10-K 1 form10-k_031306.htm REGAL-BELOIT CORPORATION FORM 10-K FOR THE PERIOD ENDING 12/31/2005 REGAL-BELOIT CORPORATION Form 10-K For the Period Ending 12/31/2005
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2005
 
Commission file number 1-7283


REGAL-BELOIT CORPORATION
(Exact Name of Registrant as Specified in Its Charter)

Wisconsin
39-0875718
(State of Incorporation)
(IRS Employer Identification No.)

200 State Street, Beloit, Wisconsin 53511
(Address of principal executive offices)

(608) 364-8800
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12 (b) of the Act:

   
Name of Each Exchange on
Title of Each Class
  
Which Registered
Common Stock ($.01 Par Value)
  
New York Stock Exchange
Rights to Purchase Common Stock
  
New York Stock Exchange
     
Securities registered pursuant to Section 12 (g) of the Act
None
(Title of Class)

Indicate by check mark if the registrant is well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes T No £
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes £ No T
 
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 T No £
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   £
 
Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer T       Accelerated filer £       Non-accelerated filer £
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Indicated by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes £ No T
 
The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2005 was approximately $827,000,000.
 
On March 7, 2006, the registrant had outstanding 30,727,004 shares of common stock, $.01 par value, which is registrant’s only class of common stock.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the Proxy Statement for the Annual Meeting of Shareholders to be held on April 26, 2006 are incorporated by reference into Part III.
 
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PART II
 
 
 
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53
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PART III
 
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PART IV
  
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CAUTIONARY STATEMENT

The following is a cautionary statement made under the Private Securities Litigation Reform Act of 1995: With the exception of historical facts, the statements contained in this Annual Report on Form 10-K or incorporated by reference may be forward looking statements. Forward-looking statements represent our management’s judgment regarding future events. In many cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “plan,” “expect,” “anticipate,” “estimate,” “believe,” “predict,” “intend,” “potential” or “continue” or the negative of these terms or other words of similar import, although some forward-looking statements are expressed differently. We cannot guarantee the accuracy of the forward-looking statements, and you should be aware that results and events could differ materially and adversely from those contained in the forward-looking statements due to a number of factors, including:

·  
unanticipated fluctuations in commodity prices and raw material costs and issues affecting our ability to pass increased costs on to our customers;

·  
cyclical downturns affecting the markets for capital goods;

·  
unexpected issues and costs arising from the integration of acquired companies and businesses, such as our acquisitions of the HVAC motors and capacitors businesses and the Commercial AC motors business from General Electric Company (“GE”) in 2004;

·  
marketplace acceptance of acquisitions, including the loss of, or a decline in business from, any significant customers;

·  
substantial increases in interest rates that impact the cost of our outstanding debt;

·  
the impact of capital market transactions that we may effect;

·  
unanticipated costs associated with litigation matters;

·  
the success of our management in increasing sales and maintaining or improving the operating margins of our businesses;

·  
actions taken by our competitors;

·  
difficulties in staffing and managing foreign operations;

·  
our ability to satisfy various covenant requirements under our credit facility; and

·  
other risks and uncertainties described in Item 1A “Risk Factors” of this Form 10-K and from time to time in our reports filed with U.S. Securities and Exchange Commission, which are incorporated by reference.

All subsequent written and oral forward-looking statements attributable to us or to persons acting on our behalf are expressly qualified in their entirety by the applicable cautionary statements. The forward-looking statements included in this Form 10-K are made only as of their respective dates, and we undertake no obligation to update these statements to reflect subsequent events or circumstances.
 
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Unless the context requires otherwise, references in this Annual Report to “we,” “us,” “our” or the “Company” refer collectively to REGAL-BELOIT CORPORATION and its subsidiaries.
 
ITEM 1 - BUSINESS
 
OUR COMPANY
 
We are one of the largest global manufacturers of commercial, industrial, and HVAC electric motors, electric generators and controls, and mechanical motion control products. Many of our products hold leading market positions in a variety of essential commercial, industrial and residential applications, and we believe we have one of the most comprehensive product lines in the markets we serve. We sell our products to a diverse global customer base using more than 20 recognized brand names through a multi-channel distribution model to leading original equipment manufacturers (“OEMs”), distributors and end users across many markets. We believe this strategy, coupled with a high level of customer service, provides us with a competitive selling advantage and allows us to more fully penetrate our target markets.

We manufacture and market electrical and mechanical products. Our electrical products include HVAC motors, a full line of AC and DC commercial and industrial electric motors, electric generators and controls, capacitors and electrical connecting devices. Our mechanical products include gears and gearboxes, marine transmissions, high-performance automotive transmissions and ring and pinions, manual valve actuators, and cutting tools. OEMs and end users in a variety of motion control and other industrial applications increasingly combine the types of electrical and mechanical products we offer. We seek to take advantage of this trend and to enhance our market penetration by leveraging cross-marketing and product line bundling opportunities between our electrical and mechanical products.

We market our products through multiple business units, with each typically having its own branded product offering and sales organization. These sales organizations consist of varying combinations of our own internal direct sales people as well as exclusive and non-exclusive manufacturers’ representative organizations. We manufacture the vast majority of the products that we sell, and we have manufacturing, sales, engineering and distribution facilities throughout the United States and Canada as well as in Mexico, India, China and Europe.

We believe our competitive strengths include:

·  
management experience and depth
·  
strategic product offering
·  
leading market positions
·  
multi-channel/multi-brand distribution
·  
broad and diverse customer base
·  
differentiated and innovative technology
·  
strategic global and rapid response operations

Our business strategy includes:

·  
capitalizing on new product opportunities
·  
capitalizing on our Asian manufacturing and commercial base
·  
leveraging our global manufacturing and sourcing structures to achieve operating margin improvements
·  
leveraging Lean Six Sigma
·  
innovating new products
·  
people and process excellence
·  
industry consolidation through acquisitions
 
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ELECTRICAL SEGMENT

Our Electrical segment includes a full line of AC and DC commercial and industrial electric motors, HVAC motors, electric generators and controls, capacitors and electrical connecting devices. Over the past eight years, we have focused on building our Electrical segment through a combination of strategic acquisitions and internal growth initiatives. Our initial focus was to establish our Company as a significant manufacturer of industrial electric motors, since our mechanical products businesses serve similar markets and their products are often used in combination with a motor. With our acquisitions of Marathon Electric Manufacturing Corporation in 1997, the Lincoln Motors business of Lincoln Electric Holdings, Inc. in 1999 and LEESON Electric Corporation in 2000, we believe we became one of the two largest producers of industrial electric motors serving the North American market and are able to offer our customers both electrical and mechanical products. Additionally, these acquisitions have brought products that are complementary to our core electric motor lines in such areas as electric generators and generator controls, motor controls, and electrical connecting devices. The integration of these acquisitions provides significant cost savings and synergies that further strengthen the competitive position of our electrical products businesses.
 
During 2004, we separately acquired two electric motor businesses from GE which were natural extensions to our core electric motor lines. In August 2004, we acquired GE’s commercial AC motors business, which manufactures a full line of alternating current motors for pump, compressor and commercial heating, ventilating and air conditioning applications. In December 2004, we acquired GE’s HVAC motors and capacitors businesses, which produce a full line of electric motors for use principally in residential HVAC systems, as well as capacitors for HVAC systems, high intensity lighting and other applications. The acquisitions of these businesses complement our existing electrical products businesses, providing us with:
 
·  
a leading market position and brand name in the HVAC motor market;
·  
diversification of our served markets and a broad base of leading HVAC customers;
·  
patented electronically commutated motor (ECM) technology;
·  
a strong management team and infrastructure in place to support growth; and
·  
significant scale and low cost manufacturing capabilities in Mexico and India.

We manufacture and market AC and DC commercial, industrial and HVAC electric motors ranging in size from sub-fractional to small integral horsepowers to larger commercial and industrial motors from 50 through 800 horsepower. We offer thousands of stock models of electric motors in addition to the motors we produce to specific customer specifications. We also produce and market precision servo motors, electric generators ranging in size from five kilowatts through four megawatts, automatic transfer switches and paralleling switchgear to interconnect and control electric power generation equipment and electrical connecting devices such as terminal blocks, fuse holders and power blocks. Additionally, our Electrical segment markets a line of AC and DC adjustable speed drives. We manufacture capacitors for use in HVAC systems, high intensity lighting and other applications. We sell our Electrical segment’s products to distributors, original equipment manufacturers and end users across many markets.

Our power generation business, which includes electric generators and power generation components and controls, represents a growing portion of our Electrical segment’s net sales. The market for electric power generation components and controls has grown in recent years as a result of a desire on the part of end users to reduce losses due to power disturbances. Our generators are used in industrial, agricultural, marine, military, transportation and other applications.
 
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We leverage efficiencies across our motor operations. We centralize the manufacturing, purchasing, engineering, accounting, information technology and quality control activities of our Electrical segment. Furthermore, we specifically foster the sharing of best practices across each of the Electrical segment and create focused centers of excellence in each of our manufacturing functions. The following is a description of our major Electrical product businesses and the primary products that they manufacture and market:

GE Commercial Motors by REGAL-BELOIT. Manufactures a full line of motors for pump, compressor, commercial and residential HVAC applications. Manufactures capacitors for use in HVAC systems, high intensity lighting and other applications.

LEESON Electric. Manufactures AC motors up to 800 horsepower and DC motors up to five horsepower, gear reducers, gearmotors and drives primarily for the power transmission, pump, food processing, fitness equipment and industrial machinery markets.

Lincoln Motors. Manufactures AC motors from 1/4 horsepower to 800 horsepower primarily for industrial and commercial pumps, compressors, elevators, machine tools, and specialty products.
 
Marathon Electric. Manufactures AC motors up to 800 horsepower primarily for HVAC, pumps, power transmissions, fans and blowers, compressors, agriculture products, processing and industrial manufacturing equipment.

Marathon Generators. Manufactures AC generators from five kilowatts to four megawatts that primarily serve the standby power, prime power, refrigeration, industrial and irrigation markets.

Marathon Special Products. Manufactures fuse holders, terminal blocks, and power blocks primarily for the HVAC, telecommunications, electric control panel, utilities and transportation markets.

Thomson Technology. Manufactures automatic transfer switches, paralleling switchgear and controls, and systems controls primarily for the electric power generation market.
 
MECHANICAL SEGMENT
 
Our Mechanical segment includes a broad array of mechanical motion control products and cutting tools. Our products include: standard and custom worm gear, bevel gear, helical gear and concentric shaft gearboxes; marine transmissions; high-performance after-market automotive transmissions and ring and pinions; custom gearing; gearmotors; manual valve actuators and cutting tools. Our gear and transmission related products primarily control motion by transmitting power from a source, such as a motor or engine, to an end use, such as a conveyor belt, usually reducing speed and increasing torque in the process. Our valve actuators are used primarily in oil and gas, water distribution and treatment and chemical processing applications. Our high-speed steel and carbide rotary perishable cutting tools are used in metalworking applications. Mechanical products are sold to original equipment manufacturers, distributors and end users across many industry segments. The following is a description of our major Mechanical segment businesses and the primary products they manufacture and market:
 
CML (Costruzioni Meccaniche Legananesi S.r.L.). Manufactures bevel gear valve actuators primarily for the oil, gas, wastewater and water distribution markets.

Durst. Manufactures standard and specialized industrial transmissions and hydraulic pump drives primarily for the construction, agriculture, energy, material handling, forestry, lawn and garden and railroad maintenance markets.

Electra-Gear. Manufactures specialized aluminum gear reducers and gearmotors primarily for the food processing, medical equipment, material handling and packaging markets.
 
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Grove Gear. Manufactures standard and custom industrial gear reducers primarily for the material handling, food processing, robotics, healthcare and power transmission markets.

Hub City/Foote-Jones. Manufactures gear drives, sub-fractional horsepower gearmotors, mounted bearings, large-scale parallel shaft and right-angle gear drives and accessories primarily for the packaging, construction, material handling, healthcare, food processing markets, mining, oil, pulp and paper, forestry, aggregate, construction and steel markets.

Mastergear. Manufactures manual valve actuators for liquid and gas flow control primarily for the petrochemical processing, fire protection and wastewater markets.

New York Twist Drill. Manufactures a full line of industrial quality cutting tools in high speed steel and carbide primarily for the aerospace, automotive, railroad and general manufacturing markets.
 
Ohio Gear. Manufactures gear reducers and gearmotors primarily for the material handling, lawn and garden vehicle and food processing markets.

Opperman Mastergear, Ltd. Manufactures valve actuators and industrial gear drives primarily for the material handling, agriculture, mining and liquid and gas flow control markets.

Regal Cutting Tools. Manufactures high-speed steel and carbide rotary cutting tools primarily for the aerospace, agriculture, automotive and general industrial markets.

Richmond Gear. Manufactures ring and pinions and transmissions primarily for the high-performance automotive aftermarket.

Velvet Drive Transmissions. Manufactures marine and industrial transmissions primarily for the pleasure boat, off-road vehicle and forestry markets.
 
THE BUILDING OF OUR BUSINESS

Our growth from our founding as a producer of high-speed cutting tools in 1955 to our current size and status has largely been the result of the acquisition and integration of 41 businesses to build a strong multi-product offering. Our senior management has substantial experience in the acquisition and integration of businesses, aggressive cost management, and efficient manufacturing techniques, all of which represent activities that are critical to our long-term growth strategy. Since 1979, our current management team has completed and successfully integrated 26 acquisitions. We have a proven track record of acquiring complementary businesses and product lines, integrating their activities into our organization and aggressively managing their cost structures to reduce waste and unnecessary expenditures. The following table summarizes select acquisitions since 1990.
 
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Product Line
Year
Acquired
Annual Revenues
at Acquisition
(in millions)
 
Product Listing at Acquisition
Electrical Products
GE Commercial AC Motors
2004
$
144
  
AC motors for pump, compressor, equipment and commercial HVAC
 
GE HVAC Motors and Capacitors
2004
  
442
  
Full line of motors and capacitors for residential and commercial HVAC systems
 
LEESON Electric Corporation
2000
  
175
  
AC motors (to 350 horsepower) gear reducers, gearmotors and drives
 
Thomson Technology, Inc.
2000
  
14
  
Automatic transfer switches, paralleling switchgear and controls and controls systems
 
Lincoln Motors
1999
  
50
  
AC motors (1/4 to 800 horsepower)
 
Marathon Electric Manufacturing Corporation
1997
  
245
  
AC motors (to 500 horsepower), AC generators (5 kilowatt to 2.5 megawatt), fuse holders, terminal blocks and power blocks
Mechanical Products
  
Powertrax assets of Vehicular Technologies
2002
  
3
  
Differential locking devices for high performance automotive applications
 
Spiral bevel gear product line of Philadelphia Gear
 
2001
  
4
  
Spiral bevel gears
Velvet Drive Transmissions
1995
  
27
  
Marine and industrial transmissions
 
Hub City, Inc.
1992
  
44
  
Gear drives, sub-fractional horsepower gearmotors, mounted bearings and accessories
 
Opperman Mastergear, Ltd. (U.K., U.S. and Germany)
1991
  
20
  
Manual valves actuators and industrial gear drives
 
 
SALES, MARKETING AND DISTRIBUTION
 
We sell our products directly to original equipment manufacturers (“OEMs”), distributors and end-users across many markets. We have multiple business units, with each unit typically having its own branded product offering and sales organization. These sales organizations consist of varying combinations of our own internal direct sales people as well as exclusive and non-exclusive manufacturers’ representative organizations. In 2005, across all of our business units, we sold products to a very broad base of original equipment manufacturers and distributors.

With our 2004 electric motor acquisitions, we have added leading HVAC OEMs to our customer base. These motors are vital components of an HVAC system and are used to move air into and away from furnaces, heat pumps, air conditioners, ventilators, fan filter boxes and humidifiers. We believe that a majority of our HVAC motors are used in applications that replace existing equipment, with the remainder used in new equipment applications. The business enjoys a large installed base of equipment and long-term relationships with its major customers.
 
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MARKETS AND COMPETITORS

The worldwide market for electric motors is estimated in excess of $25 billion. The overall domestic market for electric motors is estimated at $9 billion annually, although we estimate the sectors in which we primarily compete, commercial and industrial electric motors and HVAC/refrigeration motors, to be approximately a $5.0 billion segment of the overall domestic market. We believe approximately 60% of all electricity generated in the U.S. runs through electric motors. With the acquisitions of Marathon Electric in 1997, Lincoln Motors in 1999 and LEESON Electric in 2000, we believe we became one of the two largest producers of industrial electric motors in the United States. With our 2004 acquisitions of GE’s commercial AC and HVAC motors businesses, we believe we are among the largest producers of commercial and industrial motors and the largest producer of HVAC motors. In addition, we believe that we are the largest electric generator manufacturer in the United States that is not affiliated with a diesel engine manufacturer. Major domestic competitors for our electrical products include Baldor Electric, U.S. Electric Motors (a division of Emerson Electric Co.), Reliance Electric Company (a division of Rockwell International), A. O. Smith Corporation, General Electric Company and Newage (a division of Cummins, Inc). Major foreign competitors include Siemens AG, Toshiba Corporation, Weg S.A., Leroy-Somer, Inc. and ABB Ltd.
 
We serve various mechanical product markets and compete with a number of different companies depending on the particular product offering. We believe that we are a leading manufacturer of several mechanical products and that we are the leading manufacturer in the United States of worm gear drives and bevel gear drives. Our competitors in these markets include Boston Gear (a division of Altra Industrial Motion, Inc.), Dodge (a division of Rockwell International), Emerson Electric Co. and Winsmith (a division of Peerless-Winsmith, Inc.). Major foreign competitors include SEW Eurodrive GmbH & Co., Flender GmbH, Nord, Sumitomo Corporation and Zahnrad Fabrik GmbH Co.

During the past several years, niche product market opportunities have become more prevalent due to changing market conditions. Manufacturers, who historically may have made component products for inclusion in their finished goods, have chosen to outsource their requirements to specialized manufacturers like us because we can make these products more cost effectively. In addition, we have capitalized on this competitive climate by making acquisitions and increasing our manufacturing efficiencies. Some of these acquisitions have created new opportunities by allowing us to enter new markets in which we had not been involved. In practice, our operating units have sought out specific niche markets concentrating on a wide diversity of customers and applications. We believe that we compete primarily on the basis of quality, price, service and our promptness of delivery. We had one customer, United Technologies Corporation, that accounted for more than 10% of our sales in 2005. There were no customers that accounted for more than 10% of sales in 2004.
 
PRODUCT DEVELOPMENT AND ENGINEERING

Each of our business segments has its own product development and design teams that continuously enhance our existing products and develop new products for our growing base of customers that require custom and standard solutions. We have one of the electric motor industry’s most sophisticated product development and testing laboratories. We believe these capabilities provide a significant competitive advantage in the development of high quality motors and electric generators incorporating leading design characteristics such as low vibration, low noise, improved safety, reliability and enhanced energy efficiency.

We are continuing to expand our business by developing new, differentiated products in each of our business segments. We work closely with our customers to develop new products or enhancements to existing products that improve performance and meet their needs.

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As part of our 2004 HVAC motors and capacitors acquisition, we acquired new ECM motor technology. An ECM motor is a brushless DC electric motor with integrated speed control made possible through sophisticated electronic and sensing technology. ECM motors operate at variable speeds with attractive performance characteristics versus competitive variable speed solutions in comfort, energy efficiency, motor life and noise. GE developed the first generation ECM motors over 15 years ago. ECM technology is protected by over 125 patents, and we acquired from GE intellectual property and usage rights relating to ECM technology. ECM motors offer significantly greater temperature and air quality control as well as increased energy efficiency. While we believe that our brands and innovation are important to our continued growth and strong financial results, we do not consider any individual brand or patent, except for the ECM related patents, to be material.
 
MANUFACTURING AND OPERATIONS
 
We have developed and acquired global operations in lower cost locations such as Mexico, India, and China that complement our flexible, rapid response operations in the United States, Canada and Europe. Our vertically integrated manufacturing operations, including our own aluminum die casting and steel stamping operations are an important element of our rapid response capabilities. In addition, we have an extensive internal logistics operation that consists of 52 semi-tractors and 100 customized semi-trailers and a network of distribution facilities with the capability to modify stock products to quickly meet specific custom requirements in many instances. This gives us a competitive advantage, as we are able to deliver a customer’s product when they want it, where they want it and in the condition they want it.
 
We manufacture a majority of the products that we sell, but also strategically outsource components and finished goods to an established global network of suppliers. Although we have aggressively pursued global sourcing to reduce our overall costs, we still maintain a dual sourcing capability in our existing domestic facilities to ensure a reliable supply source for our customers. We regularly invest in machinery and equipment and other improvements to, and maintenance of, our facilities. Additionally, we have typically obtained significant amounts of quality capital equipment as part of our acquisitions, often increasing overall capacity and capability. Base materials for our products consist primarily of: steel in various types and sizes, including bearings and weldments; copper magnet wire; and ferrous and non-ferrous castings. We purchase our raw materials from many suppliers and, with few exceptions, do not rely on any single supplier for any of our base materials.
 
We have also continued to upgrade our manufacturing equipment and processes, including increasing our use of computer aided manufacturing systems, developing our own testing systems, redesigning plant layout and redesigning products to take full advantage of our more productive equipment and to improve product flow. We believe that our continued product redesign and efficient plant layout often provide us with a competitive cost advantage in our manufacturing operation. Our goal is to be a low cost producer in our core product areas.
 
FACILITIES

We have manufacturing, sales and service facilities throughout the United States and Canada and in Mexico, Europe, China and India. Our Electrical segment currently operates 50 manufacturing and service and distribution facilities. The Electrical segment’s present operating facilities contain a total of approximately 3,990,310 square feet of space of which approximately 882,000 square feet are leased. Our Mechanical segment currently operates 19 manufacturing and service and distribution facilities. The Mechanical segment’s present operating facilities contain a total of approximately 1,472,000 square feet of space of which approximately 57,000 square feet are leased. Our principal executive offices are located in Beloit, Wisconsin in an owned approximately 24,000 square foot office building. We believe our equipment and facilities are well maintained and adequate for our present needs.

BACKLOG

Our business units have historically shipped the majority of their products in the month the order is received. Since total backlog is less than 10% of our annual sales, we believe that backlog is not a reliable indicator of our future sales. As of December 31, 2005, our backlog was $140.4 million, as compared to $104.4 million on December 31, 2004. We believe that virtually all of our backlog is shippable in 2006.
 
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PATENTS, TRADEMARKS AND LICENSES

We own a number of United States patents and foreign patents relating to our businesses. While we believe that our patents provide certain competitive advantages, we do not consider any one patent or group of patents essential to our business other than our ECM patents which relate to a material portion of our sales. We also use various registered and unregistered trademarks, and we believe these trademarks are significant in the marketing of most of our products. However, we believe the successful manufacture and sale of our products generally depends more upon our technological, manufacturing and marketing skills.
 
EMPLOYEES

As of the close of business on December 31, 2005, the Company employed approximately 11,000 worldwide employees. We consider our employee relations to be very good.

ENVIRONMENTAL MATTERS

We are currently involved with environmental proceedings related to certain of our facilities. Based on available information, we believe that the outcome of these proceedings and future known environmental compliance costs will not have a material adverse effect on our financial position or results of operations.
 
EXECUTIVE OFFICERS

The names, ages, and positions of the executive officers of the Company as of March 1, 2006, are listed below along with their business experience during the past five years. Officers are elected annually by the Board of Directors at the Meeting of Directors immediately following the Annual Meeting of Shareholders in April. There are no family relationships among these officers, nor any arrangements of understanding between any officer and any other persons pursuant to which the officer was selected.
 
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Name
Age
Position
Business Experience and PrincipalOccupation
James L. Packard
63
Executive Chairman
Elected Chairman in 1986; Chief Executive Officer 1984 to April 2005; served as President from 1980 to April 2002; joined the Company in 1979.
 
Henry W. Knueppel
57
Chief Executive Officer
Elected Chief Executive Officer April 2005; served as President from April 2002 to December 2005 and Chief Operating Officer from April 2002 to April 2005; served as Executive Vice President from 1987 to April 2002; joined the Company in 1979.
 
Mark Gliebe
45
President and Chief Operating Officer
Elected President and Chief Operating Officer in December 2005. Joined the Company in January 2005 as Vice President and President - Electric Motors Group, following our acquisition of the HVAC motors and capacitors businesses from GE; previously employed by GE as the General Manager of GE Motors & Controls in the GE Consumer & Industrial business unit from June 2000 to December 2004.
 
David A. Barta
44
Vice President and
Chief Financial Officer
Joined the Company in June 2004 and was elected Vice President, Chief Financial Officer in July 2004. Prior to joining the Company, Mr. Barta served in several financial management positions for Newell Rubbermaid Inc. from 1995 to June 2004, serving most recently as Chief Financial Officer Levolor/Kirsch Division. His prior positions during this time included Vice President - Group Controller Corporate Key Accounts, Vice President - Group Controller Rubbermaid Group and Vice President Investor Relations.
 
Kenneth F. Kaplan
60
Vice President, Treasurer and Secretary
Joined the Company in September 1996 and served as Vice President, Chief Financial Officer and Secretary until July 2004; has served in his current position since July 2004.
 
David L. Eisenreich
62
Vice President and President, Power Generation and Mechanical Components
Elected Vice President and President of Motor Technologies Group in 2001; Senior Vice President of Operations at Marathon Electric from 1997 until 2001.

WEBSITE DISCLOSURE

The Company’s Internet address is www.regal-beloit.com. We make available free of charge (other than an investor’s own Internet access charges) through our Internet website our Annual Report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. We are not including the information contained on or available through our website as a part of, or incorporating such information by reference into, this Annual Report on Form 10-K.
 
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ITEM 1A - RISK FACTORS
 
You should carefully consider each of the risks described below, together with all of the other information contained in this Annual Report on Form 10-K, before making an investment decision with respect to our securities. If any of the following risks develop into actual events, our business, financial condition or results operations could be materially and adversely affected and you may lose all or part of your investment.
 
Our future success depends on our ability to integrate effectively acquired companies and manage our growth.

On August 30, 2004, we completed the acquisition of GE’s commercial AC motors business. On December 31, 2004, we completed the acquisition of the HVAC motors and capacitors business of GE. With these two acquisitions, we have more than doubled the number of our employees to over 11,000 (with more than 3,600 new employees in Mexico and 1,700 new employees in India, including temporary workers), added five manufacturing operations in the United States, Mexico, India and China, and significantly increased our revenue.

Realization of the benefits of these GE acquisitions requires the integration of some or all of the sales and marketing, distribution, manufacturing, engineering, finance and administrative operations and information of the newly acquired businesses. Combined, these GE acquisitions constitute the largest acquisitions we have completed to date and, although GE has agreed to provide various services to us during a transition period, the magnitude of these acquisitions may present significant integration challenges and costs to us. The successful integration of these businesses will require substantial attention from our senior management and the management of the acquired businesses, which may decrease the time that they have to serve and attract customers. In addition, we continue to pursue new acquisitions, some of which could be material to our business if completed. We cannot assure you that we will be able to integrate successfully our recent acquisitions or any future acquisitions, that these acquired companies will operate profitably, or that we will realize the potential benefits from these acquisitions. Our financial condition, results of operations, and cash flows could be materially and adversely affected if we do not successfully integrate the new businesses.

Our dependence on, and the price of, raw materials may adversely affect our profits.

The principal raw materials used to produce our products are copper, aluminum and steel. We source raw materials on a global or regional basis, and the prices of those raw materials are susceptible to significant price fluctuations due to supply/demand trends, transportation costs, government regulations and tariffs, changes in currency exchange rates, price controls, the economic climate and other unforeseen circumstances. If we are unable to pass on raw material price increases to our customers, our future profitability may be materially adversely affected.

In our HVAC motor business, we depend on revenues from several significant customers, and any loss, cancellation or reduction of, or delay in, purchases by these customers may have a material adverse effect on our business.

Several significant customers of our HVAC motors business represent a significant portion of our revenues. Our success will depend on our continued ability to develop and manage relationships with these customers. We expect that significant customer concentration will continue for the foreseeable future in our HVAC motor business. Our dependence in the HVAC motor business on sales from a relatively small number of customers makes our relationship with each of these customers important to our business. We cannot assure you that we will be able to retain significant customers. Some of our customers may in the future shift some or all of their purchases of products from us to our competitors or to other sources. The loss of one or more of our largest customers, any reduction or delay in sales to these customers, our inability to develop relationships successfully with additional customers, or future price concessions that we may make could have a material adverse effect on our business.
 
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We increasingly manufacture our products outside the United States, which may present additional risks to our business.

As a result of our recent acquisitions, a significant portion of our net sales are attributable to products manufactured outside of the United States, principally in Mexico, India and China. Approximately half of our over 11,000 total employees and 10 of our 32 principal manufacturing facilities are located outside the United States. International operations generally are subject to various risks, including political, societal and economic instability, local labor market conditions, the imposition of foreign tariffs and other trade restrictions, the impact of foreign government regulations, and the effects of income and withholding taxes, governmental expropriation and differences in business practices. We may incur increased costs and experience delays or disruptions in product deliveries and payments in connection with international manufacturing and sales that could cause loss of revenue. Unfavorable changes in the political, regulatory, and business climate in countries where we have operations could have a material adverse effect on our financial condition, results of operations and cash flows.

Cyclicality adversely affects us.

Our business is cyclical and dependent on industrial and consumer spending and is therefore impacted by the strength of the economy generally, interest rates and other factors. Economic factors adversely affecting OEM production and consumer spending could adversely impact us. During periods of expansion in OEM production, we generally have benefited from increased demand for our products. Conversely, during recessionary periods, we have been adversely affected by reduced demand for our products.
 
We operate in highly competitive electric motor, power generation and mechanical motion control markets.

The electric motor, power generation and mechanical motion control markets are highly competitive. Some of our competitors are larger and have greater financial and other resources than we do. There can be no assurance that our products will be able to compete successfully with the products of these other companies.
 
The failure to obtain business with new products or to retain or increase business with redesigned existing or customized products could also adversely affect our business. It may be difficult in the short-term for us to obtain new sales to replace any unexpected decline in the sale of existing or customized products. We may incur significant expense in preparing to meet anticipated customer requirements, which may not be recovered.

Our leverage could adversely affect our financial health and make us vulnerable to adverse economic and industry conditions.

We have incurred indebtedness that is substantial relative to our shareholders’ investment. Our indebtedness has important consequences. For example, it could:

·  
make it difficult for us to fulfill our obligations under our credit and other debt agreements;
·  
make it more challenging for us to obtain additional financing to fund our business strategy and acquisitions, debt service requirements, capital expenditures and working capital;
·  
increase our vulnerability to interest rate changes and general adverse economic and industry conditions;
·  
require us to dedicate a substantial portion of our cash flow from operations to service our indebtedness, thereby reducing the availability of our cash flow to finance acquisitions and to fund working capital, capital expenditures, research and development efforts and other general corporate activities;
·  
limit our flexibility in planning for, or reacting to, changes in our business and our markets; and
·  
place us at a competitive disadvantage relative to our competitors that have less debt.

Page 15 of 83
 
In addition, our credit facility requires us to maintain specified financial ratios and satisfy certain financial condition tests, which may require that we take action to reduce our debt or to act in a manner contrary to our business objectives. If an event of default under our credit facility occurs, then the lenders could elect to declare all amounts outstanding under the credit facility, together with accrued interest, to be immediately due and payable, and a cross default could occur under the terms of our senior subordinated convertible notes allowing the trustee or the holders of the notes to declare the principal amount of the notes, together with accrued interest, to be immediately due and payable.
 
Our sales of products incorporated into HVAC systems are seasonal and affected by the weather; mild or cooler weather could have an adverse effect on our operating performance.

Many of our motors are incorporated into HVAC systems that OEMs sell to end users. The number of installations of new and replacement HVAC systems or components is higher during the spring and summer seasons due to the increased use of air conditioning during warmer months. Mild or cooler weather conditions during the spring and summer season often result in end users deferring the purchase of new or replacement HVAC systems or components. As a result, prolonged periods of mild or cooler weather conditions in the spring or summer season in broad geographical areas could have a negative impact on the demand for our HVAC motors and, therefore, could have an adverse effect on our operating performance. In addition, due to variations in weather conditions from year to year, our operating performance in any single year may not be indicative of our performance in any future year.
 
We may be adversely impacted by an inability to identify and complete acquisitions.

A substantial portion of our growth in the past five years has come through acquisitions, and an important part of our growth strategy is based upon acquisitions. We may not be able to identify and successfully negotiate suitable acquisitions, obtain financing for future acquisitions on satisfactory terms or otherwise complete acquisitions in the future. If we are unable to successfully complete acquisitions, our ability to grow our company significantly will be limited.
 
We are subject to litigation that may adversely affect our business and results of operations.

We are, from time to time, a party to litigation that arises in the normal course of our business operations, including, among other things, contract disputes, product warranty and liability claims, and environmental, asbestos, employment and other litigation matters. Litigation may have an adverse effect on us because of potential adverse outcomes, the costs associated with defending lawsuits, the diversion of our management’s resources and other factors.

Goodwill comprises a significant portion of our total assets, and if we determine that goodwill has become impaired in the future, net income in such years may be materially and adversely affected.

Goodwill represents the excess of cost over the fair market value of net assets acquired in business combinations. We review goodwill and other intangibles annually for impairment and any excess in carrying value over the estimated fair value is charged to the results of operations. A reduction in net income resulting from the write down or impairment of goodwill would affect financial results and could have a material and adverse impact upon the market price of our common stock.
 
Page 16 of 83
 
We may suffer losses as a result of foreign currency fluctuations.

The net assets, net earnings and cash flows from our wholly owned subsidiaries in Mexico and India are based on the U.S. dollar equivalent of such amounts measured in the applicable functional currency. These foreign operations have the potential to impact our financial position due to fluctuations in the local currency arising from the process of re-measuring the local functional currency in the U.S. dollar. Any increase in the value of the U.S. dollar in relation to the value of the local currency will adversely affect our revenues from our foreign operations when translated into U.S. dollars. Similarly, any decrease in the value of the U.S. dollar in relation to the value of the local currency will increase our development costs in foreign operations, to the extent such costs are payable in foreign currency, when translated into U.S. dollars.
 
We may be adversely affected by environmental, health and safety laws and regulations.

We are subject to various laws and regulations relating to the protection of the environment and human health and safety and have incurred and will continue to incur capital and other expenditures to comply with these regulations. Failure to comply with any environmental regulations could subject us to future liabilities, fines or penalties or the suspension of production. In addition, we are currently involved in some remediation activities at certain sites. If unexpected obligations at these or other sites or more stringent environmental laws are imposed in the future, we could be adversely affected.
 
Our stock may be subject to significant fluctuations and volatility.

The market price of shares of our common stock may be volatile. Among the factors that could affect our common stock price are those discussed above under “Risks Factors” as well as:

·  
quarterly fluctuation in our operating income and earnings per share results;
·  
decline in demand for our products;
·  
significant strategic actions by our competitors, including new product introductions or technological advances;
·  
fluctuations in interest rates;
·  
cost increases in energy, raw materials or labor;
·  
changes in revenue or earnings estimates or publication of research reports by analysts; and
·  
domestic and international economic and political factors unrelated to our performance.

In addition, the stock markets have experienced extreme volatility that has often been unrelated to the operating performance of particular companies. These broad market fluctuations may adversely affect the trading price of our common stock.
 
The success of the Company is highly dependent on qualified and sufficient staffing. Our failure to attract or retain qualified personnel could lead to a loss of revenue or profitability.

Our success depends, in part, on the efforts and abilities of our senior management team and key employees. Their skills, experience and industry contacts significantly benefit our operations and administration. The failure to attract or retain members of our senior management team and key employees could have a negative effect on our operating results.

The operations and success of the Company can be impacted by natural disasters, terrorism, acts of war, international conflict, political and governmental actions which could harm our business.

Natural disasters, acts or threats of war or terrorism, international conflicts, and the actions taken by the United States and other governments in response to such events could cause damage or disrupt our business operations, our suppliers, or our customers, and could create political or economic instability, any of which could have an adverse effect on our business. Although it is not possible to predict such events or their consequences, these events could decrease demand for our products, could make it difficult or impossible for us to deliver products, or could disrupt our supply chain. The Company may also be impacted by actions by foreign governments, including currency devaluation, tariffs and nationalization, where our facilities are located which could disrupt manufacturing and commercial operations.

Page 17 of 83
 
The Company’s operations are highly dependent on information technology infrastructure and failures could significantly affect our business.

We depend heavily on our information technology infrastructure in order to achieve our business objectives. If we experience a problem that impairs this infrastructure, such as a computer virus, a problem with the functioning of an important IT application, or an intentional disruption of our IT systems by a third party, the resulting disruptions could impede our ability to record or process orders, manufacture and ship in a timely manner, or otherwise carry on our business in the ordinary course. Any such events could cause us to lose customers or revenue and could require us to incur significant expense to eliminate these problems and address related security concerns.
 
We are in the process of introducing a global Enterprise Resource Planning (ERP) system that will redesign and deploy a common information system over a period of several years. As we implement the ERP system, the new system may not perform as expected. This could have an adverse effect on our business.

The Company has numerous pension plans and future legislation or regulations intended to reform the funding and reporting of pension benefit plans could adversely affect our operating results and cash flows, as could changes in market conditions that impact the assumptions we use to measure our liabilities under these plans.

Legislators and agencies of the U.S. government have proposed legislation and regulations to amend, restrict or eliminate various features of, and mandate additional funding of, pension benefit plans. If legislation or new regulations are adopted, we may be required to contribute additional cash to these plans, in excess of our current estimates. Market volatility in interest rates, investment returns and other factors could also adversely affect the funded status of our pension plans. Moreover, future changes to the accounting and reporting standards related to pension plans could create significant volatility in our operating results.
 
The Company is subject to tax laws and regulations in many jurisdictions and the inability to successfully defend claims from taxing authorities related to our current and/or acquired businesses could adversely affect our operating results and financial position.
 
We conduct business in many countries, which requires us to interpret the income tax laws and rulings in each of those taxing jurisdictions. Due to the subjectivity of tax laws between those jurisdictions as well as the subjectivity of factual interpretations, our estimates of income tax liabilities may differ from actual payments or assessments. Claims from taxing authorities related to these differences could have an adverse impact on our operating results and financial position.


None.
 

We have manufacturing, sales and service facilities throughout the United States and Canada and in Mexico, Europe, China and India. Our Electrical segment currently includes 50 manufacturing, service and distribution facilities, of which 14 are principal manufacturing facilities. The Electrical segment’s present operating facilities contain a total of approximately 3,990,310 square feet of space of which approximately 882,000 square feet are leased. Our Mechanical segment currently includes 19 manufacturing, service and distribution facilities, of which 6 are principal manufacturing facilities. The Mechanical segment’s present operating facilities contain a total of approximately 1,472,000 square feet of space of which approximately 57,000 square feet are leased. Our principal executive offices are located in Beloit, Wisconsin in an owned approximately 24,000 square foot office building. We believe our equipment and facilities are well maintained and adequate for our present needs.
 
Page 18 of 83
 
The following table provides information regarding our principal facilities.

Location
Square Footage
Status
Description of Use
Electrical Segment
      
Wausau, WI
498,329
Owned
Manufacturing
Juarez, Mexico
335,000
Owned
Manufacturing
Reynosa, Mexico
320,000
Owned
Manufacturing
Springfield, MO
290,000
Owned
Manufacturing
Grafton, WI(1)
230,000
Owned
Manufacturing
Shanghai
226,000
Owned
Manufacturing
Indianapolis, IN
220,832
Leased
Warehouse
Faridabad, India
220,000
Owned
Manufacturing
Lebanon, MO
186,900
Owned
Manufacturing
Lincoln, MO
120,000
Owned
Manufacturing
Lima, OH
107,000
Owned
Manufacturing
Blytheville, AR
107,000
Leased
Manufacturing
West Plains, MO
106,000
Owned
Manufacturing
Black River Falls, WI
103,000
Owned
Manufacturing
All Other (36)
920,249
(2)
(2)
Mechanical Segment
      
Chicago, IL
282,973
Owned
Manufacturing
Liberty, SC
173,516
Owned
Manufacturing
Aberdeen, SD
164,960
Owned
Manufacturing
Shopiere, WI
132,000
Owned
Manufacturing
Union Grove, WI
122,000
Owned
Manufacturing
New Bedford, MA
116,200
Owned
Manufacturing
All Other (13)
480,664
(3)
(3)
 
(1) Sold in January of 2006 to a third party. Company is leasing 65,450 square feet for seven years at a lease rate of $350,000 per year.
(2) Less significant manufacturing, service and distribution and engineering facilities located in the United States, Canada, Europe, and Asia: Electrical leased square footage 554,139.
(3) Mechanical leased 56,692.


An action was filed on June 4, 2004, and amended in September 2004, against one of the Company’s subsidiaries, Marathon Electric Manufacturing Corporation (“Marathon”), by Enron Wind Energy Systems, LLC, Enron Wind Contractors, LLC and Zond Minnesota Construction Company, LLC (collectively, “Enron Wind”). The action was filed in the United States Bankruptcy Court for the Southern District of New York where each of the Enron Wind entities has consolidated its Chapter 11 bankruptcy petition as part of the Enron Corporation bankruptcy proceedings. In the action against Marathon, Enron Wind has asserted various claims relating to the alleged failures and/or degradations of performance of about 564 generators sold by Marathon to Enron Wind from 1997 to 1999. In January 2001, Enron Wind and Marathon entered into a “Generator Warranty and Settlement Agreement and Release of All Claims” (“Warranty Agreement”). This Warranty Agreement resolved various issues related to past performance of the generators, provided a limited warranty related to the generators going forward, and contained a release by all parties of any claims related to the generators other than those arising out of the obligations contained in the Warranty Agreement.
 
Page 19 of 83
 
Enron Wind is seeking to recover the purchase price of the generators and transportation costs totaling about $21 million. In addition, although the Warranty Agreement contains a waiver of consequential, incidental, and punitive damages, Enron Wind claims that this limitation is unenforceable and seeks recovery of consequential, incidental and punitive damages incurred by it and by its customers, totaling an additional $100 million. Enron Wind has asserted claims of breach of contract, breach of the implied covenant of good faith and fair dealing, promissory fraud, and intentional interference with contractual relations. Marathon has filed a motion with the court seeking to have many of Enron Wind’s claims dismissed. Enron Wind recently has filed a motion with the court seeking a declaration that Marathon had an obligation under the Warranty Agreement to repair or replace the generators in the first instance regardless of whether an actual breach of warranty had occurred. The court has held hearings on both motions, but has not yet ruled.

The Company believes that this action is without merit and that it has meritorious defenses to the action. The Company intends to defend vigorously all of the asserted claims. The litigation is in an early discovery phase and it is difficult for the Company to predict the impact the litigation may ultimately have on the Company’s results of operations or financial condition, including the expenses the Company may incur to defend against the action. As of December 31, 2005, the Company continues to accrue for anticipated costs in defending against this matter and such accumulated reserves as of December 31, 2005 are immaterial.

From time to time, the Company, in the normal course of business, is involved in various claims and legal actions arising out of its operations. The Company does not believe that the ultimate disposition of any currently pending claims or actions would have a material adverse effect on the Company or its financial condition.


There were no matters submitted to a vote of security holders during the quarter ended December 31, 2005.
 
Page 20 of 83
 
PART II
 
 ITEM 5 - 
 
 MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
The Company’s Common Stock, $.01 par value (“Common Stock”), is traded on the New York Stock Exchange under the symbol “RBC.” Prior to January 21, 2005, the Company’s stock was traded on the American Stock Exchange under the symbol “RBC.” The following table sets forth the range of high and low closing sales prices for the Common Stock for the period from January 1, 2004 through December 31, 2005. The Company submitted its Section 303A.12(a) CEO Certification to the NYSE on January 21, 2005.

 
2005
  
2004
 
Price Range
  
Price Range
 
 
High
  
 
Low
  
Dividends
Paid
  
 
High
  
 
Low
  
Dividends
Paid
1st Quarter
$
32.08
  
$
27.69
  
$
.12
  
$
23.20
  
$
19.41
  
$
.12
2nd Quarter
  
29.41
    
25.25
    
.12
    
22.22
    
19.14
    
.12
3rd Quarter
  
33.70
    
28.15
    
.13
    
24.33
    
20.40
    
.12
4th Quarter
  
38.94
    
30.30
    
.13
    
29.38
    
23.13
    
.12

The Company has paid 182 consecutive quarterly dividends through January 2006. The number of registered holders of Common Stock as of December 31, 2005 was 742.
 
The Board of Directors approved, in 2000, a repurchase program of up to 2,000,000 common shares of Company stock. Management was authorized to effect purchases from time to time in the open market or through privately negotiated transactions. In April 2004, in association with the Company’s convertible subordinated debt offering, the Company repurchased 614,200 shares of its stock at a price of $20.35. From April 2004 through December 31, 2005, the Company has repurchased 774,100 shares at an average purchase price of $19.67 per share under this program. There were no repurchases during the year ended December 31, 2005.

GE sold 4,559,048 shares issued to it as part of the consideration for our December 2004 acquisition of the HVAC motor and capacitor business during the Company’s secondary offering which closed August 10, 2005. REGAL-BELOIT also issued 1,530,321 primary shares as part of the August 2005 offering.

Item 12 of this Annual Report on Form 10-K contains certain information relating to the Company's equity compensation plans.
 
Page 21 of 83
 
ITEM 6 - SELECTED FINANCIAL DATA
 
The selected statement of income data for the years ended December 31, 2005, 2004 and 2003 and the balance sheet data at December 31, 2005 and 2004 are derived from, and are qualified by reference to, the audited financial statements of the Company included elsewhere in this Annual Report on Form 10-K. The selected statement of income data for the years ended December 31, 2002 and 2001 and the balance sheet data at December 31, 2003, 2002 and 2001 are derived from audited financial statements not included herein.
 
 
(In Thousands, Except Per Share Data)
Year Ended December 31
 
2005
  
2004
  
2003
  
2002
  
2001
Net Sales
$
1,428,707
  
$
756,557
  
$
619,098
  
$
605,292
  
$
663,571
Income from Operations
  
134,572
    
55,162
    
47,226
    
47,227
    
56,060
Net Income
  
69,557
    
30,435
    
25,206
    
24,518
    
19,590
Total Assets
  
1,342,554
    
1,352,052
    
734,445
    
733,988
    
746,599
Long-term Debt
  
386,332
    
547,350
    
195,677
    
222,812
    
345,667
Shareholders’ Investment
  
647,996
    
538,179
    
398,704
    
381,423
    
280,150
Per Share of Common Stock:
                            
Earnings Per Share
  
2.34
    
1.24
    
1.01
    
1.01
    
.94
Earnings Per Share - Assuming
                           
Dilution
  
2.25
    
1.22
    
1.00
    
1.01
    
.93
Cash Dividends Declared
  
.51
    
.48
    
.48
    
.48
    
.48
Shareholders’ Investment
  
21.84
    
21.87
    
15.93
    
15.24
    
13.42
Basic Average Shares Outstanding
  
29,675
    
24,603
    
25,030
    
24,187
    
20,869
Diluted Average Shares Outstanding
  
30,879
    
24,904
    
25,246
    
24,310
    
21,124
 
 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

OVERVIEW

REGAL-BELOIT CORPORATION seeks to deliver strong, consistent business results and superior shareholder returns by providing value added products to our customers who serve the commercial, industrial, and residential markets. 

To this end, we are focused on two product segments: Electrical and Mechanical. Within these segments, we follow a closely defined business strategy to develop and increase market leadership positions in key product categories and improve financial performance. On an ongoing basis, we focus on a variety of key indicators to monitor business performance. These indicators include organic and total sales growth (including volume and price components), market share, gross profit margin, operating profit, net income and earnings per share, and measures to optimize the management of working capital, capital expenditures, cash flow and return on capital. The monitoring of these indicators, as well as our corporate governance practices (including the Company’s Code of Conduct), are used to ensure that business health and strong internal controls are maintained.
 
To achieve our financial objectives, we are focused on initiatives to drive and fund growth. We seek to capture significant opportunities for growth by identifying and meeting customer needs within our core categories and identifying category expansion opportunities. These product needs are met through extensive product research and development efforts as well as through a disciplined acquisition strategy. Growth opportunities are emphasized that offer stronger market growth potential as a result of geographic based expansion or industry expansion. The investments needed to fund our growth are developed through continuous, corporate-wide initiatives to lower costs and increase effective asset utilization. We also prioritize investments toward higher return on capital businesses.

Net Sales in 2005 increased, including the impact of the GE Commercial AC and HVAC motor acquisitions in 2004, 89% to $1.429 billion. Net income rose 128.5% to $69.6 million.
 
Given the continued competitive marketplace and high raw material and energy costs, we anticipate that the near-term operating environment will remain challenging. However, we anticipate that the impact of new products, favorable federal energy legislation, and the impact of our Lean Six Sigma program will provide additional funds for investment in support of key categories and new product development while also supporting an increased level of profitability.
Page 22 of 83
 
RESULTS OF OPERATIONS

2005 versus 2004

Net Sales 
 
Worldwide sales were $1.429 billion in 2005. Sales increased 89% from the $756.6 million reported for 2004. The 2004 acquisitions of the Commercial AC motor and HVAC motor and capacitor businesses from General Electric Company (GE) accounted for $615.0 million of the increase. Also impacting sales was the divestiture of the Illinois Gear business that was sold by the Company in May of 2005. The sale of this business decreased sales by approximately $5.0 million for 2005.
 
Sales in the Electrical segment were $1.228 billion, up 120% from 2004, including the $615.0 million from the businesses acquired from GE. Excluding the sales from the acquired businesses, sales increased 10%. Sales for the HVAC motor business were positively impacted by the convergence of several factors including hotter than normal weather and the increase in HVAC system inventory levels in the OEM and distributor channels in anticipation of the government legislated SEER 13 efficiency requirement which was effective on January 23, 2006. We estimate that this industry-wide volume increase favorably impacted our sales by approximately $30 million in the fourth quarter of 2005. We also saw strength in sales of commercial and industrial motors that have benefited from overall economic strength.
 
Sales in the Mechanical segment grew 1% to $201.0 million. Sales in this segment were reduced approximately $5.0 million as a result of the sale of the Illinois Gear business in May of 2005. Individual division results varied significantly with several divisions benefiting from the continued strength of the industrial economy.

Gross Profit
 
Our gross profit margin was 21.8% in 2005 as compared to 22.1% in 2004. The reduction in gross profit during 2005 resulted primarily from increases in raw material costs, particularly copper. The price of copper increased from approximately $1.40 per pound at the end of 2004 to over $2.00 per pound at the end of 2005. The increase in material costs was only partially offset by price increases implemented in all of our channels and the benefits from productivity and Lean Six Sigma projects. The gross profit margin for the Electrical segment reflected these impacts and decreased to 21.4% from 21.7% in 2004. Mechanical segment gross profit margin increased from 23.2% in 2004 to 23.7% primarily as a result of net benefits from plant consolidations and productivity projects.

Operating Expenses
 
Operating expenses as a percentage of sales were 12.3% in 2005 as compared to 14.8% in 2004. The decrease in operating expense as a percent of sales results from leveraging of fixed costs on the higher sales levels. Additionally, the HVAC and CAC businesses operate with a lower operating expense structure due, in part, to the concentration of sales with their large OEM customer base. Electrical segment operating expenses decreased to 11.8% of sales from 15.3% of sales in 2004 as a result of these factors. Mechanical operating expenses as a percent of sales increased from 15.0% in 2004 to 15.6% in 2005.
 
Income from Operations (Operating Profit)
 
In 2005, operating profit increased 143.8% to $134.6 million from the $55.2 million reported in 2004. As a percent of sales, operating profit increased to 9.4% of sales for 2005 from 7.3% in 2004. Electrical segment income from operations increased 200.8% in 2005 to $118.5 million from $39.4 million in 2004, and operating income margin increased to 9.7% in 2005 from 7.1% in 2004. The contributions from the 2004 acquisitions of GE’s HVAC and CAC businesses, price increases, favorable volume impacts, and the operating expense fixed cost leveraging and productivity were the main drivers of the improved performance. Electrical Segment operating profit was negatively impacted by increases in raw material costs, particularly copper and aluminum. Mechanical segment income from operations increased 1.9% to $16.0 million in 2005 from $15.7 million in 2004. The Mechanical segment operating income margin for 2005 improved to 8.0% from 7.9% in 2004. The results of the Mechanical segment reflect the positive impacts of increased volume and price increases, partially offset by increases in raw material costs and the non-repeat of the 2004 sale of property located in the United Kingdom ($1.5 million pretax).
 
Page 23 of 83
 
Interest Expense, Net
 
Interest expense, net was $21.6 million in 2005 compared with $6.6 million in 2004. Higher interest rates and higher average debt levels, due primarily to debt incurred as a result of the HVAC and CAC acquisitions, have resulted in increased interest expense in 2005. The average interest rate paid under the Company’s revolving credit facility was 4.7% in 2005 and 2.7% in 2004. The average balance outstanding under the Facility in 2005 was $395,969,000 and in 2004 was $150,596,000.
 
Income Taxes
 
The effective income tax rate for 2005 was 35.3% compared with 32.4% in 2004. The increase to the effective rate was primarily due to the one-time realization of benefits in 2004 for the resolution of tax audits. The 2005 effective rate reflected a benefit of approximately .5% attributable to the Domestic Production Activities Deduction that was incorporated in the American Jobs Creation Act of 2004. (See also Note 9 to Notes to Consolidated Financial Statements.)
 
Net Income
 
Net income was $69.6 million in 2005 or $2.25 per share on a diluted basis compared with $30.4 million in 2004 or $1.22 per share.
 
2004 versus 2003

Net Sales

Our net sales were $756.6 million in 2004, a 22.2% increase from $619.1 million in 2003. Excluding the sales impact from the acquisition of the CAC business, sales increased 13.5%. The increase in sales was driven by strong demand in the majority of our markets. Sales in the Electrical segment increased 27.1% to $557.0 million. Excluding the sales from the CAC business, sales in the Electrical segment were $503.3 million, an increase of 14.8% over 2003. Sales for the joint ventures that the Company owned for the entire year, which are included in the Electrical segment, increased $10.7 million, or 53% over 2003. Sales in our Mechanical segment were $199.6 million, which was an increase of 10.4% over 2003. Sales in both segments were positively impacted by improved consumer and business spending and the price increases implemented by the Company during 2004.

Gross Profit

Our gross profit was $167.1 million, an increase of 13.8% over the $146.8 million reported in 2003. As a percent of sales, gross profit was 22.1% as compared to 23.7% in 2003. The increase in raw material costs drove this decrease, as price increases and our implemented productivity actions only partially offset the increased costs.

Page 24 of 83
 
Operating Expenses

Our operating expenses in 2004 were $111.9 million, 12.4% above $99.5 million in 2003. The increase was primarily driven by the sales and distribution costs driven by the sales volume increase. Operating expenses as a percentage of sales decreased to 14.8% in 2004 from 16.1% in 2003, reflecting fixed cost leverage and productivity.
 
Income from Operations (Operating Profit)

Income from operations was $55.2 million, an increase of 16.8% over the $47.2 million reported in 2003. Income from operations as a percentage of sales (“operating income margin”) was 7.3% in 2004 versus 7.6% in 2003. Electrical segment income from operations increased 16.4% in 2004 to $39.4 million from $33.9 million in 2003, and operating income margin decreased to 7.1% in 2004 from 7.7% in 2003. The impact of the raw material cost increases coupled with an increase in healthcare costs for employees were the primary drivers of this decrease. These factors were partially offset by price increases, favorable volume impacts, and the operating expense fixed cost leveraging and productivity. Mechanical segment income from operations increased 17.8% to $15.7 million in 2004 from $13.3 million in 2003. The Mechanical segment operating income margin for 2004 improved to 7.9% from 7.4% in 2003. The results of the Mechanical segment reflect the positive impacts of increased volume, price increases, and the 3rd quarter gain on the sale of property located in the U.K. ($1.5 million pretax), partially offset by raw material cost increases.

Interest Expense, Net

Our net interest expense in 2004 was $6.6 million, which was an increase of 3.5% over the $6.4 million in 2003. This increase was due to a slightly increased balance of average debt outstanding. The average interest rate we paid on outstanding debt in 2004 was 2.7% which was unchanged from the 2.7% average in 2003.

Income Taxes

Our effective tax rate on income before taxes decreased to 32.4% in 2004 from 36.2% in 2003, including tax effects of the minority interest. This decrease was due primarily to the impact of the favorable resolution of several tax matters recorded in the fourth quarter ($1.4 million) and the favorable tax treatment of the third quarter gain on the sale of property located in the U.K ($.5 million).

Net Income

Our 2004 net income of $30.4 million improved 20.7% from the $25.2 million in 2003. Net income as a percentage of sales was 4.0% versus 4.1% in 2003. Basic earnings per share was $1.24 in 2004, a 22.8% increase from $1.01 in 2003. Fully diluted earnings per share was $1.22, a 22.0% increase from $1.00 in 2003.
 
LIQUIDITY AND CAPITAL RESOURCES

Our working capital was $268.5 million at December 31, 2005, a decrease of 4.0% from $279.7 million at year-end 2004. The $11.2 million decrease was due primarily to a $28.4 million reduction in inventories and a $23.5 million reduction in accounts payable during 2005, partially offset by a $25.0 million increase in short-term commercial paper borrowings initiated in December 2005. The inventory decrease reflected improved turnover and shipments above expectations in the fourth quarter of 2005. The accounts payable reduction was due primarily to one-time payments to GE in 2005 of payables acquired as a part of the 2004 acquisitions and included in the December 31, 2004 accounts payable balance. Additionally, theses accounts were impacted by the Final GE Purchase Price Settlement and Final Purchase Accounting Allocations. Our current ratio, the ratio of our current assets to current liabilities, at December 31, 2005 decreased to 2.2:1 from 2.4:1 from the previous year-end.
 
Page 25 of 83
 
Cash flow provided by operating activities (“operating cash flow”) was $112.2 million in 2005, a 193.7% increase from 2004. Increased net income of $39.1 million and a $44.9 million increase in cash flow generated from inventory changes (a $16.5 million use of cash in 2004 versus a $28.4 million of cash provided in 2005) were the major factors in the operating cash flow improvement in 2005. Cash flow used in investing activities was $11.8 million in 2005, a fraction of the $338.5 million in 2004. The large decrease was due to the $327.9 million of cash invested in our 2004 acquisitions from GE, of which $12.0 million was repaid to the Company in 2005 as a result of the Final GE Purchase Price Settlement. Capital spending increased to $28.3 million in 2005 from $16.3 million a year earlier. In 2005, we received $9.9 million from sales of surplus assets, primarily vacant facilities. Such sales were up from $5.9 million in 2004. Our commitments for property, plant and equipment as of December 31, 2005 were approximately $9.8 million. We believe that our present facilities, augmented by planned capital expenditures, are sufficient to provide adequate capacity for our operations in 2006.
 
Cash flow used in financing activities was $98.1 million in 2005 following $322.4 million provided from financing activities in 2004. Our strong operating cash flow coupled with net proceeds from our stock offering in August 2005 enabled us to reduce our total debt outstanding by 24.8% to $412.0 million at December 31, 2005 from $547.6 million at year-end 2004, a reduction of $135.6 million. We received $43.7 million of net proceeds from the sale of 1,530,321 primary shares of common stock issued by the Company. Additionally, we received $9.3 million from GE’s net proceeds from the sale in the same August offering of all 4,559,048 shares GE received from us on December 31, 2004 as part of the acquisition purchase price of GE’s HVAC motors and capacitors business. The $9.3 million was paid by GE to us under a shareholder agreement between GE and the Company filed with our Current Report on Form 8-K dated January 6, 2005. We paid $14.7 million in dividends to shareholders in 2005, with our quarterly dividend increasing from $.12 to $.13 per share starting with the July 2005 dividend payment. In December 2005, we initiated short-term borrowings through a $35.0 million unsecured commercial paper facility with one of our banks. In December 2005, we commenced the short-term borrowings with $25.0 million of commercial paper, all of which was outstanding at December 31, 2005, and repaid a like amount of debt outstanding under the Facility described below. (See also Note 5 of Notes to Consolidated Financial Statements.)

Our primary financing source is our $475 million long-term unsecured revolving credit facility (the “Facility”) that terminates on May 5, 2009. The Company has the option to increase the Facility up to $550 million subject to achievement of certain approvals and covenants. The Facility requires us to maintain specified financial ratios and to satisfy certain financial condition tests. We were in compliance with all of these ratios and tests as of December 31, 2005. The tests consist of a minimum interest coverage ratio of 3.75 to 1, a maximum funded debt to EBITDA (earnings before interest, taxes, depreciation and amortization) ratio of 4.00 to 1 and a maximum senior funded debt to EBITDA ratio of 3.00 to 1, both of which reduce to 3.75 to 1 and to 2.75 to 1, respectively, at December 31, 2006, and a minimum net worth consisting of the sum of $435 million plus 50% of net income for each quarter ending on or after March 31, 2005 plus 75% of the net proceeds of all issuances of equity securities by the Company. At year-end 2005, we had $175.8 million of available borrowing capacity. We believe we will satisfy the Facility’s financial ratios and tests for the foreseeable future. We further believe that the combination of our operating cash flow and borrowing availability under the Facility will provide sufficient cash flow to finance our existing operations for the foreseeable future. (See also Note 5 of Notes to Consolidated Financial Statements.)
 
The Company is exposed to interest rate risk on certain of its short-term and long-term debt obligations used to finance our operations and acquisitions. At December 31, 2005, we had $141.5 million of fixed rate debt and $270.5 million of variable rate debt, the latter subject to interest rate risk. The variable rate debt is primarily under a credit facility with an interest rate based on a margin above LIBOR. As a result, interest rate changes impact future earnings and cash flow assuming other factors are constant. A hypothetical 10% change in our weighted average borrowing rate on outstanding variable rate debt at December 31, 2005 would result in a change in after-tax annualized earnings of approximately $700,000.
 
 
Page 26 of 83
 
OFF-BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
 
The following is a summary of the Company’s contractual obligations and payments due by period as of December 31, 2005 (in thousands):
 
 
 
Payments due by Period
Debt
Including Estimated*
Interest Payments
  
 
 
Operating Leases
  
 
Purchase and Other
Obligations
  
 
Total Contractual Obligations
                               
Less than 1 Year
$
40,738
    
$
6,170
    
$
77,198
    
$
124,106
  
1 - 3 Years
  
31,475
      
10,139
      
4,840
      
46,454
  
3 - 5 Years
  
380,371
      
3,989
      
3,578
      
387,938
  
More than 5 Years
  
3,450
      
3,234
      
6,757
      
13,441
  
Total
$
456,034
    
$
23,532
    
$
92,373
    
$
571,939
  

*Variable rate debt based on December 31, 2005 rates.
 
We utilize blanket purchase orders (“blankets”) to communicate expected annual requirements to many of our suppliers. Requirements under blankets generally do not become “firm” until a varying number of weeks before our scheduled production. The purchase obligations shown in the above table represent the value we consider “firm”.

At December 31, 2005, the Company had outstanding standby letters of credit totaling $6,902,000, $52,000 of which expires in 2007; the balance expires in 2006. We had no other material commercial commitments.

The Company did not have any variable interest entities as of December 31, 2005. Other than disclosed in the table above and the previous paragraph, the Company had no other material off-balance sheet arrangements.

CRITICAL ACCOUNTING POLICIES

Revenue Recognition

The Company recognizes revenue upon transfer of title, which generally occurs upon shipment of the product to the customer. The pricing of products sold is generally supported by customer purchase orders, and accounts receivable collection is reasonably assured at the time of shipment. Estimated discounts and rebates are recorded as a reduction of sales in the same period revenue is recognized. Product returns and credits are estimated and recorded at the time of shipment based upon historical experience. Shipping and handling costs are recorded as revenue when billed to the customers.

Goodwill and Other Intangibles

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized; however it is tested for impairment at least annually and with any resulting adjustment charged to the results of operations. Amortization is recorded for intangible assets with definite lives. (See Note 3, “Goodwill and Other Intangibles” of Notes to Consolidated Financial Statements.)

Retirement Plans

Approximately half of our domestic employees are covered by defined benefit pension plans with the remaining employees covered by defined contribution plans. Most of our foreign employees are covered by government sponsored plans in the countries in which they are employed. Our obligations under our domestic defined benefit plans are determined with the assistance of actuarial firms. The actuaries make certain assumptions regarding such factors as withdrawal rates and mortality rates. The actuaries also provide us with information and recommendations from which management makes further assumptions on such factors as the long-term expected rate of return on plan assets, the discount rate on benefit obligations and where applicable, the rate of annual compensation increases. Based upon the assumptions made, the investments made by the plans, overall conditions and movement in financial markets, particularly the stock market and how actual withdrawal rates, life-spans of benefit recipients and other factors differ from assumptions, annual expenses and recorded assets or liabilities of these defined benefit plans may change significantly from year to year. Based on our annual review of actuarial assumptions as well as historical rates of return on plan assets and existing long-term bond rates, we set the long-term rate of return on plan assets at 8.75% and the discount rate at 5.75% for our defined benefit plans as of December 31, 2005. (See also Note 7 of Notes to Consolidated Financial Statements).
 
Further discussion of the Company’s accounting policies is contained in Note 2 of Notes to Consolidated Financial Statements. The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States requires the use of estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
 
Page 27 of 83
 
New Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”), which requires companies to expense the value of employee stock options and similar awards. This Statement is a revision of FASB Statement No. 123(R), “Accounting for Stock-Based Compensation”. This Statement supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”. The incremental share-based compensation expense under SFAS 123(R) is estimated to be in the range of $.05 to $.10 per share in 2006, including options granted in January of 2006. The ultimate impact of adopting SFAS 123(R) on 2006’s results of operations and financial position will depend upon many factors including the level of stock-based compensation granted in 2006, the fair value of those options which will be determined at the date of grant, the related tax benefits recorded and the diluted shares outstanding. The Company has adopted the provisions of the new standard using the modified prospective method and using the Black-Scholes option pricing model effective January 1, 2006.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs,” an amendment of ARB No. 43, Chapter 4. The amendments made by SFAS No. 151 clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The pronouncement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The adoption of this pronouncement is not expected to have a significant impact on the Company’s results of operations or financial position.
 
We are exposed to market risk relating to the Company’s operations due to changes in interest rates, foreign currency exchange rates and commodity prices of purchased raw materials. We manage the exposure to these risks through a combination of normal operating and financing activities and derivative financial instruments such as commodity cash flow hedges and foreign currency forward exchange contracts.
 
Page 28 of 83
 
The Company is exposed to interest rate risk on certain of its short-term and long-term debt obligations used to finance our operations and acquisitions. At December 31, 2005, we had $141.5 million of fixed rate debt and $270.5 million of variable rate debt, the latter subject to interest rate risk. The variable rate debt is primarily under a credit facility with an interest rate based on a margin above LIBOR. As a result, interest rate changes impact future earnings and cash flow assuming other factors are constant. A hypothetical 10% change in our weighted average borrowing rate on outstanding variable rate debt at December 31, 2005, would result in a change in after-tax annualized earnings of approximately $700,000.

The Company periodically enters into commodity futures and options hedging transactions to reduce the impact of changing copper, aluminum and natural gas commodity prices. Contract terms of commodity hedge instruments generally mirror those of the hedged item, providing a high degree of risk reduction and correlation.

We are also exposed to foreign currency risks that arise from normal business operations. These risks include the translation of local currency balances of foreign subsidiaries, intercompany loans with foreign subsidiaries and transactions denominated in foreign currencies. Our objective is to minimize our exposure to these risks through a combination of normal operating activities and the utilization of foreign currency hedging contracts to manage our exposure on the transactions denominated in currencies other than the applicable functional currency. Due to our two acquisitions in August and December 2004, in 2005 we significantly increased our manufacturing operations outside the United States. In the first half of 2005, we began to enter into contracts to hedge foreign-currency denominated forecasted transactions. Contracts are executed with creditworthy banks and are denominated in currencies of major industrial countries. It is our policy not to enter into derivative financial instruments for speculative purposes.

All hedges are recorded on the balance sheet at fair value and are treated as cash flow hedges, with changes in fair value recorded in accumulated other comprehensive income (“AOCI”) in each accounting period. An ineffective portion of the hedge’s change in fair value, if any, is recorded in earnings in the period of change. The impact due to ineffectiveness was immaterial for the years ended December 31, 2005, 2004 and 2003.
 
In 2005, $4.2 million, of net increased hedge value was recorded in AOCI. At December 31, 2005, we had a balance of $2.4 million in current assets related to unamortized cash flow hedges and a net after tax gain of $4.8 million in AOCI, representing the deferred gains on cash flow hedges. Of the total current assets and AOCI values, $1.4 and $1.1 million, respectively, related to currency hedges, with the balance of $1.0 million and $3.7 million, respectively, relating to commodity hedges.
 

Quarterly Financial Information (Unaudited)
 
   
(In Thousands, Except Per Share Data)
  
   
1st Quarter
  
2nd Quarter
  
3rd Quarter
  
4th Quarter
  
   
2005
  
2004
  
2005
  
2004
  
2005
  
2004
  
2005
  
2004
  
Net Sales
        
$
337,823
  
$
163,084
  
$
368,768
  
$
177,652
  
$
345,894
  
$
193,888
  
$
376,222
  
$
221,933
  
Gross Profit
          
68,444
    
38,187
    
79,800
    
40,841
    
76,598
    
42,944
    
85,922
    
45,088
  
Income from Operations
          
25,865
    
12,444
    
35,811
    
14,174
    
34,608
    
15,591
    
38,290
    
12,953
  
Net Income
          
12,286
    
6,860
    
18,445
    
7,629
    
18,517
    
8,927
    
20,309
    
7,019
  
Earnings Per Share
          
.42
    
.27
    
.63
    
.31
    
.62
    
.37
    
.66
    
.29
  
Earnings Per Share - Assuming Dilution
          
.41
    
.27
    
.62
    
.31
    
.59
    
.36
    
.63
    
.28
  
Average Number of Shares Outstanding
          
29,034
    
25,042
    
29,065
    
24,450
    
29,913
    
24,456
    
30,644
    
24,463
  
Average Number of Shares - Assuming
                                                        
Dilution
          
30,244
    
25,278
    
29,720
    
24,677
    
31,234
    
24,725
    
32,317
    
24,937
  
 
 
Page 29 of 83
 
MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of REGAL-BELOIT CORPORATION (the “Company”) is responsible for the accuracy and internal consistency of the preparation consolidated financial statements and footnotes contained in this annual report.

The Company’s management is also responsible for establishing and maintaining adequate internal control over financial reporting. REGAL-BELOIT CORPORATION operates under a system of internal accounting controls designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of published financial statements in accordance with generally accepted accounting principles. The internal accounting control system is evaluated for effectiveness by management and is tested, monitored and revised as necessary. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. In making its assessment, the Company’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework. Based on the results of its evaluation, the Company’s management concluded that, as of December 31, 2005, the Company’s internal control over financial reporting is effective based on those criteria.

The Company’s independent auditors, Deloitte & Touche LLP, have audited the financial statements prepared by the management of REGAL-BELOIT CORPORATION and management’s assessment of internal control over financial reporting.

Page 30 of 83
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders and Board of Directors of REGAL-BELOIT CORPORATION:
 
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that REGAL-BELOIT CORPORATION and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and disposition of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control as of December 31, 2005, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2005 of the Company and our report dated March 7, 2006 expressed an unqualified opinion on those financial statements.

 
DELOITTE & TOUCHE LLP