UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Washington, D.C. 20549
Form 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2008
Commission FileNumber: 1-11376
The Allied Defense Group, Inc.
(Exact name of Registrant as specified in its charter)
| Delaware (State or other jurisdiction of incorporation or organization) | 04-2281015 (I.R.S. Employer Number) |
8000 Towers Crescent Drive, Suite 260
Vienna, Virginia 22182
(Address of principal executive offices, including zip code)
(703) 847-5268
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule12b-2 of the Exchange Act. (Check one):
Large accelerated filer o | Accelerated filer o | Non-accelerated filer o | Smaller reporting company þ | |||
| (Do not check if a smaller reporting company) |
Indicate by check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Act). Yes o No þ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of September 30, 2008: 8,080,203.
THE ALLIED DEFENSE GROUP, INC.
INDEX
The Allied Defense Group, Inc.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(Thousands of Dollars, except per share and share data)
(Thousands of Dollars, except per share and share data)
| September 30, | December 31, | |||||||
| 2008 | 2007(a) | |||||||
ASSETS | ||||||||
Current Assets | ||||||||
| Cash and cash equivalents | $ | 5,093 | $ | 21,750 | ||||
| Restricted cash | 7,993 | 13,052 | ||||||
| Accounts receivable, net | 19,881 | 6,965 | ||||||
| Costs and accrued earnings on uncompleted contracts | 56,100 | 39,313 | ||||||
| Inventories, net | 22,569 | 22,027 | ||||||
| Prepaid and other current assets | 6,627 | 4,098 | ||||||
| Assets held for sale | 18,095 | 24,177 | ||||||
| Total current assets | 136,358 | 131,382 | ||||||
PROPERTY, PLANT AND EQUIPMENT, NET | 21,177 | 24,585 | ||||||
Other Assets | ||||||||
| Intangible assets, net | 479 | 493 | ||||||
| Goodwill | — | 3,495 | ||||||
| Other assets | 235 | 296 | ||||||
| Total other assets | 714 | 4,284 | ||||||
TOTAL ASSETS | $ | 158,249 | $ | 160,251 | ||||
CURRENT LIABILITIES | ||||||||
| Current maturities of senior secured convertible notes | $ | 19,493 | $ | 13,610 | ||||
| Bank overdraft facility | 5,372 | 7,239 | ||||||
| Current maturities of long-term debt | 4,433 | 881 | ||||||
| Accounts payable | 19,443 | 16,370 | ||||||
| Accrued liabilities | 20,880 | 15,780 | ||||||
| Belgium social security | 3,983 | 8,307 | ||||||
| Customer deposits | 30,250 | 26,835 | ||||||
| Foreign exchange contracts | 1,398 | — | ||||||
| Income taxes | 3,969 | 3,680 | ||||||
| Liabilities held for sale | 3,801 | 5,830 | ||||||
| Total current liabilities | 113,022 | 98,532 | ||||||
LONG TERM OBLIGATIONS | ||||||||
| Long-term debt, less current maturities and unamortized discount | 7,450 | 9,439 | ||||||
| Senior secured convertible notes, less current maturities | — | 5,782 | ||||||
| Derivative instrument | 283 | 183 | ||||||
| Other long-term liabilities | 691 | 660 | ||||||
| Total long-term obligations | 8,424 | 16,064 | ||||||
TOTAL LIABILITIES | 121,446 | 114,596 | ||||||
CONTINGENCIES AND COMMITMENTS | ||||||||
STOCKHOLDERS’ EQUITY | ||||||||
| Preferred stock, no par value; authorized 1,000,000 shares; none issued | — | — | ||||||
| Common stock, par value, $.10 per share; authorized 30,000,000 shares; issued and outstanding, 8,080,203 at September 30, 2008 and 8,013,161 at December 31, 2007 | 808 | 801 | ||||||
| Capital in excess of par value | 55,765 | 55,355 | ||||||
| Retained deficit | (36,518 | ) | (27,909 | ) | ||||
| Accumulated other comprehensive income | 16,748 | 17,408 | ||||||
| Total stockholders’ equity | 36,803 | 45,655 | ||||||
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY | $ | 158,249 | $ | 160,251 | ||||
| (a) | Condensed consolidated balance sheet as of December 31, 2007, has been derived from audited consolidated financial statements. |
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
2
The Allied Defense Group, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(Thousands of Dollars, except per share and share data)
(Thousands of Dollars, except per share and share data)
| Three Months Ended | Nine Months Ended | |||||||||||||||
| September 30, | September 30, | |||||||||||||||
| 2008 | 2007 | 2008 | 2007 | |||||||||||||
Revenue | $ | 50,813 | $ | 11,247 | $ | 121,530 | $ | 21,573 | ||||||||
Cost and expenses | ||||||||||||||||
| Cost of sales | 44,078 | 10,938 | 100,671 | 29,444 | ||||||||||||
| Selling and administrative | 5,678 | 5,962 | 17,285 | 19,046 | ||||||||||||
| Research and development | 683 | 599 | 2,067 | 1,797 | ||||||||||||
| Impairment of goodwill and long-lived assets | 3,957 | — | 3,957 | — | ||||||||||||
| Operating loss | (3,583 | ) | (6,252 | ) | (2,450 | ) | (28,714 | ) | ||||||||
Other income (expenses) | ||||||||||||||||
| Interest income | 103 | 75 | 513 | 382 | ||||||||||||
| Interest expense | (1,432 | ) | (1,584 | ) | (5,494 | ) | (9,359 | ) | ||||||||
| Net gain (loss) on fair value of senior convertible notes and warrants | (155 | ) | 1,080 | (682 | ) | (6,686 | ) | |||||||||
| Other-net | (2,173 | ) | (37 | ) | (2,290 | ) | (171 | ) | ||||||||
| (3,657 | ) | (466 | ) | (7,953 | ) | (15,834 | ) | |||||||||
| Loss from continuing operations before income taxes | (7,240 | ) | (6,718 | ) | (10,403 | ) | (44,548 | ) | ||||||||
Income tax (benefit) expense | 174 | (8 | ) | 496 | 3 | |||||||||||
Loss from continuing operations | (7,414 | ) | (6,710 | ) | (10,899 | ) | (44,551 | ) | ||||||||
Income from discontinued operations, net of tax | ||||||||||||||||
| Gain on sale of subsidiaries | — | 29,774 | 113 | 29,774 | ||||||||||||
| Income (loss) from discontinued operations | 1,194 | (781 | ) | 2,177 | (4,949 | ) | ||||||||||
| 1,194 | 28,993 | 2,290 | 24,825 | |||||||||||||
NET INCOME (LOSS) | $ | (6,220 | ) | $ | 22,283 | $ | (8,609 | ) | $ | (19,726 | ) | |||||
Earnings (loss) per share — basic and diluted: | ||||||||||||||||
| Net loss from continuing operations | $ | (0.92 | ) | $ | (0.85 | ) | $ | (1.36 | ) | $ | (6.37 | ) | ||||
| Net earnings from discontinued operations | 0.15 | 3.67 | 0.29 | 3.55 | ||||||||||||
| Total earnings (loss) per share — basic and diluted | $ | (0.77 | ) | $ | 2.82 | $ | (1.07 | ) | $ | (2.82 | ) | |||||
Weighted average number of common shares: | ||||||||||||||||
Basic and diluted | 8,067,089 | 7,897,299 | 8,034,164 | 6,987,508 | ||||||||||||
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
3
The Allied Defense Group, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
AND COMPREHENSIVE INCOME (LOSS)
(Unaudited)
(Thousands of Dollars, except per share and share data)
(Thousands of Dollars, except per share and share data)
| Accumulated | ||||||||||||||||||||||||||||
| Preferred | Common Stock | Capital | Other | Total | ||||||||||||||||||||||||
| Stock, No | $.10 | in Excess | Retained | Comprehensive | Stockholders’ | |||||||||||||||||||||||
| Par Value | Shares | Par value | of Par value | (Deficit) | Income (Loss) | Equity | ||||||||||||||||||||||
Balance at January 1, 2007 | $ | — | 6,440,944 | $ | 644 | $ | 43,312 | $ | (6,631 | ) | $ | 18,022 | $ | 55,347 | ||||||||||||||
| Common stock awards | — | 59,986 | 6 | 710 | — | — | 716 | |||||||||||||||||||||
| Retired stocks | — | (1,668 | ) | — | (14 | ) | — | — | (14 | ) | ||||||||||||||||||
| Employee stock purchase plan purchases | — | 47,431 | 4 | 358 | — | — | 362 | |||||||||||||||||||||
| Common stock converted from Notes | — | 150,500 | 15 | 1,392 | — | — | 1,407 | |||||||||||||||||||||
| Common stock issued to noteholders | — | 1,288,000 | 129 | 9,415 | — | — | 9,544 | |||||||||||||||||||||
| Directors’ deferred stock compensation | — | — | — | (275 | ) | — | — | (275 | ) | |||||||||||||||||||
| Issue of stock options | — | — | — | 216 | — | — | 216 | |||||||||||||||||||||
| Exercise of warrants | 27,968 | 3 | 241 | — | — | 244 | ||||||||||||||||||||||
| Comprehensive loss: | ||||||||||||||||||||||||||||
| Net loss for the year ended | — | — | — | — | (21,278 | ) | — | (21,278 | ) | |||||||||||||||||||
| Currency translation adjustment related to sale of The VSK Group | — | — | — | — | — | (4,491 | ) | (4,491 | ) | |||||||||||||||||||
| Currency translation adjustment | — | — | — | — | — | 3,877 | 3,877 | |||||||||||||||||||||
| Total comprehensive loss | (21,892 | ) | ||||||||||||||||||||||||||
Balance at December 31, 2007 | $ | — | 8,013,161 | $ | 801 | $ | 55,355 | $ | (27,909 | ) | $ | 17,408 | $ | 45,655 | ||||||||||||||
| Common stock awards | — | 52,395 | 5 | 224 | — | — | 229 | |||||||||||||||||||||
| Retired stocks | — | (1,351 | ) | — | (9 | ) | — | — | (9 | ) | ||||||||||||||||||
| Employee stock purchase plan purchases | — | 15,998 | 2 | 92 | — | — | 94 | |||||||||||||||||||||
| Issue of stock options | — | — | — | 49 | — | — | 49 | |||||||||||||||||||||
| Directors’ deferred stock compensation | — | — | — | 54 | — | — | 54 | |||||||||||||||||||||
| Comprehensive loss: | ||||||||||||||||||||||||||||
| Net loss for the nine months ended | — | — | — | — | (8,609 | ) | — | (8,609 | ) | |||||||||||||||||||
| Currency translation adjustment | — | — | — | — | — | (660 | ) | (660 | ) | |||||||||||||||||||
| Total comprehensive loss | (9,269 | ) | ||||||||||||||||||||||||||
Balance at September 30, 2008 | $ | — | 8,080,203 | $ | 808 | $ | 55,765 | $ | (36,518 | ) | $ | 16,748 | $ | 36,803 | ||||||||||||||
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
4
The Allied Defense Group, Inc.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Thousands of Dollars)
(Thousands of Dollars)
| Nine Months Ended September 30, | ||||||||
| 2008 | 2007 | |||||||
Cash flows from operating activities | ||||||||
| Net loss | $ | (8,609 | ) | $ | (19,726 | ) | ||
| Less: Gain on sale of subsidiaries | (113 | ) | (29,774 | ) | ||||
| Discontinued operations, net of tax | (2,177 | ) | 4,949 | |||||
| Loss from continuing operations | (10,899 | ) | (44,551 | ) | ||||
| Adjustments to reconcile net loss from continuing operations to net cash used in operating activities, net of divestitures: | ||||||||
| Depreciation and amortization | 4,254 | 3,834 | ||||||
| Amortization of debt discount and debt issue costs | 88 | 3,297 | ||||||
| Impairment of goodwill and long-lived assets | 3,957 | — | ||||||
| Unrealized loss on forward contracts | 1,473 | — | ||||||
| Loss (gain) on sale of fixed assets | (19 | ) | (18 | ) | ||||
| Net loss related to fair value of notes and warrants | 682 | 6,686 | ||||||
| Interest and penalties converted to debt principal | — | 1,204 | ||||||
| Provision for estimated losses on contracts | 926 | 1,216 | ||||||
| Provision for warranty reserves, uncollectible accounts and inventory obsolescence | 738 | 1,254 | ||||||
| Common stock and stock option awards | 292 | 1,099 | ||||||
| Deferred director stock awards | 54 | (293 | ) | |||||
| (Increase) decrease in operating assets and increase (decrease) in liabilities, net of effects from discontinued businesses | ||||||||
| Restricted cash | 5,076 | 3,621 | ||||||
| Accounts receivable | (13,913 | ) | 2,353 | |||||
| Costs and accrued earnings on uncompleted contracts | (18,504 | ) | 6,221 | |||||
| Inventories | (1,326 | ) | 649 | |||||
| Prepaid and other current assets | (2,553 | ) | 645 | |||||
| Accounts payable and accrued liabilities | 3,832 | 7,678 | ||||||
| Customer deposits | 4,074 | (10,855 | ) | |||||
| Deferred compensation | 40 | 2 | ||||||
| Income taxes | 390 | (219 | ) | |||||
| Net cash used in operating activities — continuing operations | (21,338 | ) | (16,177 | ) | ||||
| Net cash provided by operating activities — discontinued operations | 3,788 | 3,915 | ||||||
| Net cash used in operating activities | (17,550 | ) | (12,262 | ) | ||||
5
| Nine Months Ended September 30, | ||||||||
| 2008 | 2007 | |||||||
Cash flows from investing activities | ||||||||
| Capital expenditures | (1,556 | ) | (726 | ) | ||||
| Proceeds from sale of subsidiaries | 2,433 | 43,474 | ||||||
| Proceeds from sale of fixed assets | 20 | 12 | ||||||
| Net cash provided by investing activities — continuing operations | 897 | 42,760 | ||||||
| Net cash used in investing activities — discontinued operations | (71 | ) | (1,991 | ) | ||||
| Net cash provided by investing activities | 826 | 40,769 | ||||||
Cash flows from financing activities | ||||||||
| Decrease in bank overdraft | (1,822 | ) | (5,632 | ) | ||||
| Principal payment on senior secured notes | (481 | ) | (867 | ) | ||||
| Increase in short-term borrowings | 2,588 | — | ||||||
| Proceeds from issuance of senior convertible notes | — | 15,376 | ||||||
| Net cash transferred to discontinued operations | — | (411 | ) | |||||
| Principal payments on long-term borrowing | (58 | ) | (1,675 | ) | ||||
| Repayment on capital lease obligations | (691 | ) | (1,426 | ) | ||||
| Debt issue cost on senior secured notes | — | (1,296 | ) | |||||
| Proceeds from employee stock purchases | 80 | 285 | ||||||
| Retirement of stock | (9 | ) | — | |||||
| Net cash provided by (used in) financing activities — continuing operations | (393 | ) | 4,354 | |||||
| Net cash provided by financing activities — discontinued operations | — | 161 | ||||||
| Net cash provided by (used in) financing activities | (393 | ) | 4,515 | |||||
| Net change in cash of discontinued operations | — | (2,085 | ) | |||||
| Effects of exchange rate on cash | 460 | 2,944 | ||||||
| NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS | (16,657 | ) | 33,881 | |||||
Cash and cash equivalents at beginning of period | 21,750 | 16,397 | ||||||
Cash and cash equivalents at end of period | $ | 5,093 | $ | 50,278 | ||||
Supplemental Disclosures of Cash Flow information | ||||||||
| Cash paid during the period for | ||||||||
| Interest | $ | 5,518 | $ | 3,695 | ||||
| Taxes | $ | 99 | $ | 1,018 | ||||
Supplemental Disclosures of Non-Cash Investing and Financing Activities | ||||||||
| Issuance of common stock in exchange of convertible notes | $ | — | $ | 9,544 | ||||
| Interest and financing charges converted to debt principal | $ | — | $ | 1,605 | ||||
| Capital leases | $ | 26 | $ | 2 | ||||
The accompanying notes are an integral part of these unaudited condensed consolidated statements.
6
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
(Thousands of Dollars)
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
(Thousands of Dollars)
| NOTE 1 — | CONDENSED CONSOLIDATED FINANCIAL STATEMENTS |
The Allied Defense Group Inc. (“Allied” or the “Company”), a Delaware corporation, is a strategic portfolio of defense and security businesses, with presence in worldwide markets, offering both government and commercial customers leading edge products and services. These products and services are marketed to the ordinance and electronic security markets.
The accompanying unaudited condensed consolidated financial statements have been prepared by the Company. We have continued to follow the accounting policies disclosed in the consolidated financial statements included in our 2007Form 10-K filed with the Securities and Exchange Commission. In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all necessary adjustments and reclassifications (all of which are of a normal, recurring nature) that are necessary for fair presentation for the periods presented.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. The results of operations for the three and nine months ended September 30, 2008 and 2007 are not necessarily indicative of the operating results for the full year.
It is suggested that these unaudited condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s latest shareholders’ annual report(Form 10-K) for the period ending December 31, 2007.
As discussed in Note 17, the results of operations, financial position and cash flows of Titan Dynamics Systems, SeaSpace, The VSK Group and GMS, that were previously reported in the AWE segment, Other segment and the ES segments, respectively, have been reported as discontinued operations for all periods presented. SeaSpace was sold by the Company in July 2007, The VSK Group in September 2007, Titan in March 2008 and GMS in October 2008. Unless otherwise indicated, all disclosures in the notes to the unaudited interim consolidated financial statements relate to the Company’s continuing operations.
Liquidity and Capital Resources
During 2007, the Company faced liquidity challenges mainly resulting from the reduction of revenues and significant operating losses at MECAR, financing costs associated with registration delay penalties and interest premiums paid to the holders of its Convertible Notes, legal and restructuring costs associated with alleged events of default with the Convertible Note holders and the issuance of new Convertible Notes in June and July 2007, operational restructuring activities at MECAR and NSM to reduce the fixed cost base of those operations, and the continuing use of cash at several of the Company’s smaller US-based subsidiaries. Over the past twelve months, the Company has divested several subsidiaries and improved its operating results. In the nine months ended September 30, 2008, the Company increased its revenue by $99,957, more than 463%, and reduced operating losses.
The Company managed through its cash liquidity issues in 2007 by issuing an additional $15,376 of Convertible Notes in June and July 2007 and from cash generated as a result of the divestitures of SeaSpace in July 2007 and The VSK Group in September 2007. SeaSpace generated net proceeds of $674 while the VSK group generated net proceeds of $21,894, after repayment of $19,949 to the Note holders, pursuant to the terms of the Convertible Notes. In addition, on October 1, 2008, the Company’s GMS subsidiary sold substantially all of its assets in a transaction that provided net proceeds of approximately $6,800, after repayment of $10,908 to the note holders, pursuant to the terms of the Convertible Notes and the repayment of the GMS acquisition promissory note of $3,392.
7
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
In April 2008, MECAR reached an agreement with its existing bank group regarding its credit facility. The agreement provides for an expansion of the total credit facility from approximately $61,914 (€42,850) to $65,924 (€45,625). The credit facility was restructured and the portion designated for tax prepayments was terminated. The agreement provides for a cash line of $14,738 (€10,200) and performance bond and advance payment guarantee line of $51,186 (€35,425). The agreement required a partial repayment of MECAR’s cash line of $7,369 (€5,100) in July 2008 and the remainder to be repaid by November 30, 2008. The performance bond and advance payment guarantee line expires on December 31, 2008. After that date the Company will be unable to issue any new performance bonds or advance payment guarantees without a new credit facility. Based on the timing of MECAR’s shipments in July 2008, the Company was unable to repay half of the cash line by July 31, 2008, but subsequently made the required repayments to the banking facility in the third quarter of 2008. Based on cash flow projections, the Company believes its MECAR subsidiary will be able to repay the remaining $7,369 (€5,100) by November 30, 2008 with cash generated from operations. MECAR has shipments of approximately $52,258 (€ 36,167) which have occurred and are projected for the balance of the fourth quarter of 2008 to its largest client that will allow the subsidiary to generate cash in the fourth quarter in addition to other operating activities that will generate cash.
In addition, in April 2008, MECAR’s bank group received local government support that will guarantee an additional portion of MECAR’s performance bonds and advance payment guarantees from May through November 2008. This additional guarantee will reduce the required restricted cash balances at MECAR and allow the Company to fund MECAR through its critical working capital expansion period. This agency began guaranteeing approximately 50% of MECAR’s new performance bonds and advance payment guarantees in July 2007.
The Company is in discussions with members of the existing MECAR bank facility and other financial institutions to replace the existing credit facility. The anticipated new credit facility will have both a revolving cash line facility and performance bond and advance payment guarantee line like the existing facility. The Company may look to expand the size of the performance bond and advance payment guarantee line to meet its projected requirements. The refinancing of the credit facility, in some form, is critical to the Company’s ability to continue operations. Initial interest in establishing a new banking relationship has been expressed by certain existing bank group members although specific terms have not been documented at this time.
As of September 30, 2008, the principal outstanding balance of the Convertible Notes was $19,876. From October 4 through 14, 2008, the Company repaid $10,908 of the Convertible Notes with the proceeds of the GMS asset sale as required by terms of the agreement. In addition, as described in Note 8 of the condensed consolidated financial statements, the Company’s Convertible Notes have a put feature that allows the holders to put the notes back to the Company on December 26, 2008and/or January 19, 2009 based on the date of issuance. As permitted by the provisions of the Company’s Convertible Notes, on October 10 through 14, 2008, the Company received notices from all four of its note holders requiring the Company to redeem all of the outstanding Notes at face value on December 26, 2008 and January 19, 2009. The Company is required to redeem $8,039 on December 26, 2008 and $928 on January 19, 2009. The Company will use the remaining GMS proceeds, its existing cash balances, and cash generated from operations, as needed, to repay the Convertible Notes.
At September 30, 2008, the Company had $5,093 in cash on hand. For the nine months ended September 30, 2008, the Company used $21,338 of cash for operating activities from continuing operations mainly related to increases in accounts receivable and costs and accrued earnings on uncompleted contracts at MECAR as it performs on its substantial backlog. The Company does not anticipate continuing to use cash at this level for the remainder of 2008 as MECAR will increase its billings as the contracts in progress are shipped and generate cash collections from accounts receivable in the fourth quarter of 2008.
In general, the Company believes that it has adequate cash sources to fund operations for the remainder of 2008 based on its strong current backlog and its history of performing on a profitable basis when backlog is substantial. The Company believes it will have adequate cash to meet the convertible note holders “put” in
8
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
December 2008 and January 2009. As noted above, management has begun the process of securing a long-term credit facility solution for MECAR. Management believes, based on MECAR’s historic performance when it has substantial backlog as well as its operating performance since the fourth quarter of 2007, that adequate opportunities will be available to finalize a long-term solution for the Company’s credit needs.
While the Company is looking to secure long-term MECAR financing and be able to satisfy the put feature on its Convertible Notes, there can be no assurance that:
| • | The Company will be successful securing MECAR’s long-term financing. | |
| • | The Company will be successful generating adequate cash at its MECAR subsidiary in the fourth quarter of 2008 to repay its existing credit facility. | |
| • | The Company will be successful in taking necessary steps to be in a position to satisfy the “put” of its senior secured convertible notes which will be made in December 2008 and January 2009. | |
| • | The Company will be successful in its restructuring and turnaround efforts at its subsidiaries. | |
| • | The Company will be able to meet the financial debt covenants of its debt instruments. |
The Company has less than $200 of firm commitments for capital expenditures outstanding as of September 30, 2008.
Reclassification
Certain items previously reported in specific financial statement captions have been reclassified to conform to the current presentation.
| NOTE 2 — | PRINCIPLES OF CONSOLIDATION |
The unaudited condensed consolidated financial statements include the accounts of The Allied Defense Group, Inc. (“Allied” or the “Company”), a Delaware corporation, and its wholly-owned subsidiaries as follows:
| • | ARC Europe, S.A. (“ARC Europe”), a Belgian company, | |
| • | Allied Research Corporation Limited (“Limited”), an inactive United Kingdom company, | |
| • | News/Sports Microwave Rental, Inc. (“NSM”), a California corporation, | |
| • | MECAR USA, Inc. (“MECAR USA”), a Delaware corporation, | |
| • | Global Microwave Systems, Inc (GMS), a California corporation. (Discontinued Operation) |
ARC Europe includes its wholly-owned subsidiaries MECAR S.A. (“MECAR”), Sedachim S.I. S.A., and Hendrickx S.A.
The Company operates in two primary operating segments, which are outlined below:
Ammunition & Weapons Effects. This segment includes the Belgium subsidiary MECAR and the U.S. subsidiary MECAR USA. MECAR and MECAR USA focus on ammunition, light weapons and some pyrotechnic devices and has begun purchasing and selling weapon systemsand/or ammunition manufactured by others, in the form of pass through contracts for the benefit of the U.S government and other foreign governments. Titan and Allied Technology were previously included in this segment. Titan designs, manufactures and sells an extensive line of battlefield effects simulators. Titan and Allied Technology were sold on March 17, 2008 and have been eliminated from all segment reporting.
Electronic Security. This segment includes the operations of NSM. The Electronic Security (ES) segment provides products in the areas of security systems, surveillance and electronic data transmission. NSM designs, manufactures, distributes and services industrial and law enforcement security products and systems. The VSK Group and GMS were previously included in this segment. The VSK Group and GMS
9
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
were sold in September 2007 and October 2008, respectively, and have been eliminated from all segment reporting.
Other. This segment consisted solely of SeaSpace which provides products in the area of environmental monitoring. SeaSpace designs, manufactures, distributes and services weather and environmental satellite ground reception systems. SeaSpace was sold in July 2007 and has been eliminated from all segment reporting.
Allied, the parent company, provides management and business development services to its subsidiaries and has no operating activities. Significant intercompany transactions have been eliminated in consolidation.
| NOTE 3 — | ACCOUNTS RECEIVABLE AND COSTS AND ACCRUED EARNINGS ON UNCOMPLETED CONTRACTS |
Accounts receivable at September 30, 2008 and December 31, 2007 are comprised as follows:
| September 30, | December 31, | |||||||
| 2008 | 2007 | |||||||
| Direct and indirect receivables from governments | $ | 17,650 | $ | 2,657 | ||||
| Commercial and other receivables | 3,259 | 4,960 | ||||||
| 20,909 | 7,617 | |||||||
| Less: Allowance for doubtful receivables | (1,028 | ) | (652 | ) | ||||
| $ | 19,881 | $ | 6,965 | |||||
Receivables from governments and government agencies are generally due within 30 days of shipment, less a 10% hold back provision which is generally due within 90 days. Since these receivables are typically supported by letters of credit or other guarantees, no provision for doubtful accounts is deemed necessary. The Company maintains an allowance for doubtful accounts on commercial receivables or receivables from governments that are deemed uncollectible, which is determined based on historical experience and management’s expectations of future losses. Losses have historically been within management’s expectations.
Costs and accrued earnings on uncompleted contracts totaled $56,100 and $39,313 at September 30, 2008 and December 31, 2007, respectively.
| NOTE 4 — | INVENTORIES |
Inventories at September 30, 2008 and December 31, 2007 are comprised as follows:
| September 30, | December 31, | |||||||
| 2008 | 2007 | |||||||
| Raw materials | $ | 13,042 | $ | 13,106 | ||||
| Work in process | 11,600 | 11,096 | ||||||
| Finished goods | 393 | — | ||||||
| 25,035 | 24,202 | |||||||
| Less: Reserve for obsolescence | (2,466 | ) | (2,175 | ) | ||||
| $ | 22,569 | $ | 22,027 | |||||
10
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
| NOTE 5 — | GOODWILL |
The Company had goodwill of $3,495 at December 31, 2007. Goodwill is solely from the ES Segment. As required by SFAS No. 142, the Company performs, at the component level of the segments, a review each year or earlier if an indicator of potential impairment of goodwill exists. The impairment review is based on a discounted cash flow approach that uses estimates of future cash flows discounted at the Company’s weighted average cost of capital. The estimates used are consistent with the plans and estimates that the Company uses to manage the underlying businesses. No impairment was recorded at December 31, 2007. In the fourth quarter of 2008, the Company committed to a formal plan to sell NSM, which has been previously reported in the Electronic Security segment. The Company is in negotiations with prospective purchasers. Based on such negotiations and nonbinding offers received during the third quarter of 2008, the Company recorded a goodwill impairment of $3,495 during the third quarter of 2008 to write down NSM’s assets to estimated fair value less costs to sell.
| NOTE 6 — | IMPAIRMENT OF LONG-LIVED ASSETS |
On September 30, 2008, the Company recorded $462 in impairment charges for long-lived assets related to the Company’s Enterprise Reporting Package (ERP) computer system. As the Company has reduced its head count as a result of selling a number of its subsidiaries, the Company determined that the carrying value of the ERP system exceeds its fair value. The fair value of the ERP system was determined based on replacement cost.
| NOTE 7 — | BANK OVERDRAFT CREDIT FACILITY |
MECAR is obligated under an agreement (the Agreement), modified in April 2008, with its foreign banking syndicate that provides credit facilities of up to €45,625 (approximately $65,924) primarily for bank guarantees including performance bonds, letters of credit and similar instruments required for specific sales contracts, as well as a line of credit for working capital. The Agreement provides for certain bank charges and fees as the facility is used, plus fees of 2% of guarantees issued and quarterly fees at an annual rate of 1.25% of guarantees outstanding. These fees are charged to interest expense. The Agreement requires that MECAR maintain certain financial covenants. As of December 31, 2007, MECAR was not in compliance with the facility covenants due to violations of the financial performance covenants. In April 2008, MECAR obtained a waiver from the bank group for this 2007 noncompliance. In April 2008, the Company reached an agreement to extend and expand the credit facility until December 31, 2008. This agreement required a partial repayment of MECAR’s cash line of approximately €5,100 in July 2008 and the remainder to be repaid by November 30, 2008. The Company did not meet the first requirement on July 31, 2008 but subsequently made this required repayment to the bank facility later in the third quarter of 2008.
Effective July 1, 2007, a local Belgian regional agency began providing guarantees up to 50% of MECAR’s credit requirements relative to performance bonds and advance payment guarantees, to reduce the exposure of the existing bank group. In April 2008, MECAR’s bank group received additional temporary local support from the agency to provide additional guarantees on the performance bonds and advance payment guarantees from May to November 2008. These additional guarantees allow MECAR to reduce its restricted cash requirements by approximately $8,669 (€6,000) during the May to November 2008 period.
As of September 30, 2008 and December 31, 2007, the guarantees and performance bonds of approximately $55,172 and $37,523, respectively, were outstanding. Advances for working capital provided for under the bank overdraft facility and notes payable, amounted to $7,828 and $7,239 at September 30, 2008 and December 31, 2007, respectively. Performance bonds and advance payment guarantees under the Agreement are secured by restricted cash of approximately $7,737 and $12,838, at September 30, 2008 and December 31, 2007, respectively. MECAR is generally required under the terms of its contracts with foreign governments and its distributor to provide performance bonds and advance payment guarantees. The credit
11
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
facility agreement is used to provide these financial guarantees and places restrictions on certain cash deposits and other liens on MECAR’s assets. In addition, certain customers make advance deposits and require MECAR’s bank to restrict up to forty percent of the advance deposit as collateral. Amounts outstanding are also collateralized by the letters of credit received under the contracts financed, and a pledge of all of MECAR’s assets. The credit facility agreement will expire on December 31, 2008, although the existing outstanding performance bonds and advance payment guarantees will be in place until their intended maturity.
| NOTE 8 — | LONG-TERM OBLIGATIONS |
Long-term obligations as of September 30, 2008 and December 31, 2007 consist of the following:
| September 30, | December 31, | |||||||
| 2008 | 2007 | |||||||
| Fair value of Senior secured convertible notes | $ | 19,493 | $ | 19,392 | ||||
| SOGEPA loan | 8,670 | 8,837 | ||||||
| Bank note payable | 2,456 | — | ||||||
| Capital leases and other | 757 | 1,483 | ||||||
| Total long-term debt | 31,376 | 29,712 | ||||||
| Less: Current maturities | (23,926 | ) | (14,491 | ) | ||||
| Long-term debt, less current maturities and unamortized discount | $ | 7,450 | $ | 15,221 | ||||
On March 9, 2006, the Company entered into a Securities Purchase Agreement with four purchasers for the private placement of senior subordinated convertible notes (the “Initial Notes”) in the principal amount of $30,000 and related warrants to purchase common stock of the Company (the “2006 Transactions”).
During the period February 20, 2007 through March 23, 2007, the Company received separate letters from each of the four purchasers asserting the existence of an event of default under the Initial Notes. In addition, one of the purchasers filed suit against the Company based on the alleged default.
On June 19, 2007, the Company and each of the purchasers entered into an Amended and Restated Securities Purchase Agreement (the “Amendment Agreement”) to refinance the terms of the original transaction and to provide for the issuance of additional convertible notes totaling up to $15,376. Pursuant to the Amendment Agreement, each purchaser agreed to withdraw the alleged events of default and the one purchaser agreed to dismiss the lawsuit.
Senior secured convertible notes. The Company entered into the Amendment Agreement with each purchaser whereby the Company exchanged the Initial Notes in the principal amount of $30,000 and $1,204 of unpaid and accrued interest and penalties for Senior Secured Convertible Notes (the “Amended Notes”) in the principal amount of $27,204 and 1,288,000 shares of the Company’s common stock (“Exchange Transaction”). In addition, the Amendment Agreement provided for the issuance of an additional $15,376 of Senior Secured Convertible Notes (the “New Notes”). On June 26, 2007, the Company closed on its first phase of the financing whereby it executed the Exchange Transaction and issued $5,376 of New Notes (“First Closing”). On July 19, 2007, mainly as a result of the announcement of a significant new sales contract by MECAR on July 11, 2007, the Company closed on the second phase of financing whereby it issued an additional $10,000 of New Notes (“Second Closing”).
The Company elected to carry both the Initial Notes and the Amended Notes at fair value under SFAS 155Accounting for Certain Hybrid Instruments. At June 26, 2007, the Company determined the fair value of the Initial Notes was $36,979. In determining fair value, the Company considers all available information, including the terms of any potential settlementand/or modification and the probability of such settlementand/or modification occurring. As a result, the carrying amount of the Initial Notes immediately prior to the
12
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
closing of the Exchange Transaction reflected the settlement provisions of Amendment Agreement so that the fair value of the Initial Notes immediately prior to the Exchange Transaction equaled the fair value of the common stock issued of $9,544 plus the fair value of the Amended Notes of $27,435.
In connection with the Amendment Agreement, the Company incurred debt issue costs of $1,707 of which $1,306 was paid and the remaining $401 was included in the principal of the New Notes. These debt issue costs were expensed immediately upon execution of the Amendment Agreement as interest expense. The Amended and New Notes, the “Notes”, mature on June 26, 2010, subject to the right of the purchasers to demand payment eighteen months after closing (this means December 26, 2008 for the notes issued on June 26, 2007 and January 19, 2009 for the notes issued on July 19, 2007). The Notes accrue interest at 8.95%, with accrued interest payable quarterly in arrears. The Company had the option to convert interest through December 31, 2007 to debt principal; thereafter, all interest must be paid in cash or in shares of the Company’s common stock. The Notes are convertible into shares of the Company’s common stock at the conversion price of $9.35 per share, subject to certain standard anti-dilution provisions and an adjustment for stock splits. Upon a change of control, as defined in the Notes or in the event the Company sells both its MECAR S.A. and The VSK Group subsidiaries, the holders will have certain redemption rights.
As of September 30, 2008, the principal outstanding balance of Convertible Notes was $19,876. From October 4 through 14, 2008, the Company repaid $10,908 of the Convertible Notes with the proceeds of the GMS asset sale as required by terms of the agreement. The GMS asset sale was completed on October 1, 2008. As permitted by the provisions of the Notes, on October 10 through 14, 2008, the Company received notices from all four of its note holders requiring the Company to redeem all of the outstanding Notes at face value on December 26, 2008 and January 19, 2009. The Company is required to redeem $8,039 on December 26, 2008 and $928 on January 19, 2009. The Company will use the remaining GMS proceeds, its existing cash balances, and cash generated from operations, as needed, to repay the Notes.
The Notes are secured by a first lien on all assets of the Company and its domestic subsidiaries; a pledge of the stock of the Company’s domestic subsidiaries; and a pledge of 65% of the stock of certain of the Company’s foreign subsidiaries. The Company is required to comply with certain financial covenants based on the Company’s financial performance commencing with the Company’s financial performance for the third quarter of 2007 and is limited in its ability to incur any additional indebtedness. In addition, the Notes contain cross-default provisions. Such provisions specifically exclude the Company’s current non-compliance of MECAR’s credit facility covenants.
In connection with the Amendment Agreement, the Company also entered into an Amended and Restated Registration Rights Agreement which required the Company to have an effective registration statement with the SEC for the resale of the common stock underlying the convertible notes within 365 days of initial closing of the Amendment Agreement or June 26, 2008 (“the Effectiveness Deadline”). The Amended Registration Rights Agreement provided for additional interest and penalties in the event the Company failed to have the registration statement effective within the required time frame. On January 1, 2007, the Company adoptedFSP 00-19-2Accounting for Registration Payment Arrangements. Prior to adoptingFSP 00-19-2, the Company’s policy was to accrue liquidated damages when incurred. In accordance withFSP 00-19-2, the Company accrued for interest penalties under FAS 5Accounting for Contingencieswhen probable and estimable. At January 1, 2007, liquidated damages under the Initial Note Registration Rights Agreement were not probable or estimable. As of December 31, 2007, the Company did not believe that such liquidated damages under the Amended and Restated Registration Rights Agreement were probable or estimable and, as such, no accrual was made. Effective February 15, 2008, the Securities and Exchange Commission issued new provisions with regard to Rule 144. These provisions allowed a non-affiliate to resell restricted securities such as the securities underlying the Notes after a six-monthly holding period as long as the Company was current in its SEC filings or after a one year holding period without any restrictions. The Company has reached an agreement with the holders of the Notes to suspend its efforts to register the securities that were required to be
13
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
registered pursuant to the Amended and Restated Registration Rights Agreements. The Company was no longer subject to these liquidating damages as provided in the Amended and Restated Registration Rights Agreements.
The Company determined that the Notes are hybrid instruments that could be carried at fair value, with any changes in fair value reported as gains or losses in subsequent periods.
The Company determined the fair value of the Notes at September 30, 2008 and December 31, 2007 was as follows:
| September 30, | December 31, | |||||||
| 2008 | 2007 | |||||||
| Amended Notes | $ | 12,886 | $ | 13,134 | ||||
| First Closing of New Notes | 500 | 476 | ||||||
| Second Closing of New Notes | 6,107 | 5,782 | ||||||
| $ | 19,493 | $ | 19,392 | |||||
For the three and nine months ended September 30, 2008, the Company recorded a net loss of $67 and $582, respectively, related to the calculated fair values of the Amended Notes, First Closing and Second Closing of New Notes at September 30, 2008. For the three and nine months ended September 30, 2007, the net gain and net loss related to the calculated fair values of the Amended Notes and First Closing of New Notes was $1,240 and $7,425, respectively, at September 30, 2007.
The face value of the amount owed on the Notes as of September 30, 2008 and December 31, 2007 was as follows:
| September 30, | December 31, | |||||||
| 2008 | 2007 | |||||||
| Amended Notes | $ | 13,282 | $ | 13,763 | ||||
| First Closing of New Notes | 499 | 499 | ||||||
| Second Closing of New Notes | 6,095 | 6,095 | ||||||
| $ | 19,876 | $ | 20,357 | |||||
As noted above, on October 4 through 14, 2008, $10,908 of these Notes were repaid from the proceeds of the GMS sale that was completed on October 1, 2008.
Warrants On March 6, 2006, in conjunction with the issuance of the Initial Notes, the Company issued detachable warrants to the purchasers exercisable for an aggregate of 226,800 shares of Allied common stock. The warrants are exercisable for a term of five years at an exercise price of $27.68 per share, subject to anti-dilution provisions similar to the provisions set forth in the Notes and expire on March 9, 2011. The original exercisable shares of 226,800 and exercise price of $27.68 was adjusted to 349,297 and $17.97, respectively, to account for the December 2006 Private Placement and the Amendment Agreement. The warrants did not meet the requirement for equity classification in accordance withEITF 00-19,Accounting for Derivative Instruments Index to, and Potentially Settled in, a Company’s Own Stock, mainly because the warrants are required to settle in registered shares of the Company’s common stock. The warrants were recorded as liabilities, presented as derivative instrument on the balance sheet, and are being recorded and carried at the fair value of the instrument. At September 30, 2008 and December 31, 2007, the Company determined the fair value of the warrants was $283 and $183, respectively. For the three and nine months ended September 30, 2008, the Company recorded a loss of $88 and $100, respectively, related to the calculated fair value adjustment of the warrants at September 30, 2008. For the three and nine months ended September 30, 2007, the Company recorded a loss of $160 and a gain of $739, respectively, related to the calculated fair value adjustment of the warrants at September 30, 2007.
14
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
SOGEPA Loan. On December 20, 2007, MECAR entered into a €6,000 (approximately $9,479) loan agreement with theSociété Wallonne de Gestion et de Participations(“SOGEPA”), a local Belgian regional agency to provide MECAR with additional working capital financing. The loan matures on December 20, 2012 and accrues interest at 4.95% per year. Quarterly interest payments are due during the first year of the loan, with quarterly principal and interest payments due thereafter. The loan is secured by a mortgage covering property owned by MECAR. As part of the loan, MECAR is required to maintain certain capital requirements as defined in the loan agreement. MECAR paid debt issue costs of $141 in connection with the loan which is being amortized over the term of the loan. The unamortized debt issue cost was $118 and $141 at September 30, 2008 and December 31, 2007, respectively. The outstanding balance due on the loan was $8,669 (€6,000) and $8,837 (€6,000) at September 30, 2008 and December 31, 2007, respectively.
Capital lease and other. The Company is also obligated on various vehicle, and equipment capital lease obligations and other loans. The notes and leases are generally secured by the assets acquired, bear interest at rates ranging from 2.92% to 11.00% and mature at various dates through 2010. In addition, NSM had a note for a vehicle of $4 at December 31, 2007, which was fully paid-off during the nine months ended September 30, 2008.
Other than as disclosed above with regard to the Notes, no other debt classified as long-term contain cross-default provisions.
| NOTE 9 — | DERIVATIVE FINANCIAL INSTRUMENTS |
Derivatives not designated as hedges
The Company uses foreign currency futures contracts to minimize the foreign currency exposures that arise from sales contracts with certain foreign customers and certain purchase commitments. Under the terms of these sales contracts, the selling price and certain costs are payable in U.S. dollars rather than the Euro, which is MECAR’s functional currency. The Company records all derivatives on the balance sheet at fair value. The accounting for the changes in the fair value of the derivative depends on the intended use of the derivative and the resulting designation. The Company no longer utilizes derivatives that are designated as fair value or cash flow hedges. As such, realized and unrealized (gains) losses from derivative contracts are reported in the income statement and amounted to $1,249 and $1,398, for the three and nine months ended September 30, 2008, respectively. In 2007, the Company did not enter any foreign currency future contracts or forward exchange rates to minimize the foreign currency exposures.
| NOTE 10 — | FAIR VALUE MEASUREMENTS |
Effective January 1, 2008, the Company adopted the provisions of Statement of Financial Accounting Standards No. 157,Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value and expands disclosures about such measurements that are permitted or required under other accounting pronouncements. While SFAS No. 157 may change the method of calculating fair value, it does not require any new fair value measurements. The SFAS No. 157 requirements for certain non-financial assets and liabilities have been deferred until the first quarter of 2009 in accordance with Financial Accounting Board Staff PositionFSP 157-2. The adoption of SFAS 157 did not have a material impact on our results of operations, financial position or cash flows.
In accordance with SFAS No. 157, the Company determines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company generally applies the income approach to determine fair value. This method uses valuation techniques to convert future amounts to a single present amount. The measurement is based on the value indicated by current market expectations about those future amounts.
15
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
SFAS 157 establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to active markets for identical assets and liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). We classify fair value balances based on the observability of those inputs. The three levels of the fair value hierarchy are as follows:
| • | Level 1 — Observable inputs such as quoted prices in active markets for identical assets or liabilities | |
| • | Level 2 — Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active and amounts derived from valuation models where all significant inputs are observable in active markets | |
| • | Level 3 — Unobservable inputs that reflect management’s assumptions |
For disclosure purposes, assets and liabilities are classified in their entirety in the fair value hierarchy level based on the lowest level of input that is significant to the overall fair value measurement. Our assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the placement within the fair value hierarchy levels.
The following table sets forth the assets and liabilities measured at fair value on a recurring basis, by input level, in the condensed consolidated balance sheet at September 30, 2008:
| Quoted Prices in | Significant | |||||||||||||||
| Active Markets for | Other | Significant | ||||||||||||||
| Identical Assets or | Observable | Unobservable | ||||||||||||||
| Liabilities (Level 1) | Inputs (Level 2) | Inputs (Level 3) | Total | |||||||||||||
Liabilities | ||||||||||||||||
| Senior secured convertible notes | $ | — | $ | 19,493 | $ | — | $ | 19,493 | ||||||||
| Derivative instrument | — | 283 | — | 283 | ||||||||||||
| Foreign exchange contract | — | 1,398 | — | 1,398 | ||||||||||||
| $ | — | $ | 21,174 | $ | — | $ | 21,174 | |||||||||
The fair values of the Company’s senior secured convertible notes and warrants disclosed above are primarily derived from valuation models where significant inputs such as historical price and volatility of the Company’s stock as well as U.S. Treasury Bill rates are observable in active markets. The fair values of the Company’s foreign exchange contracts are valued using a discounted cash flow model that takes into account the present value of future cash flows under the terms of the contracts using current market information as of the reporting date such as prevailing foreign currency spot and forward rates.
16
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
| NOTE 11 — | EARNINGS (LOSS) PER SHARE |
Basic earnings (loss) per share excludes potential common shares and is computed by dividing net earnings (loss) by the weighted average number of common shares outstanding for the period. The computation of diluted earnings (loss) per share excludes the effects of stock options, warrants, restricted stock (unvested stock awards) and convertible debentures, if such effect is anti-dilutive. The table below shows the calculation of basic and diluted earnings (loss) per share for the three and nine months ended September 30, 2008 and 2007, respectively:
| Three Months Ended | Nine Months Ended | |||||||||||||||
| September 30, | September 30, | |||||||||||||||
| 2008 | 2007 | 2008 | 2007 | |||||||||||||
| Net loss from continuing operations | $ | (7,414 | ) | $ | (6,710 | ) | $ | (10,899 | ) | $ | (44,551 | ) | ||||
| Net earnings from discontinued operations | 1,194 | 28,993 | 2,290 | 24,825 | ||||||||||||
| Net earnings (loss) | $ | (6,220 | ) | $ | 22,283 | $ | (8,609 | ) | $ | (19,726 | ) | |||||
| Weighted average number of basic and diluted shares | 8,067,089 | 7,897,299 | 8,034,164 | 6,987,508 | ||||||||||||
| Basic and diluted net loss per share from continuing operations | $ | (0.92 | ) | $ | (0.85 | ) | $ | (1.36 | ) | $ | (6.37 | ) | ||||
| Basic and diluted net earnings per share from discontinued operations | 0.15 | 3.67 | 0.29 | 3.55 | ||||||||||||
| Total | $ | (0.77 | ) | $ | 2.82 | $ | (1.07 | ) | $ | (2.82 | ) | |||||
For the three and nine months ended September 30, 2008, the Company has excluded convertible notes and warrants of 2,125,738 and 411,593 shares, respectively, from the calculation of earnings per share since their effect would be anti-dilutive. At September 30, 2007, convertible notes, stock options and warrants of 4,461,280, 12,256 and 411,593 shares, respectively were excluded from the calculation of earnings per share for the three and nine months ended September 30, 2007 since their effect would be anti-dilutive.
| NOTE 12 — | COMPREHENSIVE INCOME (LOSS) |
A summary of the components of Comprehensive Income (Loss) for the three and nine months ended September 30, 2008 and 2007 are as follows:
| Three Months Ended | Nine Months Ended | |||||||||||||||
| September 30, | September 30, | |||||||||||||||
| 2008 | 2007 | 2008 | 2007 | |||||||||||||
| Net Income (Loss) | $ | (6,220 | ) | $ | 22,283 | $ | (8,609 | ) | $ | (19,726 | ) | |||||
| Currency Translation Adjustment | (3,146 | ) | 2,620 | (660 | ) | 3,386 | ||||||||||
| Accumulated currency translation adjustments attributable to the VSK Group | — | (4,448 | ) | — | (4,448 | ) | ||||||||||
| Comprehensive Income (Loss) | $ | (9,366 | ) | $ | 20,455 | $ | (9,269 | ) | $ | (20,788 | ) | |||||
The currency translation adjustment for the three and nine months ended September 30, 2008 and 2007 resulted from the change in the value of the Euro during the respective periods.
17
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
| NOTE 13 — | SHARE-BASED COMPENSATION |
Total share-based compensation was $131 (including outside directors compensation of $85) and $225 (including outside directors compensation of $63) for the three months ended September 30, 2008 and 2007, respectively. For the nine months ended September 30, 2008 and 2007, respectively, the Company incurred $436 (including outside directors compensation of $211) and $725 (including outside directors compensation of $182) in total share-based compensation. The share-based compensation expense for the period includes costs associated with stock options, restricted stock grants, and the compensatory element of the Employee Stock Purchase Plan.
On March 4, 2008, the Company granted options to purchase 20,000 shares of its common stock. The fair value of each option grant was estimated on the date of grant using the Black-Scholes options pricing model. The weighted-average fair values of each option at the date of grant were $2.67. The weighted average assumptions used in the model for the nine months ended September 30, 2008 were as follows:
| Nine Months Ended | ||||
| September 30, | ||||
| 2008 | ||||
| Risk free interest rate | 1.53 | % | ||
| Expected volatility rate | 92.11 | % | ||
| Expected life — year | 1 | |||
| Dividend yield | — | |||
The risk free interest rate is equal to the U.S. Treasury Bill rate for the auction closest to period end. The expected volatility is calculated from the Company’s daily closing stock price starting with the options grant date and going back one year. The expected life in years is the vesting period of the stock options based on general Company experience that the options will be exercised upon vesting. Though no restricted shares of its common stock were granted, as part of the annual directors’ compensation for 2008, 52,395 shares were issued to five directors during the nine months ended September 30, 2008.
During the nine months ended September 30, 2007, the Company granted no options but did grant 18,800 nonvested restricted shares of its common stock. In addition, 18,881 shares were issued to three directors who retired from the Company’s Board of Directors in February 2007 in settlement of the deferred compensation obligations to these directors and 23,405 shares were issued to five directors as part of the annual directors’ compensation on July 1, 2007.
| NOTE 14 — | INDUSTRY SEGMENTS |
| Three Months Ended | Nine Months Ended | |||||||||||||||
| September 30, | September 30, | |||||||||||||||
| 2008 | 2007 | 2008 | 2007 | |||||||||||||
Revenues from external customers | ||||||||||||||||
| Ammunitions & Weapons Effects | $ | 49,248 | $ | 10,193 | $ | 116,365 | $ | 16,744 | ||||||||
| Electronic Security | 1,565 | 1,054 | 5,165 | 4,829 | ||||||||||||
| $ | 50,813 | $ | 11,247 | $ | 121,530 | $ | 21,573 | |||||||||
Segment profit (loss) before provision for income taxes | ||||||||||||||||
| Ammunitions & Weapons Effects | $ | 53 | $ | (3,050 | ) | $ | 2,840 | $ | (18,351 | ) | ||||||
| Electronic Security | (4,106 | ) | (1,030 | ) | (4,240 | ) | (2,233 | ) | ||||||||
| Corporate | (3,187 | ) | (2,638 | ) | (9,003 | ) | (23,964 | ) | ||||||||
| $ | (7,240 | ) | $ | (6,718 | ) | $ | (10,403 | ) | $ | (44,548 | ) | |||||
18
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
The segment profit (loss) before provision for income taxes includes all revenue and expenses at the subsidiary level excluding any corporate fees passed to the subsidiary in the form of management fees. Corporate includes all expenses of the Corporate office before an allocation of management fees to the subsidiaries.
| NOTE 15 — | PROVISION FOR TAXES |
As required under Accounting Principles Board (“APB”) Opinion No. 28, “Interim Financial Reporting”, the Company has estimated its annual effective tax rate for the full fiscal year 2008 and applied that rate to its income before income taxes in determining its provision for income taxes for the nine months ended September 30, 2008 and 2007. For the three and nine months ended September 30, 2008, the Company’s consolidated annualized effective tax rate was 2% and 5%, respectively. For the three and nine months ended September 30, 2007, the Company’s consolidated annualized effective tax rate was zero for both periods.
The Company adopted FIN 48 on January 1, 2007, which requires financial statement benefits to be recognized for positions taken for tax return purposes when it is more-likely-than-not that the position will be sustained. There has been no change in our financial position and results of operations due to the adoption of FIN 48.
As of January 1, 2007 and September 30, 2008, the Company had no unrecognized tax benefits, nor did it have any that would have an effect on the effective tax rate. Income taxes are provided based on the liability method for financial reporting purposes. No interest or penalties were accrued as of January 1, 2007 as a result of the adoption of FIN 48. For each of the three and nine months ended September 30, 2008 and 2007, there was no interest or penalties recorded or included in tax expense.
In the United States, the Company is still open to examination from 2004 forward. In Belgium, the Company is still open to examination by the Belgian tax authorities from 2005 forward, although carryforward tax attributes that were generated prior to 2003 may still be adjusted upon examination by the Belgian tax authorities if they either have been or will be utilized.
The determination of our consolidated provision for income taxes, deferred tax assets and liabilities, and the related valuation allowance requires management to make certain judgments and estimates. As a company with subsidiaries in foreign jurisdictions, the Company is required to calculate and provide for estimated income tax liabilities for each of the tax jurisdictions in which we operate. This process involves estimating current tax obligations and exposures in each jurisdiction as well as making judgments regarding the future recoverability of deferred tax assets. Changes in the estimated level of annual pre-tax income, changes in tax laws, and changes resulting from tax audits can all affect the overall effective income tax rate which, in turn, impacts the overall level of income tax expense and net income. Judgments and estimates related to the Company’s projections and assumptions are inherently uncertain; therefore, actual results could differ materially from projections.
Currently, the Company has significant net deferred tax assets that have a full valuation allowance in accordance with SFAS No. 109Accounting for Income Taxes. The Company will continue to periodically review the adequacy of the tax valuation allowance and may, at some point in the future based on continued profit, reverse the tax valuation allowance. At December 31, 2007, the Company had US net operating loss carryforwards of $46,705, which will begin to expire in 2010 and foreign NOLs of approximately $79,947, which may be carried forward indefinitely. The Company had foreign tax credits and alternative minimum tax credits of approximately $5,104 and $458, respectively, at December 31, 2007. The foreign tax credits will begin to expire in 2012 and the alternative minimum tax credits do not expire.
See Note 16 — Commitments and Contingencies for disclosure on Belgian tax contingency.
19
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
| NOTE 16 — | COMMITMENTS AND CONTINGENCIES |
There are no material pending legal proceedings, other than ordinary routine litigation to Allied’s business, to which Allied or any of its subsidiaries is a party or to which any of their property is subject.
The Company has entered into consulting and employment agreements with certain management personnel at the Company’s subsidiaries and with certain domestic management personnel. Certain of these agreements provide for severance payments in the event of termination under certain conditions.
The Company’s domestic operations do not provide post employment benefits to its employees. Under Belgian labor provisions, the Company may be obligated for future severance costs for its employees. After giving effect to prior workforce reductions, current workloads, expected levels of future operations, severance policies and future severance costs, post employment benefits are not expected to be material to the Company’s financial position.
Indemnification provisions.
On July 6, 2007, the Company signed a Stock Purchase Agreement to sell SeaSpace for $1,541 in net proceeds. The Stock Purchase Agreement contains certain indemnification provisions pursuant to which the Company may be required to indemnify the buyer for a period subsequent to the completion of the sale for liabilities, losses, costs or expenses arising out of breaches of covenants, certain breaches of representations and warranties and any actions or suits relating to the condition of the business prior to and at the time of sale. Theses indemnification provisions have been capped at $1,000. At September 30, 2008, no amount has been accrued related to this indemnification as a liability is not deemed probable.
On September 6, 2007, ARC Europe, a wholly-owned subsidiary of the Company, entered into a Stock Purchase Agreement to sell The VSK Group for approximately $48,737 in cash subject to a purchase price adjustment to be determined following closing. On September 18, 2007, the Company completed the sale. The Stock Purchase Agreement contains certain indemnification provisions pursuant to which the Company may be required to indemnify the buyer for a period subsequent to the completion of the sale for any and all actions, liabilities, encumbrances, losses, damages, fines, penalties, taxes, fees, costs or expenses or amounts paid in settlement suffered or incurred arising out of any breach of or inaccuracy in any representation or warranties made by the seller or any breach or violation of any covenants or agreements of the Company. An escrow amount of approximately $2,741 was established to satisfy any such claims. The terms of the escrow agreement provide that a portion of the remaining escrow balance in excess of $1,767 will be released on April 1, 2009 with the entire remaining balance released December 31, 2012. At September 30, 2008, the Company has fully reserved the escrow balance as it is uncertain as to the nature and timing of potential future claims, if any. Total indemnification provisions have been capped at $7,900.
In conjunction with the sale of The VSK Group, and pursuant to the terms of employment agreements with The VSK Group’s management team, the Company committed to pay approximately $1,767 (€1,200) as a retention bonus. Of this total retention amount, approximately $674 (€492) was paid in October 2007 and the remainder was paid in September 2008 under the escrow agreement terms.
On January 24, 2008, the Company entered into a Purchase Agreement to sell Titan for $4,750 in cash. The Company completed the sale of Titan on March 17, 2008. The Purchase Agreement contains certain indemnification provisions pursuant to which the Company may be required to indemnify the buyer for a period subsequent to the completion of the sale for losses, liabilities, damages or expenses arising for any breach of covenants, representation or warranties; income tax liabilities existing prior to closing; and violations of environmental laws. The indemnification amount can be as much as the purchase price for certain covenants but generally are capped at $950. At September 30, 2008, no amount has been accrued related to this indemnification as a liability is not deemed probable.
20
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Tax Litigation
As part of its 2004 tax audit with the Belgian tax authorities, the Company recorded a liability of $3,385 and $3,552 at September 30, 2008 and December 31, 2007, respectively, related to tax due on unrealized/realized foreign currency gains as well as associated interest and penalties. The Company is currently negotiating in the Belgian tax court for a workable repayment arrangement to resolve the liability due.
Social Security Litigation
As of September 30, 2008, MECAR had not paid all of its Belgian social security payments related to the first, second and fourth quarters of 2007. Accordingly, the Company has accrued $2,026 and $2,184 at September 30, 2008 and December 31, 2007, respectively, related to past due social security payments which includes associated interest and penalties of $646 and $276, respectively. As of September 30, 2008, MECAR accrued an additional $1,957 for social security payments related to the third quarter of 2008. MECAR has agreed to a payment plan approved by the local authorities and expects to have repaid the entire past due balance by December 31, 2008. MECAR began making its payments in 2008 and through October MECAR has paid approximately $12,579 in social security payments ($6,451, net of foreign exchange loss of $329 for 2007 and $6,128, net of foreign exchange loss of $313, for the first, second and third quarter of 2008), which leaves $3,983 as the total outstanding balance relating to Belgian social security.
| NOTE 17 — | DISCONTINUED OPERATIONS |
The Consolidated Financial Statements and related note disclosures reflect SeaSpace, The VSK Group, CMS Security Systems, Titan Dynamic Systems, Inc. and Global Microwave Systems, Inc. as “Long-Lived Assets to be Disposed of by Sale” for all periods presented in accordance with SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets. Accordingly, our results of operations for all periods presented have been reclassified to reflect SeaSpace, The VSK Group, CMS Security Systems, Titan Dynamic Systems, Inc. and Global Microwave Systems, Inc. as discontinued operations in the consolidated statement of operations and the assets and liabilities of such entities have been reclassified as held for sale in the consolidated balance sheets for all periods presented.
SeaSpace Corporation
In the first quarter of 2007, the Company committed to a formal plan to sell SeaSpace, which has previously been reported in the Other segment, as part of management’s plan to dispose of certain non-strategic assets of the Company. At March 31, 2007, the Company recorded a loss of $3,878 to write down SeaSpace’s assets to fair value less costs to sell based on nonbinding offers received from potential buyers during the first quarter of 2007. The loss accrual reflects the write-off of intangible assets including goodwill.
On July 6, 2007, the Company signed a Stock Purchase Agreement to sell SeaSpace for $1,500 in cash. The transaction closed on July 23, 2007 and generated proceeds of $1,541, net of costs to sell of $109. No gain or loss was recognized on the closing date as the loss recorded on March 31, 2007 to write down SeaSpace’s assets to fair value less cost to sell, was adjusted on July 6, 2007 to reflect the higher sales price of the Stock Purchase Agreement. The Company did not record a significant tax expense or benefit from this transaction.
The VSK Group
In the third quarter of 2007, the Company committed to a formal plan to sell The VSK Group, which has previously been reported in the Electronic Security segment, as part of management’s continuing plan to dispose of certain non-strategic assets of the Company and reduce debt and improve the Company’s liquidity.
On September 6, 2007, ARC Europe, a wholly-owned subsidiary of the Company, entered into a Stock Purchase Agreement to sell The VSK Group for approximately $48,737 in cash subject to a purchase price
21
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
adjustment to be determined following closing. The transaction closed on September 18, 2007 and generated net proceeds of $41,843. The sales price was adjusted for disposal costs which included a working capital adjustment of $62, funds held in escrow of $2,741, investment banking and legal fees of $1,730, management retention and incentive plans of $1,645 and a final purchase price adjustment of $716. The Stock Purchase Agreement requires a total of $2,741 be held in escrow to provide for certain indemnifications as stated for the Stock Purchase Agreement. At this time, the Company is not certain of all contingencies that will be identified and whether it will be able to receive any portion of the $2,741 balance. The Stock Purchase Agreement contains certain indemnification provisions pursuant to which the Company may be required to indemnify the buyer for a period subsequent to the completion of the sale for any and all actions, liabilities, encumbrances, losses, damages, fines, penalties, taxes, fees, costs or expenses or amounts paid in settlement suffered or incurred arising out of any breach of or inaccuracy in any representation or warranties made by the seller or any breach or violation of any covenants or agreements of the Company. Accordingly, such amount has not been included in the determination of the gain on sale. If these potential contingencies are resolved in favor of the Company, the additional consideration received will serve to increase the Company’s gain on the sale of The VSK Group. A gain of $29,314 was recorded at September 18, 2007. In accordance with SFAS No. 52:Foreign Currency Translation, the gain included $4,448 of accumulated foreign currency translation gains related to The VSK Group. The Company did not record a significant tax expense or benefit from this transaction as the gain is expected to be offset by the Company’s existing net operating loss carryforwards.
CMS Security Systems
CMS Security Systems (CMS) was originally a wholly-owned subsidiary of The VSK Group, but was not included as part of its sale. With the sale of The VSK Group, CMS became a wholly-owned subsidiary of ARC Europe. The Company committed to a plan to sell CMS Security Systems in the third quarter of 2007 as part of the decision to dispose of The VSK Group. Accordingly, the Company recorded a loss of $594 to write-off all CMS Security Systems’ remaining assets. CMS was sold to The VSK Group on January 1, 2008 for minimal consideration.
Titan Dynamics Systems, Inc.
On October 22, 2007, the Company committed to a formal plan to sell Titan, which has been previously reported in the Ammunitions & Weapons Effects segment, as part of management’s continuing plan to dispose of certain non-strategic assets of the Company. At September 30, 2007, the Company recorded a loss of $1,395 to write down Titan’s assets to fair value less costs to sell based on a nonbinding offer received from a potential buyer during the fourth quarter of 2007. On January 24, 2008, the Company entered into a Purchase Agreement to sell Titan for $4,750 in cash. An additional loss of $1,300 was recorded to reflect additional costs to sell including a separation agreement with a former Titan employee as well as additional funding provided up to the date of sale. The loss accrual reflects the write-off of Titan’s intangible assets including goodwill. The transaction closed on March 17, 2008 and generated proceeds of $2,433, net of costs to sell of $2,317. The Company did not record a significant tax expense or benefit from this transaction.
Global Microwave Systems, Inc.
On August 14, 2008, the Company committed to a formal plan to sell GMS, which has been previously reported in the Electronic Security segment. On August 19, 2008, the Company entered into a Asset Purchase Agreement to sell substantially all of the assets of GMS for $26,000 subject to a final working capital adjustment to be determined following closing. The transaction closed on October 1, 2008 and generated net proceeds of $21,100. The sales price was adjusted for disposal costs which included funds held in escrow of $2,500, investment banking and legal fees of $985 and management retention and incentive plans of $1,415. The Asset Purchase Agreement requires a total of $2,500 be held in escrow to provide for certain indemnifications as stated for in the Asset Purchase Agreement. At this time, the Company is not certain of all contingencies that will be
22
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
identified and whether it will be able to receive any portion of the $2,500 balance. The Asset Purchase Agreement contains certain indemnification provisions pursuant to which the Company may be required to indemnify the buyer for a period subsequent to the completion of the sale of any and all liabilities, losses, claims, damages, diminution of value or other costs and expenses paid by the buyer arising out any breach or inaccuracy of any representations or warranties made by the seller or any breach or violation of any covenants or agreements of the Company. Accordingly, such amount has not been included in the determination of the gain on sale. If these potential contingencies are resolved in favor of the Company, the additional consideration received will increase the Company’s gain on sale of GMS. The Company expects to record a gain of approximately $2,350, net of tax, in the fourth quarter of 2008, as a result of the October 1, 2008 sale of GMS.
In accordance with the terms of the Asset Purchase Agreement, the Company was required to repay the outstanding principal balance and any unpaid accrued interest due on a $6,700 loan entered into on November 1, 2005 to fund the acquisition of GMS. This loan had no significant covenants and was originally payable in installments over three years bearing interest at the rate of 7.5% per year payable quarterly. The outstanding principal balance of the loan was $3,350 at both September 30, 2008 and December 31, 2007. The unamortized discount of the loan was $10 and $98 at September 30, 2008 and December 31, 2007, respectively. On October 1, 2008, the Company repaid the outstanding principal loan balance of $3,350 and unpaid accrued interest of $42 and expensed the remaining unamortized discount of $10.
At September 30, 2008 and December 31, 2007, there were no assets and liabilities held for sale for The VSK Group, SeaSpace, or CMS as The VSK Group and SeaSpace transactions had been completed and CMS was fully written off in the quarter ended September 30, 2007. At September 30, 2008, there were no assets and liabilities held for sale for Titan as the Titan transaction had been completed. The following is a summary of assets and liabilities classified as held for sale at September 30, 2008 and December 31, 2007, respectively:
| September 30, 2008 | December 31, 2007 | |||||||||||||||
| GMS | GMS | Titan | Total | |||||||||||||
| Cash | $ | — | $ | — | $ | 74 | $ | 74 | ||||||||
| Accounts receivable, net | 1,758 | 2,375 | 714 | 3,089 | ||||||||||||
| Inventories, net | 2,689 | 2,678 | 2,219 | 4,897 | ||||||||||||
| Other assets | 13,648 | 14,525 | 1,592 | 16,117 | ||||||||||||
| Assets held for sale | $ | 18,095 | $ | 19,578 | $ | 4,599 | $ | 24,177 | ||||||||
| Accounts payable | $ | 388 | $ | 437 | $ | 883 | $ | 1,320 | ||||||||
| Accrued liabilities | 73 | 90 | 241 | 331 | ||||||||||||
| Customer deposits | — | — | 922 | 922 | ||||||||||||
| Other liabilities | 3,340 | 3,252 | 5 | 3,257 | ||||||||||||
| Liabilities held for sale | $ | 3,801 | $ | 3,779 | $ | 2,051 | $ | 5,830 | ||||||||
The following discloses the results of discontinued operations for the three and nine months ended September 30, 2008 for Titan and GMS:
| For the Three Months Ended September 30, 2008 | ||||||||||||
| Titan | GMS | Total | ||||||||||
| Revenues | $ | — | $ | 4,425 | $ | 4,425 | ||||||
| Income (loss) before taxes | — | 1,194 | 1,194 | |||||||||
| Income (loss), net of tax | — | 1,194 | 1,194 | |||||||||
| Discontinued operations, net of tax | $ | — | $ | 1,194 | $ | 1,194 | ||||||
23
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
| For the Nine Months Ended September 30, 2008 | ||||||||||||
| Titan | GMS | Total | ||||||||||
| Revenues | $ | 668 | $ | 10,083 | $ | 10,751 | ||||||
| Income (loss) before taxes | (142 | ) | 2,320 | 2,178 | ||||||||
| Income (loss), net of tax | (142 | ) | 2,319 | 2,177 | ||||||||
| Gain on sale of subsidiaries, net of tax | 113 | — | 113 | |||||||||
| Discontinued operations, net of tax | $ | (29 | ) | $ | 2,319 | $ | 2,290 | |||||
The following discloses the results of discontinued operations for the three and nine months ended September 30, 2007:
| For the Three Months Ended September 30, 2007 | ||||||||||||||||||||||||
| The VSK | CMS Security | |||||||||||||||||||||||
| Group | Systems | SeaSpace | Titan | GMS | Total | |||||||||||||||||||
| Revenues | $ | 6,077 | $ | 94 | $ | 100 | $ | 604 | $ | 2,591 | $ | 9,466 | ||||||||||||
| Income (loss) before taxes | 1,243 | (737 | ) | (423 | ) | (1,940 | ) | 614 | (1,243 | ) | ||||||||||||||
| Income (loss), net of tax | 901 | (737 | ) | 381 | (1,940 | ) | 614 | (781 | ) | |||||||||||||||
| Gain on sale of subsidiaries, net of tax | 29,774 | — | — | — | — | 29,774 | ||||||||||||||||||
| Discontinued operations, net of tax | $ | 30,675 | $ | (737 | ) | $ | 381 | $ | (1,940 | ) | $ | 614 | $ | 28,993 | ||||||||||
| For the Nine Months Ended September 30, 2007 | ||||||||||||||||||||||||
| The VSK | CMS Security | |||||||||||||||||||||||
| Group | Systems | SeaSpace | Titan | GMS | Total | |||||||||||||||||||
| Revenues | $ | 22,719 | $ | 146 | $ | 2,947 | $ | 4,215 | $ | 6,465 | $ | 36,492 | ||||||||||||
| Income (loss) before taxes | 3,297 | (974 | ) | (5,087 | ) | (2,247 | ) | 368 | (4,643 | ) | ||||||||||||||
| Income (loss), net of tax | 2,194 | (974 | ) | (4,284 | ) | (2,252 | ) | 367 | (4,949 | ) | ||||||||||||||
| Gain on sale of subsidiaries, net of tax | 29,774 | — | — | — | — | 29,774 | ||||||||||||||||||
| Discontinued operations, net of tax | $ | 31,968 | $ | (974 | ) | $ | (4,284 | ) | $ | (2,252 | ) | $ | 367 | $ | 24,825 | |||||||||
| NOTE 18 — | SUBSEQUENT EVENTS |
Sale of GMS
On October 1, 2008, the Company completed the sale of substantially all the assets and business of GMS. The sale was completed in accordance with the terms and conditions of the Asset Purchase Agreement dated as of August 19, 2008 and generated net proceeds of $21,100. In accordance with the terms of the Asset Purchase Agreement, the Company repaid the entire outstanding balance of a loan entered into in 2005 to fund the acquisition of GMS. On October 1, 2008, the Company repaid $3,392 which consisted of $3,350 in principal and $42 in unpaid accrued interest. In accordance with the requirements under the Amended and Restated Senior Secured note holders’ agreement, the Company offered $10,908 of the net proceeds from the GMS sale to the note holders. All four note holders elected to receive their share of the net proceeds and on October 4 through October 14, 2008, the Company repaid $10,908 of the outstanding principal, thereby reducing the Company’s debt and the potential number of common shares the Company may have to issue upon conversion of the Notes.
24
The Allied Defense Group, Inc.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Sale of NSM
In the fourth quarter of 2008, the Company committed to a formal plan to sell NSM, which has been previously reported in the Electronic Security segment. The Company is in negotiations with prospective purchasers. Based on such negotiations and nonbinding offers received during the third quarter of 2008, the Company recorded a goodwill impairment of $3,495 during the third quarter of 2008 to write down NSM’s assets to estimated fair value less costs to sell.
The Company expects to reclassify NSM as discontinued operations in the fourth quarter of 2008. The carrying amounts of the assets and liabilities of NSM as of September 30, 2008 and December 31, 2007 are as follows:
| September 30, | December 31, | |||||||
| 2008 | 2007 | |||||||
| Cash | $ | 284 | $ | 99 | ||||
| Accounts receivable, net | 1,668 | 2,449 | ||||||
| Inventories, net | 1,133 | 1,078 | ||||||
| Other assets | 970 | 4,722 | ||||||
| Assets held for sale | $ | 4,055 | $ | 8,348 | ||||
| Accounts payable | $ | 254 | $ | 815 | ||||
| Accrued liabilities | 510 | 516 | ||||||
| Customer deposits | — | 169 | ||||||
| Other liabilities | 131 | 74 | ||||||
| Liabilities held for sale | $ | 895 | $ | 1,574 | ||||
Senior Secured Convertible Notes
As described in Note 8 of the condensed consolidated financial statements, the Company’s Convertible Notes have a put feature that allows the holders to put the notes back to the Company on December 26, 2008and/or January 19, 2009 based on the date of issuance. As permitted by the provisions of the Company’s Convertible Notes, on October 10 through 14, 2008, the Company received notices from all four of its Note holders requiring the Company to redeem all of the outstanding Notes at face value on December 26, 2008 and January 19, 2009. The Company is required to redeem $8,039 on December 26, 2008 and $928 on January 19, 2009.
25
The Allied Defense Group, Inc.
AND RESULTS OF OPERATIONS
September 30, 2008
(Thousands of Dollars)
(Unaudited)
Overview
Allied is a strategic portfolio of defense and security businesses, with presence in worldwide markets, offering both government and commercial customers’ leading edge products and services. The Company has two reporting segments, the Ammunition & Weapons Effects (AWE) segment and the Electronic Security (ES) segment. In addition, the Company had a third, Other segment, that solely consisted of the Company’s SeaSpace subsidiary. In July 2007, September 2007, March 2008 and October 2008, the Company sold SeaSpace, The VSK Group, Titan and GMS, respectively. Accordingly, the results of operations, financial position and cash flows of SeaSpace, The VSK Group, Titan and GMS, have been reported as discontinued operations for all periods presented and are eliminated from the segment discussion provided below. Headquarters expenses are reported separately on the segment reporting schedules.
The AWE segment provides conventional ammunition and other training devices to the U.S. military and 30 countries worldwide, dealing with defense departments or ministries of defense in US/European Community approved sovereign entities. The ES segment encompasses a wide range of fixed and deployable systems and equipment used to address today’s security and surveillance requirements in the U.S. The ES segment markets its products to governments, law enforcement, and commercial security personnel. In addition to having distinct differences in client base and application of products, the production processes of the segments are distinct.
| • | Ammunition & Weapons Effectssegment consists of MECAR, located in Belgium, and MECAR USA, located in Marshall, TX. MECAR develops and produces medium caliber, tank, mortar and other ammunition. MECAR USA became operational in late 2005 and pursues contracts from U.S. and foreign governments for ammunition and pyrotechnics devices with a focus on the 105MM market. More recently, MECAR USA has begun purchasing and selling weapon systemsand/or ammunition manufactured by others, in the form of procurement contracts for the benefit of the U.S government and other foreign governments. | |
| • | Electronic Securitysegment consists of News Sports Microwave (NSM) located near San Diego, California. NSM designs, manufactures, installs and services industrial and law enforcement surveillance products and integrated systems for the law enforcement community and agencies of the Department of Homeland Security and the Department of Defense. |
Allied, the parent Company, provides management, business development and related services to its subsidiaries and has no operating activities.
The Company continues to evaluate it strategic options. The Company sold GMS to be in a position to satisfy the “put” of its senior secured convertible notes which will be made in December 2008 and January 2009, as discussed below. The Company has committed to a plan to sell NSM. In addition, the Board of Directors of the Company is evaluating a possible disposition of all operating units of the Company and the return of the net remaining proceeds to the shareholders. The Directors of the Board continue to evaluate the future plans for the Company, and will continue to evaluate the alternatives to maximizing shareholder value through either the divestiture process or a more focused, cohesive business strategy centered on the MECAR and MECAR USA business.
Liquidity and Capital Resources
As described in the Company’sForm 10-K filed for December 31, 2007, the Company encountered liquidity difficulties in 2006 and 2007. The liquidity position improved markedly in the third and fourth quarters of 2007, but the Company encountered some liquidity challenges in the summer months of 2008 as
26
MECAR performed on its increased backlog and was limited in its ability to ship product to its largest customer during the summer months of June through August.
The Company has two significant liquidity challenges in the coming months. MECAR must reconstitute its credit facility and the Company must repay the outstanding balances of its senior secured convertible notes. The Company believes it will meet these challenges and upon doing so, the Company will have substantially reduced its indebtedness.
The Company is uncertain at this time what impact the current financial crisis will have on its ability to refinance the MECAR credit facility. The Company has had current discussions with MECAR’s existing bank group to refinance the credit facility but no formal agreement has been reached at this date.
In April 2008, MECAR reached an agreement with its existing bank group regarding its credit facility. The agreement provides for an expansion of the total credit facility from approximately $61,914 (€42,850) to $65,924 (€45,625). The credit facility was restructured and the portion designated for tax prepayments was terminated. The agreement provides for a cash line of $14,738 (€10,200) and performance bond and advance payment guarantee line of $51,186 (€35,425). The agreement required a partial repayment of MECAR’s cash line of $7,369 (€5,100) in July 2008 and the remainder to be repaid by November 30, 2008. The performance bond and advance payment guarantee line expires on December 31, 2008, although the existing outstanding performance bonds and advance payment guarantees will be in place until their intended maturity. After that date the Company will be unable to issue any new performance bonds or advance payment guarantees without a new credit facility. Based on the timing of MECAR’s shipments in July 2008, the Company was unable to repay half of the cash line by July 31, 2008, but subsequently made the required repayments to the banking facility in the third quarter of 2008. Based on cash flow projections, the Company believes its MECAR subsidiary will be able to repay the remaining $7,369 (€5,100) by November 30, 2008 with cash generated from operations. MECAR has shipments of approximately $52,258 (€36,167) which have occurred and are projected for the balance of the fourth quarter of 2008 to its largest client that will allow the subsidiary to generate cash in the fourth quarter in addition to other operating activities that will generate cash.
In addition, in April 2008, MECAR’s bank group received local government support that will guarantee an additional portion of MECAR’s performance bonds and advance payment guarantees from May through November 2008. This additional guarantee will reduce the required restricted cash balances at MECAR and allow the Company to fund MECAR through its critical working capital expansion period. This agency began guaranteeing approximately 50% of MECAR’s new performance bonds and advance payment guarantees in July 2007.
The Company in is discussions with members of the existing MECAR bank facility and other financial institutions to replace the existing credit facility. The anticipated new credit facility will have both a revolving cash line facility and performance bond and advance payment guarantee line like the existing facility. The Company may look to expand the size of the performance bond and advance payment guarantee line to meet its projected requirements. The refinancing of the credit facility, in some form, is critical to the Company’s ability to continue operations. Initial interest in establishing a new banking relationship has been expressed by certain existing bank group members although specific terms have not been documented at this time.
As of September 30, 2008, the principal outstanding balance of the Convertible Notes was $19,876. From October 4 through 14, 2008, the Company repaid $10,908 of the Convertible Notes with the proceeds of the GMS sale as required by terms of the agreement. In addition, as described in Note 8 of the condensed consolidated financial statements, the Company’s Convertible Notes have a put feature that allows the holders to put the notes back to the Company on December 26, 2008and/or January 19, 2009 based on the date of issuance. As permitted by the provisions of the Company’s Convertible Notes, on October 10 through 14, 2008, the Company received notices from all four of its note holders requiring the Company to redeem all of the outstanding Notes at face value on December 26, 2008 and January 19, 2009. The Company is required to redeem $8,039 on December 26, 2008 and $928 on January 19, 2009. The Company will use the remaining GMS proceeds, its existing cash balances, and cash generated from operations, as needed, to repay the Convertible Notes.
At September 30, 2008, the Company had $5,093 in cash on hand. The Company had a net loss of $8,609 for the nine months ended September 30, 2008. A substantial portion of these charges were of a non-
27
cash nature. For the nine months ended September 30, 2008, the Company used $21,338 of cash for operating activities from continuing operations mainly related to increases in accounts receivable and costs and accrued earnings on uncompleted contracts at MECAR as it performs on its substantial backlog. The Company does not anticipate continuing to use cash at this level for the remainder of 2008 as MECAR will increase its billings as the contracts in progress are shipped and generate cash collections from accounts receivable in the fourth quarter of 2008.
In general, the Company believes that it has adequate cash sources to fund operations for the remainder of 2008 based on its strong current backlog and its history of performing on a profitable basis when backlog is substantial. The Company believes it will have adequate cash to meet the convertible note holders “put” in December 2008 and January 2009. As noted above, management has begun the process of securing a long-term credit facility solution for MECAR. Management believes, based on MECAR’s historic performance when it has substantial backlog as well as its operating performance since the fourth quarter of 2007, that adequate opportunities will be available to finalize a long-term solution for the Company’s credit needs.
While the Company is looking to secure long-term MECAR financing and be able to satisfy the put feature on its Convertible Notes, there can be no assurance that:
| • | The Company will be successful securing MECAR’s long-term financing. | |
| • | The Company will be successful generating adequate cash at its MECAR subsidiary in the fourth quarter of 2008 to repay its existing credit facility. | |
| • | The Company will be successful in taking necessary steps to be in a position to satisfy the “put” of its senior secured convertible notes which will be made in December 2008 and January 2009. | |
| • | The Company will be successful in its restructuring and turnaround efforts at its subsidiaries. | |
| • | The Company will be able to meet the financial debt covenants of its debt instruments. |
The Company has less than $200 of firm commitments for capital expenditures outstanding as of September 30, 2008.
Overview Results
Allied had a net loss of $6,220 in the three months ended September 30, 2008 as compared to net income of $22,283 in the three months ended September 30, 2007. In the nine months ended September 30, 2008, Allied had a net loss of $8,609 as compared to a net loss of $19,726 for the comparable period in 2007. The 2008 loss includes three non cash items: a charge for impairment of goodwill and long-lived assets, losses relating to changes in fair value of its participating forward European currency contracts and a change in the fair value of convertible notes and warrants. In the three months ended September 30, 2008, these items accounted for $5,361 of the $6,220 loss.
The net loss from continuing operations before income taxes was $7,240 for the three months ended September 30, 2008 as compared to a net loss from continuing operations before income taxes of $6,718 for the comparable period in 2007. The increase in net loss for the three months ended September 30, 2008 was negatively impacted by a charge for the impairment of goodwill and long-lived assets of $3,957, an increase in the other expenses mainly resulting from foreign currency fluctuations of $2,136 and a fluctuation in the change in the fair value of notes and warrants of $1,235. These fluctuations were offset by improved operating results at the AWE segment.
The net loss from continuing operations before income taxes was $10,403 for the nine months ended September 30, 2008 as compared to $44,548 for the comparable period in 2007. The decrease in loss from continuing operations before income taxes in 2008 resulted from improved operating performance mainly at AWE segment and reduced restructuring and refinancing activities and interest expense associated with the senior convertible notes. In addition, the net loss on the fair value of senior convertible notes and warrants was $6,686 in 2007 as compared to $682 in the current period.
In July 2007, MECAR announced that it had successfully negotiated several new orders with various clients in Asia, Europe, North America and other export markets, with a total expected value exceeding $170,000 over a three year period. In addition, in February 2008, the Company announced the award of an
28
additional multi-year contract at MECAR for $43,500. The backlog at MECAR was $156,134 at September 30, 2008 as compared to $127,608 at September 30, 2007. The backlog at MECAR USA has grown to $12,229 at September 30, 2008 as compared to $884 at September 30, 2007, driven by new procurement contracts. On a consolidated basis, the Company had firm committed backlog of $169,744 and additional unfunded backlog of $19,724 at September 30, 2008.
The Company’s results were significantly affected by the foreign exchange impact on the operations of the Company’s Euro-based business units. All Euro-based results of operations were converted at the average 2008 and 2007 exchange rates of 1.52254 and 1.34454, U.S. Dollar to 1 Euro, respectively.
Results of Operations for the Three Months Ended September 30, 2008 and 2007
| Three Months Ended September 30, | ||||||||||||||||
| 2008 | 2007 | |||||||||||||||
| Amount | % | Amount | % | |||||||||||||
| Revenue | $ | 50,813 | 100.0 | % | $ | 11,247 | 100.0 | % | ||||||||
| Cost and expenses | ||||||||||||||||
| Cost of sales | 44,078 | 86.8 | 10,938 | 97.3 | ||||||||||||
| Selling and administrative | 5,678 | 11.2 | 5,962 | 53.0 | ||||||||||||
| Research and development | 683 | 1.3 | 599 | 5.3 | ||||||||||||
| Impairment of goodwill and long-lived assets | 3,957 | 7.8 | — | — | ||||||||||||
| Operating loss | (3,583 | ) | (7.1 | ) | (6,252 | ) | (55.6 | ) | ||||||||
| Other income (expense) | ||||||||||||||||
| Interest income | 103 | 0.2 | 75 | 0.6 | ||||||||||||
| Interest expense | (1,432 | ) | (2.8 | ) | (1,584 | ) | (14.1 | ) | ||||||||
| Gain (loss) from fair value of notes and warrants | (155 | ) | (0.3 | ) | 1,080 | 9.6 | ||||||||||
| Other — net | (2,173 | ) | (4.3 | ) | (37 | ) | (0.3 | ) | ||||||||
| Loss from continuing operations before income taxes | (7,240 | ) | (14.3 | ) | (6,718 | ) | (59.8 | ) | ||||||||
| Income tax expense (benefit) | 174 | 0.3 | (8 | ) | (0.1 | ) | ||||||||||
| Net loss from continuing operations, net of tax | (7,414 | ) | (14.6 | ) | (6,710 | ) | (59.7 | ) | ||||||||
| Gain on sale of subsidiaries, net of tax | — | — | 29,774 | 264.7 | ||||||||||||
| Income (loss) from discontinued operations, net of tax | 1,194 | 2.4 | (781 | ) | (6.9 | ) | ||||||||||
| Income from discontinued operations, net of tax | 1,194 | 2.4 | 28,993 | 257.8 | ||||||||||||
| Net Income (loss) | $ | (6,220 | ) | (12.2 | )% | $ | 22,283 | 198.1 | % | |||||||
Revenue. The table below shows revenue by segment for the three months ended September 30, 2008 and 2007, respectively. Allied had revenue of $50,813 during the current period, which was 352% higher than its revenue in the same period of 2007.
| Revenue by Segment | ||||||||||||||||
| Three Months Ended | Three Months Ended | |||||||||||||||
| September 30, 2008 | September 30, 2007 | |||||||||||||||
| Percentage | Percentage | |||||||||||||||
| Amount | of total | Amount | of total | |||||||||||||
| Ammunitions & Weapons Effects | $ | 49,248 | 97 | % | $ | 10,193 | 91 | % | ||||||||
| Electronic Security | 1,565 | 3 | 1,054 | 9 | ||||||||||||
| Total | $ | 50,813 | 100 | % | $ | 11,247 | 100 | % | ||||||||
The Ammunition & Weapons Effects (AWE) segment revenue for the three months ended September 30, 2008 increased $39,055 (383%) from the prior period mainly due to a higher volume of MECAR contracts in process due to increased orders received in July 2007 and in 2008. AWE segment revenues for the three
29
months ended September 30, 2008 included $32,213 of revenues from MECAR and $17,035 of revenues from MECAR USA as compared to $9,117 of revenues from MECAR and $1,076 in revenue at MECAR USA in the prior period. The 2008 revenue for MECAR USA has increased significantly based on a receipt of several new procurement contracts in 2008. Since its inception in late 2005, MECAR USA had been participating in numerous bids for procurement contracts that require the Company to supply ammunition manufactured by other parties. In late 2007 and February 2008, MECAR USA was successful in receiving several of these contracts and has grown revenue levels in the current period.
Revenue for the Electronic Security (ES) segment for the three months ended September 30, 2008 increased $511 (48%) from the prior comparable period of 2007. The increase of $511 in NSM revenue was primarily due to receipt of orders from government customers for frequency reallocation equipment upgrades. The growth experienced by NSM was mainly attributable to the Commercial Spectrum Enhancement Act, which was signed into law in December 2004. Under this law the U.S government sold portions of the radio frequency spectrum used by Federal agencies to commercial wireless companies. This sale forced those agencies to vacate the spectrum that they had historically used, and upgrade systems and equipment to migrate to a new frequency for their operations. The cost of the upgrades is being borne by the commercial wireless carriers.
Cost of Sales. Cost of sales, as a percentage of revenue, for the three months ended September 30, 2008, was 87% compared to 97% for the same period in 2007. Gross profit (loss), as a percentage of revenues, was 13% and 3% for the three months ended September 30, 2008 and 2007, respectively.
| Cost of Sales as a Percentage of Revenue by Segment | ||||||||||||||||
| Three Months Ended | Three Months Ended | |||||||||||||||
| September 30, 2008 | September 30, 2007 | |||||||||||||||
| Percentage of | Percentage of | |||||||||||||||
| Amount | Segment Revenue | Amount | Segment Revenue | |||||||||||||
| Ammunitions & Weapons Effects | $ | 42,851 | 87 | % | $ | 9,769 | 96 | % | ||||||||
| Electronic Security | 1,227 | 78 | 1,169 | 111 | ||||||||||||
| Total | $ | 44,078 | 87 | % | $ | 10,938 | 97 | % | ||||||||
Cost of sales for the AWE segment was $42,851 (87% of segment revenue) in 2008 as compared to $9,769 (96% of segment revenue) in 2007. The change in cost of sales for the three months ended September 30, 2008 resulted primarily from higher sales activity at MECAR and MECAR USA. In 2007, MECAR’s cost of sales were almost equal to revenues as a result of a low level of revenues on MECAR’s fixed cost structure. Current period results were negatively impacted by overtime pay and shift premiums that were required to be paid based on supply chain issues at MECAR in order to deliver contracts on a timely basis. Most sales contracts at MECAR have penalties associated with late delivery. In addition, in the current period MECAR recorded $589 in contract loss provision related to specific products that are included in a significant sales contract that became funded in September 2008. The revised estimated costs of those non-standard products, after allocating all appropriate overhead costs, would result in a loss thereby requiring MECAR to record a loss provision at this point in time. Gross profit for the AWE segment was $6,397 (13% of segment revenue) in 2008 as compared to gross profit of $424 (4% of segment revenue) in the prior period. Gross profit for the three months ended September 30, 2008 consisted of $5,429 from MECAR and $968 from MECAR USA, as compared to gross profit of $70 from MECAR and $354 from MECAR USA in the prior period. The difference between MECAR and MECAR USA’s margin rates mainly resulted from in-house manufacturing that made up most of the MECAR’s revenue as compared to procurement contracts at MECAR USA that have lower margin. MECAR’s gross profit rate in the current period was 17% as MECAR USA’s margin rate was 6% in the current period.
Cost of sales for the ES segment, consisting of NSM, was $1,227 (78% of segment revenue) in 2008 as compared to $1,169 (111% of segment revenue) in 2007. Gross profit for NSM was $338 (22% of segment revenue) in 2008 as compared to a gross loss of $115 (11% of segment revenue) in 2007. The improvement of gross profit for the three months period in 2008 was a result of an increased sales volume at NSM and reduced fixed operating costs, including the outsourcing of manufacturing.
30
Overall, most of the Company’s subsidiaries operate with a relatively high fixed cost structure. As a result, reduced revenue levels can have an unfavorable impact on profitability. The Company is focused on reducing these breakeven points wherever it can — on both a tactical and strategic level and is investing in business development and sales and marketing programs to ensure sales stay above break-even levels.
Selling and Administrative Expenses. Selling and Administrative (SA) expenses as a percentage of revenue were 11% and 53% for the three months ended September 30, 2008 and 2007, respectively. SA expenses for the three months ended September 30, 2008 consisted of $2,740 from the AWE segment, $801 from the ES segment and $2,137 from the Corporate segment as compared to expenses of $2,373 from the AWE segment, $714 from the ES segment and $2,875 from the Corporate segment in the prior period.
The increase of $367 in the AWE segment was mainly due to a higher level of spending for professional services related to restructuring activities at MECAR and a higher level of operating activity at both MECAR and MECAR USA in the current period. The increase in the ES segment was attributable to a provision taken for bad debts in the current period. The decrease of $738 in the Corporate segment resulted from reduced spending in staffing, legal and professional costs.
The Company is focused on reducing administrative costs across all business segments. It is focused on significant reductions in corporate expenses as restructuring consultants have been reduced in 2008.
Research and Development. Research and development (R&D) costs increased $84 or (14)% for the three months ended September 30, 2008 from 2007 levels. This increase was attributable to overall increase in cost on R&D projects in the current period. The Company had more technical resources focused on Research and Development (R&D) during the three months ended September 30, 2008. Research and development expenses are incurred at MECAR where there is a full time staff of engineers available for projects.
Impairment of Goodwill and Long-Lived Assets. In the fourth quarter of 2008, the Company committed to a formal plan to sell NSM. The Company is in negotiations with prospective purchasers. Based on such negotiations and nonbinding offers received during the third quarter of 2008, the Company, on September 30, 2008, recorded a loss of $3,495 to write down NSM’s assets to fair value less costs to sell. In addition, on September 30, 2008, the Company recorded $462 in impairment charges for long-lived assets related to the Company’s ERP computer system. As the Company has reduced its head count as a result of selling a number of its subsidiaries, the Company determined that the carrying value of the ERP system exceeds its fair value.
Interest Income. Interest income for the three months ended September 30, 2008 increased by $28 from 2007 levels. The increase in interest income was a result of having higher average cash levels in 2008 compared to prior comparable period’s cash levels in 2007.
Interest Expense. Interest expense for the three months ended September 30, 2008 was $1,432 as compared to prior period expense of $1,584. This decrease was mainly due to an overall lower Corporate interest expense of $473 based on the reduced outstanding debt at Corporate in 2008. In October 2007, with the proceeds of The VSK Group sale, the Company repaid $19,949 of the Notes that were issued in June and July 2007. Current period results were negatively impacted by $321 of increased interest expense at MECAR associated with higher borrowing and increased financing charges associated with MECAR’s short term restructuring of its credit facility.
Net Loss on fair value of the senior convertible notes and warrants. For the three months ended September 30, 2008, the Company recognized net loss of $155 related to the fair value of the Notes and warrants as compared to the a net gain of $1,080 for the comparable period in 2007. The change in the fair value of the Notes and warrants is due primarily to the change in the Company’s closing stock price, the volatility of the Company’s stock price during the period and the redemption features of the Notes relative to the Company’s announced subsidiary asset sales. On September 30, 2008, the Company’s stock closed at $6.10 per common share as compared to $7.88 per common share on September 30, 2007. See Note 8 for a description of these instruments.
Other — Net. Other — net for the three months ended September 30, 2008 increased to a loss of $2,173 from a loss of $37 in the prior period. This unfavorable result was associated with MECAR’s foreign currency transactions. Approximately $1,249 of this loss is attributed to unrealized losses from the change in fair value of its participating forward European currency contracts. MECAR had participating forward European currency
31
contracts in place mainly for a significant U.S. Dollar denominated sales contract that spans over the next four years. This sales contract was reported in the funded backlog and at the signing of the sales contract MECAR entered into the forward currency contract to protect MECAR’s anticipated profitability on these contracts. Subsequent to entering into the forward currency contract, the USD value has improved, thereby yielding unrealized losses on an interim basis relative to the life of the forward contract. As the Company does not designate these contracts as fair value or cash flow hedges, changes in fair value must be as reported in the statement of operations on a quarterly basis. Other currency losses reported in the period of $930 represents the impact of other foreign currency transactions at MECAR.
Pre-Tax Income (Loss)
The table below shows the pre-tax income (loss) by segment for the three months ended September 30, 2008 as compared to the same period in prior year.
| Pre-Tax Income (Loss) by Segment | ||||||||||||||||
| Three Months Ended | Three Months Ended | |||||||||||||||
| September 30, 2008 | September 30, 2007 | |||||||||||||||
| Percentage of | Percentage of | |||||||||||||||
| Amount | Total Revenue | Amount | Total Revenue | |||||||||||||
| Ammunitions & Weapons Effects | $ | 53 | — | % | $ | (3,050 | ) | (27 | )% | |||||||
| Electronic Security | (4,106 | ) | (8 | ) | (1,030 | ) | (9 | ) | ||||||||
| Corporate | (3,187 | ) | (6 | ) | (2,638 | ) | (23 | ) | ||||||||
| Total | $ | (7,240 | ) | (14 | )% | $ | (6,718 | ) | (59 | )% | ||||||
Ammunitions & Weapons Effects segment earned pre-tax income of $53 for the three months ended September 30, 2008 as compared to a pre-tax loss of $3,050 for the comparable period in 2007. The improvement resulted from the higher revenue levels from receipt of several new large orders from various clients in Europe, North America and other export markets awarded in the second half of 2007 and in 2008 at MECAR. At MECAR, the operating loss improved to $707 in the current period from a loss of $3,303 in the prior period. Current period results were negatively impacted by $2,179 of foreign currency losses, reported asOther-net expense, and $321 of increased interest expense associated with higher borrowing and increased financing charges associated with the MECAR’s short term restructuring of its Credit Facility. For the three months ended September 30, 2008, MECAR USA’s pre-tax income improved to $760 from prior period pre-tax income of $253 in 2007 due to increased revenues from the receipt of procurement contracts in late 2007 and 2008.
Electronic Security segment had a pre-tax loss of $4,106 in 2008 as compared to pre-tax loss of $1,030 in 2007. This increased in loss was mainly due to a goodwill impairment of $3,495 during the three months ended September 30, 2008. After adjusting for goodwill impairment, the pre-tax loss was reduced as a result of increased revenues in the current period and improved margins associated with fixed cost reductions made in NSM’s restructuring activities.
Corporate segment had pre-tax loss of $3,187 in 2008 as compared to pre-tax loss of $2,638 in 2007. The most significant fluctuation in the Corporate loss was the impairment of long-lived assets of $462 related to its ERP system. Due to reduced head count from selling a number of its subsidiaries during the three months ended September 30, 2008, an impairment charge was necessary to adjust the carrying value of the ERP system to its fair value.
Income Taxes. The effective income tax rate for the three months ended September 30, 2008 and 2007 was 2% and 0%, respectively. The increase in the effective tax rate was due to an increase in the projected income in certain foreign and U.S subsidiaries that could not be offset by carryforward losses from prior years. The Company’s interim accounting for income taxes is in accordance with Financial Accounting Standard Board Interpretations Number 18,Accounting for Income Taxes in Interim periods.
Income (Loss) from discontinued operations, net of tax. Income(loss) from discontinued operations consisted of gains on the sales of subsidiaries and the income (loss) from discontinued operations. The Company had income of $1,194 for the three months ended September 30, 2008 compared to income of
32
$28,993 in the same comparable period of 2007. This decline was due to one-time net gain recognized from the sale of The VSK Group in 2007 of $29,774. Current period income reflects the operating results of GMS.
Net Income(Loss). The Company had net loss of $6,220 for the three months ended September 30, 2008 compared to a net income of $22,283 in the same comparable period of 2007. This decline was mainly due to the sale of The VSK Group in September 2007. In 2007, the Company recorded one-time net gain from the sale of The VSK Group of $29,774. Overall, the current period loss from continuing operations was consistent with the prior comparable period’s result, even though there was a significant increase in revenue at MECAR and MECAR USA, and reduced restructuring, legal expenses and interest expense at Corporate. The current period results were negatively impacted by charges for impairment of goodwill and long-lived assets of $3,957, an increase in the other expenses mainly resulting from foreign currency losses of $2,136 and the change in the gain (loss) recorded on the fair value of notes and warrants of $1,235.
Results of Operations for the Nine Months Ended September 30, 2008 and 2007
| Nine Months Ended September 30, | ||||||||||||||||
| 2008 | 2007 | |||||||||||||||
| Amount | % | Amount | % | |||||||||||||
| Revenue | $ | 121,530 | 100.0 | % | $ | 21,573 | 100.0 | % | ||||||||
| Cost and expenses | ||||||||||||||||
| Cost of sales | 100,671 | 82.8 | 29,444 | 136.5 | ||||||||||||
| Selling and administrative | 17,285 | 14.2 | 19,046 | 88.3 | ||||||||||||
| Research and development | 2,067 | 1.7 | 1,797 | 8.3 | ||||||||||||
| Impairment of goodwill and long-lived assets | 3,957 | 3.3 | — | — | ||||||||||||
| Operating loss | (2,450 | ) | (2.0 | ) | (28,714 | ) | (133.1 | ) | ||||||||
| Other income (expense) | ||||||||||||||||
| Interest income | 513 | 0.4 | 382 | 1.8 | ||||||||||||
| Interest expense | (5,494 | ) | (4.5 | ) | (9,359 | ) | (43.4 | ) | ||||||||
| Loss from fair value of notes and warrants | (682 | ) | (0.6 | ) | (6,686 | ) | (31.0 | ) | ||||||||
| Other — net | (2,290 | ) | (1.9 | ) | (171 | ) | (0.8 | ) | ||||||||
| Loss from continuing operations before income taxes | (10,403 | ) | (8.6 | ) | (44,548 | ) | (206.5 | ) | ||||||||
| Income tax expense | 496 | 0.4 | 3 | — | ||||||||||||
| Net loss from continuing operations, net of tax | (10,899 | ) | (9.0 | ) | (44,551 | ) | (206.5 | ) | ||||||||
| Gain on sale of subsidiaries, net of tax | 113 | 0.1 | 29,774 | 138.0 | ||||||||||||
| Income (loss) from discontinued operations, net of tax | 2,177 | 1.8 | (4,949 | ) | (22.9 | ) | ||||||||||
| Income from discontinued operations, net of tax | 2,290 | 1.9 | 24,825 | 115.1 | ||||||||||||
| Net Loss | $ | (8,609 | ) | (7.1 | )% | $ | (19,726 | ) | (91.4 | )% | ||||||
Revenue. The table below shows revenue by segment for the nine months ended September 30, 2008 and 2007, respectively. Allied had revenue of $121,530 during the current period, which was 463% higher than its revenue in the same period of 2007.
| Revenue by Segment | ||||||||||||||||
| Nine Months Ended | Nine Months Ended | |||||||||||||||
| September 30, 2008 | September 30, 2007 | |||||||||||||||
| Percentage | Percentage | |||||||||||||||
| Amount | of Total | Amount | of Total | |||||||||||||
| Ammunitions & Weapons Effects | $ | 116,365 | 96 | % | $ | 16,744 | 78 | % | ||||||||
| Electronic Security | 5,165 | 4 | 4,829 | 22 | ||||||||||||
| Total | $ | 121,530 | 100 | % | $ | 21,573 | 100 | % | ||||||||
33
The Ammunition & Weapons Effects (AWE) segment revenue for the nine months ended September 30, 2008 increased $99,621 (595%) from the prior period mainly due to a higher volume of MECAR contracts in process resulting from MECAR’s receipt of several new large orders from various clients in Europe, North America and other export markets awarded in July 2007 and February 2008. The 2008 revenue for MECAR USA has increased significantly based on a receipt of several new procurement contracts in the current year. AWE segment revenues for the nine months ended September 30, 2008 included $89,887 of revenues from MECAR and $26,478 of revenues from MECAR USA as compared to $15,562 of revenues from MECAR and $1,182 of revenues from MECAR USA in the prior period.
Revenue for the Electronic Security (ES) segment for the nine months ended September 30, 2008 increased $336 (7%) from the prior comparable period of 2007. The increase of $336 in NSM revenue was primarily due to receipt of orders from government customers for frequency reallocation equipment upgrades, offset by a lag in receipt of follow-on contracts with NSM’s largest customer, the U.S Army.
Cost of Sales. Cost of sales, as a percentage of revenue, for the nine months ended September 30, 2008, was 83% compared to 136% for the same period in 2007. Gross profit (loss), as a percentage of revenues, was 17% and (36)% for the nine months ended September 30, 2008 and 2007, respectively.
| Cost of Sales as a Percentage of Revenue by Segment | ||||||||||||||||
| Nine Months Ended | Nine Months Ended | |||||||||||||||
| September 30, 2008 | September 30, 2007 | |||||||||||||||
| Percentage of | Percentage of | |||||||||||||||
| Amount | Segment Revenue | Amount | Segment Revenue | |||||||||||||
| Ammunitions & Weapons Effects | $ | 97,323 | 84 | % | $ | 25,298 | 151 | % | ||||||||
| Electronic Security | 3,348 | 65 | 4,146 | 86 | ||||||||||||
| Total | $ | 100,671 | 83 | % | $ | 29,444 | 136 | % | ||||||||
Cost of sales for the AWE segment was $97,323 (84% of segment revenue) in 2008 as compared to $25,298 (151% of segment revenue) in 2007. The change in cost of sales for the nine months ended September 30, 2008 resulted primarily from higher revenue levels at MECAR and MECAR USA. In 2007, MECAR’s costs of sales were almost equal to revenues as a result of a low level of revenues on MECAR’s fixed cost structure. Although MECAR had been effective in temporarily idling much of its workforce through agreements entered into with its labor unions to reduce its fixed cost structure during periods of low sales, the reductions were not sufficient to offset the reduced revenues for the nine months ended September 30, 2007. Current period results were negatively impacted by overtime pay and shift premiums that were required to be paid based on supply chain issues and the delivery of certain inventory components. The overtime was required to ensure that MECAR would be shipping on a timely basis relative to its sales contracts. In addition, in the current period MECAR recorded $589 in contract loss provision related to specific products that are included in a significant sales contract that became funded in September 2008. The revised estimated costs of those non-standard products, after allocating all appropriate overhead costs, would result in a loss thereby requiring MECAR to record a loss provision at this point in time. Gross profit for the AWE segment was $19,042 (16% of segment revenue) in 2008 as compared to a gross loss of $8,554 (51% of segment revenue) in the prior period. Gross profit for the nine months ended September 30, 2008 consisted of $17,576 from MECAR and $1,466 from MECAR USA, as compared to a gross loss of $8,660 from MECAR and gross profit of $106 from MECAR USA in the prior period. The difference between MECAR and MECAR USA’s margin rates mainly resulted from in-house manufacturing that made up most of the MECAR’s revenue as compared to procurement contracts at MECAR USA that have lower margins.
Cost of sales for the ES segment was $3,348 (65% of segment revenue) in 2008 as compared to $4,146 (86% of segment revenue) in 2007. Gross profit for the ES segment was $1,817 (35% of segment revenue) in 2008 as compared to $683 (14% of segment revenue) in 2007. The growth of the NSM gross profit in 2008 was a result of increased sales volume and reduced costs at associated with the outsourcing of NSM’s production and restructuring of their fixed cost structure.
Overall, most of the Company’s subsidiaries within the Company’s segment operate with a relatively high fixed cost structure. As a result, revenue levels can have an unfavorable impact on profitability. The Company is focused
34
on reducing these breakeven points wherever it can — on both a tactical and strategic level. The Company is also investing in business development and sales and marketing programs to ensure sales stay above break-even levels.
Selling and Administrative Expenses. Selling and Administrative (SA) expenses as a percentage of revenue were 14% and 88% for the nine months ended September 30, 2008 and 2007, respectively. SA expenses for the nine months ended September 30, 2008 consisted of $8,421 from the AWE segment, $2,160 from the ES segment and $6,704 from the Corporate segment as compared to expenses of $6,590 from the AWE segment, $2,235 from the ES segment and $10,221 from the Corporate segment in the prior period.
The increase of $1,831 in the AWE segment was mainly due to a higher level of spending in professional services for the restructuring activities and increased payroll costs at MECAR and increased level of operating activity at both MECAR and MECAR USA in the current period. The reduction of SA in the ES segment was a result of a reduction in NSM’s fixed cost structure. The decrease of $3,517 in the Corporate segment resulted from reduced spending in staffing, legal and professional costs.
The Company is focused on reducing administrative costs across all business segments. It is focused on significant reductions in corporate expenses as restructuring consultants have been reduced in 2008.
Research and Development. Research and development (R&D) costs increased $270 or 15% for the nine months ended September 30, 2008 from 2007 levels. All R&D expenses were at MECAR. During the nine months ended September 30, 2008, MECAR had more technical resources focused on Research and Development (R&D) projects than during the prior year when many of the projects were idle.
Impairment of Goodwill and Long-Lived Assets. In the fourth quarter of 2008, the Company committed to a formal plan to sell NSM. The Company is in negotiations with prospective purchasers. Based on such negotiations and nonbinding offers received during the third quarter of 2008, the Company, on September 30, 2008, recorded a loss of $3,495 to write down NSM’s assets to fair value less costs to sell. In addition, on September 30, 2008, the Company recorded $462 in impairment charges for long-lived assets related to the Company’s ERP computer system. As the Company has reduced its head count as a result of selling a number of its subsidiaries, the Company determined that the carrying value of the ERP system exceeds its fair value.
Interest Income. Interest income for the nine months ended September 30, 2008 increased by $131 from 2007 levels. The increase in interest income was a result of having higher average cash levels at Corporate in 2008 compared to prior comparable period’s cash levels in 2007.
Interest Expense. Interest expense for the nine months ended September 30, 2008 was $5,494 as compared to 2007 expense of $9,359. This decline of $3,865 was due to expenses recorded from the debt restructuring in 2007 and consisted of a write-down of outstanding unamortized debt issue cost of $1,749 and an immediate recognition of costs incurred from the debt restructuring transactions of $1,671, an overall lower interest expense of $1,221 based on the reduced outstanding debt in 2008 and the elimination of registration delay penalties in 2008 which totaled $1,200 in 2007. Current period results were negatively impacted by $1,963 of increased interest expense associated with higher borrowing and increased financing charges associated with the MECAR’s short term credit facility restructuring that was completed in April 2008.
Net Loss on fair value of the senior convertible notes and warrants. The net loss recognized for the nine months ended September 30, 2008 from the change in fair value of the Notes and warrants was $682 as compared to the net loss of $6,686 for the comparable period in 2007. The change in the fair value of the Notes and warrants is due primarily to the change in the Company’s closing stock price, the volatility of the Company’s stock price during the period and the redemption features of the Notes relative to the Company’s announced subsidiary asset sales. On September 30, 2008, the Company’s stock closed at $6.10 per common share as compared to $7.88 per common share at September 30, 2007. In addition, the change in the fair value of the Notes and warrants for the nine months ended September 30, 2007, included a $5,544 loss upon restructuring of the Notes. See Note 8 for a description of these instruments.
Other — Net. Other — net for the nine months ended September 30, 2008 increased to a loss of $2,290 from a loss of $171 in the prior period. This unfavorable result was associated with MECAR’s foreign currency transactions. In the current period, with its increased operating performance and U.S. Dollar denominated sales contracts in funded backlog, MECAR had more exposures to foreign currency fluctuations as several large contracts were USD denominated and several significant vendors required transactions to be in
35
USD. Approximately $1,398 of this loss is attributed to unrealized losses from the change in fair value of its participating forward European currency contracts. MECAR had participating forward European currency contracts in place for significant U.S. Dollar denominated sales contract that spans over the next four years. Subsequent to entering into these contracts, the USD value has improved, thereby yielding unrealized losses on an interim basis relative to the life of the forward contract. As the Company does not designate these contracts as fair value or cash flow hedges, changes in fair value must be as reported in the statement of operations on quarterly basis. Other currency losses reported in the period represents the impact of foreign currency transactions at MECAR.
Pre-Tax Income (Loss)
The table below shows the pre-tax income (loss) by segment for the nine months ended September 30, 2008 as compared to the same period in prior year.
| Pre-Tax Loss by Segment | ||||||||||||||||
| Nine Months Ended | Nine Months Ended | |||||||||||||||
| September 30, 2008 | September 30, 2007 | |||||||||||||||
| Percentage of | Percentage of | |||||||||||||||
| Amount | Total revenue | Amount | Total revenue | |||||||||||||
| Ammunitions & Weapons Effects | $ | 2,840 | 2 | % | $ | (18,351 | ) | (85 | )% | |||||||
| Electronic Security | (4,240 | ) | (4 | ) | (2,233 | ) | (10 | ) | ||||||||
| Corporate | (9,003 | ) | (7 | ) | (23,964 | ) | (111 | ) | ||||||||
| Total | $ | (10,403 | ) | (9 | )% | $ | (44,548 | ) | (206 | )% | ||||||
Ammunitions & Weapons Effects segment earned pre-tax income of $2,840 for the nine months ended September 30, 2008 as compared to pre-tax loss of $18,351 for the comparable period in 2007. The improvement was associated with the higher level of sales volume at both MECAR and MECAR USA. At MECAR the operating income improved to $1,908 in the current period from a loss of $18,096 in the prior period. For the nine months ended September 30, 2008, MECAR USA recognized an increase in pre-tax income of $1,187 from prior period pre-tax loss of $255, due to successful receipt of procurement contracts that require the Company to supply ammunition manufactured by other parties in late 2007 and into 2008.
Electronic Security segment had pre-tax loss of $4,240 in 2008 as compared to pre-tax loss of $2,233 in 2007. This increase in pre-tax loss was primarily due to goodwill impairment of $3,495 in the current period, offset by higher sales activity and reduced fixed costs at NSM.
Corporate segment had pre-tax loss of $9,003 in 2008 as compared to pre-tax loss of $23,964 in 2007. This improvement in pre-tax loss was attributable to a smaller loss incurred from the fair value of the Notes and warrants for the nine months ended September 30, 2008 and reduced administrative expenses and interest expense in the current period, offset by the impairment charge of $462 to long-lived assets in the current period.
Income Taxes. The effective income tax rate for the nine months ended September 30, 2008 and 2007 was 5% and 0%, respectively. The increase in the effective tax rate was due to an increase in the projected income in certain foreign subsidiaries that could not be offset by carryforward losses from prior years. The Company’s interim accounting for income taxes is in accordance with Accounting Principles Board (“APB”) Opinion No. 28, “Interim Financial Reporting” and Financial Accounting Standard Board Interpretations Number 18,Accounting for Income Taxes in Interim periods.
Income (Loss) from discontinued operations, net of tax. Loss from discontinued operations consisted of the gain on the sale of subsidiaries and the loss from discontinued operations. SeaSpace and The VSK Group were sold in 2007 and Titan in 2008. The income from discontinued operations for the nine months ended September 30, 2008 was $2,290 as compared to an income of $24,825 in 2007. The prior nine months income included a write-down of $3,878 of SeaSpace’s intangible assets and goodwill and gain recognized from the sale of The VSK Group in September 2007 of $29,774. For the current nine months ended September 30, 2008, the Company recognized a significantly lower gain from the sale of Titan and GMS generated earnings of $2,319 from increased sales volume.
36
Net Loss. The Company had a net loss of $8,609 for the nine months ended September 30, 2008 compared to a net loss of $19,726 in the same comparable period of 2007. This positive change was associated with an increased sales volume and an improved profitability at the subsidiaries, a smaller loss incurred from the change in the fair value of the Notes and warrants at September 30, 2008 and reduced restructuring, legal and interest expenses at Corporate. The current period results were negatively impacted by impairment charges for the impairment of goodwill and long-lived assets of $3,957 and an increase in the other expenses mainly resulting from foreign currency losses of $2,119.
Backlog. As of September 30, 2008, the Company’s firm committed backlog was $169,744 compared to $130,782 at September 30, 2007. This backlog is calculated by taking all committed contracts and orders and deducting shipments or revenue recognized pursuant to the percentage of completion method of accounting, as applicable. The table below shows the backlog by segment at September 30, 2008 and 2007, respectively.
| Backlog by Segment | ||||||||||||||||
| At September 30, | At September 30, | |||||||||||||||
| 2008 | 2007 | |||||||||||||||
| Percentage | Percentage | |||||||||||||||
| of Total | Amount | of Total | ||||||||||||||
| Ammunitions & Weapons Effects | $ | 168,363 | 99 | % | $ | 128,492 | 98 | % | ||||||||
| Electronic Security | 1,381 | 1 | 2,290 | 2 | ||||||||||||
| Total | $ | 169,744 | 100 | % | $ | 130,782 | 100 | % | ||||||||
In addition, the Company had unfunded backlog, which is subjected to an appropriation of governmental funds, of approximately $19,724 and $6,297 at September 30, 2008 and 2007, respectively, from both the AWE and ES segments. These are contracts or portions of contracts that do not have all of the appropriate approvals to be performed on. In most cases, these contracts require a formal budget approval before they can be added to the funded, firm backlog.
The increase in September 30, 2008 backlog for the AWE segment was attributable to MECAR’s receipt of funding on the second tranche of the July 2007 contract in the current period that previously has been recorded as unfunded. MECAR USA’s backlog has also grown to $12,229 at September 30, 2008 as compared to $884 at September 30, 2007, driven in part by new procurement contracts received in 2008.
Electronic Security’s current period backlog level reduced from the prior period levels due to a lag in receipt of follow-on contracts with NSM’s largest customer, the U.S Army.
37
Balance Sheet
The table below provides the summary consolidated balance sheets as of September 30, 2008 and December 31, 2007:
| September 30, | December 31, | |||||||
| 2008 | 2007 | |||||||
ASSETS | ||||||||
| Cash | $ | 13,086 | $ | 34,802 | ||||
| Accounts receivable, net | 19,881 | 6,965 | ||||||
| Costs and accrued earnings on uncompleted contracts | 56,100 | 39,313 | ||||||
| Inventories, net | 22,569 | 22,027 | ||||||
| Other current assets | 24,722 | 28,275 | ||||||
| Other assets | 21,891 | 28,869 | ||||||
TOTAL ASSETS | $ | 158,249 | $ | 160,251 | ||||
LIABILITIES | ||||||||
| Bank overdraft facility | $ | 5,372 | $ | 7,239 | ||||
| Accounts payable and accrued liabilities | 44,306 | 40,457 | ||||||
| Customer deposits | 30,250 | 26,835 | ||||||
| Other current liabilities | 9,168 | 9,510 | ||||||
| Senior convertible notes | 19,493 | 19,392 | ||||||
| Long-term debt and other liabilities | 12,857 | 11,163 | ||||||
TOTAL LIABILITIES | 121,446 | 114,596 | ||||||
STOCKHOLDERS’ EQUITY | 36,803 | 45,655 | ||||||
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY | $ | 158,249 | $ | 160,251 | ||||
The Company’s September 30, 2008 unaudited condensed consolidated balance sheet was affected by the value of the Euro. All Euro values were converted at the September 30, 2008 and December 31, 2007 conversion ratios of $1.4449 and $1.4729, respectively.
Working capital, which includes restricted cash, was $23,336 at September 30, 2008 as compared to $32,850 at December 31, 2007. This decrease in working capital of $9,514 was primarily due to the reclassification of approximately $5,782 of the senior convertible notes to current liabilities based on the January 2009 “Put” date of the notes, increased current maturities of long-term debt at September 30, 2008, and increased accounts payable, accrued liabilities and customer deposits at September 30, 2008 due to purchases in support of the increased revenue and backlog levels.
The cash balance, restricted and unrestricted, at September 30, 2008 was $13,086 as compared to $34,802 at December 31, 2007. Restricted cash balances were $7,993 and $13,052 at September 30, 2008 and December 31, 2007, respectively. The restricted cash balance consists mainly of MECAR’s customer deposits of which a portion has been restricted to secure bank issued advance payment guarantees. The reduction in the restricted cash balance from December 31, 2007 was associated with local government support in Belgium that began in April 2008 to guarantee a larger portion of MECAR’s performance bonds and advance payment guarantees for MECAR’s bank group, thereby reducing the restricted cash requirements. These additional guarantees by the local government will be in place until November 30, 2008. The unrestricted cash balances have decreased $16,675 to $5,093 at September 30, 2008 as compared $21,750 at December 31, 2007 as a result of increased cash used in operating activities associated with the steep increase in revenues in the current period.
Accounts receivable at September 30, 2008 increased by $12,916 from December 31, 2007 primarily due to the higher billings at MECAR, offset by increased collections in recent months at NSM and MECAR USA. Costs and accrued earnings on uncompleted contracts increased by $16,787 from the year ended December 31, 2007 primarily due to progress on MECAR’s backlog that will be completed and shipped later in 2008.
38
MECAR was prohibited from shipping products to its largest customer in the months June through September due to contractual restraints, thereby causing a buildup of contracts in progress in these months until completion and shipping arrangements can be made in the fourth quarter of 2008.
Inventories remained consistent between the two periods as a result of a constant build up and use of inventories at MECAR as it performs its backlog.
Other current assets decreased to $24,722 at September 30, 2008 from $28,275 at December 31, 2007. This decline was due to an offset between an increase in advance payments made to suppliers and a decrease in assets held for sale due to the completion of the sale of Titan in March 2008. In the prior period, Titan’s assets of $4,599 were included in assets held for sale in other current assets.
Other assets decreased from $28,869 at December 31, 2007 to $21,891 at September 30, 2008. This decline was attributable to impairment of goodwill and long-lived assets of $3,957 and the recognition of scheduled nine months depreciation and amortization expense of $4,275 offset by approximately $1,556 of added capital expenditures in 2008 and a negative performance in the value of the Euro versus the U.S dollar.
The bank overdraft facility decreased by $1,867 from December 31, 2007 as a result of repayments made during the nine month period in 2008 in accordance with the April 2008 restructuring. Accounts payable and accrued liabilities at September 30, 2008 increased by $3,849 from December 31, 2007 related to increased material purchases and the ramp up of contract activity at MECAR. Customer deposits increased by $3,415, primarily at MECAR, as a result of the increased backlog and new deposits collected from customers.
Other current liabilities remained consistent between the two periods ended September 31, 2008 and December 31, 2007, although a reduction in liabilities held for sale of $2,051 from the sale of Titan in March 2008 and the recognition of loss on the fair value foreign exchange contracts of $1,398 were reflected in the September 30, 2008 balance.
Senior convertible notes balance remained consistent betweens two periods as a result of having a similar calculated fair value at both September 30, 2008 and December 31, 2007. See Note 8 of the financial statements for a full description of the transactions. In January 2008, $5,782 of the notes were reclassified as current liabilities.
Long-term debt and long-term liabilities increased by $1,694 at September 30, 2008 from the December 31, 2007 level of $11,163. This increase was primarily attributable to MECAR’s $2,456 note issued in lieu of borrowing under revolving overdraft portions of the cash facility in 2008, offset by a repayment of $749 made in 2008.
Stockholders’ equity as of September 30, 2008, was negatively affected by the net loss for the nine month period in 2008. This decrease was also supported by a negative performance in the value of the Euro versus the U.S. dollar, which resulted in an decrease in accumulated other comprehensive income. The Euro depreciated by approximately 2% from December 31, 2007.
Cash Flows
The table below provides the summary cash flow data for the periods presented.
| For Nine Months | ||||||||
| Ended September 30, | ||||||||
| 2008 | 2007 | |||||||
| Net cash used in operating activities | $ | (17,550 | ) | $ | (12,262 | ) | ||
| Net cash provided by investing activities | 826 | 40,769 | ||||||
| Net cash provided by (used in) financing activities | (393 | ) | 4,515 | |||||
| Effects of exchange rate on cash | 460 | 2,944 | ||||||
Operating Activities. The Company used $17,550 of cash in its operating activities during the nine months ended September 30, 2008 as compared to $12,262 of cash used in its operating activities during the same period of 2007. The cash used in continuing operations was $21,388 in 2008 as compared to $16,177 in the prior comparable period.
39
The increase in cash used from continuing operations resulted from a significant change in operating assets and liabilities. The change in operating assets and liabilities used cash of $22,884 during the nine month period of 2008 as compared to $10,095 of generated cash in the prior comparable period. The fluctuation in accounts receivable, and cost and accrued earnings on uncompleted contracts utilized cash of $32,417 in the nine months ended September 30, 2008 as compared to $8,574 of generated cash in the prior period. In the current period, MECAR had substantially higher level of revenues resulting in a corresponding increase in accounts receivable and cost and accrued earnings on uncompleted contracts as compared to the prior comparable period. Due to an increase in 2008 inventory purchasing, the Company utilized $1,326 of cash in 2008, as compared to generated cash of $649 in the prior comparable period of 2007. Due to required prepayments and deposits to the suppliers in 2008, the Company utilized $2,553 of cash in current period as opposed to generated cash of $645 in the prior comparable period of 2007. As a result of a growth in customer deposits in the current period, the Company generated cash of $4,074 during the nine months ended September 30, 2008 as opposed to the utilized cash of $10,855, driven by the relief of customer deposits from completed contracts in the prior comparable period. Cash paid for interest was $5,518 and $3,695 for the nine months ended September 30, 2008 and 2007, respectively. Cash paid for income taxes was $99 and $1,018 for the nine months ended September 30, 2008 and 2007, respectively, and includes federal, international and state taxes.
Investing Activities. Net cash provided by investing activities decreased to $826 for the nine months ended September 30, 2008 from the prior period generated cash of $40,769. This stemmed from the higher net proceeds received from the sale of SeaSpace and The VSK Group of $40,769 in 2007 as compared to the net proceeds of $2,433 from the sale of Titan in 2008. The Company estimates that it has less than $200 of non-firm capital commitments outstanding as of September 30, 2008.
Financing Activities. The Company utilized cash of $393 from its financing activities during the nine months ended September 30, 2008 compared to a generated cash of $4,515 during the same comparable period in 2007. This negative impact in the current period was primarily related to the net proceeds received from the refinancing of secured convertible notes of $15,376 in 2007.
Effects of Exchange Rate. Due to a slight decline of fluctuation in exchange rates between USD and Euro between September 30, 2008 and 2007, the Company generated $460 of cash in current period compared to generated cash of $2,944 in the prior comparable period.
Allied. The parent Company continues to operate based on management fees and dividends received from certain subsidiaries and proceeds of divestitures. The parent Company received dividends of $3,100 from GMS in 2008. Allied has made cash infusions in MECAR, NSM, and MECAR USA to support working capital requirements and operating losses in 2008. MECAR, MECAR USA and NSM are projected to operate without additional financing from Allied for the remaining periods of 2008.
MECAR. MECAR continues to operate from internally generated cash, funds provided by its bank facility, financing from capital leases and cash received from Allied and other affiliates. In addition, a loan of approximately $8,669 was provided by a local Belgian regional agency to extend MECAR’s working capital. The bank facility agreement provides (i) lines of credit for working capital and (ii) a facility for guarantees/bonds to support customer contracts. The financial lending terms and fees are denominated in Euros and the dollar equivalents will fluctuate according to global economic conditions. The bank agreement imposes two financial covenants requiring MECAR to maintain minimum net worth and working capital levels. In April 2008, the Company reached an agreement to extend and expand the credit facility until December 31, 2008. This agreement would require a partial repayment of MECAR’s cash line of approximately €5,100 in July 2008 and the remainder to be repaid by November 30, 2008. The Company did not meet the first requirement on July 31, 2008 but subsequently made the required repayments to the bank facility later in the third quarter of 2008. In April 2008, MECAR received additional temporary local support from the bank group to provide additional guarantees on the performance bonds and advance payment guarantees from May to November 2008.
Other Subsidiaries. NSM and MECAR USA operated in 2008 from cash generated from operations and cash infusions by Allied. In 2008, GMS operated from cash generated from operations.
40
Stock Repurchases. The Company did not repurchase any shares of its common stock during the nine months ended September 30, 2008 and does not anticipate repurchasing shares of its common stock during the remainder of 2008.
Off-Balance Sheet Arrangements. As part of our ongoing business, the Company does not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of September 30, 2008, the Company is not involved in any material unconsolidated SPE transactions. MECAR is required to provide performance bonds and advance payment guarantees for certain contracts, which are provided by MECAR’s banking group. MECAR is obligated to repay the bank group any amounts it pays as a result of any demands on the bonds or guarantees.
The Company’s cash balances are held in numerous locations throughout the world, including substantial amounts held outside the U.S. Most of the amounts held outside the U.S. could be repatriated to the U.S., but, under current law, would be subject to federal income taxes, less applicable foreign tax credits. Repatriation of some foreign balances is restricted by local laws. Allied has provided for the U.S. federal tax liability on these amounts for financial statement purposes, except for foreign earnings that are considered indefinitely reinvested outside the U.S.
Critical Accounting Policies
The Company’s discussion and analysis of its financial condition, results of operations and cash flows are based upon the Company’s unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, sales, and expenses, and related disclosure of contingent assets and liabilities. The Company re-evaluates its estimates on an on-going basis. The Company’s estimates and judgments are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates or judgments under different assumptions or conditions.
The Company believes the following are its critical accounting policies which affect its more significant judgments and estimates used in the preparation of its unaudited condensed consolidated financial statements:
| • | Revenue recognition via the percentage of completion method | |
| • | Goodwill and intangible asset valuation | |
| • | Inventory reserves and allowance for doubtful accounts | |
| • | Foreign currency translations | |
| • | Derivative Instruments | |
| • | Valuation of deferred income taxes and income tax reserves. |
A complete discussion of these policies is contained in ourForm 10-K filed on March 26, 2008 with the Securities and Exchange Commission for the period ending December 31, 2007. There were no significant changes to the critical accounting policies discussed in the Company’s10-K filed for December 31, 2007.
Recent Accounting Pronouncements
In April 2008, the FASB issuedFSP 142-3,Determining the Useful Life of Intangible Assets.FSP 142-3 amends the factors to be considered in determining the useful life of intangible assets. Its intent is to improve the consistency between the useful life of an intangible asset and the period of expected cash flows used to measure its fair value.FSP 142-3 is effective for fiscal years beginning after December 15, 2008. We are currently evaluating the impactFSP 142-3 will have on our financial position or results of operations.
In March 2008, the FASB issued SFAS No. 161,Disclosures about Derivative Instruments and Hedging Activities — an amendment of FASB Statement No. 133, (SFAS No. 161). This statement requires additional disclosures for derivative instruments and hedging activities that include how and why an entity uses
41
derivatives, how these instruments and the related hedged items are accounted for under SFAS No. 133 and related interpretations, and how derivative instruments and related hedged items affect the entity’s financial position, results of operations and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. We are still evaluating the impact SFAS No. 161 will have on our financial position or results of operations.
In February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Additionally, SFAS No. 159 establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective fiscal years beginning after November 15, 2007, with early adoption permitted. The Company adopted SFAS No. 159 effective January 1, 2008. The adoption of SFAS No. 159 did not have a significant impact on our financial position or results of operations.
In September 2006, the FASB issued SFAS No. 157,Fair Value Measurementswhich defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements. However, the application of SFAS No. 157 may change current practice for some entities. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. In February 2008, the FASB issued FASB Staff PositionNo. 157-2,Effective Date of FASB Statement No. 157(“FSP 157-2”), which delays the effective date of SFAS No. 157 for all nonrecurring fair value measurements of nonfinancial assets and nonfinancial liabilities until fiscal years beginning after November 15, 2008. The Company adopted SFAS No. 157 effective January 1, 2008. The adoption of SFAS No. 157 did not have a significant impact on our financial position or results of operations.
Forward-Looking Statements
This Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements that are based on current expectations, estimates and projections about the Company and the industries in which it operates. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecast in such forward-looking statements. The Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
We operate in a very competitive and rapidly changing environment. New risk factors can arise and it is not possible for management to predict all such risk factors, nor can it assess the impact of all such risk factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results.
42
The Allied Defense Group, Inc.
September 30, 2008
| ITEM 3. | QUANTITATIVE AND QUALITATIVE MARKET RISK DISCLOSURE |
Not required for a smaller reporting company.
| ITEM 4T. | DISCLOSURE CONTROLS AND PROCEDURES |
| 1. | Evaluation of disclosure controls and procedures |
Disclosure Controls and Procedures
Under the direction and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company carried out an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Exchange ActRule 13a-15 as of the end of the period covered by this quarterly report. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the registrant’s disclosure controls and procedures were effective as of September 30, 2008.
| 2. | Changes in internal controls |
There were no changes in the registrant’s internal control over financial reporting during the period covered by this quarterly report that have materially affected, or are reasonably likely to materially affect, the registrant’s internal control over financial reporting.
43
PART II. OTHER INFORMATION
| Item 1. | Legal Proceedings |
None.
| Item 1A. | Risk Factors |
Not required for a smaller reporting company.
| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
None.
| Item 3. | Defaults Upon Senior Securities |
None
| Item 4. | Submission of Matters to a Vote of Security Holders |
None
| Item 5. | Other Information |
None
44
| Item 6. | Exhibits |
Exhibit No. | Description of Exhibits | |||
| 10 | .29 | Consolidated EBITDA Schedule | ||
| 31 | .1 | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | ||
| 31 | .2 | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | ||
| 32 | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |||
45
SIGNATURE
Pursuant to the requirements 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.
THE ALLIED DEFENSE GROUP, INC.
| /s/ Deborah F. Ricci |
Deborah F. Ricci
Chief Financial Officer and Treasurer
Date: November 13, 2008
46