**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **(Mark One)**                                                                                                                                                                        |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                  |   |
| **ý**                                                                                                                                                                            | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                  |   |
| **For the quarterly period ended****December  28, 2002**                                                                                                                              |
|                                                                                                                                                                                  |   |
| **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-MCQUAY  INC.**                                                                                      |
|-----------------------------------------------------------------------------------------------------------|
| (Exact name of  Registrant 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 filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes ýNo o

 

Indicate by a checkmark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).  Yes o No ý

 

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 27, 2003.

 

 

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INDEX

 

AAF-MCQUAY INC. ANDSUBSIDIARIES

 
| Part I - Financial  Information |
|---------------------------------|
|                            |   |
| Item 1.                         | Financial Statements  (unaudited) |
|                            |   |
|                            | Condensed  Consolidated Balance Sheets as of  -  December 31, 2002 and June 30, 2002 |
|                            |   |
|                            | Condensed  Consolidated Statements of Operations - Three and Six Months Ended December  31, 2002 and 2001 |
|                            |   |
|                            | Condensed  Consolidated Statements of Cash Flows - Six Months Ended December 31, 2002  and 2001 |
|                            |   |
|                            | Condensed  Consolidated Statements of Comprehensive Income - Three and Six Months Ended  December 31, 2002 and 2001 |
|                            |   |
|                            | Notes  to the Condensed 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 |
|                            |   |
| Item 4.                         | Controls and  Procedures |
|                            |   |
| Part II - Other Information     |
|                            |   |
| Item 1.                         | Legal Proceedings |
|                            |   |
| Item 6.                         | Exhibits and  Reports on Form 8-K |
|                            |   |
|                            | Signatures |
|                            |   |
|                            | Certifications |

 

2

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**PARTI:     FINANCIAL INFORMATION**

 

**Item1.  Financial Statements**

 

**AAF-McQUAYINC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

(unaudited)

(dollars in thousands,except share data)

 
|                                                                                         |   | **December  31,  2002** |       | **June 30,  2002** |       |
|----------------------------------------------------------------------------------------------|--------|-------------------------|------------|--------------------|------------|
| **ASSETS**                                                                                   |   |                    | ** ** |               | ** ** |
| Current assets:                                                                              |   |                    |       |               |       |
| Cash and cash equivalents                                                                    |   | $                       | 9,755      |               | $          | 11,821 |   |
| Accounts receivable                                                                          |   | 178,863                 |       | 188,939            |       |
| Inventories                                                                                  |   | 102,124                 |       | 94,946             |       |
| Other current assets                                                                         |   | 7,715                   |       | 7,379              |       |
| Total current  assets                                                                        |   | 298,457                 |       | 303,085            |       |
|                                                                                         |   |                    |       |               |       |
| Property, plant  and equipment, net                                                          |   | 105,587                 |       | 110,475            |       |
| Cost in excess  of net assets acquired                                                       |   | 107,457                 |       | 103,882            |       |
| Other  identifiable intangibles, net                                                         |   | 74,976                  |       | 80,283             |       |
| Other assets and  deferred charges                                                           |   | 18,740                  |       | 15,611             |       |
| Total assets                                                                                 |   | $                       | 605,217    |               | $          | 613,336 |   |
|                                                                                         |   |                    | ** ** |               | ** ** |
| **LIABILITIES AND STOCKHOLDER’S  EQUITY**                                               |   |                    | ** ** |               | ** ** |
| Current  liabilities:                                                                        |   |                    |       |               |       |
| Short-term borrowings                                                                        |   | $                       | 8,868      |               | $          | 38,935 |   |
| Current maturities of  long-term debt                                                        |   | 9,958                   |       | 107,561            |       |
| Accounts payable, trade                                                                      |   | 90,703                  |       | 100,383            |       |
| Accrued warranty                                                                             |   | 17,897                  |       | 19,918             |       |
| Accrued employee  compensation                                                               |   | 26,412                  |       | 26,871             |       |
| Other accrued  liabilities                                                                   |   | 34,107                  |       | 34,535             |       |
| Total current  liabilities                                                                   |   | 187,945                 |       | 328,203            |       |
|                                                                                         |   |                    |       |               |       |
| Long-term debt                                                                               |   | 135,543                 |       | 9,940              |       |
| Deferred income  taxes                                                                       |   | 20,576                  |       | 21,057             |       |
| Other  liabilities                                                                           |   | 53,907                  |       | 55,242             |       |
| Total  liabilities                                                                           |   | 397,971                 |       | 414,442            |       |
|                                                                                         |   |                    |       |               |       |
| Stockholder’s  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                                                                            |   | 46,883                  |       | 41,414             |       |
| Accumulated other  comprehensive loss                                                        |   | (19,802                 | )          | (22,685            | )          |
| Total  stockholder’s equity                                                             |   | 207,246                 |       | 198,894            |       |
| Total  liabilities and stockholder’s equity                                             |   | $                       | 605,217    |               | $          | 613,336 |   |

 

See Accompanying Notes tothe Condensed Consolidated Financial Statements

 

3

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**AAF-McQUAY INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

(unaudited)

(dollars in thousands)

 
|                                                     |   | **Three  Months Ended  December 31,** |    | **Six Months  Ended  December 31,** |   |
|----------------------------------------------------------|--------|---------------------------------------|---------|-------------------------------------|--------|
|                                                     |   | **2002**                              |    | **2001**                            |   | **2002** |   | **2001** |   |
| Net sales                                                |   | $                                     | 187,278 |                                | $      | 193,848 |   | $ | 385,828 |   | $ | 403,926 |   |
| Cost of sales                                            |   | 138,576                               |    | 146,018                             |   | 283,479 |   | 299,897 |   |
| Gross profit                                             |   | 48,702                                |    | 47,830                              |   | 102,349 |   | 104,029 |   |
| Operating expenses:                                      |   |                                  |    |                                |   |   |   |   |   |
| Selling, general  and administrative                     |   | 42,638                                |    | 41,325                              |   | 84,898 |   | 84,635 |   |
| Restructuring                                            |   | —                                |    | 450                                 |   | — |   | 450 |   |
| Amortization of  intangible assets                       |   | 1,112                                 |    | 2,689                               |   | 2,224 |   | 5,446 |   |
|                                                     |   | 43,750                                |    | 44,464                              |   | 87,122 |   | 90,531 |   |
| Income from  operations                                  |   | 4,952                                 |    | 3,366                               |   | 15,227 |   | 13,498 |   |
| Interest  expense, net                                   |   | 2,906                                 |    | 3,770                               |   | 6,060 |   | 8,118 |   |
| Other expense,  net                                      |   | 453                                   |    | 193                                 |   | 402 |   | 58 |   |
| Income (loss)  before income taxes and minority interest |   | 1,593                                 |    | (597                                | )      | 8,765 |   | 5,322 |   |
| Minority  interest.                                      |   | (10                                   | )       | 88                                  |   | (1 | ) | 69 |   |
| Provision  (benefit) for income taxes                    |   | 599                                   |    | (305                                | )      | 3,297 |   | 2,181 |   |
| Net income  (loss)                                       |   | $                                     | 1,004   |                                | $      | (380 | ) | $ | 5,469 |   | $ | 3,072 |   |

 

See Accompanying Notes tothe Condensed Consolidated Financial Statements

 

4

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**AAF-McQUAY INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

 (unaudited)

(dollars in thousands)

 
|                                                             |   | **Six Months  Ended  December 31,** |   |
|------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                             |   | **2002**                            |   | **2001** |   |
| Cash flows from  operating activities:                           |   |                                |   |   |   |
| Net income                                                       |   | $                                   | 5,469  |   | $ | 3,072 |   |
| Adjustments to  reconcile to net cash from operating activities: |   |                                |   |   |   |
| Depreciation and  amortization                                   |   | 11,170                              |   | 14,262 |   |
| Other non-cash  items, net                                       |   | 376                                 |   | 375 |   |
| Changes in  operating assets and liabilities                     |   | (12,924                             | )      | (16,245 | ) |
| Net cash from  operating activities                              |   | 4,091                               |   | 1,464 |   |
|                                                             |   |                                |   |   |   |
| Cash flows from  investing activities:                           |   |                                |   |   |   |
| Capital  expenditures, net                                       |   | (3,367                              | )      | (3,404 | ) |
| Proceeds from  sale of business                                  |   | —                              |   | 13,308 |   |
| Net cash from  investing activities                              |   | (3,367                              | )      | 9,904 |   |
|                                                             |   |                                |   |   |   |
| Cash flows from  financing activities:                           |   |                                |   |   |   |
| Net repayments  under short-term borrowing arrangements          |   | (30,526                             | )      | (463 | ) |
| Payments on  long-term debt                                      |   | (13,659                             | )      | (3,496 | ) |
| Proceeds from  issuance of long-term debt                        |   | 63,600                              |   | 2,393 |   |
| Repurchase of  senior notes                                      |   | (22,098                             | )      | (14,990 | ) |
| Net cash from  financing activities                              |   | (2,683                              | )      | (16,556 | ) |
|                                                             |   |                                |   |   |   |
| Effect of  exchange rate changes on cash                         |   | (107                                | )      | 295 |   |
| Net decrease in  cash and cash equivalents                       |   | (2,066                              | )      | (4,893 | ) |
| Cash and cash  equivalents at beginning of period                |   | 11,821                              |   | 14,254 |   |
|                                                             |   |                                |   |   |   |
| Cash and cash  equivalents at end of period                      |   | $                                   | 9,755  |   | $ | 9,361 |   |

 

See Accompanying Notes tothe Condensed Consolidated Financial Statements

 

5

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**AAF-McQUAYINC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME**

(unaudited)

(dollars in thousands)

** **
|                                                                                       |   | **Three  Months Ended  December 31,** |   | **Six Months  Ended  December 31,** |   |
|--------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                                                                                       |   | **2002**                              |   | **2001**                            |   | **2002** |   | **2001** |   |
| Net income  (loss)                                                                         |   | $                                     | 1,004  |                                | $      | (380 | ) | $ | 5,469 |   | $ | 3,072 |   |
| Other  comprehensive income (loss):                                                        |   |                                  |   |                                |   |   |   |   |   |
| Foreign currency  translation adjustments                                                  |   | 2,951                                 |   | (1,787                              | )      | 2,883 |   | 1,559 |   |
| Write off of  accumulated foreign currency translation adjustments due to sale of business |   | —                                |   | —                              |   | — |   | (221 | ) |
| Comprehensive  income (loss)                                                               |   | $                                     | 3,955  |                                | $      | (2,167 | ) | $ | 8,352 |   | $ | 4,410 |   |

 

See Accompanying Notes tothe Condensed Consolidated Financial Statements

 

6

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

 

***1. Basis of Presentation***

 

The accompanying unaudited condensed consolidatedfinancial statements include the accounts of AAF-McQuay Inc. (the “Company”)and all of its consolidated subsidiaries. All intercompany transactions have been eliminated.  The condensed consolidated financial statementshave been prepared in accordance with the rules and regulations of theSecurities and Exchange Commission including the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally includedin financial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America 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”) as of and for theyear ended June 30, 2002.  In theopinion of management, all adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation have been included.

 

The operating results for the six months endedDecember 31, 2002 are not necessarily indicative of the operating results thatmay be expected for the full year ending June 30, 2003.  The Company’s period end is the Saturdayclosest to December 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.

 

***2. Inventories***

 

Inventories consist of the following:

 
|            |   | **December  31,  2002** |    | **June 30,  2002** |   |
|-----------------|--------|------------------------------|---------|--------------------|--------|
|            |   | **(dollars  in thousands)**  |    |
| FIFO cost:      |   |                         |    |               |   |
| Raw materials   |   | $                            | 40,180  |               | $      | 38,471 |   |
| Work-in-process |   | 15,578                       |    | 15,006             |   |
| Finished goods  |   | 47,268                       |    | 42,464             |   |
|            |   | 103,026                      |    | 95,941             |   |
| LIFO adjustment |   | (902                         | )       | (995               | )      |
|            |   | $                            | 102,124 |               | $      | 94,946 |   |

 

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

 

The tax provisions for the threeand six month periods ended December 31, 2002 and 2001 are based on theestimated effective tax rates applicable for the full years, and after givingeffect to significant unusual items related specifically to the interimperiods.  The difference between theCompany’s reported tax provision for the three month and six month periodsended December 31, 2002 and the tax provision computed based on U.S. statutoryrates is primarily attributable to unbenefitted foreign losses and export salestax benefit.  The difference between theCompany’s reported tax provision for the three month and six month periodsended December 30, 2001 and the tax provision computed based on U.S. statutoryrates is primarily attributable to nondeductible goodwill amortization,unbenefitted foreign losses and export sales tax benefit.

 

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

 

In the second quarter of fiscal2003, the Company finalized a new bank credit agreement (the “New BankCredit Agreement”).  The purpose of theNew Bank Credit Agreement was to replace both its existing Bank CreditAgreement and Senior Notes, which mature in February 2003.  The New Bank Credit Agreement contains $170million in total lending commitments and is comprised of a $75 million termloan and a $95 million revolving credit facility (“revolver”).   The Company plans to draw on the term loan(unfunded as of December 31, 2002) as needed to retire the Senior Notes.  The term loan has a five-year term and ispayable in 18 quarterly installments of $3.0 million starting June 30, 2003with a final payment of $21.0 million due at maturity (December 5, 2007).  The revolver, with a balance of $63.6million at December 31, 2002, is available for a period of five years and isdesigned to provide financing for working capital and other general corporateneeds.  Interest under the New Bank Credit Agreement is generally payablequarterly, primarily on the basis of LIBOR plus a specified premium.   The premium, set initially at 2.25%, isdetermined by a financial ratio matrix and allows for future reductionsdepending on the financial ratio.  AtDecember 31, 2002, the company’s borrowing rate under the New Bank CreditAgreement was 3.6%.

 

7

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The New Bank Credit Agreementcontains covenants that, among other things, impose limitations on incurrenceof indebtedness, mergers and the disposition of assets, investments by theCompany, and transactions involving the capital of the Company.  In addition, the New Bank Credit Agreementcontains financial convenants relating to net worth, leverage, asset coverage,and fixed charge coverage.  The Companyis in compliance with the covenants of the New Bank Credit Agreement.

 

In the first quarter of fiscal2003, the Company repurchased a total of $21.9 million face value of its SeniorNotes at a slight premium, resulting in a pre-tax loss after write off ofassociated debt issuance costs of approximately $0.3 million.  The Company plans to hold these repurchasednotes until their maturity in February 2003. The balance of Senior Notes heldoutside the Company after the repurchase and included in the Company’s debt atDecember 31, 2002 was $71.9 million. After December 31, 2002, the Company repurchased an additional $20.8million of its Senior Notes at par by making a tender offer to its existingbondholders.  The remainder of theoutstanding Senior Notes will be redeemed in February 2003.

 

In January 2000, the Company entered into an interestrate swap transaction whereby the Company received a fixed rate and paid afloating rate on the basis of 3-month LIBOR. The January 2000 swap had a three-year term and a notional amount of $30million and effectively converted a portion of the Company’s fixed rateborrowings to a floating rate.  InNovember 2001, the Company terminated its $30 million floor, which required theCompany to make payments if 3-month LIBOR fell below a certain level.  The transaction cost of this termination waspaid by accepting a lower swap rate on the January 2000 swap and by changingthe floating rate basis from 3-month to 6-month LIBOR.  In January 2002, the Company increased theswap notional amount from $30 million to $60 million.  The measurement dates and maturity dates of the swap matched theinterest payment dates and maturity date of the Senior Notes.  These positions were not accounted for ashedges.  The Company recorded the swapin its balance sheet at fair market value. In August 2002, the Company terminated its swap for consideration of$0.8 million, and recognized a gain of $0.3 million in the first quarter offiscal 2003.   A loss of $30,000 was recorded as a result of these positions forthe six months ended December 31, 2001.

 

The Company secures pricing on aportion of its copper requirements through forward contracts.  At December 31, 2002, contracts for 4.1million pounds of copper were in place. These contracts have various expiration dates through December 2003.

 

***5. Goodwill and Other Intangible Assets***

 

Effective July 1, 2002, the Company adopted Statementof Financial Accounting Standards (SFAS) No. 141, *Business Combinations*.  SFAS 141 requires the use of the purchasemethod of accounting for all business combinations and modifies the applicationof the purchase accounting method.  SFAS141 also specifies criteria to be used in determining whether intangible assetsacquired in a purchase method business combination must be recognized andreported separately from goodwill.  OnJuly 1, 2002, the Company reclassified its assembled workforce intangible assetto goodwill in the amount of $3.1 million as the assembled workforce intangibleasset does not meet the criteria of SFAS 141 to be recognized as an asset apartfrom goodwill.

 

Effective July 1, 2002 the Company also adopted SFASNo. 142, *Goodwilland Other Intangibles*.  SFAS142 eliminates the requirement to amortize goodwill and indefinite-livedintangible assets, addresses the amortization of intangible assets with definedlives, and addresses impairment testing and recognition for goodwill andindefinite-lived intangible assets. SFAS 142 applies to goodwill and intangible assets arising fromtransactions completed before and after its effective date.  As a result of adopting SFAS 142, theCompany ceased amortization of goodwill and indefinite-lived intangible assetsbeginning July 1, 2002.  Additionally,in accordance with the requirements of SFAS 142, the Company completed separatetransitional impairment tests of goodwill and indefinite-lived intangibleassets, as of July 1, 2002, which indicated no impairment.

 

8

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The following table provides a summary of net incomeas reported and as adjusted to exclude goodwill amortization for the threemonths and six months ended December 31, 2002 and 2001:

 
|                                        |   | **Three  Months Ended  December 31,** |   | **Six Months  Ended  December 31,** |   |
|---------------------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                                        |   | **2002**                              |   | **2001**                            |   | **2002** |   | **2001** |   |
|                                        |   | **(dollars  in thousands)**           |   | **(dollars  in thousands)**         |   |
| Reported net  income (loss)                 |   | $                                     | 1,004  |                                | $      | (380 | ) | $ | 5,469 |   | $ | 3,072 |   |
| Goodwill  amortization, net of income taxes |   | —                                |   | 1,094                               |   | — |   | 2,188 |   |
| Other  amortization, net of income taxes    |   | —                                |   | 221                                 |   | — |   | 442 |   |
| Adjusted net  income                        |   | $                                     | 1,004  |                                | $      | 935 |   | $ | 5,469 |   | $ | 5,702 |   |

 

The changes in the carrying amount of goodwill on a quarter-to-date andyear-to-date basis in fiscal 2003 are as follows (dollars in thousands):

 
| Balance as of September 30, 2002         |   | $      | 107,166 |   |
|------------------------------------------|--------|--------|---------|--------|
| Reclassification  of assembled workforce |   | — |    |
| Foreign currency                         |   | 291    |    |
| Balance as of  December 31, 2002         |   | $      | 107,457 |   |
|                                     |   |   |    |
| Balance as of June 30, 2002              |   | $      | 103,882 |   |
| Reclassification  of assembled workforce |   | 3,081  |    |
| Foreign currency                         |   | 494    |    |
| Balance as of  December 31, 2002         |   | $      | 107,457 |   |

 

Indefinite-lived intangible assets as of December 31,2002 totaled approximately $45.4 million and consisted of trademarks.  Amortizable intangible assets at December31, 2002, net of accumulated amortization of $37.2 million, totaledapproximately $29.6 million and consisted primarily of drawings andtechnology.  Amortization expense forthe three months and six months ended December 31, 2002 was approximately $1.1million and $2.2 million, respectively, and is estimated to be $4.4 million forfiscal 2003 and for the next five fiscal years.

 

***6. Contingencies and Guarantees***

 

***Environmental Matters -***The Company is subject to potential liabilityunder the Comprehensive Environmental Response, Compensation, and Liability Actof 1980, as amended (CERCLA), and other federal, state and local statutes and regulationsgoverning the discharge of pollutants into the environment and the handling anddisposal of hazardous substances and waste. These statutes and regulations,among other things, impose potential liability on the Company for the cost ofremediation of contamination arising from the Company’s past and presentoperations and from former operations of other entities at sites later acquiredand now owned by the Company. Many of the Company’s facilities have operatedfor many years, and substances which are or might be considered hazardous weregenerated, used, and disposed of at some locations, both on- and off-site.Therefore, it is possible that environmental liabilities in addition to thosedescribed in Note 14 of the Annual Report may arise in the future. The Companyrecords liabilities if, in management’s judgment, environmental assessments orremedial efforts are probable and the costs can be reasonably estimated. Theseaccrued liabilities are not discounted. Such estimates are adjusted if necessarybased upon the completion of a formal study or the Company’s commitment to aformal plan of action.

 

***Litigation -***The Company is involved in various lawsuits inthe 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 thedeductibles. All other claims and lawsuits are also provided for on acase-by-case basis.

 

9

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The Company does not believethat the potential liability from the ultimate outcome of environmental andlitigation matters will have a material adverse effect on its financial statements or liquidity.

 

In November 2002, the FinancialAccounting Standards Board issued FASB Interpretation No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*, which elaborates on requireddisclosures by a guarantor in its financial statements about obligations undercertain guarantees that it has issued and clarifies the need for a guarantor torecognize, at the inception of certain guarantees, a liability for the fairvalue of the obligation undertaken in issuing the guarantee. The Company isreviewing the provisions of this Interpretation relating to initial recognitionand measurement of guarantor liabilities, which are effective for qualifyingguarantees entered into or modified after December 31, 2002, but does notexpect it to have a material impact on the Company’s financial statements. Thedisclosure requirements of the Interpretation, which are effective for thequarter ended December 31, 2002, are included in the following paragraphs.

 

***Guarantees -***In the normal course of business, the Company mayprovide financial performance guarantees, which are generally backed by standbyletters of credit or surety bonds.  Ingeneral, the Company would only be liable for the amount of these guarantees inthe event of default in the performance of obligations, the probability ofwhich is remote in management’s opinion. Bank bonds, indemnities and guarantees (“performance guarantees”)amounting to approximately $18.2 million were outstanding with recourse to theCompany as of December 31, 2002.  Theseperformance guarantees are generally outstanding until project or productdelivery, start-up, or the end of the Company’s warranty period.   In addition, the Company has guarantees ofapproximately $1.2 primarily in support of working capital credit lines andleases established with local financial institutions for certain of its jointventures.

 

The Company has also providedother letters of credit, guarantees and surety bonds of approximately $8.2million to various government agencies, insurance companies and other entitiesin support of its obligations.  TheCompany believes that no payments will be required resulting from theseaccommodation obligations.

 

***Warranties -***Warranties are recorded as aliability on the balance sheet as charges to current expense for estimatednormal warranty costs and, if applicable, for specific performance issues knownto exist on products sold.  The expensesestimated to be incurred are provided at the time of sale, based primarily uponestimates derived from experience. Warranty costs on some purchased parts and components are partiallyreimbursed to the Company by supplying vendors.  Estimated obligations beyond one year are classified as otherlong-term liabilities.  Revenue from thesale of extended warranty and related service contracts is deferred andamortized over the respective contract life on a straight-line basis.

 

Changes in the Company’s warranty accrual during the period are asfollows: 

 

| **(dollars  in thousands)**                                                                                          |   |    |   |
|----------------------------------------------------------------------------------------------------------------------|--------|---------|--------|
| Balance as of  June 30, 2002                                                                                         |   | $       | 31,053 |   |
| Provision for  warranty liability for sales made during the two quarters ended December 31,  2002                    |   | 5,051   |   |
| Settlements made  during the two quarters ended December 31, 2002                                                    |   | (6,909  | )      |
| Other adjustments  to the liability including those for translation during the two quarters  ended December 31, 2002 |   | (285    | )      |
| Balance as of  December 31, 2002                                                                                     |   | $       | 28,910 |   |
| Less:  Portion included in other long-term  liabilities                                                         |   | (11,013 | )      |
|                                                                                                                 |   |    |   |
| Current accrued  warranty as of December 31, 2002                                                                    |   | $       | 17,897 |   |

 

10

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***7. 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, 2002 and 2001 is as follows:

 
|                                           |   | **Three  Months Ended  December 31,** |    | **Six Months  Ended  December 31,** |   |
|------------------------------------------------|--------|---------------------------------------|---------|-------------------------------------|--------|
| **Classified  By Industry**                    |   | **2002**                              |    | **2001**                            |   | **2002** |   | **2001** |   |
|                                           |   | **(dollars  in thousands)**           |    |
| Net Sales:                                     |   |                                  |    |                                |   |   |   |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                     | 119,070 |                                | $      | 111,532 |   | $ | 247,310 |   | $ | 241,338 |   |
| Filtration  Products                           |   | 68,669                                |    | 82,755                              |   | 139,448 |   | 165,072 |   |
| Eliminations                                   |   | (461                                  | )       | (439                                | )      | (930 | ) | (2,484 | ) |
| Total                                          |   | $                                     | 187,278 |                                | $      | 193,848 |   | $ | 385,828 |   | $ | 403,926 |   |
| Operating  Income:                             |   |                                  |    |                                |   |   |   |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                     | 2,269   |                                | $      | 781 |   | $ | 9,007 |   | $ | 7,633 |   |
| Filtration  Products                           |   | 2,480                                 |    | 2,254                               |   | 5,950 |   | 5,352 |   |
| Corporate                                      |   | 203                                   |    | 331                                 |   | 270 |   | 513 |   |
| Total                                          |   | $                                     | 4,952   |                                | $      | 3,366 |   | $ | 15,227 |   | $ | 13,498 |   |
| Depreciation and  Amortization:                |   |                                  |    |                                |   |   |   |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                     | 4,080   |                                | $      | 4,806 |   | $ | 8,492 |   | $ | 9,612 |   |
| Filtration  Products                           |   | 1,341                                 |    | 2,223                               |   | 2,673 |   | 4,640 |   |
| Corporate                                      |   | 3                                     |    | 5                                   |   | 6 |   | 10 |   |
| Total                                          |   | $                                     | 5,424   |                                | $      | 7,034 |   | $ | 11,171 |   | $ | 14,262 |   |
| Capital  Expenditures:                         |   |                                  |    |                                |   |   |   |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                     | 858     |                                | $      | 1,162 |   | $ | 1,952 |   | $ | 2,198 |   |
| Filtration  Products                           |   | 860                                   |    | 611                                 |   | 1,415 |   | 1,206 |   |
| Total                                          |   | $                                     | 1,718   |                                | $      | 1,773 |   | $ | 3,367 |   | $ | 3,404 |   |

 

The Company estimates corporate expenses anddetermines fixed allocations of these expenses for each business segment at thebeginning of the fiscal year.  Any overor under allocation of actual expenses incurred results in income or expensereported at the corporate level.  Areconciliation of segment profit to the Company’s earnings before taxes foreach quarter is as follows:

 
|                                     |   | **Three  Months Ended  December 31,** |   | **Six Months  Ended  December 31,** |   |
|------------------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                                     |   | **2002**                              |   | **2001**                            |   | **2002** |   | **2001** |   |
|                                     |   | **(dollars  in thousands)**           |   |
| Operating income  from business segments |   | $                                     | 4,749  |                                | $      | 3,035 |   | $ | 14,957 |   | $ | 12,985 |   |
| Over allocation  of corporate expenses   |   | 203                                   |   | 331                                 |   | 270 |   | 513 |   |
| Interest  expense, net                   |   | 2,906                                 |   | 3,770                               |   | 6,060 |   | 8,118 |   |
| Other expense,  net                      |   | 453                                   |   | 193                                 |   | 402 |   | 58 |   |
| Income (loss)  before income taxes       |   | $                                     | 1,593  |                                | $      | (597 | ) | $ | 8,765 |   | $ | 5,322 |   |

 

***8. Other Recent Accounting Pronouncements***

 

In August 2001, the Financial Accounting StandardsBoard issued SFAS No. 143, *Accounting for Asset Retirement Obligations*,which is effective for fiscal years beginning after June 15, 2002.  SFAS 143 addresses the financial accountingand reporting for obligations associated with the retirement of tangiblelong-lived assets and the associated asset retirement costs.  SFAS 143 was effective for the Companybeginning with the first quarter of fiscal 2003 and its adoption did not have amaterial impact on the Company’s results of operations or financial position.

 

In August 2001, the Financial Accounting StandardsBoard issued SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*.  SFAS No.144 addresses the financial accounting and reporting for the impairment ordisposal of long-lived

 

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assets. SFAS No. 144 supersedes SFAS No. 121, *Accounting for the Impairment ofLong-Lived Assets and for the Long-Lived Assets to Be Disposed Of*,and the accounting and reporting provisions of APB Opinion No. 30, *Reportingthe Results of Operations - Reporting the Effects of Disposal of a Segment of aBusiness, and Extraordinary, Unusual and Infrequently Occurring Events andTransactions*, for the disposal of a segment of a business (aspreviously defined in that Opinion). SFAS No. 144 also amends Accounting Research Bulletin No. 51, *ConsolidatedFinancial Statements*, to eliminate the exception to consolidationfor a subsidiary for which control is likely to be temporary.  The provisions of this statement areeffective for fiscal years beginning after December 15, 2001.  SFAS 144 was effective for the Companybeginning with the first quarter of fiscal 2003 and its adoption did not have amaterial impact on the Company’s results of operations or financial position.

 

In April 2002, the Financial Accounting StandardsBoard issued SFAS No. 145, *Rescission of FASB Statements No. 4, 44, and 64,Amendment of FASB Statement No. 13, and Technical Corrections*, whichis effective for fiscal years beginning after May 15, 2002.  SFAS 145 addresses the financial accountingand reporting for a number of areas, including gains and losses derived fromthe extinguishment of debt and the treatment of sale-leasebacktransactions.  SFAS 145 was effectivefor the Company beginning with the first quarter of fiscal 2003 and its adoptiondid not have a material impact on the Company’s results of operations orfinancial position.

 

In June 2002, the Financial Accounting Standards Boardissued SFAS No. 146, *Accounting for Costs Associated with Exit or DisposalActivities*.  SFAS 146 addressesfinancial accounting and reporting for costs associated with exit or disposalactivities.  SFAS No. 146 supercedesEmerging Issues Task Force (EITF) Issue 94-3, *Liability Recognition for CertainEmployee Termination Benefits and Other Costs to Exit an Activity (includingCertain Costs Incurred in a Restructuring)*.  SFAS 146 requires that a liability for acost associated with an exit or disposal activity be recognized when theliability is incurred.  Under Issue94-3, a liability for an exit cost as defined in EITF 94-3 was recognized atthe date of an entity’s commitment to an exit plan. SFAS No. 146 alsoestablishes that the liability should initially be measured and recorded atfair value.  The provisions of thisstatement are effective for exit or disposal activities that are initiatedafter December 31, 2002, with early adoption permitted.  Adoption of SFAS No. 146 is not expected tomaterially impact the Company’s consolidated financial statements.

 

In January 2003, the FinancialAccounting Standards Board issued FASBInterpretation No. 46, *Consolidation of Variable Interest Entities*,which addresses consolidation by a business of variable interest entities inwhich it is the primary beneficiary. The Interpretation is effectiveimmediately for certain disclosure requirements and variable interest entitiescreated after January 31, 2003, and in fiscal 2004 for all other variableinterest entities. The Company is reviewing the provisions of thisInterpretation and complies with the disclosure requirements, but does notexpect it to have a material impact on the Company’s consolidated financialstatements.

 

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

 

**Results of Operations**

 

***Net Sales***were $187.3 million for thethree months ended December 31, 2002, which represents a decrease of $6.5million, or 3.4%, as compared to $193.8 million for the same period in theprior year.  Net sales decreased $18.1million, or 4.5%, to $385.8 million from $403.9 million for the six monthsended December 31, 2002 and 2001, respectively.  In September 2001, the Company sold its Singapore subsidiary,which had sales of $3.6 million for the six months ended December 31, 2001.  The Company also sold its Korean jointventure in January 2002, which had sales of $3.1 million and $4.9 million forthe three months and six months ended December 31, 2001, respectively.  Additionally, the Company estimates thatsales have increased by approximately $6.8 million and $10.8 million for thethree months and six months ending December 31, 2002, respectively, due to theimpact of favorable currency trends in translating European sales.  Excluding the net sales attributable to theoperations in Singapore and Korea for fiscal 2002 and currency impact, netsales for the three months and six months ended December 31, 2002 decreased$10.3 million or 5.4% and $20.4 million or 5.2%, respectively, as compared tothe corresponding period of the prior year.

 

**Commercial Air Conditioning and Refrigeration**netsales for the three months ended December 31, 2002 increased $7.6 million, or6.8%, to $119.1 million as compared to $111.5 million for the three monthsended December 31, 2001.  The Companyestimates that sales have increased by approximately $3.1 million for the threemonths ended December 31, 2002 due to the impact of favorable currency trendsin translating European sales. Excluding the currency impact, net sales for the three months endedDecember 31, 2002 increased $4.5 million or 4.0% as compared to the prioryear.  Domestic sales increased 6.4%,while international sales decreased 3.1%. The domestic sales increase is primarily attributable to improveddomestic and export Chiller activity and aftermarket revenues, as the overallU.S. equipment market continues to show weakness.  The decrease in international sales volume is primarily theresult of a softening of the U.K. equipment market, partially offset by volumeincreases related to new product offerings.

 

Year-to-date sales increased $6.0 million, or 2.5%, to$247.3 million from $241.3 million.  TheCompany estimates that sales have increased by approximately $4.9 million forthe six months ended December 31, 2002 due to the impact of favorable currencytrends in translating European sales. Excluding the currency impact, net sales increased $1.1 million, or0.4%, as compared to the prior year. Domestic sales increased 1.3%, while international sales decreased 2.4%.The domestic sales increase is primarily attributable to improved domestic andexport Chiller activity and aftermarket revenues, as the overall U.S. equipmentmarket continues to show weakness.  Thedecrease in international sales volume is primarily the result of a softeningof the U.K. equipment market, partially offset by volume increases related tonew product offerings.

 

Backlog for the Commercial Air Conditioning andRefrigeration segment was $96 million at December 31, 2002 as compared to $98million and $86 million at June 30, 2002 and December 31, 2001, respectively.

 

**Filtration Products**net sales for the threemonths ended December 31, 2002 decreased $14.1 million, or 17.0%, to $68.7million as compared to $82.8 million for the three months ended December 31,2001.  This decrease is partiallyattributable to the sale of the Company’s Korean joint venture in January2002.  Additionally, the Companyestimates that sales have increased by approximately $3.7 million for the threemonths ended December 31, 2002 due to the impact of favorable currency trendsin translating European sales. Excluding these two items, net sales decreased $14.7 million or 18.4%.This decrease is the result of a 12.1% decrease in domestic sales and a 24.0%decrease in international sales.  Thedecrease in domestic sales is primarily attributable to decreased machineryfiltration and acoustical systems (“MFAS”) volume, related to the slowdown inthe gas turbine market, and retail replacement filter sales in the U.S.  The decrease in international sales isprimarily due to decreased MFAS volume in the U.K. related to slowdown in thegas turbine market, partially offset by improved air pollution control andreplacement air filter sales in Europe.

 

Year-to-date sales decreased $25.6 million, or 15.5%,to $139.4 million for the six months ended December 31, 2002 from $165.1million for the six months ended December 31, 2001.  This decrease is partially attributable to the sale of theCompany’s Singapore subsidiary in September 2001 and the Company’s Korean jointventure in January 2002.  Additionally,the Company estimates that sales have increased by approximately $5.9 millionfor the six months ended December 31, 2002 due to the impact of favorablecurrency trends in translating European sales. Excluding the currency impact and sale of the Company’s Singaporesubsidiary and Korean joint venture, net sales decreased $23.0 million or 14.7%for the six months ended December 31, 2002 versus 2001.  This decrease is the result of a 12.3%decrease in domestic sales and a 17.9% decrease in international sales. Thedecrease in domestic sales is primarily attributable to decreased MFAS volume,related to the slowdown in the gas turbine market, and retail replacementfilter sales in the U.S.  The decreasein international sales is primarily due to decreased MFAS volume in the U.K.related to slowdown in the gas turbine market, partially offset by improved airpollution control and replacement air filter sales in Europe.

 

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***Gross Profit***increased to $48.7million, or 26.0% of sales, for the second quarter of fiscal 2003 as comparedto $47.9 million, or 24.7% of sales, for the second quarter of fiscal2002.  Year-to-date gross profit  for the six months ended December 31, 2002decreased to $102.3 million, or 26.5% of sales, from $104.0 million,representing 25.8% of sales, for the six months ended December 31, 2001.  In the Commercial Air Conditioning andRefrigeration segment, year-to-date gross profit as a percentage of sales was25.9% as compared to 26.2% for the same period in fiscal 2002.  This decrease in gross profit is primarilyattributable to competitive pricing pressure in all equipment lines.  The Filtration Products segment’syear-to-date gross profit as a percentage of sales increased from 24.9% infiscal 2002 to 27.5% for the same period in fiscal 2003. This increase isprimarily the result of sales mix between MFAS and replacement filter sales.

 

***Operating Expenses***were $43.7 million,or 23.4% of sales, for the second quarter of fiscal 2003 versus $44.5 million,or 22.9% of sales, for the second quarter of fiscal 2002. For the first sixmonths of fiscal years 2003 and 2002, operating expenses were $87.1 million, or22.6% of sales, versus $90.5 million, or 22.4% of sales, respectively.   Excluding amortization, year-to-dateoperating expenses were $84.9 million for fiscal 2003, or 22.0% of sales,versus $84.5 million for fiscal 2002, or 20.9% of sales.  The increase in operating expenses as apercentage of sales in the first six months of fiscal 2003 compared to thefirst six months of fiscal 2002 is primarily attributable to increased researchand development spending, investment in sales and aftermarket infrastructureand increased freight costs.

 

***Income from Operations***for the secondquarter of fiscal 2003 increased to $5.0 million, or 2.6% of sales, as comparedto $3.5 million, or 1.8% of sales, in the second quarter of fiscal 2002.  Year-to-date income from operationsincreased to $15.2 million, or 3.9% of sales, as compared to $13.5 million, or3.3% of sales, in fiscal 2002. Excluding amortization, year-to-date income from operations decreased to$17.5 million, or 4.5% of sales, compared to $19.5 million, or 4.8% of sales,in the corresponding period of the prior year.

 

The Commercial Air Conditioning and Refrigerationsegment’s income from operations, excluding amortization, increased in thesecond quarter of fiscal 2003 to $3.2 million, or 2.7% of sales, as compared to$2.4 million, or 2.1% of sales, in fiscal 2002.  Year-to-date income from operations, excluding amortization, forthe first six months of fiscal 2003 as well as fiscal 2002 was $10.9 million,or 4.4% and 4.5% of sales, respectively.

 

The Filtration Products segment’s income fromoperations, excluding amortization, for the second quarter of fiscal 2003decreased from $3.7 million, or 4.5% of sales, in fiscal 2002 to $2.7 million,or 3.9% of sales.  Year-to-date incomefrom operations, excluding amortization, decreased from $8.1 million, or 4.9%of sales, during the first six months of fiscal 2002 to $6.3 million, or 4.5%of sales, for the first six months of fiscal 2003.

 

***Net Interest Expense***decreased to $2.9million and $6.1 million for the second quarter and six months ended December31, 2002 from $3.8 million and $8.1 million for the comparable periods endedDecember 31, 2001.  The decrease ininterest expense is primarily attributable to lower debt levels and declininginterest 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 its credit facilities. During the first six months of fiscal 2003,funds generated by operating activities were $4.1 million as compared to $1.5million in the prior fiscal year for the comparable period.  Net cash from investing activities wascomprised of $3.4 million in capital expenditures during the first six monthsof fiscal 2003, which was the same amount of capital spending for the first sixmonths of fiscal 2002.   The Companyestimates total capital expenditures to be approximately $13 million for fiscalyear 2003.  In addition, as more fullydiscussed in Note 4 to the unaudited condensed consolidated financialstatements, the Company used cash of $22.1 million during the first six monthsof fiscal 2003 to repurchase its Senior Notes.

 

As more fully discussed in Note 4 to the unauditedcondensed consolidated financial statements, the Company has entered into a NewBank Credit Agreement. The New Bank Credit Agreement contains $170 million intotal lending commitments and is comprised of a $75 million term loan and a $95million revolving credit facility.   TheCompany plans to draw on the term loan as needed to retire the Senior Notes.The revolver, with a balance of $63.6 million at December 31, 2002, isavailable for a period of five years and is designed to provide financing forworking capital and other general corporate needs.

 

Management believes, based uponcurrent levels of operations and forecasted earnings, that cash flows fromoperations, together with borrowings under the New Bank Credit Agreement andother short-term credit facilities, will be adequate to make payments ofprincipal and interest on debt, to permit anticipated capital expenditures andto fund working capital requirements and other cash needs.  Nevertheless, the Company will remainleveraged to a certain extent and its debt service obligations will continue tobe substantial.

 

**Recent Accounting Pronouncements**

 

In June 2002, the Financial Accounting Standards Boardissued SFAS No. 146, *Accounting for Costs Associated with Exit or DisposalActivities*.  SFAS 146addresses financial accounting and reporting for costs associated with exit ordisposal activities.  SFAS No. 146supercedes Emerging Issues Task Force (EITF) Issue 94-3, *Liability Recognition for CertainEmployee Termination Benefits and Other Costs to Exit an Activity (includingCertain Costs Incurred in a Restructuring)*.  SFAS 146 requires that a liability for acost associated with an exit or disposal activity be recognized when theliability is incurred.  Under Issue94-3, a liability for an exit cost as defined in EITF 94-3 was recognized atthe date of an entity’s commitment to an exit plan. SFAS No. 146 alsoestablishes that the liability should initially be measured and recorded atfair value.  The provisions of thisstatement are effective for exit or disposal activities that are initiatedafter December 31, 2002, with early adoption permitted.  Adoption of SFAS No. 146 is not expected tomaterially impact the Company’s consolidated financial statements.

 

In November 2002, the FinancialAccounting Standards Board issued FASB Interpretation No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*, which elaborates on requireddisclosures by a guarantor in its financial statements about obligations undercertain guarantees that it has issued and clarifies the need for a guarantor torecognize, at the inception of certain guarantees, a liability for the fairvalue of the obligation undertaken in issuing the guarantee. The Company isreviewing the provisions of this Interpretation relating to initial recognitionand measurement of guarantor liabilities, which are effective for qualifyingguarantees entered into or modified after December 31, 2002, but does notexpect it to have a material impact on the Company’s financial statements. Thedisclosure requirements of the Interpretation, which are effective for thequarter ended December 31, 2002, are included in Note 8 to the unauditedcondensed consolidated financial statements.

 

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In January 2003, the FinancialAccounting Standards Board issued FASBInterpretation No. 46, *Consolidation ofVariable Interest Entities*, which addresses consolidation by abusiness of variable interest entities in which it is the primary beneficiary.The Interpretation is effective immediately for certain disclosure requirementsand variable interest entities created after January 31, 2003, and in fiscal2004 for all other variable interest entities. The Company is reviewing theprovisions of this Interpretation and complies with the disclosurerequirements, but does not expect it to have a material impact on the Company’sconsolidated financial statements.

 

**Critical Accounting Policies**

 

The Company’s discussion and analysis of its financialcondition and results of operations is based upon the Company’s consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States of America.  The preparation of these financial statementsrequires the Company to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses and related disclosuresof contingent assets and liabilities.

 

On an ongoing basis, the Company evaluates itsestimates and judgments, including those relating to revenue recognition,allowance for doubtful accounts, valuation of inventories, valuation oflong-lived assets, goodwill and other intangible assets, pension planassumptions, income taxes, depreciation, income tax valuation allowances andlitigation and environmental liabilities. The Company bases its estimates on historical experience and on variousother assumptions it believes to be reasonable under the circumstances, theresults of which form the basis for making judgments about carrying values ofassets and liabilities that cannot be readily determined from othersources.  There can be no assurance thatactual results will not differ from those estimates.

 

For a detailed discussion on the application of theseand other accounting policies, see the discussion of critical accountingpolicies in Item 7 “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and the “Summary of Significant Accounting Policies”in the Notes to the Consolidated Financial Statements included in the June 30,2002 Annual Report on Form 10-K.

 

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

 

There have been no material changes in the reportedmarket risks since the end of the most recent fiscal year, which weredocumented in Item 7a of the Company’s June 30, 2002 Annual Report on Form10-K.

 

**Item 4.  Controls and Procedures**

 

Within 90 days prior to the filing date of thisreport, the Company carried out an evaluation with the participation of theCompany’s management, including the Company’s Chief Executive Officer and ChiefFinancial Officer, of the effectiveness of the design and operation of theCompany’s disclosure controls and procedures. Based on that evaluation, the Company’s management, including the ChiefExecutive Officer and Chief Financial Officer, concluded that the Company’sdisclosure controls and procedures were effective.  There were no significant changes in the Company’s internalcontrols or in other factors that could significantly affect internal controlssubsequent to the date of their evaluation.

 

**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 Asian markets,unforeseen competitive pressures, warranty expenses, market acceptance of newproducts, 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**

 

**Item 1.  Legal Proceedings**

 

The Company is subject to potential liability inproceedings under federal, state and local statutes and regulations governingthe discharge of pollutants into the environment and the handling and disposalof hazardous substances and waste. These proceedings are described in Item 3 of the Company’s Annual Reporton Form 10-K for the year ended June 30, 2002.   The Company has estimated its probable remediation costs basedupon estimates prepared by environmental consultants, and believes that theseestimated costs have been adequately reserved for on its balance sheet.

 

The Company is involved in various other lawsuitsarising out of the conduct of its business. The Company believes that theoutcome of any such pending claims or proceedings will not have a materialadverse effect upon its business, financial condition or liquidity. The Companymaintains various insurance policies regarding many of such matters, includinggeneral liability and property damage insurance, as well as product liability,workers’ compensation and other policies, which it believes provide adequatecoverage for its operations.

 

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

 

(a) Exhibits

 
| **Number**   |   | **Description**                                                                                         |
|--------------|--------|---------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                    |
| Exhibit 99.1 |   | Certification of the Chief Executive Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
|         |   |                                                                                                    |
| Exhibit 99.2 |   | Certification of the Chief Financial Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

(b) Reports on Form 8-K

 
| On December 5, 2002, the Company filed a Current  Report on Form 8-K which announced that the Company has entered into a $170  million Bank Credit Agreement, which will be used to refinance its existing  $100 million Bank Credit Facility and to retire its Senior Unsecured Notes  that come due in February 2003. |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

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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  7, 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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**CERTIFICATIONS**

 

I, Ho Nyuk Choy, certify that:

 

1.                                       Ihave reviewed this quarterly report on Form 10-Q of AAF-McQuay Inc.;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
| /s/ Ho Nyuk Choy                      |   | February 7, 2002 |
|---------------------------------------|--------|------------------|
| Ho Nyuk Choy                          |   |
| President and Chief Executive Officer |   |
| (Principal Executive Officer)         |   |

 

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I, Bruce D. Krueger, certify that:

 

1.                                       Ihave reviewed this quarterly report on Form 10-Q of AAF-McQuay Inc.;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
| /s/ Bruce D.  Krueger                                  |   | February 7, 2002 |
|--------------------------------------------------------|--------|------------------|
| Bruce D. Krueger                                       |   |
| Vice President of Finance and Chief Financial  Officer |   |
| (Principal Finance and Accounting Officer)             |   |

 

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Exhibit Index

 
| **Number** |   | **Description**                                                                                         |
|------------|--------|---------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                    |
| 99.1       |   | Certification of the Chief Executive Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
|       |   |                                                                                                    |
| 99.2       |   | Certification of the Chief Financial Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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