UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

 

FORM 10-Q

 

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended July 31, 2006

 

Commission file no: 1-4121

 

 

DEERE  &  COMPANY

 

 

Delaware	36-2382580
(State of incorporation)	(IRS employer identification no.)

 

	One John Deere Place
	Moline, Illinois 61265
	(Address of principal executive offices)
	Telephone Number:  (309) 765-8000

 

 

        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 is a large accelerated filer, an 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   x

Accelerated Filer   o

Non-Accelerated Filer   o

 

        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 July 31, 2006, 231,197,372 shares of common stock, $1 par value, of the registrant were outstanding.

Index to Exhibits: Page 37

PART 1. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

DEERE & COMPANY
STATEMENT OF CONSOLIDATED INCOME
For the Three Months Ended July 31, 2006 and 2005
(In millions of dollars and shares except per share amounts) Unaudited

		2006			2005
Net Sales and Revenues
Net sales		$	5,677.3		$	5,370.1
Finance and interest income		462.5			372.6
Other income		126.9			80.7
Total		6,266.7			5,823.4
Costs and Expenses
Cost of sales		4,398.8			4,264.0
Research and development expenses		175.9			165.4
Selling, administrative and general expenses		623.1			533.1
Interest expense		261.9			196.5
Other operating expenses		126.0			94.7
Total		5,585.7			5,253.7
Income of Consolidated Group Before Income Taxes		681.0			569.7
Provision for income taxes		247.6			194.3
Income of Consolidated Group		433.4			375.4
Equity in Income of Unconsolidated Affiliates
Credit		.1			.1
Other		2.2			3.3
Total		2.3			3.4
Income from Continuing Operations		435.7			378.8
Income from Discontinued Operations		.3			8.3
Net Income		$	436.0		$	387.1
Per Share Data
Basic:
Continuing operations		$	1.87		$	1.57
Discontinued operations					.03
Net income		$	1.87		$	1.60
Diluted:
Continuing operations		$	1.85		$	1.55
Discontinued operations					.03
Net income		$	1.85		$	1.58
Average Shares Outstanding:
Basic		233.7			241.7
Diluted		235.9			244.7

See Notes to Interim Financial Statements.

 

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DEERE & COMPANY
STATEMENT OF CONSOLIDATED INCOME
For the Nine Months Ended July 31, 2006 and 2005
(In millions of dollars and shares except per share amounts) Unaudited

		2006			2005
Net Sales and Revenues
Net sales		$	15,397.6		$	14,915.8
Finance and interest income		1,282.8			1,040.1
Other income		349.9			242.8
Total		17,030.3			16,198.7
Costs and Expenses
Cost of sales		11,837.8			11,579.5
Research and development expenses		524.8			485.1
Selling, administrative and general expenses		1,704.6			1,525.8
Interest expense		742.1			543.7
Other operating expenses		414.7			274.1
Total		15,224.0			14,408.2
Income of Consolidated Group Before Income Taxes		1,806.3			1,790.5
Provision for income taxes		633.6			604.1
Income of Consolidated Group		1,172.7			1,186.4
Equity in Income of Unconsolidated Affiliates
Credit		.4			.4
Other		3.5			6.4
Total		3.9			6.8
Income from Continuing Operations		1,176.6			1,193.2
Income from Discontinued Operations		239.9			20.7
Net Income		$	1,416.5		$	1,213.9
Per Share Data
Basic:
Continuing operations		$	5.01		$	4.88
Discontinued operations		1.02			.08
Net income		$	6.03		$	4.96
Diluted:
Continuing operations		$	4.95		$	4.81
Discontinued operations		1.01			.08
Net income		$	5.96		$	4.89
Average Shares Outstanding:
Basic		235.0			244.8
Diluted		237.5			248.2

See Notes to Interim Financial Statements.

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DEERE & COMPANY
CONDENSED CONSOLIDATED BALANCE SHEET
(In millions of dollars) Unaudited

		July 31			October 31			July 31
		2006			2005			2005
Assets
Cash and cash equivalents		$	1,285.9		$	2,258.2		$	2,139.8
Marketable securities		1,865.7			2,169.1			1,671.1
Receivables from unconsolidated affiliates		29.5			18.4			26.0
Trade accounts and notes receivable — net		3,859.5			3,117.8			3,966.0
Financing receivables — net		13,328.4			12,869.4			11,883.9
Restricted financing receivables — net		2,349.4			1,457.9			1,438.7
Other receivables		514.4			523.0			441.1
Equipment on operating leases — net		1,420.0			1,335.6			1,260.4
Inventories		2,404.3			2,134.9			2,560.2
Property and equipment — net		2,534.3			2,343.3			2,159.8
Investments in unconsolidated affiliates		112.1			106.7			112.5
Goodwill		1,117.5			1,088.5			1,043.6
Other intangible assets — net		51.5			18.3			22.3
Prepaid pension costs		2,639.7			2,662.7			2,662.8
Other assets		477.7			419.8			472.4
Deferred income taxes		628.8			628.1			681.0
Deferred charges		149.1			133.8			140.0
Assets of discontinued operations					351.3			370.4
Total Assets		$	34,767.8		$	33,636.8		$	33,052.0
Liabilities and Stockholders’ Equity
Short-term borrowings		$	8,100.2		$	6,883.8		$	6,115.9
Payables to unconsolidated affiliates		186.2			140.8			150.2
Accounts payable and accrued expenses		4,617.9			4,320.9			4,172.6
Accrued taxes		260.2			214.3			233.9
Deferred income taxes		67.6			62.7			60.7
Long-term borrowings		11,240.3			11,738.8			11,738.2
Retirement benefit accruals and other liabilities		2,726.1			3,232.3			3,435.9
Liabilities of discontinued operations					191.7			207.6
Total liabilities		27,198.5			26,785.3			26,115.0
Common stock, $1 par value (issued shares at July 31, 2006 — 268,215,602)		2,190.1			2,081.7			2,043.5
Common stock in treasury		(2,349.3		)	(1,743.5		)	(1,469.2		)
Unamortized restricted stock compensation		(10.5		)	(16.4		)	(20.2		)
Retained earnings		7,697.5			6,556.1			6,401.0
Total		7,527.8			6,877.9			6,955.1
Accumulated other comprehensive income (loss)		41.5			(26.4		)	(18.1		)
Stockholders’ equity		7,569.3			6,851.5			6,937.0
Total Liabilities and Stockholders’ Equity		$	34,767.8		$	33,636.8		$	33,052.0

See Notes to Interim Financial Statements.

 

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DEERE & COMPANY
STATEMENT OF CONSOLIDATED CASH FLOWS
For the Nine Months Ended July 31, 2006 and 2005
(In millions of dollars) Unaudited

		2006			2005
Cash Flows from Operating Activities
Net income		$	1,416.5		$	1,213.9
Adjustments to reconcile net income to net cash used for operating activities:
Provision for doubtful receivables		36.0			8.0
Provision for depreciation and amortization		502.5			471.8
Gain on the sale of a business		(356.0		)
Undistributed earnings of unconsolidated affiliates		(1.9		)	(5.3		)
Credit for deferred income taxes		(8.1		)	(163.3		)
Changes in assets and liabilities:
Trade, notes and financing receivables related to sales of equipment		(1,318.8		)	(1,129.6		)
Inventories		(433.3		)	(746.2		)
Accounts payable and accrued expenses		326.4			285.8
Retirement benefit accruals/prepaid pension costs		(503.1		)	(28.7		)
Other		1.9			(33.5		)
Net cash used for operating activities		(337.9		)	(127.1		)
Cash Flows from Investing Activities
Collections of financing receivables		7,100.1			6,024.6
Proceeds from sales of financing receivables		60.7			55.4
Proceeds from maturities and sales of marketable securities		2,517.2			394.2
Proceeds from sales of equipment on operating leases		219.2			298.6
Proceeds from sales of businesses, net of cash sold		439.1			46.0
Cost of financing receivables acquired		(7,763.2		)	(7,713.1		)
Purchases of marketable securities		(2,134.0		)	(2,115.0		)
Purchases of property and equipment		(500.3		)	(274.1		)
Cost of operating leases acquired		(288.8		)	(236.7		)
Acquisitions of businesses, net of cash acquired		(54.1		)	(124.3		)
Other		(10.2		)	21.9
Net cash used for investing activities		(414.3		)	(3,622.5		)
Cash Flows from Financing Activities
Increase in short-term borrowings		840.3			1,694.2
Proceeds from long-term borrowings		2,182.4			2,725.7
Payments of long-term borrowings		(2,438.5		)	(998.1		)
Proceeds from issuance of common stock		304.2			147.4
Repurchases of common stock		(955.0		)	(633.2		)
Dividends paid		(257.4		)	(214.9		)
Excess tax benefits from share-based compensation		79.4
Other		(9.8		)	(1.4		)
Net cash provided by (used for) financing activities		(254.4		)	2,719.7
Effect of Exchange Rate Changes on Cash		34.3			(11.4		)
Net Decrease in Cash and Cash Equivalents		(972.3		)	(1,041.3		)
Cash and Cash Equivalents at Beginning of Period		2,258.2			3,181.1
Cash and Cash Equivalents at End of Period		$	1,285.9		$	2,139.8

See Notes to Interim Financial Statements.

5

Notes to Interim Financial Statements (Unaudited)

(1)             The consolidated financial statements of Deere & Company and consolidated subsidiaries have been prepared by the Company, without audit, pursuant to the rules and regulations of the U.S. Securities and Exchange Commission.  Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the U.S. have been condensed or omitted as permitted by such rules and regulations.  All adjustments, consisting of normal recurring adjustments, have been included.  Management believes that the disclosures are adequate to present fairly the financial position, results of operations and cash flows at the dates and for the periods presented.  It is suggested that these interim financial statements be read in conjunction with the financial statements and the notes thereto appearing in the Company’s latest annual report on Form 10-K.  Results for interim periods are not necessarily indicative of those to be expected for the fiscal year.

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts and related disclosures.  Actual results could differ from those estimates.

Certain amounts for prior periods have been reclassified to conform with 2006 financial statement presentations.

All cash flows from the changes in trade accounts and notes receivable are classified as operating activities in the Statement of Consolidated Cash Flows as these receivables arise from the sale of equipment to the Company’s customers.  Cash flows from financing receivables that are related to the sale of equipment to the Company’s customers are also included in operating activities.  The remaining financing receivables are related to the financing of equipment sold by independent dealers and are included in investing activities.  The Company had non-cash operating and investing activities that were not included in the Statement of Consolidated Cash Flows related to use of equipment included in the Company’s inventory (operating activity) for equipment leased to customers under operating leases (investing activity) of approximately $182 million and $176 million in the first nine months of 2006 and 2005, respectively.

(2)             The information in the notes and related commentary are presented in a format which includes data grouped as follows:

Equipment Operations — Includes the Company’s agricultural equipment, commercial and consumer equipment and construction and forestry operations with Financial Services reflected on the equity basis except for the health care operations, which are reported on a discontinued basis (see Note 13).

Financial Services — Includes the Company’s credit and certain miscellaneous service operations with the health care operations reported on a discontinued basis (see Note 13).

Consolidated — Represents the consolidation of the Equipment Operations and Financial Services with the health care operations reported on a discontinued basis (see Note 13).  References to “Deere & Company” or “the Company” refer to the entire enterprise.

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(3)             An analysis of the Company’s retained earnings in millions of dollars follows:

 

(4)             In the first quarter of 2006, the Company adopted Financial Accounting Standards Board (FASB) Statement No. 123 (revised 2004), Share-Based Payment, for the recognition of share-based employee compensation expense in its financial statements (see Note 16).  In the prior periods, the Company used the intrinsic value method for share-based employee compensation.  The pro forma net income and net income per share, as if the fair value method in FASB Statement No. 123, Accounting for Stock-Based Compensation, had been used to account for the compensation, with dollars in millions except per share amounts, were as follows:

 

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(5)             Most inventories owned by Deere & Company and its U.S. equipment subsidiaries are valued at cost on the “last-in, first-out” (LIFO) method.  If all of the Company’s inventories had been valued on a “first-in, first-out” (FIFO) method, estimated inventories by major classification in millions of dollars would have been as follows:

 

(6)             Contingencies:

The Company generally determines its total warranty liability by applying historical claims rate experience to the estimated amount of equipment that has been sold and is still under warranty (based on dealer inventories and retail sales).  The historical claims rate is primarily determined by a review of five-year claims costs and current quality developments.

A reconciliation of the changes in the warranty liability in millions of dollars follows:

 

At July 31, 2006, the Company had approximately $136 million of guarantees issued primarily to overseas banks related to third-party receivables for the retail financing of John Deere equipment.  The Company may recover a portion of any required payments incurred under these agreements from repossession of the equipment collateralizing the receivables.  At July 31, 2006, the Company had accrued losses of approximately $3 million under these agreements.  The maximum remaining term of the receivables guaranteed at July 31, 2006 was approximately seven years.

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The credit operations’ subsidiary, John Deere Risk Protection, Inc., offers crop insurance products through a managing general agency agreement (Agreement) with an insurance company (Insurance Carrier) rated “Excellent” with A.M. Best Company.  As a managing general agent, John Deere Risk Protection, Inc. will receive commissions from the Insurance Carrier for selling crop insurance to producers.  The credit operations have guaranteed certain obligations under the Agreement, including the obligation to pay the Insurance Carrier for any uncollected premiums.  At July 31, 2006, the maximum exposure for uncollected premiums was approximately $55 million.  Substantially all of the credit operations’ crop insurance risk under the Agreement has been mitigated by a syndicate of private reinsurance companies.  These reinsurance companies are rated “Excellent” or higher by A.M. Best Company.  In the event of a widespread catastrophic crop failure throughout the U.S. and the default of these highly rated private reinsurance companies on their reinsurance obligations, the credit operations would be required to reimburse the Insurance Carrier for exposure under the Agreement of approximately $370 million at July 31, 2006.  The credit operations believe that the likelihood of the occurrence of substantially all of the events that give rise to the exposure under this Agreement is extremely remote and as a result, at July 31, 2006, the credit operations have accrued probable losses of approximately $.1 million under the Agreement.

At July 31, 2006, the Company had commitments of approximately $389 million for the construction and acquisition of property and equipment.  At July 31, 2006, the Company also had pledged or restricted assets of $83 million, outside the U.S., primarily as collateral for borrowings, and $15 million of restricted other assets in the U.S. related to the sale of the health care operations.

The Company also had other miscellaneous contingent liabilities totaling approximately $40 million at July 31, 2006, for which it believes the probability for payment is primarily remote.

Secured Borrowings

Beginning in 2005, the credit operations’ new securitizations of financing receivables (retail notes) either did not meet the criteria for sales of receivables to unconsolidated special-purpose entities (SPEs) or were secured borrowings held by an SPE that was consolidated since the Company was the primary beneficiary.  The resulting secured borrowings related to both types of securitizations of retail notes are included in short-term borrowings on the balance sheet as shown in the following table.  The securitized retail notes are recorded as “Restricted financing receivables — net” on the balance sheet.  The total restricted assets on the balance sheet related to these securitizations include the restricted financing receivables less an allowance for credit losses, and other assets representing restricted cash as shown in the following table.  In addition to the restricted assets, the creditors of an unconsolidated SPE involved in both secured borrowings and sales of receivables related to a $2 billion revolving bank conduit facility have recourse to a reserve fund held by the SPE totaling approximately $25 million as of July 31, 2006.  A portion of the previous transfers of retail notes to this facility qualified as sales of receivables.  As a result, this reserve fund is also included in the following maximum exposure to losses for receivables that have been sold.

The total components of consolidated restricted assets related to securitizations follow in millions of dollars:

 

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The components of consolidated secured liabilities related to securitizations follow in millions of dollars:

 

A portion of the restricted retail notes totaling $1,122 million at July 31, 2006, $816 million at October 31, 2005 and $750 million at July 31, 2005 were related to secured borrowings and were transferred to SPEs that are not consolidated since the Company is not the primary beneficiary.  The borrowings related to these restricted retail notes are obligations to these SPEs that are payable as the restricted retail notes are liquidated.  The remaining restricted retail notes totaling $1,240 million at July 31, 2006, $650 million at October 31, 2005 and $697 million at July 31, 2005 were transferred to a SPE that utilized the retail notes for secured borrowings.  The Company has consolidated this SPE since the Company is the primary beneficiary and the SPE is not a qualified SPE that is exempt from consolidation.  These restricted retail notes are the primary assets of this consolidated SPE.  The borrowings included above for the consolidated SPE are obligations to the creditors of the SPE that are also payable as the restricted retail notes are liquidated.  SPEs utilized in securitizations of retail notes differ from other entities included in the Company’s consolidated statements because the assets they hold are legally isolated.  For bankruptcy analysis purposes, the Company has sold the receivables to the SPEs in a true sale and the SPEs are separate legal entities.  Use of the assets held by the SPEs is restricted by terms of the governing documents.  Repayment of the secured borrowings depends primarily on cash flows generated by the restricted assets and the reserve fund mentioned above.  At July 31, 2006, the maximum remaining term of the restricted receivables was approximately six years.

Sales of Receivables

The Company has certain recourse obligations on financing receivables that it has previously sold.  If the receivables sold are not collected, the Company would be required to cover those losses up to the amount of its recourse obligation.  At July 31, 2006, the maximum amount of exposure to losses under these agreements was $153 million.  The estimated risk associated with sold receivables totaled $5 million at July 31, 2006.  This risk of loss is recognized primarily in the retained interests recorded on the Company’s balance sheet, which are related to the securitization and sale of retail notes prior to 2005.  At July 31, 2006, the assets of the unconsolidated SPEs related to the Company’s prior securitization and sale of retail notes totaled approximately $1,142 million.  The Company may recover a portion of any required payments incurred under these agreements from the repossession of the equipment collateralizing the receivables.  At July 31, 2006, the maximum remaining term of the receivables sold was approximately four years.

(7)    Dividends declared and paid on a per share basis were as follows:

 

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(8)	Worldwide net sales and revenues, operating profit and identifiable assets by segment in millions of dollars follow:

 

*                    Additional intersegment sales and revenues

**             Includes equipment operations outside the U.S. and Canada as follows:

 

	Other revenues and operating profit in the prior periods as presented above decreased $182 million and $12 million, respectively, in the third quarter and $555 million and $27 million, respectively, in the first nine months from the amounts reported in 2005 due to a reclassification of the health care operations included in “Other” last year to discontinued operations this year. Identifiable “Other” assets decreased $402 million and were reclassified to discontinued operations and corporate assets (see Note 13).
***	Operating profit is income from continuing operations before external interest expense, certain foreign exchange gains and losses, income taxes and certain corporate expenses. However, operating profit of the credit segment includes the effect of interest expense and foreign exchange gains or losses.

 

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(9)	A reconciliation of basic and diluted net income per share in millions, except per share amounts, follows:

 

 

	Out of the total stock options outstanding during the third quarter and first nine months of 2006, options to purchase 3.4 million shares were excluded from the above diluted per share computation because the incremental shares related to the exercise of these options under the treasury stock method would have caused an antidilutive effect on net income per share. All stock options outstanding were included in the above computations during 2005.
(10)	Comprehensive income, which includes all changes in the Company’s equity during the period except transactions with stockholders, was as follows in millions of dollars:

 

 

(11)

The Company is subject to various unresolved legal actions which arise in the normal course of its business, the most prevalent of which relate to product liability (including asbestos related liability), retail credit, software licensing, patent and trademark matters. Although it is not possible to predict with certainty the outcome of these unresolved legal actions or the range of possible loss, the Company believes these unresolved legal actions will not have a material effect on its financial statements.

 

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(12)	The Company has several defined benefit pension plans covering its U.S. employees and employees in certain foreign countries. The Company also has several defined benefit health care and life insurance plans for retired employees in the U.S. and Canada.
	The components of net periodic pension cost consisted of the following in millions of dollars:

 

 

The components of other net periodic postretirement benefits cost (health care and life insurance) consisted of the following in millions of dollars:

 

 

	During the first nine months of 2006, the Company contributed approximately $46 million to its pension plans and $787 million to its other postretirement benefit plans. The Company presently anticipates contributing an additional $20 million to its pension plans and no additional amounts to its other postretirement benefit plans in the remainder of fiscal year 2006. These contributions include payments from Company funds to either increase plan assets or to make direct payments to plan participants.
(13)	In February 2006, the Company sold its wholly-owned subsidiary, John Deere Health Care, Inc. (health care operations), to UnitedHealthcare for approximately $500 million and recognized a gain on the sale of approximately $350 million pretax, or $220 million after-tax in the first nine months of 2006. In accordance with FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, these operations and the gain on the sale have been reflected as discontinued operations in the consolidated financial statements for all periods presented. The health care operations were previously reported by the Company as a component of “Other” under the provisions of FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information.

 

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The carrying amounts of the major classes of assets and liabilities aggregated in discontinued operations on the consolidated balance sheet in prior periods in millions of dollars follow:

 

 

*	A portion of the health care claims and reserves of the health care operations was reclassified to accounts payable and accrued expenses of the continuing operations for an incurred but not reported reserve related to the Company’s continuing health care claims.
	The amounts of revenue and pretax profit aggregated in discontinued operations on the statement of consolidated income in millions of dollars follow:

 

 

The liabilities for employee termination benefits related to the discontinued operations in the first nine months of 2006 in millions of dollars follow:

 

 

The total employee termination benefit expenses expected to be incurred in relation to this disposal is $8 million pretax, which is included in the “Income from Discontinued Operations” line on the statement of consolidated income.

 

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(14)	In January 2006, the Company decided to close its forestry manufacturing facility in Woodstock, Ontario, Canada by September 30, 2006 and consolidate this manufacturing into the Company’s existing Davenport and Dubuque, Iowa facilities. This restructuring is intended to reduce costs and further improve product delivery times. This operation is included in the construction and forestry segment.
	The liabilities for employee termination benefits related to the restructuring in the first nine months of 2006 in millions of dollars follow:

 

 

	In the first nine months of 2006, the total expense related to the closure was approximately $22 million pretax, which included the above accrued employee termination benefit expenses of $9 million; impairments and write-downs for property, equipment and inventory of $7 million; pension and other postretirement benefit expenses of $3 million; and relocation of production expenses of $3 million. All expenses were recognized in cost of sales.
	The Company expects the closure of the facility to result in total expenses of approximately $55 million pretax, which includes estimated expenses of $25 million for pension and other postretirement benefits; $10 million for employee termination benefits; $10 million for impairments and write-downs of property, equipment and inventory; and $10 million for relocation of production. The estimate of the pretax cash expenditures associated with these expenses is approximately $40 million. The expenses related to the closure are expected to be completed during the next three to six months.
(15)	In February 2006, the Company announced a cash tender offer of up to $500 million to repurchase outstanding notes. An aggregate principal amount of $433 million was repurchased in the second quarter of 2006 consisting of $144 million of 8.95% Debentures due 2019, $194 million of 7.85% Debentures due 2010 and $95 million of 8 ½% Debentures due 2022. The repurchase of these notes for approximately $500 million resulted in an expense of $70 million pretax in the first nine months of 2006.
(16)	New accounting standards adopted are as follows:
	FASB Statement No. 123 (revised 2004)
	In the first quarter of 2006, the Company adopted FASB Statement No. 123 (revised 2004), Share-Based Payment, using the modified prospective method of adoption, which does not require restatement of prior periods. The revised standard eliminated the intrinsic value method of accounting for share-based employee compensation under APB Opinion No. 25, Accounting for Stock Issued to Employees, which the Company previously used (see Note 4 for pro-forma disclosure of prior period). The revised standard generally requires the recognition of the cost of employee services for share-based compensation based on the grant date fair value of the equity or liability instruments issued. The effect of adoption of the new standard in 2006 was an additional expense in the third quarter of $11 million pretax, or $7 million after-tax ($.03 per share, basic and diluted) and in the first nine months was $64 million pretax, or $40 million after-tax ($.17 per share, basic and diluted). Also under the new standard, excess income tax benefits related to share-based compensation expense that must be recognized directly in equity are considered financing rather than operating cash flow activities. The amount of financing cash flows for these benefits in the first nine months of 2006 was $79 million.

 

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	The Company issues stock options and restricted stock to key employees under a plan approved by stockholders. Restricted stock is also issued to nonemployee directors for their services as directors under a plan approved by stockholders. Options are generally awarded with the exercise price equal to the market price at the date of grant and become exercisable in one to three years after grant. Options generally expire 10 years after the date of grant. Restricted stock generally vests after three years. According to these plans at July 31, 2006, the Company is authorized to grant an additional 11.3 million shares related to stock options or restricted stock.
	In the first nine months of 2006, the fair value of each option award was estimated on the date of grant using a binomial lattice option valuation model. Expected volatilities are based on implied volatilities from traded call options of the Company’s stock. The expected volatilities are constructed from the following three components: the starting implied volatility of short-term call options traded within a few days of the valuation date; the predicted implied volatility of long-term call options; and the trend in implied volatilities over the span of the call options’ time to maturity. The Company uses historical data to estimate option exercise behavior and employee termination within the valuation model. The expected term of options granted is derived from the output of the option valuation model and represents the period of time that options granted are expected to be outstanding. The risk-free rates utilized for periods throughout the contractual life of the options are based on U.S. Treasury security yields at the time of grant.
	Prior to adoption of the new standard, the pro-forma disclosure used a straight-line amortization of the stock option and restricted stock expense over the vesting period according to FASB Statement No. 123, Accounting for Stock-Based Compensation, which included employees eligible to retire. Under FASB Statement No. 123 (revised 2004), Share-Based Payment, the awards granted after the adoption must be recognized in expense over the requisite service period, which is either immediate if the employee is eligible to retire, or over the vesting period if the employee is not eligible to retire. The amount of expense for awards granted prior to adoption of the new standard for employees eligible to retire that continued to be amortized over the nominal vesting period in the third quarter of 2006 was approximately $5 million pretax, $3 million after-tax ($.01 per share, basic and diluted) and in the first nine months of 2006 was $15 million pretax, $9 million after-tax ($.04 per share, basic and diluted).
	The assumptions used for the binomial lattice model to determine the fair value of options granted in the first nine months of 2006 follow:

 

 

 

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