ITEM 5: OPERATING AND FINANCIAL REVIEW AND PROSPECTS
A. OPERATING RESULTS
The following discussion and analysis of the Company's financial condition and
results of operations should be read in conjunction with "Item 8: Financial
Information," and the Financial Statements included elsewhere in this Annual
Report.
GENERAL
We are a leading integrated supplier of aftermarket parts and
services to the global aerospace and defense industry. We operate a
diversified business portfolio through two divisions:
o Our engine repair and overhaul business services a wide range of small-
and medium-sized aircraft engine platforms and provides our customers with
comprehensive, value-added maintenance solutions.
o Our design and manufacturing business produces aviation parts, sub-systems
and systems that are precision-engineered and specialized, including wheel
and braking systems, heat exchangers, engine parts and rubber and polymer
products.
We operate principally in North America and Western Europe. In fiscal
2003, we generated total revenues of (pound)456.6 million. Approximately 73%
of our fiscal 2003 revenues were derived from revenues of engine repair and
overhaul services, while design and manufacturing revenues accounted for
approximately 27% of our fiscal 2003 revenues. Approximately 82% of our fiscal
2003 revenues were derived from the regional, military and business aviation
sectors. More than 90% of our fiscal 2003 revenues were derived from
aftermarket customers.
Unless otherwise indicated, financial information in this annual
report has been prepared in accordance with U.K. GAAP, which differs in
certain respects from U.S. GAAP. The principal differences between U.K. GAAP
and U.S. GAAP are summarized in Note 27 to the Company's audited consolidated
financial statements included elsewhere in this Annual Report. The following
information should be read in conjunction with, and are qualified in their
entirety by reference to our consolidated financial statements included
elsewhere in this annual report.
NEW BUSINESS INITIATIVES
Lockheed Martin/Kelly USA Contract: In February 1999, the U.S.
Department of Defense announced that a combined Oklahoma Air Logistic Center
and Lockheed Martin Kelly Aircraft Center team won a competitive tender for
the outsourcing of engine repair and overhaul operations at the former Kelly
Air Force Base in San Antonio, Texas. Kelly USA, formerly Kelly Air Force
Base, is one of the U.S. Air Force's largest aircraft repair and overhaul
centers, and the contract was the largest single engine repair and overhaul
contract ever awarded by the U.S. Air Force. Under the terms of the winning
proposal, we are the sole subcontractor to Lockheed Martin for the servicing
of the Rolls-Royce T56 engines repaired at the facility.
We effectively manage what we believe is the largest servicing
facility for the Rolls-Royce T56 engine, and services provided under this
contract represented approximately 19% of our total revenues in fiscal 2003.
We believe our contract with Lockheed Martin mirrors the contract between
Lockheed Martin and the U.S. Air Force and has a seven-year initial term with
eight one-year options to extend, exercisable by the U.S. Air Force. The price
terms in our contract with Lockheed Martin are based on fixed rates per engine
component subject to an inflation-adjusted formula. In addition, we have
entered into a contract with Rolls-Royce to supply us with component parts in
connection with our services under our contract with Lockheed Martin. The
Rolls-Royce contract has the same duration as the contract with Lockheed
Martin.
Upon initiation of the U.S. Air Force contract, we comprehensively
redesigned the former Kelly Air Force Base operations into a cellular
production facility. In doing so, we believe we have significantly improved
the efficiency and turnaround times of repair and overhaul servicing of the
U.S. Air Force's T56 engines. For example, we have reduced the number of
engines in production by substantially decreasing the engine turnaround time
from 90 days to 35 days, improving component material management and
consequently increasing monthly capacity output from nine units to sixteen
units. As a result, we have successfully met the delivery requirements set by
the U.S. Air Force. With our service program now in place, we have now met the
Department of Defense's War Readiness Engine, or WRE, requirements, which is a
measure of the minimum number of operation-ready spare engines needed in the
event of a wartime operation.
Affordable Readiness and Transformation: In September 2002, using
lessons learned from the Kelly USA cellular production facility redesign,
coupled with the experience gained in the redesign of our facilities
worldwide, we launched a new business venture named Affordable Readiness and
Transformation, or ART. This new business venture was designed to sell these
redesign services to other military and commercial aerospace Maintenance
Repair/Overhaul, or MRO, installations and derive revenues through the sharing
of benefits gained from these redesign efforts, In 2003, we provided services
to Oklahoma City - Air Logistics Center, or OC-ALC, and Ogden-Air Logistics
Center, or OO-ALC, that amounted to approximately $3 million in revenues. In
2004, we will continue to provide service to OC-ALC and OO-ALC and will
provide unsolicited proposals for redesign services to other military and
commercial installation.
Kelly USA CFM: On October 1, 2003, the U.S. Air Force, through the
Lockheed Martin/Kelly USA contract, awarded us a contract to supply materials
for the Kelly USA contract which, assuming all options are exercised, expires
in 2014. We estimate that the annual revenues related to this contract will
exceed $125 million annually through 2007, the initial term of the contract.
This contract is renewable annually at the U.S. Government's option through
2014.
U.S. Navy Contract: On December 22, 2003, we were awarded a five year
contract (one year firm with four renewal years) to support the U.S. Navy's
fleet of T56 engines from both our San Antonio and Winnipeg facilities. We
estimate the revenues from this new service work will exceed $250 million
during the life of the contract, assuming all renewal options are exercised by
the U.S. Navy. We are the prime contractor on the U.S. Navy contract.
General Electric CF34 Authorization: In September 2001, we entered
into an agreement with GE Engine Services Inc. to become an Authorized CF34TM
Service Provider. The agreement allowed us to become the first GE authorized
independent MRO company in North America to provide service to the CF34 engine
market. In the year ended December 31, 2002, we recognized $6.24 million of
revenues relating to our provision of maintenance services for the CF34 Series
1 and 3 engines and we recognized a further (pound)14 million in the year
ended December 31, 2003. Through the end of 2003, we have invested a total of
$38 million in connection with the completion of the CF34 Series 1 and 3
engine maintenance capability and the required license payments. In June 2003,
we obtained Transport Canada limited authorization for Model CF34-8 Series
modules. We expect to invest an additional $5.4 million by the end of 2004
with respect to CF34 Series 8 engine maintenance capability.
Brake Programs: We began supplying wheels, brakes and braking systems
for the Eurofighter Typhoon program in 2001. We expect to generate significant
revenues from the Eurofighter Typhoon in coming years as the number of
Typhoons manufactured continues to increase over each of the next several
years. In addition, in partnership with Honeywell, we have been selected to
provide carbon brakes for the Airbus A380 program and the Joint Strike Fighter
program. We expect to generate significant revenues from these programs in
coming years. We currently expect initial revenues from the Airbus A380
program in 2006 and from the Joint Strike Fighter program in 2006.
EFFECT OF CURRENCY MOVEMENTS ON RESULTS OF OPERATIONS
We conduct business in the United States, the United Kingdom, Canada
and in various other countries around the world. Accordingly, our results of
operations are subject to currency translation and transaction risks. Our
revenues and costs are primarily denominated in three currencies: U.S.
dollars, pounds sterling and Canadian dollars. The table below shows the
percentage of our revenues that each currency accounted for in 2001, 2002 and
2003.
% Revenues
Years Ended December 31,
-------------------------------------------------
Currency 2003 2002 2001
--------- ---------- -----------
U.S. dollars 75% 72% 72%
Pounds sterling 17% 19% 20%
Canadian dollars 8% 9% 8%
|
Currency Translation Risk. With respect to currency translation risk,
our financial condition and results of operations are measured and recorded in
the relevant payment currency and then translated into pounds sterling for
inclusion in our financial statements. We translate profits and losses from
overseas businesses into pounds sterling at average rates of exchange during
the relevant financial period. Any difference arising from their retranslation
at exchange rates at the end of the relevant period is treated as a movement
in reserves and is included in the statement of total recognized gains and
losses.
Currency differences arising from the translation at period end rates
of the net investment in overseas businesses are also taken to reserves,
together with related exchange gains and losses arising on foreign currency
borrowings which finance a proportion of foreign currency investments (the
latter, however, cannot exceed the former under U.K. GAAP). These exchange
differences are also included in the statement of total recognized gains and
losses.
Assets and liabilities in foreign currencies which are to be settled
at a contracted rate are translated at the appropriate contract rate. All
other assets and liabilities in foreign currencies are translated at the
period end rate. Exchange differences arising from this translation are
recorded in the profit and loss account. All other exchange differences are
also included in the profit and loss account for the relevant periods.
We generally attempt to hedge our currency translation risk by
financing our investments in overseas operations through borrowings
denominated in local currencies. We have several forward foreign exchange
contracts held for hedging operating cash flows in U.S. dollars.
The effect of currency translation on our financial statements
arising from the appreciation of the pound sterling against the U.S. dollar
shows a negative impact on our revenues and profit as reported in pounds
sterling in our financial statements. Conversely, depreciation of the pound
sterling against the U.S. dollar shows a positive impact on our revenues and
profit. For example, the pound sterling appreciated 8.7% against the U.S.
dollar in fiscal 2003 when compared to 2002 (based on average exchange rates
for that year), which had a negative effect on our U.S. dollar revenues when
reported on a pounds sterling basis. In fiscal 2002, the pound sterling
appreciated 4.2% against the U.S. dollar when compared to 2001 (based on
average exchange rates for that year), which had a negative effect on our U.S.
dollar revenues when reported on a pounds sterling basis. The appreciation of
the sterling pound against the U.S. dollar in fiscal 2003, however, has
decreased our costs denominated in U.S. dollars when reported on a pound
sterling basis. The net effect of the appreciation of the pound sterling
against the U.S. dollar was a negative (pound)2.7 million on operating profit
when reported on a pound sterling basis in fiscal 2003; and the net effect of
the appreciation of the pound sterling against the U.S. dollar was a negative
(pound)1.4 million on operating profit in fiscal 2002. However, there was a
positive impact on our financing costs for our U.S. dollar denominated debt as
a result of the appreciation of the pound sterling of (pound)1.3 million for
fiscal 2003 and (pound)0.3 million for fiscal 2002.
Currency Transaction Risk. In addition to currency translation risk,
we are exposed to currency transaction risk whenever one of our operating
subsidiaries enters into either a purchase or revenues transaction using a
currency other than its functional currency. Currency transaction risk is
reduced by matching revenues and costs in the same currency, which is
generally the practice in our industry given the percentage of contracts that
are denominated in either U.S. dollars or pounds sterling. Currency hedging is
generally used by businesses to protect against transaction risk. We currently
have a series of outside currency hedging contracts, as the surplus U.S.
dollar funds generated by our manufacturing operations in the United Kingdom
are hedged and used to fund our U.S. dollar interest and debt repayment
requirements. In the past we have also hedged our exposure to revenues in U.S.
dollars when we did not have U.S. dollar-denominated interest and debt
repayment requirements to fund. See "Risk Factors--Risks Relating to the
Company--Risk of Foreign Exchange Rate Fluctuations."
In fiscal 2003, approximately 75% (2002: 72%) of our revenues were
transacted in U.S. dollars, with another 17% (2002: 19%) transacted in pounds
sterling, and approximately 8% (2002: 9%) in Canadian dollars.
RESULTS OF OPERATIONS
The following discussion should be read in conjunction with our
historical consolidated financial statements. The following table sets forth
selected financial data for the last three years.
These historical financial statements were prepared in accordance
with U.K. GAAP.
Consolidated Consolidated Consolidated
------------ ------------ ------------
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2003 2002 2001
---- ---- ----
((Pound) in millions)
Revenues
Engine Repair and Overhaul......... (pound)335.2 (pound)320.5 (pound)291.7
Design and Manufacturing........... 121.4 131.3 153.2
----- ----- -----
Total.............................. 456.6 451.8 444.9
Gross Profit
Engine Repair and Overhaul......... 60.6 60.3 52.7
Design and Manufacturing........... 56.7 65.0 77.7
----- ----- -----
Total.............................. 117.3 125.2 130.5
Selling, General & Administrative and Other
Expenses
Engine Repair and Overhaul......... 31.0 28.8 29.9
Design and Manufacturing........... 24.4 27.6 24.9
----- ----- -----
Total.............................. 55.4 56.4 54.8
Operating Profit (pre-exceptional)
Engine Repair and Overhaul......... 29.6 31.5 22.8
Design and Manufacturing........... 32.2 37.4 52.9
----- ----- -----
Total.............................. 61.8 68.9 75.7
Profit for the Financial Period....... (pound)13.0 (pound)11.9 (pound)20.5
==== ==== ====
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Critical Accounting Policies
The accounting policies discussed below are important to the
presentation of our results of operations and financial condition and require
the application of judgment by our management in determining the appropriate
assumptions to be used in the preparation of our financial statements. These
assumptions are based on our previous experience, trends in the industry, the
terms of existing contracts and information available from other outside
sources and factors. Adjustments are recorded when our actual experience
differs from the expected experience underlying these assumptions. These
adjustments could be material if our experience is significantly different
from that assumed.
Revenue Recognition. Within our engine repair and overhaul division,
we use the percentage of completion method to recognize revenues and costs.
Under this method of accounting, we expense all costs as they are incurred and
simultaneously recognize estimated revenues based upon revenues which we
typically achieve from similar service work. Costs include direct labor,
direct materials and subcontract costs, as well as an allocated share of our
overhead and general and administrative costs. Assumptions used for recording
revenues and costs may be adjusted over the course of the work period to
reflect revisions in estimated revenues and estimated costs. In the period in
which we determine that a loss would be incurred on a particular work order,
we apply the entire amount of the estimated loss to profit. Revenues within
our design and manufacturing division are generally recognized when the
finished goods are shipped.
Amortization of Goodwill and Related Impairment Testing. Goodwill,
representing the excess of the purchase consideration over the fair value of
the net separable assets acquired, is capitalized. Goodwill is amortized over
an appropriate period, unless there is clear evidence of the durability of
goodwill when an indefinite life is appropriate. The directors have considered
the durability of goodwill arising on the acquisition of the group's
businesses on October 1, 1998. Taking into account the significant investment
costs of entering these businesses; the regulatory barriers imposed; the
stability and long term prospects of the aerospace industry; the long life
span of individual models of aircraft for which the business has exclusive
licenses to repair and overhaul or for which it manufactures certain parts as
sole or principal supplier; and the group's strong reputation and
technological leadership, the directors believe that this goodwill has an
indefinite life and consequently amortization is not being provided. Goodwill
that is amortized over a period exceeding 20 years, or where not amortized at
all (as is the case at December 31, 2003, December 31, 2002 and December 31,
2001), is reviewed annually for impairment by discounting estimated future
cash flows of the individual businesses at an appropriate discount rate. The
discount rate used is typically the group's weighted average cost of capital.
Goodwill is denominated in the functional currency of the acquired company. In
the absence of any charge for impairment, profit for the financial period
recorded in any period will be higher than might otherwise be the case in
light of the elimination of periodic goodwill amortization charges. At
December 31, 2003 the Company had goodwill balances that were not amortized of
(pound)304.1 million (2002:(pound)313.9 million).
Capitalization and Amortization of Deferred and Intangible Costs.
Deferred costs are comprised of costs associated with OEMs, including required
OEM licensing and authorization fees incurred in obtaining principal supplier
status and the provision of initial manufactured parts onto new aircraft.
Deferred costs are amortized over the periods expected to benefit from
receiving the status of "principal supplier," generally over terms ranging
from three to 10 years, except OEM licensing fees which are amortized over the
license periods ranging from five to 25 years. Deferred costs are reviewed
annually for impairment. Deferred costs for `initial manufactured parts
provided' are included within debtors. Licensing and OEM authorization fees
are included within intangible fixed assets. Research and development
expenditure is expensed as incurred, with the exception of development
expenditure on major projects that are undertaken where the related
expenditure is separately identifiable and management are satisfied as to the
ultimate commercial viability of the project based on all relevant available
information. In such cases, the expenditure is included in development costs
within intangible fixed assets and written off over the periods expected to
benefit commencing with the launch of the product. Research and development
expenditure recovered from customers is accounted for on a receivable basis
where contractually committed otherwise on a receipts basis. At December 31,
2003 the Company had deferred costs of (pound)12.4 million (2002: (pound)5.8
million).
Accounting Estimates. The preparation of financial statements in
conformity with U.K. GAAP requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities. Actual
results could differ from those estimates. In particular, estimates are used
when determining appropriate amounts for certain items such as allowance for
doubtful accounts, inventory provisions, depreciation of fixed assets,
employee benefit plans, taxes and other contingencies.
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002
Revenues. Our 2003 revenues increased 1.1% to (pound)456.6 million
from (pound)451.8 million in 2002. This increase was primarily attributable to
a 4.6% increase in engine repair and overhaul revenues to (pound)335.3 million
in 2003 from (pound)320.5 million in 2002. As a percentage of total revenues,
engine repair and overhaul revenues increased to 73.4% in 2003 from 70.9% in
2002. Revenues from our design and manufacturing operations decreased 7.6% to
(pound)121.4 million in 2003 from (pound)131.3 million in 2002.
Engine repair and overhaul revenues increased by 13.7% in terms of
their U.S. dollar functional currency. Military volumes, including work at
Kelly USA, grew 15.2% compared to the same period of 2002. AE3007 regional jet
engine inputs remained strong although revenues were essentially flat due to
the effects of lower revenues per unit as the breadth of event work scopes
declined. Turboprop and industrial revenues declined reflecting difficult
market conditions in 2003. Our T56 engine repair and overhaul revenues were
affected by some large long term contracts signings being delayed well into
2003 despite being awarded in late 2002. The Canadian Air Force also extended
its T56 TBO (time between overhaul) which reduced our 2003 revenues. Our new
CF34 operations generated approximately $23 million in revenues 2003.
The (pound)10 million decrease in our design and manufacturing
revenues was principally due to reduced OEM part revenues and a reduction of
our wheel and brake business, reflecting reduced flying hours by many of our
customers. In addition, the cancellation of the RJ146 and Dornier 328 programs
caused the revenues from OEM brakes to decrease further. The cancellation of
the Concorde program in 2003 also reduced our spares revenues. Market
pressures continued in certain design and manufacturing and engine repair and
overhaul sectors again in 2003. In particular, our design and manufacturing
OEM build activities (Fluid Dynamics and Polymers and Composite units) were
negatively affected by civil aircraft production remaining suppressed. Our
design and manufacturing wheel and brake operation Boeing 757 and RJ146 spares
revenues have been reduced due to lower flying rates, with approximately 300
RJ146 currently parked.
Our engine repair and overhaul revenues and approximately 15% of our
design and manufacturing revenues are denominated in U.S. dollars. The 8.7%
average increase in the value of the pound sterling against the U.S. dollar
during the year ended December 31, 2003 negatively affected our revenues by
(pound)31.3 million.
Gross Profit. Gross profit for 2003 decreased 6.4% to (pound)117.3
million from (pound)125.2 million in 2002. The decrease of (pound)8.0 million
was attributable to the decrease in our design and manufacturing revenues.
Gross profit as a percentage of revenues decreased to 25.7% for 2003 from
27.7% for 2002, as a result of the increase to 73.4% in the percentage of our
revenues derived from our lower margin engine repair and overhaul business for
2003 from 70.9% in 2002.
Gross profit as a percentage of revenues in engine repair and
overhaul decreased from 18.8% in 2002 to 18.1% in 2003. Efficiency gains in
several product units were offset by challenges experienced in our turbo prop
gross margins reflecting continued difficult conditions in these markets.
Design and manufacturing gross profit as a percentage of revenues decreased
from 49.5% in 2002 to 46.7% in 2003 reflecting changes in product mix,
composite production challenges and reduced revenues.
Selling, General and Administrative Expense and Other Expenses. SG&A
and other expenses decreased 1.6% to (pound)55.4 million in 2003 from
(pound)56.4 million in 2002. SG&A and other expenses as a percentage of
revenues decreased from 12.5% in 2002 to 12.1% in 2003.
SG&A and other expenses increased 7.7% in engine repair and overhaul
to (pound)31.0 million in 2003 from (pound)28.8 million in 2002. This rise
reflects insurance premiums, increased depreciation and amortization related
to the recent plant expansion of the new CF34 program and the negative impact
of the strengthening Canadian dollar. SG&A and other expenses decreased in
design and manufacturing 11.4% to (pound)24.4 million in 2003 from (pound)27.5
million in 2002 as a result of reduced revenues resulting in payroll savings
and reduced overheads. Design and manufacturing SG&A and other expenses in
2002 included costs related to a redundancy program completed in 2003. Major
program spending for the year ended December 31, 2003 related to Airbus A380,
metal matrix composites, the Joint Strike Fighter and electric brake programs.
SG&A and other expenses as a percentage of revenues increased to 9.3% in 2003
from 9.0% in 2002 in engine repair and overhaul and decreased to 20.1% in 2003
from 21.0% in 2002 in design and manufacturing.
Operating Profit (before exceptional items). Operating profit in 2003
decreased 10.2% to (pound)61.8 million from (pound)68.9 million in 2002.
Engine repair and overhaul operating profit decreased 5.9% from (pound)31.5
million in 2002 to (pound)29.6 million in 2003, reflecting the impact of the
appreciation of the pound sterling. Design and manufacturing operating profit
decreased 13.9% from (pound)37.4 million in 2002 to (pound)32.2 million in
2003, primarily attributable to lost variable margin on declining volumes.
Total currency effects resulting from appreciation of the pound
sterling against the U.S. dollar in 2003 compared to 2002 decreased 2003
operating profit by approximately (pound)2.6 million. In constant currency
terms, operating profit decreased by 6.5% in 2003 over 2002.
The current year exceptional item charge of (pound)3.7 million
relates to our efforts to acquire a business that was ultimately purchased by
another company. These costs have been expensed as an exceptional item.
Finance Costs. Finance costs in 2003 decreased 26.1% to (pound)32.0
million from (pound)43.2 million in 2002. This decrease was caused by reduced
borrowing rates as a result of the expiration in November 2002 of the interest
rate derivatives we previously had in place and reduced interest rates in
2003. Accordingly, the interest rates on our senior bank debt for 2003 were
substantially lower than in 2002.
Income Taxes. Income taxes increased 31.0% in 2003 to (pound)13.1
million from (pound)10.0 million in 2002. The (pound)3.1 million increase
reflects the tax on the (pound)4.3 million increase in profit before income
taxes, and the impact of changes in foreign exchange rates.
Net Income. Net income increased 10.0% to (pound)13.0 million in 2003
from (pound)11.9 million in 2002, reflecting the reduction in finance costs
which more than offset the reduction in operating profit for 2003.
Year Ended December 31, 2002 Compared to Year Ended December 31, 2001
The economic challenges experienced in the aerospace industry
impacted our results in 2002. Low commercial aircraft production and lower
commercial aftermarket revenues affected our products linked to these market
segments. Military volumes increased in 2002 as activity in this segment was
not affected by the economic challenges faced by the commercial aerospace
segment.
Revenues. Our 2002 revenues increased 1.6% to (pound)451.8 million
from (pound)444.9 million in 2001. This increase was primarily attributable to
a 9.9% increase in engine repair and overhaul revenues to (pound)320.5 million
in 2002 from (pound)291.7 million in 2001. As a percentage of our total
revenues, engine repair and overhaul revenues increased to 70.9% in 2002 from
65.6% in 2001. Revenues from our design and manufacturing operations decreased
14.3% to (pound)131.3 million in 2002 from (pound)153.2 million in 2001.
The (pound)28.8 million revenue increase in engine repair and
overhaul reflected growth across our base engine platforms. Military volumes,
including work at Kelly U.S.A., showed strong growth during 2002. Regional jet
engine inputs remained strong although revenue has been affected by lower
revenue per unit as the breadth of event work scopes declined. Turboprop,
helicopter and industrial revenues also increased.
The (pound)21.9 million decrease in our design and manufacturing
revenues was principally due to reduced OEM part revenues and a reduction of
our wheel and brake business, reflecting reduced stock and build levels at
most of our customers. In addition, the cancellation of the RJ70 and Dornier
328 programs caused the revenues from OEM brakes to decrease further. Orders
for large commercial aircraft engine and airframe parts have fallen as build
rates are significantly down from 2001.
Our engine repair and overhaul revenues and approximately 15% of our
design and manufacturing revenues are denominated in U.S. dollars. The 4.2%
average increase in the value of the pound sterling against the U.S. dollar
during 2002 negatively affected our revenues by (pound)14.6 million.
Gross Profit. Gross profit for 2002 decreased 4.1% to (pound)125.2
million from (pound)130.5 million in 2001. The decrease of (pound)5.2 million
was primarily attributable to the decrease in our design and manufacturing
revenues. Gross profit as a percentage of revenues decreased to 27.7% for 2002
from 29.3% for 2001, as a result of the increase to 70.9% in 2002 from 65.6%
in 2001 in the percentage of our revenues derived from our lower margin engine
repair and overhaul business.
Gross profit as a percentage in engine repair and overhaul increased
from 18.1% in 2001 to 18.8% in 2002 reflecting improved operating efficiency.
Facility expansions and redesigns in Knoxville, Tilburg and San Antonio were
completed and contributed to operating efficiency gains. These gains were
offset, somewhat, by decreased turbo prop gross margins. Design and
manufacturing gross profit fell (pound)12.7million in 2002. Design and
manufacturing gross profit as a percentage of revenues decreased from 50.7% in
2001 to 49.5% in 2002 reflecting changes in product mix, composite production
challenges and reduced revenues.
Selling, General and Administrative Expense and Other Expenses. SG&A
and other expenses increased 2.8% to (pound)56.4 million in 2002 from
(pound)54.8 million in 2001. SG&A and other expenses as a percentage of
revenues increased slightly to 12.5% in 2002 from 12.3% in 2001.
SG&A and other expenses decreased in engine repair and overhaul to
(pound)28.8 million in 2002 from (pound)29.9 million in 2001. Engine repair
and overhaul SG&A expenses benefited from occupancy efficiencies in San
Antonio, reduced reliance on third party revenues agents and positive impact
of US dollar to pound sterling translation. SG&A and other expenses increased
in design and manufacturing to (pound)27.6 million in 2002 from (pound)24.9
million in 2001. Design and manufacturing SG&A and other expenses include
costs related to a redundancy program undertaken in 2002. Major program
spending in 2002 related to the Airbus A380, metal matrix composites and
electric brake programs. In connection with certain new programs, we are
reimbursed for all or a portion of research and development expenses incurred
in relation to such programs. SG&A and other expenses as a percentage of
revenue decreased to 9.0% in 2002 from 10.3% in 2001 in engine repair and
overhaul and increased to 21.0% in 2002 from 16.2% in 2001 in design and
manufacturing.
Operating Profit (before exceptional items). Operating profit in 2002
decreased 8.9% to (pound)68.9 million from (pound)75.7 million in 2001. Engine
repair and overhaul profit increased 38.1% from (pound)22.8 million in 2001 to
(pound)31.5 million in 2002, reflecting the strong revenue growth and improved
operating efficiency. Design and manufacturing profit decreased 29.2% from
(pound)52.9 million in 2001 to (pound)37.4 million in 2002, primarily
attributable to lost variable margin on declining volumes.
Total currency effects resulting from appreciation of the pound
sterling against the U.S. dollar in 2002 compared to 2001 decreased 2002
operating profit by approximately (pound)1.4 million. In constant currency
terms, operating profit decreased by 7.1% in 2002 over 2001.
The total exceptional item charge relates to costs incurred in
relation to a proposed initial public offering of Dunlop Standard Limited, a
Bermuda company incorporated to acquire the assets of our parent, Dunlop
Standard Aerospace Group Limited and a proposed amendment to our credit
facility. As these efforts were placed on hold, the costs have been expensed
as an exceptional item.
Finance Costs. Finance costs in 2002 increased 3.1% to (pound)43.2
million from (pound)41.9 million in 2001. This increase is the result of
increased borrowing rates. In connection with our obtaining the CF34 engine
service authorization, we renegotiated our Credit Agreement to provide that
the capital expenditure facility would be available exclusively to finance a
new facility dedicated to the CF34 service program. As a result, our credit
agreement was also amended to increase the interest margins applicable to
loans under our credit agreement by 25 basis points in February 2002.
Income Taxes. Income taxes decreased 24.4% in 2002 to (pound)10.0
million from (pound)13.3 million in 2001. The (pound)3.2 million decrease
reflects the tax on the (pound)11.8 million decrease in income before income
taxes.
Net Income. Net income decreased to(pound)11.9 million in 2002
from(pound)20.5 million in 2001.
For a list of recently issued accounting standards refer to page F-46
elsewhere in this report.
B. LIQUIDITY AND CAPITAL RESOURCES
Gross cash decreased (pound)16.0 million to (pound)17.6 million at
December 31, 2003 from (pound)33.6 million at December 31, 2002. Gross cash
increased by (pound)4.5 million to (pound)33.6 million at December 31, 2002
from (pound)29.1 million at December 31, 2001 (excluding (pound)11.5 million
of restricted cash). Cash overdrafts were (pound)nil in 2003, (pound)18.1 in
2002 and (pound)nil in 2001. Our cash flow from operating activities in the
2003 increased by (pound)22.8 million over 2002. This reflects an improvement
in the use of cash for working capital in 2003, compared to 2002. This
improvement offset a (pound)7.3 million reduction in earnings before interest,
taxes, depreciation and amortization for 2003 compared to the same period in
2002. Our interest and finance charges for 2003 were reduced by (pound)11.3
million as the derivatives we previously had in place until November 4, 2002
expired and we financed our bank debt on the basis of much lower current
interest rates in 2003. We also reduced our capital expenditures for tangible
fixed assets and development expenditure, licensing and OEM fees by
(pound)12.8 million during 2003 compared to the same period in 2002.
The 2002 cash flow from operating activities decreased by (pound)17.9
million compared to 2001. This reflects a decrease in earnings before
interest, taxes, depreciation and amortization and an increase in the use of
cash for working capital needs to fund growth in engine repair and overhaul.
This was offset by a (pound)9.6 million decrease in expenditures on
free-of-charge brake ship sets and OEM authorization costs. The (pound)11.5
million of restricted cash was applied against the outstanding indebtedness
under the credit facility on January 31, 2002 after we entered into the fourth
credit facility amendment There were no cash outflows related to acquisitions
in 2001, 2002 or 2003.
We believe the funds available from these and other sources will be
sufficient to satisfy our debt in the foreseeable future.
We made capital expenditures to acquire tangible fixed assets of
(pound)10.3 million in 2003, (pound)33.5 million in 2002, (pound)28.5 million
in 2001 and (pound)22.7 million in 2000. Of these amounts, capital
expenditures in respect of the engine repair and overhaul business were
(pound)5.2 million, (pound)25.6 million, (pound)21.4 million, and (pound)12.9
million respectively, and capital expenditures in respect of the design and
manufacturing business were (pound)5.1 million, (pound)7.9 million, (pound)7.1
million, and (pound)9.8 million, respectively. The increased capital
expenditures in 2002 reflect expenditures in connection with building the CF34
building, the expansion and redesign of our facilities in Knoxville, San
Antonio, and Tilburg, the Netherlands, as well as the completion of the
dynamometer and purchase of a Mark II Furnace at our Coventry, England
facility. Capital expenditures in fiscal 2003 predominately reflect
expenditures on establishing metal matrix composite manufacturing and
equipment for our CF34 and military engine repair and overhaul operations.
We currently anticipate that our capital expenditures for fiscal year
2004 will be approximately (pound)26 million. The 2004 expenses will primarily
be for the maintenance of our facilities, further expansion of our production
facilities, the purchase of additional equipment and various cost reduction
projects. We currently expect to fund our projected future capital expenditure
needs from our existing bank credit commitments and cash from operations.
We made expenditures on free-of-charge brake ship-sets and other
deferred development and OEM authorization costs of approximately (pound)12
million for 2003 and anticipate that expenditures will be approximately
(pound)12 million for 2004, which compares to equivalent expenditure of
(pound)6 million for 2002 and (pound)15 million for 2001. We expect to fund
these and our other future cash requirements from operating cash flow and
existing borrowing facilities. We will also evaluate opportunities to expand
our production facilities in order to meet anticipated growth in demand. If
our capital investment needs exceed expected levels, we may seek additional
financing to fund longer-term growth. Our ability to obtain any such
additional financing may be restricted by the credit agreement and the
indenture governing the senior notes.
In recent years, our primary sources of short-term and long-term
funding have been our operating cash flows, borrowings under our Credit
Agreement, proceeds from the issuance of Senior Notes and proceeds from the
issuance of preference shares by our parent company. As of December 31, 2003,
we had (pound)346.8 million in total debt outstanding and (pound)25.3 million
available in undrawn commitments under our credit agreement with The Mizuho
Corporate Bank, Limited.
Total short-term borrowings amounted to (pound)50.3 million as of
December 31, 2003, which consisted of the current portion of bank loan
repayments scheduled under the Credit Agreement and (pound)23.0 million
outstanding under our Tranche D revolving credit facility, discussed below.
The Credit Agreement contains a (pound)50 million revolving credit facility,
designated as the Tranche D facility. At December 31, 2003, in addition to the
(pound)23.0 million outstanding borrowing discussed above, approximately
(pound)11.4 million of our Tranche D commitments were unavailable as a result
of offsets required by the Credit Agreement for any outstanding bank overdraft
lines established for our local operating units. The Tranche D Facility does
not have any scheduled reductions in availability prior to maturity in 2006
Our long-term debt consists in part of senior term debt facilities
provided under the Credit Agreement. The facilities under this agreement
include three separate Tranches, Tranches A, B and C, which bear interest
rates based on the London Interbank Offered Rate ("LIBOR") and provide
approximately (pound)162.9 million in borrowings all of which were fully drawn
at December 31, 2003. The Tranche A Facility provides for repayments beginning
in 1999 and generally increasing until the loan is fully repaid in 2006. The
Tranche B and C Facilities provide for annual repayments equal to 1% of the
amount outstanding under the facility, beginning in 1999, and a final balloon
payment of principal when the facilities are repaid in 2006 and 2007,
respectively. These bank loans, along with the Tranche D revolving credit
facility described above and the capital expenditure facility described below
are secured by substantially all the shares of our direct and indirect
subsidiaries, as well as security interests in certain assets of these
subsidiaries except for our subsidiaries located in the Netherlands, Singapore
and Australia.
The Tranche E facility provides funding for our CF34 capital
expenditure requirements and is scheduled to be repaid in 2006 and 2007, based
on the dates the initial funds were drawn. At December 31, 2003, we had
(pound)34.6 million of borrowings outstanding under the Tranche E facility and
a further (pound)14.5 million committed but undrawn at that date. In
connection with our obtaining the CF34 engine service authorization, we
renegotiated our credit agreement to provide that the Tranche E facility would
be available exclusively to finance the CF34 service program. The total
facility was reduced from (pound)75.0 million to (pound)49.1 million as a
result. Our credit agreement was also amended to increase the interest margins
applicable to loans under our credit agreement by 25 basis points. We also
paid the banks a one-time fee of (pound)0.35 million in connection with the
amendment.
Under the Credit Agreement, we must make mandatory prepayments in
certain circumstances from the proceeds of certain material asset disposals
and insurance claims or any adjustments on the purchase price or any other
claims recovered or received from BTR plc (now Invensys plc). We are also
permitted to make voluntary prepayments on the loans under the Credit
Agreement. We must also comply with certain financial covenants, including
minimum debt-service and interest-coverage ratios and a minimum net worth
test.
Our long-term debt at December 31, 2003 also includes $225 million
aggregate principal amount of 11?% Senior Notes due 2009.
Our liquidity requirements arise primarily from the need to:
o fund capital expenditures for the maintenance of our facilities;
o purchase testing equipment, repair equipment, replacement parts and whole
replacement engines in order to support expected growth in the repair and
overhaul market;
o expand our business, including the construction of the facility to
service the General Electric CF34 engine;
o fund debt service requirements;
o fund research and development;
o fund new program bids;
o fund working capital requirements;
o fund expenditures on free-of-charge brake ship-sets;
o fund costs of obtaining OEM authorizations; and
o fund potential acquisitions consistent with our business strategy.
On February 10, 2004, we incurred $120.0 million of additional
indebtedness with the issuance of the New Senior Notes with the same terms as
the current notes hereby and have paid (pound)23 million of outstanding
indebtedness under our Tranche D revolving credit facility with a portion of
the proceeds therefrom.
The Notes are scheduled to be repaid in one installment in 2009.
However, noteholders may require us to repurchase the Notes in the event of a
change of control. We may not be able to do so without the consent of our
lenders under the Credit Agreement. At our discretion, the Notes may be
redeemed on or after May 15, 2004 at specified redemption prices. The Credit
Agreement was amended on January 29, 2004 to, among other things, enable us to
complete a potential acquisition currently under negotiation. Pursuant to that
amendment, $25.0 million of the proceeds from the New Senior Notes will be
placed into an account secured in favour of the lenders to be used as partial
payment for the potential acquisition. If we do not close the acquisition by
May 31, 2004, we have agreed with the lenders under the Credit Agreement to
use the proceeds in the escrow account to redeem $25.0 million of the Notes
(which includes both the Initial Notes and the New Notes) pursuant to the
optional redemption provision of the indenture.
Commitments and contingencies
The following is a summary of our contractual cash obligations at
December 31, 2003.
Less than
Contractual Obligations Total 1 Year 1-3 Years 4-5 Years After 5 Yrs
----------------------- ----- ---------- ---------- --------- -----------
(in thousands)
Long-term debt
Tranche A ((pound)) (pound)71,520 (pound)28,000 (pound)43,520 -- --
Tranche B ($) 45,664 481 45,183 -- --
Tranche C ($) 45,672 488 962 44,222 --
Tranche D ((pound)) 23,000 23,000 -- -- --
Tranche D ($) -- -- -- -- --
Tranche E ($) 33,780 -- 16,890 16,890 --
Tranche E ((pound)) 800 -- 400 400
Senior Notes ($) 126,404 -- 126,404
------- ------ -------
Total 346,840 51,969 106,955 61,512 126,404
Other long-term obligations (pound)17,867 (pound)4,768 (pound)8,166 (pound)4,051
Finance lease obligations 3,823 997 2,826 -- (pound)882
--
Total contractual cost
obligations (pound)368,530 (pound)57,734 (pound)117,947 (pound)65,563 (pound)127,286
============== ============= ============== ============= ==============
|
On 10 February, 2004, we issued $120.0 million ((pound)64.5 million)
of additional indebtedness with the issuance of New Senior Notes that have the
same terms as the current Senior Notes (repayable in one installment 2009),
and repaid (pound)23 million of outstanding indebtedness under our Tranche D
revolving credit facility (which is reflected as due in less than one year in
the above table) with a portion of the proceeds.
Financing Activities Relating to the Acquisition
We incurred substantial indebtedness in connection with our
acquisition from BTR and, as a result, we are highly leveraged. Our ability to
incur additional indebtedness in the future is restricted by the credit
agreement and is further restricted by the Indenture.
Scheduled payments under the credit agreement will significantly
impact liquidity. Loans under the Credit Agreement were issued under five
Tranches, designated Tranche A through Tranche E. Repayment on these
facilities is provided for as follows:
o The Tranche A Facility provides for repayments beginning in 1999 and
generally increasing until the loan is fully repaid in 2006;
o The Tranche B Facility and the Tranche C Facility provide for annual
repayments equal to 1% of the amount outstanding under the facility,
beginning in 1999, and a final balloon payment of principal when the
loans are repaid in 2006 and 2007, respectively;
o The Tranche D Facility, a (pound)50 million revolving line of credit,
does not have any scheduled reductions in availability prior to
maturity in 2006; and
o The Tranche E Facility for capital expenditures related to our CF34
program provides for repayments in 2006 and 2007, based on the dates
the initial funds were drawn.
Under the Credit Agreement, we must make mandatory prepayments in
certain circumstances from the proceeds of certain material asset disposals
and insurance claims or any adjustments on the purchase price or any other
claims recovered or received from BTR (now Invensys plc). We are also
permitted to make voluntary prepayments on the loans under the credit
agreement. Borrowings under the credit agreement bear interest at LIBOR-based
floating rates for varying interest periods. The Credit Agreement and the
Indenture restrict us in various ways described elsewhere in this annual
report. We must also comply with certain financial covenants, including
minimum debt-service and interest-coverage ratios and a minimum net worth
test. As of the date on the cover of this annual report, we believe we are in
compliance with the covenants in the Indenture and the Credit Agreement.
The Senior Notes are scheduled to be repaid in one installment in
2009. However, noteholders may require us to repurchase the Senior Notes in
the event of a change of control. We may not be able to do so without the
consent of our lenders under our credit agreement. At the Company's
discretion, the Senior Notes may be redeemed on or after May 15, 2004 at
specified redemption prices.
C. Research and development, patents, licenses, etc.
Engine Repair and Overhaul
We have invested (pound)0.5 million, (pound)0.5 million and
(pound)0.1 million in 2001, 2002 and 2003 on research and development
activities related to our engine repair and overhaul division. Most of our
research and development relating to repair and overhaul focuses on developing
new and innovative component repairs for the engines that we service. In
particular, we have invested significant resources in developing internal
remanufacturing technologies which can deliver more efficient production
processes at lower costs and high quality. We have established dedicated
facilities with specialized equipment and highly trained engineers to achieve
these objectives. An important element of this capability is our designation
as a Design Approval Organization as authorized by Transport Canada. This
status, which is recognized by the FAA under bilateral agreements, simplifies
the approvals of our component repairs in the North American market and with
several other allied nations. We work closely with engine OEMs on selected
component repairs to gain official recognition, commercial support and wider
market access. The primary objectives of our component repair development are
to provide market differentiation, by means of lower cost part replacement
options, and to increase the value-added content of our engine repair and
overhaul projects. Our ability to remanufacture components has also enabled us
to minimize the use of subcontractors, which we believe has helped us to
enhance delivery, quality control and sales of our work.
Design and Manufacturing
We have invested (pound)10.2 million, (pound)11.7 million and
(pound)10.3 million in 2001,2002 and 2003 on research and development
activities related to our design and manufacturing division. Our design and
manufacturing operations are engaged in research and development aimed to
develop new products and technologies which improve product performance across
a wide range of parameters including operating conditions, weight, size,
quality and reliability. Our design and manufacturing operations focus on
advanced materials, product design, manufacturing processes, systems and
software development and include use of advanced analysis techniques. Research
is conducted at the business unit level enabling rapid response to customer
and market demands.
We are well advanced in the development of electrically actuated
brakes and have achieved full compliance with one of the most stringent of the
required tests. Electric brakes are expected to yield substantial system
weight savings, improved maintainability and safety with greatly enhanced
battlefield survivability. We are a lead participant in electric brake
development activity working in conjunction with a major aircraft OEM,
defining the standards to be used by that OEM for electric brake architecture
and are also researching carbon disc wear phenomena to improve brake life.
Sensor technology has been developed for use with our wheels and brakes to
include total landing system performance monitoring and diagnostics, where the
object is to reduce customer operating costs and spares inventory. Metal
matrix composites have been developed for use in new aircraft programs. Our
valve capability has been extended to include flow management and acoustic
control techniques which we believe have applications in both aerospace and
non-aerospace markets.
We have a strong focus on capturing and retaining the intellectual
property resulting from our research and development investment. To that end,
we are active in protecting our inventions through patents, trademarks,
licensing and retention of our know-how. Where we do not own the intellectual
property, we may seek to license the technology. Of similar importance to
patents and trademarks in protecting our intellectual property is our ability
to retain design rights for our products through ownership and control of
higher assembly drawings.
D. Trend Information
A number of trends in the commercial aviation industry affect our
operating results. Prior to 2001, for example, increased air travel had driven
the demand for new aircraft and engines and had also increased rates of
aircraft utilization. Overall, the increase in the size of the commercial
aircraft fleet has increased the size of our installed base and has positively
impacted both our engine repair and overhaul business and our design and
manufacturing business. In particular, the increase in deliveries of regional
jet aircraft is a positive trend, as we service certain of the engines used on
such aircraft and also provide brake parts to some of these aircraft.
Conversely, due to economic downturn, terrorist threats, recent military
actions, and health concerns demand for air travel has declined. This has
resulted in airline bankruptcies and restructuring, reduced build rates for
certain aircraft and engines and increases in aircraft placed out of service.
This trend has negatively affected our design and manufacturing business and
engine repair and overhaul business on aircraft and engine models that have
been impacted by the negative trend and for which we provide service or parts.
In addition, airlines, governments, particularly military
organizations, and some OEMs are increasingly outsourcing repair and overhaul
and some manufacturing work. This has enabled us to obtain more engine repair
and overhaul work and may in the future provide additional opportunities. For
example, in October 2003 we were awarded a contract to supply materials for
our T56 service contract at Kelly USA. The contract expires in 2007, after
which it is renewable through 2014.
Our manufacturing operations are also well positioned to take
advantage of expected changes in the aircraft market. For example, our
expertise relating to carbon braking systems should permit us to grow our
revenues as carbon brakes continue to supersede steel brakes. We currently
provide such systems for 15 existing aircraft platforms. Of those platforms,
six are in the regional aircraft market. We have also entered into agreements
to provide carbon brakes for other aircraft programs and, in partnership with
Honeywell, we will provide carbon brakes for the Joint Strike Fighter and the
Airbus A380.
E. Off Balance Sheet Arrangements
Not applicable
F. Contractual Obligations
See Section 5.B, "Liquidity and Capital Resources - Commitments and
Contingencies."
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