NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
Note 1. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying unaudited Condensed Consolidated Financial Statements of Donaldson Company, Inc. and its subsidiaries (the Company) have been prepared in accordance with generally accepted accounting principles in the United States (GAAP) and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair statement of earnings, comprehensive income, financial position and cash flows have been included and are of a normal recurring nature. Operating results for the
three
month period ended
October 31, 2018
are not necessarily indicative of the results that may be expected for future periods. The year-end condensed consolidated balance sheet information was derived from the Company's audited financial statements but does not include all disclosures required by GAAP. For further information, refer to the Audited Consolidated Financial Statements and Notes thereto included in the Company’s Annual Report on Form 10-K for the year ended
July 31, 2018
.
New Accounting Standards Recently Adopted
In May 2014, the FASB issued ASU 2014-09,
Revenue from Contracts with Customers
(ASC 606), which amended revenue recognition guidance to clarify the principles for recognizing revenue from contracts with customers. The guidance requires an entity to recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which an entity expects to be entitled in exchange for those goods or services. The guidance also requires expanded disclosures relating to the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Additionally, qualitative and quantitative disclosures are required about customer contracts, significant judgments and changes in judgments and assets recognized from the costs to obtain or fulfill a contract. In 2016, the FASB issued ASU 2016-08, ASU 2016-10, ASU 2016-11, ASU 2016-12 and ASU 2016-20 to clarify, among other things, the implementation guidance related to principal versus agent considerations, identifying performance obligations and accounting for licenses of intellectual property. This accounting guidance was effective for the Company beginning in the first quarter of
fiscal 2019
. The standard was adopted using the modified retrospective method, applying the guidance to those contracts which were not completed as of July 31, 2018, with the cumulative effect of adoption recognized during the first quarter. Refer to Note 6 for the impact of the adoption of this new standard.
In January 2017, the FASB issued ASU 2017-01,
Business Combinations: Clarifying the Definition of a Business
(ASU 2017-01). The new guidance provides a more robust framework to use in determining when a set of assets and activities is a business. The amendments provide more consistency in applying the guidance, reduce the costs of application and make the definition of a business more operable. ASU 2017-01 is effective for the Company beginning in the first quarter of
fiscal 2019
. The Company adopted ASU 2017-01 in the first quarter of fiscal 2019 and it did not have a material impact on its Condensed Consolidated Financial Statements.
In March 2017, the FASB issued ASU 2017-07,
Compensation - Retirement Benefits (Topic 715)
(ASU 2017-07). The new guidance requires employers to disaggregate and present separately the current service cost component from the other components of net benefit cost within the consolidated statement of earnings. ASU 2017-07 is effective for the Company beginning in the first quarter of
fiscal 2019
. The Company adopted ASU 2017-07 in the first quarter of
fiscal 2019
using the retrospective method. This resulted in a reclassification of net benefit costs in its Condensed Consolidated Statements of Earnings, with a decrease of
$1.6 million
in operating income and a corresponding
$1.6 million
increase to other income, net for the
three months ended October 31, 2017
.
In August 2017, the FASB issued ASU 2017-12,
Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities
(ASU 2017-12), which improves the financial reporting of hedging relationships to better portray the economic results of an entity's risk management activities in its financial statements and make certain targeted improvements to simplify the application of the hedge accounting guidance. The guidance expands the ability to hedge non-financial and financial risk components, reduces complexity in fair value hedges of interest rate risk, eliminates the requirement to separately measure and report hedge ineffectiveness and eases certain hedge effectiveness assessment requirements. ASU 2017-12 is effective for the Company beginning in the first quarter of
fiscal 2020
, and early adoption is permitted. The Company adopted ASU 2017-12 in the first quarter of fiscal 2019 and it did not have a material impact on its Condensed Consolidated Financial Statements.
New Accounting Standards Not Yet Adopted
In February 2016, the FASB issued ASU 2016-02,
Leases (Topic 842)
(ASU 2016-02), which requires lessees to recognize right-of-use assets and lease liabilities for substantially all leases. This accounting guidance is effective for the Company beginning in the first quarter of
fiscal 2020
on a modified retrospective basis. The Company has established a project team that is currently evaluating the population of leased assets to assess the impact of the adoption of ASU 2016-02 on its Consolidated Financial Statements.
In June 2016, the FASB issued ASU 2016-13,
Measurement of Credit Losses on Financial Instruments
(ASU 2016-13). This guidance introduces a new model for recognizing credit losses on financial instruments based on an estimate of current expected credit losses. Financial instruments impacted include accounts receivable, trade receivables, other financial assets measured at
amortized cost and other off-balance sheet credit exposures. The new guidance is effective for the Company beginning in the first quarter of
fiscal 2021
, with early adoption permitted. The Company is evaluating the effect of ASU 2016-13 on its Consolidated Financial Statements.
In February 2018, the FASB issued ASU 2018-02,
Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income
(ASU 2018-02). The guidance allows a company to elect to reclassify from accumulated other comprehensive income (AOCI) to retained earnings the stranded tax effects from the adoption of the newly enacted federal corporate tax rate as a result of the U.S. Tax Cuts and Jobs Act. The amount of the reclassification is calculated as the difference between the amount initially charged to other comprehensive income (OCI) at the previously enacted tax rate that remains in AOCI and the amount that would have been charged using the newly enacted tax rate, excluding any valuation allowance previously charged to income. ASU 2018-02 is effective for the Company beginning in the first quarter of
fiscal 2020
, and early adoption is permitted. The Company is evaluating the impact of the adoption of ASU 2018-02 on its Consolidated Financial Statements.
In August 2018, the FASB issued ASU 2018-15,
Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract
(ASU 2018-15). The
amendments in this update align the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). The accounting for the service element of a hosting arrangement that is a service contract is not affected by the amendments in this update. The amendments in this update are effective for interim and annual periods for the Company beginning in the first quarter of
fiscal 2021
, with early adoption permitted. The amendments in this update should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. The Company is evaluating the impact of the adoption of ASU 2018-15 on its Consolidated Financial Statements.
Note 2. Acquisitions
On October 18, 2018, the Company acquired
88%
of the shares of BOFA International LTD (BOFA), headquartered in the United Kingdom, for cash consideration of
$98.2 million
less cash acquired of
$2.2 million
. BOFA designs, develops and manufactures fume extraction systems across a wide range of industrial air filtration applications. The acquisition will allow Donaldson to accelerate its global growth in the fume collection business and add additional filtration technology to the Company's existing product lines. The fair values assigned to the acquired assets and liabilities of BOFA were approximately
$12.2 million
of net tangible assets,
$48.8 million
of identifiable intangible assets,
$71.0 million
of goodwill,
$8.6 million
of deferred tax liabilities and
$14.3 million
of assumed debt. The assumed debt was repaid in October 2018. The identifiable intangible assets were related to customer relationships, patents, trademarks and technology and have estimated useful lives ranging from
5
to
15
years. The acquired intangible assets including goodwill are not deductible for tax purposes. The purchase price allocation is preliminary pending the outcome of the final valuation of the net assets acquired. The Company is reporting BOFA’s results of operations within the Industrial Products segment. Transaction costs were expensed as incurred and were not significant for the three months ended
October 31, 2018
.
The acquisition also provides call and put options that, if exercised by either the Company or the minority interest holders after a certain period of time, would obligate the Company to purchase the remaining
12%
of the shares of BOFA at a price indexed to the performance of the acquired entity. Due to the redemption features, the minority interest holders’ value is classified as a redeemable non-controlling interest in the Company’s Condensed Consolidated Balance Sheets at the fair value upon acquisition of
$13.1 million
.
Pro forma financial information for this acquisition has not been presented because it is not material to the Company's consolidated results of operations.
Note 3. Supplemental Balance Sheet Information
The components of net inventories are as follows (in millions):
|
|
|
|
|
|
|
|
|
|
October 31,
2018
|
|
|
July 31,
2018
|
|
Raw materials
|
$
|
119.7
|
|
|
$
|
128.7
|
|
Work in process
|
41.2
|
|
|
27.4
|
|
Finished products
|
199.6
|
|
|
178.0
|
|
Inventories, net
|
$
|
360.5
|
|
|
$
|
334.1
|
|
The components of net property, plant and equipment are as follows (in millions):
|
|
|
|
|
|
|
|
|
|
October 31,
2018
|
|
|
July 31,
2018
|
|
Land
|
$
|
23.7
|
|
|
$
|
22.8
|
|
Buildings
|
309.2
|
|
|
310.8
|
|
Machinery and equipment
|
775.1
|
|
|
769.1
|
|
Computer software
|
133.4
|
|
|
132.6
|
|
Construction in progress
|
74.1
|
|
|
64.4
|
|
Less: accumulated depreciation
|
(797.6
|
)
|
|
(790.4
|
)
|
Property, plant and equipment, net
|
$
|
517.9
|
|
|
$
|
509.3
|
|
Note 4. Earnings Per Share
The Company’s basic net earnings per share is computed by dividing net earnings by the weighted average number of outstanding common shares. The Company’s diluted net earnings per share is computed by dividing net earnings by the weighted average number of outstanding common shares and common share equivalents relating to stock options and stock incentive plans. Certain outstanding options were excluded from the diluted net earnings per share calculations because their exercise prices are greater than the average market price of the Company’s common stock during those periods. Options excluded from the diluted net earnings per share calculations were
0.8 million
and
zero
for the
three
months ended
October 31, 2018
and
2017
, respectively.
The following table presents the information necessary to calculate basic and diluted net earnings per share (in millions, except per share amounts):
|
|
|
|
|
|
|
|
|
|
Three Months Ended
October 31,
|
|
2018
|
|
|
2017
|
|
Net earnings for basic and diluted earnings per share computation
|
$
|
73.8
|
|
|
$
|
60.9
|
|
|
|
|
|
Weighted average common shares outstanding:
|
|
|
|
Weighted average common shares – basic
|
128.8
|
|
|
130.8
|
|
Dilutive impact of share-based awards
|
2.2
|
|
|
1.9
|
|
Weighted average common shares – diluted
|
131.0
|
|
|
132.7
|
|
|
|
|
|
Net earnings per share – basic
|
$
|
0.57
|
|
|
$
|
0.47
|
|
Net earnings per share – diluted
|
$
|
0.56
|
|
|
$
|
0.46
|
|
Note 5. Goodwill and Other Intangible Assets
The following is a reconciliation of goodwill by reportable segment for the
three months ended October 31, 2018
(in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Engine
Products
|
|
Industrial
Products
|
|
Total
Goodwill
|
Balance as of July 31, 2018
|
$
|
84.9
|
|
|
$
|
153.5
|
|
|
$
|
238.4
|
|
Goodwill acquired
|
—
|
|
|
71.0
|
|
|
71.0
|
|
Foreign exchange translation
|
(0.3
|
)
|
|
(3.7
|
)
|
|
(4.0
|
)
|
Balance as of October 31, 2018
|
$
|
84.6
|
|
|
$
|
220.8
|
|
|
$
|
305.4
|
|
The following is a reconciliation of net intangible asset classes for the
three months ended October 31, 2018
(in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
Customer relationships and lists
|
Gross Carrying Amount
|
|
Accumulated Amortization
|
|
Net Intangible Assets
|
Balance as of July 31, 2018
|
$
|
63.0
|
|
|
$
|
(35.7
|
)
|
|
$
|
27.3
|
|
Intangibles acquired
|
42.0
|
|
|
—
|
|
|
42.0
|
|
Amortization expense
|
—
|
|
|
(1.0
|
)
|
|
(1.0
|
)
|
Foreign exchange translation
|
(1.7
|
)
|
|
0.2
|
|
|
(1.5
|
)
|
Balance as of October 31, 2018
|
$
|
103.3
|
|
|
$
|
(36.5
|
)
|
|
$
|
66.8
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Patents, trademarks and technology
|
Gross Carrying Amount
|
|
Accumulated Amortization
|
|
Net Intangible Assets
|
Balance as of July 31, 2018
|
$
|
43.7
|
|
|
$
|
(35.4
|
)
|
|
$
|
8.3
|
|
Intangibles acquired
|
6.8
|
|
|
—
|
|
|
6.8
|
|
Amortization expense
|
—
|
|
|
(0.4
|
)
|
|
(0.4
|
)
|
Foreign exchange translation
|
(1.1
|
)
|
|
0.9
|
|
|
(0.2
|
)
|
Balance as of October 31, 2018
|
$
|
49.4
|
|
|
$
|
(34.9
|
)
|
|
$
|
14.5
|
|
Note 6. Revenue
The Company recognizes revenue on a wide range of filtration solutions sold to customers in many industries around the globe. The vast majority of the Company’s performance obligations within customer sales contracts are for manufactured filtration systems and replacement parts. The Company does have limited services, such as nonrecurring engineering (NRE) and installation. Customer contracts may include multiple performance obligations and the transaction price is allocated to each distinct performance obligation based on its relative standalone selling price.
Revenue Recognition Policy
Revenue is measured as the amount of consideration the Company expects to receive in exchange for the fulfillment of performance obligations. The transaction price of a contract could be reduced by variable consideration including product refunds, returns, volume rebates and discounts in the determination of net sales. The Company primarily relies on historical experience and anticipated future performance to estimate the variable consideration. Revenue is recognized to the extent that it is probable that a significant reversal of revenue will not occur when the contingency is resolved. The Company also accounts for amounts billed to customers for reimbursement of shipping and handling as fulfillment costs by recording these amounts as revenue and accruing the costs when the related revenue is recognized.
For most customer contracts, the Company recognizes revenue at a point in time when control of the goods or services is transferred to the customer. For product sales, control is typically deemed to have transferred in accordance with the shipping terms, either at the time of shipment from the plants or distribution centers or the time of delivery to the customers. Revenue is recognized for services upon completion of those services.
Due to the customized nature of some of the Company’s products, together with contractual provisions in certain customer contracts that provide the Company with an enforceable right to payment of the transaction price for performance completed to date, revenue is recognized for these contracts over time. For these contracts, the Company recognizes revenue on products by an output measure of production, which fairly depicts the amount of revenue the Company is entitled to. The timing of revenue recognized from these products is slightly accelerated compared to revenue recognized at the point in time of shipment or delivery. Revenue generated from NRE services is also satisfied over time, measured as contractual milestones are achieved as this represents value transferred to the customer.
Incremental costs of obtaining a contract with a customer and other costs to fulfill a contract are required to be capitalized. The only such cost material to the Company is sales commission expense. The Company has elected to expense these costs of obtaining a contract as incurred when the related contract period is less than one year. The Company does not pay upfront sales commissions on contracts when the related contract period is greater than one year, thus has not capitalized any amounts as of
October 31, 2018
.
Revenue Disaggregation
Net sales disaggregated by geography based on the location where the customer's order was placed (in millions):
|
|
|
|
|
|
|
|
|
|
Three Months Ended
October 31,
|
|
2018
|
|
2017
|
United States
|
$
|
305.1
|
|
|
$
|
274.4
|
|
Europe, Middle East and Africa
|
196.3
|
|
|
184.8
|
|
Asia Pacific
|
147.3
|
|
|
132.1
|
|
Latin America
|
52.7
|
|
|
53.5
|
|
Total net sales
|
$
|
701.4
|
|
|
$
|
644.8
|
|
Net sales disaggregated by product group (in millions):
|
|
|
|
|
|
|
|
|
|
Three Months Ended
October 31,
|
|
2018
|
|
2017
|
Engine Products segment
|
|
|
|
Off-Road
|
$
|
76.2
|
|
|
$
|
75.0
|
|
On-Road
|
45.9
|
|
|
33.3
|
|
Aftermarket
|
331.2
|
|
|
309.1
|
|
Aerospace and Defense
|
27.6
|
|
|
24.7
|
|
Engine Products segment net sales
|
480.9
|
|
|
442.1
|
|
|
|
|
|
Industrial Products segment
|
|
|
|
Industrial Filtration Solutions
|
149.4
|
|
|
134.5
|
|
Gas Turbine Systems
|
25.5
|
|
|
26.3
|
|
Special Applications
|
45.6
|
|
|
41.9
|
|
Industrial Products segment net sales
|
220.5
|
|
|
202.7
|
|
|
|
|
|
Total net sales
|
$
|
701.4
|
|
|
$
|
644.8
|
|
Contract Assets and Liabilities
The satisfaction of performance obligations and the resulting recognition of revenue typically corresponds with billing of the customer. In limited circumstances, the customer may be billed at a time later than when revenue is recognized, resulting in contract assets, which are reported in prepaid expenses and other current assets on the Condensed Consolidated Balance Sheets. Contract assets were
$13.1 million
as of
October 31, 2018
. In other limited circumstances, the Company will require a down payment from the customer prior to the satisfaction of performance obligations. This results in contract liabilities, or deferred revenue, which is reported in other current liabilities and other long-term liabilities on the Condensed Consolidated Balance Sheets, depending on when revenue is expected to be recognized. Contract liabilities were
$12.0 million
and
$10.5 million
as of
October 31, 2018
and
July 31, 2018
, respectively.
The Company will recognize revenue in future periods related to remaining performance obligations for certain open contracts. Generally, these contracts have terms of one year or less. The amount of revenue related to unsatisfied performance obligations in which the original duration of the contract is greater than one year is not significant.
Adoption of ASC 606
Note 1 describes the requirements of the new revenue recognition standard, ASC 606. The cumulative effect of the adoption on the Company’s August 1, 2018 opening balance sheet is as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance at July 31, 2018
|
|
Adjustments for ASC 606
|
|
Balance at August 1, 2018
|
Assets
|
|
|
|
|
|
Inventories, net
|
$
|
334.1
|
|
|
$
|
(7.3
|
)
|
|
$
|
326.8
|
|
Prepaid expense and other current assets
|
52.3
|
|
|
14.0
|
|
|
66.3
|
|
Liabilities
|
|
|
|
|
|
Other current liabilities
|
86.6
|
|
|
0.3
|
|
|
86.9
|
|
Deferred income taxes
|
4.2
|
|
|
1.1
|
|
|
5.3
|
|
Equity
|
|
|
|
|
|
Retained earnings
|
1,122.1
|
|
|
5.3
|
|
|
1,127.4
|
|
These adjustments primarily related to certain contracts that qualify for revenue recognition over time under the new standard. This change does not have a material impact on revenue recognized during the three months ended
October 31, 2018
.
In addition, the adoption of ASC 606 impacted one set of contracts within the Engine Products segment in which Donaldson is deemed to be the principal under the new standard because the Company has control through the manufacturing of products prior to the sale of those products to the customer. For these contracts, the previous practice of recognizing revenue on a net basis, in which the amount of net sales recorded is the net amount retained after paying product costs to suppliers, has changed under ASC 606 to recognizing revenue on a gross basis, in which the amount of net sales recorded is the gross amount received from the customer, with corresponding product costs recorded as cost of sales. This change did not result in a cumulative effect adjustment under the modified retrospective method of adoption since there is no impact to the timing of revenue recognition but it has increased net sales and cost of sales on a prospective basis. The increase in net sales and cost of sales for this change was
$5.1 million
for the three months ended
October 31, 2018
.
Note 7. Warranty
The Company estimates warranty expense on certain products at the time of sale. The following is a reconciliation of warranty reserves, included in other current liabilities and other long-term liabilities, for the
three months ended October 31, 2018
and
2017
(in millions):
|
|
|
|
|
|
|
|
|
|
Three Months Ended
October 31,
|
|
2018
|
|
|
2017
|
|
Balance at beginning of period
|
$
|
18.9
|
|
|
$
|
14.6
|
|
Accruals for warranties issued during the reporting period
|
0.3
|
|
|
0.7
|
|
Accruals related to pre-existing warranties (including changes in estimates)
|
(0.4
|
)
|
|
0.9
|
|
Less: settlements made during the period
|
(1.7
|
)
|
|
(0.5
|
)
|
Balance at end of period
|
$
|
17.1
|
|
|
$
|
15.7
|
|
There were no material specific warranty matters accrued for or significant settlements made in the
three months ended October 31, 2018
or
2017
. The Company’s warranty matters are not expected to have a material impact on the Company's results of operations, liquidity or financial position.
Note 8. Stock-Based Compensation
Stock-based compensation expense is recognized using the fair-value method for all awards. The Company determines the fair value of stock option awards using the Black-Scholes option pricing model. Options are granted whereby the option exercise price is equivalent to the market price of the Company's common stock at the date of grant. For the
three
months ended
October 31, 2018
, the Company recorded pretax stock-based compensation expense associated with stock options of
$4.9 million
and recorded
$1.1 million
of related tax benefits. For the
three
months ended
October 31, 2017
, the Company recorded pretax stock-based compensation expense associated with stock options of
$3.8 million
and recorded
$1.2 million
of related tax benefits. In addition, for the
three
months ended
October 31, 2018
, the Company recorded expense associated with performance-based awards of
$1.7
million
. For the
three
months ended
October 31, 2017
, the Company recorded expense associated with performance-based awards of
$2.7 million
.
The following table summarizes stock option activity during the
three months ended October 31, 2018
:
|
|
|
|
|
|
|
|
|
Options
Outstanding
|
|
Weighted
Average
Exercise Price
|
Outstanding as of July 31, 2018
|
6,785,812
|
|
|
$
|
34.93
|
|
Granted
|
841,725
|
|
|
$
|
59.18
|
|
Exercised
|
(743,708
|
)
|
|
$
|
24.24
|
|
Canceled
|
(14,732
|
)
|
|
$
|
44.19
|
|
Outstanding as of October 31, 2018
|
6,869,097
|
|
|
$
|
39.03
|
|
The total intrinsic value of options exercised during the
three months ended October 31, 2018
and
2017
was
$21.7 million
and
$4.2 million
, respectively. The weighted average fair value for options granted during the
three
months ended
October 31, 2018
and
2017
was
$12.43
and $
9.18
per share, respectively.
The following table summarizes information concerning outstanding and exercisable options as of
October 31, 2018
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Range of Exercise Prices
|
|
Number Outstanding
|
|
Weighted
Average
Remaining
Contractual
Life (Years)
|
|
Weighted
Average
Exercise
Price of Outstanding Options
|
|
Number
Exercisable
|
|
Weighted
Average
Exercise
Price of Exercisable Options
|
$ 0.00 to $27.69
|
|
390,413
|
|
|
1.10
|
|
$
|
20.78
|
|
|
390,413
|
|
|
$
|
20.78
|
|
$27.70 to $32.69
|
|
1,394,058
|
|
|
5.18
|
|
$
|
28.56
|
|
|
1,095,417
|
|
|
$
|
28.67
|
|
$32.70 to $37.69
|
|
1,247,671
|
|
|
3.79
|
|
$
|
34.44
|
|
|
1,246,838
|
|
|
$
|
34.44
|
|
$37.70 to $42.69
|
|
1,305,734
|
|
|
5.94
|
|
$
|
40.35
|
|
|
1,218,534
|
|
|
$
|
40.21
|
|
$42.70 and above
|
|
2,531,221
|
|
|
8.76
|
|
$
|
49.20
|
|
|
631,993
|
|
|
$
|
44.40
|
|
|
|
6,869,097
|
|
|
6.16
|
|
$
|
39.03
|
|
|
4,583,195
|
|
|
$
|
34.80
|
|
As of
October 31, 2018
, the aggregate intrinsic value of options outstanding and exercisable was
$90.7 million
and
$75.7 million
, respectively.
As of
October 31, 2018
, there was
$12.6 million
of total unrecognized compensation expense related to non-vested stock options granted under the 2010 Master Stock Incentive Plan. This unvested expense is expected to be recognized during fiscal years
2019
,
2020
,
2021
and
2022
.
Note 9. Employee Benefit Plans
The Company and certain of its international subsidiaries have defined benefit pension plans for many of their hourly and salaried employees. There are
two
types of U.S. plans. The first type of U.S. plan (Hourly Pension Plan) is a traditional defined benefit pension plan primarily for union production employees. The second plan (Salaried Pension Plan) is for some salaried and non-union production employees that provides defined benefits pursuant to a cash balance feature whereby a participant accumulates a benefit comprised of a percentage of current salary that varies with years of service, interest credits and transition credits. The Company no longer allows entrants into the U.S. Salaried Pension Plan and the employees no longer accrue Company contribution credits under the plan. Instead, eligible employees receive a
3%
annual Company retirement contribution to their 401(k) in addition to the Company’s normal 401(k) match. The non-U.S. plans generally provide pension benefits based on years of service and compensation level.
Net periodic benefit costs for the Company’s pension plans include the following components (in millions):
|
|
|
|
|
|
|
|
|
|
Three Months Ended
October 31,
|
|
2018
|
|
|
2017
|
|
Net periodic benefit costs:
|
|
|
|
|
|
Service cost
|
$
|
1.5
|
|
|
$
|
2.0
|
|
Interest cost
|
4.1
|
|
|
3.7
|
|
Expected return on assets
|
(6.6
|
)
|
|
(6.5
|
)
|
Prior service cost amortization
|
0.1
|
|
|
0.1
|
|
Actuarial loss amortization
|
1.1
|
|
|
1.1
|
|
Net periodic benefit costs
|
$
|
0.2
|
|
|
$
|
0.4
|
|
The Company’s general funding policy is to make at least the minimum required contributions as required by applicable regulations, plus any additional amounts that it determines to be appropriate. For the
three months ended October 31, 2018
, the Company made required contributions of
$1.0 million
to its non-qualified U.S. pension plans and
$0.3 million
to its non-U.S. pension plans. The estimated minimum funding requirement for the Company’s qualified U.S. plans for the plan year ending
July 31, 2019
is
$3.1 million
. In accordance with the Pension Protection Act of 2006, this contribution obligation may be met with existing credit balances that resulted from payments above the minimum obligation in prior years. The Company has sufficient credit balances to meet the minimum obligation for the plan year ending
July 31, 2019
. The Company estimates it will contribute an additional
$1.0 million
to its non-U.S. pension plans during the remainder of
fiscal 2019
based upon the local government prescribed funding requirements. Future estimates of the Company’s required pension plan contributions may change significantly depending on the actual rate of return on plan assets, discount rates and regulatory requirements.
Note 10. Income Taxes
On December 22, 2017, the U.S. Tax Cuts and Jobs Act (TCJA) was enacted into law. The TCJA significantly reforms the Internal Revenue Code of 1986, including but not limited to reducing the U.S. federal corporate income tax rate from 35 percent to 21 percent and moving toward a territorial tax system with a one-time transition tax imposed on previously unremitted foreign earnings and profits.
Staff Accounting Bulletin 118 (SAB 118) includes additional guidance allowing companies to use a measurement period that should not extend beyond one year from the TCJA enactment date to account for the impacts of the law in their financial statements.
There have been no material measurement period adjustments made during the three months ended October 31, 2018 related to the provisional amounts recorded and disclosed in the Company’s Annual Report on Form 10-K for the year ended
July 31, 2018
.
During the three months ended
October 31, 2018
, the Company made the accounting policy election to treat taxes related to the Global Intangible Low-Taxed Income (GILTI) provision of the TCJA as a current period expense when incurred.
Although the Company believes it has made reasonable estimates in accounting for the impacts of the TCJA, these tax charges and benefits are provisional, as the Company is still analyzing certain aspects of the legislation and refining calculations as information becomes available during the measurement period as allowed by SAB 118. The accounting for the income tax effects of the TCJA is expected to be completed during the second quarter of fiscal 2019 and any future adjustments will be recognized as discrete income tax expense or benefit in the period the adjustments are determined.
As of
October 31, 2018
, the gross unrecognized tax benefits were
$19.4 million
and accrued interest and penalties on these unrecognized tax benefits were
$1.9 million
. The Company recognizes accrued interest and penalties related to unrecognized tax benefits in income tax expense. If the Company were to prevail on all unrecognized tax benefits recorded, substantially all of the unrecognized tax benefits would benefit the effective tax rate. With an average statute of limitations of approximately five years, up to
$1.7 million
of the unrecognized tax benefits could potentially expire in the next 12-month period, unless extended by an audit.
The Company files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. With few exceptions, the Company is no longer subject to state and foreign income tax examinations by tax authorities for years before 2010. The United States Internal Revenue Service (IRS) has completed examinations of the Company’s U.S. federal income tax returns through 2016. The Company protested certain IRS proposed material adjustments for fiscal years 2015 and 2016 and entered into the administrative appeals process with the IRS. As previously stated, the Company continues to believe the claims to be without merit and will vigorously defend its position, through litigation if necessary.
The Company believes that it is remote that any adjustment necessary to the reserve for income taxes over the next 12-month period will be material. However, it is possible the ultimate resolution of audits or disputes may result in a material change to the reserve for income taxes, although the quantification of such potential adjustments cannot be made at this time.
Note 11. Fair Value Measurements
As of
October 31, 2018
, the carrying values of cash and cash equivalents, accounts receivables, short-term borrowings and trade accounts payable approximate fair value because of the short-term nature of these instruments. As of
October 31, 2018
, the estimated fair value of long-term debt with fixed interest rates was
$258.6 million
compared to its carrying value of
$275.0 million
. The fair value is estimated by discounting the projected cash flows using the rate at which similar amounts of debt could currently be borrowed. Long-term debt would be classified as Level 2 in the fair value hierarchy. The carrying values of long-term debt with variable interest rates approximate fair value.
Note 12. Shareholders' Equity
The Company’s Board of Directors authorized the repurchase of up to
14.0 million
shares of common stock under the Company's stock repurchase plan. This repurchase authorization is effective until terminated by the Board of Directors. During the
three months ended October 31, 2018
, the Company repurchased
1.6 million
shares for
$80.9 million
. As of
October 31, 2018
, the Company had remaining authorization to repurchase
2.9 million
shares under this plan.
On November 30, 2018, the Company's Board of Directors declared a cash dividend in the amount of
19.0 cents
per common share, payable December 21, 2018, to shareholders of record as of December 11, 2018.
Note 13. Accumulated Other Comprehensive Income
Changes in accumulated other comprehensive loss by component for the
three months ended October 31, 2018
and
2017
are as follows (in millions):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Foreign
Currency
Translation
Adjustment
|
|
Pension
Benefits
|
|
Derivative
Financial
Instruments
|
|
Total
|
Balance as of July 31, 2018, net of tax
|
$
|
(66.1
|
)
|
|
$
|
(82.9
|
)
|
|
$
|
(0.8
|
)
|
|
$
|
(149.8
|
)
|
Other comprehensive (loss) income before reclassifications and tax
|
(24.2
|
)
|
|
—
|
|
|
1.0
|
|
|
(23.2
|
)
|
Tax expense
|
—
|
|
|
—
|
|
|
(0.3
|
)
|
|
(0.3
|
)
|
Other comprehensive (loss) income before reclassifications, net of tax
|
(24.2
|
)
|
|
—
|
|
|
0.7
|
|
|
(23.5
|
)
|
Reclassifications, before tax
|
—
|
|
|
2.0
|
|
|
(0.3
|
)
|
|
1.7
|
|
Tax (expense) benefit
|
—
|
|
|
(0.4
|
)
|
|
0.1
|
|
|
(0.3
|
)
|
Reclassifications, net of tax
|
—
|
|
|
1.6
|
|
(1)
|
(0.2
|
)
|
(2)
|
1.4
|
|
Other comprehensive (loss) income, net of tax
|
(24.2
|
)
|
|
1.6
|
|
|
0.5
|
|
|
(22.1
|
)
|
Balance as of October 31, 2018, net of tax
|
$
|
(90.3
|
)
|
|
$
|
(81.3
|
)
|
|
$
|
(0.3
|
)
|
|
$
|
(171.9
|
)
|
|
|
|
|
|
|
|
|
Balance as of July 31, 2017, net of tax
|
$
|
(58.8
|
)
|
|
$
|
(95.1
|
)
|
|
$
|
(3.1
|
)
|
|
$
|
(157.0
|
)
|
Other comprehensive (loss) income before reclassifications and tax
|
(5.1
|
)
|
|
—
|
|
|
3.1
|
|
|
(2.0
|
)
|
Tax expense
|
—
|
|
|
—
|
|
|
(1.5
|
)
|
|
(1.5
|
)
|
Other comprehensive (loss) income before reclassifications, net of tax
|
(5.1
|
)
|
|
—
|
|
|
1.6
|
|
|
(3.5
|
)
|
Reclassifications, before tax
|
—
|
|
|
1.3
|
|
|
1.1
|
|
|
2.4
|
|
Tax expense
|
—
|
|
|
(0.5
|
)
|
|
(0.4
|
)
|
|
(0.9
|
)
|
Reclassifications, net of tax
|
—
|
|
|
0.8
|
|
(1)
|
0.7
|
|
(2)
|
1.5
|
|
Other comprehensive (loss) income, net of tax
|
(5.1
|
)
|
|
0.8
|
|
|
2.3
|
|
|
(2.0
|
)
|
Balance as of October 31, 2017, net of tax
|
$
|
(63.9
|
)
|
|
$
|
(94.3
|
)
|
|
$
|
(0.8
|
)
|
|
$
|
(159.0
|
)
|
|
|
(1)
|
Primarily includes net amortization of prior service costs and actuarial losses included in net periodic benefit cost (see Note 9) that were reclassified from accumulated other comprehensive loss to operating expenses or cost of sales.
|
|
|
(2)
|
Relates to foreign currency cash flow hedges that were reclassified from accumulated other comprehensive loss to other income, net.
|
Note 14. Guarantees
The Company and Caterpillar Inc. equally own the shares of Advanced Filtration Systems Inc. (AFSI), an unconsolidated joint venture, and guarantee certain debt of the joint venture. As of
October 31, 2018
, AFSI had
$35.8 million
of outstanding debt, of which the Company guarantees half. In addition, during the three months ended
October 31, 2018
and
2017
, the Company recorded a loss of
$0.3 million
and earnings of
$0.1 million
, respectively, from this equity method investment. During the three months ended
October 31, 2018
and
2017
, the Company recorded royalty income related to AFSI of
$1.7 million
and
$1.9 million
, respectively, in other income, net.
As of
October 31, 2018
and
July 31, 2018
, the Company had a contingent liability for standby letters of credit totaling
$11.2 million
and
$8.2 million
, respectively, that have been issued and are outstanding. The letters of credit guarantee payment to third parties in the event the Company is in breach of contract terms as detailed in each letter of credit. As of
October 31, 2018
and
July 31, 2018
, there were
no
amounts drawn upon these letters of credit.
Note 15. Commitments and Contingencies
The Company records provisions with respect to identified claims or lawsuits when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Claims and lawsuits are reviewed quarterly and provisions are taken or adjusted to reflect the status of a particular matter. The Company believes the recorded estimated liability in its Condensed Consolidated Financial Statements is adequate in light of the probable and estimable outcomes. The recorded liabilities were not material to the Company’s results of operations, liquidity or financial position and the Company believes it is remote that the settlement of any of the currently identified claims or litigation will be materially in excess of what is accrued.
Note 16. Segment Reporting
The Company has identified
two
reportable segments: Engine Products and Industrial Products. Segment determination is based on the internal organization structure, management of operations and performance evaluation by management and the Company’s Board of Directors. Corporate and Unallocated includes corporate expenses elected to be non-allocable to the segments, such as interest expense.
The Company has an internal measurement system to evaluate performance and allocate resources. The Company’s manufacturing facilities serve both reporting segments. Therefore, the Company uses an allocation methodology to assign costs and assets to the segments. Segment assets assigned are primarily accounts receivable, inventories, property, plant and equipment and goodwill.
The Company is an integrated enterprise, characterized by substantial intersegment cooperation, cost allocations and sharing of assets. Therefore, the Company does not represent that these segments, if operated independently, would report the earnings before income taxes and other financial information shown below.
Segment detail is summarized as follows (in millions):
|
|
|
|
|
|
|
|
|
|
Three Months Ended
October 31,
|
|
2018
|
|
|
2017
|
|
Net sales
|
|
|
|
Engine Products segment
|
$
|
480.9
|
|
|
$
|
442.1
|
|
Industrial Products segment
|
220.5
|
|
|
202.7
|
|
Total
|
$
|
701.4
|
|
|
$
|
644.8
|
|
|
|
|
|
|
|
Earnings before income taxes
|
|
|
|
Engine Products segment
|
$
|
63.9
|
|
|
$
|
62.7
|
|
Industrial Products segment
|
36.6
|
|
|
29.4
|
|
Corporate and Unallocated
|
(4.1
|
)
|
|
(7.4
|
)
|
Total
|
$
|
96.4
|
|
|
$
|
84.7
|
|
There were
no
customers that accounted for over 10% of net sales for the
three
months ended
October 31, 2018
or
2017
. There were
no
customers that accounted for over 10% of gross accounts receivable as of
October 31, 2018
or
July 31, 2018
.