UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

Form 10-K

 

 

Commission file number 1-892

 

 

 

 

GOODRICH CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (704) 423-7000

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

 

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:  None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes o     No þ

 

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 o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

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

 

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

 

The aggregate market value of the voting and non-voting common equity of the registrant, consisting solely of common stock, held by nonaffiliates of the registrant as of June 30, 2005 was $5.5 billion.

 

The number of shares of common stock outstanding as of January 31, 2006 was 123,408,839 (excluding 14,000,000 shares held by a wholly owned subsidiary).

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the proxy statement dated March 10, 2006 are incorporated by reference into Part III (Items 10, 11, 12, 13 and 14).

 

 

PART I

 

Item 1.  Business

 

Overview

 

We are one of the largest worldwide suppliers of components, systems and services to the commercial and general aviation airplane markets. We are also a leading supplier of systems and products to the global defense and space markets. Our business is conducted on a global basis with manufacturing, service and sales undertaken in various locations throughout the world. Our products and services are principally sold to customers in North America, Europe and Asia.

 

We were incorporated under the laws of the State of New York on May 2, 1912 as the successor to a business founded in 1870.

 

Our principal executive offices are located at Four Coliseum Centre, 2730 West Tyvola Road, Charlotte, North Carolina 28217 (telephone 704-423-7000).

 

We maintain an Internet site at http://www.goodrich.com. The information contained at our Internet site is not incorporated by reference in this report, and you should not consider it a part of this report. Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and any amendments to those reports, are available free of charge on our Internet site as soon as reasonably practicable after they are filed with, or furnished to, the Securities and Exchange Commission. In addition, we maintain a corporate governance page on our Internet site that includes key information about our corporate governance initiatives, including our Guidelines on Governance, the charters for our standing board committees and our Business Code of Conduct. These materials are available to any shareholder upon request.

 

Unless otherwise noted herein, disclosures in this Annual Report on Form 10-K relate only to our continuing operations. Our discontinued operations include the Performance Materials segment, which was sold in February 2001, the Engineered Industrial Products segment, which was spun-off to shareholders in May 2002, the Avionics business, which was sold in March 2003, the Passenger Restraints business, which ceased operating during the first quarter of 2003, and the Test Systems business, which was sold in April 2005.

 

Unless the context otherwise requires, the terms “we”, “our”, “us”, “Company” and “Goodrich” as used herein refer to Goodrich Corporation and its subsidiaries.

 

As used in this Form 10-K, the following terms have the following meanings:

 

 

Acquisitions

 

Sensors Unlimited, Inc.

 

On October 31, 2005, we acquired Sensors Unlimited, Inc. (SUI) for $60.9 million in cash. The purchase price is subject to post-closing adjustments. SUI develops imaging products and technologies and is included in our Electronics Systems segment.

TRW’s Aeronautical Systems Businesses

 

On October 1, 2002, we completed our acquisition of TRW Inc.’s aeronautical systems businesses. The acquired businesses design and manufacture commercial and military aerospace systems and equipment, including engine controls, flight controls, power systems, cargo systems, hoists and winches and actuation systems. At the time of acquisition, these businesses employed approximately 6,200 employees in 22 facilities in nine countries, including manufacturing and service operations in the United Kingdom, France, Germany, Canada, the United States and several Asia/Pacific countries. The purchase price for these businesses, after giving effect to post-closing purchase price adjustments, was approximately $1.4 billion.

 

Discontinued Operations

 

Sale of the Test Systems Business

 

On April 19, 2005, we completed the sale of our Test Systems business to Aeroflex Incorporated for $34 million in cash, net of expenses and purchase price adjustments. We reported an after tax gain on the sale of this business of $13.2 million, or $0.11 per diluted share, in the quarter ended June 30, 2005. Prior periods have been adjusted to reflect Test Systems as a discontinued operation.

 

Sale of the Avionics Business

 

On March 28, 2003, we completed the sale of our Avionics business (Avionics) to L-3 Communications Corporation for $188 million, or $181 million net of fees and expenses. The gain on the sale was $63 million after tax, which was reported as income from discontinued operations. Avionics marketed a variety of state-of-the art Avionics instruments and systems primarily for general aviation and military aircraft. Prior period financial statements have been adjusted to reflect Avionics as a discontinued operation.

 

Passenger Restraint Systems

 

During the first quarter of 2003, our Passenger Restraint Systems (PRS) business ceased operations. Prior period financial statements have been adjusted to reflect the PRS business as a discontinued operation.

 

Spin-off of Engineered Industrial Products

 

On May 31, 2002, we completed the tax-free spin-off of our Engineered Industrial Products (EIP) segment. The spin-off was effected through a tax-free distribution to our shareholders of all of the capital stock of EnPro Industries, Inc. (EnPro), then a wholly owned subsidiary of Goodrich. In the spin-off, our shareholders received one share of EnPro common stock for every five shares of our common stock owned on the record date, May 28, 2002.

 

At the time of the spin-off, EnPro’s only material asset was all of the capital stock and certain indebtedness of Coltec Industries Inc (Coltec). Coltec and its subsidiaries owned substantially all of the assets and liabilities of the EIP segment, including the associated asbestos liabilities and related insurance.

 

Prior to the spin-off, Coltec also owned and operated an aerospace business. Before completing the spin-off, Coltec’s aerospace business assumed all intercompany balances outstanding between Coltec and us and Coltec then transferred to us by way of a dividend all of the assets, liabilities and operations of Coltec’s aerospace business, including these assumed balances. Following this transfer and prior to the spin-off, all of the capital stock of Coltec was contributed to EnPro, with the result that at the time of the spin-off Coltec was a wholly-owned subsidiary of EnPro.

In connection with the spin-off, we and EnPro entered into a distribution agreement, a tax matters agreement, a transition services agreement, an employee matters agreement and an indemnification agreement, which govern the relationship between us and EnPro after the spin-off and provide for the allocation of employee benefits, tax and other liabilities and obligations attributable to periods prior to the spin-off.

 

The spin-off was recorded as a dividend and resulted in a reduction in shareholders’ equity of $409.1 million representing the recorded value of net assets of the business distributed, including cash of $47 million. The distribution agreement provided for certain post-distribution adjustments relating to the amount of cash to be included in the net assets distributed, which adjustments resulted in a cash payment by EnPro to us of $0.6 million.

 

The $150 million of outstanding Coltec Capital Trust 51/4 percent convertible trust preferred securities (TIDES) that were reflected in liabilities of discontinued operations prior to the spin-off remained outstanding as part of the EnPro capital structure following the spin-off. The TIDES were convertible into shares of both Goodrich and EnPro common stock. We guaranteed amounts owed by Coltec Capital Trust with respect to the TIDES and guaranteed Coltec’s performance of its obligations with respect to the TIDES and the underlying Coltec convertible subordinated debentures. EnPro, Coltec and Coltec Capital Trust agreed to indemnify us for any costs and liabilities arising under or related to the TIDES after the spin-off. On November 28, 2005, Coltec Capital Trust redeemed all of the outstanding TIDES. Our guarantee of the TIDES terminated upon full payment of the redemption price of all of the TIDES, subject to reinstatement if at any time any TIDES holder must repay any sums paid to it with respect to the TIDES or our guarantee.

 

Sale of Performance Materials Segment

 

On February 28, 2001, we completed the sale of our Performance Materials (PM) segment to an investor group led by AEA Investors, Inc. for approximately $1.4 billion. Total net proceeds, after anticipated tax payments and transaction costs, included approximately $1 billion in cash and $172 million in payment-in-kind notes (Noveon PIK Notes) issued by the buyer, which is now known as Noveon International Inc. (Noveon). The transaction resulted in an after tax gain of $93.5 million.

 

In June and October 2002, Noveon prepaid a total of $62.5 million of the outstanding principal of the Noveon PIK Notes for $49.8 million in cash. Because these prepayments did not exceed the original discount recorded at the inception of the notes, no gain or loss was required to be recognized. We sold the remaining Noveon PIK Notes in March 2003 for $155.8 million, which resulted in an after tax gain of $4.6 million.

 

Pursuant to the terms of the transaction, we retained certain assets and liabilities, primarily pension, postretirement and environmental liabilities, of PM. We also agreed to indemnify Noveon for liabilities arising from certain events as defined in the agreement. Such indemnification is not expected to be material to our financial condition, but could be material to our results of operations in a given period.

 

Business Segments

 

We have three business segments: Airframe Systems, Engine Systems and Electronic Systems. For financial information about the sales, operating income and assets of our segments, as well as financial information about sales by product categories, see Note 3 to our Consolidated Financial Statements.

 

A summary of the products and services provided by our business segments is as follows:

Airframe Systems

 

Airframe Systems provides systems and components pertaining to aircraft taxi, take-off, landing and stopping. Several business units within the segment are linked by their ability to contribute to the integration, design, manufacture and service of entire aircraft undercarriage systems, including landing gear, wheels and brakes and certain brake controls. Airframe Systems also includes the aviation technical services business unit, which performs comprehensive total aircraft maintenance, repair, overhaul and modification services for many commercial airlines, independent operators, aircraft leasing companies and airfreight carriers. The segment also includes the actuation systems and flight controls business units. The actuation systems business unit provides systems that control the movement of steering systems for missiles and electro-mechanical systems that are characterized by high power, low weight, low maintenance, resistance to extreme temperatures and vibrations and high reliability. The actuation systems business unit also provides actuators for primary flight control systems that operate elevators, ailerons and rudders, and secondary flight controls systems such as flaps and slats. The engineered polymer products business unit provides large-scale marine composite structures, marine acoustic materials, acoustic/vibration damping structures, fireproof composites and high performance elastomer formulations to government and commercial customers.

 

Engine Systems

 

Engine Systems includes the aerostructures business, a leading supplier of nacelles, pylons, thrust reversers and related aircraft engine housing components. The segment also produces engine and fuel controls, pumps, fuel delivery systems, and structural and rotating components such as discs, blisks, shafts and airfoils for both aerospace and industrial gas turbine applications. The segment includes the cargo systems, engine controls and customer services business units. The cargo systems business unit produces fully integrated main deck and lower lobe cargo systems for wide body aircraft. The engine controls business unit provides engine control systems and components for jet engines used on commercial and military aircraft, including fuel metering controls, fuel pumping systems, electronic control software and hardware, variable geometry actuation controls, afterburner fuel pump, metering unit nozzles, and engine health monitoring systems. The customer services business unit primarily sells aftermarket products.

 

Electronic Systems

 

Electronic Systems produces a wide array of products that provide flight performance measurements, flight management, and control and safety data. Included are a variety of sensor systems that measure and manage aircraft fuel and monitor oil debris, engine, and transmission and structural health. The segment’s products also include ice detection systems, interior and exterior aircraft lighting systems, landing gear cables and harnesses, satellite control, data management and payload systems, launch and missile telemetry systems, airborne surveillance and reconnaissance systems, laser warning systems, aircraft evacuation systems, de-icing systems, ejection seats, crew and attendant seating, engine shafts primarily for helicopters, electronic flight bags and air data probes, reduced vertical separation minimums (RVSM) sensors, specialty heated products, potable water systems, drain masts, proximity sensors, laser perimeter awareness systems (LPAS) and cockpit video systems. The power systems business unit provides systems that produce and control electrical power for commercial and military aircraft, including electric generators for both main and back-up electrical power, electric starters, electric starter generating systems, power management and distribution systems. The hoists and winches business unit, provides airborne hoists and winches used on both helicopters and fixed wing aircraft. The segment also includes, as a result of the acquisition of SUI in October 2005, short wave (SWIR) and near infrared (NIR) imaging products for a variety of military and commercial customers.

Key Products

 

Our key products include:

 

 

Customers

 

We serve a diverse group of customers worldwide in the commercial and general aviation airplane markets and in the global defense and space markets. We market our products, systems and services directly to our customers through an internal marketing and sales force.

 

In 2005, 2004 and 2003, direct and indirect sales to the United States (U.S.) government totaled approximately 18 percent, 20 percent and 19 percent, respectively, of consolidated sales. Indirect sales to the U.S. government include a portion of the direct and indirect sales to Boeing referred to in the following paragraph.

 

In 2005, 2004 and 2003, direct and indirect sales to Airbus totaled approximately 16 percent, 16 percent and 14 percent, respectively, of consolidated sales. In 2005, 2004 and 2003, direct and indirect sales to Boeing totaled approximately 12 percent, 13 percent and 17 percent, respectively, of consolidated sales.

 

Competition

 

The aerospace industry in which we operate is highly competitive. Principal competitive factors include price, product and system performance, quality, service, design and engineering capabilities, new product innovation and timely delivery. We compete worldwide with a number of

U.S. and foreign companies that are both larger and smaller than us in terms of resources and market share, and some of which are our customers.

 

The following table lists the companies that we consider to be our major competitors for each major aerospace product or system platform for which we believe we are one of the leading suppliers.

 

 

 

 

Backlog

 

At December 31, 2005, we had a backlog of approximately $4.4 billion, of which approximately 70 percent is expected to be filled during 2006. The amount of backlog at December 31, 2004 was approximately $3.5 billion. Backlog includes fixed, firm contracts that have not been shipped and for which cancellation is not anticipated. Backlog is subject to delivery delays or program cancellations, which are beyond our control.

 

Raw Materials and Components

 

We purchase a variety of raw materials and components for use in the manufacture of our products, including aluminum, titanium, steel and carbon fiber. In some cases we rely on sole-source suppliers for certain of these raw materials and components, and a delay in delivery of these materials and components could create difficulties in meeting our production and delivery obligations. During 2005, we experienced margin and cost pressures in some of our businesses due to increased prices and limited availability of some raw materials, such as titanium and steel. We are taking steps to address these issues and we believe that we currently have adequate sources of supply for our raw materials and components.

 

Environmental

 

We are subject to various domestic and international environmental laws and regulations which may require that we investigate and remediate the effects of the release or disposal of materials at sites associated with past and present operations, including sites at which we have been identified as a potentially responsible party under the federal Superfund laws and comparable state laws. We are currently involved in the investigation and remediation of a number of sites under these laws. For additional information concerning environmental matters, see “Item 3. Legal Proceedings — Environmental.”

Research and Development

 

We perform research and development under company-funded programs for commercial products and under contracts with others. Research and development under contracts with others is performed on both defense and commercial products. Total research and development expenses from continuing operations in the years ended December 31, 2005, 2004 and 2003 were $379 million, $346.2 million and $287.5 million, respectively. Of these amounts, $112.1 million, $99.5 million and $87.9 million, respectively, were funded by customers.

 

Intellectual Property

 

We own or are licensed to use various intellectual property rights, including patents, trademarks, copyrights and trade secrets. While such intellectual property rights are important to us, we do not believe that the loss of any individual property right or group of related rights would have a material adverse effect on our overall business or on any of our operating segments.

 

Human Resources

 

As of December 31, 2005, we had approximately 15,300 employees in the U.S. Additionally, we employed approximately 7,300 people in other countries. We believe that we have good relationships with our employees. The hourly employees who are unionized are covered by collective bargaining agreements with a number of labor unions and with varying contract termination dates through March 2010. Approximately 15 percent of our global labor force is covered by collective bargaining arrangements and approximately 8 percent of our global labor force is covered by collective bargaining arrangements that will expire within one year. There were no material work stoppages during 2005.

 

Foreign Operations

 

We are engaged in business in foreign markets. Our foreign manufacturing and service facilities are located in Australia, Canada, China, England, France, Germany, India, Indonesia, Ireland, Japan, Mexico, Poland, Scotland, Spain and Singapore. We market our products and services through sales subsidiaries and distributors in a number of foreign countries. We also have joint venture agreements with various foreign companies.

 

Currency fluctuations, tariffs and similar import limitations, price controls and labor regulations can affect our foreign operations, including foreign affiliates. Other potential limitations on our foreign operations include expropriation, nationalization, restrictions on foreign investments or their transfers and additional political and economic risks. In addition, the transfer of funds from foreign operations could be impaired by the unavailability of dollar exchange or other restrictive regulations that foreign governments could enact.

 

For financial information about our U.S. and foreign sales and assets, see Note 3 to our Consolidated Financial Statements.

 

 

Our business, financial condition, results of operations and cash flows can be affected by a number of factors, including but not limited to those set forth below and elsewhere in this Annual Report on Form 10-K, any one of which could cause our actual results to vary materially from recent results or from our anticipated future results.

 

Our future success is dependent on demand for and market acceptance of new commercial and military aircraft programs.

 

We are currently under contract to supply components and systems for a number of new commercial, general aviation and military aircraft programs, including the Airbus A380 and

The significant consolidation occurring in the aerospace industry could adversely affect our business and financial results.

 

The aerospace industry in which we operate has been experiencing significant consolidation among suppliers, including us and our competitors, and the customers we serve. Commercial airlines have increasingly been merging and creating global alliances to achieve greater economies of scale and enhance their geographic reach. Aircraft manufacturers have made acquisitions to expand their product portfolios to better compete in the global marketplace. In addition, aviation suppliers have been consolidating and forming alliances to broaden their product and integrated system offerings and achieve critical mass. This supplier consolidation is in part attributable to aircraft manufacturers and airlines more frequently awarding long-term sole source or preferred supplier contracts to the most capable suppliers, thus reducing the total number of suppliers from whom components and systems are purchased. Our business and financial results may be adversely impacted as a result of consolidation by our competitors or customers.

 

Expenses related to employee and retiree medical and pension benefits may continue to rise.

 

We have periodically experienced significant increases in expenses related to our employee and retiree medical and pension benefits. Although we have taken action seeking to contain these cost increases, including making material changes to some of these plans, there are risks that our expenses will rise as a result of continued increases in medical costs due to increased usage of medical benefits and medical cost inflation in the U.S. Pension expense may increase if investment returns on our pension plan assets do not meet our long-term return assumption, if there are further reductions in the discount rate used to determine the present value of our benefit obligation, or if other actuarial assumptions are not realized.

 

The aerospace industry is highly regulated.

 

The aerospace industry is highly regulated in the U.S. by the Federal Aviation Administration and in other countries by similar regulatory agencies. We must be certified by these agencies and, in some cases, by individual OE manufacturers in order to engineer and service systems and components used in specific aircraft models. If material authorizations or approvals were revoked or suspended, our operations would be adversely affected. New or more stringent governmental regulations may be adopted, or industry oversight heightened, in the future, and we may incur significant expenses to comply with any new regulations or any heightened industry oversight.

 

We may have liabilities relating to environmental laws and regulations that could adversely affect our financial results.

 

We are subject to various domestic and international environmental laws and regulations which may require that we investigate and remediate the effects of the release or disposal of materials at sites associated with past and present operations. We are currently involved in the investigation and remediation of a number of sites for which we have been identified as a potentially responsible party under these laws. Based on currently available information, we do not believe that future environmental costs in excess of those accrued with respect to such sites will have a material adverse effect on our financial condition. We cannot assure you that additional future developments, administrative actions or liabilities relating to environmental matters will not have a material adverse effect on our results of operations and/or cash flows in a given period.

Third parties may not satisfy their contractual obligations to indemnify us for environmental and other claims arising out of our divested businesses.

 

In connection with the divestiture of our tire, vinyl and other businesses, we received contractual rights of indemnification from third parties for environmental and other claims arising out of the divested businesses. If these third parties do not honor their indemnification obligations to us, it could have a material adverse effect on our financial condition, results of operations and/or cash flows.

 

Any material product liability or environmental claims in excess of insurance may adversely affect us.

 

We are exposed to potential liability for personal injury or death with respect to products that have been designed, manufactured, serviced or sold by us, including potential liability for asbestos and other toxic tort claims. In addition, we are exposed to potential liability pursuant to various domestic and international environmental laws and regulations. While we believe that we have substantial insurance coverage available to us related to any such claims, our insurance may not cover all liabilities. Additionally, insurance coverage may not be available in the future at a cost acceptable to us. Any material liability not covered by insurance or for which third-party indemnification is not available could have a material adverse effect on our financial condition, results of operations and/or cash flows.

 

Any material product warranty obligations may adversely affect us.

 

Our operations expose us to potential liability for warranty claims made by third parties with respect to aircraft components that have been designed, manufactured, distributed or serviced by us. Any material product warranty obligations could have a material adverse effect on our financial condition, results of operations and/or cash flows.

 

Our operations depend on our production facilities throughout the world. These production facilities are subject to physical and other risks that could disrupt production.

 

Our production facilities could be damaged or disrupted by a natural disaster, labor strike, war, political unrest, terrorist activity or a pandemic. Although we have obtained property damage and business interruption insurance, a major catastrophe such as an earthquake or other natural disaster at any of our sites, or significant labor strikes, work stoppages, political unrest, war or terrorist activities in any of the areas where we conduct operations, could result in a prolonged interruption of our business. Any disruption resulting from these events could cause significant delays in shipments of products and the loss of sales and customers. We cannot assure you that we will have insurance to adequately compensate us for any of these events.

 

We have significant international operations and assets and are therefore subject to additional financial and regulatory risks.

 

We have operations and assets throughout the world. In addition, we sell our products and services in foreign countries and seek to increase our level of international business activity. Accordingly, we are subject to various risks, including: U.S.-imposed embargoes of sales to specific countries; foreign import controls (which may be arbitrarily imposed or enforced); price and currency controls; exchange rate fluctuations; dividend remittance restrictions; expropriation of assets; war, civil uprisings and riots; government instability; the necessity of obtaining governmental approval for new and continuing products and operations; legal systems of decrees, laws, taxes, regulations, interpretations and court decisions that are not always fully developed and that may be retroactively or arbitrarily applied; and difficulties in managing a global enterprise. We may also be subject to unanticipated income taxes, excise duties, import taxes, export taxes or other governmental assessments. Any of these events could result in a loss

of business or other unexpected costs that could reduce sales or profits and have a material adverse effect on our financial condition, results of operations and/or cash flows.

 

We are exposed to foreign currency risks that arise from normal business operations. These risks include transactions denominated in foreign currencies and the translation of certain non-functional currency balances of our subsidiaries. Our international operations also expose us to translation risk when the local currency financial statements are translated to U.S. Dollars, our parent company’s functional currency. As currency exchange rates fluctuate, translation of the statements of income of international businesses into U.S. Dollars will affect comparability of revenues and expenses between years.

 

Creditors may seek to recover from us if the businesses that we spun off are unable to meet their obligations in the future, including obligations to asbestos claimants.

 

On May 31, 2002, we completed the spin-off of our wholly owned subsidiary, EnPro. Prior to the spin-off, we contributed the capital stock of Coltec to EnPro. At the time of the spin-off, two subsidiaries of Coltec were defendants in a significant number of personal injury claims relating to alleged asbestos-containing products sold by those subsidiaries. It is possible that asbestos-related claims might be asserted against us on the theory that we have some responsibility for the asbestos-related liabilities of EnPro, Coltec or its subsidiaries, even though the activities that led to those claims occurred prior to our ownership of any of those subsidiaries. Also, it is possible that a claim might be asserted against us that Coltec’s dividend of its aerospace business to us prior to the spin-off was made at a time when Coltec was insolvent or caused Coltec to become insolvent. Such a claim could seek recovery from us on behalf of Coltec of the fair market value of the dividend.

 

A limited number of asbestos-related claims have been asserted against us as “successor” to Coltec or one of its subsidiaries. We believe that we have substantial legal defenses against these claims, as well as against any other claims that may be asserted against us on the theories described above. In addition, the agreement between EnPro and us that was used to effectuate the spin-off provides us with an indemnification from EnPro covering, among other things, these liabilities. The success of any such asbestos-related claims would likely require, as a practical matter, that Coltec’s subsidiaries were unable to satisfy their asbestos-related liabilities and that Coltec was found to be responsible for these liabilities and was unable to meet its financial obligations. We believe any such claims would be without merit and that Coltec was solvent both before and after the dividend of its aerospace business to us. If we are ultimately found to be responsible for the asbestos-related liabilities of Coltec’s subsidiaries, we believe it would not have a material adverse effect on our financial condition, but could have a material adverse effect on our results of operations and cash flows in a particular period. However, because of the uncertainty as to the number, timing and payments related to future asbestos-related claims, there can be no assurance that any such claims will not have a material adverse effect on our financial condition, results of operations and cash flows. If a claim related to the dividend of Coltec’s aerospace business were successful, it could have a material adverse impact on our financial condition, results of operations and/or cash flows.

 

 

Not applicable.

 

 

We operate manufacturing plants and service and other facilities throughout the world.

 

Information with respect to our significant facilities that are owned or leased is set forth below:

 

 

 

 

Our headquarters is in Charlotte, North Carolina. In May 2000, we leased approximately 110,000 square feet for an initial term of ten years, with two five-year options to 2020. The offices provide space for our corporate and segment headquarters.

 

We and our subsidiaries are lessees under a number of cancelable and non-cancelable leases for real properties, used primarily for administrative, maintenance, repair and overhaul of aircraft, aircraft wheels and brakes and evacuation systems and warehouse operations.

 

In the opinion of management, our principal properties, whether owned or leased, are suitable and adequate for the purposes for which they are used and are suitably maintained for such purposes. See Item 3, “Legal Proceedings-Environmental” for a description of proceedings under applicable environmental laws regarding some of our properties.

 

 

General

 

There are pending or threatened against us or our subsidiaries various claims, lawsuits and administrative proceedings, all arising from the ordinary course of business with respect to commercial, product liability, asbestos and environmental matters, which seek remedies or damages. We believe that any liability that may finally be determined with respect to commercial and non-asbestos product liability claims should not have a material effect on our

consolidated financial position, results of operations or cash flow. From time to time, we are also involved in legal proceedings as a plaintiff involving tax, contract, patent protection, environmental and other matters. Gain contingencies, if any, are recognized when they are realized. Legal costs are generally expensed when incurred.

 

Environmental

 

We are subject to various domestic and international environmental laws and regulations which may require that we investigate and remediate the effects of the release or disposal of materials at sites associated with past and present operations, including sites at which we have been identified as a potentially responsible party under the federal Superfund laws and comparable state laws. We are currently involved in the investigation and remediation of a number of sites under these laws.

 

Estimates of our environmental liabilities are based on currently available facts, present laws and regulations and current technology. These estimates take into consideration our prior experience in site investigation and remediation, the data concerning cleanup costs available from other companies and regulatory authorities and the professional judgment of our environmental specialists in consultation with outside environmental specialists, when necessary. Estimates of our environmental liabilities are further subject to uncertainties regarding the nature and extent of site contamination, the range of remediation alternatives available, evolving remediation standards, imprecise engineering evaluations and estimates of appropriate cleanup technology, methodology and cost, the extent of corrective actions that may be required and the number and financial condition of other potentially responsible parties, as well as the extent of their responsibility for the remediation.

 

Accordingly, as investigation and remediation of these sites proceed, it is likely that adjustments in our accruals will be necessary to reflect new information. The amounts of any such adjustments could have a material adverse effect on our results of operations in a given period, but the amounts, and the possible range of loss in excess of the amounts accrued, are not reasonably estimable. Based on currently available information, however, we do not believe that future environmental costs in excess of those accrued with respect to sites for which we have been identified as a potentially responsible party are likely to have a material adverse effect on our financial condition. There can be no assurance, however, that additional future developments, administrative actions or liabilities relating to environmental matters will not have a material adverse effect on our results of operations or cash flows in a given period.

 

Environmental liabilities are recorded when our liability is probable and the costs are reasonably estimable, which generally is not later than at completion of a feasibility study or when we have recommended a remedy or have committed to an appropriate plan of action. The liabilities are reviewed periodically and, as investigation and remediation proceed, adjustments are made as necessary. Liabilities for losses from environmental remediation obligations do not consider the effects of inflation and anticipated expenditures are not discounted to their present value. The liabilities are not reduced by possible recoveries from insurance carriers or other third parties, but do reflect anticipated allocations among potentially responsible parties at federal Superfund sites or similar state-managed sites and an assessment of the likelihood that such parties will fulfill their obligations at such sites.

 

Our Consolidated Balance Sheet included an accrued liability for environmental remediation obligations of $81 million and $88.5 million at December 31, 2005 and December 31, 2004, respectively. At December 31, 2005 and December 31, 2004, $18.3 million and $16.2 million, respectively, of the accrued liability for environmental remediation was included in current liabilities as Accrued Expenses. At December 31, 2005 and December 31, 2004, $31.4 million and $29.6 million, respectively, was associated with ongoing operations and $49.6 million and $58.9 million, respectively, was associated with businesses previously disposed of or discontinued.

The timing of expenditures depends on a number of factors that vary by site, including the nature and extent of contamination, the number of potentially responsible parties, the timing of regulatory approvals, the complexity of the investigation and remediation, and the standards for remediation. We expect that we will expend present accruals over many years and will complete remediation in less than 30 years at all sites for which we have been identified as a potentially responsible party. This period includes operation and monitoring costs that are generally incurred over 15 to 25 years.

 

Asbestos

 

We and a number of our subsidiaries have been named as defendants in various actions by plaintiffs alleging injury or death as a result of exposure to asbestos fibers in products, or which may have been present in our facilities. A number of these cases involve maritime claims, which have been and are expected to continue to be administratively dismissed by the court. These actions primarily relate to previously owned businesses. We believe that pending and reasonably anticipated future actions, net of anticipated insurance recoveries, are not likely to have a material adverse effect on our financial condition, results of operations or cash flows. There can be no assurance, however, that future legislative or other developments will not have a material effect on our results of operations in a given period.

 

We believe that we have substantial insurance coverage available to us related to any remaining claims. However, the primary layer of insurance coverage for most of these claims is provided by the Kemper Insurance Companies. Kemper has indicated that, due to capital constraints and downgrades from various rating agencies, it has ceased underwriting new business and now focuses on administering policy commitments from prior years. Kemper has also indicated that it is currently operating under a “run-off” plan approved by the Illinois Department of Insurance. We cannot predict the impact of Kemper’s financial position on the availability of the Kemper insurance.

 

In addition, a portion of our primary and excess layers of general liability insurance coverage for most of these claims was provided by insurance subsidiaries of London United Investments plc (KWELM). KWELM is insolvent and in the process of distributing its assets and dissolving. In September 2004, we entered into a settlement agreement with KWELM pursuant to which we agreed to give up our rights with respect to the KWELM insurance policies in exchange for $18.3 million, subject to increase under certain circumstances. The settlement represents a negotiated payment for our loss of insurance coverage, as we no longer have the KWELM insurance available for claims that would have qualified for coverage. The initial settlement amount of $18.3 million was paid to us during 2004, was recorded as a deferred settlement credit and will be used to offset asbestos and other toxic tort claims in future periods.

 

The KWELM insolvent fund managers made additional settlement distributions to us in 2005 totaling $11.3 million following completion of the insolvent scheme of arrangement process in the United Kingdom. The additional distribution was recorded as a deferred settlement credit and will be used to offset asbestos and other toxic tort claims in future periods. One final distribution may be made depending on the final valuation of KWELM.

 

Tax

 

We are continuously undergoing examination by the Internal Revenue Service (IRS), as well as various state and foreign jurisdictions. The IRS and other taxing authorities routinely challenge certain deductions and credits reported by us on our income tax returns. In accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (SFAS 109) and Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (SFAS 5) we establish reserves for tax contingencies that reflect our best estimate of the deductions and credits that we may be unable to sustain, or that we could be willing to concede

as part of a broader tax settlement. Differences between the reserves for tax contingencies and the amounts ultimately owed by us are recorded in the period they become known. Adjustments to our reserves could have a material effect on our financial statements. As of December 31, 2005, we had recorded tax contingency reserves of approximately $325.6 million.

 

In 2000, Coltec, our former subsidiary, made a $113.7 million payment to the IRS for an income tax assessment and the related accrued interest arising out of certain capital loss deductions and tax credits taken in 1996. On February 13, 2001, Coltec filed suit against the U.S. Government in the U.S. Court of Federal Claims seeking a refund of this payment. The trial portion of the case was completed in May 2004. On November 2, 2004, we were notified that the trial court ruled in favor of Coltec and ordered the U.S. Government to refund federal tax payments of $82.8 million to Coltec. This tax refund would also bear interest to the date of payment. As of December 31, 2005, the interest amount was approximately $52 million before tax, or approximately $33 million after tax. The U.S. Court of Federal Claims entered a final judgment in this case on February 15, 2005. During July 2005, the U.S. Government filed its brief related to its appeal of the decision with the U.S. Court of Appeals for the Federal Circuit. Coltec filed its brief related to the U.S. Government’s appeal on September 6, 2005. Oral arguments were heard by the U.S. Court of Appeals for the Federal Circuit on February 8, 2006. A decision is expected by the U.S. Court of Appeals for the Federal Circuit sometime in 2006. If the trial court’s decision is ultimately upheld, we will be entitled to this tax refund and related interest pursuant to an agreement with Coltec. If we receive these amounts, we expect to record income of approximately $149 million, after tax, based on interest through December 31, 2005, including the release of previously established reserves. If the IRS were to ultimately prevail in this case, Coltec will not owe any additional interest or taxes with respect to 1996. We may, however, be required by the IRS to pay up to $32.7 million plus accrued interest with respect to the same items claimed by Coltec in its tax returns for 1997 through 2000. The amount of the previously estimated tax liability if the IRS were to prevail for the 1997 through 2000 period remains fully reserved.

 

In 2000, the IRS issued a statutory notice of deficiency asserting that Rohr, Inc. (Rohr), our subsidiary, was liable for $85.3 million of additional income taxes for the fiscal years ended July 31, 1986 through 1989. In 2003, the IRS issued an additional statutory notice of deficiency asserting that Rohr was liable for $23 million of additional income taxes for the fiscal years ended July 31, 1990 through 1993. The proposed assessments relate primarily to the timing of certain tax deductions and tax credits. Rohr has filed petitions in the U.S. Tax Court opposing the proposed assessments. At the time of settlement or final determination by the court, there will be a net cash outlay by cost to us, due at least in part to the reversal of a timing item. We believe that our total net cash outlay is unlikely to exceed $100 million. We reserved the estimated liability associated with these cases. We are in advanced stages of discussion with the IRS to settle the Rohr case and to resolve the open issues in the tax years through 1999 as described below.

 

Our current IRS examination cycle began on September 29, 2005 and involves the taxable years ended December 31, 2000 through December 31, 2004. The prior examination cycle which began in March 2002 has reached an advanced stage of discussion with the IRS. We anticipate substantially all of the open issues for the consolidated income tax groups in the audit periods identified below to be resolved in 2006:

 

There are numerous tax issues that have been raised during the examinations by the IRS, including, but not limited to, transfer pricing, research and development credits, foreign tax credits, tax accounting for long-term contracts, tax accounting for inventory, tax accounting for stock options, depreciation, amortization and the proper timing for certain other deductions for income tax purposes. We have reached a tentative agreement with the IRS on a substantial number of the issues raised in the prior examination cycle and the U.S. Tax Court litigation involving Rohr described above. The final settlement of these issues is subject to a further review and approval process, the outcome of which cannot be predicted at this time. If we settle pursuant to these discussions, we would anticipate reversing some portion of previously established reserves, which could be material to our financial statements. We anticipate a final settlement in 2006.

 

Rohr has been under examination by the State of California for the tax years ended July 31, 1985, 1986 and 1987. The State of California has disallowed certain expenses incurred by one of Rohr’s subsidiaries in connection with the lease of certain tangible property. California’s Franchise Tax Board held that the deductions associated with the leased equipment were non-business deductions. The additional tax associated with the Franchise Tax Board’s position is approximately $4.5 million. The amount of accrued interest associated with the additional tax is approximately $19 million as of December 31, 2005. In addition, the State of California enacted an amnesty provision that imposes nondeductible penalty interest equal to 50 percent of the unpaid interest amounts relating to taxable years ended before 2003 for amounts not paid by March 31, 2005. The penalty interest is approximately $10 million as of December 31, 2005. The tax and interest amounts continue to be contested by Rohr. We believe that we are adequately reserved for this contingency. Rohr made a voluntary payment during the three months ended March 31, 2005 of approximately $3.9 million related to items that were not being contested, consisting of approximately $0.6 million related to tax and approximately $3.3 million related to interest on the tax. Rohr made an additional payment during the three months ended December 31, 2005 of approximately $4.5 million related to the contested tax amount pursuant to the State’s assessment notice dated October 20, 2005. No payment has been made for the $19 million of interest or $10 million of penalty interest. Under California law, Rohr may be required to pay the full amount of interest prior to filing any suit for refund. If required, Rohr expects to make this payment and file suit for a refund before the end of 2007.

 

 

Not applicable.

 

Executive Officers of the Registrant

 

Marshall O. Larsen, age 57, Chairman, President and Chief Executive Officer

 

Mr. Larsen joined the Company in 1977 as an Operations Analyst. In 1981, he became Director of Planning and Analysis and subsequently Director of Product Marketing. In 1986, he became Assistant to the President and later served as General Manager of several divisions of the Company’s aerospace business. He was elected a Vice President of the Company and named a Group Vice President of Goodrich Aerospace in 1994 and was elected an Executive Vice President of the Company and President and Chief Operating Officer of Goodrich Aerospace in 1995. He was elected President and Chief Operating Officer and a director of the Company in February 2002, Chief Executive Officer in April 2003 and Chairman in October 2003. Mr. Larsen is a director of Lowe’s Companies, Inc. He received a B.S. in engineering from the U.S. Military Academy and an M.S. in industrial management from the Krannert Graduate School of Management at Purdue University.

John J. Carmola, age 50, Vice President and Segment President, Airframe Systems

 

Mr. Carmola joined the Company in 1996 as President of the Landing Gear Division. He served in that position until 2000, when he was appointed President of the Engine Systems Division. Later in 2000, Mr. Carmola was elected a Vice President of the Company and Group President, Engine and Safety Systems. In 2002, he was elected Vice President and Group President, Electronic Systems. He was elected Vice President and Segment President, Engine Systems, in 2003 and Vice President and Segment President, Airframe Systems, in 2005. Prior to joining the Company, Mr. Carmola served in various management positions with General Electric Company. Mr. Carmola received a B.S. in mechanical and aerospace engineering from the University of Rochester and an M.B.A. in finance from Xavier University.

 

Cynthia M. Egnotovich, age 48, Vice President and Segment President, Engine Systems

 

Ms. Egnotovich joined the Company in 1986 and served in various positions with the Ice Protection Systems Division, including Controller from 1993 to 1996, Director of Operations from 1996 to 1998 and Vice President and General Manager from 1998 to 2000. Ms. Egnotovich was appointed as Vice President and General Manager of Commercial Wheels and Brakes in 2000. She was elected a Vice President of the Company and Group President, Engine and Safety Systems in 2002. In 2003, she was elected Vice President and Segment President, Electronic Systems. Ms. Egnotovich was elected Vice President and Segment President, Engine Systems in 2005. Ms. Egnotovich received a B.B.A. in accounting from Kent State University and a B.S. in biology from Immaculata College.

 

John J. Grisik, age 59, Vice President and Segment President, Electronic Systems

 

Mr. Grisik joined the Company in 1991 as General Manager of the De-Icing Systems Division. He served in that position until 1993, when he was appointed General Manager of the Landing Gear Division. In 1995, he was appointed Group Vice President of Safety Systems and served in that position until 1996 when he was appointed Group Vice President of Sensors and Integrated Systems. In 2000, Mr. Grisik was elected a Vice President of the Company and Group President, Landing Systems. He was elected Vice President and Segment President, Airframe Systems, in 2003 and Vice President and Segment President, Electronic Systems, in 2005. Prior to joining the Company, Mr. Grisik served in various management positions with General Electric Company and U.S. Steel Company. Mr. Grisik received a B.S., M.S. and D.S. in engineering from the University of Cincinnati and an M.S. in management from Stanford University.

 

Terrence G. Linnert, age 59, Executive Vice President, Administration and General Counsel

 

Mr. Linnert joined the Company in 1997 as Senior Vice President and General Counsel. In 1999, he was elected to the additional positions of Senior Vice President, Human Resources and Administration, and Secretary. He was elected Executive Vice President, Human Resources and Administration, General Counsel in 2002 and Executive Vice President, Administration and General Counsel in February 2005. Prior to joining Goodrich, Mr. Linnert was Senior Vice President of Corporate Administration, Chief Financial Officer and General Counsel of Centerior Energy Corporation. Mr. Linnert received a B.S. in electrical engineering from the University of Notre Dame and a J.D. from the Cleveland-Marshall School of Law at Cleveland State University.

 

Stephen R. Huggins, age 62, Senior Vice President, Strategy and Business Development

 

Mr. Huggins joined the Company in 1988 as Group Vice President, Specialty Products. He later served as Group Vice President, Engine and Fuel Systems from 1991 to 1995 and as Vice President, Business Development, Aerospace from 1995 to 1999. In 1999, he was elected Vice President, Strategic Planning and Chief Knowledge Officer. In 2000, Mr. Huggins was elected Senior Vice President, Strategic Resources and Information Technology. In 2003, Mr. Huggins was

elected Senior Vice President, Strategy and Business Development. Mr. Huggins received a B.S. in aerospace engineering from Virginia Polytechnic Institute.

 

Scott E. Kuechle, age 46, Senior Vice President and Chief Financial Officer

 

Mr. Kuechle joined the Company in 1983 as a Financial Analyst in the Company’s former Tire Division. He has held several subsequent management positions, including Manager of Planning and Analysis in the Tire Division, Manager of Analysis in Corporate Analysis and Control as well as Director of Planning and Control for the Company’s former Water Systems and Services Group. He was promoted to Director of Finance and Banking in 1994 and elected Vice President and Treasurer in 1998. Mr. Kuechle was elected Vice President and Controller in September 2004 and served in that position until his election as Senior Vice President and Chief Financial Officer in August 2005. Mr. Kuechle received a B.B.A. in economics from the University of Wisconsin — Eau Claire and an M.S.I.A. in finance from Carnegie-Mellon University.

 

Jerry S. Lee, age 64, Senior Vice President, Technology and Innovation

 

Mr. Lee joined the Company in 1979 as Manager of Engineering Science, Engineered Products Group. He later served as Director of R&D, Goodrich Aerospace from 1983 to 1988, Vice President, Technology from 1989 to 1998 and Vice President, Technology and Innovation from 1998 to 2000. In 2000, Mr. Lee was elected Senior Vice President, Technology and Innovation. Mr. Lee received a B.S. in mechanical engineering and Ph.D. in mechanical engineering from North Carolina State University.

 

Jennifer Pollino, age 41, Senior Vice President, Human Resources

 

Ms. Pollino joined the Company in 1992 as an Accounting Manager at Aircraft Evacuation Systems and since that time has served in a variety of positions, including Controller of Aircraft Evacuation Systems from 1995 to 1998, Vice President, Finance of the Safety Systems from 1999 to 2000, Vice President and General Manager of Aircraft Seating Products from 2000 to 2001, President and General Manager of Turbomachinery Products from 2001 to 2002 and President and General Manager of Aircraft Wheels and Brakes from 2002 to 2005. She was elected as Senior Vice President, Human Resources in February 2005. Prior to joining Goodrich, Ms. Pollino served as a Field Accounting Officer for the Resolution Trust Corporation from 1990 to 1992, as Controller of Lincoln Savings and Loan Association from 1987 to 1990 and as an Auditor for Peat Marwick Main & Co. from 1986 to 1987. Ms. Pollino received a B.B.A. in accounting from the University of Notre Dame.

 

Scott A. Cottrill, age 40, Vice President and Controller

 

Mr. Cottrill joined the Company in 1998 as Director — External Reporting. He later served as Director — Accounting and Financial Reporting from 1999 to 2002 and as Vice President, Internal Audit from 2002 to 2005. Mr. Cottrill was elected as Vice President and Controller effective October 2005. Prior to joining the Company, Mr. Cottrill served as a Senior Manager with PricewaterhouseCoopers LLP. Mr. Cottrill received a B.S. in accounting from The Pennsylvania State University and is a Certified Public Accountant and a Certified Internal Auditor.

 

PART II

 

 

Our common stock (symbol GR) is listed on the New York Stock Exchange. The following table sets forth on a per share basis, the high and low sale prices for our common stock for the periods indicated as reported on the New York Stock Exchange composite transactions reporting system, as well as the cash dividends declared on our common stock for these periods.

 

 

As of December 31, 2005, there were 9,294 holders of record of our common stock.

 

Our debt agreements contain various restrictive covenants that, among other things, place limitations on the payment of cash dividends and our ability to repurchase our capital stock. Under the most restrictive of these agreements, $531.2 million of income retained in the business and additional capital was free from such limitations at December 31, 2005.

 

The following table summarizes our purchases of our common stock for the quarter ended December 31, 2005:

 

ISSUER PURCHASES OF EQUITY SECURITIES

 

 

 

 

 

Selected Financial Data(a)

 

 

 

 

 

YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH OUR AUDITED CONSOLIDATED FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS DOCUMENT.

 

THIS MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTAINS FORWARD-LOOKING STATEMENTS. SEE “FORWARD-LOOKING INFORMATION IS SUBJECT TO RISK AND UNCERTAINTY” FOR A DISCUSSION OF CERTAIN OF THE UNCERTAINTIES, RISKS AND ASSUMPTIONS ASSOCIATED WITH THESE STATEMENTS.

 

OUR FORMER JCAIR INC. (TEST SYSTEMS), AVIONICS, AND PASSENGER RESTRAINT SYSTEMS (PRS) BUSINESSES HAVE BEEN ACCOUNTED FOR AS DISCONTINUED OPERATIONS. UNLESS OTHERWISE NOTED HEREIN, DISCLOSURES PERTAIN ONLY TO OUR CONTINUING OPERATIONS.

 

OVERVIEW

 

We are one of the largest worldwide suppliers of aerospace components, systems and services to the commercial and general aviation airplane markets. We are also a leading supplier of systems and products to the global defense and space markets. Our business is conducted globally with manufacturing, service and sales undertaken in various locations throughout the world. Our products and services are principally sold to customers in North America, Europe and Asia.

 

Key Market Channels for Products and Services, Growth Drivers and Industry and our Highlights

 

We participate in three key market channels: commercial and general aviation airplane original equipment (OE); commercial and general aviation airplane aftermarket; and defense and space. We expect industry-wide growth in each of these market channels for the next several years, and we expect to participate in this growth.

 

Commercial and General Aviation Airplane OE

 

Commercial and general aviation airplane OE includes sales to Airbus and Boeing, as well as to regional, business and small airplane manufacturers.

 

The key growth drivers in this market channel include the number of orders for new airplanes, which will be delivered to the manufacturers’ customers over a period of several years, OE manufacturer production and delivery rates and introductions of new airplane models such as the Boeing 787 and the Airbus A380 and A350 airplanes.

 

During 2005, orders for Airbus and Boeing commercial airplanes were at record levels, with many of the orders for deliveries beyond 2008. While orders for regional airplanes were not nearly as strong in 2005 as those for the larger airplanes, the unfilled backlog of orders remained substantial. Orders for general aviation airplanes, including business jets, continued to be strong.

 

We have significant sales content on most of the airplanes manufactured in this market channel. During 2005, we benefited from increased production rates and deliveries of Airbus and Boeing airplanes and from our substantial content on many of the more popular regional and general aviation airplanes. We were also awarded several new contracts for our products on airplanes currently in a pre-production stage, including the Airbus A350 and the Boeing 787, which should provide substantial future sales growth for us.

Commercial and General Aviation Airplane Aftermarket

 

The commercial and general aviation airplane aftermarket channel includes sales of products and services for existing commercial and general aviation airplanes, primarily to airlines and freight forwarders around the world.

 

The key growth drivers in this channel include worldwide passenger capacity growth measured by Available Seat Miles (ASM) and the size of the airplane fleet. Other important factors affecting growth in this market channel are the age of the airplanes in the fleet and Gross Domestic Product (GDP) trends in countries and regions around the world.

 

We estimate that capacity in the global airline system, as measured by ASMs, grew at about 5 to 6 percent during 2005. We expect ASMs to continue to grow at about 5 percent annually in 2006 through 2010. It is expected that the global airplane fleet will continue to grow in 2006 and beyond, as the OE manufacturers deliver more airplanes than are retired.

 

We have significant product content on most of the airplane models that are currently in service. Sales of our products and services in this market channel experienced strong growth in 2005, and we expect growth to continue in 2006 and beyond. We have benefited from good growth in ASMs, especially in Asia, as well as the aging of the worldwide fleet of airplanes.

 

Defense and Space

 

Worldwide defense and space sales include sales to prime contractors such as Boeing, Northrop Grumman, Lockheed Martin, the U.S. Government and foreign companies and governments.

 

The key growth drivers in this channel include the level of defense spending by the U.S. and foreign governments, the number of new platform starts, the level of military flight operations and the level of upgrade, overhaul and maintenance activities associated with existing platforms.

 

During 2005, the industry continued to experience strong growth in support of new platforms under development, such as the F-22 Raptor and the F-35 JSF, as well as significant growth in requirements for upgrade and overhaul and maintenance activities on many existing platforms, such as the C-17 Globemaster-III, F-18 Super Hornet and several helicopter programs. Additionally, the industry experienced rapid growth for programs associated with homeland defense and surveillance and reconnaissance missions.

 

The market for our defense and space products is global, and is not dependent on any single program, platform or customer. While we anticipate fewer new platform starts over the next several years, which are expected to negatively affect defense and space OE sales, we anticipate that upgrades on existing platforms will be necessary, and will provide long-term growth in this market channel. Additionally, we are participating in, and developing new products for, the rapidly expanding homeland defense and surveillance and reconnaissance markets, which should further strengthen our position in this market channel.

 

Long-term Sustainable Growth in Our Key Market Channels

 

We have received awards for key products on several new and emerging programs, including the Airbus A380 and A350, the Boeing 787, the Embraer 190, the Dassault Falcon 7X and the Lockheed Martin F-35 JSF and F-22 Raptor, which should fuel consistent, long-term sustainable growth. With these awards, we have improved our market presence and increased the expected sales dollar content per aircraft in this segment of the market. As the industry moves beyond the current upcycle, we should be well positioned to continue to grow our commercial aftermarket and defense and space sales due to:

 

 

 

2005 Sales Content by Market Channel

 

During the year ended December 31, 2005, 94 percent of our sales were from our three primary market channels (described above). Following is a summary of the percentage of sales by market channel:

 

 

2005 Summary Performance

 

Our 2005 sales and income performance was driven primarily by rapid sales growth in all of our market channel:

 

 

Net income during the years ended December 31, 2005 and 2004 were also impacted by the following:

 

 

 

Cash flow from operations for the year ended December 31, 2005 was $345 million as compared to $410 million for the year 2004. Full year 2005 cash flow from operations included contributions of $145 million to our worldwide pension plans, compared to contributions of $129 million in 2004. Cash flow from operations in 2004 included $99 million from the partial settlement with Northrop Grumman related to the acquisition of aeronautical systems, which did not recur during 2005.

 

Capital expenditures were $216 million for the year 2005, as compared to $152 million for the year 2004.

 

2006 Outlook

 

We expect the following results for the year ending December 31, 2006:

 

 

Our 2006 outlook is based on the following market assumptions:

 

 

 

The 2006 outlook includes significant increases in costs associated with pension expense, foreign exchange and stock-based compensation. The pension expense assumptions reflect the January 1, 2006 discount rates, actuarial assumptions and asset values. These items are more fully discussed below:

 

 

The current sales, net income and cash flow from operations outlook for 2006 does not include an estimate for the impact of resolution of the Rohr and Coltec tax litigation, additional acquisitions or divestitures, an estimate for the impact of resolution of potential remaining A380 contractual disputes with Northrop Grumman relating to the Airbus A380 program, or planned changes to our U.S. defined benefit and defined contribution pension plans.

 

RESULTS OF OPERATIONS

 

Changes in Accounting Methods

 

Effective January 1, 2004, we changed two aspects of the application of contract accounting to preferable methods for our aerostructures business, which is included in the Engine Systems segment. The first is a change to the cumulative catch-up method from the reallocation method for accounting for changes in contract estimates of revenue and costs. The change was effected by adjusting contract profit rates from the balance to complete gross profit rate to the estimated gross profit rate at completion of the contract. The second change related to pre-certification costs. Under the old policy, pre-certification costs exceeding the level anticipated in our original investment model used to negotiate contractual terms were expensed when determined regardless of overall contract profitability. Under the new policy, pre-certification costs, including those in excess of original estimated levels, are included in total contract costs used to evaluate overall contract profitability. The impact of the changes in accounting method

was to record a $16.2 million after tax gain ($23.3 million before tax gain) as a Cumulative Effect of Change in Accounting. Had these methods of accounting been in effect during 2003, the segment operating income as previously reported for the Engine Systems segment, as well as our total operating income for the year ended December 31, 2003, would have been $21.4 million lower.

 

Also effective January 1, 2004, we changed our method of accounting for stock-based compensation. We previously accounted for stock-based compensation under APB No. 25. We adopted the provisions of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123) and Financial Accounting Standard No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of FASB Statement No. 123”. As such, we expense stock options and the discount and option value of shares issued under our employee stock purchase plan. The expense is recognized over the period the stock options and shares are earned and vest. The adoption of FASB No. 123 reduced before tax income by $12.1 million ($7.7 million after tax, $0.06 per diluted share) for the year ended December 31, 2004. During the year ended December 31, 2005, before tax income was reduced by $10.4 million ($6.8 million before tax, $0.05 per diluted share).

 

The U.S. Medicare Prescription Drug Improvement and Modernization Act of 2003 (the Medicare Act) was signed into law on December 8, 2003. Effective with the second quarter 2004, we adopted retroactively to January 1, 2004, the Financial Accounting Standards Board Staff Position No. FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003”. The effect of the Medicare Act was measured as of January 1, 2004 and is reflected in our Consolidated Financial Statements. The effect of the Medicare Act was a $34 million reduction of the accumulated postretirement benefit obligation for our retiree benefit plans as well as a reduction in the net periodic postretirement benefit cost. The effect of the reduction in net periodic postretirement benefit cost was an increase to before tax income from continuing operations of $5 million ($3.2 million after tax) for the year ended December 31, 2004.

 

Partial Settlement with Northrop Grumman

 

During the fourth quarter 2004, we entered into a $99 million partial settlement agreement with Northrop Grumman, as successor to TRW, relating to our acquisition of TRW’s aeronautical systems businesses in October 2002. The partial settlement agreement primarily relates to customer warranty and other contract claims for products that were designed, manufactured or sold by TRW prior to our purchase of aeronautical systems. Under the terms of the settlement, we have assumed certain liabilities associated with future customer warranty and other contract claims for these products. The settlement excluded amounts associated with any claims that we may have against Northrop Grumman relating to the Airbus 380 actuation systems development program and certain other liabilities retained by TRW under the acquisition agreement. As a result of the partial settlement in 2004, we recorded a liability for the estimated undiscounted future liabilities of $71.7 million that we assumed. We recorded a charge of $23.4 million to Cost of Sales representing the amount by which our estimated undiscounted future liabilities plus our receivable from Northrop Grumman for these matters exceeded the settlement amount. The charge is reflected in the applicable segments’ operating income.

Year Ended December 31, 2005 Compared with Year Ended December 31, 2004

 

 

Changes in sales and segment operating income are discussed within the “Business Segment Performance” section below.

 

Corporate general and administrative costs of $88.4 million for the year ended December 31, 2005 decreased $4.6 million, or 4.9 percent, from $93 million for the year ended December 31, 2004 primarily due to lower tax litigation costs and lower information technology costs, partially offset by higher incentive compensation costs. Corporate general and administrative costs as a percentage of sales were 1.6 percent in the year ended December 31, 2005 and 2 percent in the year ended December 31, 2004.

 

Net interest expense of $125.8 million in the year ended December 31, 2005 decreased $14 million, or 10 percent from $139.8 million in the year ended December 31, 2004, primarily due to lower debt levels in 2005.

 

Other Income (Expense) — Net decreased by $16.3 million, or 26.9 percent, to expense of $44.4 million in the year ended December 31, 2005 from expense of $60.7 million in the year ended December 31, 2004. The decrease in expense resulted primarily from the absence in 2005 of a $7 million impairment of a note receivable that was recorded during 2004 and lower expenses related to divested operations of $10.3 million. Premiums and associated costs related to the early retirement of debt totaled $11.6 million during the year ended December 31, 2005 and $15.4 million during the year ended December 31, 2004.

 

Our effective tax rate from continuing operations was 32.9 percent during the year ended December 31, 2005 and 21.6 percent during the year ended December 31, 2004. The increase in our effective tax rate resulted from U.S. income tax associated with dividends from certain foreign subsidiaries, growth in before tax book income relative to our significant permanent items, the phase-in of the American Jobs Creation Act, which replaces certain export sales deductions with a deduction for income from qualified domestic production activities, and the absence of favorable state and foreign tax settlements, offset in part by additional reserves for certain income tax issues.

 

Income from discontinued operations, after tax, was $19.8 million during the year ended December 31, 2005 primarily included the $13.2 million gain, from the sale of the Test Systems, which was sold during the second quarter of 2005. Income from discontinued operations for Test Systems included net income of $0.9 million in the year ended December 31, 2005 and net income of $1.7 million in the year ended December 31, 2004. Income from discontinued

operations also included a $7.5 million gain recognized as a result of our settlement with several insurers relating to the recovery of past costs to remediate environmental issues at a former chemical plant.

 

As noted previously in the “Changes in Accounting Methods” section, effective January 1, 2004, we changed two aspects of the application of contract accounting for our aerostructures business which resulted in a $16.2 million after tax gain ($23.3 million before tax gain) that was recorded as a Cumulative Effect of Change in Accounting in the first quarter 2004.

 

Year Ended December 31, 2004 Compared with Year Ended December 31, 2003

 

 

Changes in sales and segment operating income are discussed within the “Business Segment Performance” section below.

 

Corporate general and administrative costs of $93 million for the year ended December 31, 2004 increased $21.6 million, or 30.3 percent, from $71.4 million for the year ended December 31, 2003 primarily due to higher incentive compensation costs including expensing of stock-based compensation, higher tax litigation expenses and expenses to comply with the Sarbanes-Oxley Act of 2002. Corporate general and administrative costs as a percentage of sales were 2 percent in the year ended December 31, 2004 and 1.6 percent in the year ended December 31, 2003.

 

Net interest expense decreased $9.7 million, or 6.5 percent, primarily due to a lower debt level in 2004 and the favorable effect of interest rate swaps entered into in 2003. This was offset in part by lower interest income due to the sale of the Noveon PIK Notes in the first quarter of 2003.

 

Other Income (Expense) — Net increased by $34.4 million, or 130.8 percent, to expense of $60.7 million in the year ended December 31, 2004 from expense of $26.3 million in the year ended December 31, 2003. The increase in expense resulted from $15.4 million for premiums and associated costs related to the early retirement of debt, a $7 million impairment of a note receivable, the absence in the year ended December 31, 2004 of the $6.9 million gain on the sale of the Noveon PIK Notes, which was recognized in the first quarter 2003, $7.9 million in costs associated with businesses previously sold, including settlement of a lawsuit and higher life insurance expense, $2.8 million of lower income from affiliated companies and $1.6 million of higher minority interest expense offset in part by a $1.5 million gain on the sale of a product line. Included in 2003 was the write-off of our equity investment in Cordiem LLC of $11.7 million.

Our effective tax rate from continuing operations was 21.6 percent during the year ended December 31, 2004 and 32.8 percent during the year ended December 31, 2003. The lower rate in the year ended December 31, 2004 as compared to the year ended December 31, 2003 reflected favorable state and foreign tax settlements and adjustments related to state income taxes and to the finalization of our 2003 federal tax return, offset in part by additional reserves for certain income tax issues.

 

Income from discontinued operations, after tax, was $62.6 million during the year ended December 31, 2003 primarily representing the $63 million gain on the sale of our Avionics business, which was sold during the first quarter of 2003. Income from discontinued operations for our Test Systems, Avionics and PRS businesses included a net loss of $0.4 million in the year ended December 31, 2003. Income from discontinued operations for Test Systems included net income of $1.7 million for the year ended December 31, 2004. The sale of our Test Systems business was completed in the second quarter of 2005 and our PRS business ceased operations in the first quarter of 2003. Refer to Note 25 “Discontinued Operations” of the Consolidated Financial Statements.

 

As noted previously in the “Changes in Accounting Methods” section, effective January 1, 2004, we changed two aspects of the application of contract accounting for our aerostructures business which resulted in a $16.2 million after tax gain ($23.3 million before tax gain) that was recorded as a Cumulative Effect of Change in Accounting in the first quarter 2004.

 

The Cumulative Effect of Change in Accounting for the year ended December 31, 2003 of a loss of $0.5 million, after tax, represented the adoption of Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations”. We established a liability for contractual obligations for the retirement of long-lived assets.

 

BUSINESS SEGMENT PERFORMANCE

 

Our operations are reported as three business segments: Airframe Systems, Engine Systems and Electronic Systems. An analysis of Net Customer Sales and Operating Income by business segment follows.

 

In the following tables, segment operating income is total segment revenue reduced by operating expenses directly identifiable with that business segment.

 

Year Ended December 31, 2005 Compared with the Year Ended December 31, 2004

 

Airframe Systems:  Airframe Systems segment sales of $1,854.2 million for the year ended December 31, 2005 increased $224.5 million, or 13.8 percent, from $1,629.7 million for the year ended December 31, 2004. The increase was primarily due to:

 

 

The increases in sales volume were partially offset by a decrease in regional and general aviation aftermarket sales volume in our actuation systems business.

 

Airframe Systems segment operating income decreased $14.1 million, or 15.6 percent, from $90.1 million for the year ended December 31, 2004 to $76 million for the year ended December 31, 2005. The increased volume from sales described above was more than offset by the following:

 

 

 

Partially offsetting the higher operating costs was the impact of:

 

 

Engine Systems:  Engine Systems segment sales of $2,237.6 million in the year ended December 31, 2005 increased $298 million, or 15.4 percent, from $1,939.6 million in the year ended December 31, 2004. The increase was due to the following:

 

 

 

Engine Systems segment operating income increased $134.9 million, or 50.9 percent, from $264.9 million in the year ended December 31, 2004 to $399.8 million in the year ended December 31, 2005. Segment operating income was higher due to:

 

 

The increase in Engine Systems segment operating income was partially offset by:

 

 

Electronic Systems:  Electronic Systems segment sales of $1,304.7 million in the year ended December 31, 2005 increased $173.6 million, or 15.3 percent, from $1,131.1 million in the year ended December 31, 2004. The increase was primarily due to:

 

 

Electronic Systems segment operating income increased $10.7 million, or 7.9 percent, from $135.2 million in the year ended December 31, 2004 to $145.9 million in the year ended December 31, 2005. Segment operating income was higher due to:

 

 

The increase in segment operating income was partially offset by:

 

 

Future Restructuring and Consolidation Costs for Programs Announced and Initiated

 

We expect to incur additional expenses of approximately $11 million for restructuring programs announced and initiated prior to December 31, 2005. We expect to incur most of these restructuring charges through December 31, 2007.

 

During 2005, we announced and initiated a restructuring program to downsize a German facility in our Electronic Systems segment with partial transfers of operations to an existing facility in Florida and to a new facility in India. The aim of this project is to reduce operating costs and foreign exchange exposure. The total restructuring cost is expected to be approximately $15 million, of which approximately $11 million relates to costs to be incurred in 2006 and 2007.

 

Year Ended December 31, 2004 Compared with the Year Ended December 31, 2003

 

 

Airframe Systems:  Airframe Systems segment sales of $1,629.7 million in the year ended December 31, 2004 increased $65.9 million, or 4.2 percent, from $1,563.8 million in the year ended December 31, 2003. The increase was due to:

 

 

Partially offsetting the higher sales were decreased sales volumes in military aircraft wheels and brakes.

Airframe Systems segment operating income increased $11 million, or 13.9 percent, from $79.1 million in the year ended December 31, 2003 to $90.1 million in the year ended December 31, 2004. The increase in operating income was primarily due to the following:

 

 

Partially offsetting the increase in segment operating income were the following:

 

 

Engine Systems:  Engine Systems segment sales in the year ended December 31, 2004 of $1,939.6 million increased $224.7 million, or 13.1 percent, from $1,714.9 million in the year ended December 31, 2003. The increase was due to the following:

 

 

The increase was partially offset by lower U.S. military turbomachinery repair sales.

 

Engine Systems segment operating income increased $167.6 million, or 172.3 percent, from $97.3 million in the year ended December 31, 2003 to $264.9 million in the year ended December 31, 2004. Segment operating income was higher due to:

 

 

The increase in Engine Systems segment operating income was partially offset by the following:

 

 

Electronic Systems:  Electronic Systems segment sales of $1,131.1 million in the year ended December 31, 2004 increased $43.4 million, or 4 percent, from $1,087.7 million in the year ended December 31, 2003. The increase was primarily due to:

 

 

The increase in Electronic Systems segment sales was partially offset by the following:

 

 

Electronic Systems segment operating income decreased $4.4 million, or 3.2 percent, from $139.6 million in the year ended December 31, 2003 to $135.2 million in the year ended December 31, 2004. Segment operating income was unfavorably affected by:

 

 

The decrease in operating income was partially offset by lower restructuring costs. Restructuring costs for the year ended December 31, 2004 were $7.7 million, compared to $8.8 million for the year ended December 31, 2003.

 

FOREIGN OPERATIONS

 

We are engaged in business in foreign markets. Our foreign manufacturing and service facilities are located in Australia, Canada, China, England, France, Germany, India, Indonesia, Ireland, Japan, Mexico, Poland, Scotland, Spain and Singapore. We market our products and services

through sales subsidiaries and distributors in a number of foreign countries. We also have joint venture agreements with various foreign companies.

 

Currency fluctuations, tariffs and similar import limitations, price controls and labor regulations can affect our foreign operations, including foreign affiliates. Other potential limitations on our foreign operations include expropriation, nationalization, restrictions on foreign investments or their transfers and additional political and economic risks. In addition, the transfer of funds from foreign operations could be impaired by the unavailability of dollar exchange or other restrictive regulations that foreign governments could enact.

 

Sales to non-U.S. customers were $2,501.7 million or 46 percent of total sales, $2,270.1 million or 48 percent of total sales and $1,857.2 million or 43 percent of total sales for the years ended December 31, 2005, 2004 and 2003, respectively.

 

LIQUIDITY AND CAPITAL RESOURCES

 

We currently expect to fund expenditures for capital requirements, including the implementation of a common enterprise resource planning (ERP) system, as well as liquidity needs from a combination of cash, internally generated funds and financing arrangements. We believe that our internal liquidity, together with access to external capital resources, will be sufficient to satisfy existing commitments and plans and also provide adequate financial flexibility.

 

Cash

 

At December 31, 2005, we had cash and marketable securities of $251.3 million, as compared to $297.9 million at December 31, 2004.

 

Credit Facilities

 

In May 2005, we replaced our $500 million committed global syndicated revolving credit facility expiring in August 2006 with a new $500 million committed global syndicated revolving credit facility that expires in May 2010. The new facility has similar terms and is with substantially the same group of global banks as the previous facility. This facility permits borrowing, including letters of credit, up to a maximum of $500 million. At December 31, 2005, there were $34.9 million in borrowings (classified as Long-Term Debt) and $19.6 million in letters of credit outstanding under this facility. At December 31, 2004, there were no borrowings and $26.2 million in letters of credit outstanding under the previous facility.

 

The level of unused borrowing capacity under our committed syndicated revolving credit facility varies from time to time depending in part upon our compliance with financial and other covenants set forth in the related agreement, including the consolidated net worth requirement and maximum leverage ratio. We are currently in compliance with all such covenants. As of December 31, 2005, we had borrowing capacity under this facility of $445.5 million, after reductions for borrowings and letters of credit outstanding.

 

At December 31, 2005, we maintained $75 million of uncommitted domestic money market facilities and $111.5 million of uncommitted and committed foreign working capital facilities with various banks to meet short-term borrowing requirements. As of December 31, 2005 there was $22.4 million outstanding under these facilities. At December 31, 2004, there were no borrowings under these facilities. These credit facilities are provided by a small number of commercial banks that also provide us with committed credit through the syndicated revolving credit facility and with various cash management, trust and other services.

 

Our credit facilities do not contain any credit rating downgrade triggers that would accelerate the maturity of our indebtedness. However, a ratings downgrade would result in an increase in the interest rate and fees payable under our committed syndicated revolving credit facility. Such

a downgrade also could adversely affect our ability to renew existing or obtain access to new credit facilities in the future and could increase the cost of such new facilities.

 

QUIPS

 

On March 2, 2004, we completed the redemption of all of the $63.5 million in outstanding 8.30% Cumulative Quarterly Income Preferred Securities, Series A (QUIPS) issued by BFGoodrich Capital, a Delaware business trust, all of the common equity of which was owned by us. The QUIPS were supported by our 8.30% Junior Subordinated Debentures, Series A (QUIPS Debentures), which were also redeemed on March 2, 2004.

 

Long-Term Financing

 

At December 31, 2005, we had long-term debt and capital lease obligations, including current maturities, of $1,743.8 million with maturities ranging from 2006 to 2046. Long-term debt includes $34.9 million borrowed under the committed revolving credit facility to facilitate our implementation of the cash repatriation provisions of the American Jobs Creation Act. The earliest maturity of a material long-term debt obligation is April 2008. We also maintain a shelf registration statement that allows us to issue up to $1.4 billion of debt securities, series preferred stock, common stock, stock purchase contracts and stock purchase units.

 

On April 26, 2005, we redeemed $100 million in aggregate principal amount of our 6.45 percent notes due in 2007. We recorded $6.4 million of debt premiums and associated costs in Other Income (Expense) — Net. On March 29, 2005, we entered into a $100 million reverse treasury lock to offset changes in the redemption price of the 6.45 percent notes due to movements in treasury rates prior to the redemption date. The reverse treasury lock matured on April 21, 2005 and we received $0.7 million in cash, which was recorded as a gain in Other Income (Expense) — Net. On April 4, 2005, we terminated $17.9 million of a $100 million fixed-to-floating interest rate swap on our 6.45 percent notes due in 2007. We paid $0.3 million in cash to terminate this portion of the interest rate swap and the amount was recorded as an expense in Other Income (Expense) — Net. This portion of the interest rate swap was terminated so that the then outstanding notional amount of the fixed-to-floating interest rate swap would match the outstanding principal amount, subsequent to the redemption of the 6.45 percent notes due in 2007.

 

On August 30, 2005, we redeemed all remaining outstanding 6.45 percent notes due in 2007 in the aggregate principal amount of $82.1 million. We recorded $3.9 million of debt premiums and associated costs in Other Income (Expense) — Net. On August 25, 2005, we terminated the remaining $82.1 million fixed-to-floating interest rate swap on the 6.45 percent notes due in 2007 that were redeemed. We paid $1.7 million in cash to terminate the interest rate swap and the amount was recorded as an expense in Other Income (Expense) — Net.

 

Off-Balance Sheet Arrangements

 

We utilize several forms of off-balance sheet financing arrangements. At December 31, 2005, these arrangements included:

 

Lease Agreements

 

We finance some of our office and manufacturing facilities and machinery and equipment, including corporate aircraft, under committed lease arrangements provided by financial institutions. Some of these arrangements allow us to claim a deduction for the tax depreciation on the assets, rather than the lessor, and allow us to lease aircraft having a maximum unamortized value of $55 million at December 31, 2005. At December 31, 2005, $19.5 million of future minimum lease payments were outstanding under these arrangements. The other arrangements are standard operating leases. Future minimum lease payments under the standard operating leases approximated $142.2 million at December 31, 2005.

 

Additionally, at December 31, 2005, we had guarantees of residual values of lease obligations of $24.8 million. The residual values relate to corporate aircraft which we are obligated to either purchase at the end of the lease term or remarket.

 

Under some of these operating lease agreements we receive rent holidays, which represent periods of free or reduced rent. Rent holidays are recorded as a liability and recognized on a straight-line basis over the lease term. In addition, we may receive incentives or allowances from the lessor as part of the lease agreement. We recognize these payments as a liability and amortize them as reductions to lease expense over the lease term. We capitalize leasehold improvements and amortize them over the shorter of the lease term or the asset’s useful life.

 

In December 2005, we terminated a production equipment lease that was maturing in January 2006 and purchased the leased assets for $26.2 million.

 

Sale of Receivables

 

At December 31, 2005, we had in place a variable rate trade receivables securitization program pursuant to which we could sell receivables up to a maximum of $140 million. Accounts receivable sold under this program were $97.1 million at December 31, 2005. Continued availability of the securitization program is conditioned upon compliance with covenants, related primarily to operation of the securitization, set forth in the related agreements. We are currently in compliance with all such covenants. The securitization does not contain any credit rating downgrade triggers pursuant to which the program could be terminated.

 

Cash Flow Hedges

 

We have subsidiaries that conduct a substantial portion of their business in Euros, Great Britain Pounds Sterling, Canadian Dollars and Polish Zlotys, but have significant sales contracts that are denominated in U.S. Dollars. Approximately 10 percent of our revenues and approximately 25 percent of our costs are denominated in currencies other than the U.S. Dollar. Over 95 percent of these net costs are in Euros, Great Britain Pounds Sterling and Canadian Dollars. Periodically, we enter into forward contracts to exchange U.S. Dollars for Euros, Great Britain Pounds Sterling, Canadian Dollars and Polish Zlotys to hedge a portion of our exposure from U.S. Dollar sales.

 

The forward contracts described above are used to mitigate the potential volatility of earnings and cash flow arising from changes in currency exchange rates that impact our U.S. Dollar sales for certain foreign operations. The forward contracts are being accounted for as cash flow hedges. The forward contracts are recorded on our Consolidated Balance Sheet at fair value with the net change in fair value reflected in Accumulated Other Comprehensive Income/(Loss), net of deferred taxes. The notional value of the forward contracts at December 31, 2005 was $1,148.4 million. The fair value of the forward contracts at December 31, 2005, was a net asset of $8.7 million, including:

 

 

The fair value of our forward contracts of $9.1 million (before deferred taxes of $3.2 million) at December 31, 2005, including $0.4 million of gains on previously matured hedges of intercompany sales, is recorded in Accumulated Other Comprehensive Income/(Loss) and will be reflected in income as the individual contracts mature which will offset the earnings effect of the hedged items. As of December 31, 2005, the portion of the $9.1 million fair value that would be reclassified into earnings as an increase in sales to offset the effect of the hedged item in the next 12 months is a net gain of $6.5 million.

 

In March 2005, we called for the redemption of $100 million in aggregate principal amount of our 6.45 percent notes due in 2007 and entered into a $100 million reverse treasury lock to offset changes in the redemption price to movements in treasury rates prior to the redemption date. In accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133), at March 31, 2005, the reverse treasury lock was accounted for as a cash flow hedge and was recorded in our Consolidated Balance Sheet at fair value with the offset reflected in Accumulated Other Comprehensive Income/(Loss), net of deferred taxes. The reverse treasury lock matured on April 21, 2005 and we recorded a $0.7 million gain in Other Income (Expense) — Net.

 

Fair Value Hedges

 

In July 2003, we entered into a $100 million fixed-to-floating interest rate swap on the 6.45 percent notes due in 2007. In April 2005, we terminated $17.9 million of this interest rate swap so that the outstanding notional amount of the swap would match the then outstanding principal amount of the 6.45 percent notes due in 2007. We paid $0.3 million in cash to terminate this portion of the swap and recorded the amount as an expense in Other Income (Expense) — Net. In August 2005, we terminated the remaining $82.1 million of the interest rate swap in connection with the redemption of all remaining outstanding 6.45 percent notes due in 2007. We paid $1.7 million in cash to terminate the swap and recorded the amount as an expense in Other Income (Expense) — Net.

 

In October 2003, we entered into two $50 million fixed-to-floating interest rate swaps. One $50 million swap is on our 7.5 percent notes due in 2008 and the other $50 million swap is on our 6.45 percent notes due in 2008. In December 2003, we entered into another $50 million fixed-to-floating interest rate swap on our 7.5 percent notes due in 2008.

 

The purpose of entering into these swaps was to increase our exposure to variable interest rates. The settlement and maturity dates on each swap are the same as those on the referenced notes. In accordance with SFAS 133, the interest rate swaps are being accounted for as fair value hedges and the carrying value of the notes has been adjusted to reflect the fair values of the interest rate swaps. The fair value of the interest rate swaps was a liability/(loss) of $4.4 million at December 31, 2005.

 

Other Forward Contracts

 

As a supplement to our foreign exchange cash flow hedging program, in January 2004 we began to enter into forward contracts to manage our foreign currency risk related to the translation of monetary assets and liabilities denominated in currencies other than the relevant functional currency. These forward contracts mature monthly and the notional amounts are adjusted periodically to reflect changes in net monetary asset balances. The gains or losses on these forward contracts are being recorded in Cost of Sales in order to mitigate the earnings impact of the translation of net monetary assets. Under this program, as of December 31, 2005, we had forward contracts with a notional value of $92.4 million to buy Great Britain Pounds

Sterling, forward contracts with a notional value of $20.1 million to buy Euros and forward contracts with a notional value of $44.8 million to sell Canadian Dollars.

 

Contractual Obligations and Other Commercial Commitments

 

The following charts reflect our contractual obligations and commercial commitments as of December 31, 2005. Commercial commitments include lines of credit, guarantees and other potential cash outflows resulting from a contingent event that requires performance by us pursuant to a funding commitment.

 

 

 

 

The table excludes our pension and other postretirement benefits obligations. We made pension contributions of $144.7 million and $128.6 million worldwide in the years ended December 31, 2005 and 2004, respectively. These contributions include both voluntary and required employer contributions, as well as pension benefits paid directly by us. Of these amounts, $130 million and $116 million were contributed voluntarily to the qualified U.S. pension plan in the years ended December 31, 2005 and 2004, respectively. We expect to make pension contributions of $100 million to $125 million to our worldwide pension plans during 2006. Our postretirement benefits other than pensions are not required to be funded in advance, so benefit payments, including medical costs and life insurance, are paid as they are incurred. We made postretirement benefit payments other than pension of $36 million and $38 million in the years ended December 31, 2005 and 2004, respectively. We expect to pay $36 million during 2006. See Note 16 “Pensions and Postretirement Benefits” of the Notes to Consolidated Financial Statements for a further discussion of our pension and postretirement other than pension plans.

 

CASH FLOW

 

The following table summarizes our cash flow activity for the years ended December 31, 2005, 2004 and 2003:

 

 

Year Ended December 31, 2005 as Compared to December 31, 2004

 

Operating Activities of Continuing Operations

 

Net cash provided by operating activities decreased $65.4 million from $410.3 million during the year ended December 31, 2004 to $344.9 million during the year ended December 31, 2005. The decrease in net cash from operations was primarily due to higher working capital requirements to support the increase in sales and production rates for large commercial aircraft, offset partially by higher income and the absence of the $99 million partial settlement with Northrop Grumman in 2004. Net cash provided by operating activities in the year ended December 31, 2005 also included an increase in the accounts receivable sold under our securitization program of $24.8 million, offset by worldwide pension contributions of $144.7 million and net tax payments of approximately $52.1 million. Net cash provided by operating activities in the year ended December 31, 2004 included cash received from the partial settlement with Northrop Grumman of $99 million, termination of certain life insurance policies of $23 million and commutation of a general liability insurance policy of $18 million, offset by worldwide pension contributions of $128.6 million, net tax payments of approximately $32 million, a reduction of $25 million in receivables sold under our securitization program and cash paid to acquire certain aftermarket rights of $15 million.

 

During 2006, we expect to contribute $100 million to $125 million to our worldwide qualified and non-qualified pension plans and $36 million to our postretirement benefit plans.

Investing Activities of Continuing Operations

 

Net cash used by investing activities was $272 million in the year ended December 31, 2005 and $140.9 million in the year ended December 31, 2004. Net cash used by investing activities for the year ended December 31, 2005 included capital expenditures of $215.5 million and the acquisitions of SUI for $60.9 million and the minority interest in one of our businesses for $8.8 million. Net cash used by investing activities in the year ended December 31, 2004 included capital expenditures of $151.8 million.

 

We expect capital expenditures in 2006 to be in the range of $240 million to $260 million, reflecting increased cash expenditures for investments in recently awarded programs such as the Boeing 787 and the Airbus A350, capital expenditures to support higher OE deliveries to Airbus and Boeing and productivity initiatives that are expected to enhance long-term margins. The breakdown of expected 2006 capital expenditures by segment is as follows:

 

 

In December 2005, our Board of Directors authorized the purchase and implementation of a single, integrated ERP system across all of our strategic business units. We purchased the ERP software and licenses in the fourth quarter 2005 for approximately $10 million, which is the initial payment for the software implementation expected to take place over seven years between 2006 and 2012.

 

Financing Activities of Continuing Operations

 

Net cash used by financing activities was $139.1 million in the year ended December 31, 2005, compared to $358.1 million for the year ended December 31, 2004. During the year ended December 31, 2005, we redeemed all remaining outstanding 6.45 percent notes due in 2007 in the aggregate principal amount of $182.1 million. Also during the year ended December 31, 2005, we issued common stock of $107.7 million, primarily through the exercise of stock options, and paid dividends to shareholders of $97.3 million. During the year ended December 31, 2004, we repurchased $142.2 million principal amount of long-term debt and redeemed $60 million principal amount of Special Facilities Airport Revenue Bonds, $5.9 million principal amount of industrial revenue bonds and $63.5 million principal of the QUIPS debentures.

 

Discontinued Operations

 

Net cash provided by discontinued operations was $24.6 million in the year ended December 31, 2005 and $5.1 million in the year ended December 31, 2004. After tax proceeds of approximately $13.2 million from the sale of Test Systems were included in the net cash provided by discontinued operations in the year ended December 31, 2005.

 

Year Ended December 31, 2004 as Compared to December 31, 2003

 

Operating Activities of Continuing Operations

 

Net cash provided by operating activities of continuing operations decreased $140.7 million from $551 million during the year ended December 31, 2003 to $410.3 million during the year ended December 31, 2004. Net cash provided by operating activities of continuing operations in the year ended December 31, 2004 included cash received from the partial settlement with Northrop Grumman of $99 million, termination of certain life insurance policies of $23 million

and commutation of a general liability insurance policy of $18 million, offset by worldwide pension contributions of $128.6 million, a reduction of $25 million in receivables sold under our receivables securitization program and cash paid to acquire certain aftermarket rights of $15 million. Increased working capital, including higher inventory, also contributed to lower net cash provided by operating activities of continuing operations in the year ended December 31, 2004. Net cash provided by operating activities of continuing operations in the year ended December 31, 2003 included tax refunds of $107 million. There were net income tax payments during the year ended December 31, 2004 of approximately $32 million. Net cash provided by operating activities of continuing operations was reduced by worldwide pension contributions of $62.7 million in the year ended December 31, 2003.

 

Investing Activities of Continuing Operations

 

Net cash provided by (used by) investing activities of continuing operations was a use of cash of $140.9 million in the year ended December 31, 2004 and an inflow of cash of $57.3 million in the year ended December 31, 2003. Net cash used by investing activities of continuing operations for the year ended December 31, 2004 included capital expenditures of $152 million. Net cash provided by investing activities of continuing operations in the year ended December 31, 2003 included proceeds from the sale of the Noveon PIK Notes of $151.9 million and the receipt of a $35 million purchase price adjustment related to the acquisition of aeronautical systems, offset in part by capital expenditures of $125.1 million.

 

Financing Activities of Continuing Operations

 

Net cash used by financing activities of continuing operations was $358.1 million in the year ended December 31, 2004, compared to $525.4 million for the year ended December 31, 2003. During the year ended December 31, 2004, we repurchased $142.2 million principal amount of long-term debt and redeemed $60 million principal amount of Special Facilities Airport Revenue Bonds, $5.9 million principal amount ofindustrial revenue bonds and $63.5 million principal amount of the QUIPS Debentures. During the year ended December 31, 2003 we repaid short-term debt and redeemed a portion of the QUIPS Debentures, using the net after tax cash proceeds from the sale of our Avionics business, cash proceeds from the sale of the Noveon PIK Notes and cash provided by operating activities, net of dividends and capital expenditures.

 

Discontinued Operations

 

Net cash provided by discontinued operations of $140.2 million in the year ended December 31, 2003 included $134.1 million of proceeds from the sale of our Avionics business.

 

CONTINGENCIES

 

General

 

There are pending or threatened against us or our subsidiaries various claims, lawsuits and administrative proceedings, arising in the ordinary course of business with respect to commercial, product liability, asbestos and environmental matters, which seek remedies or damages. We believe that any liability that may finally be determined with respect to commercial and non-asbestos product liability claims should not have a material effect on our consolidated financial position, results of operations or cash flows. From time to time, we are also involved in legal proceedings as a plaintiff involving tax, contract, patent protection, environmental and other matters. Gain contingencies, if any, are recognized when they are realized. Legal costs are generally expensed when incurred.

 

Environmental

 

We are subject to various domestic and international environmental laws and regulations which may require that we investigate and remediate the effects of the release or disposal of materials

at sites associated with past and present operations, including sites at which we have been identified as a potentially responsible party under the federal Superfund laws and comparable state laws. We are currently involved in the investigation and remediation of a number of sites under these laws.

 

Estimates of our environmental liabilities are based on currently available facts, present laws and regulations and current technology. These estimates take into consideration our prior experience in site investigation and remediation, the data concerning cleanup costs available from other companies and regulatory authorities and the professional judgment of our environmental specialists in consultation with outside environmental specialists, when necessary. Estimates of our environmental liabilities are further subject to uncertainties regarding the nature and extent of site contamination, the range of remediation alternatives available, evolving remediation standards, imprecise engineering evaluations and estimates of appropriate cleanup technology, methodology and cost, the extent of corrective actions that may be required and the number and financial condition of other potentially responsible parties, as well as the extent of their responsibility for the remediation.

 

Accordingly, as investigation and remediation of these sites proceed, it is likely that adjustments in our accruals will be necessary to reflect new information. The amounts of any such adjustments could have a material adverse effect on our results of operations in a given period, but the amounts, and the possible range of loss in excess of the amounts accrued, are not reasonably estimable. Based on currently available information, however, we do not believe that future environmental costs in excess of those accrued with respect to sites for which we have been identified as a potentially responsible party are likely to have a material adverse effect on our financial condition. There can be no assurance, however, that additional future developments, administrative actions or liabilities relating to environmental matters will not have a material adverse effect on our results of operations or cash flows in a given period.

 

Environmental liabilities are recorded when the liability is probable and the costs are reasonably estimable, which generally is not later than at completion of a feasibility study or when we have recommended a remedy or have committed to an appropriate plan of action. The liabilities are reviewed periodically and, as investigation and remediation proceed, adjustments are made as necessary. Liabilities for losses from environmental remediation obligations do not consider the effects of inflation and anticipated expenditures are not discounted to their present value. The liabilities are not reduced by possible recoveries from insurance carriers or other third parties, but do reflect anticipated allocations among potentially responsible parties at federal Superfund sites or similar state-managed sites and an assessment of the likelihood that such parties will fulfill their obligations at such sites.

 

Our Consolidated Balance Sheet included an accrued liability for environmental remediation obligations of $81 million and $88.5 million at December 31, 2005 and December 31, 2004, respectively. At December 31, 2005 and December 31, 2004, $18.3 million and $16.2 million, respectively, of the accrued liability for environmental remediation was included in current liabilities as Accrued Expenses. At December 31, 2005 and December 31, 2004, $31.4 million and $29.6 million, respectively, was associated with ongoing operations and $49.6 million and $58.9 million, respectively, was associated with businesses previously disposed of or discontinued.

 

The timing of expenditures depends on a number of factors that vary by site, including the nature and extent of contamination, the number of potentially responsible parties, the timing of regulatory approvals, the complexity of the investigation and remediation, and the standards for remediation. We expect that we will expend present accruals over many years, and will complete remediation in less than 30 years at all sites for which we have been identified as a potentially responsible party. This period includes operation and monitoring costs that are generally incurred over 15 to 25 years.

Asbestos

 

We and a number of our subsidiaries have been named as defendants in various actions by plaintiffs alleging injury or death as a result of exposure to asbestos fibers in products, or which may have been present in our facilities. A number of these cases involve maritime claims, which have been and are expected to continue to be administratively dismissed by the court. These actions primarily relate to previously owned businesses. We believe that pending and reasonably anticipated future actions, net of anticipated insurance recoveries, are not likely to have a material adverse effect on our financial condition, results of operations or cash flows. There can be no assurance, however, that future legislative or other developments will not have a material adverse effect on our results of operations in a given period.

 

We believe that we have substantial insurance coverage available to us related to any remaining claims. However, the primary layer of insurance coverage for most of these claims is provided by the Kemper Insurance Companies. Kemper has indicated that, due to capital constraints and downgrades from various rating agencies, it has ceased underwriting new business and now focuses on administering policy commitments from prior years. Kemper has also indicated that it is currently operating under a “run-off” plan approved by the Illinois Department of Insurance. We cannot predict the impact of Kemper’s financial position on the availability of the Kemper insurance.

 

In addition, a portion of our primary and excess layers of general liability insurance coverage for most of these claims was provided by insurance subsidiaries of London United Investments plc (KWELM). KWELM is insolvent and in the process of distributing its assets and dissolving. In September 2004, we entered into a settlement agreement with KWELM pursuant to which we agreed to give up our rights with respect to the KWELM insurance policies in exchange for $18.3 million, subject to increase under certain circumstances. The settlement represents a negotiated payment for our loss of insurance coverage, as we no longer have the KWELM insurance available for claims that would have qualified for coverage. The initial settlement amount of $18.3 million was paid to us during 2004, was recorded as a deferred settlement credit and will be used to offset asbestos and other toxic tort claims in future periods.

 

The KWELM insolvent fund managers made additional settlement distributions to us in 2005 totaling $11.3 million following completion of the insolvent scheme of arrangement process in the United Kingdom. The additional distribution was recorded as a deferred settlement credit and will be used to offset asbestos and other toxic tort claims in future periods. One final distribution may be made depending on the final valuation of KWELM.

 

Liabilities of Divested Businesses

 

Asbestos

 

In May 2002, we completed the tax-free spin-off of our Engineered Products (EIP) segment, which at the time of the spin-off included EnPro Industries, Inc. (EnPro) and Coltec Industries Inc (Coltec). At that time, two subsidiaries of Coltec were defendants in a significant number of personal injury claims relating to alleged asbestos-containing products sold by those subsidiaries. It is possible that asbestos-related claims might be asserted against us on the theory that we have some responsibility for the asbestos-related liabilities of EnPro, Coltec or its subsidiaries, even though the activities that led to those claims occurred prior to our ownership of any of those subsidiaries. Also, it is possible that a claim might be asserted against us that Coltec’s dividend of its aerospace business to us prior to the spin-off was made at a time when Coltec was insolvent or caused Coltec to become insolvent. Such a claim could seek recovery from us on behalf of Coltec of the fair market value of the dividend.

 

A limited number of asbestos-related claims have been asserted against us as “successor” to Coltec or one of its subsidiaries. We believe that we have substantial legal defenses against

these claims, as well as against any other claims that may be asserted against us on the theories described above. In addition, the agreement between EnPro and us that was used to effectuate the spin-off provides us with an indemnification from EnPro covering, among other things, these liabilities. The success of any such asbestos-related claims would likely require, as a practical matter, that Coltec’s subsidiaries were unable to satisfy their asbestos-related liabilities and that Coltec was found to be responsible for these liabilities and was unable to meet its financial obligations. We believe any such claims would be without merit and that Coltec was solvent both before and after the dividend of its aerospace business to us. If we are ultimately found to be responsible for the asbestos-related liabilities of Coltec’s subsidiaries, we believe such finding would not have a material adverse effect on our financial condition, but could have a material adverse effect on the results of operations and cash flows in a particular period. However, because of the uncertainty as to the number, timing and payments related to future asbestos-related claims, there can be no assurance that any such claims will not have a material adverse effect on our financial condition, results of operations and cash flows. If a claim related to the dividend of Coltec’s aerospace business were successful, it could have a material adverse impact on our financial condition, results of operations and cash flows.

 

Other

 

In connection with the divestiture of our tire, vinyl and other businesses, we have received contractual rights of indemnification from third parties for environmental and other claims arising out of the divested businesses. Failure of these third parties to honor their indemnification obligations could have a material adverse effect on our financial condition, results of operations and cash flows.

 

Guarantees

 

At December 31, 2005, we had an outstanding contingent liability for guarantees of debt and lease payments of $2.4 million, letters of credit and bank guarantees of $47.5 million and residual value of lease obligations of $24.8 million.

 

We guaranteed amounts previously owed by Coltec Capital Trust with respect to $150 million of TIDES, which included $5 million of TIDES that were beneficially owned by Coltec, and guaranteed Coltec’s performance of its obligations with respect to the TIDES and the underlying Coltec convertible subordinated debentures. Following the spin-off of the EIP segment, the TIDES remained outstanding as an obligation of Coltec Capital Trust and our guarantee with respect to the TIDES remained an obligation of ours. EnPro, Coltec and Coltec Capital Trust have agreed to indemnify us for any costs and liabilities arising under or related to the TIDES after the spin-off. On November 28, 2005, Coltec redeemed all of the outstanding TIDES and underlying convertible subordinated debentures. Our guarantee of the TIDES terminated upon full payment of the redemption price of all of the TIDES, subject to reinstatement if at any time any TIDES holder must repay any sums paid to it with respect to the TIDES or our guarantee.

 

Commercial Airline Customers

 

Several of our commercial airline customers are experiencing financial difficulties. We perform ongoing credit evaluations on the financial condition of all of our customers and maintain reserves for uncollectible accounts receivable based upon expected collectibility. Although we believe our reserves are adequate, we are not able to predict the future financial stability of these customers. Any material change in the financial status of any one or group of customers could have a material adverse effect on our financial condition, results of operations or cash flows. The extent to which extended payment terms are granted to customers may negatively affect future cash flow.

Aerostructures Long-Term Contracts

 

Our aerostructures business has several long-term contracts in the pre-production phase. This phase includes design of the product to meet customer specifications as well as design of the manufacturing processes to manufacture the product. Also involved in this phase is securing a supply of material and components produced by third party suppliers, which is generally accomplished through long-term supply agreements. Because these contracts cover periods of up to 15 years or more, there is risk that estimates of future costs made during the pre-production phase will be different from actual costs and that the difference could be significant.

 

Tax

 

We are continuously undergoing examination by the IRS, as well as various state and foreign jurisdictions. The IRS and other taxing authorities routinely challenge certain deductions and credits reported by us on our income tax returns. In accordance with SFAS 109, “Accounting for Income Taxes,” and SFAS 5, “Accounting for Contingencies,” we establish reserves for tax contingencies that reflect our best estimate of the deductions and credits that we may be unable to sustain, or that we could be willing to concede as part of a broader tax settlement. Differences between the reserves for tax contingencies and the amounts ultimately owed by us are recorded in the period they become known. Adjustments to our reserves could have a material effect on our financial statements. As of December 31, 2005, we had recorded tax contingency reserves of approximately $325.6 million.

 

In 2000, Coltec, our former subsidiary, made a $113.7 million payment to the IRS for an income tax assessment and the related accrued interest arising out of certain capital loss deductions and tax credits taken in 1996. On February 13, 2001, Coltec filed suit against the U.S. Government in the U.S. Court of Federal Claims seeking a refund of this payment. The trial portion of the case was completed in May 2004. On November 2, 2004, we were notified that the trial court ruled in favor of Coltec and ordered the U.S. Government to refund federal tax payments of $82.8 million to Coltec. This tax refund would also bear interest to the date of payment. As of December 31, 2005, the interest amount was approximately $52 million before tax, or approximately $33 million after tax. The U.S. Court of Federal Claims entered a final judgment in this case on February 15, 2005. During July 2005, the U.S. Government filed its brief related to its appeal of the decision with the U.S. Court of Appeals for the Federal Circuit. Coltec filed its brief related to the U.S. Government’s appeal on September 6, 2005. Oral arguments were heard by the U.S. Court of Appeals for the Federal Circuit on February 8, 2006. A decision is expected by the U.S. Court of Appeals for the Federal Circuit sometime in 2006. If the trial court’s decision is ultimately upheld, we will be entitled to this tax refund and related interest pursuant to an agreement with Coltec. If we receive these amounts, we expect to record income of approximately $149 million, after tax, based on interest through December 31, 2005, including the release of previously established reserves. If the IRS were to ultimately prevail in this case, Coltec will not owe any additional interest or taxes with respect to 1996. We may, however, be required by the IRS to pay up to $32.7 million plus accrued interest with respect to the same items claimed by Coltec in its tax returns for 1997 through 2000. The amount of the previously estimated tax liability if the IRS were to prevail for the 1997 through 2000 period remains fully reserved.

 

In 2000, the IRS issued a statutory notice of deficiency asserting that Rohr, Inc. (Rohr), our subsidiary, was liable for $85.3 million of additional income taxes for the fiscal years ended July 31, 1986 through 1989. In 2003, the IRS issued an additional statutory notice of deficiency asserting that Rohr was liable for $23 million of additional income taxes for the fiscal years ended July 31, 1990 through 1993. The proposed assessments relate primarily to the timing of certain tax deductions and tax credits. Rohr has filed petitions in the U.S. Tax Court opposing the proposed assessments. At the time of settlement or final determination by the court, there will be a net cash cost to us due at least in part to the reversal of a timing item. We believe that

our total net cash cost is unlikely to exceed $100 million. We reserved the estimated liability associated with these cases. We are in advanced stages of discussion with the IRS to settle the Rohr case and to resolve the open issues in the tax years through 1999 as described below.

 

Our current IRS examination cycle began on September 29, 2005 and involves the taxable years ended December 31, 2000 through December 31, 2004. The prior examination cycle which began in March 2002 has reached an advanced stage of discussion with the IRS. We anticipate substantially all of the open issues for the consolidated income tax groups in the audit periods identified below to be resolved in 2006:

 

 

There are numerous tax issues that have been raised during the examinations by the IRS, including, but not limited to, transfer pricing, research and development credits, foreign tax credits, tax accounting for long-term contracts, tax accounting for inventory, tax accounting for stock options, depreciation, amortization and the proper timing for certain other deductions for income tax purposes. We have reached a tentative agreement with the IRS on a substantial number of the issues raised in the prior examination cycle and the U.S. Tax Court litigation involving Rohr described above. The final settlement of these issues is subject to a further review and approval process, the outcome of which cannot be predicted at this time. If we settle pursuant to these discussions, we would anticipate reversing some portion of previously established reserves, which could be material to our financial statements. We anticipate a final settlement in 2006.

 

Rohr has been under examination by the State of California for the tax years ended July 31, 1985, 1986 and 1987. The State of California has disallowed certain expenses incurred by one of Rohr’s subsidiaries in connection with the lease of certain tangible property. California’s Franchise Tax Board held that the deductions associated with the leased equipment were non-business deductions. The additional tax associated with the Franchise Tax Board’s position is approximately $4.5 million. The amount of accrued interest associated with the additional tax is approximately $19 million as of December 31, 2005. In addition, the State of California enacted an amnesty provision that imposes nondeductible penalty interest equal to 50 percent of the unpaid interest amounts relating to taxable years ended before 2003. The penalty interest is approximately $10 million as of December 31, 2005. The tax and interest amounts continue to be contested by Rohr. We believe that we are adequately reserved for this contingency. Rohr made a voluntary payment during the three months ended March 31, 2005 of approximately $3.9 million related to items that were not being contested, consisting of approximately $0.6 million related to tax and approximately $3.3 million related to interest on the tax. Rohr made an additional payment during the three months ended December 31, 2005 of approximately $4.5 million related to the contested tax amount pursuant to the State’s assessment notice dated October 20, 2005. No payment has been made for the $19 million of interest or $10 million of penalty interest. Under California law, Rohr may be required to pay the full amount of interest prior to filing any suit for refund. If required, Rohr expects to make this payment and file suit for a refund before the end of 2007.

 

NEW ACCOUNTING STANDARDS

 

Accounting Changes and Error Corrections

 

During May 2005, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections — a replacement of APB Opinion No. 20 and FASB Statement No. 3” (SFAS 154). Under APB Opinion No. 20, most

voluntary changes in accounting principle were recognized by including the cumulative effect of changing to the new accounting principle in net income in the period of change. SFAS 154 will require retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine the period-specific effects of the cumulative effect of the change. SFAS 154 will apply to all accounting changes made after adoption of the statement, which is required by the fiscal year beginning after December 15, 2005. We adopted SFAS 154 on January 1, 2006. To date, the adoption of SFAS 154 has not had a material impact on our financial condition, results of operations or cash flows.

 

Inventory Costs

 

The FASB recently issued Statement of Financial Accounting Standards No. 151, “Inventory Costs” (SFAS 151), an amendment of ARB No. 43, Chapter 4. Adoption of SFAS 151 is required by the year beginning January 1, 2006. The amendments made by SFAS 151 clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current period charges and requires the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. While SFAS 151 enhances ARB 43 and clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage), the statement also removes inconsistencies between ARB 43 and International Accounting Standards (IAS) 2 and amends ARB 43 to clarify that abnormal amounts of costs should be recognized as period costs. Under some circumstances, according to ARB 43, the above listed costs may be so abnormal as to require treatment as current period charges. SFAS 151 requires these items be recognized as current period charges regardless of whether they meet the criterion of “so abnormal” and requires allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. We adopted SFAS 151 on January 1, 2006. The adoption of SFAS 151 is not expected to have a material impact on our financial condition, results of operations or cash flows.

 

Stock-Based Compensation

 

On December 16, 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payments” (SFAS 123(R)), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” and amends Statement of Financial Accounting Standards No. 95, “Statement of Cash Flows”. Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. We adopted the SFAS 123 fair-value-based method of accounting for share-based payments effective January 1, 2004 using the “modified prospective method” described in Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure”. SFAS 123(R) requires that we use the valuation technique that best fits the circumstances. We currently use and will continue to use the Black-Scholes formula to estimate the fair value of stock options granted to employees. SFAS 123(R) requires that the benefits of tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow, which is our current practice. As a result, the adoption of SFAS 123(R) will reduce net operating cash flows and increase net financing cash flows in the periods after the effective date. SFAS 123(R) also requires that we estimate the number of awards that are expected to vest and to revise the estimate as the actual forfeitures differ from the estimate. Our current policy is to recognize forfeitures as they occur.

 

In accordance with SFAS 123(R), the explicit service period for employees that are eligible to retire or become eligible to retire is considered to be nonsubstantive, which would require compensation cost to be recognized over the period through the date that the employee first becomes eligible to retire and is no longer required to provide service to earn the award. Our

current policy is to recognize compensation cost over the explicit service period (i.e., up to the date of actual retirement) as opposed to through the date the employee first becomes eligible to retire. Upon adoption of SFAS 123(R), we will be required to change our policy and to recognize compensation expense for awards granted subsequent to January 1, 2006 over a period ending with the date the employee first becomes eligible for retirement. If we had previously applied the nonsubstantive vesting provisions of SFAS 123(R) when it adopted SFAS 123 on January 1, 2004, recognized compensation cost would have increased by approximately $2.4 million and $4 million for the years ended December 31, 2005 and 2004, respectively.

 

Based upon current assumptions regarding nonsubstantive vesting and grants of stock-based compensation in 2006, recognized compensation cost is expected to increase by approximately $10 million for the year ending December 31, 2006 as a result of adopting SFAS 123(R).

 

On March 29, 2005, the U.S. Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 107 (SAB 107) relating to SFAS 123(R). SAB 107 provides interpretive guidance related to the interaction between SFAS 123(R)and certain SEC rules and regulations and provides the SEC staff’s views regarding the valuation of share-based payment arrangements for public companies. SAB 107 also requires disclosures within filings made with the SEC relating to the accounting for share-based payment transactions, particularly during the transition to SFAS 123(R). We will incorporate the SAB 107 guidance in conjunction with our adoption of SFAS 123(R) on January 1, 2006.

 

Accounting for Conditional Asset Retirement Obligations

 

During March 2005, the FASB issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (FIN 47), which is an interpretation of Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (SFAS 143). The Interpretation clarifies that the term conditional asset retirement obligation refers to the legal obligation to perform an asset retirement activity in which the timing or method of settlement is conditional on a future event that may or may not be within the control of the entity. Adoption of FIN 47 is required by the fiscal year ending after December 15, 2005. We adopted FIN 47 on December 31, 2005. The adoption of FIN 47 did not have a material impact on our financial condition, results of operations or cash flows.

 

Accounting for Purchased or Acquired Leasehold Improvements

 

In June 2005, the FASB’s Emerging Issues Task Force reached a consensus on Issue No. 05-6, “Determining the Amortization Period for Leasehold Improvements Purchased after Lease Inception or Acquired in a Business Combination” (EITF 05-6). This guidance requires that leasehold improvements acquired in a business combination or purchased subsequent to the inception of a lease be amortized over the shorter of the useful life of the assets or a term that includes required lease periods and renewals that are reasonably assured at the date of the business combination or purchase. The guidance is applicable only to leasehold improvements that are purchased or acquired in reporting periods beginning after June 29, 2005. We do not expect the adoption of EITF 05-6 to have a material impact on our financial condition, results of operations or cash flows.

 

CRITICAL ACCOUNTING POLICIES

 

Our discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On

an ongoing basis, we evaluate our estimates, including those related to customer programs and incentives, product returns, bad debts, inventories, investments, intangible assets, income taxes, financing obligations, service and product warranties, excess component order cancellation costs, restructuring, long-term service contracts, pensions and other postretirement benefits, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our Consolidated Financial Statements.

 

Revenue Recognition

 

For revenues not recognized under the contract method of accounting, we recognize revenues from the sale of products at the point of passage of title, which typically is at the time of shipment. Revenues earned from providing maintenance service are recognized when the service is complete. In multiple deliverable arrangements, the revenues for products and services are allocated based upon their relative fair value.

 

Contract Accounting Percentage-of-Completion

 

Effective January 1, 2004, we changed two aspects of the application of contract accounting for our aerostructures business unit, including a change to the cumulative catch-up method from the reallocation method for accounting for changes in contract estimates of revenue and costs and a change to the accounting for certain pre-certification costs. Pre-certification costs, including those in excess of original estimated levels, are now included in total contract costs used to evaluate overall contract profitability. These contract accounting methods are described below. The impact of these changes on our financial statements was income of approximately $16 million after tax or $23 million before tax, which was reported as a Cumulative Effect of Change in Accounting in 2004.

 

Revenue Recognition

 

We have sales under long-term contracts, many of which contain escalation clauses, requiring delivery of products over several years and frequently providing the buyer with option pricing on follow-on orders. Sales and profits on each contract are recognized in accordance with the percentage-of-completion method of accounting, primarily using the units-of-delivery method. We follow the requirements of Statement of Position 81-1 (SOP 81-1), “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (the contract method of accounting), using the cumulative catch-up method in accounting for revisions in estimates. Under the cumulative catch-up method, the impact of revisions in estimates related to units shipped to date is recognized immediately when changes in estimated contract profitability are known.

 

Profit is estimated based on the difference between total estimated revenue and total estimated cost of a contract. Changes in estimated total revenue and estimated total cost are recognized as business or economic conditions change and the impact on contract profitability is recorded immediately in that period using the cumulative catch-up method. Cost includes the estimated cost of the pre-production effort, primarily tooling and engineering design, plus the estimated cost of manufacturing a specified number of production units. The specified number of production units used to establish the profit margin is predicated upon contractual terms adjusted for market forecasts and does not exceed the lesser of those quantities assumed in original contract pricing as adjusted to the date of certification, or those quantities which we

now expect to deliver in the timeframe/period assumed in the original contract pricing or at the date of certification. Our policies only allow the estimated number of production units to be delivered to exceed the quantity assumed within the original contract pricing or at date of certification when we receive firm orders for additional units or we are required to begin manufacturing of units under contractual production lead time. The assumed timeframe/period is generally equal to the period-specified in the contract. If the contract is a “life of program” contract, then such period is equal to the time period used in the original pricing model adjusted, if appropriate, to the expected period of production estimated at the date of certification. Option quantities are combined with prior orders when follow-on orders are released.

 

The contract method of accounting involves the use of various estimating techniques to project revenues and costs at completion and includes estimates of recoveries asserted against the customer for changes in specifications. These estimates involve various assumptions and projections relative to the outcome of future events, including the quantity and timing of product deliveries. Also included are assumptions relative to future labor performance and rates, and projections relative to material and overhead costs. These assumptions involve various levels of expected performance improvements. We re-evaluate our contract estimates periodically and reflect changes in estimates immediately under the cumulative catch-up method for the impact on shipments to date.

 

Included in contract costs, or estimated revenues, are the expected impact of specific contingencies that we believe are probable. If actual experience differs from estimates or facts and circumstances change, estimated costs or revenues will be revised.

 

Included in sales are amounts arising from contract terms that provide for invoicing a portion of the contract price at a date after delivery. Also included are negotiated values for units delivered and anticipated price adjustments for contract changes, claims, escalation and estimated earnings in excess of billing provisions, resulting from the percentage-of-completion method of accounting. Certain contract costs are estimated based on the learning curve concept discussed in the “Inventory” section.

 

Estimates of revenue and cost for our contracts span a period of many years from the inception of the contracts to the date of actual shipments and are based on a substantial number of underlying assumptions. We believe that the underlying factors are sufficiently reliable to provide a reasonable estimate of the profit to be generated. However, due to the significant length of time over which revenue streams will be generated, the variability of the assumptions of the revenue and cost streams can be significant if the factors change. The factors include but are not limited to the following:

 

 

Inventory

 

Inventoried costs on long-term contracts include certain pre-production costs, consisting primarily of tooling and design costs and production costs, including applicable overhead. The costs attributed to units delivered under long-term commercial contracts are based on the estimated average cost of all units expected to be produced and are determined under the learning curve

concept, which anticipates a predictable decrease in unit costs as tasks and production techniques become more efficient through repetition. This usually results in an increase in inventory (referred to as “excess-over-average”) during the early years of a contract.

 

If in-process inventory plus estimated costs to complete a specific contract exceeds the anticipated remaining sales value of such contract, such excess is charged to Cost of Sales in the period recognized, thus reducing inventory to estimated realizable value.

 

Income Taxes

 

In accordance with SFAS 109, APB Opinion No. 28, and FIN No. 18, as of each reporting period, we estimate an effective income tax rate that is expected to be applicable for the full fiscal year. The estimate of our effective income tax rate involves significant judgments regarding the application of complex tax regulations across many jurisdictions and estimates as to the amount and jurisdictional source of income expected to be earned during the full fiscal year. Further influencing this estimate are evolving interpretations of new and existing tax laws, rulings by taxing authorities and court decisions. Due to the subjective and complex nature of these underlying issues, our actual effective tax rate and related tax liabilities may differ from our initial estimates. Differences between our estimated and actual effective income tax rates and related liabilities are recorded in the period they become known. The resulting adjustment to our income tax expense could have a material effect on our results of operations in the period the adjustment is recorded.

 

In accordance with SFAS 5, we record tax contingencies when the exposure item becomes probable and the amount is reasonably estimable. As of December 31, 2005 and December 31, 2004, we had recorded tax contingency reserves of approximately $325.6 million and $315.8 million, respectively.

 

In accordance with SFAS 109, deferred tax assets and liabilities are recorded for tax carryforwards and the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes are measured using enacted tax laws and rates. A valuation allowance is provided on deferred tax assets if it is determined that it is more likely than not that the asset will not be realized.

 

Identifiable Intangible Assets

 

Identifiable intangible assets are recorded at cost, or when acquired as part of a business combination, at estimated fair value. These assets include patents and other technology agreements, sourcing contracts, trademarks, licenses, customer relationships and non-compete agreements. Intangible assets are generally amortized using the straight-line method over estimated useful lives of 5 to 25 years for all acquisitions completed on or prior to June 30, 2001. For acquisitions completed subsequent to June 30, 2001, identifiable intangible assets are amortized over their useful life using undiscounted cash flows, a method that reflects the pattern in which the economic benefits of the intangible assets are consumed.

 

Impairments of identifiable intangible assets are recognized when events or changes in circumstances indicate that the carrying amount of the asset, or related groups of assets, may not be recoverable and our estimate of undiscounted cash flows over the assets’ remaining useful lives is less than the carrying value of the assets. The determination of undiscounted cash flow is based on our segments’ plans. The revenue growth is based upon aircraft build projections from aircraft manufacturers and widely available external publications. The profit margin assumption is based upon the current cost structure and anticipated cost reductions. Measurement of the amount of impairment may be based upon an appraisal, market values of similar assets or estimated discounted future cash flows resulting from the use and ultimate disposition of the asset.

Participation Payments

 

Certain of our businesses make cash payments under long-term contractual arrangements to OE manufacturers (OEM) or system contractors in return for a secured position on the aircraft program. Participation payments are capitalized as Other Assets and amortized as Cost of Sales. Participation payments are amortized over the estimated number of production units to be shipped over the program’s production life. At December 31, 2005 and 2004, the carrying amount of participation payments was $118.2 million and $23.8 million, respectively. The carrying amount of participation payments is evaluated for recovery at least annually or when other indicators of impairment, such as a change in the estimated number of units or a revision in the economics of the program. If such estimates change, amortization expense is adjusted and/or an impairment charge is recorded, as appropriate, for the effect of the revised estimates. No such impairment charges were recorded in the years ended December 31, 2005, 2004 or 2003.

 

Entry Fees

 

Certain businesses in our Engine Systems segment make cash payments to an OEM under long-term contractual arrangements related to new engine programs. The payments are referred to as entry fees and entitle us to a controlled access supply contract and a percentage of total program revenue generated by the OEM. Entry fees are capitalized in Other Assets and are amortized on a straight-line basis to Cost of Sales over the program’s estimated useful life following aircraft certification, which typically approximates 20 years. As of December 31, 2005 and 2004, the carrying amount of entry fees was $113.9 million and $111.3 million, respectively. The carrying amount of entry fees is evaluated for recovery at least annually or when other significant assumptions or economic conditions change. Recovery of entry fees is assessed based on the expected cash flow from the program over the remaining program life as compared to the recorded amount of entry fees. If carrying value of the entry fees exceeds the cash flow to be generated from the program, a charge would be recorded for the amount by which the carrying amount of the entry fee exceeds its fair value. No such impairment charges were recorded in the years ended December 31, 2005, 2004 or 2003.

 

As with any investment, there are risks inherent in recovering the value of entry fees. Such risks are consistent with the risks associated in acquiring a revenue-producing asset in which market conditions may change or the risks that arise when a manufacturer of a product on which a royalty is based has business difficulties and cannot produce the product. Such risks include but are not limited to the following:

 

 

Sales Incentives

 

We offer sales incentives to certain airline customers in connection with sales contracts. These incentives may consist of up-front cash payments, merchandise credits and/or free products. The cost of these incentives is recognized in the period incurred unless recovery of these costs is specifically guaranteed by the customer in the contract. If the contract contains such a guarantee, then the cost of the sales incentive is capitalized as Other Assets and amortized to Cost of Sales using the straight-line method over the remaining contract term. At December 31, 2005

and 2004, the carrying amount of sales incentives was $67.1 million and $68.7 million, respectively. The carrying amount of sales incentives is evaluated for recovery when indicators of potential impairment exist. The carrying value of the sales incentives is also compared annually to the amount recoverable under the terms of the guarantee in the customer contract. If the amount of the carrying value of the sales incentives exceeds the amount recoverable in the contract, the carrying value is reduced. No such charges were recorded in the years ended December 31, 2005, 2004 or 2003.

 

Flight Certification Costs

 

When a supply arrangement is secured, certain of our businesses may agree to supply hardware to an OEM to be used in flight certification testing and/or make cash payments to reimburse an OEM for costs incurred in testing the hardware. The flight certification testing is necessary to certify aircraft systems/components for the aircraft’s airworthiness and allows the aircraft to be flown and thus sold in the country certifying the aircraft. Flight certification costs are capitalized in Other Assets and are amortized to Cost of Sales over the projected number of aircraft to be manufactured. As of December 31, 2005 and 2004, the carrying amount of flight certification costs was $26.2 million. The carrying amount of flight certification costs is evaluated for recovery when indicators of impairment exist. The carrying value of the asset and amortization expense is adjusted when the estimated number of units to be manufactured changes. A charge of $2.1 million was recorded in the year ended December 31, 2003 for a reduction in the estimate of the number of units to be manufactured of a program. No such charges were recorded in the years ended December 31, 2005 or 2004.

 

Service and Product Warranties

 

We provide service and warranty policies on certain of our products. We accrue liabilities under service and warranty policies based upon specific claims and a review of historical warranty and service claim experience in accordance with SFAS 5. Adjustments are made to accruals as claim data and historical experience change. In addition, we incur discretionary costs to service our products in connection with product performance issues.

 

Our service and product warranty reserves are based upon a variety of factors. Any significant change in these factors could have a material impact on our results of operations. Such factors include but are not limited to the following:

 

 

Pension and Postretirement Benefits Other Than Pensions

 

Assumptions used in determining the benefit obligations and the annual expense for our pension and postretirement benefits other than pensions are evaluated and established. We consult with an outside actuary for most of the assumptions. Assumptions such as the rate of compensation increase and the long-term rate of return on plan assets are based upon our historical and benchmark data, as well as our outlook for the future. Health care cost projections and the mortality rate assumption are evaluated annually. We have changed from a U.S. discount rate benchmarked on the Moody’s Aa Index, which was used to determine the benefit obligations as of December 31, 2004 to a rate in the current year that better matches the benefit payment obligations of the plans. For December 31, 2005 the U.S. discount rates were determined at the end of the year based on a customized yield curve approach that matches the benefit payment obligation. Our pension and postretirement benefit payment streams were

each plotted against a yield curve composed of a large, diverse group of Aa-rated corporate bonds. The resulting discount rates were used to determine the benefit obligations as of December 31, 2005. In the U.K., the iBoxx AA long-term high quality bond rate was used as the basis for determining the discount rate for both 2004 and 2005. The appropriate benchmarks by applicable country were used for other non-U.S. and non-U.K. pension plans to determine the discount rate assumptions.

 

Following is a summary of our 2005 assumptions for determining the pension and postretirement benefits other than pension obligations and the annual cost for 2005.

 

Weighted-Average Assumptions Used to Determine the Benefit Obligations as of December 31, 2005

 

 

Also for measurement purposes, we changed to the RP2000 mortality table from the GAM83 table for the determination of the benefit obligations as of December 31, 2005.

 

To determine postretirement benefits other than pension obligations, a 9 percent annual rate of increase in the per capita cost of covered health care benefits was assumed for 2006. The rate was assumed to decrease gradually to 5 percent for 2010 and remain at that level thereafter.

 

Weighted-Average Assumptions Used to Determine the Net Periodic Pension Benefit Costs for the Year Ended December 31, 2005