ITEM 1.
BUSINESS
The Allied Defense Group, Inc. (“Allied” or the “Company”) is a diversified, multinational portfolio of defense and security businesses. Through our two primary segments, Ammunition & Weapons Effects and Electronic Security we specialize in delivering sophisticated defense and security solutions for government and commercial requirements worldwide.
Allied was incorporated as a Delaware corporation in 1961 under the name Allied Research Associates, Inc. Allied changed its corporate name to Allied Research Corporation in 1988 and subsequently changed its name to The Allied Defense Group, Inc. effective January 2, 2003. Allied’s strategic defense and security businesses are conducted through its various subsidiaries: MECAR S.A. (“MECAR”), MECAR USA, Inc. (“MECAR USA”), News/Sports Microwave Rental Inc. (“NSM”), and Global Microwave Systems, Inc. (“GMS”). In late 2003, the Company organized MECAR USA, Inc. (“MECAR USA”). In 2004, Allied Technology, LLC (“Allied Technology”) was formed to coordinate the activities of MECAR USA and Titan Dynamics Systems, Inc. (“Titan”). Allied Technology and Titan were sold on March 17, 2008 herein referred to solely as (“Titan”). The following table summarizes the Company’s significant acquisitions and dispositions:
All amounts are reported in thousands of dollars, except for share data and Item 11 - Executive Compensation.
Description of Business
Allied. Allied, as the parent holding company, provides management, strategic guidance, business development, sales, marketing, export licensing, procurement, logistic support, treasury and government relations services for its subsidiaries. Allied reorganized its operations in 2005, adopting a new management model to increase coordination and synergies between the various operating units. The Company refocused itself on two core competencies - Ammunition and Weapons Effects and Electronic Security. In addition, the Company had an Other segment that included the Seaspace division. In July 2007 and September 2007, the Company sold SeaSpace and The VSK Group, respectively. On October 22, 2007, the Company committed to sell Titan in an effort to focus on its munitions capabilities. The sale of Titan occurred on March 17, 2008. Accordingly, the results of operations, financial position and cash flows of SeaSpace, The VSK Group and Titan, have been reported as discontinued operations for all periods presented. Headquarters expenses are reported separately on the segment reporting schedules.
Ammunition & Weapons Effects Segment
This segment includes the Belgium subsidiary MECAR and the U.S. subsidiary MECAR USA (first became operational in 2005). MECAR and MECAR USA focus on ammunition, light weapons and some pyrotechnic devices. As noted above, Titan is reported as a discontinued operation and has been eliminated from all segment reporting.
MECAR. MECAR designs, develops, manufactures and sells ammunition and light weapons for military use. Substantially all of MECAR’s revenues are derived from the sale of ammunition which is used with weapons that are generally considered defensive weapons. From time to time, MECAR provides system integration services pursuant to which it purchases and resells weapon systems and/or ammunition manufactured by others. MECAR’s products consist of a wide variety of ammunition and grenades in the medium caliber, artillery, anti-tank and anti-material categories. The following are the principal products produced and sold by MECAR:
90mm Ammunition MECAR develops and produces a complete family of 90mm ammunition that includes Armor Piercing Fin Stabilized Discarding Sabot (APFSDS), High Explosive (HE), High Explosive Anti-Tank (HEAT), Smoke (SMK) and High Explosive Squash Head (HESH) rounds for the COCKERILL Mk II and III, ENGESA EC-90, the DEFA and the CN 90 & guns. The 90mm MKVIII KENERGA Weapon System has been jointly developed by Cockerill Mechanical Systems (“CMI”) and MECAR to provide the modern LAV with anti-tank punch similar to that of tanks equipped with 105mm guns, without sacrifice to the range, mobility and maintainability of the light LAV. In this signed strategic alliance, CMI is responsible for the turret and weapon while MECAR is responsible for the ammunition. The ammunition products include the APFSDS, HESH and SMK versions with their corresponding training rounds.
105mm Tank Ammunition MECAR produces an entire range of 105mm tank ammunition. This range includes the APFSDS, HEAT, HESH and SMK, with their corresponding training rounds. Additionally, it has produced specialized short range training rounds for the Belgian Army. In 2003, MECAR, in conjunction with L-3 Communications, won the contract to deliver the 105mm High Explosive Plastic - Tracer (HEP-T) and Training Practice - Tracer (TP-T) rounds to the U.S. Army for the Stryker BCT systems. The rounds have been type classified as the M393A3 and M467A1 respectively.
120mm Tank Ammunition MECAR has entered into a signed strategic alliance to produce a 120mm HEP round for the 120mm smooth-bore tank gun. Based on the highly successful 105mm HEP round, this will provide the same capabilities to defeat a wide variety of material targets to the Abrams and Leopard 2 tanks.
Mortar Ammunition The 120mm family is state of the art ammunition for standard field mortars and for the turreted Armored Mortar System (AMS). The current version of this ammunition has successfully completed qualification with the U.S. Army, together with the 120mm AMS Light Armored Vehicle (LAV) system. This system is capable of direct as well as indirect fire. MECAR has developed and qualified a direct fire fuze for the AMS. The 81mm family of mortar ammunition has been modernized to compete with the latest generation of this product line. A family of 60mm mortar ammunition is under development at this time.
Other Ammunition MECAR has produced 155mm HE, SMK(WP) and Illuminating rounds for various customers. The 25mm APFSDS-T ammunition round is MECAR’s entry into the medium caliber arena. MECAR manufactures HE, CAN, HESH and HESH-PRAC ammunition for the 76mm L23 guns, which are in service with armored vehicles in several countries in Europe, South America, Africa and the Far East. MECAR has developed and manufactured ammunition for the 106mm Recoilless Rifle. MECAR has also developed and manufactured the 84mm SAKR Recoilless Rifle and its associated family of ammunition. The SAKR fills the gap between rifle grenades and the 90mm family of guns and ammunition. The SAKR ammunition (HEAT, HE, SMK, ILL and HEAT-TP-T) is also interoperable with existing 84mm systems.
Grenades MECAR manufactures two types of grenades: the M72 controlled fragmentation hand grenade and the universal bullet trap rifle grenade. The universal bullet trap rifle grenade is designed to be light, effective, accurate and simple to use. It is fitted over the muzzle of any standard military rifle with a muzzle outer diameter of 22mm and fired from the shoulder in the normal manner. MECAR manufactures several different bullet trap grenades including high explosive fragmentation, anti-personnel, armor piercing, smoke generating, white phosphorus, and parachute flare (night illuminating). A new dual-purpose rifle grenade with an electronic dual safety fuse has been developed for a European client. It is in its final stages of production.
ALLIED TECHNOLOGY. Allied Technology was formed to coordinate the activities of MECAR USA and Titan. Allied Technology was sold on March 17, 2008 and has been eliminated from all segment reporting.
MECAR USA. MECAR USA pursues contracts from the U.S. Government and others for ammunition and pyrotechnics devices. MECAR USA became operational in late-2005 following construction of a new facility in Marshall, Texas. More recently, MECAR USA has begun purchasing and selling weapon systems and/or ammunition manufactured by others, in the form of pass through contracts for the benefit of the U.S. government and other foreign governments. MECAR USA is focusing on the 105mm tank ammunition market for the development of its existing manufacturing facilities.
Titan. Titan was previously included in this segment. Titan designs, manufactures and sells an extensive line of battlefield effects simulators. Titan was sold on March 17, 2008 and has been eliminated from all segment reporting.
Electronic Security Segment
This segment includes the operations of NSM and GMS. The Electronic Security (ES) segment provides products in the areas of security systems, surveillance and, electronic data transmission.
NSM. NSM develops sophisticated microwave surveillance systems used in law enforcement, port security, border security, airport security, high-end commercial security, citywide surveillance applications and defense applications. The company is currently providing operations support for U.S. forces in Iraq and Afghanistan. NSM’s products and services are used for gathering, transmitting, receiving and processing multiple signals from remote locations. NSM develops, assembles and sells electronic technology products and systems for users to operate through NSM’s proprietary hardware, software and communication links. NSM’s systems and products include cameras, command/control systems, video concealments, intelligent software, microwave link solutions, radars, and other sensors. NSM offers fixed observation/transmit surveillance installations in addition to mobile command centers and airborne camera/tracking/transmit packages.
Global Microwave Systems. GMS designs and manufactures miniature and sub-miniature FM and digital transmitters, receivers, and related equipment for investigative, surveillance, and security applications, and live TV news/sports/entertainment coverage. GMS’s proprietary products occupy a commanding position within the Federal law enforcement community, and are widely used in organized crime, narcotics, and anti-terrorism investigations and prosecutions. GMS products are currently in use by both U.S. and coalition forces in counter-insurgency and anti-terrorism operations abroad. Because of their sub-miniature size, low power requirements, high fidelity, and long ranges, they have proven ideal for incorporation into the sensor suites of numerous air vehicles, including police and military helicopters and unmanned vehicles. GMS is now selling its proprietary, high definition video link, which has gained wide acceptance in high-profile televised sports applications.
The VSK Group. The VSK Group was previously included in this segment. The VSK Group designs, manufactures, sells and installs security systems for government and private industry. The VSK Group was sold in September 2007 and has been eliminated from all segment reporting.
Other Segment.
This segment consisted solely of SeaSpace that provides products in the area of environmental monitoring. SeaSpace designs, manufactures, distributes and services weather and environmental satellite ground reception systems. SeaSpace was sold in July 2007 and has been eliminated from all segment reporting.
Geographic Areas and Industry Segments
See Note T of Allied’s consolidated financial statements for information concerning the geographic areas and industry segments of Allied. The Company operates in two principal segments: Ammunition & Weapons Effects segment which consists of MECAR and MECAR USA and the Electronic Security segment which consists of NSM and GMS.
Market and Customers
Allied derives the principal portion of its revenue in the Ammunition & Weapons Effects segment from direct and indirect sales to foreign governments and prime contractors, primarily on fixed price contracts. One foreign
government accounted for approximately 41% in 2007 and 42% in 2006, of Allied’s revenue, directly or indirectly, as detailed in Note A to the consolidated financial statements. Commencing in early 2000, MECAR designated a former marketing representative as its independent distributor/value added reseller (“Distributor”) to foreign government customers. The Distributor obtains a contract from the end user customer and subcontracts a portion of the work to MECAR. The products that MECAR produces are sold to the Distributor for resale to the foreign government customers end users. The use of a Distributor for these purposes is not in conflict with European Community or Department of Defense regulations or protocol.
Ammunition & Weapons Effects products are sold either directly or indirectly to the defense departments of governments. MECAR is regulated by Belgian law regarding the foreign governments with which it may do business. The sales by MECAR in any given period and its backlog at any particular time may be significantly influenced by one or a few large orders. An order for MECAR’s products is often for a large quantity and/or a substantial aggregate price, primarily because materials required for the manufacture of the products cannot be economically purchased in small quantities and because of the favorable economies of large volume production. Most of the contracts received by MECAR require delivery in approximately one year. Accordingly, MECAR’s business is dependent upon its ability to obtain such large orders. MECAR frequently accepts smaller orders to increase its customer base and efficiently use its manufacturing capacity.
When MECAR obtains a contract for the sale of its products, it generally receives down payment(s) and/or letter(s) of credit to be applied to the purchase price upon shipment of the products. In such cases, MECAR is generally required to provide advance payment guarantees and performance bonds issued by its banking group pursuant to the terms of the company’s credit facility. MECAR has from time-to-time received foreign military sale (“FMS”) contracts from the U.S. Government for the manufacture of ammunition for the benefit of a foreign government customer. Such contracts may be terminated for convenience by the government or upon default by the manufacturer. The contracts received by MECAR through the FMS system do not require down payments, letters of credit, advance payment guarantees or performance bonds. MECAR completed its last FMS contract in 2005. MECAR USA’s current customers are mainly the U.S government and U.S.-based prime contractors.
In the Electronic Security segment, NSM’s customers include U.S. Government agencies and the Department of Defense, as well as, state and local law enforcement agencies. Contracts from U.S. Government agencies have historically accounted for a majority of NSM’s revenues. GMS sells its products to Law Enforcement markets and integrators in the surveillance, search and rescue, military, TV broadcast and entertainment markets worldwide. The Electronic Security segment is not dependent upon any single large customer for a majority of its revenue.
Principal Customers
MECAR has historically received a large percentage of its revenue from agencies of a foreign government. See Note A to Allied’s consolidated financial statements. MECAR receives contracts for the benefit of these customers via the Distributor and has also received contracts for the benefit of these customers via the FMS program. NSM has historically received the substantial majority of its revenue from agencies of the U.S. Government. GMS receives the substantial majority of its revenue from Government Federal Agency contracts, and from customers who integrate their products in Military UAV/UGV programs and from television broadcasters.
Raw Materials and Suppliers
In the Ammunition & Weapons Effects segment, production of ammunition requires an ample supply of chemicals, pyrotechnic materials, metal component parts and casings. MECAR generally attempts to ensure that several vendors will be available in the open market to compete for all supply contracts. However, once the development phase is complete and the design has been stabilized for certain products, the continued availability of supplies can become critical to its ability to perform on a particular contract. MECAR seeks to protect itself against shortages and similar risks by planning alternative means of production, by producing internally, and by monitoring the availability and sources of supplies. MECAR and MECAR USA depend upon major suppliers to provide a continuous flow of such components and materials where in-house capability does not exist, and has generally found such materials and supplies to be readily available.
In the Electronic Security segment, NSM and GMS rely upon a number of select subcontractors to supply the requisite electronic hardware for its security systems. To date, each entity has found such subcontract materials to be readily available. Both firms outsource the majority of their hardware assembly and manufacturing while maintaining the core design, assembly, integration, engineering and test activities in-house.
Prolonged disruptions in the supply of any of the Company’s raw materials, difficulty completing qualification of new sources of supply, or implementing use of replacement materials or new sources of supply could have a material adverse effect on the Company’s business, financial condition, or results of operations.
Marketing
The marketing activities of the Ammunition & Weapons Effects segment are strategically managed by a business development team with personnel based in both Belgium and the United States dedicated solely to that segment. The day to day marketing activities are handled by MECAR and MECAR USA staff of sales engineers, and executive personnel. For MECAR and MECAR USA, an even greater effort has been made to expand its customer base into new foreign governments in order to mitigate the potential downfalls of relying on a few large customers. MECAR USA currently focuses more of its marketing efforts on procuring finished goods for resale in pass through contracts, based on its limited manufacturing capabilities. In addition, MECAR advertises in trade journals and participates in trade shows. MECAR is also represented by marketing representatives in different markets and has designated a Distributor for indirect sales to its principal end user customer.
Electronic Security (ES) segment markets its products principally through its executive personnel and the sales personnel staff of NSM and GMS and a corporate business development team dedicated to the ES segment. GMS and NSM marketing includes exhibiting at industry trade shows, advertising in industry publications and Internet search advertising. GMS also relies on System Integrators and Original Equipment Manufacturer (OEM) customers for resale of its products. The corporate business development team focuses in five areas: coordinating marketing efforts among the ES segment subsidiaries to reduce overlap and missed opportunities; connect subsidiaries with high level officials in U.S and overseas; arranging demonstrations of the ES segment products throughout the United States to a variety of law enforcement agencies, government agencies and commercial interests; enhancing current marketing materials and developing new materials to attract the attention of the potential customer base; and coordinating the activities of all sales personnel and outside distributors. In late 2007, NSM restructured its marketing team to include a group of independent manufacturer representatives and a sales manager to monitor their activities on a full time basis.
Research and Development
In the Ammunition & Weapons Effects segment, the development of ammunition and weapon systems requires knowledge and experience in aerodynamics, mechanical engineering, chemistry, combustion, materials behavior and ballistics. MECAR maintains an active research and development staff, including a staff of design engineers, in order to determine how materials can be used or combined in new ways to improve performance or to solve new problems. In 2007 and 2006, the Ammunition & Weapons Effects segment expended $1,617, and $2,071, respectively, for research and development activities. MECAR designed most of the products which it currently manufactures. MECAR designs and develops most of its special tooling, fixtures and special explosive loading and testing systems in addition to its munitions.
The Electronic Security business requires continuous investment in research and development to update and enhance its security systems. NSM and GMS employ staffs of design engineers specialized in the field of electronic hardware and software system design. During 2007 and 2006, the Electronic Security segment expended $2,489 and $2,901, respectively, on research and development.
Backlog
As of December 31, 2007 and 2006, Allied had backlog orders, believed to be firm, after giving effect to the percentage of completion method of accounting for its contracts of $110,822 and $42,609, respectively. This backlog is calculated by taking all committed contracts and orders and deducting shipments or revenue recognized pursuant to the percentage of completion method of accounting as applicable. The December 31, 2007 and 2006 backlogs were as follows:
The December 31, 2007 and 2006 amounts do not include unfunded portions of contracts, which are subject to the appropriation or authorization of government funds, of approximately $102,423 and $6,992, respectively, from both the AWE and ES segments. These are contracts or portions of contracts that do not have all of the appropriate approval to be performed on. In most cases, these contracts require a formal budget approval before they can be added to the funded, firm backlog. Of this total funded and unfunded backlog orders, approximately 69% are from our principal customer.
Competition
The munitions business is highly competitive. MECAR has a number of competitors throughout the world, including competitors in the United States. Many of its competitors are substantially larger companies with greater capital resources and broader product lines. Many of its competitors have existing relationships with governments and countries in which MECAR markets its products. For example, many countries will only acquire ammunition and other military items from vendors located in said countries. In many other countries, it is important to have an independent marketing representative. Competition is mainly based upon accessibility to potential markets, technical expertise, quality, capabilities of the product, price and ability to meet delivery schedules. In the United States, the market place is dominated by several large domestic manufacturers that make it difficult for MECAR and MECAR USA to directly compete. In some instances, MECAR and MECAR USA have signed strategic alliance with the larger competitors in order to work with them to develop new niche products. The downsizing of the munitions industrial base has resulted in a reduction in the number of competitors through consolidations and departures from the industry. This has reduced the number of competitors in some programs, but has strengthened the capabilities of some of the remaining competitors. In addition, it is possible that there will be increasing competition from the remaining competitors in business areas in which they do not currently compete.
The nature of the competition encountered by the Electronic Security segment depends upon the sub-segment of the security systems business. In the development and manufacturing area, there are a number of larger competitors, many with greater financial resources. NSM competes with niche suppliers of specialized security products as well as much larger companies with substantially greater financial and other resources. GMS competes with a small number of different manufacturers that operate in its niche markets.
Seasonal Nature of Business
The Company’s business in general is not seasonal, although the summer and winter holiday seasons affect Company revenue because of the impact of holidays and vacations on the Company’s international operations. Our ability to invoice certain customers in the Middle East is restricted in the summer months, which can increase our funding requirement during those periods. Variations in the Company’s business may also occur at the expiration of major contracts until such contracts are renewed or new businesses obtained.
The U.S. Government’s fiscal year ends on September 30 of each year. It is not uncommon for government agencies to award extra tasks or complete other contract actions in the weeks before the end of the fiscal year in order to avoid the loss of un expended fiscal year funds. Moreover, in the years when the U.S. Government does not
complete its budget process before the end of its fiscal year, government operations typically are funded pursuant to a “continuing resolution” that authorizes agencies of the government to continue to operate but traditionally does not authorize spending on new initiatives. When the government operates pursuant to a continuing resolution, delays can occur in procurement of products and services, and such delays can affect the Company’s revenue and profit during the period of delay. In recent years, NSM and GMS have experienced their periods of greatest revenues in the third and fourth calendar quarters.
Personnel
As of December 31, 2007, the Company collectively had 430 employees as follows:
The classification of employees noted above for MECAR is in accordance with Belgian law. MECAR’s hourly workers are represented by a labor union. The Company’s relations with the labor union have been good.
Patents and Trademarks
NSM holds a patent on a mechanical mast that is a key component of certain security systems it supplies to law enforcement agencies. The patent was granted in 1997. None of the other Allied subsidiaries hold significant patents or trademarks.
Environmental Regulations
The Company does not anticipate that compliance with any laws or regulations relating to environmental protection will have a material effect on its capital expenditures, earnings or competitive position, although new environmental regulations continue to go into effect in Belgium which may require some level of expenditure by MECAR in the future. MECAR has accrued approximately $132 at December 31, 2007 for all known expenditures required to be made by the Company at a later date in order to be compliant with current Belgian regulations.
Available Information
Our principal Internet address is www.allieddefensegroup.com. We make available free of charge on www.allieddefensegroup.com our annual, quarterly and current reports, and amendments to those reports, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. In addition, you may request a copy of these filings (excluding exhibits) at no cost by writing or telephoning us at the following address or telephone number:
The Allied Defense Group, Inc.
8000 Towers Crescent Drive, Suite 260
Vienna, Virginia 22182
(703) 847-5268
ITEM 1A.
ITEM 1A.
RISK FACTORS
Not required for a smaller reporting company.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.
PROPERTIES
Allied’s principal executive offices are located in Vienna, Virginia, where it leases approximately 6,400 square feet of office space. The lease expires in February 2013. The following table shows the principal properties of Allied’s subsidiaries as of December 31, 2007:
(1)
MECAR’s principal factory is located approximately 25 miles south of Brussels near Nivelles, Belgium. The factory principally consists of a manufacturing and administrative complex which has been occupied by MECAR since 1989. The manufacturing and the administration facility area is approximately 339,000 square feet. There are a number of older buildings on the property that are still used in conjunction with the new complex. A small test firing range is maintained on this property. MECAR also previously owned 600 acres in the vicinity of the Village of Marche in the Ardennes region of Belgium, which was previously used as a test range. MECAR ceased its use of the Ardennes firing range in 2001, and sold the property at the end of 2005. MECAR is now utilizing other test ranges, including a test range owned by the Belgian Army, although it is also exploring the prospects of securing the use of a new test range. Throughout 2007, MECAR operated using partial shifts. At December 31, 2007, MECAR was operating at approximately 93% of its productive capacity, after being under utilized for the first half of 2007.
(2)
NSM operates from leased office, production and warehouse facilities in Spring Valley, California. In 2004, NSM expanded to a second warehouse facility in close proximity to its original facility providing an additional 10,000 square feet. The original facility is leased on a month to month basis while the additional 10,000 square feet are leased through June 30, 2008. Due to NSM’s successful trend towards outsourcing that will continue in 2008, NSM plans to complete the process of consolidating its operations into one 10,000 square foot building by March 31, 2008. NSM is currently operating at 60% of its productive capacity.
(3)
Global Microwave Systems operates from leased facilities in Carlsbad, CA. The original office lease expired in October 2007 and has been renewed through September 2010. GMS is currently operating at 50% of its productive capacity.
(4)
MECAR USA operates from an office and manufacturing facility in Marshall, Texas, constructed in 2005 with assistance from the local development authority. In addition to the manufacturing facility, MECAR USA has leased 12,500 square feet of warehouse space since 2005 and increased that to 36,000 square feet in 2007. The facilities at MECAR USA have been sized in anticipation of future period revenue growth. MECAR USA is currently operating at 50% of productive capacity. In addition upon disposition, Titan will continue leasing approximately 6,500 of MECAR USA’s square footage on a short-term basis.
The above facilities are considered to be in good operating condition, adequate for present use, and have sufficient plant capacity to meet current and anticipated operating requirements.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
On April 27, 2007, the Company was served notice that Kings Road, one of note holders of the Senior Subordinated Convertible Notes, filed suit in the Southern District of New York seeking payments of the principal amount, redemption premium and accrued and unpaid interest of not less than $16,665. The Company resolved this issue with the note holder on June 19, 2007 in conjunction with the refinancing and additional funding described in
Note K of the consolidated financial statements. On July 5, 2007, the Company received confirmations of the dismissal of the suit by Kings Road.
There are no other material pending legal proceedings, other than ordinary routine litigation incidental to Allied’s business, to which Allied or any of its subsidiaries is a party or to which any of their property is subject.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matter was submitted to a vote of security holders during the fourth quarter of 2007, through the solicitation of proxies or otherwise.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information. Allied’s Common Stock has been listed for trading on the American Stock Exchange (“AMEX”) since September 15, 1992. Its AMEX trading symbol is ADG. Its media listing is under the symbol Allied Defense. The table below shows the high and low sales prices of Allied’s Common Stock during 2007 and 2006 (as reported by AMEX):
Stockholders. The number of holders of record of the Common Stock at December 31, 2007 was 941.
Dividends. There have been no dividends declared or paid by Allied since November 1992. The payment of dividends is within the discretion of Allied’s Board of Directors and any decision to pay dividends in the future will depend upon an evaluation of a number of factors, including earnings, capital requirements, operating and financial condition, and any contractual limitation then in effect. The terms of the senior subordinated convertible notes do not permit the Company to redeem, repurchase, declare or pay any cash dividend or distribution on its capital stock without approval of a majority in interest of the note holders for as long as any of the notes are outstanding. In addition, MECAR’s bank syndicate agreement requires the maintenance by MECAR of minimum financial covenants, which effectively restricts the amount of dividends that might be paid from MECAR’s assets. As of December 31, 2007 and 2006 MECAR was not compliant with those financial covenants, and although a waiver was obtained at December 31, 2006, MECAR is not allowed to remit a dividend based on the terms of its borrowing arrangements with its bank group and a Belgian regional agency.
Equity Compensation Plan Information. The following table provides information as of December 31, 2007 about the Company’s Common Stock that may be issued upon the exercise of options and rights under all of the Company’s existing equity compensation plans as of December 31, 2007, including the 2001 Equity Incentive Plan, the 1997 Incentive Stock Plan and the 1992 Employee Stock Purchase Plan (all of which have been approved by the
Company’s stockholders), as well as rights to acquire shares of the Company’s Common Stock granted to unaffiliated institutional investors.
(1)
Consists of 349,297 warrants issued to purchaser of convertible notes as part of the 2007 Amended Restructuring and 62,296 warrants issued to the financial advisor for the 2006 financing.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
Not required for a smaller reporting company.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (amounts in thousands of dollars, other than share data)
Overview
Allied is a strategic portfolio of defense and security businesses, with presence in worldwide markets, offering both government and commercial customers leading edge products and services. The Company has two main reporting segments, the Ammunition & Weapons Effects (AWE) segment and the Electronic Security (ES) segment. In addition, the Company had a third, Other segment, that solely consisted of the Company’s SeaSpace subsidiary. In July 2007 and September 2007, the Company sold SeaSpace and The VSK Group, respectively. On October 22, 2007, the Company committed to sell Titan to focus on its munitions capabilities. Titan was sold on March 17, 2008. Accordingly, the results of operations, financial position and cash flows of SeaSpace, The VSK Group and Titan, have been reported as discontinued operations for all periods presented and are eliminated from the segment discussion provided below. Headquarters expenses are reported separately on the segment reporting schedules.
The AWE segment provides conventional ammunition and other training devices to the U.S. military and 30 countries worldwide, dealing with defense departments or ministries of defense in US/European Community approved sovereign entities. The ES segment encompasses a wide range of fixed and deployable systems and equipment used to address today’s security and surveillance requirements in the U.S. The ES segment markets its products to governments, law enforcement, and commercial security personnel. In addition to having distinct differences in client base and application of products, the production processes of the segments are distinct. The AWE segment constitutes manufacturing operations while the ES segment is more focused on the assembly, integration, testing and deployment of components manufactured by other suppliers.
•
Ammunition & Weapons Effects segment consists of MECAR, located in Belgium, and MECAR USA, located in Marshall, TX. MECAR develops and produces medium caliber, tank, mortar and other ammunition. MECAR USA became operational in late 2005 and pursues contracts from U.S. and foreign governments for ammunition and pyrotechnics devices with a focus on the 105MM market. More recently, MECAR USA has begun purchasing and selling weapon systems and/or ammunition manufactured by others, in the form of pass through contracts for the benefit of the U.S government and other foreign governments. MECAR and MECAR USA have similar products and services, similar production processes, similar methods to sell and distribute their products and operate in a similar regulatory environment.
•
Electronic Security segment consists of News Sports Microwave (NSM) and Global Microwave Systems (GMS), both located near San Diego, California. NSM designs, manufactures, installs and services industrial
and law enforcement surveillance products and integrated systems for the law enforcement community and agencies of the Department of Homeland Security and the Department of Defense. GMS designs and manufactures miniature and sub-miniature FM and digital transmitters, receivers, and related equipment for investigative, surveillance, and security applications, and live TV news/sports/entertainment coverage.
Allied, the parent Company, provides management, business development and related services to its subsidiaries and has no operating activities.
Liquidity and Capital Resources
As described further below, the Company encountered serious liquidity difficulties in 2006 and 2007. The liquidity position improved markedly in the third and fourth quarters of 2007. The Company expects to have some liquidity challenges in the first half of 2008 as MECAR begins to perform on its increased backlog but anticipates that these challenges will decrease in the second half of 2008 as MECAR begins to receive payment on its first deliveries from its increased backlog. As described below, MECAR continues working on refinancing of its credit facility. Further, the Company will consider its options (including raising additional capital or the disposition of another subsidiary) to be in a position to satisfy a potential “put” of its senior secured convertible notes which may be made in December 2008 or January 2009, as discussed below.
The Company faced serious liquidity challenges in 2007 mainly resulting from the reduction of revenues and significant operating losses at MECAR, the financing costs associated with registration delay penalties and interest premiums paid to the holders of its Convertible Notes, legal and restructuring costs associated with alleged events of default with the convertible note holders and with the issuance of new convertible notes in June and July 2007, operational restructuring activities at MECAR and NSM to reduce the fixed cost base of those operations, and the funding of continuing operating losses at several of the Company’s smaller US-based subsidiaries. The downturn in the MECAR business resulted from lack of replenishment orders from MECAR’s largest customer after the completion of a large multi-year contract in early 2005. In fiscal year 2006 and in the first nine months of 2007, MECAR incurred significant operating losses and used its cash balances and credit facilities to fund these losses.
The Company managed its initial liquidity issues in 2007 through a combination of a restructuring of its convertible notes and sales of certain subsidiaries. In July 2007, MECAR received substantial replenishment contracts from several customers, which required a working capital investment in the second half of 2007. It was followed by additional orders received by MECAR throughout the balance of 2007 and early 2008 and increased orders received by GMS and NSM in the fourth quarter of 2007. The increase in orders resulted in the Company recording net income from continuing operations of $283 for the fourth quarter of 2007.
The Company restructured its convertible notes in June and July 2007. In connection with the restructuring, the note holders withdrew their allegation of events of default and purchased an additional $15,376 of convertible notes. At year end, MECAR obtained an additional loan from a Belgian regional agency. The Company sold each of its SeaSpace and The VSK Group subsidiaries in 2007. SeaSpace generated net proceeds of $674 while the sale of The VSK group generated net proceeds of $21,894, after repayment of $20,816 to the convertible note holders, pursuant to the terms of the convertible notes. As a result of these actions, the Company ended 2007 with unrestricted cash of $21,750.
Outlook for 2008.
MECAR has begun to work on the substantial backlog it accumulated in the second half of 2007. Further, MECAR has obtained substantial additional orders in early 2008, including a multiyear contract for $43,500. As a result, the Company expects to report a profit in 2008. Notwithstanding the healthy cash position at the end of 2007, the Company expects liquidity challenges in 2008 as it executes on its backlog. MECAR expects to make substantial shipments in the second and third quarters of 2008 and payment for these shipments will not be received until the third and fourth quarters of 2008. This situation is also impacted by the status of the MECAR credit facility. Based on the timing of purchases and the building of inventory, cash availability is expected to be at its lowest point in May and August of 2008.
During 2007, as MECAR worked to secure its new long term sales contract and reduce its fixed cost base, the subsidiary was also working on restructuring its credit facility. MECAR has failed to be in compliance with annual covenant requirements for the facility at December 31, 2005, 2006 and 2007 although MECAR did obtain debt waivers for 2005 and 2006. Early in 2007, the Company committed to MECAR’s banking group that it would look to completely refinance the credit facility by March 1, 2008. In the fourth quarter of 2007, the Company faced difficulties refinancing MECAR as a result of a tight credit market, political issues associated with financing ammunition manufacturers in Europe, and the lack of profitable historical results reported by MECAR prior to the fourth quarter of 2007. In January and February of 2008, the banking group notified MECAR that it would hold MECAR to its commitment to refinance the facility in early 2008. The Company has had extensive discussions with MECAR’s banking group in an effort to persuade them to continue to finance MECAR’s operations. A tentative agreement has been reached to extend and expand the credit facility until November 30, 2008. The finalization of the agreement is subject to local government support that will guarantee an additional portion of MECAR’s performance bonds and advance payment guarantees from April through November 2008. This additional guarantee will reduce the required restricted cash balances at MECAR and allow the Company to fund MECAR through it critical working capital expansion period.
The Company’s cash projections for 2008 show that the Company, particularly MECAR, should be able to generate cash from operations in 2008. In order for MECAR to be able to generate this cash, MECAR must secure its credit facility, at least at its current level as described in Note I of the consolidated financial statements. In addition to securing the credit facility, MECAR will require additional cash in the first half of 2008 in order to expand its working capital as it performs on its backlog. In addition, the terms of the senior secured convertible notes, limit the additional secured debt the Company can incur with preference to the convertible notes. At December 31, 2007, the Company had approximately 4,000 of additional availability that could be borrowed against on a secured basis. The Company believes it will be able to finance MECAR’s operations, in addition to the other operations, if the credit facility is secured for remainder of 2008 at the current levels. The Company’s projections show that, if the credit facility is secured until November 30, 2008, the Company should be able to manage through its liquidity issues and repay MECAR’s cash line and debt obligations.
As described in Note K of the consolidated financial statements, the senior secured convertible notes have a put feature that allows the holders to put the notes back to the Company on December 26, 2008 or January 19, 2009. The current principal balance outstanding on these notes is $20,357. The Company is currently evaluating strategic alternatives and may look to sell another of its subsidiaries to ensure it has the funds available to meet this put feature. The put feature requires the holders of the senior convertible notes to provide at least 75 days notice of intent to enforce this feature.
At December 31, 2007, the Company had $21,750 in cash on hand and the MECAR cash credit line had approximately $7,239 of cash availability at year end. For the year ended December 31, 2007, the Company used $20,508 of cash for operating activities from continuing operations. As explained above, the Company does not anticipate using cash at this level in 2008, mainly as a result of the substantial increase in the sales backlog at MECAR. In addition to the operational improvements that are anticipated for 2008, the cash loss in 2007 was negatively impacted by significant cash expenditures that are not recurring in nature and are not projected for 2008. These 2007 expenditures include items such as:
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Registration delay payments and interest premiums paid for failure to register the Company’s common stock associated with the senior convertible notes of $1,200.
•
Financing fees paid in conjunction with additional borrowings of senior convertible notes of $1,000.
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Additional legal costs associated with bondholder issues of $307.
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Cash funding of Subsidiaries that have been divested. SeaSpace Corporation (sold July 2007) and Titan Dynamics Systems, Inc. (sold March 2008) of $1,709.
•
Restructuring consultants and advisors fees of $2,375.
In general, the Company believes, it will be able to successfully find a solution for MECAR’s credit facility and fund operations in 2008 and meet the obligations associated with the potential put on its convertible notes based on
its current backlog, history of performing at a profit when backlog is substantial, the ability to raise capital and the ability to further divest of its subsidiaries. The Company’s independent audit firm has issued an audit opinion that expresses doubt about the Company’s ability to continue as a going concern mainly due to losses from operations and the uncertainty of the Company’s ability to refinance the MECAR credit facility. The Company’s backlog has shown substantial improvement from the prior year, and the profitability of the contracts should permit the Company to generate cash from its operations in 2008. The Company continues to work on a solution for the MECAR credit facility. The major obstacle to finalizing the restructured terms with the existing bank group is the approval of additional local government support related to guarantees for the performance bonds and advance payment guarantees. The Company is requesting that the local government agency guarantee a larger portion of the performance bonds and advance payment guarantees than they currently do, thereby lowering MECAR’s restricted cash requirements and providing more operating cash to MECAR. This agency started providing guarantees on MECAR’s performance bonds and advance payment guarantees on July 1, 2007 as MECAR initially faced its liquidity challenges associated with the receipt of its new substantial sales contract. The local government agency is scheduled to meet in mid-April 2008 to review MECAR’s proposal.
While the Company is looking to secure long-term financing for operations for the remainder of 2008 and 2009, there can be no assurance that:
•
The Company will be successful securing new MECAR financing or restructuring its existing banking group at MECAR.
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The Company will be successful in taking necessary steps to be in a position to satisfy a potential “put” of its senior secured convertible notes which may be made in December 2008 or January 2009.
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The Company will be successful in its restructuring and turnaround efforts at its subsidiaries.
•
The Company will be able to meet the financial debt covenants of its debt instruments.
The Company has less than $100 of firm commitments for capital expenditures outstanding as of December 31, 2007. No additional capital commitments are necessary to support the Company’s 2008 revenue projections. In addition, with the assistance of its investment banker, the Company continues to examine its strategic alternatives.
Results of Operations
Allied had a net loss of $21,278 for the year ended December 31, 2007 as compared to a net loss of $41,097 for the comparable period in 2006. The 2007 results were favorably impacted by a substantial gain on the sale of subsidiaries, particularly the VSK Group, of $29,314, while the 2006 results were negatively impacted by tax expense of $8,891 related to the full valuation allowance recorded against MECAR’s deferred tax assets.
The net loss from continuing operations before income taxes was $43,897 for the year ended December 31, 2007 as compared to $30,039 for the comparable period in 2006. The increased loss from continuing operations before income taxes in 2007 mainly resulted from the following non-recurring expenses:
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increased legal and professional fees at Corporate and MECAR of $2,682 mainly associated with restructuring activities,
•
the write off of debt issue costs associated with the Company’s 2006 financing and 2007 refinancing of $3,456 and,
•
an increase in the loss from the fair value adjustment of the Company’s convertible notes of $8,564 due primarily to the settlement provisions of the Amendment Agreement.
In general, after adjusting for these non-recurring charges, the Company continued to sustain losses at the 2006 level because of reduced revenues. In 2005, MECAR completed a significant multi-year contract with its largest customer and a replenishment contract was not received from the customer until July 2007. Notwithstanding the large orders received by MECAR in July through December 2007, MECAR suffered a substantial decrease in revenue in 2007. Inasmuch as MECAR had virtually no work in early 2007, its revenues in 2007 were only $37,822 compared to $66,002 in 2006. MECAR was able to cut its operating costs in 2007 by keeping the facility idle in the early part of 2007 prior to the receipt of significant new orders. In the quarter ended December 31, 2007, as raw
materials and components were received for MECAR’s new contracts, MECAR ramped up its production and generated revenues of $22,260 and pretax income of $1,187. The Company expects continued improved performance from MECAR throughout 2008.
In July 2007, MECAR announced that it had successfully negotiated several new orders with various clients in Asia, Europe, North America and other export markets, with a total expected value exceeding $170,000 over a three year period. Of the $170,000, the segment had already received firm contracts totaling more than $90,000 for delivery during 2007 and 2008. The Company expects MECAR to receive a second tranche of these contracts of approximately $80,000 in early to mid 2008. In addition in February 2008, the Company announced the award of an additional multi-year contract at MECAR for $43,500. On a consolidated basis, the Company had firm committed backlog of $110,822 and additional unfunded backlog of $102,423 at December 31, 2007.
The Company expects improved performance for MECAR and the other subsidiaries. The Company has engaged consultants at MECAR and NSM to restructure the operations in order to decrease the break-even point at each subsidiary. The Company estimates that the break even point is approximately 55,000 per year in revenue for MECAR while NSM’s break even point is estimated at annual revenue of approximately $10,000. At NSM, the Company has also restructured the subsidiary’s sales and marketing structure for improved effectiveness.
The Company’s results were significantly affected by the foreign exchange impact on the operations of the Company’s Euro-based business units. All Euro-based results of operations were converted at the average 2007 and 2006 exchange rates of 1.3707 and 1.2562, U.S. Dollar to 1 Euro, respectively.
The following table sets forth, for the years ended December 31, 2007 and 2006, certain items from Allied’s consolidated statements of operations expressed as a percentage of revenue.
compared to 2006
Revenue. Allied had revenue of $55,618 for 2007, which was 36% lower than prior year’s revenue The table below shows revenue by segment for the two year period.
The Ammunition & Weapons Effects (AWE) segment revenue for the year ended December 31, 2007 decreased $28,660 (43%) from the prior period due to a lower volume of MECAR contracts in process resulting from a continuing delay in the receipt of new customer orders during the first six months of 2007. MECAR’s ability to produce under the new contracts was also limited in the current period due to the prolonged lead time of inventory purchases for the substantial new contracts. The normal purchasing lead time for many of MECAR’s component parts is four to six months as many of these purchases are from foreign vendors and require export and import licensing to ship. AWE segment revenues for the year ended December 31, 2007 included $37,822 of revenues from MECAR and $781 of revenues from MECAR USA as compared to $66,002 of revenues from MECAR and $1,261 of revenues from MECAR USA in the prior period. The 2007 revenue for MECAR USA was also down from the prior year level as a result of the completion of a major contract in early 2007. Based on a constant 2006 currency exchange rate for the year, the decrease in the year for MECAR would have been $31,340 (47%) as compared to an actual decrease of $28,180 (43%) from 2006 levels.
Revenue for the Electronic Security (ES) segment decreased $2,737 (14%) from prior year 2006 levels. Revenue for the year ended December 31, 2007 included $9,945 of revenue at GMS and $7,070 of revenues at NSM as compared to $7,269 of revenues at GMS and $12,483 of revenues at NSM in the prior period. The revenue for GMS was up by $2,676 for the year ended December 31, 2007 from the prior year as a result of the introduction of a number of new products and applications by GMS in 2007. The decline of $5,413 in NSM revenue was primarily due to a lag in follow-on contracts with NSM’s largest customer, the U.S Army, in the year ended December 31, 2007.
Cost of Sales. Cost of sales (COS) as a percentage of revenue was 90% and 93% in 2007 and 2006, respectively. Gross margins, as a percentage of revenues, were 10% and 7% in 2007 and 2006, respectively. The 3% improvement in the gross margin from 2006 was associated with higher sales volume at GMS in 2007. In general, GMS’ gross margin percentage is traditionally higher than the AWE segment and NSM. As GMS made up a larger portion of the total revenues in 2007, the overall gross margin percentage increased. Overall, COS in 2007 was $31,148 lower than the prior year levels as a result of lower sales activity at MECAR.
Cost of sales for the AWE segment was $41,245 (107% of segment revenue) in 2007 as compared to $72,526 (108% of segment revenue) in 2006. The change in cost of sales for the year ended December 31, 2007 resulted primarily from lower sales activity at MECAR. In 2007, MECAR’s cost of sales exceeded revenues as a result of a low level of revenues on MECAR’s fixed cost structure. MECAR has been effective in temporarily idling much of its workforce through agreements entered into with its labor unions to reduce its fixed cost structure during periods of low sales. The reductions, however, were not at a level low enough to offset the reduced revenues for the year
ended December 31, 2007. Gross loss for the AWE segment was $2,642 (7% of segment revenue) in 2007 as compared to a gross loss of $5,263 (8% of segment revenue) in the prior period. Gross loss for the year ended December 31, 2007 consisted of $1,559 loss from MECAR and $1,083 loss from MECAR USA, as compared to a gross loss of $4,648 from MECAR and $615 from MECAR USA in the prior period. MECAR USA experienced an increase in gross loss as a result of reduced volume and higher manufacturing and fixed cost structure in 2007. In constant U.S Dollars, based on 2006 currency exchange rates, MECAR would have reported a gross loss of $1,320 rather than the reported gross loss of $1,559, which would have been a decrease of $239 in gross loss as a result of exchange rates.
Cost of sales for the ES segment was $8,704 (51% of segment revenue) in 2007 as compared to $8,571 (43% of segment revenue) in 2006. Gross margin for the ES segment was $8,311 (49% of segment revenue) in 2007 as compared to $11,181 (57% of segment revenue) in 2006. Gross margins for the year ended December 31, 2007 consisted of $7,064 from GMS and $1,247 from NSM as compared to the gross margins of $5,338 from GMS and $5,843 from NSM in the prior year. The decline of the ES segment margins in 2007 was a result of a relatively high level of fixed production costs at NSM with lower sales volume. The gross margin on GMS’ products is typically more favorable than NSM’s margins as GMS production is manufacturing of a niche product and less system integration manufacturing than NSM.
Overall, many of the Company’s segments operate within a relatively fixed cost environment. Sales declines on a year to year basis, below these fixed costs levels, can have an unfavorable impact on profitability. The Company is focused on reducing these breakeven points wherever it can - on both a tactical and strategic level. The Company is also investing in business development and sales and marketing programs to ensure sales stay well above break-even levels.
Selling and Administrative Expenses. Selling and Administrative (SA) expenses as a percentage of revenue were 49% and 31% for 2007 and 2006, respectively. SA expenses for the year ended December 31, 2007 increased $726 from the prior year. SA expenses for the year ended December 31, 2007 consisted of $9,454 from the AWE segment, $5,892 from the ES segment and $12,041 from the Corporate segment as compared to expenses of $7,264 from the AWE segment, $7,564 from the ES segment and $11,833 from the Corporate segment in the prior year.
The increase of $2,190 in the AWE segment was due to a higher level of spending in professional services for restructuring of operations in 2007. The increase in the Corporate segment reflected higher restructuring professional costs offset by reduced spending in staffing in the current year. The decrease of $1,672 in the ES segment expense was associated with overall reduced spending, mainly related to staffing, at NSM and GMS in 2007 compared to the prior year.
The Company is focused on reducing administrative costs across all business segments. It is consolidating back office functions within operating segments and is focused on significant reductions in corporate expenses as restructuring consultants are reduced in 2008. The Company does not anticipate recognizing the following nonrecurring expenditures:
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Registration delay payments and interest premiums paid for failure to register common stock associated with senior convertible notes timely of $1,200,
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Financing fees paid in conjunction with additional borrowings of senior convertible notes of $1,000,
•
Additional legal costs associated with bondholder issues of $307 and
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Restructuring consultants and advisors fees of $2,375.
Research and Development. Research and development costs as a percentage of revenue were 7% and 6%, for the years ended 2007 and 2006, respectively. The total expense for research and development was $4,106 in 2007 as compared to $4,972 in 2006. The decrease in spending for 2007 was in line with the Company’s overall cost reductions in 2007.
Interest Income. Interest income as a percentage of revenue for the years ended 2007 and 2006, remained consistent at 1%. Due to lower levels of cash during the first eight months of 2007, interest income for 2007 was
$139 lower than 2006 level. Income earned on interest bearing accounts throughout the Company has been affected by higher interest rates.
Interest expense. Interest expense for the year ended December 31, 2007 was $11,588 as compared to $8,884 in 2006. This 2007 increase was mainly due to a write off of the remaining unamortized debt issue costs of $1,749 from the Initial Notes, the immediate recognition of debt issue costs incurred on the debt restructuring completed in 2007 of $1,707 and a higher interest rate on the refinanced notes, offset by reduced interest expense associated with lower debt levels in late 2007.
Net (Loss) Gain on fair value of senior convertible notes and warrants. The net loss recognized for the year ended December 31, 2007 from the fair value of the convertible notes and warrants was $6,663 as compared to the net gain of $1,901 for the comparable period in 2006. This loss was associated with the calculated fair value of the Notes and warrants as of December 31, 2007 as compared to the calculated fair value of the Notes and warrants for the comparable period in 2006. In June 2007, the Company exchanged the senior subordinated convertible notes that were outstanding for new senior secured convertible notes and common stock. See Note K of the consolidated financial statements for a description of this transaction.
Other - Net. Other-Net for the year ended December 31, 2007 decreased by $2,342 from 2006 levels. This decrease was mostly associated with the Belgium-base operations entering into fewer foreign currency transaction contracts in 2007 as compared to the prior year’s levels. The Company recognized currency exchange loss of $252 in 2007 as compared to currency exchange gains of $1,055 in 2006. This fluctuation is based on the currencies set on MECAR’s long term sales contracts. The receipt of lower income from insurance recoveries and higher penalties of $384 in 2007 had an additional impact on this overall decline in the current year.
Pre-Tax Loss.
Ammunition and Weapons Effects segment incurred a pre-tax loss of $18,545 in 2007 as compared to a pre-tax loss of $18,802 in 2006. The continued losses were associated with the lack of a large high-margin contract and relatively high fixed cost structures in 2007 and 2006 at MECAR.
Electronic Security segment recognized a pre-tax loss of $1,456 in 2007 as compared to a pre-tax loss of $669 in 2006. This increase in pre-tax loss was mainly due to lower sales activity at NSM in 2007 due to a lag in follow-on contracts with NSM’s largest customer, the U.S Army, during the year ended December 31, 2007. The increased loss at NSM was offset by improved profitability at GMS in the current period.
Corporate segment had a pre-tax loss of $23,896 in 2007 as compared to a pre-tax loss of $10,568 in 2006. This increase in loss was attributable to the $6,663 loss recognized on the fair value of the convertible notes and warrants compared to a $1,901 gain recognized in 2006, higher interest expense in 2007 as compared to the prior year and other increased costs associated with the Company’s liquidity challenges in 2007.
Income Taxes-Expense (Benefit). The effective income tax rates in 2007 and 2006 were zero and 39%, respectively. The reduced tax rate for 2007 was associated with a loss recognized in both 2007 and 2006 and a full tax valuation allowance of $24,037 recorded by MECAR and U.S. operations in 2006. These tax valuation allowances were recorded by the Company based on the losses incurred over the past few years for these subsidiaries.
Income (loss) from discontinued operations, net of tax. Income (loss) from discontinued operations consisted of gain on sale of subsidiaries and income (loss) from discontinued operations. SeaSpace and The VSK Group were
sold during 2007 and Titan was sold on March 17, 2008. The income from discontinued operations for the year ended December 31, 2007 was $22,623 as compared to income of $282 in 2006. The current year income included gains recognized from the sale of The VSK Group of $29,314, offset by losses of $4,313 and $3,665 at SeaSpace and Titan, respectively.
Net Loss. The Company incurred a net loss of $21,278 in 2007 as compared to net losses of $41,097 in 2006. This decrease in loss was associated with the gain recognized from the sale of The VSK Group. The net loss from continuing operations was $43,901 in 2007 as compared to $41,379 in 2006.
Backlog. As of December 31, 2007, the Company’s firm committed backlog was $110,822, compared to $42,609 at December 31, 2006. This backlog is calculated by taking all committed contracts and orders and deducting shipments or revenue recognized pursuant to the percentage of completion method of accounting, as applicable. The table below shows the backlog by segment for the two year period.
In addition, the Company had unfunded backlog, subject to an appropriation of governmental funds, of approximately $102,423 and $6,992, at December 31, 2007 and 2006, respectively, from both the AWE and ES segments. These are contracts or portions of contracts that do not have all of the appropriate approvals to be performed on. In most cases, these contracts require a formal budget approval before they can be added to the funded, firm backlog.
The significant increase in 2007 for the AWE segment was attributable to MECAR’s receipt of several new large orders, a total expected value exceeding $170,000 over a three year period, with various clients in Europe, North America and other export markets awarded in July 2007. The 2006 level was substantially lower because of MECAR’s continuing delay in receipt of these orders and the completion of previously awarded contracts, offset by an appreciation of the Euro during the current year. In addition to meeting the ammunition needs of its traditional customers, MECAR has undertaken a customer diversification effort in the past few years, which has contributed to several new orders in 2006 and 2007.
Electronic Security’s lower backlog level at 2007 as compared to the prior period was attributable to a delay at NSM in receipt of new orders from its larger customers, the U.S. Army, offset by a small increase orders at GMS in 2007. In 2006, NSM received significant firm committed orders from the U.S Army, which were mostly completed in late 2006 and early 2007.
Balance Sheet.
The table below provides the summary consolidated balance sheets as of December 31, 2007 and 2006:
All items on the Company’s December 31, 2007 consolidated balance sheet were affected by the increased value of the Euro in 2007. All Euro-based activity was converted at the December 31, 2007 and 2006 closing exchange rates of $1.4729 and $1.3203 U.S. Dollar to 1 Euro, respectively.
Historically, the Company’s cash flow from operations and available credit facilities have provided adequate liquidity and working capital to fund the Company’s operational needs. Working capital, which includes restricted cash, was $18,421 at December 31, 2007 as compared to $13,443 at December 31, 2006. This increase in working capital was primarily a result of repayments made on the senior notes from proceeds received from the sale of VSK and SeaSpace and a reduction of the bank overdraft balance from proceeds of the SOGEPA loan, offset by an increase in accounts payable and accrued liabilities at 12/31/07.
The cash balance, restricted and unrestricted, at December 31, 2007 was $34,802 as compared to $24,798 at December 31, 2006. This increase was mainly attributable to the proceeds received from the sale of SeaSpace and The VSK Group in 2007 of $43,384, offset by the elected redemption by the Company’s senior convertible note holders of approximately $20,816 of the outstanding senior secured convertible notes in 2007 and the cash used in operating activities. Restricted cash balances were $13,052 and $8,401 at December 31, 2007 and 2006, respectively. The restricted cash balance consists mainly of MECAR’s customer deposits of which a portion has been restricted to secure bank issued advance payment guarantees.
Accounts receivable at December 31, 2007 increased by $1,366 from December 31, 2006 primarily from the higher billings at MECAR and GMS during the fourth quarter. Costs and accrued earnings on uncompleted contracts increased by $13,779 from the year ended December 31, 2006 primarily due to the pending shipments of MECAR’s contracts in process in 2007. MECAR had significant orders in process and higher backlog than in prior years as the business negotiated several new orders with various clients in Europe, North America and other export markets in 2007.
Inventories increased from December 31, 2006 by $3,614 due to a build up of work in process for contracts in progress at December 31, 2007 offset by an increase in the reserve for obsolescence of $1,041 due to aging of MECAR’s inventory and no specific plans for the utilization of that inventory. In most years and for most contracts, the Company looks to purchase inventory late in the sales process and close to the receipt of a signed sales contract.
Other current assets decreased by $31,716 from December 31, 2006 due to the sale of SeaSpace and The VSK Group in 2007. In the prior year, these subsidiaries’ assets were considered as assets held for sale. The balance at December 31, 2007 represents the assets of Titan which were sold on March 17, 2008.
Other assets decreased from $48,123 at December 31, 2006 to $43,298 at December 31, 2007. This decline was attributable to the write-off of unamortized debt issued costs of $1,749 from the completed debt restructuring in June 2007 and the recognition of scheduled yearly depreciation and amortization expense of $6,461 offset by approximately $1,916 of capital expenditures in 2007.
The bank overdraft facility declined by $6,463 from December 31, 2006 as a result of partial repayments made in 2007. Accounts payable and accrued liabilities at December 31, 2007 increased by $18,085 from December 31, 2006 as a result of the timing of cash payments at MECAR and the U.S. based operations and the ramp up of contract activity at MECAR. MECAR has had to continue to tightly manage its cash as it renegotiates with its banking group and begins shipping on its new contracts. Customer deposits increased by $6,980, primarily at MECAR, as a result of the receipt of new sales contracts in 2007 of more than $90,000 with delivery required during 2007 and 2008.
Other current liabilities increased by $453 from December 31, 2006 primarily due to unpaid Belgian social security payments of $8,307 offset by a reduction in liabilities held for sale due the sale of SeaSpace and The VSK Group in 2007.
Senior subordinated convertible notes decreased as the notes were refinanced and replaced by senior secured convertible notes. In June 2007, the Company retired the $30,000, face value senior subordinated convertible notes and agreed to pay $1,204 of unpaid interest and penalties. In exchange the Company issued $27,204 of senior secured convertible notes and 1,288,000 shares of the Company’s common stock. The Amended Notes mature on June 26, 2010 and become puttable by the holders after December 26, 2008. In addition, the Company issued $15,376 of senior secured convertible notes to raise additional capital to the same note holders of the $30,000 in conjunction with the exchange transaction in June and July 2007. In July 2007, the Company repaid $867 of principal with the proceeds of the SeaSpace sale. In October 2007, the Company repaid approximately $19,949 of the outstanding notes from the proceeds of The VSK Group sale. See Note K of the consolidated financial statements for a full description of the transactions.
Other long-term liabilities decreased by $1,319 at December 31, 2007 from the prior year level of $15,734. This was mainly associated with the calculated fair value of the warrants as of December 31, 2007 as compared to the calculated fair value of the warrants in 2006.
Stockholders’ equity as of December 31, 2007, was negatively affected by the net loss for 2007. This decrease was offset by a positive performance in the value of the Euro versus the U.S. dollar, which resulted in an increase in accumulated other comprehensive income. The Euro appreciated by approximately 12% from December 31, 2006. Additional paid-in capital increased due to the issuance of common stock from debt restructuring (see Note K of the consolidated financial statements), restricted stock grants and employee stock purchases.
Cash Flows.
The table below provides the summary cash flow data for the periods presented:
Operating Activities. The Company used $18,294 of cash in its operating activities during 2007 as compared to $2,400 of cash used in its operating activities during 2006. The cash used in continuing operations was $20,508 in 2007 as compared to $4,150 in the prior comparable period. Discontinued operations generated $2,214 of cash in the year ended December 31, 2007 as compared to $1,750 generated in the prior period.
The increase in cash used from continuing operations resulted from a $43,897 loss from continuing operations and a reduction in the cash generated from changes in operating assets. The change in operating assets provided $1,658 of cash in 2007 as compared to $21,312 of cash generated in the prior comparable period. The most significant change in operating assets and liabilities was an increase in cash generated by accounts payable and accrued liabilities of $15,137 in 2007, which resulted from cash constraints and holding back of certain vendor payments particularly at MECAR, as compared to $20,503 of cash used for accounts payable and accrued liabilities in 2006. The fluctuation in accounts receivable and cost and accrued earnings on uncompleted contracts utilized cash of $10,412 in the year ended December 31, 2007 as compared to $13,987 of cash generated in the prior period. Due to an increase in 2007 inventory balance, the Company utilized $2,712 of cash in 2007, as compared to $12,470 of generated cash in the prior comparable period of 2006. The Company generated $4,422 of cash from the growth of customer deposits in the current period as compared to $9,471 of cash generated in the prior period. Cash paid for interest was $5,453 and $7,440 for the year ended December 31, 2007 and 2006, respectively. Cash paid for income taxes was $1,036 and $1,780 for the year ended December 31, 2007 and 2006, respectively, which included federal, international and state taxes, mainly related to the discontinued operations of The VSK Group.
Investing Activities. Net cash provided by investing activities increased by $46,572 between the two periods reported. This stemmed from the sale of The VSK Group in September 2007 and SeaSpace in July 2007, which generated net proceeds of $43,384 and reduced capital expenditures at the MECAR USA and MECAR. The Company estimates that it has less than $1,300 of non-firm capital commitments and $100 of firm capital commitments outstanding as of December 31, 2007.
Financing Activities. The Company used $16,044 of cash from its financing activities during the year ended December 31, 2007 compared to $19,942 of generated cash during the same period of 2006. A large portion of the cash generated from financing activities in 2006 was a result of the March 2006 issuance of senior subordinated convertible notes in the amount of $30,000. The decline in cash generated in the current period was related to the repayment of $20,816 of the senior secured convertible notes in conjunction with the sales of SeaSpace and The VSK Group , the reduction of MECAR’s bank overdraft facility by $7,488 and scheduled repayment of long term obligations of $3,350, offset by $15,376 of cash generated from the additional issuance of senior convertible notes and $8,224 of long-term debt issued at MECAR to a Belgian regional agency, SOGEPA, in December 2007. The reduction in MECAR’s bank overdraft facility was based on the timing of payments immediately made prior to December 31, 2007. MECAR will fully use the bank overdraft facility for most of 2008 as working capital requirements increase as MECAR produces under its significant backlog. The financing activities of the operating subsidiaries are more fully explained below.
Effects of Exchange Rate. Due to significant fluctuation in exchange between USD and Euro between December 31, 2007 and 2006 and higher cash balances being maintained in euros, the Company generated $1,429 of cash in current period as compared to $802 of generated cash in the same comparable period of 2006.
Allied. The parent Company continues to operate based on management fees and dividends received from certain subsidiaries and proceeds of divestitures. Allied has made cash infusions in MECAR, NSM, MECAR USA and Titan to support working capital requirements and operating losses in 2007. The parent company plans to use the proceeds of The VSK Group sale to fund operations in 2008. In 2008, Allied mainly will look to fund MECAR on an interim basis as its working capital demands increase. MECAR USA, NSM and GMS are projected to operate without permanent financing from Allied.
MECAR. MECAR continues to operate from internally generated cash, funds provided by its bank facility, financing from capital leases and cash received from Allied and other affiliates. In addition, a loan of approximately $8,837 was provided by a local Belgian regional agency to extend MECAR’s working capital. The bank facility agreement provides (i) lines of credit for tax prepayments and working capital and (ii) a facility for guarantees/bonds to support customer contracts. The financial lending terms and fees are denominated in Euros and the dollar equivalents will fluctuate according to global economic conditions. The bank agreement imposes two financial
covenants requiring MECAR to maintain minimum net worth and working capital levels. As of December 31, 2007 and 2006, MECAR was not in compliance with the facility covenants. The Company has obtained a waiver for the year ending December 31, 2006 and is in discussion with the lenders regarding a waiver for 2007 and a potential refinancing. MECAR’s banking group has been working with the Company to restructure the terms of the facility as MECAR has been restructuring its business to return to profitability. Early in 2007, the Company committed to the banking group that MECAR would refinance its credit facility, no later than March 1, 2008. In January and February of 2008, the banking group notified MECAR that it would hold MECAR to its commitment to refinance the facility in early 2008. The Company has reached a tentative agreement with the lenders for a short term solution as the Company continues to look for alternative financing and generates cash from its backlog position.
Other Subsidiaries. NSM and the MECAR USA operated in 2007 from cash generated from operations and cash infusions by Allied. In 2007, GMS operated from cash generated from operations.
Stock Repurchases. The Company did not repurchase any shares of its common stock in 2007 and does not anticipate repurchasing any shares in 2008.
Future Liquidity. Allied’s initial focus is to secure the restructuring of the MECAR bank facility. As described above, this will likely require assistance from the Belgian local government. Assuming this restructuring is completed, Allied must then take the steps necessary to assure that it can meet a put option of its convertible notes at year-end 2008. As noted above, Allied is considering a sale of another of its subsidiaries to generate sufficient cash for this purpose. Allied’s future liquidity will depend on its ability to generate cash in 2008 based on its significant increase in backlog. On a longer term basis, Allied’s future liquidity will depend on continuing to receive orders at the rate realized in the second half of 2007 from its traditional customers and the success of its efforts to broaden its revenue base.
The Company’s ability to cover its anticipated future operating and capital requirements is dependent upon its continued ability to generate positive cash flow from operations of its subsidiaries, particularly the operations of MECAR, and the Company’s ability to minimize its corporate overhead structure. Over the past two years, the Company has spent a significant amount on audit fees associated with multi-year accounting restatements; consulting and strategic advisor fees used to reduce the fixed operating structure of its subsidiaries, refinance its senior convertible notes and evaluate its strategic alternatives including the sale of its subsidiaries; and increased legal costs associated with the 2007 alleged defaults of its senior convertible notes, their subsequent refinancing and the uncertainty regarding MECAR’s credit facility on a long-term basis.
As described in Note K of the consolidated financial statements, the senior secured convertible notes have a put feature that allows the holders to put the notes back to the Company on December 26, 2008 and January 19, 2009. The put feature requires the holders of the senior convertible notes to provide at least 75 days notice of intent to enforce this feature. The Company will take necessary steps (including raising additional capital or the disposition of another subsidiary) to be in a position to satisfy the potential “put” of its senior secured convertible notes. The Company is currently evaluating strategic alternatives to ensure it has the funds available to meet this put feature.
In 2008, the Company expects to fund its domestic operations and MECAR with cash available at December 31, 2007 and possible additional financing from MECAR’s bank facility. MECAR’s cash flow is expected to be positive in 2008 assuming that it resolves its current financing issues which will enable MECAR to perform on the backlog it has today. In addition to normal operating costs, MECAR may incur additional legal, consulting and financing costs in conjunction with resolving its short-term and long-term financing alternatives. The Company continues to work to reduce the fixed cost structure at MECAR and may incur additional costs to achieve any permanent cost restructuring at MECAR. Additional costs related to a permanent restructuring of MECAR or additional legal and restructuring costs may have to come from the sale of equity by the Company and/or the sale of existing assets.
Off-Balance Sheet Arrangements. As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2007, we are not involved in any material unconsolidated SPE transactions.
MECAR is required to provide performance bonds and advance payment guarantees for certain contracts, which are provided by MECAR’s banking group. MECAR is obligated to repay the bank group any amounts it pays as a result of any demands on the bonds or guarantees.
The Company’s cash balances are held in numerous locations throughout the world, including substantial amounts held outside the U.S. Most of the amounts held outside the U.S. could be repatriated to the U.S., but, under current law, would be subject to federal income taxes, less applicable foreign tax credits. Repatriation of some foreign balances is restricted by local laws. Allied has provided for the U.S. federal tax liability on these amounts for financial statement purposes, except for foreign earnings that are considered indefinitely reinvested outside the U.S.
Recent Accounting Pronouncements. See Note A to the consolidated financial statements for a description of recently issued accounting pronouncements. Allied does not anticipate that any of such pronouncements will have a material impact on its financial results.
Critical Accounting Policies
The Company’s discussion and analysis of its financial condition, results of operations and cash flows are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, sales, and expenses, and related disclosure of contingent assets and liabilities. The Company re-evaluates its estimates on an on-going basis. The Company’s estimates and judgments are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates or judgments under different assumptions or conditions.
The Company believes the following are its critical accounting policies which affect its more significant judgments and estimates used in the preparation of its consolidated financial statements:
•
Revenue recognition via the percentage of completion method
•
Goodwill and intangible asset valuation
•
Inventory reserves and allowance for doubtful accounts
•
Foreign currency translations
•
Derivative Instruments
•
Valuation of deferred income taxes and income tax reserves.
Revenue Recognition via the Percentage of Completion Method. We believe our most critical accounting policies include revenue recognition and cost estimation on fixed price contracts for which we use the percentage of completion method of accounting. The percentage of completion method is used by MECAR and NSM for substantially all of their fixed price sales contracts. Approximately 81% and 92% of consolidated revenue was recognized under the percentage of completion method during 2007 and 2006, respectively.
Under the percentage of completion method, revenue is recognized on these contracts as work progresses during the period, using the percentage of direct labor incurred to total estimated direct labor (MECAR) or on a total cost incurred to total estimated cost basis (NSM). Management reviews these estimates as work progresses and the effect of any change in cost estimates is reflected in the calculation of the expected margin and the percent complete. If the contract is projected to create a loss, the entire estimated loss is charged to operations in the period such loss first becomes known.
Accounting for the profit on a contract requires (1) the total contract value, (2) the estimated total direct labor cost to complete which is equal to the sum of the actual incurred labor costs to date on the contract and the estimated labor costs to complete the contract’s scope of work, (and/or the actual total cost to date on the contract and the total estimated cost to complete the contracts scope of work), and (3) the measurement of progress towards completion. The estimated profit or loss on a contract is equal to the difference between the contract value and the estimated total cost at completion. Adjustments to original estimates are often required as work progresses under a contract, as experience is gained and as more information is obtained, even though the scope of work required under the contract
may not change, or if contract modifications occur. A number of internal and external factors affect our cost of sales estimates, including labor rates and efficiency variances and testing requirements. While we believe that the systems and procedures used by the subsidiaries, coupled with the experience of their management teams, provide a sound basis for our estimates, actual results will differ from management’s estimates. The complexity of the estimation process and issues related to the assumptions, risks and uncertainties inherent with the application of the percentage of completion method affect the amounts reported in our financial statements.
Revenue on contracts that do not qualify for the percentage of completion method is taken on a shipment basis, usually FOB shipping point.
Goodwill and intangible asset valuation. The Company adopted FASB No. 141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible Assets on accounting for business combinations and goodwill as of the beginning of fiscal year 2002. Accordingly, the Company no longer amortizes goodwill from acquisitions, but continues to amortize other acquisition-related intangibles with definitive lives and other costs. As of December 31, 2007, the Company had $9,932 of goodwill recorded in Other Assets on the consolidated balance sheet. In conjunction with the implementation of the accounting rules for goodwill, the Company completed a goodwill impairment analysis in the fourth quarter of 2007 and determined that no impairment charge to earnings was required. As required by SFAS No. 142, the Company will perform a similar review each year or earlier if indicators of potential impairment exist. The impairment review is based on a discounted cash flow approach that uses estimates of future cash flows discounted at the Company’s weighted average cost of capital and a market capitalization approach. The estimates used are consistent with the plans and estimates that the Company uses to manage the underlying businesses. If market conditions in these business units fail to meet expectations, it could negatively impact revenue or cost, and could result in charges for the impairment of goodwill in future periods.
For intangible assets with definitive lives, the Company amortizes the cost over the estimated useful life and assesses any impairment by estimating the future cash flow from the associated asset. As of December 31, 2007, the Company had $7,737 of gross intangible assets with definitive lives, which includes developed technologies, patents, customer lists, trademarks, etc. If the estimated undiscounted cash flow related to these assets decreases in the future or the useful life is shorter than originally estimated, the Company may incur charges to reflect the impairment of these assets. Impairment could also result if the underlying technology fails to gain market acceptance, if the products fail to gain expected market acceptance or if the market conditions in the related businesses are unfavorable pursuant to SFAS 144. For intangible assets with indefinite lives the Company performs an impairment evaluation in accordance with FAS 142. At December 31, 2007 the Company had $3,220 of intangible assets with indefinite lives.
Inventory reserves and allowance for doubtful accounts. Inventories are stated at the lower of cost or market. Cost is determined based on the weighted average cost method. The Company’s inventory includes raw materials, work-in process and finished goods of $24,706 as of December 31, 2007. The Company reviews its recorded inventory and estimates a write-down for obsolete or slow-moving items to their net realizable value. The write-down is based on current and forecasted demand and the age of the item, and therefore, if actual demand and market conditions are less favorable than those projected by management, additional write-downs may be required. Allowances for doubtful accounts are evaluated based upon detailed analysis and assessment of receivables that may not be collected in the normal course of operations. Some of our customers share the same weapons platforms. For these customers, MECAR, at times, produces inventory in anticipation of receiving signed contracts for their manufacture. This inventory, while designated for a particular contract, can be used to fulfill other contracts as long as the customer uses the same weapons platform. At times the Company may have inventory in excess of the amount designated in a signed contract. The Company feels that this inventory is still viable as it is able to sell it to other customers that share the same platforms.
Foreign Currency Translation. The assets and liabilities of ARC Europe and subsidiaries including MECAR and ARC Limited are translated into U.S. dollars at year-end exchange rates. The resulting translation gains and losses are accumulated in a separate component of stockholders’ equity. In years with greater currency fluctuation, the impact on the apparent change for the same line item (e.g. Property, Plant & Equipment) would appear more significant than if all assets or liabilities were held in the same functional currency (e.g. US Dollars). As of December 31, 2007, 83% of all Company assets are located in Belgium, making the Company sensitive to year-to-
year fluctuations in currency, particularly the Euro. Income and expense items are converted into U.S. dollars at average rates of exchange prevailing during the year. Foreign currency transaction gains and losses are credited or charged directly to operations. For 2007, revenue from Belgium represented 68% of the total revenue for the Company. The Company recognizes the significance of foreign subsidiary operations on reported financial results thus making this a critical accounting policy.
Derivative Instruments. The Company designates its derivatives based upon the criteria established by Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS 133, as amended by SFAS 138 and SFAS 149, requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The accounting for the changes in the fair value of the derivative depends on the intended use of the derivative and the resulting designation. The Company no longer utilizes derivatives that are designated as fair value or cash flow hedges. Therefore, changes in fair value of the Company’s derivatives are recognized currently in net income. The Company believes that derivative accounting is critical to its estimates and financial reporting. Pursuant to SFAS 133, hedge accounting and the subsequent restatements related to non-hedge accounting have been material to the Company’s financial results and thereby represent a significant policy to the Company. The Company believes hedge accounting provides financial results that better describe the underlying economics of the Company’s transactions rather than the results reported under non-hedge accounting.
Valuation of deferred income taxes. The Company is subject to taxation by federal, state and international jurisdictions. The Company’s annual provision for income taxes and the determination of the resulting deferred tax assets and liabilities involve a significant amount of management judgment and are based on the best information available at the time. The Company believes that it has recorded adequate liabilities and reviews those balances on a quarterly basis. Judgment is also applied in determining whether deferred tax assets will be realized in full or in part. When it is more likely than not that all or some portion of specific deferred tax assets such as foreign tax credit carryovers will not be realized, a valuation allowance is established for the amount of the deferred tax assets that are determined not to be realizable. Currently, the Company has full valuation allowances recorded for all deferred tax assets based mainly on the substantial losses incurred over the past three years. The Company will continue to evaluate the adequacy of these valuation allowance on a quarterly basis as MECAR performs on its substantial backlog.
Forward-Looking Statements
This Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements that are based on current expectations, estimates and projections about the Company and the industries in which it operates. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecast in such forward-looking statements. The Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not required for a smaller reporting company.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary financial information and data required by this Item are set forth in the pages indicated in Item 15(a) (1) and (2). See Note U of the consolidated financial statements for supplementary quarterly financial data required by this item.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
There were no disagreements on any matter of accounting principles, financial statement disclosure or auditing scope or procedure to be reported under this item. BDO Seidman, LLP was the Company’s independent accountants for both 2007 and 2006.
ITEM 9A
ITEM 9A (T).
CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Under the direction and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company carried out an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Exchange Act Rule 13a-15 as of the end of the period covered by the report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective as of December 31, 2007.
Management’s Report on Internal Control over Financial Reporting
The management of The Allied Defense Group, Inc. is responsible for establishing and maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. The Company’s internal control system was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2007. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. Based on our assessment we believe that, as of December 31, 2007, the Company’s internal control over financial reporting was effective based on those criteria. During the year ended December 31, 2007, the Company implemented changes, as described below, related to the remediation of previously disclosed material weaknesses in internal control over financial reporting. We have concluded that our remediation efforts have effectively addressed our previously disclosed material weaknesses relating to contract accounting at our Belgian subsidiary, MECAR SA, and our financial reporting process.
Changes in Internal Control Over Financial Reporting
Changes were made during the fiscal year and fourth quarter ended December 31, 2007, in the Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15) that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. These changes, as described below were made to implement policies and procedures to remediate material weaknesses identified in the prior year and to improve internal controls. During the Company’s year ended December 31, 2006 assessment, the Company identified two material weaknesses in our internal control over financial reporting. The first material weakness concerned accounting for contract costs at our Belgian subsidiary, MECAR SA. MECAR SA did not maintain an accurate contract accounting cost ledger. The second material weakness related to the Company’s inadequate financial reporting process. The Company’s third quarter 2006 restatement as well as the Company’s general consolidation and reporting processes were not adequate to meet the needs of the public reporting requirements during 2006.
In response to the material weaknesses in internal control over financial reporting described above, management implemented the following controls and procedures to remediate those material weaknesses: (1) Contract Accounting: We have implemented effective new processes and procedures for documenting and accounting for contract costs. In 2006, we upgraded our MRP SAP system at MECAR and have continued to develop procedures to ensure the accuracy and timeliness of the information and transactions that are processed in the system. In addition,
the Company has added detailed substantive internal audit procedures performed by a third party consultant to review the contract cost ledger on a quarterly basis; (2) Financial Reporting Process: We have put in place tighter controls to ensure consistency and transparency in subsidiary reporting which should enable us to provide timely and accurate consolidated financial results. We have put in place a monthly accounting review process with each subsidiary’s management to review both the results of their operations and their current accounting policies and have created a more comprehensive and formalized periodic reporting to the corporate offices from the subsidiaries.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
There was no information required to be disclosed in a report on Form 8-K during the fourth quarter of 2007 which was not so disclosed.
PART III
ITEM 10.
ITEM 10.
DIRECTORS EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The following are the directors of Allied:
J. H. Binford Peay, III, (General (Ret.)), age 68, became a director in April 2000 and was elected Chairman of the Board, President and Chief Executive Officer in January, 2001. General Peay resigned as President and Chief Executive Officer of the Company as of June 1, 2003 to become Superintendent of the Virginia Military Institute. He remains as Chairman of the Board. General Peay retired in 1997 as Commander in Chief, United States Central Command, with responsibility for operations in some 20 countries throughout Africa, the Middle East, Persian Gulf and South Asia. Previously, he was Vice Chief of Staff, U.S. Army. General Peay is currently a director of BAE Systems, Inc., a subsidiary of BAE Systems, plc an international defense aerospace company.
John G. Meyer, Jr., (Major General (Ret)), age 64, became a director in January 2003 when he was also elected as President of the Company. He served as Executive Vice President and Chief Operating Officer since January, 2001. He succeeded General Peay as the CEO on June 1, 2003 and served in that position until June 2005. From June 2005 through August 2007, he served as Chief Executive Officer of Heckler & Koch, a defense contractor. Mr. Meyer is currently a private investor. Mr. Meyer previously retired from the U.S. Army having served as its most senior Public Affairs Officer during his last four years of military service.
Ronald H. Griffith, (General (Ret.)), age 69, became a director of Allied in April 2000. Mr. Griffith is Executive Vice President and Chief Operating Officer of MPRI, Inc., a professional services company, since 1998. Formerly, he served as Vice Chief of Staff of the U.S. Army.
Gilbert F. Decker, age 71, became a director of Allied in June 2002. Mr. Decker is a consultant to companies in the defense and aerospace industries. He previously served as Executive Vice President of Engineering and Production at Walt Disney Imagineering as well as previously serving as Assistant Secretary of the Army for Research, Development and Acquisitions. Mr. Decker is currently on the board of directors of Digital Fusion Corporation and CoVant Technologies, Ltd.
John J. Marcello, (Major General (Ret.)), age 60, became a director in June 2006 and was elected President and Chief Executive Officer since June 2005. He previously served as Chief Operating Officer and then Managing Director of MECAR S.A. from November 2002 to May 2005. Mr. Marcello retired from the U.S. Army as a Major General in 2002.
Charles S. Ream, age 64, became a director in June 2006. Mr. Ream served as Executive Vice President and Chief Financial Officer of Anteon International Corporation from 2003-2006. Previously, he served as Senior Vice President and Chief Financial Officer of Newport News Shipbuilding, Inc. from 2000-2001 and Senior Vice President of Finance and Strategic Initiatives of Raytheon Systems Company from 1998-2000. Mr. Ream is also a director of Dyncorp International as well as a director of Stanley, Inc.
Frederick G. Wasserman, age 53, is a self-employed financial consultant. Previously, he served as Chief Operating/Financial Officer of Mitchell & Ness Nostalgia Company, a manufacturer of licensed sportswear,
from 2005 through 2006, as President of Goebel of North America, a manufacturer of select giftware and home décor items, from 2002 to 2005, and as Chief Financial Officer of Goebel of North America from 2001 and 2005. Mr. Wasserman is also on the board of directors of Acme Communications, Inc., AfterSoft Group, Inc., Crown Crafts, Inc., TeamStaff, Inc., Breeze Eastern Corporation, and Gilman and Ciocia, Inc. At the request of Wynnefield Capital Management LLC, Frederick G. Wasserman was elected to the Board.
Tassos Recachinas, age 24, has served as a Senior Investment Analyst with Pirate Capital LLC, where he has been employed since January 2007. Prior to that, he was an Equity Research Associate at Raymond James & Associates from 2005 to 2006, where he provided equity research coverage on several Defense and Technology equity securities. Mr. Recachinas attended the George Washington University from 2001 to 2005, where he graduated Summa Cum Laude studying mechanical/aerospace engineering. Mr. Recachinas also attended Oxford University in England, from 2003 to 2004, where he studied engineering and economics. At the request of Pirate Capital, LLC, the Board of Directors has elected Tassos Recachinas to the Board.
The Audit Committee is currently comprised of Messrs. Decker, Ream and Wasserman. Among its functions, the Audit Committee (i) recommends the selection of the Company’s independent public accountants, (ii) reviews the scope of the independent public accountants’ audit activity, (iii) reviews the financial statements which are the subject of the independent public accountants’ certification, and (iv) reviews the adequacy of the Company’s basic accounting and internal control systems. Each of the Audit Committee members satisfies the independence requirements and other established criteria of the AMEX and the Securities and Exchange Commission. The Board of Directors has determined that each of Gilbert F. Decker, Charles S. Ream, and Frederick G. Wasserman qualify as an “audit committee financial expert” as defined under applicable Securities and Exchange Commission rules and is financially sophisticated as defined by AMEX rules.
All directors were elected/re-elected to the Board based on the shareholders votes received on January 22, 2008.
Executive Officers
The following are the executive officers of Allied:
Mr. Marcello is the President and Chief Executive Officer of Allied.
Monte L. Pickens, age 62, was elected Executive Vice President and Chief Operating Officer in May 2003. Previously, Mr. Pickens was the Vice President of T. Marzetti Company. Mr. Pickens retired from the U.S. Army as a Colonel.
Deborah F. Ricci, age 43, was elected as the Chief Financial Officer on April 6, 2007. Ms. Ricci was promoted from her position as Controller and Corporate Secretary, which she has held since early 2006. Ms. Ricci has extensive experience as a financial executive, including serving as Chief Financial Officer of Hemagen Diagnostics, Vice President of Finance and Administration of Schondstedt Instrument Company, and Chief Financial Officer and Vice President of J.E. Morgan Knitting Mills.
Wayne F. Hosking, Jr., age 42, was elected Vice President for Corporate Strategic Development in April 2004. Previously, Mr. Hosking served as Vice President of Sales for Horne Engineering Services, Inc.
Allied has adopted a code of business conduct and ethics for directors, officers (including Allied’s principal executive officer, principal operating officer, principal financial officer and controller) and employees. The code of ethics is available on the Company’s website at http://www.allieddefensegroup.com. Stockholders may request a free copy of the code of ethics from:
Allied Defense Group, Inc.
8000 Towers Crescent Drive, Suite 260
Vienna, Virginia 22182
(703) 847-5268
Attn: Investor Relations
There have been no material changes to the procedures by which the Company’s shareholders may recommend nominees to the Company’s Board of Directors.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
(1)
The amounts in this column reflect the expense recognized for financial statement reporting purposes for the year ended December 31, 2007, in accordance with FAS 123(R), from stock awards and restricted stock grants made under the 2001 Equity Incentive Plan during and prior to 2006; and the portion paid by Allied (15%) for stock purchases made through the 1992 Employee Stock Purchase Plan (ESPP) during 2007 and 2006. Assumptions used in the calculation of these amounts are included in Footnote A to the Company’s audited financial statements included in this Form 10-K.
(2)
The amounts in this column reflect the expense recognized for financial statement reporting purposes for the year ended December 31, 2007 and 2006, in accordance with FAS 123(R), of option grants made under the 2001 Equity Incentive Plan during and prior to 2006. Assumptions used in the calculation of these amounts are included in Footnote A to the Company’s audited financial statements included in this Form 10-K
(3)
This column includes the contribution to a participant’s 401(K) plan account equal to 10% of an employee’s base salary. In 2007, this column includes $88,152 tax payment due to Belgium for Mr. Marcello based on income earned by Mr. Marcello in Belgium in the year 2005. For Mr. Marcello and Mr. Pickens this column also includes a payment of $4,000 each for premiums for life insurance policies.
OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END
AS OF DECEMBER 31, 2007
(1)
Options vest equally (8,000 annually) on January 1, 2008 and 2009.
(2)
Options vest on January 1, 2008.
(3)
Based on closing price of common stock at December 31, 2007 of $5.77 per share.
POTENTIAL PAYMENTS UPON TERMINATION OF CHANGE OF CONTROL
The Company has an employment agreement with each of our named executive officers which provides for severance compensation to be paid if employment is terminated following certain triggering events.
In the event of any termination within twelve (12) months following a change of control, the named executive officers will be entitled to the following severance payments:
Both John J. Marcello and Monte L. Pickens would receive a lump sum payment equal to the sum of two (2) times base salary at time of termination plus two (2) times average annual bonus earned during the three (3) most recent years. At December 31, 2007, this would have resulted in severance payments of $656,000 and $539,000 to Messrs. Marcello and Pickens, respectively. In addition, each named executive officer would be entitled to continue to receive medical, dental, vision, life, short and long-term disability insurance coverage, business travel accident insurance, flexible spending account and employee assistance program participation and the 401(k) benefit for two (2) years. Mr. Pickens is also entitled to receive two (2) years of long-term care insurance.
Wayne Hosking - Lump sum payment equal to one (1) times base salary at time of termination plus one (1) times average annual bonus earned during the three (3) most recent years. At December 31, 2007, this would have resulted in severance payments of $240,000 for Mr. Hosking. In addition, named executive officer would be entitled to continue to receive medical, dental, vision, life, short and long-term disability insurance coverage, business travel accident insurance, flexible spending account and employee assistance program participation and the 401(k) benefit for one (1) year. Mr. Hosking is also entitled to receive one (1) year of long-term care insurance.
In the event of any termination initiated by the Company without cause or initiated by the named executive officer following a material adverse alteration or diminution in the nature of his status or authority, a reduction in his title or a reduction in his base salary, the named executive officers would be entitled to the following severance payments:
Both John J. Marcello and Monte L. Pickens would receive a lump sum payment equal to the sum of one (1) times base salary at the time of termination plus one (1) times average annual bonus earned during the three (3) most recent years. At December 31, 2007, this would have resulted in severance payments of $328,000 and $269,000, respectively. In addition, each named executive officer would be entitled to continue to receive medical, dental, vision, life, short and long-term disability insurance coverage, business travel accident insurance, flexible spending account and employee assistance program participation and the 401(k) benefit for one (1) year. Mr. Pickens is also entitled to receive one (1) year of long-term care insurance.
Wayne Hosking - Payments of base salary at the time of termination for a one (1) year period plus one (1) times average annual bonus earned during the three (3) most recent years. At December 31, 2007, this would have resulted in severance payments of $240,000 for Mr. Hosking. In addition, named executive officer would be entitled to continue to receive medical, dental, vision, life, short and long-term disability insurance coverage, business travel accident insurance, flexible spending account and employee assistance program participation and the 401(k) benefit for one (1) year. Mr. Hosking is also entitled to receive one (1) year of long-term care insurance.
We also have restricted stock and stock option agreements with our named executive officers which provide for accelerated vesting in the event of a termination of employment within twelve (12) months following a change of control, in the event of a termination of employment initiated by the Company “without cause”, or in the event of a termination of employment initiated by the executive as described above. As of December 31, 2007, these provisions would have resulted in the following acceleration of vesting:
John J. Marcello - 8,000 shares of restricted stock
Monte L. Pickens - Options for 16,000 shares of stock
Wayne Hosking - Options for 8,000 shares of stock and 250 shares of restricted stock
COMPENSATION OF DIRECTORS
Each director is compensated for service at the annual rate of $24,000 in cash and $36,000 in Allied stock. The directors are allowed to defer receipt of the cash and/or the Allied stock until they retire from the Allied board. As Chairman of the Board, General Peay received the same cash and stock-based compensation as paid to non-employee members of the Board of Directors plus (i) an additional $1,000 per month and (ii) reimbursement of annual premiums paid on a $1 million life insurance policy, together with all applicable income taxes. The Company also reimburses directors for out-of-pocket expenses incurred in connection with their service.
DIRECTOR COMPENSATION
(1)
Mr. Marcello, Chief Executive Officer, does not receive additional compensation as a director. All of his compensation is reported in the Summary Compensation Table.
(2)
Mr. Meyer and Mr. Decker have elected to defer their cash and stock compensation received as directors until they cease to serve on the Board.
(3)
Cumulative stock compensation for each of the above as a non-employee member of the Company’s Board of Directors are as follows: Mr. Peay, 10,882 shares; Mr. Meyer, 7,879 shares with 6,318 deferred; Mr. Griffith, 13,882 shares; Mr. Decker, 11,882 shares with 9,882 deferred; Mr. Ream, 6,318 shares. Mr. Hudson, 4,681 shares and Mr. Wasserman, 4,681 shares as of July 1, 2007.
(4)
Cumulative option compensation for each of the above as a non-employee member of the Company’s Board of Directors are as follows: Mr. Peay, 6,500 options; Mr. Griffith, 6,500 options; and Mr. Decker, 6,500 options Messrs. Meyer, Ream, Hudson and Wasserman were not members of the Board in 2003, the last year that options were granted for service.
(5)
In 1992, the Board of Directors adopted the Outside Directors Retirement Plan (the “Directors Retirement Plan”) to provide retirement benefits for long-standing non-employee directors (“Outside Directors”). Under the Directors Retirement Plan, Outside Directors are eligible for a retirement benefit if they retire from the Board and have served as a member of the Board for a minimum of five (5) years. An eligible Outside Director who retires from the Board is entitled to receive, commencing on the last day of the first month following the month in which the director attains age seventy (70), monthly payments equal to the monthly cash compensation received from Allied at the time the director terminated service in such capacity. Such payments will cease upon the earlier of the expiration of a period of time equivalent to the period of time the director served as a member of the Board or the death of the director. The Directors Retirement Plan was suspended in 2001. Messrs. Christ and Warner ceased to serve as members of the Board as of February 15, 2007. In accordance with the agreements reached with the Company upon the 2001 suspension of the Directors Retirement Plan, (i) Mr. Warner has received 3,278 shares of Allied stock, and (ii) Mr. Christ will receive monthly cash benefits commencing when he reaches the age 70 (starting in 2017), which could aggregate to a maximum of $136,000. No further benefits have accrued or will accrue under the plan since its suspension in 2001.
(6)
This is the annual payment for a $1 million life insurance policy including the gross-up for taxes.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table sets forth information with respect to the shares of the Company’s common stock which are held by the only persons known to the Company to be the beneficial owners of more than 5% of such common stock based upon the most recent filings made by the undersigned with the Securities and Exchange Commission:
(1)
Based upon 8,013,161 shares of common stock outstanding.
(2)
Pirate Capital LLC and Thomas R. Hudson, Jr. filed a Schedule 13D/A with the SEC on June 27, 2007. Previous filings state that Pirate Capital LLC and Thomas R. Hudson, Jr. are deemed to have shared voting and shared dispositive power with respect to 1,175,042 shares, which shares are owned of record by Jolly Roger Fund LP and Jolly Roger Offshore Fund Ltd.
(3)
Ironwood Investment Management, LLC. filed an amendment to its Schedule 13G with the SEC on February 14, 2008.
(4)
Aegis Financial Corporation, William S. Berno, Paul Gamble, and Scott L. Barbee jointly filed an amendment to its Schedule 13G with the SEC on February 14, 2008.
(5)
Wynnefield Capital Management, LLC, Wynnefield Capital, Inc., Joshua H. Landes, Wynnefield Partners Small Cap Value, L.P., Wynnefield Partners Small Cap Value, L.P. I., and Wynnefield Small Cap Value Offshore Fund,Ltd., filed a Schedule 13D/A with the SEC on June 29, 2007.
(6)
Dimensional Fund Advisors, Inc. (“Dimensional”), a registered investment advisor, filed an amended Schedule 13G/A with the SEC on February 6, 2008.
The following information is furnished as of December 31, 2007, with respect to the beneficial ownership by management of the Company’s common stock:
(1)
Based upon 8,013,161 shares of common stock outstanding plus any outstanding options, by director.
(2)
Pirate Capital LLC and Thomas R. Hudson, Jr. filed a Schedule 13D/A with the SEC on June 27, 2007. Previous filings state that Pirate Capital LLC and Thomas R. Hudson, Jr. are deemed to have shared voting and shared dispositive power with respect to 1,175,042 shares, which shares are owned of record by Jolly Roger Fund LP and Jolly Roger Offshore Fund Ltd.
(3)
Includes stock options for 206,500 shares which may be exercised within sixty (60) days.
(4)
Includes 6,318 shares issuable upon retirement from the Board pursuant to the Directors Deferred Compensation Plan.
(5)
Includes stock options for 72,000 shares which may be exercised within sixty (60) days.
(6)
Includes stock options for 12,000 shares which may be exercised within sixty (60) days.
(7)
Includes stock options for 40,000 shares which may be exercised within sixty (60) days.
(8)
Includes stock options for 6,500 shares which may be exercised within sixty (60) days.
(9)
Includes stock options for 6,500 shares which may be exercised within sixty (60) days and 9,882 shares issuable upon retirement from the Board pursuant to the Directors Deferred Compensation Plan.
(10)
This total includes stock options for 343,500 shares which may be exercised within sixty (60) days and 16,200 shares issuable upon retirement from the Board.
*
Less than 0.90%
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE.
In early February, 2006, Robert P. Dowski, Chief Financial Officer of the Company, made a $1,000 bridge loan to the Company. The loan advance, together with interest at twelve percent (12%) per annum, was repaid to Mr. Dowski in early March, 2006, when the Company closed its $30,000 convertible note financing.
The following members of the Board of Directors of the Company have been determined to qualify as independent members of the Board of Directors pursuant to the standards set forth by the American Stock Exchange: Gilbert F. Decker, Ronald H. Griffith, Charles S. Ream, Thomas R. Hudson, Jr. and Frederick G. Wasserman. The Company’s Audit, Compensation and Nominating Committees consist solely of independent directors.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTING FEES AND SERVICE.
The following table sets forth the fees paid by the Company to BDO Seidman LLP (BDO) for audit and other services provided for 2007 and 2006:
Audit fees include work in connection with quarterly reviews.
Statutory audit fees of $497 and $237 were included in the table above for Audit fees paid by the Company in 2007 and 2006, respectively, to the principal auditor.
The Audit Committee considered whether the provision of services referenced above is compatible with maintaining independence.
The Audit Committee’s policy is to pre-approve all audit and permissible non-audit services provided by the independent registered public accounting firm. These services may include audit services, audit-related services, tax services and other services. Pre-approval is generally provided for up to one year. The Audit Committee may also pre-approve particular services on a case-by-case basis.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)
Filed herewith
Reports on Form 8-K
On February 9, 2007, the Company filed a Form 8-K and a Form 8K/A reporting that the Company will restate its financial results for the quarter ended September 30, 2006.
On February 26, 2007, the Company filed a Form 8-K reporting the Company received a letter from one of holders of the Company’s $30,000, Senior Subordinated Convertible Notes asserting events of default under the Note. The letter states that the holder is electing to accelerate and redeem the Note in its entirety, in addition to a redemption premium and unpaid interest.
On March 20, 2007, the Company filed a Form 8-K reporting the results for the fourth quarter and for the year ended December 31, 2006 and reporting that the Company received a letter from one of the holders of the Company’s $30,000 Senior Subordinated Convertible Notes asserting events of default under the Note. The letter states that the holder is electing to accelerate and redeem the Note in its entirety in addition to a redemption premium and unpaid interest.
On March 26, 2007, the Company filed a Form 8-K reporting the receipt of letters from two other holders of the Company’s $30,000 Senior Subordinated Convertible Notes asserting events of default under the Note.
On April 2, 2007, the Company filed a Form 8-K reporting the resignation of former Chief Financial Officer and the selection of new Chief Financial Officer effective April 6, 2007.
On April 5, 2007, the Company filed a Form 8-K reporting the receipt of separate letters from the Holders asserting an additional event of default based on the failure of the Company to timely effect registration of shares of the Company’s stock.
On May 11, 2007 the Company filed a Form 8-K reporting the announcement of its financial results for the quarter ended March 31, 2007.
On June 20, 2007, the Company filed a Form 8-K reporting the Amended and Restated Registration Rights Agreement entered with the note holders.
On June 28, 2007, the Company filed a Form 8-K reporting the completion of the first phase of the financing reported on its Form 8-K filed on June 20, 2007.
On July 12, 2007, the Company filed a Form 8-K reporting the announcement of the receipt of approximately $90,000 contract orders from MECAR’s larger customers.
On July 24, 2007, the Company filed a Form 8-K reporting the completion of the second phase of the financing reported on its Form 8-K filed on June 20, 2007.
On August 16, 2007 the Company filed a Form 8-K reporting the announcement of its financial results for the quarter ended June 30, 2007.
On September 10, 2007, the Company filed a Form 8-K reporting a definitive stock purchase agreement entered with Ving Holdings (Belgium) BVBA, an affiliate of Pacific Equity Partners Pty Ltd, for the sale by ARC Europe of all of the capital stock of VSK Electronics NV for a purchase price of approximately $47,600, subject to working capital adjustment on September 6, 2007.
On September 24, 2007, the Company filed a Form 8-K reporting the announcement of the completion of the sale of the sale of its VSK Electronics NV subsidiary (“VSK”) to Ving Holdings (Belgium) BVBA, an affiliate of Pacific Equity Partners Pty Ltd (the “Purchaser”). The sale was completed in accordance with the terms and conditions of that certain Stock Purchase Agreement between the Company and the Purchaser dated as of September 6, 2007.
On October 16, 2007, the Company filed a Form 8-K reporting the issuance of October 11, 2007, The Allied Defense Group, Inc. (the “Company”) issued 122,300 shares of its common stock to L B I Group, Inc (LBI Group) on October 11, 2007 and 28,200 shares of its common stock to Portside Growth & Opportunity Fund (“Portside”) on October 5, 2007.
On November 13, 2007 the Company filed a Form 8-K reporting the announcement of its financial results for the quarter ended September 30, 2007.
On March 20, 2008, the Company filed a Form 8-K reporting the results for the fourth quarter and for the year ended December 31, 2007.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Allied has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
The Allied Defense Group, Inc.
By:
/s/ John J. Marcello
John J. Marcello
Chief Executive Officer and President
Date: March 24, 2008
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Allied and in the capacities and on the dates indicated.
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.
CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
December 31, 2007
FORMING A PART OF
ANNUAL REPORT PURSUANT TO
THE SECURITIES EXCHANGE ACT OF
FORM 10-K
OF
The Allied Defense Group, Inc.
The Allied Defense Group Inc.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
The Allied Defense Group, Inc.
Vienna, Virginia
We have audited the accompanying consolidated balance sheets of The Allied Defense Group, Inc. and subsidiaries (the “Company”) as of December 31, 2007 and 2006 and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for the years then ended. We have also audited the schedules listed in the accompanying index. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The Allied Defense Group, Inc. and subsidiaries at December 31, 2007 and 2006, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.
Also, in our opinion, the financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein
As discussed in Note A to the consolidated financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), Share-Based Payment. As discussed in Note K to the consolidated financial statements, effective in March 2006, the Company adopted Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Instruments. As discussed in Note R of the consolidated financial statements, effective January 1, 2007, the Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (FIN 48).
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note B to the consolidated financial statements, in 2007 and 2006 the Company suffered losses from operations. Also, in January and February 2008, the banking group of the Company’s key subsidiary sent notifications to the Company of their intentions to terminate the credit facilities. Subsequently, in March 2008, the members of the banking group notified the Company of their intentions to continue with the credit facility contingent upon the resolution of additional requirements. These factors raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note B. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
/s/ BDO Seidman LLP
Bethesda, Maryland
March 24, 2008
The Allied Defense Group, Inc.
CONSOLIDATED BALANCE SHEETS
December 31,
See accompanying notes to consolidated financial statements.
The Allied Defense Group, Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31,
See accompanying notes to consolidated financial statements.
The Allied Defense Group, Inc.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND
COMPREHENSIVE INCOME (LOSS)
See accompanying notes to consolidated financial statements.
The Allied Defense Group, Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31,
See accompanying notes to consolidated financial statements.
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Thousands of Dollars)
NOTE A -
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation. The consolidated financial statements of the Company include the accounts of Allied and its wholly-owned subsidiaries as follows:
•
ARC Europe, S. A. (ARC Europe), a Belgian company,
•
Allied Research Corporation Limited (ARC Limited), an inactive United Kingdom company,
•
News/Sports Microwave Rental, Inc. (NSM), a California corporation,
•
Titan Dynamics Systems, Inc., (Titan), a Texas corporation (Discontinued Operation),
•
SeaSpace Corporation (SeaSpace), a California corporation (Discontinued Operation),
•
MECAR USA, a Delaware corporation,
•
Allied Technology, LLC (“Allied Technology”), a Maryland limited liability company (Discontinued Operation),
•
Global Microwave Systems, Inc. (“GMS”), a California corporation.
ARC Europe includes its wholly-owned subsidiaries MECAR S.A. (MECAR), Sedachim S.I., S.A. and The VSK Group. The VSK Group (Discontinued Operation), is comprised of VSK Electronics N.V. and its wholly-owned subsidiaries, Tele Technique Generale, S.A., Intelligent Data Capturing Systems, N.V., Belgian Automation Units, N.V., VIGITEC S.A., and CMS Security Systems.
As discussed in Note W, the results of operations, financial position and cash flows of Seaspace, The VSK Group, and Titan, previously reported in the Other operating segment, the ES segment and the AWE segment, respectively, have been reported as discontinued operations for all periods presented. SeaSpace was sold in July 2007 and The VSK Group was sold in September 2007. Titan was sold in March 2008. Unless otherwise indicated, all disclosures in the notes to the consolidated financial statements relate to the Company’s continuing operations.
Significant intercompany transactions have been eliminated in the consolidation.
Nature of Operations. The Allied Defense Group Inc. (Allied), a Delaware corporation, is a strategic portfolio of defense and security businesses, with presence in worldwide markets, offering both government and commercial customers leading edge products and services. These products and services are marketed to the ordinance and electronic security markets.
Foreign Currency Translation. The assets and liabilities of ARC Europe and subsidiaries including MECAR and ARC Limited are translated into U.S. dollars at year-end exchange rates. In years with greater currency fluctuation, the impact on the apparent change for the same balance sheet category from one year to the next could appear more significant than in if all assets or liabilities were held in the same functional currency (e.g. US Dollars). The resulting translation gains and losses are accumulated in a separate component of stockholders’ equity. Income and expense items are converted into U.S. dollars at average rates of exchange prevailing during the year. Foreign currency transaction gains and losses are credited or charged directly to operations.
Reclassifications. Certain items in the financial statements have been reclassified to conform to the current presentation.
Use of Estimates. In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenue and expenses during the reporting period. Actual results could differ from those estimates.
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Cash and cash equivalents. The Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. At December 31, 2007, the Company had cash equivalents of $4,248 as compared to zero cash equivalents at December 31, 2006.
Accounts Receivable. Accounts receivable from foreign government agencies are supported by letters of credit or other guarantees. They are stated at the amount the Company expects to collect from balances outstanding at year end. Based on management’s assessment of the supported letters of credit and other guarantees, it has concluded that no allowance for doubtful accounts is required. The Company maintains an allowance for uncollectible accounts receivable for commercial receivables, or occasionally for government receivables, which is determined based on historical experience and management’s expectations of future losses. Losses have historically been within management’s expectations. The Company charges the accounts receivable to the established provision when collection efforts have been exhausted and the receivables are deemed uncollectible.
Costs and Accrued Earnings on Uncompleted Contracts. Costs and accrued earnings on uncompleted contracts represent recoverable costs incurred and, where applicable, accrued profit related to long-term contracts for which the customer has not yet been billed (unbilled receivables).
Inventories. Inventories consist of raw materials, work in process, and finished goods, and are stated at the lower of cost or market. Cost is determined principally by the weighted average cost method. The Company reviews its recorded inventory periodically and estimates an allowance for obsolete, excess or slow-moving items. The inventory allowance is based on current and forecasted demand and the age of the item, and therefore, if actual demand and market conditions are less favorable than those projected by management, additional allowances may be required.
Property, Plant and Equipment. Property, Plant and Equipment are stated at cost and depreciated using the straight-line method over their estimated service lives, as follows:
Leasehold improvements are amortized over the shorter of the lease term or their estimated useful lives. Accelerated depreciation methods are used for tax purposes on certain assets. Maintenance and repairs are charged to expense as incurred; additions and betterments are capitalized. Upon retirement or sale, the cost and related accumulated depreciation of the disposed assets are removed and any resulting gain or loss is credited or charged to operations.
Assets under capital lease obligations are recorded at the lesser of the present value of the minimum lease payments or the fair market value of the leased asset, at the inception of the lease. Amortization of assets acquired under capital lease obligations is recorded in depreciation expense.
Property, plant and equipment includes demonstration inventory, which is recorded at cost. Amortization of demonstration inventory is included in depreciation expense.
Impairment of Long-Lived Assets. The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Impairment losses, where identified, are determined as the excess of the carrying value over the estimated fair value of the long-lived asset. The Company assesses the recoverability of the carrying value of assets held for use based on a review of projected discounted cash flows.
Intangibles/Goodwill. Intangibles and goodwill, acquired in connection with business acquisitions, are stated at cost. Approximately 71% of the values of intangible assets, other than goodwill, are amortized on a straight-line basis over their expected lives of three to ten years. A patent in the Electronic Security segment is
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
amortized over fifteen years. Goodwill is not amortized, but is subject to an impairment test along with other indefinite lived intangibles, pursuant to the provision of SFAS No. 142, Goodwill and Other Intangible Assets. Intangible assets with finite lives are evaluated for impairment in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. In addition, the Company evaluates the useful lives of finite life intangibles annually. The primary indicators in evaluating impairment are current and forecasted profitability and cash flow of the related businesses. No impairment was recognized in either 2007 or 2006.
Derivative Financial Instruments. The Company designates its derivatives based upon the criteria established by SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS 133, as amended by SFAS 138 and SFAS 149, requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. The accounting for the changes in the fair value of the derivative depends on the intended use of the derivative and the resulting designation. The Company no longer utilizes derivatives that are designated as fair value or cash flow hedges. Therefore, changes in fair value of the Company’s derivatives are recognized currently in net income. It is the Company’s policy to classify all of its derivative instruments for cash flow purposes as operating activities.
Revenue and Cost Recognition.
•
Percentage of Completion Method - Revenues under fixed price contracts are recognized on the percentage-of-completion method measured by direct labor incurred to total estimated direct labor (MECAR) or on a total cost incurred to total estimated cost basis (NSM). The actual costs on these contracts may differ from the Company’s estimate at completion. Provision for estimated losses and penalties on contracts are recorded when identified. Revenues under cost-plus-fixed-fee and time and material contracts are recognized on the basis of costs incurred during the period plus the fee earned. As contracts extend over one or more years, revisions in costs and earnings estimated during the course of the work are reflected in the accounting period in which the facts which require the revision become known. The revenue recognized during the year under the percentage of completion method for 2007 and 2006 were $45,141 and $79,746, respectively. Costs and accrued profits on uncompleted direct and indirect fixed price contracts with foreign governments, direct and indirect U.S. government foreign military sales (FMS) contracts, and custom designed domestic security systems, which are billable upon completion, are carried as costs and accrued earnings on uncompleted contracts.
•
Other Method - Revenues from the sale of traditional security systems are recognized upon shipment. Revenues from service work rendered are recorded when performed. Revenues from pass through contracts are evaluated based on the guidelines of EITF 99-19 Reporting Revenue Gross as a Principal versus Net as an Agent. Accordingly, the Company bases its decision on whether to report revenue from such pass through contracts on a gross basis or net basis based on the relative strength of each of the following factors: whether the Company (1) is the primary obligor in the arrangement, (2) has general inventory risk, (3) has latitude in establishing price, (4) changes the product or performed part of the service, (5) has discretion in supplier selection and (6) is involved in the determination of product or service specifications. There are no provisions related to performance, cancellation, termination or refunds.
In the normal course of the Company’s business, it does not bill shipping and handling costs to customers. Shipping and handling costs are included in cost of sales. Costs of sales also include inbound freight charges, purchasing and receiving costs, inspection costs and warehousing costs. No production costs are included in selling and administrative expense.
The Company records deposits received from customers as current liabilities.
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Advertising. Advertising costs are expensed as incurred. These costs are not material to the Company’s operations.
Research and Development. Research and development costs are expensed as incurred. Such costs include salaries and benefits, rents, supplies, and other costs related to various products under development.
Capitalization of Software. The Company capitalizes purchased software systems in accordance with Statement of Position 98-1 (SOP 98-1), Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, which require that computer software meeting the characteristics of internal-use software be capitalized once the preliminary project stage has been completed. Once the capitalization criteria has been met, external direct costs of materials and services consumed in developing or obtaining internal-use computer software; payroll and payroll related costs for employees who are directly associated with and who devote time to the internal-use computer software project and interest costs incurred when developing computer software for internal use should be capitalized. No costs were capitalized in 2007. During 2006, an implementation cost of an ERP system of $1,359 was capitalized.
Warranties. The Company grants warranties on certain products for periods varying from one to five years. Provision is made for estimated losses arising from warranty claims on ammunition products as incurred, based on a minimal level of claims historically for that segment. Provision is made for estimated warranty costs on the sale of security systems at the time of the sale. The reserves for warranty expense were not significant.
Environmental Regulations. The Company does not anticipate that compliance with any laws or regulations relating to environmental protection will have a material effect on its capital expenditures, earnings or competitive position, although new environmental regulations continue to go into effect in Belgium which may require some level of expenditure by MECAR in the future. MECAR has accrued approximately $132 and $119 at December 31, 2007 and 2006, respectively, for all known expenditures required to be made by the Company at a later date in order to be compliant with the current Belgian regulations.
Income Taxes. Income taxes are provided based on the liability method for financial reporting purposes. Under this method, deferred and prepaid taxes are provided for on temporary differences in the basis of assets and liabilities which are recognized in different periods for financial and tax reporting purposes. Valuation allowances are provided if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Where it is not more likely than not that the Company’s tax position will be sustained, the Company records its best estimate of the resulting tax liability and interest in the consolidated financial statements. It is the Company’s policy to record interest and penalties, if any, related to unrecognized tax benefits as part of income tax expense for financial reporting purposes.
Earnings Per Common Share. Basic earnings per share amounts have been computed based on the weighted average number of common shares outstanding. Diluted earnings per share reflects the increase in weighted average common shares outstanding that would result from the assumed exercise of outstanding options, warrants, and convertible debt calculated using the treasury stock method, unless they are anti-dilutive.
Stock-Based Compensation - On January 1, 2006, the Company adopted the provisions of SFAS No. 123 (Revised 2004), Share-Based Payments (SFAS 123R) which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation, (SFAS 123), and the related SEC rules included in Staff Accounting Bulletin No. 107, on a modified prospective basis. SFAS 123R supersedes APB 25 and amends SFAS No. 95, Statement of Cash Flows. SFAS 123R requires all share-based payments to employees, including grants of stock options and the compensatory elements of employee stock purchase plans, to be recognized in the statement of operations based upon their fair values. Share-based employee compensation cost is recognized as a component of selling, general and administrative expense in the consolidated statements of operations.
SFAS 123R requires that the Company report the tax benefit from the tax deduction related to share-based compensation that is in excess of recognized compensation costs as a financing cash flow rather than as an operating
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
cash flow in the consolidated statements of cash flows. Before January 1, 2006, APB 25 required that the Company report the entire tax benefit related to the exercise of stock options as an operating cash flow.
Allied’s principal Equity Incentive Plan (the Plan), which was approved by the Board of Directors and shareholders in 2001 authorizes the Compensation Committee of the Board of Directors to grant up to 990,000 stock options , stock appreciation rights, restricted (non-vested) stock, performance shares and cash awards. Each type of grant places certain requirements and restrictions upon the Company and grantee. The options for common shares generally are exercisable over a one to five year period and expire up to five years from the date of grant and are valued at the closing market price on the date of grant. Restricted shares generally vest over periods of one to five years from the date of award and are also valued at the closing market price on the date of grant.
Total share-based compensation was $918 (including outside directors compensation of $245) for the year ended December 31, 2007 and $1,147 (including outside directors compensation of $307) for the year ended December 31, 2006. The share-based compensation expense for the period includes costs associated with stock options, restricted stock grants, and the compensatory element of the Employee Stock Purchase Plan.
The Company used the modified prospective transition method to adopt the provisions of SFAS 123R and as such there will be no restatement of prior period financial statements. Under this method, employee compensation cost recognized in 2007 and 2006 includes: (1) compensation cost for all share-based payments granted after the effective date that have met the requisite service requirement and (2) compensation cost for the portion of awards that have met the requisite service period on or after the effective date based on the grant-date fair value of those awards. In accordance with SFAS 123R, the fair value of options grants are estimated on the date of grant using the Black-Scholes option pricing model.
As of December 31, 2007, the total compensation cost related to unvested stock-based awards that had not been recognized was approximately $294. This cost will be amortized on a straight-line basis over a period of approximately 23 months.
No options were granted during the year ended December 31, 2007. Options granted during the year ended December 31, 2006 were 30,000. In addition, the Company granted 19,350 and 8,300 nonvested restricted shares of its common stock during the years ended December 31, 2007 and 2006, respectively. The fair value of each option grant was estimated on the date of grant using the Black-Scholes options pricing model. The weighted-average fair values of each option at the dates of grant during the year ended December 31, 2006 was $4.45. The weighted average assumptions used in the model for the year ended December 31, 2006 were as follows:
The risk free interest rate is equal to the U.S. Treasury Bill rate for the auction closest to period end. The expected volatility is calculated from the Company’s weekly closing stock price starting with the period end date and going back four years. The expected lives in years is the vesting period for most of the stock option grants in the period with vesting periods based on the assumption and on general Company experience that the options will be exercised upon vesting.
Major Customers. The Company derives the majority of its revenues directly or indirectly from foreign governments (some of which are through the U.S. government via the Foreign Military Sales program), primarily on fixed price type contracts. Direct and indirect sales to the Company’s largest customer (a foreign government in the Middle East) accounted for approximately 41% and 42% of revenue in 2007 and 2006, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Concentrations of Credit Risk. Financial instruments and related items which potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments, trade receivables and costs and accrued earnings on uncompleted contracts. The Company places its temporary cash investments with high credit quality financial institutions. Credit risk with respect to trade receivables and costs and accrued earnings on uncompleted contracts are concentrated due to the nature of the Company’s customer base. The Company generally receives guarantees and letters of credit from its foreign customers and performs ongoing credit evaluations of its other customers’ financial condition. The Company’s allowance for doubtful accounts as of December 31, 2007 and 2006 totaled $675 and $592, respectively.
The majority of ammunition sales are to or for the benefit of agencies of foreign governments. MECAR’s ammunition sales in any given period and its backlog at any particular time may be significantly influenced by one or a few large orders. In addition, the production period required to fill most orders ranges from several months to a year. Accordingly, MECAR’s business is dependent upon its ability to obtain such large orders and the required financing for these orders. As of December 31, 2007 and 2006, the Company’s firm committed backlog was $110,822 and $42,609, respectively. In addition to the firm committed backlogs, the Company had unfunded amounts, which are subject to an appropriation or authorization of governmental funds, of $102,423 and $6,992 as of December 31, 2007 and 2006, respectively.
U.S. Government contracts and subcontracts are by their terms subject to termination by the Government or the prime contractor either for convenience or for default. U.S. Government sponsored foreign military sales contracts are subject to U.S. Government review. It is not anticipated that adjustments, if any, with respect to determination of costs under these direct contracts or subcontracts will have a material effect on the Company’s consolidated results of operations or financial position.
Restricted and unrestricted cash balances in foreign banks at December 31, 2007 and 2006 were $27,011 and $20,071, respectively. Changes in the value of the U.S. dollar and other currencies affect the Company’s financial position and results of operations since the Company has assets and operations in Belgium and sells its products on a worldwide basis.
Recent Accounting Pronouncements. In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations, which replaces SFAS No 141. SFAS No. 141(R) retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It also changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. SFAS No. 141(R) is effective for acquisitions completed in fiscal years beginning after December 15, 2008. The effect the adoption of SFAS No. 141(R) will have on the Company’s financial statements will depend on the nature and size of acquisitions the Company completes after the Company adopts SFAS No. 141(R).
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB 51, which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement and, upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized in earnings. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. The Company will adopt SFAS No. 160 in fiscal year 2009. We expect that the adoption of SFAS No. 160 will not have a significant impact on our financial position or results of operations.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
In February 2007, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 159 The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115 which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Additionally, SFAS No. 159 establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective fiscal years beginning after November 15, 2007, with early adoption permitted. The Company will adopt SFAS No. 159 effective January 1, 2008. We expect that the adoption of SFAS No. 159 will not have a significant impact on our financial position or results of operations.
In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157 Fair Value Measurements which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements. However, the application of SFAS No. 157 may change current practice for some entities. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. The Company will adopt SFAS No. 157 effective January 1, 2008.
NOTE B -
LIQUIDITY AND CAPITAL RESOURCES
The Company faced liquidity challenges in 2007 mainly resulting from the reduction of revenues and significant operating losses at MECAR, financing costs associated with registration delay penalties and interest premiums paid to the holders of its Convertible Notes, legal and restructuring costs associated with alleged events of default with the Convertible Note holders and the issuance of new Convertible Notes in June and July 2007, operational restructuring activities at MECAR and NSM to reduce the fixed cost base of those operations, and the continuing use of cash at several of the Company’s smaller US-based subsidiaries. The downturn in the MECAR business resulted from lack of replenishment orders from MECAR’s largest customer after the completion of a large multi-year contract in early 2005. In fiscal year 2006 and in the first nine months of 2007, MECAR incurred significant operating losses and used its cash balances and credit facilities to fund these losses.
In addition, in July 2007, MECAR received substantial replenishment contracts from several customers for approximately $170 million with approximately half of that amount due to ship within the following twelve months which required a working capital investment in the second half of 2007.
The Company managed through its cash liquidity issues in 2007 by issuing an additional $15,376 of Convertible Notes in June and July 2007 and from cash generated as a result of the divestitures of SeaSpace in July 2007 and The VSK Group in September 2007. SeaSpace generated net proceeds of $674 while the VSK group generated net proceeds of $21,894, after repayment of $19,949 to the Note holders, pursuant to the terms of the senior convertible notes. The additional Convertible Notes that were issued in 2007 were issued in conjunction with the Company’s refinancing of the convertible notes issued in March 2006.
During 2007, as MECAR worked to secure its new multi-year sales contract and reduce its fixed cost base, MECAR was also working on restructuring its credit facility. MECAR has failed to be in compliance with annual covenant requirements for the facility at December 31, 2005, 2006 and 2007 although MECAR did obtain debt waivers for 2005 and 2006 and have agreed to a waiver for 2007. Early in 2007, the Company committed to MECAR’s banking group that it would look to completely refinance the credit facility by March 1, 2008. In the fourth quarter of 2007, the Company faced difficulties refinancing MECAR as a result of a tight credit market, political issues associated with financing ammunition manufacturers in Europe, and the lack of profitable historical results reported by MECAR prior to the fourth quarter of 2007. At a November 2007 bank meeting, MECAR reported to its banking group that a refinancing by March 1, 2008 was unlikely but that the Company was continuing to work on financing alternatives. In January and February of 2008, the banking group notified MECAR that it
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
would hold MECAR to its commitment to refinance the facility in early 2008. In March 2008, the Company reached a tentative agreement to extend and expand the credit facility until November 30, 2008. This agreement would require a partial repayment of MECAR’s cash line in July 2008. The finalization of the agreement is subject to local government support that will guarantee an additional portion of MECAR’s performance bonds and advance payment guarantees from April through November 2008. This additional guarantee will reduce the required restricted cash balances at MECAR and allow the company to fund MECAR through it critical working capital expansion period.
The Company’s cash projections for 2008 show that the Company, particularly MECAR, should be able to generate cash from operations in 2008. MECAR’s ability to generate cash is dependent on its ability to secure its credit facility. In additional to securing the credit facility, MECAR will require additional cash in the first half of 2008 to expand its working capital as it performs on its substantial backlog. The cash balances available at December 31, 2007 in addition to the availability on the cash line of MECAR’s credit facility at December 31, 2007, is expected to be sufficient to manage MECAR’s operational plans in 2008. The tentative agreement reached with MECAR’s lenders should provide additional cash for this purpose. The Company’s projections show that, if the credit facility is secured until November 30, 2008, the Company should be able to manage through its liquidity issues and repay MECAR’s cash line and debt obligations.
In February and March 2007, the Company received letters from all of the convertible note holders asserting events of default under the facility. On or after March 30, 2007, all four note holders, by separate letter, provided an additional event of default based on the Company’s failure to timely effect the registration of shares of the Company’s common stock. On June 19, 2007, the Company reached an agreement with its convertible note holders to refinance its $30,000 senior subordinated convertible notes, to provide additional funding of $15,376 to the Company, and release the Company of all alleged defaults and penalties that were claimed by the note holders earlier in 2007.
On June 26, 2007 the Company completed the first closing of this agreement which provided for the exchange of $30,000 of senior subordinated convertible notes and the settlement of $1,204 of unpaid interest and penalties for the issuance of $27,204 of senior secured convertible notes and 1,288,000 shares of the Company’s common stock. In addition, at that time, the Company issued $5,376 of additional senior secured convertible notes, the proceeds of which were used to pay $1,707 in transaction costs. On July 19, 2007, after the announcement by MECAR of the receipt of significant new sales contracts, the Company completed the second note holder closing that provided $10,000 of additional funding for the Company.
On September 18, 2007, the Company sold its wholly owned subsidiary, The VSK Group for net cash proceeds of $41,843 resulting in a gain of $29,314. Pursuant to the terms of the convertible notes, each of the purchasers of the Senior Secured convertible notes were offered the opportunity to have the Company redeem up to $21,949 of the Notes. The purchasers elected to receive $19,949 of these net proceeds, thereby reducing the Company’s debt and the potential number of common shares the Company may have to issue upon conversion of the Notes. In October 2007, these redemption amounts along with accrued and unpaid interest were paid to the note holders.
In addition, in October 2007, two of the purchasers elected to convert a portion of their respective Notes into shares of the Company’s common stock. On those dates, $264 and $1,144 of the Notes were converted into 28,200 and 122,300 shares of the Company’s common stock as described above. Pursuant to the terms of the Notes, the Company also paid make-whole interest payments totaling $344, representing the remaining interest that would have been paid on the converted amount through June 26, 2010 if the amount had not been converted. As of December 31, 2007, the principal outstanding balance of senior secured convertible notes was $20,357.
In addition, as described in Note K of the financial statements, the Company’s Convertible Notes have a put feature that allows the holders to put the notes back to the Company on December 26, 2008 or January 19, 2009. In addition, the terms of the senior secured convertible notes, limit the additional secured debt the Company can incur with preference to the convertible notes. At December 31, 2007, the Company had approximately 4,000 of
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
additional availability that could be borrowed against on a secured basis. The Company is currently evaluating strategic alternatives and may look to sell another of its subsidiaries to ensure it has the funds available to meet this put feature. The put feature requires the holders of the senior convertible notes to give at least 75 days notice of their intent to enforce this feature.
At December 31, 2007, the Company had $21,750 in cash on hand and the MECAR cash credit line had approximately $7,239 of cash availability at year end. For the twelve months ended December 31, 2007, the Company used $20,508 of cash for operating activities from continuing operations. As explained above, the Company does not anticipate using cash at this level in 2008, mainly as a result of the substantial increase in the sales backlog at MECAR. In addition to the operational improvements that are anticipated for 2008, cash losses in 2007 were negatively impacted by significant cash expenditures that are not recurring in nature and are not projected for 2008. These expenditures include items such as:
•
Registration delay payments and interest premiums paid for failure to register common stock associated with senior convertible notes timely of $1,200.
•
Financing fees paid in conjunction with additional borrowings of senior convertible notes of $1,000.
•
Additional legal costs associated with bondholder issues of $307.
•
Cash funding of Subsidiaries that have been divested. SeaSpace Corporation (sold July 2007) and Titan Dynamics Systems, Inc. (sold March 2008) of $1,709.
•
Restructuring consultants and advisors fees of $2,375.
In general, the Company believes, that it will be able to successfully find a solution for MECAR’s credit facility and fund operations in 2008 and meet the obligations associated with the potential put on its convertible notes based on its strong current backlog, history of performing profitable when backlog is substantial, the ability to raise capital and the ability to further diverse of its subsidiaries. The Company’s independent audit firm has issued an audit opinion that expresses doubt about the Company’s ability to continue as a going concern mainly due to losses from operations and the uncertainty of the Company’s ability to refinance the MECAR credit facility. The Company’s backlog has shown substantial improvement from the prior year, and the profitability of the contracts should permit the Company to generate cash from its operations in 2008. The Company continues to work on a solution for the MECAR credit facility. The major obstacle to finalizing the restructured terms with the existing bank group is the approval of additional local government support related to guarantees for the performance bonds and advance payment guarantees. The Company is requesting that the local government agency guarantee a larger portion of the performance bonds and advance payment guarantees than they currently do, thereby lowering MECAR’s restricted cash requirements and providing more operating cash to MECAR. This agency started providing guarantees on MECAR’s performance bonds and advance payment guarantees on July 1, 2007 as MECAR initially faced its liquidity challenges associated with the receipt of its new substantial sales contract. The local government agency is scheduled to meet in mid-April 2008 to review MECAR’s proposal.
While the Company is looking to secure long-term financing for operations for the remainder of 2008 and 2009, there can be no assurance that:
•
The Company will be successful securing new MECAR financing or restructuring its existing banking group at MECAR.
•
The Company will be successful in taking necessary steps to be in a position to satisfy a potential “put” of its senior secured convertible notes which may be made in December 2008 or January 2009.
•
The Company will be successful in its restructuring and turnaround efforts at its subsidiaries.
•
The Company will be able to meet the financial debt covenants of its debt instruments.
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
The Company has less than $100 of firm commitments for capital expenditures outstanding as of December 31, 2007. No additional capital commitments are necessary to support the Company’s 2008 revenue projections.
NOTE C -
RESTRICTED CASH
Restricted cash at December 31 is comprised as follows:
MECAR is generally required under the terms of its contracts with foreign governments and its distributor to provide performance bonds and advance payment guarantees. The credit facility agreement used to provide these financial guarantees place restrictions on certain cash deposits and other liens on MECAR’s assets. In addition, as certain customers make advance deposits, MECAR’s banking group restricts up to forty percent of the advance deposit as collateral for the issuance of an advance payment guarantee. The majority of the restricted cash balance relates to requirements under our sales contracts to provide performance bonds and advance payment guarantees. These instruments typically expire within one year or operating cycle and the restriction on the cash is released. As such, the restricted cash is classified as current for the periods presented. Cash of $12,920 and $8,317 at December 31, 2007 and 2006, respectively, was restricted or pledged as collateral for these agreements.
NOTE D -
ACCOUNTS RECEIVABLE AND COSTS & ACCRUED EARNINGS ON UNCOMPLETED CONTRACTS
Accounts receivable at December 31 are comprised as follows:
Receivables from foreign governments and government agencies are generally due within 30 days of shipment, less a 10% hold back provision which is generally due within 90 days. Since these receivables are typically supported by letters of credit or other guarantees, no provision for doubtful accounts is deemed necessary. The Company maintains an allowance for doubtful accounts on commercial receivables, which is determined based on historical experience and management’s expectations of future losses. Losses have historically been within management’s expectations.
Costs and accrued earnings on uncompleted contracts totaled $39,313 and $25,534 at December 31, 2007 and 2006, respectively. The revenue recognized on the contracts in progress for the years ended December 31, 2007 and 2006 were $45,141 and $79,746, respectively. The revenue recognized from the contracts in progress generally is not billed until products are completed and shipped.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
NOTE E -
INVENTORIES
Inventories at December 31 are comprised as follows:
NOTE F -
PROPERTY, PLANT & EQUIPMENT
Property, Plant & Equipment at December 31 are comprised as follows:
Depreciation expense was $5,347 and $4,877 for the years ended December 31, 2007 and 2006, respectively.
Capital Leases. The Company leases equipment under various capital leases, with lease terms through 2010. The economic substance of the leases is that the Company is financing the acquisition of the assets through the leases, and accordingly, they are recorded in the Company’s assets and liabilities.
The following is an analysis of the leased property under capital leases included in property, plant and equipment:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
The following is a schedule by years of future minimum lease payments under capital leases together with the present value of the net minimum lease payments as of December 31, 2007:
NOTE G -
INTANGIBLE ASSETS
Intangible assets at December 31, 2007 and 2006 are comprised as follows:
Consolidated amortization expense related to intangible assets, excluding goodwill, for 2007 and 2006 was $1,114 and $1,053, respectively. Estimated future aggregate annual amortization for intangible assets is as follows:
NOTE H -
GOODWILL
As required by SFAS No. 142, the Company performs, at the component level of the segments, a review each year or earlier if an indicator of potential impairment of goodwill exists. The impairment review is based on a discounted cash flow approach that uses estimates of future cash flows discounted at the Company’s weighted average cost of capital. The estimates used are consistent with the plans and estimates that the Company uses to
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
manage the underlying businesses. Goodwill was $9,932 at both December 31, 2007 and 2006 and no impairment was recognized in both 2007 and 2006. Goodwill at December 31 is as follows:
In 2006, the Company experienced an increase in goodwill balance of $473 due to the final payment for GMS acquisition.
NOTE I -
BANK CREDIT FACILITY
MECAR is obligated under an agreement (the Agreement), modified in March 2006, with its foreign banking syndicate that provides credit facilities of up to 42,850 (approximately $63,114) primarily for bank guarantees including performance bonds, letters of credit and similar instruments required for specific sales contracts, as well as a line of credit for tax prepayments and working capital. The Agreement provides for certain bank charges and fees as the facility is used, plus fees of 2% of guarantees issued and quarterly fees at an annual rate of 1.25% of guarantees outstanding. These fees are charged to interest expense. The Agreement requires that MECAR maintain certain net worth and working capital covenants. As of December 31, 2007 and 2006, MECAR was not in compliance with the facility covenants due to violations of the financial performance covenants. The Company has obtained a waiver for the year ended December 31, 2006 and is in discussion with the lenders regarding a waiver for the year ended December 31, 2007. MECAR’s banking group has been working with the Company to restructure the terms of the facility as MECAR has been restructuring its business to return to profitability. In March 2008, the Company reached a tentative agreement to extend and expand the credit facility until November 30, 2008. This agreement would require a partial repayment of MECAR’s cash line in July 2008, as MECAR makes shipments on its current backlog. The finalization of the agreement is subject to local government support that will guarantee an additional portion of MECAR’s performance bonds and advance payment guarantees from April through November 2008. As described below, this is the local Belgian regional agency that is currently providing 50% guarantees on MECAR’s performance bonds and advance payment guarantees on a long term basis. The additional interim guarantee will reduce the required restricted cash balances at MECAR and allow the company to fund MECAR through it critical working capital expansion period.
Effective July 1, 2007 the local Belgian regional agency began providing guarantees up to 50% of MECAR’s credit requirements relative to performance bonds and advance payment guarantees, to reduce the exposure of the existing bank group. The Company is continuing to work to restructure the credit facility over the next few months. If the Company is not successful in restructuring this financing, the Company will look to other potential lenders thereby potentially delaying performance on the significant new contracts. The Company’s banking syndicate has provided the performance bonds and advance payment guarantees for MECAR’s significant new contracts to date.
As of December 31, 2007 and 2006, guarantees and performance bonds of approximately $37,523 and $30,524, respectively, were outstanding. Advances for working capital and tax pre-payments provided for under the bank overdraft facility and notes payable, amounted to $7,239 and $18,191 at December 31, 2007 and 2006, respectively. Advances under the Agreement are secured by restricted cash of approximately $12,838 and $8,286, at December 31, 2007 and 2006, respectively. MECAR is generally required under the terms of its contracts with foreign governments and its distributor to provide performance bonds and advance payment guarantees. The credit
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
facility agreement is used to provide these financial guarantees and places restrictions on certain cash deposits and other liens on MECAR’s assets. In addition, certain customers make advance deposits and require MECAR’s bank to restrict up to forty percent of the advance deposit as collateral. Amounts outstanding are also collateralized by the letters of credit received under the contracts financed, and a pledge of all of MECAR’s assets. The Agreement has an annual term but is cancellable by either party on 90 days notice.
NOTE J -
ACCRUED LOSSES ON CONTRACTS, DEFERRED COMPENSATION AND WARRANTY RESERVES
Accrued losses on contracts. At December 31, 2007 and 2006, the Company provided for accrued losses of $1,902 and $222, respectively, in connection with the completion of certain contracts. These amounts are included in accrued liabilities.
Deferred compensation. The December 31, 2007 and 2006 deferred compensation balances of $660 and $579, respectively, represent cash compensation deferred by the non-employee directors and the retirement benefits for employees who applied for early retirement at MECAR.
Accrued Warranty Costs. At December 31, 2007 and 2006 the Company provided $95 and $97, respectively, for accrued costs related to warranties. These amounts are included in accrued liabilities.
NOTE K -
LONG-TERM DEBT
Long-term obligations as of December 31 consist of the following:
On March 9, 2006, the Company entered into a Securities Purchase Agreement with four purchasers for the private placement of senior subordinated convertible notes (the “ Initial Notes”) in the principal amount of $30,000 and related warrants to purchase common stock of the Company (the “2006 Transactions”). In connection with the 2006 Transactions, the Company entered into a Registration Rights Agreement with the purchasers to file a registration statement to cover the resale of the common stock related to the Notes and warrants.
During the period February 20, 2007 through March 23, 2007, the Company received separate letters from each of the four purchasers asserting the existence of an event of default under the Initial Notes. In addition, one of the purchasers filed suit against the Company based on the alleged default. The terms of the convertible debt facility that was put in place in March 2006 required the Company to have an effective registration statement with the SEC for the resale of the common stock underlying the convertible debt and warrants issued in the Transactions by January 28, 2007. The Company failed to meet this deadline and paid $900 in the three months ended March 31, 2007 related to these continuing delays. The terms of the Initial Notes further provided that the Company would be in default if the registration statement for the shares of common stock was not effective by March 29, 2007. The Company did not have an effective registration statement by this date. On or after March 31, 2007, all four note holders, by separate letter, alleged an additional event of default based on the Company’s failure to timely effect the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
registration of shares of the Company’s common stock. The terms of the Initial Notes provide, in the event of default, the holders have the right to demand redemption at a price equal to the sum of the face value of the notes, accrued and unpaid interest and a redemption premium equal to 25% of the face value of the notes or $7,500. Furthermore, the terms of the Initial Notes provided that the interest rate will increase to the default rate of 12.5% per annum from the stated rate of 7.5% for the duration of the term of the agreements and the Company would continue to be subject to interest penalties of $300 per month until the registration statement was declared effective. After March 29, 2007, the Company incurred an additional $300 of interest penalties for the month of April and $904 of interest expense of which $362 related to the increase in the interest rate to the default rate.
On June 19, 2007, the Company and each of the purchasers entered into an Amended and Restated Securities Purchase Agreement (the “Amendment Agreement”) to refinance the terms of the original transaction and to provide for the issuance of additional convertible notes of $15,376. Pursuant to the Amendment Agreement, each purchaser agreed to withdraw the alleged events of default and the one purchaser agreed to dismiss the lawsuit.
Senior subordinated convertible notes. On March 9, 2006, the Company issued $30,000 of Initial Notes. In connection with the 2006 Transactions, the Company paid debt issue costs of $1,908 in cash and issued warrants with a fair value of $373 on the date of issue. These debt issue costs were being amortized over the term of the Initial Notes and warrants. At December 31, 2006, the debt issue costs had an unamortized balance of $1,901. As a result of the June 19, 2007 restructuring of the Initial Notes, the Company wrote off the remaining unamortized balance, resulting in a charge to interest expense of $1,749 in June 30, 2007.
The Initial Notes accrued interest at a rate of 7.5% per annum, subject to adjustment, with accrued interest payable quarterly in arrears in cash. The Initial Notes were to mature on March 9, 2011, and were immediately convertible into shares of the Company’s common stock at the conversion price of $26.46 (adjusted to $25.85 when the Company issued common stock in December 2006) per share, subject to certain standard anti-dilution provisions and an adjustment for stock splits. Upon a change of control, as defined in the Notes, the holders of the Notes were to have certain redemption rights.
The Company determined that the Initial Notes were hybrid instruments and the warrants are derivatives that should be carried at fair value, with any changes in fair value reported as gains or losses in subsequent periods. The Initial Notes were deemed to have embedded derivatives that required bifurcation. In March, 2006, the Company adopted SFAS 155, Accounting for Certain Hybrid Instruments, which allows the Company to make an irrevocable election to initially and subsequently measure the hybrid financial instrument in its entirety at fair value after having identified all embedded derivative features contained in a hybrid instrument. The Company identified and documented the embedded derivative features, and then irrevocably elected to measure and carry the notes at fair value. At March 9, 2006, the date of issue, the Company determined the fair value of the Initial Notes and warrants issued in the 2006 Transaction had fair values of $29,120 and $2,013, respectively. At the date of issuance, a loss of $1,133 was recorded. At June 26, 2007 (the initial closing date of the refinancing), the Company determined the fair value of the Initial Notes was $36,979. For the period from January 1, 2007 to June 26, 2007, the loss related to the fair value of the Initial Notes was $8,868.
Senior secured convertible notes. On June 19, 2007, the Company entered into the Amendment Agreement with each purchaser whereby the Company exchanged the Initial Notes in the principal amount of $30,000 and $1,204 of unpaid and accrued interest and penalties for Senior Secured Convertible Notes (the “Amended Notes”) in the principal amount of $27,204 and 1,288,000 shares of the Company’s common stock (“Exchange Transaction”). In addition, the Amendment Agreement provided for the issuance of an additional $15,376 of Senior Secured Convertible Notes (the “New Notes”). On June 26, 2007, the Company closed on its first phase of the financing whereby it executed the Exchange Transaction and issued $5,376 of New Notes (“First Closing”). On July 19, 2007, mainly as a result of the announcement of a significant new sales contract by MECAR on July 11, 2007, the Company closed on the second phase of financing whereby it issued an additional $10,000 of New Notes (“Second Closing”).
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
The Company elected to carry both the Initial Notes and the Amended Notes at fair value under SFAS 155. At June 26, 2007, the Company determined the fair value of the Initial Notes was $36,979. In determining fair value, the Company considers all available information, including the terms of any potential settlement and/or modification and the probability of such settlement and/or modification occurring. As a result, the carrying amount of the Initial Notes immediately prior to the closing of the Exchange Transaction reflected the settlement provisions of Amendment Agreement so that the fair value of the Initial Notes immediately prior to the Exchange Transaction equaled the fair value of the common stock issued of $9,544 plus the fair value of the Amended Notes of $27,435.
In connection with the Amendment Agreement, the Company incurred debt issue cost of $1,707 of which $1,306 was paid and the remaining $401 was included in the principal of the New Notes. These debt issue costs were expensed immediately upon execution of the Amendment Agreement as interest expense.
The Amended and New Notes, the “Notes”, mature on June 26, 2010, subject to the right of the purchasers to demand payment eighteen months after closing (this means December 26, 2008 for the notes issued on June 26, 2007 and January 19, 2009 for the notes issued on July 19, 2007). The Notes accrue interest at 8.95%, with accrued interest payable quarterly in arrears. The Company has the option to convert interest through December 31, 2007 to debt principal; thereafter, all interest must be paid in cash or in shares of the Company’s common stock. As of December 31, 2007, no interest was converted. The Notes are convertible into shares of the Company’s common stock at the conversion price of $9.35 per share, subject to certain standard anti-dilution provisions and an adjustment for stock splits. Upon a change of control, as defined in the Notes or in the event the Company sells both its MECAR S.A. and The VSK Group subsidiaries, the holders will have certain redemption rights.
The Notes are secured by a first lien on all assets of the Company and its domestic subsidiaries; a pledge of the stock of the Company’s domestic subsidiaries; and a pledge of 65% of the stock of certain of the Company’s foreign subsidiaries. The Company is required to comply with certain financial covenants based on the Company’s financial performance commencing with the Company’s financial performance for the third quarter of 2007 and is limited in its ability to incur any additional indebtedness. In addition, the Notes contain cross-default provisions. Such provisions specifically exclude the Company’s current default of loan covenants with MECAR’s credit facility.
In connection with the Amendment Agreement, the Company also entered into an Amended and Restated Registration Rights Agreement which requires the Company to have an effective registration statement with the SEC for the resale of the common stock underlying the convertible notes within 365 days of initial closing of the Amendment Agreement or June 26, 2008 (“the Effectiveness Deadline”). The Amended Registration Rights Agreement provides for additional interest and penalties in the event the Company fails to have the registration statement effective within the required time frame. On January 1, 2007, the Company adopted FSP 00-19-2 Accounting for Registration Payment Arrangements. Prior to adopting FSP 00-19-2, the Company’s policy was to accrue liquidated damages when incurred. In accordance with FSP 00-19-2, the Company accrues for interest penalties under FAS 5 Accounting for Contingencies when probable and estimable. At January 1, 2007, liquidated damages under the Initial Note Registration Rights Agreement were not probable or estimable. As of December 31, 2007, the Company does not believe that such liquidated damages under the Amended and Restated Registration Rights Agreement are probable or estimable and, as such, no accrual was made. Effective February 15, 2008, the Securities and Exchange Commission issued new provisions with regards to Rule 144. These provisions allow a non-affiliate to resell restricted securities such as the securities underlying the Notes after a six-monthly holding period as long as the Company is current in its SEC filings or after a one year holding period without any restrictions. The Company has reached an agreement with the holders of the Notes to suspend its efforts to register the securities that were required to be registered pursuant to the Amended and Restated Registration Rights Agreements. The Company is no longer subject to these liquidating damages as provided in the Amended and Restated Registration Rights Agreements.
The Company determined that the Notes are hybrid instruments that could be carried at fair value, with any changes in fair value reported as gains or losses in subsequent periods. On June 26, 2007, the date of issue of the Amended Notes and First Closing of New Notes, the Company elected to adopt SFAS 155, Accounting for Certain
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Hybrid Instruments, which allows the Company to make an irrevocable election to initially and subsequently measure the Notes in their entirety at fair value after having identified all embedded derivative features contained in each hybrid instrument. At June 26, 2007, the Amended Notes and First Closing of New Notes had fair values of $27,435 and $5,345, respectively, resulting in a gain of $0 and $31, respectively. At July 19, 2007, the second closing of New Notes had fair values of $9,868, resulting in a gain of $132. At December 31, 2007, the Company determined the fair value of the Amended Notes and First and Second Closing of New Notes was $13,134, $476 and $5,782, respectively. For the period from June 26, 2007 to December 31, 2007, the net gain in the fair values of the Amended Notes and First Closing of New Notes as compared to the respective fair values at June 26, 2007 was a gain of $860 and a loss of $8, respectively. For the period from July 19, 2007 to September 30, 2007, the gain in the fair value of the Second Closing of New Notes as compared to the fair values at July 19, 2007 was $181. For the twelve months ended December 31, 2007, the net loss related to the calculated fair value adjustments of all Notes was $7,672.
Warrants
On March 6, 2006, in conjunction with the issuance of the Initial Notes, the Company issued detachable warrants to the purchasers exercisable for an aggregate of 226,800 shares of Allied common stock. The warrants are exercisable for a term of five years at an exercise price of $27.68 per share, subject to anti-dilution provisions similar to the provisions set forth in the Notes and expire on March 9, 2011. The original exercisable shares of 226,800 and exercise price of $27.68 was adjusted to 349,297 and $17.97, respectively, to account for the December 2006 Private Placement and the Amendment Agreement. The warrants did not meet the requirement for equity classification in accordance with EITF 00-19, Accounting for Derivative Instruments Index to, and Potentially Settled in, a Company’s Own Stock, mainly because the warrants are required to settle in registered shares of the Company’s common stock. The warrants were recorded as liabilities and are being recorded and carried at the fair value of the instrument. At December 31, 2007, the Company determined the fair value of the warrants was $183. The Company recorded a gain of $1,009 for the twelve months ended December 31, 2007 related to the calculated fair value of the warrants.
Loan for Global Microwave Systems acquisition. On November 1, 2005, the Company entered into a $6,700 loan to fund the acquisition of GMS with the prior owner of GMS. There are no significant covenants. The loan was originally payable in installments over three years bearing interest at the rate of 7.5% per year payable quarterly. On October 11, 2006, the loan was amended to defer the first installment of principal payment of $1,675 from November 1, 2006 to January 31, 2007. The Company repaid one half of the first installment of $1,675 or $838 in February 2007. On February 12, 2007, the loan was further amended to defer, until the earlier of MECAR’s receipt of a down payment on its impending contract or July 1, 2007 (“Deferral Period”), one half of the first installment payment which was due on January 31, 2007. In July 2007, the Company paid the second half of the first installment of $838. During the term of the Deferral Period, the interest rate on the entire loan was increased to 9% per year and an additional $20 per full or partial month during the Deferral Period of interest was due. The Company evaluated both amendments pursuant to the terms of EITF 96-19 Debtor’s Accounting for a Modification or Exchange of Debt Instruments and concluded that neither met the definition of a substantially different debt modification. Therefore, no gain or loss was recorded as a result of either modification. For the year ended December 31, 2007, the Company incurred additional interest of $120 for the Deferral Period.
On October 31, 2007, the Company repaid the scheduled principal due amount of $1,675. The outstanding balance of the loan was $3,350 and $6,700 at December 31, 2007 and 2006, respectively. The unamortized discount of the note was $98 and $269 at December 31, 2007 and 2006, respectively.
SOGEPA Loan. On December 20, 2007, MECAR entered into a 6,000 (approximately $8,837) loan agreement with the Société Wallonne de Gestion et de Participations (“SOGEPA”), a local Belgian regional agency to provide MECAR with a working capital line of credit. The loan matures on December 20, 2012 and accrues interest at 4.95% per year. Quarterly interest payments are due during the first year of the loan, with quarterly
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
principal and interest payments due thereafter. The loan is secured by a mortgage covering property owned by MECAR. As part of the loan, MECAR is required to maintain certain capital requirements as defined in the loan agreement. MECAR paid debt issues costs of $141 in connection with the loan which is being amortized over the term of the loan. At December 31, 2007, unamortized debt issue costs were $141 and the outstanding balance due on the loan was $8,837.
Other notes payable. At December 31, 2006, MECAR borrowed $4,489 as a straight loan, within the current credit facility, from one of the banks in their banking facility. This loan was fully repaid in 2007. In addition, NSM had a note for a vehicle of $4 and $8 at December 31, 2007 and 2006, respectively.
Capital lease and other. The Company is also obligated on various vehicle, equipment, capital lease obligations and other loans. The notes and leases are generally secured by the assets acquired, bear interest at rates ranging from 2.92% to 10.99% and mature at various dates through 2010.
The annual maturities of long-term obligations as of December 31, 2007 are as follows:
(A)
The senior secured convertible notes have a put feature that allows the holders to put the notes back to the Company on December 26, 2008 or January 19, 2009.
Other than as disclosed above with regard to the Notes, no other debt classified as long-term contain cross-default provisions.
NOTE L -
BENEFIT PLANS
In 2003, the Company adopted a 401(k) plan. Employer contributions to the plans in 2007 and 2006 were approximately $395, $454, respectively. Employee contributions to the plan in 2007 and 2006 were $572 and $547, respectively. Under the terms of labor agreements at MECAR, the Company contributes to certain governmental and labor organization employee benefit and retirement programs. In 2007 and 2006, the Company accrued $459 and $393, respectively, of retirement benefits for employees who applied for early retirement at MECAR. This retirement benefit amount was included in other long-term liabilities.
NOTE M -
CONTINGENCIES AND COMMITMENTS
There are no material pending legal proceedings, other than ordinary routine litigation to Allied’s business, to which Allied or any of its subsidiaries is a party or to which any of their property is subject.
The Company has entered into consulting and employment agreements with certain management personnel at the Company’s subsidiaries and with certain domestic management personnel. Certain of these agreements provide for severance payments in the event of termination under certain conditions.
The Company leases domestic office space and equipment under operating leases which expire at various dates through 2013. Certain leases also include escalation provisions for taxes and operating costs. The following is a
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
schedule by year of base expense due on operating leases that have initial or remaining lease terms in excess of one year as of December 31, 2007:
Total rental expense charged to operations approximated $1,006 and $1,031, for the years ended December 31, 2007 and 2006, respectively.
The Company’s domestic operations do not provide post employment benefits to its employees. Under Belgian labor provisions, the Company may be obligated for future severance costs for its employees. After giving effect to prior workforce reductions, current workloads, expected levels of future operations, severance policies and future severance costs, post employment benefits are not expected to be material to the Company’s financial position.
Indemnification provisions.
On July 6, 2007, the Company signed a Stock Purchase Agreement to sell SeaSpace for $1,541 in net proceeds. The Stock Purchase Agreement contains certain indemnification provisions pursuant to which the Company may be required to indemnify the buyer for a period subsequent to the completion of the sale for liabilities, losses, costs or expenses arising out of breaches of covenants, certain breaches of representations and warranties and any actions or suits relating to the condition of the business prior to and at the time of sale. Theses indemnification provisions have been capped at $1,000. At December 31, 2007, no amount has been accrued related to this indemnification as a liability is not deemed probable.
On September 6, 2007, ARC Europe, a wholly-owned subsidiary of the Company, entered into a Stock Purchase Agreement to sell The VSK Group for approximately $48,737 in cash subject to a purchase price adjustment to be determined following closing. On September 18, 2007, the Company completed the sale. The Stock Purchase Agreement contains certain indemnification provisions pursuant to which the Company may be required to indemnify the buyer for a period subsequent to the completion of the sale for any and all actions, liabilities, encumbrances, losses, damages, fines, penalties, taxes, fees, costs or expenses or amounts paid in settlement suffered or incurred arising out of any breach of or inaccuracy in any representation or warranties made by the seller or any breach or violation of any covenants or agreements of the Company. An escrow amount of approximately $2,741 was established to satisfy any such claims. The terms of the escrow agreement provide that a portion of the remaining escrow balance in excess of $1,767 will be released on April 1, 2009 with the entire remaining balance released December 31, 2012. At December 31, 2007, the Company has fully reserved the escrow balance as it is uncertain as to the nature and timing of potential future claims, if any. Total indemnification provisions have been capped at $7,365.
In conjunction with the sale of The VSK Group, and pursuant to the terms of employment agreements with The VSK Group’s management team, the Company committed to pay approximately $1,645 (1,200) as a retention bonus. Of this total retention amount, approximately $674 (492) was paid in October 2007 and the remainder is subject to the escrow agreement terms.
On January 24, 2008, the Company entered into a Purchase Agreement to sell Titan for $4,750 in cash. The Purchase Agreement contains certain indemnification provisions pursuant to which the Company may be required
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
to indemnify the buyer for a period subsequent to the completion of the sale for losses, liabilities, damages or expenses arising for any breach of covenants, representation or warranties; income tax liabilities existing prior to closing; and violations of environmental laws. The indemnification amount can be as much as the purchase price for certain covenants but generally are capped at $950. At December 31, 2007, no amount has been accrued related to this indemnification as a liability is not deemed probable.
In conjunction with the sale of Titan, and pursuant to the terms of employment agreements with Titan’s management team, the Company committed to pay $46 as a retention bonus. In addition, pursuant to the terms of the Settlement Agreement entered into with a former employee of Titan, the Company committed to pay $1,060 to mutually release both parties from any and all claims. Approximately $60 was paid upon execution of the agreement on January 24, 2008 and the remaining $1,000 was paid upon closing on March 17, 2008.
Tax Litigation
As part of its 2004 tax audit with the Belgian tax authorities, the Company recorded a liability of $3,552 related to tax due on unrealized/realized foreign currency gains as well as associated interest and penalties. The Company is currently negotiating in the Belgian tax court for a workable repayment arrangement to resolve the liability due.
Social Security Litigation
As of December 31, 2007, the Company had not paid its Belgian social security payments for the first, second and third quarters of 2007. Early in 2008, the third quarter payment was paid. Accordingly, the Company has accrued $2,184 related to past due social security payments which includes associated interest of $276. The Company is currently negotiating in the Belgian courts for a workable repayment arrangement to resolve the liability due.
NOTE N -
FAIR VALUE OF FINANCIAL INSTRUMENTS
At December 31, 2007 and 2006, the Company’s financial instruments include cash, receivables, payables, borrowings, guarantees and performance bonds. The face value of cash, receivables and payables approximate their carrying values because of the short-term nature of the instruments. The estimated fair value of the other financial instruments and off-balance-sheet credit obligations are as follows:
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value.
•
The fair value of notes payable and long-term obligations is estimated based on approximate market prices for the same or similar issues or the current rates offered to the Company for debt of the same remaining maturities. The Company believes the aggregate carrying value approximates fair value.
•
The senior secured convertible notes and the senior subordinated convertible notes are treated as derivatives and are carried at fair value in accordance with SFAS 155 Accounting for Certain Hybrid Instruments. The
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
fair value of convertible notes is estimated based on approximate market prices of the Company stock or the current rates offered to the Company for debt of the same remaining maturities.
•
The fair value of detachable warrants is estimated based on the Black Scholes model, the term, stock price and exercise price of the warrants. In addition, the interpolation of the 3-year and 5-year treasury rates as of December 31, 2007 and 2006, respectively, as reported by the Federal Reserve Bank for the period of time between the valuation date and the expiration date is used in the model.
•
Estimated fair values for off-balance-sheet instruments, which include performance bonds and advance payment guarantees are reflected at the face value of these obligations, since management does not expect to have any claims against these obligations based on its past experience.
NOTE O -
DERIVATIVE FINANCIAL INSTRUMENTS
Derivatives not designated as hedges
The Company uses foreign currency futures contracts to minimize the foreign currency exposures that arise from sales contracts with certain foreign customers and certain purchase commitments. Under the terms of these sales contracts, the selling price and certain costs are payable in U.S. dollars rather than the Euro, which is MECAR’s functional currency. As discussed in Note A, the Company’s accounting for foreign currency exchange contracts at MECAR did not comply with the guidelines of FAS 133. As such, realized and unrealized gains (losses) from derivative contracts are reported as a component of revenues and amounted to $404 for the year ended December 31, 2006. In 2007, the Company did not enter any foreign currency future contracts or forward exchange rates to minimize the foreign currency exposures.
Counterparty credit risk
The Company’s foreign exchange forward contracts expose the Company to credit risks to the extent that the counterparties may be unable to meet the terms of the agreement. The Company minimizes such risk by using major financial institutions as its counterparties. Management does not expect any material loss as result of default by counterparties.
NOTE P - STOCKHOLDERS’ EQUITY
The Company has various equity compensation plans for employees as well as non-employee members of the board of directors. The Company may grant stock options, stock appreciation rights, incentive and non-statutory options, performance shares and other awards to key executives, management, directors and employees under various plans at prices equal to or in excess of the market price at the date of the grant. The options for common shares generally are exercisable over a five to ten year period and expire up to ten years from the date of grant. The equity compensation plans consist of the following:
2001 Equity Incentive Plan. During 2001, the Board of Directors and stockholders approved and reserved 240,000 shares of common stock for awards to key employees of the Company and its subsidiaries. In each of 2002, 2003 and 2005, the Board of Directors and the stockholders authorized the plan to be increased by 250,000 shares. The plan authorizes the Compensation Committee of the Board of Directors to grant stock options, stock appreciation rights, restricted stock, performance shares and cash awards. Each type of grant places certain requirements and restrictions upon the Company and grantee. For the year ended December 31, 2007, the Company granted no options and 21,400 shares of stock awards to certain key employees. In addition, 18,881 shares were issued to three directors who retired from the Company’s Board of Directors in February 2007 in settlement of the deferred compensation obligations to these directors and 23,405 shares were issued to five non-employee directors as part of the annual directors’ compensation on July 1, 2007. During 2007, 3,700 previously granted shares to key employees were forfeited and fully vested 1,668 shares were retired at the option of the employee as reimbursement to Allied for payroll taxes associated with the vesting of their restricted shares. Total stock awards in 2006 were
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
19,048 shares of which 12,250 shares were grants to certain key employees, 6,548 shares were issued to non-employee directors and 250 shares to a non-employee consultant. During 2006, 2,464 previously granted shares to key employees were forfeited and 1,345 shares, after fully vesting to employees, were retired at the option of the employee as reimbursement to Allied for payroll taxes associated with the vesting of their restricted shares. As of December 31, 2007, total restricted shares of 43,418 shares were reserved for certain employees, which will vest with continued service to the Company per the vesting schedule.
1997 Incentive Stock Plan. During 1997, the Board of Directors and stockholders approved and reserved 225,000 shares of common stock for awards to key employees of the Company and its subsidiaries in the form of stock options and stock awards. The Plan is administered by the Compensation Committee of the Board of Directors. Employees of the Company and its subsidiaries who are deemed to be key employees by the Committee are eligible for awards under the Plan.
1992 Employee Stock Purchase Plan. During 1992, the Board of Directors and stockholders approved and reserved 525,000 shares for the plan. The plan is voluntary and substantially all full-time employees are eligible to participate through payroll deductions. The purchase price of each share is equal to 85% of the closing price of the common stock at the end of each calendar quarter. The Plan is subject to certain restrictions and the Board may amend or terminate it at any time. With the adoption of SFAS 123R, Share Based Payment, at January 1, 2006, the Company began recognizing the compensation cost related to the plan.
Rights Agreement. The Board of Directors adopted a Rights Agreement in 2001 and amended the agreement in June, 2006 and again in November 2006. The Agreement provides each stockholder of record a dividend distribution of one “right” for each outstanding share of common stock. Rights become exercisable the earlier of ten days following: (1) a public announcement that an acquiring person has purchased or has the right to acquire 25% or more of the Company’s common stock, or (2) the commencement of a tender offer which would result in an offeror beneficially owning 25% or more of the outstanding common stock. All rights held by an acquiring person or offeror expire on the announced acquisition date and all rights expire at the close of business on May 31, 2011.
Each right under the Rights Agreement entitles a stockholder to acquire at a purchase price of $50, one-hundredth of a share of preferred stock which carries voting and dividend rights similar to one share of common stock. Alternatively, a right holder may elect to purchase for $50 an equivalent number of common shares (or in certain circumstances, cash, property or other securities of the Company) at a price per share equal to one-half of the average market price for a specified period. In lieu of the purchase price, a right holder may elect to acquire one-half of the common shares available under the second option. The purchase price and the preferred share fractional amount are subject to adjustment for certain events as described in the Agreement.
Rights also entitle the holder to receive a specified number of shares of an acquiring company’s common stock in the event that the Company is not the surviving corporation in a merger or if 50% or more of the Company’s assets are sold or transferred.
At the discretion of a majority of the Board and within a specified time period, the Company may redeem all of the rights at a price of $.01 per right. The Board may also amend any provision of the Agreement prior to exercise of the rights.
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
The following table summarizes option activity:
The following table summarizes options outstanding at December 31, 2007:
Since the exercise price for of all the options outstanding is greater than the closing share price on December 31, 2007, no intrinsic value is available for any outstanding and exercisable options. The market value of our stock was $5.77 at December 31, 2007. The intrinsic value of stock options exercised for the year ended December 31, 2006 was $365. Cash received for the exercise of these options was $429 with a tax benefit of $28.
The following table summarizes restricted stock (nonvested) shares outstanding as of December 31,
As of December 31, 2007 and 2006, there were approximately $234 and $492, respectively, of total unrecognized compensation cost related to restricted share based compensation arrangements granted under the Plan. As of December 31, 2007 and 2006, the cost is expected to be recognized over a weighted average period of 1.03 years and 1.5 years, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
NOTE Q - OTHER - NET
Other income (expense) included in the Company’s consolidated statements of operations at December 31 is comprised of the following:
Miscellaneous - net includes income received from various sources such as subsidies, insurance recoveries, penalties, non deductible value added taxes, sublease rent and sale of materials.
NOTE R - INCOME TAXES
The Company recognizes deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based on the difference between the consolidated financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse.
Earnings (loss) before income taxes are comprised as follows:
The Company’s provision for income taxes is comprised of:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
The Company’s provision for income taxes differs from the anticipated United States federal statutory rate. Differences between the statutory rate and the Company’s provision are as follows:
The components of the deferred taxes at December 31, 2007 and 2006 are comprised as follows:
At December 31, 2007 and 2006, the Company had net operating loss carryforwards of $51,036 and $32,974, respectively, which will begin to expire in 2010 and foreign NOLs of approximately $79,947 and $56,379, respectively, which may be carried forward indefinitely. A portion of the U.S. net operating loss carryforwards are subject to limitations on the amount that can be utilized each year. The Company had foreign tax credits and alternative minimum tax credits of approximately $2,290 and $458, respectively, at both December 31, 2007 and 2006. The foreign tax credits will begin to expire in 2012 and the alternative minimum tax credits do not expire.
The Company regularly reviews the recoverability of its deferred tax assets and establishes a valuation allowance as deemed appropriate. Realization of deferred tax assets is dependent upon generation of sufficient income by the Company in the jurisdictions in which it has operations and, in some cases, by specific office locations. Because the Company experienced losses in previous years and continued losses in the current year,
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
management recorded a valuation allowance of approximately $43,486 and $33,324 against the Company’s net deferred tax asset as of December 31, 2007 and 2006, respectively. The change in the valuation allowance from December 31, 2006 to December 31, 2007 was an increase of $10,162, which is due primarily to the valuation allowance recorded against the Europe and U.S. net deferred tax assets during 2007.
The Company adopted FIN 48 on January 1, 2007, which requires financial statement benefits to be recognized for positions taken for tax return purposes when it is more-likely-than-not that the position will be sustained. There has been no change in our financial position and results of operations due to the adoption of FIN 48.
As of January 1, 2007 and December 31, 2007, the Company had no unrecognized tax benefits, nor did it have any that would have an effect on the effective tax rate. Income taxes are provided based on the liability method for financial reporting purposes. No interest or penalties were accrued as of January 1, 2007 as a result of the adoption of FIN 48. For the year ended December 31, 2007, there was no interest or penalties recorded or included in tax expense.
In Belgium, the Company is still open to examination by the Belgian tax authorities from 2005 forward. In the United States, the Company is still open to examination from 2004 forward, although carryforward tax attributes that were generated prior to 2003 may still be adjusted upon examination by the Belgian tax authorities if they either have been or will be utilized.
As of December 31, 2007 and 2006, the Company had not recorded U.S. income tax expense for $5.021 and $11,117, respectively, of unremitted earnings of its foreign subsidiaries for which it has designated as indefinitely reinvested. The amount of earnings designated as indefinitely reinvested offshore is based upon the actual deployment of such earnings in our offshore assets and our expectations of the future cash needs of our U.S. and foreign entities. In the event that actual cash needs of our U.S. entities exceed our current expectations, we may need to repatriate foreign earnings which have been designated as indefinitely reinvested offshore. This could result in additional income tax expense being recorded. During 2007, the Company recorded a deferred tax liability of $8,137 related to foreign earnings which it deems are not indefinitely reinvested.
See Note M - Contingencies and Commitments for disclosure on Belgian tax contingency.
NOTE S - EARNINGS (LOSS) PER COMMON SHARE
Basic earnings (loss) per share excluded dilution and are computed by dividing net loss by the weighted average number of common shares outstanding for the period. The computation of diluted earnings (loss) per share includes the effects of convertible debentures, stock options, warrants and restricted stock (unvested stock awards), if such effect is dilutive. The table below shows the calculation of basic and diluted earnings (loss) per share for the years ended December 31, 2007 and 2006, respectively:
At December 31, 2007, the Company has excluded convertible notes, stock options and warrants of 2,177,176; 3,758 and 411,593, respectively, since their effect would be anti-dilutive. For the year ended December 31, 2006, convertible notes, stock options and warrants of 1,160,548; 302,316, and 91,040, respectively were excluded from the calculation of earnings per share since their effect would be anti-dilutive.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
NOTE T - GEOGRAPHIC AREAS AND INDUSTRY SEGMENTS
In conformity with SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information the Company’s segment information is presented on the basis that management uses in evaluating segment performance. The Company’s operating segments are Ammunition & Weapons Effects and Electronic Security:
Ammunition & Weapons Effects segment consists of MECAR and MECAR USA. MECAR develops and produces medium caliber tank, mortar and other ammunition. MECAR USA will initially pursue contracts from the U.S. government and others for ammunition and pyrotechnics devices. MECAR USA became operational in the third quarter of 2005.
Electronic Security segment consists of NSM and GMS. NSM designs, manufactures, distributes and services industrial and law enforcement security products and systems. GMS designs and manufactures miniature and sub-miniature FM and digital transmitters, receivers, and related equipment for investigative, surveillance, and security applications, and live TV news/sports/entertainment coverage.
Allied, the parent Company, provides management and other services to its subsidiaries and has no operating activities. Significant intercompany transactions have been eliminated in consolidation.
The Company’s foreign operations are conducted by MECAR.
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Amounts Net of intersegment receivables.
The following geographic area data includes trade revenues based on customer location and assets based on physical location.
(A)
Revenues are attributed to countries based on location of customers
(1)
Includes foreign military sales for the benefit of Saudi Arabia.
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
(1)
Net of inter-segment receivables and investments.
NOTE U -
QUARTERLY FINANCIAL DATA (UNAUDITED)
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
The Company recorded, in the fourth quarter of 2006, a tax valuation allowance for the Europe and U.S. operations of $24,037.
NOTE V - OFF-BALANCE SHEET TRANSACTION
In 2005, the Company and the Marshall Economic Development Corporation (MEDCO) entered into an agreement under which MEDCO agreed to provide funds for the build out of the initial MECAR USA facilities. MEDCO is a state funded organization chartered to assist in the creation of manufacturing jobs in the Marshall, Texas area by facilitating the construction of roads and buildings for companies willing to locate manufacturing facilities in the local area. As part of the incentive package, MEDCO contributed $500 to MECAR USA toward the construction of facilities (used predominately for the installation of roads and utilities) and $1,650 worth of land to house these facilities. The Company provided $640 towards the construction of the initial buildings which was capitalized and is being amortized as an asset over the term of the lease. The agreement between the Company and MEDCO calls for a ten year lease, commencing October 1, 2004 at a total lease cost of $1 (one dollar) with a buyout option for the building and land at the end of the lease provided certain hiring targets are achieved. If, at the end of the lease term, the Company has created at least 175 full time jobs at the Marshall facility (at MECAR USA and Titan), MEDCO will convey title to the land and the facilities for which they provided funding, to the Company without any additional payment by the Company. If at the end of the lease term the Company has continuously occupied and used the facilities but has not fully met the 175 job goal, the Company will have the option to purchase the land and facilities at a price to be computed based on the actual number of full time jobs created. The purchase price will be equal to 175 minus the actual number of full time jobs created as of October 2014 times $9,750 dollars. No revised agreement has been entered into as of December 31, 2007.
NOTE W - DISCONTINUED OPERATIONS
The Consolidated Financial Statements and related note disclosures reflect SeaSpace, The VSK Group, CMS Security Systems and Titan Dynamic Systems, Inc. as “Long-Lived Assets to be Disposed of by Sale” for all periods presented in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Accordingly, our results of operations for all periods presented have been reclassified to reflect SeaSpace, The VSK Group, CMS Security Systems and Titan Dynamic Systems, Inc. as discontinued operations in the consolidated statement of operations and the assets and liabilities of such entities have been reclassified as held for sale in the consolidated balance sheets for all periods presented.
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
SeaSpace Corporation
In the first quarter of 2007, the Company committed to a formal plan to sell SeaSpace, which has previously been reported in the Other segment, as part of management’s plan to dispose of certain non-strategic assets of the Company. At March 31, 2007, the Company recorded a loss of $3,878 to write down SeaSpace’s assets to fair value less costs to sell based on nonbinding offers received from potential buyers during the first quarter of 2007. The loss accrual reflects the write-off of intangible assets including goodwill.
On July 6, 2007, the Company signed a Stock Purchase Agreement to sell SeaSpace for $1,500 in cash. The transaction closed on July 23, 2007 and generated proceeds of $1,541, net of costs to sell of $109. No gain or loss was recognized on the closing date as the loss recorded on March 31, 2007 to write down SeaSpace’s assets to fair value less cost to sell, was adjusted on July 6, 2007 to reflect the higher sales price of the Stock Purchase Agreement. The Company did not record a significant tax expense or benefit from this transaction.
The VSK Group
In the third quarter of 2007, the Company committed to a formal plan to sell The VSK Group, which has previously been reported in the Electronic Security segment, as part of management’s continuing plan to dispose of certain non-strategic assets of the Company and reduce debt and improve the Company’s liquidity.
On September 6, 2007, ARC Europe, a wholly-owned subsidiary of the Company, entered into a Stock Purchase Agreement to sell The VSK Group for approximately $48,737 in cash subject to a purchase price adjustment to be determined following closing. The transaction closed on September 18, 2007 and generated net proceeds of $41,843. The sales price was adjusted for disposal costs which included a working capital adjustment of $62, funds held in escrow of $2,741, investment banking and legal fees of $1,730, management retention and incentive plans of $1,645 and a final purchase price adjustment of $716. The Stock Purchase Agreement requires a total of $2,741 be held in escrow to provide for certain indemnifications as stated for the Stock Purchase Agreement. At this time, the Company is not certain of all contingencies that will be identified and whether it will be able to receive any portion of the $2,741 balance. The Stock Purchase Agreement contains certain indemnification provisions pursuant to which the Company may be required to indemnify the buyer for a period subsequent to the completion of the sale for any and all actions, liabilities, encumbrances, losses, damages, fines, penalties, taxes, fees, costs or expenses or amounts paid in settlement suffered or incurred arising out of any breach of or inaccuracy in any representation or warranties made by the seller or any breach or violation of any covenants or agreements of the Company. Accordingly, such amount has not been included in the determination of the gain on sale. If these potential contingencies are resolved in favor of the Company, the additional consideration received will serve to increase the Company’s gain on the sale of The VSK Group. A gain of $29,314 was recorded at September 18, 2007. In accordance with SFAS No. 52 “Foreign Currency Translation”, the gain included $4,448 of accumulated foreign currency translation gains related to The VSK Group. The Company did not record a significant tax expense or benefit from this transaction as the gain is expected
CMS Security Systems
CMS Security Systems (CMS) was originally a wholly-owned subsidiary of The VSK Group, but was not included as part of its sale. With the sale of The VSK Group, CMS became a wholly-owned subsidiary of ARC Europe. The Company committed to a plan to sell CMS Security Systems in the third quarter of 2007 as part of the decision to dispose of The VSK Group. Accordingly, the Company recorded a loss of $594 to write-off all CMS Security Systems’ remaining assets. CMS was sold to The VSK Group on January 1, 2008 for minimal consideration.
Titan Dynamics Systems, Inc.
On October 22, 2007, the Company committed to a formal plan to sell Titan, which has been previously reported in the Ammunitions & Weapons Effects segment, as part of management’s continuing plan to dispose of certain non-strategic assets of the Company. At September 30, 2007, the Company recorded a loss of $1,395 write
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
down of Titan’s assets to fair value less costs to sell based on a nonbinding offer received from a potential buyer during the fourth quarter of 2007. On January 24, 2008, the Company entered into a Purchase Agreement to sell Titan for $4,750 in cash. An additional loss of $1,300 was recorded to reflect additional costs to sell including a separation agreement with a former Titan employee as well as additional funding provided up to the date of sale. The loss accrual reflects the write-off of Titan’s intangible assets including goodwill. The transaction closed on March 17, 2008 and generated proceeds of $2,819, net of costs to sell of $1,931. The Company did not record a significant tax expense or benefit from this transaction.
At December 31, 2007, there were no assets or liabilities held for sale for The VSK Group, SeaSpace or CMS as The VSK Group and SeaSpace sale transactions had been completed and CMS was fully written off in the quarter ended September 30, 2007.
The following is a summary of Titan’s assets and liabilities at December 31, 2007:
The following is a summary of the assets and liabilities held for sale at December 31, 2006:
The Allied Defense Group, Inc.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
The following discloses the results of discontinued operations for the year ended December 31, 2007 and 2006:
NOTE X -
SUBSEQUENT EVENTS
The Company completed the sale of Titan on March 17, 2008 for $4,750. The effective date of the transaction was February 29, 2008.
In March 2008, the Company reached a tentative agreement to extend and expand the credit facility until November 30, 2008. This agreement would require a partial repayment of MECAR’s cash line in July 2008, as MECAR makes shipments on its current backlog. The finalization of the agreement is subject to local government support that will guarantee an additional portion of MECAR’s performance bonds and advance payment guarantees from April through November 2008. This additional guarantee will reduce the required restricted cash balances at MECAR and allow the company to fund MECAR through it critical working capital expansion period.
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
The Allied Defense Group, Inc.
(Parent Company)
BALANCE SHEETS
December 31,
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT - (Continued)
The Allied Defense Group, Inc.
(Parent Company)
STATEMENTS OF OPERATIONS
Years ended December 31,
SCHEDULE I - CONDENSED FINANCIAL INFORMATION OF REGISTRANT - (Continued)
The Allied Defense Group, Inc.
(Parent Company)
STATEMENTS OF CASH FLOWS
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
The Allied Defense Group, Inc.
Years ended December 31, 2007 and 2006
(1)
Represents amount of reserve relieved through completion of contracts.
(2)
Represents write-off of receivables.
(3)
Represents amounts of valuation allowance relieved through use of deferred tax assets.
EXHIBIT INDEX
E-1