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 SEPTEMBER 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 October 31, 2004, there were outstanding 92,319,013 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 $284.3 and $768.7 of
total service revenues for the three and nine months ended September 30, 2004,
respectively, and $199.0 and $530.7 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 $207.3 and $587.1 of
total service revenues for the three and nine months ended September 30, 2003,
respectively, and $136.6 and $386.9 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 nine months ended
September 30, 2004 and 2003:

The amounts of outstanding antidilutive common stock options excluded from
the computation of diluted earnings per share for the three months and nine
months ended September 30, 2004 were 0.1 and 0.0, respectively. The amount of
antidilutive restricted common stock excluded from the computation of diluted
earnings per share for the three months and nine months ended September 30, 2004
was 0.1.

The amounts of outstanding antidilutive common stock options excluded from
the computation of diluted earnings per share for the three months and nine
months ended September 30, 2003 were 0.0 and 1.7, respectively.

7) STOCK-BASED EMPLOYEE COMPENSATION

At September 30, 2004, the Company has one stock-based employee
compensation plan for issuing new stock options and restricted shares. The
Company also has one stock-based employee compensation plan and two stock-based
non-employee directors compensation plans that have stock options and restricted
shares outstanding; however no new awards will be granted under these plans.
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
Compensa-

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

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

tion," the Company's net income and earnings per share would have been reduced
to the following pro forma amounts:

The pro forma diluted earnings per share calculations for the three months
and nine months ended September 30, 2004 were computed using diluted average
common shares of 94.0 and 94.1, respectively. The pro forma diluted earnings per
share calculations for the three months and nine months ended September 30, 2003
were computed using diluted average common shares of 94.3 and 94.0,
respectively.

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 nine months ended September 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 nine month periods ended September 30,
2004 and 2003 was:

8) RESTRUCTURING AND ASSET IMPAIRMENT CHARGES

2004 RESTRUCTURING ACTIVITIES

During the third quarter of 2004, the Company recognized a $5.7 charge,
primarily for the planned severance of 76 employees, idle facility costs and
movement of production. The actions by segment are as follows:

- The Fluid Technology segment recorded $3.3 for the planned termination of
36 employees, including nine factory workers, 23 office workers and four
management employees. Other costs totaling $0.2 were also recognized
during the 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)

- The Motion & Flow Control segment recognized $0.5 for the planned
termination of 30 employees, including 23 factory workers and seven
office workers. The segment also recorded $0.6 for relocation and moving
costs.

- The Electronic Components segment recorded $0.4 for the planned
termination of ten employees. The terminations include eight office
workers and two management employees. The segment also recorded a $0.7
charge primarily for costs associated with moving two product lines from
Weinstadt, Germany to Shenzhen, China and one product line from Santa
Ana, CA to Nogales, Mexico and idle facility costs.

In addition to the restructuring actions announced during the third
quarter, the Motion & Flow Control segment recognized $0.1 of severance and
employee benefit costs related to actions announced during the first quarter of
2003 and $0.1 of previous restructuring charges were reversed.

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 planned 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 planned 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 planned
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.

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.

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

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

2003 RESTRUCTURING ACTIVITIES

During the fourth quarter of 2003 the Company announced actions to reduce
operating costs primarily through the reduction of headcount. The $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 $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.

During the second quarter of 2003 the Company continued its program to
reduce structural costs and increase profitability. 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.

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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 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 $2.7 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.

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

During the third quarter of 2004, $0.1 of restructuring accruals related to
a 2004 restructuring action was reversed into 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)

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 $24.3 and additional cash charges of $24.0 were recorded
in the first nine months of 2004. The accrual balance related to cash charges at
September 30, 2004 is $18.4, which includes $11.7 for severance and $6.7 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 nine months of 2004, the Company reduced headcount by
765 persons related to all plans and experienced employee attrition, leaving a
balance of 47 planned reductions. Actions announced during the third quarter of
2004 will be substantially completed by the end of 2004. 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
are substantially completed. 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.

At September 30, 2004 and December 31, 2003, the values of the Company's
interest rate swaps were $89.5 and $81.6, including $7.5 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 nine 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 September 30, 2004 the Company had four foreign currency cash flow
hedges outstanding that had no change in value 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 $1.0 at September 30, 2004. The applicable fair
value of these contracts at September 30, 2004 was

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

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

approximately zero. There were no ineffective portions of changes in fair values
of cash flow hedge positions reported in earnings for the nine months ended
September 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 September 30, 2004 and December 31, 2003, the Company had foreign
currency forward contracts with notional amounts of $76.1 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 approximately
zero and $0.2 at September 30, 2004 and December 31, 2003, respectively. The
ineffective portion of changes in fair values of such hedge positions reported
in operating income during the first nine months of 2004 and 2003 amounted to
$(0.3) and $(0.2), 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 nine months ended
September 30, 2004, by business segment, are as follows:

Information regarding the Company's other intangible assets follows:

During the first quarter of 2004, the Company completed the acquisition of
Wedeco AG Water Technology ("Wedeco"). The acquisition of Wedeco resulted in the
recognition of $194.8 of goodwill, $23.1

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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 intangibles for trade names and $46.0 for patents and customer relationships.
During the third quarter of 2004, the Company completed the acquisition of
Remote Sensing Systems. This acquisition preliminarily resulted in the
recognition of $616.1 of goodwill, $120.0 of intangible assets related to
customer relationships and $4.9 of other intangible assets.

Amortization expense related to intangible assets for the nine month
periods ended September 30, 2004 and 2003 was $4.8 and $2.0, respectively.
Estimated amortization expense for each of the five succeeding years is as
follows:

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 September 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 late 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 nine 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 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 $16.7 to its various plans during the
third quarter of 2004 and $123.1 for the first nine months of 2004. Additional
contributions totaling between $2.0 and $5.0 are expected over the balance of
2004.

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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 components of net periodic postretirement cost consisted of the
following:

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

In January 2004, FASB Staff Position ("FSP") No. 106-1, "Accounting and
Disclosure Requirements Related to the Medicare Prescription Drug, Improvement
and Modernization Act of 2003" ("FSP No. 106-1") was issued. Subsequently, FSP
No. 106-2 was issued, which amends FSP No. 106-1 and discusses the recognition
of the effects for the Medicare Prescription Drug, Improvement and Modernization
Act of 2003 (the Act) in the accounting for postretirement health care plans
under SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other
Than Pensions," and in providing disclosures related to the plan required by
SFAS No. 132. The Company adopted this pronouncement effective July 1, 2004, but
is unable to conclude whether benefits of its plans are actuarially equivalent
and shall measure any effects of the Act at the next measurement date for plan
assets and obligations. See Note 19, "Employee Benefit Plans," in the Notes to
Consolidated Financial Statements of the 2003 Annual Report on Form 10-K for
discussion of postretirement benefits.

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

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

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

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.

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 September 30, 2004, the Company is responsible, or is alleged
to be responsible, for approximately 100 environmental investigation and
remediation sites in various countries. In many of these proceedings, the
Company's liability is considered de minimis. At September 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 September 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
18

ITT INDUSTRIES, INC. AND SUBSIDIARIES

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

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 were solely due to
administrative (versus judicial) actions. A hearing is expected in 2005. 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 a matter, Cannon Electric, Inc. et al. v. Ace
Property & Casualty Company et al., Superior Court, County of Los Angeles, CA.,
Case No. BC 290354. A related suit filed in New York, Pacific Employers
Insurance Company et al. v. ITT Industries, Inc. et al., Supreme Court, County
of New York, N.Y., Case No. 03600463 has been stayed in deference to the
California suit. 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. 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. v. Goulds Pumps, Inc.,
Oneida County, New York, Case No. 00272103), to allocate the Goulds asbestos
liabilities between insurance policies issued by Utica and those issued by
others. The venue for this matter has been changed to the County of Los Angeles
and consolidated with the above matter. 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, Inc. 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

19

ITT INDUSTRIES, INC. AND SUBSIDIARIES

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

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. On October 5, 2004, the Company filed an action, ITT
Industries, Inc. et al. v. Fireman's Fund Insurance Company et al., Superior
Court, County of Los Angeles, BC 322546, against various insurers who issued
historic aircraft products coverage to the Company seeking a declaration that
each is liable for the costs of defense of the El Paso 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 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. In October 2004, the
Company favorably resolved this matter.

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 I, 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 is involved in an arbitration with Rayonier, Inc., a former
subsidiary of the Company's predecessor ITT Corporation. The arbitration
involves a claim by Rayonier stemming from the 1994 Distribution Agreement for
the spinoff of Rayonier by ITT Corporation. Rayonier seeks a portion of the
proceeds from certain settlements in connection with the Company's environmental
insurance recovery litigation. 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 September 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

20

ITT INDUSTRIES, INC. AND SUBSIDIARIES

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

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 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 September 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 has been released from its
obligation to perform under both of these guarantees in the third quarter of
2004. The third guarantee 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 September 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
September 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 September 30, 2004,
the Company has a product warranty accrual in the amount of $33.7.

PRODUCT WARRANTY LIABILITIES

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ITT INDUSTRIES, INC. AND SUBSIDIARIES

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

15) ACQUISITIONS

2004 ACQUISITIONS

On August 13, 2004, the Company purchased all of the Remote Sensing Systems
("RSS") business from Eastman Kodak Company for $728.8 in cash. The RSS business
is a leading supplier of high resolution satellite imaging systems and
information services. Management believes that the acquisition of RSS will
enhance the Company's competitive position in the space payload and service
product offering industry and create a full spectrum provider with the latest
visible and infrared satellite imaging technology in the remote sensing market.

The excess of the purchase price of RSS over the fair value of net assets
acquired of $616.1 was recorded as goodwill and is reflected in the Defense
Electronics & Services segment. The Company has preliminarily assigned values to
the assets and liabilities of RSS; however, the allocation is subject to further
refinement.

The Company also spent $265.8 primarily for the following acquisitions
completed in 2004:

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

- Allen Osborne Associates, a leader in the development of global
positioning system receivers for both portable and fixed sites.

- 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 $201.0 was recorded as goodwill, of which $196.0 and $5.0 are reflected in
the Fluid Technology and Defense Electronics & Services segments, respectively.

PRO FORMA RESULTS

The following unaudited pro forma financial information presents the
combined results of operations of the Company and RSS as if RSS was acquired on
January 1, 2004 and 2003. The pro forma results presented below for the three
and nine months ended September 30, 2004 combine the results of the Company for
the three and nine months ended September 30, 2004 and the historical results of
RSS from July 1, 2004 to August 12, 2004 and from January 1, 2004 to August 12,
2004, respectively. The pro forma results presented below for the three and nine
months ended September 30, 2003 combine the results of the Company for the three
and nine months ended September 30, 2003 and the historical results of RSS for
the three and nine months ended September 30, 2003. The unaudited pro forma
financial information is not intended to represent or be indicative of the
Company's consolidated results of operations that would have been reported had
RSS been acquired as of the beginning of the periods presented and should not be
taken as indicative of the

22

ITT INDUSTRIES, INC. AND SUBSIDIARIES

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

Company's future consolidated results of operations. Pro forma adjustments are
tax effected at the Company's effective tax rate.

2003 ACQUISITIONS

During the first nine months of 2003, the Company spent $44.1 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, of which $23.0 and $4.6 were recorded in the
Electronic Components and Fluid Technology segments, respectively.

16) BUSINESS SEGMENT INFORMATION

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

23

ITT INDUSTRIES, INC. AND SUBSIDIARIES

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

24

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.

25

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 results in the third quarter of 2004.
Revenues grew 21.3% from the comparable prior year quarter. Acquisitions and
foreign currency contributed growth of 8.9% and higher volume in all segments
produced an increase of 12.4%. We believe these results reflect the strength of
the Company's portfolio of businesses and the introduction of new products.

Operating income in the third quarter of 2004 was 21.4% higher than the
third quarter of 2003. The increase was led by the Defense Electronics &
Services segment, which was up 49.3%, and reflects higher volume at all of the
operating segments.

Diluted earnings per share were $1.16 for the third quarter and include the
impact of favorable tax rulings of $0.04 and restructuring charges of $(0.04).
Diluted earnings per share for the comparable prior year quarter were $1.16 and
include the impact of restructuring of $(0.01), discontinued operations of $0.07
and tax settlements and other special items of $0.14.

NINE MONTHS

The Company's revenues grew 17.7% from the comparable prior year period.
Higher volume in all segments contributed 10.9% and the remaining increase of
6.8% was due to acquisitions and foreign currency. 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 to be between $6,600 million and $6,655
million.

Operating income in the first nine months of 2004 was 16.0% higher than the
first nine months 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 11.2%.

Diluted earnings per share were $3.29 for the first nine months and include
the impact of favorable tax settlements/rulings of $0.20 and restructuring
charges of $(0.18). Diluted earnings per share for the comparable prior year
period were $3.14 and include the impact of favorable tax settlements and
related interest of $0.31, restructuring of $(0.13) and the impact of
discontinued operations of $0.15. Full year 2004 diluted earnings per share are
projected to be between $4.45 and $4.50.

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

Sales and revenues for the third quarter of 2004 were $1,667.7 million, an
increase of $292.5 million, or 21.3%, from the same period in 2003. Costs of
sales and revenues of $1,100.9 million for the third quarter of 2004 increased
$197.2 million, or 21.8%, from the comparable 2003 period. The increases in
sales and revenues and costs of sales and revenues are primarily attributable to
higher volume in the Defense Electronics & Services, Electronic Components and
Motion & Flow Control segments, contributions from acquisitions made by the
Fluid Technology and Defense Electronics & Services' segments and the impact of
foreign currency translation.

Selling, general and administrative ("SG&A") expenses for the third quarter
of 2004 were $244.6 million, an increase of $48.7 million, or 24.9%, from the
third quarter of 2003. The increase in SG&A expenses was primarily due to the
impact of foreign currency translation, increased marketing expense in all
segments, including expenses from two first quarter acquisitions and higher
general and administrative expenses. Higher general and administrative costs
reflect additional employee benefit costs, the cost of process improvement
initiatives, and increased other administrative expenses.
26

Research, development and engineering ("RD&E") expenses for the third
quarter of 2004 increased $13.2 million, or 9.6%, compared to the third quarter
of 2003. The increase is attributable to increased spending in most segments.

During the third quarter of 2004, the Company recorded a $5.8 million
restructuring charge to streamline its operating structure. The charge primarily
reflected the planned reduction of 76 persons. During the third quarter of 2003,
the Company recorded a $2.8 million restructuring charge for actions to reduce
operating costs and streamline its structure. The 2003 charge primarily
reflected the planned reduction of 72 persons. Additionally, management reviewed
the Company's remaining restructuring actions and determined that certain 2003
and 2001 actions would be completed for $1.2 million less than planned at the
Electronic Components segment. Accordingly, restructuring accruals totaling $1.2
million were reversed into income during the third quarter of 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.

Operating income for the third quarter of 2004 was $166.1 million, an
increase of $29.3 million, or 21.4%, over the third 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
third quarter of 2004 was 11.3%, which was flat with the comparable 2003 period.

Interest expense was $8.6 million (net of interest income of $1.2 million)
for the third quarter of 2004. Interest income was $5.3 million (net of interest
expense of $6.0 million) for the third quarter of 2003. The $13.9 million
increase in expense from the comparable prior year period is primarily due to
interest income received from the sale of a cost based investment during 2003
that management previously believed would not be received. Upon collection, the
Company reversed the related valuation allowance into income. Additionally,
higher average debt balances during 2004 attributable to two acquisitions made
during 2004, as well as higher interest rates also contributed to the increase.

Income tax expense was $43.9 million in the third quarter of 2004, an
increase of $6.3 million from the comparable prior year period. The increase is
primarily attributable to higher taxable income.

Income from continuing operations was $109.5 million, or $1.16 per diluted
share compared to $102.5 million or $1.09 per diluted share for the third
quarter of 2003. The increase reflects the results discussed above.

During the third quarter of 2004, the Company recognized $0.3 million of
income from discontinued operations. During the third quarter of 2003, the
Company recognized $6.7 million of income from discontinued operations. The 2003
income primarily related to the receipt of a tax refund pertaining to the
Company's discontinued businesses.

Fluid Technology's sales and revenues and costs of sales and revenues
increased $55.1 million, or 9.8%, and $29.3 million, or 7.8%, respectively, in
the third quarter of 2004 compared to the third quarter of 2003. Higher organic
sales in the water/wastewater markets and fluid handling division, 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 third quarter of 2004 increased $20.7 million, or 20.3%,
compared to the third quarter of 2003, mainly due to the impact of foreign
currency translation, increased advertising costs, sales commissions and
administrative costs in most businesses, and costs attributable to 2004
acquisitions. During the third quarter of 2004 and the comparable prior year
quarter, the segment recorded $3.5 million and $0.9 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 for
the third quarter of 2004 increased $2.7 million, or 3.6%, compared to the third
quarter of 2003, due to the activities discussed above.

Defense Electronics & Services' sales and revenues and costs of sales and
revenues for the third quarter of 2004 increased $184.3 million, or 41.3%, and
$135.5 million, or 52.2%, respectively, from the comparable prior
27

year period. The increases are primarily due to higher volume in the night
vision, advanced engineering systems and services businesses and acquisition
revenue from the space systems division. A change in product mix also
contributed to the increase in costs of sales and revenues. SG&A expenses
increased $14.8 million, or 51.2%, primarily due to increased employee benefit
and administrative costs, higher marketing costs and costs attributable to the
third quarter 2004 acquisition. RD&E expenses increased $10.3 million, or 9.4%,
due to increased spending in most businesses and the impact of the third quarter
2004 acquisition. Operating income for the third quarter of 2004 was $71.8
million, an increase of $23.7 million, or 49.3%, 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 $242.8 million and $177.5 million, respectively, during the third
quarter of 2004, reflecting increases of $19.8 million, or 8.9%, and $13.4
million, or 8.2%, from the third quarter of 2003. The increases were mainly due
to higher volume in the friction material, aerospace and spa/whirlpool
businesses and the impact of foreign currency translation. SG&A expenses
increased $0.7 million, or 3.3%, reflecting the impact of foreign currency
translation and higher administrative expenses. RD&E costs increased $1.8
million, or 20.7%, due to increased spending in all businesses. During the third
quarters of 2004 and 2003, the segment recorded $1.2 million and $0.6 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 $32.0 million was $3.3 million, or 11.5%,
higher in the third quarter of 2004, compared to the third quarter of 2003,
primarily due to the items mentioned above.

Electronic Components' sales and revenues of $178.1 million and costs of
sales and revenues of $127.0 million in the third quarter of 2004, increased
$34.3 million, or 23.9%, and $20.2 million, or 18.9%, respectively, from the
comparable prior year period. The increases reflect higher growth in the
communication, transportation and military/aerospace businesses and the impact
of foreign currency translation. SG&A expenses increased $6.1 million, or 22.3%,
due to the impact of foreign currency translation, increased marketing, employee
benefit and administrative expenses. During the third quarter of 2004, the
segment recorded a $1.1 million restructuring charge primarily relating to
planned headcount reductions and moving costs. During the third quarter of 2003,
the segment recorded a $1.3 million charge primarily for headcount reductions
and also reversed $1.2 million of restructuring accruals deemed unnecessary for
the completion of previously announced actions (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 third quarter
of 2004 increased $5.7 million from the third quarter of 2003. The increase was
due to the factors discussed above.

Corporate expenses increased $6.1 million in the third quarter of 2004,
primarily due to increased costs for process improvements and other
administrative costs.

NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED WITH NINE MONTHS ENDED SEPTEMBER
30, 2003

Sales and revenues for the first nine months of 2004 were $4,836.1 million,
an increase of $726.3 million, or 17.7%, from the same period in 2003. Costs of
sales and revenues of $3,187.0 million for the first nine months of 2004
increased $487.3 million, or 18.1%, 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 and Defense Electronics & Services' segments and
the impact of foreign currency translation. Additionally, costs of sales and
revenues increased due to a change in product mix.

SG&A expenses for the first nine months of 2004 were $712.4 million, an
increase of $117.6 million, or 19.8%, from the first nine months of 2003. The
increase in SG&A expenses was primarily due to the impact of foreign currency
translation, increased marketing expense in all segments, including expenses
from two first quarter acquisitions, and higher general and administrative
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.

28

RD&E expenses for the first nine months of 2004 increased $52.6 million, or
12.8%, compared to the first nine months of 2003. The increase is attributable
to increased spending in all segments.

During the first nine months of 2004, the Company recorded a $25.7 million
restructuring charge to streamline its operating structure. The charge primarily
reflected the planned reduction of 609 persons, the closure of two facilities
and lease cancellation costs. Additionally, $1.0 million of restructuring
accruals related to 2004, 2003, 2002 and 2001 restructuring actions were
reversed into income, as management determined that certain cash expenditures
would not be incurred. During the first nine months of 2003, the Company
recorded a $17.7 million restructuring charge to reduce operating costs and
streamline its operating structure. The charge primarily reflected the planned
reduction of 685 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 Finan