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PPO > SEC Filings for PPO > Form 10-K on 25-Feb-2014All Recent SEC Filings

Show all filings for POLYPORE INTERNATIONAL, INC.

Form 10-K for POLYPORE INTERNATIONAL, INC.


25-Feb-2014

Annual Report


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

The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto included in "Financial Statements and Supplementary Data." Some of the information contained in this discussion and analysis or included elsewhere in this report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. Please see "Forward-looking Statements" for more information. You should review "Risk Factors" for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained herein.

The following discussion includes financial information prepared in accordance with U.S. generally accepted accounting principles ("GAAP"), as well as segment operating income, which is considered a non-GAAP financial measure. Generally, a non-GAAP financial measure is a numerical measure of a financial performance that excludes amounts that are included in the most directly comparable measure calculated and presented in accordance with GAAP. The presentation of segment operating income is intended to supplement investors' understanding of our operating performance and is not intended to replace net income as determined in accordance with GAAP. Segment operating income is defined as operating income before stock-based compensation and certain non-recurring and other costs and is used by management to evaluate business segment performance and allocate resources. See Note 17, "Segment Information," in the accompanying consolidated financial statements for a reconciliation of segment operating income to income from continuing operations before income taxes.

The results of operations of Microporous are classified as discontinued operations and are excluded from continuing operations and segment results for all periods presented. All disclosures and amounts in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section relate to our continuing operations, unless otherwise indicated.

Overview

We are a leading global high-technology filtration company that develops, manufactures and markets specialized microporous membranes used in separation and filtration processes. In fiscal 2013, we generated total net sales of $636.3 million. We operate in two primary businesses: energy storage, which includes the transportation and industrial segment and the electronics and EDVs segment, and separations media. The transportation and industrial and separations media segments represent approximately 75% of our total net sales and operate in stable, growing markets, have high recurring revenue bases and generate strong cash flows. In the electronics and EDVs segment, we have a presence in the more established consumer electronics market but our most significant growth opportunity is the potentially larger and developing electric drive vehicle ("EDV") and energy storage systems ("ESS") markets where lithium is the disruptive technology. As described in more detail below, the long-term growth drivers for lithium batteries are positive, but we have and may continue to experience variability in the short term as these markets emerge.

Cash flows from operations, lower capital expenditures and proceeds from the sale of the Microporous business allowed us to generate significant amounts of cash in 2013. At December 28, 2013, we had $163.4 million in cash. We are continuing to evaluate our alternatives for cash depending on market and other conditions, including assessing options related to our capital structure and returning value to shareholders through share repurchases.

Energy Storage

In the energy storage business, our membrane separators are a critical functional component in lithium batteries, which are primarily used in consumer electronics and EDV applications, and lead-acid batteries, which are used globally in transportation and numerous industrial applications. We believe


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that the long-term growth drivers for the energy storage business-growth in Asia, demand for consumer electronics and growing demand for EDVs-are positive. The energy storage business is comprised of two reportable segments.

Electronics and EDVs. Lithium batteries are the power source in a wide variety of applications, including consumer electronics applications such as notebook computers, tablets, mobile phones and cordless power tools; EDVs; and emerging applications such as ESS. Demand for lithium batteries in consumer electronics is driven by the need for increased mobility. In EDV applications, demand is driven by the need to increase fuel efficiency to meet mileage standards in many countries such as the U.S. and China, the need to reduce carbon dioxide ("CO2") emissions around the world but especially in Europe due to regulations, conversion from nickel metal hydride to lithium battery technology in hybrid vehicles due to greater energy and power density, concern in developed countries and emerging markets over future access to petroleum at stable prices, smog and pollution control, and the need to address increasing transportation needs in developing economies. Since late 2009, we have expanded capacity at our existing Charlotte, North Carolina and Ochang, South Korea facilities and built a new facility in Concord, North Carolina. Production started for portions of the Concord facility in 2012 and the remaining capacity will ramp up over time as the nascent market for EDVs develops.

We recently signed a technology licensing agreement with Sumitomo Chemical Co., Ltd. ("Sumitomo") and a long-term supply agreement with Samsung SDI Co., Ltd. ("Samsung"), a global leader in lithium-ion batteries. The technology licensing agreement with Sumitomo entered into in December 2013 confirms the value of our intellectual property position regarding ceramic coatings and provides for an annual technology licensing fee. The long-term supply agreement with Samsung signed in January 2014 includes guaranteed purchase and supply volume requirements, volume-based price incentives and an initial four-year term with a two-year extension provision. We believe that this agreement highlights the value of our capacity investments and proven industry-leading products and technology. We will continue to seek long-term relationships with our customers and believe that the Sumitomo and Samsung agreements confirm the value of our technology and our ability to provide certainty of supply for high-growth applications like EDVs and ESS.

In January 2014, after a lengthy period of unsuccessful discussions with LG Chem, Ltd. ("LG") regarding various business terms of our relationship, we filed a complaint against LG alleging infringement of our patent covering ceramic coating technology. LG did not purchase separator from us during the fourth quarter of 2013 and has recently stated verbally that it is attempting to qualify alternate sources of supply. We do not know if or when LG will be successful in qualifying alternative separator sources.

We believe that the long-term demand drivers for our products-consumer demand for mobility, regulations for better fuel efficiency and lower CO2 emissions, conversion from nickel metal hydride to lithium battery technology in hybrids, concerns about access to petroleum, efforts to reduce pollution, and increasing transportation needs in developing countries-remain intact. While consumer electronics applications have attractive long-term market growth trends, EDV and ESS applications represent our most significant growth opportunity and the long-term outlook continues to be positive. Based on industry forecasts and industry studies, the use of lithium technology in EDV applications is expected to grow at a compound annual growth rate in excess of 40% through 2020 on an energy capacity basis. Many factors influence membrane separator usage in lithium-ion batteries, but because many new applications are incorporating large-format lithium batteries that require much greater membrane separator volume per battery, we believe that membrane separator growth will exceed battery unit sales growth and although not perfectly correlated, will more closely approximate the growth rate in energy capacity. We believe the electrification of the worldwide fleet of vehicles is just beginning, from hybrids to plug-ins to full battery electric vehicles, including automobiles, buses, taxis and commercial fleet vehicles. We believe our dry process products continue to be the preferred product in large format lithium-ion batteries for EDVs and ESS. We are currently working with existing and new customers on


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next-generation batteries, which is important considering the long lead times required to become qualified for EDV applications. EDV and ESS are emerging market applications and are being adopted around the world in many forms. We are qualified on more than fifty EDV models and have field-proven products, significant production capacity already in place, technical advantages, low-cost manufacturing capabilities and intellectual property around ceramic coatings for lithium battery separators. We believe the factors that influenced our decision to expand capacity remain valid, and we continue to expect significant sales growth and expect to utilize our current production capacity as the EDV market develops and as ESS experiences more meaningful adoption. Although the long-term growth drivers are positive for these applications, short-term fluctuations in demand can be expected in the early stages of adoption while initial penetration rates are low. Given the high-separator content for these applications and the potential size of these markets, small changes in end-market demand can have a significant impact on our business.

Transportation and industrial. In the lead-acid battery market, the high proportion of aftermarket replacement sales and the steady growth of the worldwide fleet of motor vehicles provide us with a growing recurring revenue base in lead-acid battery separators. Worldwide demand for lead-acid battery separators is expected to continue to grow at slightly more than annual economic growth. The Asia-Pacific region is the fastest growing market for lead-acid battery separators. Growth in this region is driven by the increasing penetration of automobile ownership, growth in industrial and manufacturing sectors, export incentives and ongoing conversion to the polyethylene-based membrane separators we produce.

Separations Media

In the separations media business, our filtration membranes and modules are used in healthcare and high-performance filtration and specialty applications. We believe that the separations media business will continue to benefit from continued growth in demand for higher levels of purity in a growing number of applications. The separations media business is a reportable segment.

For healthcare applications, we produce membranes used in blood filtration applications for hemodialysis, blood oxygenation and plasmapheresis. Growth in demand for hemodialysis membranes is driven by the increasing worldwide population of end-stage renal disease patients. We believe that conversion to single-use dialyzers and increasing treatment frequency will result in additional dialyzer market growth. In late 2011, we completed the expansion of our PUREMAŽ hemodialysis membrane production capacity to support future market growth.

For filtration and specialty applications, we produce a wide range of membranes and membrane-based elements for micro-, ultra- and nanofiltration and gasification/degasification of liquids. Micro-, ultra- and nanofiltration membrane element market growth is being driven by several factors, including end-market growth in applications such as water treatment and pharmaceutical processing, displacement of conventional filtration media by membrane filtration due to membranes' superior cost and performance attributes, and increasing purity requirements in industrial and other applications.

Critical accounting policies

Critical accounting policies are those accounting policies that can have a significant impact on the presentation of our financial condition and results of operations, and that require the use of complex and subjective estimates based on past experience and management's judgment. Because of the uncertainty inherent in such estimates, actual results may differ from these estimates. Below are those policies that we believe are critical to the understanding of our operating results and financial condition. Management has discussed the development and selection of these critical accounting policies with the Audit Committee of our Board of Directors. For additional accounting policies, see


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Note 2 of the consolidated financial statements included in "Financial
Statements and Supplementary Data."

Impairment of goodwill

Goodwill is subject to annual impairment testing unless circumstances dictate more frequent assessments. We perform our annual impairment assessment for goodwill as of the first day of the fourth quarter of each fiscal year and more frequently whenever events or changes in circumstances indicate that the fair value of the asset may be less than the carrying amount. Our reporting units are at the operating segment level.

We performed a quantitative two-step goodwill impairment test. Step one of the goodwill impairment test compares the fair value of our reporting units to their carrying amount. The fair value of the reporting unit is determined using the income approach, corroborated by comparison to market capitalization and key multiples of comparable companies. Under the income approach, we determine fair value based on estimated future cash flows of each reporting unit, discounted by an estimated weighted-average cost of capital. If the fair value of the reporting unit is greater than its carrying amount, there is no impairment. If the reporting unit's carrying amount exceeds its fair value, then the second step must be completed to measure the amount of impairment, if any. Step two calculates the implied fair value of goodwill by deducting the fair value of all tangible and intangible net assets of the reporting unit from the fair value of the reporting unit as calculated in step one. In this step, the fair value of the reporting unit is allocated to all of the reporting unit's assets and liabilities in a hypothetical purchase price allocation as if the reporting unit had been acquired on that date. If the carrying amount of goodwill exceeds the implied fair value of goodwill, an impairment loss will be recognized in an amount equal to the excess.

Determining the fair value of a reporting unit is judgmental in nature and requires the use of significant estimates and assumptions, including revenue growth rates, strategic plans and future market conditions, among others. There can be no assurance that our estimates and assumptions made for purposes of the goodwill impairment testing will prove to be accurate predictions of the future. If our assumptions regarding forecasted revenue or margin growth rates of certain reporting units are not achieved or changes in strategy or market conditions occur, we may be required to record goodwill impairment charges in future periods. It is not possible at this time to determine if any such future impairment charge would result or, if it does, whether such charge would be material.

In fiscal 2013, our annual impairment test indicated that the fair value of the reporting units substantially exceeded their respective carrying amounts.

Pension benefits

Certain assumptions are used in the calculation of the actuarial valuation of our defined benefit pension plans. Two critical assumptions, discount rate and expected return on assets, are important elements of plan expense and/or liability measurement and differences between actual results and these two actuarial assumptions can materially affect our projected benefit obligation or the valuation of our plan assets. Other assumptions involve demographic factors such as retirement, expected increases in compensation, mortality and turnover. The discount rate enables us to state expected future cash flows at a present value on the measurement date. The discount rate assumptions are based on the market rate for high quality fixed income investments. At December 28, 2013, a decrease of one percentage point in the discount rate would increase our projected benefit obligations and the unfunded status of our pension plans by $20.8 million. The expected rates of return on our pension plans' assets are based on the asset allocation of each plan and the long-term projected return of those assets. For 2013, if the expected rate of return on pension plan assets were reduced by one percentage point, the result would have increased our net periodic benefit expense for fiscal 2013 by $0.1 million. At December 28, 2013, if the actual plan assets were reduced by one percentage point, the unfunded status of our pension plans would increase by $0.2 million.


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Repairs and maintenance

Repair and maintenance costs, which include indirect labor and employee benefits associated with maintenance personnel and utility, maintenance and repair costs for equipment and facilities utilized in the manufacturing process, are treated as inventoriable costs. Repair and maintenance costs as a percent of cost of goods sold has been consistent for fiscal 2013, 2012 and 2011. Major planned maintenance activities outside of the normal production process are capitalized as property, plant and equipment if the costs are expected to provide future benefits by increasing the service potential of the asset to which the repair or maintenance applies. We have not had any major planned maintenance activities or capitalized significant repair and maintenance costs as property, plant and equipment in the last three fiscal years.

Stock-based compensation

Stock-based compensation expense is based on the fair value of the award at grant date using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the use of significant assumptions, including expected term of the options and expected volatility. We determine expected term based on historical experience, vesting periods, structure of option plans and contractual term of the options. Expected volatility is estimated based on our historical stock prices and implied volatility from traded options. The assumptions used in calculating the fair value of awards involve inherent uncertainty and management judgment. If factors change or we use different assumptions for estimating stock-based compensation expense in future periods, stock-based compensation expense may differ materially in the future.

Results of operations

The following table sets forth, for the fiscal years indicated, certain of our historical operating data in amount and as a percentage of net sales:

                                                                  Fiscal Year
  (in millions)                                            2013      2012      2011
  Net sales                                               $ 636.3   $ 648.7   $ 685.7


  Gross profit                                              220.7     245.2     299.5
  Selling, general and administrative expenses              132.8     121.4     129.8


  Operating income                                           87.9     123.8     169.7
  Interest expense, net                                      39.5      36.0      34.4
  Other                                                       0.7       2.4      (1.9 )


  Income from continuing operations before income taxes      47.7      85.4     137.2
  Income taxes                                               14.2      25.3      46.0


  Income from continuing operations                       $  33.5   $  60.1   $  91.2

                                                                  Fiscal Year
  (percent of sales)                                       2013      2012      2011
  Net sales                                                 100.0 %   100.0 %   100.0 %


  Gross profit                                               34.7      37.8      43.7
  Selling, general and administrative expenses               20.9      18.7      19.0


  Operating income                                           13.8      19.1      24.7
  Interest expense, net                                       6.2       5.5       5.0
  Other                                                       0.1       0.4      (0.3 )


  Income from continuing operations before income taxes       7.5      13.2      20.0
  Income taxes                                                2.2       3.9       6.7


  Income from continuing operations                           5.3 %     9.3 %    13.3 %


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Fiscal 2013 compared with fiscal 2012

Net sales. Net sales for fiscal 2013 were $636.3 million, a decrease of $12.4 million, or 1.9%, from fiscal 2012, as higher sales in the transportation and industrial and separations media segments and the positive impact of foreign currency translation of $4.9 million were more than offset by lower sales in the electronics and EDVs segment. See "Financial reporting segments" below for more information.

Gross profit. Gross profit was $220.7 million, a decrease of $24.5 million from fiscal 2012. Gross profit as a percent of net sales was 34.7% for fiscal 2013 compared to 37.8% for fiscal 2012. The decrease in consolidated gross profit and gross profit margin was primarily due to lower sales in the electronics and EDVs segment. Gross profit as a percent of net sales was consistent with the prior year in the transportation and industrial and separations media segments. See "Financial reporting segments" below for more information.

Selling, general and administrative expenses. Selling, general and administrative expenses increased $11.4 million in fiscal 2013 compared to fiscal 2012, primarily due to a $6.1 million increase in performance-based incentive compensation expense and a $4.4 million increase in stock-based compensation expense. Selling, general and administrative expenses were 20.9% of consolidated net sales in fiscal 2013 and 18.7% in fiscal 2012.

Segment operating income. Segment operating income, which excludes stock-based compensation and certain non-recurring and other costs, was $110.7 million, a decrease of $31.0 million from fiscal 2012. Segment operating income as a percent of net sales was 17.4% for fiscal 2013 compared to 21.8% for fiscal 2012. The decrease in segment operating income and segment operating income margin was primarily due to lower sales in the electronics and EDVs segment and an increase in performance-based incentive compensation expense. Operating income as a percent of net sales was consistent with the prior year in the transportation and industrial and separations media segments. See "Financial reporting segments" below for more information.

Interest expense. Interest expense for fiscal 2013 increased by $3.5 million from fiscal 2012, primarily resulting from a decrease in capitalized interest.

Income taxes. Income taxes as a percentage of pre-tax income for fiscal 2013 were 29.9% compared to 29.6% for fiscal 2012. The income tax expense recorded in the financial statements fluctuates between years due to the mix of income between the U.S. and foreign jurisdictions taxed at varying rates and a variety of other factors, including state income taxes and changes in estimates of permanent differences and valuation allowances. The mix of earnings between the tax jurisdictions has a significant impact on the effective tax rate. Each tax jurisdiction has its own set of tax laws and tax rates, and income earned by our subsidiaries is taxed independently by these various jurisdictions. Currently, the applicable statutory income tax rates in the jurisdictions in which we operate range from 0% to 42%.

The components of our effective tax rate are as follows:

                                                 Fiscal 2013     Fiscal 2012
        U.S. federal statutory rate                      35.0 %          35.0 %
        State income taxes                                  -             0.4
        Mix of income in taxing jurisdictions            (3.7 )          (6.3 )
        Other                                            (1.4 )           0.5


        Total effective tax rate                         29.9 %          29.6 %


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Fiscal 2012 compared with fiscal 2011

Net sales. Net sales for fiscal 2012 were $648.7 million, a decrease of $37.0 million, or 5.4%, from fiscal 2011, as higher sales in the transportation and industrial and separations media segments were more than offset by lower sales in the electronics and EDVs segment and the negative impact of foreign currency translation of $22.5 million. See "Financial reporting segments" below for more information.

Gross profit. Gross profit was $245.2 million, a decrease of $54.3 million from fiscal 2011. Gross profit as a percent of net sales was 37.8% for fiscal 2012 compared to 43.7% for fiscal 2011. The decrease in consolidated gross profit and gross profit margin was primarily due to lower sales and the impact of fixed costs associated with new production capacity in the electronics and EDVs segment. In addition, consolidated gross profit and gross profit margin was impacted by higher costs to export lead-acid separators from U.S. and European production facilities to meet growing demand in Asia in the transportation and industrial segment. See "Financial reporting segments" below for more information.

Selling, general and administrative expenses. Selling, general and administrative expenses decreased $8.4 million in fiscal 2012 compared to fiscal 2011, primarily due to a $13.8 million decrease in performance-based incentive compensation expense and $3.2 million lower amortization expense, partially offset by a $7.0 million increase in stock-based compensation expense. Selling, general and administrative expenses were 18.7% of consolidated net sales in fiscal 2012 and 19.0% in fiscal 2011.

Segment operating income. Segment operating income, which excludes stock-based compensation and certain non-recurring and other costs, was $141.7 million, a decrease of $37.9 million from fiscal 2011. Segment operating income as a percent of net sales was 21.8% for fiscal 2012 compared to 26.2% for fiscal 2011. The decrease in segment operating income and segment operating income margin was the result of lower sales and the impact of fixed costs associated with new production capacity in the electronics and EDVs segment, higher costs to export lead-acid separators from U.S. and European production facilities to meet growing demand in Asia in the transportation and industrial segment, partially offset by a decline in performance-based incentive compensation expense in corporate and other costs. See "Financial reporting segments" below for more information.

Interest expense. Interest expense for fiscal 2012 increased by $1.6 million from fiscal 2011, primarily resulting from a decrease in capitalized interest.

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