UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

 

 

Commission File Number 0-7087

 

 

Astronics Corporation

(Exact Name of Registrant as Specified in its Charter)

 

 

130 Commerce Way, East Aurora, N.Y. 14052

(Address of principal executive office)

 

Registrant’s telephone number, including area code

(716) 805-1599

 

Securities registered pursuant to Section 12(b) of the Act:

None

 

Securities registered pursuant to Section 12 (g) of the Act:

$.01 par value Common Stock; $.01 par value Class B Stock

(Title of Class)

 

Indicate by checkmark if the registrant is a well- known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by checkmark if the registrant is not required to file report pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirement for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

 

Indicate by checkmark if the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). o     No þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o     No þ

 

As of March 17, 2006, 7,909,101 shares were outstanding, consisting of 6,423,523 shares of Common Stock $.01 Par Value and 1,485,578 shares of Class B Stock $.01 Par Value. The aggregate market value, as of the last business day of the Company’s most recently completed second fiscal quarter, of the shares of Common Stock and Class B Stock of Astronics Corporation held by non-affiliates was approximately $62,500,000 (assuming conversion of all of the outstanding Class B Stock into Common Stock and assuming the affiliates of the Registrant to be its directors, executive officers and persons known to the Registrant to beneficially own more than 10% of the outstanding capital stock of the Corporation).

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Company’s Proxy Statement for the 2006 Annual Meeting of Shareholders to be held May 12, 2006 are incorporated by reference into Part III of this Report.

 

FORWARD LOOKING STATEMENTS

 

This Annual Report contains certain forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involves uncertainties and risks. These statements are identified by the use of the words “believes,” “expects,” “intends,” “anticipates”, “may”, “will”, “estimate”, “potential” and words of similar import. Readers are cautioned not to place undue reliance on these forward looking statements as various uncertainties and risks could cause actual results to differ materially from those anticipated in these statements. These uncertainties and risks include the success of the Company with effectively executing its plans; the timeliness of product deliveries by vendors and other vendor performance issues; changes in demand for our products from the U.S. government and other customers; the acceptance by the market of new products developed; our success in cross-selling products to different customers and markets; changes in government contracts; the state of the commercial and business jet aerospace market; the Company’s success at increasing the content on current and new aircraft platforms; the level of aircraft build rates; as well as other general economic conditions and other factors.

 

PART I

 

 

Astronics is a leading supplier of advanced, high-performance lighting, electronics and power distribution systems for the global aerospace industry. We sell our products to original equipment manufacturers (OEM’s) in the commercial transport, business jet, military markets, OEM suppliers, and aircraft operators around the world. The U.S. Government is also a major customer of ours. The Company provides its products through its wholly owned subsidiaries Luminescent Systems, Inc., Luminescent Systems Canada, Inc., collectively referred to as (LSI) and most recently through its February 2005 acquisition of Astronics Advanced Electronic Systems Corp. (AES).

 

Strategy

 

Astronics’ strategy for growth is to continue to develop or acquire the necessary technology to evolve into a leading aircraft lighting, electronics and power generation and distribution systems integrator, increasing the value and content we provide on a growing base of aircraft and missile platforms.

 

Products and Customers

 

Astronics’ products are sold worldwide to manufacturers of business jets, military aircraft, missiles, and commercial transports, as well as airlines and suppliers to the OEM’s. During 2005 the Company’s sales were divided 37% to the military market, 20% to the business jet market, 41% to the commercial transport market and 2% to other markets. Most of the Company’s sales are a result of contracts or purchase orders received from customers, placed on a day-to-day basis or for single year procurements rather than long-term multi-year contract commitments. Sales by Geographic Region, Major Customer and Canadian Operations are provided in Note 8 of Item 8, Financial Statements and Supplementary Data in this report.

 

Practices as to Maintaining Working Capital

 

Liquidity is discussed in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, in the Liquidity section in this report.

 

Competitive Conditions

 

Astronics experiences considerable competition in the Aerospace market sectors we serve, principally with respect to product performance and price, from various competitors, many of which are substantially larger and have greater resources. Success in the Aerospace markets we serve depends upon product innovation, customer support, responsiveness, and cost management. Astronics continues to invest in developing the technologies and engineering support critical to competing in our Aerospace markets.

 

Government Contracts

 

All U.S. Government contracts, including subcontracts where the U.S. Government is the ultimate customer, may be subject to termination at the election of the government.

 

Raw Materials

 

Materials, supplies and components are purchased from numerous sources. We believe that the loss of any one source, although potentially disruptive in the short-term, would not materially affect our operations in the long-term.

 

Seasonality

 

Our business is typically not seasonal.

Backlog

 

At December 31, 2005, the Company’s backlog was $95.1 million. At December 31, 2004, the Company’s backlog was $27.2 million.

 

Patents

 

The Company has a number of patents and has filed applications for others. While the aggregate protection of these patents is of value, the Company’s only material business that is dependent upon the protection afforded by these patents is its cabin power distribution product. The Company’s patents and patent applications relate to electroluminescence, instrument panels, keyboard technology and a broad patent covering the cabin power distribution technology. The Company regards its expertise and techniques as proprietary and relies upon trade secret laws and contractual arrangements to protect its rights. We have trademark protection in major markets.

 

Research, Development and Engineering Activities

 

The Company is engaged in a variety of engineering and design activities as well as basic research and development activities directed to the substantial improvement or new application of the Company’s existing technologies. These costs are expensed when incurred and included in cost of sales. Research and development and related engineering amounted to approximately $8.9 million in 2005, $5.8 million in 2004 and $3.6 million in 2003.

 

Employees

 

The Company’s continuing operations employed approximately 700 employees as of December 31, 2005. The Company considers its relations with its employees to be good.

 

Available information

 

The Company files its financial information and other materials required by the SEC electronically with the SEC. These materials can be accessed electronically via the Internet at www.SEC.gov. Such materials and other information about the Company are also available through the Company’s website at www.astronics.com.

 

 

Risks Related to our Industry

 

The markets we serve are cyclical and sensitive to domestic and foreign economic conditions and events, which may cause our operating results to fluctuate. The markets we serve are sensitive to fluctuations in general business cycles and domestic and foreign economic conditions and events. For example, demand by the business jet markets for our products is dependent upon several factors, including capital investment, product innovations, economic growth, and technology upgrades. In addition, the commercial airline industry is highly cyclical and sensitive to fuel price increases, labor disputes and economic conditions. These factors could result in a reduction in the amount of air travel. A reduction in air travel would reduce orders for new aircraft for which we supply products and for the sales of spare parts, thus reducing our sales. A reduction in air travel may also result in our commercial airline customers being unable to pay our invoices on a timely basis or at all.

 

We depend heavily on government contracts and subcontracts with defense prime contractors that may not be fully funded or may be terminated, and the failure to receive funding or the termination of one or more of these contracts could reduce our sales. Sales to the U.S. Government and its prime contractors and subcontractors represent a significant portion of our business. The funding of these programs is generally subject to annual congressional appropriations, and congressional priorities are subject to change. In addition, government expenditures for defense programs may decline or these defense programs may be terminated. A decline in governmental expenditures may result in a reduction in the volume of contracts awarded to us.

 

If our subcontractors or suppliers fail to perform their contractual obligations, our prime contract performance and our ability to obtain future business could be materially and adversely impacted. Many of our

contracts involve subcontracts with other companies upon which we rely to perform a portion of the services we must provide to our customers. There is a risk that we may have disputes with our subcontractors, including disputes regarding the quality and timeliness of work performed by the subcontractor or customer concerns about the subcontractor. Failure by our subcontractors to satisfactorily provide on a timely basis the agreed-upon supplies or perform the agreed-upon services may materially and adversely impact our ability to perform our obligations with our customer. Subcontractor performance deficiencies could result in a customer terminating our contract for default. A default termination could expose us to liability and substantially impair our ability to compete for future contracts and orders. In addition, a delay in our ability to obtain components and equipment parts from our suppliers may affect our ability to meet our customers’ needs and may have an adverse effect upon our profitability.

 

Our results of operations are affected by our fixed-price contracts. The nature of our business activities involves fixed-price contracts. Our contractual arrangements include customers’ requirements for delivery of hardware and funded nonrecurring development work that we anticipate will lead to follow-on production orders. For the year ended December 31, 2005, fixed-price contracts represented 100% of our sales. On fixed-price contracts, we agree to perform the scope of work specified in the contract for a predetermined price. Depending on the fixed price negotiated, these contacts may provide us with an opportunity to achieve higher profits based on the relationship between our costs and the contract’s fixed price. However, we bear the risk that increased or unexpected costs may reduce our profit.

 

Contracting in the defense industry is subject to significant regulation, including rules related to bidding, billing and accounting kickbacks and false claims, and any non-compliance could subject us to fines and penalties or possible debarment. Like all government contractors, we are subject to risks associated with this contracting. These risks include the potential for substantial civil and criminal fines and penalties. These fines and penalties could be imposed for failing to follow procurement integrity and bidding rules, employing improper billing practices or otherwise failing to follow cost accounting standards, receiving or paying kickbacks or filing false claims. We have been, and expect to continue to be, subjected to audits and investigations by government agencies. The failure to comply with the terms of our government contracts could harm our business reputation. It could also result in suspension or debarment from future government contracts.

 

If we are unable to adapt to technological change, demand for our products may be reduced. The technologies related to our products have undergone, and in the future may undergo, significant changes. To succeed in the future, we will need to continue to design, develop, manufacture, assemble, test, market and support new products and enhancements on a timely and cost-effective basis. Our competitors may develop technologies and products that are more effective than those we develop or that render our technology and products obsolete or uncompetitive. Furthermore, our products could become unmarketable if new industry standards emerge. We may have to modify our products significantly in the future to remain competitive, and new products we introduce may not be accepted by our customers.

 

Our new product development efforts may not be successful, which would result in a reduction in our sales and earnings. We may experience difficulties that could delay or prevent the successful development of new products or product enhancements, and new products or product enhancements may not be accepted by our customers. In addition, the development expenses we incur may exceed our cost estimates, and new products we develop may not generate sales sufficient to offset our costs. If any of these events occur, our sales and profits could be adversely affected.

 

Risks Related to our Business

 

We operate in highly competitive markets with competitors who may have greater resources than we possess, which could reduce the volume of products we can sell and our operating margins. Many of our products are sold in highly competitive markets. Some of our competitors are larger; more diversified corporations and have greater financial, marketing, production and research and development resources. As a result, they may be better able to withstand the effects of periodic economic downturns. Our operations and financial performance will be negatively impacted if our competitors:

 

 

 

We believe that the principal points of competition in our markets are product quality, price, design and engineering capabilities, product development, conformity to customer specifications, quality of support after the sale, timeliness of delivery and effectiveness of the distribution organization. Maintaining and improving our competitive position will require continued investment in manufacturing, engineering, quality standards, marketing, customer service and support and our distribution networks. If we do not maintain sufficient resources to make these investments, or are not successful in maintaining our competitive position, our operations and financial performance will suffer.

 

Our future growth and continued success is dependent on our key personnel. Our future success depends to a significant degree upon the continued contributions of our management team and technical personnel. The loss of members of our management team could have a material and adverse effect on our business. In addition, competition for qualified technical personnel in our industries is intense, and we believe that our future growth and success will depend on our ability to attract, train and retain such personnel.

 

Future terror attacks, war, or other civil disturbances could negatively impact our business. Continued terror attacks, war or other disturbances could lead to further economic instability and decreases in demand for our products, which could negatively impact our business, financial condition and results of operations. Terrorist attacks world-wide have caused instability from time to time in global financial markets and the aviation industry. The long-term effects of terrorist attacks on us are unknown. These attacks and the U.S. Government’s continued efforts against terrorist organizations may lead to additional armed hostilities or to further acts of terrorism and civil disturbance in the United States or elsewhere, which may further contribute to economic instability.

 

Our facilities could be damaged by catastrophes which could reduce our production capacity and result in a loss of customers. We conduct our operations in facilities located in the United States and Canada. Any of these facilities could be damaged by fire, floods, earthquakes, power loss, telecommunication and information systems failure or similar events. Although we carry property insurance, including business interruption insurance, our inability to meet customers’ schedules as a result of catastrophe may result in a loss of customers or significant additional costs.

 

Some of our contracts contain late delivery penalties. Failure to deliver in a timely manner due to supplier problems, development schedule slides, manufacturing difficulties, or similar schedule related events could have a material adverse effect on our business.

 

The failure of our products may damage our reputation, necessitate a product recall or result in claims against us that exceed our insurance coverage, thereby requiring us to pay significant damages. Defects in the design and manufacture of our products may necessitate a product recall. We include complex system design and components in our products that could contain errors or defects, particularly when we incorporate new technology into our products. If any of our products are defective, we could be required to redesign or recall those products or pay substantial damages or warranty claims. Such an event could result in significant expenses, disrupt sales and affect our reputation and that of our products. We are also exposed to product liability claims. We carry aircraft and non-aircraft product liability insurance consistent with industry norms. However, this insurance coverage may not be sufficient to fully cover the payment of any potential claim. A product recall or a product liability claim not covered by insurance could have a material adverse effect on our business, financial condition and results of operations.

 

 

Not applicable

 

 

The Company owns manufacturing and office facilities of approximately 70,000 square feet in the Buffalo, New York area and 80,000 square feet in Lebanon, New Hampshire. Montreal, Quebec, Canada

operations are in leased facilities of approximately 15,000 square feet. The lease expires in 2006. Astronics AES leases 73,000 square feet of space, located in Redmond, Washington. The lease expires in 2008. Upon expiration of its current leases, the Company believes that it will be able to secure renewal terms or enter into a lease for alternative locations.

 

 

There are no material pending legal proceedings, other than routine litigation incidental to the business, to which the Registrant or any of its subsidiaries is a party or of which any of their property is the subject.

 

 

Not applicable

 

PART II

 

 

The table below sets forth the range of prices for the Company’s Common Stock, traded on the Nasdaq National Market System, for each quarterly period during the last two years. The approximate number of shareholders of record as of February 22, 2006, was 759 for Common Stock and 775 for Class B Stock.

 

 

 

The Company has not paid any cash dividends in the three-year period ended December 31, 2005. It has no plans to pay cash dividends as it plans to retain all cash from operations as a source of capital to finance growth in the business. There are no restrictions, however on the Company’s ability to pay dividends.

 

Five-Year Performance Highlights

 

 

 

 

 

OVERVIEW

 

Astronics Corporation, through its subsidiaries Luminescent Systems Inc. and Luminescent Systems Canada Inc. and most recently with the February 2005 acquisition of Astronics Advanced Electronic Systems Corp., designs and manufactures lighting systems and components, electrical power generation, in-flight control and power distribution systems for aircraft. We operate four principal facilities located in New York State, New Hampshire, Washington State and Quebec, Canada. We serve the three primary aircraft markets which are the military, commercial transport and the business jet markets. In 2005, sales to the military accounted for 37% of total sales. Sales to the commercial transport market and the business jet market were 41% and 20%, respectively. Astronics strives to offer comprehensive lighting and electrical systems for aircraft which we believe makes the Company unique in our ability to serve our customers.

 

On February 3, 2005, the Company acquired substantially all of the assets of the General Dynamics — Airborne Electronic Systems (AES) business unit from a subsidiary of General Dynamics. Astronics acquired the business for $13.0 million in cash. The Company financed the acquisition and related costs by borrowing $7.0 million on its revolving line of credit and used $6.4 million of cash on hand. For the year ended

December 31, 2005, AES had sales of $28.6 million and a pre tax profit of $3.0 million. In 2004, AES had a pre tax loss of approximately $8 million. The loss was primarily a result of costs relating to a development program that included significant termination fees. See Note 10 of Item 8 Financial Statements and Supplementary Data for pro forma financial information. AES produces a wide range of products related to electrical power generation, in-flight control, and power distribution on military, commercial transport, business jet and missile platforms.

 

Key factors affecting Astronics’ growth are our ability to be designed into new aircraft, the rate at which new aircraft are produced, government funding of military programs, and the rates at which aircraft owners, including commercial airlines, refurbish or install upgrades to their aircraft. Once designed into a new aircraft, the spare parts business is frequently retained by the Company. Astronics’ strategy is to increase the amount of content on aircraft platforms, evolving the Company from our historic role of a components supplier to a turn key provider of complete systems.

 

One of the principal markets we serve is the commercial transport market. The addition this year of Astronics AES has increased our exposure to the commercial transport market. As the financial condition of the world’s airlines improves and stabilizes, the airlines are beginning to increase investments in new aircraft purchases and cabin improvements. Many airlines are expanding the number of seats equipped with in-flight entertainment systems and in-seat power. We are in a strong position to benefit from this trend with our power and data technology acquired in the Astronics AES acquisition. We believe we will benefit from the expected continued strength of this market. Our increased exposure to this market also means we have greater down side risk should the commercial transport market enter a period of retraction as it did for several years beginning in 2001. If that were to occur, it is likely that commercial airlines would reduce spending on these types of programs and have a significant negative impact on our business. The power and data business accounted for 22% of our sales and 46% of our bookings in 2005.

 

The business jet market continued to be strong in 2005. We provide a wide range of products to the business jet market including air frame power, cockpit and exterior lighting products. Our products are found on many of the aircraft manufactured by Cessna, Raytheon and Bombardier. Our exterior lighting products have received notable interest from the business jet OEM’s. Among our more significant initiatives during 2005 was the continued development of products for Eclipse Aviation’s Eclipse 500 and Cessna’s Mustang business jets. There is risk involved with any new aircraft such as the Eclipse 500 and the Cessna Mustang as neither aircraft has been certified by the FAA. Eclipse is expecting certification of the Eclipse 500 during mid 2006 and Cessna in late 2006 for its Mustang. Should certification be delayed or not achieved it would impact Astronics growth opportunities and expected profits. We believe that the business jet markets will continue to provide opportunities for growth provided the economy remains healthy.

 

Our Military market sales are typically comprised of several significant “programs” such as the power converter for the Tactical Tomahawk and Taurus missiles, with 2005 sales of $3.0 million and the Korean F-16 night vision program, with 2005 sales of $4.8 million. In addition, because our component parts are found on many different aircraft, we have many smaller program sales for upgrade programs and spares as well as new build aircraft. A large development effort over the past several years has been the exterior lighting suite for the F-35 Joint Strike Fighter. This aircraft is expected to enter low rate production in 2008. The Military market is dependent on governmental funding which can change from year to year. Risks are that overall spending may be reduced in the future and that specific programs may be eliminated. Astronics does not have significant reliance on any one program such that cancellation of a particular program will cause material financial loss. We believe that we will continue to have opportunities similar to past years regarding this market.

 

We continue to look for opportunities to capitalize on our core competencies of power generation and distribution and lighting to expand our existing business and to grow through strategic acquisitions.

 

In 2005, Astronics continued to commit significant resources for the engineering and design of next generation products which in many cases will not enter production until late 2006 or beyond. Some of the more significant efforts during 2005 were products for the various OEM’s developing very light business jets such as Cessna Aircraft and Eclipse Aviation. For the military markets our larger design and development efforts have been for the exterior lighting suite for the F-35 (Joint Strike Fighter) and multiple smaller programs. In 2005 our seat power module which provides power for in flight entertainment (IFE) systems and in seat power was selected by several airlines for installation in their cabin upgrades. For the foreseeable

future we expect that we will continue to have opportunities requiring levels of engineering resources comparable to 2005.

 

We are anticipating 2006 revenue to increase over 2005. Our 2006 plan projects revenues of about $85 to $90 million, however the year is difficult to predict. A large number of the major aircraft programs in which we are involved are nearing critical stages of their certification process. If, during 2006, these programs achieve certification and transition to production smoothly, we could potentially exceed our expectations. If these programs encounter challenges and delays, our delivery schedule could be delayed, and our 2006 shipments and profitability will be affected.

 

We ended the year with a backlog of $95.1 million of which approximately $57 million is expected to be delivered during 2006. Provided that the economy maintains its strength we anticipate that new aircraft build rates will continue to increase over the next several years providing increased opportunities to grow revenue and profits. We expect discretionary spending by the airlines will continue as the global commercial transport market continues its recovery. We expect that the military market will continue to offer opportunities for us to increase the value of the content that we provide on a growing base of aircraft platforms.

 

Challenges facing us include improving shareholder value through increased profitability. Increasing profitability is dependent on many things such as increased build rates for existing aircraft, successful certification of new aircraft such as the Cessna Mustang and Eclipse 500 business jets, continued government funding of defense programs such as the F-35 Joint Strike Fighter and V-22 Osprey and the Company’s ability to obtain production contracts for parts we currently supply or have been selected to design and develop for these programs. In addition we are faced with increasing costs for health care and corporate governance, particularly those required by Sarbanes-Oxley legislation. Finally, many of our newer development programs are based on new and unproven technology. We are challenged to develop the technology on a schedule that is consistent with specific aircraft development programs. We will continue to address these challenges by working to improve operating efficiencies and focusing on executing on the growth opportunities currently in front of us.

 

CRITICAL ACCOUNTING POLICIES

 

Our financial statements and accompanying notes are prepared in accordance with U.S. generally accepted accounting principles. The preparation of the Company’s financial statements requires management to make estimates, assumptions and judgments that affect the amounts reported. These estimates, assumptions and judgments are affected by management’s application of accounting policies, which are discussed in Note 1 of Item 8, Financial Statements and Supplementary Data of this report. The critical accounting policies have been reviewed with the audit committee of our board of directors.

 

Revenue Recognition

 

Revenue is recognized when the risks and rewards of ownership and title are transferred to the customer, principally as units are delivered or as service obligations are satisfied. The Company manufactures most of its products on a build to order basis and ships products upon completion or shortly thereafter. There are no significant contracts allowing for right of return. The Company does evaluate and record an allowance for any potential returns based on experience and any known circumstances. For the years ended December 31, 2005, 2004 and 2003 no allowances were recorded for contracts allowing for right of return. A trade receivable is recorded at the value of the sale.

 

Accounts Receivable and Allowance for Doubtful Accounts

 

The Company records a valuation allowance to account for potentially uncollectible accounts receivable. The allowance is determined based on Management’s knowledge of the business and specific customers and review and analysis of accounts receivable agings. At December 31, 2005, the Company’s allowance for doubtful accounts for accounts receivable was $0.4 million, or 3% of gross accounts receivable. At December 31, 2004, the Company’s allowance for doubtful accounts was $0.3 million, or 4% of gross accounts receivable. In addition, at December 31, 2005 and 2004, the Company fully reserved the balance of a non-current note receivable in the amount of $0.6 million.

Inventory Valuation

 

The Company records valuation reserves to provide for slow moving or obsolete inventory or to reduce inventory to the lower of cost or market value. In determining the appropriate reserve, Management considers overall inventory levels in relation to forecasted demands. At December 31, 2005, the Company’s reserve for inventory valuation was $4.8 million, or 20% of gross inventory. This is an increase of $4.1 million from $0.7 million at December 31, 2004 which represented 9% of gross inventories. Approximately $4.0 million of the increase was added as result of the AES acquisition on February 3, 2005.

 

Deferred Tax Asset Valuation Allowances

 

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We record a valuation allowance to reduce deferred tax assets to the amount of future tax benefit that we believe is more likely than not to be realized. We consider recent earnings projections, allowable tax carryforward periods, tax planning strategies and historical earnings performance to determine the amount of the valuation allowance. Changes in these factors could cause us to adjust our valuation allowance, which would impact our income tax expense when we determine that these factors have changed.

 

As of December 31, 2005, the Company had a net deferred tax asset of $0.6 million, net of a $0.3 million valuation allowance, net of federal tax benefit. These assets relate principally to liabilities or asset valuation reserves that result in timing difference between generally acceptable accounting principles recognition and treatment for income tax purposes, as well as a state investment tax credit carry-forward.

 

Negatively impacting net income was an income tax charge of approximately $0.3 million related to a change in New York State tax law, net of federal tax benefit, which makes it unlikely the company will be able to utilize certain tax credit carry-forwards. Based on historical earnings and current projections of future taxable income, the valuation allowance was recorded in the second quarter of 2005.

 

Goodwill

 

The Company’s goodwill is the result of the excess of purchase price over net assets acquired from acquisitions. As of December 31, 2005, the Company had $2.7 million of goodwill. There was no goodwill recognized as a result of the acquisition of Astronics AES in February 2005. The Company tests goodwill for impairment at least annually, during the fourth quarter, and whenever events occur or circumstances change that indicates there may be impairment. The process of evaluating the Company’s goodwill for impairment is subjective and requires significant estimates. These estimates include judgments about future cash flows that are dependent on internal forecasts, long-term growth rates and estimates of the weighted average cost of capital used to discount projected cash flows. Based on the discounted projected cash flows, management has concluded that there is no impairment of the Company’s goodwill.

 

Supplemental Retirement Plan

 

The Company maintains a supplemental retirement plan for certain executives. The accounting for this plan is based in part on certain assumptions that may be highly uncertain and may have a material impact on the financial statements if different reasonable assumptions had been used. The assumptions for increases in compensation and the discount rate for determining the cost recognized in 2005 were 5.0% and 5.75% respectively. The discount rate used for the projected benefit obligation as of December 31, 2005 was 5.50%. The assumption for compensation increases takes a long-term view of inflation and performance based salary adjustments based on the Company’s approach to executive compensation. For determining the discount rate the Company considers long-term interest rates for high-grade corporate bonds.

 

RESULTS OF OPERATIONS

 

Sales

 

Sales for 2005 increased by $40.7 million to $75.4 million, up from $34.7 million in 2004, an increase of 117%. The increase was the result of the 2005 acquisition of Astronics AES, contributing $28.6 million and an increase in organic sales of $12.1 million. Organic sales increased in the business jet market by $4.0 million,

the commercial transport market by $1.2 million and the military market by $7.0 million. These were offset partially by a $0.1 million decrease in sales to other markets. The increase in organic sales to the business jet market was primarily a result of increased production rates for new aircraft. The increase in organic sales to the military market was primarily the result of the Korean F-16 night vision retro-fit program which accounted for $4.8 million and an increase in overall volume on a wide variety of programs. Astronics AES 2005 sales were $0.7 million to the business jet market, $23.4 million to the commercial transport market and $4.5 million to the military market.

 

Sales for 2004 increased by $1.5 million to $34.7 million, up from $33.2 million in 2003, an increase of 4.6%. The increase was the result of an increase in sales to the business jet market of $2.5 million, an increase in sales to the commercial transport market of $0.1 million and an increase in other sales of $0.2 million offset partially by a $1.3 million decrease in sales to the military market. The increase in sales to the business jet market was primarily a result of increased production rates for new aircraft. The decrease of sales to the military was the result of lower demand for spare parts by the U.S. government.

 

Expenses

 

Cost of sales as a percentage of sales decreased by 7.3 percentage points to 79.4% in 2005 from 86.7% in 2004. This decrease was due to improved margins for the organic business and the addition of Astronics AES that had 2005 cost of sales totaling 70.8% of sales. Cost of sales, for the organic business as a percentage of sales decreased two percentage points to 84.7% in 2005 from 86.7% in 2004. This was a result of leverage provided by the increased revenues somewhat offset by an increase for engineering and design costs of $1.4 million to $7.2 million in 2005 as compared with $5.8 million in 2004. This increase in spending was due to the Company’s continued development of exterior lighting products, cabin lighting and higher value added cockpit lighting opportunities. It is our intention to continue investing in capabilities and technologies as needed that allows us to execute our strategy to increase the ship set content and value we provide on aircraft in all markets that we serve. The rate of spending on these activities, however, will largely be driven by opportunities that the market presents.

 

Cost of sales as a percentage of sales increased seven percentage points to 86.7% in 2004 from 79.7% in 2003. Engineering and design spending related primarily to product development increased by $2.2 million to $5.8 million in 2004 as compared with $3.6 million in 2003. This increase in spending was a result of additional engineering personnel and increased costs for goods and services supplied by vendors for qualification testing, outsourced testing and design work for the Company’s pursuit of exterior lighting, cabin lighting and higher value added cockpit lighting opportunities.

 

Selling, general and administrative expenses increased $4.7 million to $10.2 million in 2005 from $5.5 million in 2004 primarily as a result the incremental selling, general and administrative costs of $4.7 million from Astronics AES. Organic selling, general and administrative costs remained flat when compared to 2004. A $0.3 million decrease in bad debt expense offset a similar increase in professional services, principally related to increased accounting and audit costs.

 

Selling, general and administrative expenses were $5.5 million in both 2004 and 2003. During 2004, a $0.5 million increase in the provision for doubtful accounts caused primarily by the write off of a note receivable the Company held relating to the sale in 2001 of a former production facility was offset by a reduction in professional services, labor, overall spending and a reduction in the loss from foreign currency exchange.

 

Income from Continuing Operations Before Taxes

 

Income from Continuing Operations Before Taxes in 2005 increased by $6.0 million to a profit of $4.8 million from a loss of $1.2 million in 2004. This increase was a result of both the acquisition of Astronics AES, which contributed $3.0 million and improved margins in Astronics organic business. Leverage created by increased organic sales volume was somewhat offset by our increased engineering costs in 2005 which were a result of an increase in personnel as well as increased costs for goods and services supplied by vendors for qualification testing, outsourced testing and design work.

Income from Continuing Operations Before Taxes in 2004 decreased by $2.2 million to a loss of $1.2 million from a profit of 1.0 million in 2003. This decrease was a result of the increase in engineering costs referred to in preceding paragraphs.

 

Income Taxes

 

The effective tax rate was 44.7% in 2005, 6.8 percentage points higher than the effective tax rate of 37.9% in 2004. The majority of the increase was due to a reserve that we recorded to reduce our deferred tax assets relating to New York State investment tax credit carry forwards. In 2005, new tax legislation was passed that we expect will reduce the allocation of future taxable income to New York State. As a result, we expect our future tax liability to be significantly reduced and do not expect to utilize all of these credits before they expire. In the second quarter of 2005, the Company recorded a valuation allowance reducing the Company’s $0.3 million deferred tax asset relating to these state tax credits to $0.03 million. As a result of this valuation allowance, the Company recorded a non-cash charge to income tax expense of $0.3 million, net of federal taxes. We expect our effective tax rate for future years to be closer to the statutory rates in effect at those times.

 

The effective tax rate was 37.9% in 2004, 12.3 percentage points higher than the effective tax rate of 25.5% in 2003. The increase was primarily due to recognition in 2003 of research and development tax credits from prior years which reduced the effective tax rate for that year.

 

Contractual Obligations

 

 

 

 

Notes to Contractual Obligations Table

 

Note Payable and Long-Term Debt — See item 8, Financial Statements and Supplementary Data, Note 2, Long-Term Debt and Note Payable in this report.

 

Interest on Long-Term Debt — Interest on Long-Term Debt consists of payments on Industrial Revenue Bonds issued through the Erie County, New York Industrial Development Agency taking into account the interest rate swap entered into on February 6, 2006 which effectively fixes the interest rate on this obligation at 3.99% through January 2016. We have excluded the variable rate interest on our note payable and other long-term debt.

 

Operating Leases — Operating lease obligations are primarily related to facility and equipment leases for our Astronics AES operations and facility leases for our Canadian operations.

 

Purchase Obligations — These are comprised of the Company’s commitments for goods and services in the normal course of business.

LIQUIDITY AND CAPITAL RESOURCES

 

Cash flow from operating activities was $5.1 million in 2005 compared with $0.1 million in 2004. The increase in 2005 relates to higher earnings adjusted for non-cash charges such as depreciation and amortization, offset somewhat by slight increase in working capital components.

 

Cash flow from operating activities was $0.1 million in 2004 compared with $2.1 million in 2003. The decrease of $2.0 million as compared with 2003 was mainly a result of a decrease in income from continuing operations of $1.5 million to a loss of $0.7 million in 2004 from income in 2003 of $0.8 million and an increase in investment in working capital components.

 

Cash used for investing activities was $15.0 million in 2005 compared with $2.4 million in 2004, a $12.8 million increase. The increase was primarily due to the Astronics AES acquisition of $13.4 million. Cash used for investing activities in 2003 was $0.7 million.

 

Pursuant to the March 14, 2003 spin-off of its wholly owned subsidiary, MOD-PAC CORP., the Company received a one-time dividend that resulted in net cash proceeds totaling $4.8 million in 2003.

 

The Company’s cash flows from operations are primarily dependent on its sales, profit margins and the timing of collections of receivables and payments to suppliers. Sales are influenced significantly by the build rates of new aircraft, which amongst other things are subject to general economic conditions, government appropriations and airline passenger travel. Over time, sales will also be impacted by the Company’s success in executing its strategy to increase ship set content and obtain production orders for programs currently in the development stage. A significant change in new aircraft build rates could be expected to impact the Company’s profits and cash flow. A significant change in government procurement and funding and the overall health of the worldwide airline industry could be expected to impact the Company’s profits and cash flow as well.

 

The Company’s cash required for capital equipment purchases for the last three years ranged between $0.4 million and $2.5 million. Our expectation for 2006 is that capital equipment expenditures will increase to over $4.0 million. This expected increase is primarily a result of machinery and equipment purchases to increase our production capacity. Additionally, we are in the exploratory stages of evaluating the possibility of expanding our available production square footage to accommodate projected future growth. Should we choose to expand the facility, it would likely be financed with additional debt.

 

Future capital requirements depend on numerous factors, including expansion of existing product lines and introduction of new product lines. Management believes that cash, together with the Company’s cash flow from operations and current borrowing arrangements will provide for these necessary capital expenditures.

 

In March, 2005 the Company received an amended agreement from HSBC Bank USA to increase its available revolving credit facility to $15 million. The amendment also extended the revolving credit facility through June 30, 2006. We expect that the existing facility will be renewed. We believe that should our facility with HSBC not be renewed we will be able to obtain alternative senior debt financing arrangements. At December 31, 2005, the Company was in compliance with all of the covenants pursuant to this credit facility with HSBC Bank USA. These covenants are measured on an annual basis at December 31.

 

The Company’s cash needs for debt service for 2006 are not expected to change significantly from 2005 levels. For its February 2005 acquisition of AES the Company borrowed $7.0 million through the use of its credit facility. The Company may decide to convert all or a portion of the credit facility balance to a term note or pay down on the credit facility as excess cash becomes available. The impact of this credit facility balance on cash needs in 2006 will depend on the repayment terms selected.

 

The Company’s ability to maintain sufficient liquidity is highly dependent upon achieving expected operating results. The Company has successfully negotiated new credit terms with its lender in order to provide more operating flexibility than it previously had. However, failure to achieve expected operating results could have a material adverse effect on our liquidity and our operations in the future.

 

The Company’s cash needs for working capital, capital equipment and debt service during 2006 and the foreseeable future, are expected to be met by cash flows from operations, its current cash balance and if necessary utilization of its revolving credit facility.

DISCONTINUED OPERATIONS

 

On September 26, 2002, the Company announced the spin-off of its wholly owned subsidiary MOD-PAC CORP., which operated the Printing and Packaging business segment. That transaction was effective March 14, 2003 and was accomplished by a tax free distribution of the stock of MOD-PAC CORP. to the shareholders of Astronics Corporation. As such, the net assets and equity of MOD-PAC CORP. were removed from the balance sheet of Astronics resulting in a reduction of the Company’s retained earnings and related net assets of $21.0 million. In December of 2002, the Company announced the discontinuance of its Electroluminescent Lamp Business Group, whose business had involved sales of micro-encapsulated electroluminescent lamps to customers in the consumer electronics industry. The operations of MOD-PAC CORP., through the spin-off date, and the operations of the Electroluminescent Lamp Business Group have been reported as discontinued operations in the financial statements of the Company. During 2005 and 2004, there was no income or loss from discontinued operations. During 2003, income from discontinued operations attributable to MOD-PAC CORP. was $0.4 million, and the Electroluminescent Lamp Business Group had a loss of $0.04 million. The business activity for the Electroluminescent Lamp Business Group was concluded during 2003.

 

DIVIDENDS

 

Management believes that it should retain the capital generated from operating activities for investment in advancing technologies, acquisitions and debt retirement. Accordingly, there are no plans to institute a cash dividend program.

 

BACKLOG

 

At December 31, 2005, the Company’s backlog was $95.1 million compared with $27.2 million at December 31, 2004. The Company acquired $45.9 million of backlog with the acquisition of Astronics AES.

 

RELATED-PARTY TRANSACTIONS

 

See the discussion in Item 8, Financial Statements and Supplementary Data, Note 12, Discontinued Operations and Note 11 Related-Party Transactions in this report.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

On December 16, 2004 the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123(R) (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Statement 123(R) must be adopted no later than January 1, 2006, which is when the Company will adopt it.

 

As permitted by Statement 123, the Company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)’s fair value method will have an impact on our results of operations, although it will have no impact on our overall financial position. The impact of adoption of Statement 123(R) in 2006 is estimated to be approximately $0.4 million in additional expense after income taxes; however this will vary depending on levels of share-based payments granted in the future. Had we adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 1 to our consolidated financial statements. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption.

 

In November 2004, the FASB issued SFAS No. 151 “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” The amendments made by this statement clarify that abnormal amounts of idle facility expense,

freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The provisions of this statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 2004. The Company believes the adoption of this standard will not have a material impact on its results of operations or financial position.

 

 

The Company has limited exposure to fluctuation in Canadian currency exchange rates to the U.S. dollar. Nearly all of the Company’s consolidated sales, expenses and cash flows are transacted in U.S. dollars. Net assets held in or measured in Canadian dollars amounted to $0.6 million at December 31, 2005. Annual disbursements of approximately $6.0 million are transacted in Canadian dollars. A 10% change in the value of the U.S. dollar versus the Canadian dollar would impact net income by approximately $0.4 million.

 

Risk due to fluctuation in interest rates is a function of the Company’s floating rate debt obligations, which total approximately $18.2 million at December 31, 2005. To offset this exposure, the Company entered into an interest rate swap in February 2006, on its New York Industrial Revenue Bond which effectively fixes the rate at 3.99% on this $4.3 million obligation through January 2016. As a result, a change of 1% in interest rates would impact annual net income by less than $0.1 million.

 

REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Shareholders and Board of Directors of Astronics Corporation

 

We have audited the accompanying consolidated balance sheets of Astronics Corporation as of December 31, 2005 and 2004, and the related consolidated statement of operations, statement of shareholders’ equity, and statement of cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits include consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Astronics Corporation at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.

 

Ernst & Young LLP

 

Buffalo, New York

February 3, 2006

 

ASTRONICS CORPORATION

 

CONSOLIDATED STATEMENT OF OPERATIONS

 

 

See notes to financial statements.

 

 

ASTRONICS CORPORATION

 

CONSOLIDATED BALANCE SHEET

 

 

See notes to financial statements.

 

ASTRONICS CORPORATION

CONSOLIDATED STATEMENT OF CASH FLOWS

 

 

See notes to financial statements.

ASTRONICS CORPORATION

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

 

 

See notes to financial statements.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

Description of the Business

 

Astronics Corporation, through its subsidiaries Luminescent Systems, Inc., Luminescent Systems-Canada Inc. and Astronics Advanced Electronic Systems Corp. (AES) designs and manufactures lighting components and subsystems, electrical power generation, in-flight control and power distribution systems for aircraft. Astronics (AES) was acquired On February 3, 2005 (See Note 10). The Company serves the three primary markets for aircraft which are the military, commercial transport and the business jet markets.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, except for MOD-PAC CORP., which is presented with discontinued operations through its spin-off date of March 14, 2003. All intercompany transactions and balances have been eliminated.

 

Acquisitions are accounted for under the purchase method and, accordingly, the operating results for the acquired companies are included in the consolidated statements of earnings from the respective dates of acquisition.

 

Revenue and Expense Recognition

 

Revenue is recognized on the accrual basis, i.e., at the time of shipment of goods. There are no significant contracts allowing for right of return. The Company does evaluate and record an allowance for any potential returns based on experience and any known circumstances. For the years ended December 31, 2005, 2004 and 2003 no allowances were recorded for contracts allowing for right of return. A trade receivable is recorded at the value of the sale. The Company performs periodic credit evaluations of its customers’ financial condition and generally does not require collateral. The Company records a valuation allowance to account for potentially uncollectible accounts receivable. The allowance is determined based on Management’s knowledge of the business and specific customers and review and analysis of accounts receivable agings. After collection efforts have been exhausted, uncollected balances are charged off to the allowance. At December 31, 2005, the Company’s allowance for doubtful accounts for accounts receivable was $0.4 million, or 3% of gross accounts receivable. At December 31, 2004, the Company’s allowance for doubtful accounts was $0.3 million, or 4% of gross accounts receivable. In addition, at December 31, 2005 and 2004, the Company fully reserved the balance of a non-current note receivable in the amount of $0.6 million

 

Cost of products sold includes the costs to manufacture products such as direct materials and labor and manufacturing overhead as well as all engineering and developmental costs. Selling, general and administrative expenses include costs primarily related to our sales and marketing departments and administrative departments. Shipping and handling costs are expensed as incurred and are included in costs of products sold.

 

The Company is engaged in a variety of engineering and design activities as well as basic research and development activities directed to the substantial improvement or new application of the Company’s existing technologies. These costs are expensed when incurred and included in cost of sales. Research and development and related engineering amounted to $8.9 million in 2005, $5.8 million in 2004 and $3.6 million in 2003.

 

Stock-Based Compensation

 

The Company accounts for its stock-based awards using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25 and its related interpretations.

 

The measurement prescribed by APB Opinion No. 25 does not recognize compensation expense if the exercise price of the stock option equals the market price of the underlying stock on the date of grant and the number of stock options granted is fixed. Accordingly, no compensation expense related to stock options has been recorded in the financial statements.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

The following table provides pro forma earnings information as if the Company recorded compensation expense based on the fair value of stock options:

 

 

Cash and Cash Equivalents

 

All highly liquid instruments with a maturity of three months or less at the time of purchase are considered cash equivalents.

 

Short-Term Investments

 

The Company’s short-term investments consist of marketable securities that are categorized as available for sale securities as defined by SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The investment portfolio at December 31, 2004 consisted of Government Agency securities totaling $1.0 million. There was no unrealized gain or loss at December 31, 2004. There was no realized gain or loss for the years ended December 31, 2005, 2004 and 2003.

 

Inventories

 

Inventories are stated at the lower of cost or market, cost being determined in accordance with the first-in, first-out method. Inventories at December 31 are as follows:

 

 

The Company records valuation reserves to provide for slow moving or obsolete inventory or to reduce inventory to the lower of cost or market value. In determining the appropriate reserve, Management considers overall inventory levels in relation to forecasted demands. At December 31, 2005, the Company’s reserve for inventory valuation was $4.8 million, or 20% of gross inventory. This is an increase of $4.1 million from

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

$0.7 million at December 31, 2004 which represented 9% of gross inventories. Approximately $4.0 million of the increase was added as result of the AES acquisition on February 3, 2005.

 

Property, Plant and Equipment

 

Depreciation of property, plant and equipment is computed on the straight-line method for financial reporting purposes and on accelerated methods for income tax purposes. Estimated useful lives of the assets are as follows: buildings, 40 years; machinery and equipment, 4-10 years. Leasehold improvements are amortized over the terms of the lease or the lives of the assets, whichever is shorter.

 

The cost of properties sold or otherwise disposed of and the accumulated depreciation thereon are eliminated from the accounts, and the resulting gain or loss, as well as maintenance and repair expenses, are reflected in income. Replacements and improvements are capitalized.

 

Depreciation expense was $1.9 million, $1.0 million and $1.1 million in 2005, 2004 and 2003, respectively.

 

Goodwill

 

The Company tests goodwill at the reporting unit level on an annual basis or more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The Company has one reporting unit for purposes of the goodwill impairment test. The impairment test consists of comparing the fair value of the reporting unit, determined using discounted cash flows, with its carrying amount including goodwill, and, if the carrying amount of the reporting unit exceeds its fair value, comparing the implied fair value of goodwill with its carrying amount. An impairment loss would be recognized for the carrying amount of goodwill in excess of its implied fair value.

 

The Company recognized no goodwill as a result of the acquisition of Astronics AES in February 2005. The changes in the carrying amount of goodwill are as follows:

 

 

Income Taxes

 

The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting and tax basis of assets and liabilities. Deferred tax assets are reduced, if deemed necessary, by a valuation allowance for the amount of tax benefits which are not expected to be realized. Investment tax credits are recognized on the flow through method.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Earnings per Share

 

Earnings per share computations are based upon the following table:

 

 

The effect of stock options has not been included for 2004 since this would be anti-dilutive as a result of the Company’s net loss.

 

Class B Stock

 

Class B Stock is identical to Common Stock, except Class B Stock has ten votes per share, is automatically converted to Common Stock on a one for one basis when sold or transferred, and cannot receive dividends unless an equal or greater amount is declared on Common Stock. At December 31, 2005, approximately 3.2 million shares of common stock were reserved for issuance upon conversion of the Class B stock, exercise of stock options and purchases under the Employee Stock Purchase Plan.

 

Use of Estimates

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities and the reported amounts of revenues and expenses during the reporting periods in the financial statements and accompanying notes. Actual results could differ from those estimates.

 

Long-Lived Assets

 

Long-lived assets to be held and used are initially recorded at cost. The carrying value of these assets is evaluated for recoverability whenever adverse effects or changes in circumstances indicate that the carrying amount may not be recoverable. Impairments are recognized if future undiscounted cash flows and earnings from operations are not expected to be sufficient to recover long-lived assets. The carrying amounts are then reduced by the estimated shortfall of the discounted cash flows.

 

Financial Instruments

 

The Company’s financial instruments consist primarily of cash and cash equivalents, short-term investments, accounts receivable, accounts payable, notes payable, long-term debt and an interest rate swap. The carrying value of the Company’s financial instruments approximate fair value. The Company does not hold or issue financial instruments for trading purposes.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Derivatives

 

The Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use and resulting designation. At December 31, 2005 and 2004, the Company’s use of derivative instruments is limited to a cash flow hedge of interest rate risk. For a derivative designated as a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income (“OCI”) and subsequently reclassified into earnings when the hedged exposure affects earnings. The ineffective portions of all derivatives are recognized immediately into earnings as other income or expense. Ineffectiveness was not material in 2005, 2004, and 2003. For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change. The Company classifies the cash flows from hedging transactions in the same category as the cash flows from the respective hedged items. The Company reclassified $0.1 million from accumulated other comprehensive income to interest expense and $0.2 million during each of the years 2004 and 2003. The Company entered into an interest rate swap in February 2006, on its New York Industrial Revenue Bond which effectively fixes the rate at 3.99% on this $4.3 million obligation through January 2016.

 

Comprehensive Income

 

Comprehensive income (loss) consists primarily of net earnings and the after-tax impact of currency translation adjustments, mark to market adjustment for derivatives and minimum pension liability adjustments. Income taxes related to derivatives and minimum pension liability adjustments within other comprehensive income are generally recorded based on an effective tax rate of approximately 36%. No income taxes are recorded for currency translation adjustments.

 

The accumulated balances of the components of other comprehensive income net of tax, at December 31, 2005 and 2004 are as follows: accumulated foreign currency translation $0.8 million and $0.7 million, respectively; and accumulated mark to market adjustment for derivatives $0.0 million and $(0.1) million, respectively.

 

Recent Accounting Pronouncements

 

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation.  Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows.  Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Statement 123(R) must be adopted as of the first quarter of 2006, which is when the Company will adopt it.

 

As permitted by Statement 123, the Company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of Statement 123(R)’s fair value method will impact on the results of operations, although it will have no impact on overall financial position. The impact of adoption of Statement 123(R) in 2006 is estimated to be approximately $0.4 million in additional expense after income taxes; however this will vary depending on levels of share-based payments granted in the future and variations in the factors impacting the expense calculation such as; stock price volatility, risk free interest rates, dividend yields and expected life. Had the Company adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net (loss) income and (loss) earnings per share previously in Note 1 under Stock-Based Compensation.

 

In November 2004, the FASB issued SFAS No. 151 “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” The amendments made by this statement clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The provisions of this statement are effective for inventory costs incurred during fiscal

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 2005. The Company believes the adoption of this standard will not have a material impact on its results of operations or financial position.

 

 

Long-term debt consists of the following:

 

 

Principal maturities of long-term debt for each of the next five years are $0.9 million.

 

No interest costs were capitalized in 2005, 2004, and 2003.

 

The Company is in compliance with all its debt and credit facility covenants at December 31, 2005 and believes it will continue to be compliant in the future.

 

The Industrial Revenue Bonds are held by institutional investors and are guaranteed by a bank letter of credit, which is collateralized by certain property, plant and equipment assets, the carrying value of which approximates the principal balance on the bonds.

 

The Company has a standby unsecured bank letter of credit guaranteeing the note payable in Canada, the carrying value of which approximates the principal balance on the note.

 

To offset risks due to fluctuation in interest rates, the Company entered into an interest rate swap on the New York Industrial Revenue Bond through December 2005 which effectively fixed the interest rate at 4.09%. In February 2006, the Company entered into a new interest rate swap, on its New York Industrial Revenue Bond which effectively fixes the rate at 3.99% on this $4.3 million obligation through January 2016.

 

In February, 2005 the Company borrowed $7.0 million on its unsecured revolving credit facility for its acquisition of Astronics AES. On March 18, 2005 the Company received an amended agreement from HSBC Bank USA to increase the revolving credit facility to $15 million. At December 31, 2005 the Company had $7.0 million outstanding on its revolving credit facility; with interest at bank prime or LIBOR plus 175 basis points. At December 31, 2005, the Company had $8 million available on the facility. It may be converted into a four-year term loan at any time. The credit facility is renewed annually.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

A summary of the Company’s stock option activity, excluding MOD-PAC employees, and related information for the years ended December 31 follows:

 

 

In 2003, 433,754 options at a weighted average exercise price of $7.36 per share were adjusted to maintain their intrinsic value as a result of the MOD-PAC CORP. spin-off. The adjustment had the affect of increasing the number of options outstanding to 538,931 at a weighted average exercise price of $5.93 per share. The adjustment was determined by reference to the fair value of the Company’s common stock at the time of the Distribution; so as to equalize the intrinsic value of the stock options before and after the Distribution. Under SEC regulations, fair value for this purpose is defined as the last trade before and the first trade immediately following the Distribution.

 

The following is a summary of weighted average exercise prices and contractual lives for outstanding and exercisable stock options as of December 31, 2005: