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Form 10-K for FRANKLIN ELECTRIC CO INC

20-Feb-2004

Annual Report

OVERVIEW
Sales and earnings for 2003 were up from 2002. The increase in sales is attributable to the impact of foreign exchange rate changes and the full year impact of a 2002 acquisition. Sales improvements also occurred in fueling systems motors and related products, large submersible motors and international product sales. These improvements were partially offset by decline in North American and European small submersible motor sales. Prior year sales of small submersible motors were exceptionally strong due to weather conditions and an announced price increase effective in 2003. Earnings improved in 2003 as the Company's focus on productivity yielded improvements. Warranty costs were lower year over year and tax planning activities reduced the effective tax rate.

RESULTS OF OPERATIONS
- Net sales for 2003 were $359.5 million, a 1 percent increase from 2002 net sales of $354.9 million. Foreign currencies, particularly the euro and the Rand, strengthened relative to the U.S. dollar during 2003. The impact of the changes in exchange rates was a $15.9 million increase in the Company's reported 2003 sales. Net sales also increased due to full year sales related to the INCON acquisition in mid 2002, an increase of $4.7 million. Excluding the impact of changes in foreign currencies and the full year impact of the 2002 acquisition, net sales decreased $16.0 million or 5%. The sales decrease of $16.0 million relates primarily to decreased demand for submersible water products to North American customers of about $8.5 million and lower demand by European customers of about $8.8 million (when comparing both years at the current year exchange rate). Last year sales were unusually strong in the North American residential water well market as drought conditions prevailed over much of the East Coast and due to a 2003 price increase announced prior to the 2002 year end. This year residential water sales have fallen back to historical levels. Lower demand in Europe is attributed to generally wetter conditions and also to the impact of the conflict in the Middle East. Net sales for 2002 were $354.9 million, a 9.9 percent increase from 2001 net sales of $322.9 million. The increased sales were primarily the result of strong North American residential submersible electric motor sales, as well as the inclusion of Coverco, a January 2002 acquisition, and INCON, a July 2002 acquisition. Sales from these acquisitions represented 5.2 percent of sales for the year. These increases were partially offset by lower demand from the petroleum equipment industry.

Cost of sales as a percent of net sales for 2003, 2002 and 2001 was 69.1 percent, 70.4 percent and 71.2 percent, respectively. Cost of sales as a percent of net sales decreased in 2003 from 2002 primarily as a result of improved productivity which lowered labor and overhead costs by about 0.7 percent of net sales, changes in product mix from small residential motors to larger motors and fueling systems products which decreased labor and overhead costs by about 0.5 percent and quality improvements which reduced warranty costs by about 0.4 percent of net sales. Cost of sales as a percent of net sales decreased in 2002 from 2001 primarily as a result of productivity improvements and lower costs in key commodities. The Company has achieved these results by continually focusing on improving its productivity and quality as well as identifying alternative sources for certain materials.

Selling and administrative ("SG&A") expense as a percent of net sales for 2003, 2002 and 2001 was 16.4 percent, 15.4 percent and 14.7 percent, respectively. The increase of SG&A expenses in 2003 over 2002 was primarily due to the effect of changes in the foreign exchange rate, $1.4 million, and costs incurred for tax planning activities, $1.2 million. The Company also recognized full year SG&A costs related to the INCON acquisition, a $1.1 million year over year increase, and has incurred additional SG&A costs for its new plant in Mexico and the launch of new electronic products related to submersible motors.

Interest expense for 2003, 2002 and 2001 was $1.1 million, $1.3 million and $1.2 million, respectively.

Included in other income for 2003, 2002 and 2001 was interest income of $0.4 million, $0.5 million and $0.6 million, respectively, primarily derived from the investment of cash balances in short-term U.S. treasury and agency securities.

Foreign currency-based transactions produced a gain for 2003 of $0.3 million. The foreign currency-based transaction gain was due primarily to the strengthening euro relative to the U.S. dollar during most of 2003.

The provision for income taxes in 2003, 2002 and 2001 was $16.8 million, $18.3 million and $16.2 million, respectively. The effective tax rate in 2003 of 32.8 percent is lower than the 2002 rate of 36.2 percent as a result of tax credits realized in 2003. The tax credits, some of them from prior years, resulted from tax planning activities performed in 2002 and 2003 in the areas of foreign income exclusion which reduced the rate by 4.0 percent and R&D which reduced the rate by 1.2 percent. The effective tax rate differs from the United States statutory rate of 35 percent, due to the foreign income exclusion and R&D credits and to the effects of state and foreign income taxes, net of federal tax benefits.

Net income for 2003 was $34.5 million, or $3.05 per diluted share, compared to 2002 net income of $32.2 million, or $2.83 per diluted share. Net income for 2001 was $27.2 million, or $2.39 per diluted share. All share and per share data reflects the Company's two-for-one stock split effected in the form of a 100 percent stock distribution made on March 22, 2002.

CAPITAL RESOURCES AND LIQUIDITY
- Cash flows from operations provide the principal source of current liquidity. Net cash flows provided by operating activities were $47.0 million, $54.6 million and $39.9 million in 2003, 2002 and 2001, respectively. The primary source of cash from operations for 2003 was earnings. The operating cash flow decrease in 2003 is related to an increase in inventory, $2.1 million and payments to employee benefit plans, $4.0 million. Inventories increased $2.1 million, primarily in finished goods, as sales were lower than anticipated for the year. The impact of the strengthening euro and Rand increased inventory values by $4.1 million in Europe and South Africa. The 2002 operating cash flow increase was related to increased earnings and decreases in inventories and accounts receivable. Inventories decreased due to increased sales during 2002 because of the near drought conditions in the East as discussed in Results of Operations above.

Net cash flows used in investing activities were $15.5 million, $57.2 million and $10.2 million in 2003, 2002 and 2001, respectively. The primary uses of cash in 2003 were additions to property plant and equipment. The primary uses of cash in 2002 were for the acquisitions of Coverco and INCON. The Company

paid an aggregate of $30.3 million for these two acquisitions, net of cash acquired. During the third quarter of 2002, the Company paid $10.5 million in cash as contingent consideration in accordance with the terms of an agreement entered into in 1998 in which the Company purchased certain operating and intangible assets from a motor manufacturer.

Net cash flows used in financing activities were $24.0 million and $19.0 million in 2003 and 2001, respectively. Financing activities in 2002 generated $0.5 million cash flow. The primary use of cash in 2003 was the repayment of long term debt, $19.9 million. Another principal use of cash during 2003, 2002 and 2001 was purchases of Company common stock under the Company's repurchase program and the payment of dividends. During 2003, 2002 and 2001, the Company repurchased, or received as consideration for stock options exercised, 283,563, 223,499 and 408,200 shares of its common stock for $14.8 million, $10.5 million and $14.2 million, respectively. The Company paid $5.9 million, $5.5 million and $5.1 million in dividends on the Company's common stock in 2003, 2002 and 2001, respectively. The Company has authority under its Board- approved stock repurchase program to purchase an additional 465,106 shares of its common stock after January 3, 2004.

Cash and cash equivalents at the end of 2003 were $30.0 million compared to $20.1 million at the end of 2002. Working capital increased $19.8 million in 2003 and the current ratio of the Company was 2.8 and 2.2 at the end of 2003 and 2002, respectively.

Principal payments of $1.0 million per year on the Company's $20.0 million of unsecured long-term debt began in 1998 and will continue until 2008 when a balloon payment of $10.0 million will fully retire the debt. In November 2001, the Company entered into an unsecured, 38-month $60.0 million revolving credit agreement (the "Agreement"). The Agreement includes a facility fee of one- eighth of one percent on the committed amount. The Company's borrowings under the Agreement totaled $0.0 million and $10.1 at January 3, 2004 and December 28, 2002, respectively. The Company is subject to certain financial covenants with respect to borrowings, interest coverage, working capital, net worth, loans or advances, and investments. The Company was in compliance with all debt covenants at all times in 2003 and 2002. See Note 6.

At January 3, 2004, the Company had $4.5 million of commitments for the construction of a building in Linares, Mexico, and the purchase of machinery and equipment.

Management believes that internally generated funds and existing credit arrangements provide sufficient liquidity to meet current commitments.

AGGREGATE CONTRACTUAL OBLIGATIONS
- Most of the Company's contractual obligations to make payments to third parties are debt obligations. In addition, the Company has certain contractual obligations for future lease payments, as well as, purchase obligations. The payment schedule for these contractual obligations is as follows:

(In thousands)

                                   Less                            More
                                   than                            than
                      Total       1 Year   2-3 Years  4-5 Years   5 Years
                      -----       ------   ---------  ---------   -------

Debt ............... $14,141     $1,000      $2,050    $11,091     $-
Capital leases......   2,211        392         913        697      209
Operating leases ...   4,288      2,236       1,665        382        5
Purchase Obligations   4,503      4,503         -          -        -
                     -------     ------      ------    -------     ----
                     $25,143     $8,131      $4,628    $12,170     $214
                     =======     ======      ======    =======     ====

ACCOUNTING PRONOUNCEMENTS
- In May 2003, FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liability and Equity". Statement 150 affects an entity's accounting for freestanding financial instruments: mandatorily redeemable shares, put options, forward purchase contracts, and debt obligations. Most of the provisions are consistent with the existing FASB Concepts Statement No. 6, "Elements of Financial Statements". The remaining portion of Statement 150 encompasses certain obligations that an entity can or must settle by issuing equity shares, pending the relationship between the holder and issuer. The adoption of this pronouncement does not have a material impact on the Company's results of operations or financial position.

In December 2003, the FASB issued FASB Staff Position (FSP) FAS 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" (the "Act"). The Act expands Medicare, primarily by adding a prescription drug benefit for Medicare- eligibles starting in 2006. The Act provides employers currently sponsoring prescription drug programs for Medicare-eligibles with a range of options for coordinating with the new government-sponsored program to potentially reduce program cost. The FSP concludes that companies will be permitted to recognize that amount for year-end 2003 financial statements pursuant to FAS 106 or to delay having to report the effects of the Act until remaining questions are resolved. Pursuant to guidance from the FASB under FSP FAS 106-1, the Company has chosen to defer recognition of the potential effects of the Act for 2003 disclosures. The impact of the Act on the Company's accumulated pension benefit obligation and net periodic postretirement benefit cost has not been determined. When issued, the authoritative guidance on the accounting for the subsidy will address transition.

In December 2003, FASB issued a revision of SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits". The revision requires that companies provide more detail concerning plan assets, benefit obligations, cash flows, benefit costs, and other relevant information. Plan assets should be broken down by category, whereby describing investment policies, strategies, and target ranges. The Statement is effective for financial statements with fiscal years ending after December 15, 2003. However, disclosure of estimated future benefit payments is effective for fiscal years ending after June 15, 2004. In compliance with Statement 132, the

Company has expanded detail regarding plan assets, benefit obligations, benefit costs, and other pertinent information.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's discussion and analysis of its financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities. On an on-going basis, management evaluates its estimates, including those related to allowance for doubtful accounts, inventories, recoverability of long-lived assets, intangible assets, income taxes, warranty obligations, pensions and other employee benefit plan obligations, and contingencies. Management bases its estimates on historical experience and on other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Revenue Recognition: Products are shipped utilizing common carriers direct to customers or, for consignment products, to customer specified warehouse locations. Sales are recognized when the Company's products are shipped direct or transferred from a warehouse location to the customer, at which time transfer of ownership and risk of loss pass to the customer. The Company reduces sales revenues for discounts based on past experience. Differences may result in the amount of discounts if actual experience differs significantly from management estimates; such differences have not historically been material.

Accounts Receivable: Accounts receivable is comprised of balances due from customers net of estimated allowances for uncollectible accounts. In determining allowances, historical trends are evaluated and economic conditions and specific customer issues are reviewed to arrive at appropriate allowances. Allowance levels change as customer-specific circumstances and the other analysis areas noted above change. Differences may result in the amount for allowances if actual experience differs significantly from management estimates; such differences have not historically been material.

Inventory Valuation: The Company uses certain estimates and judgments to value inventory. Inventory is recorded at the lower of cost or market. The Company reviews its inventories for excess or obsolete products or components. Based on an analysis of historical usage and management's evaluation of estimated future demand, market conditions and alternative uses for possible excess or obsolete parts, reserves are recorded or changed. Significant fluctuations in demand or changes in market conditions could impact management's estimates of necessary reserves. Excess and obsolete inventory is periodically disposed through sale to third parties, scrapping or other means, and the reserves are appropriately reduced. Differences may result in the amount for reserves if actual experience differs significantly from management estimates; such differences have not historically been material.

Goodwill and other intangible assets: Under the requirements of SFAS no. 142, "Goodwill and other Intangible Assets", goodwill is no longer amortized; however it is tested for impairment

annually or more frequently whenever events or change in circumstances indicate that the asset may be impaired. The Company performs impairment reviews for its reporting unit using future cash flows based on management's judgments and assumptions. An asset's value is impaired if our estimate of the aggregate future cash flows, undiscounted and without interest charges, to be generated are less than the carrying amount of the reporting unit including goodwill. Such cash flows consider factors such as expected future operating income and historical trends, as well as the effects of demand and competition. To the extent impairment has occurred, the loss will be measured as the excess of the carrying amount of the reporting unit including goodwill over the fair value. Such estimates require the use of judgment and numerous subjective assumptions, which, if actual experience varies, could result in material differences in the requirements for impairment charges.

Income taxes: Under the requirements of SFAS No. 109, "Accounting for Income Taxes", we record deferred tax assets and liabilities for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Management judgment is required in determining the Company's provision for income taxes, deferred tax assets and liabilities, which, if actual experience varies, could result in material adjustments to deferred tax assets and liabilities.

Warranty obligations: Warranty terms are generally two years from date of manufacture or one year from date of installation. Warranty liability is recorded when revenue is recognized and is based on actual historical return rates from the most recent warranty periods. While the Company's warranty costs have historically been within its calculated estimates, it is possible that future warranty costs could exceed those estimates.

Pension and employee benefit obligations: With the assistance of actuaries and investment advisors the Company selects the discount rate to be used to determine pension and post-retirement plan liabilities based on a review of Moody's Aa bond ratings and U.S Treasury rates. A change in the discount rate selected by the Company of 25 basis points would result in a change of about $0.1 million of employee benefit expense. The Company consults with actuaries, asset allocation consultants and investment advisors to determine the expected long term rate of return on plan assets based on historical and projected rates of return on the types of assets in which the plans have invested. A change in the long term rate of return selected by the Company of 25 basis points would result in a change of about $0.3 million of employee benefit expense. See Note 3.

FACTORS THAT MAY AFFECT FUTURE RESULTS
Any forward-looking statements contained herein involve risks and uncertainties, including, but not limited to, general economic and currency conditions, various conditions specific to the Company's business and industry, market demand, competitive factors, supply constraints, technology factors, government and regulatory actions, the Company's accounting policies, future trends, and other risks, all as described in Exhibit 99.1 of this Form 10-K. These risks and uncertainties may cause actual results to differ materially from those indicated by the forward-looking statements. Any forward-looking statements included in this Form 10-K are based upon

information presently available. The Company does not assume any obligation to update any forward-looking information.

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