**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**(MarkOne)**

 

| **ý** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------|----------------------------------------------------------------------------------------------|

 

**For thequarterly period ended March 30, 2002**

 

**OR**

 

| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------|

 

**For thetransition periodfrom                             to                             **

 

**Commissionfile number:               33-80701**

 

**AAF-MCQUAYINC.**

(Exact name ofRegistrant as Specified in Its Charter)

 

| **Delaware**                                                                       |   | **41-0404230**                        |
|------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or Other  Jurisdiction of Incorporation or Organization)                    |   | (I.R.S. Employer  Identification No.) |
|                                                                               |   |                                  |
| **10300  Ormsby Park Pl. Ste 600, Louisville, Kentucky**                           |   | **40223**                             |
| (Address of  Principal Executive Offices)                                          |   | (Zip Code)                            |
|                                                                               |   |                                  |
| Registrant’s  telephone number, including area code                           |   | **(502)  637-0011**                   |
|                                                                               |   |                                  |
| **Not  applicable**                                                                |
| Former Name,  Former Address and Former Fiscal Year, if Changed Since Last Report. |

 

Indicate by check whether the registrant (1) has filedall reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes  ý No   o

 

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock, as of the latest practicable date:  2,497 shares of Common Stock, par value$100.00 per share, were outstanding as of April 25, 2002.

 

 

INDEX

 

AAF-MCQUAY INC.AND SUBSIDIARIES

 
| Part I -  |   | Financial Information                                                                                          |
|-----------|--------|----------------------------------------------------------------------------------------------------------------|
|      |   |                                                                                                           |
| Item 1.   |   | Financial Statements  (unaudited)                                                                              |
|      |   |                                                                                                           |
|      |   | Consolidated Balance Sheets  as of March 31, 2002 and June 30, 2001                                            |
|      |   |                                                                                                           |
|      |   | Consolidated  Statements of Income - Three and Nine Months Ended March 31, 2002 and 2001                       |
|      |   |                                                                                                           |
|      |   | Condensed  Consolidated Statements of Cash Flows - Nine Months Ended March 31, 2002 and  2001                  |
|      |   |                                                                                                           |
|      |   | Consolidated  Statements of Comprehensive Income (Loss) - Three and Nine Months Ended March  31, 2002 and 2001 |
|      |   |                                                                                                           |
|      |   | Notes  to the Consolidated Financial Statements                                                                |
|      |   |                                                                                                           |
| Item  2.  |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                    |
|      |   |                                                                                                           |
| Item  3.  |   | Quantitative  and Qualitative Disclosures about Market Risk                                                    |
|      |   |                                                                                                           |
| Part II - |   | Other Information                                                                                              |
|      |   |                                                                                                           |
| Item 1.   |   | Legal Proceedings                                                                                              |
|      |   |                                                                                                           |
| Item 6.   |   | Exhibits and  Reports on Form 8-K                                                                              |
|      |   |                                                                                                           |
|      |   | Signatures                                                                                                     |

 

2

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**PARTI:                 FINANCIAL INFORMATION**

 

**Item1.     Financial Statements**

 

## **AAF-McQUAYINC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

(unaudited)

(dollars inthousands, except share data)

 
|                                                                                          |   | **March 31,  2002** |       | **June 30,  2001** |       |
|-----------------------------------------------------------------------------------------------|--------|---------------------|------------|--------------------|------------|
| **ASSETS**                                                                                    |   |                | ** ** |               | ** ** |
| Current  assets:                                                                              |   |                |       |               |       |
| Cash  and cash equivalents                                                                    |   | $                   | 9,136      |               | $          | 14,254 |   |
| Accounts  receivable                                                                          |   | 163,878             |       | 191,942            |       |
| Inventories                                                                                   |   | 97,983              |       | 101,802            |       |
| Other  current assets                                                                         |   | 6,274               |       | 8,370              |       |
| Total  current assets                                                                         |   | 277,271             |       | 316,368            |       |
|                                                                                          |   |                |       |               |       |
| Property,  plant and equipment, net                                                           |   | 108,538             |       | 118,744            |       |
| Cost  in excess of net assets acquired and other identifiable intangibles, net                |   | 186,114             |       | 201,731            |       |
| Other  assets and deferred charges                                                            |   | 14,299              |       | 17,171             |       |
| Total  assets                                                                                 |   | $                   | 586,222    |               | $          | 654,014 |   |
|                                                                                          |   |                | ** ** |               | ** ** |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                |   |                | ** ** |               | ** ** |
|                                                                                          |   |                |       |               |       |
| Current  liabilities:                                                                         |   |                |       |               |       |
| Short-term  borrowings                                                                        |   | $                   | 51,023     |               | $          | 63,938 |   |
| Current  maturities of long-term debt                                                         |   | 6,031               |       | 6,120              |       |
| Accounts  payable, trade                                                                      |   | 85,765              |       | 100,585            |       |
| Accrued  warranty                                                                             |   | 19,216              |       | 19,567             |       |
| Accrued  employee compensation                                                                |   | 24,461              |       | 27,155             |       |
| Other  accrued liabilities                                                                    |   | 25,946              |       | 42,947             |       |
| Total  current liabilities                                                                    |   | 212,442             |       | 260,312            |       |
|                                                                                          |   |                |       |               |       |
| Long-term  debt.                                                                              |   | 113,406             |       | 131,429            |       |
| Deferred  income taxes                                                                        |   | 24,399              |       | 26,029             |       |
| Other  liabilities                                                                            |   | 43,027              |       | 49,003             |       |
| Total  liabilities                                                                            |   | 393,274             |       | 466,773            |       |
|                                                                                          |   |                |       |               |       |
| Stockholders’  equity:                                                                   |   |                |       |               |       |
| Preferred  stock ($1 par value; 1,000 shares authorized, none issued)                         |   | —              |       | —             |       |
| Common  stock ($100 par value; 8,000 shares authorized, 2,497 shares issued and  outstanding) |   | 250                 |       | 250                |       |
| Additional  paid-in capital                                                                   |   | 179,915             |       | 179,915            |       |
| Retained  earnings                                                                            |   | 33,266              |       | 29,606             |       |
| Accumulated  other comprehensive loss                                                         |   | (20,483             | )          | (22,530            | )          |
| Total  stockholders’ equity                                                              |   | 192,948             |       | 187,241            |       |
| Total  liabilities and stockholders’ equity                                              |   | $                   | 586,222    |               | $          | 654,014 |   |

 

See Notes to theConsolidated Financial Statements

 

3

----

 

**AAF-McQUAY INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF INCOME**

(unaudited)

(dollars inthousands)

 
|                                 |   | **Three  Months Ended  March 31,** |    | **Nine  Months Ended  March 31,** |   |
|--------------------------------------|--------|------------------------------------|---------|-----------------------------------|--------|
|                                 |   | **2002**                           |    | **2001**                          |   | **2002** |   | **2001** |   |
|                                 |   |                               |    |                              |   |   |   |   |   |
| Net  sales                           |   | $                                  | 182,899 |                              | $      | 210,997 |   | $ | 586,824 |   | $ | 637,883 |   |
| Cost  of sales                       |   | 137,246                            |    | 156,056                           |   | 437,142 |   | 471,930 |   |
| Gross  profit                        |   | 45,653                             |    | 54,941                            |   | 149,682 |   | 165,953 |   |
| Operating  expenses:                 |   |                               |    |                              |   |   |   |   |   |
| Selling,  general and administrative |   | 39,877                             |    | 45,089                            |   | 124,512 |   | 132,499 |   |
| Restructuring                        |   | —                             |    | 631                               |   | 450 |   | 7,177 |   |
| Amortization  of intangible assets   |   | 2,689                              |    | 2,758                             |   | 8,135 |   | 8,276 |   |
|                                 |   | 42,566                             |    | 48,478                            |   | 133,097 |   | 147,952 |   |
| Income  from operations              |   | 3,087                              |    | 6,463                             |   | 16,585 |   | 18,002 |   |
| Interest  expense, net               |   | 3,450                              |    | 4,663                             |   | 11,569 |   | 14,958 |   |
| Gain  on sale of property            |   | —                             |    | —                            |   | — |   | (4,538 | ) |
| Loss  on sale of business            |   | 495                                |    | —                            |   | 475 |   | — |   |
| Other  (income) expense, net         |   | (1,823                             | )       | 42                                |   | (1,745 | ) | (419 | ) |
| Income  before income taxes          |   | 965                                |    | 1,758                             |   | 6,286 |   | 8,001 |   |
| Minority  interest earnings (loss)   |   | 20                                 |    | (32                               | )      | (49 | ) | (124 | ) |
| Provision  for income taxes          |   | 396                                |    | 827                               |   | 2,577 |   | 3,762 |   |
| Net  income                          |   | $                                  | 589     |                              | $      | 899 |   | $ | 3,660 |   | $ | 4,115 |   |

 

See Notes to theConsolidated Financial Statements

 

4

----

 

**AAF-McQUAY INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

 (unaudited)

(dollars inthousands)

 
|                                                                 |   | **Nine  Months Ended  March 31,** |   |
|----------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                 |   | **2002**                          |   | **2001** |   |
| Cash  flows from operating activities:                               |   |                              |   |   |   |
| Net  income                                                          |   | $                                 | 3,660  |   | $ | 4,115 |   |
| Adjustments  to reconcile to net cash from operating activities:     |   |                              |   |   |   |
| Depreciation  and amortization                                       |   | 21,251                            |   | 21,323 |   |
| Loss  on sale of business                                            |   | 475                               |   | — |   |
| Gain  on sale of property                                            |   | —                            |   | (4,538 | ) |
| Other  non-cash items, net                                           |   | (1,575                            | )      | (400 | ) |
| Changes  in operating assets and liabilities                         |   | (7,144                            | )      | (7,005 | ) |
|                                                                 |   |                              |   |   |   |
| Net  cash from operating activities                                  |   | 16,667                            |   | 13,495 |   |
|                                                                 |   |                              |   |   |   |
| Cash  flows from investing activities:                               |   |                              |   |   |   |
| Capital  expenditures, net                                           |   | (5,443                            | )      | (10,567 | ) |
| Proceeds  from sale of property                                      |   | —                            |   | 6,922 |   |
| Proceeds  from sale of business                                      |   | 14,952                            |   | — |   |
| Net  cash from investing activities                                  |   | 9,509                             |   | (3,645 | ) |
|                                                                 |   |                              |   |   |   |
| Cash  flows from financing activities:                               |   |                              |   |   |   |
| Net  borrowings (repayments) under short-term borrowing arrangements |   | (13,173                           | )      | 2,508 |   |
| Payments  on long-term debt                                          |   | (5,833                            | )      | (6,322 | ) |
| Proceeds  from issuance of long-term debt                            |   | 2,393                             |   | 238 |   |
| Repurchase  of senior notes                                          |   | (14,990                           | )      | (7,443 | ) |
| Net  cash from financing activities                                  |   | (31,603                           | )      | (11,019 | ) |
|                                                                 |   |                              |   |   |   |
| Effect  of exchange rate changes on cash                             |   | 309                               |   | (920 | ) |
| Net  decrease in cash and cash equivalents                           |   | (5,118                            | )      | (2,089 | ) |
| Cash  and cash equivalents at beginning of period                    |   | 14,254                            |   | 11,522 |   |
|                                                                 |   |                              |   |   |   |
| Cash  and cash equivalents at end of period                          |   | $                                 | 9,136  |   | $ | 9,433 |   |

 

See Notes to theConsolidated Financial Statements

 

5

----

 

# **AAF-McQUAYINC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFCOMPREHENSIVE INCOME (LOSS)**

(unaudited)

(dollars inthousands)

** **
|                                                                                        |   | **Three  Months Ended  March 31,** |   | **Nine  Months Ended  March 31,** |   |
|---------------------------------------------------------------------------------------------|--------|------------------------------------|--------|-----------------------------------|--------|
|                                                                                        |   | **2002**                           |   | **2001**                          |   | **2002** |   | **2001** |   |
| Net  income                                                                                 |   | $                                  | 589    |                              | $      | 899 |   | $ | 3,660 |   | $ | 4,115 |   |
| Other  comprehensive income (loss):                                                         |   |                               |   |                              |   |   |   |   |   |
| Foreign  currency translation adjustments                                                   |   | 1,345                              |   | (2,086                            | )      | 2,905 |   | (3,255 | ) |
| Write  off of accumulated foreign currency translation adjustments due to sale of  business |   | (637                               | )      | —                            |   | (858 | ) | — |   |
| Comprehensive  income (loss)                                                                |   | $                                  | 1,297  |                              | $      | (1,187 | ) | $ | 5,707 |   | $ | 860 |   |

 

See Notes to theConsolidated Financial Statements

 

6

----

** **

**Notesto the Consolidated Financial Statements (unaudited)**

 

***1.  Basis of Presentation***

 

The consolidatedfinancial statements include the accounts of the Company and all of itswholly-owned subsidiaries.  Allinter-company transactions have been eliminated.  The accompanying unaudited consolidated financial statements havebeen prepared in accordance with accounting principles generally accepted inthe United States for interim reporting and with the instructions to Form 10-Qand Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with accountingprinciples generally accepted in the United States have been omitted.  For further information, refer to theconsolidated financial statements and footnotes thereto included in theCompany’s Annual Report on Form 10-K (the “Annual Report”) for the year endedJune 30, 2001.  In the opinion ofmanagement, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation have been included.

 

The operating results forthe nine months ended March 31, 2002 are not necessarily indicative of theoperating results that may be expected for the full year ending June 30,2002.  The Company’s period end is theSaturday closest to March 31. For clarity in presentation all periods presentedherein are shown to end on the last calendar day of the month.  Certain reclassifications of amounts in theconsolidated financial statements have been made to reflect comparability.

 

**RecentAccounting Pronouncements**

 

In June 2001, theFinancial Accounting Standards Board (“FASB”) issued Statements of FinancialAccounting Standards (SFAS) No. 141, *Business Combinations*, and No. 142, *Goodwill andOther Intangibles Assets*, effective for fiscal years beginning afterDecember 15, 2001.  Under the new rules,goodwill and intangible assets deemed to have indefinite lives will no longerbe amortized, but will be subject to annual impairment tests in accordance withthe Statements.  Other intangible assetswill continue to be amortized over their useful lives.  The Company is required to apply the newrules on accounting for goodwill and other intangible assets beginning thefirst quarter of fiscal 2003.  TheCompany is currently assessing the financial impact that SFAS Nos. 141 and 142will have on its earnings and financial position.

 

In August 2001, the FASBissued SFAS No. 144*, Accounting for the Impairment or Disposal ofLong-Lived Assets*, which addresses financial accounting andreporting for the impairment or disposal of long-lived assets and supercedesSFAS No. 121, *Accounting for the Impairment of Long-Lived Assets and for Long-LivedAssets to be Disposed Of*, and the accounting and reportingprovisions of APB No. 30, *Reporting the Results of Operations*, for adisposal of a segment of a business. SFAS No. 144 is effective for fiscal years beginning after December 15,2001.  The Company expects to adopt SFASNo. 144 as of July 1, 2002 and it does not expect that the adoption of theStatement will have a significant impact on the Company’s financial positionand results of operations.

 

***2.  Inventories***

 

Inventories consist of the following:

 
|             |   | **March  31,  2002**   |   | **June 30,  2001** |   |
|------------------|--------|-----------------------------|--------|--------------------|--------|
|             |   | **(dollars  in thousands)** |   |
| FIFO  cost:      |   |                        |   |               |   |
| Raw  materials   |   | $                           | 39,830 |               | $      | 42,706 |   |
| Work-in-process  |   | 18,250                      |   | 17,691             |   |
| Finished  goods  |   | 40,432                      |   | 41,851             |   |
|             |   | 98,512                      |   | 102,248            |   |
| LIFO  adjustment |   | (529                        | )      | (446               | )      |
|             |   | $                           | 97,983 |               | $      | 101,802 |   |

 

7

----

 

***3.  Provision for Income Taxes***

 

Thetax provisions for the three month and nine month periods ended March 31, 2002and 2001 are based on the estimated effective tax rates applicable for the fullyears, and after giving effect to significant unusual items relatedspecifically to the interim periods. The difference between the Company’s reported tax provisions, for thethree month and nine month periods ended March 31, 2002 and 2001, and the taxprovisions computed based on U.S. statutory rates is primarily attributable tonondeductible goodwill amortization, unbenefittedforeign losses and export sales tax benefit.

 

***4.  Debt and Financial Instruments***

 

Inthe first quarter of fiscal 2002, the Company repurchased $2 million of itsSenior Notes at a discount. The Company plans to hold these repurchased notesuntil their maturity in February 2003. In the second quarter of fiscal 2002, the Company repurchased andretired $13 million of its Senior Notes at par with proceeds from the sale ofits Singapore subsidiary.  Thesetransactions resulted in the write-off of associated debt issuance costs of$20,000 and $95,000 in the first and second quarters of fiscal 2002,respectively.  See Note 6 to theunaudited consolidated financial statements for further discussion. Theoutstanding principal amount of Senior Notes after the repurchases and includedin the Company’s long-term debt at March 31, 2002 was $94 million.

 

InJanuary 2000, the Company entered into an interest rate swap transactionwhereby the Company receives a fixed rate and pays a floating rate on the basisof 3-month Libor.  The January 2000 swaphas a three-year term and a notional amount of $30 million and effectivelyconverts a portion of the Company’s fixed rate borrowings to a floatingrate.  Measurement dates and thematurity date of the swap match interest payment dates and the maturity date ofthe Company’s Senior Notes.  In November2001, the Company terminated its $30 million interest rate floor, whichrequired the Company to make payments if 3-month Libor fell below a certainlevel.  The transaction cost of thistermination was paid by accepting a lower swap rate on the January 2000 swapand by changing the floating rate basis from 3-month Libor to 6-monthLibor.  The Company records its swap andfloor in its balance sheet at fair market value.  A loss of $0.2 million and income of $0.3 million was recorded asa result of these positions for the nine months ended March 31, 2002 and 2001,respectively.

 

***5.  Restructuring Charges***

 

Inthe second quarter of fiscal 2002, the Company approved and commencedrestructuring actions in its Filtration Products segment, recording reserves ofapproximately $0.5 million.  The reserveprimarily represents severance accruals related to the elimination ofapproximately 30 employees in its Latin American and European air filtrationmanufacturing units.  The Companycompleted these restructuring efforts in the quarter ended March 31, 2002.

 

Asdescribed in Note 9 of the Annual Report, the Company implemented severalrestructuring plans throughout fiscal 2001 in both the Commercial AirConditioning and Refrigeration and Filtration Products segments.  Through March 31, 2002, the Company hasspent $6.7 million of the $7.2 million restructuring reserve recorded in fiscal2001 primarily for severance arrangements. All the fiscal 2001 restructuring efforts are expected to be completedby the end of fiscal 2002.

 

***6.  Sale of Subsidiaries***

 

InSeptember 2001, the Company sold its Singapore subsidiary to a subsidiary ofits parent, O.Y.L. Industries Berhad (“OYL”), for approximately $13.1 million,which resulted in a gain of approximately $20,000, after writing off associatedgoodwill and intangible assets.  TheSingapore subsidiary’s first quarter sales of $3.6 million and net income of$75,000 are included in the Company’s fiscal 2002 results.  The Singapore subsidiary had sales of $4.8million and $13.7 million for the three months and nine months ended March 31,2001, respectively.  Proceeds from thesale were used to repurchase and retire $13.0 million of the Company’soutstanding Senior Notes.

 

8

----

 

On January 30, 2002, theCompany sold its 54% ownership interest in its Korean joint venture to itspartner, Century Corporation, for approximately $1.6 million.  This transaction resulted in a pre-tax lossof approximately $0.5 million.  Inaddition, the Company realized approximately $0.6 million in relatedaccumulated currency translation adjustment losses.  The Korean joint venture’s sales of $5.9 million and net incomeof $0.1 million are included in the Company’s fiscal 2002 results.  The joint venture had sales of $1.5 millionand $5.8 million for the three months and nine months ended March 31, 2001,respectively.

 

***7.  Commitments and Contingencies***

 

***Purchase Commitments-***The Company securespricing on a portion of its copper requirements through forward contractsexecuted with certain suppliers.  AtMarch 31, 2002, contracts for 2.0 million pounds of copper were in place.  These contracts have various expirationdates through March 31, 2003.

 

***Environmental Matters -***The Company issubject to potential liability under the Comprehensive Environmental Response,Compensation, and Liability Act of 1980, as amended (CERCLA), and otherfederal, state and local statutes and regulations governing the discharge of pollutants into the environment and the handling and disposal ofhazardous substances and waste. These statutes and regulations, among otherthings, impose potential liability on the Company for the cost of remediationof contamination arising from the Company’s past and present operations andfrom former operations of other entities at sites later acquired and now ownedby the Company. Many of the Company’s facilities have operated for many years,and substances which are or might be considered hazardous were generated, used,and disposed of at some locations, both on- and off-site. Therefore, it ispossible that environmental liabilities in addition to those described in Note15 of the Annual Report may arise in the future. The Company recordsliabilities if, in management’s judgment, environmental assessments or remedialefforts are probable and the costs can be reasonably estimated. These accruedliabilities are not discounted. Such estimates are adjusted if necessary basedupon the completion of a formal study or the Company’s commitment to a formalplan of action.

 

***Litigation -***The Company isinvolved in various lawsuits in the ordinary course of business. These lawsuitsprimarily involve claims for damages arising out of the use of theCompany’s products. The Company is also involved in litigation and administrativeproceedings involving employment matters and commercial disputes. Some of theselawsuits include claims for punitive as well as compensatory damages. The Company is insured for product liability claims foramounts in excess of established deductibles and accrues for the estimatedliability on a case-by-case basis up to the limits of the deductibles. Allother claims and lawsuits are also provided for on a case-by-case basis.

 

Duringthe third quarter of fiscal 2002, the Company won the appeal of a case involvingits Italian subsidiary and the Adv. Istituto Nazionale della Previdenza Sociale(INPS).  Based on the judgment of itsItalian counsel, the Company has reversed its loss contingency associated withthe case in the amount of $2.6 million. The amount is reflected in other income/expense in the consolidatedstatement of income.

 

TheCompany does not believe that the potential liability from the ultimate outcomeof environmental and litigation matters will have a material adverse effect onits financial position, results of operations or liquidity.

 

9

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***8. BusinessSegments Information***

 

The Company serves theglobal commercial heating, ventilation, air conditioning and refrigeration(“HVAC&R”) industry with two industry segments: Commercial Air Conditioningand Refrigeration, the manufacture, sale and distribution of heating,ventilating, air conditioning, industrial refrigeration products, andFiltration Products, the manufacture and sale of air filtration products andsystems. Information relating to operations in each industry segment as of andfor the three and nine months ended March 31, 2002 and 2001 is as follows:

 
|                                           |   | **Three  Months Ended  March 31,** |    | **Nine  Months Ended  March 31,** |   |
|------------------------------------------------|--------|------------------------------------|---------|-----------------------------------|--------|
| **Classified By Industry**                     |   | **2002**                           |    | **2001**                          |   | **2002** |   | **2001** |   |
|                                           |   | **(dollars  in thousands)**        |    |
| Net  Sales:                                    |   |                               |    |                              |   |   |   |   |   |
| Commercial  Air Conditioning and Refrigeration |   | $                                  | 106,327 |                              | $      | 126,722 |   | $ | 347,666 |   | $ | 390,542 |   |
| Filtration  Products                           |   | 77,032                             |    | 86,335                            |   | 242,103 |   | 250,855 |   |
| Eliminations                                   |   | (460                               | )       | (2,060                            | )      | (2,945 | ) | (3,514 | ) |
| Total                                          |   | $                                  | 182,899 |                              | $      | 210,997 |   | $ | 586,824 |   | $ | 637,883 |   |
| Operating  Income (Loss):                      |   |                               |    |                              |   |   |   |   |   |
| Commercial  Air Conditioning and Refrigeration |   | $                                  | (559    | )                                 | $      | 1,330 |   | $ | 7,074 |   | $ | 5,332 |   |
| Filtration  Products                           |   | 3,416                              |    | 5,311                             |   | 8,768 |   | 13,803 |   |
| Corporate                                      |   | 230                                |    | (178                              | )      | 743 |   | (1,133 | ) |
| Total                                          |   | $                                  | 3,087   |                              | $      | 6,463 |   | $ | 16,585 |   | $ | 18,002 |   |
| Depreciation  and Amortization:                |   |                               |    |                              |   |   |   |   |   |
| Commercial  Air Conditioning and Refrigeration |   | $                                  | 4,776   |                              | $      | 4,371 |   | $ | 14,388 |   | $ | 14,433 |   |
| Filtration  Products                           |   | 2,207                              |    | 2,278                             |   | 6,847 |   | 6,873 |   |
| Corporate                                      |   | 6                                  |    | 6                                 |   | 16 |   | 17 |   |
| Total                                          |   | $                                  | 6,989   |                              | $      | 6,655 |   | $ | 21,251 |   | $ | 21,323 |   |
| Capital  Expenditures:                         |   |                               |    |                              |   |   |   |   |   |
| Commercial  Air Conditioning and Refrigeration |   | $                                  | 1,058   |                              | $      | 2,622 |   | $ | 3,255 |   | $ | 7,741 |   |
| Filtration  Products                           |   | 981                                |    | 1,001                             |   | 2,184 |   | 2,821 |   |
| Corporate                                      |   | —                             |    | —                            |   | 4 |   | 5 |   |
| Total                                          |   | $                                  | 2,039   |                              | $      | 3,623 |   | $ | 5,443 |   | $ | 10,567 |   |

 

The Company estimatescorporate expenses and determines fixed allocations of these expenses for eachbusiness segment at the beginning of the fiscal year.  Any over or under allocation of actual expenses incurred resultsin income or expense reported at the corporate level.  A reconciliation of segment profit to the Company’s earningsbefore taxes for each quarter is as follows:

 
|                                           |   | **Three  Months Ended  March 31,** |   | **Nine  Months Ended  March 31,** |   |
|------------------------------------------------|--------|------------------------------------|--------|-----------------------------------|--------|
|                                           |   | **2002**                           |   | **2001**                          |   | **2002** |   | **2001** |   |
|                                           |   | **(dollars in thousands)**         |   |
| Operating  income from business segments       |   | $                                  | 2,857  |                              | $      | 6,641 |   | $ | 15,842 |   | $ | 19,135 |   |
| Over  (under) allocation of corporate expenses |   | 230                                |   | (178                              | )      | 743 |   | (1,133 | ) |
| Interest  expense, net                         |   | 3,450                              |   | 4,663                             |   | 11,569 |   | 14,958 |   |
| Other  (income) expense, net                   |   | (1,328                             | )      | 42                                |   | (1,270 | ) | (4,957 | ) |
| Income  (loss) before income taxes             |   | $                                  | 965    |                              | $      | 1,758 |   | $ | 6,286 |   | $ | 8,001 |   |

 

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**Item2.     Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

**Resultsof Operations**

 

***Net Sales***were $182.9 million for the three months ended March31, 2002, which represents a decrease of $28.1 million, or 13.3%, as comparedto $211.0 million for the same period in the prior year.  Net sales decreased $51.1 million, or 8.0%to $586.8 million from $637.9 million for the nine months ended March 31, 2002and 2001, respectively.  As more fullyexplained in Note 6 to the unaudited consolidated financial statements, theCompany sold its Singapore subsidiary in September 2001 and its Korean jointventure in January 2002.  Additionally,the Company estimates that sales have decreased by approximately $1.8 millionand $3.5 million for the three months and nine months ending March 31, 2002,respectively, due to the impact of unfavorable currency trends in translatingEuropean sales.  Excluding the net salesattributable to the operations in Singapore and Korea for fiscal 2001 andcurrency impact, net sales for the three months and nine months ended March 31,2002 decreased $24.9 million or 12.1% and $40.7 million or 6.5%, respectively,as compared to the corresponding period of the prior year.

 

**Commercial Air Conditioning andRefrigeration**netsales for the three months ended March 31, 2002 decreased $20.4 million, or16.1%, to $106.3 million as compared to $126.7 million for the three monthsended March 31, 2001. The Company estimates that approximately $0.6 million ofthe decrease is due to the impact of unfavorable currency trends in translatingEuropean sales.  Excluding the currencyimpact, net sales decreased $19.8 million, or 15.7%.  This decrease is the result of a 15.9% decrease in domesticsales, and a 14.6% decrease in international sales.  The domestic sales decrease is primarily attributable to thegeneral economic slowdown affecting all equipment product lines.  The decrease in international sales volume isprimarily the result of the restructuring efforts undertaken at the Company’sUnited Kingdom operations in fiscal 2001.

 

Year-to-date sales forthe nine months ended March 31, 2002 decreased $42.8 million, or 11.0%, to$347.7 million as compared to $390.5 million for the nine months ended March31, 2001.  The Company estimates thatapproximately $0.8 million of the decrease is due to the impact of unfavorablecurrency trends in translating European sales. Excluding the currency impact, net sales decreased $42.0 million, or10.8%. This decrease is the result of a 10.9% decrease in domestic sales and a10.3% decrease in international sales. The decrease in domestic sales isprimarily attributable to the general economic slowdown affecting all equipmentproduct lines. The decrease in international sales volume is primarily theresult of the restructuring efforts undertaken at the Company’s United Kingdomoperations in fiscal 2001.

 

Backlog for theCommercial Air Conditioning and Refrigeration segment was $95 million at March31, 2002 as compared to $111 million and $114 million at June 30, 2001 andMarch 31, 2001, respectively.

 

**Filtration Products**net sales for the three months endedMarch 31, 2002 decreased $9.3 million, or 10.8%, to $77.0 million as comparedto $86.3 million for the three months ended March 31, 2001.  This decrease is attributable to the sale ofthe Company’s Singapore subsidiary in September 2001 and Korean joint venturein January 2002.  Additionally, theCompany estimates that sales have decreased by approximately $1.2 million forthe third quarter of fiscal 2002 due to the impact of unfavorable currencytrends in translating European sales. Excluding these three items, net sales decreased $3.0 million or 3.7%.This decrease is the result of a 16.7% decrease in domestic sales offset by an11.1% increase in international sales. The decrease in domestic sales is primarily attributable to a downturnin cleanroom market demand and an unusually mild winter impacting thereplacement filter business.  Theincrease in international sales is primarily due to strong Machinery Filtrationand Acoustical Systems “MFAS” market activity in Europe driven by the gasturbine market, partially offset by a decrease in Air Pollution Control System“APCS” projects in Latin America this quarter versus the prior year.

 

Year-to-date sales forthe nine months ended March 31, 2002 decreased $8.8 million, or 3.5%, to $242.1million as compared to $250.9 million for the nine months ended March 31,2001.  The Company estimates that saleshave decreased by approximately $2.6 million for the first nine months offiscal 2002 due to the impact of unfavorable currency trends in translatingEuropean sales.  Excluding the currencyimpact and sale of the Company’s Singapore subsidiary and Korean joint venture,net sales increased $7.9

 

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million or 3.3% for the nine months ended March 31,2002 versus 2001.  Domestic salesdecreased 6.7%, while international sales increased 15.8%. The decrease indomestic sales is primarily attributable to a downturn in the cleanroom market,partially offset by an increase in MFAS activity.  The increase in international sales is primarily due to strongMFAS activity in Europe driven by the gas turbine market, partially offset by adecrease in APCS projects in Latin America.

 

***Gross Profit***decreased to $45.7 million, or 25.0% of sales, for thethree months ended March 31, 2002 as compared to $54.9 million, or 26.0 % ofsales, for the three months ended March 31, 2001.  Year-to-date gross profit for the nine months ended March 31,2002 decreased to $149.7 million, or 25.5% of sales, from $166.0 million,representing 26.0% of sales, for the nine months ended March 31, 2001.  In the Commercial Air Conditioning andRefrigeration segment, year-to-date gross profit as a percentage of sales was25.5% as compared to 24.9% for the same period in fiscal 2001.  This improvement in gross margin isprimarily attributable to the closure of the Company’s Scottsboro, Alabamaplant and the successful consolidation of its applied air handling manufacturingoperations in Minnesota, partially offset by competitive pricing pressures inall equipment product lines.  TheFiltration Products segment’s year-to-date gross profit as a percentage ofsales decreased from 27.4% in fiscal 2001 to 25.3% for the same period infiscal 2002. This decrease is primarily the result of sales mix between MFASand replacement filter sales and continued competitive pricing pressures in theNorth American replacement filter business.

 

***Operating Expenses*******were $42.6 million, or 23.3% of sales,for the third quarter of fiscal 2002 versus $48.5 million, or 23.0 % of sales,for the third quarter of fiscal 2001. For the first nine months of fiscal years2002 and 2001, operating expenses were $133.1 million, or 22.7 % of sales, versus$148.0 million, or 23.2% of sales, respectively.   Excluding amortization and restructuring charges, year-to-dateoperating expenses were $124.5 million for fiscal 2002, or 21.2% of sales,versus $132.5 million for fiscal 2001, or 20.8% of sales.  The decrease in year-to-date operatingexpenses compared to the first nine months of fiscal 2001 is primarilyattributable to lower commissions due to favorable sales mix and lower volume,improved warranty experience and continued focus on cost control.

 

***Income from Operations***for the third quarter of fiscal 2002 decreased to $3.1million, or 1.7% of sales, as compared to $6.5 million, or 3.1% of sales, inthe third quarter of fiscal 2001. Year-to-date income from operations decreased to $16.6 million, or 2.8%of sales, as compared to $18.0 million, or 2.8% of sales in fiscal 2001.  Excluding amortization and restructuringcharges, year-to-date income from operations decreased to $25.2 million, or4.3% of sales, compared to $33.5 million, or 5.2% of sales, in thecorresponding period of the prior year.

 

The Commercial AirConditioning and Refrigeration segment’s income from operations decreased inthe third quarter of fiscal 2002 to $1.0 million, or 0.9% of sales, as comparedto $3.5 million, or 2.8% of sales in fiscal 2001, excluding amortization andrestructuring charges.  Year-to-dateincome from operations, excluding amortization and restructuring charges,decreased from $16.7 million, or 4.3% of sales, to $11.9 million, or 3.4% ofsales, for the first nine months of fiscal 2001 as compared to the first ninemonths of fiscal 2002, respectively.

 

The Filtration Productssegment’s income from operations, excluding amortization and restructuringcharges, for the third quarter of fiscal 2002 decreased from $6.5 million, or7.5% of sales, in fiscal 2001 to $4.5 million, or 5.9% of sales.  Year-to-date income from operations,excluding amortization and restructuring charges, decreased from $17.9 million,or 7.1% of sales, during the first nine months of fiscal 2001 to $12.6 million,or 5.2% of sales, for the first nine months of fiscal 2002.

 

***Net Interest Expense***decreased to $3.5 million and $11.6 million for thethree months and nine months ended March 31, 2002 from $4.7 million and $15.0million for the comparable periods ended March 31, 2001.  Decrease in interest expense is primarilyattributable to lower debt levels and declining interest rates.

 

***Other Income/Expense, net*** increased to income of $1.8 million and $1.7 millionfor the three months and nine months ended March 31, 2002, respectively, fromexpense of $42,000 and income of $0.4 million for the three months and ninemonths ended March

 

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31, 2001, respectively.  The increase in the three months ended March 31, 2002 as comparedto the three months ended March 31, 2001 is primarily attributable to thereversal of the INPS litigation accrual, which is more fully explained in Note7 to the unaudited consolidated financial statements, partially offset by the accumulatedcurrency translation adjustment loss on the sale of the Company’s Korean jointventure.  The increase in the first ninemonths of fiscal 2002 compared to the first nine months of fiscal 2001 isprimarily attributable to the reversal of the INPS accrual, offset by theaccumulated currency translation adjustment loss on the sale of the Company’sKorean joint venture and the decline in the market value of the Company’s swap,as described in Note 4 to the unaudited consolidated financial statements.

 

**Liquidity and Capital Resources**

 

TheCompany’s liquidity needs are provided by cash generated fromoperating activities and supplemented when necessary by short-term creditfacilities. During the first nine months of fiscal 2002, funds generated byoperating activities were $16.7 million as compared to $13.5 million of fundsgenerated in the prior fiscal year for the comparable period.  During the first nine months of fiscal 2002,net cash from investing activities is comprised of $15.0 million in cash proceedsfrom the sale of business, partially offset by $5.4 million in capitalexpenditures.  Capital spending for thefirst nine months decreased from $10.6 million in the prior year to $5.4million this year due to higher than normal spending in the first nine monthsof fiscal 2001 related to the consolidation of the Company’s applied airhandling operations in Minnesota.  Inthe first nine months of fiscal 2001, the Company sold property for cashproceeds of $6.9 million.

 

TheCompany’s U.S. bank credit facilities are comprised of a Term Loan of $30million and a Revolving Credit Facility of $90 million (“Bank CreditAgreement”).  The Bank Credit Agreementhas a three-year term and is designed to provide added flexibility andborrowing availability.  At March 31,2002, remaining borrowing availability under the Revolving Credit portion ofthe Bank Credit Agreement was $32.9 million. Net repayments on long-term debt for the first nine months of fiscal2002 were $3.4 million. In addition, as more fully discussed in Note 4 to theunaudited consolidated financial statements, the Company repurchased $15.0million of its Senior Notes. Short-term borrowings decreased by $13.2 million during the nine-monthperiod ended March 31, 2002.

 

Ashort-term credit facility provided to a subsidiary of the Company is supportedby an £8.5 million letter of credit from OYL, which expires on May 31, 2002.This support arrangement may be extended for additional time periods with theconsent of OYL and the bank providing the facilities.  The Company does not anticipate any problemsin renewing this letter of credit, if required by its lender.

 

Managementbelieves, based upon current levels of operations and forecasted earnings, thatcash flows from operations, together with borrowings under the Bank CreditAgreement and other short-term credit facilities, will be adequate to makepayments of principal and interest on debt, to permit anticipated capitalexpenditures and to fund working capital requirements and other cash needs. Nevertheless,the Company will remain leveraged to a significant extent and its debt serviceobligations will continue to be substantial. If the Company’s sources of fundswere to fail to satisfy the Company’s requirements, the Company may need torefinance its existing debt or obtain additional financing.  There is no assurance that any such newfinancing alternatives would be available, and, in any case, such new financing(if available) would be expected to be more costly and burdensome than the debtagreements currently in place.

 

**RecentAccounting Pronouncements**

 

In June 2001, theFinancial Accounting Standards Board (“FASB”) issued Statements of FinancialAccounting Standards (SFAS) No. 141, *Business Combinations*, and No. 142, *Goodwill andOther Intangibles Assets*, effective for fiscal years beginning afterDecember 15, 2001.  Under the new rules,goodwill and intangible assets deemed to have indefinite lives will no longerbe amortized, but will be subject to annual impairment tests in accordance withthe Statements.  Other intangible assetswill continue to be amortized over their useful lives.  The Company is required to apply the newrules on accounting for goodwill and other intangible assets beginning thefirst quarter of fiscal 2003.  TheCompany is currently assessing the financial impact that SFAS Nos. 141 and 142will have on its earnings and financial position.

 

In August 2001, the FASBissued SFAS No. 144*, Accounting for the Impairment or Disposal ofLong-Lived Assets*, which addresses financial accounting andreporting for the impairment or disposal of long-lived assets and supercedesSFAS No. 121, *Accounting for the Impairment of Long-LivedAssets and for Long-Lived Assets to be Disposed Of*, and theaccounting and reporting

 

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provisions of APB No. 30, *Reporting the Results of Operations*,for a disposal of a segment of a business. SFAS No. 144 is effective for fiscal years beginning after December 15,2001.  The Company expects to adopt SFASNo. 144 as of July 1, 2002 and it does not expect that the adoption of theStatement will have a significant impact on the Company’s financial positionand results of operations.

 

**Item3.     Quantitative and QualitativeDisclosure about Market Risk**

 

There have been nomaterial changes in the reported market risks since the end of the most recentfiscal year.  See Note 4 to theunaudited consolidated financial statements for disclosures related tofinancial instruments.

 

**Forward-LookingStatements**

 

When used in this reportthe words “believes”, “anticipates”, “estimates”, “plans” and “expects” andsimilar expressions are intended to identify forward-looking statements.  These forward-looking statements areintended to provide management’s current expectations or plans for the futureoperating and financial performance of the Company, based on assumptionscurrently believed to be valid. A variety of factors could cause actual resultsto differ materially from those anticipated in the Company’s forward-lookingstatements, some of which include risk factors previously discussed in this andother SEC reports filed by the Company. These risk factors include, but are not limited to, economic conditionsin the United States, changes in world financial markets, environmental lawsand regulations, risks associated with currency fluctuations, a weakening inLatin America markets, unforeseen competitive pressures, warranty expenses,market acceptance of new products, unfavorable weather conditions, unforeseendifficulties in maintaining mutually beneficial relationships with strategicpartnerships and alliances, and the results of restructuring activities.Readers are cautioned not to place undue reliance on these forward-lookingstatements, which speak only as of the date on which those statements aremade.  The Company undertakes noobligation to update any forward-looking statements to reflect unanticipatedevents or circumstances occurring after that date.

 

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**PARTII:                OTHER INFORMATION**

 

**Item1.     Legal Proceedings**

 

Not applicable.

 

**Item6.     Exhibits and Reports on Form 8-K**

 

(a)          Exhibits

 
| **Number**    |   | **Description**                                                                                                   |
|---------------|--------|-------------------------------------------------------------------------------------------------------------------|
|          |   |                                                                                                              |
| Exhibit 10.12 |   | Fourth Amendment to Revolving Credit, Term Loan and  Security Agreement dated April 22, 2002, with PNC Bank, N.A. |

 

(b)         Reports on Form 8-K

 

On February 26, 2002, theCompany filed a Current Report on Form 8-K which reported the Company’sdecision to change its principal independent certified accountant to KPMG LLP.

 

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SIGNATURES

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|   |        |   |   |   |   |   | AAF-MCQUAY INC.                                    |
|--------|-------------|--------|--------|--------|--------|--------|----------------------------------------------------|
|   |        |   |   |   |   |   |                                               |
|   |        |   |   |   |   |   |                                               |
|   |        |   |   |   |   |   |                                               |
| DATE   | May 8, 2002 |   |   |   | By:    |   | /s/ BRUCE D. KRUEGER                               |
|   |        |   |   |   |   |   | Bruce D. Krueger                                   |
|   |        |   |   |   |   |   | Vice President of Finance and CFO                  |
|   |        |   |   |   |   |   | (Principal Financial and Chief Accounting Officer) |

 

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