2006 parker hannifin annual report

7/28/2019 2006 Parker Hannifin Annual Report

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The Premier Diversified Motion & Control CompanyAnnual Report 2006


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Parker is the world leader in motion

and control technologies, serving

hundreds of markets. We are adiversified

investment in our industry space,

generating strongreturns for our

shareholders year after year.

9 Billion in Sales

118 Divisions

292 Manufacturing Plants

1,200 Markets

8,400 Distributors

57,000 Employees

417,000 Customers

900,000 Products

2006 IN REVIEW 2 LETTER TO SHAREHOLDERS3

GROWTH 6 MARKETS 7 SERVICE 8 PEOPLE 9 TECHNOLOGY 10 PERFORMANCE 11

FINANCIAL REPORT 12


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AVERAGE SALES/EMPLOYEEThousands of Dollars

02 03 04 05 06

CASH FLOWS FROMOPERATING ACTIVITIESMillions of Dollars

02 03 04 05 06 05

NET INCOMEMillions of Dollars

02 03 04 05 06 05

NET SALESMillions of Dollars

02 03 04 05 06 05

FOR THE YEARS ENDED JUNE 30, 2006 2005 2004(in thousands, except per share data)

OPERATING DATANet sales $ 9,385,888 $ 8,068,805 $ 6,887,596

Gross prot 2,018,270 1,677,328 1,309,708

Net income 673,167 604,692 345,783

Net cash provided by operating activities 954,639 853,506 662,398

Net cash (used in) investing activities (921,243) (565,383) (270,472)

Net cash (used in) nancing activities (194,192) (137,538) (448,491)

PER SHARE DATA Diluted earnings per share $ 5.57 $ 5.02 $ 2.91

Dividends .92 .78 .76Book value 35.46 28.14 25.24 RATIOS Return on sales 7.2% 7.5% 5.0%

Return on average assets 9.0 9.3 5.7

Return on average equity 17.8 19.1 12.6

Debt to debt-equity 21.1 22.5 24.9

OTHER Number o shareholders 57,986 54,632 54,683

Number o employees 57,073 50,019 47,433

THE YEAR IN REVIEW

180

160

140

120

100

80

60

40

20

0

1,000

900

800

700

600

500

400

300

200

100

0

630

560

490

420

350

280

210

140

70

0

9,000

8,000

7,000

6,000

5,000

4,000

3,000

2,000

1,000

0


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In 2006, we delivered recordresults to our shareholders by

executing the three pillars o ourWin Strategy: Premier customerservice, fnancial perormanceand proftable growth.

The cover o this years annualreport illustrates the manydimensions that have enabledParker to become thepremierdiversied motion and controlcompany. Indeed, diversifcationis one o our greatest strengths.

We are diverse in our global scope,the products we manuacture, themarkets we reach, the customers weserve, and the talented people weemploy. Our motion and controltechnologies are virtually everywhere saving energy, speeding processes,building inrastructure, ensuringsaety and improving lives. Thisocused breadth o capabilitieshelps us to mitigate market risk,counter business cyclicality, and

create ongoing opportunities

or growth. We believe investorswill nd ew companies better

positioned or consistent long-termperormance.

And while we are diverse, we arealso united by a single commonplatorm: The Parker WinStrategy.Now in its sixth year,Parkers Win Strategy continues tobe deployed across the globe in everypart o our business. This simpleramework provides each o ourdecentralized and entrepreneurial

business units with operationalclarity, the tools to execute, and themetrics to determine success. Forshareholders, the result is a ocused,yet diverse, company much greaterthan the sum o its parts.

Winning ResultsEverywhereOur employees continued embraceo the Parker Win Strategy droverecord results across the company in

2006.

Sales climbed to $9.4 billion, anincrease o 16.3 percent over 2005,

with organic growth drivingnearly hal o the increase.

Income rom continuingoperations increased 19.7 percentto a record $638.3 million, or$5.28 per diluted share, comparedwith $533.2 million or $4.43 perdiluted share a year ago.

Cash fow rom operationsreached a record $954.6 millionor 10.2 percent o sales, surpassinglast years record o $853.5

million. We increased our annual dividend

or the 50th consecutive year, oneo the longest records o dividendincreases among the Standard &Poors 500.

We achieved near top quartilereturn on invested capital amongour peers.

We were ranked in the top 10percent amongBarronsmagazines500 best perorming companies.

LETTER TO SHAREHOLDERS

Don Washkewicz, Chairman o the Board and Chie Executive Ocer, and Nick Vande Steeg, President and Chie Operating Ocer.


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Parker Continues Its DisciplinedApproach To Strategic Acquisitions

DENQUIP, Hydraulics, South AfricaDOMNICK HUNTER, Filtration, UKFILTRAN, Seal, USHERL REFRIGERATION, Climate & Industrial Controls, GermanyKENMORE INTERNATIONAL, Climate & Industrial Controls, UK

KURODA PNEUMATICS, Automation, JapanPORTER INSTRUMENT, Instrumentation, USRESISTOFLEX AEROSPACE, Aerospace, USSSD DRIVES, Automation, UKSTERLING HYDRAULICS, Hydraulics, UKTAIYO, Hydraulics, JapanTEXLOC & PAGE, Fluid Connectors, USTTXE, Seal, US

Multiple Paths toNew BusinessWhile our 2006 results weretremendous, our growth prospectsare even more exciting. The goodnews or shareholders is that we arenot dependent on any single avenueto generate that growth.

Consider strategic acquisitions.Few companies in our space haveour record o success. During thepast year, we acquired thirteenmotion and control businesses,adding nearly $1 billion inannualized revenues and thousandso talented employees. O particularnote: Domnick Hunterdramatically

adds to one o our strongestperorming and astest growing

businesses: Filtration. SSD Drives ootprint in the

U.S., Europe and China gives us avery strong position in the globalelectromechanical and drivesmarket.

Alliances with Taiyo and KurodaPneumatics evolved into majoritypositions, giving us additionalgrowth platorms or Japan andthe entire Asia Pacic region.

We continue to be our industrysacquirer o choice. As we identiyadditional opportunities in 2007, wewill continue to invest in a ocusedand disciplined way.

Internally, weve ramped up oureorts to develop breakthroughinnovative products. Though ourWinovation program is still in its

early stages, it is already yieldingadvancements such as intelligenthydraulic cylinders, regenerativeltration products, leak-sensingsolenoid valves and conductivethermoplastics.

The marriage o acquired andinternally developed products also

increases our ability to grow throughsystem solutions. Recent systemwins include:

Fuel, fight control and hydraulicsystems or the new ARJ21 aircratwhich will support the rapidlyexpanding civil aviation market inChina. Market potential: Up to$300 million.

A vehicle energy recovery systemusing hydraulic technology to

improve uel eciency by upto 50 percent. Initial marketpotential: Up to $150 million.

A high-throughput autosamplersystem using motion, fuidic andsealing technologies to eliminatebottlenecks in bioanalyticalsample processing. Marketpotential: Up to $10 millionannually.

We also grow through our cross

sales leads program. Cross leads arisewhen one business unit o Parkernds an opportunity or a sisterunit. This year, approximately 1,000cross leads worldwide generatedmillions o dollars in new businessthat might not otherwise have beencaptured.

Through it all, we have strategicallymaintained our roughly50-50

balance between OEM and MRObusiness. This gives us the abilityto grow proftably throughoutbusiness cycles, supplying newproducts to original equipmentmakers when the economy isstrong, and maintenance, repair andoverhaul o parts when the cyclecools.

Whats more, our lean enterpriseeorts are ampliying the eect o

all o our growth platorms throughcontinuous cost reduction andoperating eciencies.

Many Ways toServe the CustomerWe believe in creating value orour customers and shareholdersthrough premier customer service.Everything begins with meetingthe customers delivery request date.Delivering when others cant is oten

MARKETS

TECH

NOLO

GY

PRODUCTS

SERVICES

CUSTOMERSACQUISITIONS

DISTRIBUTI

ON GEOGRA

PHY

PEOPLE

OPERATIONS

Parker is diversied in its core components, all of which combine to createa focused company resistant to cyclicality, volatility, and risk. Our uniquebusiness model emphasizes decentralized divisions empowered to actquickly to meet customer needs.


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a strategic advantage or Parker.Our current on-time delivery rateo approximately 95 percent isrewarding us in the marketplacewith strong orders. Using leantechniques and other elements o theWin Strategy, were usually able tobring the businesses we acquire tothis same high level o perormance

relatively quickly.

Another service dierentiator isour global network o 12,000independent distributor, wholesaleand retail locations. Through thisdistinctive resource, Parker productsand services are almost never outo reach. Examples abound, romhelping bring gas and oil producersback online in the atermath oHurricane Katrina to repairing

heavy equipment at Chinas ThreeGorges Dam, the worlds largestconstruction project.

Other value-added services,including custom manuacturing,inventory management, kitting,Hose Doctor service vans, onlineordering and technical training, plusthe long service and low turnovero our workorce, continue to makeParker a preerred supplier or new

and existing customers alike.

World of MarketOpportunitiesParker technologies are essential toa world in motion. Hundreds oindustries rely on our engineering.Our hydraulics let us move massiveloads. We automate actory assemblylines, and we shield the delicateelectronics in hand-held devices.Our cooling expertise lets us chilleverything rom ice cream tocomputer chips. We lter drinkingwater and diesel uel. We harvestcrops, we generate power, and wefy. And emerging areas such as liesciences and uel cells demonstrateour ability to apply our coreexpertise in new ways.

Global customer needs in thesemarkets drive our geographicexpansion. This year we added to

PHconnect

our operational, sales and servicecapabilities in numerous countries,including strategic growth regionssuch as India, China and Turkey.We will continue to ollow ourmany customers wherever they mayneed us.

Investors can take comortin

this combination o market andgeographic diversication. Clearly,our ortunes are not tied to anysingle market or business. We arepositioning ourselves to weathervolatility and or continued globalgrowth.

Greater than theSum of Our PartsDiversifcation within our industryis good. Our record perormance

in 2006 is proo o that. In 2007and beyond, we will continue tocapitalize on Parkers many acets orthe benet o all our stakeholders.

Amongour continuing goals: Compound growth rate o greater

than 10 percent. Top quartile return on invested

capital among our peers. Operating cash fow o greater

than 10 percent.

Continued dividend growth.

So, as we close 2006, we thankour customers or giving us theopportunity to earn and maintaintheir business. We thank ourdistributors and business partnerswho continue to help us grow.We thank our 57,000 talentedand hard-working employeeswho continue to execute our Win

Strategy.And we thank you, ourshareholders, or entrusting uswith the management o yourinvestment in Parker, the premierdiversifed motion and controlcompany.

Sincerely,

Donald E. WashkewiczChairman and Chie Executive Ofcer

Nickolas W. Vande SteegPresident and Chie Operating Ofcer

The Win Strategy gives clarity to our people and operations around the world. Our vision obeing the #1 motion and control company rests on the relentless execution o the strategyspillars o premier customer service, nancial perormance and protable growth.


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GROWTHMultiple Paths toNew Business

As customer needs become more

complex, our industry-leading product

breadth and systems capabilities

drive our organic growth.

Additional growth comes rom our

Winovation methodology, which

directs our resources to innovative

product ideas with the highest market

potential.

Acquisitions result rom staying

close to potential partners. As such

businesses become available, our

superior cash fow enables us to act

decisively. Our goal is to remain the

motion and control industrys acquirer

o choice.

Parker increased revenues

by $1.3 billion this scal year.

Organic growth accounted

or approximately hal o the

increase, as customers continued to

rely on our combination o technical

expertise, product availability and

premier customer service.

We also completed a record

thirteen acquisitions this year, all

complementary to one or more o our

core motion and control technologies.

These businesses continue to add

new and growing revenue streams.

STRATEGY EXECUTION RESULTS

Diversication begins at Parker with

the way we grow. By mixing organic

growth with strategic acquisitions,

we can expand protably while

avoiding reliance on any single

product line, business, or geographic

area.

This balanced ormula delivers

reliable growth year ater year.


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MARKETSA World of Opportunities

Parker serves thousands

o customers in many end

markets. As a result, we are

not overly dependent on any one

industry or revenues and prots.

This diversication strategy means

overall business cycles tend to

be less volatile or us, competi-

tors nd it dicult to match us,

and risk is reduced or those whoinvest in us.

The essential nature o Parkers

technologies enables us to apply

them just about anywhere.

For example, our ltration know-

how reduces engine emissions and

puries semiconductor abrication.

Sealing prociency reduces hazard-

ous leaks and shields electronic

devices. Cooling expertise chills

vaccines and rerigerates oodwarehouses.

Solving these and other motion

and control challenges transcends

geographic boundaries. Our people,

products and operations respond

to customer needs wherever they

may be.

Parker has diversied into 1,200

markets. No single market

dominates our business.

We have maintained leadership in

our growing traditional markets,

and we are penetrating new high-

margin, counter-cyclical markets

such as uel cells, lie sciences,

electronics, and pharmaceuticals.

The payo:A 9.3 percent

compound annual growth rate

over the last twenty years and

9.4 percent over the last ve.



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SERVICEAdding Value Throughout

the Chain

Parkers excellence in service is

based on the oundation o deliv-

ering quality products on time.

We extend our basic service prom-

ise through our global network

o more than 12,000 indepen-

dent distributor locations. This

competitive dierentiator ensures

replacement products and techni-

cal expertise are readily available.

Finally, we elevate the service

experience by partnering with

our customers, improving their

designs, removing waste rom

their processes, and increasing

their prots.

Despite ever-shortening customer

lead times, our lean operations

are providing on-time deliveries

when competitors cannot.

Together with our distributors, we

are meeting customer requests

or just-in-time replenishment

programs, customized kits, and on-

site engineering.

Service innovations, such as retail

ParkerStores, Hose Doctor emer-

gency repair vans, mobile Tech

Tours, and our PHconnect Web

portal, continue to make us

a supplier o choice.

All o our operating divisions

are at or nearing our 95 percent

or above on-time delivery

goal. The year also saw our North

America 1-800-C-PARKER call

center process nearly 200,000 cus-

tomer inquiries.

Our channel partners continue to

nd new ways to serve Parkers

end customers. Sales to our top100 global distributors grew

nearly 17 percent.

These and other examples are

among the many steps in our con-

tinuing customer service journey.



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PEOPLEDiverse Talents to GrowDiverse Markets

Weve built our entire Win Strat-

egy on the concept o empowered

employees. The local knowl-

edge and expertise o Parkers

57,000-member team lets us

understand and meet customer

needs in dozens o countries.

Employees know that their skills,

more than any other actor, are

what make them valuable. Theyrecognize that Parkers continued

success depends on their diverse

talents, cultures and points o view.

Parker is continually deepening

its talent pool. We recruit rom

dozens ocolleges each year,

seeking outstanding unctional

skills balanced with diverse lie

experiences.

Current employees, new recruits,

and people joining Parker via ac-

quisition grow their skills through

more than 100core courses, 800online courses, and company-

sponsored academic study.

Succession planning is also

addressed continuously, placing

the best talent in the most

critical jobs.

Our diverse workorce is making

us stronger and more competitive.

By embracing lean concepts,

Parker employees have steadily

increased their productivity, as

measured by sales per employee.

Local empowerment has also en-

abled them to decrease inventory

and improve customer service.

At Parker, what we know and how

diligently we apply our knowl-

edge in concert with others will

always be o greatest importance.

Diverse talent is a strength we

celebrate.



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TECHNOLOGYA Portfolio of Essential Engineering

Market diversication comes rom

our related core technologies:

Hydraulics, pneumatics, electro-

mechanical, ltration, sealing &

shielding, process control, fuid

& gas handling, aerospace and

climate control.

We are experts in applying and

developing each technology. We

have assembled the widest productbreadth available rom any single

manuacturer in our industry.

We leverage our capabilities into

integrated systems that oten com-

bine multiple technologies. We

strive to meet the entire range

o customer needs.

Our Winovation process is

spurring advancements in the

next generation o motion and

control technologies, such as

hollow ber membrane gas sepa-

ration, laser optic particle detec-

tion, alternative rerigerants, smart

materials, and intelligent devices.

We provide systems. Weve

married hydraulic, fuid handlingand ltration technologies or

o-road vehicles. In aerospace,

we deliver uel, hydraulic, fight

control, pneumatic and inerting

systems. Weve even combined

motion, sealing and fuidics to

simpliy medical sample analysis.

Parker technology is solving

increasingly complex customer

problems. We are puriying air

and water, reducing pollution, in-

creasing energy eciency, building

inrastructure, aiding the disabled,

and acilitating communication.

Our repeated ability to apply our

technologies is resulting in greater

demand and protable growth. Ourreputation or innovation continues

to expand.

In every case, the goal is the

same: A dierentiated product

or system with a clear com-

petitive advantage.



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PERFORMANCEGreater Than the Sum of Our Parts

Parkers Win Strategy is raising

the perormance o the com-

pany or the benet o all Parker

stakeholders. We are serving the

customer, growing protably, and

perorming nancially.

Our Win Strategy relies on a set

o center-led initiatives designed

to capture value across the entire

chain.

Our commitment to strategic

procurement, strategic pricing and

lean enterprise has not and will

not change. We are ocused on

sustained operational

excellence.

Strategic procurement agree-

ments are providing fows o raw

materials, even when competitors

experience shortages. Pricing spe-

cialists are nding and capturing

the true value o our products. All

employees are solving problems

by using standard lean tools and

metrics.

These initiatives are beingimplemented daily at our 118

divisions. Our lean journey con-

tinues ever orward, as we seek

to increase eciency in every

unctional area.

Our reduced supplier base is

providing cost-saving ideas worth

millions. Lean has improved pro-

ductivity as measured by sales per

employee. Inventory is down and

service levels are up.

In 2006, we generated returns

above our cost o capital, and we

remained near thetop quartile

in return on invested capitalamong our peers. Cash fow,

sales and earnings are at re-

cord levels.

2006 also marked our 50th

consecutive scal year o

increased dividends.



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0

2

4

6

8

10

12

14

.30 .40 .50 60 .70 .80

Net Assets/Sales

16%

%o

fReturnonSa

les

GOAL

FINANCIAL STRENGTH

Above-the-Line Performance in 2006 This chart contains two important

nancial measures: Operating margin and net assets/sales. The corporategoal, represented by the line, helps divisions focus on controlling costs andassets while growing sales. The quickest way to meet the target is to movenorth by northwest. Since the launch of the Win Strategy, Parker hassteadily moved toward the goal, reaching the line in 2005 and eclipsing itin 2006.

Over the last ve years, Parkers Win Strategy has driven the companys nancial performance to a higher level. Asour employees continue to execute our Win Strategy, we will continue to operate from a position of nancial strength,

enabling us to invest in strategic new opportunities, grow our business, and provide strong returns to our shareholders.

Cash Flow from OperationsMillions of Dollars

01 02 03 04 05 06

$1,000

800

600

400

12%

10

8

6

4

Record Dollars in 2006 In 2006, cash ow from operations reached a

record $954.6 million or 10.2% of sales. This strong position allows us theexibility to invest in strategic acquisitions, develop innovative products,develop our employees, repurchase shares and provide dividends.

% of Sales

Net Cash

Our North By Northwest Goal

6.9%

0% 5% 10% 15% 20% 25% 30% 35%

8.0%

12.6%

14.9%

12.6%

15.4%

16.6%

15.8%

16.7%

18.7%

18.1%

20.7%

25.9%

21.2%

28.0%

32.5%

32.1%

20.9%

9.5%

PARKER

Parker ROIC Versus Peers ROIC*

*Return on Invested Capital (ROIC) is dened as: Earnings before interest and taxes (EBIT) divided by average capital (average of debt and equity at the beginning and endof the scal year). Parkers ROIC peers include CAT, CBE, CMI, DE, DHR, DOV, EMR, ETN, FLS, GR, HON, IR, ITT, ITW, PLL, ROK, SPW, and TXT. The information for Parker and its

peers is based on the last completed scal year of each company.

Strong ROIC Performance in 2006 Our ROIC continuesto outpace our weighted average cost of capital, creat-ing value for our shareholders.

Peers Parker

Return on Invested Capital %


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ManageMents Discussion anD analysis

FIVE-YEARCOMPOUNDSALES GROWTH

Goal: 10%

5.0%

10.0%

15.0%

02 03 04 05 06

RETURNON SALES

Goal: 6.5%

3.0%

6.0%

9.0%

02 03 04 05 06

AVERAGEASSETS/SALES

Goal: $.80

$.40

$.80

$1.20

02 03 04 05 06

RETURN ONAVERAGEEQUITY

Goal: 15.0%

8.0%

16.0%

24.0%

02 03 04 05 06

DIVIDENDPAYOUT RATIO

Goal: 25.0%

25.0%

50.0%

75.0%

02 03 04 05 06

Financial Review

or

The Cmpany is a leadin wrldwide diversified manfactrer f mtin cntrl

technlies and systems, prvidin precisin enineered sltins fr a wide varietyf cmmercial, mbile, indstrial and aerspace markets.

The Cmpanys rder rates prvide a near-term perspective f t he Cmpanys ftrerevenes particlarly when viewed in the cntext f prir and ftre rder rates.The Cmpany pblishes its rder rates n a mnthly basis. The lead t ime betweenthe time an rder is received and revene is realized can rane frm ne day t 12weeks fr cmmercial, mbile and indstrial rders and frm ne day t 18 mnthsfr aerspace rders. The Cmpany believes the leadin ecnmic indicatrs f thesemarkets that have a strn crrelatin t t he Cmpanys ftre rder rates are theInstitte f Spply Manaement (ISM) index f manfactrin activity with respectt cmmercial, mbile and indstrial markets and aircraft miles flwn, revenepassener miles and Department f Defense spendin fr aerspace markets.

An ISM index abve 50 indicates that t he manfactrin ecnmy is expandinresltin in the expectatin that t he Cmpanys rder rates in the cmmercial, mbileand indstrial markets shld be psitive year-ver-year. The ISM index at the end ffiscal 2006 was 53.8 cmpared t 54.0 at the end f Jne 2005. With respect tthe aerspace market, aircraft miles flwn and revene passener miles in 2006have shwn mderate imprvement ver cmparable fiscal 2005 levels and theCmpany expects cntined imprvement in 2007. The Cmpany anticipates thatDepartment f Defense spendin in fiscal 2007 will remain at the fiscal 2006 levels.

The Cmpany als believes that there is a hih crrelatin between interest rates andIndstrial manfactrin activity. The Federal Reserve raised the federal fnds rate

eiht times drin fiscal 2006. Additinal increases in interest rates cld havea neative impact n indstrial prdctin thereby lwerin ftre rder rates.

The Cmpanys majr pprtnities fr rwth are as fllws: Leverae the Cmpanys brad prdct line with cstmers desirin

t cnslidate their vendr base and tsrce enineerin, Marketin systems sltins fr cstmer applicatins, Expand the Cmpanys bsiness presence tside f Nrth America, New prdct intrdctins, incldin thse resltin frm the Cmpanys

innvatin initiatives, and Strateic acqisitins in a cnslidatin indstr y.

The financial cnditin f the Cmpany remains strn as evidenced by the cntinedeneratin f sbstantial cash flws frm peratins, a debt t debt-eqity ratif 21.1 percent, ample brrwin capabilities and strn shrt-term credit ratins.Cash flws frm peratins in 2006 were $955 millin, r 10.2 percent f sales.

Many acqisitin pprtnities remain available t the Cmpany within its taretmarkets. Drin fiscal 2006, the Cmpany cmpleted 13 acqisitins whseareate annal revenes were apprximately $983 millin. The Cmpany believesthat ftre financial reslts will reflect the benefit f a fast and efficient interatinf the cmpanies recently acqired. Acqisitins will cntine t be cnsidered frmtime t time t the extent there is a strn strateic fit, while at the same time,maintainin the Cmpanys strn financial psitin. The Cmpany will als cntinet assess the strateic fit f its existin bsinesses and initiate effrts t divestbsinesses that are nt cnsidered t be a d ln-term fit fr the Cmpany,as evidenced by the divestit res cmpleted in fiscal 2006 and 2005.

Cnslidated Statement f Cash Flws pae 23Ntes t Cnslidated Financial Statement s pae 24

Eleven-Year Financial Smmary pae 36

Parker Hannifin Corporation annual report 2006

Cnslidated Statement s f Incme and Cmprehensive Incme pae 20Bsiness Sement Infrmati n pae 21

Cnslidated Balance Sheet pae 22


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Crrent challenes facin the Cmpany inclde maintainin premier cstmer servicelevels while benefitin frm strn cstmer demand, sccessflly matchin priceincreases t raw material cst increases and manain risin expenses related t

emplyee retirement and health care benefits. The Cmpany is als challened withtryin t minimize the ptential adverse impact f the weakenin financial cnditinf its atmtive market cstmers. The Cmpany has implemented a nmber fstrateic financial perfrmance initiatives relatin t rwth and marin imprvementin rder t meet these challenes, incldin strateic prcrement, strateic pricin,lean manfactrin and bsiness realinments.

The discssin belw is strctred t separately discss each f the financialstatements presented n paes 20 t 23. All year references are t fiscal years.

D f cdd sm f im

The Cnslidated Statement f Incme smmarizes the Cmpanys peratinperfrmance ver the last three fiscal years.

(millions) 2006 2005 2004

Net sales $ 9,386 $ 8,069 $ 6,888

Gross profit margin 21.5% 20.8% 19.0%

Selling, general andadministrative expenses $ 1,037 $ 860 $ 766

Goodwil l impairment loss 1

Interest expense 76 67 73

Other (income) expense, net (9) 8 (1)

Loss (gain) on disposal of assets 15 4 (2)

Effective tax rate fromcontinuing operations 29.1% 27.8% 29.8%

Income fromcontinuing operations $ 638 $ 533 $ 332

Income fromcontinuing operations,as a percent of sales 6.8% 6.6% 4.8%

Discontinued operations $ 35 $ 72 $ 14

Net income $ 673 $ 605 $ 346

Net sales in 2006 were 16.3 percent hiher than 2005. The increase in salesin 2006 primarily reflects hiher vlme experienced acrss all Sements.Acqisitins cmpleted within the last 12 mnths cntribted abt ne-half fthe net sales increase. The effect f crrency rate chanes redced net sales byapprximately $38 millin.

Net sales in 2005 were 17.1 percent hiher than 2004. The increase in sales in2005 primarily reflects hiher vlme experienced thrht all f the Cmpanys

Sements, especially in the Indstrial Nrth American and Indstrial Internatinalperatins. Acqisitins cmpleted within the last 12 mnths cntribted abtne-third f the sales increase and the ef fect f crrency rate chanes increasednet sales by apprximately $165 millin.

Drin 2006, the Cmpany experienced strn bsiness cnditins in mst fthe markets that the Indstrial Nrth American bsinesses serve. The Cmpanyanticipates that favrable bsiness cnditins will prevail fr mst f 2007translatin int sales rwth in t he mid-sinle diit rane and peratin marinsremainin clse t their 2006 level. Sales in the Indstrial Internatinal peratins

are expected t increase apprximately 18 percent with peratin marins expectedt remain at r be slihtly hiher t han their 2006 level. Aerspace peratins salesare expected t increase in the mid-sinle diit rane with peratin marins

remainin near their 2006 level. Climate & Indstrial Cntrls sales are expectedt increase in the mid-sinle diit rane with an peratin marin imprvement fabt 25 percent ver their 2006 level.

Gross profit marGiN was hiher in 2006 primarily de t a cmbinatin f theincrease in sales as well as the ef fects f the Cmpanys financial perfrmanceinitiatives, especially in the areas f lean manfactrin and st rateic prcrement.Inclded in 2006 rss prfit is $10.3 millin f expense related t stck-basedcmpensatin awards. The hiher marins in 2005 reflect the effects f t heCmpanys financial perfrmance initiatives, resltin in better manfactrintilizatin levels. Crrent-year acqisitins, nt yet flly interated, neativelyaffected the crrent-year rss marin.

selliNG, GeNeral aNd admiNistrative expeNses increased 20.5 percent in

2006 primarily de t the hiher sales vlme, $23.1 millin f expense related tstck-based cmpensatin awards, hiher amrtizatin expense related t intanibleassets and hiher incentive cmpensatin.

Goodwill impairmeNt loss in 2004 reslted frm the Cmpanys dwillimpairment test reqired t be perfrmed nder the prvisins f SFAS N. 142.N impairment lss was reqired t be recnized in 2006 r 2005.

iNterest expeNse increased in 2006 primarily de t hiher averae debttstandin resltin frm an increase in brrwins sed t fnd acqisitin activit yin 2006. Interest expense declined in 2005 as a reslt f lwer averae debttstandin.

loss (GaiN) oN disposal of assets incldes, plant and eqipment dispsals,

divestitres f bsinesses and asset impairments and ther miscellanes assetadjstments.

(millions) 2006 2005 2004

Plant andequipment disposals $ (1) $ 3 $ 2

Divestitures 10 (11)

Asset adjustments 6 1 7

See Nte 2 n pae 26 fr a discssin f divestitres. See Nte 3 n pae 27 fra discssin f asset adjstments.

effective tax rate from coNtiNuiNG operatioNs in 2006 was hiher primarilyde t a lwer level f research and develpment tax credits as cmpared t 2005,partially ffset by the effect f tax plannin initiatives. The effective tax rate in

2005 was lwer primarily de t a favrable rlin btained frm the InternalRevene Service reardin research and develpment tax credits as well as theeffect f tax plannin initiati ves related t recent acqisitins.

iNcome from coNtiNuiNG operatioNs In additin t the individal incmestatement items discssed abve, net incme in 2006 and 2005 was adverselyaffected by an additinal expense f apprximately $15 millin and $11 millin,respectively, related t dmestic qalified defined benefit plans. The increase inexpense assciated with the Cmpanys dmestic qalified defined benefit plansreslted primarily frm chanes in actarial assmptins fr 2006 and hiher


MANAgEMENTS DISCuSSIoN & ANALYSIS


17/48

amrtizatin f prir years actarial lsses. Net incme in 2007 is expected tbe psitively affect ed by a decrease in pensin expense related t the Cmpanysdmestic qalified defined benefit plans f apprximately $19 millin. The decrease

in pensin expense in 2007 is primarily de t an increase in the discnt rate frm5.25 percent t 6.0 percent and lwer expense frm the amrtizatin f priryears actarial lsses.

discoNtiNued operatioNs represents the peratin reslts and related ain n thesale, net f tax, f the Ast rn Bildins bsiness which was divested in Ast 2005and the Wynns Specialty Chemical bsiness which was divested in December 2004.

other compreheNsive iNcome (loss) Items inclded in ther cmprehensiveincme (lss) are ains and lsses that nder enerally accepted accntinprinciples are recrded directly int stckhlders eqity. The fllwin are theCmpanys items f ther cmprehensive incme (lss):

(millions) 2006 2005 2004

Foreign currency

translation $ 104 $ 13 $ 34Net unrealized (loss) gain

on marketableequity securities (11) 5

Minimum pension liability 167 (154) 95

Net unrealized gain (loss)on cash flow hedges 5 (7)

The chane in frein crrency translatin in 2006 primarily reslted frm theweakenin f the u.S. dllar aainst mst ther crrencies. The minimm pensinliability was recrded in cmprehensive incme in accrdance with the reqirementsf SFAS N. 87 (see Nte 10 n pae 30 fr frther discssin).

D f B sm ifrm

The Bsiness Sement infrmatin presents sales, peratin incme and assets n abasis that is cnsistent with the manner in which the Cmpanys varis bsinessesare manaed fr internal review and decisin-makin. See Nte 1 n pae 24 fra descriptin f the Cmpanys reprtable bsiness sements.

IndustrIal segment

(millions) 2006 2005 2004

SalesNorth America $ 3,993 $ 3,517 $ 3,017International 2,903 2,398 1,970

Operating incomeNorth America 597 468 291

International 354 267 160

Operating incomeas a percent of sales

North America 15.0% 13.3% 9.6%

International 12.2% 11.1% 8.1%

Backlog $ 1,178 $ 944 $ 840

Assets 6,154 4,714 4,277

Return on average assets 11.0% 10.4% 7.1%

Sales in 2006 fr the Indstrial Nrt h American peratins were 13.6 percent hiherthan 2005 fllwin a 16.6 percent increase frm 2004 t 2005. The increase insales in 2006 was primarily de t acqisitins, which accnted fr abt ne-half

f the sales increase, as well as hiher end-ser demand experienced in virtallyall markets, with the larest increases in heavy-dt y trck, cnstrctin, mbileeqipment and il and as. The sales increase frm 2004 t 2005 was primarilyde t hiher end-ser demand experienced in the heavy-dty trck, cnstrct inand aricltre and mbile eqipment markets.

Sales in t he Indstrial Internatinal peratins increased 21.0 percent in 2006fllwin an increase f 21.8 percent frm 2004 t 2005. The sales increase in2006 was primarily de t acqisitins, which accnted fr abt 70 percent fthe sales increase, as well as hiher vlme in Erpe and the Asia Pacific rein,partially ffset by lwer vlme in Latin America. Frein crrency rate chanesredced net sales in 2006 by $54 millin. The increase in sales frm 2004 t 2005was primarily de t hiher vlme acrss mst markets in Erpe, Latin Americaand the Asia Pacific rein. Acqisitins cmpleted in 2005 and the effect f freincrrency rate chanes each cntribted abt 30 percent f the sales increase.

The hiher Indstrial Nrth American peratin marins in 2006 and 2005 wereprimarily de t the increased sales vlme as well as peratin ef ficiencies. Theperatin efficiencies reflect the exectin f the Cmpanys financial perfrmanceinitiatives, especially in the area f lean manfactrin and strateic prcrement.Acqisitins, nt yet flly interated, neatively impacted marins in bth 2006and 2005. Inclded in Indstrial Nrth American peratin incme in 2006, 2005and 2004 are bsiness realinment chares f $5.4 millin, $3.7 millin and $9.1millin, respectively. The bsiness realinment chares reslted frm actins theCmpany tk t strctre the Indstrial Nrth American peratins t peratein their then crrent ecnmic envirnment and primarily cnsisted f severancecsts and csts relatin t the cnslidatin f manfactrin peratins.

The Indstrial Internatinal peratin marin imprvement in 2006 and 2005was primarily de t the hiher sales vlme, especially thrht all bsinessesin Erpe, as well as the effects f the Cmpanys financial perfrmance initiatives.Acqisitins, nt flly interated, neatively impacted marins in 2006 and 2005.operatin incme in 2006, 2005 and 2004 inclded $10.3 millin, $9.9 millinand $4.5 millin, respectively, f bsiness realinment chares t hat were taken tapprpriately strctre primarily the Erpean peratins.

Indstrial Sement rder rates were hiher t hrht 2006 as virtally all marketsexperienced cntined strenth in end-ser demand. The Cmpany expects rderentry levels in 2007 in mst markets f the Indstrial Nrth American peratinst be relatively flat r decline slihtly as cmpared t their 2006 levels. TheCmpany expects sales in the Indstrial Internatinal peratins t increase abt18 percent ver 2006 reflectin strn end-ser demand and the sales cntribtinfrm acqisitins cmpleted in 2006. operatin marins in bth t he IndstrialNrth American and Indstrial Internatinal peratins are expected t remain atr be slihtly hiher than their 2006 level. Indstrial Internatinal peratin marinin 2007 is expected t be adversely af fected by recent acqisitins that will ntbe cmpletely interated fr the entire year. As part f the Cmpanys financialperfrmance initiatives, the recnitin f additinal bsiness realinment charesmay be reqired in 2007.


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19/48

the Cmpany increased t 51 days in 2006 cmpared t 47 days in 2005.The increase in days sales tstandin is primarily de t accnts receivablef cmpanies acqired drin the latt er part f 2006.

iNveNtories increased primarily de t acqisitins. Days spply f inventry nhand decreased t 60 days in 2006 frm 65 days in 2005.

plaNt aNd equipmeNt,Net f accmlated depreciatin, increased in 2006primarily de t plant and eqipment acqired in crrent-year acqisitins partiallyffset by depreciatin expense exceedin capital expenditres.

Goodwill increased primarily as a reslt f crrent-year acqisitins.

iNtaNGible assets, Net cnsist primarily f patents, trademarks and cstmer lists.Intanible assets, net increased primarily de t crrent-year acqisitins.

accouNts payable, trade increased primarily de t crrent-year acqisitins aswell as an increase in prchasin acrss all Sements f the Cmpany t spprtthe increase in cstmer rders.

accrued payrolls aNd other compeNsatioN increased t $297.1 millin frm$263.0 millin primarily de t hiher incentive cmpensatin accrals.

accrued domestic aNd foreiGN taxes increased t $140.4 millin in 2006 frm$97.9 millin in 2005 primarily de t acqisitins and hiher taxable incme in2006.

peNsioNs aNd other postretiremeNt beNefits decreased 23.2 percent in 2006.The chane in this amnt is explained frther in Nte 10 t the CnslidatedFinancial Statements.

Net deferred iNcome taxes decreased $96.3 millin in 2006. The chane in thisamnt is explained frther in Nte 4 t the Cnslidated Financial Statements.

other liabilities increased t $261.6 millin in 2006 frm $189.7 millin in2005 as a reslt f hiher ln-term incentive cmpensatin accrals as well as ahiher amnt f minrity interests in cnslidated sbsidiaries resltin frm theacqisitin f a majrity wnership f tw entities in 2006 that were previslyaccnted fr by the eqity methd.

shareholders equity The chane in sharehlders eqity is explained in Nte 12t the Cnslidated Financial Statements.

D f cdd sm f ch F

The Cnslidated Statement f Cash Flws reflects cash inflws and tflws frmthe Cmpanys peratin, investin and financin activities.

A smmary f cash flws fllws:(millions) 2006 2005 2004

Cash provided by (used in):

Operating activities $ 955 $ 853 $ 662

Investing activities (921) (565) (270)

Financing activities (194) (138) (449)

Effect of exchange rates (4) 2 (5)

Net (decrease) increasein cash and cash equivalents $ (164) $ 152 $ (62)

cash flows from operatiNG activities The increase in net cash prvided byperatin activities in 2006 was primarily the reslt f an increase in net incme, adecrease in net incme frm discntined peratins and the nn-cash chare related

t stck-based cmpensatin. Cash flw frm wrkin capital items decreased in2006 primarily de t an increase in cash flw sed by accnts receivable partiallyffset by an increase in cash flw prvided by accnts payable and accreddmestic and frein taxes.

cash flows used iN iNvestiNG activities The sinificant increase in theamnt f cash sed in investin activities in 2006 is attribtable t an increasein acqisitin activity. Capital expenditres increased $43.2 millin in 2006. Thelevel f capital expenditres is expected t be apprximately 3.5 percent f salesin 2007. Refer t Nte 2 n pae 26 fr a smmary f net assets f acqiredcmpanies at their respective acqisitin dates.

cash flows from fiNaNciNG activities In 2006, the Cmpany decreased it ststandin brrwins by a net ttal f $101.5 millin cmpared t a decrease f

$21.2 millin in 2005. The sbstantial level f cash flw frm peratin activitiesallwed the Cmpany t minimize the brrwins necessary t cmplete acqisitinsin 2006 and 2005. Cmmn share activity prvided cash f $16.9 millin in 2006cmpared t sin cash f $23.7 millin in 2005. The increase in cash prvided bycmmn stck activity in 2006 is primarily de t the level f stck ptin activityand share reprchases between perids.

Bk verdrafts have been exclded frm Cash flws frm financin activities andinclded in Cash flws frm peratin activities, in Accnts payable, trade. The bkverdrafts reslt frm a delay in sweepin cash frm ne bank t anther and aresettled the next bsiness day; t herefre, the bk verdrafts are nt cnsideredbank brrwins by the Cmpany. Had the bk verdrafts been reflected as bankbrrwins, cash flws frm financin activit ies wld have been $3.3 millin

hiher in 2006, $13.0 millin lwer in 2005 and $18.1 millin hiher in 2004.The Cmpany has the availability t isse secrities with an areate initial fferinprice f $775 millin nder its niversal shelf reistratin statement. Secrities thatmay be issed nder this shelf reistratin statement inclde debt secrities, cmmnstck, serial preferred stck, depsitary shares, warrants, stck prchase cntractsand stck prchase nits.

The Cmpanys al is t maintain n les s than an A ratin n senir debt tensre availability and reasnable cst f external fnds. As ne means f achievinthis bjective, the Cmpany has established a financial al f maintainin a ratif debt t debt-eqity f n mre than 37 percent.

Debt to Debt-Equity Ratio

(dollars in millions) 2006 2005

Debt $ 1,132 $ 970Debt & Equity 5,373 4,311

Ratio 21.1% 22.5%

The Cmpany relarly explres acqisitin pprtnities and additinal brrwinsmay be sed t finance acqisitins cmpleted in 2007.


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Cmmn share activity in 2006 primarily invlves the exercise f stck ptinsand the reprchase f shares f the Cmpanys cmmn stck fr treasry. Thereprchase f the Cmpanys shares is dne prsant t a prram t reprchase

p t 5.0 millin f the Cmpanys cmmn shares per fiscal year n the penmarket, at prevailin prices, incldin the systematic reprchase f p t $20millin in cmmn shares each fiscal qarter.

Dividends have been paid fr 224 cnsective qarters, incldin a yearly increasein dividends fr the last 50 fiscal years. The expected annal dividend rate fr fiscal2007 is $1.04 per share.

As f Jne 30, 2006, the Cmpany has a line f credit ttalin $1,025 millinthrh a mlti-crrency revlvin credit areement with a rp f banks. TheCmpany has the riht, n mre than nce a year, t increase the facility amnt,in minimm increments f $25 millin p t a maximm facility amnt f $1,250millin. The credit areement expires September 2010, hwever, the Cmpany hasthe riht t reqest a ne-year extensin f t he expiratin date n an annal basis.

The credit areement spprts t he Cmpanys cmmercial paper nte prram, whichis rated A-1 by Standard & Prs, P-1 by Mdys and F-1 by Fitch, Inc. Theseratins are cnsidered investment rade. The revlvin credit areement cntainsprvisins that increase the facility fee f the credit areement in the event theCmpanys credit ratins are lwered. A lwerin f the Cmpanys credit ratinswld nt limit the Cmpanys ability t se the credit areement nr wld itaccelerate the repayment f any tstandin brrwins.

The Cmpany seeks t minimize its ttal cst f brrwin and therefre ses itscmmercial paper nte prram as its primary srce f wrkin capital liqidity. Theprimary alternative srce f brrwin fr wrkin capital liqidity is the cmmittedline f credit, which typically bears a hiher cst f brrwin.

The Cmpanys revlvin credit areement and indentres vernin certain debt

areements cntain varis cvenants, the vilatin f which wld limit r precldethe se f the revlvin credit areement fr ftre brrwins, r miht acceleratethe matrity f the related tstandin brrwins cvered by the indentres. Atthe Cmpanys present ratin level, the mst restrictive financial cvenant prvidesthat the rati f secred debt t net tanible assets be less t han 10 percent. As fJne 30, 2006, the rati f secred debt t net tanible assets was less than nepercent. The Cmpany is in cmpliance with all cvenants and expects t remainin cmpliance drin the term f the areement and indentres.

Based pn the Cmpanys past perfrmance and crrent expectatins, manaementbelieves the cash flws enerated frm ftre peratin activit ies shld prvideadeqate fnds t spprt internal rwth and cntined imprvements in theCmpanys manfactrin facilities and eqipment. The Cmpanys wrldwide

financial capabilities may be sed t spprt planned rwth as needed.

coNtractual obliGatioNs The fllwin table smmarizes the Cmpanys fixedcntractal bliatins.

(In thousands) Payments due by period

Contractual Less than More thanobligations Total 1 year 1-3 years 3-5 years 5 years

Long-termdebt(Note 9) $1,125,444 $ 65,983 $ 62,021 $ 402,114 $ 595,326

Interest onlong-termdebt 381,781 54,973 100,067 93,040 133,701

Operatingleases(Note 9) 200,296 55,302 70,118 29,281 45,595

Retirementbenefits(Note 10) 1,580,572 250,702 240,254 268,606 821,010

Total $3,288,093 $426,960 $472,460 $793,041 $1,595,632

Q d Q Dr ab Mr R

The Cmpany enters int frward exchane cntracts and cstless cllar cntracts tredce its expsre t flctatins in related frein crrencies. The ttal carryinand fair vale f pen cntracts and any risk t t he Cmpany as a reslt f thesearranements is nt material t the Cmpanys financial psitin, liqidity r resltsf peratins. Drin 2006, tw interest rate swap areements were settled. Theswap areements were desinated as a hede aainst the anticipated refinancin fthe Cmpanys Er Ntes that were de in Nvember 2005. The Cmpany madea net payment f $3.5 millin t settle the swaps. This net payment is beinrecnized as an adjstment t interest expense ver the term f the Er Bndsissed in Nvember 2005.

The Cmpanys debt prtfli cntains variable rate debt, inherently expsin theCmpany t interest rate risk. The Cmpanys bjective is t maintain a 60/40 mixbetween fixed rate and variable rate debt thereby limitin its expsre t chanes innear-term interest rates. A 100 basis pint increase in near-term interest rates wldincrease annal interest expense n variable rate debt existin at Jne 30, 2006 byapprximately $0.3 millin.

off-B sh arrm

The Cmpany des nt have f f-balance sheet arranements.

cr a P

The preparatin f financial statements in cnfrmity with accntin principlesenerally accepted in the united States f America reqires manaement t makeestimates and assmptins that affect the amnts reprted in the financialstatements and accmpanyin ntes. The plicies discssed belw are cnsideredby manaement t be mre critical than ther plicies becase their applicatinplaces the mst sinificant demands n manaements jdment.

reveNue recoGNitioN Sbstantially all f the Indstrial Sement and the Climate& Indstrial Cntrls Sement revenes are recnized when the risks and rewardsf wnership and title t the prdct have transferred t the cstmer. This enerallytakes place at the time the prdct is shipped. The Aerspace Sement ses the


MANAgEMENTS DISCuSSIoN & ANALYSIS


21/48

percentae f cmpletin methd t recnize a prtin f its revene. Thepercentae f cmpletin methd reqires the se f estimates f cst s t cmpleteln-term cntracts and fr sme cntracts incldes estimatin csts related t

aftermarket rders. The estimatin f these csts reqires sbstantial jdment nthe part f manaement de t the dratin f the cntracts as well as the technicalnatre f the prdcts invlved. Adjstments t estimated csts are made n acnsistent basis and a cntract reserve is established when the csts t cmpletea cntract exceed the cntract revenes.

impairmeNt of Goodwill aNd loNG-lived assets gdwill is tested frimpairment, at the reprtin nit level, n an annal basis and between annaltests whenever events r circmstances indicate that the carr yin vale f a reprtinnit may exceed its fair vale. A discnted cash flw mdel is sed t estimatethe fair vale f a reprtin nit. This mdel reqires the se f ln-term planninfrecasts and assmptins reardin indstry specific ecnmic cnditins that aretside the cntrl f the Cmpany. Ln-lived assets held fr se are evalated frimpairment whenever events r circmstances indicate that the ndiscnted netcash flws t be enerated by their se and evental dispsitin is less than theircarryin vale. The ln-term natre f these assets reqires the estimatin fits cash inflws and tf lws several years int the ftre and nly t akes intcnsideratin technlical advances knwn at the time f the impairment test.

iNveNtories Inventries are valed at the lwer f cst r market. Cst isdetermined n the last-in, first-t basis fr a majrity f u.S. inventries and n thefirst-in, first-t basis fr the balance f t he Cmpanys inventries. Inventries havebeen redced by an allwance fr bslete inventries. The estimated allwance isbased n manaements review f inventries n hand cmpared t estimated ftresae and sales. Chanes in the allwance have nt had a material effect n theCmpanys reslts f peratins, financial psitin r cash flws.

peNsioNs aNd postretiremeNt beNefits other thaN peNsioNs The annal netperidic expense and benefit bliatins related t the Cmpanys defined benefit

plans are determined n an actarial basis. This determinatin reqires criticalassmptins reardin the discnt rate, ln-term retrn n plan assets, increasesin cmpensatin levels, amrtizatin perids fr actarial ains and lsses andhealth care cst trends. Assmptins are determined based n Cmpany dataand apprpriate market indicatrs, and are evalated each year as f the plansmeasrement date. Chanes in the assmptins t reflect actal experience as wellas the amrtizatin f actarial ains and lsses cld reslt in a material chanein the annal net peridic expense and benefit bliatins reprted in the financialstatements. Fr the Cmpanys dmestic defined benefit plans, a ne-half percentaepint chane in the assmed ln-term rate f retrn n plan asset s is estimatedt have a $7 millin effect n pensin expense and a ne-half percentae pint

decrease in the discnt rate is estimated t increase pensin expense by $14millin. As f Jne 30, 2006, $495 millin f past years actarial lsses relatedt the Cmpanys dmestic qalified defined benefit plans have yet t be amrtized.These lsses will enerally be amrtized ver apprximately 11.5 years and willneatively affect earnins in t he ftre. Actarial ains experienced in ftre yearswill help redce the effect f the actarial lss amrtizatin.

Frther infrmatin n pensins and pstretirement benefits ther t han pensinsis prvided in Nte 10 t the Cnslidated Financial Statements.

stock-based compeNsatioN The cmptatin f the expense assciated withstck-based cmpensatin reqires the se f a valatin mdel. The Cmpanycrrently ses a Black-Schles ptin pricin mdel t calclate t he fair vale f

its stck ptins and stck appreciatin rihts. The Black-Schles mdel reqiresassmptins reardin the vlatility f the Cmpanys stck, the expected life f thestck award and the Cmpanys dividend rati. The Cmpany primarily ses histricaldata t determine the assmptins t be sed in the Black-Schles mdel and hasn reasn t believe that ftre data is likely t differ materially frm histrical data.Hwever, chanes in the assmptins t reflect ftre stck price vlatility, ftredividend payments and ftre stck award exercise experience cld reslt in achane in the assmptins sed t vale awards in the ftre and may reslt ina material chane t t he fair vale calclatin f stck-based awards.

other loss reserves The Cmpany has a nmber f lss expsres incrredin the rdinary crse f bsiness sch as envirnmental claims, prdct liability,litiatin, recverability f deferred incme tax benefits and accnts receivablereserves. Establishin lss reserves fr t hese matters reqires manaementsestimate and jdment with reards t risk expsre and ltimate liability rrealizatin. These lss reserves are reviewed peridically and adjstments aremade t reflect the mst recent facts and circmstances.

R adpd a Prm

on Jly 1, 2005, the Cmpany adpted the prvisins f FASB Statement N. 123(revised 2004) (FAS 123R) and elected t se the mdified prspective t ransitinmethd. The mdified prspective transitin methd reqires cmpensatin cst tbe recnized in the financial statements fr all awards ranted after the date fadptin. Prir t the adptin f FAS 123R, the Cmpany sed the intrinsic-valebased methd t accnt fr stck ptins and made n chares aainst earninswith respect t ptins ranted.

The Cmpanys stck incentive plans prvide fr the rant f nnqalified ptinsand stck appreciatin rihts (SARs) t fficers, directrs and key emplyees f theCmpany. otstandin ptins and SARs are exercisable frm ne t three yearsafter the date f rant and expire n mre than ten years after the date f rant.The Cmpany ses a Black-Schles ptin pricin mdel t est imate the fair valef nnqalified ptins and SARs ranted. The adptin f FAS 123R redced Incmefrm cntinin peratins befre incme taxes in fiscal 2006 by $33.4 millin andredced fiscal 2006 Net incme by $21.8 millin ($.18 per basic and dilted share).The adptin f FAS 123R had an immaterial effect n the Cnslidated Statementf Cash flws in fiscal 2006. As f Jne 30, 2006, $14.5 millin f expensewith respect t nnvested stck-based awards has yet t be recnized and will beamrtized int expense ver a weihted-averae perid f apprximately 18 mnths.

R id a Prm

In Jly 2006, the Financial Accntin Standards Bard issed FASB InterpretatinN. 48, Accntin fr uncertainty in Incme Taxes - An Interpretatin f FASBStatement 109 (FIN 48). FIN 48 prescribes a cmprehensive mdel fr hw acmpany shld recnize, measre, present, and disclse in it s financial statementsncertain tax psitins that the cmpany has t aken r expects t take n a taxretrn. FIN 48 is effective as f the beinnin f fiscal years that start afterDecember 15, 2006. The Cmpany has nt yet determined the effect n theCmpanys financial psitin r reslts f peratins f cmplyin with theprvisins f FIN 48.


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Financial stateMents

consolIdated statementof Income

For the years ended June 30, 2006 2005 2004

Net Sales $ 9,385,888 $ 8,068,805 $ 6,887,596Cost of sales 7,367,618 6,391,477 5,577,888

Gross profit 2,018,270 1,677,328 1,309,708Selling, general and administrative expenses 1,036,646 860,278 765,570Goodwill impairment loss (Note 7) 1,033Interest expense 75,763 66,869 73,144Other (income) expense, net (9,393) 8,040 (891)Loss (gain) on disposal of assets 15,296 3,870 (2,104)

Income from continuing operations before income taxes 899,958 738,271 472,956Income taxes (Note 4) 261,682 205,105 140,871

Income from continuing operations 638,276 533,166 332,085Income from discontinued operations (Note 2) 34,891 71,526 13,698

Net Income $ 673,167 $ 604,692 $ 345,783

Earnings per Share(Note 5)Basic earnings per share

Income from continuing operations $ 5.35 $ 4.49 $ 2.82Income from discontinued operations 0.30 0.60 0.12

Net income per share $ 5.65 $ 5.09 $ 2.94

Diluted earnings per shareIncome from continuing operations $ 5.28 $ 4.43 $ 2.79Income from discontinued operations 0.29 0.59 0.12

Net income per share $ 5.57 $ 5.02 $ 2.91

The accompanying notes are an integral part of the financial statements.

consolIdated statementof comprehensIve Income (dollarsInthousands)


Net Income $ 673,167 $ 604,692 $ 345,783Other comprehensive income (loss), net of taxes (Note 11):

Foreign currency translation adjustment 103,842 13,138 34,487Minimum pension liability 167,008 (154,377) 94,513Net unrealized (loss) gain on marketable equity securities (26) (10,697) 5,272Net unrealized cash flow hedging gain (loss) 5,321 (7,318)

Comprehensive Income $ 949,312 $ 445,438 $ 480,055


(dollarsInthousands, exceptpershareamounts)

0Parker Hannifin Corporation annual report 2006


23/48

By Industry 2006 2005 2004

Net Sales:

Industrial:

North America $ 3,993,370 $ 3,516,627 $ 3,016,820

International 2,902,508 2,398,439 1,969,727

Aerospace 1,504,922 1,359,431 1,215,920

Climate & IndustrialControls 985,088 794,308 671,157

Other 13,972

$ 9,385,888 $ 8,068,805 $ 6,887,596

Segment Operating Income:

Industrial:

North America $ 597,204 $ 468,213 $ 290,783

International 353,760 267,207 159,641

Aerospace 221,005 199,187 157,946


Other 741

Total segmentoperating income 1,255,225 1,009,450 680,880

Corporate administration 133,695 111,615 106,108

Income from continuingoperations before interestexpense and other 1,121,530 897,835 574,772

Interest expense 75,763 66,869 73,144

Other expense 145,809 92,695 28,672

Income from continuingoperations beforeincome taxes $ 899,958 $ 738,271 $ 472,956

Identiiable Assets:

Industrial $ 6,153,559 $ 4,713,574 $ 4,277,413

Aerospace 748,213 658,394 634,931


Other 1,741

7,713,990 6,067,609 5,275,233

Corporate (a) 459,442 793,094 919,468

$ 8,173,432 $ 6,860,703 $ 6,194,701

Property Additions (b):

Industrial $ 292,671 $ 196,394 $ 165,983Aerospace 18,827 12,919 9,691


Corporate 24,959 9,900 852

$ 377,916 $ 259,263 $ 189,151

2006 2005 2004

Depreciation:

Industrial $ 196,751 $ 198,247 $ 195,865

Aerospace 20,412 20,777 19,723


Corporate 4,893 6,228 4,843

$ 245,681 $ 245,206 $ 239,106

By Geographic Area(c) 2006 2005 2004

Net Sales:

North America $ 6,219,054 $ 5,455,466 $ 4,714,184

International 3,166,834 2,613,339 2,173,412

$ 9,385,888 $8,068,805 $ 6,887,596

Long-Lived Assets :

North America $ 978,028 $ 1,027,376 $ 1,041,171

International 715,766 553,972 533,817

$ 1,693,794 $ 1,581,348 $ 1,574,988

The accounting policies of the business segments are the same as those described inthe Significant Accounting Policies footnote except that the business segment resultsare prepared on a basis that is consistent with the manner in which the Companysmanagement disaggregates financial information for internal review and decision-making.

(a) Crprate assets are principally cash and cash eqivalents, dmestic deferredincme taxes, investments, benefit plan assets, headqarters facilities, assetsheld fr sale and the majr prtin f the Cmpanys dmestic data prcessineqipment.

(b) Incldes the vale f net plant and eqipment at the date f acqisitin facqired cmpanies accnted fr by the prchase methd (2006 $179,803;2005 $104,358; 2004 $50,860).

(c) Net sales are attribted t cntries based n the lcatin f the sellin nit.Nrth America incldes t he united States, Canada and Mexic. N cntry therthan the united States represents reater than 10% f cnslidated sales. Ln-lived assets are cmprised f plant and eqipment based n physical lcatin.

BusIness segment InformatIon

(dollarsInthousands)


24/48

consolIdated Balance sheet (dollarsInthousands)

June 30, 2006 2005

AssetsCurrent AssetsCash and cash equivalents $ 171,553 $ 336,080

Accounts receivable, less allowance for doubtful accounts(2006 - $12,332; 2005 - $13,160) 1,592,323 1,225,423Inventories (Notes 1 and 6):

Finished products 520,159 451,459Work in process 494,469 426,432Raw materials 168,250 139,154

1,182,878 1,017,045Prepaid expenses 64,238 49,669Deferred income taxes (Notes 1 and 4) 127,986 127,490

Total Current Assets 3,138,978 2,755,707Plant and equipment (Note 1):

Land and land improvements 212,750 183,800Buildings and building equipment 1,116,634 1,021,945Machinery and equipment 2,702,389 2,512,079

Construction in progress 54,594 42,3164,086,367 3,760,140

Less accumulated depreciation 2,392,573 2,178,792

1,693,794 1,581,348Investments and other assets (Note 1) 859,107 831,595Goodwill (Notes 1 and 7) 2,010,458 1,371,024Intangible assets, net (Notes 1 and 7) 471,095 239,891Net assets of discontinued operations (Note 2) 81,138

Total Assets $ 8,173,432 $ 6,860,703

Liabilities and Shareholders EquityCurrent LiabilitiesNotes payable and long-term debt payable within one year (Notes 8 and 9) $ 72,039 $ 31,962

Accounts payable, trade 770,665 569,047

Accrued payrolls and other compensation 297,071 262,976Accrued domestic and foreign taxes 140,387 97,853Other accrued liabilities 400,943 338,986

Total Current Liabilities 1,681,105 1,300,824Long-term debt (Note 9) 1,059,461 938,424Pensions and other postretirement benefits (Note 10) 811,479 1,056,230Deferred income taxes (Notes 1 and 4) 118,544 35,340Other liabilities 261,640 189,738

Total Liabilities 3,932,229 3,520,556

Shareholders Equity(Note 11)Serial preferred stock, $.50 par value, authorized 3,000,000 shares; none issuedCommon stock, $.50 par value, authorized 600,000,000 shares;

issued 120,683,890 shares in 2006 and 120,437,280 shares in 2005 at par value 60,342 60,219

Additional capital 510,869 478,219Retained earnings 3,916,412 3,352,888Unearned compensation related to ESOP (Note 9) (25,809) (36,818)Deferred compensation related to stock options 2,347 2,347

Accumulated other comprehensive (loss) (194,819) (470,964)

4,269,342 3,385,891Common stock in treasury at cost: 368,695 shares in 2006 and 743,767 shares in 2005 (28,139) (45,744)

Total Shareholders Equity 4,241,203 3,340,147

Total Liabilities and Shareholders Equity $ 8,173,432 $ 6,860,703




25/48

FINANCIAL STATEMENTS

consolIdated statementof cash flows (dollarsInthousands)


Cash Flows From Operating Activities (Revis ed Note 1) (Revis ed Note 1)Net income $ 673,167 $ 604,692 $ 345,783

Adjustments to reconcile net income to net cash

provided by operating activities:Net (income) from discontinued operations (34,891) (71,526) (13,698)Depreciation 245,681 245,206 239,106

Amortization 35,290 17,484 10,580Stock-based compensation 33,448Deferred income taxes (50,548) 16,102 (5,572)Foreign currency transaction loss 8,216 9,092 1,846Loss on sale of plant and equipment 5,438 3,870 7,139Loss (gain) on divestiture of businesses 9,858 (11,444)Changes in assets and liabilities, net of effects

from acquisitions and divestitures:Accounts receivable (109,978) (6,540) (139,932)Inventories 17,498 17,083 74,322Prepaid expenses (2,037) (2,736) 10,217Other assets (29,419) (13,607) (74,820)

Accounts payable, trade 56,202 37,611 75,246Accrued payrolls and other compensation 17,783 23,387 29,726Accrued domestic and foreign taxes 70,451 (4,781) 48,318Other accrued liabilities (2,781) (13,999) 60Pensions and other postretirement benefits 9,470 (1,971) 3,558Other liabilities 5,050 4,997 37,089Discontinued operations (3,259) (10,858) 24,874

Net cash provided by operating activities 954,639 853,506 662,398

Cash Flows From Investing ActivitiesAcquisitions (less cash acquired of $42,429 in 2006,

$21,720 in 2005, and $63,691 in 2004) (835,981) (558,569) (200,314)Capital expenditures (198,113) (154,905) (138,291)Proceeds from sale of plant and equipment 41,098 20,284 27,195Proceeds from sale of businesses 92,715 120,000 33,213

Other (20,862) 10,223 9,780Discontinued operations (100) (2,416) (2,055)

Net cash (used in) investing activities (921,243) (565,383) (270,472)

Cash Flows From Financing ActivitiesProceeds from (payments for) common share activity 16,931 (23,724) 56,223(Payments of) notes payable, net (8,262) (16,927) (12,785)Proceeds from long-term borrowings 495,796 1,094 18,962(Payments of) long-term borrowings (589,014) (5,369) (421,605)Dividends paid, net of tax benefit of ESOP shares (109,643) (92,612) (89,286)

Net cash (used in) financing activities (194,192) (137,538) (448,491)Effect of exchange rate changes on cash (3,731) 1,648 (5,438)

Net (decrease) increase in cash and cash equivalents (164,527) 152,233 (62,003)Cash and cash equivalents at beginning of year 336,080 183,847 245,850

Cash and cash equivalents at end of year $ 171,553 $ 336,080 $ 183,847Supplemental Data:

Cash paid during the year for:Interest, net of capitalized interest $ 72,183 $ 66,827 $ 73,433Income taxes 165,180 186,853 96,097



26/48

Note 1. sf a P

The sinificant accntin plicies fllwed in t he preparatin f the accmpanyincnslidated financial statements are smmarized belw.

Nature of operatioNs The Cmpany is a leadin wrldwide fll-line manfactrerf mtin-cntrl prdcts, incldin flid pwer systems, electrmechanical cntrlsand related cmpnents. The Cmpany evalates perfrmance based n sementperatin incme befre Crprate eneral and administrative expenses, Interestexpense and Incme taxes.

The Cmpany perates in t hree bsiness sements: Indstrial, Aerspace andClimate & Indstrial Cntrls. The Indstrial Sement is an areatin fseveral bsiness nits, which manfactre mtin-cntrl and flid pwer systemcmpnents fr bilders and sers f varis types f manfactrin, packain,prcessin, transprtatin, aricltral, cnstrctin, and military vehicles andeqipment. Indstrial Sement prdcts are marketed primarily thrh fieldsales emplyees and independent distribtrs. The Nrth American Indstrialbsiness represents the larest prtin f the Cmpanys manfactrin plantsand distribtin netwrks and primarily services Nrth America. The InternatinalIndstrial peratins prvide Parker prdcts and services t cntries thrhtErpe, Asia Pacific and Latin America.

The Aerspace Sement prdces hydralic, fel and pnematic systems andcmpnents, which are tilized n virtally every dmestic cmmercial, militaryand eneral aviatin aircraft and als perfrms a vital rle in naval vessels and land-based weapns systems. This Sement serves riinal eqipment and maintenance,repair and verhal cstmers wrldwide. Aerspace Sement prdcts are marketedby field sales emplyees and are sld directly t manfactrers and end sers.

The Climate & Indstrial Cntrls Sement manfactres mtin-cntrl systems

and cmpnents fr se primarily in the refrieratin and air cnditinin andtransprtatin indstries. The prdcts in the Climate & Indstrial Cntrls Sementare marketed primarily thrh field sales emplyees and independent distribtrs.

See the table f Bsiness Sement Infrmatin By Indstry and By geraphicArea n pae 21 fr frther disclsre f bsiness sement infrmatin.

There are n individal cstmers t whm sales are three percent r mre f theCmpanys cnslidated sales. De t the diverse rp f cstmers t hrhtthe wrld the Cmpany des nt cnsider itself expsed t any cncentratin fcredit risks.

The Cmpany manfactres and markets its prdcts thrht the wrld. Alt hhcertain risks and ncertainties exist, the diversity and breadth f the Cmpanys

prdcts and eraphic peratins mitiate sinificantly the risk that adversechanes wld materially affect the Cmpanys peratin reslts.

use of estimates The preparatin f financial statements in cnfrmity withaccntin principles enerally accepted in the united States f America reqiresmanaement t make estimates and assmptins that affect t he amnts reprtedin the financial statements and accmpanyin ntes. Actal reslts cld dif fer frmthse estimates.

basis of coNsolidatioN The cnslidated financial statements inclde theaccnts f all dmestic and frein sbsidiaries. All material intercmpanytransactins and prfits have been eliminated in t he cnslidated financial

statements. The Cmpany des nt have ff-balance sheet arranements. Withinthe Bsiness Sement Infrmatin, intersement and interarea sales are recrdedat fair market vale and are immaterial in amnt.

reveNue recoGNitioN Revene is recnized when the risks and rewards fwnership and title t the prdct have transferred t the cstmer. The Cmpanysrevene recnitin plicies are in cmpliance with the SECs Staff AccntinBlletin (SAB) N. 104. Shippin and handlin csts billed t cstmers are incldedin Net sales and the related csts in Cst f sales.

cash Cash eqivalents cnsist f shrt-term hihly liqid investments, with athree-mnth r less matrit y, carried at cst pls accred interest, which are readilycnvertible int cash.

iNveNtories Inventries are stated at the lwer f cst r market. The majrityf dmestic inventries are valed by the last-in, first-t methd and the balancef the Cmpanys inventries are valed by the first-in, first-t methd. EffectiveJly 1, 2005, the Cmpany adpted the prvisins f FASB Statement N. 151,Inventry Csts an amendment f ARB N. 43, Chapter 4. This Statementreqired that certain abnrmal expenses be recnized as crrent-perid chares.The implementatin f this accntin prnncement did nt have a materialeffect n the Cmpanys reslts f peratins, financial psitin r cash flws.

loNG-term coNtracts The Cmpany enters int ln-term cntracts fr theprdctin f aerspace prdcts. Fr f inancial statement prpses, revenes arerecnized sin the percentae-f-cmpletin methd. The extent f prresstward cmpletin is measred sin the nits-f-delivery methd. unbilled cstsn these cntracts are inclded in inventry. Prress payments are netted aainstthe inventry balances. Prvisins fr estimated lsses n ncmpleted cntractsare made in the perid in which sch lsses are determined.

plaNt, equipmeNt aNd depreciatioN Plant and eqipment are recrded at cstand are depreciated principally sin the st raiht-line methd fr financial reprtinprpses. Depreciatin rates are based n estimated sefl lives f the assets,enerally 40 years fr bildins, 15 years fr land imprvements and bildineqipment, seven t 10 years fr machinery and eqipment, and three t fiveyears fr vehicles and f fice eqipment. Imprvements, which extend the sefllife f prpert y, are capitalized, and maintenance and repairs are expensed. Whenprperty is retired r therwise dispsed f, the cst and accmlated depreciatinare remved frm the apprpriate accnts and any ain r lss is inclded incrrent incme.

iNvestmeNts aNd other assets Investments in jint-ventre cmpanies inwhich wnership is 50% r less and in which the Cmpany des nt have peratin

cntrl are stated at cst pls the Cmpanys eqity in ndistribted earnins. Theseinvestments and the related earnins are nt material t t he cnslidated financialstatements. Drin 2005 the Cmpany recrded a chare f $8,766 ($.05 pershare) related t a real estate investment. Investments and ther assets incldea prepaid pensin cst at Jne 30, 2006 and 2005 f $344,987 and $366,675,respectively, and an intanible asset recnized in cnnectin with an additinalminimm pensin liability f $86,071 and $90,310 at Jne 30, 2006 and 2005,respectively.

notes to consoliDateD Financial stateMents



27/48

Goodwill The Cmpany cndcts a frmal impairment test f dwill n anannal basis and between annal tests if an event ccrs r circmstances chanethat wld mre likely than nt redce the fair vale f a reprtin nit belw its

carryin vale.iNtaNGible assets Intanible assets primarily inclde patents, trademarks andcstmer lists and are recrded at cst and amrtized n a straiht-line methd.Patents are amrtized ver t heir remainin leal life. Trademarks are amrtizedver the estimated time perid ver which an ecnmic benefit is expected t bereceived. Cstmer lists are amrtized ver a perid based n histrical cstmerattritin rates.

iNcome taxes Incme taxes are prvided based pn incme fr financial reprt inprpses. Deferred incme taxes arise frm temprary differences in the recnitinf incme and expense fr tax prpses. Tax credits and similar tax incentives areapplied t redce the prvisin fr incme taxes in the year in which the credits arise.

product warraNty In the rdinary crse f bsiness t he Cmpany warrantsits prdcts aainst defect in desin, materials and wrkmanship ver varis timeperids. The warranty accral at Jne 30, 2006 and 2005 is immaterial t t hefinancial psitin f the Cmpany and the chane in t he accral drin 2006 and2005 was immaterial t the Cmpanys reslts f peratins and cash flws.

foreiGN curreNcy traNslatioN Assets and liabilities f mst frein sbsidiariesare translated at crrent exchane rates, and incme and expenses are t ranslatedsin weihted averae exchane rates. The effects f these translatin adjstments,as well as ains and lsses frm certain intercmpany transactins, are reprted inthe Accmlated ther cmprehensive (lss) cmpnent f Sharehlders eqity.Sch adjstments will affect Net incme nly pn sale r liqidatin f thenderlyin frein investments, which is nt cntemplated at this time. Exchaneains and lsses frm transactins in a crrency ther than the lcal crrency f

the entity invlved, and translatin adjstments in cntries with hihly inflatinaryecnmies, are inclded in Net incme.

fiNaNcial iNstrumeNts The Cmpanys financial instrments cnsist primarilyf investments in cash, cash eqivalents and ln-term investments as well asbliatins nder ntes payable and ln-term debt. De t their shrt-term natre,the carryin vales fr Cash and cash eqivalents, Investments and ther assets andNtes payable apprximate fair vale. See Nte 9 fr fair vale f ln-term debt.

The Cmpany enters int frward exchane cntracts (frward cntracts) andcstless cllar cntracts t redce its expsre t flctatins in related freincrrencies. These cntracts are with majr financial institt ins and the risk flss is cnsidered remte. The Cmpany des nt hld r isse derivative financialinstrments fr tradin prpses.

gains r lsses n frward cntracts that hede specific transactins are recnizedin Net incme, ffsettin t he nderlyin frein crrency ains r lsses. gains rlsses n cstless cllar cntract s are recnized in Net incme when the spt ratef the cntract falls tside the cllar rane.

In additin, the Cmpanys frein lcatins in the rdinary crse f bsiness enterint financial arantees thrh financial instittins which enable cstmers t bereimbrsed in the event f nnperfrmance by the Cmpany.

The ttal carryin and fair vale f pen frward exchane and cstless cllarcntracts and any risk t the Cmpany as a reslt f the arranements describedabve is nt material.

stock awards on Jly 1, 2005, the Cmpany adpted the prvisins f FASBStatement N. 123 (revised 2004) and elected t se the mdified prspectivetransitin methd. The mdified prspective transitin methd reqires that

cmpensatin cst be recnized in the financial statements fr all awards rantedafter the date f adptin as well as fr existin awards fr which the reqisiteservice has nt been rendered as f the date f adptin and reqires that prirperids nt be restated. Prir t the adptin f FASB Statement N. 123 (revised2004), the Cmpany sed the intrinsic-vale based methd t accnt fr stckawards and made n chares aainst earnins with respect t awards ranted. Thefllwin table illstrates the effect n net incme and earnins per share as if thefair vale based methd had been applied t all tstandin and nvested stckawards sin the nn-sbstantive vest in perid apprach:

2005 2004

Net income, as reported $ 604,692 $ 345,783

Add: Stock-based employeecompensation included in

reported net income,net of tax 10,139 7,691

Deduct: Total stock-basedemployee compensationexpense determinedunder fair value method,net of tax 28,609 28,300

Pro forma net income $ 586,222 $ 325,174

Earnings per share:Basic: as reported $ 5.09 $ 2.94

pro forma $ 4.93 $ 2.76Diluted: as reported $ 5.02 $ 2.91

pro forma $ 4.87 $ 2.73

receNt accouNtiNG proNouNcemeNt In Jly 2006, the Financial AccntinStandards Bard issed FASB Interpretatin N. 48, Accntin fr uncertaint yin Incme Taxes An Interpretatin f FASB Statement 109 (FIN 48). FIN 48prescribes a cmprehensive mdel fr hw a cmpany shld recnize, measre,present, and disclse in its financial statements ncertain tax psitins t hat thecmpany has taken r expects t take n a tax retrn. FIN 48 is effect ive as fthe beinnin f fiscal years that st art after December 15, 2006. The Cmpanyhas nt yet determined the effect n the Cmpanys financial psitin r resltsf peratins f cmplyin with the prvisins f FIN 48.

reclassificatioNs aNd revisioNs Certain prir perid amnts have beenreclassified t cnfrm t the crrent-year presentatin. In rder t brin theCnslidated Statement f Cash Flws presentatin in cmpliance with FASB

Statement N. 95, the Cmpany revised the Cnslidated Statement f Cash Flwsfr the year ended Jne 30, 2005 and 2004 t separately disclse t he peratin,investin and financin prtins f the cash flws attribtable t discntinedperatins. The Cmpany had previsly reprted these amnts n a cmbinedbasis. The revisin reslted in a decrease in net cash prvided by peratin activitiesf $11 millin and an increase in net cash sed in investin activities f $2 millinfr the year ended Jne 30, 2005. Fr the year ended Jne 30, 2004, the revisinreslted in an increase in net cash prvided by peratin activities f $25 millinand an increase in net cash sed in investin activities f $2 millin.

(dollarsInthousands, exceptpershareamounts )


28/48

Note 2. aq d Dr

acquisitioNs In Ast 2005, the Cmpany acqired SSD, a manfactrer fAC and DC drives, as well as serv drives, mtrs and systems fr leadin riinal

eqipment manfactrers, end sers, and interatrs in atmated indstrial prcessapplicatins. In Nvember 2005, the Cmpany cmpleted it s prchase f dmnickhnter rp, plc. The dmnick hnter rp specializes in t he desin andmanfactre f filtratin, separatin, and prificatin prdcts and technlies fra wide rane f markets. In December 2005, the Cmpany cmpleted it s acqisitinf Kenmre Internatinal, a manfactrer and distribtr f cmpnents fr lbalrefrieratin and air cnditinin markets. Areate annal sales fr these and10 ther bsinesses acqired drin fiscal 2006, fr their mst recent fiscal yearprir t acqisitin, were apprximately $983 millin. Ttal prchase price fr allacqisitins acqired drin fiscal 2006 was apprximately $878 millin in cashand $231 millin in assmed debt.

In octber 2004, the Cmpany cmpleted the acqisitin f t he Sprlan Valve

Cmpany (Sprlan). Sprlan is a manfactrer f refrieratin and air cnditinincmpnents, cntrls and systems. In Nvember 2004, the Cmpany acqired AcadiaElastmers Crpratin, a prdcer f sealin sltins. Annal sales fr thesebsinesses and eiht ther bsinesses acqired drin fiscal 2005, fr their mstrecent fiscal year prir t acqisitin, were apprximately $410 millin. Ttalprchase price fr all bsinesses acqired drin fiscal 2005 was apprximately$580 millin in cash.

In Febrary 2004, the Cmpany cmpleted the acqisitin f Denisn Internatinalplc (Denisn). Denisn is an indstrial manfactrer and ser vice prvider fr hihlyenineered hydralic flid pwer systems and cmpnents. Annal sales fr thisbsiness and fr ther bsinesses acqired drin fiscal 2004, fr their mstrecent fiscal year prir t acqisitin, were apprximately $188 millin. Ttal

prchase price fr all bsinesses acqired drin fiscal 2004 was apprximately$264 millin in cash.

All acqisitins were accnted fr by the prchase methd, and reslts f peratinsfr all acqisitins are inclded as f the respective dates f acqisitin. The prchaseprice allcatin fr acqisitins in 2006, 2005 and 2004 are presented belw. Smef the 2006 prchase price allcatins are preliminary and may reqire sbseqentadjstment.

2006 2005 2004

Assets acquired:

Accounts receivable $ 223,658 $ 51,333 $ 49,556

Inventories 161,434 58,513 51,192

Prepaid expenses 11,561 2,703 2,675

Deferred income taxes 4,780 1,919 (4,462)Plant and equipment 179,803 104,358 50,860

Intangible and other assets 257,062 154,674 54,519

Goodwill 597,205 274,995 78,192

$1,435,503 $648,495 $282,532

2006 2005 2004

Liabilities assumed:

Notes payable $ 1,674 $ 8,819 $ 3,466

Accounts payable 132,733 26,301 12,139

Accrued payrolls 10,954 8,209 8,037

Accrued taxes 10,268 433 4,542

Other accrued liabilities 76,321 15,127 17,593

Long-term debt 229,463 6,415 2,402

Pensions and otherpostretirement benefits 16,833 7,239 18,583

Deferred income taxes 67,644 17,383 11,681

Other liabilities 53,632 3,775

599,522 89,926 82,218

Net assets acquired $835,981 $558,569 $200,314

divestitures In Ast 2005, the Cmpany divested a bsiness nit whichmanfactred cstm-enineered bildins. In December 2004, the Cmpany

divested a bsiness nit which develped and manfactred chemical car careprdcts and maintenance eqipment. These bsinesses were part f the otherSement fr sement reprtin prpses. The fllwin reslts f peratins frthese bsiness nits have been presented as discntined peratins fr all peridspresented:

2006 2005 2004

Net sales $ 21,672 $201,776 $ 219,311

Earnings before income taxes 1,517 24,538 21,112

Net income 1,131 18,979 $ 13,698Gain on disposal,

net of taxes $ 33,760 $ 52,547

The ain n dispsal is net f taxes f $4,602 in 2006 and $16,914 in 2005.

The net assets f discntined peratins as f Jne 30, 2005 primarily cnsistedf $15,605 f accnts receivable, $13,917 f inventry, $72,787 in dwill,$10,569 f plant and eqipment, net, $15,206 f accnts payable, $7,978 faccred taxes and $5,138 f ther liabilities.

In December 2005, the Cmpany cmpleted the divestitre f its Thermplasticsdivisin. In Jne 2004, the Cmpany cmpleted the divestitre f it s Zenith Pmp(Zenith) divisin. Thermplastics and Zenith were part f the Indstrial Sementfr sement reprtin prpses. In Febrary 2004, the Cmpany cmpleted thedivestitre f Wynns Indstrie, an indstrial lbricants nit f the Wynns SpecialtyChemicals bsiness. Wynns Indstrie was part f the other Sement fr sementreprtin prpses. The divestitres reslted in a lss f $11,018 ($9,770 after-taxr $.08 per share) and a ain f $11,070 ($6,223 after-tax r $.05 per share)

in 2006 and 2004, respectively, and are reflected in Lss (ain) n dispsal fassets in the Cnslidated Statement f Incme. The reslts f peratins and netassets f the divested bsinesses were immaterial t the cnslidated reslts fperatins and financial psitin f the Cmpany.

Note 3. chr Rd B Rm

In 2006, the Cmpany recrded a $19,367 chare ($12,042 after-tax r $.10 pershare) fr the csts t strctre its bsinesses in liht f crrent and anticipatedcstmer demand. The Cmpany believes the realinment actins taken willpsitively impact ftre reslts f peratins, bt will have n material effect n


NoTES To CoNSoLIDATED FINANCIAL STATEMENTS


29/48

liqidity and srces and ses f capital. The chare primarily related t severancecsts att ribtable t apprximately 690 emplyees in t he Indstrial Sement, 340emplyees in the Climate & Indstrial Cntrls Sement and 5 emplyees in the

Aerspace Sement. A prtin f the severance csts have been paid with t heremainin payments expected t be made by Jne 30, 2007. of the pre-tax amnt,$15,673 relates t the Indstrial Sement, $3,621 relates t the Climate &Indstrial Cntrls Sement and $73 relates t the Aerspace Sement. The bsinessrealinment csts are presented primarily in the Cst f sales captin in theCnslidated Statement f Incme fr 2006. In 2006, the Cmpany recrded a$4,793 chare resltin frm the pendin sale f plant and eqipment at facilitiesthat have been clsed. This chare is presented in the Lss (ain) n dispsal fassets captin in the Cnslidated Statement f Incme fr 2006.

In 2005, the Cmpany recrded a $14,263 chare ($8,900 after-tax r $.08 pershare) fr the csts t strctre its bsinesses in liht f crrent and anticipatedcstmer demand. The Cmpany be

2006 parker hannifin annual report

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