ITEM 1. BUSINESS
Introduction
We develop, manufacture and market advanced technical ceramic products, ceramic powders and components for defense, industrial, automotive/diesel and commercial applications.
In many high performance applications, products made of advanced technical ceramics meet specifications that similar products made of metals, plastics or traditional ceramics cannot achieve. Advanced technical ceramics can withstand extremely high temperatures, combine hardness with light weight, are highly resistant to corrosion and wear, and often have excellent electrical insulation capabilities, special electronic properties and low friction characteristics.
Our products include:
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lightweight ceramic armor for soldiers and other military applications;
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ceramic industrial components for erosion and corrosion resistant applications;
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ceramic powders, including boron carbide, boron nitride, titanium diboride, calcium hexaboride, and zirconium diboride, which are used in manufacturing armor and a broad range of industrial products;
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evaporation boats for metallization of materials for food packaging and other products;
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durable, reduced friction, ceramic diesel engine components;
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functional and frictional coatings primarily for automotive applications;
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translucent ceramic orthodontic brackets;
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ceramic-impregnated dispenser cathodes for microwave tubes, lasers and cathode ray tubes;
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ceramic crucibles for melting silicon in the photovoltaic solar cell manufacturing process;
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ceramic missile radomes (nose cones) for the defense industry; and
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structural neutron absorbing materials in combination with aluminum metal matrix composites that serve as part of a barrier system for spent fuel storage and dry storage in the nuclear industry.
Our customers include the U.S. government, prime government contractors and large industrial, automotive, diesel and commercial manufacturers in both domestic and international markets.
The principal factor contributing to our recent growth in sales is increased demand by the U.S. military for ceramic body armor that protects soldiers. This increased demand is driven by a growing recognition of the performance and life saving benefits of utilizing advanced technical ceramics in lightweight body armor. Recent military conflicts in Iraq and Afghanistan, as well as an increasingly unstable geopolitical climate and the heightened risk of international conflicts, have resulted in increased orders for these products. We believe that our ability to produce and deliver large quantities of ceramic body armor in 2005 and 2006 has led to increased orders for our products. However, ceramic armor contracts generally are awarded in an open competitive bidding process. Our future level of sales of ceramic body armor will depend on our ability to successfully compete for and retain this business.
Our sales also increased in 2004, 2005 and 2006 because of our acquisition of ESK Ceramics on August 23, 2004. The operations of ESK Ceramics have been consolidated with ours since September 1, 2004. As a result of this acquisition, we believe that we are the only ceramic body armor manufacturer with a vertically integrated approach of designing much of our key equipment and controlling the manufacturing process from the principal raw material powder to finished product.
We believe that numerous applications for ceramic products and technology have the potential to drive long-term growth of our business. Examples of applications for which we have developed or are currently developing products include:
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lightweight ceramic armor for military vehicles, boats and aircraft;
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ceramic components that have the potential to facilitate the extraction of oil from oil sands on a cost-effective basis;
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ceramic materials that have the potential to reduce significantly the cost of producing molten aluminum;
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chemical micro reactors, heat exchangers and hydraulic trim valves produced with our proprietary technology that have the potential to provide an economical substitute for steel in extreme environments;
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high purity fused silica ceramic crucibles used by several photovoltaic cell manufacturers in their silicon melting operation in order to produce polycrystalline silicon storage containers;
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storage containers made with our boron carbide powder that have the potential to be used for long-term containment of nuclear waste from nuclear power plants; and
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small complicated ceramic components made using our injection molding technology that have the potential to be used as medical implants.
To meet increasingly higher performance standards, advanced technical ceramics have stringent technical manufacturing requirements. We have designed and customized our facilities and capital equipment to enhance our advanced technical ceramic manufacturing processes. We have also implemented lean manufacturing initiatives to lower costs and drive further efficiencies in our manufacturing processes, and are expanding our facilities to add manufacturing capacity.
We conduct our operations through five operating segments: our Advanced Ceramic Operations division, our ESK Ceramics subsidiary, our Semicon Associates division, our Thermo Materials division and our new Ceradyne Canada subsidiary.
Advanced Technical Ceramics
Evolving customer requirements in industrial processing, military systems, microwave electronics, automotive/diesel engine products and orthodontics have generated a demand for high performance materials with properties not readily available in metals, plastics or traditional ceramics. The following table compares favorable typical properties of selected advanced technical ceramics with those of other selected materials.
Ceramics such as earthenware, glass, brick and tile have been made for centuries and are still in common use today. The inertness and lasting qualities of ceramics are illustrated by artifacts uncovered intact in modern times. Almost all traditional ceramics, including those of ancient times, were based on clay. In the last fifty years, significant advances have been made in ceramic technology by applying specialized manufacturing processes to produce synthetic ceramic powders. Developments in aluminum oxide and other oxides resulted in ceramics that were excellent electrical insulators and were capable of withstanding high temperatures. In addition, industry advancements in ceramic material science have led to the development of a class of ceramics that are generally non-oxides, such as carbides, borides and nitrides. These non-oxide ceramics generally have mechanical properties that exceed those of oxide ceramics developed in prior periods. Collectively, these developments resulted in the ability to manufacture ceramics with great strength at elevated temperatures and reduced fragility, historically a primary limitation of ceramics. The products that have emerged from these advances are known as advanced technical (or structural) ceramics.
The properties of advanced technical ceramics present a compelling case for their use in a wide array of modern applications. However, to meet increasingly higher performance standards, advanced technical ceramics have stringent technical manufacturing requirements. First, manufacturers must start with fine synthetic ceramic powders of very high and consistent quality that are produced using a highly technical and specialized manufacturing process. Few suppliers of these high quality starting powders exist today and not all of these suppliers can consistently produce starting powders of the necessary quality and consistency in the volumes required by ceramic manufacturers. Second, the specialized equipment required to manufacture advanced technical ceramics must often be custom designed and is not readily available, requiring a significant investment in capital equipment and facilities to allow volume production. Manufacturing costs associated with the production of these ceramics are higher than those of the materials they replace. A portion of these costs is related to the need for diamond grinding finished components to exacting tolerances. To accelerate the use of advanced technical ceramics as a direct replacement for metals, plastics or traditional ceramics, these manufacturing costs need to be reduced. Cost reduction efforts include the production of blanks or feed stock to “near net shape” configurations in order to reduce the amount of diamond grinding needed. Manufacturers are also seeking to reduce costs through the use of high volume automated processing and finishing equipment and techniques, and to achieve economies of scale in areas such as powder processing, blank fabrication, firing, finishing and inspection.
Our Solution
We develop, manufacture and market advanced technical ceramic products, ceramic powders and components for defense, industrial, automotive/diesel and commercial applications. The table on the following pages illustrates some of the solutions we have designed to meet market opportunities and demands.
Market Opportunity
Demands of the Market
Our Solution
Defense
Lightweight ceramic body armor and boron carbide powders
Due to the proliferation of automatic weapons in tactical operations and terrorist conflicts, it has become necessary for vests or other armor to stop machine gun bullets while being light enough in weight to allow freedom of movement without undue fatigue.
We have developed lightweight bullet resistant ceramic body armor solutions, including SAPI (small arms protective inserts), ESAPI (enhanced small arms protective inserts), ESBI (enhanced side ballistic inserts) and other systems. These products generally consist of hot pressed Ceralloy® 546 (boron carbide) or hot pressed Ceralloy® 146 (silicon carbide) and other ceramic coupled with backings such as Dyneema® or Spectra Shield® purchased from third parties. Our subsidiary, ESK Ceramics, is a major manufacturer of boron carbide powders, which are used by us and our competitors to manufacture lightweight ceramic body armor.
Lightweight ceramic armor for military ground-based vehicles, boats and aircraft
Military ground-based vehicles, boats and aircraft require protection against automatic weapons. Weight, cost and vehicle compatibility are critical technical parameters.
We have developed a series of lightweight, cost effective ceramic armor systems and attachment mechanisms that have multi-hit protection at various threat levels and can be added to an existing vehicle or designed into new vehicles, boats and aircraft.
Market Opportunity
Demands of the Market
Our Solution
Missile radomes (nose cones)
Defensive tactical missile systems such as the PAC-3 (Patriot Advanced Capability) and the Arrow Missile are designed to fly at extremely high velocities, survive tight turning radii and operate in severe weather conditions. These operating conditions preclude the use of conventional polymer materials for radomes.
We have developed advanced technical ceramic radomes made of fused silica ceramics which meet certain specifications of these tactical defensive missile systems, and have developed a modified silicon nitride radome for more demanding requirements. We have also established a precision diamond grinding capability to finish these radomes.
Industrial
Advanced ceramic structural parts
Applications such as high performance pump seals, blast nozzles, chemical processing, and pulp and paper manufacturing, require components with corrosion and wear resistant properties, mechanical strength, hardness, favorable friction properties and the ability to withstand extreme temperature fluctuations.
We have developed products for each of these applications which have excellent wear resistant properties, lightness, hardness and the ability to withstand extremely high temperatures. We manufacture these products using primarily our EKasic® silicon carbide, silicon nitride and boron carbide ceramic.
Boron compounds and metallurgy
Increasing productivity requirements in primary industries are met with boron nitride powders, which are used as high temperature lubricants and release agents. As filler material in polymers and silicones, boron nitride is used for heat conducting and insulating films in the electronic industry. Aluminum and steel foundries increasingly require consumables with longer lifetimes to improve their overall efficiencies.
In the aluminum extrusion industry, boron nitride powder, spray or suspension is used as a release agent to keep the hot metal away from the extrusion die. In furnace and high temperature applications it is used as insulation sleeve or support for graphite heaters. Boron nitride’s largely inert behavior towards molten metals makes it an ideal material for applications in direct contact with such materials. We supply break rings for horizontal continuous casting and side-dams for thin strip casting. We also supply high density and high purity silicon nitride products for aluminum-foundries worldwide.
Evaporation boats
Packaging materials used for snack and other food products are often lined with an aluminum coating to preserve shelf life. The coating, or metallization, process requires a tool, called an evaporation boat, which can withstand the high temperature and corrosiveness of melted aluminum.
We have developed evaporation boats, typically made using boron nitride/titanium diboride, that can withstand direct contact with highly corrosive liquids, such as melted aluminum. These evaporation boats are used in the metallization of various surfaces, including paper, plastic and glass.
Industrial equipment requiring critical protection against severe wear or corrosion
Failure of industrial equipment is often caused by premature wearing out of surfaces due to abrasive action. An example is paper making equipment where the pulp slurry runs at 5,000 feet per minute.
Sintered reaction bonded silicon nitride (SRBSN) industrial wear parts are designed to replace hard metal or oxide ceramic wear surfaces, resulting in greater productivity, quality and longer uptime. Our side damns are used in the refractory industry for the production of steel.
Market Opportunity
Demands of the Market
Our Solution
Photovoltaic (solar cell) manufacturing requiring crucibles for melting silicon
In order to produce cost effective solar cell components, it is necessary to melt silicon in a crucible or vessel that will be able to contain the molten silicon yet not allow unwanted chemicals to contaminate the melt.
We have developed a high purity fused silica ceramic crucible (receptacle) which is being used by several photovoltaic cell manufacturers in their silicon melting operation in order to produce polycrystalline silicon.
Radioactive waste management
Increasing stockpiles of radioactive nuclear waste require materials that can be used to safely transport and store items such as spent nuclear fuel rods.
The boron atom in boron carbide powder is able to capture neutrons, thus reducing the radioactive risk associated with transportation and storage of nuclear waste. Our Boral® product line, which consists of a hot-rolled aluminum sheet containing a core of uniformly distributed boron carbide and aluminum particles that is enclosed within layers of pure aluminum, forms a solid and effective barrier for the storage of nuclear waste.
Automotive/Diesel
Heavy-duty diesel truck engines
In order to achieve diesel engine life of 500,000 miles or more without major maintenance, and to meet current environmental requirements, it may be necessary to replace metal engine components with longer lasting, lighter weight, lower friction ceramic parts at acceptable unit costs.
Our SRBSN ceramic cam rollers replace conventional steel cam rollers in order to allow diesel engines to run at higher internal pressures and thus meet environmental and other requirements.
Wear-resistant functional and frictional coatings
Engines generate extreme vibration during operation that can cause components joined by nuts and bolts to loosen. Traditionally, locknut washers have been used for this application.
Our wear-resistant functional and frictional coatings utilizing entrapped hard particles, primarily diamonds, which are applied to shims in lieu of using locknut washers. These coatings increase the static friction coefficient and minimize the effects of vibration and allow more economic and efficient designs of engines, particularly in the auto industry.
Commercial
Orthodontic brackets
Traditional stainless steel orthodontic brackets are often considered unsightly. Substitute clear plastic materials can be weak and may stain. Some orthodontic patients prefer aesthetically pleasing brackets which can be affixed to each tooth to support the arch wire.
Our translucent ceramic orthodontic brackets are inert, reveal the color of the patient’s teeth, and allow the orthodontist to correct the patient’s bite. Our marketing partner, 3M Unitek, sells this translucent ceramic bracket under the brand name Clarity™.
Our Competitive Strengths
We believe that several aspects of our company provide us a competitive advantage in the markets we serve, including the following:
Broad Technical Expertise in Ceramic Material Science. Since the founding of our company in 1967, our core business has been researching, developing, designing, manufacturing and marketing advanced technical ceramic products. Specifically, our expertise is in a class of ceramics known as non-oxide structural ceramics. Many of our staff are technically trained, including 70 employees with degrees in ceramic engineering or related sciences, of which 24 have Ph.D. degrees. We have continuously sought to develop and manufacture innovative ceramic products not only for the markets that we currently serve but to identify and apply our experience and capabilities to emerging markets and applications. For example, our expertise allows us to develop ceramic armor products expeditiously and manufacture them on a significant scale.
Proprietary Equipment and Manufacturing Processes. The specialized equipment required to manufacture ceramic powders and advanced technical ceramics must often be custom designed and is not readily available. Over the past several decades, we have designed and constructed a substantial array of highly specialized and customized equipment and manufacturing processes, including our hot press lines and furnaces. We believe our proprietary equipment and manufacturing processes allow us to meet the high volume demands of our customers in the markets that we serve.
Vertically Integrated Body Armor Manufacturer. We are a vertically integrated manufacturer of lightweight ceramic body armor. Our ESK Ceramics subsidiary manufactures boron carbide powder-the key raw material used in the production of our body armor. ESK Ceramics is one of the world’s leading manufacturers of boron carbide powder and has been a supplier of boron carbide powder to us for over 30 years. We form the boron carbide powder into ceramic armor plates using our own furnaces and hot presses. We then apply backing materials purchased from third parties to the plates to complete a ceramic body armor system ready to ship to our customers. Owning a source of our principal raw material, together with the recent and ongoing expansion of our manufacturing capacity at our Lexington, Kentucky plant, should allow us to fulfill current and anticipated demand for our ceramic body armor, while enabling us to manage our costs, product yields and high quality standards.
Strong Position in Multiple Markets. We maintain a strong position in many of the markets that we serve. We believe that we are the leading supplier of lightweight ceramic armor products to the U.S. government. We further believe that we supply a significant portion of products in many of the markets we serve including: boron carbide powders; translucent ceramic orthodontic brackets; ceramic missile radomes, commonly known as nose cones, for the PAC-3 and Arrow missile programs; sintered reaction bonded silicon nitride, which we call SRBSN, for industrial and automotive applications; evaporation boats used to apply the metallic coating to packaging materials; and wear resistant functional and frictional coatings for the automotive industry. We believe that our leadership position in ceramic body armor and in many of the other markets that we serve provides us with a key advantage in securing new and continuing business.
Key Customer Relationships. We have longstanding relationships with many of our significant customers in the defense, industrial, automotive/diesel and commercial markets that we serve, which have enhanced our ability to obtain business over time. For example, for more than 20 years we have sold our advanced technical ceramic products to various agencies of the U.S. government. Since 2003, we have derived the majority of our revenues from the Army, Marines, Air Force and other branches of the U.S. military. We possess significant knowledge of the applicable purchasing requirements and product specifications within each of the branches of the U.S. military that we serve, and we believe that we have established an excellent reputation with key individuals within each branch.
Experienced Management Team and Entrepreneurial Culture. Our success is attributable in large part to the extensive knowledge and experience of our management team and key personnel. Our executive management team has substantial experience in advanced technical ceramic materials science and our Chief Executive Officer, our President of North American Operations and our Vice President of Operations each has more than 25 years of experience in the ceramics industry. Our management team has demonstrated its ability to identify, execute and integrate strategic acquisitions into our business through our acquisitions of ESK Ceramics in August 2004, Quest Technology in May 2004 and a boron carbide/aluminum cladding product line known as Boral® in June 2006. Moreover, we believe that the entrepreneurial culture that has been fostered at Ceradyne since 1967 enhances our ability to develop innovative products for the markets that we serve.
Our Business Strategy
Our goal is to create value for our stockholders by profitably developing, manufacturing and selling advanced technical ceramic components to customers in existing and new markets where there is a need for new materials that will increase the efficiency, productivity and life of our customers’ end products. Key elements of our strategy for achieving this goal include:
Capitalizing on Opportunities in the Defense Market. The current geopolitical climate, terrorist threats and heightened international conflicts such as those in Iraq and Afghanistan, have been the primary factors driving demand for our defense products. Our defense marketing and sales efforts emphasize sales of ceramic body armor for military personnel to the U.S. government and, with the authorization of the U.S. government, to foreign allies of the United States. We also intend to expand our lightweight ceramic armor products to address additional body armor applications as well as new defense applications in vehicles, boats and aircraft. We are in the process of developing the next generation of body armor that we plan to have capable of withstanding higher ballistic threats than current versions with approximately the same product weight.
Continuing to Increase our Non-Defense Revenue Base. We plan to continue to grow our non-defense customer base, primarily through promoting existing products to new customers and developing new products for new and existing customers. We focus on educating our current and potential customers on the advantages of our advanced technical ceramics compared to alternative solutions, and assisting them in developing advanced technical ceramic components for existing or new products and applications. Our highly trained technical and marketing staff educates our customers through direct sales visits, by preparing technical papers and product literature, and by participating in technical conferences, trade shows and exhibitions. Based on these efforts, we believe there is an opportunity to further expand the use of advanced technical ceramic products. For example, we are working with 3M Unitek on developing the next generation of translucent ceramic orthodontic brackets. We also are working with companies in the aluminum industry on utilizing ceramic materials in their next generation smelting production processes that have the potential to reduce the cost of producing aluminum. We also intend to further increase our customer, product and market base by converting certain advanced technical ceramics, originally developed for defense applications, to industrial and commercial applications. In addition to organically growing our product portfolio and market reach, we plan to continue to identify strategic acquisition opportunities that broaden our product lines within industrial and commercial markets. For example, a key strategic reason for our acquisitions of ESK Ceramics and the Boral® product line were to further increase our non-defense revenue base as is the expansion of our operations into Canada and China.
Identifying New Products and Markets. We intend to identify new products and markets to meet evolving customer requirements for high performance materials. Due to the special properties of the advanced technical ceramics we produce, we believe there are numerous applications and markets for such materials. Our research and development efforts have identified several new applications for advanced technical ceramics in both existing markets, such as the defense industry, and new markets, including the energy, metals production and chemical industries. Such new applications include lightweight ceramic armor for military vehicles, boats and aircraft; ceramic components that have the potential to facilitate extraction of oil from oil sands on a cost-effective basis; ceramic materials that have the potential to reduce significantly the cost of producing molten aluminum; chemical micro reactors, heat exchangers and hydraulic trim valves produced with our proprietary technology that have the potential to provide an economical substitute for steel in extreme environments; storage containers made with our boron carbide powder that have the potential to be used for long-term containment of nuclear waste from nuclear power plants; and small complicated ceramic components made using our injection molding technology that have the potential to be used as medical implants. We also expect to continue to benefit from the addition of ESK Ceramics’ expertise in ceramic powders and products, which has expanded the scope and scale of our product development efforts.
Investing to Improve our Gross Margins and Manufacturing Efficiencies. We focus on cost containment, productivity enhancements and manufacturing efficiencies as a means to drive earnings growth. We have implemented lean manufacturing initiatives, such as Demand Flow® Technology and 5-S plus Safety in order to reduce inventories, scrap and queue times and to increase productivity. Additionally, we continue to evaluate opportunities to employ automation and dedicated work cells to expand our in-line production efficiency. We also continue to seek ways to reduce our manufacturing costs by evaluating opportunities to relocate or expand manufacturing operations within the United States as well as internationally. For example, in 2004, we began expanding our high energy-utilization manufacturing processes at our new Lexington, Kentucky facility, where the cost of electricity, which comprises a significant portion of our cost of product sales, is substantially lower than in California. We plan to evaluate strategic manufacturing relationships in international markets, including joint ventures or acquisitions, particularly in low cost manufacturing areas such as Mexico and China. We expect to complete the construction in May 2007, of a new approximately 98,000 square foot facility in Tianjin, China for the manufacture of solar crucibles. We also plan to develop strategic relationships with other manufacturing companies or key customers whose expertise or financial resources can assist us in accomplishing our objectives.
Market Applications and Products
Our products are sold into four principal markets: defense, industrial, automotive/diesel and commercial. The following is a description of our principal products by market application:
Defense
Lightweight Ceramic Armor. We have developed and currently manufacture lightweight ceramic armor capable of protecting against threats as great as 12.7 millimeter armor piercing machine gun bullets. Compared to traditional steel armor plates, our ceramic armor systems offer weight savings as great as 40%. Using hot pressed Ceralloy® ceramic, our armor plates are laminated with either Spectra Shield®, Dyneema®, Kevlar™, fiberglass, custom hybrid laminates or aluminum and formed into a wide variety of shapes, structures and components. Initially, our manufactured ceramic armor was used principally for military helicopter crew seats and airframe panels. We are now also a major supplier of lightweight ceramic body armor for the U.S. military, and we believe we are a leading producer of lightweight ceramic armor for military helicopters.
Boron Carbide Powders. We manufacture boron carbide powder, which is the principal raw material used in the production of our lightweight ceramic body armor. Our ESK Ceramics subsidiary is one of the world’s leading manufacturers of this material. ESK Ceramics has been a supplier of boron carbide powder to us for over 30 years and also supplies our ceramic body armor competitors.
Missile Radomes (Nose Cones). We manufacture conical shaped, precision machined ceramic radomes which are designed for the front end of defensive missiles. These radomes are used where missile velocities are high and operating environments are severe, and the thermal shock and erosion resistance, high strength and microwave transparency properties of advanced technical ceramics are required. Our ceramic radomes are used on the PAC-3 (Patriot Advanced Capability) and the Arrow Missile.
Industrial
Fluid Handling/Wear Parts. We supply products made primarily of our EKasic® silicon carbide, silicon nitride and boron carbide, which have excellent wear resistant properties, lightness, hardness, and can withstand extremely high temperatures. Products furnished are used in high performance pump seals, bearings for fluid handling, blast nozzles and chemical processing.
Boron Compounds and Metallurgy. Boron nitride powders have excellent release properties and are highly resistant to wear and corrosion. These powders are used in the forming and bending of glass, as an additive in refractory materials, and as a lubricant for aluminum extrusion. Our silicon nitride products have excellent thermal shock resistance and temperature stability up to 1,200° Centigrade. These products are used for transportation of liquid aluminum, for use in low and high pressure casting and in liquid aluminum processes.
Evaporation Boats. Our evaporation boats are used in the metallization of various surfaces such as plastic, paper or glass. Metallization is a process based on the deposition of a metallic vapor under vacuum to coat a substrate surface with a thin layer of aluminum, zinc, copper or silver. The preferred metal for the metallizing process is aluminum. Evaporation boats have direct contact with highly corrosive liquid metal alloys and are made out of a boron nitride/titanium diboride composite material. These products provide packaging manufacturers the ability to apply vaporized aluminum to packaging material that as a finished product helps to preserve and maintain the shelf life of food products.
Industrial Wear Components. Our industrial wear components are made primarily of our Ceralloy® 147 sintered reaction bonded silicon nitride (SRBSN). These SRBSN ceramic components are generally incorporated in high wear areas of industrial machinery where severe abrasive conditions would otherwise wear out vital components. Our wear resistant parts are used to replace parts made of materials such as tungsten carbide or ceramics such as aluminum oxide. Applications include paper making equipment, abrasive blasting nozzles, metal cutting tool inserts as well as custom products.
Radioactive Waste Management. Boron carbide powder has a high cross-section for capturing neutrons, making it an ideal material for the management of radioactive nuclear waste from nuclear power plants. Typical applications include use in neutron absorbing parts, such as control rods in nuclear power plants, and nuclear shielding in the storage and transportation of nuclear waste materials. Our Boral® product line, which consists of a rolled aluminum sheet containing a core of uniformly distributed boron carbide and aluminum particles that is enclosed within layers of pure aluminum, forms a solid and effective barrier for the storage of nuclear waste.
Ceramic-Impregnated Dispenser Cathodes. We manufacture ceramic-impregnated dispenser cathodes for microwave tubes used in radar, satellite communications, electronic countermeasures and other applications. Dispenser cathodes, when heated, provide a stream of electrons which are magnetically focused into an electron beam. Microwave dispenser cathodes are primarily composed of a porous tungsten matrix impregnated with ceramic oxide compounds. The use of ceramic-impregnated cathodes reduces the amount of energy necessary to create a high level of electron emissions. Our ceramic-impregnated cathodes are also used in ion lasers and cathode ray tubes.
Tempered Glass Furnace Components and Metallurgical and Industrial Tooling. Fused silica ceramic does not, to any material extent, expand when heated or contract when cooled. This material is therefore used for industrial tooling components and molds where complicated shapes and dimensions are maintained over a wide range of temperatures. Such applications include forming and shaping titanium metal used in aircraft manufacture. Other applications take advantage of fused silica’s excellent thermal shock resistance and inertness when in contact with glass. We produce fused silica ceramic rollers up to 14 feet in length used in glass tempering furnaces.
Fused Silica Ceramic Crucibles. We manufacture fused silica ceramic crucibles, or receptacles, which are used in the fabrication of polycrystal silicon for photovoltaic cells that convert sunlight into electricity. These crucibles are designed to withstand high temperatures and thermal shock when in contact with molten silicon, without contaminating the melt.
Precision Ceramics. We manufacture a variety of hot pressed Ceralloy® ceramic compositions that are precision diamond ground to exacting tolerances, primarily for microwave tube applications. The interior cavities of microwave tubes often require microwave absorbing ceramic components capable of operating at elevated temperatures and in high vacuums.
Samarium Cobalt Permanent Magnets. We manufacture and market our samarium cobalt magnets as components primarily for microwave tube applications. Electron beams in microwave tubes generated by the dispenser cathodes described above can be controlled by the magnetic force provided by these powerful permanent magnets. The magnets are generally small sub-components of microwave traveling wave tubes.
Automotive/Diesel
Wear-Resistant Functional and Frictional Coatings. We manufacture our Ekagrip® Foils for wear-resistant functional and frictional coatings utilizing entrapped hard particles, primarily diamonds. This product line increases the static friction coefficient, minimizes the effects of vibration and allows more economic and efficient designs of engines, particularly in the auto industry.
Diesel Engine Components. We have been manufacturing ceramic cam rollers for heavy-duty diesel engines since 1999, and now have production contracts to supply cam rollers to several major engine companies. However, we are aware that some of our customers are designing new engines that do not include our cam rollers. We also supply a fuel systems manufacturer with components for a diesel fuel pump. In addition, we are engaged in development projects with a number of other diesel engine and fuel pump systems manufacturers worldwide for various ceramic components.
Commercial
Ceramic Orthodontic Brackets. In orthodontics, to correct a patient’s tooth alignment, a small stainless steel bracket is attached to each tooth. These brackets provide a guide to the archwire, which is the wire that sets into each bracket. The cosmetic appearance of this metal is often considered unattractive. Together with 3M Unitek, we have developed a patented (jointly owned by Ceradyne and 3M Unitek) ceramic bracket which 3M Unitek markets to orthodontists under the brand name Clarity™. The translucency of this ceramic bracket, together with the classic ceramic properties of hardness, chemical inertness and imperviousness, result in a cosmetic substitute for traditional stainless steel brackets. These brackets reveal the natural color of the patient’s teeth while performing the structural functions of traditional stainless steel brackets.
Operating Divisions and Facilities
We serve our markets through five segments with manufacturing facilities in several locations across the United States and two locations in Europe-Germany and France. The following table includes a summary of our facilities and products comprising our five operating segments.
Operating Segment and Facility Location
Products
Ceradyne Advanced Ceramic Operations
Defense Applications:
• Lightweight ceramic armor
Costa Mesa, Irvine and San Diego, California(1)
Approximately 272,000 square feet
Industrial Applications:
• Ceralloy® 147 SRBSN wear parts
• Precision ceramics
Lexington, Kentucky(2)
Approximately 115,000 square feet
Automotive/Diesel Applications:
• Ceralloy® 147 SRBSN automotive/diesel engine parts
Wixom, Michigan(3)
Approximately 29,000 square feet
Commercial Applications:
• Ceramic orthodontic brackets
• Components for medical devices
ESK Ceramics
Kempten, Germany(4)
Approximately 544,000 square feet
Bazet, France(5)
Approximately 88,000 square feet
Defense Applications:
• Boron carbide powders for body armor
Industrial Applications:
• Ceramic powders: boron carbide, boron nitride, titanium diboride, calcium hexaboride and zirconium diboride
• Silicon carbide parts
• Evaporation boats for the packaging industry
• High performance pump seals
Automotive/Diesel Applications:
• EKagrip® functional and frictional coatings
Ceradyne Semicon Associates
Lexington, Kentucky(6)
Approximately 35,000 square feet
Industrial Applications:
• Ceramic-impregnated dispenser cathodes for microwave tubes, lasers and cathode ray tubes
• Samarium cobalt magnets
Ceradyne Thermo Materials
Scottdale and Clarkston, Georgia(7)
Approximately 132,000 square feet
Defense Applications:
• Missile radomes (nose cones)
Industrial Applications:
• Glass tempering rolls
• Metallurgical tooling
• Castable and other fused silica products
• Crucibles for photovoltaic solar cell applications
Ceradyne Canada
• Chicoutimi, Canada(8)
• Approximately 86,000 square feet
Industrial Applications:
• Boral® structural neutron absorbing materials
• Metal matrix composite structures
(1) We have leases on our facilities in Costa Mesa, California, aggregating approximately 99,000 square feet, all of which expire in October 2010. We own our 40,000 square foot facility in Irvine, California. We also lease in Irvine, California a 24,000 square foot facility that expires in April 2009 and a 76,000 square foot facility that expires in April 2011. We also have a lease on our 23,000 square foot facility in Irvine that expires in April 2009. We have a lease on our 10,000 square foot facility in San Diego, California which expired in December 2006. We anticipate renewing this lease.
(2) We own our facility in Lexington, Kentucky.
(3) We have a lease on our Wixom, Michigan facility which expires in April 2010.
(4) We own our facility in Kempten, Germany, as well as the 22-acre property on which our facility is located.
(5) We own our facility in Bazet, France, as well as the four-acre property on which our facility is located.
(6) We own our facility in Lexington, Kentucky, as well as the five-acre property on which our facility is located.
(7) We have a lease on our 85,000 square foot facility in Scottdale, Georgia which expires in December 2015. We have a lease on our 47,000 square foot facility in Clarkston, Georgia which expires in May 2009.
(8) We own our facility in Chicoutimi, Canada, as well as the seven-acre property on which our facility is located.
Sales, Marketing and Customers
Each of our five operating segments maintains a separate sales and marketing force promoting its individual products. As of December 31, 2006, we had 78 employees directly involved in sales and marketing, including 48 sales and marketing personnel located outside the United States. We also have agreements with manufacturers’ representatives in foreign countries who are compensated as a percent of sales in their territory. Sales to customers located outside the United States represented approximately 15.9% of our net sales in 2006, 26.1% in 2005 and 20.5% in 2004.
We continue to explore various domestic and international relationships to increase our sales and market penetration. We seek long-term relationships such as multi-year agreements or exclusive relationships with our customers to achieve a more consistent and predictable flow of orders and shipments.
We sell products and components to the U.S. government and government agencies, as well as to government contractors, original equipment manufacturers and to end users. The U.S. government and government agencies collectively represented approximately 73.4% of our net sales in 2006, 65.8% in 2005 and 59.2% in 2004.
We sell our translucent ceramic orthodontic brackets, commonly known as braces, only to 3M Unitek. Sales to 3M Unitek represented approximately 1.6% of our net sales in 2006, 2.7% in 2005 and 4.6% in 2004. On December 5, 2005, we entered into a new supply agreement with 3M Unitek that expires in December 2010, and which may be extended by 3M Unitek at its option for an additional two years. This new agreement replaces our original, March 1986 joint development and supply agreement with 3M Unitek, that would have expired in September 2007. 3M Unitek is a major manufacturer of stainless steel orthodontic brackets and, early in our relationship, shared with us the functional specifications and properties which ceramic brackets would be required to satisfy. With this information and our experience with translucent ceramics in defense applications, we developed, and in 1987 began manufacturing, translucent ceramic brackets. Under the original supply agreement, 3M Unitek was required to purchase ceramic orthodontic brackets exclusively from Ceradyne until September 2007. Under the terms of the new agreement, 3M Unitek will continue to purchase 100% of their Clarity and Transcend brand ceramic orthodontic product lines exclusively from us for as long as 3M Unitek continues to sell such products. The new agreement further stipulates that Unitek must purchase from Ceradyne at least 50% of the ceramic orthodontic brackets 3M Unitek requires for next generation designs, which it intends to introduce in 2007.
Manufacturing Processes
We employ a number of advanced technical ceramic manufacturing processes that enable us to deliver high quality products designed to meet specific customer requirements. The processes used to manufacture our principal products are described below.
Hot Pressing. Our hot pressing process is generally used to fabricate ceramic shapes for lightweight ceramic armor. We have designed and constructed induction heated furnaces capable of operating at temperatures exceeding 4,000°F in inert atmospheres at pressures up to 5,000 pounds per square inch. With this equipment, we can fabricate parts more than 26 inches in diameter, which is considered large for advanced technical ceramics. Using multiple cavity dies and special tooling, we can produce a number of parts in one furnace during a single heating and pressing cycle.
Our raw materials are fine powders procured from our ESK Ceramics subsidiary, as well as from several outside suppliers. After we process them, the powders are either loaded directly into the hot pressing molds or are shaped into pre-forms prior to loading into the hot pressing molds. The powders are placed in specially prepared graphite tooling, most of which we machine to shape. Heat and pressure are gradually applied to the desired level, carefully maintained and finally reduced. The furnace is then removed from the press and allowed to cool, permitting the press to be used with another furnace. For most products, this cycle takes approximately 20 hours. The resultant ceramic product generally has mechanical, chemical and electrical properties of a quality approaching theoretical limits. Almost all products, other than armor, are then finished by diamond grinding to meet precise dimensional specifications.
Ceramic Powders (Boron Carbide TETRABOR®, Boron Nitride, Titanium Diboride, Calcium Hexaboride, Zirconium Diboride). We purchase raw materials like carbon, boric acid and oxides from outside vendors. These raw materials are converted into the final formulation in large high temperature processes using an arc furnace. After the resultant material is cooled, it is broken down into fine particulates that are then purified through a chemical treatment. The next process is the
production and classification of various grain sizes. The manufacturing processes result in a very high and consistent quality powder. The resulting finished ceramic powder products are used in a wide range of applications, such as ceramics and powders for abrasives, armor, neutron absorption and refractories.
Sintering and Reaction Bonding of Silicon Nitride (SRBSN). The sintering of reaction bonded silicon nitride results in our Ceralloy® 147 SRBSN, which is used in industrial and automotive/diesel applications. This SRBSN process begins with relatively inexpensive high purity elemental silicon (Si) powders, which contrasts sharply with some other competitors’ manufacturing techniques which start with relatively more expensive silicon nitride (Si3N4) powders.
After additives are incorporated by milling and spray drying, the silicon powders are formed into shapes through conventional ceramic processing such as dry pressing. These shapes are then fired in a nitrogen atmosphere which converts the silicon part to a silicon nitride part. At this step (reaction bonding), the silicon nitride is pressure sintered in an inert atmosphere increasing the strength of the component threefold. As a result of SRBSN processing, the ceramic crystals grow in an intertwining “needle-like” fashion which we have named NeedleLok™. The NeedleLok™ structure results in a strong, tough, high fracture energy part. This process can be used to produce extremely high production volumes of parts due to the use of conventional pressing processes.
Manufacture of Translucent Ceramics (Transtar®). We produce translucent aluminum oxide (Transtar®) components primarily for use as orthodontic ceramic brackets. We purchase the high purity powders from outside vendors and process them using dedicated conventional ceramic mechanical dry presses. The formed blanks are then fired in a segregated furnace in a hydrogen atmosphere at over 3,000°F until the ceramics enter into a mechanically strong, translucent condition. These fired translucent brackets then have certain critical features diamond ground into them. The next step is a proprietary treatment of the bonding side in order to permit a sound mechanical seal when bound to the patient’s teeth. In the final step we furnace braze a stainless steel channel into each archwire slot which has been previously diamond ground into the bracket.
Functional Coatings. Our functional coatings are formed by the deposition of hard particles, primarily diamonds, in a nickel layer on steel, aluminum or titanium. We purchase the hard particles-sized between nanometers and 60µm-from outside vendors and customize these raw materials through chemical treatment. Before being coated, the metal parts are chemically cleaned and deburred. The final product is manufactured by an electroless nickel coating process with simultaneous embedding of hard particle grains. The final step is the hardening of the nickel surface by a heat treatment process up to 660°F.
Evaporation Boats (LaserMet®, DiMet®, TriMet®, FlashMet®). Evaporation boats are ceramic sintered parts consisting of titanium diboride/boron nitride and other nitride compositions for our TriMet® product. These components, in the form of ceramic powders, are milled and conditioned. The key forming process is hot pressing, which results in solid sintered billets. From these sintered billets, the evaporation boats are machined with proprietary processes to various types and shapes.
Sintered Parts. For the production of sintered parts, we either buy raw materials like silicon carbide from outside vendors or use our own ceramic powders. With our specific developed processes, we condition the ceramic powders by incorporating additives, milling, and spray drying into ready-to-press powders. We then utilize the processing steps of forming, green machining, sintering and machining as the materials are transformed into various shapes. We utilize a broad range of technological processes and equipment to accomplish this. An example of these are cold isostatic pressing, axial dry pressing, injection molding, extrusion molding, pressure sintering, hot pressing, hot isostatic pressing and pressureless sintering.
Diamond Grinding. Many of our advanced technical ceramic products must be finished by diamond grinding because of their extreme hardness. Our finished components typically are machined to tolerances of ±.001 inch and occasionally are machined to tolerances up to ±.0001 inch. To a limited extent, we also perform diamond grinding services for customers independently of our other manufacturing processes to specifications provided by the customer. Our diamond grinding facilities can perform surface grinding, diameter grinding, ultrasonic diamond grinding, diamond lapping, diamond slicing and honing. The equipment includes manual, automatic and computer numerically controlled, or CNC, grinders. We have specially adapted the CNC grinders for precision grinding of ceramic contours to exacting tolerances.
Sintering of Fused Silica Ceramics. Sintering of fused silica ceramics is the process we use to fabricate fused silica ceramic shapes for applications in glass tempering furnaces, metallurgical tooling, missile radomes (nose cones) and other industrial uses. To fabricate fused silica ceramic shapes, fused silica powders are made into unfired shapes through slip casting or other ceramic forming processes. These unfired “green” shapes are fired at temperatures up to 2,500°F. The final shapes are often marketed in the “as fired” condition or, in some cases, precision diamond ground to achieve specific dimensional tolerances or surface finishes required by certain customers.
Injection Molding. Certain markets, like medical device components, require ceramic shapes that are small, highly configured and held to tight dimensional tolerances. Many of these can only be produced by the injection molding process.
At the present time these powders tend to be oxide ceramics, primarily zirconia, alumina and/or blends thereof that we mix in house. The ceramic powder is then blended with organic ingredients that constitute a proprietary binder system. The resultant feedstock allows us to process the material through a standard injection-molding machine into a precision mold designed by us.
Rolling of Boron Carbide and Aluminum Metal Matrix Composites. For the production metal matrix composite materials, we purchase billets consisting of a core of pure aluminum with boron carbide powder distributed uniformly throughout the billet, then roll or extrude them into sheets or shapes. For the production Boral®, we acquire an extruded aluminum material into which we place a proprietary mixture of aluminum and boron carbide powder. We roll this material into thin sheets of shield material, which can then be cut into numerous sizes.
Raw Materials
The starting raw materials for our manufacturing operations are generally fine, synthetic powders available from several domestic and foreign sources, including our subsidiary, ESK Ceramics. ESK Ceramics supplied 138 tons of boron carbide power to us in 2004, 562 tons in 2005 and 1,060.7 tons in 2006. We have owned ESK Ceramics since August 23, 2004. Other raw materials, such as the backing material for ceramic armor, graphite and metal components, are procured from several commercial sources. The backing material used in the production of body armor is currently subject to government directed allocation. We believe that sufficient quantities of this material will be available to fulfill our projected needs.
Quality Control
We make our products to a number of exacting specifications. In order to meet both internal quality criteria and customer requirements, we implement a number of quality assurance and in-process statistical process control programs. We implement these quality programs separately at each of our manufacturing locations. Our Advanced Ceramic Operations, ESK Ceramics and Thermo Materials facilities have received ISO 9001 Certification. Ceradyne Semicon Associates is ISO 9000 compliant.
Engineering and Research
Our engineering and research efforts consist of application engineering in response to customer requirements, in addition to new materials and product development. Our efforts create new products, modify existing products to fit specific customer needs and result in developing enhanced ceramic processes.
We allocate costs associated with application engineering and research between cost of product sales and research and development expense. Application engineering efforts devoted to specific customer orders generally are recognized as cost of product sales, while the balance of engineering and research costs is included in research and development and expensed as incurred. Our research and development expenses were approximately $9.9 million in 2006, $7.8 million in 2005 and $3.3 million in 2004.
Competition
Our products compete with advanced technical ceramic products and powders from other companies, as well as with high strength steel alloys and plastic products. When competing with other advanced technical ceramic products and powders, we believe the principal competitive factors are manufacturing capacity and the ability to deliver products, price, product performance, material specifications, application engineering capabilities, customer support and reputation. Some of our competitors include Armor Holdings, ArmorWorks, Ceramtec, the Cercom subsidiary of BAE Systems, CoorsTek, Denka, Momentive Performance Materials, Hitachi, HC Starck, Kyocera’s Industrial Ceramics Group, Morgan, Saint Gobain, Sintec, Spectra-Mat, UK Abrasives and Vesuvius. Many of our current or potential competitors have greater financial, marketing and technical resources than we do. We cannot guarantee that we will be able to compete successfully against our current or future competitors. If we fail to compete successfully, there could be material adverse effects on our business, financial condition and results of operations. In many applications we also compete with manufacturers of non-ceramic materials. When competing with high strength steel alloys and plastic products, we may not be able to compete effectively when price is a primary consideration, because our products are typically more expensive as a result of higher manufacturing costs associated with the production of advanced technical ceramics.
Backlog
We record an item as backlog when we receive a contract, purchase order or other notification indicating the number of units to be purchased, the purchase price, specifications, delivery requirements and other customary terms and conditions. Our backlog was approximately $276.4 million as of December 31, 2005, and approximately $344.3 million as of December 31, 2006. We expect that substantially all of our backlog as of December 31, 2006 will be shipped during 2007.
Patents, Licenses and Trademarks
We rely primarily on trade secrecy to protect compositions and processes that we believe are proprietary. In certain cases, the disclosure of information concerning such compositions or processes in issuing a patent could be competitively disadvantageous. However, our management believes that patents are important for technologies where trade secrecy alone is not a reliable source of protection. Accordingly, we have applied for, or have been granted, several U.S. patents relating to compositions, products or processes that our management believes are proprietary, including lightweight ceramic armor.
We have been issued two U.S. patents relating to translucent ceramics for orthodontic brackets. The earliest of these patents expires in September 2007. We co-invented and co-own these patents with 3M Unitek. Together with 3M Unitek, we have granted licenses to companies whose ceramic orthodontic brackets infringe our joint patents. These companies pay both of us royalties based on sales of their orthodontic ceramic brackets for the remaining life of the patents.
In addition to the above, we have been issued 20 U.S. patents and have 18 patents pending and have applied for corresponding foreign patents in various foreign countries. Of the number of patents indicated above, our subsidiary, ESK Ceramics, has been issued 14 U.S. patents, while 6 patents are pending.
The proprietary coarse grained silicon carbide materials, including silicon carbide materials with graphite inclusions, are protected by patents in Europe, the United States, Canada, Japan and the Czech Republic. These patents expire in 2017. Other patents and one patent pending also relate to sintered silicon carbide materials, the earliest expiring in 2010. Another 4 patents for evaporation boats have been issued in Europe, the United States, Canada and Japan. The earliest of these patents expires in 2018. One other patent is on Ekagrip® friction enhancing coatings, which expires in 2019, and there is an additional patent pending on Ekagrip®. Other patents relate to boron nitride materials and composite ceramic materials.
“Ceralloy®,” the name of our technical ceramics, “Ceradyne®” and the Ceradyne logo, comprising the stylized letters “CD®,” are our major trademarks registered in the United States and various foreign countries. We also have other trademarks, including “Transtar®,” “Semicon®,” “Thermo®,” “Netshape®,” “Defender®,” “NeedleLok™,” and “Ramtech™”. The ESK Ceramics logo, and ESK Ceramics’ major product trademarks, including “TETRABOR®”, “EKasic®”, “DiMet®”, “TriMet®”, “MYCROSINT®”, “EKagrip®”, “BOROMID®”, “EKamold®”, “LaserMet®”, “EllipsoMet®” and “EKatherm®” are registered in Germany and many countries worldwide. Other major product trademarks, “BORONEIGN®”, “EKathemis®” are registered in Germany and registration has been applied for in many countries worldwide.
Employees
As of December 31, 2006, we had 2,205 employees, including 70 employees with undergraduate or graduate degrees in ceramic engineering or related sciences. Of these total employees, 1,784 were in manufacturing, 201 were in engineering and research, 78 were in sales and marketing, and 142 were in general management, finance and administration. We also use temporary labor in some of our production operations. We generally consider our relationship with employees to be excellent. None of our U.S.-based employees are represented by labor unions. The employees of ESK Ceramics have elected a works council, an entity which represents employees and is entitled to information and co-determination rights under German law. We consider our relationship with the works council to be good.
Availability of SEC Filings
We file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission. You can read our SEC filings over the Internet at the SEC’s website at http://www.sec.gov. We also make our SEC filings available free of charge through our Internet website as soon as reasonably practicable after we electronically file them with, or furnish them to, the SEC. Our website address is www.ceradyne.com. The reference to our website address does not constitute incorporation by reference into this report of the information contained at that site.
EXECUTIVE OFFICERS OF CERADYNE
Our executive officers and their ages as of February 26, 2007 are as follows:
Name
Age
Position
Joel P. Moskowitz
Chairman of the Board, Chief Executive Officer and President
David P. Reed
Vice President, President of North American Operations and Assistant Corporate Secretary
Jerrold J. Pellizzon
Chief Financial Officer and Corporate Secretary
Michael A. Kraft
Vice President of Sales, Marketing and Business Development
Peter Hartl
Vice President and President of ESK Ceramics
Marc King
Vice President of Armor Operations
Bruce Lockhart
Vice President and President of Thermo Materials
Jeff Waldal
Vice President and President of Semicon Associates
Kenneth R. Morris
Vice President, Operations
Matthew Karmel
Vice President
Joel P. Moskowitz co-founded our predecessor company in 1967. He served as our President from 1974 until January 1987, and has served as our President since September 1987. In addition, Mr. Moskowitz has served as our Chairman of the Board and Chief Executive Officer since 1983. Mr. Moskowitz currently serves on the Board of Trustees of Alfred University. Mr. Moskowitz obtained a B.S. in Ceramic Engineering from Alfred University in 1961 and an M.B.A. from the University of Southern California in 1967.
David P. Reed joined us in November 1983, and has served as a Vice President since January 1988. In February 2005, Mr. Reed was appointed to the newly created position of President of North American Operations, with responsibility for all the company’s Advanced Ceramic Operations in Costa Mesa, Irvine and San Diego, California, as well as the new plant in Lexington, Kentucky; Ceradyne Thermo Materials, in Scottdale, Georgia; and Ceradyne Semicon Associates, in Lexington, Kentucky. Mr. Reed’s focus has been and will continue to be on lightweight ceramic armor systems. Prior to joining us, Mr. Reed served as Manager, Process Engineering for the Industrial Ceramic Division of Norton Co. from 1980 to 1983. Mr. Reed obtained a B.S. in Ceramic Engineering from Alfred University in 1976 and an M.S. in Ceramic Engineering from the University of Illinois in 1977.
Jerrold J. Pellizzon joined us in September 2002 and serves as our Chief Financial Officer and Corporate Secretary. Prior to joining us, Mr. Pellizzon was Chief Executive Officer of DrSoy Nutrition, Inc., a developer of soy protein based food products, from 2000 until 2002. From 1994 through 2000, Mr. Pellizzon served as Chief Operating Officer and Chief Financial Officer of Met-Rx Substrate Technologies. From 1984 to 1993, Mr. Pellizzon was Chief Financial Officer for Breton Construction, Inc., and served on their executive committee and board of directors. Prior to 1984, Mr. Pellizzon held executive and management positions at Duke Timber Construction/Tobin Steel Company and was employed as a C.P.A. in public accounting. Mr. Pellizzon obtained his B.S. in Economics from UCLA in 1975.
Michael Kraft joined us in February 2005 in the newly created position of Vice President of Sales, Marketing and Business Development. Prior to joining us, Mr. Kraft was Managing Director of BVI Capital Partners, an investment bank that provides restructuring services, from 2003 through 2005, and President and Founder of KAM Solutions, LLC, an engineering and materials testing services firm, in 2003. From 2000 through 2002, Mr. Kraft was President, USA, for Rational AG and from 1993 through 2000, he held various management and marketing positions with Kulicke & Soffa Industries, Inc. Prior to 1993, Mr. Kraft held various management and marketing positions with General Electric Company. He holds degrees with honors from Michigan State University in electrical engineering and an MBA degree from Pennsylvania State University.
Peter Hartl joined us as a result of our 2004 acquisition of ESK Ceramics. Dr. Hartl was elected a Vice President in November 2004, and is President of ESK Ceramics. He joined ESK Ceramics in 1998 as Vice President in charge of boron compounds. Prior to joining ESK Ceramics, Dr. Hartl spent 11 years at ESK Ceramics’ former parent company, Wacker Chemie, starting in Wacker’s research department and moving to the chemical regulations department as part of a management development project. He became technical support manager in Wacker’s silicone division and was later appointed regional manager for silicone sealants to establish sales, marketing, production, and service operations in Singapore.
Marc King joined us in September 2004 as Vice President of Armor Operations in Washington, D.C. to support ongoing growth of our ceramic armor business, particularly in armor for ground-based military vehicles. Prior to joining us, he was Vice President of Business Development for Mistral, Incorporated, a provider of security products and services, from 2001 to 2004, where he developed strategies for marketing and sales to the U.S. government markets, including Department of Defense and Homeland Security. Prior to Mistral, Mr. King was president of GMA Cover Corporation (USA), a supplier to the United States Army Tank-Automotive and Armaments Command and the Defense Logistics Agency, from 1996 to 2001. Before that, he was Vice President of Gichner Systems Group (GSG), and President of its refrigerated truck body division. Gichner supplied shelters, enclosures, and other troop-support equipment through the DoD. Prior to GSG, Mr. King was Director of Allied Defense Industries’ land systems and aerospace divisions, where he planned and directed the marketing of defense and defense-related equipment, including vehicle armor. Mr. King’s military experience includes responsibility for command, operations, and logistical support for U.S. Army ground and air troops and weapons and ground warfare systems deployment. He also was a Congressional coordinator for the Secretary of the Army and managed Congressional legislative directives to the Army. He completed his military career as a lieutenant colonel. Mr. King received a B.A. in History from the University of Nebraska-Omaha and a M.A. in Public Service from Western Kentucky University.
Bruce Lockhart joined our Thermo Materials division as its President in September of 2001, and was appointed a Vice President of Ceradyne in February 2003. Prior to joining us, Mr. Lockhart had 16 years of varied experience in the ceramic industry, the majority of which was with Thermal Ceramics Inc., a provider of products for engineered heat management solutions. Mr. Lockhart received a B.S. in Ceramic Engineering from Clemson University in 1985 and a M.B.A. from Clemson University in 1990.
Jeff Waldal joined our Semicon Associates division in 1995 as a quality manager, and was promoted to manufacturing manager in 1997 and to President of Semicon in 1999. Mr. Waldal was elected as a Vice President in February 2003. He is currently responsible for the operations, finances and marketing at Semicon Associates. Mr. Waldal began his career as senior materials technician at United Technologies-Pratt & Whitney Aircraft. He was employed for eight years at Ladish Company, Inc. as quality supervisor and quality manager. Mr. Waldal currently serves on the board of directors as Chairman for Kentucky Manufacturing Assistance Center and is a member of the University of Kentucky College of Engineering Dean’s Advisory Council. Mr. Waldal obtained a degree in Non-Destructive Testing from Hutchinson Technology Institute in 1984, a B.A. in Business Management from the University of Kentucky in 1995, and an M.B.A. from Eastern Kentucky University in 1998.
Kenneth R. Morris joined our Advanced Ceramics Operation division in January 2005 as Director of Body Armor and was promoted in July 2006 to Vice President, Operations. Mr. Morris has been in the advanced technical ceramic industry for more than 25 years. He began his career with Kyocera International working in supply chain management. He was formerly Ceradyne’s Assistant Vice President of Operations for its silicon carbide division. In 1986, he then became Vice President and General Manager for The Carborundum Company. In 1994, he joined Kyocera Industrial Ceramics Company as Plant Manager. During 1999, he became the Director of North American Operations and in 2004 advanced to the position of Product Development Manager for Impact Protection Materials. The ceramic operations he has been responsible for have produced products to support the semiconductor, aerospace, electro-optical and defense markets.
Matthew Karmel joined us in November 2006, and has served as a Vice President since then. From February 2006 until joining us, he served as Managing Director Europe for TDS Logistics, which provides logistics services in the automotive industry. From January 2001 through January 2006, Mr. Karmel held several management positions at Valeo SA, a global automotive supplier based in France, including President of Valeo Climate Control Corporation in North America from August 2005 through January 2006, as General Manager of the Signal-Lighting Division in Europe from April 2003 through July 2005, and as General Manager of the NA Air-Flow Division in New York from January 2001 through March 2003. Prior to joining Valeo SA, Mr. Karmel served as Director of Automotive Engineering, and then as Vice President and General Manager of Series 4000 Engines, for Detroit Diesel Corporation, a manufacturer of heavy-duty diesel engines, from 1999 to 2001. From 1998 to 1999, Mr. Karmel served as Managing Director of Vapor Management Systems for Siebe PLC, an engineering company. From 1995 to 1997, he served as Executive Vice President and General Manager of the North American subsidiary of Akebono Brake Industry Co., a Japanese supplier of brake parts and systems. Prior to joining Akebono, Mr. Karmel served in various management positions for the Ford Motor Company from 1989 to 1995, and served as a research engineer for General Motors Corporation from 1981 to 1989. Mr. Karmel obtained B.S. degrees in Mechanical Engineering and in Aeronautical Engineering at Technion, the Israel Institute of Technology, in 1973. He obtained a Masters degree and a Ph.D. in Mechanical and Aerospace Engineering from Princeton University in 1980 and 1981, respectively.
Our officers are appointed by and serve at the discretion of our Board of Directors.
ITEM 1A.
ITEM 1A. RISK FACTORS
This Annual Report on Form 10-K contains forward-looking statements, as described at page 3 of this report under the caption “Note Regarding Forward-Looking Statements.” We believe that the risks described below are the most important factors which may cause our actual future results of operations to differ materially from the results projected in the forward-looking statements.
Risks Related to Our Business
A substantial portion of our revenues is derived from the sale of defense related products, primarily ceramic body armor. If demand for ceramic body armor declines, if federal budget appropriations involving our products are reduced, if we fail to obtain new government contracts or delivery orders under existing contracts, or if existing government contracts or orders are cancelled, our revenues, profit and cash flow will be materially and adversely affected.
In recent years, a substantial portion of our revenues has been derived from the sale of defense related products, particularly ceramic body armor, either directly or indirectly to the U.S. government. The sale of defense related products represented 76.2% of our revenues in 2006, 65.8% in 2005, and 60.9% in 2004. We anticipate that a substantial portion of our revenues for the foreseeable future will continue to come from sales of defense related products; however, we cannot assure you that sales of defense related products will continue at current levels and they could decline. Our dependence on defense related business, and on sales of ceramic armor in particular, entails several risks, including those described below.
Our defense related business is highly sensitive to changes in national and international defense and budget priorities. For example, in 2003, 2004, 2005 and 2006, our revenues from the sale of ceramic body armor increased significantly due to the U.S. military’s acceleration of its program to equip its soldiers with ceramic body armor systems, in part, because of the war in Iraq. In addition, the market for ceramic body armor increased further in 2006 with the introduction of enhanced side ballistic inserts, know as ESBI, which protect the side of the soldier’s torso. If demand for ceramic body armor declines because the number of ceramic body armor systems shipped is sufficient to equip front-line troops, conflicts in the Middle East and other high risk areas subside, U.S. defense budget appropriations are reduced or because of other reasons, our revenues, profit and cash flow from the sale of defense related products would be reduced.
Many defense contracts are awarded in an open competitive bidding process, and our past success in winning government contracts does not guarantee that we will win any new contracts in the future. Our success depends upon our ability to successfully compete for and retain such government contracts. If we, or if prime contractors for which we are a subcontractor, fail to win any future bids, or if we are unable to replace business lost upon cancellation, expiration or completion of a contract, our revenues, profit and cash flow from the sale of defense related products would be reduced.
Moreover, government contracts typically may be cancelled by the government at any time without penalty, other than our right to be reimbursed for certain expenses and inventory. If the U.S. government were to cancel any of our government contracts, our revenues, profit and cash flow would be reduced.
By the end of 2007, a $562.0 million estimated adjusted maximum value Indefinite Delivery/Indefinite Quantity contract for ceramic body armor awarded to us in August 2004 will have had the full amount of all delivery orders released and the corresponding shipments will have been made. Although we believe the U.S. Army will issue a request for quotation for ceramic body armor in 2007 that will require shipments for 2008 and possibly beyond, there is no guarantee or assurance that we will be successful in winning the contract.
If the performance requirements for ceramic body armor are modified by the U.S. military, we may incur delays or additional costs to change the design of our product, or we may not be able to satisfy the new requirements with our existing ceramic materials and processes. If this were to occur, our costs could increase and our revenues, profit and cash flow would decline.
The ceramic body armor we manufacture must comply with stringent performance specifications established by the U.S. military, such as weight and the level of ballistic protection it must provide, and these specifications may be modified by the military in new procurements, as well as under existing contracts. For example, during the quarter ended March 31, 2005, the U.S. military directed us to modify the specifications of the lightweight ceramic body armor that we had been manufacturing, from the version commonly referred to as SAPI (small arms protective insert), to a revised requirement commonly referred to as ESAPI (enhanced small arms protective insert). The revised requirement is more difficult to manufacture than the SAPI version. The change to this new design resulted in production delays and increased costs to us during the first quarter of 2005 as we developed new designs to meet the revised requirement and experienced manufacturing inefficiencies. In the future the U.S. military may make additional changes to the performance requirements for body armor,
and we may experience delays or additional costs to satisfy the new requirements, or we may be unable to meet the new requirements at all with our existing ceramic materials and processes. If this were to occur, our revenues from ceramic body armor would decline and our profitability would suffer.
We rely on two critical materials to make ceramic body armor. A delay or inability to obtain sufficient quantities of these materials could limit the amount of body armor we can manufacture and therefore result in reduced revenues, profit and cash flow.
The critical materials required to manufacture our ceramic body armor are boron carbide powder, which is the principal raw material used in the production of the ceramic armor plates, and an ultra-high molecular weight polyethylene textile material, which we laminate to the surface of the ceramic armor plates.
We obtain substantially all of our boron carbide powder from ESK Ceramics, which is one of the world’s leading manufacturers of boron carbide powder and has been a supplier of boron carbide powder to us for over 30 years. We acquired ESK Ceramics in August 2004, and it is now our subsidiary. ESK Ceramics is in the process of increasing its manufacturing capacity for boron carbide powder to meet our needs, as well as the needs of its other boron carbide powder customers, due to the rapidly increasing demand for ceramic body armor. If our ESK Ceramics subsidiary experiences production problems or delays in expanding its manufacturing capacity, supplies of boron carbide powder may be insufficient from other sources to meet our requirements for ceramic body armor.
The ultra-high molecular weight polyethylene textile material is available in the United States only from Honeywell International, Inc., under the brand name Spectra Shield®, and from Royal DSM N.V., under the brand name Dyneema®. Due to the rapid escalation in the demand for ceramic body armor, the quantities of Spectra Shield and Dyneema materials have been in limited supply and on government-directed allocation. Although we believe that sufficient quantities of these materials will be available to fulfill our projected needs, a delay or interruption in the supply of either of these materials could adversely affect our ability to fulfill our current orders for ceramic body armor.
If a delay or reduction in supplies of boron carbide powder or either Spectra Shield or Dyneema occurs, we may not be able to ship all of our orders for ceramic body armor, which could result in reduced revenues, profit and cash flow.
We have recently added significant manufacturing capacity. If demand for our products declines, we may have inefficient or under-utilized capacity, and our gross margins, profit and cash flow may suffer.
In response to the increased demand for ceramic body armor for military personnel and cam rollers for diesel engines, as well as our other products, we have added significant manufacturing capacity since early 2002, and we expect to expand our capacity further in the future.
Demand for our products, particularly ceramic armor and cam rollers, may not remain at levels sufficient to utilize all of the manufacturing capacity that we have added since early 2002. Much of our manufacturing facilities and production equipment, such as our furnaces and hot presses, are special purpose in nature and cannot be adapted easily to make other products. Also, a substantial amount of the boron carbide powder produced by ESK Ceramics is currently used by us and our competitors to make ceramic body armor. If the demand for ceramic body armor declines substantially from current levels, ESK Ceramics may have significant under-utilized capacity for boron carbide powder. Therefore, a substantial decline in demand for our ceramic body armor or cam rollers could result in significant excess manufacturing capacity, which would result in under absorption of overhead expense and reduced profit.
Our two largest customers for ceramic cam rollers are developing new diesel truck engines that we expect to be introduced in their diesel trucks starting in 2007 and 2008, respectively. These new diesel truck engines are designed to use steel cam rollers rather than our more expensive ceramic cam rollers. We believe these customers will be successful in using steel cam rollers instead of our ceramic cam rollers. Consequently, we expect sales of cam rollers to these two customers will decline beginning in 2007. Unless we can replace this lost business with sales of our ceramic cam rollers to new customers, our revenues, profits and cash flow from this product line will decline beginning in 2007.
If we fail to increase our non-defense revenue, and if the demand for ceramic body armor decreases, our revenues, profit and cash flow will be materially and adversely affected.
We currently receive more than 75% of our revenues and profits from sales of defense-related products, primarily ceramic body armor, to the U.S. government. Because our dependence on defense-related products exposes us to significant risks, part of our business strategy is to continue to increase our non-defense revenue base by identifying new products and markets for our advanced technical ceramics, and by increasing sales to our existing non-defense customers. Our ability to execute this strategy successfully depends, in part, on our ability to increase market acceptance of our advanced technical
ceramics as a replacement for materials such as metals, plastics and traditional ceramics. While advanced technical ceramics have certain advantages over other materials, such as the ability to withstand extremely high temperatures and combining hardness with light weight, they are more expensive to produce. As a result, the market for advanced technical ceramic products may be limited to high-end applications where price is not a critical competitive factor, where the characteristics of advanced technical ceramics may justify the higher costs compared to other materials or where other materials are not suitable. Due to these limitations on the market for advanced technical ceramics, the market for our products may not grow as we anticipate and we may not be able to increase our non-defense revenue base. If we are unable to execute this strategy, and if the demand for ceramic body armor decreases, our revenues, profit and cash flow will be materially and adversely affected.
Growth in our operations may strain our resources, and if we fail to successfully manage potential future growth, we could incur higher operating costs and delays in the production of our products, which could result in reduced revenues, profit and cash flow.
The increase in orders for ceramic body armor for military personnel, as well as the introduction of new products, is placing, and will continue to place, a significant strain on our operational, financial and managerial resources and personnel. To effectively manage potential future growth, we must continue to:
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add manufacturing capacity and personnel;
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implement and improve our operational, financial and management information systems;
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develop the management skills of our managers and supervisors;
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add new management personnel; and
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train, motivate and manage our employees.
Any failure to effectively manage growth could result in increased operating costs and delays in the development and production of our products. If this occurs, our revenues, profit and cash flow could decline.
We may generate less profit than expected or even lose money on our fixed-price government contracts.
Most of our government contracts, including the $562.0 million estimated adjusted maximum value Indefinite Delivery/Indefinite Quantity contract for ceramic body armor awarded to us in August 2004 and the $611.7 million estimated maximum value Indefinite Delivery/Indefinite Quantity contract for ceramic body armor side plates awarded to us in June 2006, provide for a predetermined, fixed price for the products we sell regardless of the costs we incur. When making proposals for fixed-price contracts, we must rely on our ability to accurately estimate our costs and ability to manufacture and deliver the products on time and at a reasonable profit. Our actual production costs may, however, exceed forecasts due to unanticipated delays or increased cost of materials, components, labor, capital equipment or other factors. As a result, we may incur losses on fixed price contracts that we had expected to be profitable, or such contracts may be less profitable than we expected, which could have a material adverse effect on our business, financial condition and results of operations.
Our business is subject to various laws and regulations favoring the U.S. government’s contractual position, and our failure to comply with such laws and regulations could harm our operating results and prospects.
As a contractor to the U.S. government, we must comply with laws and regulations relating to the formation, administration and performance of federal government contracts that affect how we do business with our customers and may impose added costs on our business. These rules generally favor the U.S. government’s contractual position. For example, these regulations and laws include provisions that allow unsuccessful bidders to protest or challenge contracts we have been awarded, and allow the government to unilaterally terminate, reduce or modify our government contracts.
The accuracy and appropriateness of certain costs and expenses used to substantiate our direct and indirect costs for the U.S. government under fixed-price contracts are subject to extensive regulation and audit by the Defense Contract Audit Agency, an agency of the U.S. Department of Defense. Responding to governmental audits, inquiries or investigations may involve significant expense and divert management’s attention. Our failure to comply with these or other laws and regulations could result in contract termination, suspension or debarment from contracting with the federal government, civil fines and damages and criminal prosecution and penalties. Any of these consequences could have a material adverse effect on our business, financial condition, results of operations and liquidity.
We currently depend entirely on 3M Unitek for sales of our ceramic orthodontic brackets. If we are unable to maintain our existing level of business with 3M Unitek our revenues, profit and cash flow from this product line will decline.
We sell our ceramic orthodontic brackets exclusively to 3M Unitek under a five year supply agreement that we entered into with 3M Unitek on December 2, 2005. This supply agreement replaces our original agreement with 3M Unitek that
would have expired in September 2007, under which 3M Unitek was required to purchase all ceramic orthodontic brackets exclusively from us, and we were permitted to sell ceramic orthodontic brackets only to 3M Unitek. Under the terms of the new agreement, 3M Unitek will continue to purchase their Clarity and Transcend brand ceramic orthodontic product lines exclusively from us for as long as 3M Unitek continues to sell those products. The new agreement further stipulates that Unitek must purchase from Ceradyne at least 50% of the ceramic orthodontic brackets 3M Unitek requires for next generation designs, which it intends to introduce in 2007. Except under limited circumstances, Ceradyne is not permitted to sell ceramic orthodontic brackets to any other customers under the new agreement. As a result of our agreement with 3M Unitek, our revenue from ceramic orthodontic brackets is dependent entirely upon 3M Unitek. 3M Unitek also offers traditional stainless steel orthodontic brackets. We cannot guarantee that 3M Unitek will devote substantial marketing efforts to the sale of our ceramic orthodontic brackets, or that 3M Unitek will not reassess its commitment to our product. If 3M Unitek fails to actively market our ceramic orthodontic brackets or decides to promote a competing product over ours, this could cause the sales of our ceramic orthodontic brackets to decline.
Moreover, the first of our two patents for our ceramic orthodontic brackets, which we jointly own with 3M Unitek, expires in September 2007. Upon expiration of the patent, we may not be able to prevent third parties from manufacturing and selling competitive ceramic orthodontic brackets. Ceramic orthodontic brackets manufactured and sold by third parties may be less expensive than ours and may cause sales of our ceramic orthodontic brackets to decline either as a result of pricing pressure or loss of market share.
In addition, the future success of our ceramic orthodontic brackets depends on our ability to maintain and increase market acceptance for our product compared to other competitive solutions, including traditional stainless steel brackets and newer products such as transparent plastic orthodontic aligners, synthetic sapphire brackets and other ceramic brackets. If 3M Unitek reduces its purchases of ceramic orthodontic brackets from us or if competitive products gain market share, the sales of our ceramic orthodontic brackets may decline, resulting in a decrease in our revenues, profit and cash flow.
Our business is subject to risks associated with doing business outside the United States.
Shipments to customers outside of the United States accounted for approximately 15.9% of our sales in 2006, 26.1% of our sales in 2005, and 20.5% in 2004. The significant increase in 2004 and 2005 was due primarily to our acquisition of ESK Ceramics in August 2004, whose operations have been consolidated with ours since September 1, 2004. ESK Ceramics’ operations are located in Germany and France. ESK Ceramics’ sales to customers located outside of the United States represented approximately 79.0% of its total sales during the period of September 1 through December 31, 2004, approximately 64.4% of its total sales during 2005 and approximately 57.1% of its total sales during 2006 . We anticipate that international shipments will account for a significant portion of our sales for the foreseeable future. Therefore, the following risks associated with international business activities could have material adverse effects on our performance:
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burdens to comply with multiple and potentially conflicting foreign laws and regulations, including export requirements, tariffs and other barriers, health and safety requirements, and unexpected changes in any of these factors;
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difficulty in staffing and managing international operations;
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differences in intellectual property protections;
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difficulty in obtaining export licenses from the U.S. government for sales of our defense-related products;
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potentially adverse tax consequences due to overlapping or differing tax structures;
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fluctuations in currency exchange rates; and
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risks associated with operating a business in a potentially unstable political climate.
We have traditionally invoiced our sales from the United States to customers in foreign countries in U.S. dollars. Consequently, if the U.S. dollar becomes more expensive relative to the currencies of our foreign customers, the price of our products that we export from the United States to those countries will rise and our sales into those countries may fall. In addition, in the future, we may be required to denominate foreign sales in the local currencies of our customers. In that case, if the U.S. dollar were to become more expensive relative to the currencies of our foreign customers, we would receive fewer U.S. dollars for each unit of foreign currency that we receive when our customers pay us. Therefore, a more expensive U.S. dollar would cause us to incur losses upon the conversion of accounts receivable denominated in foreign currencies. Such losses could harm our results of operations.
Our ESK Ceramics subsidiary invoices approximately 50.3% of its sales in Euros. ESK Ceramics’ sales to customers located in the United States are invoiced in U.S. dollars. If the Euro becomes more expensive relative to the currencies of ESK Ceramics’ customers located outside the European Union, the price of its products sold to customers in those countries will rise and its sales into those countries may fall.
We may make future acquisitions which may be difficult to integrate, divert management resources, result in unanticipated costs, or dilute our stockholders.
Part of our continuing business strategy is to make acquisitions of, or investments in, companies, products or technologies that complement our current products, enhance our market coverage, technical capabilities or production capacity, or offer growth opportunities. Future acquisitions could pose numerous risks to our operations, including:
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we may have difficulty integrating the purchased operations, technologies or products;
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we may incur substantial unanticipated integration costs;
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assimilating the acquired businesses may divert significant management attention and financial resources from our other operations and could disrupt our ongoing business;
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acquisitions could result in the loss of key employees, particularly those of the acquired operations;
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we may have difficulty retaining or developing the acquired businesses’ customers;
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acquisitions could adversely affect our existing business relationships with suppliers and customers;
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we may fail to realize the potential cost savings or other financial benefits and/or the strategic benefits of the acquisitions; and
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we may incur liabilities from the acquired businesses for infringement of intellectual property rights or other claims, and we may not be successful in seeking indemnification for such liabilities or claims.
In connection with these acquisitions or investments, we could incur debt, amortization expenses related to intangible assets, large and immediate write-offs, assume liabilities, or issue stock that would dilute our current stockholders’ percentage of ownership. We may not be able to complete acquisitions or integrate the operations, products or personnel gained through any such acquisition without a material adverse effect on our business, financial condition and results of operations.
The cost of electricity is a significant portion of our cost of product sales. An increase in the cost of electricity may cause our profit margins to decline.
Electricity is essential for the production of our products and comprises a significant portion of our cost of product sales. The cost of electricity for our manufacturing operations in the United States and Europe was approximately $4.4 million during 2004, approximately $8.4 million during 2005 and approximately $11.1 million during 2006. Over the last several years, the cost of electricity has increased, particularly in California where a significant portion of our manufacturing facilities are located. Fluctuations in the cost of electricity affect our ability to accurately forecast future energy costs and consequently our profitability. If the cost of electricity were to increase substantially, our gross profit margins may decline.
We may not be able to adequately safeguard our intellectual property rights and trade secrets from unauthorized use, and we may become subject to claims that we infringe on others’ intellectual property rights.
We rely on a combination of patents, trade secrets, trademarks, and other intellectual property laws, nondisclosure agreements with employees and customers and other protective measures to preserve our proprietary rights to our products and production processes. These measures afford only limited protection and may not preclude competitors from developing products or processes similar or superior to ours. Moreover, the laws of certain foreign countries do not protect intellectual property rights to the same extent as the laws of the United States.
Although we implement protective measures and intend to defend our proprietary rights, these efforts may not be successful. From time to time, we may litigate within the United States or abroad to enforce our issued or licensed patents, to protect our trade secrets and know-how or to determine the enforceability, scope and validity of our proprietary rights and the proprietary rights of others. For example, we are currently involved in two lawsuits in Germany that we initiated to enforce our proprietary rights. Enforcing or defending our proprietary rights could be expensive, requires management’s attention and might not bring us timely or effective relief.
Furthermore, third parties may assert that our products or processes infringe their patent rights. Our patents may be challenged, invalidated or circumvented. Although there are no pending or threatened intellectual property lawsuits against us, we may face litigation or infringement claims in the future. Infringement claims could result in substantial costs and diversion of our resources even if we ultimately prevail. A third party claiming infringement may also obtain an injunction or other equitable relief, which could effectively block the distribution or sale of allegedly infringing products. Although we may seek licenses from third parties covering intellectual property that we are allegedly infringing, we may not be able to obtain any such licenses on acceptable terms, if at all.
Our ability to operate effectively could be impaired if we were to lose the services of our key personnel, or if we are unable to recruit qualified managers and key personnel in the future.
Our success depends on the continued service of our management team and key personnel, including Joel P. Moskowitz, our Chairman and Chief Executive Officer and President; David P. Reed, our Vice President, and President of North American Operations; Jerrold J. Pellizzon, our Chief Financial Officer and Corporate Secretary; and Peter Hartl, the President of our ESK Ceramics subsidiary. Mr. Moskowitz was diagnosed with non-Hodgkin’s lymphoma in October 2004. He completed chemotherapy treatments in January 2005, and his current diagnosis indicates that the non-Hodgkin’s lymphoma is in remission.
If Mr. Moskowitz becomes unable to continue working due to health reasons, or if one or more of these individuals were to resign or otherwise terminate their employment with us, we could experience a loss of sales, delays in new product development and diversion of management resources, and we may have difficulty replacing any of these individuals. We do not have employment agreements or key person insurance on any of our executive employees.
Competition for qualified managers and key personnel is intense and we may not be able to recruit and retain such personnel. If we are unable to retain our existing managers and employees or hire and integrate new personnel, we may experience operating inefficiencies, production delays and reduced profitability.
Our manufacturing facilities are subject to a number of operational risks, including hazards associated with ceramic manufacturing and natural disasters, any of which could have a material adverse impact on our productivity and results of operations.
Due to the nature of our business, we are exposed to hazards associated with ceramic manufacturing, such as:
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accidents or mechanical failure;
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fires or explosions of furnaces; and
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employee exposure to extreme temperatures or hazardous substances.
In addition, the location of our facilities exposes us to potential earthquakes and other natural disasters. These hazards may cause personal injury, loss of life and damage to property, which could lead to a substantial interruption or suspension of operations, potential loss of customers and sales, government fines and lawsuits by injured persons. Any such consequences could have an adverse effect on the productivity and profitability of a particular manufacturing facility or on us as a whole.
Defects in our products could harm our reputation for quality products, increase our operating expenses, reduce sales of our products and impact cash flow.
Our products have in the past contained, and may in the future contain, errors or defects that may be detected at any point in the life of the products. Such errors could result in delays in shipping and sales during the period required for their correction and additional expense associated with their reworking or replacement. Real or perceived defects in our products may result in product returns, loss of sales, delays in market acceptance, injury to our reputation and increased warranty costs, which could reduce our sales and profit. For example, in March 2002, the U.S. government notified us that several lots of our SAPI lightweight ceramic body armor failed to pass ballistics reverification tests. As a result, we stopped production of our SAPI product, modified the design of our product and resumed shipping approximately four months later. In addition, we agreed to correct or replace at our expense all supplies of our SAPI product sales that did not meet the original contractual requirements.
If we are unable to compete successfully against current and future competitors, our revenues could decline.
Our products compete with advanced technical ceramic products from other companies, as well as with high strength steel alloys and plastic products.
When competing with other advanced technical ceramic products, we believe the principal competitive factors are:
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manufacturing capacity and the ability to deliver products;
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price;
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product performance;
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material specifications;
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application engineering capabilities;
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customer support; and
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reputation.
When competing with high strength steel alloys and plastic products, we may not be able to compete effectively when price is a primary consideration, because our products are typically more expensive as a result of higher manufacturing costs associated with the production of advanced technical ceramics.
Some of our competitors include Armor Holdings, ArmorWorks, Ceramtec, the Cercom subsidiary of BAE Systems, CoorsTek, Denka, Momentive Performance Materials, Hitachi, HC Starck, Kyocera’s Industrial Ceramics Group, Morgan, Saint Gobain, Sintec, Spectra-Mat, UK Abrasives and Vesuvius. Many of our current or potential competitors have greater financial, marketing and technical resources than we do. If we fail to compete successfully against our current or future competitors, our revenues, profit and cash flow could decline.
Uninsured losses arising from third party claims brought against us could result in payment of substantial damages, which would decrease our cash reserves and could harm our profit and cash flow.
Our products are used in applications where the failure to use our products properly or their malfunction could result in serious bodily injury or death. We may not have adequate insurance to cover the payment of any potential claim related to such injuries or deaths. Insurance coverage may not continue to be available to us or, if available, may be at a significantly higher cost.
We are subject to extensive government regulation, and our failure or inability to comply with these regulations could subject us to penalties and result in a loss of our government contracts, which could reduce our revenues, profit and cash flow.
We must comply with and are affected by various government regulations that impact our operating costs, profit margins and our internal organization and operation of our business. Furthermore, we have production contracts with governmental entities and are subject to additional rules, regulations and approvals applicable to government contractors. We are also subject to routine audits to assure our compliance with these requirements. Our failure to comply with these regulations, rules and approvals could result in the impositions of penalties and the loss of our government contracts and disqualification as a U.S. government contractor. As a result, our revenues, profit and cash flow could be reduced.
In addition, a number of our employees involved with defense related business are required to obtain security clearances from the U.S. government. Our business may suffer if we or our employees are unable to obtain the security clearances that are required.
Like other companies operating internationally, we are subject to the Foreign Corrupt Practices Act and other laws which prohibit improper payments to foreign governments and their officials by U.S. and other business entities. Violations of the Foreign Corrupt Practices Act may result in severe criminal penalties, which could have a material adverse effect on our business, financial condition, results of operations and liquidity.
If we fail to comply with environmental laws and regulations, we could incur an increase in our operating costs and a decrease in our profit and cash flow.
We are subject to a variety of environmental regulations relating to the use, storage, discharge and disposal of hazardous materials used to manufacture our products. Authorities could impose fines, suspend production, alter our manufacturing processes, or stop our operations if we do not comply with these regulations.
Until 1997, we produced certain products using beryllium oxide, which is highly toxic in powder form. This powder, if inhaled, can cause chronic beryllium disease in a small percentage of the population. We have been sued in the past by former employees and by employees of one of our customers and by their family members alleging that they had contracted chronic beryllium disease as a result of exposure to beryllium oxide powders used in our products. The last of these claims was settled in 2002, and all of these claims have been dismissed without our incurring material liability. We may not, however, be able to avoid future liability to persons who may allege that they contracted chronic beryllium disease as a result of exposure to the beryllium oxide we used in prior years.
Any failure to comply with current or subsequently enacted environmental statutes and regulations could subject us to liabilities, fines or the suspension of production. Furthermore, any claims asserted against us in the future related to exposure to beryllium oxide powder may not be covered by insurance. Even if covered, the amount of insurance may be inadequate to cover any adverse judgment.
Fines and other punishments imposed on us for environmental violations and expenses we incur to remedy or comply with environmental regulations and future liability for incidences of chronic beryllium disease contracted by employees or employees of customers would decrease our cash reserves and could harm our profitability.
Risks Related to our Common Stock
Our stock price has been volatile, and the value of an investment in our common stock may decline.
The market price and trading volume of our common stock has been subject to significant volatility, and this trend may continue. The value of our common stock may decline regardless of our operating performance or prospects. Factors affecting our market price include:
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initiation of coverage by securities analysts, securities analysts’ buy/sell recommendations and any expressed beliefs of securities analysts regarding our business prospects or estimated trading multiples;
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our perceived prospects;
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variations in our operating results and whether we have achieved our key business targets;
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the limited number of shares of our common stock available for purchase or sale in the public markets;
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sales or purchases of large blocks of our stock;
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changes in, or our failure to meet, our earnings estimates;
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differences between our reported results and those expected by investors and securities analysts;
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decreases in our trading multiples on an absolute basis or relative to comparable companies;
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announcements of new contracts by us or our competitors;
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market reaction to any future acquisitions, joint ventures or strategic investments announced by us or our competitors;
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developments in the financial markets;
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market reaction to any adverse publicity or news stories; and
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general economic, political or stock market conditions.
Recent events have caused stock prices for many companies, including ours, to fluctuate in ways unrelated or disproportionate to their operating performance. The general economic, political and stock market conditions that may affect the market price of our common stock are beyond our control. The market price of our common stock at any particular time may not remain the market price in the future. In the past, securities class action litigation has been instituted against companies following periods of volatility in the market price of their securities. Any such litigation, if instituted against us, could result in substantial costs and a diversion of management’s attention and resources.
Delaware law may delay or prevent a change in control, and may discourage bids for our common stock at a premium over its market price.
We are subject to the provisions of section 203 of the Delaware General Corporation Law. These provisions prohibit large stockholders, in particular a stockholder owning 15% or more of the outstanding voting stock, from consummating a merger or combination with a corporation unless this stockholder receives board approval for the transaction or 66 2/3% of the shares of voting stock not owned by the stockholder approve the merger or transaction. These provisions of Delaware law may have the effect of delaying, deferring or preventing a change in control, and may discourage bids for our common stock at a premium over its market price.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
ITEM 2.
ITEM 2. PROPERTIES
We serve our markets through five operating segments with manufacturing facilities in several locations across the United States, Canada and two locations in Europe-Germany and France. Please see the table under the caption “Operating Divisions and Facilities” in Item 1 of this report for a summary of our facilities and products comprising our five operating segments.
IT EM 3. LEGAL PROCEEDINGS
On August 11, 2006, a shareholder derivative complaint was filed in the California Superior Court for Orange County by Fritz J. Moennighoff, Case Number 06-CC-00156. On August 25, 2006, a shareholder derivative complaint was filed in the California Superior Court for Orange County by Larry Menning, Case Number 06-CC-00175. On August 28,
2006, a shareholder derivative complaint was filed in the California Superior Court for Orange County by Rhoda Kubrick, Case Number 06-CC-00176. On September 19, 2006, a shareholder derivative complaint was filed in the California Superior Court for Orange County by John King, Case Number 06-CC-00193. All four complaints were brought purportedly on behalf of the Company against certain of the Company’s current and former directors and executive officers. The complaints assert claims for, among other things, breaches of fiduciary duty by directors and executive officers related to backdating of stock options. The complaints seek to require the individual defendants to rescind stock options they received which have an exercise price below the closing price of the Company’s common stock on the date of grant, to disgorge the proceeds of options exercised, to reimburse the Company for damages of an unspecified amount, and also seek certain equitable relief, attorneys’ fees and costs.
The plaintiff in the Kubrick case requested voluntary dismissal of her complaint in the Superior Court on or before September 29, 2006, and filed a substantially identical complaint on September 29, 2006, in the United States District Court for the Central District of California, Case No. SA CV 06-919 JVS (PJWx). The plaintiff in the King case requested voluntary dismissal of his complaint in the Superior Court on or before September 29, 2006, and filed a substantially identical complaint on September 29, 2006, in the United States District Court for the Central District of California, Case No. SA CV 06-920 JVS (PJWx). The Superior Court granted the plaintiffs’ requests for dismissal of the Kubrick and King cases on October 18, 2006.
On October 27, 2006, the Superior Court consolidated the Moennighoff and Menning cases, Case Numbers 06-CC-00156 and 06-CC-00175, under the name “In re Ceradyne, Inc. Derivative Litigation,” Lead Case No. 06-CC-00156. On December 19, 2006, a shareholder derivative complaint was filed in the California Superior Court for Orange County by John Okey, Case No. 06-CC-00260. Upon the filing of this case, plaintiff John Okey also filed a Notice of Related Action requesting the matter be assigned to the Honorable Stephen J. Sundvold, Civil Complex Department CX105, along with the consolidated actions.
On October 26, 2006, the two matters filed in the United States District Court for the Central District of California, Kubrick v. Moskowitz et al., Case No. SA CV 06-919 JVS (PJWx) and King v. Moskowitz et al., SA CV 06-920 JVS (PJWx), were consolidated under the name “In re Ceradyne, Inc. Derivative Litigation,” Master File No. SA CV 06-919 JVS, by Order of the Honorable James V. Selna. On November 27, 2006, the plaintiffs filed a consolidated shareholder derivative complaint which superseded the existing complaints filed in these two actions. On December 12, 2006, a verified shareholder derivative complaint was filed by Joel Siegfried in the United States District Court for the Central District of California, Case No. CV 06-7893 JSL (SSx) along with a Notice of Related Action bringing to the Court’s attention that it be consolidated with Master File No. SA CV 06-919 JVS. On December 30, 2006, the Siegfried matter was ordered transferred to the Honorable James V. Selna under Case No. SA CV 06-919 JVS.
In summary, there are currently three shareholder derivative actions pending, all of which contain substantially similar allegations. The Moennighoff and Menning cases, filed in the Orange County Superior Court, have been consolidated into one case, designated “In re Ceradyne, Inc. Derivative Litigation,” Lead Case No. 06-CC-00156. The Okey case, filed in the Orange County Superior Court, is still a separate action, but the plaintiff has requested that his action be consolidated in Lead Case No. 06-CC-00156. The Kubrick, King and Siegfried cases, filed in the United States District Court for the Central District of California, have all been consolidated into one case, designated “In re Ceradyne, Inc. Derivative Litigation,” Master File No. SA CV 06-919 JVS.
We intend to take all appropriate action in response to these lawsuits. Formal discovery has not yet commenced, but counsel for the parties have been engaged in preliminary settlement discussions. The impact of the outcome of these lawsuits is undeterminable at this time.
I TEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the fourth quarter of 2006.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is traded on the Nasdaq Stock Market under the symbol “CRDN.” The following table shows the high and low closing sale prices for our common stock as reported by the Nasdaq Stock Market during the calendar quarters indicated:
As of February 9, 2007, there were 419 holders of record of our common stock.
All share prices in the table above have been adjusted to give retroactive effect to a 3-for-2 split of our common stock in the form of a 50% stock dividend distributed on January 18, 2005.
We have never declared or paid cash dividends on our common stock and do not plan to pay any cash dividends in the near future. Our current policy is to retain all funds and earnings for use in the operation and expansion of our business.
We did not sell any equity securities during the year ended December 31, 2006 that were not registered under the Securities Act of 1933.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial data as of December 31, 2002, 2003 and 2004 and for the years ended December 31, 2002 and 2003 are derived from our audited consolidated financial statements for those periods, which are not included in this report. The selected consolidated financial data as of December 31, 2005 and 2006 and for the years ended December 31, 2004, 2005 and 2006 are derived from our audited consolidated financial statements which are included in this report beginning on page. The following data is qualified in its entirety by and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our consolidated financial statements and the related notes included elsewhere in this report.
(1) The operations of ESK Ceramics have been consolidated with ours since September 1, 2004.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read together with “Selected Consolidated Financial Data,” and our consolidated financial statements and related notes included elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks and uncertainties. We base these statements on assumptions that we consider reasonable. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors discussed in “Note Regarding Forward-Looking Statements,” “Item 1A - Risk Factors,” and elsewhere in report.
Overview
We develop, manufacture and market advanced technical ceramic products, ceramic powders and components for defense, industrial, automotive/diesel and commercial applications. Our products include:
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lightweight ceramic armor for soldiers and other military applications;
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ceramic industrial components for erosion and corrosion resistant applications;
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ceramic powders, including boron carbide, boron nitride, titanium diboride, calcium hexaboride, and zirconium diboride, which are used in manufacturing armor and a broad range of industrial products;
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evaporation boats for metallization of materials for food packaging and other products;
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durable, reduced friction, ceramic diesel engine components;
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functional and frictional coatings primarily for automotive applications;
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translucent ceramic orthodontic brackets;
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ceramic-impregnated dispenser cathodes for microwave tubes, lasers and cathode ray tubes;
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ceramic crucibles for melting silicon in the photovoltaic solar cell manufacturing process;
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ceramic missile radomes (nose cones) for the defense industry;
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structural neutron absorbing materials; and
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metal matrix composite structures.
Our customers include the U.S. government, prime government contractors and large industrial, automotive, diesel and commercial manufacturers in both domestic and international markets.
We conduct our operations primarily through five operating segments. The following table includes a summary of our products by applications for our five segments.
Operating Segment and Facility Location
Products
Ceradyne Advanced Ceramic Operations
Costa Mesa, Irvine and San Diego, California
Approximately 272,000 square feet
Lexington, Kentucky
Approximately 115,000 square feet
Wixom, Michigan
Approximately 29,000 square feet
Defense Applications:
• Lightweight ceramic armor
Industrial Applications:
• Ceralloy® 147 SRBSN wear parts
• Precision ceramics
Automotive/Diesel Applications:
• Ceralloy® 147 SRBSN automotive/diesel engine parts
Commercial Applications:
• Ceramic orthodontic brackets
• Components for medical devices
ESK Ceramics
Kempten, Germany
Approximately 544,000 square feet
Bazet, France
Approximately 88,000 square feet
Defense Applications:
• Boron carbide powders for body armor
Industrial Applications:
• Ceramic powders: boron carbide, boron nitride, titanium diboride, calcium hexaboride and zirconium diboride
• Silicon carbide parts
• Evaporation boats for the packaging industry
• High performance pump seals
Automotive/Diesel Applications:
• EKagrip® functional and frictional coatings
Ceradyne Semicon Associates
Lexington, Kentucky
Approximately 35,000 square feet
Industrial Applications:
• Ceramic-impregnated dispenser cathodes for microwave tubes, lasers and cathode ray tubes
• Samarium cobalt magnets
Ceradyne Thermo Materials
Scottdale and Clarkston, Georgia
Approximately 132,000 square feet
Defense Applications:
• Missile radomes (nose cones)
Industrial Applications:
• Glass tempering rolls
• Metallurgical tooling
• Castable and other fused silica products
• Crucibles for photovoltaic solar cell applications
Ceradyne Canada
Chicoutimi, Canada
Approximately 86,000 square feet
Industrial Applications:
• Boral® structural neutron absorbing materials
• Metal matrix composite structures
The tables below show, for each of our five segments, revenues and income before provision for income taxes in the periods indicated.
Segment revenues (in millions):
Segment income before provision for taxes (in millions):
We categorize our products into four market applications. The table below shows the percentage contribution to our total sales to external customers of each market application in the different time periods.
The principal factors contributing to our recent growth in sales are increased demand by the U.S. military for ceramic body armor that protects soldiers and our acquisition of ESK Ceramics in August 2004. The operations of ESK Ceramics have been consolidated with ours since September 1, 2004. In addition, the market for ceramic body armor increased further in 2006 with the introduction of enhanced side ballistic inserts, known as ESBI, which protect the side of the soldier’s torso.
Military conflicts in Iraq and Afghanistan, as well as an increasingly unstable geopolitical climate and the heightened risk of international conflicts, have resulted in increased orders for our ceramic body armor in each year since 2001. We were awarded an Indefinite Delivery/Indefinite Quantity contract by the U.S. Army in August 2004 with an adjusted maximum value of $562.0 million from an original estimated contract value of $461.0 million. Through February 2007, we received fourteen delivery orders equaling the contract amount. We expect to complete the delivery of this adjusted contract amount by the end of November 2007. We have also received a number of other orders for ceramic body armor, not covered by the Indefinite Delivery/Indefinite Quantity contract, from the Army and other branches of the U.S. military. In January 2006, we received our first production order for ESBI, or side plates, which are designed to protect the side areas of a soldier’s torso when used in conjunction with our ESAPI ceramic body armor plates. This delivery order, which totals $70.0 million, was issued to us by the U.S. Army. In June 2006, we were awarded an Indefinite Delivery/Indefinite Quantity contract by the U.S. Army with a maximum value of $611.7 million for ESBI plates. Through February 2007, 4 delivery orders totaling approximately $261.1 million have been issued to us under this contract. Based on our current backlog for ceramic body armor, we expect our shipments of ceramic body armor to be higher in fiscal year 2007 than in 2006. In addition, we believe that there will be a new government request for quotation for ceramic body armor in 2007. However, unless we receive additional orders under existing contracts or are successful in obtaining new contracts for ceramic body armor, our shipments of ceramic body armor will decline materially in 2008 from levels we expect to achieve in 2007. Moreover, government contracts typically may be cancelled by the government at any time without penalty. For the next several quarters, and perhaps longer, demand for ceramic body armor is likely to be the most significant factor affecting our sales.
Although we believe that demand for ceramic body armor will continue for many years, the quantity and timing of government orders depends on a number of factors outside of our control, such as the amount of U.S. defense budget appropriations and the level of international conflicts. Moreover, ceramic armor contracts generally are awarded in an open competitive bidding process. Therefore, our future level of sales of ceramic body armor will depend on our ability to successfully compete for and retain this business.
During the quarter ended March 31, 2005, the U.S. military directed us to modify the specifications of the lightweight ceramic body armor that we had been manufacturing, from the version commonly referred to as SAPI (small arms protective insert), to a revised requirement commonly referred to as ESAPI (enhanced small arms protective insert). The revised requirement is more difficult to manufacture than the SAPI version. We have developed five new designs to meet the revised requirement, all of which have been approved by the government, and we intend to continue to develop additional, improved armor designs.
Our ESK Ceramics subsidiary produces boron carbide powder, which serves as a starter ceramic powder in the manufacture of our lightweight ceramic body armor. Owning this source of our principal raw material, together with the recent and ongoing expansion of our manufacturing capacity for ceramic armor at our new Lexington, Kentucky plant and in our Irvine, California facility, should allow us to fulfill current and anticipated demand for our ceramic body armor.
Our order backlog was $344.3 million as of December 31, 2006 and $276.4 million as of December 31, 2005. Orders for ceramic armor represented approximately $285.5 million, or 82.9% of the total backlog as of December 31, 2006 and $209.9 million, or 75.9% of the total backlog as of December 31, 2005. We expect that substantially all of our order backlog as of December 31, 2006 will be shipped during 2007.
Our sales to customers located outside of the United States have varied in recent years, representing $105.7 million, or 15.9% of net sales in 2006, $96.1 million, or 26.1% during 2005 and $44.3 million, or 21.0% in 2004. We currently have sales offices in Germany, China, England and Canada as well as commissioned independent sales representatives in other parts of Europe and Asia. Of our sales to customers located outside the United States, 49.4% were denominated in U.S. dollars during 2006.
Net Sales. Our net sales consist primarily of revenues from the sale of products, which we recognize when an agreement of sale exists, product delivery and acceptance has occurred, and collection is reasonably assured.
Cost of Product Sales. Our cost of product sales includes the cost of materials, direct labor expenses and manufacturing overhead expenses. Our business requires us to maintain a relatively high fixed manufacturing overhead. As a result, our gross profit, in absolute dollars and as a percentage of net sales, is greatly impacted by our sales volume and the corresponding absorption of fixed manufacturing overhead expenses. Additionally, because many of our products are customized, we are frequently required to devote resources to sustaining engineering expenses, which we also include in cost of product sales and expense as incurred.
The cost of electricity comprises a significant portion of our cost of product sales. In 2004, we began expanding our high-energy utilization silicon nitride manufacturing operations at our new facility in Lexington, Kentucky, where costs, particularly for electricity and occupancy, are lower than in California. We have increased our manufacturing capacity for the production of body armor plates by adding three hot press lines at this new facility. We chose this facility for the location of the hot press expansion for the same reasons: lower cost of electricity and occupancy. The cost of electricity for our manufacturing operations in the United States and Europe was approximately $11.1 million, or 2.8% as a percentage of cost of product sales in 2006, approximately $8.4 million, or 3.5% as a percentage of cost of product sales in 2005, and approximately $4.4 million, or 3.0% as a percentage of cost of product sales in 2004.
Selling Expenses. Our selling expenses consist primarily of salaries and benefits for direct sales and marketing employees, commissions for direct sales employees and for independent sales representatives, trade show expenses, rent for our sales offices, product literature, and travel and entertainment expenses.
General and Administrative Expenses. Our general and administrative expenses consist primarily of employee salaries and benefits, employee bonuses, which are computed quarterly and accrued in the quarter earned, professional service fees, rent for facilities and expenses for information technology.
Research and Development Expenses. Our research and development expenses consist primarily of employee salaries and benefits, materials and supplies related to ongoing application engineering in response to customer requirements, and the research and development of new materials technology and products. These costs are expensed as incurred.
Review of Historical Stock Option Grant Procedures
In July 2006, the Company voluntarily initiated a review of its historical stock option grant practices and related accounting treatment. The review was conducted by a Special Committee comprised of three independent members of the Company’s Board of Directors, with the assistance of independent legal counsel and forensic accounting experts. The scope of the Special Committee’s review included all stock options granted by the Company from January 1997 through September 2003. The Special Committee has completed its review.
Until September 2003, stock option grants generally were approved by unanimous written consents signed by the members of the Stock Option Committee of the Board of Directors. Throughout this period, the Stock Option Committee consisted of the CEO and one other non-management Director. The date specified as the grant date in each unanimous written consent was used (i) to determine the exercise price of the options and (ii) as the accounting measurement date.
The review found that from January 1997 through September 2003, the date selected by management as the grant date and accounting measurement date was the date specified in the unanimous written consent, but that, in all but one case, the unanimous written consents were not prepared, approved or executed by the Company’s Stock Option Committee until a later date. There were a total of 23 grant dates from January 1997 through September 2003. The Company’s CEO was responsible for selecting the grant dates and followed a consistent practice of seeking low grant prices and he was unaware of the accounting implications of the method he used. Therefore, the use of the date specified in the unanimous written consent as the accounting measurement date was incorrect in all but one case. The proper accounting measurement date was the date the unanimous written consent was signed by the members of the Stock Option Committee.
Based upon information gathered during the review by independent legal counsel, the Special Committee and the Board of Directors have concluded that, while the Company applied an option price date selection practice that resulted in the use of incorrect accounting measurement dates for options granted between January 1997 and September 2003, the accounting errors resulting from the use of incorrect measurement dates were not the product of any deliberate or intentional misconduct by the Company or its executives, staff or Board of Directors. However, as a result of using revised measurement dates for options granted from January 1997 through September 2003, the Company recorded a charge in the second quarter ended June 30, 2006 of $3.4 million ($2.3 million after income taxes) pertaining to the years ended December 31, 1997 to 2005 and the six months ended June 30, 2006 (the “Stock-Based Charge”). The Stock-Based Charge was included as a component of general and administrative expenses in the consolidated statements of income as this is where the affected individual’s normal compensation costs are recorded. The Stock-Based Charge includes non-cash compensation expense of $2.2 million ($1.4 million after income taxes) primarily related to stock option grants made during the period from January 1997 through September 2003 that should have been measured as compensation cost at the actual stock option grant dates, and subsequently amortized to expense over the vesting period for each stock option grant. The Stock-Based Charge also includes $1.2 million ($0.9 million after income taxes) of estimated additional employment and other taxes that are expected to become payable.
From September 2003 to February 2005, all stock option grants were approved at meetings held by the Stock Option Committee, and, since February 2005, all stock option grants have been approved at meetings held by the Compensation Committee of the Board of Directors. The dates of these meetings have been used correctly as the accounting measurement date for all stock options granted since September 2003.
Had this estimated Stock-Based Charge been reflected, as and when incurred, in the Company’s results of operations for prior years, the impact on net income for Ceradyne’s fiscal years ended December 31 would have been a reduction of $21,000 in 1997, a reduction of $45,000 in 1998, a reduction of $47,000 in 1999, a reduction of $104,000 in 2000, a reduction of $269,000 in 2001, a reduction of $74,000 in 2002, a reduction of $347,000 in 2003, a reduction of $611,000 in 2004, and a reduction of $324,000 in 2005. As of December 31, 2006, the total remaining incremental stock-based compensation charge related to these stock option grants that are expected to vest in future periods with a revised accounting measurement date is immaterial. There was no impact on revenue or net cash provided by operating activities as a result of the estimated compensation charge.
The Company does not believe that a restatement of its prior-period financial statements is required for the Stock-Based Charge. Based on the materiality guidelines contained in SEC Staff Accounting Bulletin No. 99, Materiality (SAB 99), the Company believes that the Stock-Based Charge is not material to any of the individual prior periods affected and the aggregate Stock-Based Charge is not material to the results for the year ended December 31, 2006.
Prior to December 31, 2006, the current members of Ceradyne’s Board of Directors, all current executive officers and all other employees of the Company amended all unexercised stock options they held which had an exercise price that is less than the price of the Company’s common stock on the actual date of grant, by increasing the exercise price to an amount equal to the closing price of the common stock as of the actual grant date. The Company has and will continue to reimburse all non-executive officer employees for the increase in the exercise price for the modified options as they vest. Such reimbursement has and will not be material.
Results of Operations
The following table sets forth certain income and expense items from our financial statements for the years ended December 31, 2006, 2005 and 2004, expressed as a percentage of net sales.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Net Sales. Our net sales for the year ended December 31, 2006 were $662.9 million, an increase of $294.6 million, or 80.0%, from $368.3 million in the corresponding prior year period.
Our Advanced Ceramic Operations division had net sales for the year ended December 31, 2006 of $528.7 million, an increase of $285.9 million, or 117.7% from the $242.8 million in the prior year. The primary reason for this improvement was the shipment of $488.2 million of ceramic body and other armor components for defense customers, an increase of $281.1 million, or 135.7% from the $207.1 million of net sales in the prior year due to increased demand from the U.S. Department of Defense. Net sales for our automotive/diesel component product line, including cam rollers, were $17.0 million, an increase of $0.7 million, or 4.3%, from the $16.3 million in the prior year. The primary reason for this increase is that our customers produced more heavy-duty diesel truck engines due to forward buying in anticipation of increased emission standards that become effective in 2007. However, we are aware that some of our customers are designing new engines that do not include our cam rollers and, as a result, we expect that sales of cam rollers will decline when these engines are introduced starting in 2007. Net sales of our orthodontic brackets product line were $10.4 million, an increase of $0.6 million, or 5.5%, from the $9.8 million in the prior year. This was the result of a more aggressive sales and marketing plan by our customer.
Our ESK Ceramics subsidiary had net sales for the year ended December 31, 2006 of $148.2 million, an increase of $25.0 million, or 20.3% from the $123.2 million in the prior year. Approximately $1.0 million of this increase is attributable to a higher value of the Euro versus the U.S. dollar in 2006 compared to 2005. Sales of industrial products for the year ended December 31, 2006 were $78.6 million, an increase of $13.4 million, or 20.5% from the $65.2 million in the prior year. This increase was the result of a higher demand for fluid handling and industrial wear parts. Sales of automotive/diesel products for the year ended December 31, 2006 were $17.3 million, an increase of $3.2 million, or 22.5% from the $14.1 million in the prior year. Sales of defense products for the year ended December 31, 2006 were $52.3 million, an increase of $8.4 million, or 19.2% from the $43.9 million in the prior year. Included in sales of defense products for the year ended December 31, 2006 were inter-segment sales of $40.4 million compared to $17.4 million in the prior year. The increase was due to an increase in demand of boron carbide at our Advanced Ceramic Operations division which was offset by a decrease of $14.6 million in sales to third parties in the defense industry for the year ended December 31, 2006. This decrease was due to a reduction in demand for boron carbide from competitors of our Advanced Ceramic Operations division.
Our Semicon Associates division had net sales for the year ended December 31, 2006 of $9.1 million, an increase of $1.7 million or 21.8% from the $7.4 million in the prior year The increase in sales reflects higher shipments of microwave and laser cathodes in 2006 when compared to 2005.
Our Thermo Materials division had net sales for the year ended December 31, 2006 of $15.0 million, an increase of $2.8 million, or 23.4%, from the $12.2 million in the prior year. The increase was due to an increase in sales of crucibles used in the manufacture of photovoltaic cells for the solar energy markets and increased sales of components for defense applications.
Our Ceradyne Canada subsidiary, which commenced operations in July 2006, had net sales for the year ended December 31, 2006 of $2.4 million.
Gross Profit. Our gross profit was $260.9 million for the year ended December 31,2006, an increase of $129.8 million, or 98.9% from $131.1million in the prior year. As a percentage of net sales, gross profit was 39.4% for the year ended December 31, 2006, compared to 35.6% for the prior year. The increase in gross profit as a percentage of net sales in the year ended December 31, 2006 was the result of increased sales, particularly in sales of body armor, improved sales mix and higher operating leverage. In January 2005, we commenced operations of our Lexington, Kentucky hot press facility where we produce ceramic armor plates. During the year ended December 31, 2005, we incurred start up and training expenses at this new facility that were significantly reduced during the year ended December 31, 2006. The reduction of these expenses caused gross profit to increase.
Our Advanced Ceramic Operations division posted gross profit of $209.7 million for the year ended December 31, 2006, an increase of $118.4 million, or 129.7% from $91.3 million in the prior year. As a percentage of net sales, gross profit was 39.7% for the year ended December 31, 2006, compared to 37.6% for the prior year. The reasons for the increase in gross profit and gross profit as a percentage of net sales were consistent with those reasons described in the preceding paragraph.
Our ESK Ceramics subsidiary had a gross profit of $47.7 million, equal to 32.2% of net sales, for the year ended December 31, 2006, compared to gross profit $37.6 million, or 30.5% of as a percentage of net sales, for the year ended December 31, 2005. The increase in gross profit as a percentage of net sales in the year ended December 31, 2006 was the result of increased sales , improved sales mix, higher operating leverage, as well as increased sales by our Advanced Ceramics Operations division of products containing boron carbide purchased from ESK Ceramics.
Our Semicon Associates division had gross profit of $2.5 million for the year ended December 31, 2006, an increase of $0.7 million, or 42.9% from $1.8 million in the prior year. As a percentage of net sales, gross profit was 27.8% for the year ended December 31, 2006, compared to 23.6% for the prior year. The increase in gross profit and in gross profit as a percentage of net sales in the year ended December 31, 2006 was due primarily to an improved sales mix caused by higher sales of microwave and laser cathodes.
Our Thermo Materials division had gross profit of $3.2 million for the year ended December 31, 2006, an increase of $1.4 million or 74.3% compared to $1.8 million in the prior year. As a percentage of net sales, gross profit was 21.1% for the year ended December 31, 2006, compared to 15.0% for the prior year. The improvements in gross profit and gross profit as a percentage of sales were primarily due to lower sales of fused silica and casting product lines which have lower gross margins and an increase in the sales of crucibles which have higher gross margins.
Our Ceradyne Canada subsidiary, which commenced operations in July 2006, had gross loss for the year ended December 31, 2006 of $0.6 million. The loss was caused by operational start up expenses.
Selling Expenses. Our selling expenses were $22.9 million for the year ended December 31, 2006, an increase of $2.2 million, or 10.8%, from $20.7 million in the prior year. Selling expenses, as a percentage of net sales, decreased from 5.6% for the year ended December 31, 2005 to 3.5% of net sales for the year ended December 31, 2006. The decrease in selling expenses as a percentage of net sales was due to higher armor sales that did not require a proportional increase in selling expenses. Increases in the number of employees and related personnel expenses primarily accounted for the increase in selling expenses for the year ended December 31, 2006.
General and Administrative Expenses. Our general and administrative expenses for the year ended December 31, 2006 were $35.3 million, an increase of $14.3 million, or 67.9% from $21.0 million in the year ended December 31, 2005. General and administrative expenses, as a percentage of net sales, decreased from 5.7% for the year ended December 31, 2005 to 5.3% of net sales for the year ended December 31, 2006. Contributing to the increase in general and administrative expenses for the year ended December 31, 2006 was a non-cash charge of $2.2 million in the second quarter based on the results of our Special Committee’s review of our historical stock option practices, including our underlying option grant documentation and procedures, as described in more detail above under the caption “Overview - Review of Historical Stock Option Grant Procedures,” and a related charge for payroll tax and penalties of $1.2 million. Increases in the number of employees and related personnel expenses, including increased bonus accruals as a result of the Company’s higher operating profits, accounted for the remaining increase in general and administrative expenses.
Research and Development Expenses. Our research and development expenses for the year ended December 31, 2006 were $9.9 million, an increase of $2.1 million, or 27.0%, from $7.8 million in the prior year. Research and development expenses, as a percentage of net sales, decreased from 2.1% for the year ended December 31, 2005 to 1.5% of net sales for the year ended December 31, 2006. The primary reason for the decrease in research and development expenses as a
percentage of net sales was higher armor sales that did not require a proportional increase in research and development expenses. For the year ended December 31, 2006, expenses for the development of next generation body armor products and the continuing development of vehicle armor primarily accounted for the increase in research and development expenses.
Other Income (Expense). Our net other income for the year ended December 31, 2006 was $1.8 million, compared to net other expense of $8.4 million in the prior year. The primary reason for the change was an increase in interest income received from investing higher cash balances in short-term marketable securities. Interest expense was $4.1 million in the year ended December 31, 2006, compared to $9.3 million in the prior year. The decrease in interest expense was due to the repayment in December 2005 of our credit facility consisting of a term loan and line of credit, which had a higher interest rate than the convertible debt that we issued in December 2005 to replace it. Included in interest expense for the year ended December 31, 2005 was approximately $2.6 million for the write-off of unamortized debt issuance costs as we terminated our credit facility.
Income before Provision for Income Taxes. Our income before provision for income taxes for the year ended December 31, 2006 was $194.6 million, an increase of $121.4 million or 165.7% from the $73.2 million in the prior year.
Our Advanced Ceramic Operations division’s income before provision for income taxes for the year ended December 31, 2006 was $177.0 million, an increase of $113.3 million or 178.1%, from $63.7 million in the prior year. The increase in income before provision for income taxes for the year ended December 31, 2006 was a result of higher sales of body armor and a reduction of start up and training expenses in our Lexington, Kentucky hot press facility compared to the prior year.
Our ESK Ceramics subsidiary’s income before provision for income taxes for the year ended December 31, 2006 was $17.3 million, an increase of $7.1 million, or 69.3% from $10.2 million in the prior year. The increase in gross profit and gross profit as a percentage of sales was a result of an improved sales mix, as well as increased sales by our Advanced Ceramics Operations division of products containing boron carbide purchased from ESK Ceramics.
Our Semicon Associates division’s income before provision for income taxes for the year ended December 31, 2006 was $1.6 million, an increase of $0.7 million, or 76.5%, from $0.9 million in the prior year. The increase in income before provision for income taxes for the year ended December 31, 2006 was a result of higher sales of our microwave and laser cathodes products and increased manufacturing operating leverage while other operating expenses remained relatively constant.
Our Thermo Materials division’s income before provision for income taxes for the year ended December 31, 2006 was $0.9 million, an increase of $1.1 million from a loss of $209,000 before provision for income taxes in the prior year. The increase in income before provision for income taxes for the year ended December 31, 2006 was primarily due to an improved sales mix caused by higher sales of crucibles and increasing defense revenues.
Our Ceradyne Canada subsidiary had loss before provision for income taxes for the year ended December 31, 2006 of $0.7 million. The loss was caused by operational start up expenses.
Income Taxes. Our provision for income taxes for the year ended December 31, 2006 was $66.2 million, an increase of $39.7 million, or 150.1% from the $26.5 million in the prior year. The effective income tax rate for the year ended December 31, 2006 was 34.0% compared to 36.1% in the corresponding prior year period. The decrease in the effective tax rate results from a lower state tax rate due to apportionment of sales outside of California, increases in domestic production activities which generated larger manufacturing deductions and increases in extraterritorial income related deductions.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
Net Sales. Our net sales for the year ended December 31, 2005 were $368.3 million, an increase of $152.7 million, or 70.8%, from $215.6 million in the corresponding prior year period.
Our Advanced Ceramic Operations division had net sales for the year ended December 31, 2005 of $242.8 million, an increase of $83.0 million, or 52.0% from the $159.8 million in the prior year. The primary reason for this improvement was the shipment of $207.1 million of ceramic body and other armor components for defense customers, an increase of $80.0 million, or 62.9% from the $127.1 million of net sales in the prior year. This increase in net sales of armor was due to an increase in demand for lightweight body armor for military personnel, caused in part by the U.S. Army’s change from SAPI to E-SAPI armor plates. Net sales for our automotive/diesel component product line, including cam rollers, were $16.0 million, an increase of $4.3 million, or 36.7%, from the $11.7 million in the prior year. The primary reason for this increase is that our customers produced more heavy-duty diesel truck engines. Net sales of our orthodontic brackets product line were $9.8 million, which was unchanged from the prior year.
Our ESK Ceramics subsidiary had net sales for the year ended December 31, 2005 of $123.2 million, an increase of $85.4 million, or 225.5% from the $37.8 million in the prior year. We completed the acquisition of ESK Ceramics on August 23, 2004 and began to consolidate its operations with ours as of September 1, 2004.
Our Semicon Associates division had net sales for the year ended December 31, 2005 of $7.4 million, a decrease of $65,000 or 0.9%, from the $7.5 million in the prior year, also reflecting lower shipments of microwave and laser cathodes.
Our Thermo Materials division had net sales for the year ended December 31, 2005 of $12.2 million, a decrease of $120,000, or 1.0%, from the $12.3 million in the prior year. This decrease was due to several factors. Defense revenues decreased $1.4 million, and sales of fused silica rollers decreased $1.5 million, which were offset by an increase of $1.5 million of crucibles sales, and an aggregate increase of $1.3 million from sales of other product lines. The decrease in sales of fused silica rollers was caused by severe price competition from Chinese manufacturers who continued to reduce prices resulting in decreasing sales prices for our fused silica roller products.
Gross Profit. Our gross profit was $131.1 million for the year ended December 31, 2005, an increase of $62.0 million, or 89.8%, from $69.1 million in the prior year. As a percentage of net sales, gross profit was 35.6% for the year ended December 31, 2005, compared to 32.0% for the prior year. The increase in gross profit as a percentage of net sales in the year ended December 31, 2005 was the result of increased sales, particularly in sales of body armor, improved sales mix, higher operating leverage and a reduction in the cost of boron carbide, a key raw material used in the production of body armor, resulting from the acquisition of ESK Ceramics.
Our Advanced Ceramic Operations division posted gross profit of $91.3 million for the year ended December 31, 2005, an increase of $34.5 million, or 60.7%, from $56.8 million in the prior year. As a percentage of net sales, gross profit was 37.6% for the year ended December 31, 2005, compared to 35.5% for the corresponding prior year period. The reasons for the increase in gross profit and gross profit as a percentage of net sales were consistent with those reasons described in the preceding paragraph for the year ended December 31, 2005.
Our ESK Ceramics subsidiary had a gross profit of $37.6 million, equal to 30.5% of net sales, for the year ended December 31, 2005. For comparative purposes, gross profit as a percentage of net sales was 24.4% for the year ended December 31, 2004. The increase in gross profit as a percentage of net sales in the year ended December 31, 2005 was the result of increased sales, particularly in sales of boron carbide, improved sales mix and higher operating leverage. Additionally, included in ESK Ceramics’ gross profit in the year ended December 31, 2004, are $3.0 million of pre-tax expenses related to the amortization of the backlog and expensing the step up of the inventory from the application of purchase accounting in connection with the acquisition.
Our Semicon Associates division had gross profit of $1.8 million for the year ended December 31, 2005, an increase of $361,000, or 22.1% from $1.4 million in the prior year. As a percentage of net sales, gross profit was 23.6% for the year ended December 31, 2005, compared to 19.2% for the prior year. The increase in gross profit as a percentage of net sales in the year ended December 31, 2005 was the result of increased productivity and reduced costs in the production of microwave cathodes and magnets.
Our Thermo Materials division had gross profit of $1.8 million for the year ended December 31, 2005, a decrease of $187,000 or 9.3%, compared to $2.0 million in the prior year. As a percentage of net sales, gross profit was 15.0% for the year ended December 31, 2005, compared to 16.3% for the prior year. This decrease was due in part to a $0.7 million decline in gross profit in our fused silica roller product line caused by severe price competition from Chinese manufacturers.
Selling Expenses. Our selling expenses were $20.7 million for the year ended December 31, 2005, an increase of $12.4 million, or 150.4%, from $8.3 million in the prior year. Selling expenses, as a percentage of net sales, increased from 3.8% for the year ended December 31, 2004 to 5.6% of net sales for the year ended December 30, 2005. ESK Ceramics contributed $11.2 million, or 89.8% of the $12.4 million increase. ESK Ceramics’ selling expenses currently are, and we expect them to continue to be, higher as a percentage of net sales than our other divisions because ESK Ceramics sells in more foreign countries and has more customers.
General and Administrative Expenses. Our general and administrative expenses for the year ended December 31, 2005 were $21.0 million, an increase of $6.9 million, or 48.7%, from $14.1 million in the year ended December 31, 2004. General and administrative expenses, as a percentage of net sales, decreased from 6.5% for the year ended December 31, 2004 to 5.7% of net sales for the year ended December 31, 2005. For the year ended December 31, 2005, ESK Ceramics contributed $2.7 million, or 39.4% of the increase. Increases in the number of employees and related personnel expenses primarily accounted for the remaining rise in general and administrative expenses.
Research and Development Expenses. Our research and development expenses for the year ended December 31, 2005 were $7.8 million, an increase of $4.5 million, or 133.5%, from $3.3 million in the prior year. Research and development expenses, as a percentage of net sales, increased from 1.5% for the year ended December 31, 2004 to 2.1% of net sales for the year ended December 31, 2005. ESK Ceramics contributed $1.8 million, or 40.3%, of the increase in research and development expenses. For the year ended December 31, 2005, expenses for the development of new armor designs contributed to a portion of the increase.
Other Income (Expense). Our net other expenses for the year ended December 31, 2005 was $8.4 million, compared to net other income of $0.6 million in the prior year. The primary reason for the change was an increase in our interest expense, which was $9.3 million in the year ended December 31, 2005, compared to $1.7 million in the prior year. Included in interest expense for the year ended December 31, 2005 was approximately $2.6 million for the write-off of unamortized debt issuance costs as we terminated our credit facility in December 2005. The increase in interest expense was also due to higher borrowing levels for the year ended December 31, 2005 compared to the prior year. We incurred debt to acquire ESK Ceramics in August 2004. The change in other income (expense) was also due to gains on currency transactions of $1.2 million recognized in the year ended December 31, 2004 compared to gains from currency transactions of $275,000 in the year ended December 31, 2005.
Income before Provision for Income Taxes. Our income before provision for income taxes for the year ended December 31, 2005 was $73.2 million, an increase of $29.3 million, or 66.7%, from the $43.9 million in the prior year.
Our Advanced Ceramic Operations division’s income before provision for income taxes for the year ended December 31, 2005 was $63.7 million, an increase of $19.8 million, or 45.0%, from $43.9 million in the prior year. The increase in income before provision for income taxes for the year ended December 31, 2005 was a result of higher sales of armor offset in part by higher general and administrative expenses to support these sales levels.
Our ESK Ceramics subsidiary’s income before provision for income taxes for the year ended December 31, 2005 was $10.2 million after including interest expense of $6.0 million and gains from currency transactions of $1.1 million. ESK Ceramics was included in our consolidated financial results as of September 1, 2004 for the year ended December 31, 2004.
Our Semicon Associates division’s income before provision for income taxes for the year ended December 31, 2005 was $894,000, an increase of $361,000, or 67.7%, from $533,000 in the prior year. The increase in income before provision for income taxes for the year ended December 31, 2005 was a result of increased gross margins of $437,000 in our microwave cathodes business line offset by a net reduction in gross margins of the remaining product lines.
Our Thermo Materials division’s loss before provision for income taxes for the year ended December 31, 2005 was $209,000, a decrease of $290,000 from $81,000 of income before provision for income taxes in the prior year. The loss for the year ended December 31, 2005 was primarily due to reduced amounts of sales and gross margin of fused silica rolls and defense products.
Income Taxes. Our provision for income taxes for the year ended December 31, 2005 was $26.5 million, an increase of $10.2 million, or 61.8%, from the $16.3 million in the prior year. The effective income tax rate for the year ended December 31, 2005 was 36.1% compared to 37.2% in the corresponding prior year period. The reduction in the effective tax rate was the result of higher research and development credits and higher extra territorial income exclusions.
Liquidity and Capital Resources
We generally have met our operating and capital requirements with cash flow from operating activities, borrowings under our credit facility, and proceeds from the sale of shares of our common stock.
Our net cash position decreased by $78.0 million during the year ended December 31, 2006, compared to an $87.0 million increase during the year ended December 31, 2005. For the year ended December 31, 2006, cash flow provided by operating activities amounted to $139.3 million. The primary factors contributing to cash flow from operating activities in the year ended December 31, 2006, were net income of $128.4 million, and adjustments of non-cash amounts related to depreciation and amortization of $18.1 million, stock compensation of $3.9 million, and increased levels of accounts payable, accrued expenses, income tax payable, employee benefits and other liabilities that added an aggregate of $24.7 million. These contributions were offset in part by, deferred income taxes of $4.9 million, increase in accounts receivable and other receivables of $18.0 million due to higher amounts of sales over the previous year, increased levels of inventories, production tooling, prepaid expenses and other assets that totaled $13.1 million. The increase in inventory and tooling were due to the increase in sales and production to support the growth of the Advanced Ceramic Operations segment.
During the year ended December 31, 2006, we used $225.5 million of our cash for investing activities, including $36.0 million for capital expenditures, $6.7 million in acquisition costs related to the Boral® product line, and purchases of short term investments totaling $182.7 million. Capital expenditures included $8.0 million to purchase a building and equipment in Canada to enable us to enter into the manufacture and marketing of structural neutron absorbing materials and metal matrix composites.
Financing activities during the year ended December 31, 2006 provided net cash of $5.8 million. We received cash proceeds of $0.6 million relating to the issuance of common stock under our stock plan, and proceeds of $2.3 million from issuance of stock due to exercise of stock options and the excess tax benefit of $2.9 million due to exercise of stock options. The effect of exchange rates on cash and equivalents due to our investment in ESK Ceramics was a positive $2.4 million.
Our net cash position increased by $87.0 million during the year ended December 31, 2005, compared to a $6.9 million decrease during the year ended December 31, 2004. For the year ended December 31, 2005, cash flow provided by operating activities amounted to $21.1 million. The primary factors contributing to cash flow from operating activities in the year ended December 31, 2005, were net income of $46.8 million, depreciation and amortization of $15.2 million, a $1.6 million reduction of income taxes payable due to the exercise of stock options, and increased levels of accrued expenses, income tax payable, and other liabilities that added an aggregate of $7.0 million. These contributions were offset in part by an increase in accounts receivable and other receivables of $10.6 million due to higher amounts of sales over the previous year, a decrease in accounts payable of $6.7 million due to our decision to take cash discounts and shorten the days outstanding, increased levels of inventories, production tooling, prepaid expenses and other assets that totaled $29.6 million. The increase in inventory and tooling were due to the increase in sales and production to support the growth of the Advanced Ceramic Operations segment.
During the year ended December 31, 2005, we used $21.7 million of our cash for investing activities, including $20.2 million for capital expenditures and $3.7 million in additional acquisition costs related to ESK Ceramics, partially offset by the liquidation of short term investments totaling $2.2 million. A majority of our capital expenditures was for equipment to add armor manufacturing capacity primarily at our Lexington, Kentucky hot press facility and improve productivity.
Financing activities during the year ended December 31, 2005 provided net cash of $89.2 million. As described in more detail below, our primary source of cash was proceeds from the concurrent public offerings in December 2005 of shares of our common stock and senior subordinated convertible notes. We received net proceeds of $84.6 million from the common stock offering, and aggregate proceeds of $121.0 million from the senior subordinated convertible note offering. We used a portion of these proceeds to repay the balance of $109.7 million under our term loan and $9.5 million owed under our line of credit. During 2005 we also received cash proceeds of $1.8 million relating to the issuance of common stock under our stock plans, and cash proceeds of $1.1 million from the issuance of common stock due to the exercise of options. The effect of exchange rates on cash and equivalents due to our investment in ESK Ceramics was a negative $1.6 million.
During December 2005, we completed a public offering of 2,070,000 shares of our common stock at a price to the public of $43.31 per share. We received net proceeds of approximately $84.6 million from this offering after deducting offering expenses and underwriting discounts of $5.0 million. Concurrent with our common stock offering, we issued $121.0 million principal amount of 2.875% senior subordinated convertible notes due December 15, 2035. We received net proceeds of approximately $116.8 million from the notes offering after deducting offering expenses and underwriting discounts of $4.2 million.
Interest on the notes is payable on December 15 and June 15 of each year, commencing on June 15, 2006. The notes are convertible into 17.1032 shares of our common stock for each $1,000 principal amount of the notes (which represents a conversion price of approximately $58.47 per share), subject to adjustment. The notes are convertible only under certain circumstances, including if the price of our common stock reaches, or the trading price of the notes falls below, specified thresholds, if the notes are called for redemption, if specified corporate transactions or fundamental change occur, or during the 10 trading days prior to maturity of the notes. We may redeem the notes at any time after December 20, 2010, for a price equal to 100% of the principal amount plus accrued and unpaid interest, including contingent interest (as described below), if any, up to but excluding the redemption date.
With respect to each $1,000 principal amount of the notes surrendered for conversion, we will deliver the conversion value to holders as follows: (1) an amount in cash equal to the lesser of (a) the aggregate conversion value of the notes to be converted and (b) $1,000, and (2) if the aggregate conversion value of the notes to be converted is greater than $1,000, an amount in shares or cash equal to such aggregate conversion value in excess of $1,000.
The notes contain put options, which may require us to repurchase in cash all or a portion of the notes on December 15, 2012, December 15, 2015, December 15, 2020, December 15, 2025, and December 15, 2030 at a repurchase price equal to 100% of the principal amount of the notes to be repurchased plus accrued and unpaid interest, including contingent interest (as described below), if any, to but excluding the repurchase date.
We are obligated to pay contingent interest to the holders of the notes during any six-month period from June 15 to December 14 and from December 15 to June 14, commencing with the six-month period beginning December 20, 2010 and ending on June 14, 2011, if the average trading price of the note for the five trading day period ending on the third trading day immediately preceding the first day of the relevant contingent interest period equals $1,200 (120% of the principal amount of a note) or more. The amount of contingent interest payable per note for any relevant contingent interest period shall equal 0.25% per annum of the average trading price of a note for the five trading day period ending on the third trading day immediately preceding the first day of the relevant contingent interest period.
On December 19, 2005, we repaid the existing balance of our term loan of $108.9 million and $9.8 million of our line of credit, and approximately $0.1 million of accrued interest, using a portion of the net proceeds from our concurrent sale of senior subordinated convertible notes and common stock. As a result of the early repayment of the term loan, we wrote off the remaining unamortized debt issuance costs of approximately $2.6 million in the fourth quarter of 2005.
In December 2005, the Company established a new unsecured $10.0 million line of credit. As of December 31, 2006, there were no outstanding amounts on the line of credit. However, the available line of credit at December 31, 2006 has been reduced by an outstanding letter of credit in the amount of $3.8 million. The interest rate on the credit line is based on the LIBOR rate for a period of one month, plus a margin of one percent, which equaled 6.3% as of December 31, 2006.
Pursuant to the bank line of credit, the Company is subject to certain covenants, which include, among other things, the maintenance of specified minimum amounts of tangible net worth and quick assets to current liabilities ratio. At December 31, 2006, the Company was in compliance with these covenants.
Our cash, cash equivalents and short-term investments totaled $204.1 million at December 31, 2006, compared to $99.4 million at December 31, 2005. At December 31, 2006, we had working capital of $332.1 million, compared to $212.3 million at December 31, 2005. Our cash position includes amounts denominated in foreign currencies, and the repatriation of those cash balances from our ESK Ceramics subsidiary does not result in additional tax costs. We believe that our current cash and cash equivalents on hand and cash available from the sale of short-term investments, cash available from additional borrowings under our revolving line of credit and cash we expect to generate from operations will be sufficient to finance our anticipated capital and operating requirements for at least the next 12 months. Our anticipated capital requirements primarily relate to the expansion of our manufacturing facilities in both the United States and Germany. We also may utilize cash, and, to the extent necessary, borrowings from time to time to acquire other businesses, technologies or product lines that complement our current products, enhance our market coverage, technical capabilities or production capacity, or offer growth opportunities. We have no present commitments or agreements for any material acquisitions.
Our material contractual obligations and commitments as of December 31, 2006 are as follows (amounts in thousand):
Off-Balance Sheet Arrangements
The only off-balance sheet arrangement is the conversion feature of our 2.875% convertible senior subordinated notes discussed above.
Critical Accounting Policies and Estimates
Management’s discussion and analysis of financial condition and results of operations, as well as disclosures included elsewhere in this report are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. Preparing these consolidated financial statements
requires our management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingencies. We believe that the critical accounting policies that most impact the consolidated financial statements are as described below. A summary of our significant accounting policies is included in Note 1 to our consolidated financial statements which begin on page of this report.
In applying these policies, estimates and judgments affect the amounts at which accounts receivable and inventory and certain liabilities are recorded and the useful lives of property and equipment. We apply our accounting policies on a consistent basis. As circumstances change, they are considered in our estimates and judgments. Future changes in circumstances could result in changes in amounts at which assets and liabilities are recorded. Future changes could also affect the estimated useful levels of property and equipment, which could result in changes in depreciation expense, write-offs or write-downs of such assets.
Sales Recognition. Sales are recorded when all of the following have occurred: an agreement of sale exists, product delivery and acceptance has occurred, and collection is reasonably assured. Management is required to make judgments about whether or not collectibility is reasonably assured. We reduce revenue with reserves for estimated price concessions and sales returns. Allowances, which are recorded at the time revenue is recognized, in accordance with SFAS No. 48, “Revenue Recognition When Right of Return Exists,” are based upon historical price concessions and sales returns. We do not record a warranty reserve on the sale of our products. For our largest product line, body armor, all of which is sold to the U.S. government, each lot of body armor is tested at an independent laboratory and the lot cannot be released for shipment to the U.S. government until positive test results are received by both the U.S. government and us. For our non-body armor sales, we have experienced minimal claims from these types of sales. Additionally, due to the inherent nature, strength, durability and structural properties of ceramics, as well as a rigid quality control program that includes, for some of our customers, having the customer accept quality test results prior to shipment, we do not believe a warranty reserve is necessary.
Accounts Receivable. We review our trade accounts receivables and our estimates of the allowance for doubtful accounts each period. The allowance for doubtful accounts is determined by analyzing specific customer accounts and assessing the risk of uncollectibility based on insolvency, disputes or other collection issues. In addition, we routinely analyze the different aging categories and establish allowances based on the length of time receivables are past due (based on contractual terms). A write-off will occur if the settlement of the account receivable is less than the carrying amount or we ultimately determine the balance will not be collected. The amounts we will ultimately realize could differ materially from the amounts assumed in arriving at the allowance for doubtful accounts in the financial statements included in this report beginning on page.
Inventories. Inventories are valued at the lower of cost (first-in, first-out) or market. The write-down of inventory for obsolete items is based on our estimate of the amount considered obsolete based on specific reviews of inventory items. In estimating the allowance, we rely on our knowledge of the industry as well as our current inventory levels. The amounts we will ultimately realize could differ from the estimated amounts. Inventory costs include the cost of material, labor and manufacturing overhead.
Accounting for Long-Lived Assets. In accordance with SFAS No. 144, long-lived assets and intangible assets with definite lives are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment indicators include, among other conditions, cash flow deficits, historic or anticipated declines in revenue or operating profit and adverse legal or regulatory developments. If it is determined that such indicators are present and the review indicates that the assets will not be fully recoverable, based on undiscounted estimated cash flow over the remaining amortization periods, their carrying values are reduced to estimated fair market value. Estimated fair market value is determined primarily using the anticipated cash flow discounted at a rate commensurate with the risk involved. For the purposes of identifying and measuring impairment, long-lived assets are grouped with other assets and liabilities at the lowest level for which identifiable cash flow are largely independent of the cash flow of other assets and liabilities.
Goodwill and Intangible Assets. In accordance with SFAS 142, goodwill is not being amortized, but instead is subject to an annual assessment of impairment by applying a fair-value based test.
The Company performs an annual impairment test for goodwill in the fourth quarter of each year. Goodwill is allocated to five reporting units, which represent the Company’s operating segments. The Company’s reporting units for purposes of applying the provisions of SFAS 142 are: Advanced Ceramics Operations, Semicon Associates, Thermo Materials, ESK Ceramics and Ceradyne Canada. SFAS 142 requires the Company to compare the fair value of the goodwill and indefinite lived intangible assets to the carrying amount on an annual basis to determine if there is potential impairment. If the fair value of goodwill and/or indefinite lived intangible assets is less than the carrying value, an impairment loss is recorded to the extent that the fair value of the goodwill and/or indefinite lived intangible assets is less than the carrying value. Fair value is determined based on discounted cash flows, market multiples or appraised values as appropriate. At December 31, 2006, the Company did not believe any impairment of goodwill had occurred. Intangible assets with definite lives are amortized over their estimated useful lives.
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (SFAS No. 158). SFAS No. 158 requires that employers recognize on a prospective basis the funded status of their defined benefit pension and other postretirement plans on their consolidated balance sheet and recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost. SFAS No. 158 also requires additional disclosures in the notes to financial statements. SFAS No. 158 is effective as of the end of fiscal years ending after December 15, 2006. The adoption of SFAS No. 158 did not have a material impact on our consolidated financial position, results of operations or cash flows.
In September 2006, the FASB issued SFAS 157 “Fair Value Measurement” (“SFAS 157”) which defines fair value, establishes a framework for measuring fair value and expanded disclosures about fair value measurement. Companies are required to adopt the new standard for fiscal periods beginning after November 15, 2007. We are evaluating the impact of this standard and currently do not expect it to have a significant impact on our consolidated financial position, results of operations or cash flows.
In September 2006, Staff Accounting Bulletin (“SAB”) 108 was released. The bulletin establishes an approach that requires quantification of financial statement errors based on the effects of the error on each of the company’s financial statements and the related financial statement disclosures. SAB 108 is effective for interim periods which are part of fiscal years ending on or after November 15, 2006. Our adoption of this standard did not have any impact on our consolidated financial position, results of operations or cash flows.
In June 2006, the Emerging Issues Task Force (“EITF”) issued EITF 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That is, Gross versus Net Presentation)” to clarify diversity in practice on the presentation of different types of taxes in the financial statements. The Task Force concluded that, for taxes within the scope of the issue, a company may adopt a policy of presenting taxes either gross within revenue or net. That is, it may include charges to customers for taxes within revenues and the charge for the taxes from the taxing authority within cost of sales, or, alternatively, it may net the charge to the customer and the charge from the taxing authority. If taxes subject to EITF 06-3 are significant, a company is required to disclose its accounting policy for presenting taxes and the amounts of such taxes that are recognized on a gross basis. The guidance in this consensus is effective for the first interim reporting period beginning after December 15, 2006 (the first quarter of our fiscal year 2007). We do not expect the adoption of EITF 06-3 will have a material impact on our results of operations, financial position or cash flow.
In June 2006, the FASB issued Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes. FIN 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective for fiscal years beginning after December 15, 2006 (our fiscal year 2007) and the provisions of FIN 48 will be applied to all tax positions under Statement No. 109 upon initial adoption. The cumulative effect of applying the provisions of this interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. We do not expect the adoption of FIN 48 to have a material impact on our financial position, results of operations or cash flow.
In December 2004, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS 154”). SFAS 154 changes the requirements for the accounting for, and reporting of, a change in accounting principle. SFAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented using the new accounting principle. SFAS 154 is effective for accounting changes and corrections of errors in fiscal years beginning after December 15, 2005. We adopted this standard in the first quarter of fiscal year 2006. Adoption of this standard did not have a material impact on our consolidated financial position, results of operations or cash flow.
In December 2004, the FASB issued SFAS No. 153, “Exchange of Nonmonetary Assets-an amendment of APB Opinion No. 29,” which amends Opinion 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS 153 defines a nonmonetary exchange as having commercial substance if the future cash flow of the entity is expected to change significantly as a result of the exchange. This Statement is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We adopted this standard in the third quarter of fiscal year 2005. Adoption of this standard did not have a material effect on our financial position, results of operations or cash flow.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk
Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio and our debt. We have not used derivative financial instruments in our investment portfolio. We place our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer. We protect and preserve our invested funds by limiting default, market and reinvestment risk. Our investments in marketable securities consist primarily of high-grade corporate and government securities with maturities of less than three years. Investments purchased with an original maturity of three months or less are considered cash equivalents. We classify all of our investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of stockholders’ equity. Average maturity of our investment portfolio is 67 days; therefore, the movement of interest rates should not have a material impact on our balance sheet or income statement.
At any time, a significant increase/decrease in interest rates will have an impact on the fair market value and interest earnings of our investment portfolio. We do not currently hedge this interest rate exposure. We have performed a sensitivity analysis as of December 31, 2006 and 2005, using a modeling technique that measures the change in the fair values arising from a hypothetical 50 basis points and 100 basis points adverse movement in the levels of interest rates across the entire yield curve, which are representative of historical movements in the Federal Funds Rate with all other variables held constant. The analysis covers our investment and is based on the weighted-average maturity of our investments as of December 31, 2006 and 2005. The sensitivity analysis indicated that a hypothetical 50 basis points adverse movement in interest rates would result in a loss in the fair values of our investment instruments of approximately $40,000 at December 31, 2006 and approximately $95,000 at December 31, 2005. Similarly a hypothetical 100 basis points adverse movement in interest rates would result in a loss in the fair values of our investments of approximately $79,000 at December 31, 2006 and approximately $219,000 at December 31, 2005
Actual maturities may differ from contractual maturities because the issuer of the securities may have the right to repurchase such securities. We classify short-term investments in current assets, as all such investments are available for current operations.
We are not exposed to market risks related to fluctuations in interest rates on our debt as it is fixed rate debt. Consequently, we do not utilize interest rate swaps or other types of derivative financial instruments regarding our debt.
Foreign Currency Fluctuations
We enter into foreign exchange forward contracts to reduce earnings and cash flow volatility associated with foreign exchange rate changes to allow our management team to focus its attention on its core business operations. Accordingly, we enter into contracts which change in value as foreign exchange rates change to economically offset the effect of changes in value of foreign currency assets and liabilities, commitments and anticipated foreign currency denominated sales and operating expenses. We enter into foreign exchange forward contracts in amounts between minimum and maximum anticipated foreign exchange exposures, generally for periods not to exceed one year. These derivative instruments are not designated as accounting hedges.
We measure the financial statements of our foreign subsidiaries using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate on the balance sheet date. Revenues, costs and expenses are translated at the rates of exchange prevailing during the year. Translation adjustments resulting from this process are included in stockholders’ equity. Gains and losses from foreign currency transactions are included in other income miscellaneous.
ITEM 8.
ITEM 8. FI NANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements and Supplementary Data commence at page of this report and an index thereto is included in Part IV, Item 15 of this report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and Rule 15d-15(e) under the Securities Exchange Act of 1934) were effective.
Changes in Internal Control over Financial Reporting
Our management evaluated our internal control over financial reporting and there have been no changes during the fiscal quarter ended December 31, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. 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. Our management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006. 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 have concluded that, as of December 31, 2006, the Company’s internal control over financial reporting was effective based on those criteria.
Ceradyne’s independent registered public accounting firm, PricewaterhouseCoopers LLP, audited our assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006 as stated in their report, which appears herein.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Information in response to this item (except for certain information concerning executive officers included in Part I of this report) is incorporated by reference from the registrant’s definitive proxy statement to be filed with the Commission within 120 days after the close of registrant’s fiscal year.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information in response to this item is incorporated by reference from the registrant’s definitive proxy statement to be filed with the Commission within 120 days after the close of registrant’s fiscal year.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information in response to this item is incorporated by reference from the registrant’s definitive proxy statement to be filed with the Commission within 120 days after the close of registrant’s fiscal year.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information in response to this item is incorporated by reference from the registrant’s definitive proxy statement to be filed with the Commission within 120 days after the close of registrant’s fiscal year.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information in response to this item is incorporated by reference from the registrant’s definitive proxy statement to be filed with the Commission within 120 days after the close of registrant’s fiscal year.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) List of documents filed as part of this report:
Financial Statements:
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at December 31, 2006 and 2005
Consolidated Statements of Income for the Years Ended December 31, 2006, 2005 and 2004
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2006, 2005 and 2004
Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2005 and 2004
Notes to Consolidated Financial Statements
(b) List of Exhibits
* Each of these exhibits constitutes a management contract, compensatory plan, or arrangement.
CERADYNE, INC.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To Board of Directors and Stockholders of Ceradyne, Inc.:
We have completed integrated audits of Ceradyne, Inc.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006 in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements
In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a) present fairly, in all material respects, the financial position of Ceradyne, Inc. and its subsidiaries at December 31, 2006 and December 31, 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements 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. An audit of financial statements 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, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Internal control over financial reporting
Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting 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 effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the 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.
/s/ PricewaterhouseCoopers LLP
Orange County, California
February 26, 2007
CERADYNE, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except for share data)
The accompanying notes are an integral part of these consolidated statements.
CERADYNE, INC.
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except for per share data)
The accompanying notes are an integral part of these consolidated statements.
CERADYNE, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands, except for share data)
The accompanying notes are an integral part of these consolidated statements.
CERADYNE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Description of Business
Ceradyne, Inc. (“Ceradyne” or “the Company”) develops, manufactures and markets advanced technical ceramic products and components for defense, industrial, automotive/diesel and commercial applications. The Company’s competitive advantage results from expertise in ceramic material science as well as a vertically integrated approach of designing much of its key equipment and controlling the manufacturing process from raw material powders to finished product. This allows the Company to design and manufacture precision, high quality advanced technical ceramic products to meet demanding customer specifications. The Company markets its products to a broad range of industries in 50 countries. The Company’s customers include the U.S. government, prime government contractors and large industrial and commercial manufacturers.
In many high performance applications, products made of advanced technical ceramics meet specifications that similar products made of metals, plastics or traditional ceramics cannot achieve. Advanced technical ceramics can withstand extremely high temperatures, combine hardness with light weight, are highly resistant to corrosion and wear, and often have excellent electrical insulation capabilities, special electronic properties and low friction characteristics.
2. Summary of Significant Accounting Policies
a. Principles of Consolidation and Nature of Operations
The consolidated financial statements include the financial statements of Ceradyne, Inc. (a Delaware Corporation), and its subsidiaries. Ceradyne, Inc. and its subsidiaries are collectively referred to herein as the “Company”. All significant intercompany accounts and transactions have been eliminated.
b. Cash and Cash Equivalents
The Company considers all highly liquid investments with an initial maturity of three months or less when purchased to be cash equivalents.
c. Short Term Investments
The Company’s short term investments consist of marketable securities, primarily high-grade corporate and government securities. The Company classifies all of its investments as available-for-sale based on the Company’s intent. As of December 31, 2006, the amount classified as available for sale is $190.6 million, which is recorded at fair market value. The unrealized loss of $0.1 million has been recorded as a component of other comprehensive income.
d. Foreign Exchange Risk Management
The Company measures the financial statements of its foreign subsidiaries using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate on the balance sheet date. Revenues, costs and expenses are translated at the rates of exchange prevailing during the year. Translation adjustments resulting from this process are included in stockholders’ equity. Gains and losses from foreign currency transactions are included in other income, miscellaneous.
e. Accounts Receivable, Net
Trade accounts receivable are recorded at the invoiced amount and do not bear interest. The allowance for doubtful accounts is determined by analyzing specific customer accounts and assessing the risk of uncollectibility based on insolvency, disputes or other collection issues. In addition, the Company routinely analyzes the different aging categories and establishes allowances based on the length of time receivables are past due (based on contractual terms). A write-off will occur if the settlement of the account receivable is less than the carrying amount or the Company ultimately determines the balance will not be collected. We do not have any off-balance-sheet credit exposure related to our customers.
The following are changes in the allowance for doubtful accounts for the years ended December 31, 2006, 2005 and 2004 (in thousands):
(1) Additions in 2004 include $272 of allowance that was part of the ESK Ceramics acquisition.
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
f. Inventories
Inventories are valued at the lower of cost (first-in, first-out) or market. The write-down of inventory for obsolete items is based on management’s estimate of the amount considered obsolete based on specific reviews of inventory items. In estimating the write-down, management relies on its knowledge of the industry as well as its current inventory levels. The amounts the Company will ultimately realize could differ from amounts estimated by management. Inventory costs include the cost of material, labor and manufacturing overhead. The following is a summary of inventories by component (in thousands):
g. Production Tooling
The Company’s production tooling primarily consists of graphite tooling used in the manufacturing and furnace processes. This tooling is being amortized over three to nine months.
h. Property, Plant and Equipment, Net
Property, plant and equipment is recorded at cost and consists of the following (in thousands):
Depreciation and amortization of property, plant and equipment are provided using the straight-line method over the following estimated useful lives:
Maintenance, repairs and minor renewals are charged to expense as incurred. Repairs and maintenance expense approximated $12.8 million, $ 8.8 million, and $6.1 million in 2006, 2005, and 2004, respectively. Additions and improvements are capitalized. When assets are disposed of, the applicable costs and accumulated depreciation and amortization are removed from the accounts and any resulting gain or loss is included in the results of operations. Depreciation expense was approximately $18.1 million, $15.2 million, and $7.6 million in 2006, 2005, and 2004, respectively.
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
i. Goodwill and Intangible Assets, Net
In accordance with SFAS 142, goodwill is not being amortized, but instead is subject to an annual assessment of impairment by applying a fair-value based test.
The Company performs an annual impairment test for goodwill in the fourth quarter of each year. Goodwill is allocated to five reporting units, which represent the Company’s operating segments. The Company’s reporting units for purposes of applying the provisions of SFAS 142 are: Advanced Ceramics Operations, Semicon Associates, Thermo Materials, ESK Ceramics and Ceradyne Canada. SFAS 142 requires the Company to compare the fair value of the goodwill and indefinite lived intangible assets to the carrying amount on an annual basis to determine if there is potential impairment. If the fair value of goodwill and/or indefinite lived intangible assets is less than the carrying value, an impairment loss is recorded to the extent that the fair value of the goodwill and/or indefinite lived intangible assets is less than the carrying value. Fair value is determined based on discounted cash flows, market multiples or appraised values as appropriate. At December 31, 2006, the Company did not believe any impairment of goodwill had occurred. Intangible assets with definite lives are amortized over their estimated useful lives.
The roll forward of the goodwill balance by segment for the years ended December 31, 2006 and 2005 is as follows (in thousands):
The components of intangibles assets were as follows (in thousands):
All of the intangible assets were acquired in 2004 and 2006 (see Note 3). Amortizing intangible assets are amortized over their estimated useful lives of ten years, except for backlog which is amortized over nine months. Amortization of definite-lived intangible assets will be approximately $694 in each of the fiscal years 2006 through 2009, and $274 in each of the fiscal years 2010 through 2016. Amortization expense was approximately $565 and $212 in 2006 and 2005, respectively.
j. Sales Recognition
Sales are recorded when all of the following have occurred: an agreement of sale exists, product delivery and acceptance has occurred and collection is reasonably assured. Management is required to make judgments about whether or not collectibility is reasonably assured. The Company reduces revenue with reserves for estimated price concessions and sales returns. Allowances, which are recorded at the time revenue is recognized, in accordance with SFAS No. 48, “Revenue Recognition When Right of Return Exists,” are based upon historical price concessions and sales returns. The Company does
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
not record a warranty reserve on the sale of its products. For its largest product line, body armor, all of which is sold to the U.S. Government, each lot of body armor is tested at an independent laboratory and the lot cannot be released for shipment to the U.S. Government until positive test results are received by both the U.S. Government and the Company. For its non-body armor sales, the Company has experienced minimal claims from these types of sales. Additionally, due to the inherent nature, strength, durability and structural properties of ceramics, as well as a rigid quality control program that includes, for some of our customers, having the customer accept quality test results prior to shipment, management does not believe a warranty reserve is necessary.
k. Net Income Per Share
Basic net income per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding. Diluted net income per share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding plus the effect of any dilutive stock options and restricted stock units using the treasury stock method and the net share settlement method for the convertible debt. All share data in these financial statements have been adjusted to give retroactive effect to a 3-for-2 split of the Company’s common stock in the form of a 50% stock dividend distributed on April 7, 2004, and a second 3-for-2 split of the Company’s common stock in the form of a 50% stock dividend distributed on January 18, 2005.
The following is a summary of the number of shares entering into the computation of net income per common and common equivalent share:
l. Accounting for Long-Lived Assets
In accordance with SFAS No. 144, long-lived assets and intangible assets with definite lives are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment indicators include, among other conditions, cash flow deficits, historic or anticipated declines in revenue or operating profit and adverse legal or regulatory developments. If it is determined that such indicators are present and the review indicates that the assets will not be fully recoverable, based on undiscounted estimated cash flows over the remaining amortization periods, their carrying values are reduced to estimated fair market value. Estimated fair market value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. For the purposes of identifying and measuring impairment, long-lived assets are grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities.
m. Use of Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates.
n. Engineering and Research
The costs associated with application engineering and internally-funded research are expensed as incurred and are included in cost of product sales or other operating expenses. Costs associated with research and development were $9.9 million, $7.8 million and $3.3 million for years ended December 31, 2006, 2005 and 2004, respectively. In addition, the Company historically has and continues to engage in application engineering and internally funded research to improve and reduce the cost of products and to develop new products. Costs associated with engineering were approximately $7.3 million, $7.1 million and $3.8 million in 2006, 2005 and 2004, respectively, and are included in cost of product sales.
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
o. Fair Value of Financial Instruments
The carrying value of accounts receivable and trade payables approximates the fair value due to their short-term maturities. The carrying value of the Company’s unused line of credit is considered to approximate fair market value, as the interest rates of these instruments are based predominantly on variable reference rates. The fair value of long-term debt was $144.9 million and is based on quoted market prices at December 31, 2006.
p. Income Taxes
The Company accounts for income taxes using the asset and liability approach. Under this approach, deferred taxes are determined based on the differences between the financial statements and the tax bases using rates as enacted in tax laws. A valuation allowance is established if it is “more likely than not” that all or a portion of the deferred tax asset will not be realized.
q. Share-Based Compensation
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options based on estimated fair values. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) for periods beginning in fiscal 2006. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).
On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. SFAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards” (“SFAS 123(R)-3”). The alternative transition method includes a simplified method to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee share-based compensation awards that are outstanding upon adoption of SFAS 123(R). The Company has elected to adopt the provisions of SFAS 123(R)-3.
r. Comprehensive Income
Comprehensive income encompasses all changes in equity other than those arising from transactions with stockholders, and consists of net income, currency translation adjustments, pension adjustments and unrealized net gains and losses on investments classified as available-for-sale. As of December 31, 2006 and 2005, accumulated other comprehensive income is as follows (in thousands):
s. New Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (SFAS No. 158). SFAS No. 158 requires that employers recognize on a prospective basis the funded status of their defined benefit pension and other postretirement plans on their consolidated balance sheet and recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost. SFAS No. 158 also requires additional disclosures in the notes to financial statements. SFAS No. 158 is effective as of the end of fiscal years ending after December 15, 2006. The Company adopted SFAS No. 158 in the fourth quarter ended December 31, 2006, and its adoption did not have a material impact on its financial position, results of operations or cash flows. See Note 7.
In September 2006, the FASB issued SFAS 157 “Fair Value Measurement” (“SFAS 157”) which defines fair value, establishes a framework for measuring fair value and expanded disclosures about fair value measurement. Companies are required to adopt the new standard for fiscal periods beginning after November 15, 2007. The Company is evaluating the impact of this standard and currently does not expect it to have a significant impact on its financial position, results of operations or cash flows.
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
In September 2006, Staff Accounting Bulletin (“SAB”) 108 was released. The bulletin establishes an approach that requires quantification of financial statement errors based on the effects of the error on each of the company’s financial statements and the related financial statement disclosures. SAB 108 is effective for interim periods which are part of fiscal years ending on or after November 15, 2006. The Company’s adoption of this standard did have any impact on its financial position, results of operations or cash flows.
In June 2006, the Emerging Issues Task Force (“EITF”) issued EITF 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That is, Gross versus Net Presentation)” to clarify diversity in practice on the presentation of different types of taxes in the financial statements. The Task Force concluded that, for taxes within the scope of the issue, a company may adopt a policy of presenting taxes either gross within revenue or net. That is, it may include charges to customers for taxes within revenues and the charge for the taxes from the taxing authority within cost of sales, or, alternatively, it may net the charge to the customer and the charge from the taxing authority. If taxes subject to EITF 06-3 are significant, a company is required to disclose its accounting policy for presenting taxes and the amounts of such taxes that are recognized on a gross basis. The guidance in this consensus is effective for the first interim reporting period beginning after December 15, 2006. The Company does not expect the adoption of EITF 06-3 will have a material impact on its financial position, results of operations, or cash flows.
In June 2006, the FASB issued Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes. FIN 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective for fiscal years beginning after December 15, 2006 (our fiscal year 2007) and the provisions of FIN 48 will be applied to all tax positions under Statement No. 109 upon initial adoption. The cumulative effect of applying the provisions of this interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. The Company does not expect the adoption of FIN 48 to have a material impact on its financial position, results of operations or cash flow.
In December 2004, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS 154”). SFAS 154 changes the requirements for the accounting for, and reporting of, a change in accounting principle. SFAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented using the new accounting principle. SFAS 154 is effective for accounting changes and corrections of errors in fiscal years beginning after December 15, 2005. The Company adopted this standard in the first quarter of fiscal year 2006. Adoption of this standard did not have a material impact on the Company’s consolidated financial position, results of operations or cash flow.
3. Acquisitions
On June 30, 2006, the Company completed the purchase of certain assets and technology related to the “Boral®” product line of AAR Manufacturing, Inc., a subsidiary of AAR Corp. The purchase price for the acquisition was approximately $6.7 million consisting of all cash. The Company considers this to be an immaterial acquisition.
The purchase price was allocated as follows (in thousands):
4. Debt and Bank Borrowing Arrangements; Convertible Note and Common Stock offerings
During December 2005, the Company completed a public offering of 2,070,000 shares of common stock at a price to the public of $43.31 per share. The Company received net proceeds of approximately $84.6 million from this offering after deducting offering expenses and underwriting discounts of $5.0 million. Concurrent with the common stock offering, during December 2005, the Company issued $121.0 million of 2.875% senior subordinated convertible notes due December 15, 2035.
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Interest on the notes is payable on December 15 and June 15 of each year, commencing on June 15, 2006. The notes are convertible into 17.1032 shares of Ceradyne’s common stock for each $1,000 principal amount of the notes (which represents a conversion price of approximately $58.47 per share), subject to adjustment. The notes are convertible only under certain circumstances, including if the price of the Company’s common stock reaches specified thresholds, if the notes are called for redemption, if specified corporate transactions or fundamental change occur, or during the 10 trading days prior to maturity of the notes. The Company many redeem the notes at any time after December 20, 2010, for a price equal to 100% of the principal amount plus accrued and unpaid interest, including contingent interest (as described below), if any, up to but excluding the redemption date. In addition, the Notes may be converted, at the option of the holders, on or prior to the final maturity date if during the five business day period after any five consecutive trading day period in which the trading price per $1,000 principal value amount of notes for each day of that period was less than 98% of the product of the closing price for our common stock for each day of that period and the applicable conversion rate. This conversion provision represents an embedded derivative. However, based on the de minimus value associated with this feature, no value was assigned at issuance and at December 31, 2006.
With respect to each $1,000 principal amount of the notes surrendered for conversion, the Company will deliver the conversion value to holders as follows: (1) an amount in cash equal to the lesser of (a) the aggregate conversion value of the notes to be converted and (b) $1,000, and (2) if the aggregate conversion value of the notes to be converted is greater than the $1,000, an amount in shares or cash equal to such aggregate conversion value in excess of $1,000.
The notes contain put options, which may require the Company to repurchase in cash all or a portion of the notes on December 15, 2012, December 15, 2015, December 15, 2020, December 15, 2025, and December 15, 2030 at a repurchase price equal to 100% of the principal amount of the notes to be repurchased plus accrued and unpaid interest, including contingent interest (as described below), if any, up to but excluding the repurchase date.
The Company is obligated to pay contingent interest to the holders of the notes during any six-month period from June 15 to December 14 and from December 15 to June 14, commencing with the six-month period beginning December 20, 2010 and ending on June 14, 2011, if the average trading price of the note for the five trading day period ending on the third trading day immediately preceding the first day of the relevant contingent interest period equals $1,200 (120% of the principal amount of a note) or more. The amount of contingent interest payable per note for any relevant contingent interest period shall equal 0.25% per annum of the average trading price of a note for the five trading day period ending on the third trading day immediately preceding the first day of the relevant contingent interest period. This contingent interest payment feature represents an embedded derivative. However, based on the de minimus value associated with this feature, no value was assigned at issuance and at December 31, 2006.
On or prior to the maturity date of the notes, upon the occurrence of a fundamental change, under certain circumstances, the Company will provide for a make whole amount by increasing, for the time period described herein, the conversion rate by a number of additional shares for any conversion of the notes in connection with such fundamental change transactions. The amount of additional shares will be determined based on the price paid per share of Ceradyne’s common stock in the transaction constituting a fundamental change and the effective date of such transaction. This make whole premium feature represents an embedded derivative. Since this feature has no measurable impact on the fair value of the notes and no separate trading market exists for this derivative, the value of the embedded derivative was determined to be de minimis. Accordingly, no value has been assigned at issuance or at December 31, 2006.
The Company utilizes a convertible bond pricing model and a probability weighted valuation model, as applicable, to determine the fair values of the embedded derivatives noted above.
On December 19, 2005, the Company repaid the balance of its term loan of $108.9 million and $9.8 million of its line of credit, and approximately $0.1 million of accrued interest, using the net proceeds from the notes and proceeds from its concurrent public offering of its common stock. The Company retired the credit facility. As a result of the termination of the term loan, the Company wrote off the remaining unamortized debt issuance costs of approximately $2.6 million in the fourth quarter of 2005.
In December 2005, the Company established a new unsecured $10.0 million line of credit. As of December 31, 2006, there were no outstanding amounts on the line of credit. However, the available line of credit at December 31, 2006 has been reduced by an outstanding letter of credit in the amount of $3.8 million. The interest rate on the credit line is based on the LIBOR rate for a period of one month, plus a margin of one percent, which equaled 6.3% as of December 31, 2006.
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Pursuant to the bank line of credit, the Company is subject to certain covenants, which include, among other things, the maintenance of specified minimum amounts of tangible net worth and quick assets to current liabilities ratio. At December 31, 2006, the Company was in compliance with these covenants.
5. Financial Instruments
Foreign Exchange Risk Management
The Company enters into foreign exchange forward contracts to reduce earnings and cash flow volatility associated with foreign exchange rate changes to allow management to focus its attention on its core business operations. Accordingly, the Company enters into contracts which change in value as foreign exchange rates change to economically offset the effect of changes in value of foreign currency assets and liabilities, commitments and anticipated foreign currency denominated sales and operating expenses. The Company enters into foreign exchange forward contracts in amounts between minimum and maximum anticipated foreign exchange exposures, generally for periods not to exceed one year. These derivative instruments are not designated as accounting hedges.
In June and July 2004, the Company entered into forward exchange contracts outstanding totaling approximately $126.0 million exchangeable into 110.0 million Euros. These contracts were opened in connection with the purchase of ESK Ceramics and in August 2004 were converted into Euros to serve as part of the purchase price. The fair market value of the contract at expiration in August 2004 was $1.9 million, which was recognized as a gain during the year ended December 31, 2004. This was recorded in the miscellaneous income line of the income statement. As of December 31, 2006, the Company did not have any outstanding forward exchange contracts.
The Company measures the financial statements of its foreign subsidiaries using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate on the balance sheet date. Revenues, costs and expenses are translated at the rates of exchange prevailing during the year. Translation adjustments resulting from this process are included in stockholders’ equity. Gains and losses from foreign currency transactions are included in other income, miscellaneous.
6. Income Taxes
The provision (benefit) for income taxes is comprised of the following for the year ended December 31 (in thousands):
The components of the Company’s deferred tax asset (liability) as of December 31, 2006 and 2005 are as follows (in thousands):
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The effective income tax rate for the years ended December 31, 2006, 2005 and 2004 differs from the Federal statutory income tax rate due to the following items (in thousands):
The exercise of stock options represents a tax benefit and has been reflected as a reduction of taxes payable and an increase to the additional paid-in capital account. The benefit recorded was $2.5 million, $1.6 million and $3.1 million for the years ended December 31, 2006, 2005 and 2004, respectively.
7. Employee Retirement and Other Benefit Plans
Supplemental Retirement Plan
In December 1988, the Board of Directors of the Company approved the adoption of a supplemental retirement plan, the Ceradyne SMART 401(k) Plan (the Plan), in which substantially all employees are eligible to participate after completing 90 days of employment. Participation in the Plan is voluntary. An employee may elect to contribute up to fifteen percent (15% or the maximum deferred tax amount of $20,000 in 2006, whichever is less) of the employee’s pretax compensation as a basic contribution. The Company may contribute any amount which the Board of Directors annually determines appropriate. Company contributions fully vest and are non-forfeitable after the participant has completed five years of service. The Company’s related contributions for the years ended December 31, 2006, 2005 and 2004 were $1,140,000, $880,000 and $556,000, respectively.
The Company’s contribution is in the form of shares of its common stock. The number of shares to be contributed will be determined by dividing the total Company match for the Plan year by the higher of the market value per share of common stock as of the end of that Plan year (December 31), or the audited book value per share of common stock as of the end of that Plan year. The participants’ cash contributions may be invested, at their discretion, in several funds.
Based on the market value per share of the Company’s common stock on December 31, 2006, a total of 19,264 shares will be contributed in 2007 as the Company’s matching contribution under the Plan for 2006. After that contribution, there were 530,576 shares remaining and available for future contribution under the Plan.
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Pension and Other Postretirement Benefit Plans
In September 2006, the FASB issued SFAS No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statement No. 87, 88, 106, and 132 (R)”.
The most significant change is the requirement for an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income of a business entity. Public companies are required to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures as of the end of the fiscal year ending after December 15, 2006. We adopted SFAS No. 158 in the fourth quarter ended December 31, 2006, and its adoption did not have a significant impact on our consolidated financial position.
The Company’s German Pension and Benefit Plans (Overview):
The Company provides pension benefits to its employees in Germany. These pension benefits are rendered for the time after the retirement of the employees by payments into legally independent pension and relief facilities. They are generally based on length of service, wage level and position in the company. The direct and indirect obligations comprise obligations for pensions that are already paid currently and expectations for those pensions payable in the future. The Company has four separate plans in Germany: a) Pensionskasse - Old; b) Pensionskasse - New; c) Additional Compensation Plan; and d) Deferred Compensation plan. For financial accounting purposes, the Additional and Deferred Compensation Plans are accounted for as single-employer defined benefit plans, Pensionskasse - Old is a multiemployer defined benefit plan and the Pensionskasse - New is a defined contribution plan.
The measurement date for the Company’s pension plan assets and obligations, including Pensionskasse - Old, is principally December 31. The measurement date for the Company’s net periodic pension cost is principally January 1. Assumed discount rates and rates of increase in remuneration used in calculating the projected benefit obligation together with long-term rates of return on plan assets vary according to the economic conditions.
The Pensionskasse - New covers all German employees with membership as of January 1, 2005. Contributions and costs are determined as 2.0 percent of each covered employee’s salary and totalled $40,783 in 2006 and $14,102 in 2005.
Components of net periodic benefit costs under the Additional and Deferred Compensation Plans for the years ended December 31, 2006 and 2005 were as follows (in thousands):
The weighted-average assumptions used to determine net periodic benefit costs were as follows:
Components of the change in benefit obligations, changes in plan assets and funded status of the Additional and Deferred Compensation Plans for December 31, 2006 and 2005 were as follows (in thousands):
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The amounts in accumulated other comprehensive income was $1.0 million and $1.0 million as of December 31, 2006 and 2005. The estimated net loss for the Additional Compensation Plan that will be amortized from accumulated other comprehensive income over the next fiscal year is $57,086.
As noted above the Pensionskasse - Old is a multi employer defined benefit pension plan. ESK Germany is one of numerous employers who participate in the plan. The accumulated benefit obligations and projected benefit obligations are computed utilizing the same methods and assumptions as those used in the Additional and Deferred Compensation Plans noted above and are solely based on the ESK employees participating in the plan. However, the assets of the plan are allocated based upon the relative percentage of the projected benefit obligation to the total for all participating employers. The Company had incorrectly accounted for this plan since the acquisition of ESK. The resulting correction was to reduce other long term assets and increase goodwill by $2.8 million. The long-term asset structure of the Pensionskasse is determined significantly by asset-liability-studies conducted regularly in collaboration with external consultants calculating an optimal investment portfolio. The operative investment policy has to conform to legal requirements (insurance control and investment law) as well as to internal investment -guidelines and restrictions. At December 31, 2006, the overall allocation of the plan assets is 41% (2005: 39%) in bonds, 30% (2005: 29%) in equities, 21% (2005: 22%) in real estate, 3% (2005: 5%) in cash and 5% (2005: 5%) in private equity funds. The contributions to the Pensionskasse- Old plan were $578,534 and $558,401 for the years ended December 31, 2006 and 2005, respectively. The following is additional information related to the Pensionskasse- Old plan as of December 31, 2006 and 2005 (in thousands):
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The company expects to contribute to its defined benefit plans in 2007:
The following estimated future benefit payments are expected to be paid in the years indicated (in thousands):
8. Commitments and Contingencies
a. Operating Lease Obligations
The Company leases certain of its manufacturing facilities under noncancelable operating leases expiring at various dates through October 2015. The Company incurred rental expense under these leases of $2.8 million, $2.0 million and $1.3 million for the years ended 2006, 2005 and 2004, respectively. The approximate minimum rental commitments required under existing noncancelable leases as of December 31, 2006 are as follows (in thousands):
b. Legal Proceedings
In August 2006, shareholder derivative lawsuits were filed purportedly on behalf of the company against various current and former officers and directors of the company relating to alleged backdating of stock options. The derivative suits filed in federal court were subsequently consolidated in the action styled In re Ceradyne Derivative Litigation pending in the Federal District Court for the Central District of California. A consolidated complaint was filed on or about November 27, 2006, alleging claims for violations of Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder, violations of Section 14(a) of the Securities Exchange Act, violations of Section 20(a) of the Securities Exchange Act, insider selling under the California Corporations Code, as well as common law claims for accounting, breach of fiduciary duty, aiding and abetting breaches of fiduciary duty, unjust enrichment, and rescission against certain current and former officers, directors and employees. Two shareholder derivative suits are pending in Superior Court in Orange County, California. Those suits were filed in August 2006 purportedly on behalf of Ceradyne and each alleges claims for breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, unjust enrichment, accounting, rescission, constructive trust, and violations of California Corporations Code against certain current and former officers, directors and employees. Formal discovery has not commenced and the impact of the outcome of these lawsuits is undeterminable at this time. The Company intends to vigorously defend these lawsuits.
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
9. Disclosure About Segments of Enterprise and Related Information
The Company serves its markets and manages its business through five operating segments, each of which has its own manufacturing facilities and administrative and selling functions. The Company’s Advanced Ceramic Operations, located in Costa Mesa, Irvine and San Diego, California, Lexington, Kentucky and Wixom, Michigan primarily produces armor, orthodontic products, diesel engine parts, components for semiconductor equipment, and houses the Company’s SRBSN research and development activities. The Company’s cathode development and production are handled through its Semicon Associates division located in Lexington, Kentucky. Fused silica products, including missile radomes, are produced at the Company’s Thermo Materials division located in Scottdale and Clarkston, Georgia. The Company’s ESK Ceramics subsidiary is located in Kempten, Germany and Bazet, France. This subsidiary produces ceramic powders, including boron carbide powder for ceramic body armor, evaporation boats for metallization, functional and frictional coatings utilized in the automotive and textile industries, high performance pump seals, fluid handling and refactory products. The Company added a fifth operating segment in June 2006, when its newly formed subsidiary, Ceradyne Canada, acquired certain assets, including a building, equipment and technology, related to the production of structural neutron absorbing materials. The building and operations of Ceradyne Canada are located in Chicoutimi, Canada. The U.S. government and government agencies collectively represented approximately 73.4% of our net sales in 2006, 65.8% in 2005 and 59.2% in 2004.
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
SEGMENT INFORMATION FOR THE YEARS ENDED
DECEMBER 31, 2006, 2005 AND 2004
(amounts in thousands)
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
SEGMENT INFORMATION FOR THE YEARS ENDED
DECEMBER 31, 2006, 2005 AND 2004
The following is revenue by product line for Advanced Ceramic Operations for the years ended (amounts in thousands):
10. Stock Options
See Note 11 below for information concerning an internal investigation into our stock option grant practices for the period of 1997 through June 30, 2006. The information in this Note 10 is qualified by reference to the information set forth in Note 11 to the extent applicable.
The Company adopted SFAS 123(R) using the modified prospective application transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The Company’s Consolidated Financial Statements as of and for the year ended December 31, 2006 reflect the impact of SFAS 123(R). In accordance with this transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Share-based compensation expense recognized under SFAS 123(R) for the year ended December 31, 2006 was $1.5 million which was related to stock options and restricted stock units. Additionally, a pretax stock-based compensation charge of approximately $2.4 million was taken in the year ended December 31, 2006. See further discussion in Note 11.
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the grant-date using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Consolidated Statements of Income. Prior to the adoption of SFAS 123(R), the Company accounted for share-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under the intrinsic value method, no share-based compensation expense related to stock options had been recognized in the Company’s Consolidated Statements of Operations on the basis that the exercise price of the Company’s stock options granted to employees and directors equaled the fair market value of the underlying stock at the grant-date. Specifically, the Company’s original accounting was based upon the understanding that options were granted with no intrinsic value. However, as described in Note 11, the Company now believes that certain options were granted with a positive intrinsic value.
Share-based compensation expense is based on the value of the portion of share-based payment awards that is ultimately expected to vest. SFAS 123(R) requires forfeitures to be estimated at the time of grant in order to estimate the amount of share-based awards that will ultimately vest. The forfeiture rate is based on historical rates. Share-based compensation expense recognized in the Company’s Consolidated Statements of Income for the year ended December 31, 2006 includes (i) compensation expense for share-based payment awards granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the pro forma provisions of SFAS 123 and (ii) compensation expense for the share-based payment awards granted subsequent to December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). As share-based compensation expense recognized in the Consolidated Statement of Income for the year ended December 31, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. In the Company’s pro forma information required under SFAS 123 for the periods prior to fiscal 2006, the Company accounted for forfeitures as they occurred.
The Company maintains the 1994 Stock Incentive Plan and 2003 Stock Incentive Plan. The 1995 Employee Stock Purchase Plan ended in December 2005.
The Company was authorized to grant options for up to 2,362,500 shares under its 1994 Stock Incentive Plan. The Company has granted options for 2,691,225 shares and has had cancellations of 401,336 shares through December 31, 2006. There are no remaining stock options available to grant under this plan. The options granted under this plan generally became exercisable over a five-year period for incentive stock options and six months for nonqualified stock options and have a maximum term of ten years.
The 2003 Stock Incentive Plan was amended in 2005 to allow the issuance of Restricted Stock Units (the “Units”) to eligible employees and non-employee directors. The Units are payable in shares of the Company’s common stock upon vesting. For directors, the Units vest annually over three years on the anniversary date of their issuance. For officers and employees, the Units vest annually over five years on the anniversary date of their issuance.
The Company may grant options and Units for up to 1,125,000 shares under the 2003 Stock Incentive Plan. The Company has granted options for 475,125 shares and Units for 154,550 shares under this plan through December 31, 2006. There have been cancellations of 19,000 shares associated with this plan through December 31, 2006. The options under this plan have a life of ten years.
During the years ended December 31, 2006 and 2005, the Company issued Units to certain directors, officers and employees with weighted average grant date fair values and Units issued as indicated in the table below. Pursuant to SFAS 123(R), the Company records compensation expense for the amount of the grant date fair value on a straight line basis over the vesting period. The Company incurred charges associated with the vesting of the Units of $827,000 for the year ended December 31, 2006 and $222,000 for the year ended December 31, 2005.
Share-based compensation expense reduced the Company’s results of operations as follows (Dollars in thousands, except per share amounts):
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The amounts above include the impact of recognizing compensation expense related to non-qualified stock options.
As of December 31, 2006, there was $1.6 million of total unrecognized compensation cost related to 195,900 non-vested outstanding stock options, with a per share weighted average value of $15.30. The unrecognized expense is anticipated to be recognized on a straight-line basis over a weighted average period of 2.3 years. In addition, the aggregate intrinsic value of stock options exercised for the twelve months ended December 31, 2006 was $62.3 million.
As of December 31, 2006, there was approximately $4.9 million of total unrecognized compensation cost related to non-vested Units granted under the 2003 Stock Incentive Plan. That cost is expected to be recognized over a weighted average period of 4.1 years.
The following is a summary of stock option activity:
The following is a summary of Unit activity::
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following table summarizes information regarding options outstanding and options exercisable at December 31, 2006:
The following table summarizes information regarding Units outstanding at December 31, 2006:
The following table illustrates the effect on net income and earnings per share for the year ended December 31, 2005 and 2004, as if the Company had applied the fair value recognition provisions of SFAS 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”) (dollars in thousands, except per share data):
The pro forma amounts and share based compensation were estimated using the Black-Scholes option-pricing model with the following assumptions:
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. The Company’s options have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimate.
The Company calculates expected volatility based on historical data of the Company’s common stock. The risk-free interest rate assumption is based upon an observed interest rate appropriate for the term of the Company’s employee stock options. The dividend yield assumption is based on the Company’s intent not to issue a dividend under its dividend policy. The expected holding period assumption was estimated based on historical experience.
11. Review of Historical Stock Option Grant Procedures
In July 2006, the Company voluntarily initiated a review of its historical stock option grant practices and related accounting treatment. The review was conducted by a Special Committee comprised of three independent members of the Company’s Board of Directors, with the assistance of independent legal counsel and forensic accounting experts. The scope of the Special Committee’s review included all stock options granted by the Company from January 1997 through September 2003. The Special Committee has completed its review.
Until September 2003, stock option grants generally were approved by unanimous written consents signed by the members of the Stock Option Committee of the Board of Directors. Throughout this period, the Stock Option Committee consisted of the CEO and one other non-management Director. The date specified as the grant date in each unanimous written consent was used (i) to determine the exercise price of the options and (ii) as the accounting measurement date.
The review found that from January 1997 through September 2003, the date selected by management as the grant date and accounting measurement date was the date specified in the unanimous written consent, but that, in all but one case, the unanimous written consents were not prepared, approved or executed by the Company’s Stock Option Committee until a later date. There were a total of 23 grant dates from January 1997 through September 2003. The Company’s CEO was responsible for selecting the grant dates and followed a consistent practice of seeking low grant prices and he was unaware of the accounting implications of the method he used. Therefore, the use of the date specified in the unanimous written consent as the accounting measurement date was incorrect in all but one case. The proper accounting measurement date was the date the unanimous written consent was signed by the members of the Stock Option Committee.
Based upon information gathered during the review by independent legal counsel, the Special Committee and the Board of Directors have concluded that, while the Company applied an option price date selection practice that resulted in the use of incorrect accounting measurement dates for options granted between January 1997 and September 2003, the accounting errors resulting from the use of incorrect measurement dates were not the product of any deliberate or intentional misconduct by the Company or its executives, staff or Board of Directors. However, as a result of using revised measurement dates for options granted from January 1997 through September 2003, the Company recorded a charge in the second quarter ended June 30, 2006 of $3.4 million ($2.3 million after income taxes) pertaining to the years ended December 31, 1997 to 2005 and the six months ended June 30, 2006 (the “Stock-Based Charge”). The Stock-Based Charge was included as a component of general and administrative expenses in the consolidated statements of income as this is where the affected individual’s normal compensation costs are recorded. The Stock-Based Charge includes non-cash compensation expense of $2.2 million ($1.4 million after income taxes) primarily related to stock option grants made during the period from January 1997 through September 2003 that should have been measured as compensation cost at the actual stock option grant dates, and subsequently amortized to expense over the vesting period for each stock option grant. The Stock-Based Charge also includes $1.2 million ($0.9 million after income taxes) of estimated additional employment and other taxes that are expected to become payable.
From September 2003 to February 2005, all stock option grants have been approved at meetings held by the Stock Option Committee, and, since February 2005, all stock option grants have been approved at meetings held by the Compensation Committee of the Board of Directors. The dates of these meetings have been used correctly as the accounting measurement date for all stock options granted since September 2003.
CERADYNE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Had this estimated Stock-Based Charge been reflected, as and when incurred, in the Company’s results of operations for prior years, the impact on net income for Ceradyne’s fiscal years ended December 31 would have been a reduction of $21,000 in 1997, a reduction of $45,000 in 1998, a reduction of $47,000 in 1999, a reduction of $104,000 in 2000, a reduction of $269,000 in 2001, a reduction of $74,000 in 2002, a reduction of $347,000 in 2003, a reduction of $611,000 in 2004, and a reduction of $324,000 in 2005. As of December 31, 2006, the total remaining incremental stock-based compensation charge related to these stock option grants that are expected to vest in future periods with a revised accounting measurement date is immaterial. There was no impact on revenue or net cash provided by operating activities as a result of the estimated compensation charge.
The Company does not believe that a restatement of its prior-period financial statements is required for the Stock-Based Charge. Based on the materiality guidelines contained in SEC Staff Accounting Bulletin No. 99, Materiality (SAB 99), the Company believes that the Stock-Based Charge is not material to any of the individual prior periods affected and the aggregate Stock-Based Charge is not material to the results for the year ended December 31, 2006.
Prior to December 31, 2006, the current members of Ceradyne’s Board of Directors, all current executive officers and all other employees of the Company amended all unexercised stock options they held which had an exercise price that is less than the price of the Company’s common stock on the actual date of grant, by increasing the exercise price to an amount equal to the closing price of the common stock as of the actual grant date. The Company has and will continue to reimburse all non-executive officer employees for the increase in the exercise price for the modified options as they vest. Such reimbursement has and will not be material.
12. Quarterly Financial Information (unaudited)
The results by quarter for 2006 and 2005 (amounts in thousands except per share data):
Quarter Ending
Quarter Ending
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
* Each of these exhibits constitutes a management contract, compensatory plan, or arrangement.