Form 10-Q
Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

x

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

For the quarterly period ended September 30, 2010

OR

 

¨

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

For the transition period from              to             

Commission file number 000-22418

ITRON, INC.

(Exact name of registrant as specified in its charter)

 

Washington   91-1011792
(State of Incorporation)   (I.R.S. Employer Identification Number)

2111 N Molter Road, Liberty Lake, Washington 99019

(509) 924-9900

(Address and telephone number of registrant’s principal executive offices)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Large accelerated filer

 

x

  

Accelerated filer

 

¨

 
 

Non-accelerated filer

 

¨  (Do not check if a smaller reporting company)

  

Smaller reporting company

 

¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of September 30, 2010 there were outstanding 40,406,002 shares of the registrant’s common stock, no par value, which is the only class of common stock of the registrant.

 

 

 


Table of Contents

 

Itron, Inc.

Table of Contents

 

         Page      

PART I: FINANCIAL INFORMATION

  

Item 1: Financial Statements (Unaudited)

  

Consolidated Statements of Operations

     2   

Consolidated Balance Sheets

     3   

Consolidated Statements of Cash Flows

     4   

Notes to Condensed Consolidated Financial Statements

     5   

Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations

     39   

Item 3: Quantitative and Qualitative Disclosures About Market Risk

     53   

Item 4: Controls and Procedures

     54   

PART II: OTHER INFORMATION

  

Item 1: Legal Proceedings

     55   

Item 1A: Risk Factors

     55   

Item 5: Other Information

     55   

Item 6: Exhibits

     55   

SIGNATURE

     56   


Table of Contents

 

PART I: FINANCIAL INFORMATION

Item 1: Financial Statements (Unaudited)

ITRON, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

 

       Three Months Ended September 30,          Nine Months Ended September 30,    
     2010      2009      2010      2009  
     (in thousands, except per share data)  

Revenues

     $ 575,968           $ 408,358           $ 1,644,708           $ 1,210,624     

Cost of revenues

     391,761           278,879           1,125,282           818,452     
                                   

Gross profit

     184,207           129,479           519,426           392,172     

Operating expenses

           

Sales and marketing

     41,197           37,669           123,708           112,569     

Product development

     34,038           31,077           100,100           93,044     

General and administrative

     30,710           26,606           97,052           84,097     

Amortization of intangible assets

     16,882           25,121           51,459           72,788     
                                   

Total operating expenses

     122,827           120,473           372,319           362,498     
                                   

Operating income

     61,380           9,006           147,107           29,674     

Other income (expense)

           

Interest income

     166           (45)          444           971     

Interest expense

     (13,328)          (20,075)          (42,216)          (53,319)    

Loss on extinguishment of debt, net

     -              (2,460)          -              (12,800)    

Other income (expense), net

     (4,423)          (4,534)          (5,440)          (9,445)    
                                   

Total other income (expense)

     (17,585)          (27,114)          (47,212)          (74,593)    
                                   

Income (loss) before income taxes

     43,795           (18,108)          99,895           (44,919)    

Income tax (provision) benefit

     (14,687)          15,146           (17,100)          37,517     
                                   

Net income (loss)

     $ 29,108           $ (2,962)          $ 82,795           $ (7,402)    
                                   

Earnings (loss) per common share-Basic

     $ 0.72           $ (0.07)          $ 2.05           $ (0.19)    
                                   

Earnings (loss) per common share-Diluted

     $ 0.71           $ (0.07)          $ 2.02           $ (0.19)    
                                   

Weighted average common shares outstanding-Basic

     40,400           40,039           40,307           38,003     

Weighted average common shares outstanding-Diluted

     40,828           40,039           40,950           38,003     

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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ITRON, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)

 

         September 30, 2010              December 31, 2009      
     (unaudited)         

ASSETS

     

Current assets

     

Cash and cash equivalents

     $ 148,114           $ 121,893     

Accounts receivable, net

     383,814           337,948     

Inventories

     225,765           170,084     

Deferred tax assets current, net

     22,965           20,762     

Other current assets

     72,371           75,229     
                 

Total current assets

     853,029           725,916     

Property, plant, and equipment, net

     302,306           318,217     

Prepaid debt fees

     5,704           8,628     

Deferred tax assets noncurrent, net

     49,612           89,932     

Other noncurrent assets

     16,298           18,117     

Intangible assets, net

     315,756           388,212     

Goodwill

     1,236,583           1,305,599     
                 

Total assets

     $ 2,779,288           $ 2,854,621     
                 

LIABILITIES AND SHAREHOLDERS’ EQUITY

     

Current liabilities

     

Accounts payable

     $ 238,095           $ 219,255     

Other current liabilities

     59,806           64,583     

Wages and benefits payable

     96,713           71,592     

Taxes payable

     22,879           14,377     

Current portion of debt

     226,246           10,871     

Current portion of warranty

     28,232           20,941     

Unearned revenue

     30,749           40,140     

Deferred tax liabilities current, net

     1,669           1,625     
                 

Total current liabilities

     704,389           443,384     

Long-term debt

     436,704           770,893     

Long-term warranty

     24,993           12,932     

Pension plan benefits

     60,013           63,040     

Deferred tax liabilities noncurrent, net

     52,128           80,695     

Other long-term obligations

     68,417           83,163     
                 

Total liabilities

     1,346,644           1,454,107     

Commitments and contingencies

     

Shareholders’ equity

     

Preferred stock

     0           0     

Common stock

     1,321,287           1,299,134     

Accumulated other comprehensive income (loss), net

     (1,688)          71,130     

Retained earnings

     113,045           30,250     
                 

Total shareholders’ equity

     1,432,644           1,400,514     
                 

Total liabilities and shareholders’ equity

     $ 2,779,288           $ 2,854,621     
                 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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ITRON, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

 

         Nine Months Ended September 30,      
     2010      2009  
     (in thousands)  

Operating activities

     

Net income (loss)

     $ 82,795           $ (7,402)    

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

     

Depreciation and amortization

     97,184           113,812     

Stock-based compensation

     14,222           13,467     

Amortization of prepaid debt fees

     4,219           6,384     

Amortization of convertible debt discount

     7,505           7,262     

Loss on extinguishment of debt, net

     -              9,960     

Deferred taxes, net

     711           (51,341)    

Other adjustments, net

     4,008           1,768     

Changes in operating assets and liabilities, net of acquisitions:

     

Accounts receivable

     (53,770)          11,608     

Inventories

     (57,698)          (4,211)    

Accounts payables, other current liabilities, and taxes payable

     38,139           (2,473)    

Wages and benefits payable

     26,799           (10,404)    

Unearned revenue

     (8,564)          9,272     

Warranty

     16,087           (5,735)    

Other operating, net

     (4,521)          (4,880)    
                 

Net cash provided by operating activities

     167,116           87,087     

Investing activities

     

Acquisitions of property, plant, and equipment

     (45,507)          (38,023)    

Business acquisitions & contingent consideration, net of cash equivalents acquired

     -              (1,317)    

Other investing, net

     5,412           4,101     
                 

Net cash used in investing activities

     (40,095)          (35,239)    

Financing activities

     

Payments on debt

     (106,524)          (236,495)    

Issuance of common stock

     7,931           165,235     

Prepaid debt fees

     (1,347)          (3,936)    

Other financing, net

     (983)          (1,309)    
                 

Net cash used in financing activities

     (100,923)          (76,505)    

Effect of foreign exchange rate changes on cash and cash equivalents

     123           4,988     
                 

Increase (decrease) in cash and cash equivalents

     26,221           (19,669)    

Cash and cash equivalents at beginning of period

     121,893           144,390     
                 

Cash and cash equivalents at end of period

     $ 148,114           $ 124,721     
                 

Non-cash transactions:

     

Property, plant, and equipment purchased but not yet paid, net

     $ (5,998)          $ 5,492     

Exchange of debt (face value) for common stock

     -              120,984     

Contingent consideration payable for previous acquisitions

     -              2,000     

Supplemental disclosure of cash flow information:

     

Cash paid during the period for:

     

Income taxes

     $ 17,447           $ 19,308     

Interest, net of amounts capitalized

     31,666           43,207     

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

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ITRON, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2010

(UNAUDITED)

In this Quarterly Report on Form 10-Q, the terms “we,” “us,” “our,” “Itron,” and the “Company” refer to Itron, Inc.

Note 1:    Summary of Significant Accounting Policies

We were incorporated in the state of Washington in 1977. We provide a portfolio of products and services to utilities for the energy and water markets throughout the world.

Financial Statement Preparation

The condensed consolidated financial statements presented in this Quarterly Report on Form 10-Q are unaudited and reflect entries necessary for the fair presentation of the Consolidated Statements of Operations for the three and nine months ended September 30, 2010 and 2009, the Consolidated Balance Sheets as of September 30, 2010 and December 31, 2009, and the Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and 2009 of Itron, Inc. and its subsidiaries. All entries required for the fair presentation of the financial statements are of a normal recurring nature, except as disclosed.

Certain information and notes normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) regarding interim results. These condensed consolidated financial statements should be read in conjunction with the 2009 audited financial statements and notes included in our Annual Report on Form 10-K for the year ended December 31, 2009, as filed with the SEC on February 25, 2010. The results of operations for the three and nine months ended September 30, 2010 are not necessarily indicative of the results expected for the full fiscal year or for any other fiscal period.

Basis of Consolidation

We consolidate all entities in which we have a greater than 50% ownership interest. We use the equity method of accounting for entities in which we have a 50% or less investment and exercise significant influence. Entities in which we have less than a 20% investment and where we do not exercise significant influence are accounted for under the cost method. We consider for consolidation any variable interest entity of which we are the primary beneficiary. At September 30, 2010, our investments in variable interest entities and noncontrolling interests were not material. Intercompany transactions and balances have been eliminated upon consolidation.

Cash and Cash Equivalents

We consider all highly liquid instruments with remaining maturities of three months or less at the date of acquisition to be cash equivalents.

Derivative Instruments

All derivative instruments, whether designated in hedging relationships or not, are recorded on the Consolidated Balance Sheets at fair value as either assets or liabilities. The components and fair values of our derivative instruments, which are primarily interest rate swaps, are determined using the fair value measurements of significant other observable inputs (Level 2), as defined by GAAP.

The net fair value of our derivative instruments may switch between a net asset and a net liability depending on market circumstances at the end of the period. We include the effect of our counterparty credit risk based on current published credit default swap rates when the net fair value of our derivative instruments are in a net asset position and the effect of our own nonperformance risk when the net fair value of our derivative instruments are in a net liability position. If the derivative is designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded as a component of other comprehensive income (loss) (OCI) and are recognized in earnings when the hedged item affects earnings. For our hedge of a net investment, the effective portion of any unrealized gain or loss from the foreign currency revaluation of the hedging instrument is reported in OCI as a net unrealized gain or loss on derivative instruments. Ineffective portions of fair

 

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value changes or the changes in fair value of derivative instruments that do not qualify for hedging activities are recognized in other income (expense) in the Consolidated Statements of Operations. We classify cash flows from our derivative programs as cash flows from operating activities in the Consolidated Statements of Cash Flows.

Derivatives are not used for trading or speculative purposes. Our derivatives are with major international financial institutions, with whom we have master netting agreements; however, our derivative positions are not disclosed on a net basis. There are no credit-risk-related contingent features within our derivative instruments. Refer to Note 7 and Note 12 for further disclosures of our derivative instruments and their impact on OCI.

Accounts Receivable and Allowance for Doubtful Accounts

Accounts receivable are recorded for invoices issued to customers in accordance with our contractual arrangements. Interest and late payment fees are minimal. Unbilled receivables are recorded when revenues are recognized upon product shipment or service delivery and invoicing occurs at a later date. The allowance for doubtful accounts is based on our historical experience of bad debts and our specific review of outstanding receivables at period-end. Accounts receivable are written-off against the allowance when we believe an account, or a portion thereof, is no longer collectible.

Inventories

Inventories are stated at the lower of cost or market using the first-in, first-out method. Cost includes raw materials and labor, plus applied direct and indirect costs.

Property, Plant, and Equipment

Property, plant, and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally thirty years for buildings and improvements and three to five years for machinery and equipment, computers and purchased software, and furniture. Leasehold improvements are capitalized and amortized over the term of the applicable lease, including renewable periods if reasonably assured, or over the useful lives, whichever is shorter. Construction in process represents capital expenditures incurred for assets not yet placed in service. Costs related to internally developed software and software purchased for internal uses are capitalized and are amortized over the estimated useful lives of the assets. Repair and maintenance costs are expensed as incurred. We have no major planned maintenance activities.

We review long-lived assets for impairment whenever events or circumstances indicate the carrying amount of an asset or asset group may not be recoverable. We have had no significant impairments of long-lived assets. Assets held for sale are classified within other current assets in the Consolidated Balance Sheets, are reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. We had no assets held for sale at September 30, 2010 or December 31, 2009.

Prepaid Debt Fees

Prepaid debt fees represent the capitalized direct costs incurred related to the issuance of debt and are recorded as noncurrent assets. These costs are amortized to interest expense over the lives of the respective borrowings, including contingent maturity or call features, using the effective interest method, or straight-line method when associated with a revolving credit facility. When debt is repaid early, the related portion of unamortized prepaid debt fees is written-off and included in interest expense.

Business Combinations

On the date of acquisition, the assets acquired, liabilities assumed, and any noncontrolling interests in the acquiree are recorded at their fair values. The acquiree results of operations are also included as of the date of acquisition in the consolidated results. Intangible assets that arise from contractual/legal rights, or are capable of being separated, as well as in-process research and development, are measured and recorded at fair value, and amortized over the estimated useful life. If practicable, assets acquired and liabilities assumed arising from contingencies are measured and recorded at fair value. If not practicable, such assets and liabilities are measured and recorded when it is probable that a gain or loss has occurred and the amount can be reasonably estimated. The residual balance of the purchase price, after fair value allocations to all identified assets and liabilities, represents goodwill. Acquisition-related costs are expensed as incurred. Restructuring costs are generally expensed in periods subsequent to the acquisition date, and changes in deferred tax asset valuation allowances and acquired income tax uncertainties, including penalties and interest, after the measurement period are recognized as a component of provision for income taxes.

 

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Goodwill and Intangible Assets

Goodwill and intangible assets have resulted from our acquisitions. We use estimates in determining and assigning the fair value of goodwill and intangible assets at acquisition, including estimates of useful lives of intangible assets, the amount and timing of related future cash flows, and fair values of the related operations. Our intangible assets have finite lives, are amortized over their estimated useful lives based on estimated discounted cash flows, and are tested for impairment when events or changes in circumstances indicate the carrying value may not be recoverable.

Goodwill is assigned to our reporting units based on the expected benefit from the synergies arising from each business combination, determined by using certain financial metrics, including the forecasted discounted cash flows associated with each reporting unit. Goodwill is tested for impairment as of October 1 of each year, or more frequently if a significant impairment indicator occurs. Determining the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions. We forecast discounted future cash flows at the reporting unit level using risk-adjusted discount rates and estimated future revenues and operating costs, which take into consideration factors such as existing backlog, expected future orders, supplier contracts, and expectations of competitive and economic environments. We also identify similar publicly traded companies and develop a correlation, referred to as a multiple, to apply to the operating results of our reporting units.

Warranty

We offer standard warranties on our hardware products and large application software products. We accrue the estimated cost of warranty claims based on historical and projected product performance trends and costs. Testing of new products in the development stage helps identify and correct potential warranty issues prior to manufacturing. Continuing quality control efforts during manufacturing reduce our exposure to warranty claims. If our quality control efforts fail to detect a fault in one of our products, we could experience an increase in warranty claims. We track warranty claims to identify potential warranty trends. If an unusual trend is noted, an additional warranty accrual may be assessed and recorded when a failure event is probable and the cost can be reasonably estimated. Management continually evaluates the sufficiency of the warranty provisions and makes adjustments when necessary. The warranty allowances may fluctuate due to changes in estimates for material, labor, and other costs we may incur to repair or replace projected product failures, and we may incur additional warranty and related expenses in the future with respect to new or established products, which could adversely affect our financial position and results of operations. The long-term warranty balance includes estimated warranty claims beyond one year. Warranty expense is classified within cost of revenues.

Contingencies

A loss contingency is recorded if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. We evaluate, among other factors, the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of the ultimate loss. Changes in these factors and related estimates could materially affect our financial position and results of operations.

Bonus and Profit Sharing

We have various employee bonus and profit sharing plans, which provide award amounts for the achievement of annual financial and nonfinancial targets. If management determines it is probable that the targets will be achieved, and the amounts can be reasonably estimated, a compensation accrual is recorded based on the proportional achievement of the financial and nonfinancial targets. Although we monitor and accrue expenses quarterly based on our progress toward the achievement of the annual targets, the actual results at the end of the year may require awards that are significantly greater or less than the estimates made in earlier quarters.

Defined Benefit Pension Plans

We sponsor both funded and unfunded non-U.S. defined benefit pension plans. We recognize a liability for the projected benefit obligation in excess of plan assets or an asset for plan assets in excess of the projected benefit obligation. We also recognize the funded status of our defined benefit pension plans on our Consolidated Balance Sheets and recognize as a component of OCI, net of tax, the actuarial gains or losses and prior service costs or credits, if any, that arise during the period but that are not recognized as components of net periodic benefit cost.

 

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Revenue Recognition

Revenues consist primarily of hardware sales, software license fees, software implementation, project management services, installation, consulting, and post-sale maintenance support.

On January 1, 2010, we adopted Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2009-13, Revenue Recognition (Topic 605) – Multiple-Deliverable Revenue Arrangements (a consensus of the FASB Emerging Issues Tax Force) and ASU 2009-14, Software (Topic 985), Certain Revenue Arrangements That Include Software Elements (a consensus of the FASB Emerging Issues Task Force) on a prospective basis for new arrangements and arrangements that are materially modified. This new guidance did not have a material impact on our financial statements for the three and nine months ended September 30, 2010, as we already had the ability to divide the deliverables within our revenue arrangements into separate units of accounting. Further, there would have been no change to the amount of revenue recognized in the year ended December 31, 2009 if arrangements prior to the adoption of ASU 2009-13 and ASU 2009-14 had been subject to the measurement requirements of this new guidance.

We allocate consideration to each deliverable in an arrangement based on its relative selling price. We determine selling price using vendor specific objective evidence (VSOE), if it exists, otherwise third-party evidence (TPE). If neither VSOE nor TPE of selling price exists for a unit of accounting, we use estimated selling price (ESP).

VSOE is generally limited to the price charged when the same or similar product is sold separately or, if applicable, the stated renewal rate in the agreement. If a product or service is seldom sold separately, it is unlikely that we can determine VSOE for the product or service. We define VSOE as a median price of recent standalone transactions that are priced within a narrow range. TPE is determined based on the prices charged by our competitors for a similar deliverable when sold separately.

For arrangements entered into or materially modified after January 1, 2010, if we are unable to establish selling price using VSOE or TPE, we will use ESP in the allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact if the product or service were sold by us on a standalone basis. Our determination of ESP involves a weighting of several factors based on the specific facts and circumstances of the arrangement. Specifically, we consider the cost to produce the deliverable, the anticipated margin on that deliverable, the selling price and profit margin for similar parts, our ongoing pricing strategy and policies (as evident in the price list established and updated by management on a regular basis), the value of any enhancements that have been built into the deliverable, and the characteristics of the varying markets in which the deliverable is sold.

We analyze the selling prices used in our allocation of arrangement consideration on an annual basis. Selling prices are analyzed on a more frequent basis if a significant change in our business necessitates a more timely analysis or if we experience significant variances in our selling prices.

Revenue arrangements with multiple deliverables are divided into separate units of accounting if the delivered item(s) have value to the customer on a standalone basis and delivery/performance of the undelivered item(s) is probable. The total arrangement consideration is allocated among the separate units of accounting based on their relative fair values and the applicable revenue recognition criteria considered for each unit of accounting. For our standard contract arrangements that combine deliverables such as hardware, meter reading system software, installation, and project management services, each deliverable is generally considered a single unit of accounting. The amount allocable to a delivered item is limited to the amount that we are entitled to collect and that is not contingent upon the delivery/performance of additional items.

Revenues are recognized when (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the sales price is fixed or determinable, and (4) collectability is reasonably assured. Hardware revenues are generally recognized at the time of shipment, receipt by customer, or, if applicable, upon completion of customer acceptance provisions.

For multiple element software arrangements that do not include hardware, revenue recognition is dependent upon the availability of VSOE for fair value for each of the elements. The lack of VSOE, or the existence of extended payment terms or other inherent risks, may affect the timing of revenue recognition for software arrangements.

 

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We primarily enter into two types of multiple deliverable arrangements, which may include any combination of hardware and associated software and services.

Arrangements that do not include the deployment of our OpenWay® technology are recognized as follows:

 

   

Revenue from hardware shipments is recognized upon delivery once title and risk of loss pass to the customer.

 

   

If implementation services are essential to the functionality of the associated software, software and implementation revenues are recognized using either the percentage-of-completion methodology of contract accounting if project costs can be estimated, or the completed contract methodology if project costs cannot be reliably estimated.

Arrangements to deploy our OpenWay technology are recognized as follows:

 

   

Revenue from hardware shipments is recognized upon delivery once title and risk of loss pass to the customer.

 

   

Revenue from associated software and services is recognized using the units-of-delivery method of contract accounting. This methodology often results in the deferral of costs and revenues as professional services and software implementation typically commence prior to deployment of hardware.

In all cases, hardware and software post-sale maintenance support fees are recognized ratably over the life of the related service contract.

Shipping and handling costs and incidental expenses billed to customers are recorded as revenue, with the associated cost charged to cost of revenues. We record sales, use, and value added taxes billed to our customers on a net basis.

Unearned revenue is recorded when a customer pays for products or services, but the criteria for revenue recognition have not been met as of the balance sheet date. Unearned revenues of $36.6 million and $45.4 million at September 30, 2010 and December 31, 2009 related primarily to professional services and software associated with our OpenWay contracts, extended warranty, and prepaid post contract support. Deferred cost is recorded for products or services for which ownership (typically defined as title and risk of loss) has transferred to the customer, but the criteria for revenue recognition have not been met as of the balance sheet date. Deferred costs were $10.0 million and $19.7 million at September 30, 2010 and December 31, 2009 and are recorded within other assets in the Consolidated Balance Sheets.

Product and Software Development Costs

Product and software development costs primarily include employee compensation and third party contracting fees. For software we develop to be marketed or sold, we capitalize development costs after technological feasibility is established. Due to the relatively short period of time between technological feasibility and the completion of product and software development, and the immaterial nature of these costs, we generally do not capitalize product and software development expenses.

Stock-Based Compensation

We measure and recognize compensation expense for all stock-based awards made to employees and directors, including stock options, stock sold pursuant to our Amended and Restated 2002 Employee Stock Purchase Plan (ESPP), and the issuance of restricted and unrestricted stock awards and units, based on estimated fair values. The fair values of stock options and ESPP awards are estimated at the date of grant using the Black-Scholes option-pricing model, which includes assumptions for the dividend yield, expected volatility, risk-free interest rate, and expected life. For restricted and unrestricted stock awards and units, the fair value is the market close price of our common stock on the date of grant. We expense stock-based compensation, adjusted for estimated forfeitures, using the straight-line method over the required vesting period. Excess tax benefits are credited to common stock when the deduction reduces cash taxes payable. When we have tax deductions in excess of the compensation cost, they are classified as financing cash inflows in the Consolidated Statements of Cash Flows.

Loss on Extinguishment of Debt, Net

Upon partial or full redemption of our borrowings, we recognize a gain or loss for the difference between the cash paid and the net carrying amount of the debt redeemed. Included in the net carrying amount is any unamortized premium or

 

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discount from the original issuance of the debt. Due to the particular characteristics of our convertible notes, we recognize a gain or loss upon conversion or derecognition for the difference between the net carrying amount of the liability component (including any unamortized discount and debt issuance costs) and the fair value of the consideration transferred to the holder that is allocated to the liability component, which is equal to the fair value of the liability component immediately prior to extinguishment. In the case of an induced conversion, a loss is recognized for the amount of the fair value of the securities or other consideration transferred to the holder in excess of fair value of the consideration issuable in accordance with the original conversion terms of the debt.

Income Taxes

We account for income taxes using the asset and liability method of accounting. Deferred tax assets and liabilities are recognized based upon anticipated future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective income tax bases, and operating loss and tax credit carryforwards in each of the jurisdictions in which we operate. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The calculation of our tax liabilities involves applying complex tax regulations in different tax jurisdictions to our tax positions. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets if it is more likely than not that such assets will not be realized. We do not record tax liabilities on undistributed earnings of international subsidiaries that are permanently reinvested.

We compute our interim income tax provision through the use of an estimated annual effective tax rate (ETR) applied to year-to-date operating results and specific events that are discretely recognized as they occur. In determining the estimated annual ETR, we analyze various factors, including projections of our annual earnings, taxing jurisdictions in which the earnings will be generated, the impact of state and local income taxes, our ability to use tax credits and net operating loss carryforwards, and available tax planning alternatives. Discrete items, including the effect of changes in tax laws, tax rates, and certain circumstances with respect to valuation allowances or other unusual or non-recurring tax adjustments, are reflected in the period in which they occur as an addition to, or reduction from, the income tax provision, rather than included in the estimated annual ETR.

A tax position is first evaluated for recognition based on its technical merits. Tax positions that have a greater than fifty percent likelihood of being realized upon ultimate settlement are then measured to determine amounts to be recognized in the financial statements. This measurement incorporates information about potential settlements with taxing authorities. A previously recognized tax position is derecognized in the first period in which the position no longer meets the more-likely-than-not recognition threshold. We classify interest expense and penalties related to uncertain tax positions and interest income on tax overpayments as part of income tax expense.

Foreign Exchange

Our consolidated financial statements are reported in U.S. dollars. Assets and liabilities of international subsidiaries with a non-U.S. dollar functional currency are translated to U.S. dollars at the exchange rates in effect on the balance sheet date, or the last business day of the period, if applicable. Revenues and expenses for these subsidiaries are translated to U.S. dollars using a weighted average rate for the relevant reporting period. Translation adjustments resulting from this process are included, net of tax, in OCI. Gains and losses that arise from exchange rate fluctuations for monetary asset and liability balances that are not denominated in an entity’s functional currency are included within other income (expense), net in the Consolidated Statements of Operations. Currency gains and losses of intercompany balances deemed to be long-term in nature or designated as a hedge of the net investment in international subsidiaries are included, net of tax, in OCI.

Fair Value Measurements

For assets and liabilities measured at fair value, the GAAP fair value hierarchy prioritizes the inputs used in different valuation methodologies, assigning the highest priority to unadjusted quoted prices for identical assets and liabilities in actively traded markets (Level 1) and the lowest priority to unobservable inputs (Level 3). Level 2 inputs consist of quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in non-active markets; and model-derived valuations in which significant inputs are corroborated by observable market data either directly or indirectly through correlation or other means (inputs may include yield curves, volatility, credit risks, and default rates). We hold no assets or liabilities measured using Level 1 fair value inputs.

 

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Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Due to various factors affecting future costs and operations, actual results could differ materially from these estimates.

New Accounting Pronouncements

In April 2010, the FASB issued ASU 2010-13, Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Primarily Trades, to eliminate disparity in practice. ASU 2010-13 clarifies that differences between currencies of the underlying equity securities of the share-based payment award and the functional currency of the employer entity or the employee’s payroll currency should not be considered to contain a condition that is not a market, performance, or service condition. Therefore, an entity would not classify such an award as a liability if it otherwise qualifies as equity. This pronouncement will be effective on January 1, 2011 and will not have an impact on our consolidated financial statements as we treat this type of share-based payment award as equity.

 

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Note 2:    Earnings Per Share and Capital Structure

The following table sets forth the computation of basic and diluted earnings per share (EPS):

 

     Three Months Ended September 30,      Nine Months Ended September 30,  
     2010      2009      2010      2009  
     (in thousands, except per share data)  

Net income (loss) available to common shareholders

     $ 29,108           $ (2,962)          $ 82,795           $ (7,402)    

Weighted average common shares outstanding-Basic

     40,400           40,039           40,307           38,003     

Dilutive effect of convertible notes

     -             -             138           -        

Dilutive effect of stock-based awards

     428           -             505           -        
                                   

Weighted average common shares outstanding-Diluted

     40,828           40,039           40,950           38,003     
                                   

Earnings (loss) per common share-Basic

     $ 0.72           $ (0.07)           $ 2.05           $ (0.19)    
                                   

Earnings (loss) per common share-Diluted

     $ 0.71           $ (0.07)           $ 2.02           $ (0.19)    
                                   

Convertible Notes

We are required, pursuant to the indenture for the convertible notes, to settle the principal amount of the convertible notes in cash and may elect to settle the remaining conversion obligation (stock price in excess of conversion price) in cash, shares, or a combination. We include in the EPS calculation the amount of shares it would take to satisfy the conversion obligation, assuming that all of the convertible notes are converted. The average closing prices of our common stock for the three and nine months ended September 30, 2010 and 2009 were used as the basis for determining the dilutive effect on EPS. The average price of our common stock for the nine months ended September 30, 2010 exceeded the conversion price of $65.16 and, therefore, approximately 138,000 shares have been included in the diluted EPS calculation for that period. The average price of our common stock for the three months ended September 30, 2010 and the three and nine months ended September 30, 2009 did not exceed the conversion price of $65.16 and, therefore, did not have an effect on diluted shares outstanding.

Stock-based Awards

For stock-based awards, the dilutive effect is calculated using the treasury stock method. Under this method, the dilutive effect is computed as if the awards were exercised at the beginning of the period (or at time of issuance, if later) and assumes the related proceeds were used to repurchase common stock at the average market price during the period. Related proceeds include the amount the employee must pay upon exercise, future compensation cost associated with the stock award, and the amount of excess tax benefits, if any. Approximately 526,000 and 1.0 million stock-based awards were excluded from the calculation of diluted EPS for the three months ended September 30, 2010 and 2009, and approximately 432,000 and 1.0 million stock-based awards were excluded from the calculation of diluted EPS for the nine months ended September 30, 2010 and 2009 because they were anti-dilutive. These stock-based awards could be dilutive in future periods.

Preferred Stock

We have authorized the issuance of 10 million shares of preferred stock with no par value. In the event of a liquidation, dissolution, or winding up of the affairs of the corporation, whether voluntary or involuntary, the holders of any outstanding preferred stock will be entitled to be paid a preferential amount per share to be determined by the Board of Directors prior to any payment to holders of common stock. Shares of preferred stock may be converted into common stock based on terms, conditions, and rates as defined in the Rights Agreement, which may be adjusted by the Board of Directors. There was no preferred stock sold or outstanding at September 30, 2010 and December 31, 2009.

 

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Note 3:    Certain Balance Sheet Components

Accounts receivable, net

 

         At September 30,    

 

2010

         At December 31,    

 

2009

 
     
     (in thousands)  

Trade receivables (net of allowance of $5,766 and $6,339)

     $ 343,358           $ 319,237     

Unbilled receivables

     40,456           18,711     
                 

Total accounts receivable, net

     $ 383,814           $ 337,948     
                 

A summary of the allowance for doubtful accounts activity is as follows:

 

         Three Months Ended September 30,              Nine Months Ended September 30,      
     2010      2009      2010      2009  
     (in thousands)  

Beginning balance

     $ 6,298           $ 7,271           $ 6,339           $ 5,954     

Provision for (release of) doubtful accounts, net

     (904)          (378)          (242)          1,512     

Accounts written off

     (21)          (112)          (194)          (748)    

Effects of change in exchange rates

     393           123           (137)          186     
                                   

Ending balance

     $ 5,766           $ 6,904           $ 5,766           $ 6,904     
                                   

Inventories

         At September 30,    

 

2010

         At December 31,    

 

2009

 
     (in thousands)  

Materials

     $ 115,760           $ 85,358     

Work in process

     20,832           17,668     

Finished goods

     89,173           67,058     
                 

Total inventories

     $ 225,765           $ 170,084     
                 

Our inventory levels may vary period to period as a result of our factory scheduling and timing of contract fulfillments.

Consigned inventory is held at third-party locations; however, we retain title to the inventory until purchased by the third-party. Consigned inventory, consisting of raw materials and finished goods, was $15.5 million and $10.6 million at September 30, 2010 and December 31, 2009, respectively.

Property, plant, and equipment, net

 

         At September 30,    

 

2010

         At December 31,    

 

2009

 
       
     (in thousands)  

Machinery and equipment

     $ 258,073           $ 243,652     

Computers and purchased software

     61,248           66,787     

Buildings, furniture, and improvements

     144,705           144,639     

Land

     36,586           37,738     

Construction in progress, including purchased equipment

     22,464           22,009     
                 

Total cost

     523,076           514,825     

Accumulated depreciation

     (220,770)          (196,608)    
                 

Property, plant, and equipment, net

     $ 302,306           $ 318,217     
                 

Depreciation expense for the three and nine months ended September 30 was as follows:

 

     Three Months Ended September 30,      Nine Months Ended September 30,  
       2010          2009          2010          2009    
     (in millions)   

Depreciation expense

     $ 15.2           $ 14.3           $ 45.7           $ 41.0     

 

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Note 4:    Intangible Assets

The gross carrying amount and accumulated amortization of our intangible assets, other than goodwill, are as follows:

 

     At September 30, 2010      At December 31, 2009  
       Gross Assets          Accumulated  

 

Amortization

         Net            Gross Assets          Accumulated  

 

Amortization

     Net  
     (in thousands)  

Core-developed technology

     $ 384,229           $ (267,666)          $     116,563           $ 398,043           $ (244,545)          $     153,498     

Customer contracts and relationships

     289,533           (106,580)          182,953           306,061           (92,187)          213,874     

Trademarks and trade names

     74,378           (59,037)          15,341           77,439           (57,957)          19,482     

Other

     24,386           (23,487)          899           24,713           (23,355)          1,358     
                                                     

Total intangible assets

     $ 772,526           $ (456,770)          $     315,756           $ 806,256           $ (418,044)          $     388,212     
                                                     

A summary of the intangible asset account activity is as follows:

 

        Nine Months Ended September 30,      
    2010     2009  
    (in thousands)  

Beginning balance, intangible assets, gross

    $ 806,256          $ 796,236     

Effect of change in exchange rates

    (33,730)         18,996     
               

Ending balance, intangible assets, gross

    $ 772,526          $ 815,232     
               

Intangible assets of our international subsidiaries are recorded in their respective functional currency; therefore, the carrying amounts of intangible assets increase or decrease, with a corresponding change in accumulated OCI, due to changes in foreign currency exchange rates.

Intangible asset amortization expense is as follows:

 

     Three Months Ended September 30,      Nine Months Ended September 30,  
       2010          2009          2010          2009    
     (in millions)  

Amortization of intangible assets

     $ 16.9           $ 25.1           $ 51.5           $ 72.8     

Estimated future annual amortization expense is as follows:

 

Years ending December 31,    Estimated Annual
Amortization
 
     (in thousands)  

2010 (amount remaining at September 30, 2010)

     $ 17,488     

2011

     59,849     

2012

     46,096     

2013

     37,289     

2014

     30,616     

Beyond 2014

     124,418     
        

Total intangible assets, net

     $ 315,756     
        

 

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Note 5:    Goodwill

The following table reflects goodwill allocated to each reporting segment at September 30, 2010 and 2009:

 

         Itron North    
America
     Itron
   International   
       Total Company    
     (in thousands)  

Goodwill balance at January 1, 2009

     $ 193,598           $ 1,092,255           $ 1,285,853     

Adjustment of previous acquisitions

     2,100           -              2,100     

Effect of change in exchange rates

     1,218           34,761           35,979     
                          

Goodwill balance at September 30, 2009

     $ 196,916           $ 1,127,016           $ 1,323,932     
                          

Goodwill balance at January 1, 2010

     $ 197,515           $ 1,108,084           $ 1,305,599     

Effect of change in exchange rates

     130           (69,146)          (69,016)    
                          

Goodwill balance at September 30, 2010

     $ 197,645           $ 1,038,938           $ 1,236,583     
                          

Due to continued refinements of our management and geographic reporting structures, minor amounts of goodwill have been reallocated between our reporting segments. Historical segment information has been revised to conform to our current segment reporting structure.

Adjustment of previous acquisitions in 2009 represents contingent consideration that became payable associated with two acquisitions completed in 2006.

Note 6:    Debt

The components of our borrowings are as follows:

 

        At September 30,   
2010
        At December 31,  
2009
 
     (in thousands)  

Term loans

     

USD denominated term loan

     $ 220,154           $ 284,693     

EUR denominated term loan

     227,123           288,902     

Convertible senior subordinated notes

     215,673           208,169     
                 
     662,950           781,764     

Current portion of debt

     (226,246)          (10,871)    
                 

Long-term debt

     $ 436,704           $ 770,893     
                 

Credit Facility

Our credit facility is dated April 18, 2007 and includes two amendments dated April 24, 2009 and February 10, 2010. The principal balance of our euro denominated term loan at September 30, 2010 and December 31, 2009 was €168.3 million and €200.8 million, respectively. Interest rates on the credit facility are based on the respective borrowing’s denominated London Interbank Offered Rate (LIBOR) or the Wells Fargo Bank, National Association’s prime rate, plus an additional margin subject to our consolidated leverage ratio. The additional interest rate margin was 3.50% at September 30, 2010 and 3.75% at December 31, 2009. Our interest rates were 3.77% for the U.S. dollar denominated and 4.26% for the euro denominated term loans at September 30, 2010. Scheduled amortization of principal payments is 1% per year (0.25% quarterly) with an excess cash flow provision for additional annual principal repayment requirements. The amount of the excess cash flow provision payment varies according to our consolidated leverage ratio. Maturities of the term loans and the multicurrency revolving line of credit are in April 2014 and 2013, respectively. The credit facility is secured by substantially all of the assets of Itron, Inc. and our U.S. domestic operating subsidiaries and includes covenants, which contain certain financial ratios and place restrictions on the incurrence of debt, the payment of dividends, certain investments, incurrence of capital expenditures above a set limit, and mergers.

 

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The credit facility includes a multicurrency revolving line of credit, which was increased from $115 million to $240 million on June 9, 2010. The increase was completed without amending the credit facility. Prepaid debt fees of $1.1 million were capitalized associated with the increase in the credit line. There were no other changes to the credit facility.

At September 30, 2010, there were no borrowings outstanding under the revolving line of credit, and $46.8 million was utilized by outstanding standby letters of credit, resulting in $193.2 million being available for additional borrowings.

We repaid $32.6 million and $106.5 million of the term loans during the three and nine months ended September 30, 2010, respectively. Repayments of $57.0 million and $127.2 million were made during the three and nine months ended September 30, 2009, respectively. These term loan repayments were made with cash flows from operations and cash on hand. We were in compliance with the debt covenants under the credit facility at September 30, 2010.

Convertible Senior Subordinated Notes

On August 4, 2006, we issued $345 million of 2.50% convertible notes due August 2026. Fixed interest payments are required every six months, in February and August of each year. For each six month period beginning August 2011, contingent interest payments of approximately 0.19% of the average trading price of the convertible notes will be made if certain thresholds are met or events occur, as outlined in the indenture. The convertible notes are registered with the SEC and are generally transferable. Our convertible notes are not considered conventional convertible debt as the number of shares, or cash, to be received by the holders was not fixed at the inception of the obligation. We have concluded that the conversion feature of our convertible notes does not need to be bifurcated from the host contract and accounted for as a freestanding derivative, as the conversion feature is indexed to our own stock and would be classified within stockholders’ equity if it were a freestanding instrument.

The convertible notes may be converted at the option of the holder at a conversion rate of 15.3478 shares of our common stock for each $1,000 principal amount of the convertible notes, under the following circumstances, as defined in the indenture:

 

  ¡

 

 

 

if the closing sale price per share of our common stock exceeds $78.19, which is 120% of the conversion price of $65.16, for at least 20 trading days in the 30 consecutive trading day period ending on the last trading day of the preceding fiscal quarter;

  ¡

 

 

between July 1, 2011 and August 1, 2011, and any time after August 1, 2024;

  ¡

 

 

during the five business days after any five consecutive trading day period in which the trading price of the convertible notes for each day was less than 98% of the average conversion value of the convertible notes;

  ¡

 

 

if the convertible notes are called for redemption;

  ¡

 

 

if a fundamental change occurs; or

 

 

 

¡

 

upon the occurrence of defined corporate events.

The amount payable upon conversion is the result of a formula based on the closing prices of our common stock for 20 consecutive trading days following the date of the conversion notice. Based on the conversion ratio of 15.3478 shares per $1,000 principal amount of the convertible notes, if our stock price is lower than the conversion price of $65.16, the amount payable will be less than the $1,000 principal amount and will be settled in cash. Our closing stock price at September 30, 2010 was $61.23 per share.

Upon conversion, the principal amount of the convertible notes will be settled in cash and, at our option, the remaining conversion obligation (stock price in excess of conversion price) may be settled in cash, shares, or a combination. The conversion rate for the convertible notes is subject to adjustment upon the occurrence of certain corporate events, as defined in the indenture, to ensure that the economic rights of the convertible note holders are preserved.

The convertible notes also contain purchase options, at the option of the holders, which if exercised would require us to repurchase all or a portion of the convertible notes on August 1, 2011, August 1, 2016, and August 1, 2021 at 100% of the principal amount, plus accrued and unpaid interest.

On or after August 1, 2011, we have the option to redeem all or a portion of the convertible notes at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest.

 

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The convertible notes are unsecured, subordinated to our credit facility (senior secured borrowings), and are guaranteed by one U.S. subsidiary, which is 100% owned. The convertible notes contain covenants, which place restrictions on the incurrence of debt and certain mergers. We were in compliance with these debt covenants at September 30, 2010.

On July 1, 2010, we classified the convertible notes as current on the Consolidated Balance Sheet due to the combination of put, call, and conversion options occurring within the next 12 months.

Our convertible notes were separated between the liability and equity components, in a manner that reflected our non-convertible debt borrowing rate. Our non-convertible debt borrowing rate at the time of our convertible notes’ issuance was determined to be 7.38%, which also reflects the effective interest rate on the liability component. The carrying amounts of the debt and equity components are as follows:

 

         At September 30,    
2010
         At December 31,    
2009
 
     (in thousands)  

Face value of convertible debt

     $ 223,604           $ 223,604     

Unamortized discount

     (7,931)          (15,435)    
                 

Net carrying amount of debt component

     $ 215,673           $ 208,169     
                 

Carrying amount of equity component

     $ 31,831           $ 31,831     
                 

The interest expense relating to both the contractual interest coupon and amortization of the discount on the liability component are as follows:

 

      Three Months Ended September 30,         Nine Months Ended September 30,    
    2010     2009     2010     2009  
    (in thousands)  

Contractual interest coupon

    $ 1,398          $ 1,398          $ 4,193          $ 4,442     

Amortization of the discount on the liability component

    2,547          2,367          7,504          7,262     
                               

Total interest expense

    $ 3,945          $ 3,765          $ 11,697          $ 11,704     
                               

Due to the combination of put, call, and conversion options that are part of the terms of the convertible note agreement, the remaining discount on the liability component will be amortized over nine months as of September 30, 2010.

During the first quarter of 2009, we entered into exchange agreements with certain holders of our convertible notes to issue, in the aggregate, approximately 2.3 million shares of common stock, valued at $132.9 million, in exchange for, in the aggregate, $121.0 million principal amount of the convertible notes, representing 35% of the aggregate principal outstanding at the date of the exchanges. All of the convertible notes we acquired pursuant to the exchange agreements were retired upon the closing of the exchanges.

The exchange agreements were treated as induced conversions as the holders received a greater number of shares of common stock than would have been issued under the original conversion terms of the convertible notes. At the time of the exchange agreements, none of the conversion contingencies were met. Under the original terms of the convertible notes, the amount payable on conversion was to be paid in cash, and the remaining conversion obligation (stock price in excess of conversion price) was payable in cash or shares of common stock, at our option. Under the terms of the exchange agreements, all of the settlement was paid in shares. The difference in the value of the shares of common stock issued under the exchange agreement and the value of the shares of common stock used to derive the amount payable under the original conversion agreement resulted in a loss on extinguishment of debt of $23.3 million (the inducement loss). Upon derecognition of the convertible notes, we remeasured the fair value of the liability and equity components using a borrowing rate for similar non-convertible debt that would be applicable to us at the date of the exchange agreements. Because borrowing rates increased, the remeasurement of the components of the convertible notes resulted in a gain on extinguishment of $13.4 million (the revaluation gain). As a result, we recognized a net loss on extinguishment of debt of $10.3 million, calculated as the inducement loss, plus an allocation of advisory fees, less the revaluation gain. The remaining settlement consideration of $9.5 million, including an allocation of advisory fees, was recorded as a reduction of common stock.

 

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Senior Subordinated Notes

On July 17, 2009, we paid the remaining $111.7 million outstanding balance on our 7.75% senior subordinated notes and recognized a loss on extinguishment of $2.5 million, which included the remaining unamortized debt discount of $336,000. Unamortized prepaid debt fees of $2.0 million were recorded to interest expense.

Note 7:     Derivative Financial Instruments

As part of our risk management strategy, we use derivative instruments to hedge certain foreign currency and interest rate exposures. Refer to Note 1, Note 12, and Note 13 for additional disclosures on our derivative instruments.

The fair values of our derivative instruments are determined using the income approach and significant other observable inputs (also known as “Level 2”), as defined by Accounting Standards Codification (ASC) 820-10-20, Fair Value Measurements. We have used observable market inputs based on the type of derivative and the nature of the underlying instrument. The key inputs used at September 30, 2010 included interest rate yield curves (swap rates and futures) and foreign exchange spot and forward rates, all of which are available in an active market. We have utilized the mid-market pricing convention for these inputs at September 30, 2010. We include the effect of our counterparty credit risk based on current published credit default swap rates when the net fair value of our derivative instruments is in a net asset position. We consider our own nonperformance risk when the net fair value of our derivative instruments is in a net liability position by discounting our derivative liabilities to reflect the potential credit risk to our counterparty through applying a current market indicative credit spread to all cash flows.

The fair values of our derivative instruments determined using the fair value measurement of significant other observable inputs (Level 2) at September 30, 2010 and December 31, 2009 are as follows:

 

          Fair Value  
    

Balance Sheet Location

   At
  September  30,  
2010
     At
  December 31,  
2009
 

Asset Derivatives

        (in thousands)  

Derivatives not designated as hedging instruments under ASC 815-20

     

Foreign exchange forward contracts

  

Other current assets

     $ 283           $ 3,986     
                    

Liability Derivatives

                  

Derivatives designated as hedging instruments under ASC 815-20

     

Interest rate swap contracts

  

Other current liabilities

    $ (7,775)          $ (11,478)    

Interest rate swap contracts

  

Other noncurrent obligations

     (1,675)          (3,676)    

Euro denominated term loan *

  

Current portion of long-term debt

     (4,522)          (4,820)    

Euro denominated term loan *

  

Long-term debt

     (222,601)          (284,082)    
                    

Total derivatives designated as hedging instruments under ASC 815-20

     $ (236,573)          $ (304,056)    
                    

Derivatives not designated as hedging instruments under ASC 815-20

     

Foreign exchange forward contracts

  

Other current liabilities

     $ (87)          $ (2,442)    
                    

Total liability derivatives

        $ (236,660)          $ (306,498)    
                    

* The euro denominated term loan is a nonderivative financial instrument designated as a hedge of our net investment in international operations. It is recorded at its carrying value in the Consolidated Balance Sheets and is not recorded at fair value.

 

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OCI during the reporting period for our derivative and nonderivative instruments designated as hedging instruments (collectively, hedging instruments), net of tax, was as follows:

 

           2010                 2009        
     (in thousands)  

Net unrealized loss on hedging instruments at January 1,

     $ (30,300 )       $ (29,772 )  

Unrealized gain (loss) on derivative instruments

     (2,920 )       (5,906 )  

Unrealized gain (loss) on a nonderivative net investment hedging instrument

     12,203        (5,676 )  

Realized (gains) losses reclassified into net income (loss)

     5,874        6,025   
                

Net unrealized loss on hedging instruments at September 30,

     $ (15,143 )       $ (35,329 )  
                

Cash Flow Hedges

We are exposed to interest rate risk through our credit facility. We enter into swaps to achieve a fixed rate of interest on the hedged portion of debt in order to increase our ability to forecast interest expense. The objective of these swaps is to protect us from increases in the LIBOR base borrowing rates on our floating rate credit facility. The swaps do not protect us from changes to the applicable margin under our credit facility.

We have entered into one-year pay-fixed receive one-month LIBOR interest rate swaps to convert $200 million of our U.S. dollar term loan from a floating LIBOR interest rate to a fixed interest rate. Our outstanding swaps are as follows:

 

  Transaction Date

   Effective Date of Swap            Notional amount              Fixed Interest Rate
          (in thousands)       

July 1, 2009

   June 30, 2010 - June 30, 2011      $ 100,000         2.15%

July 1, 2009

   June 30, 2010 - June 30, 2011      $ 100,000         2.11%

At September 30, 2010 and December 31, 2009, our U.S. dollar term loan had a balance of $220.2 million and $284.7 million, respectively. The cash flow hedges have been and are expected to be highly effective in achieving offsetting cash flows attributable to the hedged risk through the term of the hedge. Consequently, effective changes in the fair value of the interest rate swap are recorded as a component of OCI and are recognized in earnings when the hedged item affects earnings. The amounts paid or received on the hedge are recognized as adjustments to interest expense. The amount of net losses expected to be reclassified into earnings in the next 12 months is approximately $2.7 million, which was based on the Bloomberg U.S. dollar swap yield curve as of September 30, 2010.

In 2007, we entered into a pay fixed 6.59% receive three-month Euro Interbank Offered Rate (EURIBOR), plus 2%, amortizing interest rate swap to convert a significant portion of our euro denominated variable-rate term loan to fixed-rate debt, plus or minus the variance in the applicable margin from 2%, through December 31, 2012. The cash flow hedge is currently, and is expected to be, highly effective in achieving offsetting cash flows attributable to the hedged risk through the term of the hedge. Consequently, effective changes in the fair value of the interest rate swap are recorded as a component of OCI and are recognized in earnings when the hedged item affects earnings. The amounts paid or received on the hedge are recognized as adjustments to interest expense. The notional amount of the swap is reduced each quarter and was $173.1 million (€128.3 million) and $252.9 million (€175.8 million) as of September 30, 2010 and December 31, 2009, respectively. The amount of net losses expected to be reclassified into earnings in the next 12 months is approximately $4.9 million (€3.6 million), which was based on the Bloomberg euro swap yield curve as of September 30, 2010.

We will continue to monitor and assess our interest rate risk and may institute additional interest rate swaps or other derivative instruments to manage such risk in the future.

 

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The before tax effect of our cash flow derivative instruments on the Consolidated Balance Sheets and the Consolidated Statements of Operations for the three months and nine months ended September 30 are as follows:

 

Derivatives in ASC 815-20 Cash   

Amount of Gain (Loss)

Recognized in OCI on

Derivative (Effective

     Gain (Loss) Reclassified from Accumulated
OCI into Income (Effective Portion)
     Gain (Loss) Recognized in Income on Derivative
(Ineffective Portion)
 

    Flow Hedging Relationships

   Portion)      Location      Amount      Location      Amount  
     2010      2009             2010      2009             2010      2009  
     (in thousands)             (in thousands)             (in thousands)  

Three months ended September 30,

                       

Interest rate swap contracts

     $ (603)           $ (3,588)           Interest expense         $ (2,715)           $ (3,808)           Interest expense         $ (11)           $ (88)     

Nine months ended September 30,

                       

Interest rate swap contracts

     $ (4,725)           $ (9,753)           Interest expense         $ (9,525)           $ (9,970)           Interest expense         $ (85)           $ (272)     

Net Investment Hedge

We are exposed to foreign exchange risk through our international subsidiaries. As a result of our acquisition of an international company in 2007, we entered into a euro denominated term loan, which exposes us to fluctuations in the euro foreign exchange rate. Therefore, we have designated this foreign currency denominated term loan as a hedge of our net investment in international operations. The non-functional currency term loan is revalued into U.S. dollars at each balance sheet date, and the changes in value associated with currency fluctuations are recorded as adjustments to long-term debt with offsetting gains and losses recorded in OCI. The notional amount of the term loan declines each quarter due to repayments and was $227.1 million (€168.3 million) and $288.9 million (€200.8 million) as of September 30, 2010 and December 31, 2009, respectively. We had no hedge ineffectiveness.

The before tax and net of tax effect of our net investment hedge nonderivative financial instrument on OCI for the three and nine months ended September 30 are as follows:

 

Nonderivative Financial Instruments in ASC 815-20 Net

Investment Hedging Relationships

     Euro Denominated Term Loan Designated as a Hedge  
of Our Net Investment in International Operations
 
     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2010      2009      2010      2009  
            (in thousands)         

Gain (loss) recognized in OCI on derivative (Effective Portion)

           

Before tax

     $     (19,703)           $     (13,770)           $     19,795           $     (9,157)     

Net of tax

     $     (12,149)           $     (8,524)           $     12,203           $     (5,676)     

Derivatives Not Designated as Hedging Relationships

We are also exposed to foreign exchange risk when we enter into non-functional currency transactions, both intercompany and third-party. At each period-end, foreign currency monetary assets and liabilities are revalued with the change recorded to other income and expense. We enter into monthly foreign exchange forward contracts (170 during the nine months ended September 30, 2010), not designated for hedge accounting, with the intent to reduce earnings volatility associated with certain of these balances. The notional amounts of the contracts ranged from less than $1 million to $50 million, offsetting our exposures from the euro, British pound, Canadian dollar, Czech koruna, Hungarian forint, and various other currencies.

The effect of our foreign exchange option and forward derivative instruments on the Consolidated Statements of Operations for the three and nine months ended September 30 are as follows:

 

Derivatives Not Designated as Hedging

Instrument under ASC 815-20

       Gain (Loss) Recognized on Derivatives in     
Other Income (Expense)
 
     Three Months Ended September 30,      Nine Months Ended September 30,  
     2010      2009      2010      2009  
            (in thousands)         

Foreign exchange option and forward contracts

     $     (803)           $     (1,976)           $     2,244           $     (2,503)     

 

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Note 8:     Defined Benefit Pension Plans

We sponsor both funded and unfunded defined benefit pension plans for our employees in Germany, France, Spain, Italy, Belgium, Chile, Portugal, Hungary, and Indonesia offering death and disability, retirement, and special termination benefits. The defined benefit obligation is calculated annually by using the projected unit credit method. The measurement date for the pension plans was December 31, 2009.

Our defined benefit pension plans are denominated in the functional currencies of the respective countries in which the plans are sponsored; therefore, the balances increase or decrease, with a corresponding change in OCI, due to changes in foreign currency exchange rates. Amounts recognized on the Consolidated Balance Sheets consist of:

 

         At September 30,    
2010
        At December 31,    
2009
 
     (in thousands)  

Plan assets in other noncurrent assets

     $ (577)          $ (613)     

Current portion of pension plan liability in wages and benefits payable

     3,390           2,975      

Long-term portion of pension plan liability

     60,013           63,040      
                

Net pension plan benefit liability

     $     62,826           $     65,402      
                

Our asset investment strategy focuses on maintaining a portfolio using primarily insurance funds, which are accounted for as investments and measured at fair value, in order to achieve our long-term investment objectives on a risk adjusted basis. Our general funding policy for these qualified pension plans is to contribute amounts sufficient to satisfy regulatory funding standards of the respective countries for each plan. We contributed $37,000 and $375,000 to the defined benefit pension plans for the three and nine months ended September 30, 2010, and $49,000 and $101,000 for the three and nine months ended September 30, 2009, respectively. The timing of when contributions are made can vary by plan from year to year. For 2010, assuming that actual plan asset returns are consistent with our expected rate of return, and that interest rates remain constant, we expect to contribute approximately $500,000 in 2010 to our defined benefit pension plans. We contributed $397,000 to the defined benefit pension plans for the year ended December 31, 2009.

Net periodic pension benefit costs for our plans include the following components:

 

         Three Months Ended September 30,              Nine Months Ended September 30,      
     2010      2009      2010      2009  
            (in thousands)         

Service cost

     $ 493           $ 457           $ 1,493           $ 1,325     

Interest cost

     858           933           2,608           2,673     

Expected return on plan assets

     (73)          (74)          (221)          (215)    

Amortization of actuarial net gain

     (6)          (106)          (19)          (288)    

Amortization of unrecognized prior service costs

     -               7            -               20      
                                   

Net periodic benefit cost

     $ 1,272           $ 1,217           $ 3,861           $ 3,515     
                                   

 

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Note 9:    Stock-Based Compensation

We record stock-based compensation expense for awards of stock options, stock sold pursuant to our ESPP, and the issuance of restricted and unrestricted stock awards and units. We expense stock-based compensation using the straight-line method over the vesting requirement period. For the three and nine months ended September 30, stock-based compensation expense and the related tax benefit were as follows:

 

         Three Months Ended September 30,              Nine Months Ended September 30,      
         2010              2009              2010              2009      
            (in thousands)         

Stock options

     $ 843             $ 1,600             $ 3,138           $ 6,172     

Restricted stock awards and units

     3,962           2,336           10,344           6,629     

Unrestricted stock awards

     175           119           364           254     

ESPP

     121           115           376           394     
                                   

Total stock-based compensation

     $ 5,101           $ 4,170           $ 14,222           $ 13,449     
                                   

Related tax benefit

     $ 1,421           $ 1,031           $ 4,153           $ 3,487     
                                   

We issue new shares of common stock upon the exercise of stock options or when vesting conditions on restricted awards are fully satisfied.

The fair value of stock options and ESPP awards issued were estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

 

     Employee Stock Options  
     Three Months Ended September 30,      Nine Months Ended September 30,  
         2010 (1)              2009 (1)              2010              2009      

Dividend yield

     -                 -                 -                -          

Expected volatility

     -                 -                 48.7%          50.2%    

Risk-free interest rate

     -                 -                 2.3%          1.8%    

Expected life (years)

     -                 -                 4.60          4.91     
     ESPP  
     Three Months Ended September 30,      Nine Months Ended September 30,  
         2010              2009              2010              2009      

Dividend yield

     -                 -                 -                 -           

Expected volatility

     42.6%          51.9%          36.0%          75.8%    

Risk-free interest rate

     0.2%          0.2%          0.1%          0.4%    

Expected life (years)

     0.25            0.25            0.25            0.25      

 

(1)There were no employee stock options issued for the three months ended September 30, 2010 and 2009.

   

Expected volatility is based on a combination of historical volatility of our common stock and the implied volatility of our traded options for the related expected life period. We believe this combined approach is reflective of current and historical market conditions and an appropriate indicator of expected volatility. The risk-free interest rate is the rate available as of the award date on zero-coupon U.S. government issues with a term equal to the expected life of the award. The expected life is the weighted average expected life of an award based on the period of time between the date the award is granted and the date an estimate of the award is fully exercised. Factors considered in estimating the expected life include historical experience of similar awards, contractual terms, vesting schedules, and expectations of future employee behavior. We have not paid dividends in the past and do not plan to pay dividends in the foreseeable future.

 

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Subject to stock splits, dividends, and other similar events, 3,500,000 shares of common stock are reserved and authorized for issuance under our 2010 Stock Incentive Plan (Stock Incentive Plan). Awards consist of stock options, restricted stock units, restricted stock awards, and unrestricted stock awards. At September 30, 2010, shares available for issuance under the Stock Incentive Plan were 2,946,065.

Stock Options

Options to purchase our common stock are granted to employees and the Board of Directors with an exercise price equal to the market close price of the stock on the date the Board of Directors approves the grant. Options generally become exercisable in three equal annual installments beginning one year from the date of grant and generally expire 10 years from the date of grant. Compensation expense is recognized only for those options expected to vest, with forfeitures estimated based on our historical experience and future expectations.

A summary of our stock option activity for the nine months ended September 30 is as follows:

 

     Shares      Weighted
Average Exercise
Price per Share
     Weighted Average
Remaining
Contractual Life
     Aggregate
Intrinsic

Value (1)
     Weighted
Average Grant
Date Fair Value
 
       (in thousands)             (years)        (in thousands)         

Outstanding, January 1, 2009

     1,374            $ 51.53           6.99           $ 25,809        

Granted

     50            57.96                 $ 25.94   

Exercised

     (134)           20.20              $ 4,565        

Forfeited

     (18)           58.98              

Expired

     (7)           57.23              
                    

Outstanding, September 30, 2009

     1,265            $ 54.96           6.66           $ 20,408        
                                      

Exercisable and expected to vest, September 30, 2009

     1,203            $ 53.22           6.56           $ 20,373        
                                      

Exercisable, September 30, 2009

     971            $ 46.91           6.11           $ 20,052        
                                      

Outstanding, January 1, 2010

     1,179            $ 52.93           5.90           $ 22,863        

Granted

     71            61.97                 $ 27.18   

Exercised

     (144)           40.82              $ 4,413        
                    

Outstanding, September 30, 2010

     1,106            $ 55.11           5.83           $ 14,660        
                                      

Exercisable and expected to vest, September 30, 2010

     1,096            $ 54.99           5.80           $ 14,449        
                                      

Exercisable, September 30, 2010

     952            $ 52.25           5.40           $ 14,551        
                                      

 

(1)

The aggregate intrinsic value is the amount by which the market value of the underlying stock exceeded the exercise price of the outstanding options before applicable income taxes, based on the closing stock price on the last business day of the period, which represents amounts that would have been received by the optionees had all options been exercised on that date.

As of September 30, 2010, total unrecognized stock-based compensation expense related to nonvested stock options was approximately $2.5 million, which is expected to be recognized over a weighted average period of approximately 17 months.

Restricted Stock Awards

Certain employees and senior management receive restricted stock units or restricted stock awards (collectively, restricted awards) as a component of their total compensation. The fair value of a restricted award is the market close price of our common stock on the date of grant. Restricted awards generally vest over a three year period. Compensation expense, net of forfeitures, is recognized over the vesting period.

Subsequent to vesting, the restricted awards are converted into shares of our common stock on a one-for-one basis and issued to employees. We are entitled to an income tax deduction in an amount equal to the taxable income reported by the employees upon vesting of the restricted awards.

 

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The restricted awards issued under the Long Term Performance Restricted Stock Unit Award Agreement (Performance Award Agreement) are determined based on the attainment of annual performance goals after the end of the calendar year performance period. During the year, if management determines that it is probable that the targets will be achieved, compensation expense, net of forfeitures, is recognized on a straight-line basis over the annual performance and subsequent vesting period. Performance Awards typically vest and are released in three equal installments at the beginning of each year following attainment of the performance goals. For U.S. participants who retire during the performance period, a pro-rated number of restricted awards (based on the number of days of employment during the performance period) immediately vest based on the attainment of the performance goals as assessed after the end of the performance period. During the vesting period, unvested restricted awards immediately vest at the date of retirement for U.S. participants who retire during that period. For U.S. participants who are or will become retirement eligible during either the annual performance or vesting period, compensation expense is accelerated and recognized over the greater of the performance period (one year) or the participant’s retirement eligible date. For the 2010 Performance Awards, the maximum restricted awards that may become eligible for vesting is 133,000 with a grant date fair value of $61.49.

The following table summarizes restricted award activity for the nine months ended September 30:

 

     Number of
  Restricted Awards  
     Weighted
Average Grant
  Date Fair Value  
     Aggregate
  Intrinsic Value(1)  
 
     (in thousands)             (in thousands)  

Outstanding, January 1, 2009

     313            

Granted

     59            $ 69.44        

Released

     (23)              $ 1,472     

Forfeited

     (6)           
              

Outstanding, September 30, 2009

     343            
              

Outstanding, January 1, 2010

     326            

Granted(2)

     215            $ 63.42        

Released

     (78)              $ 5,216     

Forfeited

     (14)           
              

Outstanding, September 30, 2010

     449            
              

Vested, September 30, 2010

     2               $ 97     
                    

Expected to vest, September 30, 2010

     372               $ 22,788     
                    

 

(1)

The aggregate intrinsic value is the market value of the stock released, vested, or expected to vest, before applicable income taxes, based on the closing price on the stock release dates or at the end of the period for stock vested but not released.

(2)

These restricted awards do not include the 2010 awards under the Performance Awards Agreement, which are not eligible for vesting until December 31, 2010.

At September 30, 2010, unrecognized compensation expense was $19.0 million, which is expected to be recognized over a weighted average period of approximately 24 months.

Unrestricted Stock Awards

We issue unrestricted stock awards to our Board of Directors as part of their compensation. Awards are fully vested and expensed when issued. The fair value of unrestricted stock awards is the market close price of our common stock on the date of grant.

 

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The following table summarizes unrestricted stock award activity for the three and nine months ended September 30:

 

         Three Months Ended September 30,          Nine Months Ended September 30,      
     2010      2009      2010      2009  

Shares of unrestricted stock issued

     2,896           2,168           5,662           4,284     

Weighted average grant date fair value

     $ 60.39           $ 55.27           $ 64.35           $ 59.40     

Employee Stock Purchase Plan

Under the terms of the ESPP, eligible employees can elect to deduct up to 10% of their regular cash compensation to purchase our common stock at a discounted price. The purchase price of the common stock is 85% of the fair market value of the stock at the end of each fiscal quarter. The sale of the stock occurs at the beginning of the subsequent quarter.

The following table summarizes ESPP activity for the three and nine months ended September 30:

 

         Three Months Ended September 30,          Nine Months Ended September 30,      
     2010      2009      2010      2009  

Shares of stock sold to employees(1)

     14,819           16,663           37,905           49,413     

Weighted average fair value per ESPP award(2)

     $ 9.16           $ 9.62           $ 9.69           $ 8.13     

 

(1)

Stock sold to employees during each fiscal quarter under the ESPP is associated with the offering period ending on the last day of the previous fiscal quarter.

(2)

Relating to awards associated with the offering period(s) during the three and nine months ended September 30.

The fair value of ESPP awards is estimated using the Black-Scholes option-pricing model. At September 30, 2010, all compensation cost associated with the ESPP had been recognized. There were approximately 210,000 shares of common stock available for future issuance under the ESPP at September 30, 2010.

Note 10:     Income Taxes

Our tax provisions (benefits) as a percentage of income (loss) before tax typically differs from the federal statutory rate of 35%, and may vary from period to period, due to fluctuations in the forecasted mix of earnings in domestic and international jurisdictions, new or revised tax legislation and accounting pronouncements, tax credits, state income taxes, adjustments to valuation allowances, and interest expense and penalties related to uncertain tax positions, among other items.

For the three and nine months ended September 30, 2010, we had tax provisions of 34% and 17%, based on a percentage of income before tax, as compared with tax benefits of 84% for the same periods in 2009.

Our tax provisions in 2010 reflect higher projected pretax earnings in high tax jurisdictions, the benefit of certain interest expense deductions, and an election under U.S. Internal Revenue Code Section 338 with respect to a foreign acquisition in 2007. The 2010 tax provisions also include a benefit for the receipt of a clean energy manufacturing tax credit awarded as part of the American Recovery and Reinvestment Act and a benefit related to the reduction of tax reserves for certain foreign subsidiaries.

Our tax benefits in 2009 are the result of certain interest expense deductions and an election under U.S. Internal Revenue Code Section 338 with respect to a foreign acquisition in 2007, as well as the forecasted mix of earnings in different tax jurisdictions, which included lower income in higher tax jurisdictions.

 

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We classify interest expense and penalties related to unrecognized tax liabilities and interest income on tax overpayments as components of income tax expense. Interest and penalties recognized, and accrued interest and penalties recorded, are as follows:

 

         Three Months Ended September 30,              Nine Months Ended September 30,      
     2010      2009      2010      2009  
            (in thousands)         

Interest and penalties expense

     $ 277            $ 656            $ 1,463            $ 1,988      

Interest and penalties benefit

     (449)           (98)           (1,339)           (137)     
                                   

Net interest and penalties recognized

     $ (172)           $ 558            $ 124            $ 1,851      
                                   

 

         At September 30,    
2010
         At December 31,    
2009
 
     (in millions)  

Accrued interest

     $ 4.7            $ 4.1      

Accrued penalties

     2.9            3.4      

 

         At September 30,    
2010
         At December 31,    
2009
 
     (in millions)  

Unrecognized tax benefits related to uncertain tax positions

     $ 33.3            $ 46.2      

The amount of unrecognized tax benefits that, if recognized, would affect our effective tax rate

     33.3            46.2      

At September 30, 2010, we expect to pay $630,000 in income taxes, interest, or penalties related to uncertain tax positions over the next twelve months. We are not able to reasonably estimate the timing of future cash flows relating to the remaining balance.

We believe it is reasonably possible that our unrecognized tax benefits may decrease by approximately $5.9 million within the next twelve months due to the potential lapse of certain applicable statutes of limitations and the final resolution of certain tax audits.

Note 11:    Commitments and Contingencies

Guarantees and Indemnifications

We are often required to obtain standby letters of credit (LOC’s) or bonds in support of our obligations for customer contracts. These standby LOC’s or bonds typically provide a guarantee to the customer for future performance, which usually covers the installation phase of a contract and may on occasion cover the operations and maintenance phase of outsourcing contracts.

 

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Our available lines of credit, outstanding standby LOC’s, and bonds are as follows:

 

           At September 30,              At December 31,    
     2010      2009  
     (in millions)  

Credit facility(1)

     

Multicurrency revolving line of credit

     $ 240.0            $ 115.0      

Standby LOC’s issued and outstanding

     (46.8)            (39.9)      
                 

Net available for additional borrowings and LOC’s

     $ 193.2            $ 75.1      
                 

Unsecured multicurrency revolving lines of credit with various financial institutions

     

Total lines of credit

     $ 46.1            $ 38.7      

Standby LOC’s issued and outstanding

     (18.5)            (10.9)      

Short-term borrowings(2)

     (1.5)            (2.1)      
                 

Net available for additional borrowings and LOC’s

     $ 26.1            $ 25.7      
                 

Unsecured surety bonds in force

     $ 97.7            $ 71.4      

 

(1)

See Note 6 for details regarding our credit facility, which is secured.

(2)

Short-term borrowings are included in “Other current liabilities” on the Consolidated Balance Sheets.

In the event any such bond or standby LOC is called, we would be obligated to reimburse the issuer of the standby LOC or bond; however, we do not believe that any currently outstanding bond or LOC will be called.

We generally provide an indemnification related to the infringement of any patent, copyright, trademark, or other intellectual property right on software or equipment within our sales contracts, which indemnifies the customer from and pays the resulting costs, damages, and attorney’s fees awarded against a customer with respect to such a claim provided that (a) the customer promptly notifies us in writing of the claim and (b) we have the sole control of the defense and all related settlement negotiations. We also provide an indemnification to our customers for third party claims resulting from damages caused by the negligence or willful misconduct of our employees/agents in connection with the performance of certain contracts. The terms of our indemnifications generally do not limit the maximum potential payments. It is not possible to predict the maximum potential amount of future payments under these or similar agreements.

Legal Matters

We are subject to various legal proceedings and claims of which the outcomes are subject to significant uncertainty. Our policy is to assess the likelihood of any adverse judgments or outcomes related to legal matters, as well as ranges of probable losses. A determination of the amount of the liability required, if any, for these contingencies is made after an analysis of each known issue. A liability is recorded and charged to operating expense when we determine that a loss is probable and the amount can be reasonably estimated. Additionally, we disclose contingencies for which a material loss is reasonably possible, but not probable. Liabilities recorded for legal contingencies at September 30, 2010 were not material to our financial condition or results of operations.

On December 18, 2009, we received a statement of claim in the matter of an arbitration between Cinclus Technology (Cinclus) and Itron Metering Solutions UK Ltd (Itron UK). The claim relates to an alleged defect in meters sold to Cinclus during 2007 for installation on a project Cinclus was managing for E.ON, a utility with customers in Sweden. On December 23, 2009, we received a statement of claim in the matter of an arbitration between Cinclus and Itron UK relating to an alleged defect in meters sold to Cinclus during 2007 - 2009 for installation on a project Cinclus was managing for Fortum, a utility with customers in Sweden. Both arbitrations were filed with the Arbitration Institute of the Stockholm Chamber of Commerce. In both arbitrations, Cinclus claimed the meters provided by Itron UK failed to meet specifications because in certain environments the meters were affected by high frequency pollution from third party devices in the home environment, which impairs the meters’ capability to measure energy accurately. Cinclus asserted that all meters must be replaced at Itron UK’s cost and expense, including the cost of field work to replace the meters, plus other losses and damages to be specified at a later date. Itron UK resolved the claim by Cinclus related to the E.ON project in the second quarter of 2010. Itron UK resolved the claim by Cinclus related to the Fortum claim in the third quarter of 2010.

 

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Warranty

A summary of the warranty accrual account activity is as follows:

 

         Three Months Ended September 30,              Nine Months Ended September 30,      
     2010      2009      2010      2009  
            (in thousands)         

Beginning balance

     $     49,203            $     34,065            $     33,873            $     38,255      

New product warranties

     3,516            2,223            9,212            5,345      

Other changes/adjustments to warranties

     7,845            1,641            23,438            4,750      

Reclassification from other current liabilities

     -               -               2,878            -         

Claims activity

     (9,585)            (5,067)           (16,648)            (15,788)      

Effect of change in exchange rates

     2,246            653            472            953      
                                   

Ending balance, September 30

     53,225            33,515            53,225            33,515      

Less: current portion of warranty

     (28,232)           (20,751)           (28,232)            (20,751)      
                                   

Long-term warranty

     $ 24,993            $ 12,764          $ 24,993            $ 12,764      
                                   

Total warranty expense is classified within cost of revenues and consists of new product warranties issued and other changes and adjustments to warranties.

Warranty expense for the three and nine months ended September 30 is as follows:

 

         Three Months Ended September 30,              Nine Months Ended September 30,      
     2010      2009      2010      2009  
            (in millions)         

Warranty expense

     $ 11.4           $ 3.9           $ 32.7           $ 10.1     

Warranty expense associated with our segments was as follows for the nine months ended September 30:

 

       2010          2009    

Itron North America

     50%           85%     

Itron International

     50%           15%     

The increase in Itron International’s warranty expense was primarily the result of $13.8 million recorded for the arbitration claims in Sweden noted above in legal matters.

Health Benefits

We are self insured for a substantial portion of the cost of our U.S. employee group health insurance. We purchase insurance from a third party, which provides individual and aggregate stop loss protection for these costs. Each reporting period, we expense the costs of our health insurance plan including paid claims, the change in the estimate of incurred but not reported (IBNR) claims, taxes, and administrative fees (collectively, the plan costs). Plan costs and the IBNR accrual, which is included in wages and benefits payable, are as follows:

 

         Three Months Ended September 30,              Nine Months Ended September 30,      
     2010      2009      2010      2009  
            (in millions)         

Plan costs

     $     5.1           $     5.4           $     14.5             $     15.4     
         At September 30,    
2010
         At December 31,    
2009
        
     (in millions)     

IBNR accrual

     $     2.0           $     3.3        

Our IBNR accrual and expenses may fluctuate due to the number of plan participants, claims activity, and deductible limits. Due to a change in our medical plan administrator, we have reduced our claims processing time. Therefore, the

 

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IBNR accrual is lower at September 30, 2010 compared with December 31, 2009. For our employees located outside of the United States, health benefits are provided primarily through governmental social plans, which are funded through employee and employer tax withholdings.

Note 12:    Other Comprehensive Income (Loss)

OCI is reflected as a net increase (decrease) to shareholders’ equity and is not reflected in our results of operations. Total comprehensive income (loss) during the reporting periods, net of tax, was as follows:

 

         Three Months Ended September 30,              Nine Months Ended September 30,      
     2010      2009      2010      2009  
            (in thousands)         

Net income (loss)

     $ 29,108           $ (2,962)          $ 82,795           $ (7,402)    

Foreign currency translation adjustment, net

     125,179           65,895           (87,292)          62,971     

Net unrealized gain (loss) on derivative instruments, designated as cash flow hedges, net

     (378)          (2,102)          (2,920)          (5,906)    

Net unrealized gain (loss) on a nonderivative net investment hedging instrument, net

     (12,149)          (8,524)          12,203           (5,676)    

Net hedging (gain) loss reclassified into net income (loss), net

     1,677           2,222           5,874           6,025     

Pension plan benefits liability adjustment, net

     2           (29)          (683)          (187)    
                                   

Total comprehensive income (loss)

     $     143,439           $     54,500           $     9,977           $ 49,825     
                                   

Income tax (provision) benefit related to OCI during the reporting periods was as follows:

 

         Three Months Ended September 30,              Nine Months Ended September 30,      
     2010      2009      2010      2009  
            (in thousands)         

Income tax (provision) benefit on foreign currency translation adjustment

     $ (750)          $ (1,691)          $ (1,335)        $ (5,367)    

Income tax (provision) benefit on net unrealized gain (loss) on derivative instruments(1)

     225           1,266           1,805           3,627     

Income tax (provision) benefit on net unrealized gain (loss) on a nonderivative net investment hedging instrument

     7,554           5,246           (7,592)          3,481     

Income tax (provision) benefit on net hedging (gain) loss reclassified into net income (loss)

     (1,038)          (1,366)          (3,651)          (3,725)    

Income tax benefit on pension plan benefits liability adjustment

     (1)          13           220           80     
                                   

Total income tax (provision) benefit on other comprehensive income (loss)

     $     5,990           $     3,468           $ (10,553)        $ (1,904)    
                                   

 

(1)

Designated as cash flow hedges

Accumulated other comprehensive income (loss), net of tax, was ($1.7) million at September 30, 2010 and $71.1 million at December 31, 2009. These amounts include adjustments for foreign currency translation, the unrealized gain (loss) on our hedging instruments, the hedging gain (loss), and the pension liability adjustment as indicated above.

Note 13:    Fair Values of Financial Instruments

The fair values provided are representative of fair values only at September 30, 2010 and December 31, 2009 and do not reflect subsequent changes in the economy, interest rates, tax rates, and other variables that may affect the determination of fair value.

 

         At September 30, 2010              At December 31, 2009      
         Carrying    
Amount
     Fair
    Value     
         Carrying    
Amount
     Fair
    Value     
 
            (in thousands)         

Assets

           

Cash and cash equivalents

     $     148,114          $ 148,114          $ 121,893          $ 121,893    

Foreign exchange forwards

     283          283          3,986          3,986    

Liabilities

           

Term loans

           

USD denominated term loan

     $ 220,154        $ 220,704          $ 284,693          $ 284,693    

EUR denominated term loan

     227,123          227,691          288,902          288,902    

Convertible senior subordinated notes

     215,673          248,199          208,169          282,859    

Interest rate swaps

     9,450          9,450          15,154          15,154    

Foreign exchange forwards

     87          87          2,442          2,442    

 

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The following methods and assumptions were used in estimating fair values:

Cash and cash equivalents: Due to the liquid nature of these instruments, the carrying value approximates fair value.

Term loans: The term loans are not registered with the SEC but are generally transferable through banks that hold the debt and make a market. The fair value is based on quoted prices from recent trades of the term loans.

Convertible senior subordinated notes: The convertible notes are registered with the SEC and are generally transferable. The fair value is based on quoted prices from recent broker trades of the convertible notes. The carrying value is lower than the face value of the convertible notes as a result of separating the liability and equity components. The face value of the convertible notes was $223.6 million at September 30, 2010 and December 31, 2009. See Note 6 for further discussion.

Derivatives: See Note 7 for a description of our methods and assumptions in determining the fair value of our derivatives, which were determined using fair value measurements of significant other observable inputs (Level 2).

Note 14:    Segment Information

We have two operating segments: Itron North America and Itron International. Itron North America generates a majority of its revenues in the United States and Canada, while Itron International generates a majority of its revenues in Europe, and the balance primarily in Africa, South America, and Asia/Pacific. Due to the continued refinement of our management and geographic reporting structures, as of January 1, 2010, Itron International includes our Taiwan operations, which were previously part of Itron North America. Historical segment information has been revised to conform to our current segment reporting structure.

We have three measures of segment performance: revenue, gross profit (margin), and operating income (margin). Intersegment revenues were minimal. Corporate operating expenses, interest income, interest expense, gain (loss) on extinguishment of debt, other income (expense), and income tax provision (benefit) are not allocated to the segments, nor included in the measure of segment profit or loss.

Depreciation and amortization expense associated with our segments was as follows:

 

     Three Months Ended September 30,      Nine Months Ended September 30,  
     2010      2009      2010      2009  
     (in millions)  

Itron North America

     $ 11.5           $ 12.4           $ 34.2           $ 35.4     

Itron International

     20.6           27.0           63.0           78.4     
                                   

Total Company

     $ 32.1           $ 39.4           $ 97.2           $ 113.8     
                                   

Segment Products

 

Itron North America   

Electronic and smart electricity meters; gas and water meters; electricity, gas, and water automated meter reading (AMR) and advanced metering infrastructure (AMI)/smart meter modules; handheld, mobile, and network AMR data collection technologies; AMI network technologies; software, installation, implementation, consulting, maintenance support, and other services.

Itron International

  

Electromechanical, electronic, and smart electricity meters; mechanical and ultrasonic water and heat meters; diaphragm, turbine, and rotary gas meters; one-way and two-way electricity prepayment systems, including smart key, keypad, and smart card; two-way gas prepayment systems using smart card; AMR and AMI data collection technologies; installation, implementation, maintenance support, and other managed services.

 

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     Three Months Ended September 30,      Nine Months Ended September 30,  
   2010      2009      2010      2009  
   (in thousands)  

Revenues

           

Itron North America

     $ 315,335            $ 137,351            $ 861,607            $ 419,658      

Itron International

     260,633            271,007            783,101            790,966      
                                   

Total Company

     $ 575,968            $ 408,358            $ 1,644,708            $ 1,210,624      
                                   

Gross profit

           

Itron North America

     $ 111,858            $ 42,524            $ 294,880            $ 144,737      

Itron International

     72,349            86,955            224,546            247,435      
                                   

Total Company

     $ 184,207            $ 129,479            $ 519,426            $ 392,172      
                                   

Operating income (loss)

           

Itron North America

     $ 64,581            $ (1,188)           $ 155,892            $ 12,459      

Itron International

     7,652            17,319            23,314            40,018      

Corporate unallocated

     (10,853)          (7,125)          (32,099)          (22,803)    
                                   

Total Company

     61,380            9,006            147,107            29,674      

Total other income (expense)

     (17,585)          (27,114)          (47,212)          (74,593)    
                                   

Income (loss) before income taxes

     $ 43,795            $ (18,108)          $ 99,895            $ (44,919)    
                                   

One customer represented more than 10% of total Company revenues for the three and nine months ended September 30, 2010, while no single customer did for the same periods in 2009. Three customers each accounted for more than 10% of Itron North America revenues for the three and nine months ended September 30, 2010, while no single customer did for the same periods in 2009. No single customer represented more than 10% of Itron International revenues for the three and nine months ended September 30, 2010 and 2009.

Revenues by region were as follows:

 

     Three Months Ended September 30,      Nine Months Ended September 30,  
   2010      2009      2010      2009  
   (in thousands)  

United States and Canada

     $ 312,851           $ 131,986           $ 854,923           $ 402,761     

Europe

     173,936           203,834           562,284           610,869     

Other

     89,181           72,538           227,501           196,994     
                                   

Total revenues

     $         575,968           $         408,358           $         1,644,708           $         1,210,624     
                                   

 

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Note 15:    Consolidating Financial Information

Our convertible notes, issued by Itron, Inc., are guaranteed by one U.S. subsidiary, which is 100% owned. Our senior subordinated notes issued in May 2004, which were redeemed in 2009, were guaranteed by multiple U.S. operating subsidiaries. We have not restated the comparative prior period results to reflect the change in certain U.S. subsidiaries from guarantors to non-guarantors as they are immaterial.

The guaranty by our U.S. subsidiary is joint and several, full, complete, and unconditional. There are currently no restrictions on the ability of the subsidiary guarantor to transfer funds to the parent company.

Consolidating Statement of Operations

Three Months Ended September 30, 2010

 

          Parent           Guarantor
  Subsidiary  
    Combined
 Non-guarantor 
Subsidiaries
      Eliminations         Consolidated    
    (in thousands)  

Revenues

    $    313,593           $            -              $ 276,771           $ (14,396)          $ 575,968      

Cost of revenues

    204,233           -              201,924           (14,396)          391,761      
                                       

Gross profit

    109,360           -              74,847           -              184,207      

Operating expenses

         

Sales and marketing

    16,090           -              25,107           -              41,197      

Product development

    21,855           -              12,183           -              34,038      

General and administrative

    14,174           -              16,536           -              30,710      

Amortization of intangible assets

    4,084           -              12,798           -              16,882      
                                       

Total operating expenses

    56,203           -              66,624           -              122,827      
                                       

Operating income

    53,157           -              8,223           -              61,380      

Other income (expense)

         

Interest income

    62           888          137           (921)          166      

Interest expense

    (14,157)          -              (92)          921           (13,328)     

Other income (expense), net

    (1,716)          -              (2,707)          -              (4,423)     
                                       

Total other income (expense)

    (15,811)          888          (2,662)          -              (17,585)     
                                       

Income before income taxes

    37,346           888          5,561           -              43,795      

Income tax provision

    (12,814)          -              (1,873)          -              (14,687)     

Equity in earnings of guarantor and non-guarantor subsidiaries, net

    4,576           -              -              (4,576)          -         
                                       

Net income

    $ 29,108          $ 888          $ 3,688          $ (4,576)          $ 29,108     
                                       

 

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Consolidating Statement of Operations

Three Months Ended September 30, 2009

 

    Parent     Combined
Guarantor
  Subsidiaries  
    Combined
 Non-guarantor 
Subsidiaries
      Eliminations         Consolidated    
    (in thousands)  

Revenues

    $         133,898           $ 1,005          $     282,183           $     (8,728)          $     408,358      

Cost of revenues

    93,219           940          193,448           (8,728)          278,879      
                                       

Gross profit

    40,679           65          88,735           -              129,479      

Operating expenses

         

Sales and marketing

    14,400           -              23,269           -              37,669      

Product development

    19,207           -              11,870           -              31,077      

General and administrative

    9,941           -              16,665           -              26,606      

Amortization of intangible assets

    5,874           -              19,247           -              25,121      
                                       

Total operating expenses

    49,422           -              71,051           -              120,473      
                                       

Operating income (loss)

    (8,743)          65          17,684           -              9,006      

Other income (expense)

         

Interest income

    29,145           877          (112)          (29,955)          (45)     

Interest expense

    (20,499)          -              (29,818)          30,242           (20,075)     

Loss on extinguishment of debt, net

    (2,460)          -              -              -              (2,460)     

Other income (expense), net

    (912)          (7)          (3,328)          (287)          (4,534)     
                                       

Total other income (expense)

    5,274           870          (33,258)          -               (27,114)     
                                       

Income (loss) before income taxes

    (3,469)          935          (15,574)          -               (18,108)     

Income tax benefit

    13,252           -              1,894           -               15,146      

Equity in losses of guarantor and non-guarantor subsidiaries, net

    (12,745)          (2,428)          -              15,173           -         
                                       

Net loss

    $ (2,962)          $ (1,493)          $ (13,680)          $ 15,173           $ (2,962)     
                                       

 

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Table of Contents

 

Consolidating Statement of Operations

Nine Months Ended September 30, 2010

 

    Parent     Guarantor
  Subsidiary  
    Combined
  Non-guarantor  
Subsidiaries
      Eliminations         Consolidated    
    (in thousands)  

Revenues

    $         856,416          $ -              $     828,890             $     (40,598)          $     1,644,708      

Cost of revenues

    568,684          -              597,196           (40,598)          1,125,282      
                                       

Gross profit

    287,732          -              231,694           -              519,426      

Operating expenses

         

Sales and marketing

    47,363          -              76,345           -              123,708      

Product development

    64,084          -              36,016           -              100,100      

General and administrative

    41,424          -              55,628           -              97,052      

Amortization of intangible assets

    12,256          -              39,203           -              51,459      
                                       

Total operating expenses

    165,127          -              207,192           -              372,319      
                                       

Operating income

    122,605          -              24,502           -              147,107      

Other income (expense)

         

Interest income

    537          2,422          363           (2,878)          444      

Interest expense

    (44,357)         -              (736)          2,877           (42,216)     

Other income (expense), net

    1,256          -              (6,697)          1           (5,440)     
                                       

Total other income (expense)

    (42,564)         2,422          (7,070)          -              (47,212)     
                                       

Income before income taxes

    80,041          2,422          17,432           -              99,895      

Income tax provision

    (16,579)        -              (521)          -              (17,100)     

Equity in earnings of guarantor and non-guarantor subsidiaries, net

    19,333          -              -              (19,333)          -         
                                       

Net income

    $ 82,795          $ 2,422          $ 16,911           $ (19,333)          $ 82,795      
                                       

Consolidating Statement of Operations

Nine Months Ended September 30, 2009

 

     Parent      Combined
Guarantor
Subsidiaries
     Combined
Non-guarantor
Subsidiaries
     Eliminations      Consolidated  
     (in thousands)  

Revenues

     $         410,367            $ 3,116            $ 829,870            $ (32,729)           $ 1,210,624      

Cost of revenues

     270,709            3,298            577,174            (32,729)           818,452      
                                            

Gross profit (loss)

     139,658            (182)           252,696            -               392,172      

Operating expenses

              

Sales and marketing

     42,546            -               70,023            -               112,569      

Product development

     58,869            -               34,175            -               93,044      

General and administrative

     31,495            -               52,602            -               84,097      

Amortization of intangible assets

     17,633            -               55,155            -               72,788      
                                            

Total operating expenses

     150,543            -               211,955            -               362,498      
                                            

Operating income (loss)

     (10,885)           (182)           40,741            -               29,674      

Other income (expense)

              

Interest income

     83,472            2,876            537            (85,914)           971      

Interest expense

     (56,003)           -               (83,517)           86,201            (53,319)     

Loss on extinguishment of debt, net

     (12,800)           -               -               -               (12,800)     

Other income (expense), net

     (2,802)           (3)           (6,353)           (287)           (9,445)     
                                            

Total other income (expense)

     11,867            2,873            (89,333)           -               (74,593)     
                                            

Income (loss) before income taxes

     982            2,691            (48,592)           -               (44,919)     

Income tax benefit

     36,938            -               579            -               37,517      

Equity in losses of guarantor and non-guarantor subsidiaries, net

     (45,322)           (5,466)           -               50,788            -         
                                            

Net loss

     $ (7,402)           $   (2,775)           $ (48,013)           $ 50,788            $ (7,402)     
                                            

 

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Table of Contents

 

Consolidating Balance Sheet

September 30, 2010

 

     Parent      Guarantor
    Subsidiary    
     Combined
 Non-guarantor 
Subsidiaries
         Eliminations            Consolidated    
     (in thousands)  
ASSETS               

Current assets

              

Cash and cash equivalents

     $ 18,517            $ -                $ 129,597            $ -                $ 148,114      

Accounts receivable, net

     157,970            -                225,844            -                383,814      

Intercompany accounts receivable

     5,821            -                1,350            (7,171)           -          

Inventories

     112,223            -                114,160            (618)           225,765      

Deferred tax assets current, net

     11,952            -                11,013            -                22,965      

Other current assets

     20,110            -                52,261            -                72,371      

Intercompany other

     2,021            888            2            (2,911)           -          
                                            

Total current assets

     328,614            888            534,227            (10,700)           853,029      

Property, plant, and equipment, net

     116,610            -                185,696            -                302,306      

Prepaid debt fees

     5,704            -                -                -                5,704      

Deferred tax assets noncurrent, net

     28,038            -                21,574            -                49,612      

Other noncurrent assets

     4,368            -                11,930            -                16,298      

Intangible assets, net

     45,914            -                269,842            -                315,756      

Goodwill

     184,751            -                1,051,832            -                1,236,583      

Investment in subsidiaries

     317,383            -                -                (317,383)           -          

Intercompany notes receivable

     1,317,923            99,703            -                (1,417,626)           -          
                                            

Total assets

     $     2,349,305            $ 100,591            $ 2,075,101            $ (1,745,709)           $ 2,779,288      
                                            

LIABILITIES AND SHAREHOLDERS’ EQUITY

              

Current liabilities

              

Accounts payable

     $ 74,970            $ -                $ 163,125            $ -                $ 238,095      

Other current liabilities

     14,723            -                45,083            -                59,806      

Intercompany accounts payable

     1,389            -                5,782            (7,171)           -          

Wages and benefits payable

     42,018            -                54,695            -                96,713      

Taxes payable

     1,500            -                21,379            -                22,879      

Current portion of debt

     226,246            -                -                -                226,246      

Current portion of warranty

     11,498            -                16,734            -                28,232      

Unearned revenue

     23,896            -                6,853            -                30,749      

Deferred tax liabilities current, net

     1,015            -                654            -                1,669      

Short-term intercompany advances

     887            -                2,024            (2,911)           -          
                                            

Total current liabilities

     398,142            -                316,329            (10,082)           704,389      

Long-term debt

     436,704            -                -                -                436,704      

Long-term warranty

     12,468            -                12,525            -                24,993      

Pension plan benefits

     -                -                60,013            -                60,013      

Intercompany notes payable

     99,703            -                1,317,923            (1,417,626)           -          

Deferred tax liabilities noncurrent, net

     (46,436)           -                98,564            -                52,128      

Other long-term obligations

     16,080            -                52,337            -                68,417      
                                            

Total liabilities

     916,661            -                1,857,691            (1,427,708)           1,346,644      

Shareholders’ equity

              

Preferred stock

     -                -                -                -                -          

Common stock

     1,321,287            97,377            65,511            (162,888)           1,321,287      

Accumulated other comprehensive income (loss), net

     (1,688)           (7,787)           45,658            (37,871)           (1,688)     

Retained earnings

     113,045            11,001            106,241            (117,242)           113,045      
                                            

Total shareholders’ equity

     1,432,644            100,591            217,410            (318,001)           1,432,644      
                                            

Total liabilities and shareholders’ equity

     $ 2,349,305            $ 100,591            $ 2,075,