**UNITED STATESSECURITIES 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  September 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 filenumber:             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 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  ý       No o

 

Indicate by a checkmark whether the registrant is an accelerated filer(as defined in Rule 126-2 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 October 31, 2002.

 

 

----

 

INDEX

 

AAF-MCQUAY INC.AND SUBSIDIARIES

 
| Part I -  | Financial Information                                                                                         |
|-----------|---------------------------------------------------------------------------------------------------------------|
|      |                                                                                                          |
| Item 1.   | Financial Statements  (unaudited)                                                                             |
|      |                                                                                                          |
|      | Condensed  Consolidated Balance Sheets as of  -   September 30, 2002 and June 30, 2002                   |
|      |                                                                                                          |
|      | Condensed  Consolidated Statements of Income -   Three Months Ended September 30, 2002 and 2001               |
|      |                                                                                                          |
|      | Condensed  Consolidated Statements of Cash Flows -   Three Months Ended September 30, 2002 and 2001           |
|      |                                                                                                          |
|      | Condensed  Consolidated Statements of Comprehensive Income -   Three Months Ended September 30, 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

----

 

**PARTI:****                   FINANCIALINFORMATION**

 

**Item 1.****     FinancialStatements**

 

**AAF-McQUAYINC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

(unaudited)

(dollars in thousands,except share data)

 
|                                                                                          |   | **September  30,  2002** |       | **June 30,  2002** |       |
|-----------------------------------------------------------------------------------------------|--------|--------------------------|------------|--------------------|------------|
| **ASSETS**                                                                                    |   |                     | ** ** |               | ** ** |
| Current assets:                                                                               |   |                     |       |               |       |
| Cash and cash  equivalents                                                                    |   | $                        | 10,314     |               | $          | 11,821 |   |
| Accounts  receivable, net                                                                     |   | 181,743                  |       | 188,939            |       |
| Inventories                                                                                   |   | 94,284                   |       | 94,946             |       |
| Other current  assets                                                                         |   | 8,056                    |       | 7,379              |       |
| Total current  assets                                                                         |   | 294,397                  |       | 303,085            |       |
|                                                                                          |   |                     |       |               |       |
| Property, plant  and equipment, net                                                           |   | 107,381                  |       | 110,475            |       |
| Cost in excess  of net assets acquired                                                        |   | 107,166                  |       | 103,882            |       |
| Other  identifiable intangibles, net                                                          |   | 76,077                   |       | 80,283             |       |
| Other assets and  deferred charges                                                            |   | 16,625                   |       | 15,611             |       |
| Total assets                                                                                  |   | $                        | 601,646    |               | $          | 613,336 |   |
|                                                                                          |   |                     | ** ** |               | ** ** |
| **LIABILITIES AND STOCKHOLDER’S  EQUITY**                                                |   |                     | ** ** |               | ** ** |
|                                                                                          |   |                     |       |               |       |
| Current  liabilities:                                                                         |   |                     |       |               |       |
| Short-term  borrowings                                                                        |   | $                        | 56,520     |               | $          | 38,935 |   |
| Current  maturities of long-term debt                                                         |   | 84,578                   |       | 107,561            |       |
| Accounts payable                                                                              |   | 90,934                   |       | 100,383            |       |
| Accrued warranty                                                                              |   | 19,103                   |       | 19,918             |       |
| Accrued employee  compensation                                                                |   | 27,405                   |       | 26,871             |       |
| Other accrued  liabilities                                                                    |   | 36,765                   |       | 34,535             |       |
| Total current  liabilities                                                                    |   | 315,305                  |       | 328,203            |       |
|                                                                                          |   |                     |       |               |       |
| Long-term debt                                                                                |   | 8,845                    |       | 9,940              |       |
| Deferred income  taxes                                                                        |   | 20,558                   |       | 21,057             |       |
| Other  liabilities                                                                            |   | 53,647                   |       | 55,242             |       |
| Total  liabilities                                                                            |   | 398,355                  |       | 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                                                                            |   | 45,879                   |       | 41,414             |       |
| Accumulated  other comprehensive loss                                                         |   | (22,753                  | )          | (22,685            | )          |
| Total  stockholder’s equity                                                              |   | 203,291                  |       | 198,894            |       |
| Total liabilities  and stockholder’s equity                                              |   | $                        | 601,646    |               | $          | 613,336 |   |

 

See Accompanying Notes tothe Condensed Consolidated Financial Statements

 

3

----

 

**AAF-McQUAY INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF INCOME**

(unaudited)

(dollars in thousands)

 
|                                                            |   | **Three  Months Ended  September 30,** |    |
|-----------------------------------------------------------------|--------|----------------------------------------|---------|
|                                                            |   | **2002**                               |    | **2001** |   |
|                                                            |   |                                   |    |   |   |
| Net sales                                                       |   | $                                      | 198,550 |   | $ | 210,077 |   |
| Cost of sales                                                   |   | 144,903                                |    | 153,878 |   |
| Gross profit                                                    |   | 53,647                                 |    | 56,199 |   |
| Operating  expenses:                                            |   |                                   |    |   |   |
| Selling, general  and administrative                            |   | 42,260                                 |    | 43,311 |   |
| Amortization of  intangible assets                              |   | 1,112                                  |    | 2,757 |   |
|                                                            |   | 43,372                                 |    | 46,068 |   |
| Income from  operations                                         |   | 10,275                                 |    | 10,131 |   |
| Interest  expense, net                                          |   | 3,154                                  |    | 4,348 |   |
| Other income,  net                                              |   | (51                                    | )       | (135 | ) |
| Income before  provision for income taxes and minority interest |   | 7,172                                  |    | 5,918 |   |
| Minority  interest                                              |   | 9                                      |    | (19 | ) |
| Provision for  income taxes                                     |   | 2,698                                  |    | 2,485 |   |
| Net income                                                      |   | $                                      | 4,465   |   | $ | 3,452 |   |

 

See Accompanying Notes tothe Condensed Consolidated Financial Statements

 

4

----

 

**AAF-McQUAY INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

(unaudited)

(dollars in thousands)

 
|                                                                    |   | **Three  Months Ended  September 30,** |   |
|-------------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                                    |   | **2002**                               |   | **2001** |   |
|                                                                    |   |                                   |   |   |   |
| Cash flows from  operating activities:                                  |   |                                   |   |   |   |
| Net income                                                              |   | $                                      | 4,465  |   | $ | 3,452 |   |
| Adjustments to  reconcile net income to cash from operating activities: |   |                                   |   |   |   |
| Depreciation and  amortization                                          |   | 5,747                                  |   | 7,228 |   |
| Other non-cash  items, net                                              |   | (49                                    | )      | (97 | ) |
| Net changes in  operating assets and liabilities                        |   | (4,496                                 | )      | (18,709 | ) |
|                                                                    |   |                                   |   |   |   |
| Net cash  provided by (used in) operating activities                    |   | 5,667                                  |   | (8,126 | ) |
|                                                                    |   |                                   |   |   |   |
| Cash flows from  investing activities:                                  |   |                                   |   |   |   |
| Capital  expenditures                                                   |   | (1,649                                 | )      | (1,630 | ) |
| Proceeds from  sale of business                                         |   | —                                 |   | 13,308 |   |
| Net cash (used  in) provided by investing activities                    |   | (1,649                                 | )      | 11,678 |   |
|                                                                    |   |                                   |   |   |   |
| Cash flows from  financing activities:                                  |   |                                   |   |   |   |
| Net borrowings  under short-term borrowing arrangements                 |   | 17,608                                 |   | 4,857 |   |
| Proceeds from  issuance of long-term debt                               |   | —                                 |   | 2,393 |   |
| Payments on  long-term debt                                             |   | (1,930                                 | )      | (1,745 | ) |
| Repurchases of  senior notes                                            |   | (22,098                                | )      | (1,990 | ) |
| Net cash (used  in) provided by financing activities                    |   | (6,420                                 | )      | 3,515 |   |
|                                                                    |   |                                   |   |   |   |
| Effect of  exchange rate changes on cash and cash equivalents           |   | 895                                    |   | 792 |   |
| Net (decrease)  increase in cash and cash equivalents                   |   | (1,507                                 | )      | 7,859 |   |
| Cash and cash  equivalents at beginning of period                       |   | 11,821                                 |   | 14,254 |   |
|                                                                    |   |                                   |   |   |   |
| Cash and cash  equivalents at end of period                             |   | $                                      | 10,314 |   | $ | 22,113 |   |

 

See Accompanying Notes tothe Condensed Consolidated Financial Statements

 

5

----

 

**AAF-McQUAYINC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME**

(unaudited)

(dollars inthousands)

** **
|                                                                                       |   | **Three  Months Ended  September 30,** |   |
|--------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                                                       |   | **2002**                               |   | **2001** |   |
|                                                                                       |   |                                   |   |   |   |
| Net income                                                                                 |   | $                                      | 4,465  |   | $ | 3,452 |   |
| Other  comprehensive income (loss), net of tax:                                            |   |                                   |   |   |   |
| Foreign currency  translation adjustments                                                  |   | (68                                    | )      | 3,346 |   |
| Write off of  accumulated foreign currency translation adjustments due to sale of business |   | —                                 |   | (221 | ) |
| Comprehensive  income                                                                      |   | $                                      | 4,397  |   | $ | 6,577 |   |

 

See Accompanying Notes tothe Condensed Consolidated Financial Statements

 

6

----

 

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

 

***1.  Basis of Presentation***

 

The accompanying unaudited condensed consolidatedfinancial statements include the accounts of the Company and all of itswholly-owned subsidiaries.  Allinter-company transactions have been eliminated.  The condensed consolidated financial statements have beenprepared in accordance with the rules and regulations of the Securities andExchange Commission including 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 of America have been omitted. For further information, refer to the consolidated financial statementsand footnotes thereto included in the Company’s Annual Report on Form 10-K (the“Annual Report”) as of and for the year ended June 30, 2002.  In the opinion of management, alladjustments (consisting of normal recurring accruals) considered necessary for afair presentation have been included.

 

The operating results for the three months endedSeptember 30, 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 September 30. 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:

 
|            |   | **September  30,  2002** |   | **June 30,  2002** |   |
|-----------------|--------|-------------------------------|--------|--------------------|--------|
|            |   | **(dollars  in thousands)**   |   |
| FIFO cost:      |   |                          |   |               |   |
| Raw materials   |   | $                             | 42,944 |               | $      | 38,471 |   |
| Work-in-process |   | 12,814                        |   | 15,006             |   |
| Finished goods  |   | 38,858                        |   | 42,464             |   |
|            |   | 94,616                        |   | 95,941             |   |
| LIFO adjustment |   | (332                          | )      | (995               | )      |
|            |   | $                             | 94,284 |               | $      | 94,946 |   |

 

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

 

The tax provisions for thequarters ended September 30, 2002 and 2001 are based on the estimated effectivetax rates applicable for the full years, and after giving effect to significantunusual items related specifically to the interim periods.  The difference between the Company’sreported tax provision for the quarter ended September 30, 2002 and the taxprovision computed based on U.S. statutory rates is primarily attributable tounbenefitted foreign losses and export sales tax benefit.  The difference between the Company’sreported tax provision for the quarter ended September 30, 2001 and the taxprovision computed based on U.S. statutory rates is primarily attributable tonondeductible goodwill amortization, unbenefitted foreign losses and exportsales tax benefit.

 

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

 

In the first quarter of fiscal 2003, the Company repurchased a totalof $21.9 million face value of its Senior Notes at a slight premium, resultingin a pre-tax loss after write off of associated debt issuance costs ofapproximately $0.3 million.  The Companyplans to hold these repurchased notes until their maturity in February 2003.The balance of Senior Notes held outside the Company after the repurchase andincluded in the Company’s debt at September 30, 2002 was $71.9 million.

 

7

----

 

As of the filing date of this interim report, theCompany is in the process of finalizing the terms and documentation related toa new bank credit agreement (the “Refinancing”).  The purpose of the Refinancing will be to replace both itsexisting Bank Credit Agreement and Senior Notes, which mature in February 2003.Although the Company is confident in its ability to consummate the Refinancing,accounting principles generally accepted in the United States of Americarequire the amounts contemplated in the Refinancing to be shown in currentmaturities of long-term debt until the Refinancing documents are executed, aportion of which would otherwise be shown in long-term debt.

 

In January 2000, the Company entered into an interestrate swap transaction whereby the Company receives a fixed rate and pays afloating rate on the basis of 3-month LIBOR. The January 2000 swap has a three-year term and a notional amount of $30million and effectively converts 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 falls 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 matchinterest payment dates and maturity date of the Senior Notes.  These positions are not accounted for ashedges.  The Company records the swap inits 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.  No gain or loss resultedfrom the swap or floor in the first quarter of fiscal 2002.

 

***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-lived intangibleassets, addresses the amortization of intangible assets with defined lives, andaddresses impairment testing and recognition for goodwill and indefinite-livedintangible assets.  SFAS 142 applies togoodwill and intangible assets arising from transactions completed before andafter its effective date.  As a resultof adopting SFAS 142, the Company ceased amortization of goodwill andindefinite-lived intangible assets beginning July 1, 2002.  Additionally, in accordance with therequirements of SFAS 142, the Company completed separate transitionalimpairment tests of goodwill and indefinite-lived intangible assets, as of July1, 2002, which indicated no impairment.

 

8

----

 

The following table provides a summary of net incomeas reported and as adjusted to exclude goodwill amortization for the threemonths ended September 30, 2002 and 2001:

 
|                                        |   | **Three  Months Ended  September 30,** |   |
|---------------------------------------------|--------|----------------------------------------|--------|
|                                        |   | **2002**                               |   | **2001** |   |
|                                        |   | **(dollars  in thousands)**            |   |
|                                        |   |                                   |   |   |   |
| Reported net  income                        |   | $                                      | 4,465  |   | $ | 3,452 |   |
| Goodwill  amortization, net of income taxes |   | —                                 |   | 1,094 |   |
| Other  amortization, net of income taxes    |   | —                                 |   | 221 |   |
| Adjusted net  income                        |   | $                                      | 4,465  |   | $ | 4,767 |   |

 

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

 
| Balance as of  June 30, 2002             |   | $     | 103,882 |   |
|------------------------------------------|--------|-------|---------|--------|
| Reclassification  of assembled workforce |   | 3,081 |    |
| Foreign currency                         |   | 203   |    |
| Balance as of  September 30, 2002        |   | $     | 107,166 |   |

 

Indefinite-lived intangible assets as of September 30,2002 totaled approximately $45.4 million and consisted of trademarks.  Amortizable intangible assets at September30, 2002, net of accumulated amortization of $36.1 million, totaledapproximately $30.7 million and consisted primarily of drawings and technology.  Amortization expense for the three monthsended September 30, 2002 was approximately $1.1 million and is estimated to be$4.4 million for fiscal 2003 and for the next five fiscal years.

 

***6.  Commitments and Contingencies***

 

***Purchase Commitments -***The Company secures pricing on a portion of itscopper requirements through forward contracts. At September 30, 2002, contracts for 2.3 million pounds of copper werein place.  These contracts have variousexpiration dates through June 2003.

 

***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 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 14 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 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.

 

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

 

9

----

 

***7.  Business Segments Information***

 

The Company globally manufactures and marketscommercial air conditioning and air filtration products and systems within twoprincipal 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 is as follows as of and for the three months endedSeptember 30, 2002 and 2001:

 
|                                           |   | **Three  Months Ended  September 30,** |    |
|------------------------------------------------|--------|----------------------------------------|---------|
| **Classified By Industry**                     |   | **2002**                               |    | **2001** |   |
|                                           |   | **(dollars  in thousands)**            |    |
|                                           |   |                                   |    |   |   |
| Net Sales:                                     |   |                                   |    |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                      | 128,240 |   | $ | 129,807 |   |
| Filtration Products                            |   | 70,779                                 |    | 82,316 |   |
| Eliminations                                   |   | (469                                   | )       | (2,046 | ) |
| Total                                          |   | $                                      | 198,550 |   | $ | 210,077 |   |
| Operating  Income:                             |   |                                   |    |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                      | 6,738   |   | $ | 6,852 |   |
| Filtration  Products                           |   | 3,470                                  |    | 3,098 |   |
| Corporate                                      |   | 67                                     |    | 181 |   |
| Total                                          |   | $                                      | 10,275  |   | $ | 10,131 |   |
| Depreciation/Amortization:                     |   |                                   |    |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                      | 4,411   |   | $ | 4,806 |   |
| Filtration  Products                           |   | 1,333                                  |    | 2,417 |   |
| Corporate                                      |   | 3                                      |    | 5 |   |
| Total                                          |   | $                                      | 5,747   |   | $ | 7,228 |   |
| Capital  Expenditures:                         |   |                                   |    |   |   |
| Commercial Air  Conditioning and Refrigeration |   | $                                      | 1,094   |   | $ | 1,035 |   |
| Filtration  Products                           |   | 555                                    |    | 592 |   |
| Corporate                                      |   | —                                 |    | 3 |   |
| Total                                          |   | $                                      | 1,649   |   | $ | 1,630 |   |

 

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 period is as follows:

 
|                                     |   | **Three  Months Ended  September 30,** |   |
|------------------------------------------|--------|----------------------------------------|--------|
|                                     |   | **2002**                               |   | **2001** |   |
|                                     |   | **(dollars  in thousands)**            |   |
| Operating income  from business segments |   | $                                      | 10,208 |   | $ | 9,950 |   |
| Over allocation  of corporate expenses   |   | 67                                     |   | 181 |   |
| Interest  expense, net                   |   | 3,154                                  |   | 4,348 |   |
| Other income,  net                       |   | (51                                    | )      | (135 | ) |
| Income before  income taxes              |   | $                                      | 7,172  |   | $ | 5,918 |   |

 

***8. 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 Company beginningwith the first quarter of fiscal 2003 and its adoption did not have a materialimpact on the Company’s results of operations or financial position.

 

10

----

 

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 assets.  SFAS No.144 supersedes SFAS No. 121, *Accounting for the Impairment of Long-Lived Assetsand for the Long-Lived Assets to Be Disposed Of*, and the accountingand reporting provisions of APB Opinion No. 30, *Reporting the Results of Operations —Reporting the Effects of Disposal of a Segment of a Business, andExtraordinary, Unusual and Infrequently Occurring Events and Transactions*,for the disposal of a segment of a business (as previously defined in thatOpinion).  SFAS No. 144 also amendsAccounting Research Bulletin No. 51, *Consolidated Financial Statements*, toeliminate the exception to consolidation for a subsidiary for which control islikely to be temporary.  The provisionsof this statement are effective for fiscal years beginning after December 15,2001.  SFAS 144 was effective for theCompany beginning with the first quarter of fiscal 2003 and its adoption didnot have a material impact on the Company’s results of operations or financialposition.

 

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 itsadoption did not have a material impact on the Company’s results of operationsor financial position.

 

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.

 

11

----

 
| **Item 2.** |   | **Management’s Discussion and  Analysis of Financial Condition and Results of Operations** |
|-------------|--------|-------------------------------------------------------------------------------------------------|

 

 

**Resultsof Operations **

 

***Net Sales***were $198.6 million in thethree months ended September 30, 2002, which represents a decrease of $11.4million, or 5.5%, as compared to $210.0 million for the same period in theprior year.  The Company sold itsSingapore subsidiary in September 2001 and its Korean joint venture in January2002 which had sales of $3.6 million and $1.7 million, respectively, for thethree months ended September 30, 2001. Additionally, the Company estimates that sales have increased byapproximately $2.6 million for the three months ended September 30, 2002 due tothe impact of favorable currency trends in translating European sales.  Excluding net sales attributable to theoperations in Singapore and Korea for fiscal 2002 and the currency impact, netsales for the three months ended September 30, 2002 decreased $8.7 million or4.2% as compared to the corresponding period of the prior year.

 

**Commercial Air Conditioning and Refrigeration**netsales for the three months ended September 30, 2002 decreased $1.6 million, or1.2%, to $128.2 million as compared to $129.8 million for the three monthsended September 30, 2001.  However,sales have increased by approximately $1.8 million for the three months endedSeptember 30, 2002 due to the impact of favorable currency trends intranslating European sales.  Excludingthe currency impact, net sales for the three months ended September 30, 2002decreased $3.4 million or 2.6% as compared to the prior year.  This decrease is the result of a 2.8%decrease in domestic sales and a 1.8% decrease in international sales.  The decrease in domestic sales is primarilyattributable to the general economic slowdown affecting all equipment productlines, while parts and service revenues improved slightly.  The decrease in international sales isprimarily due to a softening of the U.K. equipment market, partially offset byvolume increases related to new product offerings.

 

Backlog for the Commercial Air Conditioning and Refrigerationsegment was $101 million at September 30, 2002 as compared to $98 million and$94 million at June 30, 2002 and September 30, 2001, respectively.

 

**Filtration Products**net sales for the threemonths ended September 30, 2002 decreased $11.5 million, or 14.0%, to $70.8million as compared to $82.3 million for the three months ended September 30,2001. This decrease is attributable to the sale of the Company’s Singaporesubsidiary in September 2001 and Korean joint venture in January 2002.  Additionally, sales have increased byapproximately $0.7 million due to the impact of favorable currency trends intranslating European sales.  Excludingthese three items, net sales for the three months ended September 30, 2002decreased by approximately $6.8 million or 8.9%. This decrease is the result ofan 11.0% decrease in domestic sales and a 6.4% decrease in internationalsales.  The decrease in domestic salesis primarily attributable to the market slowdown in the construction ofcleanroom capacity and decreased machinery filtration and acoustical systems(“MFAS”) and retail volume in the U.S. The decrease in international sales is primarily due to decreased MFASvolume in the U.K. related to slowdown in the gas turbine market, partiallyoffset by improved air pollution control and replacement air filter sales inEurope.

 

***Gross Profit***decreased to $53.6million, or 27.0% of sales, for the three months ended September 30, 2002 ascompared to $56.2 million, or 26.8% of sales, for the three months endedSeptember 30, 2001.  In the CommercialAir Conditioning and Refrigeration segment, gross profit as a percentage ofsales was 26.8% as compared to 27.2% for the same period in fiscal 2002.  The decrease in gross margin is primarilyattributable to competitive pricing pressure in all equipment lines.  The Filtration Products segment’s grossprofit as a percentage of sales increased from 25.4% in fiscal 2002 to 27.2%for the same period in fiscal 2003. This increase is primarily the result ofthe sales mix between MFAS volume and replacement filter sales.

 

***Operating Expenses***were $43.4 million,or 21.8% of sales, for the first quarter of fiscal 2003 versus $46.1 million,or 21.9% of sales, for the first quarter of fiscal 2002.  Excluding amortization, first quarter fiscal2003 operating expenses were $42.3 million, or 21.3% of sales, versus $43.2million for fiscal 2002, or 20.5% of sales. The decrease of $0.9 million is primarily attributable to favorablewarranty experience, lower commissions and continued focus on cost control,partially offset by an increase in freight costs and selling expense.

 

***Income from Operations***for the firstquarter of fiscal 2003 increased to $10.3 million, or 5.2% of sales, ascompared to $10.1 million, or 4.8% of sales, in the first quarter of fiscal2002.  Excluding amortization, firstquarter income from operations decreased to $11.4 million, or 5.7% of sales, ascompared to $13.0 million, or 6.2% of sales, in the corresponding period of theprior year.

 

12

----

 

The Commercial Air Conditioning and Refrigerationsegment’s income from operations, excluding amortization, decreased from $8.5million, or 6.6% of sales, in the first quarter of fiscal 2002 to $7.7 million,or 6.0% of sales, in the first quarter of fiscal 2003.

 

The Filtration Products segment’s income fromoperations, excluding amortization, for the first quarter of fiscal 2003decreased from $4.3 million, or 5.2% of sales, in fiscal 2002 to $3.7 million,or 5.2% of sales.

 

***Net Interest Expense***decreased to $3.2million during the quarter ended September 30, 2002 from $4.3 million for thecomparable period ended September 30, 2001. The decrease in interest expense is primarily attributable to lower debtlevels and declining interest rates.

 

 

**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 three months offiscal 2003, funds generated by operating activities were $5.7 million ascompared to $8.1 million of funds used in the prior fiscal year for thecomparable period.  Net cash provided byoperating activities in the first quarter of fiscal 2002 was negativelyimpacted by the Company’s sale of its Singapore subsidiary for $13.1million.  Net cash from investingactivities was comprised of $1.6 million in capital expenditures during thefirst three months of fiscal 2003, which was the same amount of capitalspending for the first three months of fiscal 2002.  The Company estimates total capital expenditures to beapproximately $12 million for fiscal year 2003.

 

A portion of the Company’s financing needs is providedby a Bank Credit Agreement which includes a Revolving Credit Facility of $90 millionand a Term Loan with a balance of $11.6 million as of September 30, 2002.  AtSeptember 30, 2002, remaining borrowing availability under the Revolving Creditportion of the Bank Credit Agreement was $33.5 million. Payments on long-termdebt for the first three months of fiscal 2003 were $1.9 million.  In addition, as more fully discussed in Note4 to the unaudited condensed consolidated financial statements, the Companyused cash of $22.1 million to repurchase its Senior Notes.  Short-term borrowings increased by $17.6million during the three-month period.

 

As more fully discussed in Note 4 to the unauditedcondensed consolidated financial statements, the Company is in the process offinalizing the terms of and completing the documentation related to a new bankcredit agreement (the “Refinancing”). The proceeds of the Refinancing will be sufficient to replace itsexisting Bank Credit Agreement and repay its Senior Notes, both of which maturein February 2003.  The Company isconfident it will consummate the anticipated Refinancing prior to the maturityof the existing Bank Credit Agreement and Senior Notes.  After consummation of the Refinancing andretirement of the Senior Notes, the Company will remain leveraged to a certainextent and its debt service obligations will continue to be substantial.  If the Refinancing is not completed asanticipated, or if the Company’s sources of funds otherwise were to fail tosatisfy the Company’s requirements, the Company would 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) could be expectedto be more costly and restrictive than the debt agreements currently in place.

 

13

----

 

**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 this statementare effective for exit or disposal activities that are initiated after December31, 2002, with early adoption permitted. Adoption of SFAS No. 146 is not expected to materially impact theCompany’s consolidated 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 financialstatements requires the Company to make estimates and judgments that affect thereported amounts of assets, liabilities, revenues and expenses and relateddisclosures of 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, the resultsof which form the basis for making judgments about carrying values of assetsand liabilities that cannot be readily determined from other sources.  There can be no assurance that actualresults 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.

 

14

----

 

**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, 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 the Company’sdisclosure 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-Looking Statements**

 

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.

 

15

----

 

**PART II:                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 based uponestimates 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.

 
| **Item 6.** |                                                        | **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  |
|        |                                                        |                                  |
|        | There were no reports filed on Form 8-K during the  period. |
|             |                                                             |                                       |  |  |  |  |  |

 

16

----

 

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   November 11, 2002 | By:             | /s/ BRUCE D. KRUEGER |   |
|                          |            | Bruce D. Krueger |
|                          |            | Vice President of Finance and CFO |
|                          |            | (Principal Financial and Chief Accounting Officer) |

 

17

----

 

**CERTIFICATIONS**

 

I, Ho Nyuk Choy, certify that:

 

1.             I have reviewed thisquarterly report on Form 10-Q of AAF-McQuay Inc.;

 

2.             Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.             Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.             The registrant’sother certifying officers and I are responsible for establishing andmaintaining 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.             The registrant’sother certifying officers and I have disclosed, based on our most recentevaluation, 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.             The registrant’sother certifying officers and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

 
| */s/*  Ho Nyuk Choy                                                  |   | November 11, 2002 |
|----------------------------------------------------------------------|--------|-------------------|
| Ho Nyuk Choy                                                         |   |
| President and Chief Executive Officer  (Principal Executive Officer) |   |

 

18

----

 

I, Bruce D. Krueger, certify that:

 

1.             I have reviewed thisquarterly report on Form 10-Q of AAF-McQuay Inc.;

 

2.             Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.             Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.             The registrant’sother certifying officers and I are responsible for establishing andmaintaining 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.             The registrant’sother certifying officers and I have disclosed, based on our most recentevaluation, 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.             The registrant’sother certifying officers and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

 
| */s/*Bruce  D. Krueger                                                                             |   | November 11, 2002 |
|----------------------------------------------------------------------------------------------------|--------|-------------------|
| Bruce D. Krueger                                                                                   |   |
| Vice President of Finance and Chief Financial  Officer  (Principal Finance and Accounting Officer) |   |

 

19

----

 

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 |
|       |   |                                                                                                    |

 

20

----