Component Costs
Although the cost of direct materials is nearly 50% of sales, changes in raw material prices had a limited impact on the Company's performance in the beginning of the three-year period. Usually, it takes between six and twelve months for changes in raw material prices to feed through to Autoliv's cost of materials.
However, in the second half of 2004, significant price increases of raw materials, in particular steel, began to take effect and, during 2005, the Company was directly or indirectly through its suppliers faced with about $90 million higher costs. To offset this 1.5 percentage point negative effect on margins, we have introduced global sourcing programs, consolidated our supplier base, phased out unprofitable inflators and seat components, and begun to increasingly source components from low-cost countries. In combination with plant consolidations and moving production to low-cost countries, these measures have enabled Autoliv to improve gross margin to 20.4% from 18.9% in 2003. Of the improvement, 0.3 percentage points are due to a reclassification in 2005 of certain costs to R,D&E expense.
For additional information on the Company's exposure to raw materials and component costs refer to page 29.
Pricing Pressure
During 2003-2005, pricing pressure from vehicle manufacturers has increased, but the actual price concessions that the automotive safety industry has accepted have not been higher than in preceding three-year periods. However, in combination with the higher raw material prices and the financial problems of some of our customers and suppliers, it has become increasingly difficult to offset the continuous pricing pressure. The pressure from customers has also taken new forms, such as reluctance to pay for engineering work and introduction of very long payment periods for engineering projects. This has been a main reason for the increase in Autoliv's R,D&E expense to 6.2% of sales in 2005 from 5.8% in 2003.
In this challenging environment we have fared comparably well thanks to higher growth in the automotive safety segment than in most automotive markets, our market share gains and the above-mentioned cost-reduction actions. As a result, operating margin has remained above 8% throughout the whole three-year period and even improved excluding a one-time license income in 2003 that boosted operating margin by 0.6 percentage points (see "Items Affecting Comparability" below).
Foreign Exchange Rates
During 2003 and 2004, currency translation effects increased reported sales by 11% and 7%, respectively, mainly due to a 31% fall in the dollar against the Euro from the beginning of 2003 until the end of 2004. In 2005, the impact of currency rate changes was negligible on sales.
Similarly, currency translation effects increased earnings per share by 19 cents in 2003, by 39 cents in 2004 and by 6 cents in 2005 and were a major contributor to the improvement in earnings per share to $3.26 in 2005 from $2.81 in 2003.
For additional information on the Company's currency exposure, refer to pages 30-31.
Higher Capital Efficiency
Over the past three years, the Company has generated $800 million in cash before financing activities. This reflects a 40% sales growth since 2002 and a 59% increase in operating profits achieved by a mere 9% increase in capital employed.
As a result, the trend of higher capital efficiency from previous years has continued and the capital turnover rate has been raised to 1.9 in 2005 from 1.7 in 2003. In addition, the return on capital employed improved to 16% from 14%.
Share Buybacks and Dividends
In order to increase shareholder value by taking advantage of Autoliv's strong cash flow, balance sheet and low borrowing cost, the Company accelerated, in August 2005, its repurchases of shares and declared the sixth dividend increase in less than three years.
As a result, the Company returned $565 million to shareholders during 2003-2005 through its stock repurchase program and another $226 million through quarterly dividends. This corresponds to a pay-out ratio of 89% in relation to total net income during 2003-2005.
The 20 million shares that have been repurchased since the inception of the program in 2000 have been acquired at an average cost of $34.85 per share compared to the close price at the end of 2005 of $45.42.
Items affecting comparability
Jobs Creation Act Transactions
During 2005, Autoliv made internal distributions of $337 million in August and of $518 million in December under the American Jobs Creation Act of 2004 (the "Jobs Act" or the "Act"). Of this amount, $810 million qualified under the Act.
The Act provides for an 85% deduction on certain earnings repatriated before 2006 to the U.S. The distributions also enabled Autoliv to replace some of its U.S. debt with debt in Europe at lower interest rates.
Savings from the transactions are expected – given current interest rates in Sweden and the U.S. – to be around $17 million annually on the net income line. In 2005, the transactions resulted in an incremental tax expense of $17 million and an incremental SG&A expense of $1 million partially offset by interest expense savings on an after-tax basis of $5 million.
Taking all effects into account, net income in 2005 would have been $13 million higher or $306 million, earnings per share assuming dilution $3.41 and the return on equity 12.2%. The transactions also boosted cash and cash equivalents at the end of 2005 (see page 27).
One time License Revenue
In 2003, operating income was affected by license revenue of $31 million included in other income. This was a result of Autoliv's wholly-owned subsidiary OEA, Inc. receiving a one-time consideration for past and future use of certain patents.
The license revenue increased net income by $26 million.
Non-U.S.GAAP Measures
Some of the following discussions refer to non- U.S. GAAP measures. Management believes that these non-U.S. GAAP measures may assist investors in analyzing trends in the Company's business.
Investors should consider these non-U.S. GAAP measures in addition to, rather than as a substitute for, financial reporting measures prepared in accordance with U.S. GAAP.
Year ended December 31, 2005 versus year ended December 31, 2004
Net Sales
Net sales for 2005 increased by 1% or by $61 million to $6,205 million due to currency effects and the consolidation of two joint ventures (see page 25). Excluding these effects, organic sales (i.e. sales excluding currency effects and acquisitions/divestitures) was flat despite a 3% decline in West European light vehicle production with a negative model mix for Autoliv.
Organic sales grew by 5% in the first quarter and by 1% in the second quarter. In the third quarter organic sales stood almost unchanged and declined by 4% in the fourth quarter due to the changes in West European light vehicle production. Organic growth was primarily driven by higher market penetration rates for curtain airbags, a favorable sales mix in North America and by the effects of Autoliv's strong presence in Asia. This increase was offset by pricing pressure and the phase-out of certain unprofitable products in addition to the negative effects from West European vehicle production.
A 1% organic increase in sales of airbag products was principally due to the continuing rollout of curtain airbags and market share gains in steering wheels, offset by the expiration of certain frontal airbag contracts and the phase-out of certain unprofitable airbag inflator contracts. A 1% organic decline in sales of seatbelt products was due to the decrease in West European vehicle production and the phase-out of certain unprofitable seat component products.
In Europe, where Autoliv generates more than 50% of its revenues, sales declined by 4% due to the impacts from West European light vehicle production.
In North America, which accounts for a quarter of Autoliv's revenues, sales increased by 4% despite flat light vehicle production. Sales were driven by strong demand for curtain airbags and other side airbags and by a favorable customer mix. This was partially offset by the expiration of some frontal airbag contracts and the continued phase-out of unprofitable inflators.
In Japan, which accounts for almost 10% of revenues, sales rose by 6% despite a negative currency effect of nearly 2%. Organic growth of slightly more than 7% was 3% better than the Japanese light vehicle production.
In the Rest of the World, which generated about one tenth of 2005 revenues, sales surged by 21% due to organic growth of 9%, currency effects of 7% and a 5% impact from the consolidation of two joint ventures. Organic growth was driven by sales in Korea and China, particularly for curtain airbags, steering wheels and seatbelts.
Gross Margin
Gross profit rose by 4% to $1,268 million and gross margin improved to 20.4% from 19.9% despite more than $90 million in additional cost in the supply chain from higher raw material prices. This negative margin effect of 1.5 percentage points was offset by improvements in purchasing and supplier performance.
Gross margin was also boosted by a 0.3 percentage point reclassification of certain costs to Research, Development & Engineering as well as by the trend that more customers are paying for engineering work as a part of the piece price rather than as one-time R,D&E reimbursement.
Operating Income
Operating income stood unchanged at $513 million and operating margin amounted to 8.3% compared to 8.4% in 2004 despite the effect from higher raw material prices and a 0.3 percentage point effect from higher costs in 2005 for plant closures and other restructuring activities.
The external costs for Sarbanes-Oxley were reduced to $6 million from $9 million.
"R,D&E" increased to 6.2% of sales from 6.0%, partly due to the above-mentioned reclassification. Amortization of intangibles declined to 0.2% of sales from 0.3% in 2004.
Other expense, net increased to $23 million or 0.4% of sales from $11 million and 0.2% of sales in 2004 due to higher restructuring costs.
Interest Expense, Net
Interest expense, net increased to $37 million from $36 million in 2004 due to the effect of a $28 million higher average net debt which was used for stock repurchases and dividend payments. Net debt increased from $599 million at the beginning of the year to $877 million at year-end, despite the fact that operations generated $176 million of cash before financing activities.
The weighted average interest rate, net stood unchanged at 5.1% in 2005 compared to 2004. Higher floating dollar interest rates were offset by the effects of the American Jobs Creations Act transactions, (see page 22).
Income Taxes
The Jobs Act transactions resulted in a $17 million tax expense, which caused the effective tax rate to increase by 3.5%. The effective rate, which increased to 35.9% from 30.8%, also rose as a result of taxes being provided on the income of several former loss-generating companies. Most of any remaining benefit coming from the use of the losses generated in previous years was recognized in 2004. The increases were somewhat offset by other net favorable adjustments.
Net Income and Earnings per Share
Income before taxes stood almost unchanged at $482 million despite the higher raw material prices and restructuring costs.
Net income declined to $293 million from $326 million in 2004, primarily due to higher taxes, and declined in relation to sales to 4.7% from 5.3% in 2004.
Earnings per share, assuming dilution, declined by 20 cents to $3.26 from $3.46 in 2004. The higher tax rate reduced earnings per share, assuming dilution, by 28 cents, of which approximately 19 cents was due to the Jobs Act transactions. The stock repurchase program had a favorable effect of 11 cents and currency effects had a favorable effect of 6 cents.
Outlook for 2006
During the full year 2006, light vehicle production in the Triad is expected to increase by 1% despite a 2% decline in West European vehicle production with a negative vehicle model mix for Autoliv.
The 8% decline in Autoliv's sales in the first quarter is expected to diminish already in the second quarter, and during the fall sales are expected to start to pick up gradually with a positive momentum into 2007. As a result, organic sales for 2006 are expected to be relatively flat while reported sales are expected to decline by 2% due to negative currency effects, provided that the February 1 exchange rates prevail.
The Company's interest expense, net should be favorably impacted by the Jobs Act transaction in 2005 and by Autoliv's Eurobond coming to maturity in May 2006. These transactions could potentially reduce interest expense in 2006 by approximately $15 million, given current exchange rates and interest rate differences in Sweden and the U.S. However, this favorable effect may be offset by higher market interest rates and a higher average net debt in 2006 than in 2005 due to the share repurchase program.
The 2006 effective tax rate is forecasted to be around 33%, but it is likely to be more volatile quarter by quarter.
As of 2006, the new accounting statement FAS-123(R) applies to Autoliv. As a result, the Company will expense stock options in the income statement. The change is expected to reduce operating margin by less than 0.1 percentage point.