Table of Contents

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

(Mark One)

 

 

For the quarterly period ended December 31, 2009

 

OR

 

 

For the transition period from             to             

 

Commission file number: 1-14064

 

The Estée Lauder Companies Inc.

(Exact name of registrant as specified in its charter)

 

Delaware		11-2408943
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)
767 Fifth Avenue, New York, New York		10153
(Address of principal executive offices)		(Zip Code)

 

212-572-4200

(Registrant’s telephone number, including area code)

 

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

 

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

 

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

 

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

 

Large accelerated filer x		Accelerated filer o
Non-accelerated filer o		Smaller reporting company o
(Do not check if a smaller reporting company)

 

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

 

At January 22, 2009, 118,920,894 shares of the registrant’s Class A Common Stock, $.01 par value, and 78,017,261 shares of the registrant’s Class B Common Stock, $.01 par value, were outstanding.

 

 

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THE ESTÉE LAUDER COMPANIES INC.

 

INDEX

 

	Page
Part I. Financial Information
Item 1. Financial Statements
Consolidated Statements of Earnings — Three and Six Months Ended December 31, 2009 and 2008	2
Consolidated Balance Sheets — December 31, 2009 and June 30, 2009	3
Consolidated Statements of Cash Flows — Six Months Ended December 31, 2009 and 2008	4
Notes to Consolidated Financial Statements	5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	24
Item 3. Quantitative and Qualitative Disclosures About Market Risk	41
Item 4. Controls and Procedures	41
Part II. Other Information
Item 1. Legal Proceedings	42
Item 1A. Risk Factors	42
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	43
Item 4. Submission of Matters to a Vote of Security Holders	44
Item 6. Exhibits	45
Signatures	46

 

Table of Contents

 

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements.

 

THE ESTÉE LAUDER COMPANIES INC.

 

CONSOLIDATED STATEMENTS OF EARNINGS

(Unaudited)

 

		Three Months Ended December 31						Six Months Ended December 31
		2009			2008			2009			2008
		(In millions, except per share data)
Net Sales		$	2,262.3		$	2,041.0		$	4,095.7		$	3,944.5
Cost of Sales		525.4			508.0			970.5			1,008.1
Gross Profit		1,736.9			1,533.0			3,125.2			2,936.4
Operating expenses:
Selling, general and administrative		1,282.4			1,262.4			2,432.1			2,573.2
Restructuring and other special charges		9.3			0.3			27.5			0.4
Goodwill impairment		16.6			—			16.6			—
Impairment of intangible assets		29.0			—			29.0			—
		1,337.3			1,262.7			2,505.2			2,573.6
Operating Income		399.6			270.3			620.0			362.8
Interest expense, net		19.9			19.6			39.5			34.9
Earnings before Income Taxes		379.7			250.7			580.5			327.9
Provision for income taxes		118.0			89.4			181.0			117.0
Net Earnings		261.7			161.3			399.5			210.9
Net earnings attributable to noncontrolling interests		(5.5		)	(3.3		)	(2.6		)	(1.8		)
Net Earnings Attributable to The Estée Lauder Companies Inc.		$	256.2		$	158.0		$	396.9		$	209.1
Net earnings attributable to The Estée Lauder Companies Inc. per common share:
Basic		$	1.30		$	.80		$	2.01		$	1.07
Diluted		1.28			.80			1.99			1.06
Weighted average common shares outstanding:
Basic		197.3			196.6			197.0			195.9
Diluted		200.4			197.5			199.3			198.1
Cash dividends declared per common share		$	.55		$	.55		$	.55		$	.55

 

See notes to consolidated financial statements.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

CONSOLIDATED BALANCE SHEETS

 

		December 31			June 30
		2009			2009
		(Unaudited)
		($ in millions)
ASSETS
Current Assets
Cash and cash equivalents		$	1,223.6		$	864.5
Accounts receivable, net		1,098.5			853.3
Inventory and promotional merchandise, net		756.4			795.0
Prepaid expenses and other current assets		371.0			399.7
Total current assets		3,449.5			2,912.5
Property, Plant and Equipment, net		1,012.0			1,026.7
Other Assets
Investments, at cost or market value		13.0			12.7
Goodwill		751.4			759.9
Other intangible assets, net		123.6			150.1
Other assets		362.0			314.7
Total other assets		1,250.0			1,237.4
Total assets		$	5,711.5		$	5,176.6
LIABILITIES AND EQUITY
Current Liabilities
Short-term debt		$	27.8		$	33.8
Accounts payable		314.3			329.8
Accrued income taxes		110.5			33.2
Other accrued liabilities		1,203.1			1,062.4
Total current liabilities		1,655.7			1,459.2
Noncurrent Liabilities
Long-term debt		1,375.9			1,387.6
Accrued income taxes		259.7			259.1
Other noncurrent liabilities		411.6			406.7
Total noncurrent liabilities		2,047.2			2,053.4
Contingencies (Note 7)
Equity
Common stock, $.01 par value; 650,000,000 shares Class A authorized; shares issued: 186,066,807 at December 31, 2009 and 183,921,350 at June 30, 2009; 240,000,000 shares Class B authorized; shares issued and outstanding: 78,017,261 at December 31, 2009 and 78,067,261 at June 30, 2009		2.6			2.6
Paid-in capital		1,236.5			1,145.6
Retained earnings		3,482.7			3,195.0
Accumulated other comprehensive loss		(77.0		)	(117.1		)
		4,644.8			4,226.1
Less: Treasury stock, at cost; 66,900,196 Class A shares at December 31, 2009 and 65,294,477 Class A shares at June 30, 2009		(2,663.2		)	(2,586.1		)
Total stockholders’ equity — The Estée Lauder Companies Inc.		1,981.6			1,640.0
Noncontrolling interests		27.0			24.0
Total equity		2,008.6			1,664.0
Total liabilities and equity		$	5,711.5		$	5,176.6

 

See notes to consolidated financial statements.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		Six Months Ended December 31
		2009			2008
		(In millions)
Cash Flows from Operating Activities
Net earnings		$	399.5		$	210.9
Adjustments to reconcile net earnings to net cash flows from operating activities:
Depreciation and amortization		127.7			125.9
Deferred income taxes		(28.9		)	(2.1		)
Non-cash stock-based compensation		30.8			32.1
Excess tax benefits from stock-based compensation arrangements		(1.0		)	(1.4		)
Loss on disposal of property, plant and equipment		10.8			4.0
Non-cash charges associated with restructuring activities		7.0			—
Goodwill and intangible asset impairments		45.6			—
Other non-cash items		0.3			0.9
Changes in operating assets and liabilities:
Increase in accounts receivable, net		(226.3		)	(88.9		)
Decrease in inventory and promotional merchandise, net		48.6			14.7
Decrease (increase) in other assets, net		2.0			(67.9		)
Decrease in accounts payable		(22.2		)	(30.5		)
Increase (decrease) in accrued income taxes		95.3			(20.5		)
Increase in other liabilities		127.7			39.5
Net cash flows provided by operating activities		616.9			216.7
Cash Flows from Investing Activities
Capital expenditures		(104.2		)	(157.5		)
Acquisition of businesses and other intangible assets, net of cash acquired		(9.3		)	(63.8		)
Proceeds from the disposition of long-term investments		—			0.8
Purchases of long-term investments		(0.1		)	(0.4		)
Net cash flows used for investing activities		(113.6		)	(220.9		)
Cash Flows from Financing Activities
Increase (decrease) in short-term debt, net		(5.3		)	121.8
Proceeds from issuance of long-term debt, net		—			297.7
Repayments and redemptions of long-term debt		(15.0		)	(7.6		)
Net proceeds from stock-based compensation transactions		56.3			109.5
Excess tax benefits from stock-based compensation arrangements		1.0			1.4
Payments to acquire treasury stock		(78.1		)	(62.6		)
Dividends paid to stockholders		(109.1		)	(108.4		)
Net cash flows (used for) provided by financing activities		(150.2		)	351.8
Effect of Exchange Rate Changes on Cash and Cash Equivalents		6.0			(20.4		)
Net Increase in Cash and Cash Equivalents		359.1			327.2
Cash and Cash Equivalents at Beginning of Period		864.5			401.7
Cash and Cash Equivalents at End of Period		$	1,223.6		$	728.9

 

See notes to consolidated financial statements.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1 —SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The accompanying consolidated financial statements include the accounts of The Estée Lauder Companies Inc. and its subsidiaries (collectively, the “Company”).  All significant intercompany balances and transactions have been eliminated.

 

The unaudited interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements.  In the opinion of management, all adjustments of a normal recurring nature considered necessary for a fair presentation have been included.  The results of operations of any interim period are not necessarily indicative of the results of operations to be expected for the full fiscal year.  For further information, refer to the consolidated financial statements and accompanying footnotes included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2009.

 

In accordance with recently adopted accounting guidance, net earnings attributable to The Estée Lauder Companies Inc. and net earnings attributable to noncontrolling interests are disclosed separately on the face of the accompanying consolidated statements of earnings.  In addition, noncontrolling interests are reported as a separate component of equity in the consolidated balance sheets.  Except as otherwise indicated, references to net earnings or components of stockholders’ equity in the notes to consolidated financial statements will represent amounts attributable to The Estée Lauder Companies Inc.  Accordingly, certain amounts in the consolidated financial statements of prior periods have been reclassified to conform to current period presentation.

 

In preparing these consolidated financial statements, the Company has evaluated events and transactions for potential recognition or disclosure through the date the consolidated financial statements were issued.

 

Management Estimates

 

The preparation of financial statements and related disclosures in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses reported in those financial statements.  Certain significant accounting policies that contain subjective management estimates and assumptions include those related to revenue recognition, inventory, pension and other post-retirement benefit costs, goodwill, intangible assets and other long-lived assets, income taxes and derivatives.  Descriptions of these policies are discussed in the Company’s Annual Report on Form 10-K for the year ended June 30, 2009.  Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, and makes adjustments when facts and circumstances dictate.  Illiquid credit markets, volatile equity markets, changes in foreign currency exchange rates and declines in consumer spending have combined to increase the uncertainty inherent in such estimates and assumptions.  As future events and their effects cannot be determined with precision, actual results could differ significantly from those estimates and assumptions.  Significant changes, if any, in those estimates resulting from continuing changes in the economic environment will be reflected in the consolidated financial statements in future periods.

 

Currency Translation and Transactions

 

All assets and liabilities of foreign subsidiaries and affiliates are translated at period-end rates of exchange, while revenue and expenses are translated at weighted average rates of exchange for the period.  Unrealized translation gains or losses are reported as cumulative translation adjustments through other comprehensive income (loss).  Such adjustments amounted to $0.1 million of unrealized translation gains, net of tax, and $124.7 million of unrealized translation losses, net of tax, during the three months ended December 31, 2009 and 2008, respectively, and $33.7 million of unrealized translation gains, net of tax, and $208.7 million of unrealized translation losses, net of tax, during the six months ended December 31, 2009 and 2008, respectively.  The accompanying consolidated statements of earnings include net exchange losses on foreign currency transactions of $13.1 million and $6.2 million during the three months ended December 31, 2009 and 2008, respectively, and $13.5 million and $26.2 million during the six months ended December 31, 2009 and 2008, respectively.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Accounts Receivable

 

Accounts receivable is stated net of the allowance for doubtful accounts and customer deductions totaling $41.9 million and $41.4 million as of December 31, 2009 and June 30, 2009, respectively.

 

Concentration of Credit Risk

 

The Company is a worldwide manufacturer, marketer and distributor of skin care, makeup, fragrance and hair care products.  Domestic and international sales are made primarily to department stores, perfumeries and specialty retailers.  The Company grants credit to all qualified customers and does not believe it is exposed significantly to any undue concentration of credit risk.

 

The Company’s largest customer sells products primarily within the United States and accounted for $225.4 million, or 10% and $238.6 million, or 12%, of the Company’s consolidated net sales for the three months ended December 31, 2009 and 2008, respectively, and $471.5 million, or 12% and $502.9 million, or 13%, of the Company’s consolidated net sales for the six months ended December 31, 2009 and 2008, respectively.  This customer accounted for $104.4 million, or 10%, and $97.1 million, or 11%, of the Company’s accounts receivable at December 31, 2009 and June 30, 2009, respectively.

 

Inventory and Promotional Merchandise

 

		December 31			June 30
		2009			2009
		(In millions)
Inventory and promotional merchandise, net consists of:
Raw materials		$	196.8		$	188.5
Work in process		36.7			43.8
Finished goods		353.1			375.6
Promotional merchandise		169.8			187.1
		$	756.4		$	795.0

 

Property, Plant and Equipment

 

Property, plant and equipment consists of:

 

		December 31			June 30
		2009			2009
		(In millions)
Assets (Useful Life)
Land		$	14.6		$	14.5
Buildings and improvements (10 to 40 years)		187.2			183.2
Machinery and equipment (3 to 10 years)		1,116.3			1,080.2
Furniture and fixtures (5 to 10 years)		90.8			86.1
Leasehold improvements		1,128.3			1,112.8
		2,537.2			2,476.8
Less accumulated depreciation and amortization		1,525.2			1,450.1
		$	1,012.0		$	1,026.7

 

The cost of assets related to projects in progress of $139.0 million and $144.9 million as of December 31, 2009 and June 30, 2009, respectively, is included in their respective asset categories in the table above.  Depreciation and amortization of property, plant and equipment was $59.2 million and $60.0 million during the three months ended December 31 , 2009 and 2008, respectively, and $121.2 million and $119.3 million during the six months ended December 31 , 2009 and 2008, respectively.  Depreciation and amortization related to the Company’s manufacturing process is included in cost of sales and all other depreciation and amortization is included in selling, general and administrative expenses in the accompanying consolidated statements of earnings.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Income Taxes

 

The effective rate for income taxes was 31.1% and 35.7% for the three months ended December 31, 2009 and 2008, respectively, and 31.2% and 35.7% for the six months ended December 31, 2009 and 2008, respectively.  The decrease in the effective income tax rate was primarily attributable to a lower effective tax rate relating to the Company’s foreign operations.

 

As of December 31, 2009 and June 30, 2009, the gross amount of unrecognized tax benefits, exclusive of interest and penalties, totaled $259.2 million and $259.1 million, respectively.  The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $133.0 million.  The total gross interest and penalties accrued related to unrecognized tax benefits during the three and six months ended December 31, 2009 in the accompanying consolidated statements of earnings was $0.3 million and $3.3 million, respectively.  The total gross accrued interest and penalties in the accompanying consolidated balance sheets at December 31, 2009 and June 30, 2009 was $71.8 million and $67.9 million, respectively.  On the basis of the information available as of December 31, 2009, it is reasonably possible that the total amount of unrecognized tax benefits could decrease in a range of $30 million to $60 million within 12 months as a result of projected resolutions of global tax examinations and controversies and a potential lapse of the applicable statutes of limitations.

 

Recently Adopted Accounting Standards

 

In August 2009, the FASB issued authoritative guidance to provide clarification on measuring liabilities at fair value when a quoted price in an active market is not available.  In these circumstances, a valuation technique should be applied that uses either the quote of the liability when traded as an asset, the quoted prices for similar liabilities or similar liabilities when traded as assets, or another valuation technique consistent with existing fair value measurement guidance, such as an income approach or a market approach.  The new guidance also clarifies that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability.  This guidance became effective for the Company’s fiscal 2010 second quarter and did not have an impact on the Company’s consolidated financial statements.

 

In June 2009, the FASB established the FASB Accounting Standards Codification TM  (the “Codification”) as the single source of authoritative U.S. generally accepted accounting principles (“U.S. GAAP”) recognized by the FASB to be applied by nongovernmental entities.  Rules and interpretive releases of the United States Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants.  The Codification did not have a material impact on the Company’s consolidated financial statements upon adoption.  Accordingly, the Company’s notes to consolidated financial statements will explain accounting concepts rather than cite the topics of specific U.S. GAAP.

 

In April 2009, the FASB issued authoritative guidance that principally requires publicly traded companies to provide disclosures about fair value of financial instruments in interim financial information.  The adoption of this disclosure-only guidance is included in Note 5 — Fair Value Measurements and did not have an impact on the Company’s consolidated financial results.

 

In April 2009, the FASB issued authoritative guidance to require that assets acquired and liabilities assumed in a business combination that arise from contingencies be recognized at fair value if fair value can be reasonably determined.  If the fair value of such assets or liabilities cannot be reasonably determined, then they would generally be recognized in accordance with certain other pre-existing accounting standards.  This guidance also amends the subsequent accounting for assets and liabilities arising from contingencies in a business combination and certain other disclosure requirements.  This guidance became effective for assets or liabilities arising from contingencies in business combinations that are consummated on or after the beginning of the Company’s fiscal 2010 and did not have an impact on the Company’s consolidated financial statements.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

In November 2008, the FASB issued authoritative guidance regarding the accounting for defensive intangible assets.  Defensive intangible assets are assets acquired in a business combination that the acquirer (a) does not intend to use or (b) intends to use in a way other than the assets’ highest and best use as determined by an evaluation of market participant assumptions.  While defensive intangible assets are not being actively used, they are likely contributing to an increase in the value of other assets owned by the acquiring entity.  This guidance will require defensive intangible assets to be accounted for as separate units of accounting at the time of acquisition and the useful life of such assets would be based on the period over which the assets will directly or indirectly affect the entity’s cash flows.  This guidance is to be applied prospectively for defensive intangible assets acquired on or after the beginning of the Company’s fiscal 2010 and did not have an impact on the Company’s consolidated financial statements.

 

In November 2008, the FASB issued authoritative guidance to address questions about equity-method accounting.  The primary issues include how the initial carrying value of an equity method investment should be determined, how to account for any subsequent purchases and sales of additional ownership interests, and whether the investor must separately assess its underlying share of the investee’s indefinite-lived intangible assets for impairment.  This guidance became effective beginning in the Company’s fiscal 2010 and did not have an impact on the Company’s consolidated financial statements.

 

In April 2008, the FASB issued authoritative guidance to amend the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset and to require additional disclosures.  The guidance for determining useful lives must be applied prospectively to intangible assets acquired after the effective date.  The disclosure requirements must be applied prospectively to all intangible assets recognized as of the effective date.  This guidance became effective for fiscal years, and interim periods within those fiscal years, beginning in the Company’s fiscal 2010 and did not have a material impact on the Company’s consolidated financial statements.

 

In February 2008, the FASB issued authoritative guidance that permitted the delayed application of fair value measurement accounting to nonrecurring nonfinancial assets and nonfinancial liabilities.  The Company’s nonfinancial assets and nonfinancial liabilities principally consist of intangible assets acquired through business combinations, long-lived assets when assessing potential impairment, and liabilities associated with restructuring activities.  This guidance became effective beginning in the Company’s fiscal 2010.  See Note 5 — Fair Value Measurements for further discussion on the application of fair value measurements.

 

In December 2007, the FASB issued authoritative guidance to affirm that the acquisition method of accounting (previously referred to as the purchase method) be used for all business combinations and for an acquirer to be identified for each business combination.  This guidance defines the acquirer as the entity that obtains control of one or more businesses in the business combination and establishes the acquisition date as the date that the acquirer achieves control.  Among other requirements, this guidance requires the acquiring entity in a business combination to recognize the identifiable assets acquired, liabilities assumed and any noncontrolling interest in the acquiree at their acquisition-date fair values, with limited exceptions; acquisition-related costs generally will be expensed as incurred.  This guidance requires certain financial statement disclosures to enable users to evaluate and understand the nature and financial effects of the business combination.  This guidance must be applied prospectively to business combinations that are consummated on or after July 1, 2009.  During the six months ended December 31, 2009, the Company did not have significant business combinations.  Accordingly, the adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

 

In December 2007, the FASB issued authoritative guidance to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary.  Among other requirements, this guidance clarifies that a noncontrolling interest in a subsidiary, which is sometimes referred to as minority interest, is to be reported as a separate component of equity in the consolidated financial statements.  This guidance also requires consolidated net income to include the amounts attributable to both the parent and the noncontrolling interest and to disclose those amounts on the face of the consolidated statement of earnings.  This guidance must be applied prospectively for fiscal years, and interim periods within those fiscal years, beginning in the Company’s fiscal 2010, except for the presentation and disclosure requirements, which will be applied retrospectively for all periods presented.  The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

In December 2007, the FASB issued authoritative guidance to address accounting for collaborative arrangement activities that are conducted without the creation of a separate legal entity for the arrangement.  Revenues and costs incurred with third parties in connection with the collaborative arrangement should be presented gross or net by the collaborators pursuant to pre-existing accounting standards.  Payments to or from collaborators should be presented in the income statement based on the nature of the arrangement, the nature of the company’s business and whether the payments are within the scope of other accounting literature.  Other detailed information related to the collaborative arrangement is also required to be disclosed.  The requirements under this guidance must be applied to collaborative arrangements in existence at the beginning of the Company’s fiscal 2010 using a modified version of retrospective application.  The Company is currently not a party to significant collaborative arrangement activities, as defined by this guidance, and therefore the adoption of this guidance did not have an impact on the Company’s consolidated financial statements.

 

Recently Issued Accounting Standards

 

In June 2009, the FASB issued authoritative guidance to eliminate the exception to consolidate a qualifying special-purpose entity, change the approach to determining the primary beneficiary of a variable interest entity and require companies to more frequently re-assess whether they must consolidate variable interest entities.  Under the new guidance, the primary beneficiary of a variable interest entity is identified qualitatively as the enterprise that has both (a) the power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance, and (b) the obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity.  This guidance becomes effective for the Company’s fiscal 2011 year-end and interim reporting periods thereafter.  The Company does not maintain any variable interests with unconsolidated entities that would be expected to have a material impact on its financial condition or results of operations.  Accordingly, the Company does not expect this guidance to have a material impact on its consolidated financial statements.

 

In December 2008, the FASB issued authoritative guidance to require employers to provide additional disclosures about plan assets of a defined benefit pension or other post-retirement plan.  These disclosures should principally include information detailing investment policies and strategies, the major categories of plan assets, the inputs and valuation techniques used to measure the fair value of plan assets and an understanding of significant concentrations of risk within plan assets.  While earlier application of this guidance is permitted, the required disclosures shall be provided for fiscal years ending after December 15, 2009 (the Company’s fiscal 2010, the anticipated period of adoption).  Upon initial application, this guidance is not required to be applied to earlier periods that are presented for comparative purposes.  The Company does not expect this guidance to have a material impact on its consolidated financial statements.

 

NOTE  2 — GOODWILL AND OTHER INTANGIBLE ASSETS

 

During the second quarter of fiscal 2010, the Ojon reporting unit altered and delayed certain components of its future expansion plans, resulting in revisions to its internal forecasts.  The Company concluded that these changes in circumstances in the Ojon reporting unit triggered the need for an interim impairment review of its goodwill and trademark.  Additionally, these changes in circumstances were also an indicator that the carrying amount of the customer list may not be recoverable.  The Company performed an interim impairment test for the trademark and a recoverability test for the customer list as of December 31, 2009 on this reporting unit.  The Company concluded that the carrying value of the Ojon trademark and customer list exceeded their estimated fair values, which were determined based on the application of a royalty rate to discounted estimated future cash flows (“relief-from-royalty method”) for the trademark and discounted expected future cash flows for the customer list.  As a result, the Company recognized impairment charges of $6.0 million for the trademark and $17.2 million for the customer list, at the exchange rate in effect at that time.  After adjusting the carrying value of the trademark and customer list, the Company completed an interim impairment test for goodwill and recorded a goodwill impairment charge related to the Ojon reporting unit of $16.6 million at the exchange rate in effect at that time.  The fair value of the reporting unit was based upon weighting of the income and market approaches, utilizing estimated cash flows and a terminal value, discounted at a rate of return that reflects the relative risk of the cash flows, as well as valuation multiples derived from comparable publicly traded companies that are applied to operating performance of the reporting unit.  These impairment charges were reflected in the hair care and skin care product categories and in the Americas region.  As of December 31, 2009, the carrying value of goodwill related to the Ojon reporting unit was $28.1 million.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

During the second quarter of fiscal 2010, the Darphin reporting unit identified issues related to the planned streamlining of its distribution process, resulting in revisions to its internal forecasts.  The Company concluded that these changes in circumstances in the Darphin reporting unit triggered the need for an interim impairment test of its trademark and goodwill.  The Company determined that the trademark was impaired, with fair value estimated based upon the relief-from-royalty method, and therefore recorded an impairment charge of $5.8 million in the skin care product category and in the Europe, the Middle East & Africa region.  After adjusting the carrying value of the trademark, the Company completed step one of the impairment test for goodwill and concluded that the fair value of the Darphin reporting unit was in excess of its carrying value including goodwill.  The fair value of the reporting unit was based upon the income approach, utilizing estimated cash flows and a terminal value, discounted at a rate of return that reflects the relative risk of the cash flows.  As of December 31, 2009, the carrying value of goodwill related to the Darphin reporting unit was $10.3 million.

 

Other intangible assets consists of the following:

 

		December 31, 2009									June 30, 2009
(In millions)		Gross Carrying Value			Accumulated Amortization			Total Net Book Value			Gross Carrying Value			Accumulated Amortization			Total Net Book Value
Amortizable intangible assets:
Customer lists and other		$	200.1		$	133.7		$	66.4		$	199.2		$	115.9		$	83.3
License agreements		43.2			43.0			0.2			43.2			43.0			0.2
		$	243.3		$	176.7		66.6			$	242.4		$	158.9		83.5
Non-amortizable intangible assets:
Trademarks and other								57.0									66.6
Total intangible assets								$	123.6								$	150.1

 

The aggregate amortization expense related to amortizable intangible assets for the three months ended December 31, 2009 and 2008 was $2.6 million and $2.7 million, respectively, and for the six months ended December 31, 2009 and 2008 was $5.1 million and $5.5 million, respectively.  The estimated aggregate amortization expense for the remainder of fiscal 2010 and each of fiscal years ending June 30, 2011 to 2014 is $4.8 million, $9.7 million, $9.3 million, $8.9 million and $6.6 million, respectively.

 

NOTE 3 — CHARGES ASSOCIATED WITH RESTRUCTURING ACTIVITIES

 

In an effort to drive down costs and achieve synergies within the organization, in February 2009, the Company announced the implementation of a multi-faceted cost savings program (the “Program”) to position itself to achieve long-term profitable growth.  The Company anticipates the Program will result in related restructuring and other special charges, inclusive of cumulative charges recorded to date and over the next few fiscal years, totaling between $350 million and $450 million before taxes.

 

The Program focuses on a redesign of the Company’s organizational structure in order to integrate it in a more cohesive way and operate more globally across brands and functions.  The principal aspect of the Program is the reduction of the workforce by approximately 2,000 employees.  Specific actions taken during the six months ended December 31, 2009 included:

 

·                   Resize and Reorganize the Organization — The Company continued the realignment and optimization of its organization to better leverage scale, improve productivity and reduce complexity in each region and across various functions.  This included reduction of the workforce which occurred through the consolidation of certain functions through a combination of normal attrition and job eliminations.

 

·                   Exit Unprofitable Operations — To improve the profitability in certain of the Company’s brands and regions, the Company has selectively exited certain channels of distribution, categories and markets.  During the first quarter of fiscal 2010, the Company approved the exit from the global wholesale distribution of its Prescriptives brand by January 31, 2010.  In connection with these activities, the Company recorded a reserve for anticipated product returns, wrote off inventory and incurred costs to reduce workforce and other exit costs.

 

·                   Outsourcing — In order to balance the growing need for information technology support with the Company’s efforts to provide the most efficient and cost effective solutions, the Company continued the outsourcing of certain information technology processes.  The Company incurred costs to transition services to an outsource provider.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

The following table presents aggregate restructuring charges related to the Program:

 

( In millions)		Employee-Related Costs			Asset Write-offs			Contract Terminations			Other Exit Costs			Total
Fiscal 2009		$	60.9		$	4.2		$	3.4		$	1.8		$	70.3
Three months ended September 30, 2009		13.4			0.2			0.6			0.5			14.7
Three months ended December 31, 2009		0.6			0.5			0.6			4.2			5.9
Charges recorded through December 31, 2009		$	74.9		$	4.9		$	4.6		$	6.5		$	90.9

 

The total amount of restructuring charges expected to be incurred (including those recorded as set forth in the table above), plus other initiatives approved through January 20, 2010, include approximately $94 million for employee-related costs, approximately $9 million in asset write-offs and approximately $20 million of contract terminations and other exit costs.

 

The following table presents accrued restructuring and the related activity as of and for the six months ended December 31, 2009 under the Program:

 

( In millions)		Employee-Related Costs			Asset Write-offs			Contract Terminations			Other Exit Costs			Total
Balance at June 30, 2009		$	51.6		$	—		$	2.9		$	0.2		$	54.7
Charges		14.0			0.7			1.2			4.7			20.6
Cash payments		(27.5		)	—			(1.1		)	(2.0		)	(30.6		)
Non-cash write-offs		—			(0.7		)	—			—			(0.7		)
Translation adjustments		0.6			—			—			—			0.6
Balance at December 31, 2009		$	38.7		$	—		$	3.0		$	2.9		$	44.6

 

Accrued restructuring charges at December 31, 2009 are expected to result in cash expenditures funded from cash provided by operations of approximately $29 million, $14 million and $2 million in fiscal 2010, 2011 and 2012, respectively.

 

The Company recorded other special charges in connection with the implementation of the Program for the three and six months ended December 31, 2009 of $3.4 million and $6.9 million, respectively, related to consulting, other professional services, and accelerated depreciation.  The total amount of other special charges expected to be incurred to implement these initiatives, including those recorded through December 31, 2009 plus other initiatives approved through January 20, 2010, is approximately $40 million.  During the three months ended December 31, 2009, the Company recorded adjustments to reflect revised estimates of anticipated sales returns and the write-off of inventory related to the exit from the global wholesale distribution of the Prescriptives brand.  For the three months ended December 31, 2009, the Company recorded an adjustment of $7.4 million to reduce anticipated sales returns and a related cost of sales of $1.6 million in addition to a benefit of $3.2 million to reduce the anticipated write-off of inventory associated with exiting unprofitable operations.  For the six months ended December 31, 2009, the Company recorded $11.1 million reflecting anticipated sales returns (less a related cost of sales of $2.3 million) and a write-off of inventory associated with exiting unprofitable operations of $6.3 million.  The total amounts expected to be incurred, including those recorded through December 31, 2009 plus other initiatives approved through January 20, 2010, is between $33 million and $36 million related to sales returns and approximately $11 million related to inventory write-offs.

 

Total charges associated with restructuring activities included in operating income for the three and six months ended December 31, 2009 were $0.3 million and $42.6 million, respectively.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 4 — DERIVATIVE FINANCIAL INSTRUMENTS

 

The Company addresses certain financial exposures through a controlled program of risk management that includes the use of derivative financial instruments.  The Company primarily enters into foreign currency forward and option contracts to reduce the effects of fluctuating foreign currency exchange rates and interest rate derivatives to manage the effects of interest rate movements on the Company’s aggregate liability portfolio.  The Company also enters into foreign currency forward and option contracts, not designated as hedging instruments, to mitigate the change in fair value of specific assets and liabilities on the balance sheet.  The Company does not utilize derivative financial instruments for trading or speculative purposes.  Costs associated with entering into these derivative financial instruments have not been material to the Company’s consolidated financial results.

 

For each derivative contract entered into where the Company looks to obtain special hedge accounting treatment, the Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking the hedge transaction, the nature of the risk being hedged, how the hedging instruments’ effectiveness in offsetting the hedged risk will be assessed prospectively and retrospectively, and a description of the method of measuring ineffectiveness.  This process includes linking all derivatives to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions.  The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items.  If it is determined that a derivative is not highly effective, or that it has ceased to be a highly effective hedge, the Company will be required to discontinue hedge accounting with respect to that derivative prospectively.

 

The fair values of the Company’s derivative financial instruments included in the consolidated balance sheets as of December 31, 2009 and June 30, 2009 are presented as follows:

 

		Asset Derivatives								Liability Derivatives
				Fair Value (1)								Fair Value (1)
(In millions)		Balance Sheet Location		December 31 2009			June 30 2009			Balance Sheet Location		December 31 2009			June 30 2009
Derivatives Designated as Hedging Instruments:
Foreign currency forward contracts		Prepaid expenses and other current assets		$	10.3		$	13.9		Other accrued liabilities		$	(17.6	)	$	(24.9	)
Interest rate swap contracts		Other assets		23.8			24.5			Not applicable		—			—
Total Derivatives Designated as Hedging Instruments				34.1			38.4					(17.6		)	(24.9		)
Derivatives Not Designated as Hedging Instruments:
Foreign currency forward contracts		Prepaid expenses and other current assets		2.4			2.8			Other accrued liabilities		(4.3		)	(1.3		)
Total Derivatives				$	36.5		$	41.2				$	(21.9	)	$	(26.2	)

 

(1)  See Note 5 — Fair Value Measurements for further information about how the fair value of derivative assets and liabilities are determined.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

The amounts of the gains and losses related to the Company’s derivative financial instruments designated as hedging instruments for the three and six months ended December 31, 2009 are presented as follows:

 

		Amount of Gain or (Loss) Recognized in OCI on Derivatives (Effective Portion)								Amount of Gain or (Loss) Reclassified from Accumulated OCI into Earnings (Effective Portion) (1)
(In millions)		Three Months Ended December 31, 2009			Six Months Ended December 31, 2009			Location of Gain or (Loss) Reclassified from Accumulated OCI into Earnings (Effective Portion)		Three Months Ended December 31, 2009			Six Months Ended December 31, 2009
Derivatives in Cash Flow Hedging Relationships:
Foreign currency forward contracts		$	(1.7	)	$	(6.5	)	Cost of sales		$	(3.7	)	$	(3.7	)
								Selling, general and administrative		(4.6		)	(6.9		)
Total derivatives		$	(1.7	)	$	(6.5	)			$	(8.3	)	$	(10.6	)

 

(1)  The amount of loss recognized in earnings related to the amount excluded from effectiveness testing was $0.1 million and $0.4 million for the three and six months ended December 31, 2009.  There was no gain (loss) recognized in earnings related to the ineffective portion of the hedging relationships for the three and six months ended December 31, 2009.

 

				Amount of Gain or (Loss) Recognized in Earnings on Derivatives (1)
(In millions)		Location of Gain or (Loss) Recognized in Earnings on Derivatives		Three Months Ended December 31, 2009			Six Months Ended December 31, 2009
Derivatives in Fair Value Hedging Relationships:
Interest rate swap contracts		Interest expense, net		$	(6.7	)	$	(0.7	)

 

(1)  Changes in the fair values of the interest rate swap agreements are exactly offset by changes in the fair value of the underlying long-term debt.

 

The amounts of the gains and losses related to the Company’s derivative financial instruments not designated as hedging instruments for the three and six months ended December 31, 2009 are presented as follows:

 

				Amount of Gain or (Loss) Recognized in Earnings on Derivatives
(In millions)		Location of Gain or (Loss) Recognized in Earnings on Derivatives		Three Months Ended December 31, 2009			Six Months Ended December 31, 2009
Derivatives Not Designated as Hedging Instruments:
Foreign currency forward contracts		Selling, general and administrative		$	0.8		$	(3.4	)

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Foreign Currency Cash-Flow Hedges

 

The Company enters into foreign currency forward contracts to hedge anticipated transactions, as well as receivables and payables denominated in foreign currencies, for periods consistent with the Company’s identified exposures.  The purpose of the hedging activities is to minimize the effect of foreign exchange rate movements on costs and on the cash flows that the Company receives from foreign subsidiaries.  The majority of foreign currency forward contracts are denominated in currencies of major industrial countries.  The Company may also enter into foreign currency option contracts to hedge anticipated transactions where there is a high probability that anticipated exposures will materialize.  The foreign currency forward contracts entered into to hedge anticipated transactions have been designated as foreign currency cash-flow hedges and have varying maturities through the end of June 2010.  Hedge effectiveness of foreign currency forward contracts is based on a hypothetical derivative methodology and excludes the portion of fair value attributable to the spot-forward difference which is recorded in current-period earnings.  Hedge effectiveness of foreign currency option contracts is based on a dollar offset methodology.  The ineffective portion of both foreign currency forward and option contracts is recorded in current-period earnings.  For hedge contracts that are no longer deemed highly effective, hedge accounting is discontinued and gains and losses accumulated in other comprehensive income (loss) are reclassified to earnings when the underlying forecasted transaction occurs.  If it is probable that the forecasted transaction will no longer occur, then any gains or losses in accumulated other comprehensive income (loss) are reclassified to current-period earnings.  As of December 31, 2009, the Company’s foreign currency cash-flow hedges were highly effective, in all material respects.  The estimated net gain as of December 31, 2009 that is expected to be reclassified from accumulated other comprehensive income (loss) into earnings within the next six months is $4.0 million.

 

At December 31, 2009, the Company had foreign currency forward contracts in the amount of $1,084.6 million.  The foreign currencies included in foreign currency forward contracts (notional value stated in U.S. dollars) are principally the British pound ($258.2 million), Swiss franc ($206.7 million), Euro ($156.1 million), Canadian dollar ($96.1 million), Hong Kong dollar ($83.6 million), Australian dollar ($73.9 million) and Japanese yen ($35.9 million).

 

Fair Value Hedges

 

The Company enters into interest rate derivative contracts to manage its exposure to interest rate fluctuations on its funded indebtedness and anticipated issuance of debt for periods consistent with the identified exposures.  The Company has interest rate swap agreements, with a notional amount totaling $250.0 million, to effectively convert the fixed rate interest on its 2017 Senior Notes to variable interest rates based on six-month LIBOR.  These interest rate swap agreements are designated as fair value hedges of the related long-term debt and the changes in the fair values of the interest rate swap agreements are exactly offset by changes in the fair value of the underlying long-term debt.  As of December 31, 2009, these fair-value hedges were highly effective in all material respects.

 

Credit Risk

 

As a matter of policy, the Company only enters into derivative contracts with counterparties that have at least an “A” (or equivalent) credit rating.  The counterparties to these contracts are major financial institutions.  Exposure to credit risk in the event of nonperformance by any of the counterparties is limited to the gross fair value of contracts in asset positions, which totaled $36.5 million at December 31, 2009, of which 86% were attributable to two counterparties.  To manage this risk, the Company has established strict counterparty credit guidelines that are continually monitored and reported to management.  Accordingly, management believes risk of loss under these hedging contracts is remote.

 

Certain of the Company’s derivative financial instruments contain credit-risk-related contingent features.  As of December 31, 2009, the Company was in compliance with such features and there were no derivative financial instruments with credit-risk-related contingent features that were in a net liability position.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 5 — FAIR VALUE MEASUREMENTS

 

The Company records its financial assets and liabilities at fair value, which is defined as the price that would be received to sell an asset or paid to transfer a liability, in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants at the measurement date.  Effective beginning in the Company’s fiscal 2010, the accounting for fair value measurements must be applied to nonrecurring nonfinancial assets and nonfinancial liabilities, which principally consist of assets or liabilities acquired through business combinations, goodwill, indefinite-lived intangible assets and long-lived assets for purposes of calculating potential impairment, and liabilities associated with restructuring activities.  The Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The three levels of inputs that may be used to measure fair value are as follows:

 

Level 1: Inputs based on quoted market prices for identical assets or liabilities in active markets at the measurement date.

 

Level 2: Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets and liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

 

Level 3: Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date.  The inputs are unobservable in the market and significant to the instrument’s valuation.

 

The following table presents the Company’s hierarchy for its financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2009:

 

		Quoted Prices in Active Markets for Identical Assets			Significant Other Observable Inputs			Significant Unobservable Inputs
(In millions)		(Level 1)			(Level 2)			(Level 3)			Total
Assets:
Foreign currency forward contracts		$	—		$	12.7		$	—		$	12.7
Interest rate swap contracts		—			23.8			—			23.8
Available-for-sale securities		6.0			—			—			6.0
Total		$	6.0		$	36.5		$	—		$	42.5
Liabilities:
Foreign currency forward contracts		$	—		$	21.9		$	—		$	21.9

 

The following table presents the Company’s hierarchy for certain of its nonfinancial assets measured at fair value on a nonrecurring basis, due to a change in circumstances that triggered an interim impairment review and a recoverability test, as of December 31, 2009:

 

(In millions)		Impairment charges			Carrying Value December 31, 2009			Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3) (1)
Goodwill		$	16.6		$	28.1		$	—		$	—		$	28.1
Other intangible assets, net		29.0			41.2			—			—			41.2
Total		$	45.6		$	69.3		$	—		$	—		$	69.3

 

(1)  See Note 2 for discussion of the valuation techniques used to measure fair value, the description of the inputs and information used to develop those inputs.

 

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THE ESTÉE LAUDER COMPANIES INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Fair Value of Financial Instruments

 

The following methods and assumptions were used to estimate the fair value of the Company’s classes of financial instruments for which it is practicable to estimate that value:

 

Cash and cash equivalents - The carrying amount approximates fair value, primarily because of the short maturity of cash equivalent instruments.

 

Available-for-sale securities - Available-for-sale securities are generally comprised of mutual funds and are valued using quoted market prices on an active exchange.  Available-for-sale securities are included in investments in the accompanying consolidated balance sheets.

 

Foreign currency forward contracts - The fair values of the Company’s foreign currency forward contracts were valued using pricing models, with all significant inputs derived from or corroborated by observable market data such as yield curves, currency spot and forward rates and currency volatilities.

 

Interest rate swap contracts - The fair values of the Company’s outstanding interest rate swap contracts were determined based on non-binding offers from the counterparties that are corroborated by observable market data.

 

Short-term and long-term debt - The fair value of the Company’s debt was estimated based on the current rates offered to the Company for debt with the same remaining maturities.  To a lesser extent, debt also includes capital lease obligations for which the carrying amount approximates the fair value.

 

The estimated fair values of the Company’s financial instruments at December 31, 2009 are as follows:

 

(In millions)		Carrying Amount			Fair Value
Nonderivatives
Cash and cash equivalents		$	1,223.6		$	1,223.6
Available-for-sale securities		6.0			6.0
Short-term and long-term debt		1,403.7			1,453.4
Derivatives
Foreign currency forward contracts — asset (liability)		(9.2		)	(9.2		)
Interest rate swap contracts — asset (liability)		23.8			23.8

 

NOTE 6 — PENSION AND POST-RETIREMENT BENEFIT PLANS

 

The Company maintains pension plans covering substantially all of its full-time employees for its U.S. operations and a majority of its international operations.  The Company also maintains a domestic post-retirement benefit plan which provides certain medical and dental benefits to eligible employees.  Descriptions of these plans are discussed in the Company’s Annual Report on Form 10-K for the year ended June 30, 2009.

 

The components of net periodic benefit cost for the three months ended December 31, 2009 and 2008 consisted of the following:

 

														Other than
		Pension Plans												Pension Plans
		U.S.						International						Post-retirement
(In millions)		2009			2008			2009			2008			2009			2008
Service cost		$	5.6		$	5.2		$	4.6		$	3.9		$	0.8		$	0.9
Interest cost		7.3			7.0			4.9			4.3			2.0			1.9
Expected return on plan assets		(8.0		)	(8.3		)	(5.1		)	(4.5		)	—			—
Amortization of:
Prior service cost		0.2			0.2			0.6			0.6			—			—
Actuarial loss		1.0			0.4			0.5			0.2			0.2			0.3
Settlements and curtailments		—			—			0.7			—			—			—
Net periodic benefit cost		$	6.1		$	4.5		$	6.2		$	4.5		$	3.0		$	3.1

 

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