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MOG-A > SEC Filings for MOG-A > Form 10-K on 20-Nov-2012All Recent SEC Filings

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Form 10-K for MOOG INC


20-Nov-2012

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.

OVERVIEW
We are a worldwide designer, manufacturer and integrator of high performance precision motion and fluid controls and control systems for a broad range of applications in aerospace and defense and industrial markets. Within the aerospace and defense market, our products and systems include military and commercial aircraft flight controls, thrust vector controls for space launch vehicles, controls for gun aiming, stabilization and automatic ammunition loading for armored combat vehicles, satellite positioning controls and controls for steering tactical and strategic missiles. In the industrial market, our products are used in a wide range of applications including injection molding machines, metal forming, heavy industry, material and automotive testing, pilot training simulators, wind energy, enteral clinical nutrition pumps, infusion therapy pumps, oil exploration, motors used in sleep apnea devices, power generation, surveillance systems and slip rings used on CT scanners. We operate under five segments, Aircraft Controls, Space and Defense Controls, Industrial Systems, Components and Medical Devices. Our principal manufacturing facilities are located in the United States, England, the Philippines, Germany, China, India, Italy, The Netherlands, Japan, Costa Rica, Luxembourg, Ireland and Canada.
We have long-term contracts with some of our customers. These contracts are predominantly within Aircraft Controls and Space and Defense Controls and represent 32% of our sales. We recognize revenue on these contracts using the percentage of completion, cost-to-cost method of accounting as work progresses toward completion. The remainder of our sales are recognized when the risks and rewards of ownership and title to the product are transferred to the customer, principally as units are delivered or as service obligations are satisfied. This method of revenue recognition is predominantly used within the Industrial Systems, Components and Medical Devices segments, as well as with aftermarket activity.
We concentrate on providing our customers with products designed and manufactured to the highest quality standards. In achieving a leadership position in the high performance, precision controls market, we have capitalized on our strengths, which include:

superior technical competence,

customer diversity and broad product portfolio, and

well-established international presence serving customers worldwide.

We intend to increase our revenue base and improve our profitability and cash flows from operations by building on our market leadership positions, by strengthening our niche market positions in the principal markets that we serve and by extending our participation on the platforms we supply by providing more systems solutions. We also expect to maintain a balanced, diversified portfolio in terms of markets served, product applications, customer base and geographic presence. Our strategy to achieve our objectives includes:

maintaining our technological excellence by building upon our systems integration capabilities while solving our customers' most demanding technical problems,

striving for continuing cost improvements,

taking advantage of our global capabilities,

developing products for new and emerging markets,

growing our profitable aftermarket business, and

capitalizing on strategic acquisitions and opportunities.

We face numerous challenges to improve shareholder value. These include, but are not limited to, adjusting to dynamic global economic conditions that are influenced by governmental, industrial and commercial factors, pricing pressures from customers, strong competition, foreign currency fluctuations and increases in employee benefit costs. We address these challenges by focusing on strategic revenue growth and by continuing to improve operating efficiencies through various process and manufacturing initiatives and using low cost manufacturing facilities without compromising quality.


Acquisitions

All of our acquisitions are accounted for under the purchase method and, accordingly, the operating results for the acquired companies are included in the consolidated statements of earnings from the respective dates of acquisition. Under purchase accounting, we record assets and liabilities at fair value and such amounts are reflected in the respective captions on the balance sheet. The purchase price described for each acquisition below is net of any cash acquired and includes debt issued or assumed.

In 2012, we completed four business combinations. Two of these business combinations were in our Components segment. We acquired Protokraft, LLC, based in Tennessee, for $13 million plus contingent consideration with an initial fair value of $5 million. Protokraft designs and manufacturers opto-electronic transceivers, ethernet switches and media converters packaged into rugged, environmentally-sealed connectors. We also acquired Tritech International Limited, based in the UK, for $33 million. Tritech is a leading designer and manufacturer of high performance acoustic sensors, sonars, video cameras and mechanical tooling equipment. We also completed two business combinations in our Space and Defense Controls segment. We acquired Bradford Engineering, based in The Netherlands, for $13 million. Bradford is a developer and manufacturer of satellite equipment including attitude control, propulsion and thermal control subsystems. We also acquired In-Space Propulsion for $45 million. In-Space Propulsion has locations in New York, California, Ireland and the United Kingdom and is a developer and manufacturer of liquid propulsion systems and components for satellites and missile defense systems.

In 2011, we completed three business combinations within two of our segments. We completed two business combinations within our Aircraft Controls segment, both of which are located in the U.S. We acquired Crossbow Technology Inc., based in California, for $32 million. Crossbow designs and manufacturers acceleration sensors that are integrated into inertial navigation and guidance systems used in a variety of aerospace, defense and transportation applications. We also acquired a business that complements our military aftermarket business for $2 million in cash. We completed one business combination within our Components segment by acquiring Animatics Corporation, based in California. The purchase price was $24 million, which included 466,541 shares of Moog Class A common stock valued at $19 million. Animatics supplies integrated servos, linear actuators and control electronics that are used in a variety of industrial, medical and defense applications.
CRITICAL ACCOUNTING POLICIES
Our financial statements and accompanying notes are prepared in accordance with U.S. generally accepted accounting principles. The preparation of these consolidated financial statements requires us to make estimates, assumptions and judgments that affect the amounts reported. These estimates, assumptions and judgments are affected by our application of accounting policies, which are discussed in Note 1 of Item 8, Financial Statements and Supplementary Data of this report. We believe the accounting policies discussed below are the most critical in understanding and evaluating our financial results. These critical accounting policies have been reviewed with the Audit Committee of our Board of Directors.
Revenue Recognition on Long-Term Contracts Revenue representing 32% of 2012 sales was accounted for using the percentage of completion, cost-to-cost method of accounting. This method of revenue recognition is predominantly used within the Aircraft Controls and Space and Defense Controls segments due to the contractual nature of the business activities, with the exception of their respective aftermarket activities. The contractual arrangements are either firm fixed-price or cost-plus contracts and are with the U.S. Government or its prime subcontractors, foreign governments or commercial aircraft manufacturers, including Boeing and Airbus. The nature of the contractual arrangements includes customers' requirements for delivery of hardware as well as funded nonrecurring development work in anticipation of follow-on production orders.
We recognize revenue on contracts in the current period using the percentage of completion, cost-to-cost method of accounting as work progresses toward completion as determined by the ratio of cumulative costs incurred to date to estimated total contract costs at completion, multiplied by the total estimated contract revenue, less cumulative revenue recognized in prior periods. Changes in estimates affecting sales, costs and profits are recognized in the period in which the change becomes known using the cumulative catch-up method of accounting, resulting in the cumulative effect of changes reflected in the period. Estimates are reviewed and updated quarterly for substantially all contracts. A significant change in an estimate on one or more contracts could have a material effect on our results of operations.


Occasionally, it is appropriate to combine or segment contracts. Contracts are combined in those limited circumstances when they are negotiated as a package in the same economic environment with an overall profit margin objective and constitute, in essence, an agreement to do a single project. In such cases, we recognize revenue and costs over the performance period of the combined contracts as if they were one. Contracts are segmented in limited circumstances if the customer had the right to accept separate elements of the contract and the total amount of the proposals on the separate components approximated the amount of the proposal on the entire project. For segmented contracts, we recognize revenue and costs as if they were separate contracts over the performance periods of the individual elements or phases.
Contract costs include only allocable, allowable and reasonable costs which are included in cost of sales when incurred. For applicable Government contracts, contract costs are determined in accordance with the Federal Acquisition Regulations and the related Cost Accounting Standards. The nature of these costs includes development engineering costs and product manufacturing costs such as direct material, direct labor, other direct costs and indirect overhead costs. Contract profit is recorded as a result of the revenue recognized less costs incurred in any reporting period. Amounts representing performance incentives, penalties, contract claims or change orders are considered in estimating revenues, costs and profits when they can be reliably estimated and realization is considered probable. Revenue recognized on contracts for unresolved claims or unapproved contract change orders was not material in 2012, 2011 or 2010. Contract Loss Reserves
At September 29, 2012, we had contract loss reserves of $48 million. For contracts with anticipated losses at completion, a provision for the entire amount of the estimated remaining loss is charged against income in the period in which the loss becomes known. Contract losses are determined considering all direct and indirect contract costs, exclusive of any selling, general or administrative cost allocations that are treated as period expenses. Loss reserves are more common on firm fixed-price contracts that involve, to varying degrees, the design and development of new and unique controls or control systems to meet the customers' specifications. Reserves for Inventory Valuation
At September 29, 2012, we had net inventories of $538 million, or 35% of current assets. Reserves for inventory were $97 million, or 15% of gross inventories. Inventories are stated at the lower-of-cost-or-market with cost determined primarily on the first-in, first-out method of valuation.
We record valuation reserves to provide for slow-moving or obsolete inventory by using both a formula-based method that increases the valuation reserve as the inventory ages and, additionally, a specific identification method. We consider overall inventory levels in relation to firm customer backlog in addition to forecasted demand including aftermarket sales. Changes in these and other factors such as low demand and technological obsolescence could cause us to increase our reserves for inventory valuation, which would negatively impact our gross margin. As we record provisions within cost of sales to increase inventory valuation reserves, we establish a new, lower cost basis for the inventory. Reviews for Impairment of Goodwill
At September 29, 2012, we had $763 million of goodwill, or 25% of total assets. We test goodwill for impairment for each of our reporting units at least annually, during our fourth quarter, and whenever events occur or circumstances change, such as changes in the business climate, poor indicators of operating performance or the sale or disposition of a significant portion of a reporting unit.
We identify our reporting units by assessing whether the components of our operating segments constitute businesses for which discrete financial information is available and segment management regularly reviews the operating results of those components. Certain of our reporting units are our operating segments while others are one level below our operating segments.
Companies may perform a qualitative assessment as the initial step in the annual goodwill impairment testing process for all or selected reporting units. Companies are also allowed to bypass the qualitative analysis and perform a quantitative analysis if desired. Economic uncertainties and the length of time from the calculation of a baseline fair value are factors that we would consider in determining whether to perform a quantitative test.


When we evaluate the potential for goodwill impairment using a qualitative assessment, we consider factors including, but not limited to, macroeconomic conditions, industry conditions, the competitive environment, changes in the market for our products and services, regulatory and political developments, entity specific factors such as strategy and changes in key personnel and overall financial performance. If, after completing this assessment, it is determined that it is more likely than not that the fair value of a reporting unit is less than its carrying value, we proceed to a quantitative two-step impairment test.
Quantitative testing first requires a comparison of the fair value of each reporting unit to the carrying value. We use the discounted cash flow method to estimate the fair value of each of our reporting units. The discounted cash flow method incorporates various assumptions, the most significant being projected revenue growth rates, operating profit margins and cash flows, the terminal growth rate and the discount rate. Management projects revenue growth rates, operating margins and cash flows based on each reporting unit's current business, expected developments and operational strategies over a five-year period. If the carrying value of the reporting unit exceeds its fair value, goodwill is considered impaired and any loss must be measured. In measuring the impairment loss, the implied fair value of goodwill is determined by assigning a fair value to all of the reporting unit's assets and liabilities, including any unrecognized intangible assets, as if the reporting unit had been acquired in a business combination at fair value. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss would be recognized in an amount equal to that excess.
For our annual test of goodwill impairment in 2012, we performed a quantitative assessment for our Medical Devices reporting unit, which had $126 million of goodwill as of the date of our test. In performing this assessment, we used a 3% terminal growth rate, which is supported by our historical growth rate, near-term projections and long-term expected market growth. We then discounted the projected cash flows using a weighted average cost of capital of 10.5%. This discount rate reflects management's assumptions of marketplace participants' cost of capital and risk assumptions, both specific to the Medical Devices reporting unit and overall in the economy. Based on this test, the fair value of the Medical Devices reporting unit exceeded its carrying value by over 10%. Therefore, goodwill was not impaired. Had we used a discount rate that was 100 basis points higher than what we assumed, the fair value of the Medical Devices reporting unit would not have exceeded its carrying value and we would have measured impairment of goodwill. However, if we had we used a discount rate that was 50 basis points higher or a terminal growth rate that was 100 basis points lower than those we assumed, the fair value of the Medical Devices reporting unit would have continued to exceed its carrying value.
The determination of each of our assumptions is subjective and requires significant estimates. Changes in these estimates and assumptions could materially affect the results of our impairment review. If cash flows generated by our Medical Devices reporting unit were to decline significantly in the future or there were negative revisions to key assumptions, we may be required to record impairment charges. Among other things, our Medical Devices assumptions include growth of revenue, margins, and increased cash flows over time. If actual results differ from these assumptions, it may result in an impairment of our goodwill.
We performed qualitative assessments for the other seven reporting units and concluded that it is more likely than not that their fair values exceed their carrying values.
Based on our annual qualitative and quantitative assessments of our reporting units, we concluded that goodwill was not impaired. Purchase Price Allocations for Business Combinations During 2012, we completed four business combinations for a total purchase price of $110 million. Under purchase accounting, we recorded assets and liabilities at fair value as of the acquisition dates. We identified and ascribed value to programs, customer relationships, patents and technology, trade names, backlog and contracts and estimated the useful lives over which these intangible assets would be amortized. Valuations of these assets were performed largely using discounted cash flow models. These valuations support the conclusion that identifiable intangible assets had a value of $45 million. The resulting goodwill was $30 million.

Ascribing value to intangible assets requires estimates used in projecting relevant future cash flows, in addition to estimating useful lives of such assets. Using different assumptions could have a material effect on our current and future amortization expense


Pension Assumptions
We maintain various defined benefit pension plans covering employees at certain locations. Pension expense for all defined benefit plans for 2012 was $35 million. Pension obligations and the related costs are determined using actuarial valuations that involve several assumptions. The most critical assumptions are the discount rate and the long-term expected return on assets. Other assumptions include mortality rates, salary increases and retirement age. The discount rate is used to state expected future cash flows at present value. Using a lower discount rate increases the present value of pension obligations and increases pension expense. We used the Mercer Pension Discount Yield Curve to determine the discount rate for our U.S. plans. The discount rate is determined by discounting the plan's expected future benefit payments using a yield curve developed from high quality bonds that are rated AA or better by Moody's as of the measurement date. The yield curve calculation matches the notional cash inflows of the hypothetical bond portfolio with the expected benefit payments to arrive at the discount rate. In determining expense for 2012 for our largest U.S. plan, we used a 4.8% discount rate, compared to 5.3% for 2011. We will use a 3.8% discount rate to determine our expense in 2013 for this plan. This 100 basis point decrease in the discount rate will increase our pension expense by $10 million in 2013.

The long-term expected return on assets assumption reflects the average rate of return expected on funds invested or to be invested to provide for the benefits included in the projected benefit obligation. In determining the long-term expected return on assets assumption, we consider our current and target asset allocations. We consider the relative weighting of plan assets, the historical performance of total plan assets and individual asset classes and economic and other indicators of future performance. Asset management objectives include maintaining an adequate level of diversification to reduce interest rate and market risk and to provide adequate liquidity to meet immediate and future benefit payment requirements. In determining the 2012 expense for our largest plan, we used an 8.9% return on assets assumption, the same as we used in 2011. A 50 basis point decrease in the long-term expected return on assets assumption would increase our annual pension expense by $2 million.

Deferred Tax Asset Valuation Allowances
At September 29, 2012, we had gross deferred tax assets of $292 million and a deferred tax asset valuation allowance of $2 million. The deferred tax assets principally relate to benefit accruals, inventory obsolescence, tax benefit carry forwards and contract loss reserves. The $2 million deferred tax asset valuation allowance relates to certain tax benefit carryforwards.
We record a valuation allowance to reduce deferred tax assets to the amount of future tax benefit that we believe is more likely than not to be realized. We consider recent earnings projections, allowable tax carryforward periods, tax planning strategies and historical earnings performance to determine the amount of the valuation allowance. Changes in these factors could cause us to adjust our valuation allowance, which would impact our income tax expense when we determine that these factors have changed.


CONSOLIDATED RESULTS OF OPERATIONS AND OUTLOOK

                                                                  2012 vs. 2011               2011 vs. 2010
(dollars in millions
except per share data)     2012        2011        2010      $ Variance    % Variance    $ Variance    % Variance
Net sales                $ 2,470     $ 2,331     $ 2,114      $     139           6 %     $     217         10 %
Gross margin                30.2 %      29.2 %      29.0 %
Research and development
expenses                 $   116     $   106     $   103      $      10           9 %     $       3          3 %
Selling, general and
administrative expenses
as a percentage of sales    15.6 %      15.2 %      14.8 %
Restructuring expense    $     -     $     1     $     5      $      (1 )      (100 %)    $      (4 )      (80 %)
Interest expense         $    34     $    36     $    39      $      (2 )        (4 %)    $      (3 )       (8 %)
Effective tax rate          27.0 %      26.0 %      27.7 %
Net earnings             $   152     $   136     $   108      $      16          12 %     $      28         26 %
Diluted earnings per
share                    $  3.33     $  2.95     $  2.36      $    0.38          13 %     $    0.59         25 %

Net sales increased in 2012 compared to 2011 due to growth in Aircraft Controls and Components. During 2011, net sales increased in all of our segments with the exception of Components.
Our gross margin increased in 2012 compared to 2011 due to more beneficial product mix across multiple segments. We had stronger gross margins in Aircraft Controls, Components and Industrial Systems, while gross margins were fairly flat in Space and Defense Controls and Medical Devices. Our gross margin was relatively unchanged in 2011 compared to 2010. Volume increases and a more favorable product mix were offset by more additions to contract loss reserves. The loss reserves are primarily within our Aircraft Controls segment. Research and development increased in 2012 due to the ramp up of activity on the Airbus A350 program, partially offset by reduced activity on the Boeing 787-8 program. In 2011, research and development increased due to more activity on A350 development.
Our selling, general and administrative expenses as a percentage of sales increased in 2012 compared to 2011 due to a shift of activity from direct product support to selling support. The increase in 2011 compared to 2010 is a result of increased marketing efforts and bid and proposal activity for aerospace programs, partially offset by the efficiencies gained from our higher sales volume.
In 2009, we initiated restructuring efforts to better align our cost base with the lower level of sales and operating margins associated with the global recession. These actions continued in 2010 and 2011. In 2010, the restructuring actions were primarily in Aircraft Controls, Space and Defense Controls and Industrial Systems. In 2011, restructuring actions were primarily in the Industrial Systems segment.
Interest expense decreased in 2012 compared to 2011 as a result of lower interest rates. Interest expense decreased in 2011 compared to 2010 as a result of lower average borrowings and lower interest rates.

The effective tax rate for 2012 was higher than 2011 due to a lower foreign tax credits and research and development tax credits. Partially offsetting these items were a reduction in the deferred tax asset valuation allowance associated with net operating loss carryforwards from a foreign operation and a decrease in the legislated statutory tax rate in the U.K. affecting the measurement of deferred tax liabilities. The effective tax rate for 2011 is lower than 2010 primarily from the recognition of current and future tax benefits associated with the same net operating loss carry forward.

Net earnings and earnings per share increased in 2012, primarily driven by increases in operating profit from Aircraft Controls and, to a lesser extent, Components and Medical Devices. In 2011, net earnings and earnings per share increased as all of our segments, except for Components, had higher levels of operating profit than in 2010.


2013 Outlook - We expect sales in 2013 to increase between 6% and 8% to between $2.62 billion and $2.67 billion. This range reflects strength in most of our segments as well as uncertainty in the macro-economic picture within our Industrial Systems segment. We expect operating margin to be between 11.4% and 11.6%. We expect margin expansion in Aircraft Controls, Components and Medical Devices and a slight compression in Space and Defense Controls. We expect our Industrial Systems segment operating margin to be between 9.6% and 10.9%. We expect net earnings to increase to between $161 and $170 million and diluted earnings per share to increase between 5% and 11% to between $3.50 and $3.70. This outlook excludes any effect for 2013 from sequestration (as noted in Economic Conditions and Market Trends).


SEGMENT RESULTS OF OPERATIONS AND OUTLOOK
Operating profit, as presented below, is net sales less cost of sales and other
operating expenses, excluding interest expense, equity-based compensation
expense and other corporate expenses. Cost of sales and other operating expenses
are directly identifiable to the respective segment or allocated on the basis of
sales, manpower or profit. Operating profit is reconciled to earnings before
income taxes in Note17 of Item 8, Financial Statements and Supplementary Data of
this report.

Aircraft Controls

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