ITT INDUSTRIES INC - 10-Q Quarterly Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004

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

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 1-5672

ITT INDUSTRIES, INC.

INCORPORATED IN THE STATE OF INDIANA 13-5158950
(I.R.S. Employer
Identification Number)

4 WEST RED OAK LANE, WHITE PLAINS, NY 10604
(Principal Executive Office)

TELEPHONE NUMBER: (914) 641-2000

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 and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ]

As of July 31, 2004, there were outstanding 92,277,513 shares of common
stock ($1 par value per share) of the registrant.

ITT INDUSTRIES, INC.

TABLE OF CONTENTS

1

PART I.

FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

The following unaudited consolidated condensed financial statements have
been prepared pursuant to the rules and regulations of the Securities and
Exchange Commission (SEC) and, in the opinion of management, reflect all
adjustments (which include normal recurring adjustments) necessary for a fair
presentation of the financial position, results of operations, and cash flows
for the periods presented. Certain information and note disclosures normally
included in financial statements prepared in accordance with accounting
principles generally accepted within the United States have been condensed or
omitted pursuant to such SEC rules. The Company believes that the disclosures
herein are adequate to make the information presented not misleading. Certain
amounts in the prior periods' consolidated condensed financial statements have
been reclassified to conform to the current period presentation. These financial
statements should be read in conjunction with the financial statements and notes
thereto included in the Company's 2003 Annual Report on Form 10-K.

ITT INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED INCOME STATEMENTS
(IN MILLIONS, EXCEPT PER SHARE)
(UNAUDITED)

- ---------------

The accompanying notes to consolidated condensed financial statements are an
integral part of the above income statements.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED BALANCE SHEETS
(IN MILLIONS, EXCEPT FOR SHARES AND PER SHARE)
(UNAUDITED)

- ---------------

The accompanying notes to consolidated condensed financial statements are an
integral part of the above balance sheets.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(IN MILLIONS)
(UNAUDITED)

- ---------------

The accompanying notes to consolidated condensed financial statements are an
integral part of the above cash flow statements.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

1) RECEIVABLES, NET

Net receivables consist of the following:

2) INVENTORIES, NET

Net inventories consist of the following:

3) PLANT, PROPERTY AND EQUIPMENT, NET

Net plant, property and equipment consist of the following:

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

4) SALES AND REVENUES AND COSTS OF SALES AND REVENUES

Sales and revenues and costs of sales and revenues consist of the
following:

The Defense Electronics & Services segment comprises $249.3 and $484.4 of
total service revenues for the three and six months ended June 30, 2004,
respectively, and $169.8 and $331.7 of total costs of service revenues,
respectively, during the same period. The Fluid Technology segment comprises the
remaining balances of service revenues and costs of service revenues.

The Defense Electronics & Services segment comprises $201.3 and $379.8 of
total service revenues for the three and six months ended June 30, 2003,
respectively, and $132.1 and $250.4 of total costs of service revenues,
respectively, during the same period. The Fluid Technology segment comprises the
remaining balances of service revenues and costs of service revenues.

5) COMPREHENSIVE INCOME

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

6) EARNINGS PER SHARE

The following is a reconciliation of the shares used in the computation of
basic and diluted earnings per share for the three and six months ended June 30,
2004 and 2003:

There were no amounts of outstanding antidilutive common stock options
excluded from the computation of diluted earnings per share for the three months
and six months ended June 30, 2004.

The amounts of outstanding antidilutive common stock options excluded from
the computation of diluted earnings per share for the three months and six
months ended June 30, 2003 were 1.9 and 1.7, respectively.

7) STOCK-BASED EMPLOYEE COMPENSATION

At June 30, 2004, the Company has one stock-based employee compensation
plan that is issuing new options and restricted shares. The Company also has two
stock-based employee compensation plans and two stock-based non-employee
directors compensation plans that have options and restricted shares
outstanding, but will not be issuing additional stock-based compensation. These
plans are described more fully in Note 20, "Shareholders' Equity," within the
Notes to Consolidated Financial Statements of the 2003 Annual Report on Form
10-K. The Company accounts for these plans under the recognition and measurement
principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees,"
and related interpretations. Had compensation expense for these plans been
determined based on the fair value recognition provisions of Statement of
Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based
Compensation," the Company's net income and earnings per share would have been
reduced to the following pro forma amounts:

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

The fair value of each option grant was estimated on the date of grant
using the Black-Scholes option-pricing model and the following weighted-average
assumptions for grants in the three months and six months ended June 30, 2004
and 2003:

The value of stock-based compensation that was recognized in selling,
general and administrative expenses within the Consolidated Condensed Income
Statements during the three month and six month periods ended June 30, 2004 and
2003 was:

8) RESTRUCTURING AND ASSET IMPAIRMENT CHARGES

2004 RESTRUCTURING ACTIVITIES

During the second quarter of 2004, the Company recognized a $13.9 charge,
primarily for the planned severance of 430 employees and the recognition of
lease cancellation fees. The actions by segment are as follows:

- The Electronic Components segment recorded $4.5 of the charge for the
recognition of lease cancellation costs. Severance of $1.2 was recorded
for the reduction of 340 employees. The terminations include 273 factory
workers, 64 office workers and three management employees. The segment
also recorded a $1.1 charge for the disposal of machinery and equipment.

- The Fluid Technology segment recorded $2.4 for the termination of 45
employees, including eight factory workers and 37 office workers. Lease
commitments totaling $0.7 were recognized related to the closure of two
facilities (one in Sweden and one in Florida). Asset write-offs and other
costs totaling $0.2 and $0.1, respectively, were also recognized during
the quarter.

- The Motion & Flow Control segment recognized $2.1 for the termination of
44 employees, including seven factory workers, 32 office workers and five
management employees.

- Corporate headquarters recorded $1.6 for the severance of one management
employee.

In addition to the restructuring actions announced during the second
quarter, the Motion & Flow Control segment recognized $0.3 of severance and
employee benefit costs related to actions announced during the first quarter of
2003 and the Electronic Components segment recognized $0.3 of severance and
employee benefit costs related to actions announced during the first quarter of
2004 and $0.1 of outplacement related to actions announced in 2003.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

During the first quarter of 2004, the Company recognized a $5.3 charge,
primarily for the planned severance of 103 employees. The actions by segment are
as follows:

- The Fluid Technology segment recorded $2.7 for the planned termination of
50 employees, including 15 factory workers and 35 office workers. Asset
write-offs and other costs totaling $0.4 and $0.1, respectively, were
also recognized during the quarter.

- The Electronic Components segment recorded $1.7 of the charge primarily
for the planned reduction of 35 employees, including 23 factory workers,
11 office workers and one management employee.

- The Motion & Flow Control segment recognized $0.2 for the planned
termination of 16 employees, including three factory workers and 13
office workers.

- Corporate headquarters recorded $0.2 for the planned severance of one
office worker and one management employee.

2003 RESTRUCTURING ACTIVITIES

During the fourth quarter of 2003 the Company announced actions to reduce
operating costs primarily through the reduction of headcount. The new $15.4
restructuring charge primarily reflects the planned severance of 301 employees.
The actions by segment are as follows:

- The Electronic Components segment recorded $1.5 of the charge for the
planned termination of 132 employees, including 113 factory workers, 14
office workers and five management employees.

- The Fluid Technology segment recognized $12.4 of the charge for the
planned severance of 134 employees, including 39 factory workers, 90
office workers and five management employees. Lease and other costs
represent $0.3 of the charge. The segment also recorded a $0.2 charge
associated with the disposal of machinery and equipment.

- The Defense Electronics & Services segment recorded a $1.0 charge for the
planned severance of 35 employees, including seven factory workers, 19
office workers and nine management employees.

In addition to the restructuring actions announced during the fourth
quarter, the Motion & Flow Control segment recognized $0.5 of severance and
employee benefit costs related to actions announced during the first quarter and
the Electronic Components segment recognized $0.2 of outplacement related to
actions announced earlier in 2003.

During the third quarter of 2003 the Company announced actions to reduce
operating costs primarily through the reduction of headcount. The new $2.6
restructuring charge primarily reflects the planned severance of 72 employees.
The actions by segment are as follows:

- The Electronic Components segment recorded $1.2 of the charge for the
planned termination of 40 employees, including 15 factory workers and 25
office workers. The segment also recorded a $0.1 charge associated with
the disposal of machinery and equipment.

- The Fluid Technology segment recognized a $0.5 charge for the planned
severance of 13 factory workers and 14 office workers. Lease and other
costs represent $0.4 of the charge.

- The Motion & Flow Control segment recorded a $0.4 charge for the planned
severance of one management employee and four office workers.

In addition to the restructuring actions announced during the third
quarter, the Motion & Flow Control segment recognized $0.2 of severance and
employee benefit costs related to actions announced during the first quarter.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

During the second quarter of 2003 the Company continued its program to
reduce structural costs and increase profitability. New restructuring actions
totaling $4.7 were announced during the period. The charge primarily reflected
the planned severance of 148 employees and the cancellation of an operating
lease. The actions by segment are as follows:

- The Electronic Components segment comprises $2.7 of the charge and the
actions taken at this segment include the planned termination of six
management employees, 19 factory workers and 71 office workers.

- The Motion & Flow Control segment recognized $1.0 for the planned
severance of 50 employees, including six management employees, 31 factory
workers and 13 office workers. Lease termination fees of $0.7 and asset
disposal costs of $0.1 were also reflected in the charge.

- At Corporate Headquarters, a charge of $0.2 was recorded for the planned
termination of one management employee and one office worker.

In addition to the restructuring actions announced during the second
quarter, the Motion & Flow Control segment recognized $1.2 of severance and
employee benefit costs related to actions announced during the first quarter.

During the first quarter of 2003 the Company recorded a $9.0 restructuring
charge primarily for the planned severance of 465 persons. Severance of $8.3
represents the majority of the charge. The actions by segment are as follows:

- The Electronic Components segment recorded $6.8 of the charge for the
planned termination of 226 persons, comprised of 101 office workers, 116
factory workers and nine management employees. Idle facility costs of
$0.3 and asset disposal costs of $0.4 were also reflected in the charge.
The actions were prompted by management's projections of continued
weakness in certain businesses.

- Corporate Headquarters recorded $1.1 of the charge for the consolidation
of administrative tasks, including the planned termination of two
management employees.

- The Motion & Flow Control segment recorded $0.4 of the charge for the
planned termination of 237 employees, comprised of 21 office workers and
216 factory workers. The charge relates to the closure of a manufacturing
facility in Arkansas. The actions will be completed during 2003 and 2004
and the total estimated charge of approximately $2.6 will be recognized
ratably over the restructuring period as the terminations become
effective. Management deemed the restructuring actions necessary to
address the anticipated loss of certain platforms during the second half
of 2003.

2003 OTHER ASSET IMPAIRMENTS

During 2003, the Company recorded a $1.4 asset impairment charge primarily
for a technology license that will not be utilized based on management's
projections of future market conditions. The applicable assets were written down
to their fair values based on management's comparison of projected future
discounted cash flows generated by each asset to the applicable asset's carrying
value. These impairments were unrelated to the Company's restructuring
activities.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

The following is a rollforward of the accrued cash restructuring balances
for all restructuring plans.

During the second quarter of 2004, $0.1 and $0.2 of restructuring accruals
related to 2003 and 2002 restructuring actions, respectively, were reversed into
income. The reversals related to the 2003 actions primarily reflect lower than
anticipated severance costs on completed actions at the Electronic Components
segment. The reversals related to the 2002 actions represent lower than
anticipated severance costs on completed actions at the Fluid Technology
segment.

During the first quarter of 2004, $0.2 and $0.4 of restructuring accruals
related to 2003 and 2001 restructuring actions, respectively, were reversed into
income. The reversals related to the 2003 actions primarily reflect lower than
anticipated severance costs on completed actions due to favorable employee
attrition at the Electronic Components segment. The reversals associated with
the 2001 actions represent lower than anticipated closed facility costs.

At December 31, 2003, the accrual balance for restructuring activities was
$20.1. Cash payments of $17.8 and additional cash charges of $18.2 were recorded
in the first six months of 2004. The accrual balance related to cash charges at
June 30, 2004 is $19.0, which includes $12.2 for severance and $6.8 for facility
carrying costs and other.

As of December 31, 2003, remaining actions under restructuring activities
announced in 2003, 2002 and 2001 were to close one facility and reduce headcount
by 208. During the first six months of 2004, the Company reduced headcount by
491 persons related to all plans and experienced employee attrition, leaving a
balance of 244 planned reductions. Actions announced during the second quarter
of 2004 will be substantially completed by the end of the first quarter of 2005.
Actions announced during the first quarter of 2004 were substantially completed
by the end of the second quarter of 2004, with 12 headcount reductions
remaining. Actions announced during 2003 will be substantially completed by the
end of 2004. All of the actions contemplated under the 2002 and 2001 plans were
substantially completed in 2003. Closed facility expenditures and severance
run-off related to the 2001 plan will continue to be incurred in 2004.

9) DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

The nature of the Company's business activities necessarily involves the
management of various financial and market risks, including those related to
changes in interest rates, currency exchange rates, and commodity prices. As
discussed more completely in Notes 1, "Accounting Policies", and 18, "Financial
Instruments," within the Notes to Consolidated Financial Statements of the 2003
Annual Report on Form 10-K, the Company uses derivative financial instruments to
mitigate or eliminate certain of those risks.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

At June 30, 2004 and December 31, 2003, the values of the Company's
interest rate swaps were $64.7 and $81.6, including $3.6 and $4.0 of accrued
interest, respectively.

A reconciliation of current period changes contained in the accumulated
other comprehensive loss component of shareholders' equity is not required as no
material activity occurred during the first six months of 2004 and 2003.
Additional disclosures required by SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," as amended, are presented below.

HEDGES OF FUTURE CASH FLOWS

At June 30, 2004 the Company had eight foreign currency cash flow hedges
outstanding that had declines in value of $0.1 during 2004. At December 31, 2003
the Company had no foreign currency cash flow hedges outstanding. There were no
changes in the forecasted transactions during 2004 regarding their probability
of occurring that would require amounts to be reclassified to earnings.

The notional amount of the foreign currency forward contracts utilized to
hedge cash flow exposures was $14.6 at June 30, 2004. The applicable fair value
of these contracts at June 30, 2004 was $(0.1). There were no ineffective
portions of changes in fair values of cash flow hedge positions reported in
earnings for the six months ended June 30, 2004 and 2003, and no amounts were
excluded from the measure of effectiveness reported in earnings during these
periods.

HEDGES OF RECOGNIZED ASSETS, LIABILITIES AND FIRM COMMITMENTS

At June 30, 2004 and December 31, 2003, the Company had foreign currency
forward contracts with notional amounts of $81.2 and $81.1, respectively, to
hedge the value of recognized assets, liabilities and firm commitments. The fair
value of the 2004 and 2003 contracts were $0.2 at both June 30, 2004 and
December 31, 2003. The ineffective portion of changes in fair values of such
hedge positions reported in operating income during the first six months of 2004
and 2003 amounted to $(0.2) and $(0.1), respectively. There were no amounts
excluded from the measure of effectiveness.

The fair values associated with the foreign currency contracts have been
valued using the net position of the contracts and the applicable spot rates and
forward rates as of the reporting date.

10) GOODWILL AND OTHER INTANGIBLE ASSETS

The Company follows the provisions of Statement of Financial Accounting
Standards No. 142, "Goodwill and Other Intangible Assets," which requires that
goodwill and indefinite-lived intangible assets be tested for impairment on an
annual basis, or more frequently if circumstances warrant. Annual goodwill
impairment tests were completed in the first quarters of 2004 and 2003 (as of
the beginning of the year) and it was determined that no impairment exists.

Changes in the carrying amount of goodwill for the six months ended June
30, 2004, by business segment, are as follows:

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

Information regarding the Company's other intangible assets follows:

Amortization expense related to intangible assets for the six month periods
ended June 30, 2004 and 2003 was $2.4 and $0.9, respectively. Estimated
amortization expense for each of the five succeeding years is $5.4 per year.

11) DISCONTINUED OPERATIONS

In September of 1998, the Company completed the sales of its automotive
Electrical Systems business to Valeo SA for approximately $1,700 and its Brake
and Chassis unit to Continental AG of Germany for approximately $1,930. These
dispositions were treated as discontinued operations. In 1998, the Company
received notifications of claims from the buyers of the automotive business
requesting post-closing adjustments to the purchase prices under the provisions
of the sales agreements. In 1999, those claims were submitted to arbitration. In
2001 and early in 2002, both claims were favorably resolved.

At June 30, 2004, the Company had automotive discontinued operations
accruals of $186.0 that are primarily related to taxes ($154.1), product recalls
($7.8), environmental obligations ($14.2) and employee benefits ($9.9). In 2004,
the Company made immaterial payments of its automotive discontinued operations
liabilities. The Company expects that it will cash settle $154.1 of tax
obligations in 2004 or 2005.

12) PENSION AND POSTRETIREMENT MEDICAL BENEFIT EXPENSES

The components of net periodic pension cost consisted of the following:

Net periodic pension cost increased in the first six months of 2004 as a
result of the lower discount rate adopted at year-end 2003, higher average
foreign exchange rates, lower expected returns on assets as a result

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

of the operation of the asset smoothing method reflecting adverse financial
experience in 2002 and 2001 and a higher amortization of actuarial losses.

The Company contributed approximately $4.7 to its various plans during the
second quarter of 2004 and $106.3 for the first six months of 2004. Additional
contributions totaling between $15.0 and $20.0 are expected over the balance of
2004.

The components of net periodic postretirement cost consisted of the
following:

Net periodic postretirement cost decreased in the first six months of 2004
as a result of the higher than expected return on invested assets and lower than
expected benefit payments during 2003.

13) COMMITMENTS AND CONTINGENCIES

The Company and its subsidiaries from time to time are involved in legal
proceedings that are incidental to the operation of their businesses. Some of
these proceedings allege damages against the Company relating to environmental
liabilities, intellectual property matters, copyright infringement, personal
injury claims, employment and pension matters, government contract issues and
commercial or contractual disputes, sometimes related to acquisitions or
divestitures. The Company will continue to vigorously defend itself against all
claims. Although the ultimate outcome of any legal matter cannot be predicted
with certainty, based on present information including the Company's assessment
of the merits of the particular claim, as well as its current reserves and
insurance coverage, the Company does not expect that such legal proceedings will
have any material adverse impact on the cash flow, results of operations, or
financial condition of the Company on a consolidated basis in the foreseeable
future.

ENVIRONMENTAL

The Company has accrued for environmental remediation costs associated with
identified sites consistent with the policy set forth in Note 1, "Accounting
Policies" in the Notes to Consolidated Financial Statements of the 2003 Annual
Report on Form 10-K. In management's opinion, the total amount accrued and
related receivables are appropriate based on existing facts and circumstances.
It is difficult to estimate the total costs of investigation and remediation due
to various factors, including incomplete information regarding particular sites
and other potentially responsible parties, uncertainty regarding the extent of
contamination and the Company's share, if any, of liability for such conditions,
the selection of alternative remedies, and changes in clean-up standards. In the
event that future remediation expenditures are in excess of amounts accrued,
management does not anticipate that they will have a material adverse effect on
the consolidated financial position, results of operations or cash flows.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

In the ordinary course of business, and similar to other industrial
companies, the Company is subject to extensive and changing federal, state,
local, and foreign environmental laws and regulations. The Company has received
notice that it is considered a potentially responsible party ("PRP") at a
limited number of sites by the United States Environmental Protection Agency
("EPA") and/or a similar state agency under the Comprehensive Environmental
Response, Compensation and Liability Act ("CERCLA" or "Superfund") or its state
equivalent. As of June 30, 2004, the Company is responsible, or is alleged to be
responsible, for 104 environmental investigation and remediation sites in
various countries. In many of these proceedings, the Company's liability is
considered de minimis. At June 30, 2004, the Company calculated a best estimate
of $101.6, which approximates its accrual, related to the cleanup of soil and
ground water. The low range estimate for its environmental liabilities is $77.2
and the high range estimate for those liabilities is $165.1. On an annual basis
the Company spends between $8.0 and $11.0 on its environmental remediation
liabilities. These estimates, and related accruals, are reviewed periodically
and updated for progress of remediation efforts and changes in facts and legal
circumstances. Liabilities for environmental expenditures are recorded on an
undiscounted basis.

The Company is involved in an environmental proceeding in Glendale,
California relating to the San Fernando Valley aquifer. The Company is one of
numerous PRPs who are alleged by the EPA to have contributed to the
contamination of the aquifer. In January 1999, the EPA filed a complaint in the
United States District Court for the Central District of California against the
Company and Lockheed Martin Corporation, United States v. ITT Industries, Inc.
and Lockheed Martin Corp. CV99-00552 SVW AIJX, to recover costs it incurred in
connection with the foregoing. In May 1999, the EPA and the PRPs, including the
Company and Lockheed Martin, reached a settlement, embodied in a consent decree,
requiring the PRPs to perform additional remedial activities. Pursuant to the
settlement, the PRPs, including the Company, have constructed and are operating
a water treatment system. The operation of the water treatment system is
expected to continue until 2013. ITT and the other PRPs continue to pay their
respective allocated costs of the operation of the water treatment system and
the Company does not anticipate a default by any of the PRPs which would
increase its allocated share of the liability. As of June 30, 2004, the
Company's accrual for this liability was $10.4 representing its best estimate;
its low estimate for the liability is $7.0 and its high estimate is $15.9.

ITT Corporation operated a facility in Madison County, Florida from 1968
until 1991. In 1995, elevated levels of contaminants were detected at the site.
Since then, ITT has completed the investigation of the site in coordination with
state and federal environmental authorities and is in the process of evaluating
various remedies. A remedy for the site has not yet been selected. Currently,
the estimated range for the remediation is between $5.8 and $19.7. The Company
has accrued $8.3 for this matter, which approximates its best estimate.

The Company is involved with a number of PRPs regarding property in the
City of Bronson, Michigan operated by a former subsidiary of ITT Corporation,
Higbie Manufacturing, prior to the time ITT acquired Higbie. The Company and
other PRPs are investigating and remediating discharges of industrial waste
which occurred in the 1930's. The Company's current estimates for its exposure
are between $6.2 and $13.9. It has an accrual for this matter of $9.5 which
represents its best estimate of its current liabilities. The Company does not
anticipate a default on the part of the other PRPs.

In a suit filed in 1991 by the Company, in the California Superior Court,
Los Angeles County, ITT Corporation, et al. v. Pacific Indemnity Corporation et
al., against its insurers, the Company is seeking recovery of costs it incurred
in connection with its environmental liabilities including the three listed
above. Discovery, procedural matters, changes in California law, and various
appeals have prolonged this case. Currently, the matter is before the California
Court of Appeals from a decision by the California Superior Court dismissing
certain claims of the Company. The dismissed claims were claims where the costs
incurred

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

were solely due to administrative (versus judicial) actions. A hearing is
expected in 2004. In the event the appeal is successful, the Company will pursue
the administrative claims against its excess insurers. During the course of the
litigation the Company has negotiated settlements with certain defendant
insurance companies and is prepared to pursue its legal remedies where
reasonable negotiations are not productive. A portion of the recoveries from the
insurance settlements have been placed in a trust and are used to reimburse the
Company for its environmental costs.

PRODUCT LIABILITY

The Company and its subsidiary Goulds Pumps, Inc. ("Goulds") have been
joined as defendants with numerous other industrial companies in product
liability lawsuits alleging injury due to asbestos. These actions against the
Company have been managed by our historic product liability insurance carriers.
These claims stem primarily from products sold prior to 1985 that contained a
part manufactured by a third party, e.g., a gasket, which allegedly contained
asbestos. The asbestos was encapsulated in the gasket (or other) material and
was non-friable. In certain other cases, it is alleged that former ITT companies
were distributors for other manufacturers' products that may have contained
asbestos.

Frequently, the plaintiffs are unable to demonstrate any injury or do not
identify any ITT or Goulds product as a source of asbestos exposure. During
2003, ITT and Goulds resolved approximately 2,000 claims through settlement or
dismissal. The average amount of settlement per plaintiff has been nominal and
substantially all defense and settlement costs have been covered by insurance.
Based upon past claims experience, available insurance coverage, and after
consultation with counsel, management believes that these matters will not have
a material adverse effect on the Company's consolidated financial position,
results of operations, or cash flows.

The Company is involved in two actions, Cannon Electric, Inc. et al. v. Ace
Property & Casualty Company et al. Superior Court, County of Los Angeles, CA.,
Case No. BC 290354, and Pacific Employers Insurance Company et al., v. ITT
Industries, Inc., et al., Supreme Court, County of New York, N.Y., Case No.
03600463. The parties in both cases are seeking an appropriate allocation of
responsibility for the Company's historic asbestos liability exposure among its
insurers. The California action is filed in the same venue where the Company's
environmental insurance recovery litigation has been pending since 1991. Both
actions have been stayed to allow the parties to negotiate an acceptable
allocation arrangement. In April 2004, the Company and Ace Property & Casualty
Company entered into an agreement resolving both cases as they relate to Ace
Property & Casualty Company. The Company will pursue similar agreements with
several of its other insurers. In addition, Utica National, Goulds' historic
insurer, filed an action in Oneida County, New York, Utica Mutual Insurance Co.
Goulds Pumps, Inc., Case No. 00272103, to allocate the Goulds asbestos
liabilities between insurance policies issued by Utica and those issued by
others. The parties are currently considering a settlement agreement similar to
the Ace agreement. The Company is continuing to receive the benefit of insurance
payments during the pendency of these proceedings. The Company believes that
these actions will not materially affect the availability of its insurance
coverage and will not have a material adverse effect on the Company's
consolidated financial position, results of operations or cash flows.

The Company is one of several defendants in a suit filed in El Paso, Texas,
Bund zur Unterstutzung Radargeschadigter et al. v. ITT Industries et al., Sup.
Ct., El Paso, Texas, C.A. No. 2002-4730. This Complaint, filed by both U.S. and
German citizens, alleges that ITT and four other major companies failed to warn
the plaintiffs of the dangers associated with exposure to x-ray radiation from
radar devices. The Complaint also seeks the certification of a class of
similarly injured persons. The Company's aviation insurers are contributing to
the defense of this matter. Management believes that this matter will not have a
material adverse effect on the Company's consolidated financial position,
results of operations or cash flows.

18

ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

The Company is involved in a product liability suit filed in Superior Court
of New York, Danis v. Rule Industries et al., Sup. Ct. N.Y., C.A. No. 115975-02,
seeking damages for injuries sustained in a boat explosion. The suit contains a
number of causes of action against various defendants including the boat
manufacturer, the marina operator, and individuals working at the marina. As to
the Company, the Complaint alleges that a fume detector, manufactured by ITT's
subsidiary Rule Industries, Inc. prior to the date the Company acquired Rule,
malfunctioned. The Company's insurer is on notice of this matter. Management
believes that this matter will not have a material adverse effect on the
Company's consolidated financial position, results of operations or cash flows.

The Company has received demands from U.S. Silica for partial indemnity
regarding personal injury actions alleging injury due to silica. In 1985, the
Company sold the stock of its subsidiary Pennsylvania Glass Sand to U.S. Silica.
As part of that transaction, the Company provided an indemnity to U.S. Silica
for silica personal injury suits. That indemnity expires in September 2005.
Costs incurred in these matters related to the defense, settlements or judicial
awards are allocated between U.S. Silica and the Company. The Company's
allocated portion is paid in part by its historic product liability carriers and
then shared pursuant to the Distribution Agreement. See "Company History and
Certain Relationships" within Part 1, Item 1 of the 2003 Annual Report on Form
10-K for a description of the Distribution Agreement. Management believes that
these matters will not have a material adverse effect on the Company's
consolidated financial position, results of operations or cash flows.

OTHER

The Company has received a Notice of Claim from Rayonier, Inc., a former
subsidiary of the Company's predecessor ITT Corporation. This claim stems from
the 1994 Distribution Agreement for the spinoff of Rayonier by ITT Corporation
and seeks an allocation of proceeds from certain settlements in connection with
the Company's environmental insurance recovery litigation. The parties are
seeking a resolution of this matter through arbitration. The Company believes
the claim is grossly overstated and will not have a material adverse effect on
the Company's consolidated financial position, results of operations or cash
flows.

14) GUARANTEES, INDEMNITIES AND WARRANTIES

GUARANTEES & INDEMNITIES

In September of 1998, the Company completed the sale of its automotive
electrical systems business to Valeo SA for approximately $1,700. As part of the
sale, the Company provided Valeo SA with representations and warranties with
respect to the operations of the Business, including: Conveyance of Title,
Employee Benefits, Tax, Product Liability, Product Recall, Contracts,
Environmental, Intellectual Property, etc. The Company also indemnified Valeo SA
for losses related to a misrepresentation or breach of the representations and
warranties. With a few limited exceptions, the indemnity periods within which
Valeo SA may assert new claims have expired. Under the terms of the sales
contract, the original maximum potential liability to Valeo SA on an
undiscounted basis is $680. However, because of the lapse of time, or the fact
that the parties have resolved certain issues, at June 30, 2004 the Company has
an accrual of $7.8 which is its best estimate of the potential exposure.

In September of 1998, the Company completed the sale of its brake and
chassis unit to Continental AG for approximately $1,930. As part of the sale,
the Company provided Continental AG with representations and warranties with
respect to the operations of that Business, including: Conveyance of Title,
Employee Benefits, Tax, Product Liability, Product Recall, Contracts,
Environmental, Intellectual Property, etc. The Company also indemnified
Continental AG for losses related to a misrepresentation or breach of the
representations and warranties. With a few limited exceptions, the indemnity
periods within which Continental AG may assert new claims have expired. Under
the terms of the sales contract, the original maximum potential liability to
19

ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

Continental AG on an undiscounted basis is $950. However, because of the lapse
of time, or the fact that the parties have resolved certain issues, at June 30,
2004 the Company has an accrual of $14.2 which is its best estimate of the
potential exposure.

Since its incorporation in 1920, the Company has acquired and disposed of
numerous entities. The related acquisition and disposition agreements contain
various representation and warranty clauses and may provide indemnities for a
misrepresentation or breach of the representations and warranties by either
party. The indemnities address a variety of subjects; the term and monetary
amounts of each such indemnity are defined in the specific agreements and may be
affected by various conditions and external factors. Many of the indemnities
have expired either by operation of law or as a result of the terms of the
agreement. The Company does not have a liability recorded for the historic
indemnifications and is not aware of any claims or other information that would
give rise to material payments under such indemnities. The Company has
separately discussed material indemnities provided within the last eight years.

The Company provided three guarantees with respect to its real estate
development activities in Flagler County, Florida. Two of these guarantee bonds
were issued by the Dunes Community Development District (the District). The bond
issuances were used primarily for the construction of infrastructure, such as
water and sewage utilities and a bridge. The Company would be required to
perform under these guarantees if the District failed to provide interest
payments or principal payments due to the bond holders. The maximum amount of
the undiscounted future payments on these guarantees equal $28.9. At June 30,
2004, the Company does not believe that a loss contingency is probable for these
guarantees and therefore does not have an accrual recorded in its financial
statements. The third guaranty is a performance bond in the amount of $10.0 in
favor of Flagler County, Florida. The Company would be required to perform under
this guarantee if certain parties did not satisfy all aspects of the development
order, the most significant aspect being the expansion of a bridge. The maximum
amount of the undiscounted future payments on the third guarantee equals $10.0.
At June 30, 2004, the Company has an accrual related to the expansion of a
bridge in the amount of $10.0.

In December of 2002, the Company entered into a sales-type lease agreement
for its corporate aircraft and then leased the aircraft back under an operating
lease agreement. The Company has provided, under the agreement, a residual value
guarantee to the counterparty in the amount of $44.8, which is the maximum
amount of undiscounted future payments. The Company would have to make payments
under the residual value guarantee only if the fair value of the aircraft was
less than the residual value guarantee upon termination of the agreement. At
June 30, 2004, the Company does not believe that a loss contingency is probable
and therefore does not have an accrual recorded in its financial statements.

PRODUCT WARRANTIES

Accruals for estimated expenses related to warranties are made at the time
products are sold or services are rendered. These accruals are established using
historical information on the nature, frequency, and average cost of warranty
claims. The Company warrants numerous products, the terms of which vary widely.
In general, the Company warrants its products against defect and specific
nonperformance. In the automotive businesses, liability for product defects
could extend beyond the selling price of the product and could be significant if
the defect shuts down production or results in a recall. At June 30, 2004, the
Company has a product warranty accrual in the amount of $34.5.

20

ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

PRODUCT WARRANTY LIABILITIES

15) ACQUISITIONS

During the first six months of 2004, the Company spent $257.3 primarily for
the acquisitions of the following:

- WEDECO AG Water Technology ("WEDECO"), the world's largest manufacturer
of UV disinfection and ozone oxidation systems, which are alternatives to
chlorine treatment.

- Shanghai Hengtong Purified Water Development Co. Ltd. and Shanghai
Hengtong Water Treatment Engineering Co. Ltd. ("Hengtong"), a
Shanghai-based producer of reverse-osmosis, membrane and other water
treatment systems for the power, pharmaceutical, chemical and
manufacturing markets in China.

The excess of the purchase price over the fair value of net assets acquired
of $179.7 was recorded as goodwill.

During the first six months of 2003, the Company spent $42.5 primarily for
the acquisition of the following:

- The VEAM/TEC division of the Northrop Grumman Corporation ("VEAM"). VEAM
is a designer and manufacturer of cylinder, filter and fiber optic
connectors for the military/aerospace, industrial, transit, entertainment
and nuclear markets.

- Uniservice Wellpoint Srl., a manufacturer of high quality diesel and
electric powered, vacuum primed centrifugal pumps, along with spear or
well point dewatering systems for the rental market and sale.

The excess of the purchase price over the fair value of net assets acquired
of $27.6 was recorded as goodwill.

21

ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

16) BUSINESS SEGMENT INFORMATION

Financial information of the Company's business segments for the three
months and the six months ended June 30, 2004 and 2003 were as follows:

22

ITT INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS -- (CONTINUED)
(IN MILLIONS, EXCEPT PER SHARE, UNLESS OTHERWISE STATED)

17) QUARTERLY FINANCIAL PERIODS

The Company's quarterly financial periods end on the Saturday before the
last day of the quarter, except for the last quarterly period of the fiscal
year, which ends on December 31st. For simplicity of presentation, the quarterly
financial statements included herein are presented as ending on the last day of
the quarter. The presentation is consistent for all periods.

23

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS

EXECUTIVE SUMMARY

THREE MONTHS

The Company produced strong operating performance in the second quarter of
2004. Revenues grew 14.9% from the comparable prior year quarter. Acquisitions
and foreign currency contributed 4.8% of the growth and the remaining 10.1% of
the increase was attributable to higher volume in all segments. We believe these
results reflect the strength of the Company's portfolio of businesses and the
introduction of new products.

Operating income in the second quarter of 2004 was 9.5% higher than the
second quarter of 2003. The increase was led by the Defense Electronics &
Services segment, which was up 19.5%, and reflects higher volume at all of the
operating segments.

Diluted earnings per share were $1.18 for the second quarter and include
the impact of favorable tax rulings of $0.12, restructuring of $(0.10) and a
$(0.01) loss from discontinued operations. Diluted earnings per share for the
comparable prior year quarter were $1.06 and include the impact of restructuring
of $(0.04) and discontinued operations of $0.08.

SIX MONTHS

The Company's revenues grew 15.9% from the comparable prior year.
Acquisitions and foreign currency contributed 5.7% of the growth and the
remaining 10.2% of the increase was attributable to higher volume in all
segments. These results reflect the strength of the Company's portfolio of
businesses and the introduction of new products. Based on these results and
current/projected market conditions, the Company projects full year 2004 revenue
between $6,450 million and $6,600 million.

Operating income in the first half of 2004 was 13.0% higher than the first
half of 2003. The increase reflects higher volume, partially offset by
acquisition integration and start up costs primarily attributable to the
acquisition of WEDECO AG Water Technology. Management projects full year 2004
segment operating margin to be between 11.1% and 11.5%.

Diluted earnings per share were $2.13 for the first six months and include
the impact of favorable tax settlements/rulings of $0.18 and restructuring of
$(0.14). Diluted earnings per share for the comparable prior year period were
$1.98 and include the impact of favorable tax settlements and related interest
of $0.17, restructuring of $(0.12) and the impact of discontinued operations of
$0.08. Full year 2004 diluted earnings per share are projected to be between
$4.40 and $4.50.

THREE MONTHS ENDED JUNE 30, 2004 COMPARED WITH THREE MONTHS ENDED JUNE 30,
2003

Sales and revenues for the second quarter of 2004 were $1,652.5 million, an
increase of $214.3 million, or 14.9%, from the same period in 2003. Costs of
sales and revenues of $1,079.0 million for the second quarter of 2004 increased
$129.4 million, or 13.6%, from the comparable 2003 period. The increases in
sales and revenues and costs of sales and revenues are primarily attributable to
higher volume in all segments, contributions from acquisitions made by the Fluid
Technology segment and the impact of foreign currency translation.

Selling, general and administrative ("SG&A") expenses for the second
quarter of 2004 were $237.6 million, an increase of $39.0 million, or 19.6%,
from the second quarter of 2003. The increase in SG&A expenses was primarily due
to increased marketing expense in all segments, including expenses from two
first quarter acquisitions, higher general and administrative expenses and other
operating expenses. Higher general and administrative costs reflect additional
employee benefit costs, the cost of process improvement initiatives, and
increased other administrative expenses.
24

Research, development and engineering ("RD&E") expenses for the second
quarter of 2004 increased $24.1 million, or 16.9%, compared to the second
quarter of 2003. The increase is attributable to increased spending in all
segments.

During the second quarter of 2004, the Company recorded a $14.6 million
restructuring charge to streamline its operating structure. The charge primarily
reflected the planned reduction of 430 persons, the closure of two facilities
and lease cancellation costs. Additionally, $0.3 million of restructuring
accruals related to 2003 and 2002 restructuring actions were reversed into
income, as management determined that certain cash expenditures would not be
incurred. During the second quarter of 2003, the Company recorded a $5.9 million
restructuring charge to reduce operating costs. The charge primarily reflected
the planned reduction of 148 persons. Refer to the section entitled "Status of
Restructuring and Asset Impairments" and Note 8, "Restructuring and Asset
Impairment Charges," in the Notes to Consolidated Condensed Financial Statements
for additional information.

Operating income for the second quarter of 2004 was $154.9 million, an
increase of $13.4 million, or 9.5%, over the second quarter of 2003. The
increase is primarily due to improved sales and revenues at each of the segments
offset by increased SG&A and RD&E expenses. Segment operating margin for the
second quarter of 2004 was 10.7%, which was 0.4% below the segment operating
margin for the comparable 2003 period. The decrease reflects the impact of Fluid
Technology acquisitions, which produced operating margins below the segment
average and changes in sales mix between segments, partially offset by higher
operating margins in the Motion & Flow Control segment, Defense Electronics &
Services segment and the Electronic Components segment.

Interest expense was $5.4 million (net of interest income of $0.7 million).
This was flat with the comparable 2003 period.

Income tax expense was $33.7 million in the second quarter of 2004, a
decrease of $7.8 million with the comparable prior year period. The decrease is
primarily attributable to the impact of a favorable tax ruling.

Income from continuing operations was $112.7 million, or $1.19 per diluted
share compared to $92.1 million or $0.98 per diluted share for the second
quarter of 2003. The increase reflects the results discussed above.

During the second quarter of 2004, the Company recognized $0.7 million of
employee benefit costs (net of tax effect) attributable to discontinued
operations. During the second quarter of 2003, the Company recognized $7.8
million of income from discontinued operations. The income relates to the
collection of a disputed receivable related to the Company's automotive
businesses and the receipt of a tax refund also pertaining to the Company's
discontinued businesses. Upon collection, the Company reversed the related
valuation allowances, which had been previously established for both assets,
resulting in the above mentioned income.

Fluid Technology's sales and revenues and costs of sales and revenues
increased $80.3 million, or 14.1%, and $51.1 million, or 13.5%, respectively, in
the second quarter of 2004 compared to the second quarter of 2003. Higher
organic sales in the water/wastewater markets and industrial products
businesses, acquisition revenue from the water treatment business and the impact
of foreign currency translation were the primary factors for the increases.
These items were partially offset by lower sales in the engineered process
solutions business. SG&A expenses for the second quarter of 2004 increased $21.9
million, or 20.7%, compared to 2003, mainly due to increased advertising costs,
sales commissions and administrative costs in most businesses, and costs
attributable to 2004 acquisitions. During the second quarter of 2004, the
segment recorded a $3.4 million restructuring charge mainly related to a planned
reduction in headcount and the closure of two facilities (refer to the section
entitled "Status of Restructuring and Asset Impairments" and Note 8,
"Restructuring and Asset Impairment Charges," in the Notes to Consolidated
Condensed Financial Statements for additional information). Operating income for
the second quarter of 2004 increased $1.6 million, or 2.2%, compared to the
second quarter of 2003, due to the activities discussed above.

Defense Electronics & Services' sales and revenues and costs of sales and
revenues for the second quarter of 2004 increased $78.3 million, or 17.3%, and
$43.1 million, or 15.8%, respectively, from the comparable prior
25

year period. The increases are primarily due to higher volume in the night
vision, advanced engineering systems and radar businesses. SG&A expenses
increased $6.7 million, or 31.5%, primarily due to increased employee benefit
and administrative costs and other operating expenses. RD&E expenses increased
$19.4 million, or 17.3%, due to increased spending in all businesses. Operating
income for the second quarter of 2004 was $55.8 million, an increase of $9.1
million, or 19.5%, compared to the same quarter in 2003. The increase reflects
the results discussed above.

Motion & Flow Control recorded sales and revenues and costs of sales and
revenues of $281.3 million and $201.4 million, respectively, during the second
quarter of 2004, reflecting increases of $18.6 million, or 7.1%, and $11.3
million, or 5.9%, from the second quarter of 2003. The increases were mainly due
to higher volume in the friction materials and leisure marine businesses and the
impact of foreign currency translation, partially offset by scheduled platform
rolloffs in the fluid handling business. SG&A expenses increased $2.4 million,
or 10.4%, reflecting higher marketing costs and administrative expenses in most
businesses. During the second quarters of 2004 and 2003, the segment recorded
$2.4 million and $3.0 million of restructuring charges, respectively, mainly
related to planned reductions in headcount (refer to the section entitled
"Status of Restructuring and Asset Impairments" and Note 8, "Restructuring and
Asset Impairment Charges," in the Notes to Consolidated Condensed Financial
Statements for additional information). Operating income of $41.3 million was
$4.2 million, or 11.3%, higher in the second quarter of 2004, compared to the
second quarter of 2003, primarily due to the items mentioned above.

Electronic Components' sales and revenues of $191.4 million and costs of
sales and revenues of $135.2 million in the second quarter of 2004, increased
$37.7 million, or 24.5%, and $24.8 million, or 22.5%, respectively, from the
comparable prior year period. The increases reflect higher volume in all
businesses and the impact of foreign currency translation. SG&A expenses
increased $6.2 million due to increased marketing, employee benefit and
administrative expenses. During the second quarter of 2004, the segment recorded
a $7.2 million restructuring charge primarily relating to planned headcount
reductions and lease cancellation costs (refer to the section entitled "Status
of Restructuring and Asset Impairments" and Note 8, "Restructuring and Asset
Impairment Charges," in the Notes to Consolidated Condensed Financial Statements
for additional information). Operating income for the second quarter of 2004
increased $1.4 million from the second quarter of 2003. The increase was due to
the factors discussed above.

Corporate expenses increased $2.9 million in the second quarter of 2004,
primarily due to higher restructuring costs, ($1.6 million in 2004 versus $0.2
million in 2003), (refer to the section entitled "Status of Restructuring and
Asset Impairments" and Note 8, "Restructuring and Asset Impairment Charges," in
the Notes to Consolidated Condensed Financial Statements for additional
information) and increased other operating expenses.

SIX MONTHS ENDED JUNE 30, 2004 COMPARED WITH SIX MONTHS ENDED JUNE 30, 2003

Sales and revenues for the first six months of 2004 were $3,168.4 million,
an increase of $433.8 million, or 15.9%, from the same period in 2003. Costs of
sales and revenues of $2,086.1 million for the first six months of 2004
increased $290.1 million, or 16.2%, from the comparable 2003 period. The
increases in sales and revenues and costs of sales and revenues are primarily
attributable to higher volume in all segments, contributions from acquisitions
made by the Fluid Technology segment and the impact of foreign currency
translation.

Selling, general and administrative ("SG&A") expenses for the first six
months of 2004 were $467.8 million, an increase of $68.9 million, or 17.3%, from
the first six months of 2003. The increase in SG&A expenses was primarily due to
increased marketing expense in all segments, including expenses from two first
quarter acquisitions, higher general and administrative expenses and other
operating expenses. Higher general and administrative costs reflect additional
employee benefit costs, the cost of process improvement initiatives,
administrative expenses related to the two first quarter acquisitions and
increased other administrative expenses.

26

Research, development and engineering ("RD&E") expenses for the first six
months of 2004 increased $39.4 million, or 14.5%, compared to the first six
months of 2003. The increase is attributable to increased spending in all
segments.

During the first six months of 2004, the Company recorded a $19.9 million
restructuring charge to streamline its operating structure. The charge primarily
reflected the planned reduction of 533 persons, the closure of two facilities
and lease cancellation costs. Additionally, $0.9 million of restructuring
accruals related to 2003, 2002 and 2001 restructuring actions were reversed into
income, as management determined that certain cash expenditures would not be
incurred. During the first six months of 2003, the Company recorded a $14.9
million restructuring charge to reduce operating costs. The charge primarily
reflected the planned reduction of 613 persons. Additionally, in 2003, the
Company recorded an asset impairment charge of $1.4 million primarily to
write-off a technology license that will not be utilized in the foreseeable
future due to projected market conditions. Refer to the section entitled "Status
of Restructuring and Asset Impairments" and Note 8, "Restructuring and Asset
Impairment Charges," in the Notes to Consolidated Condensed Financial Statements
for additional information.

Operating income for the first six months of 2004 was $283.9. million, an
increase of $32.7 million, or 13.0%, over the first six months of 2003. The
increase is primarily due to improved sales and revenues at each of the segments
offset by increased SG&A and RD&E expenses. Segment operating margin for the
first six months of 2004 was 10.2%, which was 0.4% below the segment operating
margin for the comparable 2003 period. The decrease reflects the impact of Fluid
Technology acquisitions, which produced operating margins below the segment
average and changes in sales mix between segments, partially offset by higher
operating margins in the Defense Electronics & Services segment and the
Electronic Components segment.

Interest expense was $6.5 million (net of interest income of $6.0 million,
of which $4.3 million relates to a first quarter 2004 tax settlement) for the
first six months of 2004. The Company recognized $9.3 million of interest income
during the first six months of 2003. The variance between years is primarily due
to interest income of $22.1 million, related to a 2003 first quarter tax refund,
partially offset by lower average debt balances in 2004.

Income tax expense was $69.9 million in the first six months of 2004, a
decrease of $9.0 million from the comparable prior year period. The decrease is
primarily attributable to the impact of a favorable tax ruling.

Income from continuing operations was $200.8 million, or $2.13 per diluted
share in the first six months of 2004, compared to $178.8 million or $1.90 per
diluted share for the first six months of 2003. The increase reflects the
results discussed above.

During the first half of 2003, the Company recognized $7.8 million of
income from discontinued operations. The income related to the collection of a
disputed receivable related to the Company's automotive businesses and the
receipt of a tax refund also pertaining to the Company's discontinued
businesses. Upon collection, the Company reversed the related valuation
allowances, which had been previously established for both assets, resulting in
the above mentioned income.

Fluid Technology's sales and revenues and costs of sales and revenues
increased $151.6 million, or 14.1%, and $98.1 million, or 13.8%, respectively,
in the first six months of 2004 compared to the first six months of 2003. Higher
organic sales in the water/wastewater markets and industrial products
businesses, acquisition revenue from the water treatment business and the impact
of foreign currency translation were the primary factors for the increases.
These items were partially offset by lower volume in the engineered process
solutions business. SG&A expenses for the first six months of 2004 increased
$44.5 million, or 21.5%, compared to 2003, mainly due to increased advertising
costs, sales commissions and administrative costs in most businesses, and costs
attributable to 2004 acquisitions. During the first six months of 2004, the
segment recorded a $6.6 million restructuring charge mainly related to a planned
reduction in headcount and the closure of two facilities (refer to the section
entitled "Status of Restructuring and Asset Impairments" and Note 8,
"Restructuring and Asset Impairment Charges," in the Notes to Consolidated
Condensed Financial Statements for additional information). Operating income for
the first six months of 2004 was down $1.8 million, or 1.4%, compared to the
first six months of 2003, due to the activities discussed above.

27

Defense Electronics & Services' sales and revenues and costs of sales and
revenues for the first six months of 2004 increased $193.4 million, or 22.9%,
and $128.7 million, or 25.7%, respectively, from the comparable prior year
period. The increases are primarily due to higher volume in all businesses.
Additionally, a change in product mix also contributed to the increase in costs
of sales and revenues. SG&A expenses increased $12.0 million, or 24.6%, from the
comparable prior year period, primarily due to increased employee benefit and
administrative costs and other operating expenses. RD&E expenses increased $29.3
million, or 13.7%, from the comparable prior year period, due to increased
spending in all businesses. Operating income for the first six months of 2004
was $104.5 million, an increase of $23.4 million, or 28.9%, compared to the same
period in 2003. The increase reflects the results discussed above.

Motion & Flow Control recorded sales and revenues and costs of sales and
revenues of $555.3 million and $400.0 million, respectively, during the first
six months of 2004, reflecting increases of $34.5 million, or 6.6%, and $22.1
million, or 5.8%, from the first six months of 2003. The increases were mainly
due to higher volume in the friction and leisure marine businesses and the
impact of foreign currency translation, partially offset by scheduled platform
rolloffs in the fluid handling business. SG&A expenses increased $4.9 million,
or 10.6%, from the comparable prior year period, reflecting higher marketing
costs and administrative expenses in most businesses and other operating
expenses. During the first six months of 2004 and 2003, the segment recorded
$2.6 million and $3.4 million of restructuring charges, respectively, mainly
related to planned reductions in headcount (refer to the section entitled
"Status of Restructuring and Asset Impairments" and Note 8, "Restructuring and
Asset Impairment Charges," in the Notes to Consolidated Condensed Financial
Statements for additional information). Operating income of $80.4 million was
$5.3 million, or 7.1%, higher in the first six months of 2004, compared to the
first six months of 2003, primarily due to the items mentioned above.

Electronic Components' sales and revenues of $353.2 million and costs of
sales and revenues of $247.7 million in the first six months of 2004, increased
$54.7 million, or 18.3%, and $39.3 million, or 18.9%, respectively, from the
comparable prior year period. The increases reflect higher volume in most
businesses and the impact of foreign currency translation. SG&A expenses
increased $9.0 million, or 15.0%, from the comparable prior year period, due to
increased marketing, employee benefit and administrative expenses. During the
first six months of 2004, the segment recorded a $8.9 million restructuring
charge primarily relating to planned headcount reductions and lease cancellation
costs. During the first six months of 2003, the segment recorded a $10.2 million
restructuring charge primarily relating to planned headcount reductions and a
$1.4 million asset impairment charge mainly to write-off a license agreement for
technology, which will not be utilized in the foreseeable future due to
projected market conditions (refer to the section entitled "Status of
Restructuring and Asset Impairments" and Note 8, "Restructuring and Asset
Impairment Charges," in the Notes to Consolidated Condensed Financial Statements
for additional information). Operating income for the first six months of 2004
increased $7.1 million from the first six months of 2003. The increase was due
to the factors discussed above.

Corporate expenses increased $1.3 million in the first six months of 2004,
primarily due to higher restructuring costs, ($1.8 million in 2004 versus $1.3
million in 2003), (refer to the section entitled "Status of Restructuring and
Asset Impairments" and Note 8, "Restructuring and Asset Impairment Charges," in
the Notes to Consolidated Condensed Financial Statements for additional
information) and higher other operating expenses.

STATUS OF RESTRUCTURING AND ASSET IMPAIRMENTS

2004 RESTRUCTURING ACTIVITIES

During the second quarter of 2004, the Company recognized a $13.9 million
charge, primarily for the planned severance of 430 employees and the recognition
of lease cancellation costs. The actions by segment are as follows:

- The Electronic Components segment recorded $4.5 million of the charge for
the recognition of lease cancellation costs. Severance of $1.2 million
was recorded for the reduction of 340 employees. The terminations include
273 factory workers, 64 office workers and three management employees.
The segment also recorded a $1.1 million charge for the disposal of
machinery and equipment.
28

- The Fluid Technology segment recorded $2.4 million for the termination of
45 employees, including eight factory workers and 37 office workers.
Lease commitments totaling $0.7 million were recognized related to the
closure of two facilities (one in Sweden and one in Florida). Asset
write-offs and other costs totaling $0.2 million and $0.1 million,
respectively, were also recognized during the quarter.

- The Motion & Flow Control segment recognized $2.1 million for the
termination of 44 employees, including seven factory workers, 32 office
workers and five management employees.

- Corporate headquarters recorded $1.6 million for the severance of one
management employee.

As of June 30, 2004, the Company had made $0.6 million of payments
attributable to the 2004 second quarter restructuring actions. Future
restructuring expenditures will be funded with cash from operations,
supplemented, as required, with commercial paper borrowings.

The projected future