**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

#### **FORM 10-Q**

 

**(Mark One)**

 

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

 

 

**For the quarterly period ended December29, 2001**

 

 

**OR**

 

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

 

 

 

**For the transition period from                   to**

 

 

**Commission file number:               33-80701**

 

 

 

**AAF-MCQUAYINC.**

(Exact name of Registrantas Specified in Its Charter)

 

 
| **Delaware**                                             |   | **41-0404230**                        |
|----------------------------------------------------------|--------|---------------------------------------|
| (State or Other  Jurisdiction of                         |   | (I.R.S. Employer  Identification No.) |
| Incorporation or  Organization)                          |   |                                  |
|                                                     |   |                                  |
|                                                     |   |                                  |
| **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 SinceLast Report.

 

Indicate by check whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes x No o

 

Indicate the number of shares outstanding of each of the issuer’sclasses 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

January 25, 2002.

 

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|               | **INDEX**                                                                                                      |   |   |
|--------------------|----------------------------------------------------------------------------------------------------------------|--------|--------|
|               |                                                                                                           |   |   |
|               | **AAF-MCQUAY  INC. AND SUBSIDIARIES**                                                                          |   |   |
|               |                                                                                                           | Page   |   |
|               |                                                                                                           |   |   |
| **Part I —**  | Financial Information                                                                                          | 3      |   |
|               |                                                                                                           |   |   |
| **Item 1.**        | Financial Statements  (unaudited)                                                                              | 3      |   |
|               |                                                                                                           |   |   |
|               | Consolidated Balance Sheets  as of  — December 31, 2001 and June  30, 2001                           | 3      |   |
|               |                                                                                                           |   |   |
|               | Consolidated  Statements of Operations — Three and Six Months Ended December 31, 2001 and  2000           | 4      |   |
|               |                                                                                                           |   |   |
|               | Condensed  Consolidated Statements of Cash Flows — Six Months Ended December 31, 2001  and 2000           | 5      |   |
|               |                                                                                                           |   |   |
|               | Consolidated  Statements of Comprehensive Income — Three and Six Months Ended December 31,  2001 and 2000 | 6      |   |
|               |                                                                                                           |   |   |
|               | Notes  to the Consolidated Financial Statements                                                                | 7      |   |
|               |                                                                                                           |   |   |
| **Item  2.**       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                    | 11     |   |
|               |                                                                                                           |   |   |
| **Item  3.**       | Quantitative  and Qualitative Disclosures about Market Risk                                                    | 13     |   |
|               |                                                                                                           |   |   |
| **Part II —** | Other Information                                                                                              | 15     |   |
|               |                                                                                                           |   |   |
| **Item 1**         | Legal Proceedings                                                                                              | 15     |   |
|               |                                                                                                           |   |   |
| **Item 6(b).**     | Reports on Form 8-K.                                                                                           | 15     |   |
|               |                                                                                                           |   |   |
|               | Signatures                                                                                                     | 16     |   |

 

2

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**PARTI:****                                                                                                                                                                                                                                          ****FINANCIALINFORMATION**

                **Item 1.    Financial Statements**

** **

**AAF-McQUAY INC. AND SUBSIDIARIES****CONSOLIDATEDBALANCE SHEETS******(unaudited)(dollars in thousands, except share data)
|                                                                                          |   | **December  31,  2001** |       | **June 30,  2001** |       |
|-----------------------------------------------------------------------------------------------|--------|-------------------------|------------|--------------------|------------|
| **ASSETS**                                                                                    |   |                    |       |               |       |
| Current assets:                                                                               |   |                    |       |               |       |
| Cash and cash equivalents                                                                     |   | $                       | 9,361      |               | $          | 14,254 |   |
| Accounts receivable                                                                           |   | 174,095                 |       | 191,942            |       |
| Inventories                                                                                   |   | 98,262                  |       | 101,802            |       |
| Other current assets                                                                          |   | 7,067                   |       | 8,370              |       |
| Total current  assets                                                                         |   | 288,785                 |       | 316,368            |       |
|                                                                                          |   |                    |       |               |       |
| Property, plant  and equipment, net                                                           |   | 112,927                 |       | 118,744            |       |
| Cost in excess  of net assets acquired and other identifiable intangibles, net                |   | 188,970                 |       | 201,731            |       |
| Other assets and  deferred charges                                                            |   | 15,729                  |       | 17,171             |       |
| Total assets                                                                                  |   | $                       | 606,411    |               | $          | 654,014 |   |
|                                                                                          |   |                    | ** ** |               | ** ** |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                |   |                    | ** ** |               | ** ** |
|                                                                                          |   |                    |       |               |       |
| Current  liabilities:                                                                         |   |                    |       |               |       |
| Short-term  borrowings                                                                        |   | $                       | 63,922     |               | $          | 63,938 |   |
| Current maturities  of long-term debt                                                         |   | 6,808                   |       | 6,120              |       |
| Accounts  payable, trade                                                                      |   | 81,964                  |       | 100,585            |       |
| Accrued warranty                                                                              |   | 18,931                  |       | 19,567             |       |
| Accrued employee  compensation                                                                |   | 24,490                  |       | 27,155             |       |
| Other accrued  liabilities                                                                    |   | 30,676                  |       | 42,947             |       |
| Total current  liabilities                                                                    |   | 226,791                 |       | 260,312            |       |
|                                                                                          |   |                    |       |               |       |
| Long-term debt.                                                                               |   | 114,950                 |       | 131,429            |       |
| Deferred income  taxes                                                                        |   | 24,533                  |       | 26,029             |       |
| Other  liabilities                                                                            |   | 48,486                  |       | 49,003             |       |
| Total  liabilities                                                                            |   | 414,760                 |       | 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                                                                            |   | 32,678                  |       | 29,606             |       |
| Accumulated other  comprehensive loss                                                         |   | (21,192                 | )          | (22,530            | )          |
| Total  stockholders’ equity                                                              |   | 191,651                 |       | 187,241            |       |
| Total  liabilities and stockholders’ equity                                              |   | $                       | 606,411    |               | $          | 654,014 |   |

 See Notes to the Consolidated FinancialStatements 

 

3

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 **AAF-McQUAY INC. AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF OPERATIONS**(unaudited)(dollars in thousands)  

 
|                                  |   | **Three  Months Ended  December 31,** |    | **Six Months  Ended  December 31,** |   |
|---------------------------------------|--------|---------------------------------------|---------|-------------------------------------|--------|
|                                  |   | **2001**                              |    | **2000**                            |   | **2001** |   | **2000** |   |
|                                  |   |                                  |    |                                |   |   |   |   |   |
| Net sales                             |   | $                                     | 193,848 |                                | $      | 211,877 |   | $ | 403,926 |   | $ | 426,886 |   |
| Cost of sales                         |   | 146,018                               |    | 159,212                             |   | 299,897 |   | 315,873 |   |
| Gross profit                          |   | 47,830                                |    | 52,665                              |   | 104,029 |   | 111,013 |   |
| Operating  expenses:                  |   |                                  |    |                                |   |   |   |   |   |
| Selling, general  and administrative  |   | 41,325                                |    | 42,687                              |   | 84,635 |   | 87,410 |   |
| Restructuring                         |   | 450                                   |    | 3,041                               |   | 450 |   | 6,547 |   |
| Amortization of  intangible assets    |   | 2,689                                 |    | 2,759                               |   | 5,446 |   | 5,517 |   |
|                                  |   | 44,464                                |    | 48,487                              |   | 90,531 |   | 99,474 |   |
| Income from  operations               |   | 3,366                                 |    | 4,178                               |   | 13,498 |   | 11,539 |   |
| Interest  expense, net                |   | 3,770                                 |    | 5,072                               |   | 8,118 |   | 10,295 |   |
| Gain on sale of  property             |   | ——                          |    | (4,538                              | )      | —— |   | (4,538 | ) |
| Other (income)  expense, net          |   | 193                                   |    | (366                                | )      | 58 |   | (462 | ) |
| Income (loss)  before income taxes    |   | (597                                  | )       | 4,010                               |   | 5,322 |   | 6,244 |   |
| Minority  interest loss               |   | 88                                    |    | 27                                  |   | 69 |   | 92 |   |
| Provision  (benefit) for income taxes |   | (305                                  | )       | 1,797                               |   | 2,181 |   | 2,936 |   |
| Net income  (loss)                    |   | $                                     | (380    | )                                   | $      | 2,186 |   | $ | 3,072 |   | $ | 3,216 |   |

 See Notes to the Consolidated FinancialStatements

 

4

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 **AAF-McQUAY INC. AND SUBSIDIARIES****CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**(unaudited)(dollars in thousands)  
|                                                             |   | **Six Months  Ended  December 31,** |   |
|------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                             |   | **2001**                            |   | **2000** |   |
|                                                             |   |                                |   |   |   |
| Cash flows from  operating activities:                           |   |                                |   |   |   |
| Net income                                                       |   | $                                   | 3,072  |   | $ | 3,216 |   |
| Adjustments to  reconcile to net cash from operating activities: |   |                                |   |   |   |
| Depreciation and  amortization                                   |   | 14,262                              |   | 14,668 |   |
| Gain on sale of  property                                        |   | ——                        |   | (4,538 | ) |
| Other non-cash  items, net                                       |   | 375                                 |   | (511 | ) |
| Changes in  operating assets and liabilities                     |   | (16,245                             | )      | 3,633 |   |
| Net cash from  operating activities                              |   | 1,464                               |   | 16,468 |   |
|                                                             |   |                                |   |   |   |
| Cash flows from  investing activities:                           |   |                                |   |   |   |
| Capital  expenditures, net                                       |   | (3,404                              | )      | (6,944 | ) |
| Proceeds from  sale of property                                  |   | ——                        |   | 6,922 |   |
| Proceeds from  sale of business                                  |   | 13,308                              |   | —— |   |
| Net cash from  investing activities                              |   | 9,904                               |   | (22 | ) |
|                                                             |   |                                |   |   |   |
| Cash flows from  financing activities:                           |   |                                |   |   |   |
| Net repayments  under short-term borrowing arrangements          |   | (463                                | )      | (8,122 | ) |
| Payments on  long-term debt                                      |   | (3,496                              | )      | (4,633 | ) |
| Proceeds from  issuance of long-term debt                        |   | 2,393                               |   | 238 |   |
| Repurchase of  senior notes                                      |   | (14,990                             | )      | (4,500 | ) |
| Net cash from  financing activities                              |   | (16,556                             | )      | (17,017 | ) |
|                                                             |   |                                |   |   |   |
| Effect of  exchange rate changes on cash                         |   | 295                                 |   | (950 | ) |
| Net decrease in  cash and cash equivalents                       |   | (4,893                              | )      | (1,521 | ) |
| Cash and cash  equivalents at beginning of period                |   | 14,254                              |   | 11,522 |   |
|                                                             |   |                                |   |   |   |
| Cash and cash  equivalents at end of period                      |   | $                                   | 9,361  |   | $ | 10,001 |   |
|                                                                  |        |                                     |        |  |  |  |  |  |  |

 See Notes to the Consolidated FinancialStatements

 

5

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 **AAF-McQUAYINC. AND SUBSIDIARIES****CONSOLIDATED STATEMENTS OF COMPREHENSIVEINCOME (LOSS)**(unaudited)(dollars in thousands)

** **
|                                                                                       |   | **Three  Months Ended December 31,** |   | **Six Months  Ended December 31,** |   |
|--------------------------------------------------------------------------------------------|--------|--------------------------------------|--------|------------------------------------|--------|
|                                                                                       |   | **2001**                             |   | **2000**                           |   | **2001** |   | **2000** |   |
|                                                                                       |   |                                 |   |                               |   |   |   |   |   |
| Net income  (loss)                                                                         |   | $                                    | (380   | )                                  | $      | 2,186 |   | $ | 3,072 |   | $ | 3,216 |   |
| Other  comprehensive income (loss):                                                        |   |                                 |   |                               |   |   |   |   |   |
| Foreign currency  translation adjustments                                                  |   | (1,787                               | )      | 1,016                              |   | 1,559 |   | (1,169 | ) |
| Write off of  accumulated foreign currency translation adjustments due to sale of business |   | ——                         |   | ——                       |   | (221 | ) | —— |   |
| Comprehensive  income (loss)                                                               |   | $                                    | (2,167 | )                                  | $      | 3,202 |   | $ | 4,410 |   | $ | 2,047 |   |

See Notes to theConsolidated Financial Statements

 

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

***1. Basis of Presentation***

        The consolidated financialstatements include the accounts of the Company and all of its wholly-ownedsubsidiaries.  All inter-companytransactions have been eliminated.  Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim reporting and with the instructions to Form 10-Q and Article 10 ofRegulation S-X.  Accordingly, certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States have been omitted.  Forfurther information, refer to the consolidated financial statements andfootnotes thereto included in the Company’s Annual Report on Form 10-K (the“Annual Report”) for the year ended June 30, 2001.  In the opinion of management, all adjustments (consisting ofnormal recurring accruals) considered necessary for a fair presentation havebeen included.

        The operating results forthe six months ended December 31, 2001 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 December 31. For clarity in presentation all periodspresented herein 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.

**Recent Accounting 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: |   | **December  31,  2001** |   | **June 30,  2001** |   |
|---------------------------------------|--------|------------------------------|--------|--------------------|--------|
|                                  |   | **(dollars  in thousands)**  |   |
| FIFO cost:                            |   |                         |   |               |   |
| Raw materials                         |   | $                            | 38,920 |               | $      | 42,706 |   |
| Work-in-process                       |   | 17,988                       |   | 17,691             |   |
| Finished goods                        |   | 42,178                       |   | 41,851             |   |
|                                  |   | 99,086                       |   | 102,248            |   |
| LIFO adjustment                       |   | (824                         | )      | (446               | )      |
|                                  |   | $                            | 98,262 |               | $      | 101,802 |   |

 

7

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***3.  Provision forIncome Taxes***

Thetax provisions for the three month and six month periods ended December 31,2001 and 2000 are based on the estimated effective tax rates applicable for thefull years, 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 six month periods ended December 31, 2001 and 2000, and the taxprovisions computed based on U.S. statutory rates is primarily attributable tonondeductible goodwill amortization, unbenefitted foreign losses and exportsales tax benefit.

***4.  Debt and FinancialInstruments***

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 December 31, 2001 was $94 million.

          In January 2000, the Company entered into an interest rate swaptransaction whereby the Company receives a fixed rate and pays a floating rateon the basis of 3-month Libor.  TheJanuary 2000 swap has a three year term and a notional amount of $30 millionand effectively converts a portion of the Company’s fixed rate borrowings to afloating rate.  Measurement dates andthe maturity date of the swap match interest payment dates and the maturitydate of the Company’s Senior Notes.  InNovember 2001, the Company terminated its $30 million interest rate floor,which required the Company to make payments if 3-month Libor fell below acertain level.  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 $30,000 and income of $0.3 million was recorded as aresult of these positions for the six months ended December 31, 2001 and 2000,respectively.

***5.  RestructuringCharges***

         In the second quarter of fiscal 2002,the Company approved and commenced restructuring actions in its FiltrationProducts segment, recording reserves of approximately $0.5 million.  The $0.5 million reserve primarilyrepresents severance accruals related to the elimination of approximately 30employees in its Latin American and European air filtration manufacturing units.  The Company has spent approximately $0.1million of the recorded reserve through December 31, 2001.

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 December 31, 2001, the Company hasspent $6.5 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 ofSubsidiary***

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 write-off ofassociated goodwill and intangible assets. The Singapore subsidiary’s first quarter sales of $3.6 million and netincome of $75,000 are included in the Company’s fiscal 2002 results.  The Singapore subsidiary had sales of $5.8million and $8.9 million for the three months and six months ended December 31,2000, respectively.  Proceeds from thesale were used to repurchase and retire $13.0 million of the Company’soutstanding Senior Notes.

 

8

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***7.  Commitments andContingencies***

***         PurchaseCommitments-***The Company secures pricing on a portion of its copperrequirements through forward contracts executed with certain suppliers.  At December 31, 2001, contracts for 2.1million pounds of copper were in place. These contracts have various expiration dates through December 31, 2002.

***         EnvironmentalMatters -***The Company is subject to potential liability under theComprehensive Environmental Response, Compensation, and Liability Act of 1980,as amended (CERCLA), and other federal, state and local statutes andregulations governing the discharge of pollutants into the environment and thehandling and disposal of hazardous substances and waste. These statutes andregulations, among other things, impose potential liability on the Company forthe cost of remediation of contamination arising from the Company’s past andpresent operations and from former operations of other entities at sites lateracquired and now owned by the Company. Many of the Company’s facilities haveoperated for many years, and substances which are or might be consideredhazardous were generated, used, and disposed of at some locations, both on- andoff-site. Therefore, it is possible that environmental liabilities in additionto those described in Note 15 of the Annual Report may arise in the future. TheCompany records liabilities if, in management’s judgment, environmentalassessments or remedial efforts are probable and the costs can be reasonablyestimated. These accrued liabilities are not discounted. Such estimates areadjusted if necessary based upon the completion of a formal study or theCompany’s commitment to a formal plan of action.

         ***Litigation -***The Company is involved in various lawsuitsin the ordinary course of business. These lawsuits primarily involve claims fordamages arising out of the use of the Company’s products. The Company is alsoinvolved in litigation and administrative proceedings involving employmentmatters and commercial disputes. Some of these lawsuits include claims forpunitive as well as compensatory damages. The Company is insured for productliability claims for amounts in excess of established deductibles and accruesfor the estimated liability on a case-by-case basis up to the limits of the deductibles.All other claims and lawsuits are also provided for on a case-by-case basis.

TheCompany does not believe that the potential liability from the ultimate outcomeof environmental and litigation matters will have a material adverse effect onits financial statements.

***8****.***  *Subsequent Event***

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 will be recorded in thethird quarter of fiscal 2002, resulting in a pre-tax loss of approximately $0.5million.  In addition, the Company willrealize approximately $0.6 million in related accumulated currency translationadjustment losses.  The joint venturehad sales of $4.9 million and $4.3 million for the six months ended December31, 2001 and 2000, respectively.

 

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***9. Business Segments Information***

         The Company serves the global commercial heating,ventilation, air conditioning and refrigeration (“HVAC&R”) industry withtwo industry segments: Commercial Air Conditioning and Refrigeration, themanufacture, sale and distribution of heating, ventilating, air conditioning,industrial refrigeration products, and Filtration Products, the manufacture andsale of air filtration products and systems. Information relating to operationsin each industry segment as of and for the three and six months ended December31, 2001 and 2000 is as follows:
|                                           |   | **Three  Months Ended  December 31,** |    | **Six Months  Ended  December 31,** |   |
|------------------------------------------------|--------|---------------------------------------|---------|-------------------------------------|--------|
| **Classified By Industry**                     |   | **2001**                              |    | **2000**                            |   | **2001** |   | **2000** |   |
|                                           |   | **(dollars  in thousands)**           |    |
| Net Sales:                                     |   |                                  |    |                                |   |   |   |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                     | 111,532 |                                | $      | 128,547 |   | $ | 241,338 |   | $ | 263,820 |   |
| Filtration  Products                           |   | 82,755                                |    | 84,410                              |   | 165,072 |   | 164,520 |   |
| Eliminations                                   |   | (439                                  | )       | (1,080                              | )      | (2,484 | ) | (1,454 | ) |
| Total                                          |   | $                                     | 193,848 |                                | $      | 211,877 |   | $ | 403,926 |   | $ | 426,886 |   |
| Operating Income  (Loss):                      |   |                                  |    |                                |   |   |   |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                     | 781     |                                | $      | 336 |   | $ | 7,633 |   | $ | 4,002 |   |
| Filtration  Products                           |   | 2,254                                 |    | 4,293                               |   | 5,352 |   | 8,492 |   |
| Corporate                                      |   | 331                                   |    | (451                                | )      | 513 |   | (955 | ) |
| Total                                          |   | $                                     | 3,366   |                                | $      | 4,178 |   | $ | 13,498 |   | $ | 11,539 |   |
| Depreciation and  Amortization:                |   |                                  |    |                                |   |   |   |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                     | 4,806   |                                | $      | 5,039 |   | $ | 9,612 |   | $ | 10,062 |   |
| Filtration  Products                           |   | 2,223                                 |    | 2,303                               |   | 4,640 |   | 4,594 |   |
| Corporate                                      |   | 5                                     |    | 6                                   |   | 10 |   | 12 |   |
| Total                                          |   | $                                     | 7,034   |                                | $      | 7,348 |   | $ | 14,262 |   | $ | 14,668 |   |
| Capital  Expenditures:                         |   |                                  |    |                                |   |   |   |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                     | 1,162   |                                | $      | 1,672 |   | $ | 2,198 |   | $ | 5,119 |   |
| Filtration  Products                           |   | 611                                   |    | 880                                 |   | 1,206 |   | 1,825 |   |
| Total                                          |   | $                                     | 1,773   |                                | $      | 2,552 |   | $ | 3,404 |   | $ | 6,944 |   |

        The Company estimates corporate expensesand determines fixed allocations of these expenses for each business segment atthe beginning of the fiscal year.  Anyover or under allocation of actual expenses incurred results in income orexpense reported at the corporate level. A reconciliation of segment profit to the Company’s earnings beforetaxes for each quarter is as follows:
|                                           |   | **Three  Months Ended  December 31,** |   | **Six Months  Ended  December 31,** |   |
|------------------------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                                           |   | **2001**                              |   | **2000**                            |   | **2001** |   | **2000** |   |
|                                           |   | **(dollars  in thousands)**           |   |
| Operating income from business segments        |   | $                                     | 3,035  |                                | $      | 4,629 |   | $ | 12,983 |   | $ | 12,495 |   |
| Over (under)  allocation of corporate expenses |   | 331                                   |   | (451                                | )      | 513 |   | (956 | ) |
| Interest expense,  net                         |   | 3,770                                 |   | 5,072                               |   | 8,118 |   | 10,295 |   |
| Other (income)  expense, net                   |   | 193                                   |   | (4,904                              | )      | 58 |   | (5,000 | ) |
| Income (loss)  before income taxes             |   | $                                     | (597   | )                                   | $      | 4,010 |   | $ | 5,322 |   | $ | 6,244 |   |

* *

 

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**Item2.            Management’s Discussionand Analysis of Financial Condition and Results of Operations**

**Results of Operations**

**                *Net Sales***were $193.8 million for the three monthsended December 31, 2001, which represents a decrease of $18.1 million, or 8.5%,as compared to $211.9 million for the same period in the prior year.  Net sales decreased $23.0 million, or 5.4%to $403.9 million from $426.9 million for the six months ended December 31,2001 and 2000, respectively.  InSeptember 2001, the Company sold its air filtration subsidiary  in Singapore, which had sales of $5.8million in the second quarter of fiscal 2001. Additionally, the Company estimates that sales have decreased byapproximately $0.4 million and $1.7 million for the three months and six monthsending December 31, 2001, respectively, due to the impact of unfavorablecurrency trends in translating European sales. Excluding the net sales attributable to the operation in Singapore forfiscal 2001 and currency impact, net sales for the three months and six monthsended December 31, 2001 decreased $11.9 million or 5.8% and $15.5 million or3.7%, respectively, as compared to the corresponding period of the prior year.

**                CommercialAir Conditioning and Refrigeration** net sales for the three months endedDecember 31, 2001 decreased $17.0 million, or 13.2%, to $111.5 million ascompared to $128.5 million for the three months ended December 31, 2000. Thisdecrease is the result of a 14.2% decrease in domestic sales, and a 10.6%decrease in international sales.  Thedomestic sales decrease is primarily attributable to the general economicslowdown affecting all equipment product lines.  The decrease in international sales volume is primarily theresult of the restructuring efforts undertaken at the Company’s United Kingdom operationsin fiscal 2001.

                Year-to-date sales decreased $22.5 million, or 8.5%,to $241.3 million from $263.8 million. The Company estimates that approximately $0.3 million of the decrease isdue to the impact of unfavorable currency trends in translating Europeansales.  Excluding the currency impact,net sales decreased  $22.2 million, or8.4%. This decrease is the result of an 8.4% decrease in domestic sales and an8.3% 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 $86 million atDecember 31, 2001 as compared to $111 million and $116 million at June 30, 2001and December 31, 2000, respectively.

                **Filtration Products** net sales for the threemonths ended December 31, 2001 decreased $1.6 million, or 2.0%, to $82.8million as compared to $84.4 million for the three months ended December 31,2000.  This decrease is attributable tothe sale of the Company’s Singapore subsidiary in September 2001.  Additionally, the Company estimates thatsales have decreased by approximately $0.5 million for the second quarter offiscal 2001 due to the impact of unfavorable currency trends in translatingEuropean sales.  Excluding these twoitems, net sales increased $4.6 million or 5.8%. This increase is the result ofa 17.4% increase in international sales, partially offset by a 6.1% decrease indomestic sales.  The decrease indomestic sales is primarily attributable to a downturn in cleanroom marketdemand and unusually warm weather impacting the replacement filter business,partially offset by an increase in Machinery Filtration and Acoustical Systems“MFAS” market activity.  The increase ininternational sales is primarily due to the MFAS market in Europe driven by anincrease in gas turbine product sales, partially offset by a decrease in AirPollution Control System projects in Latin America this quarter versus theprior year.

                Year-to-date sales increased $0.6 million, or 0.4%,to $165.1 million from $164.5 million for the six months ended December 31,2000.  The Company estimates that saleshave decreased by approximately $1.4 million for the first six months of fiscal2002 due to the impact of unfavorable currency trends in translating Europeansales.  Excluding the currency impactand sale of the Company’s Singapore subsidiary, net sales increased $7.8million or 4.9% for the six months ended December 31, 2001 versus 2000.  Domestic sales decreased 1.3%, whileinternational sales increased 12.3%. The decrease in domestic sales isprimarily attributable to a downturn in the cleanroom market, partially offsetby an increase in MFAS market activity. The increase in international sales is primarily due to the MFAS marketin Europe driven by an increase in gas turbine product sales, partially offsetby a decrease in Air Pollution Control System projects in Latin America.

 

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                ***Gross Profit***decreased to $47.8 million, or 24.7% of sales, for thethree months ended December 31, 2001 as compared to $52.7 million, or 24.9% ofsales, for the three months ended December 31, 2000.  Year-to-date gross profit decreased to $104.0 million, or 25.8%of sales, from $111.0 million, representing 26.0% of sales, for the six monthsended December 31, 2000.  In theCommercial Air Conditioning and Refrigeration segment, year-to-date grossprofit as a percentage of sales was 26.2% as compared to 25.1% for the sameperiod in fiscal 2001.  This increase ingross margin is primarily attributable to the successful closure of theCompany’s Scottsboro, Alabama plant and consolidation of its applied airhandling manufacturing operations in Minnesota.  The Filtration Products segment’s year-to-date gross profit as apercentage of sales decreased from 27.3% in fiscal 2001 to 24.9% for the sameperiod in fiscal 2002. This decrease is primarily the result of sales mixbetween MFAS and replacement filter sales and continued competitive pricingpressures in the North American replacement filter business.

***                OperatingExpenses***were $44.5 million, or 22.9% of sales,for the second quarter of fiscal 2002 versus $48.5 million, or 22.9% of sales,for the second quarter of fiscal 2001. For the first six months of fiscal years2002 and 2001, operating expenses were $90.5 million, or 22.4% of sales, versus$99.5 million, or 23.3% of sales, respectively.   Excluding amortization and restructuring charges, year-to-dateoperating expenses were $84.6 million for fiscal 2002, or 20.9% of sales, versus$87.4 million for fiscal 2001, or 20.5% of sales.  The decrease from the first six months of fiscal 2001 compared tothe first six months of fiscal 2002 is primarily attributable to lowercommissions due to favorable sales mix and lower volume, improved warrantyexperience and continued focus on cost control, partially offset by an increasein selling expenses.

***                Incomefrom Operations***forthe second quarter of fiscal 2002 decreased to $3.4 million, or 1.7% of sales,as compared to $4.2 million, or 2.0% of sales, in the second quarter of fiscal2001.  Year-to-date income fromoperations increased to $13.5 million, or 3.3% of sales, as compared to $11.5million, or 2.7% of sales in fiscal 2001. Excluding amortization and restructuring charges, year-to-date incomefrom operations decreased to $19.4 million, or 4.8% of sales, compared to $23.6million, or 5.5% of sales in the corresponding period of the prior year.

                The Commercial Air Conditioning and Refrigerationsegment’s income from operations decreased in the second quarter of fiscal 2002to $2.4 million, or 2.1% of sales, as compared to $5.0 million, or 3.9% ofsales in fiscal 2001, excluding amortization and restructuring charges.  Year-to-date income from operations,excluding amortization and restructuring charges, decreased from $13.2 million,or 5.0% of sales, to $10.9 million, or 4.5% of sales, for the first six monthsof fiscal 2001 as compared to the first six months of fiscal 2002,respectively.

                The Filtration Products segment’s income fromoperations, excluding amortization and restructuring charges, for the secondquarter of fiscal 2002 decreased from $5.5 million, or 6.5% of sales, in fiscal2001 to $3.7 million, or 4.5% of sales. Year-to-date income from operations, excluding amortization andrestructuring charges, decreased from $11.4 million, or 6.9% of sales, duringthe first six months of fiscal 2001 to $8.1 million, or 4.9% of sales, for thefirst six months of fiscal 2002.

                ***Net Interest Expense***decreased to $3.8 million and $8.1million for the second quarter and six months ended December 31, 2001 from $5.1million and $10.3 million for the comparable periods ended December 31,2000.  Decrease in interest expense isprimarily attributable to lower debt levels and declining interest rates. 

 

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**Liquidity and Capital Resources**

                The Company’s liquidity needsare provided by cash generated from operating activities and supplemented whennecessary by short-term credit facilities. During the first six months offiscal 2002, funds generated by operating activities were $1.5 million ascompared to $16.5 million of funds generated in the prior fiscal year for thecomparable period.  During the first sixmonths of fiscal 2002, net cash from investing activities is comprised of $13.3million in cash proceeds from the sale of business, partially offset by $3.4million in capital expenditures. Capital spending for the first six months decreased from $6.9 million inthe prior year to $3.4 million this year due to higher than normal spending inthe first six months of fiscal 2001 related to the consolidation of theCompany’s applied air handling operations in Minnesota.  In the first six months of fiscal 2001, theCompany sold property for cash proceeds of $6.9 million.

                The Company’s U.S. bank creditfacilities are comprised of a Term Loan of $30 million and a Revolving CreditFacility of $90 million (“Bank Credit Agreement”).  The Bank Credit Agreement has a three-year term and is designedto provide added flexibility and borrowing availability.  At December 31, 2001, remaining borrowingavailability under the Revolving Credit portion of the Bank Credit Agreementwas $29.4 million.  Net payments onlong-term debt for the first six months of fiscal 2001were $1.1 million. Inaddition, as more fully discussed in Note 4 to the unaudited consolidatedfinancial statements, the Company repurchased $15.0 million of its SeniorNotes.  Short-term borrowings decreasedby $0.5 million during the six-month period ended December 31, 2001.

                A short-term credit facilityprovided to a subsidiary of the Company is supported by an £8.5 million letterof credit from OYL, which expires on May 31, 2002. This support arrangement maybe extended for additional time periods with the consent of OYL and the bankproviding the facilities.

                Management believes, based uponcurrent levels of operations and forecasted earnings, that cash flows fromoperations, together with borrowings under the Bank Credit Agreement and othershort-term credit facilities, will be adequate to make payments of principaland interest on debt, to permit anticipated capital expenditures and to fundworking capital requirements and other cash needs. Nevertheless, the Companywill remain leveraged to a significant extent and its debt service obligationswill continue to be substantial. If the Company’s sources of funds were to failto satisfy the Company’s requirements, the Company may need to refinance itsexisting debt or obtain additional financing. There is no assurance that any such new financing alternatives would beavailable, and, in any case, such new financing (if available) would beexpected to be more costly and burdensome than the debt agreements currently inplace.

**Item3. Quantitative and Qualitative Disclosure about Market Risk**

                There have been no material changes in the reportedmarket risks since the end of the most recent fiscal year.  See Note 4 to the unaudited consolidatedfinancial statements for disclosures related to financial instruments. 

 

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**Forward-LookingStatements**

                When used in this report the words “believes,”anticipates, “estimates”, “plans” and “expects” and similar expressions areintended to identify forward-looking statements.  These forward-looking statements are intended to providemanagement’s current expectations or plans for the future operating andfinancial performance of the Company, based on assumptions currently believedto be valid. A variety of factors could cause actual results to differmaterially from those anticipated in the Company’s forward-looking statements,some of which include risk factors previously discussed in this and other SECreports filed by the Company.  Theserisk factors include, but are not limited to, economic conditions in the UnitedStates, changes in world financial markets, environmental laws and regulations,risks associated with currency fluctuations, a weakening in Latin Americamarkets, unforeseen competitive pressures, warranty expenses, market acceptanceof new products, unfavorable weather conditions, unforeseen difficulties inmaintaining mutually beneficial relationships with strategic partnerships andalliances, and the results of restructuring activities. Readers are cautionednot to place undue reliance on these forward-looking statements, which speakonly as of the date on which those statements are made.  The Company undertakes no obligation toupdate any forward-looking statements to reflect unanticipated events orcircumstances occurring after that date.

 

 

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**PARTII:                OTHER INFORMATION**

**Item1.  Legal Proceedings**

                Notapplicable

**Item6(b).  Reports on Form 8-K**

                There were noreports filed on Form 8-K during the period.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|   |              |   | AAF-MCQUAY INC.                                    |
|--------|-------------------|--------|----------------------------------------------------|
|   |              |   |                                               |
|   |              |   |                                               |
|   |              |   |                                               |
| DATE   | February 11, 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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