10-Q 1 q63002.txt 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (MARK ONE) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002 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 1-10596 ESCO TECHNOLOGIES INC. (Exact name of registrant as specified in its charter) MISSOURI 43-1554045 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 8888 LADUE ROAD, SUITE 200 63124-2090 ST. LOUIS, MISSOURI (Zip Code) (Address of principal executive offices) Registrant's telephone number, including area code:(314) 213-7200 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 X No The number of shares of the registrant's stock outstanding at July 31, 2002 was 12,599,233. PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS ESCO TECHNOLOGIES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (Dollars in thousands, except per share amounts) Three Months Ended __________________ June 30, ________ 2002 2001 ____ ____ Net sales $94,701 87,862 ______ ______ Costs and expenses: Cost of sales 63,609 59,847 Selling, general and administrative expenses 21,173 18,329 Interest expense 111 51 Other, net 622 2,273 ______ ______ Total costs and expenses 85,515 80,500 ______ ______ Earnings before income taxes 9,186 7,362 Income tax expense 3,448 2,805 ______ ______ Net earnings $ 5,738 4,557 ====== ====== Earnings per share: Net earnings - Basic $ .46 .37 -Diluted .44 .35 === === See accompanying notes to consolidated financial statements. ESCO TECHNOLOGIES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (Dollars in thousands, except per share amounts) Nine Months Ended _________________ June 30, ________ 2002 2001 ____ ____ Net sales $ 267,261 257,639 _______ _______ Costs and expenses: Cost of sales 180,165 177,149 Selling, general and administrative expenses 60,078 52,688 Interest expense 221 136 Other, net 1,550 6,828 _______ _______ Total costs and expenses 242,014 236,801 _______ _______ Earnings before income taxes 25,247 20,838 Income tax expense 9,544 8,016 _______ _______ Net earnings $ 15,703 12,822 ======= ======= Earnings per share: Net earnings - Basic $ 1.26 1.04 -Diluted 1.21 1.00 ==== ==== See accompanying notes to consolidated financial statements. ESCO TECHNOLOGIES INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands) June 30, September 30, 2002 2001 ________ _____________ ASSETS (Unaudited) Current assets: Cash and cash equivalents $ 13,703 14,506 Accounts receivable, less allowance for doubtful accounts of $720 and $1,122, respectively 67,271 61,351 Costs and estimated earnings on long-term contracts, less progress billings of $5,813 and $21,913, respectively 5,605 6,637 Inventories 56,438 48,167 Current portion of deferred tax assets 14,502 15,278 Other current assets 7,448 5,491 _______ _______ Total current assets 164,967 151,430 ________ _______ Property, plant and equipment, at cost 117,954 107,940 Less accumulated depreciation and amortization 50,835 42,902 _______ _______ Net property, plant and equipment 67,119 65,038 Goodwill, less accumulated amortization of $12,674 102,834 102,163 Deferred tax assets 35,996 38,573 Other assets 27,179 18,373 _______ _______ $398,095 375,577 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Short-term borrowings and current maturities of long-term debt $ 22 122 Accounts payable 35,876 35,180 Advance payments on long-term contracts, less costs incurred of $1,718 and $809, respectively 1,942 1,534 Accrued expenses and other current liabilities 30,211 27,233 _______ _______ Total current liabilities 68,051 64,069 _______ _______ Other liabilities 17,350 15,890 Long-term debt 8,088 8,338 Total liabilities 93,489 88,297 ======= ======= Commitments and contingencies -- -- Shareholders' equity: Preferred stock, par value $.01 per share, authorized 10,000,000 shares -- -- Common stock, par value $.01 per share, authorized 50,000,000 shares; issued 13,599,013 and 13,409,934 shares, respectively 136 134 Additional paid-in capital 207,641 206,282 Retained earnings since elimination of deficit at September 30, 1993 115,352 99,649 Accumulated other comprehensive loss (5,848) (6,518) _______ _______ 317,281 299,547 Less treasury stock, at cost: 1,001,246 and 985,469 common shares, respectively (12,675) (12,267) _______ _______ Total shareholders' equity 304,606 287,280 _______ _______ $398,095 375,577 ======= ======= See accompanying notes to consolidated financial statements. ESCO TECHNOLOGIES INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Dollars in thousands) Nine Months Ended June 30, _________________ 2002 2001 ____ ____ Cash flows from operating activities: Net earnings $15,703 12,822 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 9,553 11,489 Changes in operating working capital (11,257) (7,180) Change in long-term portion of deferred tax assets 2,578 5,191 Other 1,712 (1,646) _______ _______ Net cash provided by operating activities 18,289 20,676 _______ _______ Cash flows from investing activities: Capital expenditures (9,217) (7,558) Acquisition of technology rights/business (9,546) (13,517) _______ _______ Net cash used by investing activities (18,763) (21,075) _______ _______ Cash flows from financing activities: Net (decrease) increase in short-term borrowings (12) 143 Proceeds from long-term debt 144 5,154 Principal payments on long-term debt (483) (159) Purchases of common stock into treasury (456) (266) Other 478 222 ______ ______ Net cash (used) provided by financing activities (329) 5,094 ______ ______ Net(decrease)increase in cash and cash equivalents (803) 4,695 Cash and cash equivalents, beginning of period 14,506 5,620 ______ ______ Cash and cash equivalents, end of period $13,703 10,315 ====== ====== See accompanying notes to consolidated financial statements. ESCO TECHNOLOGIES INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. BASIS OF PRESENTATION The accompanying consolidated financial statements, in the opinion of management, include all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation of the results for the interim periods presented. The consolidated financial statements are presented in accordance with the requirements of Form 10-Q and consequently do not include all the disclosures required by accounting principles generally accepted in the United States of America (GAAP). For further information refer to the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended September 30, 2001. Certain prior year amounts have been reclassified to conform to the fiscal 2002 presentation. The results for the three and nine month periods ended June 30, 2002 are not necessarily indicative of the results for the entire 2002 fiscal year. 2. GOODWILL AND OTHER INTANGIBLE ASSETS - ADOPTION OF SFAS NO. 142 Management adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 142 Goodwill and Other Intangible Assets effective October 1, 2001, the beginning of the Company's fiscal year. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. In addition, to the extent an intangible asset is identified as having an indefinite useful life, the Company is required to test the intangible asset for impairment in accordance with the provisions of SFAS No. 142. Any impairment loss will be measured as of the date of adoption and recognized as the cumulative effect of a change in accounting principle. No impairment loss was recorded upon the adoption of SFAS No. 142. The following table presents a reconciliation of net earnings for the three and nine month periods ended June 30, 2001, as restated, to reflect the removal of goodwill amortization in accordance with SFAS No. 142, to be used for comparison purposes with the three and nine month periods ended June 30, 2002. (Dollars in thousands, except per share amounts). Earnings per share of $1.15 for the nine months ended June 30, 2001 includes a cumulative $.02 per share tax impact of goodwill amortization. Three Months Nine Months Ended June 30, Ended June 30, 2001 2001 ____ ____ Reported net earnings $4,557 $12,822 Add back: Goodwill amortization, net of tax 637 1,896 _____ ______ Adjusted net earnings $5,194 $14,718 ===== ====== Earnings per share - Basic: As Reported $ .37 $ 1.04 Goodwill amortization .05 .15 ___ ____ Adjusted $ .42 $ 1.19 === ==== Earnings per share - Diluted: As Reported $ .35 $ 1.00 Goodwill amortization .05 .15 ___ ____ Adjusted $ .40 $ 1.15 === ==== 3. EARNINGS PER SHARE (EPS) Basic EPS is calculated using the weighted average number of common shares outstanding during the period. Diluted EPS is calculated using the weighted average number of common shares outstanding during the period plus shares issuable upon the assumed exercise of dilutive common share options and performance shares by using the treasury stock method. The number of shares used in the calculation of earnings per share for each period presented is as follows (in thousands): Three Months Ended Nine Months Ended June 30, June 30, __________________ _________________ 2002 2001 2002 2001 ____ ____ ____ ____ Weighted Average Shares Outstanding - Basic 12,581 12,432 12,492 12,352 Dilutive Options and Performance Shares 513 473 537 420 ______ ______ ______ ______ Adjusted Shares-Diluted 13,094 12,905 13,029 12,772 ====== ====== ====== ====== Options to purchase approximately 34,500 shares of common stock at a price of $35.93 and options to purchase 4,500 shares of common stock at a price of $25.18 per share were outstanding during the nine month periods ended June 30, 2002 and 2001, respectively, but were not included in the computation of diluted EPS because the options' exercise prices were greater than the average market price of the common shares. These options expire in various periods through 2012. Approximately 93,000 and 157,000 Performance Shares were outstanding but unvested at June 30, 2002 and 2001, respectively, and therefore, were not included in the respective computation of diluted EPS. 4. INVENTORIES Inventories consist of the following (in thousands): June 30, September 30, 2002 2001 ________ _____________ Finished goods $ 12,250 12,065 Work in process, including long- term contracts 17,968 17,089 Raw materials 26,220 19,013 ______ ______ Total inventories $ 56,438 48,167 ====== ====== The increase in raw materials inventories at June 30, 2002 of approximately $7.2 million is mainly due to the increase in the Company's Communications segment inventories which is primarily safety stock in conjunction with the start-up of the PPL Electric Utilities Corporation (PPL) contract. 5. COMPREHENSIVE INCOME Comprehensive income for the three-month periods ended June 30, 2002 and 2001 was $7.4 million and $4.2 million, respectively. Comprehensive income for the nine-month periods ended June 30, 2002 and 2001 was $16.4 million and $11.7 million, respectively. For the nine months ended June 30, 2002, the Company's comprehensive income was positively impacted by foreign currency translation adjustments of approximately $0.7 million, which was partially offset by an decrease in fair value of the Company's interest rate swaps designated as a cash flow hedge of $0.1 million, discussed below in Item 3, Quantitative and Qualitative Disclosures About Market Risk. 6. ACQUISITIONS In March 2002, the Company acquired the exclusive rights to the patent portfolio and related intellectual property of North Carolina SRT Inc. and its affiliate (NC SRT), a manufacturer of cross-flow filtration and separation modules and equipment. The Company paid approximately $9.5 million for these filtration technology rights, including certain production assets and inventory of NC SRT. The Company will pay future consideration of $1 million in March 2003 and $1 million in March 2004. Additionally, the Company will be obligated to pay consideration, primarily in the form of royalties, based on certain future product sales and the grant of sublicenses generated as a result of the acquired rights in the patent portfolio of NC SRT. NC SRT sales of products utilizing the technologies acquired were approximately $3 million in calendar 2001. The intellectual property rights and related assets of NC SRT are included within the Company's Filtration/Fluid Flow segment. The intellectual property is being amortized over a period of fifteen years consistent with the duration of the licensed technology. 7. BUSINESS SEGMENT INFORMATION The Company is organized based on the products and services that it offers. Under this organizational structure, the Company operates in four segments: Filtration/Fluid Flow, Test, Communications and Other. Management evaluates and measures the performance of its operating segments based on "Net Sales and EBIT", which are detailed in the table below. EBIT is defined as Earnings Before Interest and Taxes. ($ in millions) Three Months ended Nine Months ended June 30, June 30, __________________ _________________ NET SALES 2002 2001 2002 2001 _________ ____ ____ ____ ____ Filtration/Fluid Flow $ 50.4 $ 47.5 142.8 138.6 Test 16.8 22.1 51.3 66.1 Communications 25.0 15.8 64.8 44.8 Other 2.5 2.5 8.4 8.1 ____ ____ _____ _____ Consolidated totals $ 94.7 $ 87.9 267.3 257.6 ==== ==== ===== ===== EBIT ____ Filtration/Fluid Flow $ 4.3 $ 3.6 9.7 8.0 Test 0.9 1.8 3.2 5.5 Communications 5.1 3.1 14.3 10.0 Other (1.0) (1.1) (1.7)(4) (2.5)(5) ___ ___ ____ ____ Consolidated totals $ 9.3 (1) $ 7.4 (2) 25.5 (1) 21.0 (3) === === ==== ==== (1) The three and nine-month periods ended June 30, 2002 exclude goodwill amortization in accordance with the adoption of SFAS No. 142. (2) The three month period ended June 30, 2001 included $0.9 million of goodwill amortization. (3) The nine month period ended June 30, 2001 included $2.6 million of goodwill amortization. (4) The amount for the nine month period ended June 30, 2002 consisted of $0.6 million related to Rantec and ($2.3) million related to unallocated corporate operating charges, which includes $0.3 million of exit costs related to the Company's joint venture in India, which was recorded in the first quarter of fiscal 2002, related to the Filtration/Fluid Flow segment. (5) The amount for the nine month period ended June 30, 2001 consisted of $0.9 million related to Rantec and ($3.4) million related to unallocated corporate operating charges, which includes $0.3 million of charges related to personnel termination costs in Brazil (Filtration/Fluid Flow segment); $0.4 million of corporate litigation costs related to the Filtration/Fluid Flow segment; and $0.3 million of residual costs to consolidate PTI's filtration business into new facilities in Oxnard, CA. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION RESULTS OF OPERATIONS NET SALES Net sales increased $6.8 million, or 7.8%, to $94.7 million for the third quarter of fiscal 2002 from $87.9 million for the third quarter of fiscal 2001. Net sales increased $9.7 million, or 3.7%, to $267.3 million for the first nine months of fiscal 2002 from $257.6 million for the first nine months of fiscal 2001. The largest increase was in the Company's Communications segment, resulting from significantly higher shipments of Automatic Meter Reading (AMR) equipment. The majority of this increase was related to PPL and various electric utility cooperatives (Co-ops). FILTRATION/FLUID FLOW Net sales were $50.4 million and $47.5 million for the third quarter of fiscal 2002 and 2001, respectively. Net sales were $142.8 million and $138.6 million for the first nine months of fiscal 2002 and 2001, respectively. Net sales during the first nine months of fiscal 2002 increased primarily as a result of the contribution from Bea Filtri S.p.A. (Bea), acquired in June 2001, which accounted for approximately $7.8 million of the increase in net sales. TEST Net sales were $16.8 million and $22.1 million for the third quarter of fiscal 2002 and 2001, respectively. For the first nine months of fiscal 2002, net sales were $51.3 million compared to $66.1 million in the prior year period. The net sales decrease in the first nine months of fiscal 2002 as compared to the prior year period is primarily due to the continued softness in the overall electronics and telecommunications markets and the prior year completion of the General Motors test chamber complex, which accounted for approximately $4 million of the decrease to net sales. COMMUNICATIONS For the third quarter of fiscal 2002, net sales of $25.0 million were $9.2 million, or 58.2%, higher than the $15.8 million of net sales recorded in the third quarter of fiscal 2001. Net sales of $64.8 million in the first nine months of fiscal 2002 were $20.0 million, or 44.6%, higher than the $44.8 million recorded in the first nine months of fiscal 2001. The increases are the result of significantly higher shipments of AMR equipment to PPL and various Co-ops. OTHER Net sales were $2.5 million in both the third quarter of fiscal 2002 and fiscal 2001. In the first nine months of fiscal 2002, net sales were $8.4 million compared to $8.1 million in the prior year period. The Other segment represents the net sales of Rantec Power Systems (Rantec). ORDERS AND BACKLOG Firm order backlog was $304.7 million at June 30, 2002, compared with $180.1 million at September 30, 2001. Orders totaling $391.8 million were received in the first nine months of fiscal 2002, which includes a backlog adjustment of $3.9 million related to the Filtration/Fluid Flow segment. Approximately $153.2 million of new orders in the first nine months of fiscal 2002 related to Filtration/Fluid Flow products, $49.7 million related to Test products, and $181.2 million related to Communications products. In February 2002, the Company received a $112 million contract from PPL Electric Utilities Corporation, a subsidiary of PPL Corporation, for an AMR system in Pennsylvania. The project is currently scheduled for completion in November 2004. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative (SG&A) expenses for the third quarter of fiscal 2002 were $21.2 million, or 22.4% of net sales, compared with $18.3 million, or 20.9% of net sales for the prior year period. For the first nine months of fiscal 2002, SG&A expenses were $60.1 million, or 22.5% of net sales, compared with $52.7 million, or 20.5% of net sales for the prior year period. The increase in SG&A spending in the first nine months of fiscal 2002 is due to the Bea acquisition, which added approximately $2.6 million of SG&A expenses in the first nine months of fiscal 2002. In addition, the Company is making significant investments in research and development, engineering, and marketing within the Communications and Filtration/Fluid Flow segments related to new product development and market expansion initiatives. OTHER COSTS AND EXPENSES, NET Other costs and expenses, net, were $0.6 million for the quarter ended June 30, 2002 compared to $2.3 million for the prior year quarter. The third quarter of fiscal 2002 excludes goodwill amortization in accordance with the adoption of SFAS No. 142, while the third quarter of fiscal 2001 included goodwill amortization of $0.9 million. Other costs and expenses, net, were $1.6 million for the first nine months of fiscal 2002 compared to $6.8 million for the prior year period. The first nine months of fiscal 2002 excludes goodwill amortization, and the first nine months of fiscal 2001 included goodwill amortization of $2.6 million. Principal components of other costs and expenses, net, for the first nine months of fiscal 2002 include $1.1 million of amortization of identifiable intangible assets, primarily patents and licenses, and $0.3 million of exit costs related to the Company's joint venture in India (Filtration/Fluid Flow segment) which was terminated in the first quarter of fiscal 2002, offset by a $0.4 million gain from insurance proceeds related to a former subsidiary. Principal components of other costs and expenses, net, for the first nine months of fiscal 2001 include $2.6 million of goodwill amortization, $1.1 million of amortization of identifiable intangible assets, $0.3 million of charges related to personnel termination costs in Brazil (Filtration/Fluid Flow segment), $0.4 million of corporate litigation costs related to the Filtration/Fluid Flow segment, $0.6 million of costs related to the consolidation of the Stockton, CA facility into the Huntley, IL facility (Filtration/Fluid Flow segment), and $0.5 million of residual costs to consolidate PTI's filtration business into new facilities in Oxnard, CA. EBIT Management evaluates the performance of its operating segments based on EBIT, which the Company defines as Earnings Before Interest and Taxes. EBIT increased $1.9 million to $9.3 million (9.8% of net sales) for the third quarter of fiscal 2002 from $7.4 million (8.4% of net sales) for the third quarter of fiscal 2001. The prior year quarter included goodwill amortization of approximately $0.9 million. Excluding the amortization of goodwill from the third quarter of fiscal 2001's results, EBIT would have been $8.3 million (9.4% of net sales). For the first nine months of fiscal 2002, EBIT increased $4.5 million to $25.5 million (9.5% of net sales) from $21.0 million (8.1% of net sales) for the first nine months of fiscal 2001. The prior year period included goodwill amortization of approximately $2.6 million. Excluding the amortization of goodwill from the first nine months of fiscal 2001's results, EBIT would have been $23.6 million (9.1% of net sales). FILTRATION/FLUID FLOW EBIT was $4.3 million and $3.6 million in the third quarter of fiscal 2002 and 2001, respectively, and $9.7 million and $8.0 million in the first nine months of fiscal 2002 and 2001, respectively. The prior year third quarter and first nine months ended June 30, 2001 included goodwill amortization of $0.5 million and $1.5 million, respectively. Excluding the goodwill amortization, EBIT for the third quarter and the first nine months of fiscal 2001 would have been $4.1 million and $9.5 million, respectively. The first nine months of the current year was impacted by softness in the commercial aerospace and semiconductor markets, and investments in new product development and market expansion initiatives, primarily in microfiltration. TEST EBIT was $0.9 million and $1.8 million in the third quarter of fiscal 2002 and 2001, respectively, and $3.2 million and $5.5 million in the first nine months of fiscal 2002 and 2001, respectively. The prior year third quarter and nine months ended June 30, 2001 included goodwill amortization of $0.4 million and $1.1 million, respectively. Excluding the goodwill amortization, EBIT for the third quarter and first nine months of fiscal 2001 would have been $2.2 million and $6.6 million, respectively. The decline in EBIT in the first nine months of fiscal 2002 as compared to the prior year period is mainly due to lower sales as a result of the continued softness in the electronics and telecommunications markets and the completion of the General Motors test chamber complex in fiscal 2001. COMMUNICATIONS Third quarter EBIT of $5.1 million in fiscal 2002 was $2.0 million, or 64.5%, higher than the $3.1 million of EBIT in the third quarter of fiscal 2001. For the first nine months of fiscal 2002, EBIT increased $4.3 million, or 43.2%, to $14.3 million from $10.0 million in fiscal 2001. The increase in EBIT is the result of significantly higher shipments of AMR equipment. In May 2002, in cooperation with the Public Service Commission of Wisconsin and the Wisconsin Department of Agriculture, Trade and Consumer Protection, the Wisconsin Public Service Corporation (WPSC) began voluntarily conducting tests involving the Company's AMR equipment (the Two-Way Automatic Communications System) (TWACS and the system's impact on stray voltage on dairy farms. The final test results are currently expected in October 2002. The Company's subsidiary, Comtrak Technologies, L.L.C.'s (Comtrak) one-year development funding agreement with ADT Security Services, Inc. (ADT) for its Securvision product expired at the end of the second quarter of fiscal 2002. Under the terms of this agreement, ADT had been providing Comtrak with $0.3 million per quarter. The Company does not anticipate that this agreement will be renewed. OTHER EBIT was ($1.0) million and ($1.7) million for the three and nine-month periods ended June 30, 2002, respectively, compared to ($1.1) million and ($2.5) million for the respective prior year periods. The amount for the third quarter ended June 30, 2002 consisted of $0.1 million related to Rantec and ($1.1) million related to unallocated corporate operating charges. EBIT for the first nine months of fiscal 2002 consisted of $0.6 million related to Rantec and ($2.3) million related to unallocated corporate operating charges, which includes $0.3 million of exit costs related to the Company's joint venture in India (Filtration/Fluid Flow segment) which was terminated in the first quarter of fiscal 2002. The amount for the first nine months of fiscal 2001 consisted of $0.9 million related to Rantec and ($3.4) million related to unallocated corporate operating charges, which includes $0.3 million of charges related to personnel termination costs in Brazil (Filtration/Fluid Flow segment), $0.4 million of corporate litigation costs related to the Filtration/Fluid Flow segment, and $0.3 million of residual costs to consolidate PTI's filtration business into new facilities in Oxnard, CA. INTEREST EXPENSE (INCOME) Interest expense, net, was approximately $0.1 million and $0.2 million for the three and nine-month periods ended June 30, 2002, respectively, compared with the prior year three and nine-months periods ended June 30, 2001 of $0.1 million each. INCOME TAX EXPENSE The third quarter fiscal 2002 effective income tax rate was 37.5% compared to 38.1% in the third quarter of fiscal 2001. The decrease in the effective income tax rate in the third quarter of fiscal 2002 compared to the prior year period is primarily due to the favorable earnings impact of the foreign operations. The effective income tax rate in the first nine months of fiscal 2002 was 37.8% compared to 38.5% in the prior year period. Management estimates the annual effective tax rate for fiscal 2002 to be approximately 38.0%. FINANCIAL CONDITION Working capital increased to $96.9 million at June 30, 2002 from $87.4 million at September 30, 2001. During the first nine months of fiscal 2002, accounts receivable increased by $5.9 million due to the increase in sales, mainly within the Company's Communications segment; inventories increased by $8.3 million to support near term demand; partially offset by a decrease in costs and estimated earnings on long-term contracts of $1.0 million due to the completion of the General Motors test chamber complex. In addition, accounts payable and accrued expenses increased by $3.7 million primarily due to the purchases of inventories and the timing of payments. Net cash provided by operating activities was $18.3 million in the first nine months of fiscal 2002 compared to net cash provided by operating activities of $20.7 million in the same period of fiscal 2001. The decrease in net cash provided by operating activities in the first nine months of fiscal 2002 as compared to prior year was the result of increased working capital requirements mentioned above. Capital expenditures were $9.2 million in the first nine months of fiscal 2002 compared with $7.6 million in the comparable period of fiscal 2001. Major expenditures in the current period included manufacturing automation equipment used in the Filtration / Fluid Flow businesses. At June 30, 2002, accounts receivable includes approximately $0.9 million of costs incurred to replace certain filtration elements resulting from the receipt of nonconforming material obtained from a supplier. The supplier has acknowledged responsibility for this matter and these costs are to be reimbursed by the supplier. Other current assets include approximately $0.7 million of capitalized legal costs that have been incurred in the defense of certain revenue generating patents used in the Company's Filtration/Fluid Flow business. The recovery of the legal costs in the above-mentioned matter, while probable, may be subject to litigation or further negotiations. Other current assets also include approximately $1.1 million of legal costs incurred to defend a customer claim related to the Company's Test business. The costs associated with the Test business matter are covered by and will be reimbursed through insurance. Effective April 5, 2002, the Company amended its existing $75 million revolving credit facility changing the scheduled reductions and extending the $25 million increase option through April 11, 2004. The amendment calls for $5 million reductions to the credit facility on each April 11th beginning in 2002 through 2004 with the balance due upon maturity and expiration, April 11, 2005. Cash flow from operations and borrowings under the Company's bank credit facility are expected to provide adequate resources to meet the Company's capital requirements and operational needs for the foreseeable future. In March 2002, the Company paid cash of approximately $9.5 million to acquire the exclusive rights to the patent portfolio and related intellectual property of North Carolina SRT Inc. and its affiliate (NC SRT), including certain production assets and inventory. The Company has a $31.5 million obligation under a synthetic lease facility arranged by Bank of America. For GAAP purposes, this is accounted for as an operating lease. This obligation is secured by leases of three manufacturing locations, two of which are located in Oxnard, CA and the other in Cedar Park, TX, as well as a $10.6 million letter of credit issued under the Company's $75 million credit facility. The leases expire on December 29, 2005 at which time the Company will be required to extend the leases on terms to be negotiated, purchase the properties for $31.5 million, or refinance the obligation. The Financial Accounting Standards Board (FASB) has issued an exposure draft on the accounting treatment related to synthetic lease arrangements. If this exposure draft is adopted as written, the Company would record the net assets and obligations under the synthetic lease facility as property, plant and equipment and long-term obligations. On February 8, 2001, the Company approved a stock repurchase program. Under this program, the Company is authorized to purchase up to 1.3 million shares of its common stock in the open market, subject to market conditions and other factors, through September 30, 2003. The Company repurchased 20,000 shares during the first nine months of fiscal 2002. The Company continues to explore consolidation opportunities within its existing businesses that could improve future operating earnings and enhance the Company's competitive position. The Company will also continue to look for acquisitions that offer complementary products and/or new technologies. RECENT DEVELOPMENT On August 5, 2002, the Company entered into a Management Transition Agreement with Dennis J. Moore, the Company's Chairman and Chief Executive Officer, which provided for Mr. Moore to receive certain compensation in conjunction with his planned retirement which will occur during April of 2003. The significant costs associated with Mr. Moore's announced retirement as described in the Management Transition Agreement are quantified below. The Management Transition Agreement and certain of the related agreements are included as Exhibits to this quarterly report on Form 10-Q. (in millions) New Restricted Shares $ 1.2 (1) Previously Awarded Restricted Shares and Performance Shares for which vesting will be accelerated $1.0 (1) (2) Consulting Agreement $0.3 (3) _____ Total $ 2.5 ==== (1) The costs of these arrangements will be recognized over the eight month transition period, from August 2002 through March 2003. (2) These items were subject to remeasurement based on FASB Interpretation (FIN) No. 44, "Accounting for Certain Transactions Involving Stock Compensation (an Interpretation of APB Opinion No. 25)". The remeasurement was based on the closing stock price on August 5, 2002, the date the vesting of the shares were accelerated. (3) The cost of the consulting agreement will be recognized over the twelve month period from April 2003 through April 2004, consistent with the period of service. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires Company management to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying consolidated financial statements. In preparing these financial statements, management has made their best estimates and judgments of certain amounts included in the financial statements, giving due consideration to materiality. The Company does not believe there is a great likelihood that materially different amounts would be reported under different conditions or using different assumptions related to the accounting policies described below. However, application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. The Company's senior management discusses the accounting policies described below with the audit committee of the Company's board of directors on an annual basis. The following discussion of critical accounting policies is intended to bring to the attention of readers those accounting policies which management believes are critical to the Consolidated Financial Statements and other financial disclosure. It is not intended to be a comprehensive list of all significant accounting policies that are more fully described in Note 1 of the Notes to the Consolidated Financial Statements included in our 2001 Annual Report on Form 10-K. The Company has identified the following areas as critical accounting policies. Revenue Recognition The majority of the Company's revenues are recognized when products are shipped to or when services are performed for unaffiliated customers. Other revenue recognition methods the Company uses include the following: Revenue on production contracts is recorded when specific contract terms are fulfilled, usually by delivery or acceptance (the units of production or delivery methods). Revenues from cost reimbursement contracts are recorded as costs are incurred, plus fees earned. Revenue under long-term contracts for which units of production or delivery are inappropriate measures of performance is recognized on the percentage-of-completion method based upon incurred costs compared to total estimated costs under the contract. Revenue under engineering contracts is generally recognized as milestones are attained. The SEC's Staff Accounting Bulletin (SAB) No. 101, "Revenue Recognition" provides guidance on the application of generally accepted accounting principles to selected revenue recognition issues. Management believes the Company's revenue recognition policy is in accordance with generally accepted accounting principles and SAB No. 101. Accounts Receivable Accounts receivable have been reduced by an allowance for amounts that may become uncollectible in the future. This estimated allowance is based primarily on management' evaluation of the financial condition of the customer and historical bad debt experience. Inventory Inventories are valued at the lower of cost or market value and have been reduced by an allowance for excess and obsolete inventories. The estimated allowance is based on management's review of inventories on hand compared to estimated future usage and sales. Inventories under long-term contracts reflect accumulated production costs, factory overhead, initial tooling and other related costs less the portion of such costs charged to cost of sales and any unliquidated progress payments. In accordance with industry practice, costs incurred on contracts in progress include amounts relating to programs having production cycles longer than one year, and a portion thereof may not be realized within one year. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred tax assets may be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company regularly reviews its deferred tax assets for recoverability and establishes a valuation allowance when management believes it is more likely than not such assets will not be recovered, taking into consideration historical operating results, expectations of future earnings, and the expected timing of the reversals of existing temporary differences. Goodwill and Other Long-Lived Assets The Company adopted the provisions of SFAS No. 142 effective October 1, 2001. Goodwill and other long-lived assets with indefinite useful lives are reviewed by management for impairment annually or whenever events or changes in circumstances indicate the carrying amount may not be recoverable. If indicators of impairment are present, the determination of the amount of impairment is based on management's judgment as to the future operating cash flows to be generated from these assets throughout their estimated useful lives. SFAS No. 142 also requires that intangible assets with estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 121 and subsequently, SFAS No. 144 after its adoption. Pension Plans and Other Postretirement Benefit Plans The measurement of liabilities related to pension plans and other post-retirement benefit plans is based on management's assumptions related to future events including interest rates, return on pension plan assets, rate of compensation increases, and health care cost trend rates. Actual pension plan asset performance will either decrease or increase unamortized pension losses which will affect net earnings in future years. Contingencies As a normal incident of the businesses in which the Company is engaged, various claims, charges and litigation are asserted or commenced against the Company. In the opinion of management, final judgments, if any, which might be rendered against the Company in current litigation are adequately reserved, covered by insurance, or would not have a material adverse effect on its financial statements. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In July 2002, the FASB issued SFAS No. 146 "Accounting for Costs Associated with Exit or Disposal Activities", that supersedes Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit An Activity (including Certain Costs Incurred in a Restructuring)." The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations", effective for fiscal years beginning after June 15, 2002. SFAS No. 143 addresses financial accounting requirements for retirement obligations associated with tangible long-lived assets. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", that replaces SFAS No. 121,"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of". The provisions of SFAS No. 144 are effective for fiscal years beginning after December 15, 2001 and, generally, are to be applied prospectively. Management does not believe the implementation of Statements No. 143 and 144 will have a material effect on the Company's financial statements. FORWARD LOOKING STATEMENTS Statements in this report that are not strictly historical are "forward looking" statements within the meaning of the safe harbor provisions of the federal securities laws. Forward looking statements include those relating to the estimates made in connection with the Company's accounting policies and the Company's capital requirements and operational needs for the foreseeable future. Investors are cautioned that such statements are only predictions, and speak only as of the date of this report. The Company's actual results in the future may differ materially from those projected in the forward-looking statements due to risks and uncertainties that exist in the Company's operations and business environment including, but not limited to: further weakening of economic conditions in served markets; changes in customer demands or customer insolvencies; electricity shortages; competition; intellectual property rights; consolidation of internal operations; integration of recently acquired businesses; delivery delays or defaults by customers; performance issues with key suppliers and subcontractors; collective bargaining labor disputes; and the Company's successful execution of internal operating plans. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Market risks relating to the Company's operations result primarily from changes in interest rates and changes in foreign currency exchange rates. The Company has interest rate exposure relating to floating rate lease obligations and, accordingly, the Company has entered into interest rate swaps covering approximately $32 million to mitigate this exposure. These interest rate swaps relate to operating lease obligations under its synthetic lease facility, and have been arranged by Bank of America. The interest rate swaps effectively fix the interest rates on the underlying lease obligations at a weighted average rate of 6.47%. These lease obligations and their related interest rate swaps expire on December 29, 2005. In addition, the Company has interest rate exposure of approximately $4 million relating to floating rate obligations denominated in EURO dollars. Therefore, the Company has entered into an interest rate swap of approximately $4 million to mitigate this exposure which effectively fixed the interest rate on these floating rate obligations at 4.89%. These EURO dollar obligations consist of borrowings under the Company's $75 million credit facility and mature on April 11, 2005 along with the related interest rate swap. These swaps are accounted for as cash flow hedges under the provisions of SFAS 133, "Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS 138". For the nine months ended June 30, 2002, accumulated other comprehensive loss included an after tax decrease in fair value of approximately $0.1 million related to the interest rate swaps. The Company is subject to foreign currency exchange rate risk inherent in its sales commitments, anticipated sales, anticipated purchases and assets and liabilities denominated in currencies other than the U.S. dollar. The currency most significant to the Company's operations is the Euro. The Company hedges certain foreign currency commitments by purchasing foreign currency forward contracts. PART II OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. a) Exhibits Exhibit Number 3(a) Restated Articles of Incorporated by reference to Incorporation Form 10-K for the fiscal year ended September 30, 1999 at Exhibit 3(a) 3(b) Amended Certificate of Incorporated by reference to Designation Preferences Form 10-Q for the fiscal and Rights of Series A quarter ended March 31, 2000 Participating Cumulative at Exhibit 4(e) Preferred Stock of the Registrant 3(c) Articles of Merger effective Incorporated by reference to July 10, 2000 Form 10-Q for the fiscal quarter ended June 30, 2000 at Exhibit 3(c) 3(d) Bylaws, as amended Incorporated by reference to Form 10-Q for the fiscal quarter ended June 30, 2000 at Exhibit 3(d) 4(a) Specimen Common Stock Incorporated by reference to Certificate Form 10-Q for the fiscal quarter ended June 30, 2000 at Exhibit 4(a) 4(b) Specimen Rights Certificate Incorporated by reference to Exhibit B to Exhibit 4.1 to the Registrant's Current Report on Form 8-K dated February 3, 2000 4(c) Rights Agreement dated as of Incorporated by reference to September 24, 1990 (as amended Current Report on Form 8-K and Restated as of February 3, dated February 3, 2000, at 2000) between the Registrant Exhibit 4.1 and Registrar and Transfer Company, as successor Rights Agent 4(d) Amended and Restated Credit Incorporated by reference to Agreement dated as of February Form 10-Q for the fiscal 28, 2001 among the Registrant, quarter ended March 31, 2001 Bank of America, N.A., as at Exhibit 4(d) agent, and the lenders listed therein 4(e) Amendment No. 1 dated as of April 5, 2002 to Credit Agreement listed as Exhibit 4(d) above. 10(a) Management Transition Agreement dated August 5, 2002 between the Registrant and Dennis J. Moore 10(b) Amendment to 1994 Stock Option Plan effective July 18, 2002 10(c) Nonqualified Stock Option Agreement dated July 18, 2002 between Registrant and Dennis J. Moore 10(d) Notice of Award - Stock Award to Dennis J. Moore dated July 18, 2002 b) Reports on Form 8-K. During the quarter ended June 30, 2002, the Company filed the following Current Reports on Form 8-K: The Company filed a Current Report on Form 8-K, dated June 5, 2002, which reported in "Item 7. Financial Statements, Pro Forma Financial Information and Exhibits" and "Item 9. Regulation FD Disclosure" that the Company would post on its website certain materials for a Company presentation including a summary statement of strategy, five-year financial objectives and overview of the Company's three primary segments, and would issue a related press release. SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ESCO TECHNOLOGIES INC. /s/ Gary E. Muenster Gary E. Muenster Vice President and Corporate Controller (As duly authorized officer and principal accounting officer of the registrant) Dated: August 7, 2002