Filed with the SEC from Jan 22 to Jan 28:
Standard Motor Products (SMP)
Mario Gabelli's Gamco Investors (GBL) sent to Standard Motor CEO Lawrence Sills, suggesting that SMP consider "a going-dark transaction." Under it, SMP would cut its total of shareholders and eventually delist its shares from the New York Stock Exchange. Gamco would support this, if SMP's securities are then traded in the pink sheets and the company provides continuing information to shareholders. Gamco and affiliates hold about 3.04 million shares (16.15%).
We are a leading independent manufacturer, distributor and marketer of replacement parts for motor vehicles in the automotive aftermarket industry, with an increasing focus on the original equipment and original equipment service markets. We are organized into two major operating segments, each of which focuses on a specific line of replacement parts. Our Engine Management Segment manufactures ignition and emission parts, ignition wires, battery cables and fuel system parts. Our Temperature Control Segment manufactures and remanufactures air conditioning compressors, air conditioning and heating parts, engine cooling system parts, power window accessories, and windshield washer system parts. We also sell our products in Europe through our European Segment.
We sell our products primarily to warehouse distributors, large retail chains, original equipment manufacturers and original equipment service part operations in the United States, Canada and Latin America. Our customers consist of many of the leading warehouse distributors, such as CARQUEST and NAPA Auto Parts, as well as many of the leading auto parts retail chains, such as Advance Auto Parts, AutoZone, CSK Auto, O'Reilly Automotive and Pep Boys. Our customers also include national program distribution groups, specialty market distributors and original equipment service parts organizations. We distribute parts under our own brand names, such as Standard, Blue Streak, BWD, Niehoff, Hayden and Four Seasons, and through private labels, such as CARQUEST and NAPA Auto Parts.
Our goal is to grow revenues and earnings and deliver returns in excess of our cost of capital by providing high quality original equipment and replacement products to the engine management and temperature control markets. The key elements of our strategy are as follows:
MAINTAIN OUR STRONG COMPETITIVE POSITION IN THE ENGINE MANAGEMENT AND TEMPERATURE CONTROL BUSINESSES. We are one of the leading independent manufacturers serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and imported automobiles, and our reputation for outstanding customer service, as measured by rapid order turn-around times and high-order fill rates.
To maintain our strong competitive position in our markets, we remain committed to the following:
o providing our customers with broad lines of high quality engine management and temperature control products, supported by the highest level of customer service and reliability;
o continuing to maximize our production and distribution efficiencies;
o continuing to improve our cost position through increased global sourcing and increased manufacturing in low cost countries; and
o focusing further on our engineering development efforts.
o PROVIDE SUPERIOR CUSTOMER SERVICE, PRODUCT AVAILABILITY AND TECHNICAL SUPPORT. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability and providing technical support in a cost-effective manner. In addition, our technically skilled sales force professionals provide product selection and application support to our customers.
o EXPAND OUR PRODUCT LINES. We intend to increase our sales by continuing to develop internally, or through potential acquisitions, the range of Engine Management and Temperature Control products that we offer to our customers. We are committed to investing the resources necessary to maintain and expand our technical capability to manufacture multiple product lines that incorporate the latest technologies.
o BROADEN OUR CUSTOMER BASE. Our goal is to increase our customer base by (a) continuing to leverage our manufacturing capabilities to secure additional original equipment business with automotive, industrial and heavy duty vehicle and equipment manufacturers and their service part operations and
(b) supporting the service part operations of vehicle and equipment manufacturers with value added services and product support for the life of the part.
o IMPROVE OPERATING EFFICIENCY AND COST POSITION. Our management places significant emphasis on improving our financial performance by achieving operating efficiencies and improving asset utilization, while maintaining product quality and high customer order fill rates. We intend to continue to improve our operating efficiency and cost position by:
o increasing cost-effective vertical integration in key product lines through internal development;
o focusing on integrated supply chain management;
o maintaining and improving our cost effectiveness and competitive responsiveness to better serve our customer base, including sourcing certain products from low cost countries such as those in Asia.
o adopting company-wide programs geared toward manufacturing and distribution efficiency; and
o focusing on company-wide overhead and operating expense cost reduction programs, such as closing excess facilities and consolidating redundant functions.
o CASH UTILIZATION. We intend to apply any excess cash flow from operations and the management of working capital to reduce our outstanding indebtedness, pay dividends and repurchase our stock.
THE AUTOMOTIVE AFTERMARKET
The automotive aftermarket industry is comprised of a large number of diverse manufacturers varying in product specialization and size. In addition to manufacturing, aftermarket companies allocate resources towards an efficient distribution process and product engineering in order to maintain the flexibility and responsiveness on which their customers depend. Aftermarket manufacturers must be efficient producers of small lot sizes and do not have to provide systems engineering support. Aftermarket manufacturers also must distribute, with rapid turnaround times, products for a full range of vehicles on the road. The primary customers of the automotive aftermarket manufacturers are national and regional warehouse distributors, large retail chains, automotive repair chains and the dealer service networks of Original Equipment Manufacturers ("OEMs").
During periods of economic decline or weakness, more automobile owners may choose to repair their current automobiles using replacement parts rather than purchasing new automobiles, which benefit the automotive aftermarket industry, including suppliers like us. The automotive aftermarket industry is also dependent on new car sales, although to a lesser degree than OEMs and their suppliers, because these sales increase the total number of cars available for repair. Until recently, aggressive financing programs by automakers have increased demand for new cars and trucks, which should benefit the automotive aftermarket manufacturers in the long term as vehicles age and the number of vehicles in operation increases.
The automotive aftermarket industry differs substantially from the OEM supply business. Unlike the OEM supply business that primarily follows trends in new car production, the automotive aftermarket industry's performance primarily tends to follow different trends, such as:
o growth in number of vehicles on the road;
o increase in average vehicle age;
o increase in total miles driven per year;
o new and modified environmental regulations;
o increase in pricing of new cars; and
o new car quality and related warranties.
Traditionally, the parts manufacturers of OEMs and the independent manufacturers who supply the original equipment (OE) part applications have supplied a majority of the business to new car dealer networks. However, certain parts manufacturers have become more independent and are no longer affiliated with OEMs, which has provided, and may continue to provide, opportunities for us to supply replacement parts to the dealer service networks of the OEMs, both for warranty and out-of-warranty repairs.
ENGINE MANAGEMENT SEGMENT
BREADTH OF PRODUCTS. We manufacture a full line of engine management replacement parts including distributor caps and rotors, electronic ignition control modules, voltage regulators, coils, switches, emission sensors, EGR valves and many other engine management components under our brand names Standard, BWD, Niehoff and GP Sorenson and through private labels such as CARQUEST and NAPA. We are a basic manufacturer of many of the engine management parts we market. In addition, our strategy includes sourcing certain products from low cost countries such as those in Asia. In our Engine Management Segment, replacement parts for ignition and emission control systems accounted for approximately 54%, 54% and 55% of our consolidated net sales in 2007, 2006 and 2005, respectively.
COMPUTER-CONTROLLED TECHNOLOGY. Nearly all new vehicles are factory-equipped with computer-controlled engine management systems to control ignition, emission and fuel injection systems. The on-board computers monitor inputs from many types of sensors located throughout the vehicle, and control a myriad of valves, injectors, switches and motors to manage engine and vehicle performance. Electronic ignition systems enable the engine to operate with improved fuel efficiency and reduced level of hazardous fumes in exhaust gases.
In 1992, we entered into a joint venture in Canada with Blue Streak Electronics, Inc. to rebuild automotive engine management computers and mass air flow sensors. This joint venture has further expanded its product range to include computers used in temperature control, anti-lock brake systems and air bags, and development of diagnostic repair tools.
We divide our electronic operations between product design and highly automated manufacturing operations in Orlando, Florida and assembly operations, which are performed in assembly plants in Orlando and Hong Kong.
Government emission laws have been implemented throughout the majority of the United States. The Clean Air Act, as amended in 1990, imposes strict emission control test standards on existing and new vehicles, and remains the preeminent legislation in the area of vehicle emissions. As many states have implemented required inspection/maintenance tests, the Environmental Protection Agency, through its rulemaking ability, has also encouraged both manufacturers and drivers to reduce vehicle emissions. As the Clean Air Act was "phased in" beginning in 1994, automobiles must now comply with emission standards from the time they were manufactured, and in most states, until the last day they are in use. This law and other government emissions laws have had, and we expect it to continue to have, a positive impact on sales of our ignition and emission controls parts since vehicles failing these laws may require repairs utilizing parts sold by us.
Our sales of sensors, valves, solenoids and related parts have increased steadily as automobile manufacturers equip their cars with more complex engine management systems.
WIRE AND CABLE PRODUCTS. Wire and cable parts accounted for approximately 13%, 13% and 11% of our consolidated net sales in 2007, 2006 and 2005, respectively. These products include ignition (spark plug) wires, battery cables and a wide range of electrical wire, terminals, connectors and tools for servicing an automobile's electrical system.
The largest component of this product line is the sale of ignition wire sets. We have historically offered a premium brand of ignition wires and battery cables, which capitalizes on the market's awareness of the importance of quality. We extrude high voltage wire in our Mishawaka, Indiana facility which is used in our ignition wire sets. This vertical integration of this critical component offers us the ability to achieve lower costs and a controlled source of supply and quality.
TEMPERATURE CONTROL SEGMENT
We manufacture, remanufacture and market a full line of replacement parts for automotive temperature control (air conditioning and heating) systems, engine cooling systems, power window accessories and windshield washer systems, primarily under our brand names of Four Seasons, Factory Air, Murray, Hayden, Imperial and ACi and through private labels such as CARQUEST and NAPA. The major product groups sold by our Temperature Control Segment are new and remanufactured compressors, clutch assemblies, blower and radiator fan motors, filter dryers, evaporators, accumulators, hose assemblies, expansion valves, heater valves, AC service tools and chemicals, fan assemblies, fan clutches, engine oil coolers, transmission coolers, window lift motors and windshield washer pumps. Our temperature control products accounted for approximately 26%, 26% and 28% of our consolidated net sales in 2007, 2006 and 2005, respectively.
Due to increasing offshore competitive price pressure, our Temperature Control business made several changes within its manufacturing portfolio. We have outsourced the manufacturing of several major AC product groups to low cost areas and have implemented plans to consolidate manufacturing facilities. In addition, we continue to increase production of remanufactured compressors in Reynosa, Mexico and have entered into several supply agreements for certain products with vendors in low cost countries such as those in Asia.
Today's vehicles are being produced with smaller, more complex and efficient AC system designs. These newer systems are less prone to leak resulting in fewer AC system repairs. Our Temperature Control Segment continues to be a leader in providing superior training to service dealers who seek the knowledge in which to perform proper repairs for today's vehicles. We believe that our training module (HVAC Tips & Techniques) remains one of the most sought-after training clinics in the industry and among professional service dealers.
In July 1996, we acquired an equity interest in Standard Motor Products (SMP) Holdings Limited (formerly Intermotor Holdings Limited) located in Nottingham, England. During 2002, we acquired the remaining equity interest bringing the Company's ownership percentage to 100%. SMP Holdings Limited manufactures and distributes a broad line of engine management products primarily to customers in Europe. Also in 1996, we expanded our presence in Europe by opening a European distribution center in Strasbourg, France for temperature control products, which we later divested in the fourth quarter of 2006. A joint venture (Blue Streak Europe) between SMP Holdings Limited and Blue Streak Electronics was also initiated in 1996, which joint venture supplies rebuilt engine computers for the European market.
Since 1996, we have made a series of smaller acquisitions supplementing both the Engine Management and Temperature Control portions of our business. With respect to the engine management business, in January 1999 we acquired Webcon UK Limited, an assembler and distributor of fuel system components, which we subsequently divested in June 2003. In January 1999, Blue Streak Europe acquired Injection Correction UK LTD, a subsidiary of Webcon, and in September 2001, acquired TRW Inc.'s electronic control unit remanufacturing division. In April 1999, we acquired Lemark Auto Accessories, a supplier of wire sets. In April 2002, the wire business was further expanded by acquiring Carol Cable Limited, a manufacturer and distributor of wire. In April 2006, we acquired substantially all of the assets of Biazet EI's ignition and coil business in Poland. Subsequently, we relocated certain of our UK manufacturing operations to our facility in Poland. In December 2007, we acquired Kerr Nelson Ltd., a manufacturer and distributor of wire sets.
With respect to the temperature control portion of our business, following the opening of the distribution center in France, in 1997 a joint venture was entered into with Valeo SA to remanufacture air conditioner compressors for the European market. In addition, in January 2000 we acquired Four Seasons UK Ltd. (formerly Vehicle Air Conditioning Parts Ltd.), a distributor of components for the repair of air conditioning systems. In July 2000, the Temperature Control business purchased Four Seasons Italy SRL (formerly Automotive Heater Exchange SRL) in Italy. In 2001 we entered into a joint venture with Pedro Sanz in Madrid, Spain to distribute our products in the Iberian Peninsula. In the fourth quarter of 2006, we sold a majority portion of our European Temperature Control business, consisting of our equity interests of our operations in Spain and our business in France (other than our joint venture with Valeo) and Italy. The proceeds from the divestiture were $3.1 million, and we incurred a loss on divestiture of $3.2 million in the fourth quarter of 2006.
Our European Segment accounted for approximately 5%, 6% and 5% of our consolidated net sales in 2007, 2006 and 2005, respectively. Aftermarket margins are under pressure, while volumes are in a general decline in the ignition line. We have responded to the adverse market conditions by reducing manufacturing costs through consolidating certain facilities and outsourcing products.
SALES AND DISTRIBUTION
In the traditional distribution channel, we sell our products to warehouse distributors, who supply auto parts jobbers, who in turn sell to professional technicians and to consumers who perform automotive repairs themselves. In recent years, warehouse distributors have consolidated with other distributors, and an increasing number of distributors own their jobbers. In the retail distribution channel, customers buy directly from us and sell directly to technicians and "do it yourselfers." Retailers are also consolidating with other retailers and have expanded into the jobber market, adding additional competition in the "do it for me" business segment targeting the professional technician.
As automotive parts grow more complex, consumers are less likely to service their own vehicles and may become more reliant on dealers and technicians. In addition to new car sales, automotive dealerships sell OE brand parts and service vehicles. The products available through the dealers are purchased through the original equipment service (OES) network. Traditionally, the parts manufacturers of OEMs have supplied a majority of the OES network. However, certain parts manufacturers have become independent and are no longer affiliated with OEMs. In addition, many Tier 1 OEM suppliers are disinterested in providing service parts after serial production is complete. As a result of these factors, there are additional opportunities for independent automotive aftermarket manufacturers like us to supply the OES network.
We believe that our sales force is the premier direct sales force for our product lines due to our concentration of highly-qualified, well-trained sales people dedicated to geographic territories. Our sales force allows us to provide customer service that we believe is unmatched by our competitors. We thoroughly train our sales people both in the function and application of our product lines, as well as in proven sales techniques. Customers, therefore, depend on these sales people as a reliable source for technical information. We give newly hired sales people extensive instruction at our training facility in Irving, Texas and have a continuing education program that allows our sales force to stay current on troubleshooting and repair techniques, as well as the latest automotive parts and systems technology.
We generate demand for our products by directing a significant portion of our sales effort to our customers' customers (i.e., jobbers and professional technicians). We also conduct instructional clinics, which teach technicians how to diagnose and repair complex systems related to our products. To help our sales people to be teachers and trainers, we focus our recruitment efforts on candidates who already have strong technical backgrounds as well as sales experience.
In connection with our sales activities, we offer a variety of customer discounts, allowances and incentives. For example, we offer cash discounts for paying invoices in accordance with the specified discounted terms of the invoice, and we offer pricing discounts based on volume and different product lines purchased from us. We also offer rebates and discounts to customers as advertising and sales force allowances, and allowances for warranty and overstock returns are also provided. We believe these discounts, allowances and incentives are a common practice throughout the automotive aftermarket industry, and we intend to continue to offer them in response to competitive pressures.
Our customer base is comprised largely of warehouse distributors, large retailers, OE/OES customers, other manufacturers and export customers. Our warehouse distributor customers include CARQUEST and NAPA Auto Parts, and several large independent distributors affiliated with industry marketing group associations. These associations include The Aftermarket Auto Parts Alliance, The Automotive Distribution Network, and National Pronto Association. Our retail customers include Advance Auto Parts, AutoZone, CSK Auto, O'Reilly Automotive and Pep Boys. In 2007, our consolidated net sales to our major market channels consisted of $386 million to our traditional customers, $247 million to our retail customers, $81 million to our OE/OES customers, and $76 million to other customers.
Our five largest individual customers, including members of a marketing group, accounted for 50% of our 2007 consolidated net sales. Two individual customers accounted for 17% and 15%, respectively, of our 2007 consolidated net sales.
We are a leading independent manufacturer of replacement parts for product lines in Engine Management and Temperature Control. We compete primarily on the basis of product quality, product availability, customer service, product coverage, order turn-around time, order fill rate and price. We believe we differentiate ourselves from our competitors primarily through:
o a value-added, knowledgeable sales force;
o extensive product coverage;
o sophisticated parts cataloguing systems;
o inventory levels sufficient to meet the rapid delivery requirements of customers; and
o breadth of manufacturing capabilities.
In the Engine Management business, we are one of the leading independent manufacturers in the United States. Our competitors include AC Delco, Cardone Industries, Inc., Delphi Corporation, Denso Corporation, Federal-Mogul Corporation, Robert Bosch Corporation, Visteon Corporation and Wells Manufacturing Corporation, as well as OE dealers.
Our Temperature Control business is one of the leading independent manufacturers and distributors of a full line of temperature control products in North America and other geographic areas. AC Delco, Delphi Corporation, Denso Corporation, Sanden International Inc., Proliance International, Inc., Continental/Siemens VDO Automotive and Visteon Corporation are some of our key competitors in this market.
The automotive aftermarket is highly competitive, and we face substantial competition in all markets that we serve. Our success in the marketplace continues to depend on our ability to offer competitive prices, improved products and expanded offerings in competition with many other suppliers to the aftermarket. Some of our competitors may have greater financial, marketing and other resources than we do. In addition, we face competition from automobile manufacturers who supply many of the replacement parts sold by us, although these manufacturers generally supply parts only for cars they produce through OE dealerships.
Name of Director
Position with the Company
Lawrence I. Sills
Chairman of the Board and Chief Executive Officer
William H. Turner (1)(2)
Presiding Independent Director
Robert M. Gerrity (1)(3)
Pamela Forbes Lieberman (1) .
Arthur S. Sills
Peter J. Sills
Frederick D. Sturdivant (1)
Richard S. Ward (1)(4)
Roger M. Widmann (1)
MANAGEMENT DISCUSSION FROM LATEST 10K
The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the three year period ended December 31, 2007.
We are a leading independent manufacturer, distributor and marketer of replacement parts for motor vehicles in the automotive aftermarket industry. We are organized into two major operating segments, each of which focuses on a specific segment of replacement parts. Our Engine Management Segment manufactures ignition and emission parts, ignition wires, battery cables and fuel system parts. Our Temperature Control Segment manufactures and remanufactures air conditioning compressors, and other air conditioning and heating parts. We sell our products primarily in the United States, Canada and Latin America. We also sell our products in Europe through our European Segment.
As part of our efforts to grow our business, as well as to achieve increased production and distribution efficiencies, in June 2003 we acquired substantially all of the assets and assumed substantially all of the operating liabilities of Dana Corporation's Engine Management Group ("DEM") for $130.5 million.
We place significant emphasis on improving our financial performance by achieving operating efficiencies and improving asset utilization, while maintaining product quality and high customer order fill rates. We intend to continue to improve our operating efficiency and cost position by focusing on company-wide overhead and operating expense cost reduction programs, such as closing excess facilities and consolidating redundant functions. In that regard, during 2007 and 2006, we announced initiatives to close our Puerto Rico manufacturing facility, integrate operations in Mexico, close our Fort Worth, Texas production facility and shutdown our manufacturing operations in Long Island City, New York.
For additional information about our business, strategy and competitive environment, see Item 1, "Business."
SEASONALITY. Historically, our operating results have fluctuated by quarter, with the greatest sales occurring in the second and third quarters of the year and revenues generally being recognized at the time of shipment. It is in these quarters that demand for our products is typically the highest, specifically in the Temperature Control Segment of our business. In addition to this seasonality, the demand for our Temperature Control products during the second and third quarters of the year may vary significantly with the summer weather and customer inventories. For example, a cool summer may lessen the demand for our Temperature Control products, while a hot summer may increase such demand. As a result of this seasonality and variability in demand of our Temperature Control products, our working capital requirements typically peak near the end of the second quarter, as the inventory build-up of air conditioning products is converted to sales and payments on the receivables associated with such sales have yet to be received. During this period, our working capital requirements are typically funded by borrowing from our revolving credit facility.
The seasonality of our business offers significant operational challenges in our manufacturing and distribution functions. To limit these challenges and to provide a rapid turnaround time of customer orders, we traditionally offer a pre-season selling program, known as our "Spring Promotion," in which customers are offered longer payment terms.
INVENTORY MANAGEMENT. We face inventory management issues as a result of warranty and overstock returns. Many of our products carry a warranty ranging from a 90-day limited warranty to a lifetime limited warranty, which generally covers defects in materials or workmanship and failure to meet industry published specifications. In addition to warranty returns, we also permit our customers to return products to us within customer-specific limits (which are generally limited to a specified percentage of their annual purchases from us) in the event that they have overstocked their inventories. We accrue for overstock returns as a percentage of sales, after giving consideration to recent returns history.
In order to better control warranty and overstock return levels, we tightened the rules for authorized warranty returns, placed further restrictions on the amounts customers can return and instituted a program so that our management can better estimate potential future product returns. Despite the additional controls, in the fourth quarter of 2007, we experienced significant overstock returns as customers reduced their working capital levels in response to a difficult economic climate. In addition, with respect to our air conditioning compressors, which are our most significant customer product warranty returns, we established procedures whereby a warranty will be voided if a customer does not provide acceptable proof that complete air conditioning system repair was performed.
DISCOUNTS, ALLOWANCES AND INCENTIVES. In connection with our sales activities, we offer a variety of usual customer discounts, allowances and incentives. First, we offer cash discounts for paying invoices in accordance with the specified discount terms of the invoice. Second, we offer pricing discounts based on volume and different product lines purchased from us. These discounts are principally in the form of "off-invoice" discounts and are immediately deducted from sales at the time of sale. For those customers that choose to receive a payment on a quarterly basis instead of "off-invoice," we accrue for such payments as the related sales are made and reduce sales accordingly. Finally, rebates and discounts are provided to customers as advertising and sales force allowances, and allowances for warranty and overstock returns are also provided. Management analyzes historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. We account for these discounts and allowances as a reduction to revenues, and record them when sales are recorded.
COMPARISON OF FISCAL YEARS 2007 AND 2006
SALES. Consolidated net sales for 2007 were $790.2 million, a decrease of $21.8 million or 2.7%, compared to $812 million in 2006, driven by decreases in our Engine Management, Temperature Control and European Segments of $16 million, $3.5 million and $4.8 million, respectively. The decrease in Engine Management sales was mainly due to higher sales deductions consisting primarily of customer warranty and overstock returns and other rebates and allowances. The net sales decrease in our Temperature Control Segment was due primarily to lower pricing and volume erosion caused by low cost foreign imports, partially offset by lower customer warranty returns. Europe net sales in 2006 included $13.4 million related to the European Temperature Control business that was divested in December 2006. Excluding this divested business, Europe sales increased $8.6 million.
GROSS MARGINS. Gross margins, as a percentage of consolidated net sales, increased by 0.3 percentage points to 25.6% in 2007 from 25.3% in 2006 mainly due to margin improvements in our Engine Management and European Segments of 1 percentage point and 0.5 percentage points, respectively, partially offset by a 2 percentage point decrease in our Temperature Control margin. The margins in Engine Management and Europe benefited mainly from continued improvements in procurement and lower manufacturing costs. Partially offsetting these savings in Engine Management were the impact of $15.9 million of higher sales deductions for the year that negatively impacted gross margin as a percentage of sales. The European Segment also benefited from the divestiture of its Temperature Control business which carried lower margins. The decrease in Temperature Control margin was primarily affected by selective price decreases to match offshore price competition.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative (SG&A) expenses increased by $0.9 million to $169 million or 21.4% of consolidated net sales in 2007, as compared to $168.1 million or 20.7% of consolidated net sales in 2006. The increase was due to a higher bad debt provision on certain accounts receivable and slightly higher general and administrative expenses, partially offset by a reduction in distribution expenses.
RESTRUCTURING AND INTEGRATION EXPENSES. Restructuring expenses, which include restructuring and integration expenses, increased to $10.9 million in 2007, compared to $1.9 million in 2006. The 2007 expense related to charges made for the closure of our Puerto Rico production operations, the integration of operations in Mexico, the closure of our Fort Worth, Texas production facility and severance and related costs in connection with the shutdown of our Long Island City manufacturing operations. In December 2007, we reached an agreement with the union representing the hourly employees at our Long Island City manufacturing facility relating to the shutdown of our manufacturing operations. As part of the agreement, we agreed to the payment of certain severance payments upon termination of employment and to the withdrawal from the union's multi-employer pension plan. The estimated withdrawal liability related to the multi-employer plan is calculated at $5.6 million paid quarterly over 20 years. The present value of the liability is estimated at $3.3 million and was recorded as part of restructuring and integration expenses in 2007. In addition, a $1.8 million increase in our environmental reserve was recorded in 2007 for remediation related to the planned sale of our Long Island City building.
Restructuring and integration expense in 2006 related mostly to severance costs related to the move of our European and Puerto Rican production operations and the divestiture of a production unit of our Temperature Control Segment.
OPERATING INCOME. Operating income was $22.4 million in 2007, compared to $35.3 million in 2006. The decrease of $12.9 million was primarily due to lower consolidated net sales, as well as higher restructuring and integration expenses.
OTHER INCOME (EXPENSE), NET. Other income, net was $3.9 million in 2007, which was $4.3 million higher than other expense, net of $0.4 million in 2006. Other income, net in 2007 includes a $0.8 million gain on the sale of our Fort Worth, Texas manufacturing facility, a $1.4 million gain in foreign exchange, and $0.7 million in dividend and interest income. Other income (expense), net in 2006 included a $3.2 million loss incurred on the sale of a majority portion of our European Temperature Control business. Offsetting the 2006 loss incurred on the sale of a majority portion of our European Temperature Control business are a $0.7 million gain in foreign exchange, $0.9 million in joint venture equity income and $0.5 million in dividend and interest income.
INTEREST EXPENSE. Interest expense of $18 million in 2007 was $1.3 million lower than interest expense of $19.3 million in 2006. The lower interest expense in 2007 was due primarily to lower borrowing costs and lower average borrowings during the year.
INCOME TAX PROVISION. The income tax provision was $2.8 million for 2007 compared to $6.5 million in 2006. The $3.7 million decrease was primarily due to a lower effective rate in 2007, which was 34% compared to 41.5% in 2006. The 2007 rate was lower due to the release of the valuation allowance related to U.S. capital losses in consideration of the expected capital gain in connection with our sale of our Long Island City, New York facility. The 2006 rate was higher due to the adverse impact of discrete items attributable to changes in state tax rates, while the 2007 estimated tax rate benefited from pre-tax income in Europe where previously unrecognized losses carried forward offset taxes otherwise payable. Net deferred tax assets as of December 31, 2007 were $42.8 million and are net of a valuation allowance of $26.8 million and deferred tax liabilities of $14.9 million. We have concluded that our current level of valuation allowance of $26.8 million continues to be appropriate, as discussed in Note 17 of the notes to our consolidated financial statements.
EARNINGS (LOSS) FROM DISCONTINUED OPERATION. Earnings (loss) from discontinued operation, net of tax, reflects legal expenses associated with our asbestos related liability and adjustments thereto based on the information contained in the August 2007 actuarial study and all other available information considered by us. We recorded $3.2 million as a loss and $0.2 million as income, both net of tax, from discontinued operation for 2007 and 2006, respectively. The loss for 2007 reflects a $2.8 million pre-tax adjustment to increase our indemnity liability in line with the August 2007 actuarial study, as well as legal fees incurred in litigation, whereas the income for 2006 reflects a $3.4 million pre-tax adjustment to reduce our indemnity liability in line with the August 2006 actuarial study, partially offset by legal fees incurred in litigation in 2006. As discussed more fully in Note 20 of the notes to our consolidated financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products.
COMPARISON OF FISCAL YEARS 2006 AND 2005
SALES. Consolidated net sales for 2006 were $812 million, a decrease of $18.4 million or 2%, compared to $830.4 million in 2005. The net sales decrease was primarily due to our Temperature Control net sales decreasing by $18.1 million or 8% due to reduced demand resulting from a cooler summer than the prior year and competition from low cost foreign imports. Engine Management net sales also decreased by $3.8 million or 0.7% mainly due to higher than average customer returns. Partially offsetting the decrease, net sales in Europe increased $3.6 million.
GROSS MARGINS. Gross margins, as a percentage of consolidated net sales, increased by 2.9 percentage points to 25.3% in 2006 from 22.4% in 2005 mainly driven by Engine Management margin improvements of 4.5 percentage points. The margin increase in our Engine Management Segment reflected a combination of price increases and improved procurement and manufacturing costs. Temperature Control and Europe margin percentages remained stable due to improved production and procurement costs offsetting the effect of inflation.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative (SG&A) expenses increased $1.5 million to $168.1 million or 20.7% of consolidated net sales in 2006, compared to $166.6 million or 20.1% of consolidated net sales in 2005. The increase in SG&A expenses was driven mainly by increases in marketing and general and administrative expenses, partially offset by a reduction of $3.4 million in draft expenses as we terminated our accounts receivable draft program in the fourth quarter of 2005 and a reduction in distribution costs as a result of lower sales. The increase in marketing expenses is due to an increase in promotion spending and temporary overlapping costs as we transitioned from an outsourced to an internal returns processing center. The increase in general administrative expenses was mainly due to our ongoing efforts to fully integrate our operations into a common enterprise resource planning system.
RESTRUCTURING AND INTEGRATION EXPENSES. Restructuring expenses, which include restructuring and integration expenses, decreased to $1.9 million for 2006, compared to $5.3 million in 2005. The 2006 expenses related mostly to severance costs related to the move of our European and Puerto Rican production operations and the divestiture of a production unit of our Temperature Control Segment. Expenses in 2005 were primarily for a non-cash asset impairment charge of $3.3 million in our Temperature Control business related to a strategic decision to outsource products previously manufactured, while the remainder was mostly related to the DEM restructuring, which has since been substantially completed.
OPERATING INCOME (EXPENSE), NET. Operating income increased by $21.2 million to $35.3 million in 2006, compared to $14.1 million in 2005. The increase was primarily due to higher gross profit from Engine Management's 4.5 point improvement in gross profit percentage, lower integration expenses and the elimination of the accounts receivable draft program fees, partially offset by higher SG&A expenses.
OTHER INCOME, NET. Other income, net decreased $3 million in 2006 compared to 2005, due to a $3.2 million loss incurred on the sale of a majority portion of our European Temperature Control business, partially offset by higher foreign exchange gains. A benefit in 2005 was from a discount of $1.3 million on a debt reduction not repeated in 2006.
INTEREST EXPENSE. Interest expense increased by $2.2 million for 2006 compared to 2005 due to higher average borrowings and higher borrowing costs. The increase in average borrowings is due to the termination of our accounts receivable draft program in the fourth quarter of 2005, as well as the funding of the repurchase of our common stock held by Dana for $11.9 million at that time.
INCOME TAX PROVISION. The income tax provision was $6.5 million for 2006 compared to $1.4 million for 2005. The increase was primarily due to higher pre-tax earnings and a higher effective rate for 2006 which was 41.5%. We had an increase in our on-going tax rate primarily due to the January 1, 2006 expiration of Section 936 of the Internal Revenue Code with regard to our Puerto Rico operations which are taxed at the U.S. statutory rate starting in 2006. This increase was offset in 2006 by the one-time impact of our Puerto Rico deferred tax assets becoming recoverable at the higher US tax rate. Our taxes were also higher as a result of recording a valuation allowance for the capital loss on disposition of our European Temperature Control business which is not expected to be recoverable in the future. Net deferred tax assets as of December 31, 2006 were $38.4 million and are net of a valuation allowance of $28 million and deferred tax liabilities of $15.7 million. The tax expense of $1.4 million in 2005 on losses of $0.3 million was mostly due to the recording of discrete items, namely with regards to a reduced statutory rate applicable to opening deferred tax assets and a larger increase to the tax valuation allowance.
EARNINGS (LOSS) FROM DISCONTINUED OPERATION. Earnings (loss) from discontinued operation, net of tax, reflects legal expenses associated with our asbestos related liability and adjustments thereto based on the information contained in the actuarial study and all other available information considered by us. We recorded $0.2 million as income and $1.8 million as a loss, both net of tax, from discontinued operation for 2006 and 2005, respectively. The income for 2006 includes a $3.4 million pre-tax adjustment to reduce our indemnity liability in line with our most recent actuarial valuation report, partially offset by legal fees incurred in litigation, whereas the loss for 2005 reflects only legal expenses. As discussed more fully in Note 20 of the notes to our consolidated financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products.
LIQUIDITY AND CAPITAL RESOURCES
OPERATING ACTIVITIES. During 2007, cash used by operations amounted to $7.8 million, compared to cash provided by operations of $33.7 million in 2006. The $41.5 million decrease in operating cash flow is primarily due to an increase in inventories in order to bridge our requirements while we proceed with our facility integration efforts, an increase in accounts receivable reflecting an expansion in days sales outstanding from 119 to 127, and lower net earnings.
During 2006, cash provided by operations amounted to $33.7 million, compared to cash used by operations of $2.2 million in 2005. The year over year improvement of $35.9 million is primarily attributable to a lower increase in accounts receivable of $13.8 million and increased net earnings. The greater increase in accounts receivable in 2005 was due to the end of the accounts receivable draft program in 2005 compared to 2004 when our major accounts were under the draft program. The lower increase in accounts receivable in 2006 reflects a stabilized situation with no draft program in place. Partially offsetting these improvements was a slight increase in inventory compared to a decrease of $10 million in 2005, driven by our need to provide a bridge of inventory as we undergo a rationalization of our production facilities.
INVESTING ACTIVITIES. Cash used in investing activities was $13.4 million in 2007, compared to $6 million in 2006. The increase of $7.4 million was primarily due to an increase in capital expenditures of $3.9 million in 2007 and the acquisition in December 2007 of a European wire and cable business for $3.8 million, offset in part by proceeds of $4.2 million from the sale of our Fort Worth, Texas manufacturing facility. During 2006, we received $3.1 million in proceeds from the sale of a majority portion of our European Temperature Control business.
Cash used in investing activities was $6 million in 2006, compared to $7.8 million in 2005. The decrease of $1.8 million was primarily due to proceeds from the sale of a majority portion of our European Temperature Control business in 2006.
FINANCING ACTIVITIES. Cash provided by financing activities was $9.3 million in 2007, compared to cash used in financing activities of $20.2 million in 2006. The increase is primarily due to higher borrowings, an increase in cash overdrafts, and proceeds received from the exercise of employee stock options, partially offset by a $5 million purchase of treasury stock, essentially completing our share buyback program.
Cash used in financing activities was $20.2 million in 2006, compared to cash provided by financing activities of $9.7 million in 2005. The change is primarily due to repayments made on our line of credit in 2006 due to an improvement in cash provided by operating activities and a decrease in our bank overdraft balances. The 2005 increase to our line of credit was driven by the settlement of the note held by Dana and the repurchase of the common stock held by Dana, which note and common stock were originally issued to Dana in connection with our acquisition of Dana's engine management business.
In March 2007, we entered into a Second Amended and Restated Credit Agreement with General Electric Capital Corporation, as agent, and a syndicate of lenders for a secured revolving credit facility. This restated credit agreement replaces our prior credit facility with General Electric Capital Corporation, which prior credit facility provided for a $305 million credit facility and which was to expire in 2008. The restated credit agreement provides for a line of credit of up to $275 million (inclusive of the Canadian term loan described below) and expires in 2012. The restated credit agreement also provides a $50 million accordion feature, which would allow us to expand the facility. Direct borrowings under the restated credit agreement bear interest at the LIBOR rate plus the applicable margin (as defined), or floating at the index rate plus the applicable margin, at our option. The interest rate may vary depending upon our borrowing availability. The restated credit agreement is guaranteed by our same subsidiaries and secured by our same assets as the prior $305 million credit facility.
Borrowings under the restated credit agreement are collateralized by substantially all of our assets, including accounts receivable, inventory and fixed assets, and those of certain of our subsidiaries. After taking into account outstanding borrowings under the restated credit agreement, there was an additional $80.3 million available for us to borrow pursuant to the formula at December 31, 2007. At December 31, 2007, the interest rate on our restated credit agreement was 6.4%, and at December 31, 2006, the interest rate on our prior credit agreement was 7.8%. Outstanding borrowings under the restated credit agreement (inclusive of the Canadian term loan described below), which are classified as current liabilities, were $148.7 million and $133.3 million at December 31, 2007 and December 31, 2006, respectively.
At any time our borrowing availability in the aggregate is less than $30 million and until such time that we have maintained an average borrowing availability in the aggregate of $30 million or greater for a continuous period of 90 days, the terms of our restated credit agreement provide for, among other provisions, financial covenants requiring us, on a consolidated basis, (1) to maintain specified levels of fixed charge coverage at the end of each fiscal quarter (rolling twelve months), and (2) to limit capital expenditure levels. As of December 31, 2007, we were not subject to these covenants. Availability under our restated credit agreement is based on a formula of eligible accounts receivable, eligible inventory and eligible fixed assets. In addition, the restated credit agreement provides that, beginning on January 15, 2008 and on a quarterly basis thereafter, $15 million of our borrowing availability shall be reserved for the repayment, repurchase or redemption, as the case may be, of the aggregate outstanding amount of our convertible debentures. Our restated credit agreement also permits dividends and distributions by us provided specific conditions are met.
Our profitability and working capital requirements are seasonal due to the sales mix of Temperature Control products. Our working capital requirements usually peak near the end of the second quarter, as the inventory build-up of air conditioning products is converted to sales and payments on the receivables associated with such sales begin to be received. These increased working capital requirements are funded by borrowings from our lines of credit. We anticipate that our present sources of funds will continue to be adequate to meet our near term needs.
In March 2007, we amended our credit agreement with GE Canada Finance Holding Company, for itself and as agent for the lenders. This credit agreement amends our existing $7 million credit agreement which was to expire in 2008. The amended credit agreement provides for a line of credit of up to $12 million, of which $7 million is currently outstanding and which amount is part of the $275 million available for borrowing under our restated credit agreement with General Electric Capital Corporation (described above). The amended credit agreement is guaranteed and secured by us and certain of our wholly-owned subsidiaries and expires in 2012. Direct borrowings under the amended credit agreement bear interest at the same rate as our restated credit agreement with General Electric Capital Corporation (described above).
Our European subsidiary has revolving credit facilities which, at December 31, 2007, provide for a line of credit up to $8.8 million. The amount of short-term bank borrowings outstanding under these facilities was $8 million on December 31, 2007 and $6.5 million on December 31, 2006. The weighted average interest rate on these borrowings on December 31, 2007 and December 31, 2006 was 6.7% and 6.3 %, respectively.
In June 2003, we borrowed $10 million under a mortgage loan agreement. The loan was payable in equal monthly installments. The loan had interest at a fixed rate of 5.50% maturing in July 2018. The mortgage loan was secured by our Long Island City property. On March 12, 2008, in connection with the closing of the sale of our Long Island City property the mortgage loan was defeased. For further information on the sale of the building and the defeasance of the mortgage loan, see Notes 4, 10 and 22 of the notes to our consolidated financial statements.
In October 2003, we entered into an interest rate swap agreement with a notional amount of $25 million that matured in October 2006. Under this agreement, we received a floating rate based on the LIBOR interest rate, and paid a fixed rate of 2.45% on the notional amount of $25 million. We have not entered into a new swap agreement to replace this agreement.
In July 1999, we issued convertible debentures, payable semi-annually, in the aggregate principal amount of $90 million. The debentures carry an interest rate of 6.75%, payable semi-annually. The debentures are convertible into 2,796,120 shares of our common stock, and mature on July 15, 2009.
In August 2007, our Board of Directors authorized a $3.3 million increase in our stock repurchase program. The program is in addition to our existing program authorizing $1.7 million of stock repurchases. During 2007, we repurchased 541,750 shares of our common stock, essentially completing the entire $5 million repurchase program. No shares of our common stock were repurchased in the comparable 2006 period.
CRITICAL ACCOUNTING POLICIES
We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout "Management's Discussion and Analysis of Financial Condition and Results of Operations," where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 of the notes to our consolidated financial statements. You should be aware that preparation of our consolidated annual and quarterly financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. We can give no assurance that actual results will not differ from those estimates.
REVENUE RECOGNITION. We derive our revenue primarily from sales of replacement parts for motor vehicles from both our Engine Management and Temperature Control Segments. We recognize revenues when products are shipped and title has been transferred to a customer, the sales price is fixed and determinable, and collection is reasonably assured. For some of our sales of remanufactured products, we also charge our customers a deposit for the return of a used core component which we can use in our future remanufacturing activities. Such deposit is not recognized as revenue but rather carried as a core liability. The liability is extinguished when a core is actually returned to us. We estimate and record provisions for cash discounts, quantity rebates, sales returns and warranties in the period the sale is recorded, based upon our prior experience and current trends. As described below, significant management judgments and estimates must be made and used in estimating sales returns and allowances relating to revenue recognized in any accounting period.
INVENTORY VALUATION. Inventories are valued at the lower of cost or market. Cost is determined on the first-in, first-out basis. Where appropriate, standard cost systems are utilized for purposes of determining cost; the standards are adjusted as necessary to ensure they approximate actual costs. Estimates of lower of cost or market value of inventory are determined at the reporting unit level and are based upon the inventory at that location taken as a whole. These estimates are based upon current economic conditions, historical sales quantities and patterns and, in some cases, the specific risk of loss on specifically identified inventories.
We also evaluate inventories on a regular basis to identify inventory on hand that may be obsolete or in excess of current and future projected market demand. For inventory deemed to be obsolete, we provide a reserve on the full value of the inventory. Inventory that is in excess of current and projected use is reduced by an allowance to a level that approximates our estimate of future demand.
We utilize cores (used parts) in our remanufacturing processes for air conditioning compressors. The production of air conditioning compressors involves the rebuilding of used cores, which we acquire generally either in outright purchases or from returns pursuant to an exchange program with customers. Under such exchange programs, we reduce our inventory, through a charge to cost of sales, when we sell a finished good compressor, and put back to inventory at standard cost through a credit to cost of sales the used core exchanged at the time it is eventually received from the customer.
SALES RETURNS AND OTHER ALLOWANCES AND ALLOWANCE FOR DOUBTFUL ACCOUNTS. Management must make estimates of potential future product returns related to current period product revenue. Management analyzes historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. At December 31, 2007, the allowance for sales returns was $23.1 million. Similarly, management must make estimates of the uncollectability of our accounts receivables. Management specifically analyzes accounts receivable and analyzes historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. At December 31, 2007, the allowance for doubtful accounts and for discounts was $9 million.
NEW CUSTOMER ACQUISITION COSTS. New customer acquisition costs refer to arrangements pursuant to which we incur change-over costs to induce a new customer to switch from a competitor's brand. In addition, change-over costs include the costs related to removing the new customer's inventory and replacing it with Standard Motor Products inventory commonly referred to as a stocklift. New customer acquisition costs are recorded as a reduction to revenue when incurred.
ACCOUNTING FOR INCOME TAXES. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that it is more likely than not that the deferred tax assets will not be recovered, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase or decrease this allowance in a period, we must include an expense or recovery, respectively, within the tax provision in the statement of operations.
Significant management judgment is required in determining the adequacy of our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. At December 31, 2007, we had a valuation allowance of $26.8 million, due to uncertainties related to our ability to utilize some of our deferred tax assets. The assessment of the adequacy of our valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable.
In the event that actual results differ from these estimates, or we adjust these estimates in future periods for current trends or expected changes in our estimating assumptions, we may need to modify the level of valuation allowance which could materially impact our business, financial condition and results of operations.
In accordance with the provisions of SFAS Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No.109" ("FIN 48"), we recognize in our financial statements only those tax positions that meet the more-likely-than-not-reco gnition threshold. We establish tax reserves for uncertain tax positions that do not meet this threshold. Interest and penalties associated with income tax matters are included in the provision for income taxes in our consolidated statement of operations.
VALUATION OF LONG-LIVED AND INTANGIBLE ASSETS AND GOODWILL. We assess the impairment of identifiable intangibles and long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. With respect to goodwill, we test for impairment at least annually in the fourth quarter of each year as part of our annual budgeting process. Factors we consider important, which could trigger an impairment review, include the following: (a) significant underperformance relative to expected historical or projected future operating results; (b) significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and (c) significant negative industry or economic trends. We review the fair values of each of our reporting units using the discounted cash flows method and market multiples.
In the event our planning assumptions were modified resulting in impairment to our assets, we would be required to include an expense in our statement of operations, which could materially impact our business, financial condition and results of operations.
RETIREMENT AND POST-RETIREMENT MEDICAL BENEFITS. Each year, we calculate the costs of providing retiree benefits under the provisions of SFAS 87, "Employers' Accounting for Pensions" and SFAS 106, "Employers' Accounting for Post-Retirement Benefits Other than Pensions". The key assumptions used in making these calculations are the eligibility criteria of participants, the discount rate used to value the future obligation, expected return on plan assets and health care cost trend rates. We select discount rates commensurate with current market interest rates on high-quality, fixed-rate debt securities. The expected return on assets is based on our current review of the long-term returns on assets held by the plans, which is influenced by historical averages. The medical cost trend rate is based on our actual medical claims and future projections of medical cost trends. Under SFAS Staff Position No.106-2 ("FSP 106-2"), "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003," we have concluded that our post-retirement plan is actuarially equivalent to the Medicare Part D benefit and accordingly we recognize subsidies from the federal government in the measurement of the accumulated post-retirement benefit obligation pursuant to the requirements of SFAS 106, "Employers' Accounting for Post-Retirement Benefits Other Than Pensions." In September 2005, in accordance with SFAS No. 106, "Employers' Accounting For Post-Retirement Benefits Other Than Pensions", we recognized a curtailment gain of $3.8 million for our post-retirement plan related to changes made to our plan, namely reducing the number of participants eligible for our plan by making all active participants hired after 1995 no longer eligible.
ENVIRONMENTAL RESERVES. We are subject to various U.S. federal and state and local environmental laws and regulations and are involved in certain environmental remediation efforts. We estimate and accrue our liabilities resulting from such matters based upon a variety of factors including the assessments of environmental engineers and consultants who provide estimates of potential liabilities and remediation costs. Such estimates may or may not include potential recoveries from insurers or other third parties and are not discounted to reflect the time value of money due to the uncertainty in estimating the timing of the expenditures, which may extend over several years.
ASBESTOS RESERVE. We are responsible for certain future liabilities relating to alleged exposure to asbestos-containing products. In accordance with our accounting policy, our most recent actuarial study as of August 31, 2007 estimated an undiscounted liability for settlement payments, excluding legal costs, ranging from $23.8 million to $55.2 million for the period through 2050. As a result, in 2007 an incremental $2.8 million provision in our discontinued operation was added to the asbestos accrual increasing the reserve to approximately $23.8 million as of that date. Based on the information contained in the actuarial study and all other available information considered by us, we concluded that no amount within the range of settlement payments was more likely than any other and, therefore, recorded the low end of the range as the liability associated with future settlement payments through 2050 in our consolidated financial statements. In addition, according to the updated study, legal costs, which are expensed as incurred and reported in earnings (loss) from discontinued operation, are estimated to range from $18.7 million to $32.6 million during the same period. We plan to perform an annual actuarial analysis during the third quarter of each year for the foreseeable future. Based on this analysis and all other available information, we will continue to reassess the recorded liability and, if deemed necessary, record an adjustment to the reserve, which will be reflected as a loss or gain from discontinued operation.
OTHER LOSS RESERVES. We have other loss exposures, such as environmental claims, product liability and litigation. Establishing loss reserves for these matters requires the use of estimates and judgment of risk exposure and ultimate liability. We estimate losses using consistent and appropriate methods; however, changes to our assumptions could materially affect our recorded liabilities for loss.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS MADE PURSUANT TO THE SAFE HARBOR
PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. FORWARD-LOOKING STATEMENTS IN THIS REPORT ARE INDICATED BY WORDS SUCH AS "ANTICIPATES," "EXPECTS," "BELIEVES," "INTENDS," "PLANS," "ESTIMATES," "PROJECTS" AND SIMILAR EXPRESSIONS. THESE STATEMENTS REPRESENT OUR EXPECTATIONS BASED ON CURRENT INFORMATION AND ASSUMPTIONS AND ARE INHERENTLY SUBJECT TO RISKS AND UNCERTAINTIES. OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE WHICH ARE ANTICIPATED OR PROJECTED AS A RESULT OF CERTAIN RISKS AND UNCERTAINTIES, INCLUDING, BUT NOT LIMITED TO, ECONOMIC AND MARKET CONDITIONS; THE PERFORMANCE OF THE AFTERMARKET SECTOR; CHANGES IN BUSINESS RELATIONSHIPS WITH OUR MAJOR CUSTOMERS AND IN THE TIMING, SIZE AND CONTINUATION OF OUR CUSTOMERS' PROGRAMS; CHANGES IN THE PRODUCT MIX AND DISTRIBUTION CHANNEL MIX; THE ABILITY OF OUR CUSTOMERS TO ACHIEVE THEIR PROJECTED SALES; COMPETITIVE PRODUCT AND PRICING PRESSURES; INCREASES IN PRODUCTION OR MATERIAL COSTS THAT CANNOT BE RECOUPED IN PRODUCT PRICING; SUCCESSFUL INTEGRATION OF ACQUIRED BUSINESSES; PRODUCT AND ENVIRONMENTAL LIABILITY MATTERS (INCLUDING, WITHOUT LIMITATION, THOSE RELATED TO ASBESTOS-RELATED CONTINGENT LIABILITIES OR ENVIRONMENTAL REMEDIATION LIABILITIES); AS WELL AS OTHER RISKS AND UNCERTAINTIES, SUCH AS THOSE DESCRIBED
Okay. Good morning. I see there are some people here who know us very well, and some people who, I guess, don't know us at all. I don't know how much detail to go into. I will probably split the difference and satisfy no one. But I'll do what I can. All right. This is a forward-looking statement. I think I can skip over that. Okay. Myself, Jim Burke, will keep moving forward. Here we go.
All right. I want to give a short synopsis of the background. As I say, I'm probably going to split the difference and satisfy nobody. But the key point to remember, is that within this industry the automotive aftermarket is a big and stable industry. We are a major player. That's a key fact to keep in mind.
We go to market with two product lines: Engine Management and Temperature Control. We are number one in each. We have a greater than 50% market share in each. And we enhanced our position in Engine Management about four years ago, when we made our major leap forward. We acquired our biggest competitor, Dana Engine Management, which, before that was actually our biggest single, individual competitor. It added about 60% to our Engine Management business.
There are large benefits to being number one. Obviously, you have economies of scale, but even more important, it gives you the ability to stand up with your customers, who themselves are growing larger and more powerful. We go to market with a broad array of products. If you're going to be in this business, you got to have a gigantic product line. You have to provide within your field every part for every car, domestic and import, all the way back 30 years ago to 2 years ago.
Well, you see here some of our products. The one on the upper right is the point and condenser, that hasn't been on a car since 1976, and we still sell over a million of them--a slow-moving industry. And on the bottom, you see some of the newer products, electronic. It's a wide variety of products. Now, this broad line gives you an edge. It gives you an edge over a short line distributor who tries to compete on price. You can command a price premium, because they need the coverage. It's also a difficult entry business.
So, someone who had a standing start and come up with 30,000 parts numbers is essentially inconceivable. So, there have been no new entries as a full line vendor for many, many years. And we do have, if you just look at the different kinds of products, a wide variety of manufacturing skills, which bodes well for the future as we go into different products in the future.
Our [technical difficulty] air conditioning, it's not quite as broad. We're talking only about 8000 SKUs, compared to the 30,000 for Engine Management. The key product is on the right-hand corner thereâ€¦the compressor, which is the heart of the air conditioning part of your car. We rebuild them. We take the old one, we get them back, we take them apart, we clean them, we put in new parts where needed, and send them out again. We are the leading re-builder in the world, really, by a lot. We rebuild roughly 600,000 of these a year.
Now lately, this business, and specifically the compressor business, has been affected with imports coming in from China. This is the one part of our business where China has had a significant effect. Selling new ones at roughly the same price we sell a rebuild and give a consumer a choice of rather having new versus the rebuild is cheaper. Pardon?
Unidentified Audience Member
So far, we haven't seen a problem. Most of the defects in this line, by the way, are not from the products. They are from poor installation. So it gets hard to tell what the true quality of the product really is. But, unfortunately, they're not covered with lead paint. If they were covered with lead paint, that would be helpful, but they're not.
So, our strategy is, therefore, to relocate our rebuilding operation currently just outside of Dallas, we're in the process of relocating it to Reynosa, Mexico. This is a labor-intensive part, so, obviously, labor-saving. We believe we can save roughly $7-$10 a unit in Mexico, versus Texas. Our goal will be, therefore, to sell a rebuild unit at roughly 25%-30% below the new one coming in from China. And we think we can do that, and do that profitably. And we're about half way moved to Mexico by the year 2008.
Unidentified Audience Member
We hope to be able to maintain our margins today, once we are fully there in Mexico, okay, and sell it at a 25% lower than the new one. That's the main issue with that. Looking at the industry, the demographics give you a mixed data. So, it's a huge industry. It's, essentially, a stable industry. It doesn't change much, year-to-year.
Some positive factors--the average age of the car is rising, the cars are lasting longer. This is a good thing for us, because we sell parts for old cars. So the more old cars, this is good. They refer to the sweet spot as 6-10 years old. That's a prime replace. If you guys own cars that are 6-10 years old, that's when we sell you parts. And that so-called sweet spot is also rising Okay.
Now, some facts. There are, and I don't have choice for, miles driven typically went up about a point or two a year. It's been growing up a point or two a year for us. We haven't seen the '07 numbers--they're not out yet, but we believe from what we see, that the price of oil, which I'm sure will be one of your questions, has not caused a decrease, but the increase has slowed down, so that maybe instead of 1% or 2%, it maybe up a half a point. But people are still driving; they'll have to get to work. So miles driven has not suffered--just a little bit, not much.
And with the newer products, the unit prices are higher. So those are all the favorable trends, balanced by the parts are, frankly, made better, the cycle of the parts are longer Some of the new technology you're going from wearing parts--the points and condensers were wearing--they rubbed against each other, they had to be replaced. Now you have electronics, doesn't move. It still needs to be replaced, but much less frequently.
The line of moving products here. We calculate, and it's improving, so that they tend to balance out. And our forecast, and that has been so for the last few years, is that in dollars -- not in units, we thought them as a unit -- and dollars is going to be, roughly, flat. And that is our plan, and our estimate going forward. Therefore, to grow, you got to either get in new businesses or get new customers--because your current customers are roughly flat. And if you see that, if you follow the industry, you see the big guys are all 1% or 2%, one way or the other, up or down. So it's basically a flat industry in dollars.
Okay. There are three [technical difficulty] parts in the market. One in the left is still the major part of the business. We refer to it as the traditional channel. It is the one that winds up at the independent repair shop. It takes three steps to get there because of all of the inventory. There are huge players here, the biggest one is NAPA, Genuine Parts. They have huge national chain. The second largest is a private company, we refer to as CARQUEST, and then there are a host of independents. We are very, very strong in that channel, still the biggest channel. We sell, essentially, everybody, I just said.
The central column, the retailers, there are five big retailers. They are all public. They cater to the do-it-yourself. They are AutoZone, Pep Boys, O'Reilly, Advance, CSK, all public companies. Okay. They tend to be for older cars, less affluent customer. We do well with this chain as well. We are the major supplier to four of them and a minor supplier to AutoZone.
The channel on the right, this is through the car dealer. This is where you bring your car to the car dealer to get it fixed. We do very little in this channel. It should be about 20% of the business. We do very little and this we see as our growth opportunity.
Here's the chart. It shows that our traditional, the retail, others -- sales other. OE/OES is only 7% of our business. If we were to get to 20%, which is the national average, we would gain about $150 million in sales, it will get us to 20%.
Now, the timing for this is good. Delphi, the General Motors supplier, as you all know, closing down 20 of their 29 factories suddenly. They need a home for these products. They have to supply these replacement parts through the car dealer. Visteon is likely to follow. Some of the large OE houses, OE suppliers are looking to exit the service business. They hate the service business. They're not paying in that today. They want to be able to concentrate on new car production and the service business because, they have to carry their parts for another 10 years, they hate it.
Well, that's our business. We're going after it aggressively. We have picked up about $25 million of new business. We haven't hit on numbers yet. It will mostly hit in '08. But these are signed agreements, and we are looking for more. And we think this is a potential area for excellent growth, naturally the growth rate.
All right. Just quickly, and I will go through the numbers, there are some recent things. I mentioned the -- I'm sorry, yeah..
Unidentified Audience Member
The manufacturers hate the service business.
Unidentified Audience Member
Do the car dealers hate the service business?
No. The car dealers like the service business.
Unidentified Audience Member
They like the service business.
They make a lot of money in the service business.
Unidentified Audience Member
So how does that play out?
Well, it plays out that the only guy would like to just sell the new production, but he is selling 100,000 at a time. (inaudible), sets up his machines and run through months on him. Now, he has to supply the next 10 years. He hates to supply the next 10 years, but he has to. He has an agreement to supply the next 10 years, because they need the parts. They love if we can get this out of their hand. One of them said, the replacement business; the service business, is 1% of my volume and 50% of my whole. Okay. But they have to supply the car dealers. The car dealer needs that business and loves that business. Does that answer your question?
Unidentified Audience Member
Unidentified Audience Member
They can't get out. What they would like to do, is going back to manufacturer. But ideally, the manufacturer would like to have someone like us take over that job through them.
Unidentified Audience Member
I don't know if that answers your question, but it seems okay. So that is, in fact, what's transpired.
Okay. I mentioned we acquired Echlin roughly four years ago. Biggest thing we ever did at the company--that had nine facilities, we closed seven of them. We moved them into our locations. A lot of work, quite costly, there were a lot of inventory write-downs, there were a lot of learning curve issues, lots of issues. Our numbers suffered. Our gross margin went from, historically, in the 28% range, it hit a low--I think about three years ago, of 20%. The numbers suffered dramatically.
We've been digging ourselves out of the hole. Jim will go over the numbers. We now broke 26%, and we're looking to get back to that 28%-29% number. The best news is, we kept every single customer, and they had some really good ones. We kept NAPA, O'Reilly, CSK, Pep Boys. This was their customer list; kept them all. But that was very good performance; we were very pleased about that.
Second event, we're in the process of relocating two of our oldest facilities: one here in Long IslandCity, some of you may have visited it, and another one in Puerto Rico. Long Island City just got too expensive; Puerto Rico get lots of 936 tax benefits. Post jobs, roughly 400 in total, being transferred mostly to Mexico.
One-time costs, some of which we took this year, some of which we will take next year, of roughly $9 million, once fully located, and they will be fully located by next year--mid third or fourth quarter next year-with the annualized savings of $9 million, which we'll mostly get in the year '09; some of it '08, all of it in '09.
Unidentified Audience Member
Well, they are reactive with the Four Seasons. This is not (inaudible) when I said the reactive had to do with the Four Seasons, which, coincidently, is also going to Mexico. This is Engine Management, but we do not have a Chinese pressure. We do not that kind of pricing pressure. So most of the savings will hit the bottom line. I may have jumped at your questionâ€¦was that your question?
Unidentified Audience Member
Yeah, it's a good question. We do not see this, I can't say zero, but it will be much less of a factor in Engine Management than it is in Temperature. And the difference is Temperature Control is a more consolidated line. Those compressors are half the business and there may be 10 models of compressors. So it's a more consolidated product. The volumes per SKU are much higher and it's a relatively simple product to make. That perfectly lends itself to China. This is a broad array of products. There is not a huge amount of volume in any one, and there are highly technical specifications.
Unidentified Audience Member
Yes. There are some others in the temp side as well. They are, frankly, we're getting it from China as well, and they go along for the ride. The board game is the compressors. And there are products in this line, as well, and we buy some products in Engine Management from China, as well. But you don't have that huge visible impact that you had in the compressors--the air conditioning compressors. Okay.
That's Engine Management. Here we've talked about this. We reduced prices in '07. We hit our numbers in '07. We hit our gross margin in '07, which you will see. Frankly, we're going to have some reductions in '08. Hopefully, that will be the end of it. And we'll start to come out of the hole as we relocate the compressors to Mexico. And our goal is to maintain the current margins and perhaps even improve them in the future, because we'll not only be relocating into Mexico, but we're looking to hit some overhead costs as well. This is a more price competitive business than the Engine.
Okay. The third one is Europe, which is a big success story. We went from a loss to a profit and we've done it really by doing all the right things. So it's gratifying. You do something right and it works. We exited the business. We exited the air conditioning business in Europe. We just weren't big enough to be effective. We closed down the factory in UK, which was high cost. And we opened up what I think will be a very excellent operation in Eastern Poland, which is a low cost; the wages in the Eastern Poland roughly the same as Mexico.
And with the part of the EUC, you can sell throughout Europe without the trade barriers, and as opposed to Mexico. There's tremendous amount of skill workers available, engineers down to unskilled labors, all readily available. We see this as a place to grow in. So we are pleased with that.
All right. That's again a very quick summary of the company. I'll let Jim now go over some numbers, then I'll wrap it up and then we'll open up for questions.
Hi, good morning. I'm going to hit the highlights from the recent third quarter filing and cover the three months, nine months and the key drivers in our business. Looking at the recent quarter against the three months '06, you can see net sales were up $2.4 million, a little more than 1%.
However, as Larry pointed out, we divested a business in December of '06 in Europe: our Temperature Control business. So, the third quarter of '06 included $3.3 million of sales from that business. So excluding that, we were actually up $5.7 million, or roughly 2.9%. Sales were up in all segments.
Looking at the gross profit percent, you can see that we were up 2.3 points, generating an incremental $5.3 million. This was primarily from the Engine Management business, which was up a full 4 points within the three-month period, and I have a slide on that coming up, also.
I've broken out operating profit excluding restructuring expenses. As Larry pointed out, we're going to be incurring $9 million over the '07-'08 period, and we want to isolate that. So looking at operating profit before restructuring expenses, we were up $2.5 million, or 1.1 points. The restructuring expenses, again, in this period here was inclusive of Puerto Rico, and we sold the building in Fort Worth, part of our Temperature Control business, generated $3.5 million from the sale of that building, and incurred some expenses, as we relocated into one of our other facilities.
As you drop down, look at the diluted earnings per share, again, we excluded the restructuring expenses, but we also excluded the gain on the Fort Worth building. We had a gain of 800,000 something there. So the results were $0.30 against $0.16 for the prior quarter.
Now, Standard Motors has a discontinued operation. Again, we were just trying to hit highlights here, pick a point out for you. That was a break business that we sold back in '98. We have recurring [specific] expenses on the liability on our books in the current quarter.
Once a year, we have an independent actuarial valuation on that. In the current quarter--we do it the third quarter of every year--we incurred a $2.8 million adjustment to that increase in the reserve, the pre-tax adjustment. That basically offset the favorable adjustment that the actuaries calculated last year.
This time last year, we took a favorable $3.2 million. If you look at the two combined, that basically was a net adjustment in there. The total reserve is approximately $25 million on our books, which is for a period out over the next 50 years.
Looking at the nine-month numbers, you can see our sales were down roughly $20 million, but $11 million of that was related to the nine months of Temperature Control in Europe at $11.7 million, or so. So, excluding that, sales were up $8.7 million or 1.4%.
However, the gross profit, even on the reduced sales, was up 1.4 points, or up $3.9 million. Again, operating profit excluding the restructuring expenses that was up almost $2 million over 0.5 points. Inclusive in there were nice teams from both Engine Management in our European business.
Temperature Control, as Larry has pointed out, had contracted sales on lower margins, related to the Chinese imports. However, we feel and we've reviewed the plans of relocating that business that we know to reduce costs and improve the profitability. Again, on a nine-month basis, the diluted earnings per share excluding the special items $0.80 against $0.61 for the nine months.
We put up a slide really to explain the Engine Management, what's happened over the gross margin. This is really the key driver in our recovery. And if you look at the 12 months so far, that's when we hit the low point at 20%. In 2006, we recovered 4.5 points to 24.6, and we're pleased with the results for 2007.
As you can see, we recovered again another 2.5 points from 24.2 to 26.7 for the nine months. Each point were $550 million in Engine Management--sales roughly adds $5.5 million--so at 26.7, with a stated goal, of looking for 28%-29% in the future. How we are going to get there? We talked about the moves from Puerto Rico and Long Island City that are going to be generating savings in that area.
Now, we talk about OES opportunities. The OES business, those come with lower gross margins, but with significantly lower SG&A expenses. So, we're sticking with the stated goal of 28% to 29%, unless we gain a significant business, but they will deliver the same operating profit margin percents.
Our balance sheet and the comparison we have up there is for September '06, and basically in line. I'll point out one area from working capital, which is the inventory. We had an $11 million increase. This again relates planned build, inventory build for the transition for the move, so that we're able to supply the customers when we shut down the plants and machining centers for a couple of months during that move.
So, we expect once the moves are complete, that we'd able to take out $15 million. One point is also within the third quarter '07, we completed our share buyback, and we bought back, roughly, 542,000 shares, or roughly $5 million.
With that, I'll turn it back over to Larry to review future initiatives. Thank you.
Well, this is just the quick summary in conclusion, then we will open it up. We're very optimistic about the future. We think we have a good story on both the topline and the bottomline. In the topline we see a large potential in this OES business, can be really a dramatic change in the company if some pf the thing will happen. So we see a good topline potential and we see a cost saving on the bottom side through the plant moves.
And then one thing, which I didn't really spend anytime talking about, but we are now, and have been for a year, engaged in sourcing material and component parts and some finished goods, mostly from the Far East. We now have a buying office in Shanghai. We have engineers on site. And we've been able to get some very nice savings, some of which have hit the P&L, some of which will hit next year.
So to me, if you combine all these things, we got the topline potential with OES, we got the bottomline savings to plant moves to low cost countries and through sourcing more to low cost countries and we have a good story. So, that's it. We're optimistic about the future and I thank you for listening. It was a very quick summary, but anything you want go ahead.