Hexcel 10-Q 2009
Washington, D.C. 20549
For the Quarterly Period Ended September 30, 2009
For the transition period from to
Commission File Number 1-8472
(Exact name of registrant as specified in its charter)
Two Stamford Plaza
281 Tresser Boulevard
Stamford, Connecticut 06901-3238
(Address of principal executive offices and zip code)
Registrants telephone number, including area code: (203) 969-0666
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 o
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 o No o
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.
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes o No x
Indicate the number of shares outstanding of each of the registrants classes of common stock, as of the latest practicable date.
HEXCEL CORPORATION AND SUBSIDIARIES
Hexcel Corporation and Subsidiaries
The accompanying notes are an integral part of these condensed consolidated financial statements.
Hexcel Corporation and Subsidiaries
The accompanying notes are an integral part of these condensed consolidated financial statements.
Hexcel Corporation and Subsidiaries
The accompanying notes are an integral part of these condensed consolidated financial statements.
HEXCEL CORPORATION AND SUBSIDIARIES
Note 1 Significant Accounting Policies
In these notes, the terms Hexcel, the Company, we, us, or our mean Hexcel Corporation and subsidiary companies. The accompanying condensed consolidated financial statements are those of Hexcel Corporation. Refer to Note 1 to the consolidated financial statements included in the Annual Report on Form 10-K for the year ended December 31, 2008 for a discussion of our significant accounting policies.
Basis of Presentation
The accompanying condensed consolidated financial statements have been prepared from the unaudited records of Hexcel pursuant to rules and regulations of the Securities and Exchange Commission (SEC) and in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information. Certain information and footnote disclosures normally included in financial statements have been omitted pursuant to rules and regulations of the SEC.
In the opinion of management, the condensed consolidated financial statements include all adjustments necessary for a fair presentation of financial position, results of operations and cash flows for the interim periods presented. The condensed consolidated balance sheet as of December 31, 2008 was derived from the audited 2008 consolidated balance sheet. Interim results are not necessarily indicative of results expected for any other interim period or for the full year. The information included in this Form 10-Q should be read in conjunction with the financial statements and notes thereto included in our 2008 Annual Report on Form 10-K.
Reclassifications and revisions
Certain prior year amounts have been reclassified to conform to the current year presentation.
Cash provided by operating activities for the nine months ended September 30, 2008 was revised to $48.6 million from the $43.4 million previously reported, while cash used for investing activities increased by the same amount. Investing activities now include only cash payments for capital expenditures, whereas previously they included additions to property, plant and equipment on an accrual basis. The adjustment to the cash basis is reflected in the change in accounts payable.
Management will revise the Statements of Cash Flows for comparative periods in future filings to appropriately reflect capital expenditures on a cash basis. For annual periods ended December 31, 2008, 2007 and 2006, cash provided by operating activities will be revised from $98.9 million to $97.5 million, $106.3 million to $100.9 million and $98.3 million to $95.7 million, respectively. Cash provided by operating activities will be revised for the year-to-date periods ended March 31, 2009 and 2008 and June 30, 2009 and 2008 from $3.1 million to $13.6 million, ($14.7) million to ($13.3) million, $69.9 million to $86.2 million and ($5.5) million to $2.1 million, respectively. Cash used in investing activities will also be revised in each year-to-date period in an equal and offsetting amount. Management has concluded that these revisions are immaterial.
New Accounting Pronouncements
In December 2008 the FASB issued new authoritative guidance regarding employers disclosures about postretirement benefit plan assets. This guidance adds required disclosures about (1) how investment allocation decisions are made by management, (2) major categories of plan assets and (3) significant concentrations of risk. Additionally, employers are required to disclose information about the valuation of plan assets similar to that required under existing fair value guidance. The new guidance is effective for our fiscal year ending December 31, 2009. The principal impact from this new guidance will be expanded disclosures regarding our benefit plan assets.
In June 2009, the FASB issued revised authoritative guidance that amends the consolidation guidance applicable to variable interest entities. The amendments will significantly affect the overall consolidation analysis under previously issued guidance. The revised guidance is effective as of the beginning of the first fiscal year that begins after November 15, 2009, which is January 1, 2010 for the Company. The Company does not expect this new guidance to have a material impact on the Companys financial position and results of operations.
In October 2009, the FASB issued new authoritative guidance regarding Revenue Recognition Multiple Deliverable Revenue Arrangements. This update provides amendments for separating consideration in multiple deliverable arrangements and removes the objective-and-reliable-evidence-of-fair-value criterion from the separation criteria used to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting, replaces references to fair value with selling price to distinguish from the fair value measurements required under the Fair Value Measurements and Disclosures guidance, provides a hierarchy that entities must use to estimate the selling price, eliminates the use of the residual method for allocation, and expands the ongoing disclosure requirements. This update is effective for the Company beginning January 1, 2011 and can be applied
prospectively or retrospectively. We are currently evaluating the effect that adoption of this update will have, if any, on the Companys consolidated financial position and results of operations.
Recently adopted accounting pronouncements
In March 2008, the FASB issued revised authoritative guidance concerning disclosures about derivative instruments and hedging activities. The new guidance requires entities that utilize derivative instruments to provide qualitative disclosures about their objectives and strategies for using such instruments, as well as any details of credit-risk-related contingent features contained within derivatives. This also requires entities to disclose additional information about the amounts and location of derivatives located within the financial statements and the impact that hedges have on an entitys financial position, financial performance, and cash flows. The Company adopted the new guidance on January 1, 2009 and has expanded the disclosures regarding derivative instruments and hedging activities within Note 5.
In September 2006, the FASB issued new authoritative guidance regarding fair value measurements and the fair value option for financial assets and financial liabilities. This guidance defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosure about fair value measurements. In February 2008, the FASB issued revised authoritative guidance, which provided a one year deferral for fair-value measurements of non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. As of January 1, 2009, the Company adopted the new guidance with respect to its non-financial assets and liabilities that are measured at fair value within the financial statements. See Note 11.
In April 2009, the FASB issued new authoritative guidance requiring interim disclosures about fair value of financial instruments. The new guidance is effective for interim reporting periods ending after June 15, 2009. The Company adopted this guidance in the second quarter of 2009. As a result, we have expanded our disclosures regarding derivative instruments and hedging activities within Note 4.
In May 2009, the FASB issued new authoritative guidance regarding Subsequent Events, which established general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The new guidance became effective in the second quarter of 2009. The Company has performed an evaluation of subsequent events through October 26, 2009, which is the date the financial statements were issued.
In June 2009, the FASB issued new authoritative guidance regarding accounting standards codification that will become the source of authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental entities. The Company adopted the new guidance in the third quarter of fiscal 2009. The new guidance did not affect the Companys financial position and results of operations, but did affect the way U.S. GAAP is referenced within the consolidated financial statements and accounting policies.
In August 2009, the FASB issued new authoritative guidance regarding Measuring Liabilities at Fair Value. The new guidance provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using prescribed techniques. We adopted the new guidance in the third quarter of 2009 and it did not materially affect the Companys financial position and results of operations.
Note 3 Retirement and Other Postretirement Benefit Plans
We maintain qualified and non-qualified defined benefit retirement plans covering certain current and former U.S. and European employees, retirement savings plans covering eligible U.S. employees and certain postretirement health care and life insurance benefit plans covering eligible U.S. retirees. We also participate in a union sponsored multi-employer pension plan covering certain U.S. employees with union affiliations. We completed the settlement of substantially all U.S. qualified defined benefit plan pension obligations as of March 31, 2008 and terminated the plan as of April 1, 2008. Refer to our 2008 Annual Report on Form 10-K for further information regarding these plans.
Defined Benefit Retirement Plans
Net Periodic Benefit Costs
Net periodic benefit costs of our defined benefit retirement plans for the quarters and nine months ended September 30, 2009 and 2008 were as follows:
We generally fund our U.S. non-qualified defined benefit retirement plans when benefit payments are incurred. Under the provisions of these non-qualified plans, we expect to contribute $0.3 million in 2009 to cover unfunded benefits. We contributed $0.6 million to our U.S. non-qualified defined benefit retirement plans during the 2008 fiscal year.
We contributed $1.9 million and $0.4 million to our European defined benefit retirement plans in the third quarters of 2009 and 2008, respectively. Contributions were $4.1 million and $2.6 million for the nine months ended September 30, 2009 and 2008, respectively. Meeting governing requirements, we plan to contribute approximately $4.3 million during 2009 to our European plans. We contributed $4.8 million to our European plans during the 2008 fiscal year.
We contributed $7.5 million to our U.S. qualified and non-qualified defined benefit retirement plans during the first nine months of 2008. Of the total contributed during 2008, $6.4 million was for final settlement of the U.S. qualified plans remaining benefit obligations, bringing the total contribution for final settlement to $9.7 million. We recorded a pre-tax loss of $2.7 million during the first quarter of 2008 on the final settlement, bringing the total U.S. qualified plan settlement costs to $12.1 million.
Postretirement Health Care and Life Insurance Benefit Plans
Net periodic benefit costs of our postretirement health care and life insurance benefit plans for the quarters and nine months ended September 30, 2009 and 2008 were as follows:
In connection with our postretirement plans, we contributed $0.2 million and $0.3 million during each of the third quarters of 2009 and 2008, respectively, and $0.5 million and $0.9 million during the nine-month periods ended September 30, 2009 and 2008, respectively. We periodically fund our postretirement plans to pay covered expenses as they are incurred. Under the provisions of these post retirement plans, we expect to contribute approximately $1.1 million in 2009 to cover unfunded benefits. We contributed $0.8 million to our postretirement plans during the 2008 fiscal year.
Note 4 - Notes Payable and Capital Lease Obligations
Estimated Fair Values of Notes Payable
The approximate, aggregate fair value of our notes payable as of September 30, 2009 and December 31, 2008 were as follows:
The aggregate fair values of the notes payable were estimated on the basis of quoted market prices; however, trading in these securities is limited and may differ from the amount for which the security could be transferred in an active market.
Senior Secured Credit Facility
On May 21, 2009, Hexcel Corporation entered into a new $300 million senior secured credit facility (Senior Secured Credit Facility), consisting of a $175 million term loan and a $125 million revolving loan. The term loan matures on May 21, 2014 and the revolving loan matures on May 21, 2013. Hexcel has the option of selecting either a LIBOR-based (the current option used) or U.S. domestic-based interest rate for each of the term loan and the revolving loans. Term and revolving loans borrowed as LIBOR-based
loans bear interest at a rate of LIBOR plus 4%, and term and revolving loans borrowed as U.S. base rate loans bear interest at the base rate plus 3%. There is a LIBOR floor of 2.5%, and a base rate floor of 4%. The margin for revolving loans will decrease by 50 basis points if Hexcels leverage ratio decreases below 2 to 1, and will decrease an additional 25 basis points if Hexcels leverage ratio decreases below 1.75 to 1. The term loan was borrowed at closing and once repaid cannot be reborrowed. The term loan is scheduled to be repaid at a rate of approximately $2.2 million per quarter starting in the third quarter of 2009 and increasing to $17.5 million in August 2013 with two final payments of $52.5 million in 2014. Depending upon our leverage ratio, there may be a mandatory repayment each year based on 50% of the cash flow generated for the year, as defined in the agreement. The amounts, if any, will be based on final year-end results. In September 2009, we prepaid $8.8 million of the term loan which represented the next four scheduled quarterly payments and resulted in $0.2 million of accelerated amortization of deferred financing costs.
Proceeds from the term loan, and from an initial borrowing under the revolving loan, were used to repay all amounts, and terminate all commitments, outstanding under Hexcels former credit agreement and to pay fees and expenses in connection with the refinancing. The Company incurred $10.4 million in issuance costs related to the refinancing of the Senior Secured Credit Facility, which will be expensed over the life of the new facility, and recorded $1.7 million in interest expense related to the write-off of deferred financing costs associated with the previous credit facility. At September 30, 2009, the Company had no borrowings outstanding under the revolving loan.
The Senior Secured Credit Facility contains financial and other covenants, including, but not limited to, restrictions on the incurrence of debt and the granting of liens, as well as the maintenance of an interest coverage ratio and a leverage ratio, and limitations on capital expenditures. A violation of any of these covenants could result in a default under this facility, which would permit the lenders to accelerate the payment of all borrowings and to terminate the facility. In addition, such a default could, under certain circumstances, permit the holders of other outstanding unsecured debt to accelerate the repayment of such obligations.
In accordance with the terms of the Senior Secured Credit Facility, we are required to maintain a minimum interest coverage ratio of 4.00 (based on the ratio of EBITDA, as defined in the credit agreement, to interest expense) and may not exceed a maximum leverage ratio of 2.75 (based on the ratio of total debt to EBITDA) throughout the term of the Senior Secured Credit Facility. In addition, the Senior Secured Credit Facility contains other terms and conditions such as customary representations and warranties, additional covenants and customary events of default. As of September 30, 2009, we were in compliance with all debt covenants.
The Senior Secured Credit Facility permits us to issue letters of credit up to an aggregate amount of $40 million. Any outstanding letters of credit reduce the amount available for borrowing under the revolving loan. As of September 30, 2009, we had issued letters of credit totaling $11.8 million under the Senior Secured Credit Facility. As we had no borrowings under the revolving loan at September 30, 2009, total undrawn availability under the Senior Secured Credit Facility as of September 30, 2009 was $113.2 million.
Note 5 - Derivative Financial Instruments
We enter into foreign currency forward contracts to reduce the risks associated with the changes in foreign exchange rates on sales and purchases denominated in other currencies. As described below, we have also entered into a cross-currency interest rate swap agreement. We do not use these or any other contracts for speculative or trading purposes.
Cross-Currency Interest Rate Swap Agreement
In 2006, we entered into a cross-currency interest rate swap agreement. It has been designated as a hedge of our investment in Hexcel France SA. To the extent it is effective, gains and losses are recorded as an offset in the cumulative translation account, the same account in which translation gains and losses on the investment in Hexcel France SA are recorded. All other changes, including any difference in current interest, are excluded from the assessment of effectiveness and are thereby included as a component of interest expense. By excluding the interest rate component of risk in this instrument, and recognizing it in current period earnings, we have diversified our floating rate interest rate exposure to include Euro interest rates which provide a better matching with the underlying currency of operating cash flows. There was no impact to interest expense in the current quarter. The impact to interest expense for the nine months ended September 30, 2009 was a net increase of $0.1million, compared to a net increase of $1.5 million and $1.4 million for the quarter and nine months ended September 30, 2008, respectively. This agreement has a notional value of $63.4 million, a term of five years, and is scheduled to mature on September 20, 2011. We receive interest in U.S. dollars quarterly and pay interest in Euros on the same day. U.S. interest is based on the three month LIBOR rate. Euro interest is based on the three month EURIBOR. The fair value of the swap at September 30, 2009 and December 31, 2008 was a liability of $9.6 million and $7.3 million, respectively. There were no credit contingency features in this derivative.
Foreign Currency Forward Exchange Contracts
A number of our European subsidiaries are exposed to the impact of exchange rate volatility between the U.S. dollar and the subsidiaries functional currencies, being either the Euro or the British pound. We have entered into contracts to exchange U.S.
dollars for Euros and British pounds through 2011. The aggregate notional amount of these contracts was $92.3 million at September 30, 2009. The purpose of these contracts is to hedge a portion of the forecasted transactions of European subsidiaries under long-term sales contracts with certain customers. These contracts are expected to provide us with a more balanced matching of future cash receipts and expenditures by currency, thereby reducing our exposure to fluctuations in currency exchange rates. These forward contracts are designated as cash flow hedges of forecasted revenues. The effective portion of the hedges of $1.3 million and $3.5 million is recorded in other comprehensive income (OCI) for the three and nine months ended September 30, 2009. We exclude the forward points from the effectiveness assessment of $0.1 million and $0.2 million for the three and nine months ended September 30, 2009 which is recorded in interest expense. For the quarters and nine months ended September 30, 2009 and 2008, hedge ineffectiveness was immaterial.
In addition, we enter into foreign exchange forward contracts which are not designated as hedges. These are used to provide an offset to transactional gains or losses arising from the remeasurement of non-functional monetary assets and liabilities such as accounts receivable. The change in the fair value of the derivatives is recorded in the statement of operations. There are no credit contingency features in these derivatives. The carrying amount of these contracts was $3.5 million in other assets and $13.3 million classified in other liabilities on the Consolidated Balance Sheets. During the three and nine months ended September 30, 2009 we recognized net losses of $0.8 million and $4.8 million, respectively recorded in sales and cost of sales. During the three and nine months ended September 30, 2009 we recognized net gains of $1.3 million and net losses of $6.4 million, respectively, in other comprehensive income. Asset and liability derivatives not designated as hedging instruments were not material.
The change in fair value of our foreign currency forward exchange contracts under hedge designations recorded net of tax within accumulated other comprehensive income for the quarters and nine months ended September 30, 2009 and 2008 was as follows:
As of September 30, 2009, the unrealized losses recorded in accumulated other comprehensive income, net of tax, of $1.4 million, are expected to be reclassified into earnings over the next twelve months as the hedged sales are recorded.
Note 6 Other (Income) Expense
In the third quarter we recorded a $1.7 million gain related to a prior year sale of a business, primarily due to an earn-out payment from the buyer. During the second quarter of 2009, we updated our estimate of costs required to remediate environmental exposures at former sites in Lodi, New Jersey and in France and accordingly increased our reserves by $1.7 million. During the first nine months of 2008, we increased our environmental accruals by $7.6 million for the former site in Lodi, New Jersey and recorded $2.7 million of expense in connection with the termination of our U.S. Qualified Defined Benefit Retirement Plan.
Note 7 Income Taxes
The effective tax rates for the third quarters ended September 30, 2009 and 2008 were 19.7% and 36.1%, respectively. The rates reflect tax benefits of $1.2 million from the recognition of additional 2008 and 2009 U.S. Research and Development (R&D) tax credits during the third quarter 2009, the result of our tax planning initiatives and $1.8 million related to the reversal of a reserve for uncertain tax positions partly offset by an additional provision of $0.8 million related to the gain on the sale of our interest in BHA in the third quarter 2008.
The effective tax rates for the nine months ended September 30, 2009 and 2008 were 28.0% and 21.8%, respectively. In addition to the third quarter items mentioned above, the rates also reflect tax benefits of $1.1 million from the reversal of reserves for uncertain tax positions as a result of an audit settlement for the first nine months of 2009 and $17.2 million for the reinstatement of U.S. deferred tax assets which had previously been written off for the first nine months of 2008. In addition, primarily as a result of the elimination of our U.S. defined pension plan, a $3.6 million tax charge (previously included in other comprehensive income) was recognized in the nine month period of 2008.
Note 8 - Net Income per Common Share
Total shares underlying stock options of 2.0 million for the quarter and 2.1 million for the nine months were excluded from the computation of diluted net income per share for the periods ended September 30, 2009, as they were anti-dilutive.
Note 9 - Comprehensive Income
Comprehensive income represents net income and other gains and losses affecting stockholders equity that are not reflected in the condensed consolidated statements of operations. The components of comprehensive income for the quarters and nine months ended September 30, 2009 and 2008 were as follows:
Note 10 Investments in Affiliated Companies
Asian Composites Manufacturing Sdn. Bhd.
Prior to September 2009, we had a 33.33% ownership interest in this joint venture located in Alor Setar, Malaysia. The joint venture manufactures composite parts for secondary structures for commercial aircraft. In September 2009, we increased our ownership percentage to 50%. Concurrently, Boeing Worldwide Operations Limited, the other existing equity investor also increased its ownership percentage to 50%. In connection therewith, we have considered the accounting and disclosure requirements regarding variable interest entities, and believe that we are not the primary beneficiary of such entity, and therefore, are not required to consolidate this entity.
BHA Aero Composite Parts Co., Ltd.
The Companys former joint venture, BHA Aero Composite Parts Co., Ltd. (BHA), is located in Tianjin, China, and manufactures composite parts for secondary structures and interior applications for commercial aircraft. On July 18, 2008 we sold our 40.48% interest in BHA. The Company received cash proceeds (before taxes) in the amount of $22.3 million and recorded a pre-tax gain on the sale of $12.5 million in the third quarter of 2008 which is included in equity in earnings on the accompanying condensed consolidated statement of operations. We also recorded a tax provision of $0.8 million related to the sale, so the after-tax gain was $11.7 million or $0.12 per diluted share.
Note 11 Fair Value Measurements
The authoritative guidance for fair value measurements establishes a hierarchy for observable and unobservable inputs used to measure fair value, into three broad levels, which are described below:
· Level 1: Quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities. The fair value hierarchy gives the highest priority to Level 1 inputs.
· Level 2: Observable prices that are based on inputs not quoted on active markets, but corroborated by comparable market data.
· Level 3: Unobservable inputs are used when little or no market data is available. The fair value hierarchy gives the lowest priority to Level 3 inputs.
In determining fair value, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible as well as considers counterparty credit risk in its assessment of fair value.
For derivative assets and liabilities that utilize Level 2 inputs we prepare estimates of future cash flows of our derivatives, which are discounted to a net present value. The estimated cash flows and the discount factors used in the valuation model are based on observable inputs, and incorporate non-performance risk (the credit standing of the counterparty when the derivative is in a net asset position, and the credit standing of Hexcel when the derivative is in a net liability position). Below is a summary of valuation techniques for all Level 2 financial assets and liabilities:
· Cross-Currency interest rate swap derivative liabilities valued using LIBOR and EURIBOR yield curves at the reporting date. Counterparties to these contracts are highly rated financial institutions none of which experienced any significant downgrades in the three months ended September 30, 2009 that would reduce the receivable amount owed, if any, to the Company.
· Foreign exchange derivative assets and liabilities valued using quoted forward foreign exchange prices at the reporting date. Counterparties to these contracts are highly rated financial institutions none of which experienced any significant downgrades in the three months ended September 30, 2009 that would reduce the receivable amount owed, if any, to the Company.
· Money market funds considered available-for-sale, and classified as cash equivalents.
At September 30, 2009 assets measured at fair value include money market funds of $70.6 million and foreign currency exchange contracts of $3.7 million; liabilities measured at fair value include foreign currency exchange contracts of $3.9 million and cross-currency interest rate swaps of $9.6 million. The measurements for these assets and liabilities were based upon Level 2 inputs.
Note 12 - Segment Information
The financial results for our operating segments are prepared using a management approach, which is consistent with the basis and manner in which we internally segregate financial information for the purpose of assisting in making internal operating decisions. We evaluate the performance of our operating segments based on operating income, and generally account for intersegment sales based on arms length prices. Corporate and certain other expenses are not allocated to the operating segments, except to the extent that the expense can be directly attributable to the business segment.
Financial information for our business segments for the quarters and nine months ended September 30, 2009 and 2008 is as follows:
(a) Operating income for the quarter ended September 30, 2009 within the corporate and other segment includes a $1.7 million gain on the sale of a business sold in a prior year resulting from an earn-out payment from the buyer. Operating income for the nine months ended September 30, 2009 within the corporate and other segment also includes an offsetting expense of $1.7 million related to the increase in environmental remediation liabilities. Operating income for the nine months ended September 30, 2008 within the corporate and other segment includes $7.6 million related to the increase in environmental remediation liabilities and $2.7 million of other expense as described within Note 6 to the condensed consolidated financial statements.
Goodwill and Intangible Assets
The carrying amount of goodwill and intangible assets by segment is as follows:
Note 13 - Business Consolidation and Restructuring Programs
Reserves associated with the remaining restructuring programs include certain expected severance payments associated with reorganization programs announced in prior years and lease payments remaining on facilities no longer used. The aggregate business consolidation and restructuring liabilities accrued for these programs at December 31, 2008, consisted of $2.0 million for employee severance and $0.9 for the facility and equipment. There have been no additional expenses during 2009. Severance payments related to these programs were $0.1 million for the quarter and $1.2 million for the nine months of 2009. Facility related payments were $0.1 million for the quarter and $0.3 million for the nine months of 2009. At September 30, 2009, we have a $1.4 million reserve to cover future payments.
Note 14 Commitments and Contingencies
We are involved in litigation, investigations and claims arising out of the normal conduct of our business, including those relating to commercial transactions, environmental, employment, and health and safety matters. We estimate and accrue our liabilities when a loss becomes probable and estimable. These judgments take into consideration a variety of factors, including the stage of the proceeding; potential settlement value; assessments by internal and external counsel; and assessments by environmental engineers and consultants of potential environmental liabilities and remediation costs. Such estimates are not discounted to reflect the time value of money due to the uncertainty in estimating the timing of the expenditures, which may extend over several years.
While it is impossible to ascertain the ultimate legal and financial liability with respect to certain contingent liabilities and claims, we believe, based upon our examination of currently available information, our experience to date, and advice from legal counsel, that any individual and aggregate liabilities resulting from the ultimate resolution of these contingent matters, after taking into consideration our existing insurance coverage and amounts already provided for, will not have a material adverse impact on our consolidated results of operations, financial position or cash flows.
We are subject to various U.S. and international federal, state and local environmental, and health and safety laws and regulations. We are also subject to liabilities arising under the Federal Comprehensive Environmental Response, Compensation and Liability Act (CERCLA or Superfund), the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, and similar state and international laws and regulations that impose responsibility for the control, remediation and abatement of air, water and soil pollutants and the manufacturing, storage, handling and disposal of hazardous substances and waste.
We have been named as a potentially responsible party (PRP) with respect to several hazardous waste disposal sites that we do not own or possess, which are included on, or proposed to be included on, the Superfund National Priority List of the U.S. Environmental Protection Agency (EPA) or on equivalent lists of various state governments. Because CERCLA allows for joint and several liability in certain circumstances, we could be responsible for all remediation costs at such sites, even if we are one of many PRPs. We believe, based on the amount and the nature of our waste, and the number of other financially viable PRPs, that our liability in connection with such matters will not be material.
Lodi, New Jersey Site
Pursuant to the New Jersey Industrial Site Recovery Act, we entered into a Remediation Agreement to pay for the environmental remediation of a manufacturing facility we own and formerly operated in Lodi, New Jersey. We have commenced remediation of this site in accordance with an approved plan; however, the ultimate cost of remediating the Lodi site will depend on developing circumstances. The total accrued liability related to this matter was $6.2 million as of September 30, 2009.
Lower Passaic River Study Area
In October 2003, we received, along with 66 other entities, a directive from the New Jersey Department of Environmental Protection (NJDEP) that requires the entities to assess whether operations at various New Jersey sites, including our former manufacturing site in Lodi, New Jersey, caused damage to natural resources in the Lower Passaic River watershed. In May 2005, the NJDEP dismissed us from the Directive. In February 2004, 42 entities, including Hexcel, received a general notice letter from the EPA which requested that the entities consider helping to finance an estimated $10 million towards an EPA study of environmental conditions in the Lower Passaic River watershed. In May 2005, we signed onto an agreement with the EPA to participate (bringing the total number of participating entities to 43) in financing such a study up to $10 million, in the aggregate. Since May 2005,
a number of additional PRPs have joined into the agreement with the EPA. In October 2005, we along with the other EPA notice recipients were advised by the EPA that the notice recipients share of the costs of the EPA study was expected to significantly exceed the earlier EPA estimate. While we and the other recipients were not obligated by our agreement to share in such excess, a Group of notice recipients (73 companies including Hexcel) negotiated an agreement with the EPA to assume responsibility for the study pursuant to an Administrative Order on Consent. Work on the study is ongoing. We believe we have viable defenses to the EPA claims and expect that other as yet unnamed parties also will receive notices from the EPA. In June 2007, the EPA issued a draft Focused Feasibility Study (FFS) that considers six interim remedial options for the lower eight miles of the river, in addition to a no action option. The estimated costs for the six action options range from $900 million to $2.3 billion. The PRP group provided comments to the EPA on the FFS; EPA has not yet taken further action. The Administrative Order on Consent regarding the study does not cover work contemplated by the FFS. Furthermore, the Federal Trustees for natural resources have indicated their intent to perform a natural resources damage assessment on the river and invited the PRPs to participate in the development and performance of this assessment. The PRP Group, including Hexcel, has not agreed to participate in the assessment at this time. Finally, on February 4, 2009, Tierra Solutions (Tierra) and Maxus Energy Corporation (Maxus) filed a third party complaint in New Jersey Superior Court against us and over 300 other entities in an action brought against Tierra and Maxus (and other entities) by the State of New Jersey. We entered into a Joint Defense Agreement with many of the third-party defendants (approximately 120 to date). New Jerseys suit against Tierra and Maxus relates to alleged discharges of contaminants by Tierra and Maxus to the Passaic River and seeks payment of all past and future costs the State has and will incur regarding cleanup and removal of contaminants, investigation of the Passaic River and related water bodies, assessment of natural resource injuries and other specified injuries. The third party complaint seeks contribution from us for all or part of the damages that Tierra and Maxus may owe to the State. We have not yet responded to the complaint; our response is due thirty days after Tierra and Maxus file documentation purportedly supporting their allegations against Hexcel, which have not been filed to date. Our initial disclosures are due 45 days after filing our answer; however, substantially all additional third-party discovery and motions practice have been stayed until May 2010. Our ultimate liability for investigatory costs, remedial costs and/or natural resource damages in connection with the Lower Passaic River cannot be determined at this time.
Kent, Washington Site
We were party to a cost-sharing agreement regarding the operation of certain environmental remediation systems necessary to satisfy a post-closure care permit issued to a previous owner of the our Kent Washington, site by the EPA. Under the terms of the cost-sharing agreement, we were obligated to reimburse the previous owner for a portion of the cost of the required remediation activities. Management has determined that the cost-sharing agreement terminated in December 1998; however, the other party disputes this determination. The Washington Department of Ecology (Ecology) has issued a unilateral Enforcement Order requiring us to (a) maintain the interim remedial system and to perform system separation, (b) to conduct a focused remedial investigation and (c) to conduct a focused feasibility study to develop recommended long term remedial measures. We asserted defenses against performance of the order, particularly objecting to the remediation plan proposed by the previous owner, who still owns the adjacent contaminated site. Hexcel and Ecology have reached an agreement to modify certain work requirements and to extend certain deadlines, which agreement is being formalized; we believe this agreement will remove current and potential compliance issues.
Omega Chemical Corporation Superfund Site, Whittier, CA
We are a PRP at a former chemical waste site in Whittier, CA. The PRPs at Omega have established a PRP Group, the Group, and are currently investigating and remediating soil and groundwater at the site pursuant to a Consent Decree with the EPA, entered into in March 2000. Hexcel contributed approximately 1.07% of the waste tonnage sent to the site during its operations. The EPA has recently sent a Special Notice letter to 155 PRPs, including the Company, requiring the Group to remediate on-site soils and to begin good faith negotiations with EPA regarding $10 million in Agency oversight expenses. In addition to the Omega site specifically, there is regional groundwater contamination in the area as well. EPA has not determined who it will identify as PRPs to investigate and, as necessary, remediate the regional groundwater contamination. Although, as a member of the Group, Hexcel has contributed, and expects to continue to contribute, funds which will offset the regional investigation and remediation, our ultimate liability, if any, in connection with this matter cannot be determined at this time.
Our estimate of liability as a PRP and our remaining costs associated with our responsibility to remediate the Lodi, New Jersey; Kent, Washington; and other sites are accrued in the consolidated balance sheets. As of September 30, 2009, our aggregate environmental related accruals were $9.0 million, of which $4.5 million was included in accrued liabilities with the remainder included in non-current liabilities. As related to certain environmental matters, the accrual was estimated at the low end of a range of possible outcomes since no amount within the range is a better estimate than any other amount. If we had accrued for these matters at the high end of the range of possible outcomes, our accrual would have been $4.5 million higher. These accruals can change significantly from period to period due to such factors as additional information on the nature or extent of contamination, the methods of remediation required, changes in the apportionment of costs among responsible parties and other actions by governmental agencies or private parties, or the impact, if any, of being named in a new matter.
Environmental remediation spending charged directly to our reserve balance was $0.8 million and $0.6 million for the quarters ended September 30, 2009 and 2008, respectively, and $2.2 million and $2.1 million for the nine months ended September 30, 2009 and 2008, respectively. In addition, our operating costs relating to environmental compliance charged directly to expense were $2.4 million and $2.7 million for the quarters ended September 30, 2009 and 2008, respectively, and $7.4 million and $8.2 million for the nine months ended September 30, 2009 and 2008, respectively. Capital expenditures for environmental matters were $1.5 million and $1.8 million for the quarters ended September 30, 2009 and 2008, respectively, and $3.5 million and $4.1 million for the nine months ended September 30, 2009 and 2008, respectively.
Gurit Infringement Claim
Our Austrian subsidiary has been sued in Germany and Austria by Gurit, a European competitor of prepreg materials sold into the wind energy market. Gurit alleges that the Companys HexFIT® prepreg made in Austria and sold in Germany to Vestas infringes a Gurit EU patent. Gurit also has had its counsel issue a cease and desist letter with respect to our sales to a minor wind energy customer in Denmark. Vestas is our largest wind energy customer and in Europe manufactures blades for wind turbines in Germany, Denmark and Spain. The suits seek an injunction to prevent the Company from making or selling HexFIT® in Germany and Austria and also seek damages for past infringement. Regarding the Gurit patent itself, we are appealing a decision of the European patent office (EPO) which upheld the validity of the patent in an opposition proceeding. In our appeal we generally assert that the patent is not valid based on prior art, particularly prior art not previously considered by the EPO when it granted and later upheld the patent. At a hearing in May 2009, the German court deferred making a final ruling and instead ordered that a technical expert be appointed to assist it in reaching a decision on whether there is infringement. The expert has not yet been selected. We intend to prosecute the appeal in the EPO which will be heard in November 2009. Furthermore, we believe that HexFIT® does not infringe the patent, and should it be upheld, we intend to vigorously defend the infringement suits in Germany and Austria.
Seemann Composites, Inc. v. Hexcel Corporation
Seemann Composites, Inc., (SCI) has sued us in the United States District Court, Southern District of Mississippi (Civil Action No. 1:09-cv-00675-HSO-JMR), filed September 16, 2009. SCI alleges that we supplied the wrong or a defective finished fabric to them, through one of our distributors, and is seeking damages, including punitive damages, due to breach of warranty, negligence, reckless and intentional misconduct. We deny their allegations and intend to vigorously defend the suit.
We provide for an estimated amount of product warranty expense at the time revenue is recognized. This estimated amount is provided by product and based on historical warranty experience. In addition, we periodically review our warranty accrual and record any adjustments as deemed appropriate. Warranty expense for the quarter and nine months ended September 30, 2009, and accrued warranty cost, included in accrued liabilities in the condensed consolidated balance sheets at September 30, 2009 and December 31, 2008, was as follows:
Hexcel Corporation and its subsidiaries, is a leading advanced composites company. We develop, manufacture, and market lightweight, high-performance composites, including carbon fibers, reinforcements, prepregs, honeycomb, matrix systems, adhesives and composite structures, for use in commercial aerospace, space and defense and industrial applications. Our products are used in a wide variety of end applications, such as commercial and military aircraft, rotorcraft, space launch vehicles and satellites, wind turbine blades, automotive and a wide variety of recreational equipment.
We serve international markets through manufacturing facilities and sales offices located in the United States, Europe and Asia, and through sales representation offices located in Asia, Australia and South America. We also hold a 50% interest in Asian Composites Manufacturing Sdn. Bhd., located in Malaysia, which manufactures composite structures for commercial aerospace.
Hexcel has two segments, Composite Materials and Engineered Products. The Composite Materials segment manufactures and markets carbon fibers, fabrics and specialty reinforcements, prepregs, structural adhesives, honeycomb, composite panels, molding compounds, polyurethane systems and laminates that are incorporated into many applications, including military and commercial aircraft, rotorcraft, wind turbine blades and recreational products. The Engineered Products segment manufactures and markets composite structures and precision machined honeycomb parts for use primarily in the aerospace industry. Composite structures are manufactured from a variety of composite and other materials, including prepregs, honeycomb, structural adhesives and advanced molding materials, using such manufacturing processes as autoclave processing, multi-axis numerically controlled machining, heat forming, compression molding and other composite manufacturing techniques.
The global economic downturn, significant supply chain inventory adjustments and availability of credit for end customers has affected demand from commercial aerospace customers and for wind energy programs. Though there are short term uncertainties, the focus on increasing alternative energy sources continues to promise a bright future for wind energy. More importantly, the compelling economics of new, lightweight, wide body aircraft that have become critical to end user demand remain intact. Although this translates into a favorable demand mix that includes a higher percentage of composite rich models, current economic conditions and new program delays lead us to be cautious in the near term regarding projected build-rates and wind energy project funding.
Net sales for the quarter were $257.1 million, 22.4% lower (21.1% lower in constant currency) than the $331.4 million reported for the third quarter of 2008. Year to date, net sales are 15.2% lower than last year in constant currency. The drop in sales is related to significant supply chain inventory adjustments, the rapid decline in the regional and business aircraft market and new program delays. The wind energy market is also now experiencing lower levels of demand as financing issues facing wind generator customers have begun to delay previously announced projects.
Therefore, in response to these tough market conditions, Hexcel has taken the difficult but necessary steps to control its cost structure in the near term while preserving our ability to meet customers needs over the medium term. In the quarter we continued to reduce headcount, controllable costs, capital expenditures and inventories. We have furloughed workers at several plants and reduced the number of days that several of our facilities are in operation in an effort to better balance our cost structure with the current demand environment. These actions have translated into strong free cash flows (defined as cash provided by operating activities less capital expenditures) for the Company as we generated $36 million in free cash flow for the quarter, and we are now $58 million free cash flow positive for the year as compared to $82 million of usage in the first nine months of 2008.
There were significant working capital improvements as the lower sales volumes combined with concerted efforts to reduce accounts receivable and inventories resulted in $30 million of cash in 2009 from working capital as compared to a $75 million use of cash for the same period in 2008. Accrual basis additions to capital expenditures were $65.8 million in the first nine months of 2009, as compared to $125.8 million during the first nine months of 2008.
Commercial aerospace sales declined 27.8% (27.0% constant currency) for the quarter and 26.1% (23.8% constant currency) for the nine month period and were down across all sectors as our customers tightened inventory management as we enter a more cautious period. The majority of our sales to this market are for large aircraft produced by Airbus and Boeing. After a three year period of record orders from 2005 to 2007, followed by a robust year of orders in 2008, these two OEMs combined only had 193 net orders and a number of deferrals for the first nine months of 2009. This however, still leaves over 6,900 planes in backlog. Based on estimates from Airbus and Boeing, they expect to deliver about 960 aircraft in 2009 (717 were delivered in the first nine months on 2009), and if this happens it would exceed the previous highest number of deliveries of 914 in 1999. Nonetheless, the current poor global credit environment leads to significant concerns about the demand, timing and financial ability of airline operators to acquire new aircraft in backlog. As a result, there remains significant uncertainty and a wide range of views regarding new aircraft build schedules in 2010 and beyond. Offsetting this negative outlook to some extent, new aircraft such as the Boeing 787 and 747-8 as well as Airbus A380 and A350 will add incremental sales as they come into production and ramp-up to full production rates because of significant increased Hexcel content per plane.
In 2008, other commercial aerospace sales, which include regional and business aircraft, totaled almost $200 million in 2008, while the current run rate based on the last two quarters is now in the range of $100 million per year. This reduction reflects the sharp
drop in demand that, for the most part, began in the second quarter of 2009 as a result of the current global economic environment.
Space and Defense sales were down 1.5% (flat in constant currency) for the quarter and essentially flat for the nine month period (up 3.5% in constant currency). We continue to benefit from our extensive qualifications to supply composite materials and, in some cases, composite structures to a broad range of rotorcraft, transport, fixed wing attack and satellite programs around the world. No one program represents more than 10% of our revenue in this market, but the C17 and F22 are among our important programs and could be curtailed in the future. These two programs combined account for about 15% of our Space and Defense sales. On the other hand, sales from rotorcraft, including the V22 tilt rotor program, and the eventual ramp-up of the Joint Strike Fighter and the new A400M transport are expected to offset the potential impact of one or two program cancellations over time.
Industrial sales were down 30.5% (27.9% in constant currency) for the quarter and down 19.5% (12.0% in constant currency) for the nine months from last year. Wind energy sales, which have historically been primarily European based, comprise more than half of the industrial sales and were down more than 25% in constant currency from third quarter 2008 levels, after being flat in constant currency for the first half of 2009 as compared to 2008. Existing and new wind turbine projects are clearly being hampered by difficult credit markets. Recent clarity in the American Recovery and Reinvestment Act of 2009 should help restart order flow in the U.S., where we have just had our first sales of qualified material from our new Windsor, Colorado facility. Our shipments to the American Centrifuge Project stopped in August as USEC, the developer of the American Centrifuge Project, works with the Department of Energy to try and obtain the necessary loan guarantees to enable them to resume the project.
The much lower sales volume more than offset improvements gained from factory productivity initiatives, headcount reductions, lower commodity and freight costs and overall good cost control for the quarter and nine months ended September 30, 2009. The strengthening of the Dollar against the Euro and the British pound over most of the last year creates mixed effects on our results. The Dollar movement against the two currencies resulted in a decrease in sales of $5.7 million in the quarter and $43.4 million in the nine-month period on a year over year basis. However, operating income was slightly favorably impacted by these same currency movements for the nine months of 2009 as compared to same period in 2008 as many European commercial aerospace sales are generally in US Dollars with related costs in Euros and British pounds.
Third Quarter and Nine Months Results
The Company uses non-GAAP financial operating measures, including sales measured in constant dollars, operating income adjusted for non-recurring operating expenses and business consolidation and restructuring expenses, net income adjusted for non-recurring expenses, the effective tax rate adjusted for certain one-time items and free cash flow. Management believes these non-GAAP measurements are meaningful to investors because they provide a view of Hexcel with respect to ongoing operating results and comparisons to prior periods. Non-recurring items and certain tax adjustments represent significant charges or credits that are important to an understanding of Hexcels overall operating results in the periods presented. Such non-GAAP measurements are not determined in accordance with generally accepted accounting principles and should not be viewed as an alternative to GAAP measures of performance. The following is a reconciliation from GAAP to non-GAAP amounts for operating and net income.