CMC shareholders had a limited amount of time in which to tender their shares in exchange for cash. In May 2008, after the prescribed time period had expired, CAD $11.8 million remained unclaimed. As a result, the paying agent returned the unclaimed amount to CMC in accordance with Canadian law. In December 2008, CMC’s former parent company instituted a legal action against the paying agent, alleging negligence and breached contract terms by returning the funds to CMC. The plaintiff lost at trial and appealed. In the second quarter of fiscal 2012, CMC received notice that the plaintiff abandoned its appeal. In addition, CMC and the paying agent settled all remaining issues. Management concluded that all contingencies relating to this matter were resolved, and accordingly, the Company recorded a gain of approximately CAD $11.8 million or $11.9 million, or $9.5 million after tax, in the second fiscal quarter of 2012.

 

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17.

The following schedules set forth condensed consolidating financial information as required by Rule 3-10 of Securities and Exchange Commission Regulation S-X as of July 27, 2012, and October 28, 2011, and for the applicable periods ended July 27, 2012, and July 29, 2011, for (a) Esterline Technologies Corporation (the Parent); (b) on a combined basis, the current subsidiary guarantors (Guarantor Subsidiaries) of the secured credit facility, Senior Notes due 2017, and Senior Notes due 2020; and (c) on a combined basis, the subsidiaries that are not guarantors of the secured credit facility, Senior Notes due 2017, and Senior Notes due 2020 (Non-Guarantor Subsidiaries). The Guarantor Subsidiaries previously guaranteed the Senior Subordinated Notes due 2013 that were repurchased or otherwise redeemed in August 2010. The Guarantor Subsidiaries are direct and indirect wholly-owned subsidiaries of Esterline Technologies Corporation and have fully and unconditionally, jointly and severally, guaranteed the secured credit facility, the Senior Notes due 2017 and the Senior Notes due 2020.

Condensed Consolidating Balance Sheet as of July 27, 2012.

 

 

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Condensed Consolidating Statement of Operations for the three month period ended July 27, 2012.

 

 

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Condensed Consolidating Statement of Operations for the nine month period ended July 27, 2012.

 

 

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Condensed Consolidating Statement of Cash Flows for the nine month period ended July 27, 2012.

 

 

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Condensed Consolidating Balance Sheet as of October 28, 2011.

 

 

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Condensed Consolidating Statement of Operations for the three month period ended July 29, 2011.

 

 

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Condensed Consolidating Statement of Operations for the nine month period ended July 29, 2011.

 

 

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Condensed Consolidating Statement of Cash Flows for the nine month period ended July 29, 2011.

 

 

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Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We operate our businesses in three segments: Avionics & Controls, Sensors & Systems and Advanced Materials.

The Avionics & Controls segment includes avionics systems, control systems, interface technologies and communication systems capabilities. Avionics systems designs and develops cockpit systems integration and avionics solutions for commercial and military applications. Control systems designs and manufactures technology interface systems for military and commercial aircraft and land- and sea-based military vehicles. Interface technologies manufactures and develops custom control panels, input systems for medical, industrial, military and casino gaming industries. Communication systems designs and manufactures military audio and data products for severe battlefield environments, as well as communication control systems to enhance security and aural clarity in military applications. In addition, communication systems designs and manufactures embedded communication intercept receivers for signal intelligence applications.

The Sensors & Systems segment includes power systems, connection technologies and advanced sensors capabilities. Power systems develops and manufactures electrical power switching and other related systems, principally for aerospace and defense customers. Connection technologies develops and manufactures highly engineered connectors for harsh environments and serves the aerospace, defense & space, power generation, rail, and industrial equipment markets. Advanced sensors develops and manufactures high precision temperature and pressure sensors for aerospace and defense customers.

The Advanced Materials segment includes engineered materials and defense technologies capabilities. Engineered materials develops and manufactures thermally engineered components and high-performance elastomer products used in a wide range of commercial aerospace and military applications. Defense technologies develops and manufactures combustible ordnance components and warfare countermeasures for military customers. Sales in all segments include domestic, international, defense and commercial customers.

Our business and strategic plan focuses on the continued development of our products principally for aerospace and defense markets. We are concentrating our efforts to expand our capabilities in these markets and to anticipate the global needs of our customers and respond to such needs with comprehensive solutions. These efforts focus on continuous research and new product development, acquisitions and strategic realignments of operations to expand our capabilities as a more comprehensive supplier to our customers across our entire product offering.

On July 26, 2011, we acquired the Souriau Group (Souriau). Souriau is a leading global supplier of highly engineered connection technologies for harsh environments. Souriau is included in our Sensors & Systems segment.

On December 30, 2010, we acquired Eclipse Electronic Systems, Inc. (Eclipse). Eclipse is a designer and manufacturer of embedded communication intercept receivers for signal intelligence applications. Eclipse is included in our Avionics & Controls segment.

During the third fiscal quarter of 2012, we recorded a $52.2 million, or $1.69 per diluted share, impairment charge against goodwill of Racal Acoustics, our military headset business, which is included in our Avionics & Controls segment. Including this charge, we incurred a net loss of $17.1 million or $0.55 per diluted share compared to net income of $37.7 million or $1.21 per diluted share during the prior-year period.

Sales increased 18.7% to $485.9 million in the third fiscal quarter of 2012, principally reflecting increased Sensors & Systems segment sales, which benefited from incremental sales from the Souriau acquisition and a 5.7% increase in Advanced Materials segment sales. These sales increases were partially offset by lower Avionics & Controls segment sales, which declined 6.2% compared to the prior-year period, principally due to lower sales of avionics systems for military aircraft.

Segment earnings as a percent of sales were 2.1% in the third fiscal quarter of fiscal 2012 compared to 14.2% in the prior-year period. Excluding the impairment charge, segment earnings as a percentage of sales were 12.8%. Avionics & Controls segment sales and earnings declined principally due to lower sales and earnings of avionics

 

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systems. Sensors & Systems segment sales and earnings increased compared to the prior-year period, principally reflecting incremental sales and operating earnings from the Souriau acquisition and strong sales and earnings of power systems, partially offset by lower earnings of advanced sensors. Advanced Materials earnings declined compared to the prior-year period due to lower earnings on sales of engineered materials for military aircraft and commercial aviation and lower sales and earnings of combustible ordnance and non-U.S. countermeasures.

The income tax rate (before the goodwill impairment charge) was 16.5% for the third fiscal quarter of 2012 compared to 6.9% for the prior-year period.

Cash flows from operating activities were $151.2 million in the first nine months of fiscal 2012 compared to $158.5 million in the prior-year period. We paid down our revolving credit facility and Euro Term Loan by $104.1 million during the first nine months of fiscal 2012.

Results of Operations

Three Month Period Ended July 27, 2012, Compared with Three Month Period Ended July 29, 2011

Sales for the third fiscal quarter increased 18.7% over the prior-year period. Sales by segment were as follows:

 

(In thousands)
		Incr./(Decr.)     from prior year period		Three Months Ended
				July 27,         2012				July 29,         2011
Avionics & Controls		(6.2)%		$	195,059			$	208,021
Sensors & Systems		93.7%			171,603				88,605
Advanced Materials		5.7%			119,287				112,886
Total Net Sales				$	485,949			$	409,512

The 6.2% decrease in sales of Avionics & Controls mainly reflected decreased sales volumes of avionics systems, reflecting lower sales of cockpit integration for military transport aircraft.

The 93.7% increase in sales of Sensors & Systems principally reflected incremental sales from the Souriau acquisition of $78 million and increased sales of power systems, reflecting higher demand for commercial aviation products. Sales in the third fiscal quarter of 2012 reflected a weaker pound sterling and euro relative to the U.S. dollar compared to the prior-year period. The average exchange rate from the pound sterling to the U.S. dollar decreased from 1.63 in the third fiscal quarter of 2011 to 1.58 in the third fiscal quarter of 2012. The average exchange rate from the euro to the U.S. dollar decreased from 1.44 in the third fiscal quarter of 2011 to 1.26 in the third fiscal quarter of 2012. If Souriau’s sales were translated at 1.44 versus 1.26, Souriau’s incremental sales would have been $89 million in the third quarter of fiscal 2012.

The 5.7% increase in sales of Advanced Materials principally reflected higher sales volumes of engineered materials for commercial aviation applications.

Overall, gross margin as a percentage of sales was 35.4%, compared to 35.1% in the same period a year ago. Gross profit was $172.1 million compared to $143.5 million in the same period a year ago.

Avionics & Controls segment gross margin was 39.0% and 37.4% for the third fiscal quarter of 2012 and 2011, respectively. Segment gross profit was $76.1 million compared to $77.9 million in the prior-year period. A $7 million decrease in gross profit on sales of avionics systems was substantially offset by higher gross profit on sales of control systems, communication systems and interface technologies.

Sensors & Systems segment gross margin was 35.5% and 34.1% for the third fiscal quarter of 2012 and 2011, respectively. Segment gross profit was $60.8 million compared to $30.2 million in the prior-year period. The increase in gross profit mainly reflected incremental gross profit from the Souriau acquisition.

 

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Advanced Materials segment gross margin was 29.5% compared to 31.4% for the prior-year period. Segment gross profit was $35.1 million compared to $35.5 million in the prior-year period. The change in gross margin primarily reflects lower gross profits on decreased sales of elastomer materials for the F-35 fighter aircraft due to the requirement of the prime contractor to rebalance its inventories. Sales and gross profit of air duct assemblies for the A-380 also declined due to the temporary production slowdown of such aircraft.

Selling, general and administrative expenses (which include corporate expenses) totaled $91.9 million, or 18.9% of sales, and $76.4 million, or 18.7% of sales, for the third fiscal quarter of 2012 and 2011, respectively. The increase in selling, general and administrative expense principally reflected incremental selling, general and administrative expenses from the Souriau acquisition of $19 million, partially offset by a $5 million decrease in corporate expense, mainly attributable to acquisition expense incurred in the prior-year period due to the Souriau acquisition.

Research, development and engineering spending was $27.2 million, or 5.6% of sales, for the third fiscal quarter of 2012 compared with $23.1 million, or 5.6% of sales, for the third fiscal quarter of 2011. The increase in research, development and engineering spending principally reflects higher spending on control systems and communication systems of $3.0 million, and incremental spending as a result of the Souriau acquisition of $3 million, partially offset by lower spending for avionics systems. Fiscal 2012 research, development and engineering spending is expected to be approximately 5.5% to 6.0% of sales.

Segment earnings (operating earnings excluding corporate expenses and other income or expense) for the third fiscal quarter of 2012 totaled $10.0 million, or 2.1% of sales, compared with $58.2 million, or 14.2% of sales, for the third fiscal quarter in 2011. The decrease in segment earnings mainly reflects the $52.2 million impairment charge against goodwill of Racal Acoustics. Excluding the impairment charge, segment earnings totaled $62.2 million, or 12.8% of sales, for the third fiscal quarter of 2012. Results of operations for the third fiscal quarter of 2012 did not meet our expectations due to decreased sales and gross profit from lower cockpit integration sales for the T-6B military trainer and retrofits of military transport aircraft, as well as air duct assemblies for the A-380 aircraft and radar absorbing material for the F-35 fighter aircraft. The decrease in sales for the T-6B was due to its manufacturer, Hawker Beechcraft, filing for bankruptcy. The decrease in sales for retrofits of military transport was due to delayed orders, and the decrease in sales for air duct assemblies for the A-380 was due to the temporary production slowdown of such aircraft. The decrease in sales of radar absorbing material for the F-35 fighter aircraft was due to the requirement of the prime contractor to rebalance its inventories.

Avionics & Controls segment losses were $(25.6) million, or (13.1)% of sales, in the third fiscal quarter of 2012 compared to earnings of $28.6 million, or 13.8% of sales, in the third fiscal quarter of 2011, mainly reflecting the $52.2 million impairment charge against goodwill of Racal Acoustics, our military headset business. During the third fiscal quarter of 2012, management performed a Step One impairment test for Racal Acoustics upon identification of an indicator of impairment, since Racal Acoustics’ third quarter forecast projected an operating loss for fiscal 2012. Additionally, management determined that requirements for hearing protection devices for the U.S. Army would not recover in our five-year planning horizon in light of the cancellation of Humvee retrofits, delays in VIS-X and the slowdown in operational tempo of the U.S. armed forces as well as a global slowdown in defense spending. As required under U.S. GAAP, a Step Two impairment test was required because the current fair value of the business using a discounted cash flow and market approach was less than its carrying amount of the business. Under the Step Two impairment test, all assets and liabilities were valued at fair value. The excess of the carrying amount of goodwill over the implied fair value of goodwill resulted in an impairment charge of $52.2 million.

Excluding the impairment charge, Avionics & Controls segment earnings were $26.6 million, or 13.6% of sales, in the third fiscal quarter of 2012 compared to $28.6 million, or 13.8% of sales, in the third fiscal quarter of 2011. The $2.0 million decrease in segment earnings from the prior-year period principally reflected lower sales volumes and earnings of avionics systems for military transport aircraft, partially offset by a $1 million increase in earnings from sales of input systems for casino gaming applications due to improved gross margin.

Sensors & Systems segment earnings were $18.3 million, or 10.7% of sales, for the third fiscal quarter of 2012 compared with $10.8 million, or 12.1% of sales, for the third fiscal quarter of 2011. The increase in segment earnings principally reflected incremental earnings from the Souriau acquisition in July 2011. The decrease in

 

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segment earnings as a percent of sales was due to lower operating margins of Souriau compared to our power systems business and reduced earnings of our advanced sensors business due to lower aftermarket sales in North America. Souriau’s earnings met our expectations and reflected solid sales and earnings from commercial aviation operations.

Advanced Materials segment earnings were $17.3 million, or 14.5% of sales, for the third fiscal quarter of 2012 compared with $18.8 million, or 16.7% of sales, for the third fiscal quarter of 2011, primarily reflecting a decrease in engineered materials gross profit on lower sales of elastomer material for the F-35 due to a re-balancing of inventory by Lockheed Martin and lower sales of air duct assemblies for the A-380 due to the temporary production slowdown of such aircraft.

Interest expense for the third fiscal quarter of 2012 was $12.2 million compared with $10.3 million for the third fiscal quarter of 2011, reflecting higher borrowings as a result of the Souriau acquisition.

The income tax rate (before the goodwill impairment charge) was 16.5% compared with 6.9% for the third fiscal quarter of 2012 and 2011, respectively. In the third fiscal quarter of 2012, we recognized $5.3 million of discrete tax benefits principally related to the following items. The first item was a $2.9 million reduction of net deferred income tax liabilities as a result of the enactment of tax laws reducing the U.K. statutory income tax rate. The second item was a $1.7 million tax benefit as a result of reconciling the prior year’s U.S. income tax return to the U.S. income tax provision.

In the third fiscal quarter of 2011, we recognized $7.7 million of tax benefits principally related to the following two items. The first item was approximately $5.6 million of tax benefits associated with net operating losses of an acquired subsidiary as a result of concluding a tax examination. The second item was approximately $3.2 million of net reduction of deferred tax liabilities as a result of the enactment of tax laws reducing the U.K. statutory income tax rate.

The income tax rate differed from the statutory rate in the third fiscal quarter of 2012 and 2011, as both quarters benefited from various tax credits and certain foreign interest expense deductions.

It is reasonably possible that within the next twelve months approximately $5.6 million of tax benefits associated with research and development tax credits, capital and operating losses that are currently unrecognized could be recognized as a result of settlement of examinations and/or the expiration of a statute of limitations.

To the extent that sales are transacted in a currency other than the functional currency of the operating unit, we are subject to foreign currency fluctuation risk.

We use forward contracts to hedge our foreign currency exchange risk. To the extent that these contracts qualify as hedges under U.S. GAAP, the amount of gain or loss is deferred in Accumulated Other Comprehensive Income (AOCI) until the related sale occurs. Also, we are subject to foreign currency gains or losses from embedded derivatives on backlog denominated in a currency other than the functional currency of our operating companies or its customers. Gains and losses on forward contracts, embedded derivatives, and revaluation of assets and liabilities denominated in a currency other than the functional currency of the Company for the three-month period ended July 27, 2012, and July 29, 2011, are as follows:

 

(In thousands)		Three Months Ended
		July 27,         2012				July 29,         2011
Forward foreign currency contracts – gain (loss)		$	(4,037	)		$	1,028
Forward foreign currency contracts reclassified from AOCI			(205	)			2,716
Embedded derivatives – gain			1,304				1,443
Revaluation of monetary assets/liabilities – gain			1,507				5,464
Total		$	(1,431	)		$	10,651

 

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Nine Month Period Ended July 27, 2012, Compared with Nine Month Period Ended July 29, 2011

Sales for the first nine months increased 20.2% over the prior-year period, principally reflecting the Souriau acquisition in July 2011. Sales by segment were as follows:

 

(In thousands)
		Incr./(Decr.)     from prior year period		Nine Months Ended
				July 27,         2012				July 29,         2011
Avionics & Controls		(9.9)%		$	569,656			$	632,020
Sensors & Systems		110.5%			527,958				250,841
Advanced Materials		9.4%			364,048				332,727
Total Net Sales				$	1,461,662			$	1,215,588

The 9.9% decrease in sales of Avionics & Controls reflected decreased sales volumes of avionics systems of $59 million. The $59 million decrease in avionics systems was principally due to lower cockpit integration sales volumes for the T-6B military trainer and retrofits of military transport aircraft. The decrease in sales for the T-6B was due the financial difficulties of Hawker Beechcraft. On May 3, 2012, Hawker Beechcraft, the manufacturer of the T-6B military trainer, filed for bankruptcy under Chapter 11 of the U.S. Bankruptcy Code. Management expects that cockpit integration sales for military transport aircraft will resume in fiscal 2013. The decrease in segment sales also reflected a $13 million decrease in sales of hearing protection headsets due to reduced demand and order delays, of which about 50% was offset by strong sales of communication intercept receivers for signal intelligence applications. Additionally, interface technologies sales decreased due to lower demand for input systems for casino gaming applications.

The 110.5% increase in sales of Sensors & Systems principally reflected incremental sales from the Souriau acquisition of $248 million and increased sales volume of advanced sensors and power systems of $29 million. About 70% of the increase in advanced sensors and power systems sales reflected increased sales of power systems due to higher demand for commercial aviation products. The increase in advanced sensors reflected higher OEM sales and strong aftermarket demand in Asia and weaker demand in North America. Sales in the first nine months of fiscal 2012 reflected a weaker euro relative to the U.S. dollar compared to the prior-year period. The average exchange rate from the euro to the U.S. dollar decreased from 1.39 in the first nine months of fiscal 2011 to 1.31 in the first nine months of fiscal 2012.

The 9.4% increase in sales of Advanced Materials principally reflected increased sales volumes of engineered materials of $39 million, partially offset by decreased sales volumes of defense technologies of $9 million. The $39 million increase in engineered materials primarily reflected strong demand for elastomer and insulation materials for commercial aviation products. The $9 million decrease in defense technologies principally reflected a decrease in sales of non-U.S. countermeasure flares due to reduced demand and order delays as well as lower demand for combustible ordnance.

Overall, gross margin as a percentage of sales was 35.2% and 35.9% for the first nine months of fiscal 2012 and 2011, respectively. Gross profit was $514.7 million and $436.6 million for the first nine months of fiscal of 2012 and 2011, respectively.

 

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Avionics & Controls segment gross margin was 38.5% and 38.6% for the first nine months of fiscal 2012 and 2011, respectively. Segment gross profit was $219.5 million compared to $244.1 million in the prior-year period. The decrease in gross profit was mainly due to lower sales volumes of cockpit integrations for the T-6B military trainer and retrofits of military aircraft. A $4 million increase in communication systems gross profit reflected increased gross profit from strong sales of communication intercept receivers for signal intelligence applications, partially offset by a $6 million decrease in gross profit from sales of hearing protection devices.

Sensors & Systems segment gross margin was 33.8% and 34.7% for the first nine months of fiscal 2012 and 2011, respectively. Segment gross profit was $178.5 million compared to $87.1 million in the prior-year period. Approximately 10% of the increase in gross profit reflected strong demand for power systems for commercial aviation applications. Approximately 90% of the increase in gross profit was due to incremental gross profit from the Souriau acquisition. Souriau’s gross profit was impacted by a $12 million charge in the first fiscal quarter of 2012 due to recording Souriau’s acquired inventory at its fair value.

Advanced Materials segment gross margin was 32.0% for the first nine months of fiscal 2012 compared to 31.7% for the same period one year ago. Segment gross profit was $116.6 million compared to $105.4 million in the prior-year period. The increase in gross profit was principally due to higher sales of elastomer materials and insulation materials primarily for commercial aviation applications. Gross profit on defense technologies decreased $3 million, principally reflecting decreased gross profit and margin on combustible ordnance due to sales mix as well as lower gross profit on non-U.S. flare countermeasures reflecting decreased demand and delayed shipments.

Selling, general and administrative expenses (which include corporate expenses) totaled $285.5 million, or 19.5% of sales, and $214.9 million, or 17.7% of sales, for the first nine months of fiscal 2012 and 2011, respectively. The increase in selling, general and administrative expense principally reflected a $61.6 million increase in selling, general and administrative expense at our Sensors & Systems segment due to incremental selling, general and administrative expense from the Souriau acquisition. Selling, general and administrative expense increased $11.1 million at Avionics & Controls and Advanced Materials. This increase reflects a $2.8 million increase in bad debt due to the bankruptcy filing of Hawker Beechcraft, $3.5 million in incremental selling, general and administrative expense from the Eclipse acquisition, and $2.4 million in severance costs.

Research, development and engineering spending was $83.1 million, or 5.7% of sales, for the first nine months of fiscal 2012 compared with $63.9 million, or 5.3% of sales, for the first nine months of fiscal 2011. The increase in research, development and engineering spending principally reflects expense on control systems, communication systems, and incremental expense as a result of the Souriau acquisition of $9 million. Fiscal 2012 research, development and engineering spending is expected to be approximately 5.5% to 6.0% of sales.

Total segment earnings (operating earnings excluding corporate expenses and other income or expense) for the first nine months of fiscal 2012 totaled $129.1 million, or 8.8% of sales, compared with $195.0 million, or 16.0% of sales, for the first nine months in fiscal 2011. The decrease in segment earnings mainly reflects the $52.2 million impairment charge against goodwill of Racal Acoustics. If the impairment charge is excluded, segment earnings totaled $181.2 million or 12.4% of sales for the first nine months of 2012.

Avionics & Controls segment earnings were $12.7 million, or 2.2% of sales, in the first nine months of fiscal 2012 and $104.5 million, or 16.5% of sales, in the first nine months of fiscal 2011. Excluding the $52.2 million impairment charge, segment earnings were $64.9 million, or 11.4% of sales, in the first nine months of fiscal 2012. The decrease in segment earnings from the prior-year period mainly reflects a $27 million decrease in avionics systems earnings and a $9 million decrease in control systems earnings. Avionics systems earnings were impacted by decreased gross profit and a $2.3 million bad debt expense due to the bankruptcy of Hawker Beechcraft. Control systems earnings were impacted by lower gross margin, a $7 million increase in research, development and engineering expense, and $0.5 million in bad debt expense related to the Hawker Beechcraft bankruptcy filing. The prior-year period gross margin benefited from a $4.4 million retroactive price settlement due to product scope changes recognized in the second quarter of fiscal 2011. Additionally, the second fiscal quarter of 2011 benefited from a $1.1 million recovery of non-recurring engineering expense upon settlement with a customer of control systems.

 

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Sensors & Systems segment earnings were $49.8 million, or 9.4% of sales, for the first nine months of fiscal 2012 compared with $33.4 million, or 13.3% of sales, for the first nine months of fiscal 2011, reflecting $12 million in incremental earnings from the Souriau acquisition and a $4 million increase in power systems. Power systems benefited from increased gross profits, partially offset by higher non-recurring engineering expenses principally related to the A400M program. The decrease in segment earnings as a percent of sales reflects the inclusion of Souriau in the segment, which has lower earnings as a percentage of sales than our advanced sensors and power systems businesses, and the $12 million charge in the first fiscal quarter of 2012 due to recording Souriau’s acquired inventory at its fair value.

Advanced Materials segment earnings were $66.5 million, or 18.3% of sales, for the first nine months of fiscal 2012 compared with $57.0 million, or 17.1% of sales, for the first nine months of fiscal 2011, primarily reflecting increased gross profit on higher sales of elastomer and insulation materials, particularly in the first six months of fiscal 2012.

Prior to our March 2007 acquisition of CMC, CMC was involved in a transaction in which CMC shareholders had a limited amount of time in which to tender their shares in exchange for cash. In May 2008, after the prescribed time period had expired, CAD $11.8 million remained unclaimed. As a result, the paying agent returned the unclaimed amount to CMC in accordance with Canadian law. In December 2008, CMC’s former parent company instituted a legal action against the paying agent, alleging negligence and breached contract terms by returning the funds to CMC. The plaintiff lost at trial and appealed. In the second quarter of fiscal 2012, CMC received notice that the plaintiff abandoned its appeal. In addition, CMC and the paying agent settled all remaining issues. Management concluded that all contingencies relating to this matter were resolved, and accordingly, the Company recorded a gain of approximately CAD $11.8 million or $11.9 million, or $9.5 million after tax, in the second fiscal quarter of 2012.

Interest expense for the first nine months of fiscal 2012 was $35.2 million compared with $28.4 million for the first nine months of fiscal 2011, reflecting higher borrowings as a result of the Souriau acquisition.

The income tax rate (before the goodwill impairment charge) was 16.6% compared with 16.4% for the first nine months of fiscal 2012 and 2011, respectively. In the first nine months of fiscal 2012, we recognized $7.2 million of discrete tax benefits principally related to three items. The first item was a $2.3 million tax benefit due to a change in French tax laws associated with the holding company structure and the financing of the Souriau acquisition. The second item was a $2.9 million reduction of net deferred tax liabilities as a result of the enactment of tax laws reducing the U.K. statutory income tax rate. The third item was a $1.7 million tax benefit as a result of reconciling the prior year’s income tax return to the U.S. income tax provision.

In the first nine months of fiscal 2011, we recognized $11.0 million of discrete tax benefits principally related to the following items. The first item was approximately $3.3 million of tax benefits due to the retroactive extension of the U.S. federal research and experimentation credits and the release of a valuation allowance related to a net operating loss of an acquired subsidiary. The second item was approximately $5.6 million of tax benefits associated with net operating losses of an acquired subsidiary as a result of concluding a tax examination. The third item was approximately $3.2 million of net reduction of deferred tax liabilities as a result of the enactment of tax laws reducing the U.K. statutory income tax rate.

The income tax rate differed from the statutory rate in the first nine months of fiscal 2012 and 2011, as both years benefited from various tax credits and certain foreign interest expense deductions.

It is reasonably possible that within the next twelve months approximately $5.6 million of tax benefits associated with research and development tax credits, capital and operating losses that are currently unrecognized could be recognized as a result of settlement of examinations and/or the expiration of a statute of limitations.

To the extent that sales are transacted in a currency other than the functional currency of the operating unit, we are subject to foreign currency fluctuation risk.

We use forward contracts to hedge our foreign currency exchange risk. To the extent that these contracts qualify as hedges under U.S. GAAP, the amount of gain or loss is deferred in Accumulated Other Comprehensive Income (AOCI) until the related sale occurs. Also, we are subject to foreign currency gains or losses from embedded

 

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derivatives on backlog denominated in a currency other than the functional currency of our operating companies or its customers. Gains and losses on forward contracts, embedded derivatives, and revaluation of assets and liabilities denominated in currency other than the functional currency of the Company for the nine month period ended July 27, 2012, and July 29, 2011, are as follows:

 

(In thousands)		Nine Months Ended
		July 27,         2012				July 29,         2011
Forward foreign currency contracts – gain (loss)		$	(9,202	)		$	3,116
Forward foreign currency contracts reclassified from AOCI			207				8,331
Embedded derivatives – gain			1,046				491
Revaluation of monetary assets/liabilities – gain			2,141				957
Total		$	(5,808	)		$	12,895

New orders for the first nine months of fiscal 2012 were $1.45 billion compared with $1.38 billion for the same period in 2011. Backlog was $1.24 billion at July 27, 2012, compared with $1.26 billion at the end of the prior-year period and $1.25 billion at the end of fiscal 2011.

Liquidity and Capital Resources

Cash and cash equivalents at July 27, 2012, totaled $213.1 million, an increase of $28.0 million from October 28, 2011. Net working capital increased to $636.7 million at July 27, 2012, from $621.0 million at October 28, 2011. Sources and uses of cash flows from operating activities principally consist of cash received from the sale of products and cash payments for material, labor and operating expenses. Cash flows provided by operating activities were $151.2 million and $158.5 million in the first nine months of fiscal 2012 and 2011, respectively, reflecting decreased income from continuing operations, cash collections from customers, and increased payments for income taxes and interest, partially offset by decreased payments for inventory.

Cash flows used by investing activities were $38.3 million and $860.2 million in the first nine months of fiscal 2012 and 2011, respectively. Cash flows used by investing activities in the first nine months of fiscal 2012 primarily reflected cash paid for capital expenditures. Cash flows used by investing activities in the first nine months of fiscal 2011 primarily reflected cash paid for acquisitions of $811.9 million and capital expenditures of $35.2 million.

Cash flows used by financing activities were $79.2 million in the first nine months of fiscal 2012. Cash flows provided by financing activities were $481.2 million in the first nine months of fiscal 2011. Cash flows used by financing activities in the first nine months of fiscal 2012 primarily reflected $104.1 million in cash repayments of long-term debt. Cash flows provided by financing activities in the first nine months of fiscal 2011 primarily reflected a $395.0 million increase in our credit facility, $180.0 million in proceeds for the issuance of long-term debt and $118.2 million in cash repayments of long-term debt.

Capital expenditures, consisting of machinery, equipment and computers, are anticipated to be approximately $65.0 million during fiscal 2012, compared to $49.5 million expended in fiscal 2011.

Total debt at July 27, 2012, was $932.4 million and consisted of $179.2 million of Senior Notes due in 2017, $250.0 million of Senior Notes due in 2020, $102.3 million (€83.0 million) under our Euro Term Loan Facility, $300.0 million under our credit facility, $44.9 million under capital lease obligations and $56.0 million of various foreign currency debt agreements and other debt agreements.

We believe cash on hand and funds generated from operations are adequate to service operating cash requirements and capital expenditures through the next twelve months.

Forward-Looking Statements

This quarterly report on Form 10-Q contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases you can identify forward-looking statements by terminology such

 

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as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “might,” “plan,” “potential,” “predict,” “should” or “will” or the negative of such terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risk factors set forth in “Forward-Looking Statements” and “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended October 28, 2011, that may cause our or the industry’s actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. You should not place undue reliance on these forward-looking statements. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, performance or achievements. Given these risks and uncertainties, you are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included or incorporated by reference into this report are made only as of the date hereof. We do not undertake and specifically decline any obligation to update any such statements or to publicly announce the results of any revisions to any such statements to reflect future events or developments, except as required by law.

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

There have been no significant changes in our exposure to market risk during the first nine months of fiscal 2012. A discussion of our exposure to market risk is provided in the Company’s Annual Report on Form 10-K for the fiscal year ended October 28, 2011.

 

Item 4.

Controls and Procedures

Our principal executive and financial officers evaluated our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of July 27, 2012. Based upon that evaluation, they concluded as of July 27, 2012, that our disclosure controls and procedures were effective to ensure that information we are required to disclose in the reports that we file under the Exchange Act is recorded, processed, summarized and reported within time periods specified in Securities and Exchange Commission rules and forms. In addition, our principal executive and financial officers concluded as of July 27, 2012, that our disclosure controls and procedures were also effective to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including to our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.

During the time period covered by this report, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II – OTHER INFORMATION

 

Item 1.

Legal Proceedings

From time to time we are involved in legal proceedings arising in the ordinary course of business. We believe that adequate reserves for these liabilities have been made and that there is no litigation pending that could have a material adverse effect on our results of operations and financial condition.

 

Item 6.

Exhibits

 

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

 

		ESTERLINE TECHNOLOGIES CORPORATION
		(Registrant)
Dated:  August 31, 2012		By:		/s/ Robert D. George
				Robert D. George
				Vice President, Chief Financial Officer,
				Corporate Development, and Secretary
				(Principal Financial Officer)

 

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